CORPORATE FINANCE

CHAPTER 2

FINANCIAL STATEMENT & CASHFLOW

Bui Ngoc Phuong (MSc.)

 Main content

1. The Balance Sheet

2. The Income Statement

3. The Cash Flow Statement & Cash Flow Management

 Sources of Information

• Businesses’ website
• https://www.annualreports.com/
• Wall Street Journal - https://www.wsj.com/
• SEC (Securities and Exchange Commission.)
• https://www.sec.gov/edgar/search-and-access
• 10K & 10Q reports
 PART 1

The Balance Sheet

 What is a Balance Sheet?

 The balance sheet is an accountant’s snapshot of a firm’s accounting value at a

specific point in time
 The balance sheet has 2 sides:
 On the left are the assets
 On the right are the liabilities and stockholders’ equity.
 The balance sheet states what the firm owns and how it is financed. The accounting
definition that underlies the balance sheet and describes the balance is:
Assets = Liabilities + Stockholders’ equity

5
 The Capital Budgeting Decision

Current Liabilities
Current Assets
Long-Term Debt

Fixed Assets
What long-term
1 Tangible investments should Shareholders’
2 Intangible the firm choose? Equity

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No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 The Capital Structure Decision

Current Liabilities
Current Assets
Long-Term Debt
How should the firm
raise funds for the
selected investments?
Fixed Assets
1 Tangible Shareholders’
2 Intangible Equity

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No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Example of Balance Sheet

The assets are listed in

order by the length of time
it would normally take a
firm with ongoing
operations to convert them
into cash.
Clearly, cash is much more
liquid than property, plant,
and equipment.
 Balance Sheet Analysis

When analyzing a balance sheet, the Financial Manager

should be aware of three concerns:

 Liquidity

 Debt vs equity

 Value vs Cost
 Liquidity

 Liquidity refers to the ease and quickness with which assets can be converted to cash
(without significant loss in value).
 Current assets are the most liquid and include cash and assets that will be turned into
cash within a year from the date of the balance sheet.
 Accounts receivable are amounts not yet collected from customers for goods or services sold to
them (after adjustment for potential bad debts).
 Inventory is composed of raw materials to be used in production, work in process, and finished
goods.
 Fixed assets are the least liquid kind of assets, including: tangible fixed assets &
intangible fixed assets.
 Liquidity

• 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

• Liabilities are obligations of the firm that require a payout of cash within a
stipulated period. Liabilities involve contractual obligations to repay a stated
amount and interest over a period.
• Stockholders’ equity is a claim against the firm’s assets that is residual and
not fixed.
 Value versus Cost

• Carrying value or book value of the assets is the accounting value of a firm’s assets.
Under Generally Accepted Accounting Principles (GAAP), accountants record the
assets at cost.
• Market value or fair value is the price at which willing buyers and sellers would trade
the assets. Job of CFO is to create value for the firm that exceeds its cost.
• Many people (i.e. banker, supplier, managers, investors) use the balance sheet, but
the information each may wish to extract is not the same
 Market Value vs Book Value

• The Cooney Corporation has fixed assets with a book value of $700 and an
appraised market value of about $1,000. Net working capital is $400 on the
books, but approximately $600 would be realized if all the current accounts were
liquidated. Cooney has $500 in long-term debt, both book value and market
value. What is the book value of the equity? What is the market value?
 Net Working Capital

• Net working capital is current assets minus current liabilities.

NWC = Current Assets – Current Liabilities
• NWC is positive when current assets are greater than current liabilities
 the cash that will become available over the next 12 months will be
greater than the cash that must be paid out.
• In addition to investing in fixed assets, a firm can invest in NWC. This is
called the change in net working capital.
• The change in NWC is usually positive in a growing firm.
 PART 2

The Income Statement

 What is an Income Statement?

• The income statement measures performance

over a specific period.
• The accounting definition of income is:
Revenue - Expenses = Income
Example of Income Statement
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
Pretax income $170
Taxes 84
Current: $71
Deferred: $13
Net income $86
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

 General Accepted Accounting Principle

 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.
 Noncash Items

There are several noncash items that are expenses against

revenues but do not affect cash flow.
 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

• In the short run, certain equipment, resources, and commitments of the

firm are fixed; but the time is long enough for the firm to vary its output
by using more labor and raw materials.
• In the long run, all costs are variable.

Financial accountants typically classify costs as

product costs from period costs, rather than
variable costs and fixed costs.
 Costs

Fixed costs Variable costs

Costs that will not change because of Change as the output of the firm changes
fixed commitments
Ex: bond interest, overhead, and property Ex: raw materials, wages for laborers…
taxes…

Product costs Period costs

- are the total production costs incurred - are costs that are allocated to a time
during a period: raw materials, direct period, including: selling, general, and
labor, and manufacturing overhead administrative expenses.
- are reported on the IS as cost of goods - E.g. company president’s salary.
sold (COGS)
 Corporate Tax

Corporate tax is the tax imposed on net profits. There are 2 types:
- Progressive tax systems have tiered tax rates that charge higher income firms higher
percentages of their income. Ex: corporate tax rates in US (2015) are as follow:

- Flat tax system tier tax rate the same for all income levels. Ex: corporate tax rate in
Vietnam is 20%
 Corporate Tax

• The one thing we can rely on with taxes is that they are always
changing

• Marginal vs. average tax rates:

• Marginal tax rate = the rate paid on next dollar of income
• Average tax rate = the tax bill / taxable income

• Other taxes
 Marginal Tax Rate vs Average Tax Rate

• 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?
 PART 3
The Cash Flows Statement
& Management
 Cash Flow of the Firm

• 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)

 Cash Flow of the Firm

Cash Flow of the Firm Operating Cash Flow:

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
EBIT $219
Capital spending -173
(Acquisitions of fixed assets Depreciation $90
minus sales of fixed assets)
Additions to net working capital -23 Current Taxes -$71
Total $42
Cash Flow of Investors in the Firm OCF $238
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of CF(A) = CF to the firm = Operating CF –
equity minus new equity financing) Capital spending – Additions to Net
Total $42
working capital
 Cash Flow of the Firm

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
Total $42
Capital Spending $173
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt Capital spending = Ending
minus long-term debt financing)
Equity 6 net fixed assets -
(Dividends plus repurchase of
equity minus new equity financing) Beginning net fixed assets
Total $42
+ Depreciation
 Cash Flow of the Firm

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
NWC grew from $275 million in
Capital spending -173 2012 from $252 million in 2011.
(Acquisitions of fixed assets
minus sales of fixed assets) This increase of $23 million is the
Additions to net working capital -23
Total $42 addition to NWC.
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
 Cash Flow of the Firm

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 Interest $49
minus sales of fixed assets)
Additions to net working capital -23 Retirement of debt 73
Total $42
Cash Flow of Investors in the Firm Debt service 122
Debt $36
(Interest plus retirement of debt Proceeds from new debt sales
minus long-term debt financing) -86
Equity 6
(Dividends plus repurchase of
equity minus new equity financing) Total $36
Total $42
Cash flow paid to creditors = Interest paid - Net new
borrowing
= Interest paid - (Ending long-term debt -
Beginning long-term debt)
 Cash Flow of the Firm

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes Cash Flow to Stockholders
plus depreciation minus taxes)
Capital spending -173 Dividends $43
(Acquisitions of fixed assets
minus sales of fixed assets)
Repurchase of stock 6
Additions to net working capital -23 Cash to Stockholders 49
Total $42
Proceeds from new stock issue -43
Cash Flow of Investors in the Firm
Debt $36 Total $6
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42 Cash flow to stockholders = Dividends paid - Net
new equity raised
= Dividends paid - (Stock sold - Stock
repurchased)
 Cash Flow of the Firm

Cash Flow of the Firm

Operating cash flow $238 The cash flow received from the
(Earnings before interest and taxes
plus depreciation minus taxes)
firm’s assets must equal the cash
Capital spending -173 flows to the firm’s creditors and
(Acquisitions of fixed assets
minus sales of fixed assets) stockholders:
Additions to net working capital -23
Total $42
Cash Flow of Investors in the Firm
C F ( A) 
Debt
(Interest plus retirement of debt
$36
CF (B)  CF (S )
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
 Cash Flow of the Firm

• Operating cash flows = Earnings before interest + depreciation – Taxes

• Operating cash flows measures the cash generated from operations

NOT counting capital spending or working capital requirements.

• Total cash flow of the firm includes adjustments for capital spending and
additions to net working capital.

• Net income is NOT cash flow.

 The Accounting Statement of Cash Flows

• There is an official accounting statement called the statement of cash

flows.
• This helps explain the change in accounting cash.
•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
Statement of CF

CF from operating CF from investing CF from financing

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

Cash flow from investing Acquisition of fixed assets -$198

activities involves changes in Sales of fixed assets 25
Total Cash Flow from Investing Activities -$173
capital assets: acquisition of
fixed assets and sales of fixed
assets (i.e., net capital
expenditures).
 Cash Flows from Financing Activities
U.S.C.C. Statement of Cash Flows

Cash flows to and from Retirement of debt (includes notes) -$73

creditors and owners include Proceeds from long-term debt sales 86
Dividends -43
changes in equity and debt.
Repurchase of stock -6
Proceeds from new stock issue 43

Total Cash Flow from Financing $7

 Example of The Statement of Cash Flows
U.S.C.C. Statement of Cash Flows
Operations
Net Income $86
The statement of cash Depreciation 90
Deferred Taxes 13
flows is the addition of Changes in Assets and Liabilities
Accounts Receivable -24
cash flows from Inventories
Accounts Payable
11
31
operations, investing, and Total Cash Flow from Operations
Investing Activities
$207
Acquisition of fixed assets -$198
financing. Sales of fixed assets 25
Total Cash Flow from Investing Activities -$173
Financing Activities
Retirement of debt (includes notes) -$73
Proceeds from long-term debt sales 86
Dividends -43
Repurchase of stock -6
Proceeds from new stock issue 43
Total Cash Flow from Financing $7
Change in Cash (on the balance sheet) $33
 Cash Flow Management

 At its simplest, cash flow management means delaying outlays of

cash as long as possible while encouraging anyone who owes you
money to pay it as rapidly as possible.
 Cash flow can be managed through 4 steps:
 Measuring Cash Flow
 Improving Receivables 
 Managing Payables 
 Surviving Shortfalls 
 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 firm’s cash flows? What are the equations,
and where do we find the information?
 CHAPTER SUMMARY

1. Financial statements of a corpoaration including:

 Balance sheet
 Income statement
 Cash Flow statement

2. Cash flow is generated by the firm and paid to creditors and

shareholders. It can be classified as:
 Cash flow from operations.
 Cash flow from changes in fixed assets.
 Cash flow from changes in working capital.