Learning ObjectivesCompute a companys profits as reflected by its income statement.

Determine a firms financial position at a point in time based on its balance sheet

Measure a companys cash flows.

Compute taxable income and income taxes owed.

Slide ContentsPrinciples used in this ChapterThe Income StatementThe Balance SheetMeasuring Cash FlowsIncome Taxes and Finance

*Principles Applied in this ChapterPrinciple 1: Cash flow is what matters

Principle 5: Conflicts of interest cause agency problems

1. The Income StatementIt is also known as Profit/Loss StatementIt measures the results of firms operation over a specific period. The bottom line of the income statement shows the firms profit or loss for a period.Sales Expenses = Profits

Income Statement TermsRevenue (Sales)Money derived from selling the companys product or serviceCost of Goods Sold (COGS)The cost of producing or acquiring the goods or services to be soldOperating ExpensesExpenses related to marketing and distributing the product or service and administering the businessFinancing CostsThe interest paid to creditorsTax ExpensesAmount of taxes owed, based upon taxable income

Figure 3-1

Figure 3-1 (cont.)

Table 3-1

Common-size Income StatementCommon-size income statement restates the income statement items as a percentage of sales.

Common-size income statement makes it easier to compare trends over time and across firms in the industry.

Table 3-2

Profit-to-Sales analysis from Common-size income statementSee Table 3-2Gross profit margin (or percentage of sales going towards gross profit) is 23.3%Operating profit margin (or percentage of sales going towards operating profit) is 12.5%Net profit margin (or percentage of sales going towards net profit) is 7%

2. The Balance SheetThe balance sheet provides a snapshot of a firms financial position at a particular date. It includes three main items: assets, liabilities and equity.Assets (A) are resources owned by the firmLiabilities (L) and owners equity (E) indicate how those resources are financedA = L + EThe transactions in balance sheet are recorded historically at cost price, so the book value of a firm may be very different from its current market value.

Figure 3-3

Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include:CashAccounts Receivable (payments due from customers who buy on credit)Inventory (raw materials, work in process, and finished goods held for eventual sale)Other assets (ex.: Prepaid expenses are items paid for in advance)Balance Sheet Terms: Assets

Fixed Assets Include assets that will be used for more than one year. Fixed assets typically include:Machinery and equipmentBuildingsLand

Other Assets Assets that are neither current assets nor fixed assets. They may include long-term investments and intangible assets such as patents, copyrights, and goodwill. Balance Sheet Terms: Assets

Debt (Liabilities) Money that has been borrowed from a creditor and must be repaid at some predetermined date.Debt could be current (must be repaid within twelve months) or long-term (repayment time exceeds one year).Balance Sheet Terms: Liabilities

Current Debt:Accounts payable (Credit extended by suppliers to a firm when it purchases inventories)Accrued expenses (Short term liabilities incurred in the firms operations but not yet paid for)Short-term notes (Borrowings from a bank or lending institution due and payable within 12 months)

Long-Term DebtBorrowings from banks and other sources for more than 1 yearBalance Sheet Terms: Liabilities

Equity: Shareholders investment in the firm in the form of preferred stock and common stock. Preferred stockholders enjoy preference with regard to payment of dividend and seniority at settlement of bankruptcy claims.Treasury Stock: Stock that have been re-purchased by the company.Retained Earnings: Cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years. Note retained earnings are not equal to hard cash!Balance Sheet Terms: Equity

Balance Sheet: A = L + EASSETS (A)Current AssetsFixed AssetsTotal AssetsLIABILITIES (L)Current LiabilitiesLong-Term LiabilitiesTotal Liabilities

OWNERS EQUITY (E)Preferred StockCommon StockRetained earningsTotal Owners EquityTotal liabilities + Equity

Table 3-3

Net Working CapitalNet Working Capital= Current assets current liabilities

Larger the net working capital, better the firms ability to repay its debt

Net working capital can be positive or zero or negative. It is generally positive.

An increase in net working capital may not always be good news. For example, if the level of inventory goes up, current assets will increase and thus net working capital will also increase. However, increasing inventory level may well be a sign of inability to sell.

Debt RatioDebt ratio is the percentage of assets that are financed by debt.

Debt ratio is an indication of financial risk. Generally, higher the ratio, the more risky the firm is, as firms have to pay interest on debt regardless of the earnings or cash flow situation.

3. Measuring Cash FlowsProfits in the financial statements are calculated on accrual basis rather than cash basis (see next slide for accrual basis accounting).

Thus profits are not equal to cash.

Accrual Basis AccountingAccrual basis is the principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid.Thus sales revenue recorded in the income statement includes both cash and credit sales.

Treatment of long-term assets: Asset acquisitions (that will last more than one year, such as equipment) are not recorded as an expense but are written off every year as depreciation expense.

Figure 3-6 How to measure a firms cash flows

Three sources of cash flowsCash flows from Operations (ex. Sales revenue, labor expenses)

Cash flows from Investments (ex. Purchase of new equipment)

Cash flows from Financing (ex. Borrowing funds, payment of dividends)

Three sources of cash flows (cont.)If we know the cash flows from operations, investments and financing, we can understand the firms cash flow position better, that is, how cash was generated and how it was used.

Income Statement Conversion: From Accrual to Cash BasisTwo steps:Add back depreciation (as it is a non-cash expense) to net incomeSubtract any uncollected sales (i.e. increase in accounts receivable) and cash payment for inventories (i.e. increase in inventories less increase in accounts payables)

Figure 3-7

Table 3-5

4. Income Taxes and Finance Computing Taxable Income for CorporationGross IncomeDollar sales from a product or service less cost of production or acquisitionTaxable IncomeGross income less tax deductible expenses, plus interest income received and dividend income received Tax Deductible ExpensesInclude Operating expenses (marketing, depreciation, administrative expenses) and interest expenseDividends paid are not deductible

Table 3-6Computing Taxable Income ($000s)

Table 3-7

Figure 3-2

Figure 3-2 (cont.)

Figure 3-4

Table 3-4

Key termsAccounts PayableAccounts ReceivableAccrual basis accountingAccrued expensesAccumulated depreciationAdditional paid-in-capitalBalance sheetCashCommon size financial statementsCommon stockCost of goods soldCurrent assetsDebtDebt ratioDepreciation expensesEBITEarnings before taxesEarnings per shareEquityFinancing cash flowsFinancing costFixed assetsFree cash flowsGross fixed assets

Key terms (cont.)Gross ProfitGross profit marginIncome statementInventoriesLong-term debtMortgageNet fixed assetsNet incomeNet profit marginNet working capitalOperating expensesOperating incomeOperating profit marginOperating working capitalPar valuePreferred stockholdersProfit marginsRetained earningsShort-term liabilitiesShort-term notes (debt)Taxable incomeTrade creditTreasury stock

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