1. Chapter 3

2. Understanding Financial Statements and Cash Flows

3. Basic Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows

4. Income Statement Profit/Loss Statement
Indicates the amount of profits generated by a firm over a given period of time
Sales – Expenses = Profit

5. Income Statement Terminology
Revenue (Sales)
Money derived from selling the company’s product or service
Cost of Goods Sold (COGS)
The cost of producing or acquiring the goods or services to be sold
Operating Expenses
Expenses related to marketing and distributing the product or service and administering the business
Financing costs
The interest paid to creditors and the dividends paid to preferred stockholders
Tax Expenses
Amount of taxes owed, based upon taxable income

6. Income Statement Sales Less cost of goods sold = Gross profit
Less operating expenses
= Operating income
Less interest expense
= Earnings before taxes
Less corporate taxes
= Earnings before preferred dividends
Less preferred stock dividends
= Net income available to common stockholders

7. Balance Sheet
Examines the firm’s financial position at a specific point in time
Assets = Liabilities + Owner’s Equity
Assets are resources owned by the firm
Liabilities and Owner’s equity indicate how those resources are financed

8. Balance Sheet Terminology
Current Assets or gross working capital Comprise assets that are relatively liquid, or expected to be converted into cash within a year.
Current Assets typically include:
Cash
Accounts Receivable
payments due from customers who buy on credit
Inventory
raw materials, work in process, and finished goods held for eventual sale
Prepaid expenses
expenses paid for in advance

9. Fixed Assets Assets held for more than one year. Typically Include:
Machinery
Equipment
Land and Buildings
Other Assets Assets that are not current assets or fixed assets
Patents
Copyrights
Goodwill

10. Debt or Liabilities
Money that has been borrowed and must be repaid at some predetermined date
Debt Capital
financing provided by a creditor
Current, short-term and long-term
Current or short-term must be repaid within the next 12 months

11. Current Liabilities: Long-Term Debt Accounts Payable Other Payables
Credit extended by suppliers
Other Payables
Interest and taxes that are owed
Accrued expenses
Liabilities incurred, but not yet paid
Short-term Notes
Borrowings from a bank or lending institution due and payable within 12 month
Long-Term Debt
Loans from banks or other institutions for longer than 12 months

12. Includes the shareholder’s investment
Equity
Includes the shareholder’s investment
Preferred stock
Common stock
Retained Earnings
cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out.
Treasury Stock
stock that was once outstanding and has been re-purchased by the company

13. Balance Sheet ASSETS Total Assets LIABILITIES Total Liabilities
Current Assets
Fixed Assets
Total Assets
LIABILITIES
Current Liabilities
Long-Term Liabilities
Total Liabilities
OWNER’S EQUITY
Preferred Stock
Common Stock
Retained earnings
Total Owner’s Equity
Total liabilities + OE

14. Terms Net Working Capital Debt/Equity Mix Accrual Basis Accounting
Current assets – current liabilities
Debt/Equity Mix
Amount of debt a firm borrows per dollar of equity
Accrual Basis Accounting
Recording revenues when earned and expenses when incurred, rather than when cash is exchanged
Free Cash Flows
Cash flow that is free and available to be distributed to the firm’s investors.

15. Cash Flows
Cash Flows generated through a firm’s assets always equal its cash flows paid to or received by the company’s investors.
Cash flows from assets = cash flows from financing

16. Traditional Statement of Cash Flows
Three sections:
Cash flows from Operating Activities
Cash flows from Investing Activities
Cash flows from Financing Activities

17. Modified Cash Flow Calculations
Cash Flows from Assets = Cash flows from Financing
Cash flows from Assets = After-tax cash flows from operations less investment in operating working capital less investments in fixed assets and other assets.

18. Cash Flows from Assets After-tax cash flow from operations -- less--
Investment in operating working capital
-- less --
Investment in fixed assets and other assets

19. After-Tax Cash Flows From Operations
Operating Income
+ Depreciation
= Earnings before interest, taxes , depreciation, and amortization
- Income taxes
= After-tax cash flows from operations

20. Change in Operating Working Capital
Change in current assets
- (change in accounts payable + change in accrued expenses)

21. Investment in Fixed Assets
A decrease in long-term assets indicates that the firm is selling assets, which is a source of cash or increases cash
An increase in long-term assets indicates that the firm is purchasing assets, which is a “use” of cash or causes cash to go down

22. Cash Flows from Financing
Financing Activities which generate cash include:
An increase in debt (a source of cash)
Issuing new stock
Financing Activities which decrease cash include:
Payment of interest
Payment of dividends
A decrease in debt (indicates payment of principal)
A decrease in equity (indicates the re-purchase of outstanding stock