Chapter 3

Report
Chapter 3
Understanding
Financial
Statements, Taxes,
and Cash Flows
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Slide Contents
• Learning Objectives
• Principles Used in This Chapter
1. An Overview of the Firm’s Financial Statements
2. The Income Statement
3. Corporate Taxes
4. The Balance Sheet
5. The Cash Flow Statement
• Key Terms
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3-2
Learning Objectives
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.
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3-3
Introduction
•
•
Use the balance sheet to describe a firm’s
investments in assets and the way it has
financed them.
Identify the sources and uses of cash flow
for a firm using the firm’s Cash Flow
Statement.
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3-4
Principles Used in This Chapter
• Principle 1: Money Has a Time Value.
– We need to recognize that financial statements
do not adjust for time value of money.
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3-5
Principles Used in This Chapter
(cont.)
• Principle 3: Cash Flows Are the Source of
Value.
– Financial statements provide an important
starting point in determining the firm’s cash
flow.
– We should be able to distinguish between
reported earnings and cash flow. It is possible
for a firm to report positive earnings but have
no cash!
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3-6
Principles Used in This Chapter
(cont.)
• Principle 4: Market Prices Reflect
Information.
– Firm’s financial statements provide important
information that is used by investors in forming
expectations about firm’s future prospects and
subsequently, the market prices.
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3-7
3.1 An Overview
of the Firm’s
Financial
Statements
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Basic Financial Statements
• Following four types of financial
statements are mandated by the
accounting and financial regulatory
authorities:
1.
2.
3.
4.
Income statement
Balance sheet
Cash flow statement
Statement of shareholder’s equity
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3-9
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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3-10
Basic Financial Statements (cont.)
• 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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Basic Financial Statements (cont.)
• 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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3-12
Basic Financial Statements (cont.)
• 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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What is the Focus of this Chapter?
• Discuss the basic Content and Format of:
– Income statement,
– Balance sheet, and
– Cash flow statement
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Why Study Financial Statements?
• Analyzing a firm’s financial statement can help
managers carry out three important tasks:
1. Assess current performance through financial
statement analysis,
2. Monitor and control operations, and
3. Forecast future performance.
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3-15
Why Study Financial Statements?
(cont.)
1. Financial statement analysis:
–
–
Financial statement analysis allows us to
assess the present financial condition of a
firm.
Chapter 4 introduces the tools and techniques
used to carry out financial statement analysis.
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3-16
Why Study Financial Statements?
(cont.)
2. Financial control:
–
–
Financial statements are used by both insiders
(such as managers, board of directors) and
outsiders (such as suppliers, creditors) to
monitor and control the firm’s operations.
For example, a creditor may analyze a firm’s
financial statements to decide whether or not
to renew company’s loan.
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3-17
Why Study Financial Statements?
(cont.)
3. Financial forecasting and planning:
–
–
Financial planning models are typically built
using the financial statements.
Financial planning is covered in chapter 17.
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What are the Accounting Principles Used
to Prepare Financial Statements?
• The following three fundamental principles are
adhered to by accountants when preparing
financial statements:
1. The revenue recognition principle,
2. The matching principle, and
3. The historical cost principle.
• An understanding of these basic principles allows
us to be a more informed user of financial
statements.
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3-19
What are the Accounting Principles Used
to Prepare Financial Statements? (cont.)
1. The revenue recognition principle:
–
It states that the revenue should be included
in the firm’s income statement for the period
in which:
• Its goods and services were exchanged for
cash or accounts receivable; or
• The firm has completed what it must do to
be entitled to the cash.
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3-20
What are the Accounting Principles Used
to Prepare Financial Statements? (cont.)
2. The matching principle:
– This principle determines whether specific costs
or expenses can be attributed to this period’s
revenues.
– The expenses are matched with the revenues
they helped produce.
• For example, employees’ salaries are recognized
when the product produced as a result of that work is
sold, and not when the wages were paid.
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3-21
What are the Accounting Principles Used
to Prepare Financial Statements? (cont.)
3. The historical cost principle:
– This principle provides the basis for
determining the dollar values the firm reports
in its balance sheet.
– Most assets and liabilities are reported in the
firm’s financial statements at historical cost i.e.
the price the firm paid to acquire them. The
historical cost generally does not equal the
current market value of the assets or liabilities.
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3-22
3.2 The Income
Statement
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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).
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3-24
An Income Statement (cont.)
• Income statement can be expressed as
follows:
– Revenues (or Sales) – Expenses = Profits
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3-25
An Income Statement (cont.)
• 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
3. Profits
• Gross profit, net operating income (also known as
EBIT), earnings before taxes (EBT), and net income
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An Income Statement (cont.)
• 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
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Sample Income Statement
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3-28
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
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3-29
Evaluating a Firm’s EPS and
Dividends (cont.)
• Example 1: A firm reports a net income
$90 million and has 35 million shares
outstanding, what will be the earnings per
share (EPS)?
• EPS = Net income ÷ Number of shares
= $90 million ÷ $35 million
= $2.57
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3-30
Evaluating a Firm’s EPS and
Dividends (cont.)
• We can determine the dividends paid by
the firm to each shareholder by dividing
the total amount of dividend (reported on
the income statement) by the total
number of shares outstanding.
• Dividends per share = Net income ÷
Number of shares
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3-31
Evaluating a Firm’s EPS and
Dividends (cont.)
• Example 2: A firm reports dividend
payment of $20 million on its income
statement and has 35 million shares
outstanding. What will be the dividends
per share?
• Dividends per share = Net income ÷
Number of shares
= $20 million ÷ $35 million
= $0.57
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3-32
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
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3-33
Connecting the Income Statement
and the Balance Sheet (cont.)
• Example 3: Review examples 1 & 2. How
much was retained or reinvested by the
firm?
• Amount retained = Net Income –
Dividends
= $90m - $20m = $70m
• The firm’s balance on retained earnings
will increase by $70 million on the balance
sheet.
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3-34
Interpreting Firm Profitability using
the Income Statement
• What can we learn from H.J. Boswell Inc.’s
income statement (Table 3-1)?
1. The firm has been profitable as its revenues
exceeded its expenses.
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3-35
Interpreting Firm Profitability using
the Income Statement (cont.)
2. The gross profit margin (GPM)
= gross profits ÷ sales
= $675 million ÷ $2,700 million
= 25%
–
GPM indicates the firm’s “mark-up” on its cost of
goods sold per dollar of sales.
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3-36
Interpreting Firm Profitability using
the Income Statement (cont.)
3. The operating profit margin
= net operating income ÷ sales
= $382.5 million ÷ $2,700 million
= 14.17%
•
The operating profit margin is equal to the ratio
of net operating income or EBIT divided by firm’s
sales.
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3-37
Interpreting Firm Profitability using
the Income Statement (cont.)
Net profit margin:
= net profits ÷ sales
= $204.75 million ÷ $2,700 million
= 7.58%
•
Net profit margin indicates the percentage of
revenues left after all expenses (including
interest and taxes) have been considered.
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3-38
Interpreting Firm Profitability using
the Income Statement (cont.)
• These profit margins (gross profit margin,
operating profit margin, and net profit
margin) should be closely monitored and
compared to previous years and those of
competing firms.
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3-39
GAAP and Earnings Management
• While the firms must adhere to set of
accounting principles, GAAP (Generally
Accepted Accounting Principles), there is
considerable room for managers to
influence the firm’s reported earnings.
• Managers have an incentive to tamper
with reported earnings as their pay
depends upon it and investors care about
it.
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3-40
Checkpoint 3.1
Constructing an Income Statement
Use the following information to construct an income statement for
Gap, Inc. (GPS). The Gap is a specialty retailing company that sells
clothing, accessories, and personal care products under the Gap, Old
Navy, Banana Republic, Piperlime, and Athleta brand names. Use the
scrambled information below to calculate the firm’s gross profits,
operating income, and net income for the year ended January 31,
2009. Calculate the firm’s earnings per share and dividends per share.
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3-41
Checkpoint 3.1
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3-42
Checkpoint 3.1
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3-43
Checkpoint 3.1: Check Yourself
Reconstruct the Gap’s income statement assuming the firm is
able to cut its cost of goods sold by 10% and where the firm
pays taxes at 40% tax rate. What is the firm’s net income and
earnings per share?
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3-44
Step 1: Picture the Problem
• The income statement can be expressed as
follows:
Revenues – Expenses = Net Income
• The template on the next slide can be used to
solve the equation.
• We are given information on revenues and
expenses (cost of goods sold, operating expenses,
interest expense and income taxes) to fill the
template.
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3-45
Step 1: Picture the Problem (cont.)
Revenues
• Less: Cost of goods sold
Less: Operating expenses
Equals Gross
profit
Equals: net
Operating income
Less: Interest expense
Equals: earnings
Before taxes
Less: Income taxes
Equals:
NET INCOME
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3-46
Step 2: Decide on a Solution
Strategy
• Given the account balances, constructing
the income statement will entail
substituting the appropriate balances into
the template of step 1.
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3-47
Step 3: Solve
Revenues = $14,526,000,000
• Less: Cost of goods sold
= $8,171,100,000
Less: Operating expenses
=$3,899,000,000
Less: Interest expense
=$1,000,000
Less: Income taxes (40%)
=$9,819,600,000
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Equals: profit
=$6,354,900,000
Equals: net
Operating income
=$2,455,900,000
Equals: earnings
Before taxes
=$2,454,900,000
Equals:
NET INCOME
=$1,472,940,000
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Step 3: Solve (cont.)
• Earnings per share:
= net income ÷ number of shares
= $1,472,940,000 ÷ 716,296,296
= $2.06
• Dividends per share
= dividends ÷ number of shares
= $243,000,000 ÷ 716,296,296 = $0.34
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3-49
Step 4: Analyze
• The firm is profitable since it earned net
income of $1,472,940,000.
• The shareholders were able be earn $2.06
per share. However, the dividends per
share were only $0.34 indicating that the
difference of $1.72 was reinvested in the
corporation.
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3-50
3.3 Corporate
Taxes
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Corporate Taxes
• A firm’s income tax liability is calculated
using its taxable income and the tax rates
on corporate income.
• See the table on next slide for corporate
tax rates.
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3-52
Corporate tax rates
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3-53
Corporate tax rates
• The table reveals the following:
– Tax rates range from 15% to 39%
– Tax rates are progressive i.e. larger
corporations with higher profits will tend to pay
more taxes compared to smaller firms with
lower profits.
– Note: In addition to federal taxes, a firm may
face State and City taxes.
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3-54
Marginal and Average Tax Rates
• While analyzing the tax consequences of a
new business venture, the appropriate tax
rate is the marginal tax rate.
• Marginal tax rate is the tax rate that the
company will pay on its next dollar of
taxable income.
• Average tax rate is total taxes paid
divided by the taxable income.
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3-55
Marginal and Average Tax Rates
• Example 3: What is the average and
marginal tax liability for a firm reporting
$100,000 as taxable income.
Taxabl
e
Incom
e
$50,00
0
Margin Increme Cumula Avera
ntal Tax tive Tax ge Tax
al tax
Liability Liability Rate
rate
15%
7,500
7,500
15.00
%
$75,00 25%
0
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6,250
13,750
18.33
%
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Marginal and Average Tax Rates
• Average tax rate
– = Total tax liability ÷ Total taxable income
– = $22,250 ÷ $100,000
– = 22.25%
• Marginal tax rate
– = 39% as the firm will have to pay 39% on its
next dollar of taxable income i.e. if its taxable
income increases from $100,000 to $100,001.
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3-57
Dividend Exclusion for Corporate
Shareholders
• The dividend received by corporate
stockholders are partially exempt from
taxation. The rationale is to avoid double
taxation at the corporate level. The
percentage of exempt taxes is based on
the degree of ownership of the firm.
• Note dividends for non-corporate
investors, like you and me, are not exempt
from taxation – they are actually, doubletaxed.
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3-58
Dividend Exclusion for Corporate
Shareholders
• Example 4
– What will be the taxable income if firm ABC
receives $200,000 in dividends from firm XYZ.
– The taxable income will depend on the degree
of ownership of XYZ by ABC.
– See next slide.
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3-59
Dividend Exclusion for Corporate
Shareholders (cont.)
Ownership Dividend
Interest
Exclusion
Dividend
Income
Taxable
Income
Less than
20%
20% to
79%
70%
$200,000
$60,000
75%
$200,000
$50,000
80% or
more
100%
$200,000
$0
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3-60
3.4 The Balance
Sheet
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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
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3-62
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.
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3-63
The Balance Sheet (cont.)
• In general, GAAP requires that the firm
report assets on its balance sheet using
the historical costs.
• Cash and assets held for sale (such as
marketable securities) are an exception to
the rule. These assets are reported using
the lower of their cost or current market
value.
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3-64
The Balance Sheet (cont.)
• Assets whose value is expected to decline
over time (such as equipment) is reported
as “net equipment” which is equal to the
historical cost minus accumulated
depreciation.
• Note, the net value reported on balance
sheet could be significantly different from
the market value of the asset.
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3-65
The Balance
Sheet (cont.)
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3-66
The Balance Sheet (cont.)
• 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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3-67
The Balance Sheet (cont.)
• 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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3-68
The Balance Sheet (cont.)
• 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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3-69
The Balance Sheet (cont.)
• 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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3-70
The Balance Sheet (cont.)
• 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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3-71
The Balance Sheet (cont.)
• (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
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3-72
The Balance Sheet (cont.)
• We can also express stockholders’ equity
as follows:
Shareholders' equity = Total Assets – Total
Liabilities
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3-73
Firm Liquidity and Net Working
Capital
• Liquidity refers to the speed with which
an the asset can be converted to cash
without loss of value.
• For example, a firm’s bank account is
perfectly liquid. Other types of assets are
less liquid as they more difficult to sell and
convert to cash such as PPE (property,
plant and equipment).
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3-74
Firm Liquidity and Net Working
Capital
• For the overall firm, liquidity generally
refers to the firm’s ability to covert its
current assts (accounts receivable and
inventories) into cash so that it can pay its
bills (current liabilities) on time.
• We can thus measure a firm’s liquidity by
computing the net working capital =
current assets – current liabilities
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3-75
Firm Liquidity and Net Working
Capital (cont.)
• If a firm’s net working capital is
significantly positive, it is in a good
position to pay its debts on time and is
consequently very liquid.
• Lenders consider the net working capital
as an important indicator of firm’s ability
to repay its loans.
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3-76
The
Balance
Sheet
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3-77
Checkpoint 3.2
Constructing a Balance Sheet
Construct a balance sheet for Gap, Inc. (GPS) using the following list
of jumbled accounts for January 31, 2009. Identify the firm’s total
assets and net working capital:
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3-78
Checkpoint 3.2
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3-79
Checkpoint 3.2
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3-80
Checkpoint 3.2
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3-81
Checkpoint 3.2: Check Yourself
Reconstruct the Gap’s balance sheet to reflect the repayment
of $1 billion in short-term debt using a like amount of the
firm’s cash. What is the balance for total assets and current
liabilities?
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3-82
Step 1: Picture the Problem
• The firm’s balance sheet can be expressed
as follows:
Total Shareholders’ Equity +
Total Liabilities
= Total Assets
• The template on the following slide shows
how to construct the balance sheet.
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3-83
Step 1: Picture the Problem (cont.)
Current Assets
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets
Long-term (fixed) assets
Gross PPE
Less: Accumulated depreciation
Net property, plant and equip.
Other long-term assets
Total long-term assets
Total Assets
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Current Liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Long-term Liabilities
Long-term debt
Owner’s Equity
Par value of common stock
Paid-in-capital
Retained earnings
Total equity
Total Liabilities and
Owners’ equity
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Step 2: Decide on a Solution
Strategy
• We are given the account balances so in
order to construct the balance sheet we
need to substitute the appropriate
balances into the template developed in
step 1.
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3-85
Step 3: Solve
Cash
Inventories
Other current
assets
756,000,000
1,506,000,000
743,000,000
Current liabilities
1,158,000,000
Total current
assets
3,005,000,000
Total current
liabilities
1,158,000,000
Net Property,
Plant and
equipment
2,993,000,000
Long-term
liabilities
1,019,000,000
Other long-term
assets
626,000,000
Common Equity
4,387,000,000
Total Assets
$6,564,000,000
Total Liabilities
and Equity
$6,564,000,000
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3-86
Step 4: Analyze
• We can make the following observations from
Gap’s Balance sheet:
– The total assets of $6,564,000,000 is financed
by a combination of current liabilities, longterm liabilities and owner’s equity. Owner’s
equity accounts for $4,387,000,000 of the
total.
– The firm has a healthy net working capital of
$1,847,000,000 (3,005,000,000 minus
1,158,000,000).
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3-87
Debt and Equity Financing
• The right-hand side of the balance sheet
reveals the sources of money used to
finance the purchase of the firm’s assets
listed on the left-hand side of the balance
sheet.
• It shows how much was borrowed (debt
financing) and how much was provided by
firm’s owners (equity financing, through
the sale of equity or retention of prior
year’s earnings).
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Debt versus Equity
• Payment: Payment for debt holders is
generally fixed (in the form of interest);
Payment for equity holders (dividends) is
not fixed nor guaranteed.
• Seniority: Debt holders are paid before
equity holders in the event of bankruptcy.
• Maturity: Debt matures after a fixed period
while equity securities do not mature.
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Book Values, Historical Costs, and
Market Values
• Book values (based on historical cost)
reported in the balance sheet can differ
from market values.
• The gap between book value and market
value is likely to be higher for fixed assets
relative to current assets for two reasons:
– Inflation affects the market price of asset; and
– Depreciation adjustments in the balance sheet
do not reflect actual changes in market values.
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3.5 The Cash
Flow Statement
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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.
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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.
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Balance Sheet for
H.J. Boswell, Inc.
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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.
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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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Cash Flow Analysis (cont.)
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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Cash Flow Analysis (cont.)
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
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Cash Flow Analysis (cont.)
• 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
= $4.50
Increase in Accounts Receivable
$22.50
Increase in long-term debt
=$51.75
Increase in inventory =
$148.50
Increase in retained earnings =
$159.75
Increase in net plant and
equipment = $40.50
Decrease in short-term notes =
$9
Total Sources of cash =
$216.00
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Total Uses of cash = $220.50
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Cash Flow Analysis (cont.)
• An analysis of H.J. Boswell’s operations reveals
the following for 2010:
– The firm used more cash than it generated,
resulting in a deficit of $4.5 million
– The primary source of cash flow was retained
earnings ($159.75 million) followed by longterm debt ($51.75 million)
– The largest use of cash was for acquiring
inventory at $148.5 million.
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Cash Flow Analysis Summary
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
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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
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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.
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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.
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H.J. Boswell,
Inc.
Statement of
Cash Flows
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Checkpoint 3.3
Interpreting the Statement of Cash Flow
You are in your second rotation in the management training program at a regional
brokerage firm and your supervisor calls you into her office on Monday morning to discuss
your next training rotation. When you enter her office you are surprised to learn that you
will be responsible for compiling a financial analysis of Chesapeake Energy Inc. (CHK).
Chesapeake is the largest producer of natural gas in the United States and is
headquartered in Oklahoma City. Your boss suggests that you begin your analysis by
reviewing the firm’s cash flow statements for 2004 through 2007 (found below):
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Checkpoint 3.3
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Checkpoint 3.3
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Checkpoint 3.3
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Checkpoint 3.3
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Checkpoint 3.3: Check Yourself
Go to http:finance.google.com/finance and get the
cash flow statements for the most recent four-year
period for Exco Resources (XCO). How does their cash
from investing activities compare to their cash flow
from operating activities in 2009.
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Step 1: Picture the Problem
• The cash flow statement uses information
from the firm’s balance sheet and income
statement to identify the net sources and
uses of cash for a specific period of time.
• The sources and uses of cash are
organized into cash from operating
activities, investing activities, and
financing activities.
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Step 1: Picture the Problem (cont.)
• 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
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Step 1: Picture the Problem (cont.)
• Here we have to compare the cash flow
from operating activities and investment
activities in 2007 for Exco Resources
(XCO).
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Step 2: Decide on a Solution
Strategy
• We can compare the cash flow from
operating activities and cash flow from
investing activities by looking at the cash
flow statement.
• The cash flow statement can be retrieved
from http://finance.google.com/finance
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Step 3: Solve
• Cash flow from operating activities
– EXCO had a positive cash flow from operating
activities of $577.83 million in 2007. In 2006,
the cash flow from operating activities was
much lower at $227.86.
– The primary contributors to the operating cash
flows in 2007 were the firm’s
depreciation/depletion expense and non-cash
expense. Net working capital is a use of cash.
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Step 3: Solve (cont.)
• Cash flow from investing activities:
– Cash flow from investing activities were
($2,396.44) million in 2007.
– EXCO had invested heavily in capital
expenditures in 2007 with a total expense of
$2,846.97 million.
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Step 4: Analyze
• The cash flow statement for 2007 depicts a
profitable firm with positive cash flow from
operations.
• The firm has been aggressively investing in fixed
assets to the tune of almost 4 times its operating
cash flows.
• The firm has been able to successfully raise
money from capital markets by issuing stocks of
nearly $2,000 million.
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Key Terms
•
•
•
•
•
•
•
Accounts receivable
Accounts payable
Accumulated depreciation
Paid-in-capital
Average tax rate
Balance sheet
Cash flow statement
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Key Terms (cont.)
•
•
•
•
•
•
•
Cost of goods sold
Current assets
Current liabilities
Depreciation expense
Dividends per share
Earnings before interest and taxes (EBIT)
Earnings per share
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Key Terms (cont.)
•
•
•
•
•
•
•
Fixed assets
Gross plant and equipment
Gross profit margin
Income statement
Inventories
Liquidity
Long-term debt
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Key Terms (cont.)
•
•
•
•
•
•
•
Marginal tax rate
Market value
Net operating income
Net income
Net plant and equipment
Net profit margin
Net working capital
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Key Terms (cont.)
•
•
•
•
•
•
•
Operating profit margin
Par value
Profits
Retained earnings
Revenues
Source of cash
Stockholders’ equity
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Key Terms (cont.)
•
•
•
•
•
Taxable income
Total assets
Total liabilities
Total shareholders’ equity
Uses of cash
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