CHAPTER

2
Financial Statements
and Cash Flow

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills

❑ Understand the information provided by

financial statements
❑ Differentiate between book and market
values
❑ Know the difference between average
and marginal tax rates
❑ Know the difference between accounting
income and cash flow
❑ Calculate a firm’s cash flow
 2.1 2.2
The Balance The Income
Sheet Statement

2.3 2.4
Taxes Net Working
CHAPTER Capital

OUTLINE 2.5 2.6

Financial Cash The Accounting
Flow Statement of
Cash Flows
2.7
Cash Flow
Management
 Sources of Information

❑ Annual reports
❑ Wall Street Journal
❑ Internet
▪ NYSE (www.nyse.com)
▪ NASDAQ (www.nasdaq.com)
▪ Textbook (www.mhhe.com)
❑ SEC
▪ EDGAR
▪ 10K & 10Q reports
 2.1 THE BALANCE SHEET

❑ An accountant’s snapshot of the firm’s

accounting value at a specific point in time
❑ The Balance Sheet Identity is:

Assets ≡ Liabilities + Stockholder’s Equity

 U.S. Composite Corporation Balance Sheet
2012 2011
Current assets: The assets are
Cash and equivalents $140 $107 listed in order by
Accounts receivable 294 270 the length of time
Inventories 269 280 it would normally
Other 58 50 take a firm with
Total current assets $761 $707 ongoing
operations to
Fixed assets:
convert them into
Property, plant, and equipment $1,423 $1,274
cash.
Less accumulated depreciation (550) (460)
Net property, plant, and equipment 873 814 Clearly, cash is
Intangible assets and other 245 221 much more liquid
Total fixed assets $1,118 $1,035 than property,
plant, and
equipment.
Total assets $1,879 $1,742
 Balance Sheet Analysis

❑ When analyzing a balance sheet, the Finance

Manager should be aware of three concerns:
1. Liquidity
2. Debt versus equity
3. Value versus cost
 Liquidity

❑ Refers to the ease and quickness with which assets

can be converted to cash—without a significant loss
in value
❑ Current assets are the most liquid.
❑ Some fixed assets are intangible.
❑ The more liquid a firm’s assets, the less likely the firm
is to experience problems meeting short-term
obligations.
❑ Liquid assets frequently have lower rates of return
than fixed assets.
 Debt versus Equity

❑ Creditors generally receive the first claim on the firm’s

cash flow.
❑ Shareholder’s equity is the residual difference
between assets and liabilities.
 Value versus Cost

❑ Under Generally Accepted Accounting Principles

(GAAP), audited financial statements of firms in the
U.S. carry assets at cost.
❑ Market value is the price at which the assets, liabilities,
and equity could actually be bought or sold, which is
a completely different concept from historical cost.
 2.2 THE INCOME STATEMENT

❑ Measures financial performance over a

specific period of time
❑ The accounting definition of income is:
Revenue – Expenses ≡ Income
 U.S.C.C. Income Statement
The operations Total operating revenues $2,262
section of the Cost of goods sold 1,655
income Selling, general, and administrative expenses 327

statement Depreciation 90
Operating income $190
reports the
Other income 29
firm’s revenues
Earnings before interest and taxes $219
and expenses
Interest expense 49
from principal
Pretax income $170
operations.
Taxes 84
Current: $71
Deferred: $13
Net income $84
Addition to retained earnings $43
Dividends: $43
 U.S.C.C. Income Statement
Total operating revenues $2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
The non-operating Operating income $190
section of the Other income 29
income statement Earnings before interest and taxes $219
includes all Interest expense 49
financing costs, Pretax income $170
such as interest Taxes 84
expense. Current: $71
Deferred: $13
Net income $84
Addition to retained earnings $43
Dividends: $43
 U.S.C.C. Income Statement
Total operating revenues $2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Interest expense 49
Usually a separate Pretax income $170
section reports the Taxes 84
amount of taxes Current: $71
levied on income. Deferred: $13
Net income $84
Addition to retained earnings $43
Dividends: $43
 U.S.C.C. Income Statement
Total operating revenues $2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Net income is the Interest expense 49

“bottom line.” Pretax income $170

Taxes 84
Current: $71
Deferred: $13
Net income $84
Addition to retained earnings $43
Dividends: $43
 Income Statement Analysis

❑ There are three things to keep in mind when

analyzing an income statement:
1. Generally Accepted Accounting Principles (GAAP)

2. Non-Cash Items

3. Time and Costs

 GAAP

❑ The matching principle of GAAP dictates that

revenues be matched with expenses.
❑ Thus, income is reported when it is earned, even
though no cash flow may have occurred.
 Non-Cash Items

❑ Depreciation is the most apparent. No firm ever writes

a check for “depreciation.”
❑ Another non-cash item is deferred taxes, which does
not represent a cash flow.
❑ Thus, net income is not cash.
 Time and Costs

❑ In the short-run, certain equipment, resources, and

commitments of the firm are fixed, but the firm can
vary such inputs as labor and raw materials.
❑ In the long-run, all inputs of production (and hence
costs) are variable.
❑ Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that distinguishes
product costs from period costs.
 2.3 TAXES

❑ The one thing we can rely on with taxes is that they

are always changing
❑ Marginal vs. average tax rates
▪ Marginal – the percentage paid on the next dollar
earned
▪ Average = the tax bill / taxable income
❑ Other taxes
 Marginal versus Average Rates

❑ Suppose your firm earns $4 million in taxable income.

▪ What is the firm’s tax liability?
▪ What is the average tax rate?
▪ What is the marginal tax rate?
❑ If you are considering a project that will increase the
firm’s taxable income by $1 million, what tax rate
should you use in your analysis?
 2.4 NET WORKING CAPITAL

❑ Net Working Capital ≡

Current Assets – Current Liabilities

❑ NWC usually grows with the firm

 U.S.C.C. Balance Sheet
$252m = $707- $455
2012 2011 2012 2011
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707

Here we see NWC grow to

$275 million in 2012 from
$275m = $761m- $486m
$252 million in 2011.
$23 million
This increase of $23 million
is an investment of the firm.
 2.5 FINANCIAL CASH FLOW

❑ In finance, the most important item that can be

extracted from financial statements is the actual cash
flow of the firm.
❑ Since there is no magic in finance, it must be the case
that the cash flow received from the firm’s assets
must equal the cash flows to the firm’s creditors and
stockholders.
CF(A)≡ CF(B) + CF(S)
 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
Operating Cash Flow:
(Earnings before interest and taxes plus
depreciation minus taxes) EBIT $219
Capital spending -173
(Acquisitions of fixed assets minus sales of Depreciation $90
fixed assets)
Additions to net working capital -23 Current Taxes -$71
Total $42
OCF $238
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt minus long-
term debt financing)
Equity 6
(Dividends plus repurchase of equity minus
new equity financing)
Total $42
 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes plus
depreciation minus taxes) Capital Spending
Capital spending -173 Purchase of fixed assets $198
(Acquisitions of fixed assets minus sales of
fixed assets) Sales of fixed assets -$25
Additions to net working capital -23 Capital Spending $173
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt minus long-
term debt financing)
Equity 6
(Dividends plus repurchase of equity minus
new equity financing)
Total $42
 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes plus
depreciation minus taxes) NWC grew from $275
Capital spending -173
(Acquisitions of fixed assets minus sales of million in 2010 from
fixed assets)
$252 million in 2009.
Additions to net working capital -23
Total $42
Cash Flow of Investors in the Firm
This increase of $23
Debt $36
(Interest plus retirement of debt minus long- million is the addition
term debt financing)
Equity 6 to NWC.
(Dividends plus repurchase of equity minus
new equity financing)
Total $42
 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes plus
depreciation minus taxes)
Capital spending -173
(Acquisitions of fixed assets minus sales of
fixed assets)
Additions to net working capital -23
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt minus long-
term debt financing)
Equity 6
(Dividends plus repurchase of equity minus
new equity financing)
Total $42
 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes plus
depreciation minus taxes)
Cash Flow to Creditors
Capital spending -173
(Acquisitions of fixed assets minus sales of Interest $49
fixed assets)
Additions to net working capital -23 Retirement of debt 73
Total $42 Debt service 122
Cash Flow of Investors in the Firm
Debt $36 Proceeds from new debt
(Interest plus retirement of debt minus long- sales -86
term debt financing)
Equity 6 Total $36
(Dividends plus repurchase of equity minus
new equity financing)
Total $42
 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes plus
depreciation minus taxes)
Capital spending -173 Cash Flow to Stockholders
(Acquisitions of fixed assets minus sales of
Dividends $43
fixed assets)
Additions to net working capital -23 Repurchase of stock 6
Total $42
Cash to Stockholders 49
Cash Flow of Investors in the Firm
Debt $36 Proceeds from new stock issu -43
(Interest plus retirement of debt minus long- Total $6
term debt financing)
Equity 6
(Dividends plus repurchase of equity minus
new equity financing)
Total $42
 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes plus The cash flow received
depreciation minus taxes)
from the firm’s assets
Capital spending -173
must equal the cash flows
(Acquisitions of fixed assets minus sales of
fixed assets)
to the firm’s creditors and
Additions to net working capital -23
stockholders:
Total $42
Cash Flow of Investors in the Firm
Debt $36
CF(A) =
(Interest plus retirement of debt minus long- CF(B) + CF(S)
term debt financing)
Equity 6
(Dividends plus repurchase of equity minus
new equity financing)
Total $42
 2.5 FINANCIAL CASH FLOW

❑ There is an official accounting statement called the

statement of cash flows.
❑ This helps explain the change in accounting cash,
which for U.S. Composite is $33 million in 2010.
❑ The three components of the statement of cash flows
are:
▪ Cash flow from operating activities
▪ Cash flow from investing activities
▪ Cash flow from financing activities
 U.S.C.C. Cash Flow from Operations

Operations
To calculate cash
flow from Net income $86
operations, start Depreciation 90
with net income, Deferred Taxes 13
add back non-cash Changes in Assets and Liabilities
items like Accounts Receivable -24
depreciation and Inventories 11
adjust for changes Accounts Payable 16
in current assets Accrued Expenses 18
and liabilities Other -8
(other than cash). Total Cash Flow from Operations $202
 U.S.C.C. Cash Flow from Investing

Acquisition of fixed assets -$198

Sales of fixed assets 25
Total Cash Flow from Investing Activities -$173

Cash flow from investing activities involves changes in capital

assets: acquisition of fixed assets and sales of fixed assets (i.e.,
net capital expenditures).
 U.S.C.C. Cash Flow from Financing
Retirement of debt (includes notes) -$73
Proceeds from long-term debt sales 86
Change in notes payable -3
Dividends -43
Repurchase of stock -6
Proceeds from new stock issue 43
Total Cash Flow from Financing $4

Cash flows to and from creditors and owners include changes

in equity and debt.
 U.S.C.C. Cash Flow from Financing
Operations
Net income $86
Depreciation 90
Deferred Taxes 13
Changes in Assets and Liabilities
Accounts Receivable -24
Inventories 11
The statement of Accounts Payable 16
cash flows is the Accrued Expenses 18
addition of cash Other -8
Total Cash Flow from Operations $202
flows from
Investing Activities
operations, Acquisition of fixed assets -$198
investing, and Sales of fixed assets 25
financing. Total Cash Flow from Investing Activities -$173
Financing Activities
Retirement of debt (includes notes) -$73
Proceeds from long-term debt sales 86
Notes Payable -3
Dividends -43
Repurchase of stock -6
Proceeds from new stock issue 43
Total Cash Flow from Financing $4
Change in Cash (on the balance sheet) $33
 2.7 Cash Flow Management

❑ Earnings can be manipulated using subjective

decisions required under GAAP
❑ Total cash flow is more objective, but the underlying
components may also be “managed”
▪ Moving cash flow from the investing section to
the operating section may make the firm’s
business appear more stable
 Quick Quiz

1 2
What is the difference between What is the difference between
book value and market value? accounting income and cash
Which should we use for decision flow? Which do we need to use
making purposes? when making decisions?

3 4
What is the difference between How do we determine a firm’s
average and marginal tax rates? cash flows? What are the
Which should we use when equations, and where do we find
making financial decisions? the information?