Chapter 2 – MBA5041 Accounting Statements The Balance Sheet The Income Statement Net Working Capital Financial Cash Flow The Statement of Cash Flows Financial Ratios

Chapter 2 – MBA5042 Balance Sheet An accountant’s snapshot of the firm’s accounting value as of a particular date. The Balance Sheet Identity is: Assets ≡ Liabilities + Stockholder’s Equity

Chapter 2 – MBA5043 Balance Sheet Analysis When analyzing a balance sheet, the financial manager should be aware of three concerns: 1.Accounting liquidity 2.Debt versus equity 3.Value versus costs

Chapter 2 – MBA5044 Accounting Liquidity Refers to the ease and quickness with which assets can be converted to cash. Current assets are the most liquid. Some fixed assets are intangible. The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations. Liquid assets frequently have lower rates of return than fixed assets.

Chapter 2 – MBA5045 Debt versus Equity Bondholders has the first claim on the firm’s cash flow. Shareholder’s equity is the residual between assets and liabilities.

Chapter 2 – MBA5046 Value versus Cost Under GAAP audited financial statements of firms in the U.S. carry assets at cost. I.e., book value refers to cost. Market value is a completely different concept, referring to value.

Chapter 2 – MBA5047 The Income Statement The income statement measures performance over a specific period of time. The accounting definition of income is Revenue – Expenses ≡ Income

Chapter 2 – MBA5048 Income Statement Analysis There are three things to keep in mind when analyzing an income statement: 1.GAAP 2.Non Cash Items 3.Time and Costs

Chapter 2 – MBA5049 Generally Accepted Accounting Principles 1.GAAP The matching principal of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, even though no cash flow may have occurred

Chapter 2 – MBA50410 Income Statement Analysis 2.Non Cash Items Depreciation is the most apparent. No firm ever writes a check for “depreciation”. Another noncash item is deferred taxes, which does not represent a cash flow. -- both of them are not cash expenses.

Chapter 2 – MBA50411 Income Statement Analysis 3.Time and Costs In the short run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials. In the long run, all costs are variable. Financial accountants do not distinguish between variable costs and fixed costs. -- product costs -- period costs

Chapter 2 – MBA50412 Net Working Capital Net Working Capital ≡ Current Assets – Current Liabilities NWC is usually growing with the firm.

Chapter 2 – MBA50413 (in $ millions) 20X2 and 20X1 Balance Sheet U.S. COMPOSITE CORPORATION Liabilities (Debt) Assets20X220X1and Stockholder's Equity20X220X1 Current assets:Current Liabilities: Cash and equivalents$140$107 Accounts payable$213$197 Accounts receivable Notes payable5053 Inventories Accrued expenses Other5850 Total current liabilities$486$455 Total current assets$761$707 Long-term liabilities: Fixed assets: Deferred taxes$117$104 Property, plant, and equipment$1,423$1,274 Long-term debt Less accumulated depreciation Total long-term liabilities$588$562 Net property, plant, and equipment Intangible assets and other245221Stockholder's equity: Total fixed assets$1,118$1,035 Preferred stock$39 Common stock ($1 par value)5532 Capital surplus Accumulated retained earnings Less treasury stock Total equity$805$725 Total assets$1,879$1,742Total liabilities and stockholder's equity$1,879$1,742

Chapter 2 – MBA50414 Financial Cash Flow cash flow from received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders. CF(A)≡ CF(B) + CF(S)

Chapter 2 – MBA50415 Financial Cash Flow of the U.S.C.C. (in $ millions) 20X2 Financial Cash Flow U.S. COMPOSITE CORPORATION Cash Flow of the Firm Operating cash flow$238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending(173) (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital(23) Total$42 Cash Flow of Investors in the Firm Debt$36 (Interest plus retirement of debt minus long-term debt financing) Equity6 (Dividends plus repurchase of equity minus new equity financing) Total$42 Operating Cash Flow: EBIT$219 Depreciation $90 Current Taxes($71) OCF$238

Chapter 2 – MBA50416 Financial Cash Flow of the U.S.C.C. (in $ millions) 20X2 Financial Cash Flow U.S. COMPOSITE CORPORATION Cash Flow of the Firm Operating cash flow$238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total Capital Spending Purchase of fixed assets $198 Sales of fixed assets (25) Capital Spending $173 (173) (23) $42 $36 6 $42 The other formula: Capital spending = change in net fixed asset + depreciation

Chapter 2 – MBA50417 Financial Cash Flow of the U.S.C.C. (in $ millions) 20X2 Financial Cash Flow U.S. COMPOSITE CORPORATION Cash Flow of the Firm Operating cash flow$238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total NWC grew from $275 million in 20X2 from $252 million in 20X1. This increase of $23 million is the addition to NWC. (173) (23) $42 $36 6 $42

Chapter 2 – MBA50418 Financial Cash Flow of the U.S.C.C. (in $ millions) 20X2 Financial Cash Flow U.S. COMPOSITE CORPORATION Cash Flow of the Firm Operating cash flow$238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total Cash Flow to Creditors Interest$49 Retirement of debt 73 Debt service122 Proceeds from new debt sales (86) Total36 (173) (23) $42 $36 6 $42

Chapter 2 – MBA50419 Financial Cash Flow of the U.S.C.C. (in $ millions) 20X2 Financial Cash Flow U.S. COMPOSITE CORPORATION Cash Flow of the Firm Operating cash flow$238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total Cash Flow to Stockholders Dividends $43 Repurchase of stock 6 Cash to Stockholders 49 Proceeds from new stock issue (43) Total $6 (173) (23) $42 $36 6 $42

Chapter 2 – MBA50420 Summary of Cash flow of the firm Operating cash flow = EBIT + Depreciation – tax Capital spending = change in net fixed assets + depreciation Net working capital = net working capital in the second year – net working capital in the first year For cash flow to creditors and shareholders, see previous slides.

Chapter 2 – MBA50421 Balance Sheet BegEndBegEnd Cash$100$150A/P$100$150 A/R200250N/P Inv300300C/L C/A$600$700LTD$400$420 NFA400500C/S5060 R/E $300$430 Total$1000$1200Total$1000$1200

Chapter 2 – MBA50422 Income Statement Sales$2000 Costs1400 Depreciation100 EBIT500 Interest100 Taxable Income 400 Taxes200 Net Income$200 Dividends$_____ Addition to R/E _____

Chapter 2 – MBA Operating cash flow=EBIT + _____________ – Taxes = $ – 200 = $_____ 2.Change in NWC= ___________ – ___________ = $350 – $_____ = $_____ 3.Net capital spending= $_____ + Dep – _____ = $ – 400 = $_____ 4.Cash flow from assets=OCF – chg. NWC – Cap. sp. =

Chapter 2 – MBA50424 Financial Ratios A. Short-term Solvency, Activity Current ratio Quick ratio Total Asset Turnover Receivable Turnover Inventory Turnover

Chapter 2 – MBA50425 B. Financial Leverage Debt ratio Interest rate coverage

Chapter 2 – MBA50426 Profitability Profit margin Return on assets Return on equity

Chapter 2 – MBA50427 Market Value Ratios Market price Price-to-earning ratio (P/E) Dividend yield Market-to-book (M/B) value and Q ratio