Chapter3

FIN 3000

Chapter 3
Financial Statements

Liuren Wu

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

Learning Objectives

1. Understand the content of the 4 basic financial
statements. Focus on
a. Income statement
b. Balance sheet statement
c. Cash flow statement

2. 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.


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.


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


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


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.


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)


Sample Income Statement


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


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


Connecting the Income Statement and
the 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.


Interpreting Firm Profitability using the
Income 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.


Interpreting Firm Profitability using the
Income 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.


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.


Checkpoint 3.1
Constructing an Income Statement

Use 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 to
calculate the firm’s gross profits, operating income, and net income for the
year ended January 31, 2009. Calculate the firm’s earnings per share and
dividends per share.


Checkpoint 3.1: Check Yourself

Reconstruct the Gap’s income statement assuming the firm is able to
cut its cost of goods sold by 10% and the firm pays taxes at 40% tax
rate. What is the firm’s net income and earnings per share?


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


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.


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

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


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.


Corporate Taxes
 A firm’s income tax liability is calculated using its taxable
income and the tax rates on corporate income.


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.


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.


 Example 3: What is the average and marginal tax liability for a
firm reporting $100,000 as taxable income.


 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.


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.


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.


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.


The stockholder’s equity

Two 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.


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.


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.


Checkpoint 3.2

Constructing a Balance Sheet
Construct a balance sheet for Gap, Inc. (GPS) using the following list of
jumbled accounts for January 31, 2009. Identify the firm’s total assets and net
working capital:


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.



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?


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


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.

 Deduct $1B from both cash and current liability.


Step 3: Solve
Cash 756,000,000 Current liabilities 1,158,000,000
Inventories 1,506,000,000
Other current 743,000,000
assets
Total current 3,005,000,000 Total current 1,158,000,000
assets liabilities
Net Property, 2,993,000,000 Long-term 1,019,000,000
Plant and liabilities
equipment
Other long-term 626,000,000 Common Equity 4,387,000,000
assets
Total Assets $6,564,000,00 Total Liabilities $6,564,000,00
0 and Equity 0


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).


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.


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.


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


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


 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


 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.


Cash Flow Analysis Summary
Sources of Cash Uses of Cash

Decrease in an asset Increase in an asset
account account
Increase in a liability Decrease in a liability
account account
Increase in an owner’s Decrease in an owners’
equity account equity account


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.


Checkpoint 3.3:
Interpreting the Statement of Cash Flow
Chesapeake Energy Inc. (CHK) is the largest producer of natural gas in
the United States and is headquartered in Oklahoma City. The firm’s
cash flow statements for 2004 through 2007:


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.



Go to http:finance.google.com/finance 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 2009.


 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.


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


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).


Strategy
 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


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.


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.


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.


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