CHAPTER 4.

FINANCIAL STATEMENTS

Accounting standards require statements that show the financial position, earnings, cash flows,

and investment (distribution) by (to) owners. These measurements are reported, respectively, by the

following statements: balance sheet, income statement, statement of cash flows, and statement of

changes in equity. These statements can be constructed in a variety of different ways and levels of

detail. An important consideration is that the financial framework of the firm should compliment the

physical performance measures of the firm.

A typical indicator used as a measure of the firm’s financial health is its cash position. Cash

flows are an important, but often misleading, indicators of the financial health of a firm. Two

necessary conditions for long-term survival in any firm are profitability and feasibility. Profitability

is defined as the difference between a firm’s revenues and its expenses. Feasibility is the solvency

or short-term ability of the firm to meet its obligations when they become due. If a firm is not both

profitable and feasible over time, it cannot survive. In the short run, a firm can be feasible but not

profitable. For a limited time, the firm can generate cash flows to remain solvent by borrowing,

refinancing existing debt, selling inventory, liquidating capital assets, increasing accounts payable, or

depleting its capital base. Unfortunately, these techniques are only temporary solutions and don’t

substitute for long-run profitability. Focusing on only the firm’s "cash position" can, and has, led to

devastating results for firms. An appropriately constructed set of financial statements will allow a

firm to monitor both profitability and solvency and diagnose any difficulties the firm has in these

areas.

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Balance Sheet

A balance sheet is a listing of a firm’s assets, debt claims, and equity claims at a particular

point in time. People are usually taught to think of it as a "snap shot" of the firm on a given date.

As a result, it is important to know the date for which the balance sheet was constructed. Table 2.4

presents 1995-97 year-end balance sheets for the hypothetical HiQuality Nursery company, which

might be organized as sole proprietorship, partnership, or corporation.

The underlying principal for any balance sheet is the fundamental accounting equation:

Assets / Liabilities + Equity.

In other words, every dollar of the firm’s assets must be financed either by a liability (debt borrowed

by the firm) or equity claim (capital supplied by the firm’s owners), or some combination of the two.

This principal results in the separation of assets from liabilities and equity on the balance sheet. We

can check the above equality by noting that the total value of assets at the bottom of the balance sheet

is equal to the total value of liabilities and equity for each year.

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 Table 4.1 Year-End Balance Sheets for HiQuality Nursery

HiQuality Nursery
Balance Sheets ($000)
Year
ASSETS 1997 1996 1995

Cash and Mkt Securities $ 600 $ 930 $1,200

Accounts Receivable 1,200 1,640 1,560
Inventory 5,200 3,750 3,150

CURRENT ASSETS 7,000 6,320 5,910

Prop, Plant, and Equip 2,800 2,990 3,270

Other Assets 600 690 710

LONG TERM ASSETS 3,400 3,680 3,980

TOTAL ASSETS 10,400 10,000 9,890

LIABILITIES

Notes Payable 1,270 1,500 1,400

Current Portion LTD 450 500 700
Accounts Payable 4,000 3,000 2,400
Accrued Liabilities 800 958 870

CURRENT LIABILITIES 6,600 5,958 5,370

TOTAL LONG TERM DEBT 1,985 2,042 2,560

TOTAL EQUITY 1,815 2,000 1,960

TOTAL DEBT AND EQUITY 10,400 10,000 9,890

The firm’s assets and liabilities are typically listed in order of liquidity or payment. For

example, current assets are expected to be liquidated within the next year and are listed above long-

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term assets, which are not expected to be liquidated during the upcoming year. Likewise, current

liabilities are debts due within the upcoming year and are listed above long-term liabilities, which are

debts that will not come due during the next year. Equity, which represents residual ownership of

the firm’s assets, has no fixed due date and is consequently listed last. Items within each category on

the balance sheet are also listed in order of liquidity or payment.

Assets

Assets represent the resources available to the firm to be used to generate earnings and

includes everything owned that has value. Current assets are represented by cash and near-cash

assets that are expected to be liquidated during the next year. Current assets are typically assets

whose liquidation will not significantly disrupt the operation of the firm. Besides cash, current assets

often include marketable securities, accounts receivable, notes receivable, and inventories.

Marketable securities are interest bearing deposits which are low risk in terms of principal balance

and can easily be converted to cash if needed. Accounts receivable are sales that have been made

but not collected from customers. Notes receivable are debt payments due to the firm during the

upcoming year. Finally, inventories represent the value of inputs used in production or

manufacturing of goods that have not been sold. Inventories are often the least liquid of the current

assets and their value is often not known until the assets are sold.

Noncurrent long-term assets are assets that yield service over a period of time and are

expected to remain in the firm beyond the upcoming year. Liquidation of fixed assets typically would

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disrupt the operations of the firm. Fixed assets include such items as machinery, equipment,

automobiles, breeding stock, contracts, long-term notes receivable, and real estate.

Book Value versus Market Value

Assets are recorded at a value equal to their acquisition costs. Many fixed assets wear out

or lose value over time. This loss in value is accounted for by depreciating, or lowering the

acquisition cost, of the assets over time. The value of each asset on the balance sheet (acquisition

cost - accumulated depreciation) is called the asset’s book value. A difficulty with financial

statement analysis is that an asset’s book value almost always differs significantly from the asset’s

market value which is what the firm can actual get if it sells the asset.

In order to understand why book value is not equal to market value, let’s think about what

determines market value. We’ll show this more formally later, but it turns out that the value of an

asset generally depends on the following three characteristics of the future cash flows the asset is

expected to generate:

1. the size and/or number of expected future cash flows;

2. the timing of expected future cash flows; and

3. the risk and variability of future cash flow.

In general, the larger the size and/or number of expected future cash flows, the larger the

assets market value will be. Likewise, the sooner you expect to get the cash flows, the higher the

market value of the asset (think about the time value of money concept). Finally, everything else held

constant, the greater the risk or variability of an asset’s future cash flows, the lower the market value

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of the asset. Hopefully, these ideas make some intuitive sense to you; if not, don’t worry. We will

revisit these concepts in detail later.

One final note on market value. In some cases, an asset’s value may not be solely based on

the future cash flows an asset will generate; the asset may provide other nonmonetary services. For

example, you might be able to purchase a $50,000 house that has a higher level of expected future

after-tax cash flows than the $100,000 house you are also considering; that is, you think you can

make more (or spend less) money by investing in the $50,000 house; however, you might buy the

$100,000 house because it will be a nicer place to live and you are willing to sacrifice some of your

wealth to increase your living standard. In other words, the house you live in is both an investment

and a consumption good. As we discussed in Chapter 1, whenever you mix management and

ownership, you can get results that aren’t solely based on value maximization.

Liabilities and Equity

Liabilities are obligations to repay debt that has been incurred. Current liabilities are

normally paid during the upcoming year. These typically include accounts payable, current principal

and interest payments, and accrued expenses. Accounts payable are expenditures that have been

made, to purchase inputs used in production, for example, but not paid yet. Current principal and

interest, often called notes payable, are the short-term debt obligations and/or the portion of long-

term debt obligations that are due during the upcoming year. Accrued expenses are expenses that

have been incurred through the operation of the firm but are not due for payment yet. Examples of

accrued expenses include taxes payable and salary and wages payable. Noncurrent or long-term

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liabilities are obligations that will be payable sometime after the upcoming year. These are usually

long-term notes payable, mortgages, or bond obligations.

Equity, or net worth, is always the difference between the total book value of assets and the

total liabilities of the firm. The value of the equity is an estimate of what owners of the firm would

have left after selling all the assets and paying all liabilities. Therefore, this is a major item of concern

in financial statements. In a corporation, the firm owns the assets and shareholders own shares of

stock in the corporation. In large corporations whose shares are traded on organized exchanges, the

value of the stock can differ substantially from the book value of the stock. Why do you think this

is the case?

The equity portion of the balance sheet looks different for a corporation than for a partnership

or sole proprietorship, simply because of the nature of the equity. Corporations report equity in terms

of the amount of initial value of the different types of stock that the shareholders own. Similarly,

withdrawals are reported as dividends in corporate reporting.

Income Statement

The balance sheet provides useful information about a firm’s financial situation at a single

point in time. Nevertheless, it doesn’t tell you much about a firm’s performance over time. Looking

at the change in retained earnings on the balance sheet from one period to the next gives a clue as to

whether the firm earned a profit, or realized a loss, but that is all the information that is discernable

about a firm’s profit-loss situation from the balance sheet. An income statement breaks a firm’s

revenues and expenses into different components that determine the firm’s profitability. Table 4.2

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shows the 1996 and 1997 income statements for HiQuality Nursery. Unlike the balance sheet which

is a picture of the firm’s assets at a particular point in time, the income statement is a record of what

has happened to the firm’s operations between two points in time in terms of profits and losses.

Total revenue is made up the gross receipts or sales that are generated by the firm during the

accounting period. Expenses during the period are then deducted from total revenue to determine

the firm’s profitability during the period. Cost of goods sold reflect the direct cost to the firm to

produce, manufacture, or purchase the goods that were sold to generate the firm’s revenue. Cost

of goods sold is typically the largest expense in most businesses. Operating expenses, or overhead,

represent the costs of operating and administrating the business beyond those expense items included

in the cost of goods sold. These expenses typically include such things as sales expenses,

administrative expenses, general office expenses, rents, salaries, and utilities. Depreciation is the

accounting measure of the decline in the value of the firm’s fixed assets during the period and can be

thought of as the cost to replace the long-term assets used up during the period.

Earnings before interest and taxes (EBIT) represents the firm’s profits from operations.

In other words, this is the profit the firm generates before paying the interest costs of the firm’s debt

financing and the tax obligations of the firm. Subtracting interest expenses from EBIT gives the firm’s

earnings before taxes (EBT) which is the firm’s profits after paying all expenses except taxes; EBT

is sometimes called profit before taxes.

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 Table 4.2 Income Statement for HiQuality Nursery

HiQuality Nursery
Income Statements ($000)

Year
1997 1996

Net Sales $40,000 $38,000

Cost of Sales 28,000 25,600

Operating Expenses 11,000 11,330
Depreciation 350 470

EARNING BEFORE INTEREST AND TAXES 650 600

Interest 480 465

EARNINGS BEFORE TAXES 170 135

Taxes 68 64

NET INCOME AFTER TAXES 102 71

Subtracting the firm’s tax liabilities from EBT gives the firm’s net income after taxes (NIAT),

which is the firm’s profit after taxes and is generally what we think about when we talk about a firm’s

profits. This is the amount of profit the firm generated during the accounting period after paying all

expenses including the debt servicing costs and taxes. NIAT is also the profit that is available to be

reinvested in the firm or withdrawn by the owners. Subtracting the amount of cash withdrawn by the

owner(s) from NIAT leaves the amount of profits reinvested in the firm, which is called retained

earnings. It is important to note that retained earnings is the link between the income statement and

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the balance sheet. The amount of retained earning during the accounting period must equal the

difference between the retained earnings on the balance sheet at the end of the period and the retained

earnings at the beginning of the accounting period; that is, the change in retained earnings between

the two periods.

Net Working Capital

Net working capital (NWC) is defined as current assets minus current liabilities and provides

a measure of the firm’s liquidity. If NWC is positive then the assets which are expected to be

converted to cash during the upcoming year will likely be sufficient to meet the liabilities due during

the upcoming year. HiQuality Nursery’s net working capital is positive each year, suggesting the firm

was capable of meeting short term debt obligations by using only the assets expected to be liquidated

during the upcoming year.

Year Current Assets - Current Liabilities = Net Working Capital

1995 $5,910,000 $5,370,000 $540,000

1996 $6,320,000 $5,958,000 $362,000

1997 $7,000,000 $6,600,000 $400,000

Typically, you would like to see a positive NWC in a firm. A firm’s investment (or deinvestment) in

working capital can be measured by the change in NWC during the year. HiQuality Nursery’s change

in NWC during 1997 is measured by taking the difference between its 1997 and 1996 NWC; in other

words NWC = $400,000 - $362,000 = $38,000 (the symbol denotes "change" in the specified

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variable, in this case, NWC). This suggests that HiQuality has increased investment in NWC.

Normally you would like to see NWC increase over time in a growing firm.

Changes in Owners Equity

Because of the importance of measuring equity, a detailed statement of the reasons for

changes in equity is sometimes reported. The statement of changes in owner’s equity reports the same

information as contained in the balance sheet but provides detail on the reasons underlying the change

in equity. The equity position in a business can change as the result of profit or losses from the firm’s

operations, withdrawals by the firm’s owners, and/or new equity contributions by owners.

The statement of changes in owners equity generally takes on the following structure:

NIAT
- Dividends
+ capital contributions
- repurchase of equity capital
Change in equity

Financial Cash Flow

The firm’s balance sheet shows its financial position at a point in time, while the income

statement gives a measure of the firm’s profits over time. Nevertheless, we have mentioned several

times that an equally important measure is the firm’s after-tax cash flow (ATCF). NIAT differs from

a firm’s cash flow because NIAT includes a number of non-cash items and because cash inflows and

outflows also occur from nonoperating sources. For example, depreciation is generally a major

expense item on the income statement for most firms. This is, however, a noncash cash accounting

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expense; in other words, no cash was spent even though there is an expense on the income statement.

Clearly, NIAT underestimates a firm’s cash flows from operations by at least the amount of

depreciation expense.

Remember that the balance sheet requires that Assets = Liabilities + Equity. Similarly it must

be the case that the cash flows from a firm’s assets (CFa) must equal the cash flows to the firms

creditors (CFc) and equity holders (CFe):

CFa = CFc + CFe

The Statement of Cash Flows identifies the sources and uses of cash during the period

between two balance sheets. It replaces a similar statement called the Sources and Uses of Funds

Statement as a result of changes in the Generally Accepted Accounting Principles (GAAP) in 1988.

The general structure of the Statement of Cash Flows is

cash flows from operations

+ cash flows from investment activities
+ cash flows from financing activities
change in cash position

This format separates cash flows into the three major management areas: 1) operation

management, 2) asset management, and 3) financial management. The cash flows from operations

are associated with the management of the firm’s operations and reflect the cash flows generated by

the firm in producing and delivering its goods and services. The cash flows from investment activities

come from the purchase and sale of capital assets that occur as a result of the firm’s asset management

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strategies. The cash flows from financing activities result from borrowing new debt, repayment of

old debt, raising new equity capital, and returning capital to owners as a result of the firm’s financial

management practices. The primary purpose of the Statement of Cash Flows is to detail the sources

of cash flows in order to assess the firm’s ability to generate future cash flows, meet obligations, pay

dividends, and obtain future financing. The Statement isolates the difference between income from

operations and cash flows, as well as the effects of the firm’s investment and financing activities.

Table 4.3 Shows the Statement of Financial Cash Flow for the HiQuality Nursery Company.

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 Table 4.3 Financial Cash Flow HiQuality Nursery

HiQuality Nursery
Statement of Cash Flows ($000)

Year
CASH FLOWS FROM OPERATIONS 1997 1996

Net Income $ 102 $ 71

Depreciation Expense 350 470

Change in Acct. Rec. 440 -80
Change in Inventory -1450 -600
Change in Current Liabilities 642 588

Net Cash from Operations 84 449

CASH FLOWS FROM INVESTMENTS

Net cash from investments -70 -170

CASH FLOWS FROM FINANCING ACTIVITIES

Payment of LTD
Payment of dividends -57 -518
Net cash from financing -287 -31
-344 -549
CHANGE IN CASH POSITION
-330 -270

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 The cash flow generated by the firm’s assets is often called the cash flow from operations and

is equal to the firm’s NIAT plus depreciation expense less the change in accounts receivable and

inventory plus the change in current liabilities. HiQuality’s operating cash flows are:

NIAT
+ Depreciation Expense
- Change in Accounts Receivable
- Change in Inventory
+ Change in Current Liabilities
Net Cash Flow From Operations

Adding depreciation expense to NIAT adjusts the firm’s profit for noncash expenses and converts

profits to an after-tax cash flows basis. Increasing (decreasing) accounts receivable or inventory uses

(generates) cash and decreases (increases) the cash flow from operations. Likewise, an increase

(decrease) in current liabilities generates (uses) cash, increasing (decreasing) the cash flows from

operations.

The cash flows from investments focuses on the reinvestment in and/or sale of the firm’s long-

term assets. Purchasing fixed assets uses cash flow, while the sale of fixed assets generates cash flow

for the firm. For example, if you go out and sell your car, you generate some cash inflow. If you

then turn around and purchase a new car, you will have spent cash creating a cash outflow. The net

cash from investments is equal to amount of long term assets purchased less the amount sold. The

cash outflow from investment can be calculated as the beginning long-term assets less depreciation

expense less ending long-term assets.

Beginning LT Assets
- Depreciation Expenses
- Ending LT Assets
Net Cash Outflow from Investments

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 The depreciation expense is the amount of assets used up during the period through

operations. The change in long-term assets represents the actual change in long-term assets during

the period and will differ from the depreciation expense if assets have been purchased or sold during

the period.

Cash flows from financing activities reflect cash flows from long-term debt and/or equity

financing. The net cash flow from financing activities is equal to the change in long-term debt less

the amount of withdrawals plus the amount of new equity capital less the amount of equity capital

repurchased:

Change in long-term debt

- Amount of dividends
+ Amount of new equity capital
- Amount of equity repurchased
Net Cash flow from financing

Increasing (decreasing) long-term borrowing increases (decreases) available cash. The

payment of dividends uses cash while a new equity contributions provides additional cash.

Repurchasing equity from same owners would require the use of cash and decrease cash flow.

Cash Versus Accrual Accounting

Another factor which causes actual cash flows to differ from profit measures and accounting

cash flow is the use of accrual accounting. Accrual accounting recognizes revenues in the period

they are earned and expenses in the period they are incurred. For example, you might sell corn in

December 1997 but not receive cash for it until January 1998. In this case you earned your revenue

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in 1997, even though you didn’t receive cash for it until 1998. Accrual accounting doesn’t care about

the timing of actual cash inflows and outflows.

An alternative available to many small businesses is to use a cash accounting system for tax

reporting purposes. Cash accounting recognizes revenues and expenses in the period in which they

are received. Using a cash accounting system in our corn example above, you would not count the

revenue from the corn sale until the cash was received in 1994 even though the grain was sold in

1997. Cash accounting allows firms to make some adjustments to revenues and expenses which

allows them to manage their tax liability to some extent.

Accrual accounting, on the other hand, provides a more accurate reflection of the firm’s

profitability and gives a better picture of the firm’s situation for monitoring and control purposes. As

a result, many small businesses use cash accounting for tax purposes and accrual accounting for

management purposes. It should be noted that businesses in which inventories are held are required

by the IRS to use an accrual based accounting system. However, most types of farm businesses are

excluded from this requirement and are allowed to use the cash basis of accounting for tax purposes.

It is usually not difficult to adjust financial statements from cash accounting to accrual accounting;

and this should be done for businesses that use a cash accounting system for tax purposes in order

to provide better information on the financial performance of the firm.

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