1

Ch 2

Financial Statements, Taxes, and Cash Flow

2

Issues in Ch.2 Three financial statements

Balance sheet Income statement Operating cash flow

The difference between accounting income and cash flow in financial decision-making process

The difference between accounting value (or book value) and market value of the firm

3

Three Financial Statements

Balance Sheet Income Statement Cash Flow Statement

4

Accounting identity

Assets = Liabilities + Shareholders’ equity

Or

Shareholders’ equity = Assets – Liabilities

Another name for Shareholders’ equity is “residual claim.”

5

Balance Sheet

The Balance Sheet is snap shot of the firm’s current condition

The asset side of the balance sheet reflects the investment decisions made by the firm

The liabilities and equity side reflect all of the financing decisions made over the same period

6

Balance Sheet

7

Balance Sheet of The firm (Snap Shot of the Firm) Current Assets have a

life of less than 1 year and include:

•Cash

•Account receivable

•Inventory

Current Liabilities have a life of less than 1 year and include:

•Short-term liability

•Accounts PayableCA - CL

Shareholders’ Equity = Assets - Liabilities

Assets = Liabilities + Shareholders’ Equity

•Bank loans

•Long-term borrowings

•Machine, Equipment

•Patents

8

Pop Quiz – Can you link them? Accounts

Receivable Long-term assets Patents Notes payable Accounts payable Long-term debt Common stock Retained earnings

Net income minus dividend

Intellectual property Loans the firm took and

must pay back within one year

Long-term borrowings Money owed to the firm

by its customers Money the firm owes to its

supplier Equipment, plant Amount of stock issued by

the firm

9

Please construct for Bobcats Co. the following statements using the information below:

Balance sheet Income statement Operating Cash Flow (OCF)

Accounts Payable = $70,000 Tax Rate = 34% Retained Earnings = $100,000 Interest Expense = $10,000 Inventory = $50,000 Depreciation Expense = $100,000 Notes Payable = $80,000 Sales = $800,000 Machinery, Buildings (net)= $400,000 Long-Term Debt = $200,000 Cash = $30,000 Cost of Goods Sold =$400,000 Patents, Trademarks =$150,000 Accounts Receivable = $20,000 Operating Expense = $100,000 Common Stock = ? Stock price = $20 per share Number of outstanding stocks = 20,000 shares

10

Put the balance sheet below.

Microsoft Excel Worksheet

11

Liquidity of Assets The order of assets on the balance sheet reflects

their liquidity. (decreasing order of liquidity) Liquidity is the speed at which the asset can be

converted to cash with little or no loss in value Liquid firms are less likely to experience financial

distress But, liquid assets earn a lower return Liquid Assets

Account receivable and possibly inventory Non-liquid Assets

specialized fixed asset (e.g., equipment) and intangible assets (e.g., patents and trademarks)

12

Net Working Capital Net Working Capital

Current Assets minus Current Liabilities Positive when the cash that will be

received over the next 12 months exceeds the cash that will be paid out

Usually positive in a healthy firm

13

Book Value vs. Market Value Find the book value of Bobcats.

Historical cost or the amount the investors originally paid for.

Recorded amount in financial statements GAAP says “You record historical cost!”

Simply the recorded value of stockholders’ equity or sum of retained earning and common stock items in balance sheet

14

Book Value vs. Market Value

Find the market value of Bobcats. Is NOT on the financial statements but

more important one True value of the firm or the value

observed in the marketplace. The amount of cash we would get if we

actually sell the firm now. Simply the current stock price * number of

outstanding stocks

Then, what is the intrinsic value? Intrinsic value

The present value of an asset’s expected future cash flows.

The fair value, given the amount, timing, and riskiness of future cash flows.

If MV > IV Overvalued If MV < IV Undervalued

15

16

Book Value vs. Market Value

Market value and book value are often very different. Why?

Which one is more important to the decision-making process?

The goal of the financial manager is to maximize the market value of the stock.

17

18

Income Statement

The income statement is the measurement of performance

You generally report revenues first and then deduct any expenses for the period

Income = Revenue - Expenses 

19

Income Statement (Example)

2012 2013Sales 3,432,000 5,834,400 COGS 2,864,000 4,980,000 Other expenses 340,000 720,000 Deprec. 18,900 116,960 Tot. op. costs 3,222,900 5,816,960 EBIT 209,100 17,440 Int. expense 62,500 176,000 EBT 146,600 (158,560)Taxes (40%) 58,640 (63,424)Net income 87,960 (95,136)

20

Put the income statement for Bobcats Co. below.

Two Issues on Income Statement Non-cash item Realization principle

21

22

Noncash items A typical noncash item is depreciation

expense

Hypothetical number

Noncash items are irrelevant to firm valuation in general because they do not represent true cash inflow or outflow

However, noncash items are still important to understand the firm’s financial condition because they affect the firm's tax liability (and, therefore, cash flow)

23

GAAP Allows Accrual Basis Accounting!

Matching principle: GAAP says to show revenue when it accrues and match the expenses required to generate the revenue

Recognition Principle: GAAP says to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined.

What does this mean? Records revenue when it is earned, whether or not the

revenue has been received in cash. Records expense when they are incurred, even if the

money has not actually been paid out.

Example Suppose DELL computer sold computers to the

University on credit at the beginning of the year. The University will pay cash at the end of the year.

Accounting journals

Now, Accounts Receivable XXXXRevenue XXXX

Expenses XXXXInventory XXXX

Later, Cash XXXXAR XXXX

24

25

Profits and cash flows are not the same thing! The potential problem with GAAP to

understand the firm’s financial condition

Mismatch between the time when the income (cost) is realized and the time when the revenue (cost) is collected

This is because GAAP requires that sales be recorded on the income statement when made, not when cash is received

GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet

26

GAAP versus Cash Flow Time Line

27

Profits and cash flows are not the same thing! In the earlier example, DELL will not receive

cash until the end of the year.There is an opportunity cost or timing

mismatch between the recognition of revenue and the receipt of cash flow in the DELL example.

As a result, net income is not equal to cash flow generated during the period.

In general, financial managers are more concerned with cash flow than accounting income.

28

So, what can we conclude? The accrual accounting and noncash items

results in inequality between cash flows and net income (or earnings).

Finance Emphasizes the Importance of Timing Timing of Cash Flow Matters Accrual Accounting May Obscure Timing “You Can’t Deposit Net Income, Only Cash”

Therefore, we must present cash flow statement to understand the firm’s financial condition better.

The Managerial Finance Function Relationship to Accounting

Finance and accounting differ with respect to decision-making.

While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making purposes.

The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.

The Managerial Finance Function Relationship to Accounting

One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method, while in finance the focus is on cash flows.

31

The Sources and Uses of Corporate Cash

Decrease in any asset

Increase in any liability

Net profits after taxes

Depreciation and other non-cash charges

Sale of stock

Increase in any asset Decrease in any liability Net loss Dividends paid Repurchase or

retirement of stock

SourcesSources UsesUses

32

Put the operating cash flow (OCF) for Bobcats Co. below.

OCF= EBIT + Depreciation Expense - Taxes

33

Cash Flows: Comprehensive View

34

Example: U.S. Corporation

CFFA = OCF – NCS - ΔNWCOCF = EBIT + depreciation – taxes

= $694 + 65 – 212 = $547NCS = ending net FA– beginning net FA + depreciation

= $1709 – 1644 + 65 = $130ΔNWC = ending NWC – beginning NWC

= ($1403 – 389) – ($1112 – 428) = $330 CFFA = 547 – 130 – 330 = $87

2009 2010 2009 2010Current Assets Current Liabilities Cash $104 $160 Accounts Payable $232 $266 Accounts Receivable 455 688 Notes Payable 196 123 Inventory 553 555 Total $428 $389 Total $1,112 $1,403Fixed Assets Net Fixed assets $1,644 $1,709 Long-term debt $408 $454

Owners' equity Common stock and paid-in surplus 600 640 Retained earnings 1,320 1,629 Total $1,920 $2,269

Total assets $2,756 $3,112Total Liabilties & Owners Equity $2,756 $3,112

Balance Sheet

Assets Liabiities & Owners' Equity

$1,509750

65$694

70$624

212$412

Dividends $103 Addition to retained earnings $309

TaxesNet Income

Depreciation

Interest PaidEarnings before interest and taxes

Taxable income

U.S. Corporation

Income Statement

Net salesCost of goods sold

35

Example: U.S. Corporation

CFFA = CF/CR + CF/SHCF/CR = interest paid – net new borrowing

= $70 – ($454 – 408) = $24CF/SH = dividends paid – net new equity

= $103 – ($640 – 600) = $63 CFFA = $24 + $63 = $87

2009 2010 2009 2010

Current Assets Current Liabilities

Cash $104 $160 Accounts Payable $232 $266

Accounts Receivable 455 688 Notes Payable 196 123

Inventory 553 555 Total $428 $389

Total $1,112 $1,403

Fixed Assets

Net Fixed assets $1,644 $1,709 Long-term debt $408 $454

Owners' equity

Common stock and

paid-in surplus 600 640

Retained earnings 1,320 1,629

Total $1,920 $2,269

Total assets $2,756 $3,112

Total Liabilties & Owners Equity $2,756 $3,112

U.S. Corporation

Balance Sheet

Assets Liabiities & Owners' Equity $1,50975065

$69470

$624212

$412 Dividends $103 Addition to retained earnings $309

TaxesNet Income

Depreciation

Interest PaidEarnings before interest and taxes

Taxable income

U.S. Corporation

Income Statement

Net salesCost of goods sold

36

37

Pop Quiz 1 Which one of the following assets is

generally the LEAST liquid?

A) plant and equipment B) inventory C) patents and goodwill D) cash E) accounts receivable

38

Pop Quiz 2 A firm's balance sheet shows current assets of

$95, net fixed assets of $250, long-term debt of $40, and owners equity of $200. What is the value of the firm's current liabilities if that is the only remaining balance sheet item? A) -$ 50 B) $ 50 C) $105 D) $145 E) $545

Pop Quiz 3Q: Explain why net income and operating

cash flow differ in amount.

A: Depreciation is a noncash expense and interest paid is a financing cash flow. While both of these affect operating cash flows indirectly through taxes, they do not directly affect the operating cash flows. They do directly reduce net income.

39

Pop Quiz 4Q:How is liquidity both beneficial and

harmful to a firm? A: Liquidity is beneficial because a firm

must have sufficient cash available to meet its obligations. Liquidity is harmful because liquid assets earn minimal rates of return as compared to less liquid assets.

40

Pop Quiz 5Which two of the following determine when revenue is recorded on the financial statements based on the GAAP?

I. when payment is collected for the sale of a good or serviceII. when the earnings process is virtually completedIII. when the value of a sale can be reliably determinedIV. when a product is physically delivered to the buyer’s location

a. I and II onlyb. I and IV onlyc. II and III onlyd. II and IV onlye. I and III only

41