1 Financial Statements Three basic statements: Balance sheet Balance sheet Income statement Income statement Statement of cash flows Statement of cash flows Why we need statements: Evaluating financial health of a company (ratio analysis) Evaluating financial health of a company (ratio analysis) Evaluating separate projects and business as a whole Evaluating separate projects and business as a whole Discounted Cash Flow (DCF) methods (need the projected cash flows) Using comparables (various ratios) (need usually last income statement and balance sheet)

2 Assets ≡ Liabilities + Shareholder’s Equity Tabulates a company’s assets and liabilities at a specific point in time (snapshot of the firm) – info on the value of the assets and the capital structure Sorting of Assets by liquidity, i.e. how fast they can be converted into cash Assets by liquidity, i.e. how fast they can be converted into cash Liabilities by maturity, i.e. when they must be paid Liabilities by maturity, i.e. when they must be paid Assets and liabilities are represented by historical costs! (GAAP) The original cost adjusted for improvements and aging = Book Value The original cost adjusted for improvements and aging = Book Value Avoid using market value, since is too volatile and easily manipulated Avoid using market value, since is too volatile and easily manipulated Preference for underestimating value Preference for underestimating value Balance Sheet Assets Current assets Fixed assets Liabilities and Equity Current liabilities Long-term liabilities Shareholders’ equity Net working capital

3 Income Statement Revenues – Expenses = Income Records revenues and expenses from transactions over a specific time period (e.g. 1 year) Accrual Accounting Principle Revenues are recognized when goods are shipped or services are provided, even if no actual cash inflow has necessarily occurred (e.g. sales on credit). Revenues are recognized when goods are shipped or services are provided, even if no actual cash inflow has necessarily occurred (e.g. sales on credit). (accrual is a difference between earnings and actual cash flows) Matching principle Costs are matched with revenues, i.e. expensed in the period when the corresponding revenue is recognized. Again, actual cash outflow does not have to occur (e.g. buying on credit from suppliers) Costs are matched with revenues, i.e. expensed in the period when the corresponding revenue is recognized. Again, actual cash outflow does not have to occur (e.g. buying on credit from suppliers)

4 Statement of Cash Flows Records how much cash was generated and how it was allocated over a specific time period (e.g. 1 year) Cash generated by operating activities Cash generated by operating activities Income statement adjusted for non-cash items Cash used for investing activities Cash used for investing activities How much was spent on investing in new assets or modernizing existing assets (net of gains from selling old assets) Cash generated by financing activities Cash generated by financing activities How much was raised from the investors (net of cash disbursement to investors)

5 Simple example Chocolate Factory (adapted from Pratt (2000), 4 th ed., ch. 5) You want to create and run a small chocolate factory. Over 1 year you do 6 transactions (1) You register a firm and contribute 10,000 to its account (1) You register a firm and contribute 10,000 to its account (2) The firm borrows additional 3,000 from a bank (2) The firm borrows additional 3,000 from a bank (3) The firm purchases equipment for 5,000 (3) The firm purchases equipment for 5,000 (4) The firm produces and sells chocolate for 12,000. It receives 8,000 in cash and 4,000 in receivables (i.e. sells for 4,000 on credit) (4) The firm produces and sells chocolate for 12,000. It receives 8,000 in cash and 4,000 in receivables (i.e. sells for 4,000 on credit) (5) The firm pays 9,000 in cash for expenses: wages, raw materials, interest and maintenance (5) The firm pays 9,000 in cash for expenses: wages, raw materials, interest and maintenance (6) You pays yourself a dividend of 1,000 (6) You pays yourself a dividend of 1,000

6 Accounts ($000 omitted) Assets=Liabities + Stockholders’ Equity Transact ion Cash + Receiva bles bles + Equip ment ment= Loan Payable + Contributed Capital Capital + Retained Earnings (1)$+10=$+10 (2)+3=$+3 (3)-5$+5= (4)+8$+4=$+12 (5)-9=-9 (6)= Total =

7 Balance Sheet Income Statement Assets Liabilities and Stockholders’ Equity Cash$6,000 Loan Payable $3,000 Receivables4,000 Contributed Capital 10,000 Equipment5,000 Retained Earnings 2,000 Total Assets $15,000 Total Liabilities and Stockholders’ Equity $15,000 Revenues from sales $12,000 Expenses: wages, interest, etc. 9,000 Net Income 3,000 Less: dividend to stockholder 1,000 Retained earnings $2,000

8 Statement of Cash Flows (using direct method) Operating activities: Sales of chocolate (4) $8,000 Payments for expenses (5) (9,000) Net cash from operating activities $(1,000) Investing activities: Purchase of equipment (3) $(5,000) Net cash from investing activities (5,000) Financing activities: Borrowings (2) $3,000 Owner contributions (1) 10,000 Payment of dividends (6) (1,000) Net cash from financing activities 12,000 Increase in cash balance $6,000 Cash balance at the beginning of the year 0 Cash balance at the end of the year $6,000

9 Global Conglomerate Corporation Balance Sheet for 2005 and 2004

10 Note on intangible assets Patents, trademarks, copyrights, etc. Goodwill Arises in acquisitions. Goodwill = amount paid for the company minus the fair market value of its assets net of its liabilities (e.g. Global paid $15 mln for a firm whose assets had a net fair market value of $5 mln – goodwill is $10 mln) Arises in acquisitions. Goodwill = amount paid for the company minus the fair market value of its assets net of its liabilities (e.g. Global paid $15 mln for a firm whose assets had a net fair market value of $5 mln – goodwill is $10 mln) Not all intangible assets are can be reported on the balance sheet. Usually only when they can clearly be associated with future benefits and their cost can be measured (e.g. a purchased patent is reported on BS but R&D expenditures are usually not – instead they are expensed in the income statement)

11 Global Conglomerate Corporation Income Statement Sheet for 2005 and 2004

12 Note on deferred taxes and depreciation Firm keeps two sets books: one for investors and one for tax authorities. There can be differences in accounting between the two. If accounting income > true taxable income  reported taxes > actually paid  increase in deferred tax liability One of the main differences between two sets of books – accounting for depreciation For tax reporting firms usually use accelerated depreciation (usually MACRS – modified accelerated cost recovery system) For tax reporting firms usually use accelerated depreciation (usually MACRS – modified accelerated cost recovery system) For investors firms are supposed to use the method that best reflects how firm’s assets lose value over time (very often – straight line depreciation) For investors firms are supposed to use the method that best reflects how firm’s assets lose value over time (very often – straight line depreciation)

13 Comparing MACRS with straight line depreciation Assume asset has a usefil life of 8 years and is depreciated for accounting purposes using a straight line method: each year depreciation is 12.5% For tax puposes, however, it was classified as a 5 year asset. The MACRS schedule is then: 20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%, 0%, 0%. Hence, for tax purposes depreciation is higher in years 1-3 and lower after on.

14 Implications of differences in accounting for depreciation for financial statements Assume: Firm lives for 3 years, at t=0 assets’ book value = 1. Firm lives for 3 years, at t=0 assets’ book value = 1. Depreciation in years 1, 2, 3: Depreciation in years 1, 2, 3: d1, d2, d3 – for reporting to investors D1, D2, D3 – for tax authorities Assets are depreciated to zero after year 3 regardless of the method: d1+d2+d3 = D1+D2+D3 = 1 Assets are depreciated to zero after year 3 regardless of the method: d1+d2+d3 = D1+D2+D3 = 1 D1 > d1, D2 > or d1, D2 > or < d2, D3 < d3 Pretax income + depreciation = X in each year. Pretax income + depreciation = X in each year. t – tax rate t – tax rate

15 Reported net income in year i: X – di – (X – di)t = X – di – (X – Di)t – (Di – di)t Reported taxes Actual taxes Deferred taxes Reported taxes Actual taxes Deferred taxes Deferred taxes are recorded as an increase (or decrease if negative) in deferred tax liability Since D1 > d1, tax liability of (D1-d1)t appears in year 1 If D2 > d2, tax liability increases by (D2-d2)t; if D2 d2, tax liability increases by (D2-d2)t; if D2 < d2, it decreases by (d2-D2)t in year 2 Since D3 < d3, tax liability decreases by (D3-d3)t in year 3. At the end of year 3 tax liability must be zero as d1+d2+d3 = D1+D2+D3 = 1 For example, an increase in the deferred tax liabilty for Global Conglomerate Corporation was 0.2 from 2004 to It means it actually paid 0.5 in taxes and not 0.7 as shown in the income statement

16 Global Conglomerate Corporation Statement of Cash Flows for 2005 and 2004 (using indirect method)