CH 2

Financial Statements
LEARNING OBJECTIVES
1. Explain the foundations of the balance

sheet and income statement
2. Use the cash flow identity to explain cash
flow.
3. Provide some context for financial reporting.
4. Recognize and view Internet sites that
provide financial information.
2.1 Financial Statements
Four main financial statements:
Balance sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flow
Our focus..
Interrelationship between the balance sheet and
the income statement for cash flow analysis
The process by which these statements can be used
to project a firm’s future cash flows
2.1 Financial Statements
(A) The Balance Sheet
 Represents the assets owned by the company and

the claims against those assets
 Based on the accounting identity:

Assets  Liabilities + Owners’ Equity (2.1)
Figure 2.1 Balance sheet
2.1 Balance Sheet
Has five main sections:
1. Cash account
 Where did the $65 million decline come from?
2. Working capital accounts
 Net working capital = Current assets – Current liabilities (2.2)
3. Long-term asset accounts
 Plant and equipment; land and buildings
 Gross value – accumulated depreciation = Net value
4. Long-term liabilities (debt) accounts
 Loans maturing in over one year
5. Ownership accounts
 Shareholders’ equity
 Retained earnings—accumulated total since inception
2.1 The Income Statement
• Shows the expenses and revenues generated by a
firm over a past period, typically a quarter or a year.
• Net income = Revenues – all expenses (2.3)
• EBIT = Revenues – operating expenses (2.4)

2.1 Income Statement
2.1 The Income Statement
Net income is not the same as cash flow
 Firm earned an income of $5,642 million
 Cash account decreased by $65 million
3 reasons:
 Accrual accounting
 Noncash expense items -- depreciation
 Preference to classify interest expense as part of
financial cash flow

2.2 Cash Flow Identity
The cash flow identity states that the cash flow on
the left-hand side of the balance sheet (the cash
generated by the company) is equal to the cash
flow on the right-hand side of the balance sheet
(the cash flow given to the lenders and owners of
the company).
CASH FLOW FROM ASSETS  CASH FLOW TO CREDITORS

+ CASH FLOW TO OWNERS
Figure 2.5 Cash Flow Identity and components
2.2 The First Component:
Cash Flow From Assets
Three components:
 Operating cash flow (OCF)
 Net capital spending (NCS)
 Change in net working capital (∆NWC)
Cash flow from assets = OCF – NCS - ∆NWC

OCF = EBIT + Depreciation – Taxes
NCS = End. Net Fixed Assets – Beg. Net Fixed Assets

+ Depreciation
∆NWC=Ending NWC – Beginning NWC

OCF = EBIT + Depreciation – Taxes
OCF = Net Income + Depreciation
+ Interest Expense
NCS = End Net Fixed Assets – Beg Net Fixed Assets
+ Depreciation
NCS= ($11,961 - $10,788) + $1,406 = $2,579

∆NWC = Ending NWC – Beginning NWC
Net working capital for 2007 = $9,130 - $6,860 = $2,270

Net working capital for 2006 = $10,454 - $9,406 = $1,048
Change in NWC = $2,270 - $1,048 = $1,222
Putting it all together….
Cash flow from Assets = OCF – NCS - ∆ NWC

= $7,287 - $2,579 - $1,222
= $3,486
Versus Net Income of $5,642

2.2 The Second Component:
Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense  Net New Borrowing from Creditors
Net New Borrowing = End Long-term Liabilities  Beg Long-Term Liabilities
Cash Flow to Creditors = $239 - (-$378) = $617

2.2 The Third Component:
Cash Flow To Owners
Cash flow to owners =
Dividends - Net new borrowing from owners
= $2,869 - $0
= $2,869
2.2 Putting It All Together: The
Cash Flow Identity
CASH FLOW FROM ASSETS  CASH FLOW TO

CREDITORS + CASH FLOW TO OWNERS
$3,486  $617 + $2,869
The company generated $3,486 million and it was
distributed to the lenders ($617 million) and the
owners ($2,869 million)
CASH FLOW STATEMENT
2.3 Financial Performance
Reporting
Annual reports to shareholders
Quarterly (10-Q) and annual (10-K) reports filed
with the SEC
Regulation Fair Disclosure (Reg. FD): Companies must
release all material information to all investors at the
same time.
– Notes to the Financial Statements: A wealth of
information about the firm
2.4 Financial Statements on the Internet
EDGAR (www.sec.gov/edgar.shtml)
Yahoo! Finance (http://finance.yahoo.com.)
Many, many more Web sites with rich stores of
information
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 1
Balance Sheet. Chuck Enterprises has current
assets of $300,000, and total assets of $750,000. It
also has current liabilities of $125,000, common
equity of $250,000, and retained earnings of
$85,000. How much long-term debt and fixed
assets does the firm have?
Problem 1
Current Assets + Fixed Assets = Total Assets
 $300,000 + Fixed Assets = $750,000
 Fixed Assets = $750,000 - $300,000 = $450,000
 Total Assets ≡ Current Liabilities + Long-term debt +

Common equity + Retained Earnings
 $750,000 = $125,000 + Long-term debt + $250,000 + 85,000
 Long-term debt = $750,000 - $125,000-$250,000 - $85,000
 Long-term debt = $290,000

Problem 2
Income Statement. The Top Class Company

had revenues of $925,000 in 2009. Its operating
expenses (excluding depreciation) amounted to
$325,000, depreciation charges were $125,000, and
interest costs totaled $55,000. If the firm pays a
average tax rate of 34 percent, calculate its net
income after taxes.
Problem 2
Revenues $925,000
Less operating expenses 325,000
= EBITDA 600,000
Less depreciation 125,000
= EBIT 475,000
Less interest expenses 55,000
= Taxable Income 420,000
Less taxes (34%) 142,800
= Net Income after taxes 277,200
Problem 3
Retained Earnings: The West Hanover Clay Co. had,

at the beginning of the fiscal year, November 1, 2009,
retained earnings of $425,000. During the year ended
October 31, 2010, the company generated net income
after taxes of $820,000 and paid out 35 percent of its
net income as dividends. Construct a statement of
retained earnings and compute the year-end balance
of retained earnings.
Problem 3
Statement of Retained Earnings for
the year ended October 31, 2010

Balance of Retained Earnings, 11/1/2009……….$425,000

Add: Net income after taxes, 10/31/2010………. $820,000
Less: Dividends paid for year-end 10/31/2010…$287,000
Balance of Retained Earnings, 10/31/20120….. $958,000

Problem 4
Working Capital: D.K. Imports, Incorporated reported
the following information at its last annual meeting:
Cash and cash equivalents = $1,225,000;

Accounts payables = $3,200,000
Inventory = $625,000;
Accounts receivables = $3,500,000;
Notes payables = $1,200,000;
Other current assets = $125,000.

Calculate the company’s net working capital.
Problem 4
Net Working Capital = Current Assets - Current Liabilities
(Cash & Cash Equivalents + Accts. Rec. + Inventory +
other current assets) - (Accounts Payables + Notes
Payables)
($1,225,000+$3,500,000+$625,000+$125,000) -
($3,200,000+$1,200,000)
$5,475,000 - $4,400,000
Net Working Capital =$1,075,000
Problem 5
Cash Flow from Operating Activities: The Mid-American
Farm Products Corporation provided the following financial
information for the quarter ending September 30, 2009:

Depreciation and amortization = $75,000
Net Income = $225,000
Increase in receivables = $95,000
Increase in inventory = $69,000
Increase in accounts payables = $80,000
Decrease in marketable securities = $34,000.

What is the cash flow from operating activities generated
during this quarter by the firm?
Problem 5
Net Income $225,000

Add depreciation and amortization 75,000
Add decrease in marketable securities 34,000
Add increase in accounts payables 80,000
Less increase in accounts receivables 95,000
Less increase in inventory 69,000

Cash flow from operating activities $250,000
Problem 6
Find operating cash flow
Sales revenue $100,000,000

Depreciation 8,300,000
Cost of Goods Sold 40,000,000
Sales and administrative expenses 7,200,000
Tax rate (30%)
Answer:
OCF = $39,450,000
ADDITIONAL PROBLEMS Problem 7-14

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Financial Statements

1. Explain the foundations of the balance

 Represents the assets owned by the company and

 Based on the accounting identity:

• Net income = Revenues – all expenses (2.3)

• EBIT = Revenues – operating expenses (2.4)

 Preference to classify interest expense as part of

financial cash flow

CASH FLOW FROM ASSETS  CASH FLOW TO CREDITORS

 Change in net working capital (∆NWC)

Cash flow from assets = OCF – NCS - ∆NWC

NCS = End. Net Fixed Assets – Beg. Net Fixed Assets

∆NWC=Ending NWC – Beginning NWC

NCS= ($11,961 - $10,788) + $1,406 = $2,579

Net working capital for 2007 = $9,130 - $6,860 = $2,270

Cash flow from Assets = OCF – NCS - ∆ NWC

Versus Net Income of $5,642

Cash Flow to Creditors = $239 - (-$378) = $617

CASH FLOW FROM ASSETS  CASH FLOW TO

 Fixed Assets = $750,000 - $300,000 = $450,000

 Total Assets ≡ Current Liabilities + Long-term debt +

 $750,000 = $125,000 + Long-term debt + $250,000 + 85,000

 Long-term debt = $750,000 - $125,000-$250,000 - $85,000

 Long-term debt = $290,000

Income Statement. The Top Class Company

Retained Earnings: The West Hanover Clay Co. had,

Balance of Retained Earnings, 10/31/20120….. $958,000

Cash and cash equivalents = $1,225,000;

Net Income $225,000

Sales revenue $100,000,000

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