Chapter2 2023

Chapter 2
Financial Statements,
Taxes, and Cash Flow
Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-1

Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 The Statement of Cash Flows
2.4 Summary and Conclusions

• Accounting:how firms consolidate international financial
statements; and how to calculate and interpret financial ratios
for decision making.
• Information systems: what data are included in the firm’s
financial statements in order to design systems that will
supply such data
• Management:how the financial statements will be analyzed
by those both inside and outside the firm to assess various
aspects of performance.

• Marketing: To understand the effects your decisions
will have on the financial statements, how analysis of ratios,

especially those involving sales figures, will affect the firm’s
decisions about levels of inventory, credit policies, and pricing
decisions.
• Operations: how assets, cost of goods sold, or inventory,

may affect requests for new equipment or facilities
• Investors: Estimating price of their stocks.

Sources of Information
• Annual reports
• Wall Street Journal
• Internet
– NYSE (www.nyse.com, Nasdaq (www.nasdaq.com)
– Text (www.mhhe.com)
– HASTC (http://hnx.vn/web/guest/home) ;
– HOSE http://www.hsx.vn/
• SEC
– EDGAR
– 10K & 10Q reports
Firms’ Disclosure of Financial
Information
• Financial statements are accounting reports

issued periodically to present past
performance.
• Investors, financial analysts, managers,
and other interested parties such as
creditors rely on financial statements to
obtain reliable information about a
corporation

Information
• Public companies must file financial results

with the Securities and Exchange
Commission (SEC)
• The annual report with financial statements
must be sent to their shareholders every
year

Information
• Preparation of Financial Statements

– Generally Accepted Accounting Principles (GAAP)
• Set by the Financial Accounting Standards Board
(FASB)
• Corporations are required to hire an auditor :
– Check the annual financial statements
– according to GAAP
– the information is reliable

Information
– International Financial Reporting Standards
• International Accounting Standards Board (IASB)
– Established in 2001 by representatives from 10 countries
– Since 2005 all publicly traded European Union companies
– Used by many other countries, including Australia,
several countries in Latin America and Africa
– Accepted by all major stock exchanges around the world
except U.S. and Japan

Information

– Convergence to IFRS in the United States is
likely in the near future
• The Sarbanes-Oxley Act of 2002 included a provision
that U.S. accounting standards move toward
international convergence

• Statement of Financial Position

• Provides a snapshot of the firm’s financial
position at a given point in time
• three concerns: accounting liquidity, debt
versus equity, and value versus cost.

• The Balance Sheet Identity

The Balance Sheet of the U.S. Composite
Corporation
U.S. COMPOSITE CORPORATION
Balance Sheet
2012 and 2011
(in $ millions)
Liabilities (Debt)
Assets 2012 2011 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:
Deferred taxes $117 $104
Fixed assets: Long-term debt 471 458
Property, plant, and equipment $1,423 $1,274 Total long-term liabilities $588 $562
Less accumulated depreciation -550 -460
Net property, plant, and equipment 873 814 Stockholder's equity:
Intangible assets and other 245 221 Preferred stock $39 $39
Total fixed assets $1,118 $1,035 Common stock ($1 per value) 55 32
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's $1,879 $1,742
equity
Accounting Liquidity
• Current assets are the most liquid.

• The more liquid a firm’s assets, the less
likely the firm is to experience problems
meeting short-term obligations.

• Current Assets
– Cash and other marketable securities
– Accounts receivable
– Inventories
– Other current assets

• Long-Term Assets
– Assets that produce benefits for more than one
year reduced through a yearly deduction called
depreciation
– The book value of an asset is its acquisition cost
less its accumulated depreciation
– Other long-term assets can include such items
as property not used in business operations,
start-up costs in connection with a new
business, trademarks and patents, and property
held for sale

• Liabilities
– Current Liabilities
• Accounts payable
• Notes payable and short-term debt
• Accrual items

• NWC

The Balance Sheet of the U.S.C.C.
Balance Sheet
$252m = $707- 2012 and 2011
(in $ millions)
$455 Liabilities (Debt)
Assets 2012 2011 and Stockholder's Equity2012 2011
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$117
Deferred taxes grow$104
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
-550 -460 to $275 million in $588
Long-term debt
2012
471
Total long-term liabilities
458
$562
Net property, plant, and equipment
Intangible assets and other 245
873 814
221
from $252 million in
Stockholder's equity:
Total fixed assets $1,118 $1,035 20X1.
$23 million
Preferred stock $39 $39
Common stock ($1 par value) 55 32
$275m = $761m- $486m This Capital surplus

increase
Accumulated of $23
retained earnings
347
390
327
347
Less treasury stock -26 -20
million
Total equityis an investment $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's $1,879
equity $1,742
of the firm.
• Liabilities
– Long-Term Liabilities
• Long-term debt
– A loan or debt obligation maturing in more than a year
• Stockholders’ Equity
– Market Value Versus Book Value
• Market capitalization

• The income statement lists the firm’s

revenues and expenses over a period of
time
• The last or “bottom” line of the income
statement shows net income
– A measure of its profitability during the period
– Also referred to as the firm’s earnings

U.S.C.C. Income Statement
Income Statement
2012
(in $ millions)
Total operating revenues $2,262

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

Income Statement
2012
(in $ millions)

The non- Cost of goods sold - 1,655
operating Selling, general, and administrative expenses - 327
Depreciation - 90
section of
Operating income $190
the income Other income 29
statement Earnings before interest and taxes $219
Interest expense - 49
includes all Pretax income $170
financing Taxes - 84
costs. Current: $71
Deferred: $13
Net income $86
Dividends: $43

Income Statement
20X2
(in $ millions)

Usually a Cost of goods sold - 1,655
separate
Depreciation - 90
section Operating income $190
reports Other income 29
as a Interest expense - 49
separate Pretax income $170
item the Taxes - 84
Current: $71
amount Deferred: $13
of taxes Net income $86
levied on Retained earnings: $43
Dividends: $43
income.
Income Statement
20x2
(in $ millions)

Cost of goods sold - 1,655
Depreciation - 90
Operating income $190
Other income 29
Interest expense - 49
Net income is Pretax income $170
the “bottom Taxes - 84
Current: $71
line”. Deferred: $13
Net income $86
Dividends: $43

• Earnings Per Share
Fully diluted EPS increases number of shares by:

• Stock options issued to employees
• Shares issued due to conversion of
convertible bonds

2.2 Income Statement
• EBITDA
– Financial analysts often compute a firm’s
earnings before interest, taxes, depreciation,
and amortization, or EBITDA
– depreciation and amortization are not cash
flows.

2.2 Income Statement
• There are three things to keep in mind when

analyzing an income statement:
1. GAAP
2. Non Cash Items
3. Time and Costs

• The firm’s statement of cash flows uses the

information from the income statement and
balance sheet
• Cash is important

- Operating activities
– Investment activities
– Financing activities

Table 2.3
Global
Corporation’s
Statement of
Cash Flows for
2013 and 2012

• Operating Activity
– Use the following guidelines to adjust for
changes in working capital:
• Accounts receivable:
– Adjust the cash flows by deducting the increases in
accounts receivable
– This increase represents additional lending by the firm to
its customers and it reduces the cash available to the
firm

– Accounts payable:
• Similarly, we add increases in accounts payable
• Accounts payable represents borrowing by the firm
from its suppliers
• This borrowing increases the cash available to the firm

– Inventory:
• deduct increases to inventory
• Increases to inventory are not recorded as an expense
and do not contribute to net income
• the cost of increasing inventory is a cash expense for
the firm and must be deducted
– add depreciation to net income

• Investment Activity
– Subtract the actual capital expenditure that the
firm made
– deduct other assets purchased or investments
made by the firm, such as acquisitions

• Financing Activity
• Dividends paid
• Cash received from sale of stock or spent repurchasing
its own stock
• Changes to short-term and long-term borrowing

• Financing Activity
– Payout Ratio and Retained Earnings
Retained Earnings = Net Income – Dividends
Dividends
Payout Ratio =
Net Income

Sample Balance Sheet
Numbers are in thousands
2010 2009 2010 2009

Cash & 3,171 6,489 A/P 313,286 340,220
Equivalents
A/R 1,095,118 1,048,991 N/P 227,848 86,631
Inventory 388,947 295,255 Other CL 1,239,651 1,098,602
Other CA 314,454 232,304 Total CL 1,780,785 1,525,453
Total CA 1,801,690 1,583,039 LT Debt 1,389,615 871,851
Net FA 3,129,754 2,535,072 C/S 1,761,044 1,648,490
Total Assets 4,931,444 4,118,111 Total Liab. 4,931,444 4,118,111

& Equity

Sample Income Statement
Numbers are in thousands, except EPS & DPS
Revenues 4,335,491
Cost of Goods Sold 1,762,721
Expenses 1,390,262
Depreciation 362,325
EBIT 820,183
Interest Expense 52,841
Taxable Income 767,342
Taxes 295,426
Net Income 471,916
Additions to retained earnings ?
Dividends Paid 395,521

Sources and Uses of Cash
LO
1
• Sources
– Cash inflow – occurs when we “sell” something
– Decrease in asset account
– Increase in liability or equity account
• Uses
– Cash outflow – occurs when we “buy” something
– Increase in asset account
– Decrease in liability or equity account

Statement of Cash Flows
LO
1
• Statement that summarizes the sources and

uses of cash
• Changes divided into three major categories
– Operating Activity – includes net income and
changes in most current accounts
– Investment Activity – includes changes in fixed
assets
– Financing Activity – includes changes in notes
payable, long-term debt and equity accounts as
well as dividends

Sample Statement of Cash Flows
LO
1
Numbers are in thousands
Cash, beginning of year 6,489 Financing Activity
Operating Activity Increase in Notes Payable 141,217
Net Income 471,916 Increase in LT Debt 517,764
Plus: Depreciation 362,325 Decrease in C/S -36,159
Increase in Other CL 141,049 Dividends Paid -395,521
Less: Increase in A/R -46,127 Net Cash from Financing 227,301
Increase in Inventory -93,692 Net Decrease in Cash -3,319
Increase in Other CA -82,150 Cash End of Year 3,170*
Decrease in A/P -26,934
Net Cash from Operations 726,387
Investment Activity
Fixed Asset Acquisition -
957,007
Net Cash from - *Difference due to rounding of dividends
Investments 957,007

2.4 Financial Cash Flow
• The cash from received from the firm’s assets

must equal the cash flows to the firm’s
creditors and stockholders.
CF(A)≡ CF(B) + CF(S)

Financial Cash Flow of the
U.S.C.C. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm

Operating cash flow $238 Operating Cash Flow
(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
OCF $238
Cash Flow of Investors in the Firm
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

Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238
plus depreciation minus taxes)
Capital
Capital spending (173) Spending
(Acquisitions of fixed assets
minus sales of fixed assets) Purchase of fixed
Additions to net working capital (23) assets $198
Total $42
Sales of fixed assets
(25)
Debt $36
(Interest plus retirement of debt Capital Spending
minus long-term debt financing) $173
Equity 6
Total $42

Financial Cash Flow
20X2
(in $ millions)

Operating cash flow $238 NWC grew
plus depreciation minus taxes) from $275
Capital spending (173) million in
minus sales of fixed assets) 20X2 from
Additions to net working capital (23)
Total $42
$252 million
in 20X1.
Debt $36
(Interest plus retirement of debt This
Equity 6
increase of
(Dividends plus repurchase of $23 million
Total $42
is the
addition to
Copyright ©2015 Pearson Education, Inc. All rights reserved.
NWC. 2-46
U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238
minus sales of fixed assets)
Total $42
Debt $36
Equity 6
Total $42

U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238 Cash Flow to
(Earnings before interest and taxes Creditors
Interest $49
(Acquisitions of fixed assets Retirement
minus sales of fixed assets) of debt 73
Total $42 Debt service
122
Debt $36 Proceeds from
(Interest plus retirement of debt new debt sales
minus long-term debt financing) (86)
Equity 6 Total 36
Total $42

Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238 Cash Flow to
(Earnings before interest and taxes Stockholders
plus depreciation minus taxes) Dividends
Capital spending (173) $43
minus sales of fixed assets) Repurchase of
Additions to net working capital (23) stock
Total $42 6
Cash Flow of Investors in the Firm Cash to
Debt $36 Stockholders 49
minus long-term debt financing) Proceeds from
Equity 6 new
(Dividends plus repurchase of stock issue
equity minus new equity financing) (43)
Total $42 Total $6

U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238 The cash from
(Earnings before interest and taxes received from
plus depreciation minus taxes) the firm’s
(Acquisitions of fixed assets assets must
minus sales of fixed assets) equal the cash
Additions to net working capital (23) flows to the
Total $42
firm’s
Cash Flow of Investors in the Firm creditors and
Debt $36 C F ( A) 
stockholders:
minus long-term debt financing) C F (B ) + C F (S )
Equity 6
Total $42

2.5 Other Financial Statement
Information
• Statement of Stockholders’ Equity

– Change in Stockholders’ Equity
= Retained Earnings + Net Sales of Stock
= Net Income – Dividends + Sales of Stock –
Repurchases of stock
• Management Discussion and Analysis
• Notes to the Financial Statements

2.6. Taxes
• The one thing we can rely on with taxes is

that they are always changing
• Marginal vs. average tax rates
▪ Marginal tax rate – the percentage
paid on the next dollar earned
▪ Average tax rate – the tax bill / taxable income
▪ Average tax rates vary widely across different
companies and industries
• Other taxes

2-52
2.6. Taxes

2.6. Taxes
• your corporation has earnings for the

year of $300,000:
• The fourth line is $100,000 to $335,000, so
that's the line you use.
• The tax is $22,500 plus 39% of the amount
over $100,000.
• 39% of 200,000 is $78,000.
• The total tax is $22,500 plus $78,000,
equals $100,500.

2.6. Taxes
• Suppose your firm earns $4 million in taxable

income.
▪ What is the firm’s tax liability?
▪ What is the average tax rate?
▪ What is the marginal tax rate?

2-55
2.6. Taxes
• Tax liability:
.15(50,000) + .25(75,000 – 50,000) +
.34(100,000 – 75,000) + .39(335,000 –
100,000) + .34(4,000,000 – 335,000) =
$1,360,000
• Average rate: 1,360,000 / 4,000,000 = .34

or 34%

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Chapter 2

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will have on the financial statements, how analysis of ratios,

• Operations: how assets, cost of goods sold, or inventory,

• Investors: Estimating price of their stocks.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-4

• Financial statements are accounting reports

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• Public companies must file financial results

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• Preparation of Financial Statements

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• Preparation of Financial Statements

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• Statement of Financial Position

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• The Balance Sheet Identity

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• Current assets are the most liquid.

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$275m = $761m- $486m This Capital surplus

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• The income statement lists the firm’s

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Total operating revenues $2,262

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Total operating revenues $2,262

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Total operating revenues $2,262

Total operating revenues $2,262

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• Earnings Per Share

Fully diluted EPS increases number of shares by:

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• There are three things to keep in mind when

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• The firm’s statement of cash flows uses the

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Retained Earnings = Net Income – Dividends

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2010 2009 2010 2009

Inventory 388,947 295,255 Other CL 1,239,651 1,098,602

Other CA 314,454 232,304 Total CL 1,780,785 1,525,453