CHAPTER 2

FINANCIAL STATEMENTS

FINANCIAL STATEMENTS

• Income Statement

• Common Size Income Statement

• Balance Sheet

• Common Size Balance Sheet

• Statement of Cash Flows

Income Statement

• Summarizes the results of the firm’s operations over a period of time

• Shows total revenues and expenses for the time period

• Shows different measures of profit

• Prepared for different time periods: Monthly, quarterly, and annually

Income Statement

• The order of the items that should be entered in the income statement is as follows:

1. Sales: Total $ income incurred by sales (revenue)

2. Cost of Goods Sold: This item includes raw material, labor, etc...

3. Gross Profit: Profit from goods sold, not including any expense other than cost of goods

Gross Profit = Sales - Cost of Goods Sold

Income Statement

4. Selling, G&A Expenses: Selling, General and Administrative Expenses. Marketing, paperwork, etc...

5. Fixed Expenses

6. Depreciation Expense: Depreciation of machinery

7. EBIT: Earnings Before Interest and Taxes. This is also called as operating income. This is the income generated from the operations of firm and excludes taxes and interest expenses

EBIT = Gross Profit - (Selling, G&A Expenses + Fixed Expenses + Depreciation Expense)

Income Statement

8. Interest Expense: Interest paid on the firm’s debt

9. Earnings Before Taxes: This item shows the income generated without including taxes

Earnings Before Taxes = EBIT - Interest Expense

10. Taxes: Assume 40% tax rate. Enter as follows:

Taxes @ 40%, or Taxes (40%)

Taxes = 0.4*Earnings Before Taxes

11. Net Income:Net Income = Earnings Before Taxes - Taxes

Common-Size Income Statements

• Common-size income statements display data not as $ amounts but as percentages of firm’s total revenues (Sales)

• Benefits:

- Easy comparison between firms of different sizes

- Show important trends which may not be seen in $ amounts

Balance Sheet

• Balance sheet describes assets, liabilities, and equity of the firm at a specific time (like a snapshot)

• Assets: (Tangible/intangible):

- Things that a firm owns.

-Assets are entered on the top or on the left of the balance sheet

Balance Sheet

• Liabilities:

- Debts of the firm

- Entered below Assets, or on the right of the balance sheet

• Equity:

- Difference between what firm owns and what it owes to others

- Entered below liabilities in the balance sheet

Balance Sheet

• NOTE:

Balance sheet must balance:Total Assets = Total Liabilities + Total Equity

should satisfy

Balance Sheet

A. ASSETS: (Top, or left of balance sheet)1. Current Assets: • Firm’s short term assets.

-Cash and Marketable Securities, -Accounts Receivable, -Inventories

2. Fixed Assets:- Assets that have long life, like plant and equipment3. Net Fixed Assets:-You deduct the accumulated depreciation of the fixed

assets from the value of fixed assets to find Net Fixed Assets

Net Fixed Assets=Fixed Assets - Accumulated Depreciation

Balance SheetB. LIABILITIES (Below Assets or on the right of Balance

Sheet)

1. Current Liabilities:

• Short term liabilities

• Typically, current liabilities are:

-Accounts payable

-Notes payable

-Accruals

2. Long-term Liabilities:

Bonds, bank loans, etc..

3. Total Liabilities:Current Liabilities + Long-term Liabilities

Balance Sheet

C. SHAREHOLDER’S EQUITY (Below Liabilities)

1. Preferred Stock:

2. Common Stock:

3. Retained Earnings:

4. Total Shareholder’s Equity:Preferred Stock + Common Stock + Retained Earnings

Balance Sheet

D. TOTAL LIABILITIES AND EQUITY (below Total Shareholder’s Equity)

Total Liabilities + Total Shareholder’s Equity

• NOTE:

Again remember that

Total Assets = Total Liabilities and Equity

Common-size Balance Sheet

• Preparing common-size balance sheet is similar to the one we did for income statement.

• Instead of Sales, for Balance Sheet, we use Total Assets to form the percentages, and

• Explain all data as a percentage of Total Assets, i.e. Format cells as %, 0.00%

Statement of Cash Flows

• Financial Transactions of Firms:

1. Sources of Funds:

Cash inflows that increase cash balance

2. Uses of Funds:

Cash outflows that decrease cash balance

Statement of Cash Flows

• How Well Managers Perform?

- Analyze how management uses shareholders’ money:

-Use Statement of Cash Flows

Statement of Cash Flows

• Statement of Cash Flows:

-Summarizes changes in firm’s cash balance

Ending Cash Balance =

Beginning Cash Balance +

Cash Inflow (Sources) -

Cash outflow (Uses)

Statement of Cash Flows

• Most of the items in statement of cash flows come from change in balance sheet items

• Therefore, we need balance sheets of two years

• We also need income statement• Operational Cash Flow (Net Income +

Depreciation) comes from Income Statement

Statement of Cash Flows

• Statement of Cash Flows separates firm activities into three parts:

1. Operating Activities

2. Investing Activities

3. Financing Activities

Statement of Cash Flows

1. Cash Flows from Operations:

Typically these are:

Net income, depreciation,

changes in -accounts receivable

-inventories

-accounts payable

-notes payable

-other current liabilities

Statement of Cash Flows

2. Cash Flows from Investing

Typically these are change in fixed assets like change in plant and equipment (investment in these assets or sale of these assets)

Statement of Cash Flows

3. Cash Flows from Financing

Typically these are:

Dividends paid to shareholders, and

Change in -debt

-stock

Statement of Cash Flows

• Increase and Decrease in Cash Flows:

- Uses of funds decrease cash flows: Increase in assets, Decrease in liabilities

- Sources of funds increase cash flows:

Decrease in assets, Increase in liabilities

• Therefore, for uses of funds, we should use a - sign in the Excel sheet.