UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS. Chapter 3

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1 1 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS Chapter 3

2 2 Learning Objectives (1 of 2) 1. Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager. 2. Evaluate firm profitability using the income statement. 3. Estimate a firm s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.

3 3 Learning Objectives (2 of 2) 4. Use the balance sheet to describe a firm s investments in assets and the way it has financed them. 5. Identify the sources and uses of cash for a firm using the firm s cash flow statement.

4 4 Principles Used in This Chapter Principle 1: Money Has a Time Value. Principle 3: Cash Flows Are the Source of Value. Principle 4: Market Prices Reflect Information. Principle 5: Individuals Respond to Incentives.

5 5 Basic Financial Statements The accounting and financial regulatory authorities mandate that firms provide the following four types of financial statements: 1. Income statement 2. Balance sheet 3. Cash flow statement 4. Statement of shareholders equity

6 6 Why Study Financial Statements? Analyzing a firm s financial statement can help managers carry out three important tasks: 1. assess the financial condition of the firm 2. monitor and control operations, and 3. financial forecasting and planning.

7 What are the Accounting Principles Used to Prepare Financial Statements? Accountants use the following three fundamental principles when preparing financial statements: 1. The revenue recognition principle, 2. The matching principle, and 3. The historical cost principle. 7

8 8 An Income Statement An income statement (also called a profit and loss statement) measures the amount of profits generated by a firm over a given time period (usually a year or a quarter). It can be expressed as follows: Revenues (or Sales) Expenses = Profits

9 Table 3.1 H. J. Boswell, Inc. (1 of 2) 9 Income Statement ($ millions, except per share data) for the Year Ended December 31, 2016 Sales Blank $2, Blank Cost of goods sold Blank (2,025.00) Blank Gross profit Blank $ Blank Operating expenses: Blank Blank Blank Selling expense $(90.00) Blank Blank General and administrative expense (67.50) Blank Blank Depreciation and amortization expense (135.00) Blank Blank Total operating expenses Blank (292.50) Blank Net operating income (EBIT, or earnings before interest and taxes) Blank $ Income from operating activities Interest expense Blank (67.50) Cost of debt financing

10 Table 3.1 H. J. Boswell, Inc. (2 of 2) 10 Earnings before taxes Blank $ Blank Income taxes Blank (110.25) Cost of corporate income Taxes Net income Blank $ Income resulting from operating and financing activities Additional information: Blank Blank Blank Dividends paid to stockholders during 2016 Blank $ Blank Number of common shares outstanding Blank Blank Earnings per share (EPS) Blank $ 2.28 Blank Dividends per share Blank $ 0.50 Blank

11 Interpreting Firm Profitability using the Income Statement From H.J. Boswell Inc. s income statement (Table 3-1) we observe that firm has been profitable. We can identify three different measures of profit or income: 1. The gross Profit margin is 25% ($675 million) 2. The operating profit margin is only 14.2% ($382.5 million) 3. The net profit margin is only 7.6% ($ million) 11

12 12 The Balance Sheet The balance sheet is a snapshot of the firm s financial position on a specific date. It is defined by the following equation: Total Assets = Total Liabilities + Total Shareholders Equity

13 13 The Balance Sheet Total assets, sum of total shareholders equity and total liabilities, 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.

14 14 Table 3.2 H. J. Boswell, Inc. Balance Sheets ($ millions), December 31, 2015 and 2016 Assets Blank Blank Liabilities and Stockholders Equity Blank Blank Blank Blank Cash $ $ Accounts payable $ $ Accounts Receivable Accrued expenses Inventory Short-term notes Other current assets Total current assets Gross plant and equipment Total current liabilities $ $ $ $ Long-term debt , , Total liabilities $1, $1,059.75

15 15 Table 3.2 H. J. Boswell, Inc. Assets Blank Blank Liabilities and Stockholders Equity Blank Blank Blank Blank Less accumulated depreciation (382.50) (517.50) Common stockholders equity Blank Blank Net plant and equipment $1, $1, Common stock-par value Total assets $1, $1, Paid-in capital Blank Blank Blank Retained earnings Blank Blank Blank Total common stockholders equity Blank Blank Blank Total liabilities and stockholders equity $ $ $1, $1,971.00

16 16 Figure 3.1 The Balance Sheet

17 Book Values, Historical Costs, and Market Values Book values reported in the balance sheet can differ from market values for three reasons. Book values are reflect their historical cost at the time the asset was acquired, not their current market value. Depreciation expense used to reduce value of fixed assets reflects accounting and tax rules rather than actual changes in market values. Intangible assets are not reflected fully in the firm s balance sheet. 17

18 18 The Cash Flow Statement The cash flow statement is a report that firms use to explain changes in their cash balances over a specific period of time by identifying all of the sources and uses of cash for that period.

19 19 Sources and Uses of Cash A source of cash is any activity that brings cash into the firm. For example, sale of equipment. A use of cash is any activity that causes cash to leave the firm. For example, payment of taxes.

20 20 Sources and Uses of Cash Sources of Cash Uses of Cash Decrease in an asset account Increase in an asset account Increase in a liability account Decrease in a liability account Increase in an owner s equity account Decrease in an owners equity account

21 21 Cash Flow Statement Format The basic format for a 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

22 22 Table 3-3 H. J. Boswell, Inc., Balance Sheets and Balance Sheet Changes (1 of 2) Blank Change Cash $ $ $ (4.50) Accounts receivable Inventory Other current assets Total current assets $ $ $ Gross plant and equipment 1, , Less accumulated depreciation (382.50) (517.50) (135.00) Net plant and equipment $1, $1, $ Total assets $1, $1, $207.00

23 23 Table 3-3 H. J. Boswell, Inc., Balance Sheets and Balance Sheet Changes (2 of 2) Blank Change Accounts payable $ $ $ 4.50 Accrued expenses Short-term notes (9.00) Total current liabilities $ $ $ (4.50) Long-term debt Total liabilities $1, $1, $ Common stockholders equity Blank Blank Blank Common stock par value Paid-in capital Retained earnings Total common stockholders equity $ $ $ Total liabilities and stockholders equity $1, $1, $207.00

24 Sources and Uses of Cash Why did the cash balance decline by $4.50m?. See table 3.3 and table below: Sources of Cash Increase in Accounts Payable = $4.50 Uses of Cash Increase in Accounts Receivable $22.50 Increase in long-term debt = $51.75 Increase in inventory = $ Increase in retained earnings = $ Increase in net plant and equipment = $40.50 Blank Decrease in short-term notes = $9 Total Sources of cash = $ Total Uses of cash = $220.50

25 25 Sources and Uses of Cash An analysis of H.J. Boswell s operations reveals the following: The firm used more cash than it generated, resulting in a deficit of $4.5 million The main source of cash flow was retained earnings ($159.75m) and long-term debt ($51.75m) The largest use of cash was for acquiring inventory at $148.5 million.

26 26 Cash Flow Statement Format Operating activities represent the company s core business, including sales and expenses. Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment.

27 27 Cash Flow Statement Format Financing activities represent changes in the firm s use of debt and equity such as issue of new shares, the repurchase of outstanding shares, and the payment of dividends.

28 28 Table 3-4 H. J. Boswell, Inc. (1 of 2) Ending cash balance for 2015 (beginning cash balance for 2016) Blank Blank $94.50 Operating activities Blank Blank Blank Net income $ Blank Blank Increase in accounts receivable (22.50) Blank Blank Increase in inventory (148.50) Blank Blank No change in other current assets 0.00 Blank Blank Depreciation expense Blank Blank Increase in accounts payable 4.50 Blank Blank No change in accrued expenses 0.00 Blank Blank Cash flow from operating activities Blank $ Blank Investing activities Blank Blank Blank Purchases of plant and equipment (175.50) Blank Blank Cash flow from investing activities Blank (175.50) Blank

29 29 Table 3-4 H. J. Boswell, Inc. (2 of 2) Ending cash balance for 2015 (beginning cash balance for 2016) Blank Blank $94.50 Financing activities Blank Blank Blank Decrease in short-term notes (9.00) Blank Blank Increase in long-term debt Blank Blank Cash dividends paid to shareholders $ (45.00) Blank Blank Cash flow from financing activities Blank (2.25) Blank Increase (decrease) in cash during the year Blank Blank $ (4.50) Ending cash balance for 2016 Blank Blank $90.00

30 Quality of Earnings: Evaluating Cash Flow from Operations Since reported earnings can sometimes be misleading, we can combine information from the firm s income statement and the statement of cash flows to evaluate the quality of firm s reported earnings. 30

31 Sustainable Capital Expenditures: Evaluating Investment Activities This ratio calculates the extent to which the firm s operating cash flows can pay for capital expenditures. Higher ratio will mean less dependence on capital markets for financing. 31

Yasheng Group 2010 Financial Results

Yasheng Group 2010 Financial Results CONSOLIDATED BALANCE SHEETS 2010 2009 2008 ASSETS 849,454,265 739,630,043 736,213,299 Current assets: Cash and cash equivalents 10,116,750 8,010,017 7,880,338 Accounts