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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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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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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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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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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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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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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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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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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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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?