Chapter 3 Understanding Financial Statements and Cash Flows

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-1 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. Explain the difference between GAAP and IRFS.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-2 Learning Objectives Compute taxable income and income taxes owed. Describe the limitations of financial statements. Calculate a firm’s free cash flows and financing cash flows.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-3 THE INCOME STATEMENT

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-4 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-5 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, general administrative expenses and depreciation expense Financing Costs –The interest paid to creditors Tax Expenses –Amount of taxes owed, based upon taxable income

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-6 Figure 3-1

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-7 Figure 3-1 (cont.)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-8 Table 3.1

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-9 Common-Sized Income Statement Common-sized income statement restates the income statement items as a percentage of sales. Common-sized income statement makes it easier to compare trends over time and across firms in the industry. See Table 3.1

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-10 Profit-to-Sales Analysis from Common-Sized Income Statement See Table 3.1 Gross profit margin (or percentage of sales going towards gross profit) is 34.3% Operating profit margin (or percentage of sales going towards operating profit) is 8.5% Net profit margin (or percentage of sales going towards net profit) is 4.9%

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-11 THE BALANCE SHEET

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-12 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 owner-supplied capital (shareholders’ 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 at cost price, so the book value of a firm may be very different from its current market value.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-13 Figure 3-2

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-14 Balance Sheet Terms: Assets 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)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-15 Balance Sheet Terms: Assets Long-Term Assets: Fixed Assets and Other Assets 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-16 Balance Sheet Terms: Liabilities 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).

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-17 Balance Sheet Terms: Liabilities Short-Term Debt (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 –Borrowings from banks and other sources for more than one year

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-18 Balance Sheet Terms: Equity 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 repurchased 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 that retained earnings are not equal to hard cash!

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-19 Balance Sheet: A = L + E 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 ASSETS (A) –Current Assets –Fixed Assets Total Assets

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-20 Table 3-2

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-21 Table 3-2 Total assets decreased by $752 million due to reduction in current assets and in net fixed assets. Total debt and equity decreased by $752 million due to paying of $263 owed on accounts payable, repurchasing stock of $2.608 billion, receipt of $335 million from issue of new stock, and increase in retained earnings of $1.769 billion.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-22 Table 3-2 (columns 4 & 5) Common-sized balance sheet reveals: –Inventories account for 25% of total assets and most of current assets –The total assets consist of about one-third current assets and two-third fixed assets –Approximately 50% of the company’s assets are financed by debt and 50% by equity

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-23 Debt Ratio –Debt ratio is the percentage of assets that are financed by debt. –Debt ratio is an indication of “financial risk.” Generally, the 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-24 Net Working Capital = Current assets – current liabilities –The larger the net working capital, the 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-25 MEASURING CASH FLOWS

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-26 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-27 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. Similarly, inventory purchases may not be entirely paid for in cash as suppliers may extend credit for some of the purchases. 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-28 Sources and Uses of Cash Sources of Cash  Decrease in an Asset  Example: Selling inventories or collecting receivables provides cash  Increase in Liability or Equity  Example: Borrowing funds or selling stocks provides cash Uses of Cash  Increase in an Asset  Example: Investing in fixed assets or buying more inventories uses cash  Decrease in Liability or Equity  Example: Paying off a loan or buying back stock uses cash

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-29 How to Measure a Firm’s Cash Flows

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-30 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)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-31 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-32 Income Statement Conversion: From Accrual to Cash Basis Cash Flow from Operations: Five Steps 1.Add back depreciation. 2.Subtract (add) any increase (decrease) in accounts receivable. 3.Subtract (add) any increase (decrease) in inventory. 4.Subtract (add) any increase (decrease) in other current assets. 5.Add (subtract) any increase (decrease) in accounts payable and other accrued expenses.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-33 Figure 3-5

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-34 Home Depot (cash flow from operations)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-35 Cash Flow from Investing in Long-Term Assets Long-term assets include fixed assets and other long-term assets. A firm may be engaged in acquisition and sale of such assets leading to cash flows. Home Depot’s spent $1.126 billion on fixed assets (as observed by the change in gross fixed assets) and $159 million on other assets.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-36 Cash Flows from Financing the Business Cash Inflows  Borrowings (as reflected by increase in short-term and long- term debt)  Owner(s) invest in business (as reflected by an increase in stockholders’ equity) Cash Outflows  Repayment of debt (as shown by decrease in short-term and/or long- term debt)  Payment of dividend  Repurchase of stock

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-37 Financing the Business Illustrated: Home Depot

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-38 Table 3-4

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-39 Tips for Statement of Cash Flows Consider one section at a time. You need only 2 items from the income statement: net income and depreciation expense. Consider change for all items in the balance sheet, except: ignore accumulated depreciation and net fixed assets; ignore change in retained earnings.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-40 GAAP AND IFRS

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-41 GAAP and IFRS U.S. follows GAAP (Generally Accepted Accounting Principles) – a set of standards, conventions and rules established by FASB. Most other countries follow IFRS (International Financial Reporting Standards) – a set of broad and general principles established by IASB. IFRS is simpler and allows more room for discretion. U.S. may switch to IFRS by 2014.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-42 INCOME TAXES AND FINANCE

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-43 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-44 Computing Taxable Income Table 3-5

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-45 Table 3-6

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-46 ACCOUNTING MALPRACTICE AND LIMITATIONS OF FINANCIAL STATEMENTS

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-47 Accounting Malpractice and Limitations of Financial Statements Since accounting rules give managers discretionary powers, it is possible that two firms with similar financial performance may report different results. There have been several cases of accounting malpractice where rules have been broken!

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-48 Key T erms Accounts payable Accounts receivable Accrual basis accounting Accounting book value Accrued expenses Accumulated depreciation Additional paid-in-capital Average tax rate Balance sheet Capital gains Cash Cash basis accounting Common size financial statements Common stock Common stock holders Cost of goods sold Current assets Current debt Debt Debt ratio Depreciation expense Dividends per share Earnings before taxes Earnings per share Equity Financing cash flows Fixed costs Fixed assets Free cash flows GAAP Gross fixed assets

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-49 Key Terms (cont.) Gross profit Gross profit margin IFRS Income statement Inventories Liquidity Long-term debt Marginal tax rate Mortgage Net fixed assets Net income Net profit margin Net working capital Operating expenses Operating income Paid-in capital Par value Preferred stockholders Profit margins Retained earnings Semi-variable costs Short-term notes (debt) Statement of cash flows Taxable income Trade credit Treasury stock Variable costs

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-50 Figure 3-3

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-51 Table 3-3