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Lecture 3
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Accounting and Finance
Understanding financial accounting is essential to
understanding corporate finance.
Key Components of the Financials:
The Balance Sheet
The Income Statement
The Statement of Cash Flows
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The Balance Sheet
The Balance Sheet is a financial statement that shows
the firm’s assets and liabilities at a particular time.
Why is it useful?
Shareholders’ Equity = Total Assets – Total Liabilities
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The Balance Sheet
Current Assets
• Cash & Securities
• Receivables
• Inventories
+
Fixed Assets
• Tangible Assets
• Intangible Assets
___________________
Total Assets
Current Liabilities
• Payables
• Short-term Debt
+
=
Long-term Liabilities
+
Shareholders’ Equity
____________________
Total Liabilities &
Shareholders’ Equity
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Assets
Assets represent the uses of a firm’s funds
i.e. Assets show what the firm “owns”
• Liquid Assets can be converted easily into cash
• Current vs. Fixed Assets
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Current Assets: Examples
Which of the following assets
is typically considered most
liquid? Least liquid?
• Marketable securities
• Accounts receivable
• Inventories
Which of the following is a
current asset?
• Property that a firm
owns
• A firm’s production
equipment
• Unsold inventories
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Fixed Assets
• Tangible Assets – Assets that can be physically seen or touched.
• Intangible Assets – Assets that have no physical existence, yet are still
very valuable for a firm.
• Goodwill - The difference between actual price paid for the acquisition of
a firm and its book value.
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Fixed Assets: Example
 Which of the following represent tangible
assets? Intangible assets?
•
•
•
•
•
•
Property
Production Facilities
Patents
Production Equipment
Trademarks
Copyrights
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Liabilities
Liabilities represent the sources of a firm’s funding.
(i.e. Liabilities represent what a firm “owes.”)
Current vs. Long-Term Liabilities
•Current Liabilities – Liabilities that are likely to be paid off within the next 12 months.
• Examples: accounts payable, debt due for repayment
•Long-Term Liabilities – Liabilities that are not likely to be paid off within the next 12 months.
Current Assets – Current Liabilities = Net Working Capital
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Liabilities: Example
 Current Liability: Obligation to pay a supplier
within 6 months
 Which of the following is a current liability?
• Bond debt that matures in 3 years
• A bank loan that is due in 24 months
• An obligation to pay a supplier within 6 months
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Net Working Capital: Example
In the balance sheet below, what was the value of net working
capital in 2008? 2009?
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Book Values vs. Market Values
 GAAP (Generally Accepted Accounting Principles)
 Book Value
• Value of assets or liabilities according to the balance
sheet.
• Values recorded at their historical cost adjusted for
depreciation
 Market Value
• The value of assets or liabilities were they to be resold
in a market
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Common-Size Balance Sheet
All balance sheet items are expressed as a
percentage of total assets.
Why is this useful?
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Common-Size Balance Sheet:
Example
Note the changes from 2008 to 2009.
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The Income Statement
Income Statement: a financial statement that
shows the revenues, expenses, and net income
of a firm over a period of time.
Why is this useful?
•Common-size Income Statement – All items on the income statement are expressed as a percentage of
revenues.
•EBIT – Earnings Before Income & Taxes
• EBIT = total revenues - costs – depreciation
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Common-size Income Statement
All items on a common-size income statement
are expressed as a percentage of revenues.
Why is this useful?
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Income Statement: Example
In the income statement below, what was the value of Home
Depot’s EBIT in 2009?
Common
Size
Income
Statement
(right column)
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Profits vs. Cash Flow
Differences between profits & cash flow:
Depreciation
Rather than deducting the cost of an investment
entirely when purchased, the accountant makes an
annual charge for depreciation on the firm’s books.
Cash vs. accrual accounting
The process of matching revenues and expenses
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Cash Flows: Example
Consider a firm that spends $1,000 to produce goods in period 1. In period 2,
it sells half of these goods for $750 and collects payment one period later.
The firm sells the other half in period 3 for another $750, and collects
payment on these sales in period 4.
What are the cash flows in each of the 4 periods for the firm?
Period:
1
2
3
4
Sales ($)
0
750
750
0
-Accounts Receivable
0
750
0
(750)
- Cost of Goods Sold
0
500
500
0
- Changes in Inventories
1000
(500)
(500)
0
= Net Cash Flow
(1000)
0
750
750
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The Statement of Cash Flows
The Statement of Cash Flows shows the firm’s
cash receipts and cash payments over time.
Why is it useful?
Free Cash Flow is cash available for distribution
to investors after the firm pays for new
investments or additions to working capital.
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The Statement of Cash Flows
Structure:
Cash flow from operations
-
1. Cash flow from operations – Adjusts net income for the parts of the income
statement that do not involve cash actually coming in or going out.
2. Cash flow from investments – Adjusts the figure from (1) to reflect all capital
expenditures during the period.
3. Cash flow from financing – Adjusts the figure from (2) to reflect the changes in a
firm’s cash flow due to gains (or losses) from financing activities.
Cash flow from
investments
+
Cash flow from
financing
Change in
cash balance
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Cash Flow: Example
Net income for your firm was $10,000 last year. The
depreciation expense was $2,500; accounts receivable increased
$1,250; accounts payable increased $800; and inventories
increased by $2,000.
What was the total cash flow from operations for the period?
Net income:
Depreciation:
Accounts Receivable:
Accounts Payable:
Inventories:
10,000
2,500
(1,250)
800
(2,000)
Cash flow from operations:
10,050
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Accounting Practice
Most managers say that accounting earnings is the
single most important number reported to investors.
What implications does this have for the
investor?
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Accounting Practice
Grey areas for financial managers:
Revenue recognition
Firms record a sale when it is made, not when the
customer actually pays; however the date of sale is
not always obvious.
Cookie-jar reserves
Firms sometimes put cash in separate accounts to be
used in times of distress to create the illusion of
growth even in bad years.
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Accounting Practice
Additional grey areas for financial managers:
Off-balance sheet assets and liabilities
Firms may hide large amounts of resources in off
balance sheet accounts in order to hide potential
liabilities (or assets) from the public.
Mark-to-market accounting
Many assets and liabilities are valued at their
historic cost, not at their current values. This may
make it more difficult to accurately value the firm.
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Corporate Taxes
In the United States, corporations pay tax on their income.
US Corporate Tax Rates, 2011
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Corporate Taxes: Example
What is the marginal tax rate for a corporation with $60,000 taxable
income and an average tax rate of 16.67% if the next-lowest marginal
tax rate of 15% covers taxable incomes up to $50,000?
($60,000) * (16.67%) = $10,000 total taxes paid
Income
Rate
Taxes Paid
$0 - $50,000
15%
$7,500
$50,001 - $60,000
?
$2,500
Total:
$10,000
($10,000) * (marginal tax rate) = $2,500
Marginal Tax Rate = 25%
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Personal Tax
US Personal Tax Rates, 2011
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Personal Tax: Example
What is the average tax rate for an individual with a net
income of $50,000, a total tax liability of $10,704.50, and a
28% marginal tax rate?
Taxable Income = $50,000 + $10,704.50
Tax Liability
$10, 704.50
Average Tax Rate =

 17.63%
Taxable Income 60, 704.50
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The Problem of “Double Taxation”
When a corporation issues a dividend, each dividend dollar is
effectively taxed twice:
1. Each dollar of earnings taxed at corporate rate.
2. Shareholders pay personal income taxes on all dividends
received.
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