11

Financial StatementsFinancial Statements

Three basic statements:Three basic statements: Balance sheetBalance sheet Income statementIncome statement Statement of cash flowsStatement of cash flows

Why we need statements:Why we need statements: Evaluating financial health of a company (ratio Evaluating financial health of a company (ratio

analysis)analysis) Evaluating separate projects and business as a wholeEvaluating separate projects and business as a whole

Discounted Cash Flow (DCF) methods (need the Discounted Cash Flow (DCF) methods (need the projectedprojected cash flows)cash flows)Using comparables (various ratios) (need usually last income Using comparables (various ratios) (need usually last income statement and balance sheet)statement and balance sheet)

22

Assets ≡ Liabilities + Shareholder’s EquityAssets ≡ Liabilities + Shareholder’s Equity

Tabulates a company’s assets and liabilities at a specific point in time Tabulates a company’s assets and liabilities at a specific point in time (snapshot of the firm) – i(snapshot of the firm) – info on the value of the assets and the capital nfo on the value of the assets and the capital structurestructureSorting ofSorting of

Assets by liquidity, i.e. how fast they can be converted into cashAssets by liquidity, i.e. how fast they can be converted into cash Liabilities by maturity, i.e. when they must be paidLiabilities by maturity, i.e. when they must be paid

Assets and liabilities are represented by Assets and liabilities are represented by historical costs! historical costs! (GAAP)(GAAP) The original cost adjusted for improvements and aging = The original cost adjusted for improvements and aging = Book ValueBook Value Avoid using market valueAvoid using market value, since is too volatile and easily manipulated, since is too volatile and easily manipulated Preference for Preference for underunderestimating valueestimating value

Balance SheetBalance Sheet

AssetsAssets

Current assetsCurrent assets

Fixed assetsFixed assets

Liabilities and EquityLiabilities and Equity

Current liabilitiesCurrent liabilities

Long-term liabilitiesLong-term liabilities

Shareholders’ equityShareholders’ equity

Net working capital

33

Income StatementIncome StatementRevenues – Expenses = IncomeRevenues – Expenses = Income

Records revenues and expenses from transactions over Records revenues and expenses from transactions over a specific time period (e.g. 1 year)a specific time period (e.g. 1 year)Accrual Accounting PrincipleAccrual Accounting Principle

Revenues are recognized when goods are shipped or services Revenues are recognized when goods are shipped or services are provided, even if are provided, even if no actual cash inflowno actual cash inflow has necessarily has necessarily occurred (e.g. sales on credit).occurred (e.g. sales on credit).((accrualaccrual is a difference between earnings and actual cash flows) is a difference between earnings and actual cash flows)

Matching principleMatching principle Costs are Costs are matchedmatched with revenues, i.e. expensed in the period with revenues, i.e. expensed in the period

when the corresponding revenue is recognized. Again, when the corresponding revenue is recognized. Again, actual actual cash outflowcash outflow does not have to occur (e.g. buying on credit from does not have to occur (e.g. buying on credit from suppliers)suppliers)

44

Statement of Cash FlowsStatement of Cash Flows

Records how much cash was generated and Records how much cash was generated and how it was allocated over a specific time period how it was allocated over a specific time period (e.g. 1 year)(e.g. 1 year) Cash generated by operating activitiesCash generated by operating activities

Income statement adjusted for non-cash itemsIncome statement adjusted for non-cash items Cash used for investing activitiesCash used for investing activities

How much was spent on investing in new assets or How much was spent on investing in new assets or modernizing existing assets (net of gains from selling old modernizing existing assets (net of gains from selling old assets)assets)

Cash generated by financing activitiesCash generated by financing activitiesHow much was raised from the investors (net of cash How much was raised from the investors (net of cash disbursement to investors)disbursement to investors)

55

Simple exampleSimple exampleChocolate FactoryChocolate Factory

(adapted from Pratt (2000), 4(adapted from Pratt (2000), 4thth ed., ch. 5) ed., ch. 5)

You want to create and run a small chocolate You want to create and run a small chocolate factory. Over 1 year you do 6 transactionsfactory. Over 1 year you do 6 transactions (1) You register a firm and contribute 10,000 to its (1) You register a firm and contribute 10,000 to its

accountaccount (2) The firm borrows additional 3,000 from a bank(2) The firm borrows additional 3,000 from a bank (3) The firm purchases equipment for 5,000(3) The firm purchases equipment for 5,000 (4) The firm produces and sells chocolate for 12,000. (4) The firm produces and sells chocolate for 12,000.

It receives 8,000 in cash and 4,000 in receivables (i.e. It receives 8,000 in cash and 4,000 in receivables (i.e. sells for 4,000 on credit)sells for 4,000 on credit)

(5) The firm pays 9,000 in cash for expenses: wages, (5) The firm pays 9,000 in cash for expenses: wages, raw materials, interest and maintenanceraw materials, interest and maintenance

(6) You pays yourself a dividend of 1,000(6) You pays yourself a dividend of 1,000

66

Accounts Accounts ($000 omitted)($000 omitted)

AssetsAssets == LiabitiesLiabities + Stockholders’ Equity+ Stockholders’ Equity

TransacTransactiontion

CashCash + Receiva+ Receiva

blesbles

+ Equip+ Equip

mentment

== Loan Loan PayablePayable

+ Contributed+ Contributed

CapitalCapital

+ Retained + Retained EarningsEarnings

(1)(1) $+10$+10 == $+10$+10

(2)(2) +3+3 == $+3$+3

(3)(3) -5-5 $+5$+5 ==

(4)(4) +8+8 $+4$+4 == $+12$+12

(5)(5) -9-9 == -9-9

(6)(6) -1-1 == -1-1

TotalTotal 66 + 4+ 4 + 5+ 5 == 33 + 10+ 10 + 2+ 2

77

Balance Sheet Balance Sheet

Income Statement Income Statement

AssetsAssets Liabilities and Stockholders’ EquityLiabilities and Stockholders’ Equity

CashCash $6,000$6,000 Loan PayableLoan Payable $3,000$3,000

ReceivablesReceivables 4,0004,000 Contributed CapitalContributed Capital 10,00010,000

EquipmentEquipment 5,0005,000 Retained EarningsRetained Earnings 2,0002,000

Total AssetsTotal Assets $15,000$15,000 Total Liabilities and Total Liabilities and Stockholders’ EquityStockholders’ Equity

$15,000$15,000

Revenues from salesRevenues from sales $12,000$12,000

Expenses: wages, interest, etc.Expenses: wages, interest, etc. 9,0009,000

Net IncomeNet Income 3,0003,000

Less: dividend to stockholderLess: dividend to stockholder 1,0001,000

Retained earningsRetained earnings $2,000$2,000

88

Statement of Cash Flows (using direct method)Statement of Cash Flows (using direct method)

Operating activities:Operating activities:

Sales of chocolate (4)Sales of chocolate (4) $8,000$8,000

Payments for expenses (5)Payments for expenses (5) (9,000)(9,000)

Net cash from operating activitiesNet cash from operating activities $(1,000)$(1,000)

Investing activities:Investing activities:

Purchase of equipment (3)Purchase of equipment (3) $(5,000)$(5,000)

Net cash from investing activitiesNet cash from investing activities (5,000)(5,000)

Financing activities:Financing activities:

Borrowings (2)Borrowings (2) $3,000$3,000

Owner contributions (1)Owner contributions (1) 10,00010,000

Payment of dividends (6)Payment of dividends (6) (1,000)(1,000)

Net cash from financing activitiesNet cash from financing activities 12,00012,000

Increase in cash balanceIncrease in cash balance $6,000$6,000

Cash balance at the beginning of the yearCash balance at the beginning of the year 00

Cash balance at the end of the yearCash balance at the end of the year $6,000$6,000

99

Global Conglomerate Corporation Balance Global Conglomerate Corporation Balance Sheet for 2005 and 2004Sheet for 2005 and 2004

1010

Note on intangible assetsNote on intangible assets

Patents, trademarks, copyrights, etc. Patents, trademarks, copyrights, etc.

GoodwillGoodwill Arises in acquisitions. Goodwill = amount paid for the company Arises in acquisitions. Goodwill = amount paid for the company

minus the fair market value of its assets net of its liabilities (e.g. minus the fair market value of its assets net of its liabilities (e.g. Global paid $15 mln for a firm whose assets had a net fair Global paid $15 mln for a firm whose assets had a net fair market value of $5 mln – goodwill is $10 mln)market value of $5 mln – goodwill is $10 mln)

Not all intangible assets are can be reported on the Not all intangible assets are can be reported on the balance sheet. Usually only when they can clearly be balance sheet. Usually only when they can clearly be associated with future benefits and their cost can be associated with future benefits and their cost can be measured (e.g. a purchased patent is reported on BS but measured (e.g. a purchased patent is reported on BS but R&D expenditures are usually not – instead they are R&D expenditures are usually not – instead they are expensed in the income statement)expensed in the income statement)

1111

Global Conglomerate Corporation Income Global Conglomerate Corporation Income Statement Sheet for 2005 and 2004Statement Sheet for 2005 and 2004

1212

Note on deferred taxes and Note on deferred taxes and depreciationdepreciation

Firm keeps two sets books: one for investors and one for Firm keeps two sets books: one for investors and one for tax authorities. There can be differences in accounting tax authorities. There can be differences in accounting between the two.between the two.If accounting income > true taxable income If accounting income > true taxable income reported reported taxes > actually paid taxes > actually paid increase in deferred tax liability increase in deferred tax liabilityOne of the main differences between two sets of books – One of the main differences between two sets of books – accounting for depreciationaccounting for depreciation

For tax reporting firms usually use For tax reporting firms usually use accelerated depreciationaccelerated depreciation (usually MACRS – modified accelerated cost recovery system)(usually MACRS – modified accelerated cost recovery system)

For investors firms are supposed to use the method that best For investors firms are supposed to use the method that best reflects how firm’s assets lose value over time (very often – reflects how firm’s assets lose value over time (very often – straight line depreciation)straight line depreciation)

1313

Comparing MACRS with straight line Comparing MACRS with straight line depreciationdepreciation

Assume asset has a usefil life of 8 years and is Assume asset has a usefil life of 8 years and is depreciated for accounting purposes using a depreciated for accounting purposes using a straight line method: each year depreciation is straight line method: each year depreciation is 12.5%12.5%For tax puposes, however, it was classified as a For tax puposes, however, it was classified as a 5 year asset. The MACRS schedule is then:5 year asset. The MACRS schedule is then:20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%, 0%, 20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%, 0%, 0%.0%.Hence, for tax purposes depreciation is higher in Hence, for tax purposes depreciation is higher in years 1-3 and lower after on. years 1-3 and lower after on.

1414

Implications of differences in accounting for Implications of differences in accounting for depreciation for financial statementsdepreciation for financial statements

Assume:Assume: Firm lives for 3 years, at t=0 assets’ book value = 1.Firm lives for 3 years, at t=0 assets’ book value = 1. Depreciation in years 1, 2, 3:Depreciation in years 1, 2, 3:

d1, d2, d3 – for reporting to investorsd1, d2, d3 – for reporting to investors

D1, D2, D3 – for tax authoritiesD1, D2, D3 – for tax authorities Assets are depreciated to zero after year 3 regardless Assets are depreciated to zero after year 3 regardless

of the method: d1+d2+d3 = D1+D2+D3 = 1of the method: d1+d2+d3 = D1+D2+D3 = 1 D1 > d1, D2 > or < d2, D3 < d3D1 > d1, D2 > or < d2, D3 < d3 Pretax income + depreciation = X in each year.Pretax income + depreciation = X in each year. t – tax ratet – tax rate

1515

Reported net income in year i:Reported net income in year i:X – di – (X – di)t = X – di – (X – Di)t – (Di – di)tX – di – (X – di)t = X – di – (X – Di)t – (Di – di)t

Reported taxes Actual taxes Deferred taxes Reported taxes Actual taxes Deferred taxes

Deferred taxes are recorded as an increase (or decrease if Deferred taxes are recorded as an increase (or decrease if negative) in deferred tax liabilitynegative) in deferred tax liability

Since D1 > d1, tax liability of (D1-d1)t appears in year 1Since D1 > d1, tax liability of (D1-d1)t appears in year 1If D2 > d2, tax liability increases by (D2-d2)t; if D2 < d2, it decreases If D2 > d2, tax liability increases by (D2-d2)t; if D2 < d2, it decreases by (d2-D2)t in year 2by (d2-D2)t in year 2Since D3 < d3, tax liability decreases by (D3-d3)t in year 3.Since D3 < d3, tax liability decreases by (D3-d3)t in year 3.At the end of year 3 tax liability must be zero as d1+d2+d3 = At the end of year 3 tax liability must be zero as d1+d2+d3 = D1+D2+D3 = 1D1+D2+D3 = 1For example, an increase in the deferred tax liabilty for Global For example, an increase in the deferred tax liabilty for Global Conglomerate Corporation was 0.2 from 2004 to 2005. It means it Conglomerate Corporation was 0.2 from 2004 to 2005. It means it actually paid 0.5 in taxes and not 0.7 as shown in the income actually paid 0.5 in taxes and not 0.7 as shown in the income statement statement

1616

Global Conglomerate Corporation Statement of Cash Global Conglomerate Corporation Statement of Cash Flows for 2005 and 2004 (using indirect method)Flows for 2005 and 2004 (using indirect method)