Chapter 3

Chapter 3
Understanding Financial Statements, Taxes, and Cash Flows
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Slide Contents
Learning Objectives Principles Used in This Chapter 1. An Overview of the Firms Financial Statements 2. The Income Statement 3. Corporate Taxes 4. The Balance Sheet 5. The Cash Flow Statement Key Terms
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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.
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Introduction
Use the balance sheet to describe a firms investments in assets and the way it has financed them. Identify the sources and uses of cash flow for a firm using the firms Cash Flow Statement.
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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.
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Principles Used in This Chapter (cont.)

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!
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Principles Used in This Chapter (cont.)

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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3.1 An Overview of the Firms Financial Statements
Basic Financial Statements

Following four types of financial statements are mandated by the accounting and financial regulatory authorities:
1. 2. 3. 4. Income statement Balance sheet Cash flow statement Statement of shareholders equity
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Basic Financial Statements (cont.)

1. Income Statement:
An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months):
Revenue, Expenses, and Profit.
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2. Balance sheet:
Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2012)
Assets (value of what the firm owns), Liabilities (value of firms debts), and Shareholders equity (the money invested by the company owners).
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3. Cash flow statement:
It reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months).
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4. Statement of shareholders equity:
It provides a detailed account of the firms activities in the following accounts over a period of time (for example, last six months):
Common stock account, Preferred stock account, Retained earnings account, and Changes to owners equity.
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What is the Focus of this Chapter?

Discuss the basic Content and Format of:
Income statement and Balance sheet
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Why Study Financial Statements?

Analyzing a firms financial statement can help managers carry out three important tasks: 1. Assess current performance through financial statement analysis, 2. Monitor and control operations, and 3. Forecast future performance.
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Why Study Financial Statements? (cont.)

1. Financial statement analysis:
Financial statement analysis allows us to assess the present financial condition of a firm. Chapter 4 introduces the tools and techniques used to carry out financial statement analysis.
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2. Financial control:
Financial statements are used by both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors) to monitor and control the firms operations. For example, a creditor may analyze a firms financial statements to decide whether or not to renew companys loan.
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3. Financial forecasting and planning:
Financial planning models are typically built using the financial statements. Financial planning is covered in chapter 17.
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What are the Accounting Principles Used to Prepare Financial Statements?

The following three fundamental principles are adhered to by accountants when preparing financial statements: 1. The revenue recognition principle, 2. The matching principle, and 3. The historical cost principle. An understanding of these basic principles allows us to be a more informed user of financial statements.
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What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 1. The revenue recognition principle:
It states that the revenue should be included in the firms income statement for the period in which: Its goods and services were exchanged for cash or accounts receivable; or The firm has completed what it must do to be entitled to the cash.
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What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 2. The matching principle:
This principle determines whether specific costs or expenses can be attributed to this periods revenues. The 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.
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What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 3. The historical cost principle:
This principle provides the basis for determining the dollar values the firm reports in its balance sheet. Most assets and liabilities are reported in the firms 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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3.2 The Income Statement
An Income Statement
An income statement is also called a profit and loss statement. An income statement measures the amount of profits generated by a firm over a given time period (usually a year or a quarter).
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An Income Statement (cont.)

Income statement can be expressed as follows:
Revenues (or Sales) Expenses = Profits
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An income statement will contain the following basic elements:
1. Revenues 2. Expenses
Cost of goods sold, Interest expenses, SGA (selling, general and administrative) expense, depreciation expense, Income tax expense
3. Profits
Gross profit, net operating income (also known as EBIT), earnings before taxes (EBT), and net income
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Sales
= Gross Profit Minus Operating Expenses
Minus Cost of Goods Sold
= Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT) Minus Income taxes
Selling expenses General and Administrative expenses Depreciation and Amortization Expense
= Net income (EAT)

EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes
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Sample Income Statement
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Evaluating a Firms EPS and Dividends

We can use the income statement to determine the earnings per share (EPS) and dividends. EPS = Net income Number of shares outstanding
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Evaluating a Firms EPS and Dividends (cont.)

Example 1: A firm reports a net income $90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)?
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We can determine the dividends paid by the firm to each shareholder by dividing the total amount of dividend (reported on the income statement) by the total number of shares outstanding. Dividends per share = Dividend payment Number of shares
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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?
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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
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Connecting the Income Statement and the Balance Sheet (cont.)

Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm? Amount retained = Net Income Dividends
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Interpreting Firm Profitability using the Income Statement

What can we learn from H.J. Boswell Inc.s income statement (Table 3-1)?
1. The firm has been profitable as its revenues exceeded its expenses.
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Interpreting Firm Profitability using the Income Statement (cont.)

2. The gross profit margin (GPM) = gross profits sales
GPM indicates the firms mark-up on its cost of goods sold per dollar of sales.
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3. The operating profit margin = net operating income sales
The operating profit margin is equal to the ratio of net operating income or EBIT divided by firms sales.
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Net profit margin: = net profits sales
Net profit margin indicates the percentage of revenues left after all expenses (including interest and taxes) have been considered.
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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 where the firm pays taxes at 40% tax rate. What is the firms net income and earnings per share?
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3.3 Corporate Taxes
Corporate Taxes
A firms income tax liability is calculated using its taxable income and the tax rates on corporate income.
See the table on next slide for corporate tax rates.
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Corporate tax rates
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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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Example 3: What is the average and marginal tax liability for a firm reporting $100,000 as taxable income.
Taxabl e Incom e $50,00 0 $75,00 0 Margin Increme Cumula Avera ntal Tax tive Tax ge Tax al tax Liability Liability Rate rate 15% 25% 7,500 6,250 7,500 13,750 15.00 % 18.33 %
$100,0 00
34%
8,500
22,250
22.25 %
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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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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. Note dividends for non-corporate investors, like you and me, are not exempt from taxation they are actually, doubletaxed.
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Dividend Exclusion for Corporate Shareholders

Example 4
What will be the taxable income if firm ABC receives $200,000 in dividends from firm XYZ. The taxable income will depend on the degree of ownership of XYZ by ABC.
See next slide.
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Dividend Exclusion for Corporate Shareholders (cont.)

Ownership Dividend Interest Exclusion Less than 20% 70% Dividend Income $200,000 Taxable Income $60,000
20% to 79% 80% or more

75%
100%
$200,000
$200,000
$50,000
$0
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3.4 The Balance Sheet
The Balance Sheet

The balance sheet provides a snapshot of the firms financial position on a specific date.
The balance sheet is defined by the following equation:

Total Assets = Total Liabilities + Total Shareholders Equity
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The Balance Sheet (cont.)

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 in the value of the firms total assets and the firms total liabilities.
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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.
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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 depreciation. Note, the net value reported on balance sheet could be significantly different from the market value of the asset.
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The balance sheet includes the following main components: 1.Assets Found on the left-hand side of the balance sheet. It includes current assets and fixed assets. 2.Sources of financing Found on the right-hand side of the balance sheet. It includes current liabilities, long-term liabilities, and owners equity.
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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.
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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.
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The stockholders equity is broken down into 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.
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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.
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(2) The amount of the firms retained earnings. Retained earnings are the portion of net income that has been retained (i.e. not paid in dividends) from prior years operations. Thus stockholders equity = Par value of common stock + Paid in Capital + Retained Earnings
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We can also express stockholders equity as follows:
Shareholders' equity = Total Assets Total Liabilities
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Firm Liquidity and Net Working Capital

Liquidity refers to the speed with which an 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 are more difficult to sell and convert to cash such as PPE (property, plant and equipment).
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Firm Liquidity and Net Working Capital

For the overall firm, liquidity generally refers to the firms ability to covert its current assts (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 (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.
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The Balance Sheet
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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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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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Debt and 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).
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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.
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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 between book value and market value is likely to be higher for fixed assets relative to current assets for two reasons:
Inflation affects the market price of asset; and Depreciation adjustments in the balance sheet do not reflect actual changes in market values.
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Key Terms
Accounts receivable Accounts payable Accumulated depreciation Paid-in-capital Average tax rate Balance sheet
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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
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Key Terms (cont.)

Fixed assets Gross plant and equipment Gross profit margin Income statement Inventories Liquidity Long-term debt
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Key Terms (cont.)

Marginal tax rate Market value Net operating income Net income Net plant and equipment Net profit margin Net working capital
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Key Terms (cont.)

Operating profit margin Par value Profits Retained earnings Revenues Source of cash Stockholders equity
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Key Terms (cont.)

Taxable income Total assets Total liabilities Total shareholders equity Uses of cash
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Chapter 3

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Chapter 3

Understanding Financial Statements, Taxes, and Cash Flows

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Principles Used in This Chapter

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Principles Used in This Chapter (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Principles Used in This Chapter (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

3.1 An Overview of the Firms Financial Statements

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

What is the Focus of this Chapter?

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Why Study Financial Statements?

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Why Study Financial Statements? (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Why Study Financial Statements? (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Why Study Financial Statements? (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

What are the Accounting Principles Used to Prepare Financial Statements?

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

3.2 The Income Statement

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Copyright 2011 Pearson Prentice Hall. All rights reserved.

An Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

An Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

An Income Statement (cont.)

= Gross Profit Minus Operating Expenses

Minus Cost of Goods Sold

= Net income (EAT)

Sample Income Statement

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Evaluating a Firms EPS and Dividends

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Evaluating a Firms EPS and Dividends (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Evaluating a Firms EPS and Dividends (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Evaluating a Firms EPS and Dividends (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Connecting the Income Statement and the Balance Sheet

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Connecting the Income Statement and the Balance Sheet (cont.)