Securitization Process (2 of 2) 2.

Balance sheet: Balance sheet contains

4. These MBSs are sold to investors who can information as of the date of its preparation of
Evaluating a Firm’s per Share Earnings
hold them as investments or resell them to the following:
and Dividends
other investors. § Assets (everything of value the company owns),
• Per Share earnings = company’s net income
Since the original lender gets the money back § Liabilities (the company’s debts), and
divided by the number of common shares
quickly and does not have to worry about § Stockholders’ equity (the money invested by the
outstanding.
repayment, it may not adequately screen the loan company owners)
• Dividends per share = total dividends paid div
applicants. Financial crisis began with poor
by the number of common shares outstanding.
screening and spread worldwide through sale of 3. Cash flow statement: It reports cash received
MBSs. and cash spent by the firm over a specific period
Evaluating a Firm’s EPS and Dividends
of time, usually a quarter of a year or a full year.
(for Boswell, Table 3.1)
Dodd—Frank Wall Street Reform and
• Earnings per share = $204.75m ÷ 90m
Consumer Act 4. Statement of shareholder’s equity: It provides a = $2.28 per share
In the wake of 2008 financial crisis, the financial detailed account of activities in the firm’s • Dividends per share = $45m ÷ 90m
industry was again transformed. The major standalone common and preferred stock accounts and its = $0.50 per share
investment banks failed or were converted to retained earnings account and of changes to
commercial banks. shareholders’ equity.
Connecting the Income Statement and the
In 2010 the Dodd-Frank Wall Street Reform and Balance Sheet
Consumer Protection Act was passed, which Why Study Financial Statements? • What can the firm do with the net income?: P
subjects banks and non-bank financial institutions to Analyzing a firm’s financial statement can help dividends to shareholders, and/or Reinvest in
more oversight and greater transparency. One of the managers carry out three important tasks: firm
rules, “Volker” rule, prohibits banks from 1. assess the financial condition of the firm – Boswell, Inc. earned net income of $204
proprietary trading. 2. monitor and control operations, and million, of which $45 million was distrib
3. financial forecasting and planning. in dividends and $159.75 million was
retained and reinvested in the firm.
Chapter 3: Understanding Financial Statements, Taxes,
and Cash Flows What are the Accounting Principles
Used to Prepare Financial Statements? Interpreting Firm Profitability using the
• Accountants use the following three fundamental Income Statement (1 of 5)
Learning Objectives (1 of 2) principles when preparing financial statements: From H.J. Boswell Inc.’s income statement (Ta
1. Describe the content of the four basic financial 1. The revenue recognition principle, we observe that firm has been profitable. We ca
statements and discuss the importance of 2. The matching principle, and identify three different measures of profit or in
financial statement analysis to the financial 3. The historical cost principle. 1. The gross Profit margin is 25% ($675 mil
manager. 2. The operating profit margin is only 14.2%
2. Evaluate firm profitability using the income ($382.5 million)
statement. 3.2 THE INCOME STATEMENT
3. The net profit margin is only 7.6% ($204.
3. Estimate a firm’s tax liability using the corporate million)
tax schedule and distinguish between the An Income Statement (1 of 2)
average and marginal tax rate. An income statement (also called a profit and loss
4. Use the balance sheet to describe a firm’s statement) measures the amount of profits Interpreting Firm Profitability using the
investments in assets and the way it has generated by a firm over a given time period Income Statement (2 of 5)
financed them. (usually a year or a quarter). It can be expressed as 1. The gross profit margin (GPM)
5. Identify the sources and uses of cash for a firm follows: = gross profits ÷ sales
using the firm’s cash flow statement. Revenues (or Sales) – Expenses = Profits = $675 million ÷ $2,700 million
= 25%
– GPM indicates the firm’s “mark-up” on its co
Principles Used in This Chapter
goods sold per dollar of sales. The markup
• Principle 1: Money Has a Time Value. An income statement will contain the following: percentage equals gross profit divided by cos
• Principle 3: Cash Flows Are the Source of Value. 1. Revenues goods sold (= $675m ÷ $2.025m = 33.3%)
• Principle 4: Market Prices Reflect Information. 2. Cost of Good Sold
• Principle 5: Individuals Respond to Incentives. 3. Gross Profit Interpreting Firm Profitability using the
4. Operating Expenses Income Statement (3 of 5)
3.1 AN OVERVIEW OF THE FIRM’S FINANCIAL 5. Net Operating Income 2. The operating profit margin
STATEMENTS 6. Interest Expense = net operating income ÷ sales
7. Earnings Before Taxes = $382.5 million ÷ $2,700 million
8. Income Taxes = 14.2%
Basic Financial Statements (1 of 4)
9. Net Income – The operating profit margin is equal to the ra
The accounting and financial regulatory authorities
mandate that firms provide the following four types net operating income or EBIT divided by fir
of financial statements: Table 3.1 H. J. Boswell, Inc. (1 of 2) sales.
1. Income statement Income Statement ($ millions, except per share data) for
2. Balance sheet the Year Ended Interpreting Firm Profitability using the
3. Cash flow statement December 31, 2016 Income Statement (4 of 5)
3. The net profit margin
4. Statement of shareholders’ equity = net profits ÷ sales
= $204.75 million ÷ $2,700 million = 7.6%

Basic Financial Statements (2 of 4)

1. Income Statement: An income statement
provides the following information for the firm
over a specific period of time (usually a quarter
of a year or a full year):
§ Revenue earned,
§ Expenses incurred, and
§ Profit earned
– Net profit margin indicates the percentage of revenues left ov
after all expenses (including interest and taxes) have been
considered.
Interpreting Firm Profitability using the 3.3 CORPORATE TAXES • Total liabilities represent the total amount of
Income Statement (5 of 5) money the firm owes its creditors
By comparing these margins to those of similar Corporate Taxes • Total shareholders’ equity refers to the
businesses, we can dissect a firm’s performance A firm’s income tax liability is calculated using its difference in the value of the firm’s total assets
and identify expenses that are out of line. taxable income and the tax rates on corporate and the firm’s total liabilities.
income. • Total assets, sum of total shareholders’ equity
GAAP and Earnings Management and total liabilities, represents the resources
• In the United States, while the firms must adhere to owned by the firm.
Computing Taxable Income
GAAP, there is considerable room for company’s
The table reveals the following:
managers to actively influence the firm’s reported The Balance Sheet (3 of 4)
– Tax rates range from 15% to 39%
earnings. • In general, GAAP requires that the firm report
– Tax rates are progressive i.e. corporations with
• Managers have an incentive to tamper with earnings assets using the historical costs.
higher profits tend to pay more taxes.
as their pay depends upon it and because investors pay • Cash and assets held for sale (such as
close attention to earnings announcements. marketable securities) are an exception to the
• An audit by an independent accounting firm serves as Marginal and Average Tax Rates (1 of 3) rule. These assets are reported using the lower
a check and balance to control management’s incentive • Marginal tax rate is the tax rate that the company of their cost or current market value.
to disguise the firm’s financial condition. will pay on its next dollar of taxable income.
• Average tax rate is total taxes paid divided by the
The Balance Sheet (4 of 4)
taxable income.
CHECKPOINT 3.1: CHECK YOURSELF • Assets whose value is expected to decline over
Constructing an Income Statement time (such as equipment) are adjusted downward
Reconstruct the firm’s income statement assuming the Example: What is the average and marginal tax periodically by depreciating the historical cost.
firm is able to cut its cost of liability for a firm reporting $100,000 as taxable Balance sheet reports the book value (equal to
goods sold by 10% and that the firm pays taxes at a income. historical cost less the accumulated depreciation).
40% rate. What is the firm’s net income and earnings • Generally, the book value is not equal to the
per share? • Average tax rate current market value of the firm’s assets.
– = Total tax liability 􀃗 Total taxable income
– = $22,250 􀃗 $100,000
Step 1: Picture the Problem (1 of 2) Table 3.2 H. J. Boswell, Inc. (1 of 9)
– = 22.25%
• The income statement can be expressed as Balance Sheets ($ millions), December 31, 2015 and
• Marginal tax rate
follows: 2016
– = 39% as the firm will have to pay 39% on its
Revenues – Expenses = Net Income
next dollar of taxable income i.e. if its taxable
• We are given information on revenues and
income increases from $100,000 to $100,001.
expenses (cost of goods sold, operating
expenses, interest expense and income taxes)
to fill the template given on next slide. Dividend Exclusion for Corporate
Shareholders (1 of 2)
For corporate stockholders, the dividend received
Step 1: Picture the Problem (2 of 2)
are at least partially exempt from taxation. The
rationale behind the exclusion is to avoid double
taxation. The percentage of exempt taxes is based
on the degree of ownership of the firm.

Example What will be the taxable income if firm A Legend:

receives $100,000 in dividends from firm B Assets: The Left-Hand Side of the Balance Sheet
Current Assets. Assets that the firm expects to
convert to cash in 12 months or less. Examples
include cash, accounts receivable, inventories, and
3.4 THE BALANCE SHEET other current assets.
• Cash. Every firm must have some cash on hand at
The Balance Sheet (1 of 4) all times because cash expenditures can sometimes
Step 2: Decide on a Solution Strategy The balance sheet is a snapshot of the firm’s exceed cash receipts.
• Given the account balances, constructing the financial position on a specific date. It is defined by • Accounts receivable. The amounts owed to the firm
income statement will entail substituting the the following equation: by it customers who purchased on credit.
appropriate balances into the template of step 1. Total Assets = Total Liabilities + Total Shareholders
Equity Table 3.2 H. J. Boswell, Inc. (4 of 9)
• Inventory. Raw materials that the firm utilizes to
build its products, partially completed items or
work in process, and finished goods held by the
firm for eventual sale.
• Other current assets. All current assets that do not
fall into one of the named categories (cash, accounts
receivable, and so forth). Prepaid expenses
(prepayments for insurance premiums, for example)
are a common example of an asset in this catch-all
category.
Step 3: Solve (1 of 2) Gross Plant and Equipment. The sum of the
Step 3: Solve (2 of 2) original acquisition prices of plant and equipment
Earnings per share: still owned by the firm.
= net income÷number of shares Accumulated Depreciation. The sum of all the
= $1,374,900,000 ÷ 716,296,296 = $1.92 depreciation expenses charged against the prior
year’s revenues for fixed assets that the firm still
owns.
Step 4: Analyze Net Plant and Equipment. The depreciated value of
The firm is profitable since it earned net income of the firm’s plant and equipment.
$1,374,900,000. The shareholders were able be
earn $1.96 per share.