BF3326 Corporate Finance

INTERPRETING FINANCIAL STATEMENTS

Need of Finance

“Although only accountants need to know

how to make financial statements, everyone
involved with business needs to know how to
interpret them.”
Brigham & Houston
Financial Information
• A manager’s primary goal is to maximize the value of his firm’s stock.

• Value is based on the stream of cash flows the firm will generate in the
future.

• But how does an investor go about estimating future cash flows, and how
does a manager decide which actions are most likely to increase cash
flows?

• The answers to both questions lie in a study of the financial statements

that publicly traded firms must provide to investors (banks, insurance,
companies, pension funds, individuals).
Financial Statements and Reports

• Corporations issue to their stockholders the

annual report

• This is probably the most important source of information

• Two types of information:

– Verbal
– Financial statements
Verbal Report

• Often presented as a letter from the chairman,

• Describes the firm’s operating results during the past year,

• Discusses new developments that will affect future operations.

Financial Statements

• Report what has actually happened to assets, earnings, and

dividends

• Over the past few years

Financial Statements

The Balance Sheet

The Income Statement

Cash Flow

These statements give an accounting picture of the firm’s operations and

financial position.
Primary Financial Statements

Primary financial statements answer basic questions

including:

– What is the company’s current financial status?

– What was the company’s operating results for the
period?
– How did the company obtain and use cash during the
period?
Balance Sheet
• A statement of the firm’s financial position at a specific point in time.

• The left-hand side

– shows the firm’s assets

• The right-hand side

– shows the liabilities and equity, or the claims against these assets

• Left = Right
The Balance Sheet

• Summary of the financial position of a company at a particular

date
• Assets: cash, accounts receivable, inventory, land, buildings,
equipment and intangible items
• Liabilities: accounts payable, notes payable and mortgages
payable
• Owners’ Equity: net assets after all obligations have been satisfied
The Balance Sheet

• What are the resources of the company?

• What are the company’s existing obligations?
• What are the company’s net assets?
Accounting Equation
Assets = Liabilities + Owners’ Equity

Resources Sources of Funding

Resources Creditors’ Owners’

to use to claims claims
generate = against
+ against
revenues resources resources
Balance Sheet
A Snapshot of Balance Sheet
Assets
Liabilities
Cash $ 40
Accounts payable $ 50
Accounts receivable 100
Notes payable 150
Land 200
$200

Total assets $340 Owners’ Equity

Capital stock $100
Retained earnings 40

Must $140
Equal Total liabilities
and owners’ equity $340
Balance Sheet
• Assets are all stated in terms of $ only cash represents actual money
• Receivables are bills others owe the company
• Inventories show the amount the company has invested in raw materials,
work-in-process, and finished goods available for sale
• Net plant and equipment reflect the amount of money the company paid for its
fixed assets when it acquired those assets in the past, less accumulated
depreciation
• The noncash assets should produce cash over time, but they do not represent
cash in hand, and the amount of cash they would bring if they were sold today
could be higher or lower than the values at which they are carried on the
books
Balance Sheet

• The claims against assets are of two types—liabilities (or money the
company owes) and the stockholders’ ownership position
• Preferred stock is a hybrid, or a cross between common stock and debt. In
the event of bankruptcy, preferred stock ranks below debt but above
common stock. The preferred dividend is fixed
• when the term “equity” is used in finance, we generally mean “common
equity” unless the word “total” is included
Balance Sheet

Assets - Liabilities - Preferred stock = Common stockholder’s equity

• If assets decline in value, Liabilities and preferred stock remain constant, so

the value of the common stockholders’ equity must decline
=> the risk of asset value fluctuations is by the common stockholders.
Balance Sheet
Inventory Accounting

– FIFO (first-in, first-out) method

– LIFO (last-in, first-out) method
• During a period of rising prices, by taking out old, low-cost inventory and leaving in new, high-
cost items, FIFO will produce a higher balance sheet inventory value but a lower cost of goods
sold on the income statement.
• companies actually use older items first.
• During the inflation: (a) its balance sheet inventories are higher than they would have been
had it used LIFO, (b) its cost of goods sold is lower than it would have been under LIFO, and
(c) its reported profits are therefore higher.
Thus, the inventory valuation method can have a significant effect on financial statements.
Balance Sheet

• Depreciation methods. Most companies prepare two sets of financial

statements—one for tax purposes and one for reporting to stockholders.

• Generally, they use the most accelerated method permitted under the law to
calculate depreciation for tax purposes, but they use straight line, which results
in a lower depreciation charge, for stockholder reporting.
Balance Sheet

The time dimension

• The balance sheet = firm’s financial position at a point in time

• The balance sheet changes every day as inventories are increased or

decreased, as fixed assets are added or retired, as bank loans are
increased or decreased, and so on.
Balance Sheet Limitations

✓ Assets recorded at historical value

✓ Only recognizes assets that can be expressed in monetary terms

✓ Owners’ equity is usually less than the company’s market value

The Income Statement

• A statement summarizing the firm’s revenues and expenses over an

accounting period, generally a quarter or a year.

Balance Sheet – “point in time“

Income Statement – “over a period of time“
The Income Statement
Earnings and costs

• Net sales are shown at the top of each statement, after which various costs
are subtracted to obtain the net income available to common shareholders,
which is generally referred to as net income.

• Costs include operating costs, interest costs, and taxes.

• Earnings and dividends per share is given at the bottom of the income
statement.
The Income Statement
Revenues
Assets (cash or AR) created through business operations

Expenses
Assets (cash or AP) consumed through business operations

Net Income or (Net Loss)

Revenues - Expenses
Snapshot of Income Statement
Income Statement
For the Years Ended December 31, 2010 and 2011

2011 2010
Revenues:
Sales $100 $ 85
Other revenue 30 15
Total revenues $130 $100
Expenses:
Cost of goods sold $ 62 $ 58
Operating & admin. 16 12
Income tax 20 18
Total expenses $ 98 $ 88
Net Income $ 32 $ 12
Statement of Retained Earnings

Beginning retained earnings An additional financial

statement that
+ Net income identifies changes in
retained earnings from
– Dividends paid
one accounting period
= Ending retained earnings to the next.

Net income results in: Dividends result in:

Increase in net assets Decrease in net assets
Increase in retained earnings Decrease in retained
Increase in owners’ equity earnings
Decrease in owners’ equity
Statement of Cash Flow

• Retained earnings as reported on the balance sheet do not represent cash

and are not “available” for the payment of dividends or anything else.

• The amount reported in the retained earnings account is not an indication

of the amount of cash the firm has. A positive number in the retained
earnings account indicates only that in the past the firm has earned some
income, but its dividends have been less than its earnings.
Statement of Cash Flows

• Reports the amount of cash collected and paid out by a

company in operating, investing and financing activities for a
period of time.
• How did the company receive cash?
• How did the company use its cash?
• Complementary to the income statement.
• Indicates ability of a company to generate income in the future.
Statement of Cash Flows

Cash inflows
Sell goods or services
Sell other assets or by borrowing
Receive cash from investments by owners

Cash outflows
Pay operating expenses
Expand operations, repay loans
Pay owners a return on investment
Classification of Cash Flows

Operating activities – Transactions and events that enter into the

determination of net income.

Investing activities – Transactions and events that involve the purchase

and sale of securities, property, plant, equipment, and other assets not
generally held for resale, and the making and collecting of loans.

Financing activities – Transactions and events whereby resources and

obtained from, or repaid to, owners and creditors.
Statement of Cash Flows

CASH INFLOWS Operating Investing Financing

Activities Activities Activities

CASH OUTFLOWS Financing

Operating
Activities
Activities Investing
Activities
Statement of Cash Flow
CASH FLOWS in the company: +/-

+ CASH Flow statement -

Cash at the beginning

Operating cash flow

Investment cash flow

Financial cash flow

Cash at the end of the period

Operating Activities

Cash Inflow Cash Outflow

• Sale of goods or • Inventory payments
services • Interest payments
• Sale of investments • Wages
in trading securities
• Utilities, rent
• Interest revenue
• Taxes
• Dividend revenue
Investing Activities

Cash Inflow Cash Outflow

• Sale of plant assets • Purchase of plant assets
• Sale of securities, other • Purchase of securities, other
than trading securities than trading securities
• Collection of principal on • Making of loans to other
loans
entities
Financing Activities

Cash Outflow
Cash Inflow
• Dividend payments
• Issuance of own stock
• Repaying principal on borrowing
• Borrowing
• Treasury stock purchase
Financial Statement Relations
+ Cash flow - A Balance sheet L Costs Income st. Earnings

Beginning
Fixed Own capital
assets Operating income
Cash flow from operations

Investment cash flow Financial income

Financial cash flow Current Liabilities Extraordinary income

assets

End
profit
Financial Statement Relations
Cash Flow Statement

Cash--Op. Act. $ 973,000

Cash--Inv. Act. (1,188,000)
Cash--Fin. Act. 245,000
Net increase $ 30,000
Beg. cash 80,000
End. cash $ 110,000 Balance
Balance Sheet 12/31/10 Sheet 12/31/11

Cash $ 80,000 Cash $ 110,000

Other 4,550,000 Income Statement Other 4,975,000
Total $4,630,000 Total $5,085,000
Revenues $12,443,000
Liabilities $2,970,000 Expenses 11,578,400 Liabilities $2,860,400
Cap. Stock 900,000 Net income $ 864,600 Cap. stock 1,000,000
R/E 760,000 R/E 1,224,600
Total $4,630,000 Total $5,085,000
Stmt of Retained Earnings

R/E 12/31/10 $ 760,000

Net income 864,600
Dividends (400,000)
R/E 12/31/11 $1,224,600