Chapter 3 Understanding Financial Statements and Cash Flows Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 3 Understanding Financial Statements and Cash Flows

Foundations of Finance Chapter Objectives Compute a company’s profits as reflected by an income statement. Determine a firm’s accounting book value, as presented in a balance sheet. Measure a company’s free cash flows. Foundations of Finance Pearson Prentice Hall

Principles Used in this Chapter Principle 3: Cash-Not Profits-Is King Principle 7: Managers Won’t Work for the Owners Unless It’s in Their Best Interest Foundations of Finance Pearson Prentice Hall

Basic Financial Statements Income Statement Balance Sheet Statement of Cash Flows Foundations of Finance Pearson Prentice Hall

Foundations of Finance Income Statement Profit/Loss Statement Indicates the amount of profits generated by a firm over a given period of time Sales – Expenses = Profit Foundations of Finance Pearson Prentice Hall

Income Statement Terminology 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 and the dividends paid to preferred stockholders Tax Expenses Amount of taxes owed, based upon taxable income Foundations of Finance Pearson Prentice Hall

Foundations of Finance Income Statement Sales Less cost of goods sold = Gross profit Less operating expenses = Operating income Less interest expense = Earnings before taxes Less corporate taxes = Earnings before preferred dividends Less preferred stock dividends = Net income available to common stockholders Foundations of Finance Pearson Prentice Hall

Starbucks Corporation Income Statement 2003 ($M) Sales $4,076 Cost of Goods Sold 3,207 Gross Profit $ 869 Operating Expenses Marketing expenses and general and Administrative expenses $227 Depreciation Expense 206 Total Operating Expenses $ 433 Operating Profits $ 436 Interest Expense 3 Earnings before taxes $ 433 Income taxes 165 Net income $ 268 Foundations of Finance Pearson Prentice Hall

Foundations of Finance Balance Sheet Provides a firm’s financial position at a specific point in time Assets are resources owned by the firm Liabilities and owner’s equity indicate how those resources are financed Total Assets = Liabilities (debt) + Shareholder’s Equity Or…A= L+OE Foundations of Finance Pearson Prentice Hall

Balance Sheet Terminology Current assets or gross working capital 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 expenses Prepaid expenses are those items paid for in advance Foundations of Finance Pearson Prentice Hall

Foundations of Finance Balance Sheet Terminology Fixed Assets – Assets held for more than one year. Typically Include: Machinery and equipment Buildings Land Other Assets – Assets that are not current assets or fixed assets Patents Copyrights Goodwill Foundations of Finance Pearson Prentice Hall

Foundations of Finance Balance Sheet Terminology Debt (Liabilities) Money that has been borrowed and must be repaid at some predetermined date Debt Capital financing provided by a creditor Current or short-term debt and long-term debt Current or short-term must be repaid within the next 12 months Foundations of Finance Pearson Prentice Hall

Foundations of Finance Balance Sheet Terminology Current Liabilities: 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 Loans from banks or other institutions for longer than 12 months Foundations of Finance Pearson Prentice Hall

Foundations of Finance Balance Sheet Terminology Equity Includes the shareholder’s investment Preferred stock Common stock Treasury Stock stock that was once outstanding and has 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 Foundations of Finance Pearson Prentice Hall

Foundations of Finance Balance Sheet ASSETS Current Assets Fixed Assets Total Assets LIABILITIES Current Liabilities Long-Term Liabilities Total Liabilities OWNER’S EQUITY Preferred Stock Common Stock Retained earnings Total Owner’s Equity Total liabilities + OE Foundations of Finance Pearson Prentice Hall

Foundations of Finance Terms Net Working Capital Current assets – current liabilities Debt Ratio Percentage of debt a firm uses to finance its assets Accrual Basis Accounting Recording revenues when earned and expenses when incurred, rather than when cash is exchanged Free Cash Flows Cash flow that is free and available to be distributed to the firm’s investors. Foundations of Finance Pearson Prentice Hall

Foundations of Finance Free Cash Flows Free cash flows: (After-tax cashflows from operations) Less (Increase or decrease in net working capital) (Increase or decrease in gross fixed assets) Foundations of Finance Pearson Prentice Hall

Traditional Statement of Cash Flows Three sections: Cash flows from Operating Activities Cash flows from Investing Activities Cash flows from Financing Activities Foundations of Finance Pearson Prentice Hall

After-Tax Cash Flows From Operations Operating Income (EBIT) + Depreciation - Income tax expense = After-tax cash flows from operations Foundations of Finance Pearson Prentice Hall

Change in Operating Working Capital (change in current assets) - (change in current liabilities) Foundations of Finance Pearson Prentice Hall

Compute the Change in Fixed Assets The final step involves computing the change in Gross Fixed Assets (not net Fixed Assets) Foundations of Finance Pearson Prentice Hall

Starbucks Free Cash Flows ($M) After-tax cash flows from operations $477 Less 2003 investments in: Investments in net working capital $ 4 Investments in Long Term Assets 566 Total investments $ 570 Free cash flows $ (93) Foundations of Finance Pearson Prentice Hall

Foundations of Finance Financing Cash Flows A firm can either receive money from or distribute money to its investors. The firm can: Pay interest to lenders Pay dividends to stockholders Increase or decrease in long-term debt Issue stock to new shareholders or repurchase stock from current shareholders Foundations of Finance Pearson Prentice Hall