Chapter 2

Principles of Finance

Financial Lecture 4

Statements
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Topics Covered

Objective and importance of Financial

Statements

Main types of Financial Statements

The Cash Flow Statement

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Objective of Financial Statements

A Finance Manager’s point of View

Before we learn to make sound

financial decision
 Its important to interpret and use the
information available in financial statements.

 Purpose here is not to assemble financial

statements, but to use them to understand
financial performance to make sound financial
decisions.

Many describe accounting as

‘The Language of Finance’

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Financial Statements
Four main financial statements:
➔ Balance sheet
➔ Income Statement
➔ Statement of Retained Earnings
➔ Statement of Cash Flow

Our focus…
➔ Interrelationship between these statements
➔ The process by which these statements can be
used to project a firm’s future cash flows
➔ Financial Statements show where the company
has been. In Finance we want to determine
where the company should go.
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Financial Statements cont.

The Balance Sheet

Represents the assets owned by the company and the
claims against those assets.
➔ It states what the company owns and what company owes
at a fixed point in time.
➔ It is like a snapshot, shows financial position of firm.

Based on the accounting identity:

Assets  Liabilities + Owners’ Equity

“Identity” is a relationship that is always

satisfied for all the variables.
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Balance sheet
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Balance Sheet cont.

Has five main sections:
1. Cash account
• Cash and equivalents
2. Working capital accounts
• Net working capital = Current assets – Current liabilities
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
• The owners of a company are also called residual claimants.
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The Income Statement

Shows the expenses and revenues generated by
a corporate over a past period, typically a
quarter or a year.
➔ Measures a company’s financial
performance over a specific period of time.

• Net income = Revenues – expenses

• EBIT = Revenues – operating expenses

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Income Statement
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The Income Statement

Net income is not the same as cash flow

• Firm earned an income of $5,642 million
• Cash account decreased by $65 million

Reasons:
• Accrual accounting
• Noncash expense items -- depreciation
• Preference to classify interest expense as
part of financial cash flow
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Statement of Retained Earnings

 Statement which shows the distribution
and reinvestment of net income for the
past period

CHANGE IN RETAINED EARNINGS  NET INCOME - DISTRIBUTED

EARNINGS

Every year a corporate

➔ Reinvest Retained earnings

➔ Distribute Distributed earnings

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Cash Flow Statement

The statement provides aggregate data on

 All cash inflows a company receives from both

its ongoing operations and external investment
sources.

 All cash outflows that pay for business activities

and investments during a given quarter.

CASH FLOW FROM ASSETS  CASH FLOW TO CREDITORS

+ CASH FLOW TO OWNERS
Cash Flow Identity and the 1- 13

Statement of Cash Flows

The cash flow identity states that the cash flow on the
left-hand side of the balance sheet is equal to the cash
flow on the right-hand side of the balance sheet.

CASH FLOW CASH FLOW CASH FLOW

FROM ASSETS = TO CREDITORS + TO OWNERS
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Cash Flow Identity

Cash flow from assets shows the success or failure
of how the company uses the assets to generate
cash inflow.
Cash flow to creditors shows how the firm uses
debt to finance the operations and its repayment to
the debt.
Cash flow to owners completes the overview of
financing and shows any additional contribution
by owners and return of capital to the owners.
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Cash Flow Identity and components

(Fig 2.5)
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The First Component:
Cash Flow From Assets
Three components of Cash flow from Assets:
1) Operating cash flow (OCF)
2) Net capital spending (NCS)
3) Change in net working capital (∆NWC)

Cash flow from assets = OCF - NCS - ∆NWC

Where as:
OCF = EBIT + Depreciation – Taxes
NCS = End. Net – Beg. Net + Depreciation
Fixed Assets Fixed Assets
∆NWC = Ending NWC – Beginning NWC
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The First Component:
Cash Flow From Assets (cont..)

OCF = EBIT + Depreciation – Taxes

Or
OCF = Net Income + Depreciation +Interest
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The First Component:
Cash Flow From Assets (cont..)
NCS = End. Net – Beg. Net + Depreciation
Fixed Assets Fixed Assets

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

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The First Component:
Cash Flow From Assets (cont..)

∆NWC=Ending NWC – Beginning NWC

Net working capital for 2011 = $9,130 - $6,860 = $2,270

Net working capital for 2010 = $10,454 - $9,406 = $1,048
Change in NWC = $2,270 - $1,048 = $1,222
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The First Component:
Cash Flow From Assets (cont..)
 Putting it all together….

 Cash flow from Assets = OCF - NCS - ∆ NWC

= $7,287 - $2,579 - $1,222
= $3,486
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The Second Component:
Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense − Net New
Borrowing from Creditors
Net New Borrowing = Ending Long-term Liabilities − Beginning Long-Term
Liabilities

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

= $ 617
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The Third Component:
Cash Flow To Owners

Cash flow to owners = Dividends - Net new borrowing from owners

= $ 2,869 - $0

= $ 2,869
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Putting It All Together:
The Cash Flow Identity

Cash flow from assets =

cash flow from creditors + cash flow to owners
CASH FLOW CASH FLOW CASH FLOW
FROM ASSETS = To/ From + TO OWNERS
CREDITORS

$3,486 = $617 + $2,869

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Financial Performance Reporting

Annual reports to shareholders
Quarterly (10-Q) and annual (10-K) reports
filed with the SEC
➔Regulation Fair Disclosure
✓ Requires companies to release all material
information to all investors.

➔Notes to the Financial Statements

✓ Helps explain many details necessary to gain a
more complete picture of a firm’s performance.
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Additional Problems with Answers
Problem 1

Balance Sheet. Star Inc. 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 Answers 1- 26

Answer 1
Current Assets + Fixed Assets = Total Assets
➔$300,000+Fixed Assets = $750,000
➔Fixed Assets = $750,000 - $300,000 = $400,000
➔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
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Additional Problems with Answers
Problem 2
Income Statement:

Monsters Inc. 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 marginal tax rate of 34 percent, calculate
its net income after taxes.
Additional Problems with Answers 1- 28

Answer 2
Revenues $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
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Additional Problems with Answers
Problem 3
Retained Earnings:

Disney Land at the beginning of the fiscal year,

November 1, 2013, retained earnings of $425,000.
During the year ended 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 Answers 1- 30

Answer 3
Statement of Retained Earnings for
the year ended October 31, 2013

Balance of Retained Earnings, 11/1/2013……….$425,000

Add: Net income after taxes ………. $820,000

Less: Dividends paid for year-end …….…$287,000

Balance of Retained Earnings …..….. $958,000

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Additional Problems with Answers
Problem 4
Working Capital: A Star Sports goods import company, reported
the following information at its last annual meeting:

Cash and cash equivalents = $1,225,000

Accounts payables = $3,200,000
Inventory = $625,000
Accounts receivables = $3,500,000
Notes payables = $1,200,000
Other current assets = $125,000

Calculate the company’s net working capital.

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Additional Problems with Answers
Answer 4
Net Working Capital = Current Assets – Current Liabilities

Where:

Current Assets = (Cash & Cash Equivalents + Accts. Rec. + Inventory

+ other current assets)

Current Assets = ($1,225,000+$3,500,000+$625,000+$125,000)

= $5,475,000

Current Liabilities = (Accounts Payables + Notes Payables)

Current Liabilities = ($3,200,000+$1,200,000) = $4,400,000

Net Working Capital = $5,475,000 - $4,400,000

Net Working Capital = $1,075,000

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Q&A

Three fundamental issues separate net income

and cash flow. Which of the answers below is
NOT one of these three fundamental issues?

A. accrual accounting
B. non-cash accounting
C. non-cash expense items
D. interest expense
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Q&A

Net Working Capital for 2007 is $3,597, and Net

Working Capital for 2008 is $1,890. What is the
change in Net Working Capital?

A. $1,707
B. –$1,707
C. –$1,727
D. –$2,527
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Q&A

Notes to the financial statements help explain

many of the details necessary to gain a more
complete picture of the firm’s

A. Capital budget.
B. Choice of management.
C. Dividend policy.
D. Performance.
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Q&A
The annual report of a company is:

A. Printed and mailed to owners and

the SEC.
B. Not available online.
C. Not mailed to owners but only to the
SEC.
D. Always available online in more
details.