Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 2 Financial Statements

Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2-2 Learning Objectives 1. Explain the foundations of the balance sheet and income statement 2. Use the cash flow identity to explain cash flow. 3. Provide some context for financial reporting. 4. Recognize and view Internet sites that provide financial information.

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Statements Four main financial statements: –Balance sheet –Income Statement –Statement of Retained Earnings –Statement of Cash Flow Our focus.. –Interrelationship between the balance sheet and the income statement –The process by which these statements can be used to project a firm’s future cash flows

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Statements (continued) (A) The Balance Sheet Represents the assets owned by the company and the claims against those assets Based on the accounting identity: Assets  Liabilities + Owners’ Equity(2.1)

Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2-5 Figure 2.1 Balance sheet

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Balance Sheet Has five main sections: 1.Cash account Where did the $65 million decline come from? 2.Working capital accounts Net working capital = Current assets – Current liabilities (2.2) 3.Long-term asset accounts Plant and equipment; land and buildings Gross value – accumulated depreciation = Net value 4.Long-term liabilities (debt) accounts Loans maturing in over one year 5.Ownership accounts Shareholders’ equity Retained earnings—accumulated total since inception

Copyright © 2010 Pearson Prentice Hall. All rights reserved (B) The Income Statement Shows the expenses and revenues generated by a firm over a past period, typically a quarter or a year. Net income = Revenues – expenses(2.3) EBIT = Revenues – operating expenses (2.4)

Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2-8 Figure 2.2 Income Statement example

Copyright © 2010 Pearson Prentice Hall. All rights reserved (B) The Income Statement (continued) Net income is not the same as cash flow Firm earned an income of $5,642 million Cash account decreased by 65 million 3 reasons: Accrual accounting Noncash expense items --depreciation Preference to classify interest expense as part of financial cash flow

Copyright © 2010 Pearson Prentice Hall. All rights reserved Cash Flow Identity The cash flow identity states that the cash flow on the left-hand side of the balance sheet is equal to the cash flow on the right-hand side of the balance sheet. CASH FLOW FROM ASSETS  CASH FLOW TO CREDITORS + CASH FLOW TO OWNERS

Copyright © 2010 Pearson Prentice Hall. All rights reserved Figure 2.5 Cash Flow Identity and components

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) The First Component: Cash Flow From Assets Three components: Operating cash flow (OCF) Net capital spending (NCS) Change in net working capital (∆NWC) Cash flow from assets = OCF – NCS - ∆NWC OCF = EBIT + Depreciation – Taxes NCS = End. Net – Beg. Net + Depreciation Fixed Assets Fixed Assets ∆NWC=Ending NWC – Beginning NWC

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) The First Component: Cash Flow From Assets (continued) OCF = EBIT + Depreciation – Taxes Figure 2.3

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) The First Component: Cash Flow From Assets (continued) NCS = End. Net – Beg. Net + Depreciation Fixed Assets Fixed Assets NCS= ($11,961 - $10,788) + $1,406 = $2,579

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) The First Component: Cash Flow From Assets (continued) ∆NWC = Ending NWC – Beginning NWC Net working capital for 2007 = $9,130 - $6,860 = $2,270 Net working capital for 2006 = $10,454 - $9,406 = $1,048 Change in NWC = $2,270 - $1,048 = $1,222

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) The First Component: Cash Flow From Assets (continued) Putting it all together…. Cash flow from Assets = OCF – NCS - ∆ NWC =$7,287-$2,579-$1,222 =$3,486

Copyright © 2010 Pearson Prentice Hall. All rights reserved (B) The Second Component: Cash Flow To Creditors Cash Flow to Creditors = Interest Expense  Net New Borrowing from Creditors Net New Borrowing = Ending Long-term Liabilities  Beginning Long-Term Liabilities Cash Flow to Creditors = $239  (-$378)  $617

Copyright © 2010 Pearson Prentice Hall. All rights reserved (C) The Third Component: Cash Flow To Owners Cash flow to owners = Dividends - Net new borrowing from owners = $2,869 – $0 = $2,869

Copyright © 2010 Pearson Prentice Hall. All rights reserved (C) Putting It All Together: The Cash Flow Identity CASH FLOW FROM ASSETS  CASH FLOW FROM CREDITORS + CASH FLOW TO OWNERS $3,486  $617 + $2,869

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Performance Reporting Annual reports to shareholders Quarterly (10-Q) and annual (10-K) reports filed with the SEC –Regulation Fair Disclosure (Reg. FD): Companies must release all material information to all investors at the same time. – Notes to the Financial Statements: A wealth of information about the firm

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Statements on the Internet EDGAR ( Yahoo! Finance ( Many, many more Web sites with rich stores of information

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 Balance Sheet. Chuck Enterprises has current assets of $300,000, and total assets of $750,000. It also has current liabilities of $125,000, common equity of $250,000, and retained earnings of $85,000. How much long- term debt and fixed assets does the firm have?

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (ANSWER) Current Assets + Fixed Assets = Total Assets  $300,000+Fixed Assets = $750,000  Fixed Assets = $750,000 - $300,000 = $400,000  Total Assets = Current Liabilities + Long-term debt +Common equity + Retained Earnings  $750,000 = $125,000 + Long-term debt + $250, ,000  Long-term debt = $750,000 - $125,000-$250,000 -$85,000  Long-term debt = $290,000

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 Income Statement. The Top Class Company had revenues of $925,000 in Its operating expenses (excluding depreciation) amounted to $325,000, depreciation charges were $125,000, and interest costs totaled $55,000. If the firm pays a marginal tax rate of 34 percent, calculate its net income after taxes.

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (ANSWER) Revenues$925,000 Less operating expenses325,000 = EBITDA 600,000 Less depreciation 125,000 = EBIT 475,000 Less interest expenses 55,000 = Taxable Income 420,000 Less taxes (34%) 142,800 = Net Income after taxes 277,200

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 Retained Earnings: The West Hanover Clay Co. had, at the beginning of the fiscal year, November 1, 2009, retained earnings of $425,000. During the year ended October 31, 2010, the company generated net income after taxes of $820,000 and paid out 35 percent of its net income as dividends. Construct a statement of retained earnings and compute the year-end balance of retained earnings.

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 (ANSWER) Statement of Retained Earnings for the year ended October 31, 2010 Balance of Retained Earnings, 11/1/2009……….$425,000 Add: Net income after taxes, 10/31/2010………. $820,000 Less: Dividends paid for year-end 10/31/2010…$287,000 Balance of Retained Earnings, 10/31/20120….. $958,000

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 4.Working Capital: D.K. Imports, Incorporated reported the following information at its last annual meeting: Cash and cash equivalents = $1,225,000; Accounts payables = $3,200,000 Inventory = $625,000; Accounts receivables = $3,500,000; Notes payables = $1,200,000; Other current assets = $125,000. Calculate the company’s net working capital.

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (ANSWER) Net Working Capital = Current Assets - Current Liabilities  (Cash & Cash Equivalents + Accts. Rec. + Inventory + other current assets) - (Accounts Payables + Notes Payables)  ($1,225,000+$3,500,000+$625,000+$125,000) - ($3,200,000+$1,200,000)  $5,475,000 - $4,400,000 Net Working Capital  $1,075,000

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 Cash Flow from Operating Activities: The Mid-American Farm Products Corporation provided the following financial information for the quarter ending September 30, 2009: Depreciation and amortization  $75,000 Net Income  $225,000 Increase in receivables  $95,000 Increase in inventory  $69,000 Increase in accounts payables  $80,000 Decrease in marketable securities  $34,000. What is the cash flow from operating activities generated during this quarter by the firm?

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (ANSWER) Net Income $225,000 Add depreciation and amortization75,000 Add decrease in marketable securities34,000 Add increase in accounts payables80,000 Less increase in accounts receivables95,000 Less increase in inventory69,000 Cash flow from operating activities$250,000

Copyright © 2010 Pearson Prentice Hall. All rights reserved Figure 2.4

Copyright © 2010 Pearson Prentice Hall. All rights reserved Figure 2.6

Copyright © 2010 Pearson Prentice Hall. All rights reserved Figure 2.7