ACCOUNTINGSTATEMENTS

ANDCASHFLOWS

Keyconceptsandskills
Understandwhatthebalancesheetsandincomestatements
tellus
Understandwhatcashflowstatements(bothfinancialand
accounting)tellus
Beabletocomputethecashflowsusedforfirmvaluation:
CFfromassets,CFtobondholders,CFtostockholders
Understandbasicratioanalysis

Outline
Balancesheet
Incomestatement
Statementofcashflows
Freecashflow
Financialratios

Sourceofinformation

Annualreports(companyswebsite)

WallStreetJournal,FinancialTimes,etc.

Internet

Databases:Bloomberg,Compustat,Datastream
Yahoofinance,Hoover
NYSE(www.nyse.com),Nasdaq(www.nasdaq.com),
LSE(www.londonstockexchange.com),etc.
U.S.SecuritiesandExchangeCommission(www.sec.gov)searchfor
companiesfilings:10K,10Q,DEF14A,8K,PREM14A,DEFM14A,S4

Balancesheet>Example
U.S.COMPOSITECORPORATION
BalanceSheet
2009and2008
(in$millions)
Assets
Currentassets:
Cashandequivalents
Accountsreceivable
Inventories
Other
Totalcurrentassets

2009

2008

140
294
269
58
761

107
270
280
50
707

Fixedassets:
Property,plant,andequipment
Lessaccumulateddepreciation
Netproperty,plant,equipment
Intangibleassetsandother
Totalfixedassets

1,423
550
873
245
1,118

1,274
460
814
221
1,035

Totalassets

1,879

1,742

Liabilities(Debt)
andStockholder'sEquity
CurrentLiabilities:
Accountspayable
Notespayable
Accruedexpenses
Totalcurrentliabilities
Longtermliabilities:
Deferredtaxes
Longtermdebt
Totallongtermliabilities
Stockholder'sequity:
Preferredstock
Commonstock($1pervalue)
Capitalsurplus
Accumulatedretainedearnings
Lesstreasurystock
Totalequity
Totalliabilitiesandstockholder'sequity

2009

2008

213
50
223
486

197
53
205
455

117
471
588

104
458
562

39
55
347
390
26
805
1,879

39
32
327
347
20
725
1,742
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Balancesheet>Overview
Accountantssnapshotoffirmsvalueonaparticulardate
Stockversusflow?
Mainequa on:AssetsLiabili es+Stockholdersequity
3keyconcerns:
Accountingliquidity
Debtvs.equity
Valuevs.cost

Balancesheet>Analysis
Whenanalyzingabalancesheet,financialmanagersshould
beawareofthreeconcerns:
1. Accountingliquidity

Accountingliquidityreferstotheeaseandquicknesswithwhich
assetscanbeconvertedtocash.
Currentassetsarethemostliquid.
Somefixedassetsareintangible.
Themoreliquidafirmsassets,thelesslikelythefirmisto
experienceproblemsmeetingshorttermobligations.
Liquidassetsoftenhavelowerreturnsthanfixedassets.

Balancesheet>Analysis
2. Debtvs.Equity

Generally,whenafirmborrowsitgivesthebondholdersfirstclaim
onthefirmscashflow.
Thusshareholdersequityistheresidualdifferencebetweenassets
andliabilities.

3. Valuevs.Cost

UnderGenerallyAcceptedAccountingPrinciples(GAAP),audited
financialstatementsoffirmsintheU.S.carryassetsatcost.Since
2005,companiesintheE.U.usemarketvalueoftheInternational
FinancialReportingStandards(IFRS).
Marketvalueisthepriceatwhichtheassets,liabilities,andequity
couldactuallybeboughtorsold,nothistoricalcost.

Balancesheet>Checkquestions
1.

Assets
Howareassetsorganizedonthebalancesheet?
Whatdoesaccountsreceivablerepresent?
Ifaccountsreceivableincreases(decreases),allelseequal,
whatdoesthismean?
Whatdoesaccumulateddepreciationrepresent?
Whatisthedifferencebetweendepreciationexpenseand
accumulateddepreciation?

Balancesheet>Checkquestions
2.

Liabilities
Howareliabilitiesorganizedonthebalancesheet?
Whatdoesaccountspayablerepresent?
Whataredeferredtaxes?Whydowehavethisaccount?

3. Equity
WheredoesRetainedEarnings(RE)comefrom?Canyougo
getmoneyfromtheREaccount?Beforeyouanswerthat,
canyougogetmoneyfromthelongtermdebtaccount?
BesidesRE,whataretheothermainequityaccounts?What
dotheseaccountsrepresent?
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Incomestatement>Example
U.S.COMPOSITECORPORATION
IncomeStatement
2009
(in$millions)

Theoperatingsectionreports
revenuesandexpensesfrom
principaloperations.
Thenonoperatingsection
includesallfinancingcosts.

Aseparatesectionreportsthe
amountoftaxesleviedonincome.

Netincomeisthebottomline.

Totaloperatingrevenues
Costofgoodssold
Selling,general,adminexpenses
Depreciation
Operatingincome
Otherincome
Earningsbeforeinterestandtaxes
Interestexpense
Pretaxincome
Taxes
Current:71
Deferred:13
Netincome
Retainedearnings:
Dividends:

2,262
1,655
327
90
190
29
219
49
170
84

86
43
43
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Incomestatement>Overview
Theincomestatementmeasuresperformanceoveraspecific
periodoftime.
Checkquestion:Howdoesthisdifferfromthetimingof
thebalancesheet?
Stockversusflow?
Keyequation:IncomeRevenues Expenses
2keyconcerns:
Noncashitems
Timeandcosts
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Incomestatement>Analysis
Thingstokeepinmindwhenanalyzinganincomestatement:
1. Noncashitems

Nofirmeverwritesacheckfordepreciation.
Deferredtaxesdonotrepresentacashflow.
Thus,netincomeisnotcash.

2. Timeandcosts

In the short run, certain equipment, resources, and commitments

of the firm are fixed, but the firm can vary such inputs as labor
and raw materials.
Inthelongrun,allinputsofproduction(andcosts)arevariable.
Financialaccountantsdonotdistinguishbetweenvariablecosts
andfixedcosts.Instead,accountingcostsusuallyfitintoa
classificationthatdistinguishesproductcostsfromperiodcosts.
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Incomestatement>Calculations&Taxes
Commonlyusedequations:
GrossProfit=Sales CostsofGoodsSold
EBITDA=GrossProfit CashOperatingExpenses
EBIT=EBDITA Depreciation Amortization
EBT=EBIT Interest
NIorEAT=EBT Taxes
Notesontaxes:Marginalvs.averagetaxrates:
Marginal:thepercentagepaidonthenextdollarearned
Average:thetaxbill/taxableincome
Whichtaxrateshouldyouuseinfinancialdecisions?
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Statementofcashflows>Example

Operatingactivities

Investingactivities

Financingactivities
ThestatementofCFsisthe
additionofCFsfromoperations,
investing&financingactivities.

Operations
NetIncome
Depreciation
DeferredTaxes
ChangesinAssetsandLiabilities
AccountsReceivable
Inventories
AccountsPayable
AccruedExpenses
NotesPayable
Other
TotalCashFlowfromOperations
InvestingActivities
Acquisitionoffixedassets
Salesoffixedassets
TotalCashFlowfromInvesting
FinancingActivities
Retirementofdebt(includesnotes)
Proceedsfromlongtermdebtsales
Dividends
Repurchaseofstock
Proceedsfromnewstockissue
TotalCashFlowfromFinancing
ChangeinCash(onthebalancesheet)

86
90
13
(24)
11
16
18
(3)
(8)
199
(198)
25
(173)
(73)
86
(43)
(6)
43
7
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Statementofcashflows>Overview
The statement of cash flows reconciles the change in cash
from last year to current year.
This helps explain the change in accounting cash (which for
the U.S. Composite Corp. is $33 million in 2009).
Thethreecomponentsofthestatementofcashflowsare
Cashflowfromoperatingactivities
Cashflowfrominvestingactivities
Cashflowfromfinancingactivities

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Financialcashflow>Overview
AlsoknownasFreeCashFlow:
a measure of how much cash a business generates after accounting
for capital expenditures such as buildings/equipment, working capital
can be used for expansion, interests, dividends, debt reduction, equity
etc.

CashflowFROMassets=
CashflowTObondholders(creditors,liabilityholders)
+CashflowTOstockholders(equityinvestors)
FCF=CF(A)=CF(B)+CF(S)
whereA=Assets,B=Bondholders,S=Stockholders

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Financialcashflow>CalculateCF(A)
CF(A)=OperatingCF Netcapitalspending ChangeinnetWC
OperatingCF=EBIT Taxes+Depreciation
USCCexample:
EBIT
Depreciation
Taxes
OCF

219
90
71
238

Note:Marginaltaxesareusedforvaluationpurpose:
OCF=EBIT (EBITxmarginaltaxrate)+Depreciation

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Financialcashflow>CalculateCF(A)
CF(A)=OperatingCF Netcapitalspending ChangeinnetWC
Netcapitalspending =Acquisitionminussaleoffixedassets
=ChangeinGrossfixedassets
USCCexample:
2008
2009
Chg
Properties,plant&equipment1,274
1,423
149
Intangiblesandothers
221 24524
TotalGrossfixedassets
1,495 1,668173
Orwecanget173fromtheinvestingsectionofthestatementofcashflows!

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Financialcashflow>CalculateCF(A)
CF(A)=OperatingCF Netcapitalspending ChangeinnetWC
Netcapitalspending =ChangeinGrossfixedassets
=ChangeinNetfixedassets+Depreciation
Example:
GrossProperties,Plant&Eq
AccumulatedDepreciation
NetProperties,Plant&Eq

2008
2009
Change
1,000
1,400
400
200 300100
800 1,100300

Netcapitalspending=ChangeinGrossPPE=400
=ChangeinNetPPE+Depreciation=300+100
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Financialcashflow>CalculateCF(A)
CF(A)=OperatingCF Netcapitalspending ChangeinnetWC
ChangeinnetWC=NetWC(currentyear) NetWC(prioryear)
where:NetWC=Currentassets Currentliabilities(foreachyear)

USCCexample:

2008
2009
Currentassets
707
761
Currentliabilities
455
486
NetWC
252
275
ChangeinnetWC=NetWC2009 NetWC2008=275 252=23
PutitalltogetherforCF(A):
CF(A)=238 173 23=42
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Financialcashflow>CalculateCF(B)
CF(B)=Interestpaid Netnewborrowing
Thinkaboutthis:WearetryingtocalculateCFtodebtholders.
Sothedebtholdersreceivetheinterest(thus,weareaddingthis),
andtheyreceiveanypayoffs(retirement)ofdebt(thusweaddthis).
However,ifthefirmtakesonnewdebt,thedebtholdersgivethatto
thefirm(sowesubtractthis).

USCCexample:
Netnewborrowing=Longtermdebt2009 Longtermdebt2008
=471

458=13
CF(B)=49 13=36
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Financialcashflow>CalculateCF(S)
CF(S)=Dividends Netnewequityraised
Conceptcheck:Ifthechangeispositive,thecompanyissuednewstock.
Ifthechangeisnegative,thecompanymayhaveboughtbackstock

USCCexample:
Netnewequity=CS,Surplus&Treasury2009 CS,Surplus&Treasury2008
=(55+347 20)
(32+327 26)=37
Orfromthestatementofcashflows!
Netnewequity=Equityissues Equityrepurchases
=43
6=37
CF(S)=43 37=6
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Financialcashflow>Finalcheck
Finalcheck:

CF(A) =CF(B)+CF(S)
42 =36+6

Takeaway:
Thecashflowgeneratedbyassetsmustbegeneratedbyor
giventodebt(bond)andequityholders.

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Financialcashflow>Practice
Estridge and Lougee (2007) Measuring free cash flows for equity
valuation: pitfalls and possible solutions, Journal of Applied
Corporate Finance 19, 6071.

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Financialcashflow>Practice

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Financialcashflow>Practice
FCFhasnostandarddefinition.
Acrosscompanies
Acrossaccountingstandards
InvestorsoftenresorttoshortcutslikeEBITDAandcash
earnings(NI+Deprec)butthesemeasuresarenotFCFs.
FCFmeasuresvarywithinvestorsvaluationpurposes.

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Ratioanalysis>Overview
Afirmhasresources.Itconvertsresourcesintoprofitsthrough
productionandsalesofgoodsandservices
Ratios
Measurerelationsbetweenresourcesandfinancialflows
Showwaysinwhichfirmssituationdeviatesfrom
Itsownpast(Timetrendanalysis)
Otherfirms(Peergroupanalysis)
Theindustry(Industrypeeranalysis)
Keyobjective:Standardizefinancialinformationforcomparisons
andevaluations
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Ratioanalysis>Types
Financialratios:
Liquidityratios
Assessabilitytocovercurrentobligations

Leverageratios
Assessabilitytocoverlongtermdebtobligations

Operationalratios:
Activity(Turnover)ratios
Assessamountofactivityrelativetoamountofresourcesused

Profitabilityratios
Assessprofitsrelativetoamountofresourcesused

Valuationratios:

Assessmarketpricerelativetoassetsorearnings
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Ratioanalysis>Types>Financialratios
Liquidityratios:
Currentratio=Currentassets Currentliabilities
Quickratio=(Currentassets Inventory) Currentliabilities
Cashratio=Cash Currentliabilities
Leverageratios:
Totaldebtratio=Totaldebt Totalassets
Debtequityratio=Totaldebt Totalequity
Equitymultiplier=Totalassets Totalequity
Interestcoverage(Timesinterestearned)=EBIT Interest
Cashcoverage=(EBIT+depreciation) Interest
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Ratioanalysis>Types>Operationalratios
Activity(Turnover)ratios:
Inventoryturnover=Costofgoodssold Inventory
Dayssalesininventory=365 Inventoryturnover
Receivablesturnover=Sales Receivables
Dayssalesinreceivables=365 Receivablesturnover
Totalassetturnover=Sales Totalassets
Daysininventory=Daysinperiod Inventoryturnover
Profitabilityratios:
Profitmargin=Netincome Sales
Returnonassets=Netincome Totalassets
Returnonequity=Netincome Totalequity

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Ratioanalysis>Types>ValuationRatios
Pricetoearningsratio(PEratio)
PEratio=Marketpricepershare Earningspershare
Markettobookratio(M/B)
M/B=Marketpricepershare Bookvaluepershare

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Ratioanalysis>DuPontIdentity
ROE=(NI/Sales)x(Sales/TA)x(TA/TE)
ROE=ProfitmarginxTotalassetturnoverxEquitymultiplier
Profitmarginisameasureofthefirmsoperatingefficiency
(i.e.howwellitcontrolscosts).
Totalassetturnoverisameasureofthefirmsassetuse
efficiency(i.e.howwellitmanagesitsassets).
Equitymultiplierisameasureofthefirmsfinancialleverage.

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Ratioanalysis>Potentialproblems
Thereisnounderlyingtheoryofwhichratiosaremostrelevant.
Benchmarkingisdifficultfordiversifiedfirms.
Globalizationandinternationalcompetitionmakescomparison
moredifficultbecauseofdifferencesinaccountingregulations.
Firmsusevaryingaccountingprocedures.
Firmshavedifferentfiscalyears.
Extraordinary,oronetime,events

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Ratioanalysis>Practice
Nissim and Penman (2001) Ratio analysis and equity valuation: From
research to practice, Review of Accounting Studies 6, 109154.
Ratios are identified as drivers of future residual earnings, free cash
flow and dividends. Ratios in current financial statements are then
viewed as information to forecast the future drivers.
To provide historical benchmarks for forecasting, typical values for
ratios are documented for the period 19631999, along with their
crosssectional variation and correlation. The time series behavior
of many of the ratios is also described and their typical longrun,
steadystate levels are documented.

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Summary
Financial statements provide important information
regarding the value of the firm.
Financialcashflow:CF(A)=CF(B)+CF(S)
Thingstokeepinmind:
Measuresofprofitabilitydonottakeriskortimingof
cashflowsintoaccount.
Financialratiosarelinkedtooneanother.
This review of accounting was necessary in order to
understand where/how to calculate the firms cash flow
used for firm valuation as well as key financial ratios.
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