1. Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows

2. Slide Contents Learning Objectives Principles Applied in This Chapter
An Overview of the Firm’s Financial Statements
The Income Statement
Corporate Taxes
The Balance Sheet
The Cash Flow Statement
Principles Applied in This Chapter
Key Terms

3. Learning Objectives
Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager.
Evaluate firm profitability using the income statement.
Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.

4. Learning Objectives (cont.)
Use the balance sheet to describe a firm’s investments in assets and the way it has financed them.
Identify the sources and uses of cash for a firm using the firm’s cash flow statement.

5. Principles Used in This Chapter
Principle 1: Money Has a Time Value.
Principle 3: Cash Flows Are the Source of Value.
Principle 4: Market Prices Reflect Information.
Principle 5: Individuals Respond to Incentives.

6. 3.1 AN OVERVIEW OF THE FIRM’S FINANCIAL STATEMENTS

7. Basic Financial Statements
The accounting and financial regulatory authorities mandate the following four types of financial statements:
Income statement
Balance sheet
Cash flow statement
Statement of shareholder’s equity

8. Basic Financial Statements (cont.)
Income Statement: An income statement provides the following information for a specific period of time (for example, a full year or quarterly):
Revenue earned,
Expenses incurred, and
Profit earned.

9. Basic Financial Statements (cont.)
Balance sheet: Balance sheet contains information on a specific date (for example, as of December 31, 2013) of the following:
Assets (everything of value the company owns),
Liabilities (the firm’s debts), and
Shareholders’ equity (the money invested by the company owners).

10. Basic Financial Statements (cont.)
Cash flow statement: It reports cash received and cash spent by the firm over a period of time.
Statement of shareholder’s equity: It provides a detailed account of the firm’s activities in the following accounts: Common stock & Preferred stock account, Retained earnings account, and Changes to owners’ equity.

11. Why Study Financial Statements?
Analyzing a firm’s financial statement can help managers carry out three important tasks:
Assess current performance,
Monitor and control operations, and
Plan and forecast future performance.

12. Why Study Financial Statements? (cont.)
This chapter discusses the distinction between the earnings numbers that the firm’s accountants calculate and the amount of cash that a firm generates.
It is possible for a firm to report positive accounting earnings while generating negative cash flows (and vice versa).

13. What are the Accounting Principles Used to Prepare Financial Statements?
Accountants use the following three fundamental principles when preparing financial statements:
The revenue recognition principle,
The matching principle, and
The historical cost principle.

14. 3.2 The Income Statement

15. An Income Statement
An income statement (also called a profit and loss statement) measures the amount of profits generated by a firm over a given time period (usually a year or a quarter). It can be expressed as follows:
Revenues (or Sales) – Expenses = Profits

16. An Income Statement (cont.)
An income statement will contain the following:
Revenues
Expenses
Cost of goods sold, Selling expenses, General and administrative expense, depreciation & amortization expense, Interest expense, and Income tax expense
Net Income
Difference between Revenue and all expenses

17. Table 3.1 H. J. Boswell, Inc.

18. Evaluating a Firm’s per Share Earnings (EPS) and Dividends
Per Share earnings = company’s net income divided by the number of common shares outstanding.
Dividends per share = total dividends paid divided by the number of common shares outstanding.

19. Evaluating a Firm’s EPS and Dividends (for Boswell, Table 3.1)
Earnings per share = $204.75m ÷ 90m = $2.28 per share
Dividends per share = $45m ÷ 90m = $0.50 per share

20. Connecting the Income Statement and the Balance Sheet
What can the firm do with the net income?: Pay dividends to shareholders, and/or Reinvest in the firm
Boswell, Inc. earned net income of $ million, of which $45 million was distributed in dividends and $ million was retained and reinvested in the firm.

21. Interpreting Firm Profitability using the Income Statement
From H.J. Boswell Inc.’s income statement (Table 3-1) we observe that firm has been profitable. We can identify three different measures of profit or income:
The gross Profit margin is 25% ($675 million)
The operating profit margin is only 14.2% ($382.5 million)
The net profit margin is only 7.6% ($ million)

22. Interpreting Firm Profitability using the Income Statement (cont.)
The gross profit margin (GPM)
= gross profits ÷ sales
= $675 million ÷ $2,700 million
= 25%
GPM indicates the firm’s “mark-up” on its cost of goods sold per dollar of sales. The markup percentage equals gross profit divided by cost of goods sold (=$675m ÷ $2.025m = 33.3%)

23. Interpreting Firm Profitability using the Income Statement (cont.)
The operating profit margin
= net operating income ÷ sales
= $382.5 million ÷ $2,700 million
= 14.17%
The operating profit margin is equal to the ratio of net operating income or EBIT divided by firm’s sales.

24. Interpreting Firm Profitability using the Income Statement (cont.)
The net profit margin
= net profits ÷ sales
= $ million ÷ $2,700 million
= 7.6%
Net profit margin indicates the percentage of revenues left over after all expenses (including interest and taxes) have been considered.

25. Interpreting Firm Profitability using the Income Statement (cont.)
By monitoring any changes in these margins and comparing these margins to those of similar businesses, we can dissect and identify a firm’s performance and identify expenses that are out of line.

26. GAAP and Earnings Management
While the firms must adhere to GAAP, there is considerable room for managers to actively influence the firm’s reported earnings.
Managers have an incentive to tamper with earnings as their pay depends upon it and because investors pay close attention to earnings announcements.

27. GAAP and Earnings Management
An audit by an independent accounting firm serves as a check and balance to control management’s incentive to disguise the firm’s financial condition.

28. CHECKPOINT 3.1: CHECK YOURSELF
Constructing an Income Statement
Reconstruct the firm’s income statement assuming the firm is able to cut its cost of goods sold by 10% and that the firm pays taxes at a 40% rate. What is the firm’s net income and earnings per share?

29. Step 1: Picture the Problem
The income statement can be expressed as follows:
Revenues – Expenses = Net Income
We are given information on revenues and expenses (cost of goods sold, operating expenses, interest expense and income taxes) to fill the template given on next slide.

30. Step 1: Picture the Problem (cont.)
Revenues
Less: Cost of goods sold
Equals Gross
profit
Less: Operating expenses
Equals: net
Operating income
Less: Interest expense
Equals: earnings
Before taxes
Less: Income taxes
Equals:
NET INCOME

31. Step 2: Decide on a Solution Strategy
Given the account balances, constructing the income statement will entail substituting the appropriate balances into the template of step 1.

32. Step 3: Solve Equals: profit =$6,201,500,000 Less: Interest expense
Revenues = $14,549,000,000
Less: Cost of goods sold
= $8,347,500,000
Equals: profit
=$6,201,500,000
Less: Operating/other expenses
=$3,841,000,000
Equals: net
Operating income
=$2,370,500,000
Less: Interest expense
=$74,000,000
Equals: earnings
Before taxes
=$2,291,500,000
Less: Income taxes (40%)
=$916,600,000
Equals:
NET INCOME
=$1,374,900,000

33. Step 3: Solve (cont.) Earnings per share:
= net income ÷ number of shares
= $1,374,900,000 ÷ 716,296,296
= $1.92

34. Step 4: Analyze
The firm is profitable since it earned net income of $1,374,900,000. The shareholders were able be earn $1.96 per share.

35. 3.3 Corporate Taxes

36. Corporate Taxes
A firm’s income tax liability is based on its taxable income and the tax rates on corporate income.

37. Computing Taxable Income
The table reveals the following:
Tax rates range from 15% to 39%
Tax rates are progressive i.e. corporations with higher profits tend to pay more taxes.

38. Marginal and Average Tax Rates
Marginal tax rate is the tax rate that the company will pay on its next dollar of taxable income.
Average tax rate is total taxes paid divided by the taxable income.

39. Marginal and Average Tax Rates
Example: What is the average and marginal tax liability for a firm reporting $100,000 as taxable income.

40. Marginal and Average Tax Rates
= Total tax liability ÷ Total taxable income
= $22,250 ÷ $100,000
= 22.25%
Marginal tax rate
= 39% as the firm will have to pay 39% on its next dollar of taxable income i.e. if its taxable income increases from $100,000 to $100,001.

41. Dividend Exclusion for Corporate Shareholders
The dividend received by corporate stockholders are partially exempt from taxation. The rationale is to avoid double taxation at the corporate level. The percentage of exempt taxes is based on the degree of ownership of the firm.

42. Dividend Exclusion for Corporate Shareholders
Example What will be the taxable income if firm A receives $100,000 in dividends from firm B.

43. 3.4 The Balance Sheet

44. The Balance Sheet
The balance sheet provides a snapshot of the firm’s financial position on a specific date. It is defined by the following equation: Total Assets = Total Liabilities + Total Shareholders Equity

45. The Balance Sheet (cont.)
Total liabilities represent the total amount of money the firm owes its creditors
Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.
Total assets, sum of total shareholders’ equity and total liabilities, represents the resources owned by the firm.

46. The Balance Sheet (cont.)
In general, GAAP requires that the firm report assets using the historical costs.
Cash and assets held for sale (such as marketable securities) are an exception to the rule. These assets are reported using the lower of their cost or current market value.

47. The Balance Sheet (cont.)
Assets whose value is expected to decline over time (such as equipment) is reported as “net equipment”(equal to historical cost less the accumulated depreciation). Net value (also known as accounting or book value) could be significantly different from the market value of the asset.

48. Table 3.2 H. J. Boswell, Inc.

49. Table 3.2 H. J. Boswell, Inc. (cont.)

50. Figure 3.1 The Balance Sheet

51. The Balance Sheet (cont.)
The balance sheet includes the following main components:
Assets – It includes current assets and fixed assets.
Liabilities and Stockholders’ Equity – It indicates how the firm finances its assets. It includes current liabilities, long-term liabilities, and owner’s equity.

52. The Balance Sheet (cont.)
Current assets consists of firm’s cash plus other assets the firm expects to convert to cash within 12 months or less, such as receivables and inventory.
Fixed assets are assets that the firm does not expect to sell within one year. For example, plant and equipment, land.

53. The Balance Sheet (cont.)
Current liabilities represent the amount that the firm owes to creditors that must be repaid within a period of 12 months or less such as accounts payable, notes payable.
Long-term liabilities refer to debt with maturities longer than a year such as bank loans, bonds.

54. The Balance Sheet (cont.)
The stockholder’s equity includes the following: Par value of common stock + Paid in Capital + Retained Earnings.
We can also express stockholders’ equity as follows:
Shareholders' equity = Total Assets – Total Liabilities

55. Firm Liquidity and Net Working Capital
Liquidity generally refers to the firm’s ability to covert its current assets into cash so that it can pay its current liabilities on time. We can thus measure a firm’s liquidity by computing its net working capital (equal to current assets less current liabilities).

56. Firm Liquidity and Net Working Capital (cont.)
If a firm’s net working capital is significantly positive, it is in a good position to pay its debts on time and is consequently very liquid.
Lenders consider the net working capital as an important indicator of firm’s ability to repay its loans.

57. CHECKPOINT 3.2: CHECK YOURSELF
Constructing a Balance Sheet
Reconstruct the Gap’s balance sheet to reflect the repayment of $1 billion in short-term debt using a like amount of the firm’s cash. What is the balance for total assets and current liabilities?

58. Step 1: Picture the Problem
The firm’s balance sheet can be expressed as follows:
Total Shareholders’ Equity +
Total Liabilities
= Total Assets

59. Step 1: Picture the Problem (cont.)
Current Assets
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets
Current Liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Long-term (fixed) assets
Gross PPE
Less: Accumulated depreciation
Net property, plant and equip.
Other long-term assets
Total long-term assets
Long-term Liabilities
Long-term debt
Owner’s Equity
Par value of common stock
Paid-in-capital
Retained earnings
Total equity
Total Assets
Total Liabilities and
Owners’ equity

60. Step 2: Decide on a Solution Strategy
We are given the account balances so in order to construct the balance sheet we need to substitute the appropriate balances into the template developed in step 1.

61. Step 3: Solve Cash Inventories Other current assets 885,000,000
1,615,000,000
809,000,000
Current liabilities
1,128,000,000
Total current assets
3,309,000,000
Total current liabilities
Net Property, Plant and equipment
2,523,000,000
Long-term liabilities
2,539,000,000
Other long-term assets
590,000,000
Common Equity
2,755,000,000
Total Assets
$6,422,000,000
Total Liabilities and Equity

62. Step 4: Analyze
We can make the following observations from Gap’s Balance sheet:
The total assets of $6,422,000,000 is financed by a combination of current liabilities, long-term liabilities and owner’s equity. Owner’s equity accounts for $2,755,000,000 of the total.
The firm has a healthy net working capital of $2,181,000,000.

63. Debt and Equity Financing
The right-hand side of the balance sheet reveals the following two sources of money used to finance the purchase of the firm’s assets listed on the left-hand side of the balance sheet.
Borrowings (debt financing)
firms owners (equity financing)

64. Debt versus Equity
Payment: Payment for debt holders is generally fixed (in the form of interest); Payment for equity holders (dividends) is not fixed nor guaranteed.
Seniority: Debt holders are paid before equity holders in the event of bankruptcy.
Maturity: Debt matures after a fixed period while equity securities do not mature.

65. Book Values, Historical Costs, and Market Values
Book values (based on historical cost) reported in the balance sheet can differ from market values. The gap is likely to be higher for fixed assets relative to current assets for two reasons:

66. 3.5 The Cash Flow Statement

67. The Cash Flow Statement
The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash for the period spanned by the statement.

68. Sources and Uses of Cash
A source of cash is any activity that brings cash into the firm. For example, sale of equipment.
A use of cash is any activity that causes cash to leave the firm. For example, payment of taxes.

69. Table 3-3 H. J. Boswell, Inc., Balance Sheets and Balance Sheet Changes

70. Cash Flow Analysis (cont.)
Why did the cash balance decline by $4.50m?. See table 3.1 and table below:
Sources of Cash
Uses of Cash
Increase in Accounts Payable = $4.50
Increase in Accounts Receivable $22.50
Increase in long-term debt =$51.75
Increase in inventory = $148.50
Increase in retained earnings = $159.75
Increase in net plant and equipment = $40.50
Decrease in short-term notes = $9
Total Sources of cash = $216.00
Total Uses of cash = $220.50

71. Cash Flow Analysis (cont.)
An analysis of H.J. Boswell’s operations reveals the following:
The firm used more cash than it generated, resulting in a deficit of $4.5 million
The main source of cash flow was retained earnings ($159.75m) and long-term debt ($51.75m)
The largest use of cash was for acquiring inventory at $148.5 million.

72. Cash Flow Analysis Summary
Sources of Cash
Uses of Cash
Decrease in an asset account
Increase in an asset account
Increase in a liability account
Decrease in a liability account
Increase in an owner’s equity account
Decrease in an owners’ equity account

73. Cash Flow Statement
The basic format for a cash flow statement is as follows: Beginning Cash Balance Plus: Cash Flow from Operating Activities Plus: Cash Flow from Investing Activities Plus: Cash Flow from Financing Activities Equals: Ending Cash Balance

74. Cash Flow Statement (cont.)
Operating activities represent the company’s core business, including sales and expenses.
Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment.

75. Cash Flow Statement (cont.)
Financing activities represent changes in the firm’s use of debt and equity such as issue of new shares, the repurchase of outstanding shares, and the payment of dividends.

76. Table 3-4 H. J. Boswell, Inc.

77. Evaluating the Cash Flow Statement
The statement can be used to answer a number of important questions such as:
How much cash did the firm generate from its operations?
How much did the firm invest in plant and equipment?
Did the firm raise additional funds, and if so, how much and from what sources?
Is the firm able to generate positive cash flows?

78. Quality of Earnings: Evaluating Cash Flow from Operations
Since reported earnings can sometimes be misleading, we can combine information from the firm’s income statement and the statement of cash flows to evaluate the quality of firm’s reported earnings.

79. Quality of Earnings: Evaluating Cash Flow from Operations (cont.)
A ratio of 1.00 indicates very high quality of earnings and that the firm’s operating cash flows and net income are in sync with each other.
A low ratio indicates firm’s reliance on non-operating sources of cash to generate net income that may not be sustainable.

80. Quality of Earnings: Evaluating Cash Flow from Operations (cont.)
The quality of earnings ratio for Boswell for 2013 = $173.25m ÷ $ m = 84.6%
Boswell’s ratio was only 84.6% due to more credit sales than it collected, increase in inventories, non-cash depreciation expense, and increased reliance on accounts payable.

81. Sustainable Capital Expenditures: Evaluating Investment Activities
This ratio calculates the extent to which the firm’s operating cash flows can pay for capital expenditures. Higher ratio will mean less dependence on capital markets for financing.

82. For Boswell, the capital acquisition ratio is:
Sustainable Capital Expenditures: Evaluating Investment Activities (cont.)
For Boswell, the capital acquisition ratio is:
= $157.75m ÷ $159.5m = 98.9%
Boswell was, on average, able to finance 98.9% of its new expenditures out of the firm’s current-year operations.

83. CHECKPOINT 3.3: CHECK YOURSELF
Interpreting the Statement of Cash Flows
Go to and get the cash flow statements for the most recent four-year period for Exco Resources (XCO). How does their cash from investing activities compare to their cash flow from operating activities in 2012.

84. Step 1: Picture the Problem
The cash flow statement identifies the net sources and uses of cash for a specific period of time into 3 groups: operating activities, investing activities, and financing activities.
Here we have to compare the cash flow from operating activities and investment activities in 2012 for Exco Resources (XCO).

85. Step 2: Decide on a Solution Strategy
We can compare the cash flow from operating activities and cash flow from investing activities by retrieving the cash flow statement from

86. Step 3: Solve Cash flow from operating activities
EXCO had a positive cash flow from operating activities of $ million in In 2011, the cash flow from operating activities was much lower at $ million. The primary contributors to the operating cash flows were adjustments to net income.

87. Step 3: Solve (cont.) Cash flow from investing activities:
Cash flow from investing activities were ($426.09) million in EXCO had invested heavily in capital expenditures with a total expense of $ million.

88. Step 4: Analyze
The cash flow statement for 2012 depicts a profitable firm with positive cash flow from operations that have been steadily increasing since In 2010, cash flow from operations were only $ million.
The firm has been aggressively investing in fixed assets. However, it has dropped significantly compared to 2011 ($1,041 million).

89. Key Terms Accounts receivable Accounts payable
Accumulated depreciation
Average tax rate
Balance sheet
Cash flow from operations
Cash flow statement

90. Key Terms (cont.) Cost of goods sold Current assets
Current liabilities
Depreciation expense
Dividends per share
Earnings before interest and taxes (EBIT)
Earnings per share

91. Key Terms (cont.) Fixed assets Gross plant and equipment
Gross profit margin
Income statement
Inventories
Liquidity
Long-term debt

92. Key Terms (cont.) Marginal tax rate Market value Net operating income
Net income
Net plant and equipment
Net profit margin
Net working capital
Notes payable

93. Key Terms (cont.) Operating profit margin Paid-in capital Par value
Profits
Quality of earnings ratio
Retained earnings
Revenues

94. Key Terms (cont.) Source of cash Stockholders’ equity Taxable income
Total assets
Total liabilities
Total shareholders’ equity
Treasury stock
Uses of cash