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7/29/2019 Ch03 Fin Statements Cash Flows
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Chapter 3
UNDERSTANDING
FINANCIAL STATEMENTS
& CASH FLOWS
3-0 2011 Pearson Prentice Hall. All rights reserved.
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3-1 2011 Pearson Prentice Hall. All rights reserved.
Slide Contents
1. The Income Statement
2. The Balance Sheet
3. Measuring Cash Flows
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1. The Income Statement
It is also known as Profit/Loss Statement
It measures the results of firms operation over aspecific period.
The bottom line of the income statement shows thefirms profit or loss for a period.
Sales Expenses = Profits
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Income Statement Terms
Revenue (Sales)
Money derived from selling the companys product or service
Cost of Goods Sold (COGS)
The cost of producing or acquiring the goods or services to be sold
Operating Expenses
Expenses related to marketing and distributing the product or
service and administering the business
Financing Costs The interest paid to creditors
Tax Expenses
Amount of taxes owed, based upon taxable income
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Figure 3-1 (cont.)
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Common-sizeIncome Statement
Common-size income statement restates the
income statement items as a percentage of
sales.
Common-size income statement makes it
easier to compare trends over time and
across firms in the industry.
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Table 3-2
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Profit-to-Sales analysis from
Common-size income statement
See Table 3-2
Gross profit margin (or percentage of
sales going towards gross profit) is 23.3% Operating profit margin (or percentage
of sales going towards operating profit) is
12.5%
Net profit margin (or percentage of salesgoing towards net profit) is 7%
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2. The Balance Sheet
The balance sheet provides a snapshot of a firmsfinancial position at a particular date.
It includes three main items: assets, liabilities and
equity. Assets (A) are resources owned by the firm
Liabilities (L) and owners equity (E) indicate how thoseresources are financed
A = L + E
The transactions in balance sheet are recordedhistorically at cost price, BV current market value.
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Figure 3-3
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Current assetscomprise assets that are relativelyliquid, or expected to be converted into cash within
12 months. Current assets typically include:
Cash
Accounts Receivable (payments due from customers who
buy on credit)
Inventory (raw materials, work in process, and finished
goods held for eventual sale)
Other assets (ex.: Prepaid expenses are items paid for in
advance)
Balance Sheet Terms: Assets
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Fixed Assets
assets that will be used for 1 year.
Machinery and equipment
Buildings
Land
Other Assets
long-term investments
intangible assets (patents, copyrights, and goodwill)
Balance Sheet Terms: Assets
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Debt (Liabilities)
Money that has been borrowed from a creditor
and must be repaid at some predetermined date. Debt could be current(must be repaid within
twelve months) orlong-term(repayment time
exceeds one year).
Balance Sheet Terms:Liabilities
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Current Debt:
Accounts payable (Credit extended by suppliers to a firm
when it purchases inventories)
Accrued expenses (Short term liabilities incurred in the firmsoperations but not yet paid for)
Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)
Long-Term Debt Borrowings from banks and other sources for more than 1
year
Balance Sheet Terms:Liabilities
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Equity:Shareholders investment in the firm in the form ofpreferred stock and common stock. Preferred stockholdersenjoy preference with regard to payment of dividend andseniority at settlement of bankruptcy claims.
Treasury Stock:Stock that have been re-purchased by thecompany.
Retained Earnings:Cumulative total of all the net income overthe life of the firm, less common stock dividends that have been
paid out over the years. Note retained earnings are not equal tohard cash!
Balance Sheet Terms:Equity
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Balance Sheet: A = L + E
ASSETS (A)
Current Assets
Fixed Assets
Total Assets
LIABILITIES (L) Current Liabilities
Long-Term Liabilities
Total Liabilities
OWNERS EQUITY (E) Preferred Stock
Common Stock Retained earnings
Total Owners Equity
Total liabilities + Equity
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Net Working Capital
NWC = Current assets current liabilities
Larger the net working capital, better the firmsability to repay its debt
Net working capital can be or0 or
An increase in net working capital may not alwaysbe good news. For example, if the level ofinventory goes up, current assets will increaseand thus net working capital will also increase.However, increasing inventory level may well be asign of inability to sell.
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Debt Ratio
Debt ratio is the percentage of assets thatare financed by debt.
Debt ratio is an indication of financialrisk. Generally, higher the ratio, the morerisky the firm is, as firms have to pay
interest on debt regardless of the earningsor cash flow situation.
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3. Measuring Cash Flows
Profits in the financial statements are
calculated on accrual basis rather than
cash basis What is accrual basis?
Thus profits are not equal to cash.
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Accrual Basis Accounting
Accrual basis is the principle of recording
1) revenues when earned (include credit sales)
2) expenses when incurred (include credit purchases)
rather than when cash is received or paid. Thus sales revenue recorded in the income statement
includes both cash and credit sales.
Treatment oflong-term assets: written off every year as depreciation expense.
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Figure 3-6
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Three sources of cash flows
Cash flows from Operations(ex. Sales revenue, labor expenses)
Cash flows from Investments(ex. Purchase of new equipment)
Cash flows from Financing(ex. Borrowing funds, payment of dividends)
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Three sources ofcash flows (cont.)
If we know the cash flows from
operations, investments and financing
=>we can understand the firms cashflow position better, that is, how cash
was generated and how it was used.
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Income Statement Conversion:From Accrual to Cash Basis
Two steps:
Add back depreciation (as it is a non-
cash expense) to net income Subtract any uncollected sales (i.e.
increase in accounts receivable) and cash
payment for inventories (i.e. increase in
inventories less increase in accounts
payables)
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Figure 3-7
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Table 3-5
Table 3 6
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Table 3-6
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Table 3-7
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Figure 3-2 (cont.)
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Figure 3-4
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Table 3-4
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3 35
TUTORIAL
Please prepare answers for thefollowing STUDY PROBLEMS before
attending tutorial next week:
CHAPTER 2
2.1, 2.4 & 2.5 CHAPTER 3
3.3 & 3.5