Chapter 3:Financial Statements

Liuren Wu

FIN 3000

FIN3000, Liuren Wu

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

Overview

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• Understand the content of the 4 basic financial statements. Focus on:1. Income statement2. Balance sheet statement3. Cash flow statement

• Evaluate firm profitability using the income statement.

• Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.

Learning objectives

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• Principle 1: Money has a time value.– We need to recognize that financial statements do not adjust for time

value of money.

• 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!

• 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.

Principles used in this chapter

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Three types of financial statements are mandated by the accounting and financial regulatory authorities:

1. Income statement – how much money you made last year?• Revenue, expense, profits over a year or quarter.

2. Balance sheet – what’s your current financial situation?A snap shot on a specific date of:• Assets (value of what the firm owns)• Liabilities (value of firm’s debts)• Shareholder’s equity (the money invested by the company

owners)3. Cash flow statement – how did the cash come and go?• Cash received/cash spent by the firm over a period of time.

Basic financial statements

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1. Assess current performance through financial statement analysis.– Next chapter provides more tools for the analysis.

2. Monitor and control operations.– Both insiders (such as managers, board of directors) and

outsiders (such as suppliers, creditors, investors) use the statements to monitor and control the firm’s operations.

3. Forecast future performance.– Financial planning models are typically built using the financial

statements.

Why study financial statements?

FIN3000, Liuren Wu

1. Revenue recognition principle: Revenue should be included in the income statement for the period in which: – Its goods/services were exchanged for cash or accounts receivable.– It has completed what it must do to be entitled to the cash.

2. Matching principle: 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.

3. Historical cost principle: Most assets and liabilities are reported in the financial statements at historical cost.– For example, the price the firm paid to acquire them.– The historical cost generally does not equal the current market value

of the assets or liabilities.

Three accounting principles

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• Sales– Minus cost of goods sold

• = Gross Profit– Minus operation expenses

• Selling expenses• General and administrative expenses• Depreciation and amortization expense

• = Operating income (EBIT)– Minus interest expense

• = Earning before taxes (EBT)– Minus income taxes

• = Net income (EAT)

An income statement

FIN3000, Liuren Wu

Sample income statement

FIN3000, Liuren Wu

• We can use the income statement to determine the earnings per share (EPS) and dividends.

• EPS = Net income/number of shares outstanding

• Example: 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

Evaluating a firm’s EPS

FIN3000, Liuren Wu

• Dividends per share = dividends paid/number of shares

• Example: A firm reports dividend payment of $20 million of its income statement and has 35 million shares outstanding. What will be the dividends per share?

Dividends per share = dividend payment/number of shares= $20 million/35

million= $0.57

Evaluating a firm’s dividends per share

FIN3000, Liuren Wu

• What can the firm do with the net income?1. Pay dividends to shareholders.2. Reinvest in the firm.

• Example: 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.

Connecting the income statement and the balance sheet

FIN3000, Liuren Wu

• What can we learn from Boswell Inc.’s income statement?1. The firm has been profitable as its revenues exceeded its

expenses.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.

Interpreting firm profitability

FIN3000, Liuren Wu

3. The operating profit margin= net operating income (EBIT)/sales= $382.5 million/$2,700 million= 14.17%

4. Net profit margin= net profits (Net income)/sales= $204.75 million/$2,700 million= 7.58%

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.

Interpreting firm profitability (con.)

FIN3000, Liuren Wu

• 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.

GAAP and earnings management

FIN3000, Liuren Wu

Constructing an Income StatementUse 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.

Dd

Interest expense $1,000,000 Revenues (Sales) $14,526,000,000Cost of goods sold $9,079,000,00

0Common stock dividends

$243,000,000

Operating expenses $3,899,000,000

Income taxes $617,000,000

Shares outstanding 716,296,296

Checkpoint 3.1

FIN3000, Liuren Wu

FIN3000, Liuren Wu

FIN3000, Liuren Wu

Reconstruct the Gap’s income statement assuming the firm is able to cut its cost of goods sold by 10% and the firm pays taxes at 40% tax rate. What is the firm’s net income and earnings per share?

Checkpoint 3.1: Check yourself

FIN3000, Liuren Wu

Step 1: Picture the problem

Revenues

Less: Cost of goods sold

Equals Grossprofit

Less: Operating expenses

Equals: net Operating income

Less: Interest expense

Equals: earnings Before taxes

Less: Income taxes

Equals:NET INCOME

FIN3000, Liuren Wu

• Given the account balances, constructing the income statement will entail substituting the appropriate balances into the template of Step 1.

Step 2: Decide on a solution strategy

FIN3000, Liuren Wu

Revenues = $14,526,000,000

Less: Cost of goods sold= $8,171,100,000

Equals: profit=$6,354,900,000

Less: Operating expenses=$3,899,000,000

Equals: net Operating income=$2,455,900,000

Less: Interest expense=$1,000,000

Equals: earnings Before taxes=$2,454,900,000

Less: Income taxes (40%)=$9,819,600,000

Equals:NET INCOME=$1,472,940,000

Step 3: Solve

FIN3000, Liuren Wu

• 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

Step 3: EPS and dividends per share

FIN3000, Liuren Wu

• The firm is profitable since it earned net income of $1,472,940,000

• The shareholders were able to 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.

• Compute gross profit margin, operating profit margin, and net profit margin.

Step 4: Analyze

FIN3000, Liuren Wu

• A firm’s income tax liability is calculated using its taxable income and the tax rates on corporate income.

Corporate taxes

Taxable Income Marginal Tax Rate

$0 - $50,000 15%

$50,001 - $75,000 25%

$75,001 - $100,000 34%

$100,001 - $335,000 39%

$355,001 - $10,000,000 34%

$10,000,001 - $15,000,000 35%

$15,000,001 - $18,333,333 38%

Over $18,333,333 35%

FIN3000, Liuren Wu

• 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.

Corporate tax rates

FIN3000, Liuren Wu

• While analyzing the tax consequences of 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.

Marginal and average tax rates

FIN3000, Liuren Wu

• Example: What is the average and marginal tax liability for a firm reporting $100,000 as taxable income?

Marginal and average tax rates (con.)

Taxable Income

Marginal tax rate

Incremental tax liability

Cumulative tax liability

Average tax rate

$50,000 15% 7,500 7,500 15.00%$75,000 25% 6,250 13,750 18.33%

$100,000 34% 8,500 22,250 22.25%

FIN3000, Liuren Wu

• 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.

Marginal and average tax rates (con.)

FIN3000, Liuren Wu

• The balance sheet provides a snapshot of the firm’s financial position on a specific date. It is defined by:

Total assets = Total liabilities/total shareholder’s equity(asset) = (sources of funding)

• Total assets represents the resources owned by the firm.

• Total liabilities represent the total amount of money the firm owes its creditors.

• Total shareholder’s equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.

The balance sheet

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• 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 and reported using the lower of their cost or current market value.

• 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.

• The net value reported on balance sheet could be significantly different from the market value of the asset.

Asset value calculation

FIN3000, Liuren Wu

FIN3000, Liuren Wu

• 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.

• 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.

Assets and liabilities

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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.– 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.

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

The stockholder’s equity

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• Liquidity refers to the speed with which 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).

• For the overall firm, liquidity generally refers to the firm’s ability to covert its current assets (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.

Firm liquidity and net working capital

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• 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.

Firm liquidity and net working capital

FIN3000, Liuren Wu

FIN3000, Liuren Wu

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.

Checkpoint 3.2

Net property, plant, and equipment

$2,933,000,000 Accounts receivable $0

Cash $1,756,000,000 Long-term liabilities $1,019,000,000

Current liabilities $2,158,000,000 Common equity $4,387,000,000

Other current assets $743,000,000 Inventories $1,506,000,000

Other long-term assets $626,000,000 Accounts payable $2,067,000,000

FIN3000, Liuren Wu

FIN3000, Liuren Wu

FIN3000, Liuren Wu

• The firm has invested a total of $7.564B in asserts, funded by $2.158B current liability, $1.019B long-term liability, and $4.387B owner equity.

• The firm as $4.005B in current assets and $2.158B in current liability, leaving the firm with a net working capital of $4.005-2.158-1.87B

Step 4: Analyze

FIN3000, Liuren Wu

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?

Checkpoint 3.2: Check yourself

FIN3000, Liuren Wu

Step 1: Picture the problem

Current AssetsCashAccounts ReceivableInventoriesOther current assetsTotal current assets

Current LiabilitiesAccounts payableShort-term debtOther current liabilities

Total current liabilities

Long-term LiabilitiesLong-term debt

Long-term (fixed) assetsGross PPELess: Accumulated depreciationNet property, plant and equip.

Other long-term assets

Total long-term assets

Owner’s EquityPar value of common stockPaid-in-capitalRetained earningsTotal equity

Total Assets Total Liabilities and Owners’ equity

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• 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.

• Deduct $1B from both cash and current liability.

Step 2: Decide on a solution strategy

FIN3000, Liuren Wu

Step 3: Solve

CashInventoriesOther current assets

756,000,0001,506,000,000 743,000,000

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

FIN3000, Liuren Wu

• 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, long-term 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 – 1,158,000,000)

Step 4: Analyze

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• 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).– 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.

Debt versus equity financing

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• 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.– 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.

The cash flow statement

Change in CashBalance for 2010

= Ending CashBalance for 2010

Ending CashBalance for 2010

-

FIN3000, Liuren Wu

FIN3000, Liuren Wu

• Why did the cash balance decline by $3.5 million from 2009 to 2010?1. Accounts receivable increased by $22.5 million representing

an increase in uncollected cash from credit sales. It represents $22.5m of use of cash to invest in accounts receivable.

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

Cash flow analysis

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4. Account payable, credit extended to the firm, increased by $4.5 million. Thus, source of cash increased by $4.5 million due to account 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.7. Retained earnings increased by $159.75 million representing a

source of cash to th firm from the firm’s operations.• In general,

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

Cash flow analysis (con.)

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• Change in cash balance = sources of cash – use of cash = $216 - $220.50 = $4.50

Cash flow analysis (con.)

Sources of Cash Uses of CashIncrease 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 Total Uses of cash = $220.50

FIN3000, Liuren Wu

• 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 long-term debt ($51.75 million).

– The largest use of cash was for acquiring inventory at $148.5 million.

Cash flow analysis (con.)

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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

FIN3000, Liuren Wu

• The format for a traditional cash flow statement is as follows:Beginning Cash Balance

+ Cash Flow from Operating Activities+ Cash Flow from Investing Activities+ Cash Flow from Financing Activities

= Ending Cash Balance• 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.

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

Cash flow statement

FIN3000, Liuren Wu

FIN3000, Liuren Wu

Interpreting the cash flow statement

Chesapeake Energy Inc. (CHK) is the largest producer of natural gas in the United States and is headquartered in Oklahoma City. The firm’s cash flow statements for 2004 through 2007:

Checkpoint 3.3:

FIN3000, Liuren Wu

•Chesapeake has had positive & growing cash flows from operations in all 4 years.–The primary contributor were the firm’s net income and depreciation expense.–Working capital is a source of cash in 3 out of 4 years, indicating the net reduction in the firm’s investment in working capital.

•Chesapeake has been very aggressive in new fixed assets and acquisitions of new oil and gas properties. Total investments have been roughly two times the cash flow from operation, which meant that the firm had to raise a substantial amount of money.•Chesapeake has been a regular issuer of both equity and debt. $13.5 billion was raised in the 4-year period. Chesapeake has made relatively modest modest cash distributions and retained most earnings.

Analyze

FIN3000, Liuren Wu

Go to http:finance.google.com/financeGet 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?

Checkpoint 3.3: Check yourself

FIN3000, Liuren Wu

• 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.

• The format for a traditional cash flow statement is as follows: Beginning Cash Balance

+ Cash Flow from Operating Activities+ Cash Flow from Investing Activities+ Cash Flow from Financing Activities

= Ending Cash Balance• Here we have to compare the cash flow from operating activities

and investment activities in 2007 for Exco Resources (XCO).

Step 1: Picture the problem

FIN3000, Liuren Wu

• 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.

Step 2: Decide on a solution strategy

FIN3000, Liuren Wu

Step 3: Solve

• Cash flow from operating activities

– EXCO had a positive cash flow from operating activities of $577.83 million in in 2007. In 2006, the cash flow from operating activities was much lower at $227.86.

– The primary contributors to the operating cash flow in 2007 were the firm’s depreciation/depletion expense and non-cash expense. Net working capital is a use of cash.

• 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.

FIN3000, Liuren Wu

• 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.

Step 4: Analyze