CHAPTER 2

Financial Statements and Cash Flow

1/ The Balance Sheet (reflecting assets and claims)

The balance sheet is an accountant’s snapshot of a firm’s accounting value on a particular date.
It states what the firm owns and how it is financed.
The balance sheet has two sides:
+ On the left is the Assets (resources that will generate a future economic benefit)
+ On the right are the Liabilities (debts) and Owners’ equity (investment by the owners)
The accounting definition describes the balance as Assets = Liabilities + Stockholders’ equity
 The balance sheet of the corporation:
CORPORATION
Balance Sheet
Time
(currency unit)
Assets Liabilities and Stockholders’ Equity .
Current assets: Current liabilities:
Cash and equivalents Accounts payable
Accounts receivable Notes payable
Inventory Accrued expenses
Others Total current liabilities
Total current assets Long-term liabilities:
Fixed assets: Deferred taxes
Property, plant, and equipment Long-term debt
Less accumulated depreciation (-) Total long-term liabilities
Net property, plant, and equipment Stockholders’ equity:
Intangible assets Preferred stock
Others Common stock ($1 par value)
Total fixed assets Accumulated retained earnings
Capital surplus
Less treasury stock (-)
Total equity

Total assets Total liabilities and stockholders’ equity

 The assets are listed in order by the length of time to convert them into cash
+ The asset structure depends on the nature of the business and how management chooses to
conduct it
+ Management must make decisions about: cash versus marketable securities, credit versus cash
sales, whether to make or buy commodities, whether to lease or purchase items, the types of
business in which to engage and so on.
 The liabilities and stockholders’ equity are presented in ascending order of return
+ Financing structure depends on management’s choice of capital structure, as between debt and
equity; between current debt and long-term debt.
+ They reflect the types and proportions of financing
+ Equity is what the stockholders would have remaining after the firm discharged its obligations
  Some special figures on the balance sheet
o Change in long-term debt = the difference between the amount of new debt and retirement of
old debt
o Change in Treasury stock is the repurchase of company stock.
o Capital surplus = Total price for selling new common stock – The par value of issued stock
= A result from donated stock
o Increase in Capital surplus = New equity – Increase in par value of common stock
 Balance sheet analysis
When analyzing a balance sheet, the Finance Manager should be aware of three concerns:
1. Liquidity
Liquidity is the ease and quickness with which assets can be converted to cash (without a
significant loss in value).
Current assets, which are the most liquid, will be turned into cash within a year from the date of
the balance sheet
Fixed assets, which are the least liquid kind of assets, are not usually used to pay expenses
Accounts receivable are amounts not yet collected from customers for goods or services sold to
them (after adjustment for potential bad debts)
The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-
term obligations. However liquid assets frequently have lower rates of return than fixed assets.
The probability an enterprise avoids financial exhaustion can be linked to its liquidity.
When investing in high liquidity assets, the business must sacrifice the opportunity to invest in
other potentially more profitable projects.
Solving two questions: How much current asset should have and Which live of current asset is
optical
2. Debt versus equity
− Liabilities (Debts) are obligations of the firm that require a payout of cash within a stipulated
period
+ Debt services that are debts and frequently associated with nominally fixed cash burdens, put
the firm in default of a contract if they are not paid
+ Many 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
+ Bondholders (creditors) can sue the firm if the firm defaults on its bond contracts. This may
lead the firm to declare itself bankrupt
+ Creditors generally receive the first claim on the firm’s cash flow.
+ The accounting value of stockholders’ equity increases when retained earnings are added. This
occurs when the firm retains part of its earnings instead of paying them out as a dividend
− Tax shield: is a reduction in taxable income for an individual or corporation achieved through
claiming allowable deductions, called tax-deductible expense, such as mortgage interest, medical
expenses, charitable donations, amortization, and depreciation.
+ Tax shield = Value of Tax-deductible expense x Tax rate
+ Tax shields reduce tax payments owed by an individual taxpayer or a business to the state and
increase shareholder value
+ Taking on debt has a tax benefit because you can use the interest as a tax-deductible expense.
 3. Value versus cost
Book value (carrying value): is determined based on the company's accounting database, which is
mainly on balance sheet accounting. (accounting terms)
→ Book value = Asset – Accumulated Depreciation
- The accounting value of a firm’s assets is referred to as the book value of the assets
- It follows the historical cost principle: record assets and liabilities at the price paid to buy them,
which is usually not the price the asset could be sold for today.
- Under Generally Accepted Accounting Principles (GAAP), audited financial statements of firms
carry assets at cost. GAAP requires assets to be carried at a lower cost or market value.
- Cost is usually lower than market value. However, when a fair market value can be readily
determined, the assets have their value adjusted to the fair market value.
- The accounting numbers are based on cost
- This misleads many readers of financial statements to think that the firm’s assets are recorded at
true market values
- The book value of the common stock is determined by the equity (total assets - total liabilities) of
the company then divided by the total number of shares outstanding.
- When considering the book value, shareholders can see the increase in value of common stock
shares after an operation which is compared to the initial capital contribution.
Market value: is the price at which willing buyers and sellers would trade the assets in the market
(economic terms)
- Market price is determined by the relationship of supply and demand in the market, so it
fluctuates frequently. At that price, willing buyers and sellers would trade the assets
- Investors and creditors use market value for decision-making purposes
- It may have value when all the current and fixed accounts were liquidated.
- The market value of a stock is not fixed by the company but is determined by the price at which
sellers are willing to sell stock and the highest price that buyers are willing to pay to buy it.
- When we say the goal of the financial manager is to increase the value of the stock, it means the
market value of the stock, not the book value.
Management’s job is to create value for the firm that exceeds its cost.
The information many people wish to extract from the balance sheet is not the same:
+ A banker may look at a balance sheet for evidence of accounting liquidity and working capital
+ A supplier may also note the size of accounts payable and therefore the general promptness of
payments
+ Managers and investors want to know the value of the firm, not its cost.
Many of the true resources of the firm do not appear on the balance sheet: good management,
proprietary assets, favorable economic conditions, and so on

2/ The Income Statement (reflecting results of business operation)

It has 3 factors: Revenue earned, Expenses incurred and Profit generated
 The income statement includes several sections
 The operations section: reports the firm’s revenues and expenses from principal operations
Total operating revenues (Sales)
− Cost of goods sold
 – Operating expenses (Selling expense, General and Administrative expense, Depreciation and
amortization)
= Operating income
* Gross profit = Sales − Cost of goods sold
* Operating expenses = selling expenses + general and administrative expenses + depreciation
and amortization expense
 The non-operating section: includes all financing costs
Earnings before interest and taxes (Operating income+Other income)
− Interest expense
= Pretax income
* EBIT: Operating profit
* Interest expense: Cost of debt financing
 The separate section: reports the amount of taxes levied on income
Pretax income – Taxes (current taxes+deferred taxes) = Net income
 The bottom line: is Net income
+ Net income = Net profit: is income resulting from operating and financing activities
Net income is expressed per share of common stock (earnings per share)
Extra part (Additional information):
- Dividends
- Addition to retained earnings = Net income – Dividends
- Number of shares outstanding
Net income
- Earnings per share = Total shares outstanding
Dividends
- Dividends per share = Total shares outstanding
NOTE:
Interest is a tax-deductible expense.
Net profit– Preferred stock dividends = Earnings available for common
 Income statement analysis
When analyzing an income statement, the financial manager keep in mind three things
1. Accounting principles applied to establishing the financial statement (GAAP or IFRS)
− The matching principle of GAAP dictates that revenues be matched with expenses
− Accrual basis:
+ Revenues are recognized when earned, not when received in cash. (Cash or Accounts
receivable)
+ Expenses are recognized when incurred, not when paid in cash. (Paid or Unpaid)
− The unrealized appreciation from owning property will not be recognized as income. This
provides a device for smoothing income by selling appreciated property at convenient times.
2. Non-cash items
 The economic value of assets is connected to their future incremental cash flows
 Cash flow does not appear on an income statement
 Several non-cash items are expenses against revenues but don’t affect cash flow:
− Depreciation: reflects the accountant’s estimate of the cost of equipment used up in the
production process (the cost of the asset is the negative cash flow incurred when the asset is
acquired with the purchased price)
− Deferred taxes: a tax that was assessed or is due for the current period but has not yet been paid
(no cash flow)
+ Resulting from differences between accounting income and true taxable income.
+ If taxable income is less than accounting income in the current year, it will be more than
accounting income later on ( taxable income = pretax income )
+ The taxes that are not paid today will have to be paid in the future, and they represent on the
balance sheet as deferred tax liability.
+ In practice, the difference between cash flows and accounting income can be quite dramatic
− Unpaid expense
 Net income is not cash
3. Time and costs
− It is often useful to visualize all of the future time as having two parts, the short run, and the long
run
− In the short-run, certain equipment, resources, and commitments of the firm are fixed
+The firm can use labor and raw materials to vary its output.
+The short run is not the same precisely for all industries. However, all firms making decisions in
the short run have some fixed costs (bond interest, overhead, and property taxes)
− In the long run, all inputs of production are variable.
+Financial accountants do not distinguish between variable costs and fixed cost
+Accounting costs distinguish product costs from period costs. Product costs (variable cost+fixed
costs) are the total production costs incurred during a period and are reported on the income
statement as the cost of goods sold - raw materials, direct labor, and manufacturing overhead.
Period costs are costs that are allocated to a period - selling, general, administrative expenses, and
the company president’s salary

3/ Taxes
 The firm’s tax
Taxes can be one of the largest cash outflows a firm experiences. The size of the firm’s tax bill is
determined by the tax code, and often amended set of rules
The tax code is the result of political, not economic, forces so there is no reason why it has to
make economic sense.
We need to examine corporate tax rates and how taxes are calculated.
 Corporate tax rates
Taxes are always changing. there are six corporate tax brackets: 15 percent, 25 percent, 34 percent,
35 percent, 38 percent, and 39 percent.
Corporate tax rates rise from 15 percent to 39 percent, but they drop back to 34 percent on income
over $335.000. The 38 and 39 percent brackets arise because of “surcharges” applied on top of the
34 and 35 percent rates.
Taxable Income Tax Rate (%)
0–50.000 15
50.001–75.000 25
75,001–100,000 34
100.001–335.000 39
335.001–10.000.000 34
10.000.001–15.000.000 35
15.000.001–18.333.333 38
 18.333.3341 + 35

 Average and marginal tax rates

 Average tax rate: is the % of your income that goes to pay taxes = tax bill / taxable income
− The more a corporation makes, the greater is the average tax
− The average tax rate never goes down, even though the marginal tax rate does.
− Taxable income = Pretax income

 Marginal tax rate is the percentage of tax you would pay if you earned one more dollar
− It will be relevant for financial decision-making because any new cash flows will be taxed at that
marginal rate.
− Financial decisions usually involve new cash flows or changes in existing ones and this rate will
tell us the marginal effect of a decision on our tax bill.
 Flat-rate tax is only one tax rate that is the same for all income levels
With such a tax, the marginal tax rate is always the same as the average tax rate
Corporate taxation becomes a true flat rate for the highest incomes.
 Tax code is a sequence of numbers, letters, or characters issued to taxpayers by a tax
authority
The purpose of using tax code is to identify each taxpayer and it is uniformly managed nationwide.
The tax code, which is various tax deductions and loopholes, allowed for certain industries and the
taxation of multinational companies
NOTE: tax rates discussed in this section relate to federal taxes only, not the overall tax rate of
state or local

4/ Net Working Capital (NWC)

Net Working Capital = Current Assets – Current Liabilities
Net working capital is positive when the cash that becomes available over the next 12 months will
be greater than the cash that must be paid out.
The change in net working capital is a short-term investment of the firm.
NWC grows with the firm. The growing firm has a positive NWC.

5/ Financial Statement of Cash Flow

The most important item that can be extracted from financial statements is the actual cash flow of
the firm.
In finance, the value of the firm is its ability to generate financial cash flow.
The key point we should mention is that cash flow is not the same as net working capital. Because
using cash will change current assets, but this does not affect net working capital.
Cash flow helps us know when money is in and out of the company.
Net income is not a cash flow
 The cash flow formula of the firm
The cash flow received from the firm’s assets CF(A) must equal the cash flows to the firm’s
creditors CF(B) and equity investors CF(S):
CF(A) = CF(B) + CF(S)
Cash flow of the firm = Cash Flow to Investors in the firm
The value of a firm’s assets = The value of the liabilities and the equity
  Cash flow of the firm – CF(A)
CF(A) = Operating cash flow − Capital spending − Additions to net working capital
CF(A) is also known as free cash flow or distributable cash flow.
CF(A) is the cash flow received from the firm’s operating activities. It represents whether the firm
raised funds or distributed funds on a net basis.
It is usually negative when the business has a high growth rate because at that time spending on
fixed inventory and assets is more than the operating cash flow created.
 Operating cash flow (OCF) = Earnings before interest and taxes + Depreciation − Current
taxes
+ OCF measures the cash generated from business activities, including sales of goods and
services.
+ It reflects tax payment (but not financing), capital spending, or changes in net working capital.
 Capital spending = Acquisitions of fixed assets − Sales of fixed assets
= Increase in tangible assets + Increase in intangible assets
= Net fixed asset + Depreciation

Ending net fixed assets – Beginning net fixed assets

It reflects changes in fixed assets.
 Additions to net working capital = Ending NWC – Beginning NWC
It reflects the cash flows used for making investments in net working capital.
 The total outgoing cash flow of the firm (cash flow of investors) can be separated into cash
flow paid to creditors and cash flow paid to stockholders
 Cash Flow to Creditors – CF(B)
Interest + Retirement of old debt − Proceeds from new debt sales
CF(B) =
Interest – Net new borrowing(change in long-term debt)
 Proceeds from new debt sales = Long-term debt financing: is the amount of unpaid debt
increased
 Net new borrowing = Ending long-term debt − Beginning long-term debt
= New debt – Retirement of old debt
- An important source of cash flow is the sale of new debt (additional debts)
- An increase in long-term debt is the net effect of new borrowing and repayment of maturing
obligations plus interest expense.
 Debt service
- Creditors are paid an amount generally referred to as debt service.
- Debt service = Interest payments + Retirement of debt(repayments of principal)
NOTE: New debt doesn’t need to be paid immediately, it can increase according to each period
 Cash flow to stockholders – CF(S)
Dividends paid + Repurchase of equity − New equity financing
CF(S) =
Dividends paid – Net new equity raised

 Cash to stockholders = Dividends + Repurchase of stock

 New equity financing is issuing new shares of stock or proceeds from a new stock issue
 Net new equity raised = The value of newly issued shares − The value of shares repurchased
 = (Common stock end + APISend ) – (Common stock begin + APIS beg )
+ APIS: Additional Paid-In Surplus
+ The common stock and capital surplus accounts go up the amount, which implies that the
company sold this amount worth of stock.
+ Treasury stock (reacquired stock) is a previously outstanding stock that is bought back from
stockholders by the issuing company. These shares are issued but no longer outstanding and are
not included in the distribution of dividends or the calculation of earnings per share (EPS).
NOTE:
- OCF > NI
- Cash flow to investor of the firm = sale of long-term debt + sale of common stock + dividends
 Some important observations of cash flow
1. Two types of cash flow are relevant to the financial situation of the firm
+ Operating cash flow: is usually positive and if operating cash flow is negative for a long time, a
firm is in trouble because the firm is not generating enough cash to pay operating costs.
+ Total cash flow of the firm (free cash flow): includes adjustments for capital spending and
additions to net working capital. It will frequently be negative when a firm is growing at a rapid
rate, spending on inventory and fixed assets can be higher than operating cash flow.
(the name free cash flow refers to cash that the firm is free to distribute to creditors and
stockholders because it is not needed for working capital or fixed asset investments and it is cash
flow from assets that can be distributed to investors)
2. Net income is not cash flow. Because a part of revenue and expense are non-cash (Revenue
have
accounts receivable and Expense has unpaid costs).
The net income is usually more than cash flow but in determining the economic and financial
condition of a firm, cash flow is more revealing

6/ The Accounting Statement of Cash Flows (reflecting cash flow)

(the Statement of cash flows)
 Benefit of using the Statement of cash flows
- Helps explain the change in accounting cash and equivalents
- Understanding the financial cash flows
 Steps to determine the change in cash
1. Figure out cash flow from operating activities (activities in producing and selling goods and
services)
2. Adjust cash flow from investing activities
3. Adjust cash flow from financing activities. Financing activities are the net payments to
creditors (excluding interest expense) and owners made during the year
 3 components of the statement of cash flows
 Cash flow from operating activities
Referring to the temporarily current resources used for operating business
To calculate we start with net income, which can be found on the income statement
Net income
Depreciation
Deferred taxes
Change in assets
 Accounts receivable
Inventories
Other
(Calculate: last year – this year )
Change in liabilities
Accounts payable
Accrued expense
(Calculate: this year – last year)
Total cash flow from operations
 Cash flow from investing activities (net capital expenditures)
It involves changes in capital assets
Sales of fixed assets
− Acquisition of fixed assets
Total cash flow from investing activities
 Cash flow from financing activities
It is cash flows to and from creditors and owners including changes in equity and debt
Retirement of long-term debt −
Proceeds from long-term debt sales +
Change in notes payable −
Dividends −
Repurchase of stock −
Proceeds from new stock issue +
Total cash flow from financing activities
→ The final line in the statement of cash flows: Change in cash (on the balance sheet) is the
addition of all cash flows (operations + investing + financing)
 A primary difference between the accounting cash flow and the financial cash flow of
the firm is: interest expense
+ Interest expense is the expense incurred from the financing activities, not the operating expense.
+ Interest paid go under financing activities in the financial cash flow (financing cost), but it is
handled as part of operations in the accounting because interest is deducted as an expense when
net income is computed (operating cost)

7/ Cash Flow Management

o Earnings can be manipulated by using subjective decisions of an accountant because they
are required under accounting standards.
o The use of cash flow is more objective but it is harder to manipulate or spin the numbers.
o There are several ways that companies can find to use cash flow as a metric to evaluate a
company by moving cash flow from the investing section to the operating section (making
business operation seem more stable) :
- The company purchased customer security with a large amount, the cash flows from these
transactions were reported in the financing activity section of the accounting statement of cash
flows. When the
The company received payments from customers, the cash inflows were reported as operating cash
flows
- Having acquired companies prepay operating expenses. Another company acquired by the
current company would pay vendors for items not yet received. When the acquired company was
consolidated with the current company, the prepayments will reduce the company’s cash outflows
and increase the operating cash flows.
- The round-trip trades. This involves the sale of natural resources to a counter-party, with the
repurchase of the resources from the same party at the same price. The company treats the cash
from the sale of the asset as an operating cash flow but classified the repurchase as an investing
cash outflow.
- The company capitalized on the labor required to install cable. The company classified this labor
expense as a fixed asset (this practice is fairly common in the telecommunications industry). The
effect of this classification was that the labor was treated as an investment cash flow, which
increased the operating cash flow.
o These movements used to boost operating cash flow, don’t affect the total cash flow of the
firm.
Therefore it is useful to focus on this number, not just operating cash flow.
That makes the firm’s business appear more stable.