1. Chapter 2
Financial Statements

2. 1. Explain the foundations of the balance sheet and income statement
LEARNING OBJECTIVES
1. Explain the foundations of the balance sheet and income statement
2. Use the cash flow identity to explain cash flow.
3. Provide some context for financial reporting.
4. Recognize and view Internet sites that provide financial information.

3. 2.1 Financial Statements Four main financial statements: Our focus..
Balance sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flow
Our focus..
Interrelationship between the balance sheet and the income statement
The process by which these statements can be used to project a firm’s future cash flows

4. 2.1 Financial Statements The Balance Sheet
Represents the assets owned by the company and the claims against those assets
Based on the accounting identity:
Assets  Liabilities + Owners’ Equity (2.1)

5. Figure 2.1 Balance sheet

6. 2.1 Balance Sheet 1. Cash account Has five main sections:
Where did the $65 million decline come from?
2. Working capital accounts
Net working capital = Current assets – Current liabilities (2.2)
3. Long-term asset accounts
Plant and equipment; land and buildings
Gross value – accumulated depreciation = Net value
4. Long-term liabilities (debt) accounts
Loans maturing in over one year
5. Ownership accounts
Shareholders’ equity
Retained earnings—accumulated total since inception

7. 2.1 The Income Statement Net income = Revenues – expenses (2.3)
Shows the expenses and revenues generated by a firm over a past period, typically a quarter or a year.
Net income = Revenues – expenses (2.3)
EBIT = Revenues – operating expenses (2.4)

8. 2.1 Income Statement

9. 2.1 The Income Statement Net income is not the same as cash flow
Firm earned an income of $5,642 million
Cash account decreased by $65 million
3 reasons:
Accrual accounting
Noncash expense items --depreciation
Preference to classify interest expense as part of financial cash flow

10. 2.2 Cash Flow Identity
The cash flow identity states that the cash flow on the left-hand side of the balance sheet (the cash generated by the company) is equal to the cash flow on the right-hand side of the balance sheet (the cash flow given to the lenders and owners of the company).
CASH FLOW FROM ASSETS  CASH FLOW TO CREDITORS
+ CASH FLOW TO OWNERS

11. Figure 2.5 Cash Flow Identity and components

12. 2.2 The First Component: Cash Flow From Assets
Three components:
Operating cash flow (OCF)
Net capital spending (NCS)
Change in net working capital (∆NWC)
Cash flow from assets = OCF – NCS - ∆NWC
OCF = EBIT + Depreciation – Taxes
NCS = End. Net Fixed Assets – Beg. Net Fixed Assets Depreciation
∆NWC=Ending NWC – Beginning NWC

13. 2.2 The First Component: Cash Flow From Assets
OCF = EBIT + Depreciation – Taxes
OCF = Net Income + Depreciation
+ Interest Expense

14. 2.2 The First Component: Cash Flow From Assets (continued)
NCS = End Net Fixed Assets – Beg Net Fixed Assets
+ Depreciation
NCS= ($11,961 - $10,788) + $1,406 = $2,579

15. 2.2 The First Component: Cash Flow From Assets
∆NWC = Ending NWC – Beginning NWC
Net working capital for 2007 = $9,130 - $6,860 = $2,270
Net working capital for 2006 = $10,454 - $9,406 = $1,048
Change in NWC = $2,270 - $1,048 = $1,222

16. 2.2 The First Component: Cash Flow From Assets
Putting it all together….
Cash flow from Assets = OCF – NCS - ∆ NWC
= $7,287 - $2,579 - $1,222
= $3,486
Versus Net Income of $5,642

17. 2.2 The Second Component: Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense  Net New Borrowing from Creditors
Net New Borrowing = End Long-term Liabilities  Beg Long-Term Liabilities
Cash Flow to Creditors = $239 - (-$378) = $617

18. 2.2 The Third Component: Cash Flow To Owners
Dividends - Net new borrowing from owners
= $2, $0
= $2,869

19. 2.2 Putting It All Together: The Cash Flow Identity
CASH FLOW FROM ASSETS  CASH FLOW TO CREDITORS + CASH FLOW TO OWNERS
$3,486  $ $2,869
The company generated $3,486 million and it was distributed to the lenders ($617 million) and the owners ($2,869 million)

20. 2.3 Financial Performance Reporting
Annual reports to shareholders
Quarterly (10-Q) and annual (10-K) reports filed with the SEC
Regulation Fair Disclosure (Reg. FD): Companies must release all material information to all investors at the same time.
– Notes to the Financial Statements: A wealth of information about the firm

21. 2.4 Financial Statements on the Internet
EDGAR (
Yahoo! Finance (
Many, many more Web sites with rich stores of information

22. ADDITIONAL PROBLEMS WITH ANSWERS Problem 1
Balance Sheet. Chuck Enterprises has current assets of $300,000, and total assets of $750,000. It also has current liabilities of $125,000, common equity of $250,000, and retained earnings of $85,000. How much long-term debt and fixed assets does the firm have?

23. ADDITIONAL PROBLEMS WITH ANSWERS Problem 1
Current Assets + Fixed Assets = Total Assets
$300,000 + Fixed Assets = $750,000
Fixed Assets = $750,000 - $300,000 = $450,000
Total Assets ≡ Current Liabilities + Long-term debt Common equity + Retained Earnings
$750,000 = $125,000 + Long-term debt + $250, ,000
Long-term debt = $750,000 - $125,000-$250,000 - $85,000
Long-term debt = $290,000

24. ADDITIONAL PROBLEMS WITH ANSWERS Problem 2
Income Statement. The Top Class Company had revenues of $925,000 in Its operating expenses (excluding depreciation) amounted to $325,000, depreciation charges were $125,000, and interest costs totaled $55,000. If the firm pays a average tax rate of 34 percent, calculate its net income after taxes.

25. ADDITIONAL PROBLEMS WITH ANSWERS Problem 2
Revenues $925,000 Less operating expenses 325,000 = EBITDA 600,000 Less depreciation 125,000 = EBIT 475,000 Less interest expenses 55,000 = Taxable Income 420,000 Less taxes (34%) 142,800 = Net Income after taxes 277,200

26. ADDITIONAL PROBLEMS WITH ANSWERS Problem 3
Retained Earnings: The West Hanover Clay Co. had, at the beginning of the fiscal year, November 1, 2009, retained earnings of $425,000. During the year ended October 31, 2010, the company generated net income after taxes of $820,000 and paid out 35 percent of its net income as dividends. Construct a statement of retained earnings and compute the year-end balance of retained earnings.

27. ADDITIONAL PROBLEMS WITH ANSWERS Problem 3
Statement of Retained Earnings for
the year ended October 31, 2010
Balance of Retained Earnings, 11/1/2009……….$425,000
Add: Net income after taxes, 10/31/2010………. $820,000
Less: Dividends paid for year-end 10/31/2010…$287,000
Balance of Retained Earnings, 10/31/2010….. $958,000

28. ADDITIONAL PROBLEMS WITH ANSWERS Problem 4
Working Capital: D.K. Imports, Incorporated reported the following information at its last annual meeting: Cash and cash equivalents = $1,225,000; Accounts payables = $3,200,000 Inventory = $625,000; Accounts receivables = $3,500,000; Notes payables = $1,200,000; Other current assets = $125,000. Calculate the company’s net working capital.

29. ADDITIONAL PROBLEMS WITH ANSWERS Problem 4
Net Working Capital = Current Assets - Current Liabilities
(Cash & Cash Equivalents + Accts. Rec. + Inventory + other current assets) - (Accounts Payables + Notes Payables)
($1,225,000+$3,500,000+$625,000+$125,000) - ($3,200,000+$1,200,000)
$5,475,000 - $4,400,000
Net Working Capital =$1,075,000

30. ADDITIONAL PROBLEMS WITH ANSWERS Problem 5
Cash Flow from Operating Activities: The Mid-American Farm Products Corporation provided the following financial information for the quarter ending September 30, 2009:
Depreciation and amortization = $75,000
Net Income = $225,000
Increase in receivables = $95,000
Increase in inventory = $69,000
Increase in accounts payables = $80,000
Decrease in marketable securities = $34,000.
What is the cash flow from operating activities generated during this quarter by the firm?

31. ADDITIONAL PROBLEMS WITH ANSWERS Problem 5
Net Income $225,000 Add depreciation and amortization 75,000 Add decrease in marketable securities 34,000 Add increase in accounts payables 80,000 Less increase in accounts receivables 95,000 Less increase in inventory 69,000 Cash flow from operating activities $250,000