CHAPTER 2

FINANCIAL STATEMENTS, TAXES, AND CASH

FLOW

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 BALANCE SHEET

• The balance sheet is a snapshot of the firm’s

assets and liabilities at a given point in time.
• Assets are listed in order of decreasing
liquidity.
 Ease of conversion to cash
 Without significant loss of value

• Balance Sheet Identity

 Assets = Liabilities + Stockholders’ Equity

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 THE BALANCE SHEET
FIGURE 2.1

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 NET WORKING CAPITAL
AND LIQUIDITY
• Net Working Capital
 = Current Assets - Current Liabilities
 Positive when the cash that will be received over the next 12 months
exceeds the cash that will be paid out
 Usually positive in a healthy firm

• Liquidity
 Ability to convert to cash quickly without a significant loss in value
 Liquid firms are less likely to experience financial distress.
 But liquid assets typically earn a lower return.
 Trade-off to find balance between liquid and illiquid assets

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 MARKET VALUE VS. BOOK VALUE

• The balance sheet provides the book value of

the assets, liabilities, and equity.
• Market value is the price at which the assets,
liabilities, or equity can actually be bought or
sold.
• Market value and book value are often very
different. Why?
• Which is more important to the decision-
making process?
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 INCOME STATEMENT

• The income statement is more like a video of

the firm’s operations for a specified period of
time.
• You generally report revenues first and then
deduct any expenses for the period.
• Matching principle – GAAP says to show
revenue when it accrues and match the
expenses required to generate the revenue

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 THE CONCEPT OF CASH FLOW

• Cash flow is one of the most important pieces

of information that a financial manager can
derive from financial statements.
• The statement of cash flows does not provide
us with the same information
that we are looking at here.
• We will look at how cash is generated from
utilizing assets and how it is paid to those that
finance the purchase of the assets.

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 CHAPTER 3
WORKING WITH FINANCIAL STATEMENTS

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 SOURCES AND USES OF CASH

• Sources
 Cash inflow – occurs when we “sell” something
 Decrease in asset account (Sample B/S)
• Accounts receivable, inventory, and net fixed assets

 Increase in liability or equity account

• Accounts payable, other current liabilities, and common stock

• Uses
 Cash outflow – occurs when we “buy” something
 Increase in asset account
• Cash and other current assets

 Decrease in liability or equity account

• Notes payable and long-term debt

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 STATEMENT OF CASH FLOWS

• Statement that summarizes the sources and

uses of cash
• Changes divided into three major categories
 Operating Activity – includes net income and
changes in most current accounts
 Investment Activity – includes changes in fixed
assets
 Financing Activity – includes changes in notes
payable, long-term debt, and equity accounts, as
well as dividends

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 SAMPLE STATEMENT OF CASH
FLOWS
Cash, beginning of year 58 Financing Activity

Operating Activity Decrease in Notes Payable -93

Net Income 893 Decrease in LT Debt -248

Plus: Depreciation 116 Change in C/S (less RE) 0

Increase in A/P 4 Dividends Paid -292

Increase in Other CL 309 Net Cash from Financing -633
Less: Increase in other CA -139
Increase in A/R -164 Net Increase in Cash 50
Increase in Inventory -140
Net Cash from Operations 879 Cash End of Year 108

Investment Activity
Purchase of Fixed Assets -196
Net Cash from Investments -196

Numbers in millions of dollars

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 STANDARDIZED FINANCIAL
STATEMENTS
• 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.

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 RATIO ANALYSIS

• Ratios allow for better comparison

through time or between companies.

• As we look at each ratio, ask yourself

what the ratio is trying to measure and why
that information is important.

• Ratios are used both internally and externally.

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 COMPUTING TOTAL ASSET
TURNOVER
• Total Asset Turnover = B/S
I/S
Sales / Total Assets
 5,000 / 5,606 = .89
 It is not unusual for TAT < 1, especially if a firm has
a large amount of fixed assets

• NWC Turnover = Sales / NWC

 5,000 / (2,168 - 1,995) = 28.90 times

• Fixed Asset Turnover = Sales / NFA

 5,000 / 3,438 = 1.45 times

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 USING THE DUPONT IDENTITY

• ROE = PM × TAT × EM
 Profit margin is a measure of the firm’s operating
efficiency – how well it controls costs.
 Total asset turnover is a measure of the firm’s asset
use efficiency – how well does it manage its assets.
 Equity multiplier is a measure of the firm’s
financial leverage.

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 WHY EVALUATE FINANCIAL
STATEMENTS?
• Internal uses
 Performance evaluation – compensation
and comparison between divisions
 Planning for the future – guide in
estimating future cash flows

• External uses
 Creditors
 Suppliers
 Customers
 Stockholders

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 BENCHMARKING

• Ratios are not very helpful by themselves; they

need to be compared to something.

• Time-Trend Analysis
 Used to see how the firm’s performance
is changing through time
 Internal and external uses

• Peer Group Analysis

 Compare to similar companies or within industries
 SIC and NAICS codes

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 POTENTIAL PROBLEMS

• There is no underlying theory, so there is no way to know

which ratios are most relevant.
• Benchmarking is difficult for diversified firms.
• Globalization and international competition makes
comparison more difficult because of differences in
accounting regulations.
• Varying accounting procedures, i.e. FIFO vs. LIFO
• Different fiscal years
• Extraordinary events

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 CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE

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 CORPORATE FINANCE
• Some important questions that are answered
using finance:
 What long-term investments should the firm
take on?

 Where will we get the long-term financing to

pay for the investment?

 How will we manage the everyday financial

activities of the firm?

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 FINANCIAL MANAGER
• Financial managers try to answer some or all of these
questions.
• The top financial manager within a firm is usually the Chief
Financial Officer (CFO).
• Other financial managers include:
 Treasurer – oversees cash management, credit
management, capital expenditures, and financial planning
 Controller – oversees taxes, cost accounting, financial
accounting and data processing

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 FINANCIAL MANAGEMENT
DECISIONS
• Capital budgeting
 What long-term investments or projects should the
business take on?

• Capital structure
 How should we pay for our assets?
 Should we use debt or equity?

• Working capital management

 How do we manage the day-to-day finances of the
firm?

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 FORMS OF BUSINESS
ORGANIZATION
• Three major forms in the United States (See:
Nolo)

• Sole Proprietorship

• Partnership
• General
• Limited

• Corporation
• Limited Liability Company
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 SOLE PROPRIETORSHIP
• Advantages • Disadvantages
 Easiest to start  Limited to life
 Least regulated of owner
 Single owner keeps all  Equity capital limited
the profits to owner’s personal
 Taxed once as personal wealth
income  Unlimited liability
 Difficult to sell
ownership interest

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 PARTNERSHIP
• Advantages • Disadvantages
 Two or more owners  Unlimited liability
 More capital available • General partnership
 Relatively easy to start • Limited partnership
 Income taxed once as  Partnership dissolves
personal income when one partner dies
or wishes to sell
 Difficult to transfer
ownership

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 CORPORATION
• Advantages • Disadvantages
 Limited liability  Double taxation
 Unlimited life (income taxed at the
 Separation of ownership corporate rate and then
and management dividends taxed at the
 Transfer of ownership is personal rate)
easy
 Easier to raise capital

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 GOAL OF FINANCIAL
MANAGEMENT
• What should be the goal of a corporation?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize the current value of the company’s stock?

• Does this mean we should do anything and

everything to maximize owner wealth?

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 THE AGENCY PROBLEM
• Agency relationship
 Principal hires an agent to represent his/her interests
 Stockholders (principals) hire managers (agents) to
run the company

• Agency problem
 Conflict of interest between principal and agent

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 MANAGING MANAGERS
• Managerial compensation
 Incentives can be used to align management and
stockholder interests.
 The incentives need to be structured carefully to make sure
that they achieve their goal.
 Salary, bonus, stock option

• Corporate control
 The threat of a takeover may result in better management.

• Other stakeholders

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 FIRM CASH FLOWS

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 FINANCIAL MARKETS
• Cash flows to and from the firm

• Primary vs. secondary markets

 Dealer vs. auction markets
 Listed vs. over-the-counter securities
• NYSE
• NASDAQ

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