Chap 3

Foundations of FinanceArthur Keown

John D. Martin

J. William Petty

Understanding Financial Statements and Cash Flows

Chapter 3

Keown, Martin, Petty - Chapter 3

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Learning Objectives

1. Compute a company’s profits as reflected by its income statement.

2. Determine a firm’s financial position at a point in time based on its balance sheet.

3. Measure a company’s cash flows.


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Slide Contents

1. Principles Used in this Chapter2. Basic Financial Statements:

Income Statement and Balance Sheet

3. Free Cash Flows4. Summary of Davies, Inc. Financial

Statements

1. Principles Used in this Chapter


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Principles Used in this Chapter

Principle 3: Cash-Not Profits-Is King

Principle 7: Managers Won’t Work for the Owners Unless It’s in Their Best Interest

2. Basic Financial Statements

The Income StatementThe Balance Sheet


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The Income Statement It is also known as Profit/Loss Statement

It measures the results of a firm’s operation over a specific period.

The bottom line of the income statement shows the firm’s profit or loss for a period.

Sales – Expenses = Profit or Loss


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Income Statement Terms

Revenue (Sales) Money derived from selling the company’s product or service

Cost of Goods Sold (COGS) The cost of producing or acquiring the goods or services to be

sold Operating Expenses

Expenses related to marketing and distributing the product or service and administering the business

Financing Costs The interest paid to creditors and the dividends paid to

preferred stockholders Tax Expenses

Amount of taxes owed, based upon taxable income


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Income Statement FormSales

Less cost of goods sold

= Gross profitLess operating expenses

= Operating incomeLess interest expense

= Earnings before taxes (EBT)Less income taxes

= Net income (earnings available for shareholders)


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Common-size Income Statement

Common-size income statement restates the income statement items as a percentage of sales.

Common-size income statement makes it easier to compare trends over time and across firms in the industry.


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Common-size Income Statement for Davies, Inc.

$ % Sales $600 100% Cost of Goods Sold 460 76.7 Gross Profit $140 23.3% Operating Expenses

Selling Expenses $20 General & Admn. Exp. 15 Depreciation Expense 30

Total Operating Expenses $ 65 10.8 Operating Income $ 75 12.5% Interest Expense 15 2.50 Earnings before taxes $ 60 10.0% Income taxes 18 3.0 Net income $ 42 7.0%


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Profit-to-Sales analysis from Common-size income statement

1. Gross profit margin (or percentage of sales going towards gross profit) is 23.3%

2. Operating profit margin (or percentage of sales going towards operating profit) is 12.5%

3. Net profit margin (or percentage of sales going towards net profit) is 7%


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Balance Sheet Provides a snapshot of firm’s financial position

at a particular date. It includes three main parts: assets, liabilities

and equity. Assets (A) are resources owned by the firm Liabilities (L) and owner’s equity (E) indicate how

those resources are financed A = L + E

The items are recorded at historical cost, so the book value of a firm may be very different from its market value.


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Balance Sheet Terms: Assets

Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include:

Cash Accounts Receivable (payments due from customers

who buy on credit) Inventory (raw materials, work in process, and

finished goods held for eventual sale) Other assets (ex.: Prepaid expenses are items paid

for in advance)


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Fixed Assets – Include assets that are held for more than one year. Fixed assets typically include:

Machinery and equipment Buildings Land

Other Assets – Assets that are neither current assets nor fixed assets. They may include intangible assets such as patents, copyrights, and goodwill.

Balance Sheet Terms: Assets


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Debt (Liabilities) Money that has been borrowed from

a creditor and must be repaid at some predetermined date

Debt could be current (must be repaid within twelve months) or long-term (repayment time exceeds one year)

Balance Sheet Terms: Liabilities


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Current Liabilities: Accounts payable (Credit extended by suppliers to a

firm when it purchases inventories) Accrued expenses (Short term liabilities incurred in

the firm’s operations but not yet paid for) Short-term notes (Borrowings from a bank or lending

institution due and payable within 12 months)

Long-Term Debt Loans from banks for longer than 12 months Bonds

Balance Sheet Terms: Liabilities


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Equity: Shareholder’s investment in the firm in the form of preferred stock and common stock.

Treasury Stock: Stock that was once outstanding and has been re-purchased by the company.

Retained Earnings: Cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years.

Balance Sheet Terms: Equity


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Balance Sheet: A=L+E

ASSETS (A) Current Assets Fixed Assets

Total Assets

LIABILITIES (L) Current Liabilities Long-Term Liabilities

Total Liabilities

OWNER’S EQUITY (E) Preferred Stock Common Stock Retained earnings

Total Owner’s Equity Total liabilities + Equity


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Net Working Capital and Debt Ratio Net Working Capital

= Current assets – current liabilities Larger the net working capital, greater the firm’s

ability to repay its debt An increase in net working capital may not always be

good news. For example, if the level of inventory goes up, current assets will increase and thus net working capital will also increase. However, increasing inventory level may be sign of inability to sell.

Debt Ratio Percentage of debt a firm uses to finance its assets Generally, higher the ratio, the more risky the firm is

as firms have to pay interest on debt regardless of the cash flow situation.


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Accrual Basis Accounting Accrual Basis Accounting

Principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid.

Thus sales revenue recorded in the income statement includes both cash and credit sales.

Treatment of long-term assets: Asset acquisitions (that will last more than one year, such as equipment) are not recorded as an expense but are written off every year as depreciation expense.

3. Free Cash Flow


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Free Cash Flow

Free Cash Flow (FCF): cash flow that is free and available to be distributed to the firm’s investors. It is obtained after a firm has paid off all its operating expenses, taxes, and made all of its investments in operating working capital and assets.


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Free Cash flow computation FCF =

After-tax cash flows from operations – change in operating working capital – change in gross fixed assets


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Free Cash flow computation

After tax cash flow from operations = Operating income

+ depreciation expense – income taxes

Change in operating working capital =

Change in current assets – change in non-interest bearing current

liabilities


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Financing Cash Flows

A firm can either receive money from or distribute money to its investors or both. The firm can:

1. Pay interest to lenders.2. Pay dividends to stockholders.3. Increase or decrease its interest bearing

long-term or short-term debt.4. Issue stock to new shareholders or

repurchase stock from current shareholders.


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Interpreting Free Cash Flows Does Positive or Negative free cash flow

maximize shareholder wealth?

Need more information to answer this question.

We need to consider the trend in cash flows and also analyze the possible causes of positive or negative free cash flows. Specifically, we need to look closely at cash flows relating to operations, working capital, long-term assets, and financing.

4. Summary of Davies, Inc.’s Financial Statements


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Summary of Davies, Inc.’s Financial Statements

1. Profitability: Davies generates 12.5 cents in operating income and 7 cents in net income for every $ of sales.

2. Financing: Raises around 54% of capital from debt to finance the assets.

3. New Investments: Primarily in fixed assets and inventories.

4. Free cash flows: Positive, suggesting that the firm is returning cash to its investors.

5. Cash flow sources: Paid in the form of interest, dividends and repayment of debt.

Chap 3

Economy & Finance

Transcript of Chap 3