Chapter 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.

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 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 –
– The process by which these statements can be
used to project a firm’s future cash flows,

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 2.1 Financial Statements
(continued)
(A) 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)

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 Figure 2.1 Balance sheet

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 2.1 (A) Balance Sheet

Has 5 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 1 year
5. Ownership accounts
• Shareholders’ equity
• Retained earnings—accumulated total since inception

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 2.1 (B) 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 – expenses (2.3)
• EBIT = Revenues – operating expenses (2.4)

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 2.1 (B) Income Statement
example

Figure 2.2

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 2.1 (B) The Income Statement
(continued)
• 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
• Non-cash expense items --depreciation
• Preference to classify interest expense as part of
financial cash flow

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 2.1 (C) The Statement of
Retained Earnings

Figure 2.4

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 2.2 Cash Flow Identity and the
Statement of Cash Flows

The cash flow identity states that the cash

flow on the left-hand side of the balance sheet
is equal to the cash flow on the right-hand
side of the balance sheet.

CASH FLOW CASH FLOW CASH FLOW

FROM ASSETS = TO CREDITORS + TO OWNERS

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 Figure 2.5 Cash Flow Identity
and components

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 2.2 (A) The First Component:
Cash Flow From Assets

3 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 or
OCF = Net Income + Depreciation + Interest Exp.
NCS = End. Net Fixed Assets –Beg. Net Fixed
Assets + Depreciation

∆NWC=Ending NWC – Beginning NWC

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 2.2 (A) The First Component:
Cash Flow From Assets (continued)

OCF = EBIT + Depreciation – Taxes

Figure 2.3

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 2.2 (A) The First Component:
Cash Flow From Assets (continued)

NCS = End. Net – Beg. Net + Depreciation

Fixed Assets Fixed Assets

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

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 2.2 (A) The First Component:
Cash Flow From Assets (continued)

∆NWC=Ending NWC – Beginning NWC

Net working capital for 2014 = $9,130 - $6,860 = $2,270

Net working capital for 2013 = $10,454 - $9,406 = $1,048
Change in NWC = $2,270 - $1,048 = $1,222

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 2.2 (A) The First Component:
Cash Flow From Assets (continued)

• Putting it all together….

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

=$7,287-$2,579-$1,222
=$3,486

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 2.2 (B) The Second Component:
Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense  Net New Borrowing
from Creditors

Net New Borrowing = Ending Long-term Liabilities  Beginning Long-Term

Liabilities

Cash Flow to Creditors = $239 (see Income Statement)

 (-$378)  $617

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 2.2 (C) The Third Component:
Cash Flow To Owners
Cash flow to owners = Dividends – Net new borrowing
from owners

= $2,869 – $0

= $2,869

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 2.2 (C) Putting It All Together:
The Cash Flow Identity

Cash flow from assets =

cash flow from creditors + cash flow to owners

$3,486 = $617 + $2,869

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 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)

– Notes to the Financial Statements

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 2.4 Financial Statements on
the Internet
• EDGAR (www.sec.gov/edgar.shtml)
• Yahoo! Finance (http://finance.yahoo.com.)
• Many, many more websites with wealth of
information

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 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?

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 Additional Problems with Answers
Problem 1 (Answer)

Current Assets + Fixed Assets = Total Assets

$300,000+Fixed Assets = $750,000
Fixed Assets = $750,000 - $300,000 = $400,000
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
 

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 Additional Problems with Answers
Problem 2
Income Statement. The Top Class Company had
revenues of $925,000 in 2014. 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 marginal tax
rate of 34 percent, calculate its net income after
taxes.

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 Additional Problems with Answers
Problem 2 (Answer)

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

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 Additional Problems with Answers
Problem 3
Retained Earnings: The West Hanover Clay Co. had,
at the beginning of the fiscal year, November 1, 2013,
retained earnings of $425,000. During the year ended
October 31, 2014, 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.

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 Additional Problems with Answers
Problem 3 (Answer)

Statement of Retained Earnings for

the year ended October 31, 2014
 
Balance of Retained Earnings, 11/1/2013……….$425,000
 
Add: Net income after taxes, 10/31/2014………. $820,000
Less: Dividends paid for year-end 10/31/2014…$287,000

Balance of Retained Earnings, 10/31/2014….. $958,000

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 Additional Problems with Answers
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.

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 Additional Problems with Answers
Problem 4 (Answer)
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

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 Additional Problems with Answers
Problem 5
Cash Flow from Operating Activities: The Mid-
American Farm Products Corporation provided the
following financial information for the quarter ending
September 30, 2014:
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?

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 Additional Problems with Answers
Problem 5 (Answer)

Net Income 225,000

Add depreciation and amortization 75,000
Add decrease in marketable securities34,000
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

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 Figure 2.6

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 Figure 2.7

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 Figure 2.8a

(cont.)
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 Figure 2.8b

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