Understanding financial statement + cash flow
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This chapter discusses key financial statements - the income statement, balance sheet, and statement of cash flows. The income statement shows a company's profits over a period of time. The balance sheet provides a snapshot of a company's financial position at a point in time by listing assets, liabilities, and equity. The statement of cash flows measures a company's free cash flows by tracking cash from operations, investing, and financing activities. Free cash flow is an important measure because cash, not profits, is what matters most to investors.
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Understanding financial statement + cash flow
- 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. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 2 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.
- 3. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 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
- 4. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 4 Basic Financial Statements • Income Statement • Balance Sheet • Statement of Cash Flows
- 5. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 5 Income Statement • Profit/Loss Statement • Indicates the amount of profits generated by a firm over a given period of time • Sales – Expenses = Profit
- 6. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 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
- 7. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 7 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
- 8. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 8 Starbucks Corporation Income Statement 2003 ($M) Sales $4,076 Cost of Goods Sold 3,207 Gross Profit $ 869 Operating Expenses Marketing expenses and general and Administrative expenses $227 Depreciation Expense 206 Total Operating Expenses $ 433 Operating Profits $ 436 Interest Expense 3 Earnings before taxes $ 433 Income taxes 165 Net income $ 268
- 9. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 9 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
- 10. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 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
- 11. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 11 • 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 Balance Sheet Terminology
- 12. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 12 • 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 Balance Sheet Terminology
- 13. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 13 • 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 Balance Sheet Terminology
- 14. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 14 • 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 Balance Sheet Terminology
- 15. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 15 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
- 16. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 16 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.
- 17. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 17 Free Cash Flows Free cash flows: (After-tax cashflows from operations) Less (Increase or decrease in net working capital) Less (Increase or decrease in gross fixed assets)
- 18. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 18 Traditional Statement of Cash Flows • Three sections: – Cash flows from Operating Activities – Cash flows from Investing Activities – Cash flows from Financing Activities
- 19. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 19 After-Tax Cash Flows From Operations Operating Income (EBIT) + Depreciation - Income tax expense = After-tax cash flows from operations
- 20. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 20 Change in Operating Working Capital Change in operating working capital = (change in current assets) - (change in current liabilities)
- 21. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 21 Compute the Change in Fixed Assets • The final step involves computing the change in Gross Fixed Assets (not net Fixed Assets)
- 22. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 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. Chapter 3 Understanding Financial Statements and Cash Flows Pearson Prentice HallFoundations of Finance3 - 23 Financing Cash Flows A firm can either receive money from or distribute money to its investors. The firm can: 1. Pay interest to lenders 2. Pay dividends to stockholders 3. Increase or decrease in long-term debt 4. Issue stock to new shareholders or repurchase stock from current shareholders