2-1

Corporate Finance
Chapter Two
Ross  Westerfield  Jaffe 2
Sixth Edition

Financial Statements and

Cash Flow

Anwar Zahid
Lecturer
Independent University, Bangladesh (IUB)
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2.1 The Balance Sheet

• An accountant’s snapshot of the firm’s accounting value as of a particular
date.

• The Balance Sheet Identity is:

A s s e ts  L ia b ilitie s  S to c k h o ld e r ' s E q u ity

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The Balance Sheet of the
Canadian Composite Corporation
CANADIAN COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 The assets are listed in 20X2
order20X1
and Stockholder's Equity
Current assets: Current Liabilities:
Cash and equivalents $140 $107 by the length of time it$213 $197
Accounts payable
Accounts receivable
Inventories
294
269
270
280
normally would take a firm
Notes payable
Accrued expenses
50
223
53
205
Other
Total current assets
58
$761
50
$707
with ongoing operations
Total current liabilities$486to $455

convert them into cash.

Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Clearly, cash is much more
Common stock ($1 per value) 55 32
Capital surplus 347 327
liquid than property, plant and
Accumulated retained earnings 390 347
equipment.
Less treasury stock
Total equity
-26
$805
-20
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

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Balance Sheet Analysis

• When analyzing a balance sheet, the

financial manager should be aware of three
concerns:
1. Liquidity
2. Debt versus equity
3. Value versus cost

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Liquidity
• Refers to the ease and speed with which
assets can be converted to cash.
• Current assets are the most liquid.
• Some fixed assets are intangible.
• The more liquid a firm’s assets, the less
likely the firm is to experience problems
meeting short-term obligations.
• Liquid assets frequently have lower rates of
return than fixed assets.

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Debt versus Equity

• Generally, when a firm borrows it gives the

bondholders first claim on the firm’s cash
flow.
• Thus shareholder’s equity is the residual
(remaining) difference between assets and
liabilities.

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Value versus Cost

• Under GAAP audited financial statements of

firms carry assets at historical cost adjusted
for depreciation.

• Market value is a completely different

concept. It is the price at which willing
buyers and sellers trade the assets.

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2.2 The Income Statement

• The income statement measures performance

over a specific period of time.
• The accounting definition of income is

R e v e nue  E xp e nse s  In c o m e

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

The operations Total operating revenues $2,262

section of the income Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
statement reports the Depreciation - 90
firm’s revenues and Operating income $190
Other income 29
expenses from
Earnings before interest and taxes $219
principal operations Interest expense - 49
Pretax income $170
Taxes - 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
The non-operating Depreciation - 90
Operating income $190
section of the income Other income 29
statement includes all Earnings before interest and taxes $219
Interest expense - 49
financing costs, such
Pretax income $170
as interest expense. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Usually a separate Interest expense - 49
section reports as a Pretax income $170
Taxes - 84
separate item the Current: $71
amount of taxes Deferred: $13
Net income $86
charged on income.
Retained earnings: $43
Dividends: $43

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20x2
(in $ millions)

Total operating revenues $2,262

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Interest expense - 49
Net income is the Pretax income $170
“bottom line”. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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Income Statement Analysis

• There are three things to keep in mind when

analyzing an income statement:
1. Generally Accepted Accounting Principles
(GAAP)
2. Non Cash Items
3. Time and Costs

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Generally Accepted Accounting Principles

1. GAAP
• The matching principal of GAAP dictates that
revenues be matched with expenses. Thus,
income is reported when it is earned, even
though no cash flow may have occurred.
• For example, when goods are sold for credit,
sales and profits are reported.

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Income Statement Analysis

2. Non Cash Items

• These are expenses that do not affect cash flow
directly.
• Depreciation is the most apparent. No firm ever
writes a cheque for “depreciation.”
• Another noncash item is deferred taxes, which
does not represent a cash flow.

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Income Statement Analysis

3. Time and Costs

• Financial accountants do not distinguish between

variable costs and fixed costs.
• Instead, accounting costs usually fit into a
classification that distinguishes product costs (ex;
raw materials, labor cost) from period costs (ex;
salary, utilities).

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2.3 Net Working Capital

NWC = CURRENT ASSETS –
CURRENT LIABILITIES
• NWC is +ve when current assets are greater than
current liabilities.
• A firm can invest in NWC. This is called change
in NWC .
• The change in NWC is usually +ve in a growing
firm.
• NWC can be negative or zero.

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The Balance Sheet of the C.C.C.

CANADIAN COMPOSITE CORPORATION
Balance Sheet
$252m = $707- $455 20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117to $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 $275 million in 20X2 from
Total long-term liabilities$588 $562
Net property, plant, and equipment
Intangible assets and other
873
245
814
221
$252 million in 20X1.
Stockholder's equity:
Total fixed assets $1,118 $1,035
$23 million
Preferred stock
Common stock ($1 par value)
$39
55
$39
32
Capital surplus 347 327
$275m = $761m- $486m Accumulated retained earnings 390 347
This increase of $23 million is
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 an investment of the firm.
Total liabilities and stockholder's equity $1,879 $1,742

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2.4 Financial Cash Flow

• In finance, the most important item that can

be extracted from financial statements is the
actual cash flow of the firm.
• Since there is no magic in finance, it must be the
case that the cash (CFA) received from the firm’s
assets must equal the cash flows to the firm’s
creditors (CFB) and stockholders (CFS).

C F ( A )  C F (B )  C F (S )

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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow CF (Asset) = CF (Creditors) + CF(equity)
20X2 42 = 36 + 6
(in $ millions)

Cash Flow of the Firm Operating Cash Flow:

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes) EBIT $219
Capital spending -173
(Acquisitions of fixed assets Depreciation $90
minus sales of fixed assets)
Additions to net working capital
Total
-23
$42
Current Taxes ($71)
Cash Flow of Investors in the Firm OCF $238
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital Spending
Capital spending -173 Purchase of fixed assets $198
(Acquisitions of fixed assets
minus sales of fixed assets) Sales of fixed assets (25)
Additions to net working capital -23
Total $42 Capital spending $173
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
NWC grew to $275
Capital spending -173 million in 20X2 from
(Acquisitions of fixed assets
minus sales of fixed assets) $252 million in 20X1.
Additions to net working capital -23
Total $42 This increase of $23
Cash Flow of Investors in the Firm million is the addition to
Debt $36
(Interest plus retirement of debt NWC.
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending -173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital -23
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Cash Flow to Creditors
Capital spending -173
(Acquisitions of fixed assets Interest
minus sales of fixed assets)
Additions to net working capital -23
$49
Total $42
Retirement of debt 73
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt Debt service 122
minus long-term debt financing)
Equity 6 Proceeds from new debt
(Dividends plus repurchase of
equity minus new equity financing) sales (86)
Total $42
Total 36
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes Cash Flow to Stockholders
plus depreciation minus taxes)
Capital spending -173 Dividends $43
(Acquisitions of fixed assets
minus sales of fixed assets) Repurchase of stock 6
Additions to net working capital -23
Total $42
Cash to Stockholders 49

Cash Flow of Investors in the Firm Proceeds from new stock issue
Debt $36
(Interest plus retirement of debt (43)
minus long-term debt financing)
Equity 6 Total $6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238 The cash received from
(Earnings before interest and taxes
plus depreciation minus taxes)
the firm’s assets must
Capital spending -173 equal the cash flows to the
(Acquisitions of fixed assets
minus sales of fixed assets) firm’s creditors and
Additions to net working capital -23 stockholders:
Total $42
Cash Flow of Investors in the Firm C F ( A) 
Debt $36
(Interest plus retirement of debt CF (B)  CF (S )
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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2.5 Summary and Conclusions

• Financial statements provide important
information regarding the value of the firm.

• A financial manager should be able to determine

cash flow from the financial statements of the
firm.

• Knowing how to determine cash flow helps the

financial manager make better decisions.

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