Chapter3

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  • FIN3000, Liuren Wu
  • FIN3000, Liuren Wu
  • Chapter3

    1. 1. FIN 3000Chapter 3 Financial Statements Liuren Wu
    2. 2. Overview 1. An Overview of the Firm’s Financial Statements 2. The Income Statement 3. Corporate Taxes 4. The Balance Sheet 5. The Cash Flow Statement 2 FIN3000, Liuren Wu
    3. 3. Learning Objectives1. Understand the content of the 4 basic financial statements. Focus on a. Income statement b. Balance sheet statement c. Cash flow statement2. Evaluate firm profitability using the income statement.3. Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate. 3 FIN3000, Liuren Wu
    4. 4. Principles Used in This Chapter Principle 1: Money Has a Time Value.  We need to recognize that financial statements do not adjust for time value of money. Principle 3: Cash Flows Are the Source of Value.  Financial statements provide an important starting point in determining the firm’s cash flow.  We should be able to distinguish between reported earnings and cash flow. It is possible for a firm to report positive earnings but have no cash! Principle 4: Market Prices Reflect Information.  Firm’s financial statements provide important information that is used by investors in forming expectations about firm’s future prospects and subsequently, the market prices. 4 FIN3000, Liuren Wu
    5. 5. Basic Financial Statements Three types of financial statements are mandated by the accounting and financial regulatory authorities: i Income statement – how much money you made last year?  Revenue, expense, profits over a year or quarter. , Balance sheet – What’s your current financial situation? a snap shot on a specific date of  Assets (value of what the firm owns),  Liabilities (value of firm’s debts), and  Shareholder’s equity (the money invested by the company owners) o Cash flow statement – How did the cash come and go? cash received and cash spent by the firm over a period of time 5 FIN3000, Liuren Wu
    6. 6. Why Study Financial Statements? 1. Assess current performance through financial statement analysis  Next chapter provides more tools for the analysis. 2. Monitor and control operations, and  Both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors, investors) use the statements to monitor and control the firm’s operations. 3. Forecast future performance.  Financial planning models are typically built using the financial statements 6 FIN3000, Liuren Wu
    7. 7. Three Accounting Principles The revenue recognition principle: Revenue should be included in the income statement for the period in which:  Its goods and services were exchanged for cash or accounts receivable; or  The firm has completed what it must do to be entitled to the cash.p The matching principle: Expenses are matched with the revenues they helped produce.  For example, employees’ salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid.s The historical cost principle: Most assets and liabilities are reported in the financial statements at historical cost, i.e., the price the firm paid to acquire them. The historical cost generally does not equal the current market value of the assets or liabilities. 7 FIN3000, Liuren Wu
    8. 8. An Income Statement Sales  Minus Cost of Goods Sold = Gross Profit Minus Operating Expenses  Selling expenses  General and Administrative expenses  Depreciation and Amortization Expense = Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT) Minus Income taxes = Net income (EAT) 8 FIN3000, Liuren Wu
    9. 9. Sample Income Statement 9 FIN3000, Liuren Wu
    10. 10. Evaluating a Firm’s EPS We can use the income statement to determine the earnings per share (EPS) and dividends. EPS = Net income/Number of shares outstanding Example 1: A firm reports a net income $90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)? EPS = Net income ÷ Number of shares = $90 million ÷ $35 million = $2.57 10 FIN3000, Liuren Wu
    11. 11. Evaluating a Firm’s Dividends per share Dividends per share = Dividends paid ÷ Number of shares Example 2: A firm reports dividend payment of $20 million on its income statement and has 35 million shares outstanding. What will be the dividends per share? Dividends per share = dividend payment ÷ Number of shares = $20 million ÷ $35 million = $0.57 11 FIN3000, Liuren Wu
    12. 12. Connecting the Income Statement andthe Balance Sheet What can the firm do with the net income?: 1. Pay dividends to shareholders, and/or 2. Reinvest in the firm Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm? Amount retained = Net Income – Dividends = $90m - $20m = $70m The firm’s balance on retained earnings will increase by $70 million on the balance sheet. 12 FIN3000, Liuren Wu
    13. 13. Interpreting Firm Profitability using theIncome Statement What can we learn from Boswell Inc.’s income statement? n The firm has been profitable as its revenues exceeded its expenses. n 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. 13 FIN3000, Liuren Wu
    14. 14. Interpreting Firm Profitability using theIncome Statement (cont.)1. The operating profit margin = net operating income (EBIT)÷ sales = $382.5 million ÷ $2,700 million = 14.17%t Net profit margin: = net profits (Net income) ÷ sales = $204.75 million ÷ $2,700 million = 7.58%These profit margins (gross profit margin, operating profit margin, and net profit margin) should be closely monitored and compared to previous years and those of competing firms. 14 FIN3000, Liuren Wu
    15. 15. GAAP and Earnings Management While the firms must adhere to set of accounting principles, GAAP (Generally Accepted Accounting Principles), there is considerable room for managers to influence the firm’s reported earnings. Managers have an incentive to tamper with reported earnings as their pay depends upon it and investors care about it. 15 FIN3000, Liuren Wu
    16. 16. Checkpoint 3.1Constructing an Income StatementUse the following information to construct an income statement for Gap, Inc.(GPS). The Gap is a specialty retailing company that sells clothing, accessories,and personal care products under the Gap, Old Navy, Banana Republic,Piperlime, and Athleta brand names. Use the scrambled information below tocalculate the firm’s gross profits, operating income, and net income for theyear ended January 31, 2009. Calculate the firm’s earnings per share anddividends per share. 16 FIN3000, Liuren Wu
    17. 17. 17 FIN3000, Liuren Wu
    18. 18. 18 FIN3000, Liuren Wu
    19. 19. Checkpoint 3.1: Check YourselfReconstruct the Gap’s income statement assuming the firm is able tocut its cost of goods sold by 10% and the firm pays taxes at 40% taxrate. What is the firm’s net income and earnings per share? 19 FIN3000, Liuren Wu
    20. 20. Step 1: Picture the Problem 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 20 FIN3000, Liuren Wu
    21. 21. Step 2: Decide on a SolutionStrategy Given the account balances, constructing the income statement will entail substituting the appropriate balances into the template of step 1. 21 FIN3000, Liuren Wu
    22. 22. Step 3: Solve Revenues = $14,526,000,000 Less: Cost of goods sold = $8,171,100,000 Equals: profit =$6,354,900,000 Less: Operating expenses =$3,899,000,000 Equals: net Operating income =$2,455,900,000 Less: Interest expense =$1,000,000 Equals: earnings Before taxes =$2,454,900,000 Less: Income taxes (40%) =$9,819,600,000 Equals: NET INCOME =$1,472,940,000 22 FIN3000, Liuren Wu
    23. 23. Step 3: EPS and dividends per share Earnings per share: = net income ÷ number of shares = $1,472,940,000 ÷ 716,296,296 = $2.06 Dividends per share = dividends ÷ number of shares = $243,000,000 ÷ 716,296,296 = $0.34 23 FIN3000, Liuren Wu
    24. 24. Step 4: Analyze The firm is profitable since it earned net income of $1,472,940,000. The shareholders were able be earn $2.06 per share. However, the dividends per share were only $0.34 indicating that the difference of $1.72 was reinvested in the corporation. Compute gross profit margin, operating profit margin, and net profit margin. 24 FIN3000, Liuren Wu
    25. 25. Corporate Taxes A firm’s income tax liability is calculated using its taxable income and the tax rates on corporate income. 25 FIN3000, Liuren Wu
    26. 26. Corporate tax rates The table reveals the following:  Tax rates range from 15% to 39%  Tax rates are progressive i.e. larger corporations with higher profits will tend to pay more taxes compared to smaller firms with lower profits.  Note: In addition to federal taxes, a firm may face State and City taxes. 26 FIN3000, Liuren Wu
    27. 27. Marginal and Average Tax Rates While analyzing the tax consequences of a new business venture, the appropriate tax rate is the marginal tax rate. 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. 27 FIN3000, Liuren Wu
    28. 28. Marginal and Average Tax Rates Example 3: What is the average and marginal tax liability for a firm reporting $100,000 as taxable income. 28 FIN3000, Liuren Wu
    29. 29. Marginal and Average Tax Rates Average tax rate = 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. 29 FIN3000, Liuren Wu
    30. 30. The Balance Sheet The balance sheet provides a snapshot of the firm’s financial position on a specific date. It is defined by: Total Assets = Total Liabilities + Total Shareholder’s Equity (asset) = (sources of funding)  Total assets represents the resources owned by the firm.  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. 30 FIN3000, Liuren Wu
    31. 31. Asset value calculation In general, GAAP requires that the firm report assets on its balance sheet 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. Assets whose value is expected to decline over time (such as equipment) is reported as “net equipment” which is equal to the historical cost minus accumulated depreciation. The net value reported on balance sheet could be significantly different from the market value of the asset. 31 FIN3000, Liuren Wu
    32. 32. 32 FIN3000, Liuren Wu
    33. 33. Assets and liabilities 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. 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. 33 FIN3000, Liuren Wu
    34. 34. The stockholder’s equityTwo components:s The amount the company received from selling stock to investors. It may be shown as common stock in the balance sheet or it may be divided into two components: par value and additional paid in capital above par. Par value is the stated or face value a firm puts on each share of stock. Paid in capital is the additional amount the firm raised when it sold the shares. For example, DLK corporation’s par value per share is $2.00 and the firm has 30 million shares outstanding such that the par value of the firm’s common equity is $60 million. If the stocks were issued to investors for $240 million, $180 million represents paid in capital.’ The amount of the firm’s retained earnings: the portion of net income that has been retained (i.e., not paid in dividends) from prior years operations. 34 FIN3000, Liuren Wu
    35. 35. Firm Liquidity and Net Working Capital Liquidity refers to the speed with which the asset can be converted to cash without loss of value. For example, a firm’s bank account is perfectly liquid. Other types of assets are less liquid as they more difficult to sell and convert to cash such as PPE (property, plant and equipment). For the overall firm, liquidity generally refers to the firm’s ability to covert its current assets (accounts receivable and inventories) into cash so that it can pay its bills (current liabilities) on time. We can thus measure a firm’s liquidity by computing the net working capital = current assets – current liabilities. 35 FIN3000, Liuren Wu
    36. 36. Firm Liquidity and Net Working Capital 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. 36 FIN3000, Liuren Wu
    37. 37. 37 FIN3000, Liuren Wu
    38. 38. Checkpoint 3.2Constructing a Balance SheetConstruct a balance sheet for Gap, Inc. (GPS) using the following list ofjumbled accounts for January 31, 2009. Identify the firm’s total assets and networking capital: 38 FIN3000, Liuren Wu
    39. 39. 39 FIN3000, Liuren Wu
    40. 40. 40 FIN3000, Liuren Wu
    41. 41. Step 4: Analyze The firm has invested a total of $7.564B in assets, funded by $2.158B current liability, $1.019B long-term liability, and $4.387B owner equity. The firm has $4.005B in current assets and $2.158B in current liability, leaving the firm with a net working capital of $4.005-2.158-1.847B. 41 FIN3000, Liuren Wu
    42. 42. Checkpoint 3.2: Check YourselfReconstruct the Gap’s balance sheet to reflect the repayment of $1billion in short-term debt using a like amount of the firm’s cash. Whatis the balance for total assets and current liabilities? 42 FIN3000, Liuren Wu
    43. 43. Step 1: Picture the Problem Current Assets Current Liabilities Cash Accounts payable Accounts Receivable Short-term debt Inventories Other current liabilities Other current assets Total current assets Total current liabilities Long-term (fixed) assets Long-term Liabilities Gross PPE Long-term debt Less: Accumulated depreciation Net property, plant and equip. Owner’s Equity Par value of common stock Other long-term assets Paid-in-capital Retained earnings Total long-term assets Total equity Total Assets Total Liabilities and Owners’ equity 43 FIN3000, Liuren Wu
    44. 44. Step 2: Decide on a SolutionStrategy 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. Deduct $1B from both cash and current liability. 44 FIN3000, Liuren Wu
    45. 45. Step 3: SolveCash 756,000,000 Current liabilities 1,158,000,000Inventories 1,506,000,000Other current 743,000,000assetsTotal current 3,005,000,000 Total current 1,158,000,000assets liabilitiesNet Property, 2,993,000,000 Long-term 1,019,000,000Plant and liabilitiesequipmentOther long-term 626,000,000 Common Equity 4,387,000,000assetsTotal Assets $6,564,000,00 Total Liabilities $6,564,000,00 0 and Equity 0 45 FIN3000, Liuren Wu
    46. 46. Step 4: Analyze We can make the following observations from Gap’s Balance sheet:  The total assets of $6,564,000,000 is financed by a combination of current liabilities, long-term liabilities and owner’s equity. Owner’s equity accounts for $4,387,000,000 of the total.  The firm has a healthy net working capital of $1,847,000,000 (3,005,000,000 minus 1,158,000,000). 46 FIN3000, Liuren Wu
    47. 47. Debt versus Equity Financing The right-hand side of the balance sheet reveals the sources of money used to finance the purchase of the firm’s assets listed on the left-hand side of the balance sheet. It shows how much was borrowed (debt financing) and how much was provided by firm’s owners (equity financing, through the sale of equity or retention of prior year’s earnings).  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. 47 FIN3000, Liuren Wu
    48. 48. 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.  Source of cash is any activity that brings cash into the firm. For example, sale of equipment.  Use of cash is any activity that causes cash to leave the firm. For example, payment of taxes. 48 FIN3000, Liuren Wu
    49. 49. 49 FIN3000, Liuren Wu
    50. 50. Cash Flow Analysis Why did the cash balance decline by $4.5 million from 2009 to 2010? Accounts receivable increased by $22.5 million representing an increase in uncollected cash from credit sales. It represents $22.5m of use of cash to invest in accounts receivable. o Inventory increased by $148.50 million indicating use of cash to procure inventory. y Equipment increased by $175.50 million indicating use of cash to invest in equipment.In general,  an increase in an asset account = use of cash  a decrease in an asset account = source of cash 50 FIN3000, Liuren Wu
    51. 51. Cash Flow Analysis (cont.)1. Accounts Payable, credit extended to the firm, increased by $4.5million. Thus source of cash increased by $4.5million due to accounts payable.2. Long-term debt increased by $51.75 million indicating a source of cash.3. Short-term debt decreased by $9 million indicating use of cash to pay off the debt.4. Retained earnings increased by $159.75 million representing a source of cash to the firm from the firm’s operations. In general, An increase in a liability account = source of cash A decrease in a liability account = use of cash 51 FIN3000, Liuren Wu
    52. 52. Cash Flow Analysis (cont.) Change in cash balance = Sources of cash – Use of Cash = $216 - $220.50 = -$4.50 Sources of Cash Uses of Cash Increase in Accounts Payable Increase in Accounts Receivable = $4.50 $22.50 Increase in long-term debt Increase in inventory = =$51.75 $148.50 Increase in retained earnings = Increase in net plant and $159.75 equipment = $40.50 Decrease in short-term notes = $9 Total Sources of cash = Total Uses of cash = $220.50 $216.00 52 FIN3000, Liuren Wu
    53. 53. Cash Flow Analysis (cont.) An analysis of H.J. Boswell’s operations reveals the following for 2010:  The firm used more cash than it generated, resulting in a deficit of $4.5 million  The primary source of cash flow was retained earnings ($159.75 million) followed by long-term debt ($51.75 million)  The largest use of cash was for acquiring inventory at $148.5 million. 53 FIN3000, Liuren Wu
    54. 54. Cash Flow Analysis Summary Sources of Cash Uses of CashDecrease in an asset Increase in an assetaccount accountIncrease in a liability Decrease in a liabilityaccount accountIncrease in an owner’s Decrease in an owners’equity account equity account 54 FIN3000, Liuren Wu
    55. 55. Cash Flow Statement The format for a traditional 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 Operating activities represent the company’s core business including sales and expenses. Basically any activity that affects net income for the period. Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment. Financing activities represent changes in the firm’s use of debt and equity such as issue of new shares, payment of dividends. 55 FIN3000, Liuren Wu
    56. 56. 56 FIN3000, Liuren Wu
    57. 57. Checkpoint 3.3:Interpreting the Statement of Cash FlowChesapeake Energy Inc. (CHK) is the largest producer of natural gas inthe United States and is headquartered in Oklahoma City. The firm’scash flow statements for 2004 through 2007: 57 FIN3000, Liuren Wu
    58. 58. Analyze Chesapeake has had positive & growing cash flows from operations in all 4 years.  The primary contributor were the firm’s net income and depreciation expense.  Working capital is a source of cash in 3 out of 4 years, indicating the net reduction in the firm’s investment in working capital. Chesapeake has been very aggressive in new fixed assets and acquisitions of new oil and gas properties. Total investments have been roughly two times the cash flow from operation, which meant that the firm had to raise a substantial amount of money. Chesapeake has been a regular issuer of both equity and debt. $13.5 billion was raised in the 4-year period. Chesapeake has made relatively modest modest cash distributions and retained most earnings. 58 FIN3000, Liuren Wu
    59. 59. Checkpoint 3.3: Check YourselfGo to http:finance.google.com/finance and get the cashflow statements for the most recent four-year period forExco Resources (XCO). How does their cash from investingactivities compare to their cash flow from operatingactivities in 2009. 59 FIN3000, Liuren Wu
    60. 60. Step 1: Picture the Problem The cash flow statement uses information from the firm’s balance sheet and income statement to identify the net sources and uses of cash for a specific period of time. The sources and uses of cash are organized into cash from operating activities, investing activities, and financing activities. 60 FIN3000, Liuren Wu
    61. 61. Step 1: Picture the Problem (cont.) The format for a traditional 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 61 FIN3000, Liuren Wu
    62. 62. Step 1: Picture the Problem (cont.) Here we have to compare the cash flow from operating activities and investment activities in 2007 for Exco Resources (XCO). 62 FIN3000, Liuren Wu
    63. 63. Step 2: Decide on a SolutionStrategy We can compare the cash flow from operating activities and cash flow from investing activities by looking at the cash flow statement. The cash flow statement can be retrieved from http:// finance.google.com/finance 63 FIN3000, Liuren Wu
    64. 64. Step 3: Solve Cash flow from operating activities  EXCO had a positive cash flow from operating activities of $577.83 million in 2007. In 2006, the cash flow from operating activities was much lower at $227.86.  The primary contributors to the operating cash flows in 2007 were the firm’s depreciation/depletion expense and non-cash expense. Net working capital is a use of cash. 64 FIN3000, Liuren Wu
    65. 65. Step 3: Solve (cont.) Cash flow from investing activities:  Cash flow from investing activities were ($2,396.44) million in 2007.  EXCO had invested heavily in capital expenditures in 2007 with a total expense of $2,846.97 million. 65 FIN3000, Liuren Wu
    66. 66. Step 4: Analyze The cash flow statement for 2007 depicts a profitable firm with positive cash flow from operations. The firm has been aggressively investing in fixed assets to the tune of almost 4 times its operating cash flows. The firm has been able to successfully raise money from capital markets by issuing stocks of nearly $2,000 million. 66 FIN3000, Liuren Wu

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