Chapter 2 Financial Statements Copyright 2010 Pearson Prentice

Chapter 2 • Financial Statements Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Learning Objectives 1. Explain the foundations of the balance sheet and income statement 2. Use the cash flow identity to explain cash flow. 3. Provide some context for financial reporting. 4. Recognize and view Internet sites that provide financial information. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -2

2. 1 Financial Statements • Four main financial statements: – – Balance sheet Income Statement of Retained Earnings Statement of Cash Flow • Our focus. . – Interrelationship between the balance sheet and the income statement – The process by which these statements can be used to project a firm’s future cash flows Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -3

2. 1 Financial Statements (continued) (A) The Balance Sheet • Represents the assets owned by the company and the claims against those assets • Based on the accounting identity: Assets Liabilities + Owners’ Equity Copyright © 2010 Pearson Prentice Hall. All rights reserved. (2. 1) 2 -4

Figure 2. 1 Balance sheet Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -5

2. 1 (A) Balance Sheet Has five main sections: 1. Cash account 2. 3. 4. 5. • Where did the $65 million decline come from? Working capital accounts • Net working capital = Current assets – Current liabilities (2. 2) Long-term asset accounts • Plant and equipment; land buildings • Gross value – accumulated depreciation = Net value Long-term liabilities (debt) accounts • Loans maturing in over one year Ownership accounts • Shareholders’ equity • Retained earnings—accumulated total sinception Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -6

2. 1 (B) The Income Statement • Shows the expenses and revenues generated by a firm over a past period, typically a quarter or a year. • Net income = Revenues – expenses (2. 3) • EBIT = Revenues – operating expenses (2. 4) Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -7

Figure 2. 2 Income Statement example Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -8

2. 1 (B) The Income Statement (continued) • Net income is not the same as cash flow • Firm earned an income of $5, 642 million • Cash account decreased by 65 million • 3 reasons: • Accrual accounting • Noncash expense items --depreciation • Preference to classify interest expense as part of financial cash flow Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -9

2. 2 Cash Flow Identity The cash flow identity states that the cash flow on the left-hand side of the balance sheet is equal to the cash flow on the right-hand side of the balance sheet. CASH FLOW FROM ASSETS CASH FLOW TO CREDITORS + CASH FLOW TO OWNERS Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -10

Figure 2. 5 Cash Flow Identity and components Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -11

2. 2 (A) The First Component: Cash Flow From Assets Three components: • Operating cash flow (OCF) • Net capital spending (NCS) • Change in net working capital (∆NWC) • Cash flow from assets = OCF – NCS - ∆NWC OCF = EBIT + Depreciation – Taxes NCS = End. Net – Beg. Net + Depreciation Fixed Assets ∆NWC=Ending NWC – Beginning NWC Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -12

2. 2 (A) The First Component: Cash Flow From Assets (continued) OCF = EBIT + Depreciation – Taxes Figure 2. 3 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -13

2. 2 (A) The First Component: Cash Flow From Assets (continued) NCS = End. Net – Beg. Net + Depreciation Fixed Assets NCS= ($11, 961 - $10, 788) + $1, 406 = $2, 579 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -14

2. 2 (A) The First Component: Cash Flow From Assets (continued) ∆NWC = Ending NWC – Beginning NWC Net working capital for 2007 = $9, 130 - $6, 860 = $2, 270 Net working capital for 2006 = $10, 454 - $9, 406 = $1, 048 Change in NWC = $2, 270 - $1, 048 = $1, 222 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -15

2. 2 (A) The First Component: Cash Flow From Assets (continued) • Putting it all together…. • Cash flow from Assets = OCF – NCS - ∆ NWC =$7, 287 -$2, 579 -$1, 222 =$3, 486 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -16

2. 2 (B) The Second Component: Cash Flow To Creditors Cash Flow to Creditors = Interest Expense Net New Borrowing from Creditors Net New Borrowing = Ending Long-term Liabilities Beginning Long-Term Liabilities Cash Flow to Creditors = $239 (-$378) $617 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -17

2. 2 (C) The Third Component: Cash Flow To Owners Cash flow to owners = Dividends - Net new borrowing from owners = $2, 869 – $0 = $2, 869 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -18

2. 2 (C) Putting It All Together: The Cash Flow Identity CASH FLOW FROM ASSETS CASH FLOW FROM CREDITORS + CASH FLOW TO OWNERS $3, 486 $617 Copyright © 2010 Pearson Prentice Hall. All rights reserved. + $2, 869 2 -19

2. 3 Financial Performance Reporting • Annual reports to shareholders • Quarterly (10 -Q) and annual (10 -K) reports filed with the SEC – Regulation Fair Disclosure (Reg. FD): Companies must release all material information to all investors at the same time. – Notes to the Financial Statements: A wealth of information about the firm Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -20

2. 4 Financial Statements on the Internet • EDGAR (www. sec. gov/edgar. shtml) • Yahoo! Finance (http: //finance. yahoo. com. ) • Many, many more Web sites with rich stores of information Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -21

ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 Balance Sheet. Chuck Enterprises has current assets of $300, 000, and total assets of $750, 000. It also has current liabilities of $125, 000, common equity of $250, 000, and retained earnings of $85, 000. How much longterm debt and fixed assets does the firm have? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -22

ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (ANSWER) Current Assets + Fixed Assets = Total Assets $300, 000+Fixed Assets = $750, 000 - $300, 000 = $400, 000 Total Assets = Current Liabilities + Long-term debt +Common equity + Retained Earnings $750, 000 = $125, 000 + Long-term debt + $250, 000 + 85, 000 Long-term debt = $750, 000 - $125, 000 -$250, 000 -$85, 000 Long-term debt = $290, 000 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -23

ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 Income Statement. The Top Class Company had revenues of $925, 000 in 2009. Its operating expenses (excluding depreciation) amounted to $325, 000, depreciation charges were $125, 000, and interest costs totaled $55, 000. If the firm pays a marginal tax rate of 34 percent, calculate its net income after taxes. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -24

ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (ANSWER) Revenues Less operating expenses = EBITDA Less depreciation = EBIT Less interest expenses = Taxable Income Less taxes (34%) = Net Income after taxes Copyright © 2010 Pearson Prentice Hall. All rights reserved. $925, 000 325, 000 600, 000 125, 000 475, 000 55, 000 420, 000 142, 800 277, 200 2 -25

ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 Retained Earnings: The West Hanover Clay Co. had, at the beginning of the fiscal year, November 1, 2009, retained earnings of $425, 000. During the year ended October 31, 2010, the company generated net income after taxes of $820, 000 and paid out 35 percent of its net income as dividends. Construct a statement of retained earnings and compute the yearend balance of retained earnings. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -26

ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 (ANSWER) Statement of Retained Earnings for the year ended October 31, 2010 Balance of Retained Earnings, 11/1/2009………. $425, 000 Add: Net income after taxes, 10/31/2010………. $820, 000 Less: Dividends paid for year-end 10/31/2010…$287, 000 Balance of Retained Earnings, 10/31/20120…. . $958, 000 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -27

ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 4. Working Capital: D. K. Imports, Incorporated reported the following information at its last annual meeting: Cash and cash equivalents = $1, 225, 000; Accounts payables = $3, 200, 000 Inventory = $625, 000; Accounts receivables = $3, 500, 000; Notes payables = $1, 200, 000; Other current assets = $125, 000. Calculate the company’s net working capital. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -28

ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (ANSWER) Net Working Capital = Current Assets - Current Liabilities (Cash & Cash Equivalents + Accts. Rec. + Inventory + other current assets) - (Accounts Payables + Notes Payables) ($1, 225, 000+$3, 500, 000+$625, 000+$125, 000) - ($3, 200, 000+$1, 200, 000) $5, 475, 000 - $4, 400, 000 Net Working Capital $1, 075, 000 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -29

ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 Cash Flow from Operating Activities: The Mid-American Farm Products Corporation provided the following financial information for the quarter ending September 30, 2009: Depreciation and amortization $75, 000 Net Income $225, 000 Increase in receivables $95, 000 Increase in inventory $69, 000 Increase in accounts payables $80, 000 Decrease in marketable securities $34, 000. What is the cash flow from operating activities generated during this quarter by the firm? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -30

ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (ANSWER) Net Income $225, 000 Add depreciation and amortization 75, 000 Add decrease in marketable securities 34, 000 Add increase in accounts payables 80, 000 Less increase in accounts receivables 95, 000 Less increase in inventory 69, 000 Cash flow from operating activities $250, 000 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -31

Figure 2. 4 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -32

Figure 2. 6 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -33

Figure 2. 7 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 2 -34