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Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 3 Understandin g Financial Statements and Cash Flows

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Page 1: 2. financial statement cash flow

Copyright © 2011 Pearson Prentice Hall.All rights reserved.

Chapter 3

Understanding Financial

Statements and Cash Flows

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3-2 © 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives

Compute a company’s profits as reflected by its income statement.

Determine a firm’s financial position at a point in time based on its balance sheet

Measure a company’s cash flows.

Compute taxable income and income taxes owed.

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3-3 © 2011 Pearson Prentice Hall. All rights reserved.

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 firm’s operation over a specific period.

The bottom line of the income statement shows the firm’s profit or loss for a period.

Sales – Expenses = Profits

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Income Statement Terms

Revenue (Sales) Money derived from selling the company’s 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 firm’s 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 owner’s 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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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)

Balance Sheet Terms: Assets

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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.

Balance Sheet Terms: Assets

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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).

Balance Sheet Terms: Liabilities

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Current Debt: Accounts payable (Credit extended by suppliers to a firm

when it purchases inventories) Accrued expenses (Short term liabilities incurred in the firm’s

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

Balance Sheet Terms: Liabilities

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Equity: Shareholder’s 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!

Balance Sheet Terms: Equity

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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

OWNER’S EQUITY (E) Preferred Stock Common Stock Retained earnings

Total Owner’s 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 firm’s 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 firm’s 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 firm’s 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 3-6Computing Taxable Income ($000’s)

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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