Chapter 3


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Chapter 3

  1. 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.
  2. 2. Chapter Objectives <ul><li>Compute a company’s profits as reflected by an income statement. </li></ul><ul><li>Determine a firm’s accounting book value, as presented in a balance sheet. </li></ul><ul><li>Measure a company’s free cash flows. </li></ul>
  3. 3. Principles Used in this Chapter <ul><li>Principle 3 : Cash-Not Profits-Is King </li></ul><ul><li>Principle 7 : Managers Won’t Work for the Owners Unless It’s in Their Best Interest </li></ul>
  4. 4. Basic Financial Statements <ul><li>Income Statement </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Statement of Cash Flows </li></ul>
  5. 5. Income Statement <ul><li>Profit/Loss Statement </li></ul><ul><li>Indicates the amount of profits generated by a firm over a given period of time </li></ul><ul><li>Sales – Expenses = Profit </li></ul>
  6. 6. Income Statement Terminology <ul><li>Revenue (Sales) </li></ul><ul><ul><li>Money derived from selling the company’s product or service </li></ul></ul><ul><li>Cost of Goods Sold (COGS) </li></ul><ul><ul><li>The cost of producing or acquiring the goods or services to be sold </li></ul></ul><ul><li>Operating Expenses </li></ul><ul><ul><li>Expenses related to marketing and distributing the product or service and administering the business </li></ul></ul><ul><li>Financing Costs </li></ul><ul><ul><li>The interest paid to creditors and the dividends paid to preferred stockholders </li></ul></ul><ul><li>Tax Expenses </li></ul><ul><ul><li>Amount of taxes owed, based upon taxable income </li></ul></ul>
  7. 7. Income Statement <ul><li>Sales </li></ul><ul><li>Less cost of goods sold </li></ul><ul><li>= Gross profit </li></ul><ul><li>Less operating expenses </li></ul><ul><li>= Operating income </li></ul><ul><li>Less interest expense </li></ul><ul><li>= Earnings before taxes </li></ul><ul><li>Less corporate taxes </li></ul><ul><li>= Earnings before preferred dividends </li></ul><ul><li>Less preferred stock dividends </li></ul><ul><li>= Net income available to common stockholders </li></ul>
  8. 8. Starbucks Corporation Income Statement 2003 ($M) <ul><li>Sales $4,076 </li></ul><ul><li>Cost of Goods Sold 3,207 </li></ul><ul><li>Gross Profit $ 869 </li></ul><ul><li>Operating Expenses </li></ul><ul><ul><li>Marketing expenses and general and </li></ul></ul><ul><ul><li>Administrative expenses $227 </li></ul></ul><ul><ul><li>Depreciation Expense 206 </li></ul></ul><ul><li>Total Operating Expenses $ 433 </li></ul><ul><li>Operating Profits $ 436 </li></ul><ul><li>Interest Expense 3 </li></ul><ul><li>Earnings before taxes $ 433 </li></ul><ul><li>Income taxes 165 </li></ul><ul><li>Net income $ 268 </li></ul>
  9. 9. Balance Sheet <ul><li>Provides a firm’s financial position at a specific point in time </li></ul><ul><li>Assets are resources owned by the firm </li></ul><ul><li>Liabilities and owner’s equity indicate how those resources are financed </li></ul><ul><li>Total Assets = </li></ul><ul><li>Liabilities (debt) + Shareholder’s Equity </li></ul><ul><li>Or…A= L+OE </li></ul>
  10. 10. Balance Sheet Terminology <ul><li>Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. </li></ul><ul><li>Current assets typically include: </li></ul><ul><ul><li>Cash </li></ul></ul><ul><ul><li>Accounts Receivable </li></ul></ul><ul><ul><ul><li>payments due from customers who buy on credit </li></ul></ul></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><ul><li>raw materials, work in process, and finished goods held for eventual sale </li></ul></ul></ul><ul><ul><li>Other expenses </li></ul></ul><ul><ul><ul><li>Prepaid expenses are those items paid for in advance </li></ul></ul></ul>
  11. 11. <ul><li>Fixed Assets – Assets held for more than one year. Typically Include: </li></ul><ul><ul><li>Machinery and equipment </li></ul></ul><ul><ul><li>Buildings </li></ul></ul><ul><ul><li>Land </li></ul></ul><ul><li>Other Assets – Assets that are not current assets or fixed assets </li></ul><ul><ul><li>Patents </li></ul></ul><ul><ul><li>Copyrights </li></ul></ul><ul><ul><li>Goodwill </li></ul></ul>Balance Sheet Terminology
  12. 12. <ul><li>Debt (Liabilities) </li></ul><ul><ul><li>Money that has been borrowed and must be repaid at some predetermined date </li></ul></ul><ul><ul><li>Debt Capital </li></ul></ul><ul><ul><ul><li>financing provided by a creditor </li></ul></ul></ul><ul><ul><ul><li>Current or short-term debt and long-term debt </li></ul></ul></ul><ul><ul><ul><li>Current or short-term must be repaid within the next 12 months </li></ul></ul></ul>Balance Sheet Terminology
  13. 13. <ul><li>Current Liabilities : </li></ul><ul><ul><li>Accounts payable </li></ul></ul><ul><ul><ul><li>Credit extended by suppliers to a firm when it purchases inventories </li></ul></ul></ul><ul><ul><li>Accrued expenses </li></ul></ul><ul><ul><ul><li>Short term liabilities incurred in the firm’s operations but not yet paid for </li></ul></ul></ul><ul><ul><li>Short-term notes </li></ul></ul><ul><ul><ul><li>Borrowings from a bank or lending institution due and payable within 12 months </li></ul></ul></ul><ul><li>Long-Term Debt </li></ul><ul><ul><li>Loans from banks or other institutions for longer than 12 months </li></ul></ul>Balance Sheet Terminology
  14. 14. <ul><li>Equity </li></ul><ul><li>Includes the shareholder’s investment </li></ul><ul><ul><li>Preferred stock </li></ul></ul><ul><ul><li>Common stock </li></ul></ul><ul><li>Treasury Stock </li></ul><ul><ul><li>stock that was once outstanding and has been re-purchased by the company </li></ul></ul><ul><li>Retained Earnings </li></ul><ul><ul><li>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 </li></ul></ul>Balance Sheet Terminology
  15. 15. Balance Sheet <ul><li>ASSETS </li></ul><ul><ul><li>Current Assets </li></ul></ul><ul><ul><li>Fixed Assets </li></ul></ul><ul><li>Total Assets </li></ul><ul><li>LIABILITIES </li></ul><ul><ul><li>Current Liabilities </li></ul></ul><ul><ul><li>Long-Term Liabilities </li></ul></ul><ul><li>Total Liabilities </li></ul><ul><li>OWNER’S EQUITY </li></ul><ul><ul><li>Preferred Stock </li></ul></ul><ul><ul><li>Common Stock </li></ul></ul><ul><ul><li>Retained earnings </li></ul></ul><ul><li>Total Owner’s Equity </li></ul><ul><li>Total liabilities + OE </li></ul>
  16. 16. Terms <ul><li>Net Working Capital </li></ul><ul><ul><li>Current assets – current liabilities </li></ul></ul><ul><li>Debt Ratio </li></ul><ul><ul><li>Percentage of debt a firm uses to finance its assets </li></ul></ul><ul><li>Accrual Basis Accounting </li></ul><ul><ul><li>Recording revenues when earned and expenses when incurred, rather than when cash is exchanged </li></ul></ul><ul><li>Free Cash Flows </li></ul><ul><ul><li>Cash flow that is free and available to be distributed to the firm’s investors. </li></ul></ul>
  17. 17. Free Cash Flows <ul><li>Free cash flows: </li></ul><ul><li>(After-tax cashflows from operations) </li></ul><ul><li>Less </li></ul><ul><li>(Increase or decrease in net working capital) </li></ul><ul><li>Less </li></ul><ul><li>(Increase or decrease in gross fixed assets) </li></ul>
  18. 18. Traditional Statement of Cash Flows <ul><li>Three sections : </li></ul><ul><ul><li>Cash flows from Operating Activities </li></ul></ul><ul><ul><li>Cash flows from Investing Activities </li></ul></ul><ul><ul><li>Cash flows from Financing Activities </li></ul></ul>
  19. 19. After-Tax Cash Flows From Operations <ul><li>Operating Income (EBIT) </li></ul><ul><li>+ Depreciation </li></ul><ul><li>- Income tax expense </li></ul><ul><li>= After-tax cash flows from operations </li></ul>
  20. 20. Change in Operating Working Capital <ul><li>Change in operating working capital = </li></ul><ul><li>(change in current assets) - </li></ul><ul><li>(change in current liabilities) </li></ul>
  21. 21. Compute the Change in Fixed Assets <ul><li>The final step involves computing the change in Gross Fixed Assets (not net Fixed Assets) </li></ul>
  22. 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 566 Total investments $ 570 Free cash flows $ (93)
  23. 23. Financing Cash Flows <ul><li>A firm can either receive money from or distribute money to its investors. The firm can: </li></ul><ul><li>Pay interest to lenders </li></ul><ul><li>Pay dividends to stockholders </li></ul><ul><li>Increase or decrease in long-term debt </li></ul><ul><li>Issue stock to new shareholders or repurchase stock from current shareholders </li></ul>