Transcript Financial statements " Final"

FIN 3000
Chapter 3
Financial Statements
Motaz Alsolaim
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Overview
An Overview of the Firm’s Financial Statements .1
The Income Statement
Corporate Taxes
The Balance Sheet
The Cash Flow Statement
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.2
.3
.4
.5
Learning Objectives
Understand the content of the 4 basic financial statements. .1
Focus on
Income statement ①
Balance sheet statement ②
Cash flow statement ③
Evaluate firm profitability using the income statement. .2
Estimate a firm’s tax liability using the corporate tax .3
schedule and distinguish between the average and marginal
tax rate.
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Principles Used in This Chapter
Principle 1: Money Has a Time Value.
•
We need to recognize that financial statements do not adjust for time –
value of money.
Principle 3: Cash Flows Are the Source of Value. •
Financial statements provide an important starting point in determining –
the firm’s cash flow.
We should be able to distinguish between reported earnings and cash –
flow. It is possible for a firm to report positive earnings but have no cash!
Principle 4: Market Prices Reflect Information.
Firm’s financial statements provide important information that is used by –
investors in forming expectations about firm’s future prospects and
subsequently, the market prices.
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•
Basic Financial Statements
Three types of financial statements are mandated by the accounting and 
financial regulatory authorities:
Income statement – how much money you made last year?
.1
Revenue, expense, profits over a year or quarter. 
Balance sheet – What’s your current financial situation?
.2
a snap shot on a specific date of
Assets (value of what the firm owns), 
Liabilities (value of firm’s debts), and 
Shareholder’s equity (the money invested by the company owners) 
Cash flow statement – How did the cash come and go?
cash received and cash spent by the firm over a period of time
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.3
Why Study Financial Statements?
Assess current performance through financial .1
statement analysis
Next chapter provides more tools for the analysis.
•
Monitor and control operations, and .2
Both insiders (such as managers, board of directors) and
outsiders (such as suppliers, creditors, investors) use the
statements to monitor and control the firm’s operations.
•
Forecast future performance. .3
Financial planning models are typically built using the
financial statements
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•
Three Accounting Principles
The revenue recognition principle: Revenue should be included in the
income statement for the period in which:
Its goods and services were exchanged for cash or accounts receivable; or
The firm has completed what it must do to be entitled to the cash.
.1
–
–
The matching principle: Expenses are matched with the revenues they
helped produce.
.2
For example, employees’ salaries are recognized when •
the product produced as a result of that work is sold,
and not when the wages were paid.
The historical cost principle: Most assets and liabilities are reported in the
7financial statements at historical cost, i.e., the price the firm paid to
acquire them. The historical cost generally does not equal the current
market value of the assets or liabilities.
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.3
An Income Statement
Sales
Minus Cost of Goods Sold 
= Gross Profit
Minus Operating Expenses
Selling expenses 
General and Administrative expenses 
Depreciation and Amortization Expense 
= Operating income (EBIT)
Minus Interest Expense
= Earnings before taxes (EBT)
Minus Income taxes
= Net income (EAT)
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
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
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
Sample Income Statement
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Evaluating a Firm’s EPS
We can use the income statement to determine the earnings per share
(EPS) and dividends.
EPS = Net income/Number of shares outstanding
Example 1: A firm reports a net income $90 million and has 35 million
shares outstanding, what will be the earnings per share (EPS)?
EPS = Net income ÷ Number of shares
= $90 million ÷ $35 million
= $2.57
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





Evaluating a Firm’s Dividends per share
Dividends per share = Dividends paid ÷ Number 
of shares
Example 2: A firm reports dividend payment of 
$20 million on its income statement and has 35
million shares outstanding. What will be the
dividends per share?
Dividends per share = dividend payment ÷ 
Number of shares
= $20 million ÷ $35 million
= $0.57
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Connecting the Income Statement and
the Balance Sheet
What can the firm do with the net income?: •
Pay dividends to shareholders, and/or .1
Reinvest in the firm .2
Example 3: Review examples 1 & 2. How much •
was retained or reinvested by the firm?
Amount retained = Net Income – Dividends •
= $90m - $20m = $70m
The firm’s balance on retained earnings will •
increase by $70 million on the balance sheet.
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Interpreting Firm Profitability using the
Income Statement
What can we learn from Boswell Inc.’s income 
statement?
The firm has been profitable as its revenues .1
exceeded its expenses.
The gross profit margin (GPM) .2
= gross profits ÷ sales
= $675 million ÷ $2,700 million
= 25%
GPM indicates the firm’s “mark-up” on its cost of goods sold per
dollar of sales.
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
Interpreting Firm Profitability using the
Income Statement (cont.)
The operating profit margin
.3
= net operating income (EBIT)÷ sales
= $382.5 million ÷ $2,700 million
= 14.17%
Net profit margin:
.4
= net profits (Net income) ÷ sales
= $204.75 million ÷ $2,700 million
= 7.58%
These profit margins (gross profit margin, operating profit margin, and net profit margin) should be
closely monitored and compared to previous years and those of competing firms.
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Checkpoint 3.1
Constructing an Income Statement
Use the following information to construct an income statement for Gap, Inc. (GPS).
The Gap is a specialty retailing company that sells clothing, accessories, and personal
care products under the Gap, Old Navy, Banana Republic, Piperlime, and Athleta brand
names. Use the scrambled information below to calculate the firm’s gross profits,
operating income, and net income for the year ended January 31, 2009. Calculate the
firm’s earnings per share and dividends per share.
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Checkpoint 3.1: Check Yourself
Reconstruct the Gap’s income statement assuming the firm is able to cut its
cost of goods sold by 10% and the firm pays taxes at 40% tax rate. What is the
firm’s net income and earnings per share?
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Step 1: Picture the Problem
Revenues
Less: Cost of goods sold
Less: Operating expenses
Equals Gross
profit
Equals: net
Operating income
Less: Interest expense
Equals: earnings
Before taxes
Less: Income taxes
Equals:
NET INCOME
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Step 2: Decide on a Solution Strategy
Given the account balances, constructing the 
income statement will entail substituting the
appropriate balances into the template of step
1.
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Step 3: Solve
Revenues = $14,526,000,000
Less: Cost of goods sold
= $8,171,100,000
Less: Operating expenses
=$3,899,000,000
Less: Interest expense
=$1,000,000
Less: Income taxes (40%)
=$9,819,600,000
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Equals: profit
=$6,354,900,000
Equals: net
Operating income
=$2,455,900,000
Equals: earnings
Before taxes
=$2,454,900,000
Equals:
NET INCOME
=$1,472,940,000
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Step 3: EPS and dividends per share
Earnings per share: 
= net income ÷ number of shares
= $1,472,940,000 ÷ 716,296,296
= $2.06
Dividends per share 
= dividends ÷ number of shares
= $243,000,000 ÷ 716,296,296 = $0.34
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Step 4: Analyze
The firm is profitable since it earned net 
income of $1,472,940,000.
The shareholders were able be earn $2.06 per 
share. However, the dividends per share were
only $0.34 indicating that the difference of
$1.72 was reinvested in the corporation.
Compute gross profit margin, operating profit 
margin, and net profit margin.
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Corporate Taxes
A firm’s income tax liability is calculated 
using its taxable income and the tax rates
on corporate income.
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Corporate tax rates
The table reveals the following:
Tax rates range from 15% to 39%
Tax rates are progressive i.e. larger corporations 
with higher profits will tend to pay more taxes
compared to smaller firms with lower profits.
Note: In addition to federal taxes, a firm may face 
State and City taxes.
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Marginal and Average Tax Rates
While analyzing the tax consequences of a 
new business venture, the appropriate tax
rate is the marginal tax rate.
Marginal tax rate is the tax rate that the 
company will pay on its next dollar of taxable
income.
Average tax rate is total taxes paid divided by 
the taxable income.
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Marginal and Average Tax Rates
Example 3: What is the average and marginal 
tax liability for a firm reporting $100,000 as
taxable income.
Taxable
Income
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Marginal Incrementa
l Tax
tax rate
Liability
Cumulativ
e Tax
Liability
Average
Tax Rate
$50,000
15%
7,500
7,500
15.00%
$75,000
25%
6,250
13,750
18.33%
$100,000
34%
8,500
22,250
22.25%
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Marginal and Average Tax Rates
Average tax rate 
= Total tax liability ÷ Total taxable income
= $22,250 ÷ $100,000
= 22.25%
Marginal tax rate
= 39% as the firm will have to pay 39% on its next
dollar of taxable income i.e. if its taxable income
increases from $100,000 to $100,001.
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The Balance Sheet
The balance sheet provides a snapshot of the 
firm’s financial position on a specific date. It is
defined by:
Total Assets = Total Liabilities + Total Shareholder’s Equity
(asset) = (sources of funding)
Total assets represents the resources owned by the 
firm.
Total liabilities represent the total amount of money 
the firm owes its creditors.
Total shareholders’ equity refers to the difference in 
the value of the firm’s total assets and the firm’s total
liabilities.
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Asset value calculation
In general, GAAP requires that the firm report assets 
on its balance sheet using the historical costs.
Cash and assets held for sale (such as marketable 
securities) are an exception to the rule. These assets
are reported using the lower of their cost or current
market value.
Assets whose value is expected to decline over time 
(such as equipment) is reported as “net equipment”
which is equal to the historical cost minus accumulated
depreciation.
The net value reported on balance sheet could be 
significantly different from the market value of the
asset.
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Assets and liabilities
Current assets consists of firm’s cash plus other assets 
the firm expects to convert to cash within 12 months
or less, such as receivables and inventory.
Fixed assets are assets that the firm does not expect 
to sell within one year. For example, plant and
equipment, land.
Current liabilities represent the amount that the firm 
owes to creditors that must be repaid within a period
of 12 months or less such as accounts payable, notes
payable.
Long-term liabilities refer to debt with maturities 
longer than a year such as bank loans, bonds.
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The stockholder’s equity
Two components:
The amount the company received from .1
selling stock to investors. It may be shown as
common stock in the balance sheet or it may
be divided into two components: par value
and additional paid in capital above par. Par value
is the stated or face value a firm puts on each share of stock. Paid in capital is
the additional amount the firm raised when it sold the shares.
For example, DLK corporation’s par value per share is $2.00 and the firm has 30 million shares
outstanding such that the par value of the firm’s common equity is $60 million. If the stocks
were issued to investors for $240 million, $180 million represents paid in capital.
The amount of the firm’s retained earnings: the portion of net income .2
that has been retained (i.e., not paid in dividends) from prior years
operations.
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