Financial Statements

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Financial Statements

• Chapter 2

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After studying this chapter you should be able to

• Read a basic balance sheet
• Distinguish between book value and market value
• Prepare a simple income statement
• Know the difference between accounting income and
  cash flow
• Distinguish between average and marginal tax
  rates
• Calculate a firms cash flow from its financial
  statements

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Balance Sheet

• The balance sheet is a snapshot of the firms
  assets and liabilities at a given point in time
• Assets are listed in order of liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Equation
• Assets Liabilities Stockholders Equity

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Figure 2.1
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U.S. Corp Balance Sheet Table 2.1
Back to Cash Flow
CF to Stock holders
CF to Creditors
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Net Working Capital (NWC)

• NWC current assets current liabilities
• A positive NWC means that more cash will be made
  available from assets than is required to cover
  liabilities
• Also represents the amount of current assets not
  financed by current liabilities
• Must be financed with long-term debt and equity
• US Corps. NWC?
• NWC(2003) 1403 389 1014

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Market Value vs. Book Value

• The balance sheet provides the book value of the
  assets, liabilities and equity.
• Market value is the price at which the assets,
  liabilities or equity can actually be bought or
  sold.
• Market value and book value are often very
  different. Why?
• Which is more important to the decision-making
  process?

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Income Statement

• The income statement is more like a video of the
  firms operations for a specified period of time.
• You generally report revenues first and then
  deduct any expenses for the period
• Matching principle GAAP say to show revenue
  when it accrues and match the expenses required
  to generate the revenue

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Table 2.2
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Work the Web Example

• Publicly traded companies must file regular
  reports with the Securities and Exchange
  Commission
• These reports are usually filed electronically
  and can be searched at the SEC public site called
  EDGAR
• Click on the web surfer, pick a company and see
  what you can find!

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Income vs. Cash Flow

• We will discover later that the value of a firm
  is determined by its cash flow.
• US Corp.
• 2003 Income 412
• 2003 Change in Cash (Cash Flow) 56
• Why the difference????
• In order to generate this income the firm had to
  invest in NWC and Fixed Assets
• The firm paid 103 in dividends

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Other differences between income and cash flow

• Accrual accounting
• Sales are recorded when made not collected
• This has led to some major revisions in income
  for some companies
• Costs are reported at sale not when paid
• Non cash expenses
• We account for depreciation as an expense on the
  income statement.
• There is no direct cash flow from depreciation

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Operating Cash Flow A quick and dirty estimate
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• Sources and Uses of Cash

USE
SOURCE
USE
SOURCE
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Cash Flow (Mgmt Approach)

• No Brainer I
• Dollars In
• -Dollars Out
• Cash Flow
• No Brainer II
• Assets Liabilities Equity

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The Managerial Approach to Cash Flow

• CF from Assets CF to Creditors CF to
  Stockholders

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Cash Flow From Assets

• Cash Flow from Assets
• Operating CF
• (Net) Capital Spending
• Additions to Net Working Capital (NWC)

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Cash Flow to Creditors Stockholders

• CF (Creditors)
• Interest Paid
• - Net new Borrowings
• CF (Stockholders)
• Dividends paid
• - Net New Equity Raised

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Example US Corp.

• CF from Assets CF to Creditors CF to Stock
• CF from assets
• Operating cash flow

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• Capital Spending

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• Additions to Net Working Capital

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• Cash Flow From Assets

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• CF to Creditors

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• CF to Stockholders

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Taxes

• Corporate Income Taxes

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• Marginal vs. Average Tax Rates
• Average Tax Rate Your tax bill divided by
  taxable income
• Marginal Tax Rate the amount you pay on the
  next dollar of taxable income.
• Example Alegron Inc., has a taxable income of
  85,000. What is Alegrons average tax rate?
  Its Marginal Tax Rate?

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• Taxes Due

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Quick Quiz

• What is the difference between book value and
  market value? Which should we use for decision
  making purposes?
• What is the difference between accounting income
  and cash flow? Which do we need to use when
  making decisions?
• What is the difference between average and
  marginal tax rates? Which should we use when
  making financial decisions?
• How do we determine a firms cash flows? What
  are the equations and where do we find the
  information?

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• The company doubled its plant capacity, opened
  new sales offices outside its home territory, and
  launched an expensive advertising campaign.
  Similar to Bordens situation, DLeons results
  were not satisfactory, to put it mildly. Its
  board of directors, which consisted of its
  president and vice-president plus its major
  stockholders (who were all local business people)
  was most upset when directors learned how the
  expansion was going. Suppliers were being paid
  late and were unhappy, and the bank was
  complaining about the deteriorating situation and
  threatening to cut off credit. As a result,
  President Watkins was informed that changes would
  have to be made, and quickly, or he would be
  fired. Also, at the boards insistence Donna
  Jamison was brought in and given the job of
  assistant to Fred Campo, a retired banker who was
  DLeons chairman and largest stockholder. Campo
  agreed to give up a few of his golfing days and
  to help nurse the company back to health, with
  Jamisons help.
•  
• Jamison began by gathering the financial
  statements and other data given in Tables C2-1,
  C2-2, and C2-3. Assume that you are Jamisons
  assistant, and you must help her answer the
  following questions for Campo.

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Balance Sheet
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Income Statement
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Questions

• Referring to the Financial Statements, what
  happened to DLeons cash reserves? What caused
  this?
• DLeon purchases supplies on 30-day terms,
  meaning they are supposed to pay suppliers within
  30 days. Do you think they do?
• DLeon spends money for labor, materials and
  fixed assets to make products. Does it appear
  that sales prices cover expenses. 

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Cont.

• Suppose that the sales manager told the sales
  staff to start offering 60-day credit terms
  instead of 30-days. If competitors reacted with
  the same terms and DLeons sales remain the
  same. What effect would this have on the cash
  account of DLeon?
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• How does it appear that DLeon financed its
  expansion. Did they use internal funds or
  external funds?
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• DLeons stock sells for 2.25 per share even
  though the company had large losses. Does the
  positive stock price indicate that some investors
  are irrational?
•