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Chapter 3

Understanding
Financial
Statements and
Cash Flows

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All rights reserved.

Learning Objectives

Compute a companys profits as reflected by its


income statement.

Determine a firms financial position at a point in


time based on its balance sheet

Measure a companys cash flows.

Compute taxable income and income taxes owed.

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Slide Contents
Principles used in this Chapter
1.

The Income Statement

2.

The Balance Sheet

3.

Measuring Cash Flows

4.

Income Taxes and Finance

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Principles Applied
in this Chapter
Principle 1:
Cash flow is what matters
Principle 5:
Conflicts of interest cause agency problems

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1. The Income Statement


It is also known as Profit/Loss Statement
It measures the results of firms operation over a
specific period.
The bottom line of the income statement shows the
firms profit or loss for a period.
Sales Expenses = Profits

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Income Statement Terms


Revenue (Sales)
Money derived from selling the companys product or service

Cost of Goods Sold (COGS)


The cost of producing or acquiring the goods or services to be sold

Operating Expenses
Expenses related to marketing and distributing the product or
service and administering the business

Financing Costs
The interest paid to creditors

Tax Expenses
Amount of taxes owed, based upon taxable income

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Figure 3-1

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Figure 3-1 (cont.)

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Table 3-1

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Common-size
Income Statement
Common-size income statement restates the
income statement items as a percentage of
sales.
Common-size income statement makes it
easier to compare trends over time and
across firms in the industry.

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Table 3-2

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Profit-to-Sales analysis from


Common-size income statement
See Table 3-2

Gross profit margin (or percentage of


sales going towards gross profit) is 23.3%
Operating profit margin (or percentage
of sales going towards operating profit) is
12.5%
Net profit margin (or percentage of sales
going towards net profit) is 7%

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2. The Balance Sheet


The balance sheet provides a snapshot of a firms
financial position at a particular date.
It includes three main items: assets, liabilities and
equity.
Assets (A) are resources owned by the firm
Liabilities (L) and owners equity (E) indicate how those
resources are financed
A=L+E

The transactions in balance sheet are recorded


historically at cost price, so the book value of a firm
may be very different from its current market value.
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Figure 3-3

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Balance Sheet Terms: Assets


Current assets comprise assets that are relatively
liquid, or expected to be converted into cash within
12 months. Current assets typically include:
Cash
Accounts Receivable (payments due from customers who
buy on credit)
Inventory (raw materials, work in process, and finished
goods held for eventual sale)
Other assets (ex.: Prepaid expenses are items paid for in
advance)

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Balance Sheet Terms: Assets


Fixed Assets Include assets that will be used for
more than one year. Fixed assets typically include:
Machinery and equipment
Buildings
Land

Other Assets Assets that are neither current


assets nor fixed assets. They may include long-term
investments and intangible assets such as patents,
copyrights, and goodwill.
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Balance Sheet Terms:


Liabilities
Debt (Liabilities)
Money that has been borrowed from a creditor
and must be repaid at some predetermined date.
Debt could be current (must be repaid within
twelve months) or long-term (repayment time
exceeds one year).

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Balance Sheet Terms:


Liabilities
Current Debt:
Accounts payable (Credit extended by suppliers to a firm
when it purchases inventories)
Accrued expenses (Short term liabilities incurred in the firms
operations but not yet paid for)
Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)

Long-Term Debt
Borrowings from banks and other sources for more than 1
year

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Balance Sheet Terms:


Equity
Equity: Shareholders investment in the firm in the form of
preferred stock and common stock. Preferred stockholders
enjoy preference with regard to payment of dividend and
seniority at settlement of bankruptcy claims.
Treasury Stock: Stock that have been re-purchased by the
company.
Retained Earnings: Cumulative total of all the net income over
the life of the firm, less common stock dividends that have been
paid out over the years. Note retained earnings are not equal to
hard cash!

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Balance Sheet: A = L + E
ASSETS (A)
Current Assets
Fixed Assets

Total Assets

LIABILITIES (L)
Current Liabilities
Long-Term Liabilities

Total Liabilities
OWNERS EQUITY (E)
Preferred Stock
Common Stock
Retained earnings

Total Owners Equity


Total liabilities + Equity
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Table 3-3

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Net Working Capital


Net Working Capital
= Current assets current liabilities
Larger the net working capital, better the firms ability to repay its
debt
Net working capital can be positive or zero or negative. It is
generally positive.
An increase in net working capital may not always be good news.
For example, if the level of inventory goes up, current assets will
increase and thus net working capital will also increase. However,
increasing inventory level may well be a sign of inability to sell.

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Debt Ratio
Debt ratio is the percentage of assets that
are financed by debt.
Debt ratio is an indication of financial risk.
Generally, higher the ratio, the more risky
the firm is, as firms have to pay interest on
debt regardless of the earnings or cash
flow situation.

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3. Measuring Cash Flows


Profits in the financial statements are
calculated on accrual basis rather
than cash basis (see next slide for
accrual basis accounting).
Thus profits are not equal to cash.

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Accrual Basis Accounting


Accrual basis is the principle of recording revenues
when earned and expenses when incurred, rather
than when cash is received or paid.
Thus sales revenue recorded in the income statement
includes both cash and credit sales.

Treatment of long-term assets: Asset acquisitions


(that will last more than one year, such as equipment)
are not recorded as an expense but are written off
every year as depreciation expense.

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Figure 3-6
How to measure a firms cash flows

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Three sources of cash flows

Cash flows from Operations


(ex. Sales revenue, labor expenses)

Cash flows from Investments


(ex. Purchase of new equipment)

Cash flows from Financing


(ex. Borrowing funds, payment of dividends)

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Three sources of
cash flows (cont.)
If we know the cash flows from
operations, investments and financing,
we can understand the firms cash flow
position better, that is, how cash was
generated and how it was used.

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Income Statement Conversion:


From Accrual to Cash Basis
Two steps:
Add back depreciation (as it is a non-cash
expense) to net income
Subtract any uncollected sales (i.e.
increase in accounts receivable) and cash
payment for inventories (i.e. increase in
inventories less increase in accounts
payables)
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Figure 3-7

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Table 3-5

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4. Income Taxes and Finance


Computing Taxable Income for Corporation
Gross Income
Dollar sales from a product or service less cost of production
or acquisition

Taxable Income
Gross income less tax deductible expenses, plus interest
income received and dividend income received
Tax Deductible Expenses
Include Operating expenses (marketing, depreciation,
administrative expenses) and interest expense
Dividends paid are not deductible

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Table 3-6
Computing Taxable Income ($000s)

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Table 3-7

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Figure 3-2

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Figure 3-2 (cont.)

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Figure 3-4

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Table 3-4

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Key terms
Accounts Payable
Accounts Receivable
Accrual basis accounting
Accrued expenses
Accumulated depreciation
Additional paid-in-capital
Balance sheet
Cash
Common size financial
statements
Common stock
Cost of goods sold
Current assets

Debt
Debt ratio
Depreciation expenses
EBIT
Earnings before taxes
Earnings per share
Equity
Financing cash flows
Financing cost
Fixed assets
Free cash flows
Gross fixed assets

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Key terms (cont.)

Gross Profit
Gross profit margin
Income statement
Inventories
Long-term debt
Mortgage
Net fixed assets
Net income
Net profit margin
Net working capital
Operating expenses

Operating income
Operating profit margin
Operating working capital
Par value
Preferred stockholders
Profit margins
Retained earnings
Short-term liabilities
Short-term notes (debt)
Taxable income
Trade credit
Treasury stock

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