FIN 3000

Chapter 3
Financial Statements
Liuren Wu

Overview
1. An Overview of the Firms Financial Statements
2.
3.
4.
5.

The Income Statement

Corporate Taxes
The Balance Sheet
The Cash Flow Statement

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Learning Objectives
1. Understand the content of the 4 basic financial statements.
Focus on

Income statement
Balance sheet statement
Cash flow statement
2. Evaluate firm profitability using the income statement.
3. Estimate a firms tax liability using the corporate tax
schedule and distinguish between the average and marginal
tax rate.

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Principles Used in This Chapter

Principle 1: Money Has a Time Value.
We need to recognize that financial statements do not adjust for time
value of money.

Principle 3: Cash Flows Are the Source of Value.

Financial statements provide an important starting point in determining
the firms cash flow.
We should be able to distinguish between reported earnings and cash
flow. It is possible for a firm to report positive earnings but have no cash!

Principle 4: Market Prices Reflect Information.

Firms financial statements provide important information that is used by
investors in forming expectations about firms future prospects and
subsequently, the market prices.

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Basic Financial Statements

Three types of financial statements are mandated by the accounting and
financial regulatory authorities:
1.

Income statement how much money you made last year?

Revenue, expense, profits over a year or quarter.

2.

Balance sheet Whats your current financial situation?

a snap shot on a specific date of
Assets (value of what the firm owns),
Liabilities (value of firms debts), and
Shareholders equity (the money invested by the company owners)

3.

Cash flow statement How did the cash come and go?
cash received and cash spent by the firm over a period of time

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Why Study Financial Statements?

1. Assess current performance through financial
statement analysis

Next chapter provides more tools for the analysis.

2. Monitor and control operations, and

Both insiders (such as managers, board of directors) and

outsiders (such as suppliers, creditors, investors) use the
statements to monitor and control the firms operations.

3. Forecast future performance.

Financial planning models are typically built using the

financial statements
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Three Accounting Principles

1.

The revenue recognition principle: Revenue should be included in the

income statement for the period in which:

Its goods and services were exchanged for cash or accounts receivable; or

2.

The firm has completed what it must do to be entitled to the cash.

The matching principle: Expenses are matched with the revenues they
helped produce.

For example, employees salaries are recognized when

the product produced as a result of that work is sold,
and not when the wages were paid.
3.

The historical cost principle: Most assets and liabilities are reported in the
financial statements at historical cost, i.e., the price the firm paid to acquire
them. The historical cost generally does not equal the current market value
of the assets or liabilities.

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An Income Statement
Sales
Minus Cost of Goods Sold
= Gross Profit
Minus Operating Expenses
Selling expenses
General and Administrative expenses
Depreciation and Amortization Expense
= Operating income (EBIT)
Minus Interest Expense
= Earnings before taxes (EBT)
Minus Income taxes
= Net income (EAT)

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Sample Income Statement

FIN3000, Liuren Wu

Evaluating a Firms EPS

We can use the income statement to determine the earnings per share
(EPS) and dividends.
EPS = Net income/Number of shares outstanding
Example 1: A firm reports a net income $90 million and has 35 million
shares outstanding, what will be the earnings per share (EPS)?
EPS = Net income Number of shares

= $90 million $35 million

= $2.57

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Evaluating a Firms Dividends per share

Dividends per share = Dividends paid Number
of shares
Example 2: A firm reports dividend payment of
$20 million on its income statement and has 35
million shares outstanding. What will be the
dividends per share?
Dividends per share = dividend payment
Number of shares
= $20 million $35 million
= $0.57
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Connecting the Income Statement and

the Balance Sheet
What can the firm do with the net income?:
1. Pay dividends to shareholders, and/or
2. Reinvest in the firm

Example 3: Review examples 1 & 2. How much

was retained or reinvested by the firm?
Amount retained = Net Income Dividends
= $90m - $20m = $70m
The firms balance on retained earnings will
increase by $70 million on the balance sheet.
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Interpreting Firm Profitability using the

Income Statement
What can we learn from Boswell Inc.s income
statement?
1. The firm has been profitable as its revenues
exceeded its expenses.
2. The gross profit margin (GPM)
= gross profits sales
= $675 million $2,700 million
= 25%

GPM indicates the firms mark-up on its cost of goods sold per
dollar of sales.
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Interpreting Firm Profitability using the

Income Statement (cont.)
3.

The operating profit margin

= net operating income (EBIT) sales
= $382.5 million $2,700 million
= 14.17%
4.
Net profit margin:
= net profits (Net income) sales
= $204.75 million $2,700 million
= 7.58%
These profit margins (gross profit margin, operating profit margin, and net profit margin) should be
closely monitored and compared to previous years and those of competing firms.

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GAAP and Earnings Management

While the firms must adhere to set of
accounting principles, GAAP (Generally
Accepted Accounting Principles), there is
considerable room for managers to influence
the firms reported earnings.
Managers have an incentive to tamper with
reported earnings as their pay depends upon
it and investors care about it.
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Checkpoint 3.1
Constructing an Income Statement
Use the following information to construct an income statement for Gap, Inc. (GPS).
The Gap is a specialty retailing company that sells clothing, accessories, and personal
care products under the Gap, Old Navy, Banana Republic, Piperlime, and Athleta brand
names. Use the scrambled information below to calculate the firms gross profits,
operating income, and net income for the year ended January 31, 2009. Calculate the
firms earnings per share and dividends per share.

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Checkpoint 3.1: Check Yourself

Reconstruct the Gaps income statement assuming the firm is able to cut its
cost of goods sold by 10% and the firm pays taxes at 40% tax rate. What is the
firms net income and earnings per share?

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Step 1: Picture the Problem

Revenues
Less: Cost of goods sold

Less: Operating expenses

Equals Gross
profit
Equals: net
Operating income

Less: Interest expense

Equals: earnings
Before taxes

Less: Income taxes

Equals:
NET INCOME

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Step 2: Decide on a Solution Strategy

Given the account balances, constructing the
income statement will entail substituting the
appropriate balances into the template of step
1.

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Step 3: Solve

Revenues = $14,526,000,000
Less: Cost of goods sold
= $8,171,100,000
Less: Operating expenses
=$3,899,000,000

Less: Interest expense

=$1,000,000
Less: Income taxes (40%)
=$9,819,600,000

Equals: profit
=$6,354,900,000
Equals: net
Operating income
=$2,455,900,000

Equals: earnings
Before taxes
=$2,454,900,000

Equals:
NET INCOME
=$1,472,940,000
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Step 3: EPS and dividends per share

Earnings per share:
= net income number of shares
= $1,472,940,000 716,296,296
= $2.06
Dividends per share
= dividends number of shares
= $243,000,000 716,296,296 = $0.34

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Step 4: Analyze
The firm is profitable since it earned net
income of $1,472,940,000.
The shareholders were able be earn $2.06 per
share. However, the dividends per share were
only $0.34 indicating that the difference of
$1.72 was reinvested in the corporation.
Compute gross profit margin, operating profit
margin, and net profit margin.
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Corporate Taxes
A firms income tax liability is calculated
using its taxable income and the tax rates
on corporate income.

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Corporate tax rates

The table reveals the following:
Tax rates range from 15% to 39%
Tax rates are progressive i.e. larger corporations
with higher profits will tend to pay more taxes
compared to smaller firms with lower profits.
Note: In addition to federal taxes, a firm may face
State and City taxes.

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Marginal and Average Tax Rates

While analyzing the tax consequences of a
new business venture, the appropriate tax
rate is the marginal tax rate.
Marginal tax rate is the tax rate that the
company will pay on its next dollar of taxable
income.
Average tax rate is total taxes paid divided by
the taxable income.
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Marginal and Average Tax Rates

Example 3: What is the average and marginal
tax liability for a firm reporting $100,000 as
taxable income.
Taxable
Income

Marginal
tax rate

Incrementa Cumulativ
l Tax
e Tax
Liability
Liability

Average
Tax Rate

$50,000

15%

7,500

7,500

15.00%

$75,000

25%

6,250

13,750

18.33%

$100,000

34%

8,500

22,250

22.25%

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Marginal and Average Tax Rates

Average tax rate
= Total tax liability Total taxable income
= $22,250 $100,000
= 22.25%

Marginal tax rate

= 39% as the firm will have to pay 39% on its next
dollar of taxable income i.e. if its taxable income
increases from $100,000 to $100,001.
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The Balance Sheet

The balance sheet provides a snapshot of the
firms financial position on a specific date. It is
defined by:
Total Assets = Total Liabilities + Total Shareholders Equity
(asset) = (sources of funding)

Total assets represents the resources owned by

the firm.

Total liabilities represent the total amount of

money the firm owes its creditors.
Total shareholders equity refers to the difference
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in the value of the firms total assets and the

Asset value calculation

In general, GAAP requires that the firm report
assets on its balance sheet using the historical
costs.
Cash and assets held for sale (such as
marketable securities) are an exception to the
rule. These assets are reported using the
lower of their cost or current market value.
Assets whose value is expected to decline
over time (such as equipment) is reported as
net equipment which is equal to the
historical cost minus accumulated
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Assets and liabilities

Current assets consists of firms cash plus
other assets the firm expects to convert to
cash within 12 months or less, such as
receivables and inventory.
Fixed assets are assets that the firm does not
expect to sell within one year. For example,
plant and equipment, land.
Current liabilities represent the amount that
the firm owes to creditors that must be repaid
within a period of 12 months or less such as
accounts payable, notes payable.
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The stockholders equity

Two components:
1.The amount the company received from
selling stock to investors. It may be shown as
common stock in the balance sheet or it may
be divided into two components: par value
and additional paid in capital above par. Par value
is the stated or face value a firm puts on each share of stock. Paid in capital is
the additional amount the firm raised when it sold the shares.

For example, DLK corporations par value per share is $2.00 and the firm has 30 million shares
outstanding such that the par value of the firms common equity is $60 million. If the stocks
were issued to investors for $240 million, $180 million represents paid in capital.

2. The amount of the firms retained earnings: the portion of net income
that has been retained (i.e., not paid in dividends) from prior years
operations.
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Firm Liquidity and Net Working

Capital
Liquidity refers to the speed with which the asset can be converted to
cash without loss of value.
For example, a firms bank account is perfectly liquid. Other types of
assets are less liquid as they more difficult to sell and convert to cash such
as PPE (property, plant and equipment).
For the overall firm, liquidity generally refers to the firms ability to covert
its current assets (accounts receivable and inventories) into cash so that it
can pay its bills (current liabilities) on time.
We can thus measure a firms liquidity by computing the net working
capital = current assets current liabilities.

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Firm Liquidity and Net Working

Capital
If a firms net working capital is significantly
positive, it is in a good position to pay its
debts on time and is consequently very liquid.
Lenders consider the net working capital as an
important indicator of firms ability to repay
its loans.

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Checkpoint 3.2
Constructing a Balance Sheet
Construct a balance sheet for Gap, Inc. (GPS) using the following list of jumbled
accounts for January 31, 2009. Identify the firms total assets and net working capital:

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Step 4: Analyze
The firm has invested a total of $7.564B in
assets, funded by $2.158B current liability,
$1.019B long-term liability, and $4.387B
owner equity.
The firm has $4.005B in current assets and
$2.158B in current liability, leaving the firm
with a net working capital of $4.005-2.1581.847B.
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Checkpoint 3.2: Check Yourself

Reconstruct the Gaps balance sheet to reflect the repayment of $1 billion in

short-term debt using a like amount of the firms cash. What is the balance
for total assets and current liabilities?

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Step 1: Picture the Problem

Current Assets
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets

Current Liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities

Long-term (fixed) assets

Gross PPE
Less: Accumulated depreciation
Net property, plant and equip.
Other long-term assets
Total long-term assets

Total Assets

Long-term Liabilities
Long-term debt
Owners Equity
Par value of common stock
Paid-in-capital
Retained earnings
Total equity

Total Liabilities and

Owners equity

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Step 2: Decide on a Solution

Strategy
We are given the account balances so in order
to construct the balance sheet we need to
substitute the appropriate balances into the
template developed in step 1.
Deduct $1B from both cash and current
liability.

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Step 3: Solve
Cash
Inventories
Other current
assets

756,000,000
1,506,000,000
743,000,000

Current liabilities

1,158,000,000

Total current
assets

3,005,000,000

Total current
liabilities

1,158,000,000

Net Property,
Plant and
equipment

2,993,000,000

Long-term
liabilities

1,019,000,000

Other long-term
assets

626,000,000

Common Equity

4,387,000,000

Total Assets

$6,564,000,000

Total Liabilities
and Equity

$6,564,000,000

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Step 4: Analyze
We can make the following observations from Gaps Balance
sheet:

The total assets of $6,564,000,000 is financed by

a combination of current liabilities, long-term
liabilities and owners equity. Owners equity
accounts for $4,387,000,000 of the total.
The firm has a healthy net working capital of
$1,847,000,000 (3,005,000,000 minus
1,158,000,000).

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Debt versus Equity Financing

The right-hand side of the balance sheet reveals the sources of money
used to finance the purchase of the firms assets listed on the left-hand
side of the balance sheet.
It shows how much was borrowed (debt financing) and how much was
provided by firms owners (equity financing, through the sale of equity or
retention of prior years earnings).
Payment: Payment for debt holders is generally fixed (in the form of
interest); Payment for equity holders (dividends) is not fixed nor
guaranteed.
Seniority: Debt holders are paid before equity holders in the event of
bankruptcy.
Maturity: Debt matures after a fixed period while equity securities do not
mature.

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The Cash Flow Statement

The Cash Flow Statement is used by firms to
explain changes in their cash balances over a
period of time by identifying all of the sources
and uses of cash.
Source of cash is any activity that brings cash into
the firm. For example, sale of equipment.
Use of cash is any activity that causes cash to
leave the firm. For example, payment of taxes.

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Cash Flow Analysis

Why did the cash balance decline by $4.5
million from 2009 to 2010?
1. Accounts receivable increased by $22.5 million
representing an increase in uncollected cash from
credit sales. It represents $22.5m of use of cash
to invest in accounts receivable.
2. Inventory increased by $148.50 million indicating
use of cash to procure inventory.
3. Equipment increased by $175.50 million
indicating use of cash to invest in equipment.

In general,
Liuren Wu
an increase in anFIN3000,
asset
account = use of cash

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Cash Flow Analysis (cont.)

4.

5.
6.
7.

Accounts Payable, credit extended to the firm, increased by $4.5million.

Thus source of cash increased by $4.5million due to accounts payable.
Long-term debt increased by $51.75 million indicating a source of cash.
Short-term debt decreased by $9 million indicating use of cash to pay off
the debt.
Retained earnings increased by $159.75 million representing a source of
cash to the firm from the firms operations.
In general,
An increase in a liability account = source of cash
A decrease in a liability account = use of cash

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Cash Flow Analysis (cont.)

Change in cash balance = Sources of cash
Use of Cash = $216 - $220.50 = -$4.50
Sources of Cash

Uses of Cash

Increase in Accounts Payable

= $4.50

Increase in Accounts Receivable

$22.50

Increase in long-term debt

=$51.75

Increase in inventory =
$148.50

Increase in retained earnings =

$159.75

Increase in net plant and

equipment = $40.50
Decrease in short-term notes =
$9

Total Sources of cash =

$216.00

Total Uses of cash = $220.50

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Cash Flow Analysis (cont.)

An analysis of H.J. Boswells operations reveals the following
for 2010:

The firm used more cash than it generated,

resulting in a deficit of $4.5 million
The primary source of cash flow was retained
earnings ($159.75 million) followed by long-term
debt ($51.75 million)
The largest use of cash was for acquiring inventory
at $148.5 million.
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Cash Flow Analysis Summary

Sources of Cash

Uses of Cash

Decrease in an asset
account
Increase in a liability
account

Increase in an asset
account
Decrease in a liability
account

Increase in an owners
equity account

Decrease in an owners
equity account

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Cash Flow Statement

The format for a traditional cash flow statement is as follows:
Beginning Cash Balance
Plus: Cash Flow from Operating Activities
Plus: Cash Flow from Investing Activities
Plus: Cash Flow from Financing Activities
Equals: Ending Cash Balance

Operating activities represent the companys core business including sales and
expenses. Basically any activity that affects net income for the period.
Investing activities include the cash flows that arise out of the purchase and sale of
long-term assets such as plant and equipment.
Financing activities represent changes in the firms use of debt and equity such as issue
of new shares, payment of dividends.

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FIN3000, Liuren Wu

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Checkpoint 3.3:
Interpreting the Statement of Cash Flow
Chesapeake Energy Inc. (CHK) is the largest producer of natural gas in
the United States and is headquartered in Oklahoma City. The firms
cash flow statements for 2004 through 2007:

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Analyze
Chesapeake has had positive & growing cash flows from operations in all 4
years.
The primary contributor were the firms net income and depreciation expense.
Working capital is a source of cash in 3 out of 4 years, indicating the net reduction
in the firms investment in working capital.

Chesapeake has been very aggressive in new fixed assets and acquisitions of
new oil and gas properties. Total investments have been roughly two times the
cash flow from operation, which meant that the firm had to raise a substantial
amount of money.
Chesapeake has been a regular issuer of both equity and debt. $13.5 billion
was raised in the 4-year period. Chesapeake has made relatively modest
modest cash distributions and retained most earnings.

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Checkpoint 3.3: Check Yourself

Go to http:finance.google.com/finance and get the cash flow
statements for the most recent four-year period for Exco
Resources (XCO). How does their cash from investing activities
compare to their cash flow from operating activities in 2009.

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Step 1: Picture the Problem

The cash flow statement uses information
from the firms balance sheet and income
statement to identify the net sources and uses
of cash for a specific period of time.
The sources and uses of cash are organized
into cash from operating activities, investing
activities, and financing activities.

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Step 1: Picture the Problem (cont.)

The format for a traditional cash flow statement is as follows:
Beginning Cash Balance
Plus: Cash Flow from Operating Activities
Plus: Cash Flow from Investing Activities
Plus: Cash Flow from Financing Activities
Equals: Ending Cash Balance

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Step 1: Picture the Problem (cont.)

Here we have to compare the cash flow from
operating activities and investment activities
in 2007 for Exco Resources (XCO).

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Step 2: Decide on a Solution

Strategy
We can compare the cash flow from operating
activities and cash flow from investing
activities by looking at the cash flow
statement.
The cash flow statement can be retrieved from
http://finance.google.com/finance

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Step 3: Solve
Cash flow from operating activities
EXCO had a positive cash flow from operating
activities of $577.83 million in 2007. In 2006, the
cash flow from operating activities was much
lower at $227.86.
The primary contributors to the operating cash
flows in 2007 were the firms
depreciation/depletion expense and non-cash
expense. Net working capital is a use of cash.
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Step 3: Solve (cont.)

Cash flow from investing activities:
Cash flow from investing activities were
($2,396.44) million in 2007.
EXCO had invested heavily in capital expenditures
in 2007 with a total expense of $2,846.97 million.

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Step 4: Analyze
The cash flow statement for 2007 depicts a profitable firm
with positive cash flow from operations.
The firm has been aggressively investing in fixed assets to the
tune of almost 4 times its operating cash flows.
The firm has been able to successfully raise money from
capital markets by issuing stocks of nearly $2,000 million.

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