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Understanding Financial Statements and Cash Flows

Chapter 3

Learning Objectives
1.

Compute a companys profits as reflected by its income statement. Determine a firms financial position at a point in time based on its balance sheet. Measure a companys cash flows.

2.

3.

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1. Basic Financial Statements


The Income Statement The Balance Sheet

The Income Statement

It is also known as Profit/Loss Statement It measures the results of a firms operation over a specific period. The bottom line of the income statement shows the firms profit or loss for a period. Sales Expenses = Profit or Loss
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Income Statement Terms

Revenue (Sales)

Money derived from selling the companys product or service The cost of producing or acquiring the goods or services to be sold Expenses related to marketing and distributing the product or service and administering the business The interest paid to creditors and the dividends paid to preferred stockholders Amount of taxes owed, based upon taxable income
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Cost of Goods Sold (COGS)

Operating Expenses

Financing Costs

Tax Expenses

Income Statement Form


Sales = = = =

Less cost of goods sold Gross profit Less operating expenses Operating income Less interest expense Earnings before taxes (EBT) Less income taxes Net income (earnings available for shareholders)
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Common-size Income Statement

Common-size income statement restates the income statement items as a percentage of sales.

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Common-size Income Statement for Davies, Inc.

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Profit-to-Sales analysis from Common-size income statement


1.
2.

Gross profit margin


(gross profit as a percentage of sales):_________

3.
4.

Operating profit margin


(operating profit as a percentage of sales):_______

5.
6.

Net profit margin


(net profit as a percentage of sales):____________

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Balance Sheet

Provides a snapshot of firms financial position at a particular date. It includes three main parts: assets, liabilities and equity.

Assets (A) are resources owned by the firm Liabilities (L) and owners equity (E) indicate how those resources are financed A=L+E

The items are recorded at historical cost, so the book value of a firm may be very different from its market value.
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Balance Sheet: A=L+E

ASSETS (A) Current Assets Fixed Assets Total Assets

LIABILITIES (L)

Current Liabilities Long-Term Liabilities

Total Liabilities OWNERS EQUITY (E)


Preferred Stock Common Stock Retained earnings

Total Owners Equity Total liabilities + Equity


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Balance Sheet Terms: Assets

Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include:

Cash Accounts Receivable (payments due from customers who buy on credit) Inventory (raw materials, work in process, and finished goods held for eventual sale) Other assets (ex.: Prepaid expenses are items paid for in advance)

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Balance Sheet Terms: Assets

Fixed Assets Include assets that are held for more than one year. Fixed assets typically include:

Machinery and equipment Buildings Land

Other Assets Assets that are neither current assets nor fixed assets. They may include intangible assets such as patents, copyrights, and goodwill.
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Balance Sheet Terms: Liabilities

Debt (Liabilities)

Money that has been borrowed from a creditor and must be repaid at some predetermined date Debt could be current (must be repaid within twelve months) or long-term (repayment time exceeds one year)

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Balance Sheet Terms: Liabilities

Current Liabilities:

Accounts payable (Credit extended by suppliers to a firm when it purchases inventories) Accrued expenses (Short term liabilities incurred in the firms operations but not yet paid for) Short-term notes (Borrowings from a bank or lending institution due and payable within 12 months)

Long-Term Debt

Loans from banks for longer than 12 months Bonds


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Balance Sheet Terms: Equity

Equity: Shareholders investment in the firm in the


form of preferred stock and common stock.

Treasury Stock: Stock that was once

outstanding and has been re-purchased by the company.

Retained Earnings: Cumulative total of all the


net income over the life of the firm, less common stock dividends that have been paid out over the years.
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Net Working Capital

Net Working Capital


= Current assets current liabilities

Larger the net working capital, better the firms ability to repay its debt Net working capital can be positive or zero or negative. It is generally positive. An increase in net working capital may not always be good news.
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Debt Ratio

Debt / Total Assets Debt ratio is an indication of financial risk. Generally, higher the ratio, the more risky the firm is, as firms have to pay interest on debt regardless of the earnings or cash flow situation.

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3. Measuring Cash Flow

Accrual Basis Accounting

Accrual Basis Accounting

Principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid. Thus sales revenue recorded in the income statement includes both cash and credit sales. Treatment of long-term assets: Asset acquisitions (that will last more than one year, such as equipment) are not recorded as an expense but are written off every year as depreciation expense.
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Three sources of cash flows

Cash flows from Operations (ex. Sales revenue, labor expenses) Cash flows from Investments (ex. Purchase of new equipment) Cash flows from Financing (ex. Borrowing funds, payment of dividends)

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Cash Flow From Operation


NET income + depreciation expense = Profit before depreciation - Increase in Account Receivables - Payment for inventory consisting of: + Increase in Inventories - Increase in Accounts Receivables

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Note on Depreciation-related items on Balance sheet and Income statement

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Cash Flow from Investments


- Change in GROSS fixed Assets

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Cash Flow from Financing


A firm can either receive money from or distribute money to its investors or both. The firm can: 1. Pay dividends to stockholders. 2. Increase or decrease its interest bearing long-term or short-term debt. 3. Issue stock to new shareholders or repurchase stock from current shareholders.
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Cash Flow from Financing


+ + + Increase in short-term borrowing Increase in long-term borrowing Issue new common stock Dividend paid

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Cash Flows Statement


Operating Activities Investment Activities Financing Activities Change In Cash Beginning Balance Ending Balance
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4. Income Taxes and Finance

Computing Taxable Income for Corporation

Gross Income

Dollar sales from a product or service less cost of production or acquisition Gross income less tax deductible expenses, plus interest income received and dividend income received Tax Deductible Expenses Include Operating expenses (marketing, depreciation, administrative expenses) and interest expense Dividends paid are not deductible

Taxable Income

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Marginal Tax Rates

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Example: Computing taxes on taxable income of $16m


$ $ $ $ _____1125_______ ________________ ________________ ________________ * * * * .15 .25 .34 .35 = = = = = 7,500 6,250 3,374,500 2,100,000

Total Tax

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