1. 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

2. 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
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3. 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
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4. Basic Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
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5. 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
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6. 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
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7. 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
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8. Starbucks Corporation Income Statement 2003 ($M)
Sales $4,076
Cost of Goods Sold ,207
Gross Profit $ 869
Operating Expenses
Marketing expenses and general and
Administrative expenses $227
Depreciation Expense
Total Operating Expenses $ 433
Operating Profits $ 436
Interest Expense
Earnings before taxes $ 433
Income taxes
Net income $ 268
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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14. 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
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15. 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
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16. 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.
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17. 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)
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18. Traditional Statement of Cash Flows
Three sections:
Cash flows from Operating Activities
Cash flows from Investing Activities
Cash flows from Financing Activities
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19. After-Tax Cash Flows From Operations
Operating Income (EBIT)
+ Depreciation
- Income tax expense
= After-tax cash flows from operations
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20. Change in Operating Working Capital
(change in current assets) -
(change in current liabilities)
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21. Compute the Change in Fixed Assets
The final step involves computing the change in Gross Fixed Assets (not net Fixed Assets)
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22. 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
Total investments $ 570
Free cash flows $ (93)
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23. 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
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