FIN 3000

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FIN 3000

• Chapter 3

Financial Statements
Liuren Wu
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Overview

• An Overview of the Firms Financial Statements
• The Income Statement
• Corporate Taxes
• The Balance Sheet
• The Cash Flow Statement

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Learning Objectives

• Understand the content of the 4 basic financial
  statements. Focus on
• Income statement
• Balance sheet statement
• Cash flow statement
• Evaluate firm profitability using the income
  statement.
• Estimate a firms tax liability using the
  corporate tax schedule and distinguish between
  the average and marginal tax rate.

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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 firms 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.
• Firms financial statements provide important
  information that is used by investors in forming
  expectations about firms future prospects and
  subsequently, the market prices.

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Basic Financial Statements

• Three types of financial statements are mandated
  by the accounting and financial regulatory
  authorities
• Income statement how much money you made last
  year?
• Revenue, expense, profits over a year or quarter.
• Balance sheet Whats your current financial
  situation?
• a snap shot on a specific date of
• Assets (value of what the firm owns),
• Liabilities (value of firms debts), and
• Shareholders equity (the money invested by the
  company owners)
• Cash flow statement How did the cash come and
  go?
• cash received and cash spent by the firm over a
  period of time

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Why Study Financial Statements?

• Assess current performance through financial
  statement analysis
• Next chapter provides more tools for the
  analysis.
• 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 firms operations.
• Forecast future performance.
• Financial planning models are typically built
  using the financial statements

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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.
• 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.
• 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.

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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)

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Sample Income Statement
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Evaluating a Firms 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

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Evaluating a Firms 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

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Connecting the Income Statement and the Balance
Sheet

• What can the firm do with the net income?
• Pay dividends to shareholders, and/or
• 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 firms balance on retained earnings will
  increase by 70 million on the balance sheet.

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Interpreting Firm Profitability using the Income
Statement

• What can we learn from Boswell Inc.s income
  statement?
• The firm has been profitable as its revenues
  exceeded its expenses.
• The gross profit margin (GPM)
• gross profits sales
• 675 million 2,700 million
• 25
• GPM indicates the firms mark-up on its cost of
  goods sold per dollar of sales.

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Interpreting Firm Profitability using the Income
Statement (cont.)

• The operating profit margin
• net operating income (EBIT) sales
• 382.5 million 2,700 million
• 14.17
• 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.

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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 firms reported
  earnings.
• Managers have an incentive to tamper with
  reported earnings as their pay depends upon it
  and investors care about it.

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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
  firms gross profits, operating income, and net
  income for the year ended January 31, 2009.
  Calculate the firms earnings per share and
  dividends per share.

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Checkpoint 3.1 Check Yourself

• Reconstruct the Gaps 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 firms net income and earnings per share?

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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
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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.

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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
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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

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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.

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Corporate Taxes

• A firms income tax liability is calculated using
  its taxable income and the tax rates on corporate
  income.

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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.

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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.

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Marginal and Average Tax Rates

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

Taxable Income Marginal tax rate Incremental Tax Liability Cumulative Tax Liability Average Tax Rate
50,000 15 7,500 7,500 15.00
75,000 25 6,250 13,750 18.33
100,000 34 8,500 22,250 22.25
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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.

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The Balance Sheet

• The balance sheet provides a snapshot of the
  firms financial position on a specific date. It
  is defined by
• Total Assets Total Liabilities Total
  Shareholders 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 firms total
  assets and the firms total liabilities.

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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.

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Assets and liabilities

• Current assets consists of firms 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.

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The stockholders equity

• Two components
• 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 corporations par value per
  share is 2.00 and the firm has 30 million shares
  outstanding such that the par value of the firms
  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 firms retained earnings the
  portion of net income that has been retained
  (i.e., not paid in dividends) from prior years
  operations.

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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 firms 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 firms 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 firms liquidity by
  computing the net working capital current
  assets current liabilities.

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Firm Liquidity and Net Working Capital

• If a firms 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 firms ability to repay
  its loans.

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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 firms total
  assets and net working capital

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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.

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Checkpoint 3.2 Check Yourself

• Reconstruct the Gaps balance sheet to reflect
  the repayment of 1 billion in short-term debt
  using a like amount of the firms cash. What is
  the balance for total assets and current
  liabilities?

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Step 1 Picture the Problem
Current Assets Cash Accounts Receivable Inventorie
s Other current assets Total current assets
Current Liabilities Accounts payable Short-term
debt Other current liabilities Total current
liabilities
Long-term Liabilities Long-term debt
Long-term (fixed) assets Gross PPE Less
Accumulated depreciation Net property, plant and
equip. Other long-term assets Total long-term
assets
Owners Equity Par value of common
stock Paid-in-capital Retained earnings Total
equity
Total Assets
Total Liabilities and Owners equity
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Step 2 Decide on a Solution 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.

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

• We can make the following observations from Gaps
  Balance sheet
• The total assets of 6,564,000,000 is financed
  by a combination of current liabilities,
  long-term liabilities and owners equity. Owners
  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).

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Debt versus Equity Financing

• The right-hand side of the balance sheet reveals
  the sources of money used to finance the purchase
  of the firms 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 firms owners
  (equity financing, through the sale of equity or
  retention of prior years 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.

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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.

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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.
• Inventory increased by 148.50 million indicating
  use of cash to procure inventory.
• 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

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Cash Flow Analysis (cont.)

• Accounts Payable, credit extended to the firm,
  increased by 4.5million. Thus source of cash
  increased by 4.5million due to accounts payable.
• Long-term debt increased by 51.75 million
  indicating a source of cash.
• Short-term debt decreased by 9 million
  indicating use of cash to pay off the debt.
• Retained earnings increased by 159.75 million
  representing a source of cash to the firm from
  the firms operations.
• In general,
• An increase in a liability account source of
  cash
• A decrease in a liability account use of cash

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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 4.50 Increase in Accounts Receivable 22.50
Increase in long-term debt 51.75 Increase in inventory 148.50
Increase in retained earnings 159.75 Increase in net plant and equipment 40.50
Decrease in short-term notes 9
Total Sources of cash 216.00 Total Uses of cash 220.50
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Cash Flow Analysis (cont.)

• An analysis of H.J. Boswells 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.

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Cash Flow Analysis Summary
Sources of Cash Uses of Cash
Decrease in an asset account Increase in an asset account
Increase in a liability account Decrease in a liability account
Increase in an owners equity account Decrease in an owners equity account
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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 companys 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
  firms use of debt and equity such as issue of
  new shares, payment of dividends.

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Checkpoint 3.3Interpreting 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 firms
  cash flow statements for 2004 through 2007

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Analyze

• Chesapeake has had positive growing cash flows
  from operations in all 4 years.
• The primary contributor were the firms net
  income and depreciation expense.
• Working capital is a source of cash in 3 out of 4
  years, indicating the net reduction in the firms
  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.

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Checkpoint 3.3 Check Yourself

• Go to httpfinance.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.

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Step 1 Picture the Problem

• The cash flow statement uses information from the
  firms 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.

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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

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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).

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Step 2 Decide on a Solution 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

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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 firms depreciation/depleti
  on expense and non-cash expense. Net working
  capital is a use of cash.

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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.

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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.