Financial Statements and Analysis

1) why income statements come before cash flow and balance sheet
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Income statements typically come before cash flow statements and balance sheets in financial
reporting because they provide information about a company's revenue, expenses, and profitability
over a specific period. Here are a few reasons why income statements are usually prepared first:

1. Focus on Performance: Income statements focus on the company's financial performance

and its ability to generate revenue and manage expenses. They provide a summary of the
company's operating activities, including sales, costs of goods sold, operating expenses, and
net income. By presenting this information first, stakeholders can assess the company's
financial performance during a specific period.
2. Timeliness of Revenue and Expenses: Income statements are prepared on an accrual basis,
meaning they recognize revenue and expenses when they are earned or incurred, regardless
of when the actual cash inflows or outflows occur. This allows for a more accurate
representation of the company's financial performance during the period, regardless of the
timing of cash transactions.
3. Basis for Calculating Net Income: Net income, which is the key metric on the income
statement, is used in various financial ratios and analysis. It serves as a starting point for
assessing profitability and financial health. Cash flow statements and balance sheets rely on
the accuracy of net income figures to calculate other financial metrics.
4. Sequential Flow of Financial Information: Financial statements are typically presented in a
specific order to provide a sequential flow of information. Income statements are the starting
point, followed by the cash flow statement, which provides details on the sources and uses of
cash during the period. Finally, the balance sheet summarizes the company's financial
position at a specific point in time.

While income statements provide valuable information about a company's profitability, cash flow
statements and balance sheets offer insights into a company's liquidity, financial position, and cash
flow dynamics. Together, these financial statements provide a comprehensive view of a company's
financial performance, cash flow generation, and overall financial health.

2) What is the difference between book value and market value? Which should we use for
decision-making purposes? What is the difference between accounting income and cash
flow? Which do we need to use when making decisions? What is the difference between
average and marginal tax rates? Which should we use when making financial decisions?
How do we determine a firm’s cash flows? What are the equations, and where do we find
the information?

1. Book Value vs. Market Value:

 Book Value: Book value refers to the value of an asset or a company's equity as
recorded on its balance sheet. It is calculated by subtracting accumulated
depreciation, amortization, and liabilities from the total assets or equity. Book
value represents the historical cost of the asset or equity.
 Market Value: Market value, on the other hand, is the current value of an asset or
a company's equity in the marketplace. It is determined by the supply and
demand dynamics in the market and reflects the price at which an asset can be
 bought or sold. Market value takes into account factors such as market
sentiment, future growth prospects, and other market conditions.

For decision-making purposes, market value is generally considered more relevant

because it reflects the current market perception and factors in expectations of future
performance. Market value is often used to determine the value of investments, to
assess the market capitalization of a publicly traded company, or to evaluate the
potential sale price of an asset. However, book value can still be useful in certain
situations, such as when analyzing the financial health of a company or assessing the
value of long-term assets.

2. Accounting Income vs. Cash Flow:

 Accounting Income: Accounting income, also known as net income or profit, is
the financial performance of a company as reported in its income statement. It is
calculated by subtracting expenses from revenues using the accrual accounting
method. Accounting income includes non-cash items such as depreciation and
deferred taxes and may not directly reflect the actual cash inflows and outflows
of a business.
 Cash Flow: Cash flow, on the other hand, represents the actual movement of cash
in and out of a company during a specific period. It includes cash receipts from
sales, cash payments for expenses, investments, and financing activities. Cash
flow provides a more direct measure of a company's liquidity and its ability to
generate cash from its operations.

When making decisions, cash flow is generally considered more relevant as it directly
measures the cash position and cash-generating ability of a company. Cash flow helps
assess the company's ability to meet its short-term obligations, invest in new projects,
pay dividends, and withstand unexpected events. However, accounting income is still
important for evaluating profitability and for compliance with accounting standards and
reporting requirements.

3. Average Tax Rate vs. Marginal Tax Rate:

 Average Tax Rate: The average tax rate is calculated by dividing the total tax
liability by the taxable income. It represents the overall tax burden as a
percentage of income.
 Marginal Tax Rate: The marginal tax rate is the tax rate applied to the next dollar
of taxable income. It represents the tax rate that applies to an additional unit of
income.

When making financial decisions, the marginal tax rate is typically more relevant. It helps
determine the tax impact of incremental changes in income or expenses. The marginal
tax rate is crucial for analyzing the financial implications of business decisions such as
expanding operations, making additional investments, or considering changes in pricing
strategies. It helps assess the after-tax profitability of specific actions.
 4. Determining Cash Flows: To determine a firm's cash flows, you can use the
following equations:
 Operating Cash Flow (OCF): OCF = Net Income + Depreciation + Amortization ±
Changes in Working Capital
 Free Cash Flow (FCF): FCF = OCF - Capital Expenditures

Information required to calculate these cash flow components can be found in the
company's financial statements, specifically the income statement and the statement of
cash flows. Net income is reported on the income statement, and depreciation and
amortization are usually included as separate line items. Changes in working capital can
be derived by comparing the current and previous period's balance sheet.

Capital expenditures, which are used to calculate free cash flow, can be obtained from
the company's investing activities section in the statement of cash flows. Additionally,
information on cash inflows and outflows from operating activities can be found in the
statement of cash flows.

It's important to note that these equations provide a general framework for calculating
cash flows, but specific adjustments or considerations may be necessary depending on
the nature of the business and its cash flow drivers.

5) What is the statement of cash flows, and what are some questions it answers? Identify and
briefly explain the four sections shown in the statement of cash flows. If during the year a
company has high cash flows from its operations, does this mean that cash on its balance sheet
will be higher at the end of the year than it was at the beginning of the year? Explain

1. Statement of Cash Flows: The statement of cash flows is a financial statement that
provides information about the cash inflows and outflows of a company during a
specific period. It summarizes the sources and uses of cash and helps
stakeholders understand the company's ability to generate cash from its
operations, finance its investments, and meet its financing obligations.

Some questions the statement of cash flows answers include:

 Where did the company's cash come from?

 How was the cash used during the period?
 What were the cash flows from operating activities, investing activities, and
financing activities?
 Did the company generate or consume cash during the period?
 What is the net change in cash and cash equivalents?
2. Sections of the Statement of Cash Flows: a) Operating Activities: This section
reports the cash flows resulting from the company's core operations. It includes
cash inflows from sales, interest received, and dividends received, as well as cash
outflows for payments to suppliers, employees, and interest expenses. It provides
 insights into the company's ability to generate cash from its day-to-day
operations.

b) Investing Activities: This section reflects the cash flows related to the acquisition or
disposal of long-term assets and investments. It includes cash inflows from the sale of
assets or investments and cash outflows for the purchase of assets, investments, or
business acquisitions. It provides information about the company's investment decisions
and capital expenditures.

c) Financing Activities: This section presents the cash flows associated with obtaining or
repaying funds to finance the company's operations or investments. It includes cash
inflows from issuing equity or debt instruments and cash outflows for debt repayments,
dividends paid, or share repurchases. It reveals how the company raises capital and
manages its financing obligations.

d) Net Change in Cash: This section summarizes the net cash increase or decrease
during the period by combining the cash flows from operating, investing, and financing
activities. It indicates the overall change in the company's cash position.

3. Cash Flows from Operations and Cash on the Balance Sheet: High cash flows
from operations during the year do not necessarily mean that cash on the
balance sheet will be higher at the end of the year than at the beginning. The
cash flows from operations reflect the cash generated from the company's core
activities, such as sales and collections from customers, but it doesn't account for
other factors that affect the company's cash position.

The ending cash balance on the balance sheet is influenced by various factors, including
cash flows from operations, cash flows from investing and financing activities, and other
changes in the company's cash position, such as capital expenditures, debt repayments,
dividend payments, and changes in working capital.

Therefore, even if a company has high cash flows from operations, the ending cash
balance can still be influenced by other cash flows and financial decisions made during
the year. It's essential to consider the entire statement of cash flows and other financial
statements to assess the overall impact on the company's cash position.

6) Why is earnings per share called “the bottom line”? What is EBIT, or operating income? What is
EBITDA? Which is more like a snapshot of the firm’s operations—the balance sheet or the income
statement? Explain your answer

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1. Earnings per Share (EPS) and "the Bottom Line": Earnings per share (EPS) is called "the
bottom line" because it represents the net income attributable to each outstanding share of
common stock. It is considered the final figure at the bottom of the income statement, which
reflects the profitability of a company on a per-share basis. EPS is a widely used measure of a
company's financial performance and is often used by investors to evaluate the profitability
of their investment.
 2. EBIT (Operating Income): EBIT stands for Earnings Before Interest and Taxes, and it is also
referred to as operating income. It represents a company's profitability from its core
operations before taking into account interest expenses and income taxes. EBIT is calculated
by subtracting operating expenses (such as cost of goods sold, operating expenses, and
depreciation) from the company's total revenue.

EBIT provides an indication of a company's ability to generate operating profits from its main
business activities. It allows for comparison of operating performance across different companies, as
it excludes the impact of interest payments and tax considerations.

3. EBITDA: EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It
is a measure of a company's operating performance that excludes the effects of non-
operating expenses, such as interest, taxes, depreciation, and amortization.

EBITDA is often used as an indicator of a company's cash flow from operations and its ability to
generate operating profits. It provides insight into the company's operational efficiency and
profitability before considering non-operational factors.

4. Snapshot of Firm's Operations: While both the balance sheet and the income statement
provide important information about a company's financial performance, the income
statement is considered more like a snapshot of the firm's operations.

The income statement summarizes a company's revenues, expenses, gains, and losses over a specific
period, typically a year or a quarter. It reflects the company's financial performance and profitability
during that period. It shows the revenue generated, the expenses incurred, and the resulting net
income or net loss.

On the other hand, the balance sheet provides a snapshot of the company's financial position at a
specific point in time. It presents the company's assets, liabilities, and shareholders' equity. The
balance sheet shows what the company owns, owes, and the residual value for shareholders.

While the balance sheet provides information about the company's financial position, it does not
directly reflect the company's operational performance or profitability. It provides a static picture of
the company's resources and obligations, whereas the income statement captures the dynamic
aspect of the company's operations and financial performance over a specific period.

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