2. financial statement cash flow

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  • 1.Chapter 3Understanding FinancialStatements andCash Flows Copyright 2011 Pearson Prentice Hall. All rights reserved.

2. 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. 2011 Pearson Prentice Hall. All rightsreserved.3-2 3. Slide Contents Principles used in this Chapter 1. The Income Statement 2. The Balance Sheet 3. Measuring Cash Flows 4. Income Taxes and Finance 2011 Pearson Prentice Hall. All rightsreserved. 3-3 4. Principles Appliedin this Chapter Principle 1: Cash flow is what matters Principle 5: Conflicts of interest cause agency problems 2011 Pearson Prentice Hall. All rightsreserved.3-4 4 5. 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 2011 Pearson Prentice Hall. All rightsreserved. 3-5 6. 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 orservice and administering the business Financing Costs The interest paid to creditors Tax Expenses Amount of taxes owed, based upon taxable income 2011 Pearson Prentice Hall. All rightsreserved. 3-6 7. Figure 3-1 2011 Pearson Prentice Hall. All rightsreserved. 3-7 8. Figure 3-1 (cont.) 2011 Pearson Prentice Hall. All rightsreserved. 3-8 9. Table 3-1 2011 Pearson Prentice Hall. All rightsreserved. 3-9 10. 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. 2011 Pearson Prentice Hall. All rightsreserved.3-10 11. Table 3-2 2011 Pearson Prentice Hall. All rightsreserved. 3-11 12. Profit-to-Sales analysis from Common-size income statement See Table 3-2 Gross profit margin (or percentage ofsales going towards gross profit) is 23.3% Operating profit margin (or percentageof sales going towards operating profit) is12.5% Net profit margin (or percentage of salesgoing towards net profit) is 7% 2011 Pearson Prentice Hall. All rightsreserved. 3-12 13. 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 thoseresources 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. 2011 Pearson Prentice Hall. All rightsreserved. 3-13 14. Figure 3-3 2011 Pearson Prentice Hall. All rightsreserved. 3-14 15. 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 whobuy on credit) Inventory (raw materials, work in process, and finishedgoods held for eventual sale) Other assets (ex.: Prepaid expenses are items paid for inadvance) 2011 Pearson Prentice Hall. All rightsreserved. 3-15 16. 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. 2011 Pearson Prentice Hall. All rightsreserved.3-16 17. Balance Sheet Terms:Liabilities Debt (Liabilities) Money that has been borrowed from a creditorand must be repaid at some predetermined date. Debt could be current (must be repaid withintwelve months) or long-term (repayment timeexceeds one year). 2011 Pearson Prentice Hall. All rightsreserved.3-17 18. Balance Sheet Terms:Liabilities Current Debt: Accounts payable (Credit extended by suppliers to a firmwhen it purchases inventories) Accrued expenses (Short term liabilities incurred in the firmsoperations but not yet paid for) Short-term notes (Borrowings from a bank or lendinginstitution due and payable within 12 months) Long-Term Debt Borrowings from banks and other sources for more than 1year 2011 Pearson Prentice Hall. All rightsreserved.3-18 19. 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! 2011 Pearson Prentice Hall. All rightsreserved. 3-19 20. Balance Sheet: A = L + E ASSETS (A) LIABILITIES (L) Current Assets Current Liabilities Fixed Assets Long-Term Liabilities Total Assets Total Liabilities OWNERS EQUITY (E) Preferred Stock Common Stock Retained earnings Total Owners Equity Total liabilities + Equity 2011 Pearson Prentice Hall. All rightsreserved. 3-20 21. Table 3-3 2011 Pearson Prentice Hall. All rightsreserved. 3-21 22. Net Working Capital Net Working Capital = Current assets current liabilities Larger the net working capital, better the firms ability torepay its debt Net working capital can be positive or zero or negative. It isgenerally positive. An increase in net working capital may not always be goodnews. For example, if the level of inventory goes up, currentassets will increase and thus net working capital will alsoincrease. However, increasing inventory level may well be asign of inability to sell. 2011 Pearson Prentice Hall. All rightsreserved.3-22 23. Debt Ratio Debt ratio is the percentage of assets thatare financed by debt. Debt ratio is an indication of financial risk.Generally, higher the ratio, the more riskythe firm is, as firms have to pay interest ondebt regardless of the earnings or cashflow situation. 2011 Pearson Prentice Hall. All rightsreserved.3-23 24. 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. 2011 Pearson Prentice Hall. All rightsreserved.3-24 25. 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 statementincludes 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. 2011 Pearson Prentice Hall. All rightsreserved. 3-25 26. Figure 3-6How to measure a firms cash flows 2011 Pearson Prentice Hall. All rightsreserved.3-26 27. 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) 2011 Pearson Prentice Hall. All rightsreserved. 3-27 28. 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. 2011 Pearson Prentice Hall. All rightsreserved. 3-28 29. Income Statement Conversion:From Accrual to Cash Basis Two steps: Add back depreciation (as it is a non-cashexpense) to net income Subtract any uncollected sales (i.e.increase in accounts receivable) and cashpayment for inventories (i.e. increase ininventories less increase in accountspayables) 2011 Pearson Prentice Hall. All rightsreserved.3-29 30. Figure 3-7 2011 Pearson Prentice Hall. All rightsreserved. 3-30 31. Table 3-5 2011 Pearson Prentice Hall. All rightsreserved. 3-31 32. 4. Income Taxes and Finance Computing Taxable Income for Corporation Gross Income Dollar sales from a product or service less cost of productionor acquisition Taxable Income Gross income less tax deductible expenses, plus interestincome received and dividend income received Tax Deductible Expenses Include Operating expenses (marketing, depreciation,administrative expenses) and interest expense Dividends paid are not deductible 2011 Pearson Prentice Hall. All rightsreserved. 3-32 33. Table 3-6 Computing Taxable Income ($000s) 2011 Pearson Prentice Hall. All rightsreserved. 3-33 34. Table 3-7 2011 Pearson Prentice Hall. All rightsreserved. 3-34 35. Figure 3-2 2011 Pearson Prentice Hall. All rightsreserved. 3-35 36. Figure 3-2 (cont.) 2011 Pearson Prentice Hall. All rightsreserved. 3-36 37. Figure 3-4 2011 Pearson Prentice Hall. All rightsreserved. 3-37 38. Table 3-4 2011 Pearson Prentice Hall. All rightsreserved. 3-38 39. Key terms Accounts Payable Debt Accounts Receivable Debt ratio Accrual basis accounting Depreciation expenses Accrued expenses EBIT Accumulated depreciation Earnings before taxes Additional paid-in-capital Earnings per share Balance sheet Equity Cash Financing cash flows Common size financial Financing coststatements Fixed assets Common stock Free cash flows Cost of goods sold Gross fixed assets Current assets 2011 Pearson Prentice Hall.All rightsreserved.3-39 40. Key terms (cont.) Gross Profit Operating income Gross profit