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Chapter Two
Chapter Outline
Accounting Statements
Corporate Finance
Ross Westerfield Jaffe

2
and Cash Flow
Seventh Edition
2.1 The Balance Sheet
Seventh Edition
2.2 The Income Statement
2.3 Net Working Capital
2.4 Financial Cash Flow
2.5 The Statement of Cash Flows
2.6 Summary and Conclusions

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2.1 The Balance Sheet The Balance Sheet of the U.S. Composite Corporation

U.S. COMPOSITE CORPORATION

An accountants snapshot of the firms accounting Balance Sheet
20X2 and 20X1
value as of a particular date. (in $ millions)
Liabilities (Debt)
The Balance Sheet Identity is: Assets 20X2 20X1 The andassets are listed
Stockholder's Equity in 20X2
order20X1
Current assets: Current Liabilities:
by the length of time it $213 $197
Assets Liabilities + Stockholders Equity Cash and equivalents
Accounts receivable
$140
294
$107
270
Accounts
normally
payable
Notes payable
would take a firm 50 53
Inventories 269 280 Accrued expenses 223 205
When analyzing a balance sheet, the financial Other 58 50 withTotalongoing operations$486
current liabilities to $455
Total current assets $761 $707
manager should be aware of three concerns: convert them into cash.
Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
accounting liquidity, debt versus equity, and value Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458

versus cost. Less accumulated depreciation

Net property, plant, and equipment
-550
873
-460
814
Total long-term liabilities $588 $562

Intangible assets and other 245 221 Stockholder's equity:

Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Clearly,
Common stock cash($1 peris much more
value) 55 32
liquid than property, plant
Capital surplus
Accumulated retained earnings
347
390
and327
347
equipment.
Less treasury
Total equity
stock -26
$805
-20
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

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Balance Sheet Analysis 2.2 The Income Statement

When analyzing a balance sheet, the The income statement measures performance
financial manager should be aware of three over a specific period of time.
concerns: The accounting definition of income is
1. Accounting liquidity
2. Debt versus equity Revenue Expenses Income
3. Value versus cost

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U.S.C.C. Income Statement Income Statement Analysis

U.S. COMPOSITE CORPORATION

There are three things to keep in mind when

Income Statement
20X2
(in $ millions)
analyzing an income statement:
Total operating revenues $2,262
The operations Cost of goods sold - 1,655 1. GAAP
section of the Selling, general, and administrative expenses - 327
income statement Depreciation - 90 2. Non Cash Items
Operating income $190
reports the firms Other income 29 3. Time and Costs
revenues and Earnings before interest and taxes $219
Interest expense - 49
expenses from Pretax income $170
principal Taxes - 84
operations Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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Generally Accepted Accounting Principles Income Statement Analysis

1. GAAP 2. Non Cash Items

The matching principal of GAAP dictates Depreciation is the most apparent. No firm ever
that revenues be matched with expenses. writes a check for depreciation.
Thus, income is reported when it is earned, Another noncash item is deferred taxes, which
even though no cash flow may have does not represent a cash flow.
occurred

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Income Statement Analysis Sample Scrambled I.S./B.S. Problem
Hint it is easiest to write out the statements and then solve for the missing numbers) Fill in the missing
3. Time and Costs numbers. If you cannot solve for a number, use $50 as a plug number and continue with the problem.
Common Stock $_______ Long Term Debt $300
In the short run, certain equipment, resources, and

Total Assets $1,286
Accounts Payable $_______
Accumulated Depreciation
Gross Profit $829
$945

commitments of the firm are fixed, but the firm can Retained Earnings -$277 Total Liabilities and Owners Equity $_______
Income Taxes $46.40 Sales $______
vary such inputs as labor and raw materials. Cash $_______ Gross Fixed Assets $1,830.0
Operating Income $239 Total Long Term Assets $984.5
In the long run, all inputs of production (and hence Cost of Goods Sold $713 Interest Expense $_______
Other Long Term Investments $______ Utilities Expense $139
costs) are variable. Depreciation $_______ Accrued Wages $16
Other Payables $36 Rent Expense $236
Financial accountants do not distinguish between Total Current Liabilities $335 Current Portion of Long Term Debt $125
Net Income $78.10 Income Before Taxes $_______
variable costs and fixed costs. Instead, accounting Inventory $128 Accounts Receivable $54.0

costs usually fit into a classification that

Prepaid Rent
Net Fixed Assets
$68.0
$885
Total Current Assets
Labor Expense $137
$301.5

distinguishes product costs from period costs. Administrative Expense $38

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2.3 Net Working Capital The Balance Sheet of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Balance Sheet
$252m = $707- $455 20X2 and 20X1
(in $ millions)
Liabilities (Debt)

Net Working Capital Current Assets Current Liabilities

Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
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

NWC is usually growing with the firm. Other

Total current assets
58
$761
50
$707
Total current liabilities $486 $455

Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117 to $104
Property, plant, and equipment
Less accumulated depreciation
$1,423 $1,274
-550 -460
$275 million in 20X2 from
Long-term debt
Total long-term liabilities
471
$588
458
$562
Net property, plant, and equipment
Intangible assets and other
873
245
814
221
$252 million
Stockholder's equity:
in 20X1.
Total fixed assets $1,118 $1,035 $23 million
Preferred stock
Common stock ($1 par value)
$39
55
$39
32
Capital surplus 347 327
$275m = $761m- $486m Accumulated retained earnings 390 347
This increase
Less treasury stock of $23 million -26 is-20
Total equity $805 $725
Total assets $1,879 $1,742 an investment
Total of the
liabilities and stockholder's equityfirm.
$1,879 $1,742

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2.4 Financial Cash Flow 2.5 The Statement of Cash Flows

There is an unusual presentation of Cash There is an official accounting statement

Flows in RWJ. called the statement of cash flows.
In finance, the most important item that can This helps explain the change in accounting
be extracted from financial statements is the cash, which for U.S. Composite is $33
actual cash flow of the firm. million in 20X2.
Since there is no magic in finance, it must be The three components of the statement of
the case that the cash from received from the cash flows are
firms assets must equal the cash flows to the Cash flow from operating activities
firms creditors and stockholders. Cash flow from investing activities
CF(A) CF(B) + CF(S) Cash flow from financing activities

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2.5 Summary and Conclusions

Financial statements provide important

information regarding the value of the firm.
You should keep in mind:
Measures of profitability do not take risk or
timing of cash flows into account.
Financial ratios are linked to one another.

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