Accounting Statements and Cash Flows - CH02

2-0
Chapter Two
Accounting Statements
Corporate Finance
Ross Westerfield Jaffe
 
2
Sixth Edition
and Cash Flow
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
2-1
Chapter Outline
2.1 The Balance Sheet

2.2 The Income Statement
2.3 Net Working Capital
2.4 Financial Cash Flow
2.5 Summary and Conclusions
Appendix 2A Financial Statement Analysis
Appendix 2B Statement of Cash Flows

2-2
Sources of Information
• Statistics Canada:
– balance sheets, income statements, selected
ratios
• Dun and Bradstreet Canada:
– key business ratios
• The Financial Post and InfoGlobe:
– financial databases

2-3
2.1 The Balance Sheet

• An accountant’s snapshot of the firm’s accounting
value as of a particular date.
• The Balance Sheet Identity is:
Assets  Liabilitie s  Stockholde r' s Equity

2-4
The Balance Sheet of the
Canadian Composite Corporation
CANADIAN COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 The assets are listed in 20X2
order20X1
and Stockholder's Equity
Current assets: Current Liabilities:
Cash and equivalents $140 $107 by the length of time it $213 $197
Accounts payable
Accounts receivable
Inventories
294
269
270
280
normally would take a firm
Notes payable
Accrued expenses
50
223
53
205
Other 58 50 with ongoing operations$486
Total current liabilities to $455
Total current assets $761 $707
convert them into cash.
Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Clearly, cash is much more
Common stock ($1 per value) 55 32
Capital surplus 347 327
liquid than property, plant and
Accumulated retained earnings 390 347
equipment.
Less treasury stock
Total equity
-26
$805
-20
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

2-5
Balance Sheet Analysis
• When analyzing a balance sheet, the

financial manager should be aware of three
concerns:
1. Liquidity
2. Debt versus equity
3. Value versus cost

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Liquidity
• Refers to the ease and speed with which

assets can be converted to cash.
• Current assets are the most liquid.
• Some fixed assets are intangible.
• The more liquid a firm’s assets, the less likely
the firm is to experience problems meeting
short-term obligations.
• Liquid assets frequently have lower rates of
return than fixed assets.

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Debt versus Equity
• Generally, when a firm borrows it gives the

bondholders first claim on the firm’s cash
flow.
• Thus shareholder’s equity is the residual
difference between assets and liabilities.

2-8
Value versus Cost
• Under GAAP audited financial statements of

firms in Canada carry assets at historical cost
adjusted for depreciation.
• Market value is a completely different
concept. It is the price at which willing
buyers and sellers trade the assets.

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2.2 The Income Statement
• The income statement measures performance

over a specific period of time.
• The accounting definition of income is
Revenue  Expenses  Income

2-10
Income Statement
Income Statement
20X2
(in $ millions)
Total operating revenues $2,262

The operations Cost of goods sold - 1,655
section of the Selling, general, and administrative expenses - 327
Depreciation - 90
income statement
Operating income $190
reports the firm’s Other income 29
revenues and Earnings before interest and taxes $219
Interest expense - 49
expenses from Pretax income $170
principal Taxes - 84
operations Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

2-11
Income Statement
Income Statement
20X2
(in $ millions)

The non- Cost of goods sold - 1,655
operating section Selling, general, and administrative expenses - 327
Depreciation - 90
of the income
statement includes Other income 29
all financing costs, Earnings before interest and taxes $219
such as interest Pretax income $170
expense. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Dividends: $43

2-12
Income Statement
Income Statement
20X2
(in $ millions)

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Other income 29
Earnings before interest and taxes $219
Usually a separate Interest expense - 49
section reports as a Pretax income $170
Taxes - 84
separate item the Current: $71
amount of taxes Deferred: $13
levied on income. Net income $86
Dividends: $43

2-13
Income Statement
Income Statement
20x2
(in $ millions)

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Other income 29
Earnings before interest and taxes $219
Net income is the Pretax income $170
“bottom line”. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Dividends: $43

2-14
Income Statement Analysis
• There are three things to keep in mind when

analyzing an income statement:
1. Generally Accepted Accounting Principles
(GAAP)
2. Non Cash Items
3. Time and Costs

2-15
Generally Accepted Accounting Principles
1. GAAP
• The matching principal of GAAP dictates that
revenues be matched with expenses. Thus,
income is reported when it is earned, even
though no cash flow may have occurred.
• For example,when goods are sold for credit,
sales and profits are reported.

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2. Non Cash Items

• These are expenses that do not affect cash flow
directly.
• Depreciation is the most apparent. No firm ever
writes a cheque for “depreciation.”
• Another noncash item is deferred taxes, which
does not represent a cash flow.

2-17
3. Time and Costs

• In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can
vary such inputs as labour and raw materials.
• In the long run, all inputs of production (and hence
costs) are variable.
• Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that
distinguishes product costs from period costs.

2-18
2.3 Net Working Capital

NWC = CURRENT ASSETS –
CURRENT LIABILITIES
• NWC is +ve when current assets are greater
than current liabilities.
• A firm can invest in NWC. This is called
change in NWC .
• The change in NWC is usually +ve in a
growing firm.

2-19
The Balance Sheet of the C.C.C.

Balance Sheet
$252m = $707- $455 20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117 to $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 $275 million in 20X2 from
Total long-term liabilities$588 $562
Net property, plant, and equipment
Intangible assets and other
873
245
814
221
$252 million in 20X1.
Stockholder's equity:
Total fixed assets $1,118 $1,035
$23 million
Preferred stock
Common stock ($1 par value)
$39
55
$39
32
Capital surplus 347 327
$275m = $761m- $486m Accumulated retained earnings 390 347
This increase of $23 million is
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 an investment of the firm.
Total liabilities and stockholder's equity $1,879 $1,742

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2.4 Financial Cash Flow
• In finance, the most important item that can

be extracted from financial statements is the
actual cash flow of the firm.
• Since there is no magic in finance, it must be
the case that the cash received from the
firm’s assets must equal the cash flows to the
firm’s creditors and stockholders.
CF ( A)  CF ( B)  CF ( S )

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Financial Cash Flow of the C.C.C.
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm Operating Cash Flow:

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes) EBIT $219
Capital spending -173
(Acquisitions of fixed assets Depreciation $90
minus sales of fixed assets)
Additions to net working capital -23 Current Taxes ($71)
Total $42
Cash Flow of Investors in the Firm OCF $238
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
2-22
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm

plus depreciation minus taxes)
Capital Spending
Capital spending -173 Purchase of fixed assets $198
(Acquisitions of fixed assets
minus sales of fixed assets) Sales of fixed assets (25)
Additions to net working capital -23
Total $42 Capital spending $173
Cash Flow of Investors in the Firm
Debt $36
Equity 6
Total $42
2-23
Financial Cash Flow
20X2
(in $ millions)

NWC grew to $275
Capital spending -173 million in 20X2 from
minus sales of fixed assets) $252 million in 20X1.
Total $42 This increase of $23
Cash Flow of Investors in the Firm million is the addition to
Debt $36
(Interest plus retirement of debt NWC.
Equity 6
Total $42
2-24
Financial Cash Flow
20X2
(in $ millions)

Total $42
Cash Flow of Investors in the Firm
Debt $36
Equity 6
Total $42
2-25
Financial Cash Flow
20X2
(in $ millions)

Cash Flow to Creditors
(Acquisitions of fixed assets Interest $49
Additions to net working capital -23 Retirement of debt 73
Total $42
Cash Flow of Investors in the Firm Debt service 122
Debt $36
(Interest plus retirement of debt Proceeds from new debt
Equity 6 sales (86)
equity minus new equity financing) Total 36
Total $42
2-26
Financial Cash Flow
20X2
(in $ millions)

(Earnings before interest and taxes Cash Flow to Stockholders
Capital spending -173 Dividends $43
minus sales of fixed assets) Repurchase of stock 6
Cash to Stockholders 49
Total $42
Cash Flow of Investors in the Firm Proceeds from new stock issue
Debt $36 (43)
minus long-term debt financing) Total $6
Equity 6
Total $42
2-27
Financial Cash Flow
20X2
(in $ millions)

Operating cash flow $238 The cash received from
the firm’s assets must
Capital spending -173 equal the cash flows to the
firm’s creditors and
Additions to net working capital -23 stockholders:
Total $42
Cash Flow of Investors in the Firm CF ( A) 
CF ( B )  CF ( S )
Debt $36
Equity 6
Total $42
2-28
2.5 Summary and Conclusions
• Financial statements provide important

information regarding the value of the firm.
• A financial manager should be able to
determine cash flow from the financial
statements of the firm.
• Knowing how to determine cash flow helps
the financial manager make better decisions.

2-29
Appendix 2A Financial Statement Analysis
• Financial ratios provide information about

five areas of financial performance:
1. Short-term solvency
2. Activity
3. Financial leverage
4. Profitability
5. Market value

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Short-term solvency ratios
• Measure the firm’s ability to meet recurring

financial obligations
Total current assets
Current ratio 
Total current liabilities
• A higher current ratio indicates greater

liquidity

2-31
Short-term solvency ratios (cont.)
Quick assets
Quick ratio 
Total current liabilities
• Quick assets = Current assets – inventories

• Quick ratio determines firm’s ability to pay
off current liabilities without relying on the
sale of inventories.

2-32
Activity ratios
• Measure how effectively the firm’s assets are

being managed
Total operating revenues
Total asset turnover 
Average total assets
• Example: retail and wholesale trade firms

tend to have high asset turnover ratios
compared to manufacturing firms

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Activity ratios (cont.)

Total operating revenues
Receivables turnover 
Average receivables
Days in period (i.e.365)

Average collection period 
Receivables turnover
•These ratios provide information on the success

of the firm in managing its investment in accounts
receivable.

2-34
Activity ratios (cont.)

Cost of goods sold
Inventory turnover 
Average inventory
Days in period (i.e.365)

Days in inventory 
Inventory turnover
•Measure how quickly inventory is produced and

sold.

2-35
Financial leverage ratios
• Measure the extent to which a firm relies on

debt financing .
Total debt
Debt ratio 
Total assets
Total debt
Debt ratio 
Total assets
Total assets
Equity multiplier 
Total equity

2-36
Financial leverage ratios (cont.)
Earnings before interest and taxes (EBIT)

Interest coverage 
Interest expense
• Interest coverage ratio is directly connected

to the firm’s ability to pay interest.

2-37
Profitability ratios
Net income
Net profit margin 
Total operating revenue
• trade firms and service firms tend to have

low and high profit ratios respectively.

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Profitability ratios (cont.)
DuPont system of financial control

Return on assets  Profit margin x Asset turnover
Net income Total operating revenue
Return on assets  x
Total operating revenue Average total assets
• Firms tend to face a trade-off between

turnover and margin

2-39
Profitability ratios (cont.)

Net income
Return on equity 
Average shareholders equity
ROE  Profit margin x Asset turnover X Equity multiplier
Net income Total operating revenue Average total assets

ROE  x x
Total operating revenue Average total assets Average shareholders' equity
•The difference between ROA and ROE is due to

financial leverage.

2-40
Market value ratios
Market price/share
Price - Earnings ratio 
current annual earnings /share
•P/E ratio shows how much investors are willing

to pay for $1 of earnings per share.
• It also reflects investors’ views of the growth
potential of different sectors.

2-41
Market value ratios (cont.)

Market price/share
Market - to - Book ratio 
Book value/share
•The M/B ratio compares the market value of the

firm’s investments to their cost .
• a M/B value < 1 indicates that the firm has
not been successful in creating value for its
shareholders.

2-42
Remarks on ratios
– Financial ratios are linked to one another.
• Measures of profitability do not take risk or

timing of cash flows into account.

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2-0

2.1 The Balance Sheet

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

2.1 The Balance Sheet

• The Balance Sheet Identity is:

Assets  Liabilitie s  Stockholde r' s Equity

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Balance Sheet Analysis

• When analyzing a balance sheet, the

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

• Refers to the ease and speed with which

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Debt versus Equity

• Generally, when a firm borrows it gives the

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Value versus Cost

• Under GAAP audited financial statements of

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

2.2 The Income Statement

• The income statement measures performance

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Total operating revenues $2,262

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Total operating revenues $2,262

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Total operating revenues $2,262

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Total operating revenues $2,262

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

• There are three things to keep in mind when

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Generally Accepted Accounting Principles

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2. Non Cash Items

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3. Time and Costs

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2.3 Net Working Capital

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The Balance Sheet of the C.C.C.

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2.4 Financial Cash Flow

• In finance, the most important item that can

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Cash Flow of the Firm Operating Cash Flow:

Cash Flow of the Firm

Cash Flow of the Firm

Cash Flow of the Firm

Cash Flow of the Firm

Cash Flow of the Firm

Cash Flow of the Firm

2.5 Summary and Conclusions

• Financial statements provide important

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• Financial ratios provide information about

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Short-term solvency ratios

• Measure the firm’s ability to meet recurring

• A higher current ratio indicates greater

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Short-term solvency ratios (cont.)