Introduc corporate finance ch2

Accounting Statements
and Cash Flow

1


Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Net Working Capital
2.4 Financial Cash Flow
2.5 The Statement of Cash Flows
2.6 Summary and Conclusions
2


Sources of Information




Annual reports
Wall Street Journal
Internet






NYSE (www.nyse.com)

Nasdaq (www.nasdaq.com)
Text (www.mhhe.com)

SEC



EDGAR
10K & 10Q reports
3


The Balance Sheet
• An accountant’s snapshot of the firm’s
accounting value as of a particular date.
• The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity

4


U. S. Composite Corporation
Balance Sheet ($ millions)
Assets
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets

20X2
$140
294
269
58
$761

20X1
$107
270
280
50
$707

Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
-550
-460
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035

Total assets

$1,879

$1,742

Liabilities (Debt)
and Stockholder's Equity
Current Liabilities:
Accounts payable
Notes payable
Accrued expenses
Total current liabilities

The assets are listed in 20X2
order20X1
by the length of time it $213 $197
50
53
normally would take a firm
223
205
with ongoing operations$486
to $455
Long-term liabilities:
convert
them into cash.
Deferred taxes
Long-term debt
Total long-term liabilities

$117
471
$588

$104
458
$562

Stockholder's equity:
Preferred stock
$39
$39
Common stock ($1 per value)
55
32
Capital surplus
347
327
Accumulated retained earnings
390
347
Less treasury stock
-26
-20
Total equity
$805
$725
Total liabilities and stockholder's equity $1,879 $1,742

Clearly, cash is much more
liquid than property, plant and
equipment.

5


Balance Sheet Analysis
When analyzing a balance sheet,
the financial manager should be
aware of three concerns:



•
•
•

Accounting liquidity
Debt versus equity
Value versus cost

6


Accounting Liquidity









The ease and quickness with which
assets can be converted to cash.
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less
likely the firm is to experience problems
meeting short-term obligations.
Liquid assets frequently have lower
rates of return than fixed assets.
7


Debt versus Equity




Generally, when a firm borrows it
gives the bondholders first claim
on the firm’s cash flow.
Thus shareholder’s equity is the
residual difference between assets
and liabilities.

8

Value versus Cost




Under GAAP audited financial
statements of firms in the U.S.
carry assets at cost.
Market value is a completely
different concept.

9


The Income Statement




The income statement measures
performance over a specific period of time.
The accounting definition of income is
Revenue – Expenses ≡ Income

10


U.S.C.C. Income Statement
The operations

section of the
income statement
reports the firm’s
revenues and
expenses from
principal
operations

Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:

$2,262
- 1,655
- 327
- 90
$190
29

$219
- 49
$170
- 84

$86
$43
$43

11


U.S.C.C. Income
Statement
The non-operating
section of the
income statement
includes all
financing costs,
such as interest
expense.

Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense

Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:

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

$86
$43
$43

12


U.S.C.C. Income
Statement

Usually a separate

section reports as a
separate item the
amount of taxes
levied on income.

Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:

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

- 84

$86
$43
$43

13


U.S.C.C. Income
Statement

Net income is the
“bottom line”.

Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:

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

$86
$43
$43

14


Income Statement Analysis
There are three things to keep in
mind when analyzing an income
statement:







GAAP
Non Cash Items
Time and Costs

15


Generally Accepted
Accounting Principles




The matching principal of GAAP
dictates that revenues be
matched with expenses.
Thus, income is reported when it
is earned, even though no cash
flow may have occurred

16


Non Cash Items


Depreciation




No firm ever writes a check for
“depreciation”.

Deferred taxes

17


Time and Costs






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.
In the long run, all inputs of production
(and hence costs) are variable.
Financial accountants do not
distinguish between variable costs and
fixed costs.
18


Net Working Capital




NWC = CA – CL
Net working capital usually grows
with the firm.

19


The Balance Sheet of
U.S.C.C.
$252m = $707- $455
Assets
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets

20X2
$140
294
269
58
$761

20X1
$107
270

280
50
$707

Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
-550
-460
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035

$275m = $761m- $486m
Total assets

$1,879

$1,742

Liabilities (Debt)
and Stockholder's Equity
Current Liabilities:
Accounts payable

Notes payable
Accrued expenses
Total current liabilities

20X2
$213
50
223
$486

20X1
$197
53
205
$455

Long-term liabilities:
Deferred taxes
Long-term debt
Total long-term liabilities

Here we see NWC grow
$117 to $104
471
458
$275 million in 20X2 from
$588
$562
$252 million in 20X1.
Stockholder's equity:

Preferred stock
$39
$39
$23
million
Common stock ($1 par value)
55
32
Capital surplus
347
327
Accumulated retained earnings
390
347
Less treasury stock
-26
-20
Total equity
$805
$725
Total liabilities and stockholder's equity $1,879 $1,742

This increase of $23 million is
an investment of the firm.
20


Financial Cash Flow




In finance, the most important item
that can be extracted from financial
statements is the actual cash flow
of the firm.
Cash from received from the firm’s
assets must equal the cash flows to
the firm’s creditors and
stockholders.
CF(A)≡ CF(B) + CF(S)
21


Financial Cash Flow of
U.S.C.C.
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity

(Dividends plus repurchase of
equity minus new equity financing)
Total

$238

Operating Cash Flow:
EBIT

(173)
(23)
$42
$36

Depreciation

$219
$90

Current Taxes ($71)
OCF

$238

6
$42

22

Financial Cash Flow of
U.S.C.C.
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total

$238

Capital Spending
(173)
(23)
$42

Purchase of fixed assets
Sales of fixed assets
Capital Spending

$198
(25)
$173

$36
6
$42

23


Financial Cash Flow of
U.S.C.C.
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)

Total

$238
(173)
(23)
$42
$36

NWC grew from $275
million in 20X2 from
$252 million in 20X1.
This increase of $23
million is the addition to
NWC.

6
$42

24


Financial Cash Flow of
U.S.C.C.
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)

Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total

$238
(173)
(23)
$42
$36
6
$42

25