LN03Titman 449327 12 LN03

Chapter 3
Understanding
Financial
Statements,
Taxes, and
Cash Flows
Slide Contents
Learning Objectives
1.
2.
3.
4.
5.
An Overview of the Firms Financial Statements

The Income Statement
Corporate Taxes
The Balance Sheet
The Cash Flow Statement
Principles Applied in This Chapter

Key Terms
Copyright 2014 Pearson Education, Inc. All rights reserved.
3-2
Learning Objectives
1. Describe the content of the four basic
financial statements and discuss the
importance of financial statement analysis
to the financial manager.
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.
3-3
Learning Objectives (cont.)

4. Use the balance sheet to describe a firms
investments in assets and the way it has
financed them.
5. Identify the sources and uses of cash for a
firm using the firms cash flow statement.
3-4
Principles Used in This Chapter

Principle 1: Money Has a Time Value.
Principle 3: Cash Flows Are the Source of
Value.
Principle 4: Market Prices Reflect
Information.
Principle 5: Individuals Respond to
Incentives.
3-5
3.1 AN OVERVIEW OF THE

FIRMS FINANCIAL
STATEMENTS
3-6
Basic Financial Statements

The accounting and financial regulatory
authorities mandate the following four types
of financial statements:
1.
2.
3.
4.
Income statement
Balance sheet
Cash flow statement
Statement of shareholders equity
3-7
Basic Financial Statements (cont.)

1. Income Statement: An income statement
provides the following information for a
specific period of time (for example, a full
year or quarterly):
Revenue earned,
Expenses incurred, and
Profit earned.
3-8

2. Balance sheet: Balance sheet contains
information on a specific date (for example,
as of December 31, 2013) of the following:
Assets (everything of value the company owns),
Liabilities (the firms debts), and
Shareholders equity (the money invested by the
company owners).
3-9

3. Cash flow statement: It reports cash
received and cash spent by the firm over a
period of time.
4. Statement of shareholders equity: It
provides a detailed account of the firms
activities in the following accounts:
Common stock & Preferred stock account,
Retained earnings account, and Changes to
owners equity.
3-10
Why Study Financial Statements?

Analyzing a firms financial statement can help
managers carry out three important tasks:
1. Assess current performance,
2. Monitor and control operations, and
3. Plan and forecast future performance.
3-11
Why Study Financial Statements?

(cont.)
This chapter discusses the distinction
between the earnings numbers that the
firms accountants calculate and the amount
of cash that a firm generates.
It is possible for a firm to report positive
accounting earnings while generating
negative cash flows (and vice versa).
3-12
What are the Accounting Principles Used

to Prepare Financial Statements?
Accountants use the following three
fundamental principles when preparing
financial statements:
1. The revenue recognition principle,
2. The matching principle, and
3. The historical cost principle.
3-13
3.2 THE INCOME STATEMENT
3-14
An Income Statement
An income statement (also called a profit and
loss statement) measures the amount of
profits generated by a firm over a given time
period (usually a year or a quarter). It can be
expressed as follows:
Revenues (or Sales) Expenses = Profits
3-15
An Income Statement (cont.)

An income statement will contain the
following:
1. Revenues
2. Expenses
Cost of goods sold, Selling expenses, General
and administrative expense, depreciation &
amortization expense, Interest expense, and
Income tax expense
3. Net Income
Difference between Revenue and all expenses
3-16
Table 3.1 H. J. Boswell, Inc.
3-17
Evaluating a Firms per Share

Earnings (EPS) and Dividends
Per Share earnings = companys net income
divided by the number of common shares
outstanding.
Dividends per share = total dividends paid
divided by the number of common shares
outstanding.
3-18
Evaluating a Firms EPS and

Dividends (for Boswell, Table 3.1)
Earnings per share
= $204.75m 90m
= $2.28 per share
Dividends per share = $45m 90m

= $0.50 per share
3-19
Connecting the Income Statement

and the Balance Sheet
What can the firm do with the net income?:
Pay dividends to shareholders, and/or
Reinvest in the firm
Boswell, Inc. earned net income of $204.75
million, of which $45 million was distributed in
dividends and $159.75 million was retained and
reinvested in the firm.
3-20
Interpreting Firm Profitability using

the Income Statement
From H.J. Boswell Inc.s income statement
(Table 3-1) we observe that firm has been
profitable. We can identify three different
measures of profit or income:
1. The gross Profit margin is 25% ($675 million)
2. The operating profit margin is only 14.2% ($382.5
million)
3. The net profit margin is only 7.6% ($204.75 million)
3-21

the Income Statement (cont.)
1. 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. The markup
percentage equals gross profit divided by cost of
goods sold (=$675m $2.025m = 33.3%)
3-22

2. The operating profit margin
= net operating income sales
= $382.5 million $2,700 million
= 14.17%
The operating profit margin is equal to the ratio
of net operating income or EBIT divided by
firms sales.
3-23

3. The net profit margin
= net profits sales
= $204.75 million $2,700 million
= 7.6%
Net profit margin indicates the percentage of
revenues left over after all expenses (including
interest and taxes) have been considered.
3-24

By monitoring any changes in these margins
and comparing these margins to those of
similar businesses, we can dissect and identify
a firms performance and identify expenses
that are out of line.
3-25
GAAP and Earnings Management

While the firms must adhere to GAAP, there
is considerable room for managers to
actively influence the firms reported
earnings.
Managers have an incentive to tamper with
earnings as their pay depends upon it and
because investors pay close attention to
earnings announcements.
3-26
GAAP and Earnings Management

An audit by an independent accounting firm
serves as a check and balance to control
managements incentive to disguise the firms
financial condition.
3-27
CHECKPOINT 3.1:
CHECK YOURSELF
Constructing an Income Statement
Reconstruct the firms income statement
assuming the firm is able to cut its cost of
goods sold by 10% and that the firm pays
taxes at a 40% rate. What is the firms net
income and earnings per share?
3-28
Step 1: Picture the Problem

The income statement can be expressed as
follows:
Revenues Expenses = Net Income
We are given information on revenues and

expenses (cost of goods sold, operating
expenses, interest expense and income
taxes) to fill the template given on next
slide.
3-29
Step 1: Picture the Problem (cont.)

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
3-30
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.
3-31
Step 3: Solve
Revenues = $14,549,000,000
Less: Cost of goods sold
= $8,347,500,000
Less: Operating/other expenses
=$3,841,000,000
Less: Interest expense

=$74,000,000
Less: Income taxes (40%)
=$916,600,000
Equals: profit
=$6,201,500,000
Equals: net
Operating income
=$2,370,500,000
Equals: earnings
Before taxes
=$2,291,500,000
Equals:
NET INCOME
=$1,374,900,000
3-32
Step 3: Solve (cont.)

Earnings per share:
= net income number of shares
= $1,374,900,000 716,296,296
= $1.92
3-33
Step 4: Analyze
The firm is profitable since it earned net
income of $1,374,900,000. The shareholders
were able be earn $1.96 per share.
3-34
3.3 CORPORATE TAXES
3-35
Corporate Taxes
A firms income tax liability is based on its
taxable income and the tax rates on corporate
income.
3-36
Computing Taxable Income

The table reveals the following:
Tax rates range from 15% to 39%
Tax rates are progressive i.e. corporations with
higher profits tend to pay more taxes.
3-37
Marginal and Average Tax Rates

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.
3-38

Example: What is the average and marginal
tax liability for a firm reporting $100,000 as
taxable income.
3-39

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.
3-40
Dividend Exclusion for Corporate

Shareholders
The dividend received by corporate
stockholders are partially exempt from
taxation. The rationale is to avoid double
taxation at the corporate level. The
percentage of exempt taxes is based on the
degree of ownership of the firm.
3-41
Dividend Exclusion for Corporate

Shareholders
Example What will be the taxable income if
firm A receives $100,000 in dividends from
firm B.
3-42
3.4 THE BALANCE SHEET
3-43
The Balance Sheet

The balance sheet provides a snapshot of the
firms financial position on a specific date. It
is defined by the following equation:
Total Assets = Total Liabilities + Total
Shareholders Equity
3-44
The Balance Sheet (cont.)

Total liabilities represent the total amount
of money the firm owes its creditors
Total shareholders equity refers to the
difference in the value of the firms total
assets and the firms total liabilities.
Total assets, sum of total shareholders
equity and total liabilities, represents the
resources owned by the firm.
3-45

In general, GAAP requires that the firm
report assets 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.
3-46

Assets whose value is expected to decline
over time (such as equipment) is reported as
net equipment(equal to historical cost less
the accumulated depreciation). Net value
(also known as accounting or book value)
could be significantly different from the
market value of the asset.
3-47
Table 3.2 H. J. Boswell, Inc.
3-48
Table 3.2 H. J. Boswell, Inc. (cont.)
3-49
Figure 3.1 The Balance Sheet
3-50

The balance sheet includes the following main
components:
1.Assets It includes current assets and fixed
assets.
2.Liabilities and Stockholders Equity It
indicates how the firm finances its assets. It
includes current liabilities, long-term liabilities,
and owners equity.
3-51

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.
3-52

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.
Long-term liabilities refer to debt with
maturities longer than a year such as bank
loans, bonds.
3-53

The stockholders equity includes the
following: Par value of common stock + Paid
in Capital + Retained Earnings.
We can also express stockholders equity as
follows:
Shareholders' equity = Total Assets Total Liabilities
3-54
Firm Liquidity and Net Working

Capital
Liquidity generally refers to the firms ability
to covert its current assets into cash so that it
can pay its current liabilities on time. We can
thus measure a firms liquidity by computing
its net working capital (equal to current
assets less current liabilities).
3-55
Firm Liquidity and Net Working

Capital (cont.)
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.
3-56
CHECKPOINT 3.2:
CHECK YOURSELF
Constructing a Balance Sheet
Reconstruct the Gaps balance sheet to
reflect the repayment of $1 billion in shortterm debt using a like amount of the firms
cash. What is the balance for total assets
and current liabilities?
3-57

The firms balance sheet can be expressed
as follows:
Total Shareholders Equity +
Total Liabilities
= Total Assets
3-58
Step 1: Picture the Problem (cont.)

Current Assets
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets
Long-term (fixed) assets
Gross PPE
Less: Accumulated depreciation
Net property, plant and equip.
Other long-term assets
Total long-term assets
Total Assets
Current Liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
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
3-59

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.
3-60
Step 3: Solve
Cash
Inventories
Other current
assets
885,000,000
1,615,000,000
809,000,000
Current
liabilities
1,128,000,000
1,128,000,000
Total current
assets
3,309,000,000
Total current
liabilities
Net Property,
Plant and
equipment
2,523,000,000
Long-term
liabilities
Other long-term 590,000,000

assets
Total Assets
Common Equity
$6,422,000,00 Total Liabilities

0
and Equity
2,539,000,000
2,755,000,000
$6,422,000,00
0
3-61
Step 4: Analyze
We can make the following observations from
Gaps Balance sheet:
The total assets of $6,422,000,000 is financed
by a combination of current liabilities, long-term
liabilities and owners equity. Owners equity
accounts for $2,755,000,000 of the total.
The firm has a healthy net working capital of
$2,181,000,000.
3-62
Debt and Equity Financing

The right-hand side of the balance sheet
reveals the following two sources of money
used to finance the purchase of the firms
assets listed on the left-hand side of the
balance sheet.
Borrowings (debt financing)
firms owners (equity financing)
3-63
Debt versus Equity

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.
3-64
Book Values, Historical Costs, and

Market Values
Book values (based on historical cost)
reported in the balance sheet can differ from
market values.
The gap is likely to be higher for fixed assets
relative to current assets for two reasons:
3-65
3.5 THE CASH FLOW

STATEMENT
3-66
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 for the period
spanned by the statement.
3-67
Sources and Uses of Cash

A source of cash is any activity that brings
cash into the firm. For example, sale of
equipment.
A use of cash is any activity that causes
cash to leave the firm. For example,
payment of taxes.
3-68
Table 3-3 H. J.
Boswell, Inc.,
Balance Sheets
and Balance
Sheet Changes
3-69
Cash Flow Analysis (cont.)

Why did the cash balance decline by $4.50m?.
See table 3.1 and table below:
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
3-70
Cash Flow Analysis (cont.)

An analysis of H.J. Boswells operations
reveals the following:
The firm used more cash than it generated,
resulting in a deficit of $4.5 million
The main source of cash flow was retained
earnings ($159.75m) and long-term debt
($51.75m)
The largest use of cash was for acquiring
inventory at $148.5 million.
3-71
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
3-72
Cash Flow Statement

The basic format for a 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
3-73
Cash Flow Statement (cont.)

Operating activities represent the companys
core business, including sales and expenses.
Investing activities include the cash flows
that arise out of the purchase and sale of
long-term assets such as plant and
equipment.
3-74
Cash Flow Statement (cont.)

Financing activities represent changes in the
firms use of debt and equity such as issue of
new shares, the repurchase of outstanding
shares, and the payment of dividends.
3-75
Table 3-4 H. J. Boswell, Inc.
3-76
Evaluating the Cash Flow Statement

The statement can be used to answer a
number of important questions such as:
How much cash did the firm generate from its
operations?
How much did the firm invest in plant and
equipment?
Did the firm raise additional funds, and if so, how
much and from what sources?
Is the firm able to generate positive cash flows?
3-77
Quality of Earnings: Evaluating Cash

Flow from Operations
Since reported earnings can sometimes be
misleading, we can combine information from
the firms income statement and the
statement of cash flows to evaluate the
quality of firms reported earnings.
3-78

Flow from Operations (cont.)
A ratio of 1.00 indicates very high quality of
earnings and that the firms operating cash
flows and net income are in sync with each
other.
A low ratio indicates firms reliance on nonoperating sources of cash to generate net
income that may not be sustainable.
3-79

Flow from Operations (cont.)
The quality of earnings ratio for Boswell for
2013 = $173.25m $ 204.75m = 84.6%
Boswells ratio was only 84.6% due to more
credit sales than it collected, increase in
inventories, non-cash depreciation expense,
and increased reliance on accounts payable.
3-80
Sustainable Capital Expenditures:

Evaluating Investment Activities
This ratio calculates the extent to which
the firms operating cash flows can pay for
capital expenditures. Higher ratio will
mean less dependence on capital markets
for financing.
3-81
Sustainable Capital Expenditures:

Evaluating Investment Activities (cont.)
For Boswell, the capital acquisition ratio is:
= $157.75m $159.5m = 98.9%
Boswell was, on average, able to finance

98.9% of its new expenditures out of the
firms current-year operations.
3-82
CHECKPOINT 3.3:
CHECK YOURSELF
Interpreting the Statement of Cash Flows
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 2012.
3-83

The cash flow statement identifies the net
sources and uses of cash for a specific
period of time into 3 groups: operating
activities, investing activities, and financing
activities.
Here we have to compare the cash flow
from operating activities and investment
activities in 2012 for Exco Resources (XCO).
3-84

Strategy
We can compare the cash flow from operating
activities and cash flow from investing
activities by retrieving the cash flow
statement from
http://finance.google.com/finance
3-85
Step 3: Solve
Cash flow from operating activities
EXCO had a positive cash flow from operating
activities of $514.78 million in 2012. In 2011,
the cash flow from operating activities was much
lower at $428.54 million. The primary
contributors to the operating cash flows were
adjustments to net income.
3-86
Step 3: Solve (cont.)

Cash flow from investing activities:
Cash flow from investing activities were
($426.09) million in 2012. EXCO had invested
heavily in capital expenditures with a total
expense of $536.92 million.
3-87
Step 4: Analyze
The cash flow statement for 2012 depicts a
profitable firm with positive cash flow from
operations that have been steadily
increasing since 2010. In 2010, cash flow
from operations were only $339.92 million.
The firm has been aggressively investing in
fixed assets. However, it has dropped
significantly compared to 2011 ($1,041
million).
3-88
Key Terms
Accounts receivable
Accounts payable
Accumulated depreciation
Average tax rate
Balance sheet
Cash flow from operations
Cash flow statement
3-89
Key Terms (cont.)
Cost of goods sold

Current assets
Current liabilities
Depreciation expense
Dividends per share
Earnings before interest and taxes (EBIT)
Earnings per share
3-90
Key Terms (cont.)
Fixed assets
Gross plant and equipment
Gross profit margin
Income statement
Inventories
Liquidity
Long-term debt
3-91
Key Terms (cont.)
Marginal tax rate

Market value
Net operating income
Net income
Net plant and equipment
Net profit margin
Net working capital
Notes payable
3-92
Key Terms (cont.)
Operating profit margin

Paid-in capital
Par value
Profits
Quality of earnings ratio
Retained earnings
Revenues
3-93
Key Terms (cont.)
Source of cash
Stockholders equity
Taxable income
Total assets
Total liabilities
Total shareholders equity
Treasury stock
Uses of cash
3-94

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Chapter 3

An Overview of the Firms Financial Statements

Principles Applied in This Chapter

Copyright 2014 Pearson Education, Inc. All rights reserved.

Learning Objectives (cont.)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Principles Used in This Chapter

Copyright 2014 Pearson Education, Inc. All rights reserved.

3.1 AN OVERVIEW OF THE

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Basic Financial Statements

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Basic Financial Statements (cont.)

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Basic Financial Statements (cont.)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Basic Financial Statements (cont.)

Why Study Financial Statements?

Copyright 2014 Pearson Education, Inc. All rights reserved.

Why Study Financial Statements?

Copyright 2014 Pearson Education, Inc. All rights reserved.

What are the Accounting Principles Used

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3.2 THE INCOME STATEMENT

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Copyright 2014 Pearson Education, Inc. All rights reserved.

An Income Statement (cont.)

Table 3.1 H. J. Boswell, Inc.

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Evaluating a Firms per Share

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Evaluating a Firms EPS and

Dividends per share = $45m 90m

Copyright 2014 Pearson Education, Inc. All rights reserved.

Connecting the Income Statement

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using

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Interpreting Firm Profitability using

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GAAP and Earnings Management

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GAAP and Earnings Management

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Step 1: Picture the Problem

We are given information on revenues and

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Step 1: Picture the Problem (cont.)

Less: Operating expenses

Less: Interest expense

Less: Income taxes

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Step 2: Decide on a Solution

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Less: Interest expense

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Step 3: Solve (cont.)