Understanding Financial Statements, Taxes, and Cash Flows

Chapter 2

Understanding Financial Statements,
Taxes, and Cash Flows

Copyright © 2011 Pearson Prentice Hall. All rights reserved.
3-1

Learning Objectives
1. To discuss about the user and needs of financial
statement
2. To explain the components in the income
statement, balance sheet, cash flow statement
and statement of shareholders’ equity
3. To explain the calculation of tax and
depreciation.

3-2

Basic Financial Statements

• Following four types of financial
statements are mandated by the
accounting and financial regulatory
authorities:
1. Income statement
2. Balance sheet
3. Cash flow statement
4. Statement of shareholder’s equity

3-3

Basic Financial Statements (cont.)

• 1. Income Statement:
– An income statement provides the following
information for a specific period of time (for
example, a year or 6 months or 3 months):
• Revenue,
• Expenses, and
• Profit.

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• 2. Balance sheet:
– Balance sheet provides a snap shot of the
following on a specific date (for example, as of
December 31, 2010)
• Assets (value of what the firm owns),
• Liabilities (value of firm’s debts), and
• Shareholder’s equity (the money invested by the
company owners).

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• 3. Cash flow statement:
– It reports cash received and cash spent by the
firm over a period of time (for example, over
the last 6 months).

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• 4. Statement of shareholder’s equity:
– It provides a detailed account of the firm’s
activities in the following accounts over a
period of time (for example, last six months):
• Common stock account,
• Preferred stock account,
• Retained earnings account, and
• Changes to owner’s equity.

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Why Study Financial Statements?
1. Assess current performance through financial
statement analysis (Financial statement
analysis allows us to assess the present
financial condition of a firm),

2. Monitor and control operations, and

3. Forecast future performance.

3-8

An Income Statement

• An income statement is also called a profit
and loss statement.

• An income statement measures the
amount of profits generated by a firm over
a given time period (usually a year or a
quarter).

3-9

An Income Statement (cont.)

• Income statement can be expressed as
follows:

– Revenues (or Sales) – Expenses = Profits

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• An income statement will contain the
following basic elements:
1. Revenues
2. Expenses
• Cost of goods sold, Interest expenses, SGA (selling,
general and administrative) expense, depreciation
expense, Income tax expense
1. Profits
• Gross profit, net operating income (also known as
EBIT), earnings before taxes (EBT), and net income

3-11

• Sales
– Minus Cost of Goods Sold
• = Gross Profit
• Minus Operating Expenses
– Selling expenses
– General and Administrative expenses
– Depreciation and Amortization Expense
• = Operating income (EBIT)
• Minus Interest Expense
• = Earnings before taxes (EBT)
• Minus Income taxes

• = Net income (EAT)

– EBIT = Earnings before interest and taxes; EBT = Earnings before
taxes; EAT = Earnings after taxes

3-12

Sample Income Statement

3-13

Evaluating a Firm’s EPS and
Dividends

• We can use the income statement to
determine the earnings per share (EPS)
and dividends.
• EPS = Net income÷ Number of shares
outstanding

3-14

Connecting the Income Statement
and the Balance Sheet

• What can the firm do with the net
income?:
1. Pay dividends to shareholders, and/or
2. Reinvest in the firm

3-15

The Balance Sheet

• The balance sheet provides a snapshot of
the firm’s financial position on a specific
date.

• The balance sheet is defined by the
following equation:
Total Assets = Total Liabilities + Total Shareholder’s Equity

3-16

The Balance Sheet (cont.)

• Total assets represents the resources
owned by the firm.
• Total liabilities represent the total
amount of money the firm owes its
creditors
• Total shareholders’ equity refers to the
difference in the value of the firm’s total
assets and the firm’s total liabilities.

3-17

The Balance
Sheet (cont.)

3-18


• The balance sheet includes the following
main components:
1.Assets – Found on the left-hand side of
the balance sheet. It includes current
assets and fixed assets.
2.Sources of financing – Found on the
right-hand side of the balance sheet. It
includes current liabilities, long-term
liabilities, and owner’s equity.

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• Current assets consists of firm’s cash
plus other assets the firm expects to
convert to cash within 12 months or less,
such as receivables and inventory.

• Fixed assets are assets that the firm
does not expect to sell within one year. For
example, plant and equipment, land.

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• Current liabilities represent the amount
that the firm owes to creditors that must
be repaid within a period of 12 months or
less such as accounts payable, notes
payable.

• Long-term liabilities refer to debt with
maturities longer than a year such as bank
loans, bonds.

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• The stockholder’s equity is broken down
into two components:
(1) The amount the company received from selling
stock to investors. It may be shown as common
stock in the balance sheet or it may be divided
into two components: par value and additional
paid in capital above par. Par value is the stated or
face value a firm puts on each share of stock. Paid in
capital is the additional amount the firm raised when it sold
the shares.

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• For example, DLK corporation’s par value
per share is $2.00 and the firm has 30
million shares outstanding such that the
par value of the firm’s common equity is
$60 million. If the stocks were issued to
investors for $240 million, $180 million
represents paid in capital.

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• (2) The amount of the firm’s retained
earnings. Retained earnings are the
portion of net income that has been
retained (i.e. not paid in dividends) from
prior years operations.

• Thus stockholder’s equity
= Par value of common stock + Paid in
Capital + Retained Earnings

3-24


• We can also express stockholders’ equity
as follows:

Shareholders' equity = Total Assets – Total
Liabilities

3-25

The Cash Flow Statement

• The Cash Flow Statement is used by
firms to explain changes in their cash
balances over a period of time by
identifying all of the sources and uses of
cash.

3-26

Sources and Uses of Cash

• Source of cash is any activity that brings
cash into the firm. For example, sale of
equipment.

• Use of cash is any activity that causes cash
to leave the firm. For example, payment of
taxes.

3-27

Balance Sheet for
H.J. Boswell, Inc.

3-28

Cash Flow Analysis

• Why did the cash balance decline by $4.5
million from 2009 to 2010?
1.Accounts receivable increased by $22.5
million representing an increase in
uncollected cash from credit sales. Thus it
represents $22.5m of use of cash to
invest in accounts receivable.

3-29

Cash Flow Analysis (cont.)

2. Inventory increased by $148.50 million
indicating use of cash to procure
inventory.
3. Equipment increased by $175.50 million
indicating use of cash to invest in
equipment.
In general,
– an increase in an asset account = use of cash
– a decrease in an asset account = source of
cash

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4. Accounts Payable, credit extended to the
firm, increased by $4.5million. Thus
source of cash increased by $4.5million
due to accounts payable.
5. Long-term debt increased by $51.75
million indicating a source of cash.
6. Short-term debt decreased by $9 million
indicating use of cash to pay off the debt.

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7. Retained earnings increased by $159.75
million representing a source of cash to the
firm from the firm’s operations.

In general,
– An increase in a liability account = source of
cash
– A decrease in a liability account = use of cash

3-32

• Change in cash balance = Sources of cash
– Use of Cash = $216 - $220.50 = -$4.50
Sources of Cash Uses of Cash
Increase in Accounts Payable Increase in Accounts
= $4.50 Receivable $22.50

Increase in long-term debt Increase in inventory = $148.50
=$51.75
Increase in retained earnings = Increase in net plant and
$159.75 equipment = $40.50

Decrease in short-term notes =
$9
Total Sources of cash = Total Uses of cash = $220.50
$216.00

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Cash Flow Analysis Summary

Sources of Cash Uses of Cash

Decrease in an asset Increase in an asset
account account
Increase in a liability Decrease in a liability
account account
Increase in an owner’s Decrease in an owners’
equity account equity account

3-34

Cash Flow Statement

• The format for a traditional cash flow
statement is as follows:
Beginning Cash Balance
Plus: Cash Flow from Operating
Activities
Plus: Cash Flow from Investing
Activities
Plus: Cash Flow from Financing
Activities
Equals: Ending Cash Balance
3-35

Cash Flow Statement (cont.)

• Operating activities represent the
company’s core business including sales
and expenses. Basically any activity that
affects net income for the period.

• Investing activities include the cash flows
that arise out of the purchase and sale of
long-term assets such as plant and
equipment.

3-36

Cash Flow Statement (cont.)

• Financing activities represent changes in
the firm’s use of debt and equity such as
issue of new shares, payment of dividends.

3-37

H.J. Boswell,
Inc.
Statement of
Cash Flows

3-38

Understanding Financial Statements, Taxes, and Cash Flows

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