Chapter 3

Chapter 3

Understanding Financial Statements and Cash Flows

Foundations of FinanceFoundations of FinanceArthur J. KeownArthur J. Keown John D. MartinJohn D. MartinJ. William PettyJ. William Petty David F. Scott, Jr.David F. Scott, Jr.

Pearson Prentice Hall

Foundations of Finance3 - 2

Chapter 3 Understanding Financial Statements and Cash Flows

Chapter ObjectivesChapter Objectives

• Compute a company’s profits as Compute a company’s profits as reflected by an income statement.reflected by an income statement.

• Determine a firm’s accounting book Determine a firm’s accounting book value, as presented in a balance sheet.value, as presented in a balance sheet.

• Measure a company’s free cash flows.Measure a company’s free cash flows.




Principles Used in this ChapterPrinciples Used in this Chapter

Principle 3Principle 3: Cash-Not Profits-Is King: Cash-Not Profits-Is King

Principle 7Principle 7: Managers Won’t Work for the : Managers Won’t Work for the Owners Unless It’s in Their Best InterestOwners Unless It’s in Their Best Interest




Basic Financial StatementsBasic Financial Statements

• Income StatementIncome Statement

• Balance SheetBalance Sheet

• Statement of Cash FlowsStatement of Cash Flows




Income StatementIncome Statement

• Profit/Loss StatementProfit/Loss Statement• Indicates the amount of profits Indicates the amount of profits

generated by a firm over a given generated by a firm over a given period of timeperiod of time

• Sales – Expenses = ProfitSales – Expenses = Profit




Income Statement TerminologyIncome Statement Terminology

• Revenue (Sales)Revenue (Sales)– Money derived from selling the company’s product or Money derived from selling the company’s product or

serviceservice• Cost of Goods Sold (COGS)Cost of Goods Sold (COGS)

– The cost of producing or acquiring the goods or services to The cost of producing or acquiring the goods or services to be soldbe sold

• Operating ExpensesOperating Expenses– Expenses related to marketing and distributing the product Expenses related to marketing and distributing the product

or service and administering the businessor service and administering the business• Financing CostsFinancing Costs

– The interest paid to creditors and the dividends paid to The interest paid to creditors and the dividends paid to preferred stockholderspreferred stockholders

• Tax ExpensesTax Expenses– Amount of taxes owed, based upon taxable incomeAmount of taxes owed, based upon taxable income




Income StatementIncome Statement

SalesSalesLess cost of goods soldLess cost of goods sold

= Gross profit= Gross profitLess operating expensesLess operating expenses

= Operating income= Operating incomeLess interest expenseLess interest expense

= Earnings before taxes= Earnings before taxesLess corporate taxesLess corporate taxes

= Earnings before preferred dividends= Earnings before preferred dividendsLess preferred stock dividendsLess preferred stock dividends

= Net income available to common stockholders= Net income available to common stockholders




Starbucks Corporation Income Starbucks Corporation Income Statement 2003 ($M)Statement 2003 ($M)

SalesSales $4,076 $4,076

Cost of Goods SoldCost of Goods Sold 3,2073,207

Gross ProfitGross Profit $ 869 $ 869

Operating ExpensesOperating Expenses

Marketing expenses and general and Marketing expenses and general and

Administrative expenses $227Administrative expenses $227

Depreciation ExpenseDepreciation Expense 206206

Total Operating ExpensesTotal Operating Expenses $ 433$ 433

Operating ProfitsOperating Profits $ 436 $ 436

Interest ExpenseInterest Expense 3 3

Earnings before taxesEarnings before taxes $ 433 $ 433

Income taxesIncome taxes 165165

Net incomeNet income $ $ 268268




Balance SheetBalance Sheet

• Provides a firm’s financial position at a Provides a firm’s financial position at a specific specific point in timepoint in time

• Assets are resources owned by the firmAssets are resources owned by the firm• Liabilities and owner’s equity indicate how Liabilities and owner’s equity indicate how

those resources are financedthose resources are financed

Total AssetsTotal Assets = =

Liabilities (debt) + Shareholder’s EquityLiabilities (debt) + Shareholder’s EquityOr…A= L+OEOr…A= L+OE




Balance Sheet TerminologyBalance Sheet Terminology

• Current assets or gross working capital Current assets or gross working capital comprise assets that are relatively liquid, or comprise assets that are relatively liquid, or

expected to be converted into cash expected to be converted into cash within 12 months.within 12 months.

• Current assets typically include:Current assets typically include:– CashCash– Accounts Receivable Accounts Receivable

payments due from customers who buy on creditpayments due from customers who buy on credit– InventoryInventory

raw materials, work in process, and finished goods held raw materials, work in process, and finished goods held for eventual salefor eventual sale

– Other expensesOther expensesPrepaid expenses are those items paid for in advancePrepaid expenses are those items paid for in advance




• Fixed Assets – Fixed Assets – Assets held for more than one Assets held for more than one year. Typically Include:year. Typically Include:– Machinery and equipmentMachinery and equipment– BuildingsBuildings– Land Land

• Other AssetsOther Assets – Assets that are not current – Assets that are not current assets or fixed assetsassets or fixed assets– PatentsPatents– CopyrightsCopyrights

– GoodwillGoodwill





• Debt (Liabilities)Debt (Liabilities) – Money that has been borrowed and must be Money that has been borrowed and must be

repaid at some predetermined daterepaid at some predetermined date– Debt Capital Debt Capital

• financing provided by a creditorfinancing provided by a creditor• Current or short-term debt and long-term debtCurrent or short-term debt and long-term debt• Current or short-term must be repaid within the Current or short-term must be repaid within the

next 12 monthsnext 12 months





• Current LiabilitiesCurrent Liabilities::– Accounts payableAccounts payable

• Credit extended by suppliers to a firm when it Credit extended by suppliers to a firm when it purchases inventoriespurchases inventories

– Accrued expensesAccrued expenses• Short term liabilities incurred in the firm’s operations Short term liabilities incurred in the firm’s operations

but not yet paid forbut not yet paid for

– Short-term notesShort-term notes• Borrowings from a bank or lending institution due and Borrowings from a bank or lending institution due and

payable within 12 monthspayable within 12 months

• Long-Term DebtLong-Term Debt– Loans from banks or other institutions for longer than 12 Loans from banks or other institutions for longer than 12

monthsmonths





• EquityEquity• Includes the shareholder’s investmentIncludes the shareholder’s investment

– Preferred stockPreferred stock– Common stockCommon stock

• Treasury StockTreasury Stock– stock that was once outstanding and has been re-stock that was once outstanding and has been re-

purchased by the companypurchased by the company

• Retained EarningsRetained Earnings– cumulative total of all the net income over the life of cumulative total of all the net income over the life of

the firm, less common stock dividends that have the firm, less common stock dividends that have been paid out over the yearsbeen paid out over the years





Balance SheetBalance Sheet

• ASSETSASSETS– Current AssetsCurrent Assets– Fixed AssetsFixed Assets

• Total AssetsTotal Assets

• LIABILITIESLIABILITIES– Current LiabilitiesCurrent Liabilities– Long-Term LiabilitiesLong-Term Liabilities

• Total LiabilitiesTotal Liabilities• OWNER’S EQUITYOWNER’S EQUITY

– Preferred StockPreferred Stock– Common StockCommon Stock– Retained earningsRetained earnings

• Total Owner’s EquityTotal Owner’s Equity• Total liabilities + OETotal liabilities + OE




TermsTerms

• Net Working CapitalNet Working CapitalCurrent assets – current liabilitiesCurrent assets – current liabilities

• Debt RatioDebt RatioPercentage of debt a firm uses to finance its assetsPercentage of debt a firm uses to finance its assets

• Accrual Basis AccountingAccrual Basis AccountingRecording revenues when earned and expenses when Recording revenues when earned and expenses when

incurred, rather than when cash is exchangedincurred, rather than when cash is exchanged

• Free Cash FlowsFree Cash FlowsCash flow that is free and available to be distributed to Cash flow that is free and available to be distributed to

the firm’s investors.the firm’s investors.




Free Cash FlowsFree Cash Flows

Free cash flows:Free cash flows:

(After-tax cashflows from operations)(After-tax cashflows from operations)

LessLess

(Increase or decrease in net working (Increase or decrease in net working capital)capital)

LessLess

(Increase or decrease in gross fixed (Increase or decrease in gross fixed assets)assets)




Traditional Statement of Cash Traditional Statement of Cash FlowsFlows

• Three sectionsThree sections::– Cash flows from Operating ActivitiesCash flows from Operating Activities– Cash flows from Investing ActivitiesCash flows from Investing Activities– Cash flows from Financing ActivitiesCash flows from Financing Activities




After-Tax Cash Flows From After-Tax Cash Flows From OperationsOperations

Operating Income (EBIT)Operating Income (EBIT)

+ Depreciation+ Depreciation

- Income tax expense- Income tax expense

= After-tax cash flows from = After-tax cash flows from operationsoperations




Change in Operating Working Change in Operating Working CapitalCapital

Change in operating working capital = Change in operating working capital =

(change in current assets) - (change in current assets) -

(change in current liabilities)(change in current liabilities)




Compute the Change in Fixed Compute the Change in Fixed AssetsAssets

• The final step involves computing The final step involves computing the change in the change in Gross Fixed Assets Gross Fixed Assets (not net Fixed Assets)(not net Fixed Assets)




Starbucks Free Cash Flows ($M)Starbucks Free Cash Flows ($M)

After-tax cash flows from operationsAfter-tax cash flows from operations $477 $477

Less 2003 investments in:Less 2003 investments in:

Investments in net working capital $ 4Investments in net working capital $ 4

Investments in Long Term Assets Investments in Long Term Assets 566566

Total investmentsTotal investments $ 570$ 570

Free cash flowsFree cash flows $ (93)$ (93)




Financing Cash FlowsFinancing Cash Flows

A firm can either receive money from or A firm can either receive money from or distribute money to its investors. The firm distribute money to its investors. The firm can:can:

1.1. Pay interest to lendersPay interest to lenders2.2. Pay dividends to stockholdersPay dividends to stockholders3.3. Increase or decrease in long-term debtIncrease or decrease in long-term debt4.4. Issue stock to new shareholders or Issue stock to new shareholders or

repurchase stock from current repurchase stock from current shareholdersshareholders

Economy & Finance

Chapter 3