Chapter 3 Understanding Financial Statements and Cash Flows Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.
Chapter 3
Understanding Financial Statements and Cash Flows
Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr.
Chapter 3 Understanding Financial Statements and Cash Flows
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Chapter Objectives
• Compute a company’s profits as reflected by an income statement.
• Determine a firm’s accounting book value, as presented in a balance sheet.
• Measure a company’s free cash flows.
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Principles Used in this Chapter
Principle 3: Cash-Not Profits-Is King
Principle 7: Managers Won’t Work for the Owners Unless It’s in Their Best Interest
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Basic Financial Statements
• Income Statement
• Balance Sheet
• Statement of Cash Flows
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Income Statement
• Profit/Loss Statement• Indicates the amount of profits
generated by a firm over a given period of time
• Sales – Expenses = Profit
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Income Statement Terminology
• Revenue (Sales)– Money derived from selling the company’s 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 and the dividends paid to preferred stockholders
• Tax Expenses– Amount of taxes owed, based upon taxable income
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Income Statement
SalesLess cost of goods sold
= Gross profitLess operating expenses
= Operating incomeLess interest expense
= Earnings before taxesLess corporate taxes
= Earnings before preferred dividendsLess preferred stock dividends
= Net income available to common stockholders
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Starbucks Corporation Income Statement 2003 ($M)
Sales $4,076Cost of Goods Sold 3,207Gross Profit $ 869Operating Expenses
Marketing expenses and general and Administrative expenses $227Depreciation Expense 206
Total Operating Expenses $ 433Operating Profits $ 436 Interest Expense 3Earnings before taxes $ 433Income taxes 165Net income $ 268
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Balance Sheet
• Provides a firm’s financial position at a specific point in time
• Assets are resources owned by the firm• Liabilities and owner’s equity indicate how
those resources are financed
Total Assets = Liabilities (debt) + Shareholder’s Equity
Or…A= L+OE
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Balance Sheet Terminology
• Current assets or gross working capital comprise assets that are relatively liquid, 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 expensesPrepaid expenses are those items paid for in
advance
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• Fixed Assets – Assets held for more than one year. Typically Include:– Machinery and equipment– Buildings– Land
• Other Assets – Assets that are not current assets or fixed assets– Patents– Copyrights– Goodwill
Balance Sheet Terminology
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• Debt (Liabilities)– Money that has been borrowed and must
be repaid at some predetermined date– Debt Capital
• financing provided by a creditor• Current or short-term debt and long-term debt• Current or short-term must be repaid within
the next 12 months
Balance Sheet Terminology
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• Current Liabilities:– Accounts payable
• Credit extended by suppliers to a firm when it purchases inventories
– Accrued expenses• Short term liabilities incurred in the firm’s
operations but not yet paid for– Short-term notes
• Borrowings from a bank or lending institution due and payable within 12 months
• Long-Term Debt– Loans from banks or other institutions for longer than
12 months
Balance Sheet Terminology
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• Equity• Includes the shareholder’s investment
– Preferred stock– Common stock
• Treasury Stock– stock that was once outstanding and has been
re-purchased by the company
• Retained Earnings– cumulative total of all the net income over the
life of the firm, less common stock dividends that have been paid out over the years
Balance Sheet Terminology
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Balance Sheet
• ASSETS– Current Assets– Fixed Assets
• Total Assets
• LIABILITIES– Current Liabilities– Long-Term Liabilities
• Total Liabilities• OWNER’S EQUITY
– Preferred Stock– Common Stock– Retained earnings
• Total Owner’s Equity• Total liabilities + OE
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Terms
• Net Working CapitalCurrent assets – current liabilities
• Debt RatioPercentage of debt a firm uses to finance its
assets
• Accrual Basis AccountingRecording revenues when earned and expenses
when incurred, rather than when cash is exchanged
• Free Cash FlowsCash flow that is free and available to be
distributed to the firm’s investors.
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Free Cash Flows
Free cash flows:(After-tax cashflows from operations)Less(Increase or decrease in net working
capital)Less(Increase or decrease in gross fixed
assets)
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Traditional Statement of Cash Flows
• Three sections:– Cash flows from Operating
Activities– Cash flows from Investing
Activities– Cash flows from Financing
Activities
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After-Tax Cash Flows From Operations
Operating Income (EBIT)+ Depreciation- Income tax expense= After-tax cash flows from
operations
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Change in Operating Working Capital
Change in operating working capital = (change in current assets) -
(change in current liabilities)
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Compute the Change in Fixed Assets
• The final step involves computing the change in Gross Fixed Assets (not net Fixed Assets)
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Starbucks Free Cash Flows ($M)
After-tax cash flows from operations $477
Less 2003 investments in:
Investments in net working capital $ 4
Investments in Long Term Assets 566
Total investments $ 570
Free cash flows $ (93)
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Financing Cash Flows
A firm can either receive money from or distribute money to its investors. The firm can:
1. Pay interest to lenders2. Pay dividends to stockholders3. Increase or decrease in long-term debt4. Issue stock to new shareholders or
repurchase stock from current shareholders