Financial Statements

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 sheetIncome StatementStatement of Retained EarningsStatement of Cash Flow

Our focus..Interrelationship between the balance

sheet and the income statementThe process by which these statements can

be used to project a firm’s future cash flows

2.1 Financial Statements(A)The 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 Balance SheetHas five 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 one year

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

2.1 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 Income Statement

2.1 The Income Statement

Net income is not the same as cash flowFirm earned an income of $5,642 millionCash account decreased by $65 million

3 reasons:Accrual accountingNoncash expense items --depreciationPreference to classify interest expense as

part of financial cash flow

2.2 Cash Flow Identity The cash flow identity states that the cash

flow on the left-hand side of the balance sheet (the cash generated by the company) is equal to the cash flow on the right-hand side of the balance sheet (the cash flow given to the lenders and owners of the company).

CASH FLOW FROM ASSETS CASH FLOW TO CREDITORS

+ CASH FLOW TO OWNERS

Figure 2.5 Cash Flow Identity and components

2.2 The First Component: Cash Flow From AssetsThree components:

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

Cash flow from assets = OCF – NCS - ∆NWCOCF = EBIT + Depreciation – Taxes

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

∆NWC=Ending NWC – Beginning NWC

2.2 The First Component: Cash Flow From Assets

OCF = EBIT + Depreciation – TaxesOCF = Net Income + Depreciation + Interest Expense

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

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

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

2.2 The First Component: Cash Flow From Assets

∆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$1,222

2.2 The First Component: Cash Flow From Assets

Putting it all together….

Cash flow from Assets = OCF – NCS - ∆ NWC = $7,287 - $2,579 -

$1,222 = $3,486$3,486

Versus Net Income of $5,642

2.2 The Second Component: Cash Flow To Creditors

Cash Flow to Creditors = Interest Expense Net New Borrowing from CreditorsNet New Borrowing = End Long-term Liabilities Beg Long-Term Liabilities

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

2.2 The Third Component: Cash Flow To Owners

Cash flow to owners = Dividends - Net new borrowing from

owners

= $2,869 - $0 = $2,869$2,869

2.2 Putting It All Together: The Cash Flow Identity

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

$3,486 $3,486 $617 + $2,869 $617 + $2,869The company generated $3,486 million and

it was distributed to the lenders ($617 million) and the owners ($2,869 million)

2.3 Financial Performance ReportingAnnual reports to shareholders Quarterly (10-Q) and annual (10-K)

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

Companies must release all material information to all investors at the same time.

– Notes to the Financial Statements: A wealth of information about the firm

2.4 Financial Statements on the Internet

EDGAR (www.sec.gov/edgar.shtml)Yahoo! Finance (http://finance.yahoo.com.)Many, many more Web sites with rich stores

of information

ADDITIONAL PROBLEMS WITH ANSWERS

Problem 1Balance 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

Current Assets + Fixed Assets = Total Assets

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

Fixed Assets = $750,000 - $300,000 = $450,000$450,000

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$290,000 

ADDITIONAL PROBLEMS WITH ANSWERSProblem 2

Income Statement. The Top Class Company had revenues of $925,000 in 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 average tax rate of 34 percent, calculate its net income after taxes.

ADDITIONAL PROBLEMS WITH ANSWERSProblem 2Revenues $925,000

Less operating expenses 325,000= EBITDA 600,000

Less depreciation 125,000= EBIT 475,000

Less interest expenses 55,000= Taxable Income 420,000

Less taxes (34%) 142,800= Net Income after taxes 277,200

ADDITIONAL PROBLEMS WITH ANSWERSProblem 3

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.

ADDITIONAL PROBLEMS WITH ANSWERSProblem 3

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

ADDITIONAL PROBLEMS WITH ANSWERSProblem 4

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

Cash and cash equivalents = $1,225,000; Accounts payables = $3,200,000Inventory = $625,000; Accounts receivables = $3,500,000; Notes payables = $1,200,000; Other current assets = $125,000.

 Calculate the company’s net working capital.

ADDITIONAL PROBLEMS WITH ANSWERSProblem 4

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=$1,075,000

ADDITIONAL PROBLEMS WITH ANSWERSProblem 5 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 = $75,000Net Income = $225,000Increase in receivables = $95,000Increase in inventory = $69,000Increase in accounts payables = $80,000Decrease in marketable securities = $34,000.

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

ADDITIONAL PROBLEMS WITH ANSWERSProblem 5

Net Income $225,000Add depreciation and amortization 75,000Add decrease in marketable securities 34,000Add increase in accounts payables 80,000Less increase in accounts receivables 95,000Less increase in inventory 69,000

 Cash flow from operating activities $250,000