FM 2016 Week 3 - Chapter 3

Chapter 3
Understanding
Financial
Statements,
Taxes, and
Cash Flows
Today Topics:
1.An Overview of the Firms Financial Statements
2.The Income Statement
3.Corporate Taxes
4.The Balance Sheet
5.The Cash Flow Statement
Copyright 2014 Pearson Education, Inc. All rights reserved.
3-2
3.1 AN OVERVIEW OF THE FIRMS

FINANCIAL STATEMENTS
3-3
BASIC FINANCIAL STATEMENTS

The accounting and financial regulatory authorities mandate
the following four types of financial statements:
Income statement
Balance sheet
Cash flow statement
Statement of shareholders equity
3-4
INCOME STATEMENT:
An income statement provides the following information for a
specific period of time (for example, a full year or quarterly):
Revenue earned
Expenses incurred
Profit earned
The purpose of the income statement is to show managers and
investors whether the company made or lost money during the period
being reported. One important thing to remember about an income
statement is that it represents a period of time like the cash flow
statement.
3-5
3-6
BALANCE SHEET:
Balance sheet contains information on a specific date (for
example, as of December 31, 2013) of the following:
Assets (everything of value the company owns)
Liabilities (the firms debts)
Shareholders equity (the money invested by the company
owners)
The balance sheet is a snapshot at a single point in time of the
company's accounts - covering its assets, liabilities and shareholders'
equity. The purpose of the balance sheet is to give users an idea of the
company's financial position along with displaying what the company
owns and owes.
3-7
3-8
CASH FLOW STATEMENT:

It reports cash received and cash spent by the firm
over a period of time.
The primary purpose of the statement of cash flows is to provide
information about cash receipts, cash payments, and the net change
in cash resulting from the operating, investing, and financing activities
of a company during the period
In financial accounting, a cash flow statement, also known as
statement of cash flows, is a financial statement that shows how
changes in balance sheet accounts and income affect cash and cash
equivalents, and breaks the analysis down to operating, investing
and financing activities.
3-9
3-10
STATEMENT OF SHAREHOLDERS EQUITY:

It provides a detailed account of the firms activities in
the following accounts: Common stock & Preferred
stock account, Retained earnings account, and
Changes to owners equity.
Statement of Stockholders Equity is a portion of the balance sheet
which contains the amount of capital earned by the company in
exchange to the stock.
The major elements of stockholders equity include capital stock, paid-in
capital, retained earnings, treasury stock, unrealized loss on long-term
investments, and foreign currency translation gains and losses.
3-11
3-12
3-13
WHY STUDY FINANCIAL STATEMENTS?

Analyzing a firms financial statement can help managers
carry out three important tasks:
Assess current performance
Monitor and control operations
Plan and forecast future performance
3-14
3.2 THE INCOME STATEMENT
3-15
AN INCOME STATEMENT
An income statement (also called a profit and loss statement)
measures the amount of profits generated by a firm over a given time
period (usually a year or a quarter). It can be expressed as follows:
Revenues (or Sales) Expenses = Profits
3-16
An INCOME
STATEMENT will contain the following:
1.Revenues
2.Expenses
Cost of goods sold, Selling expenses, General and
administrative expense, depreciation & amortization
expense, Interest expense, and Income tax expense
3.Net Income
Difference between Revenue and all expenses
3-17
Table 3.1 H. J. Boswell, Inc.
3-18
Evaluating a Firms per Share

Earnings (EPS) and Dividends
Per Share earnings = companys net income
divided by the number of common shares
outstanding.
Dividends per share = total dividends paid
divided by the number of common shares
outstanding.
3-19
Evaluating a Firms EPS and Dividends

(for Boswell, Table 3.1)
Earnings per share
= $204.75m 90m
= $2.28 per share
Dividends per share = $45m 90m

= $0.50 per share
3-20
Connecting the Income Statement and the

Balance Sheet
What can the firm do with the net income?
Pay dividends to shareholders, and/or Reinvest in the firm
3-21
Interpreting Firm Profitability using

the Income Statement
From H.J. Boswell Inc.s income statement (Table 3-1) we
observe that firm has been profitable.
We can identify three different measures of profit or income:
The gross Profit margin is 25% ($675 million)
The operating profit margin is only 14.2% ($382.5 million)
The net profit margin is only 7.6% ($204.75 million)
3-22

the Income Statement (cont.)
1. The gross profit margin (GPM)
= gross profits sales
= $675 million $2,700 million
= 25%
GPM indicates the firms mark-up on its cost of goods
sold per dollar of sales. The mark-up percentage equals
gross profit divided by cost of goods sold (=$675m
$2.025m = 33.3%)
3-23

2. The operating profit margin
= net operating income sales
= $382.5 million $2,700 million
= 14.17%
The operating profit margin is equal to the ratio of net
operating income or EBIT divided by firms sales.
3-24

3. The net profit margin
= net profits sales
= $204.75 million $2,700 million
= 7.6%
Net profit margin indicates the percentage of revenues left
over after all expenses (including interest and taxes)
have been considered.
3-25
Interpreting Firm Profitability using the

Income Statement (cont.)
By monitoring any changes in these margins and
comparing these margins to those of similar
businesses, we can dissect and identify a firms
performance and identify expenses that are out of
line.
3-26
General Accepted Accounting Principles (GAAP)

and Earnings Management
While the firms must follow the GAAP, there is considerable
room for managers to actively influence the firms reported
earnings.
Managers have an incentive to tamper with earnings as
their pay depends upon it and because investors pay close
attention to earnings announcements.
3-27
CHECKPOINT 3.1:
CHECK YOURSELF
Constructing an Income Statement
Reconstruct the firms income statement assuming the
firm is able to cut its cost of goods sold by 10% and
that the firm pays taxes at a 40% rate. What is the
firms net income and earnings per share?
3-28
Step 1: Picture the Problem

The income statement can be expressed as
follows:
Revenues Expenses = Net Income
We are given information on revenues and
expenses (cost of goods sold, operating expenses,
interest expense and income taxes) to fill the
template given on next slide.
3-29
Step 1: Picture the Problem (cont.)

Revenues
Less: Cost of goods sold
Less: Operating expenses
Equals Gross
profit
Equals: net
Operating income
Less: Interest expense

Equals: earnings
Before taxes
Less: Income taxes

Equals:
NET INCOME
3-30
Step 2: Decide on a Solution Strategy

Given the account balances, constructing the income
statement will entail substituting the appropriate
balances into the template of step 1.
3-31
Step 3: Solve
Revenues = $14,549,000,000
Less: Cost of goods sold
= $8,347,500,000
Equals: profit
=$6,201,500,000
Less: Operating/other expenses

=$3,841,000,000
Less: Interest expense

=$74,000,000
Less: Income taxes (40%)

=$916,600,000
Equals: net
Operating income
=$2,370,500,000
Equals: earnings
Before taxes
=$2,291,500,000
Equals:
NET INCOME
=$1,374,900,000
3-32
Step 3: Solve (cont.)

Earnings per share:
= net income number of shares
= $1,374,900,000 716,296,296
= $1.92
3-33
Step 4: Analyze
The firm is profitable since it earned net income of
$1,374,900,000. The shareholders were able be
earn $1.96 per share.
3-34
3.3 CORPORATE TAXES
3-35
Corporate Taxes
A firms income tax liability is based on its taxable
income and the tax rates on corporate income.
3-36
Computing Taxable Income

The table reveals the following:
Tax rates range from 15% to 39%
Tax rates are progressive i.e. corporations with higher
profits tend to pay more taxes.
3-37
Marginal and Average Tax Rates

Marginal tax rate is the tax rate that the company
will pay on its next dollar of taxable income.
Average tax rate is total taxes paid divided by the
taxable income.
3-38

Example: What is the average and marginal tax
liability for a firm reporting $100,000 as taxable
income.
3-39

Average tax rate
= Total tax liability Total taxable income
= $22,250 $100,000
= 22.25%
Marginal tax rate

= 39% as the firm will have to pay 39% on its
next dollar of taxable income i.e. if its taxable
income increases from $100,000 to $100,001.
3-40
Dividend Exclusion for Corporate

Shareholders
The dividend received by corporate stockholders are
partially exempt from taxation. The rationale is to
avoid double taxation at the corporate level. The
percentage of exempt taxes is based on the degree of
ownership of the firm.
3-41
Dividend Exclusion for Corporate

Shareholders
Example What will be the taxable income if firm A
receives $100,000 in dividends from firm B.
3-42
3.4 THE BALANCE SHEET
3-43
The Balance Sheet

The balance sheet provides a snapshot of the firms
financial position on a specific date. It is defined by
the following equation:
Total Assets =
Total Liabilities + Total Shareholders Equity
3-44
The Balance Sheet (cont.)

Total liabilities represent the total amount of
money the firm owes its creditors
Total shareholders equity refers to the
difference in the value of the firms total assets and
the firms total liabilities.
Total assets, sum of total shareholders equity and
total liabilities, represents the resources owned by
the firm.
3-45

In general, GAAP requires that the firm report
assets using the historical costs.
Cash and assets held for sale (such as marketable
securities) are an exception to the rule. These
assets are reported using the lower of their cost or
current market value.
3-46

Assets whose value is expected to decline over time
(such as equipment) is reported as net
equipment(equal to historical cost less the
accumulated depreciation). Net value (also known as
accounting or book value) could be significantly
different from the market value of the asset.
3-47
Table 3.2 H. J. Boswell, Inc.
3-48
3-49
Figure 3.1 The Balance Sheet
3-50

The balance sheet includes the following main
components:
Assets It includes current assets and fixed assets.
Liabilities and Stockholders Equity It indicates
how the firm finances its assets. It includes current
liabilities, long-term liabilities, and owners equity.
3-51

Current assets consists of firms cash plus other
assets the firm expects to convert to cash within
12 months or less, such as receivables and
inventory.
Fixed assets are assets that the firm does not
expect to sell within one year. For example, plant
and equipment, land.
3-52

Current liabilities represent the amount that the
firm owes to creditors that must be repaid within a
period of 12 months or less such as accounts
payable, notes payable.
Long-term liabilities refer to debt with maturities
longer than a year such as bank loans, bonds.
3-53

The stockholders equity includes the following:
Par value of common stock + Paid in Capital +
Retained Earnings.
We can also express stockholders equity as
follows:
Shareholders' equity = Total Assets Total Liabilities
3-54
Firm Liquidity and Net Working Capital

Liquidity generally refers to the firms ability to
covert its current assets into cash so that it can pay
its current liabilities on time. We can thus measure a
firms liquidity by computing its net working capital
(equal to current assets less current liabilities).
3-55
Firm Liquidity and Net Working

Capital (cont.)
If a firms net working capital is significantly
positive, it is in a good position to pay its debts on
time and is consequently very liquid.
Lenders consider the net working capital as an
important indicator of firms ability to repay its
loans.
3-56
CHECKPOINT 3.2:
CHECK YOURSELF
Constructing a Balance Sheet
Reconstruct the Gaps balance sheet to reflect the
repayment of $1 billion in short-term debt using a
like amount of the firms cash. What is the
balance for total assets and current liabilities?
3-57

The firms balance sheet can be expressed as
follows:
Total Shareholders Equity +
Total Liabilities
= Total Assets
3-58
Step 1: Picture the Problem (cont.)

Current Assets
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets
Long-term (fixed) assets
Gross PPE
Less: Accumulated depreciation
Net property, plant and equip.
Other long-term assets
Total long-term assets
Total Assets
Current Liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Long-term Liabilities
Long-term debt
Owners Equity
Par value of common stock
Paid-in-capital
Retained earnings
Total equity
Total Liabilities and

Owners equity
3-59
Step 2: Decide on a Solution

Strategy
We are given the account balances so in order to
construct the balance sheet we need to substitute
the appropriate balances into the template
developed in step 1.
3-60
Step 3: Solve
Cash
Inventories
Other current
assets
885,000,000
Current
liabilities
1,128,000,000
1,128,000,000
1,615,000,000
809,000,000
Total current
assets
3,309,000,000
Total current
liabilities
Net Property,
Plant and
equipment
2,523,000,000
Long-term
liabilities
Other long-term
assets
590,000,000
Common Equity
Total Assets
$6,422,000,00 Total Liabilities

0
and Equity
2,539,000,000
2,755,000,000
$6,422,000,00
0
3-61
Step 4: Analyze
We can make the following observations from Gaps
Balance sheet:
The total assets of $6,422,000,000 is financed by a
combination of current liabilities, long-term liabilities and
owners equity. Owners equity accounts for
$2,755,000,000 of the total.
The firm has a healthy net working capital of
$2,181,000,000.
3-62
Debt and Equity Financing

The right-hand side of the balance sheet reveals the
following two sources of money used to finance the
purchase of the firms assets listed on the left-hand
side of the balance sheet.
Borrowings (debt financing)
firms owners (equity financing)
3-63
Debt versus Equity

Payment: Payment for debt holders is generally
fixed (in the form of interest); Payment for equity
holders (dividends) is not fixed nor guaranteed.
Seniority: Debt holders are paid before equity
holders in the event of bankruptcy.
Maturity: Debt matures after a fixed period while
equity securities do not mature.
3-64
3.5 THE CASH FLOW STATEMENT
3-65
The Cash Flow Statement

The Cash Flow Statement is used by firms to
explain changes in their cash balances over a period
of time by identifying all of the sources and uses of
cash for the period spanned by the statement.
3-66
Sources and Uses of Cash

A source of cash is any activity that brings cash
into the firm. For example, sale of equipment.
A use of cash is any activity that causes cash to
leave the firm. For example, payment of taxes.
3-67
Table 3-3 H. J.
Boswell, Inc., Balance
Sheets and Balance
Sheet Changes
3-68
Cash Flow Analysis (cont.)

Why did the cash balance decline by $4.50m?. See
table 3.1 and table below:
Sources of Cash
Uses of Cash
Increase in Accounts
Payable = $4.50
Increase in Accounts
Receivable $22.50
Increase in long-term debt

=$51.75
Increase in inventory =
$148.50
Increase in retained
earnings = $159.75
Increase in net plant and

equipment = $40.50
Decrease in short-term
notes = $9
Total Sources of cash =

$216.00
Total Uses of cash =

$220.50
3-69
Cash Flow Analysis (cont.)

An analysis of H.J. Boswells operations reveals the
following:
The firm used more cash than it generated,
resulting in a deficit of $4.5 million
The main source of cash flow was retained earnings
($159.75m) and long-term debt ($51.75m)
The largest use of cash was for acquiring inventory
at $148.5 million.
3-70
Cash Flow Analysis Summary

Sources of Cash
Uses of Cash
Decrease in an asset
account
Increase in a liability
account
Increase in an
owners equity
account
Increase in an asset
account
Decrease in a liability
account
Decrease in an
owners equity
account
3-71
Cash Flow Statement

The basic format for a cash flow statement is as
follows:
Beginning Cash Balance
Plus: Cash Flow from Operating Activities
Plus: Cash Flow from Investing Activities
Plus: Cash Flow from Financing Activities
Equals: Ending Cash Balance
3-72
Cash Flow Statement (cont.)

Operating activities represent the companys core
business, including sales and expenses.
Investing activities include the cash flows that
arise out of the purchase and sale of long-term
assets such as plant and equipment.
Financing activities represent changes in the firms
use of debt and equity such as issue of new
shares, the repurchase of outstanding shares, and
the payment of dividends.
3-73
Table 3-4 H. J. Boswell, Inc.
3-74
Evaluating the Cash Flow Statement

The statement can be used to answer a number of
important questions such as:
How much cash did the firm generate from its operations?
How much did the firm invest in plant and equipment?
Did the firm raise additional funds, and if so, how much and
from what sources?
Is the firm able to generate positive cash flows?
3-75
Quality of Earnings: Evaluating

Cash Flow from Operations
Since reported earnings can sometimes be
misleading, we can combine information from the
firms income statement and the statement of cash
flows to evaluate the quality of firms reported
earnings.
3-76

(cont.)
A ratio of 1.00 indicates very high quality of
earnings and that the firms operating cash flows
and net income are in sync with each other.
A low ratio indicates firms reliance on nonoperating sources of cash to generate net income
that may not be sustainable.
3-77

(cont.)
The quality of earnings ratio for Boswell for 2013
= $173.25m $ 204.75m = 84.6%
Boswells ratio was only 84.6% due to more
credit sales than it collected, increase in
inventories, non-cash depreciation expense, and
increased reliance on accounts payable.
3-78
Sustainable Capital Expenditures:

Evaluating Investment Activities
This ratio calculates the extent to which the firms
operating cash flows can pay for capital
expenditures. Higher ratio will mean less
dependence on capital markets for financing.
3-79
Sustainable Capital Expenditures:

Evaluating Investment Activities (cont.)
For Boswell, the capital acquisition ratio is:
= $157.75m $159.5m = 98.9%
Boswell was, on average, able to finance 98.9% of

its new expenditures out of the firms current-year
operations.
3-80
CHECKPOINT 3.3:
CHECK YOURSELF
Interpreting the Statement of Cash Flows
Go to http:finance.google.com/finance and get the cash flow
statements for the most recent four-year period for Exco
Resources (XCO). How does their cash from investing
activities compare to their cash flow from operating
activities in 2012.
3-81

The cash flow statement identifies the net
sources and uses of cash for a specific
period of time into 3 groups: operating
activities, investing activities, and financing
activities.
Here we have to compare the cash flow
from operating activities and investment
activities in 2012 for Exco Resources (XCO).
3-82
Step 2: Decide on a Solution

Strategy
We can compare the cash flow from operating
activities and cash flow from investing activities by
retrieving the cash flow statement from
http://finance.google.com/finance
3-83
Step 3: Solve
Cash flow from operating activities
EXCO had a positive cash flow from operating activities
of $514.78 million in 2012. In 2011, the cash flow from
operating activities was much lower at $428.54 million.
The primary contributors to the operating cash flows
were adjustments to net income.
3-84
Step 3: Solve (cont.)

Cash flow from investing activities:
Cash flow from investing activities were ($426.09)
million in 2012. EXCO had invested heavily in capital
expenditures with a total expense of $536.92 million.
3-85
Step 4: Analyze
The cash flow statement for 2012 depicts a
profitable firm with positive cash flow from
operations that have been steadily increasing
since 2010. In 2010, cash flow from operations
were only $339.92 million.
The firm has been aggressively investing in fixed
assets. However, it has dropped significantly
compared to 2011 ($1,041 million).
3-86

FM 2016 Week 3 - Chapter 3

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FM 2016 Week 3 - Chapter 3

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Chapter 3

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3.1 AN OVERVIEW OF THE FIRMS

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BASIC FINANCIAL STATEMENTS

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CASH FLOW STATEMENT:

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STATEMENT OF SHAREHOLDERS EQUITY:

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WHY STUDY FINANCIAL STATEMENTS?

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3.2 THE INCOME STATEMENT

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STATEMENT will contain the following:

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Table 3.1 H. J. Boswell, Inc.

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Evaluating a Firms per Share

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Evaluating a Firms EPS and Dividends

Dividends per share = $45m 90m

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Connecting the Income Statement and the

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using the

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General Accepted Accounting Principles (GAAP)

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Step 1: Picture the Problem

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Step 1: Picture the Problem (cont.)

Less: Operating expenses

Less: Interest expense

Less: Income taxes

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Step 2: Decide on a Solution Strategy

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Less: Operating/other expenses

Less: Interest expense

Less: Income taxes (40%)

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Step 3: Solve (cont.)

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3.3 CORPORATE TAXES

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