FIN 3000 Chapter 3 Financial Statements Liuren Wu

FIN 3000 Chapter 3 Financial Statements Liuren Wu

Overview 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 2 FIN 3000, Liuren Wu

Learning Objectives 1. Understand the content of the 4 basic financial statements. Focus on ① Income statement ② Balance sheet statement ③ Cash flow statement 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. 3 FIN 3000, Liuren Wu

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. � 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. 4 FIN 3000, Liuren Wu

Basic Financial Statements 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), and Shareholder’s equity (the money invested by the company owners) 3. Cash flow statement – How did the cash come and go? cash received and cash spent by the firm over a period of time 5 FIN 3000, Liuren Wu

Why Study Financial Statements? 1. Assess current performance through financial statement analysis � 2. Monitor and control operations, and � 3. Next chapter provides more tools for the analysis. 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. Forecast future performance. � Financial planning models are typically built using the financial statements 6 FIN 3000, Liuren Wu

Three Accounting Principles 1. The revenue recognition principle: Revenue should be included in the income statement for the period in which: � � 2. 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. The 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. The historical cost principle: Most assets and liabilities are reported in the 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. 7 FIN 3000, Liuren Wu

An Income Statement 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) 8 FIN 3000, Liuren Wu

Sample Income Statement 9 FIN 3000, Liuren Wu

Evaluating a Firm’s EPS We can use the income statement to determine the earnings per share (EPS) and dividends. EPS = Net income/Number of shares outstanding 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 10 FIN 3000, Liuren Wu

Evaluating a Firm’s Dividends per share = Dividends paid ÷ Number of shares 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 = dividend payment ÷ Number of shares = $20 million ÷ $35 million = $0. 57 11 FIN 3000, Liuren Wu

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 � Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm? � Amount retained = Net Income – Dividends = $90 m - $20 m = $70 m � The firm’s balance on retained earnings will increase by $70 million on the balance sheet. 12 FIN 3000, Liuren Wu

Interpreting Firm Profitability using the Income Statement What can we learn from Boswell Inc. ’s income statement? The firm has been profitable as its revenues exceeded its expenses. The gross profit margin (GPM) = gross profits ÷ sales = $675 million ÷ $2, 700 million = 25% 1. 2. GPM indicates the firm’s “mark-up” on its cost of goods sold per dollar of sales. 13 FIN 3000, Liuren Wu

Interpreting Firm Profitability using the Income Statement (cont. ) 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. 14 FIN 3000, Liuren Wu

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. 15 FIN 3000, Liuren Wu

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. 16 FIN 3000, Liuren Wu

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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 the firm pays taxes at 40% tax rate. What is the firm’s net income and earnings per share? 19 FIN 3000, Liuren Wu

Step 1: Picture the Problem 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 20 FIN 3000, Liuren Wu

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. 21 FIN 3000, Liuren Wu

Step 3: Solve Revenues = $14, 526, 000 � Less: Cost of goods sold = $8, 171, 100, 000 Less: Operating expenses =$3, 899, 000 Less: Interest expense =$1, 000 Less: Income taxes (40%) =$9, 819, 600, 000 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 22 FIN 3000, Liuren Wu

Step 3: EPS and dividends per share Earnings per share: = net income ÷ number of shares = $1, 472, 940, 000 ÷ 716, 296 = $2. 06 Dividends per share = dividends ÷ number of shares = $243, 000 ÷ 716, 296 = $0. 34 23 FIN 3000, Liuren Wu

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. Compute gross profit margin, operating profit margin, and net profit margin. 24 FIN 3000, Liuren Wu

Corporate Taxes A firm’s income tax liability is calculated using its taxable income and the tax rates on corporate income. 25 FIN 3000, Liuren Wu

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. 26 FIN 3000, Liuren Wu

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. 27 FIN 3000, Liuren Wu

Marginal and Average Tax Rates Example 3: What is the average and marginal tax liability for a firm reporting $100, 000 as taxable income. Taxable Income Marginal Increment tax rate al Tax Liability Cumulativ Average e Tax Rate Liability $50, 000 15% 7, 500 15. 00% $75, 000 25% 6, 250 13, 750 18. 33% $100, 000 34% 8, 500 22, 250 22. 25% 28 FIN 3000, Liuren Wu

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. 29 FIN 3000, Liuren Wu

The Balance Sheet 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 shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities. 30 FIN 3000, Liuren Wu

Asset value calculation 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. 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. 31 FIN 3000, Liuren Wu

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Assets and liabilities 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. 33 FIN 3000, Liuren Wu

The stockholder’s equity 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. 34 FIN 3000, Liuren Wu

Firm Liquidity and Net Working Capital 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. 35 FIN 3000, Liuren Wu

Firm Liquidity and Net Working Capital 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. 36 FIN 3000, Liuren Wu

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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: 38 FIN 3000, Liuren Wu

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Step 4: Analyze The firm has invested a total of $7. 564 B in assets, funded by $2. 158 B current liability, $1. 019 B long-term liability, and $4. 387 B owner equity. The firm has $4. 005 B in current assets and $2. 158 B in current liability, leaving the firm with a net working capital of $4. 0052. 158 -1. 847 B. 41 FIN 3000, Liuren Wu

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? 42 FIN 3000, Liuren Wu

Step 1: Picture the Problem Current Assets Cash Accounts Receivable Inventories Other current assets Total current assets Current Liabilities Accounts payable Short-term debt Other current liabilities Total current liabilities Long-term (fixed) assets Gross PPE Less: Accumulated depreciation Net property, plant and equip. Long-term Liabilities Long-term debt Owner’s Equity Par value of common stock Paid-in-capital Retained earnings Total equity Other long-term assets Total Assets Total Liabilities and Owners’ equity 43 FIN 3000, Liuren Wu

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. Deduct $1 B from both cash and current liability. 44 FIN 3000, Liuren Wu

Step 3: Solve Cash Inventories Other current assets 756, 000 1, 506, 000 743, 000 Current liabilities 1, 158, 000 Total current assets 3, 005, 000 Total current liabilities 1, 158, 000 Net Property, Plant and equipment 2, 993, 000 Long-term liabilities 1, 019, 000 Other long-term assets 626, 000 Common Equity 4, 387, 000 Total Assets $6, 564, 000, 00 0 Total Liabilities and Equity $6, 564, 000, 00 0 45 FIN 3000, Liuren Wu

Step 4: Analyze We can make the following observations from Gap’s Balance sheet: The total assets of $6, 564, 000 is financed by a combination of current liabilities, long-term liabilities and owner’s equity. Owner’s equity accounts for $4, 387, 000 of the total. The firm has a healthy net working capital of $1, 847, 000 (3, 005, 000 minus 1, 158, 000). 46 FIN 3000, Liuren Wu

Debt versus 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). 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. 47 FIN 3000, Liuren Wu

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. 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. 48 FIN 3000, Liuren Wu

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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. It represents $22. 5 m 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 50 FIN 3000, Liuren Wu

Cash Flow Analysis (cont. ) 4. Accounts Payable, credit extended to the firm, increased by $4. 5 million. Thus source of cash increased by $4. 5 million 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. 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 51 FIN 3000, Liuren Wu

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 Total Uses of cash = $220. 50 52 FIN 3000, Liuren Wu

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 long-term debt ($51. 75 million) The largest use of cash was for acquiring inventory at $148. 5 million. 53 FIN 3000, Liuren Wu

Cash Flow Analysis Summary Sources of Cash Uses of Cash Decrease 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 54 FIN 3000, Liuren Wu

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 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. 55 FIN 3000, Liuren Wu

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Checkpoint 3. 3: Interpreting the Statement of Cash Flow 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: 57 FIN 3000, Liuren Wu

Analyze 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 cash distributions and retained most earnings. 58 FIN 3000, Liuren Wu

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. 59 FIN 3000, Liuren Wu

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. 60 FIN 3000, Liuren Wu

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 61 FIN 3000, Liuren Wu

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). 62 FIN 3000, Liuren Wu

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 63 FIN 3000, Liuren Wu

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. 64 FIN 3000, Liuren Wu

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. 65 FIN 3000, Liuren Wu

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. 66 FIN 3000, Liuren Wu