Financial Statements and Cash Flow

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Understand the information provided by financial statements
 Differentiate between book and market values

 Know the difference between average and marginal tax rates

 Know the difference between accounting income and cash flow

 Calculate a firm’s cash flow

2-3
 Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Taxes
2.4 Net Working Capital
2.5 Financial Cash Flow
2.6 The Accounting Statement of Cash Flows
2.7 Cash Flow Management

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Sources of Information
 Annual reports
 Wall Street Journal
 Internet
◼ NYSE (www.nyse.com)
◼ NASDAQ (www.nasdaq.com)
◼ Textbook (www.mhhe.com)
 SEC
◼ EDGAR
◼ 10K & 10Q reports
2-5
2.1 The Balance Sheet
incur

2-6
2.1 The Balance Sheet
❑ An accountant’s snapshot of the firm’s
accounting value at a specific point in time
❑ The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity

2-7
U.S. Composite Corporation Balance Sheet

2010 2009 The assets are listed in2010 order2009by

Current assets: Current Liabilities:
Cash and equivalents $140 $107 the length
Accounts payable of time it would $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280
normally
Accrued expenses
take a firm with
223 205
Other
Total current assets
58
$761
50
$707
ongoing
Total currentoperations
liabilities to convert
$486 $455

them into
Long-term cash. (liquidity)
liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation (550) (460) Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Clearly, cash is much more
Common stock ($1 par value) 55 32
Capital surplus 347 327
liquid than property, plant, and
Accumulated retained earnings 390 347
equipment.
Less treasury stock
Total equity
(26)
$805
(20)
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

2-8
U.S. Composite Corporation Balance Sheet
The liabilities and the
stockholders’
Current assets:
equity are
2010 listed
2009
Current Liabilities:
2010 2009

in Cashthe order in which

and equivalents $140 they
$107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
would
Inventories typically 269 280be Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
paid over time.
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation (550) (460) Total long-term liabilities $588 $562
Management’s choice of capital
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
structure, as between
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Common stock ($1 par value) 55 32
debt and equity and between Capital surplus 347 327
current debt and long-term Accumulated retained earnings
Less treasury stock
390
(26)
347
(20)
debt. Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

2-9
Balance Sheet Analysis
 When analyzing a balance sheet, the Finance Manager should
be aware of three concerns:
1. Liquidity
2. Debt versus equity
3. Value versus cost

2-10
Liquidity
 Refers to the ease and quickness with which assets can be
converted to cash—without a significant loss in value
 Current assets are the most liquid.
 Some fixed assets are intangible.
 The more liquid a firm’s assets, the less likely the firm is to
experience problems meeting short-term obligations.
 Liquid assets frequently have lower rates of return than fixed
assets.

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Debt versus Equity
 Creditors generally receive the first claim on the firm’s cash
flow.
 Shareholder’s equity is the residual difference between assets
and liabilities.

 Resources = sources

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Value versus Cost
 Under Generally Accepted Accounting Principles (GAAP),
audited financial statements of firms in the U.S. carry assets at
cost.
 Market value is the price at which the assets, liabilities, and
equity could actually be bought or sold, which is a completely
different concept from historical cost.

2-13
2.2 The Income Statement
 Measures financial performance over a
specific period of time
 The accounting definition of income is:
Revenue – Expenses ≡ Income

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U.S.C.C. Income Statement
Total operating revenues $2,262
The operations Cost of goods sold 1,655
section of the Selling, general, and administrative expenses 327
Depreciation 90
income statement
Operating income $190
reports the firm’s Other income 29
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
Addition to retained earnings $43
Dividends: $43

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U.S.C.C. Income Statement
Total operating revenues $2,262
The non-operating Cost of goods sold 1,655
section of the Selling, general, and administrative expenses 327
Depreciation 90
income statement
Operating income $190
includes all Other income 29
financing costs, Earnings before interest and taxes $219
Interest expense 49
such as interest Pretax income $170
expense. Taxes 84
Current: $71
Deferred: $13
Net income $86
Addition to retained earnings: $43
Dividends: $43

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U.S.C.C. Income Statement
Total operating revenues $2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Usually a separate Interest expense 49
section reports the Pretax income $170
Taxes 84
amount of taxes Current: $71
levied on income. Deferred: $13
Net income $86
Addition to retained earnings: $43
Dividends: $43

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U.S.C.C. Income Statement
Total operating revenues $2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Interest expense 49
Net income is the Pretax income $170
“bottom line.” Taxes 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

2-18
 Income Statement Analysis
 There are three things to keep in mind when analyzing an
income statement:
1. Generally Accepted Accounting Principles (GAAP)
2. Non-Cash Items
3. Time and Costs
Một doanh nghiệp có thể profitable trên IS nhưng với poor CF management-> vẫn có thể phá sản

2-19
 GAAP
❑ The matching principle of GAAP dictates that revenues be
matched with expenses.
❑ Thus, income is reported when it is earned, even though no
cash flow may have occurred.
MATCHING: hạch toán chi phí sau khi hạch toán doanh thu-> accrual
basis, cost mà kh tạo nên rev-> kh đc xem là expenses

2-20
 Non-Cash Items
❑ Depreciation is the most apparent. No firm ever writes a check
for “depreciation.” Depreciation + deffered tax

❑ Another non-cash item is deferred taxes, which does not

represent a cash flow.
❑ Thus, net income is not cash.

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 Time and Costs
❑ In the short-run, certain equipment, resources, and commitments of the
firm are fixed, but the firm can vary such inputs as labor and raw
materials.
❑ In the long-run, all inputs of production (and hence costs) are variable.
❑ Financial accountants do not distinguish between variable costs and
fixed costs. Instead, accounting costs usually fit into a classification that
distinguishes product costs from period costs.
Biến phí và định phí kh đc disclose trên IS-> chi phí trên IS đc phân loại theo chức năng
Product cost: production cost
pẻiod cost: selling and administrative-> kh gắn liền với sản phẩm sx ra mà đc ghi nhận theo thơi gian đc chi -> dễ manipulate hơn product cost

2-22
2.3 Taxes
 The one thing we can rely on with taxes is
that they are always changing
 Marginal vs. average tax rates
◼ Marginal – the percentage paid on the next dollar
earned
◼ Average – the tax bill / taxable income

 Other taxes

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Marginal versus Average Rates
 Suppose your firm earns $4 million in taxable income.
◼ What is the firm’s tax liability?
◼ What is the average tax rate?
◼ What is the marginal tax rate?
 If you are considering a project that will increase the firm’s
taxable income by $1 million, what tax rate should you use in
your analysis?

2-24
Marginal versus Average Rates

2-25
2.4 Net Working Capital

❑ Net Working Capital ≡

Current Assets – Current Liabilities

 NWC usually grows with the firm – the change

in NWC

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U.S.C.C. Balance Sheet
$252m = $707- $455
2010 2009 2010 2009
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
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117 to $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation (550) (460 $275 million in 2010 from
Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 $252 million
Stockholder's equity: in 2009.
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
$23 million
Common stock ($1 par value) 55 32
Capital surplus 347 327
$275m = $761m- $486m This increase
Accumulated of $23 million
retained earnings 390 347
Less treasury stock (26) (20)
isTotal
anequity
investment of the$805 firm.$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
2-27
2.5 Financial Cash Flow
 In finance, the most important item that can
be extracted from financial statements is the
actual cash flow of the firm.
 Since there is no magic in finance, it must be
the case that the cash flow received from the
firm’s assets must equal the cash flows to
the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)

2-28
U.S.C.C. Financial Cash Flow
Cash Flow of the Firm Operating Cash Flow (Cash
Operating cash flow $238
(Earnings before interest and taxes earnings before interest):
plus depreciation minus taxes)
Capital spending -173 EBIT $219
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital -23
Depreciation $90
Total $42
Current Taxes -$71
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt OCF $238
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

2-29
U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital Spending /Capital
Capital spending -173 Expenditure (CapEX)
(Acquisitions of fixed assets
minus sales of fixed assets) Purchase of fixed assets -$198
Additions to net working capital -23
Total $42 Sales of fixed assets $25
Cash Flow of Investors in the Firm Capital Spending -$173
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
NWC grew from $275
Capital spending -173 million in 2010 from $252
(Acquisitions of fixed assets
minus sales of fixed assets) million in 2009.
Additions to net working capital -23
Total $42 This increase of $23
Cash Flow of Investors in the Firm million is the addition to
Debt $36
(Interest plus retirement of debt NWC.
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending -173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital -23
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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 U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Cash Flow to Creditors
Capital spending -173
(Acquisitions of fixed assets Interest $49
minus sales of fixed assets)
Additions to net working capital -23 Retirement of debt 73
Total $42
Cash Flow of Investors in the Firm Debt service 122
Debt $36
(Interest plus retirement of debt Proceeds from new debt
minus long-term debt financing)
Equity 6 sales -86
(Dividends plus repurchase of
equity minus new equity financing) Total $36
Total $42

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U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes Cash Flow to Stockholders
plus depreciation minus taxes)
Capital spending -173 Dividends $43
(Acquisitions of fixed assets
minus sales of fixed assets) Repurchase of stock 6
Additions to net working capital -23
Cash to Stockholders 49
Total $42
Cash Flow of Investors in the Firm Proceeds from new stock issue
Debt $36 -43
(Interest plus retirement of debt
minus long-term debt financing) Total $6
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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U.S.C.C. Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238 The cash flow received
(Earnings before interest and taxes
plus depreciation minus taxes)
from the firm’s assets
Capital spending -173 must equal the cash flows
(Acquisitions of fixed assets
minus sales of fixed assets)
to the firm’s creditors and
Additions to net working capital -23 stockholders:
Total $42
Cash Flow of Investors in the Firm CF ( A ) 
CF ( B ) + CF ( S )
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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2.5 The Statement of Cash Flows
 There is an official accounting statement called the
statement of cash flows.
 This helps explain the change in accounting cash,
which for U.S. Composite is $33 million in 2010.
 The three components of the statement of cash
flows are:
◼ Cash flow from operating activities
◼ Cash flow from investing activities
◼ Cash flow from financing activities

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U.S.C.C. Cash Flow from Operations
Operations
To calculate cash Net Income $86
flow from operations, Depreciation 90
Deferred Taxes 13
start with net income,
Changes in Assets and Liabilities
add back non-cash Accounts Receivable -24
items like Inventories 11
Accounts Payable 16
depreciation and Accrued Expenses 18
adjust for changes in Other -8
current assets and Total Cash Flow from Operations $202
liabilities (other than
cash).

2-37
U.S.C.C. Cash Flow from Investing

Cash flow from Acquisition of fixed assets -$198

investing activities Sales of fixed assets 25
Total Cash Flow from Investing Activities -$173
involves changes in
capital assets:
acquisition of fixed
assets and sales of
fixed assets (i.e., net
capital expenditures).

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U.S.C.C. Cash Flow from Financing

Cash flows to and Retirement of debt (includes notes) -$73

from creditors and Proceeds from long-term debt sales 86
Change in notes payable -3
owners include Dividends -43
changes in equity and Repurchase of stock -6
debt. Proceeds from new stock issue 43

Total Cash Flow from Financing $4

2-39
U.S.C.C. Statement of Cash Flows
Operations
Net Income $86
The statement of Depreciation 90
Deferred Taxes 13
cash flows is the Changes in Assets and Liabilities
Accounts Receivable -24
addition of cash Inventories
Accounts Payable
11
16
Accrued Expenses 18
flows from Other -8
Total Cash Flow from Operations $202
operations, Investing Activities
Acquisition of fixed assets -$198
investing, and Sales of fixed assets
Total Cash Flow from Investing Activities
25
-$173
Financing Activities
financing. Retirement of debt (includes notes) -$73
Proceeds from long-term debt sales 86
Notes Payable -3
Dividends -43
Repurchase of stock -6
Proceeds from new stock issue 43
Total Cash Flow from Financing $4
Change in Cash (on the balance sheet) $33
2-40
2.7 Cash Flow Management
 Earnings can be manipulated using subjective decisions
required under GAAP
 Total cash flow is more objective, but the underlying
components may also be “managed”
◼ Moving cash flow from the investing section to the operating section
may make the firm’s business appear more stable

2-41
Quick Quiz
 What is the difference between book value and
market value? Which should we use for decision
making purposes?
 What is the difference between accounting income
and cash flow? Which do we need to use when
making decisions?
 What is the difference between average and
marginal tax rates? Which should we use when
making financial decisions?
 How do we determine a firm’s cash flows? What
are the equations, and where do we find the
information? 2-42
Financial Statements Analysis using ratios

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Know how to standardize financial statements for comparison
purposes
 Know how to compute and interpret important financial ratios

 Be able to develop a financial plan using the percentage of sales

approach
 Understand how capital structure and dividend policies affect a
firm’s ability to grow

3-44
Chapter Outline
3.1 Financial Statements Analysis
3.2 Ratio Analysis
3.3 The Du Pont Identity
3.4 Financial Models
3.5 External Financing and Growth
3.6 Some Caveats Regarding Financial Planning Models

3-45
3.1 Financial Statements Analysis
 Common-Size Balance Sheets
◼ Compute all accounts as a percent of total assets
 Common-Size Income Statements
◼ Compute all line items as a percent of sales
 Standardized statements make it easier to compare financial information,
particularly as the company grows.
 They are also useful for comparing companies of different sizes,
particularly within the same industry.

3-46
3-47
3-48
3-49
3-50
3.2 Ratio Analysis
 Ratios also allow for better comparison through time or
between companies.
 As we look at each ratio, ask yourself:
◼ How is the ratio computed?
◼ What is the ratio trying to measure and why?
◼ What is the unit of measurement?
◼ What does the value indicate?
◼ How can we improve the company’s ratio?

3-51
Categories of Financial Ratios
 Short-term solvency or liquidity ratios
 Long-term solvency or financial leverage ratios

 Asset management or turnover ratios

 Profitability ratios

 Market value ratios

3-52
Computing Liquidity Ratios
 Current Ratio = CA / CL
◼ 708 / 540 = 1.31 times
 Quick Ratio = (CA – Inventory) / CL
◼ (708 - 422) / 540 = .53 times
 Cash Ratio = Cash / CL
◼ 98 / 540 = .18 times

The primary concern is the firm’s ability to pay its

bills over the short run without undue stress
3-53
Computing Leverage Ratios
 Total Debt Ratio = (TA – TE) / TA = D/TA
◼ (3588 - 2591) / 3588 = 28%
 Debt/Equity = TD / TE
◼ (3588 – 2591) / 2591 = 38.5%
 Equity Multiplier = TA / TE = 1 + D/E
◼ 1 + .385 = 1.385
Long-term solvency ratios are intended to address the
firm’s long-run ability to meet its obligations or, more
generally, its financial leverage
3-54
Computing Coverage Ratios
 Times Interest Earned (interest coverage) = EBIT / Interest
◼ 691 / 141 = 4.9 times
 Cash Coverage = (EBIT + Depreciation + Amortization) /
Interest
◼ (691 + 276) / 141 = 6.9 times

3-55
Asset management
 Inventory turnover
 Receivables turnover

 Total asset turnover

how efficiently, or intensively, a firm uses its assets to

generate sales

3-56
Computing Inventory Ratios
 Inventory Turnover = Cost of Goods Sold /
Inventory
◼ 1344 / 422 = 3.2 times
 Days’ Sales in Inventory = 365 / Inventory
Turnover
◼ 365 / 3.2 = 114 days

3-57
Computing Receivables Ratios
 Receivables Turnover = Sales / Accounts Receivable
◼ 2311 / 188 = 12.3 times
◼ We collected our outstanding credit accounts and lent the money
again 12.3 times during the year

 Days’ Sales in Receivables = 365 / Receivables Turnover

◼ 365 / 12.3 = 30 days

3-58
Computing Receivables Ratios
 Days’ Sales in Receivables = 365 / Receivables Turnover
◼ 365 / 12.3 = 30 days
◼ On average, we collect on our credit sales in 30 days

3-59
Computing Total Asset Turnover
 Total Asset Turnover = Sales / Total Assets
◼ 2311 / 3588 = .64 times
◼ For every dollar in assets, we generated $.64 in sales
◼ It is not unusual for TAT < 1, especially if a firm has a large amount
of fixed assets.

3-60
Computing Profitability Measures
 Profit Margin = Net Income / Sales
 Return on Assets (ROA) = Net Income / Total Assets

 Return on Equity (ROE) = Net Income / Total Equity

 EBITDA Margin = EBITDA / Sales

EBITDA: Earnings before interest, taxes, depreciation,

and amortization.

How efficiently the firm uses its assets and how efficiently
the firm manages its operations

3-61
Computing Profitability Measures
 Profit Margin = Net Income / Sales
◼ 363 / 2311 = 15.7%
◼ In an accounting sense, the company generates a little less than 16
cents in net income for every dollar in sales

 EBITDA Margin = EBITDA / Sales

◼ 967 / 2311 = 41.8%

3-62
Computing Profitability Measures
 Return on Assets (ROA) = Net Income / Total Assets
◼ 363 / 3588 = 10.1%
◼ A measure of profit per dollar of assets
◼ For every dollar in the total assets, the company generated 10 cents in profit.

 Return on Equity (ROE) = Net Income / Total Equity

◼ 363 / 2591 = 14.0%
◼ A measure of how the stockholders fared during the year
◼ For every dollar in equity, the company generated 14 cents in profit.

3-63
Computing Market Value Measures
 Market Capitalization
 PE Ratio = Price per share / Earnings per share
 Market-to-book ratio = market value per share / book value per
share
 Enterprise Value (EV) = Market capitalization + Market value
of interest bearing debt – cash
 EV Multiple = EV / EBITDA

3-64
Computing Market Value Measures
 Market Capitalization = price per share x No. of shares
outstanding
$88 per share x 33 million shares = 2,904 million
 PE Ratio = Price per share / Earnings per share
 EPS (earnings per share) = Net Income / No. of shares
outstanding
◼ 88 / 11 = 8 times
◼ How much investors are willing to pay per dollar of current earnings,
Prufrock shares sell for eight times earnings
◼ Prufrock shares have, or “carry,” a PE multiple of 8
 Market-to-book ratio = market value per share / book value per
share
◼ 88 / (2591 / 33) = 1.12 times
◼ It compares the market value of the firm’s investments to their cost 3-65
Computing Market Value Measures
 EPS (earnings per share) = Net Income / No. of shares
outstanding
◼ 88 / 11 = 8 times
◼ How much investors are willing to pay per dollar of current earnings,
Prufrock shares sell for eight times earnings
◼ Prufrock shares have, or “carry,” a PE multiple of 8
 Market-to-book ratio = market value per share / book value per
share
Book value per share = Shareholders’ equity / No. of shares
outstanding
◼ 88 / (2591 / 33) = 1.12 times
◼ It compares the market value of the firm’s investments to their cost

3-66
Computing Market Value Measures
 Enterprise Value (EV) = Market capitalization + Market value
of interest bearing debt – cash
◼ 2904 + (196 + 457) – 98 = 3465
◼ How much it would take to buy all of the outstanding stock of a firm
and also to pay off the debt

 EV Multiple = EV / EBITDA
◼ 3465 / 967 = 3.6 times

3-67
3-68