chapter 2 financial statements. © 2013 pearson education, inc. all rights reserved.2-2 1.explain...

Chapter 2

Financial Statements

© 2013 Pearson Education, Inc. All rights reserved. 2-2

1. Explain the foundations of the balance sheet and income statement

2. Use the cash flow identity to explain cash flow.

3. Provide some context for financial reporting.

4. Recognize and view Internet sites that provide financial information.

Learning Objectives


2.1 Financial Statements

• Four main financial statements:– Balance sheet– Income Statement– Statement of Retained Earnings– Statement of Cash Flow

• Our focus..– Interrelationship between the balance sheet and

the income statement – – The process by which these statements can be

used to project a firm’s future cash flows,


2.1 Financial Statements (continued)

(A) Balance Sheet• Represents the assets owned by the

company and the claims against those assets

• Based on the accounting identity:Assets Liabilities + Owners’ Equity (2.1)


Figure 2.1 Balance sheet


2.1 (A) Balance Sheet

Has 5 main sections:1. Cash account

• Where did the $65 million decline come from?

2. Working capital accounts• Net working capital = Current assets – Current liabilities (2.2)

3. Long-term asset accounts• Plant and equipment; land and buildings• Gross value – accumulated depreciation = Net value

4. Long-term liabilities (debt) accounts• Loans maturing in over 1 year

5. Ownership accounts• Shareholders’ equity• Retained earnings—accumulated total since inception


2.1 (B) The Income Statement

• Shows the expenses and revenues generated by a firm over a past period, typically a quarter or a year.

• Net income = Revenues – expenses (2.3)

• EBIT = Revenues – operating expenses (2.4)


2.1 (B) Income Statement example

Figure 2.2


2.1 (B) The Income Statement (continued)

• Net income is not the same as cash flow• Firm earned an income of $5,642 million• Cash account decreased by 65 million

• 3 reasons:• Accrual accounting• Non-cash expense items --depreciation• Preference to classify interest expense as part of

financial cash flow


2.1 (C) The Statement of Retained Earnings

Figure 2.4


2.2 Cash Flow Identity and the Statement of Cash Flows

The cash flow identity states that the cash flow on the left-hand side of the balance sheet is equal to the cash flow on the right-hand side of the balance sheet.

CASH FLOW CASH FLOW CASH FLOW FROM ASSETS = TO CREDITORS + TO OWNERS


Figure 2.5 Cash Flow Identity and components


2.2 (A) The First Component: Cash Flow From Assets

3 components: • Operating cash flow (OCF)• Net capital spending (NCS)• Change in net working capital (∆NWC)

• Cash flow from assets = OCF – NCS - ∆NWCOCF = EBIT + Depreciation – TaxesNCS = End. Net – Beg. Net +

Depreciation Fixed Assets Fixed Assets

∆NWC=Ending NWC – Beginning NWC


2.2 (A) The First Component: Cash Flow From Assets (continued)

OCF = EBIT + Depreciation – Taxes

Figure 2.3



NCS = End. Net – Beg. Net + Depreciation Fixed Assets Fixed Assets

NCS= ($11,961 - $10,788) + $1,406 = $2,579



∆NWC=Ending NWC – Beginning NWC

Net working capital for 2007 = $9,130 - $6,860 = $2,270 Net working capital for 2006 = $10,454 - $9,406 = $1,048Change in NWC = $2,270 - $1,048 = $1,222



• Putting it all together….

• Cash flow from Assets = OCF – NCS - ∆ NWC =$7,287-$2,579-$1,222 =$3,486


2.2 (B) The Second Component: Cash Flow To Creditors

Cash Flow to Creditors = Interest Expense Net New Borrowing from Creditors

Net New Borrowing = Ending Long-term Liabilities Beginning Long-Term Liabilities

Cash Flow to Creditors = $239 (-$378) $617


2.2 (C) The Third Component: Cash Flow To Owners

Cash flow to owners = Dividends - Net new borrowing from owners

= $2,869 - $0

= $2,869


2.2 (C) Putting It All Together: The Cash Flow Identity

Cash flow from assets = cash flow from creditors + cash flow to owners

$3,486 = $617 + $2,869


2.3 Financial Performance Reporting

• Annual reports to shareholders • Quarterly (10-Q) and annual (10-K) reports

filed with the SEC – Regulation Fair Disclosure (Reg. FD)

– Notes to the Financial Statements


2.4 Financial Statements on the Internet

• EDGAR (www.sec.gov/edgar.shtml)• Yahoo! Finance (http://finance.yahoo.com.)• Many, many more websites with wealth of

information

http://www.sec.gov/edgar.shtml

http://finance.yahoo.com/


Additional Problems with AnswersProblem 1

Balance Sheet. Chuck Enterprises has current assets of $300,000, and total assets of $750,000. It also has current liabilities of $125,000, common equity of $250,000, and retained earnings of $85,000. How much long-term debt and fixed assets does the firm have?


Additional Problems with AnswersProblem 1 (Answer)

Current Assets + Fixed Assets = Total Assets

$300,000+Fixed Assets = $750,000

Fixed Assets = $750,000 - $300,000 = $400,000

Total Assets = Current Liabilities + Long-term debt +Common equity + Retained Earnings

$750,000 = $125,000 + Long-term debt + $250,000 + 85,000

Long-term debt = $750,000 - $125,000-$250,000 - $85,000

Long-term debt = $290,000



Income Statement. The Top Class Company had revenues of $925,000in 2009. Its operating expenses (excluding depreciation) amounted to $325,000, depreciation charges were $125,000, and interest costs totaled $55,000. If the firm pays a marginal tax rate of 34 percent, calculate its net income after taxes.



Revenues $925,000Less operating expenses 325,000

= EBITDA 600,000Less depreciation 125,000

= EBIT 475,000Less interest expenses 55,000

= Taxable Income 420,000Less taxes (34%) 142,800

= Net Income after taxes 277,200



Retained Earnings: The West Hanover Clay Co. had, at the beginning of the fiscal year, November 1, 2009, retained earnings of $425,000. During the year ended October 31, 2010, the company generated net income after taxes of $820,000 and paid out 35 percent of its net income as dividends. Construct a statement of retained earnings and compute the year-end balance of retained earnings.



Statement of Retained Earnings for the year ended October 31, 2010

Balance of Retained Earnings, 11/1/2009……….$425,000

Add: Net income after taxes, 10/31/2010………. $820,000Less: Dividends paid for year-end 10/31/2010…$287,000

Balance of Retained Earnings, 10/31/2010….. $958,000



Working Capital: D.K. Imports, Incorporated reported the following information at its last annual meeting:

Cash and cash equivalents = $1,225,000;

Accounts payables = $3,200,000

Inventory = $625,000;

Accounts receivables = $3,500,000;

Notes payables = $1,200,000;

Other current assets = $125,000.

Calculate the company’s net working capital.



Net Working Capital = Current Assets – Current Liabilities

(Cash & Cash Equivalents + Accts. Rec. + Inventory + other current assets) - (Accounts Payables + Notes Payables)

($1,225,000+$3,500,000+$625,000+$125,000) - ($3,200,000+$1,200,000)

$5,475,000 - $4,400,000

Net Working Capital $1,075,000



Cash Flow from Operating Activities: The Mid-American Farm Products Corporation provided the following financial information for the quarter ending September 30, 2009:

Depreciation and amortization $75,000

Net Income $225,000

Increase in receivables $95,000

Increase in inventory $69,000

Increase in accounts payables $80,000

Decrease in marketable securities $34,000.

What is the cash flow from operating activities generated during this quarter by the firm?



Net Income 225,000

Add depreciation and amortization 75,000

Add decrease in marketable securities 34,000

Add increase in accounts payables 80,000

Less increase in accounts receivables 95,000

Less increase in inventory 69,000

Cash flow from operating activities $250,000

chapter 2 financial statements. © 2013 pearson education, inc. all rights reserved.2-2 1.explain...

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