Financial Statement, Cash Flow

and Financial Forecasting

Chapter 2

Chapter 2 Learning Goals

LG1: Recall the major financial statements that firms must prepare and
provide to the public
LG2: Differentiate between book (or accounting) value and market value
LG3:

Explain how taxes influence corporate managers and

investors decisions

LG4: Differentiate between accounting income and cash flows

LG5: Demonstrate how to use a firm's financial statement to calculate its
cash flows
LG6:

Observe cautions that should be taken when examining

external financial statements

ACT3211 FINANCIAL
MANAGEMENT

2-2

Introduction
Corporate managers must issue many
reports to the public. The most
attention is paid to the annual report,
which contains
Balance sheet
Income statement
Statement of cash flows
Statement of retained earnings

These four statements present an

accounting-based picture of the firms
financial position.
ACT3211 FINANCIAL
MANAGEMENT

2-3

 While accountants focus on reporting

what happened in the past, financial
managers use financial statements to
draw inferences about the future
Firms must follow Generally Accepted
Accounting Principles (GAAP) when
creating these statements, but they still
have substantial discretion
ACT3211 FINANCIAL
MANAGEMENT

2-4

Balance Sheet (Statement of Financial

Position)
The balance sheet reports a firms assets,
liabilities, and equity at a particular point
in time.
Assets = Liabilities + Equity
The left side of a balance sheet lists the
assets of the firm in order of liquidity
The right side of the balance sheet lists
the liabilities in order of maturity. Equity,
which never matures, is listed last
ACT3211 FINANCIAL
MANAGEMENT

2-5

Assets
Assets fit into two major categories:
current assets and fixed assets
Current Assets
Will normally convert into cash within a year
Cash (and marketable securities)
Accounts receivable
Inventory

Fixed Assets
Have a useful life exceeding one year
Net plant and equipment (Gross plant and
equipment less accumulated depreciation)
Less tangible assets, such as patents and
trademarks
ACT3211 FINANCIAL
MANAGEMENT

2-6

Liabilities
Lenders provide funds, which become
liabilities to the firm.
Current liabilities
Obligations due within a year
Accruals (accrued wages and accrued taxes)
Accounts payable
Notes payable

Long-term debt
Long-term loans and bonds with maturities of
more than one year
ACT3211 FINANCIAL
MANAGEMENT

2-7

Equity
The difference between total assets and total
liabilities is the stockholders (or owners)
equity.
Types of Equity
Preferred Stock
Appears as the cash proceeds when the firm sells
preferred stock

Common Stock and Paid-in-Surplus

Also appear as cash proceeds when common stock is
issued

Retained Earnings
When managers reinvest earnings rather than pay them
out as dividends, these will be recorded as retained
earnings. The retained earnings account on the
balance sheet represents the cumulative amount
ACT3211 FINANCIAL
retained over the years.
MANAGEMENT

2-8

Managing the Statement of Financial

Position
Managers must monitor a number of
issues related to the firms balance sheet,
including:
The accounting method used for fixed asset
depreciation
The level of net working capital
The liquidity position of the firm
Whether to finance the firms assets with
equity or debt
The difference between the book value
reported on the balance sheet versus the true
market value of the
firm
ACT3211
FINANCIAL
MANAGEMENT

2-9

Accounting method for fixed asset

depreciation
Managers can choose the accounting method they use
to record depreciation against their fixed assets.
For reporting purposes, companies often use the
straight-line method of depreciation
For tax purposes, firms often use accelerated
depreciation such as MACRS
Why use different methods?
The straight-line method results in lower depreciation
expenses in the earlier years, resulting in higher income for
reporting to shareholders
MACRS results in higher depreciation expenses in earlier
years, leading to lower income and thus lower taxes.
A firm will often use multiple methods for calculating
depreciation for the same assets

ACT3211 FINANCIAL
MANAGEMENT

2-10

ACT3211 FINANCIAL
MANAGEMENT

2-11

Net Working Capital

Net Working Capital = Current assets
minus current liabilities
For DPH Tree Farms for 2007:
NWC = $190 - $110
NWC = $ 80 million

Firms monitor net working capital as a

measure of the firms ability to pay its
obligations
In general, a financially healthy firm has
positive NWC ACT3211 FINANCIAL
MANAGEMENT

2-12

Liquidity
Liquidity refers to the ability to turn an asset into cash
at its fair market value.
Current assets are the most liquid assets
Cash, marketable securities, accounts receivable, and
inventory
Inventory is the least liquid of the current assets

Fixed assets are less liquid

Liquidity has both good and bad aspects:
More liquidity means the firm can more easily pay its
obligations and stave off financial distress, i.e. the firm is
less risky
However, liquid assets dont provide a very high return.
Cash offers no return at all.
Fixed assets are illiquid, but provide for generating
revenue and profits
Managers must consider
the risk-return
tradeoff
ACT3211
FINANCIAL
MANAGEMENT

2-13

Debt vs. Equity Financing

Financial leverage refers to the extent to which a firm
uses debt as a source of financing
Just like a lever magnifies the ability to move objects,
financial leverage magnifies a firms gains and losses
Debtholders have a fixed claim on the firms cash flows
(they are paid interest on their securities)
Stockholders have a claim on whatever cash flow is left.
Since the obligation to debt holders is fixed, if the firm does
well stockholders do very well. If the firm does poorly,
stockholders get little or nothing.
Yet, debt increases the financial risk to the firm. If the firm
cant make the fixed payments to debtholders, the firm
faces bankruptcy

Once again, managers face a tradeoff between risk

and return as they decide the firms capital structure
ACT3211 FINANCIAL
MANAGEMENT

2-14

Book Value versus Market

Value
A firms balance sheet shows book, or historical cost,
value according to GAAP
Under GAAP, the value of assets on the balance sheet
shows what the firm paid for them regardless of what
they may be work today
In most cases, book values differ widely from market
values for the same assets
For current assets the difference will be small, but for
fixed assets the difference is likely huge
Similarly, stockholders equity on the balance sheet is
generally greatly different than the true market value of
the equity
Book value of equity represents the historical value of
contributed equity, while the market value of equity
represents the value of the firm in the market, which
depends on the present value of future cash flows
ACT3211 FINANCIAL
MANAGEMENT

2-15

Income Statement (Statement

of Comprehensive Income)
Income statements show the total
revenues and expenses of a firm over a
specific period of time
The top line of the income statement
shows the firms revenues
The statement then shows all of the
various expenses for the firm
The bottom line, or net income,
represents the difference between
revenues and expenses
ACT3211 FINANCIAL
MANAGEMENT

2-16

ACT3211 FINANCIAL
MANAGEMENT

2-17

ACT3211 FINANCIAL
MANAGEMENT

2-18

 The top part of the income statement

represents the operating income
portion of the income statement. This
part of the statement is generated by
operating the firm, and results in
operating income or EBIT
The bottom part of the income
statement reflects how the firm is
financed and taxed
ACT3211 FINANCIAL
MANAGEMENT

2-19

 Items reported below the bottom line

include:
Earnings per share (EPS)

net income
total shares of common stock outstanding

Dividends per Share (DPS)

common stock dividends paid

number of shares of common stock outstanding

Book value per share (BVPS)

common stockholders equity

number of shares of common stock outstanding

Market value per share (MVPS) the market price of the firm's commonstock

ACT3211 FINANCIAL
MANAGEMENT

2-20

Statement of Cash Flows

The balance sheet is a snapshot of a firm's financial resources and

obligations at a single point in time, and the income statement
summarizes a firm's financial activity over a period of time. These two
financial statements reflect the accrual basis of accounting required by
GAAP to match revenues with the expenses associated with generating
those revenues

Actual cash inflows and outflows may occur at very different times than
are reflected in these two financial statements. Also, the income
statement contains several non-cash entries, notably depreciation

Therefore, figures on an income statement do not reflect the actual cash

flows of the firm. Financial managers and investors are much more
interested in cash flows than accrual accounting income.

ACT3211 FINANCIAL
MANAGEMENT

2-21

 The statement of cash flows shows the

firms cash flows over a period of time.
It includes only inflows and outflows of
cash and marketable securities. It
excludes transactions that do not directly
affect cash receipts and payments, such
as depreciation and write-offs on bad
debts.
The bottom line of the statement reflects
the difference between cash sources and
uses and equals the change in cash on
the firms balance sheet
ACT3211 FINANCIAL
MANAGEMENT

2-22

Sources and Uses of Cash

Some activities increase cash, and some
activities decrease cash.
Sources of cash involve increasing
liabilities (or equity) and decreasing
assets.
Uses of cash involve decreasing liabilities
(or equity) and increasing assets.
The statement of cash flows is a cash
basis report on three types of financial
activities: operating activities, investing
activities, and financing
activities.
ACT3211 FINANCIAL
MANAGEMENT

2-23

ACT3211 FINANCIAL
MANAGEMENT

2-24

Cash Flows from Operations

The top portion of the statement of cash
flows, cash flows from operations,
represents items directly associated with
producing and selling the firms products.
Net income
Depreciation
Working capital accounts other than cash and
short-term debt

Many finance professionals consider this

portion of the statement the most
important.
ACT3211 FINANCIAL
MANAGEMENT

2-25

Cash Flows from Investing

Activities
Cash flows associated with buying or
selling fixed or other long-term assets
This section of the statement of cash
flows reflects the firms investment in
fixed assets

ACT3211 FINANCIAL
MANAGEMENT

2-26

Cash Flows from Financing

Activities
Cash flows from debt and equity
financing transactions
Issuing short- or long-term debt
Issuing stock
Using cash to pay dividends
Using cash to pay off debt
Using cash to buy back stock

ACT3211 FINANCIAL
MANAGEMENT

2-27

 The bottom line of the statement of cash flows

shows the total of cash flows from operation,
investing, and financing activities
This line reconciles to the net change in cash
and marketable securities on the balance
sheet over the period.
In the DPH example, the income statement
showed $90 million in net income, but -$1
million in cash flow
This is because net income is accounting-based
income according to GAAP and does not
necessarily reflect the flow of cash
ACT3211 FINANCIAL
MANAGEMENT

2-28

Free Cash Flow

To maintain cash flows over time, a firm
must continuously replace working capital
and depreciating fixed assets, and
develop new products
Investors are particularly interested in the
cash flows available to pay the firms
stockholders and debtholders
After adjustments for investments in working
capital
After adjustments for investments in fixed
ACT3211 FINANCIAL
assets
MANAGEMENT

2-29

FCF = Operating cash flow Investment in operating capital

FCF = (EBIT Taxes + Depreciation) (Gross fixed assets + Net
operating working capital)

Operating cash flow (OCF)

Firms generate operating cash flow from operations after
they have paid necessary taxes
Investment in operating capital (IOC)
Firms buy physical capital or earmark funds for eventual
equipment replacement to sustain firm operations
Includes the firms investment in fixed assets, current assets,
and spontaneous current liabilities (i.e. accounts payable and
accruals)

ACT3211 FINANCIAL
MANAGEMENT

2-30

Example 2-5

ACT3211 FINANCIAL
MANAGEMENT

2-31

 A positive Free Cash Flow means that the

firm has funds that can be distributed to
investors
A negative FCF might mean several things:
If FCF is negative due to negative OCF it may
indicate that the firm is experiencing operating or
managerial problems
FCF might be negative because the firm is
investing heavily in operating capital to support
growth
In this case FCF might be negative while OCF is
positive
ACT3211 FINANCIAL
MANAGEMENT

2-32

Statement of Retained Earnings

Provides additional detail about the
change in retained earnings during a
reporting period
Reconciles net income and dividends
paid with changes in retained earnings
from one period to the next:
Beginning retained earnings
+ net income for period
- cash dividends paid
= Ending retained earnings
ACT3211 FINANCIAL
MANAGEMENT

2-33

Cautions in Interpreting Financial

Statements
While firms must follow GAAP in preparing their
financial statements, firms have considerable
latitude in using accounting rules
Firms can smooth earnings, for example for
new managers to show growth
Different depreciation methods
These strategies are called earnings
management
Sarbanes Oxley Act of 2002 was passed in an
effort to prevent deceptive accounting and
management practices brought to light in highprofile scandals such as Enron and WorldCom
ACT3211 FINANCIAL
MANAGEMENT

2-34