Transcript Reviewing Financial Statements

Reviewing Financial Statements
Chapter 2
Fin 325, Section 04 - Spring 2010
Washington State University
1
Introduction
 Corporate managers must issue many reports to
the public. The most attention is paid to the
annual report, which contains
 Balance sheet
 Income statement
 Statement of cash flows
 Statement of retained earnings
 These four statements present an accounting-
based picture of the firm’s financial position.
2
Accounting and Finance
 While accountants focus on reporting what
happened in the past, financial managers use
financial statements to determine what should
happen now and in the future
 Firms must follow Generally Accepted Accounting
Principles (GAAP) when creating these
statements, but they still have substantial
discretion
3
Balance Sheet
 The balance sheet reports a firm’s assets (what it owns),
liabilities (what it owes), and equity at a particular point
in time.
Assets = Liabilities + Equity
 The left side of a balance sheet lists the assets of the firm
in order of liquidity
 The right side of the balance sheet lists the liabilities in
order of maturity. Equity, which never matures, is listed
last
4
Assets
 Assets fit into two major categories: current
assets and fixed assets
 Current Assets
 Will normally convert into cash within a year
 Cash (and marketable securities)
 Accounts receivable
 Inventory
 Fixed Assets
 Have a useful life exceeding one year
 Net plant and equipment (Gross plant and equipment
less accumulated depreciation)
 Less tangible assets, such as patents and trademarks
5
Liabilities
 Lenders provide funds, which become
liabilities to the firm.
 Current liabilities
 Obligations due within one year
 Accruals (accrued wages and accrued taxes)
 Accounts payable
 Notes payable
 Long-term debt
 Long-term loans and bonds with maturities of
more than one year
6
Equity
 The difference between total assets and total
liabilities is the stockholders’ (or owners’)
equity.
 Types of Equity
 Preferred Stock
 Common Stock
 Retained Earnings
 The retained earnings account on the balance sheet
represents the cumulative amount retained over the years.
7
Accounting method for fixed asset depreciation
 Managers can choose the accounting method they use to
record depreciation against their fixed assets.
 straight-line method of depreciation
 For reporting purposes
 reports lower depreciation expenses in the earlier years,
resulting in higher income for reporting to shareholders
 Accelerated depreciation such as MACRS (modified accelerated
cost recovery system)
 For tax purposes
 results in higher depreciation expenses in earlier years,
leading to lower income and thus lower taxes.
8
Balance Sheet Example
9
Net Working Capital
 Net Working Capital = Current Assets Current Liabilities
 For DPH Tree Farms for 2008:
 NWC = $205 - $120
 NWC = $ 85 million
 Firms monitor net working capital as a
measure of the firm’s ability to pay its
obligations
 In general, a financially healthy firm has
positive NWC
10
Book Value versus Market Value
 A firm’s balance sheet shows book value, or historical cost,
according to GAAP
 Under GAAP, the value of assets on the balance sheet shows
what the firm paid for them regardless of what they may be
worth today
 For current assets the difference will be small, but for fixed
assets the difference is likely huge
 Similarly, stockholders’ equity on the balance sheet is
generally greatly different than the true market value of the
equity
 Book value of equity represents the historical value of
contributed equity, while the market value of equity
represents the value of the firm in the market, which depends
on the present value of future cash flows
11
Income Statement
 Income statements show the total revenues
and expenses of a firm over a specific
period of time
12
Income Statement Example
Operating
Income
Finance &
Taxes
13
 Items reported below the bottom line include:
Earningsper share (EPS) 
net income
totalsharesof common stockoutstanding
Dividendsper Share (DPS) 
commonstockdividends paid
number of sharesof common stockoutstanding
Book valueper share (BVPS) 
commonstockholders equity
number of sharesof common stockoutstanding
Market val
ue per share(MVPS)  themarketpriceof thefirm's commonstock
14
Corporate Income Taxes
 Firms pay out a large portion of their earnings in
taxes (Microsoft paid $4.4 billion in taxes in 2005,
or 26 percent of EBT)
 The tax code is determined by Congress, and so is
subject to frequent changes
 The tax code is extremely complex. But taxes are
so important that firms cannot ignore it
15
Tax Code Example
The U.S. tax structure is progressive, meaning that the
larger the income, the higher the tax rate
16
Average and Marginal Tax Rate
 Average tax rate:
Average tax rate 
tax liability
taxable income
 Marginal tax rate - the amount of taxes must pay
on the next $1 in income
 Marginal tax rate is the most relevant rate for
financial decision making.
17
Example
 Indian Point Kennels earned $16.5 million
in taxable income in 2007. Their tax
liability can be determined as:
Tax liability = Tax on base amount + tax rate (amount over base)
Tax liability = $5,150,000 + .38($16,500,000 - $15,000,000)
Tax liability = $5,720,000
The average tax rate
= $5,720,000/$16,500,000
= 34.67%
 The marginal tax rate is 38 percent
18
Interest and Dividend Received
 Interest that corporations receive is taxable
 Exception: interest on state and local government
bonds is exempt from federal taxes
 When corporations own stock in another
corporation they may receive dividend income.
 The tax code exempts 70 percent of this income
from taxation. Only the remaining 30 percent is
taxed.

This reduces the effect of triple taxation
19
Interest and Dividend Paid
 Interest and Dividends Paid by the Corporation
 Interest payments appear on the income statement
and are deducted from income before calculating
taxable income
 Dividends, on the other hand, are paid with aftertax income and so are not tax deductible
 This tax deductibility of interest makes debt a much
cheaper form of financing than equity
20
Statement of Cash Flows
 The statement of cash flows shows the
firm’s cash flows over a period of time.
 It includes only inflows and outflows of
cash and marketable securities. It excludes
transactions that do not directly affect cash
receipts and payments, such as
depreciation and write-offs on bad debts.
 The bottom line of the statement reflects
the difference between cash sources and
uses and equals the change in cash on the
firm’s balance sheet
21
Sources and Uses of Cash
 Some activities increase cash, and some
activities decrease cash.
 Sources of cash involve increasing liabilities
(or equity) and decreasing assets.
 Uses of cash involve decreasing liabilities
(or equity) and increasing assets.
 The statement of cash flows is a cash basis
report on three types of financial activities:
operating activities, investing activities,
and financing activities.
22
Cash Flows from Operations
 Cash flows from operations, represents
items directly associated with producing
and selling the firm’s products.
 Net income
 Depreciation
 Working capital accounts other than cash and
short-term debt
 A stable, positive CFs from operations
represent a financially healthy and
successful firm.
23
Cash Flows from Investing Activities
 Cash flows associated with buying or selling fixed
or other long-term assets
 This section of the statement of cash flows reflects
the firm’s investment in fixed assets (NOT in
financial assets)
24
Cash Flows from Financing Activities
 Cash flows from debt and equity financing
transactions
 Issuing short- or long-term debt
 Issuing stock (IPOs or SEOs)
 Using cash to pay dividends
 Using cash to pay off debt
 Using cash to buy back stock
25
Cash Flows
 The bottom line of the statement of cash flows
shows the total of cash flows from operation,
investing, and financing activities
 To maintain cash flows over time, a firm must
continuously replace working capital and
depreciating fixed assets, and develop new
products
 Free cash flows (FCF) are the cash flows
available to pay the firm’s stockholders and
debt holders.
26
Free Cash Flow
FCF = OCF - IOC
= Operating Cash Flow – Investment in Operating Capital
 Operating cash flow (OCF)
OCF = EBIT – Taxes + Depreciation
 Investment in operating capital (IOC)
IOC = ∆Gross fixed assets + ∆Net operating working capital
FCF = (EBIT – Taxes + Depreciation) – (∆Gross fixed
assets + ∆Net operating working capital)
27
 A positive Free Cash Flow means that the
firm has funds that can be distributed to
investors
 A negative FCF might mean several things:
 If FCF is negative due to negative OCF it may indicate
that the firm is experiencing operating or managerial
problems
 FCF might be negative because the firm is investing
heavily in operating capital to support growth

In this case FCF might be negative while OCF is
positive
28
Statement of Retained Earnings
 Provides additional detail about the change in
retained earnings during a reporting period
 Reconciles net income and dividends paid with
changes in retained earnings from one period to
the next:
Beginning retained earnings
+ net income for period
- cash dividends paid
= Ending retained earnings
29
Cautions in Interpreting Financial Statements
 While firms must follow GAAP in
preparing their financial statements, firms
have considerable latitude in using
accounting rules
 Firms can “smooth” earnings, for example for
new managers to show growth
 Different depreciation methods
 These strategies are called earnings
management

Sarbanes Oxley Act of 2002 was passed in an effort to
prevent deceptive accounting and management
practices brought to light in high-profile scandals such
as Enron and WorldCom
30