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McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

CHAPTER

2Financial Statements

and Cash Flow

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Slide 2

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Key Concepts and Skills

Understand the information provided byfinancial statements

Differentiate between book and market

values

Know the difference between average andmarginal tax rates

Know the difference between accountingincome and cash flow

Calculate a firms cash flow

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Slide 3

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Chapter Outline2.1 The Balance Sheet

2.2 The Income Statement

2.3 Taxes2.4 Net Working Capital

2.5 Financial Cash Flow

2.6 The Accounting Statement of CashFlows

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

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

http://www.wsj.com/http://www.nyse.com/http://www.nasdaq.com/http://www.mhhe.com/http://www.sec.gov/http://www.sec.gov/http://www.mhhe.com/http://www.nasdaq.com/http://www.nyse.com/http://www.wsj.com/

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Slide 5

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

2.1 The Balance Sheet

An accountants snapshot of the firmsaccounting value at a specific point in time

The Balance Sheet Identity is:Assets Liabilities + Stockholders Equity

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S. Composite Corporation Balance

Sheet2007 2006 2007 2006

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 205Other 58 50 Total current liabilities $486 $455

Total current assets $761 $707

Long-term liabilities:

Fixed assets: Deferred taxes $117 $104

Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458

Less accumulated depreciation (550) (460) Total long-term liabilities $588 $562

Net property, plant, and equipment 873 814

Intangible assets and other 245 221 Stockholder's equity:

Total fixed assets $1,118 $1,035 Preferred stock $39 $39

Common stock ($1 per value) 55 32

Capital surplus 347 327

Accumulated retained earnings 390 347

Less treasury stock (26) (20)

Total equity $805 $725

Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

The assets are listed in order by

the length of time it would

normally take a firm withongoing operations to convert

them into cash.

Clearly, cash is much more

liquid than property, plant, and

equipment.

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Slide 7

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Balance Sheet Analysis

When analyzing a balance sheet, theFinance Manager should be aware ofthree concerns:

1. Liquidity

2. Debt versus equity

3. Value versus cost

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Slide 8

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Liquidity

Refers to the ease and quickness withwhich assets can be converted to cashwithout a significant loss in value

Current assets are the most liquid. Some fixed assets are intangible.

The more liquid a firms assets, the less

likely the firm is to experience problemsmeeting short-term obligations.

Liquid assets frequently have lower ratesof return than fixed assets.

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Slide 9

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Debt versus Equity

Creditors generally receive the first claimon the firms cash flow.

Shareholders equity is the residualdifference between assets and liabilities.

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

2.2 The Income Statement

Measures financial performance over aspecific period of time

The accounting definition of income is:

RevenueExpenses Income

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Slide 12

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Income Statement

Total operating revenues

Cost of goods sold

Selling, general, and administrative expenses

DepreciationOperating income

Other income

Earnings before interest and taxes

Interest expense

Pretax income

TaxesCurrent: $71

Deferred: $13

Net income

Addition to retained earnings $43

Dividends: $43

The operations

section of the

income statementreports the firms

revenues and

expenses from

principaloperations.

$2,262

1,655

327

90$190

29

$219

49

$170

84

$86

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Total operating revenues

Cost of goods sold

Selling, general, and administrative expenses

DepreciationOperating income

Other income

Earnings before interest and taxes

Interest expense

Pretax income

TaxesCurrent: $71

Deferred: $13

Net income

Addition to retained earnings: $43

Dividends: $43

Usually a separate

section reports the

amount of taxes

levied on income.

$2,262

1,655

327

90$190

29

$219

49

$170

84

$86

U.S.C.C. Income Statement

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

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

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Slide 17

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

GAAP The matching principal of GAAP dictates

that revenues be matched with expenses.

Thus, income is reported when it isearned, even though no cash flow mayhave occurred.

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

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.

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Slide 19

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Time and Costs

In the short-run, certain equipment, resources,and commitments of the firm are fixed, but thefirm 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 distinguishbetween variable costs and fixed costs. Instead,accounting costs usually fit into a classificationthat distinguishes product costs from period

costs.

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Slide 20

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

2.3 Taxes

The one thing we can rely on with taxesis that they are always changing

Marginal vs. average tax rates

Marginalthe percentage paid on the nextdollar earned

Averagethe tax bill / taxable income

Other taxes

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http://www.irs.gov/

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Marginal versus Average Rates

Suppose your firm earns $4 million intaxable income. What is the firms tax liability?

What is the average tax rate? What is the marginal tax rate?

If you are considering a project that will

increase the firms taxable income by $1million, what tax rate should you use inyour analysis?

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Slide 22

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

2.4 Net Working Capital

Net Working Capital

Current AssetsCurrent Liabilities

NWC usually grows with the firm

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Balance Sheet

2007 2006 2007 2006

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 $707Long-term liabilities:

Fixed assets: Deferred taxes $117 $104

Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458

Less accumulated depreciation (550) (460 Total long-term liabilities $588 $562

Net property, plant, and equipment 873 814

Intangible assets and other 245 221 Stockholder's equity:

Total fixed assets $1,118 $1,035 Preferred stock $39 $39

Common stock ($1 par value) 55 32Capital surplus 347 327

Accumulated retained earnings 390 347

Less treasury stock (26) (20)

Total equity $805 $725

Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

Here we see NWC grow to

$275 million in 2006 from

$252 million in 2005.

This increase of $23 million is

an investment of the firm.

$23 million$275m = $761m- $486m

$252m = $707- $455

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Slide 24

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

2.5 Financial Cash Flow

In finance, the most important item thatcan be extracted from financialstatements 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 firms assets mustequal the cash flows to the firmscreditors and stockholders.

CF(A

)

CF(B

)+

CF(S

)

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Slide 25

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow $238(Earnings before interest and taxesplus depreciation minus taxes)

Capital spending -173(Acquisitions of fixed assetsminus sales of fixed assets)

Additions to net working capital -23Total $42

Cash Flow of Investors in the Firm

Debt $36(Interest plus retirement of debtminus long-term debt financing)

Equity 6(Dividends plus repurchase ofequity minus new equity financing)

Total $42

Operating Cash Flow:

EBIT $219

Depreciation $90

Current Taxes -$71

OCF $238

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow $238(Earnings before interest and taxesplus depreciation minus taxes)

Capital spending(Acquisitions of fixed assetsminus sales of fixed assets)

Additions to net working capitalTotal

Cash Flow of Investors in the Firm

Debt(Interest plus retirement of debtminus long-term debt financing)

Equity(Dividends plus repurchase ofequity minus new equity financing)

Total

Capital Spending

Purchase of fixed assets $198

Sales of fixed assets -$25

Capital Spending $173

-173

-23$42

$36

6

$42

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Slide 27

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow $238(Earnings before interest and taxesplus depreciation minus taxes)

Capital spending(Acquisitions of fixed assetsminus sales of fixed assets)

Additions to net working capitalTotal

Cash Flow of Investors in the Firm

Debt(Interest plus retirement of debtminus long-term debt financing)

Equity(Dividends plus repurchase ofequity minus new equity financing)

Total

NWC grew from $275

million in 2007 from $252million in 2006.

This increase of $23

million is the addition to

NWC.

-173

-23$42

$36

6

$42

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow $238(Earnings before interest and taxesplus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assetsminus sales of fixed assets)

Additions to net working capitalTotal

Cash Flow of Investors in the Firm

Debt

(Interest plus retirement of debtminus long-term debt financing)Equity

(Dividends plus repurchase ofequity minus new equity financing)

Total

Cash Flow to Stockholders

Dividends $43

Repurchase of stock 6

Cash to Stockholders 49

Proceeds from new stock issue

-43

Total $6

-173

-23$42

$36

6

$42

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow $238(Earnings before interest and taxesplus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assetsminus sales of fixed assets)

Additions to net working capitalTotal

Cash Flow of Investors in the Firm

Debt(Interest plus retirement of debtminus long-term debt financing)

Equity(Dividends plus repurchase ofequity minus new equity financing)

Total

)()(

)(

SCFBCF

ACF

The cash flow received

from the firms assets

must equal the cash flows

to the firms creditors andstockholders:

-173

-23$42

$36

6

$42

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

2.5 The Statement of CashFlows

There is an official accounting statementcalled the statement of cash flows.

This helps explain the change in

accounting cash, which for U.S.Composite is $33 million in 2007.

The three components of the statementof cash flows are: Cash flow from operating activities

Cash flow from investing activities

Cash flow from financing activities

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Cash Flow from

OperationsTo calculate cash

flow from operations,

start with net income,add back non-cash

items like

depreciation and

adjust for changes in

current assets and

liabilities (other than

cash).

Operations

Net Income

Depreciation

Deferred Taxes

Changes in Assets and Liabilities

Accounts Receivable

Inventories

Accounts Payable

Accrued Expenses

Notes Payable

Other

Total Cash Flow from Operations

$86

90

13

-24

11

16

18

-3

$199

-8

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

U.S.C.C. Statement of Cash

FlowsThe statement of

cash flows is the

addition of cashflows from

operations,

investing, and

financing.

OperationsNet IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities

Accounts Receivable

InventoriesAccounts PayableAccrued ExpensesNotes PayableOther

Total Cash Flow from Operations

$869013

-24

111618-3

$199-8

Acquisition of fixed assetsSales of fixed assets

Total Cash Flow from Investing Activities

-$19825

-$173

Investing Activities

Financing ActivitiesRetirement of debt (includes notes)Proceeds from long-term debt salesDividendsRepurchase of stockProceeds from new stock issue

Total Cash Flow from Financing

-$7386-43

43$7

-6

Change in Cash (on the balance sheet) $33

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Quick Quiz

What is the difference between book valueand market value? Which should we use fordecision making purposes?

What is the difference between accounting

income and cash flow? Which do we need touse when making decisions? What is the difference between average and

marginal tax rates? Which should we usewhen making financial decisions?

How do we determine a firms cash flows?What are the equations, and where do wefind the information?