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Chapter 3: Financial Statements

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  1. FIN 3000 Chapter 3:Financial Statements Liuren Wu

  2. Overview • An overview of the firm’s financial statements • The income statement • Corporate taxes • The balance sheet • The cash flow statement FIN3000, Liuren Wu

  3. Learning objectives • Understand the content of the 4 basic financial statements. Focus on: • Income statement • Balance sheet statement • Cash flow statement • Evaluate firm profitability using the income statement. • Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate. FIN3000, Liuren Wu

  4. 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. FIN3000, Liuren Wu

  5. 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? • Revenue, expense, profits over a year or quarter. • Balance sheet – what’s your current financial situation? A snap shot on a specific date of: • Assets (value of what the firm owns) • Liabilities (value of firm’s debts) • Shareholder’s equity (the money invested by the company owners) • Cash flow statement – how did the cash come and go? • Cash received/cash spent by the firm over a period of time. FIN3000, Liuren Wu

  6. Why study financial statements? • Assess current performance through financial statement analysis. • Next chapter provides more tools for the analysis. • Monitor and control operations. • 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. • Financial planning models are typically built using the financial statements. FIN3000, Liuren Wu

  7. Three accounting principles • Revenue recognition principle:Revenue should be included in the income statement for the period in which: • Its goods/services were exchanged for cash or accounts receivable. • It has completed what it must do to be entitled to the cash. • Matching principle: Expenses are matched with the revenues they helped produce. • 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. • Historical cost principle: Most assets and liabilities are reported in the financial statements at historical cost. • For example, the price the firm paid to acquire them. • The historical cost generally does not equal the current market value of the assets or liabilities. FIN3000, Liuren Wu

  8. An income statement • Sales • Minus cost of goods sold • = Gross Profit • Minus operation expenses • Selling expenses • General and administrative expenses • Depreciation and amortization expense • = Operating income (EBIT) • Minus interest expense • = Earning before taxes (EBT) • Minus income taxes • = Net income (EAT) FIN3000, Liuren Wu

  9. Sample income statement FIN3000, Liuren Wu

  10. 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: 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 FIN3000, Liuren Wu

  11. Evaluating a firm’s dividends per share • Dividends per share = dividends paid/number of shares • Example: A firm reports dividend payment of $20 million of 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 FIN3000, Liuren Wu

  12. Connecting the income statement and the balance sheet • What can the firm do with the net income? • Pay dividends to shareholders. • Reinvest in the firm. • Example: 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. FIN3000, Liuren Wu

  13. Interpreting firm profitability • What can we learn from Boswell Inc.’s income statement? • The firm has been profitable as its revenues exceeded its expenses. • The gross profit margin (GPM) = 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. FIN3000, Liuren Wu

  14. Interpreting firm profitability (con.) 3. The operating profit margin = net operating income (EBIT)/sales = $382.5 million/$2,700 million = 14.17% 4. Net profit margin = 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. FIN3000, Liuren Wu

  15. GAAP and earnings management • While the firms must adhere to set of accounting principles, GAAP (Generally Accepted Accounting Principles), there is considerable room for managers to influence the firm’s reported earnings. • Managers have an incentive to tamper with reported earnings as their pay depends upon it and investors care about it. FIN3000, Liuren Wu

  16. 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. D d FIN3000, Liuren Wu

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  19. 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? FIN3000, Liuren Wu

  20. Step 1: Picture the problem Revenues Less: Cost of goods sold Equals Gross profit Less: Operating expenses Equals: net Operating income Less: Interest expense Equals: earnings Before taxes Less: Income taxes Equals: NET INCOME FIN3000, Liuren Wu

  21. 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. FIN3000, Liuren Wu

  22. Step 3: Solve Revenues = $14,526,000,000 Less: Cost of goods sold = $8,171,100,000 Equals: profit =$6,354,900,000 Less: Operating expenses =$3,899,000,000 Equals: net Operating income =$2,455,900,000 Less: Interest expense =$1,000,000 Equals: earnings Before taxes =$2,454,900,000 Less: Income taxes (40%) =$9,819,600,000 Equals: NET INCOME =$1,472,940,000 FIN3000, Liuren Wu

  23. 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 FIN3000, Liuren Wu

  24. Step 4: Analyze • The firm is profitable since it earned net income of $1,472,940,000 • The shareholders were able to 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. FIN3000, Liuren Wu

  25. Corporate taxes • A firm’s income tax liability is calculated using its taxable income and the tax rates on corporate income. FIN3000, Liuren Wu

  26. 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. FIN3000, Liuren Wu

  27. Marginal and average tax rates • While analyzing the tax consequences of new business venture, the appropriate tax rate is the marginal tax rate. • Marginal tax rateis the tax rate that the company will pay on its next dollar of taxable income. • Average tax rateis total taxes paid divided by the taxable income. FIN3000, Liuren Wu

  28. Marginal and average tax rates (con.) • Example: What is the average and marginal tax liability for a firm reporting $100,000 as taxable income? FIN3000, Liuren Wu

  29. Marginal and average tax rates (con.) • 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. FIN3000, Liuren Wu

  30. 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 assetsrepresents the resources owned by the firm. • Total liabilities represent the total amount of money the firm owes its creditors. • Total shareholder’s equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities. FIN3000, Liuren Wu

  31. 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 and 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. FIN3000, Liuren Wu

  32. FIN3000, Liuren Wu

  33. Assets and liabilities • Current assetsconsists 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 assetsare assets that the firm does not expect to sell within one year. For example, plant and equipment, land. • Current liabilitiesrepresent 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 liabilitiesrefer to debt with maturities longer than a year such as bank loans, bonds. FIN3000, Liuren Wu

  34. The stockholder’s equity Two components: • The amount the company received from selling stock to investors. It may be shown as common stockin 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 capitalis 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 that has been retained (i.e., not paid in dividends) from prior years operations. FIN3000, Liuren Wu

  35. Firm liquidity and net working capital • Liquidity refers to the speed with which the asset can be converted to cash without loss of value. • For example, a firm’s bank account is perfectly liquid. Other types of assets are less liquid as they more difficult to sell and convert to cash such as PPE (property, plant and equipment). • For the overall firm, liquidity generally refers to the firm’s ability to covert its current assets (accounts receivable and inventories) into cash so that it can pay its bills (current liabilities) on time. • We can thus measure a firm’s liquidity by computing the net working capital = current assets – current liabilities. FIN3000, Liuren Wu

  36. Firm liquidity and net working capital • If a firm’s net working capital is significantly positive, it is in a good position to pay its debts on time and is consequently very liquid. • Lenders consider the net working capital as an important indicator of firm’s ability to repay its loans. FIN3000, Liuren Wu

  37. FIN3000, Liuren Wu

  38. Checkpoint 3.2 Constructing a Balance Sheet Construct a balance sheet for Gap, Inc. (GPS) using the following list of jumbled accounts for January 31, 2009. Identify the firm’s total assets and net working capital. FIN3000, Liuren Wu

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  41. Step 4: Analyze • The firm has invested a total of $7.564B in asserts, funded by $2.158B current liability, $1.019B long-term liability, and $4.387B owner equity. • The firm as $4.005B in current assets and $2.158B in current liability, leaving the firm with a net working capital of $4.005-2.158-1.87B FIN3000, Liuren Wu

  42. Checkpoint 3.2: Check yourself Reconstruct the Gap’s balance sheet to reflect the repayment of $1 billion in short-term debt using a like amount of the firm’s cash. What is the balance for total assets and current liabilities? FIN3000, Liuren Wu

  43. Step 1: Picture the problem Current Assets Cash Accounts Receivable Inventories Other current assets Total current assets Current Liabilities Accounts payable Short-term debt Other current liabilities Total current liabilities Long-term (fixed) assets Gross PPE Less: Accumulated depreciation Net property, plant and equip. Other long-term assets Total long-term assets Long-term Liabilities Long-term debt Owner’s Equity Par value of common stock Paid-in-capital Retained earnings Total equity Total Assets Total Liabilities and Owners’ equity FIN3000, Liuren Wu

  44. Step 2: Decide on a solution strategy • We are given the account balances so in order to construct the balance sheet we need to substitute the appropriate balances into the template developed in step 1. • Deduct $1B from both cash and current liability. FIN3000, Liuren Wu

  45. Step 3: Solve FIN3000, Liuren Wu

  46. Step 4: Analyze • We can make the following observations from Gap’s Balance sheet: • The total assets of $6,564,000,000 is financed by a combination of current liabilities, long-term liabilities and owner’s equity. Owner’s equity accounts for $4,387,000,000 of the total. • The firm has a healthy net working capital of $1,847,000,000 (3,005,000,000 – 1,158,000,000) FIN3000, Liuren Wu

  47. Debt versus equity financing • The right-hand side of the balance sheet reveals the sources of money used to finance the purchase of the firm’s assets listed on the left-hand side of the balance sheet. • It shows how much was borrowed (debt financing) and how much was provided by firm’s owners (equity financing, through the sale of equity or retention of prior year’s earnings). • Payment: Payment for debt holders is generally fixed (in the form of interest); Payment for equity holders (dividends) is not fixed nor guaranteed. • Seniority: Debt holders are paid before equity holders in the event of bankruptcy. • Maturity: Debt matures after a fixed period while equity securities do not mature. FIN3000, Liuren Wu

  48. The cash flow statement • The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash. • Source of cash is any activity that brings cash into the firm. For example, sale of equipment. • Use of cash is any activity that causes cash to leave the firm. For example, payment of taxes. Change in Cash Balance for 2010 Ending Cash Balance for 2010 Ending Cash Balance for 2010 = - FIN3000, Liuren Wu

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  50. Cash flow analysis • Why did the cash balance decline by $3.5 million from 2009 to 2010? • Accounts receivableincreased by $22.5 million representing an increase in uncollected cash from credit sales. It represents $22.5m of use of cash to invest in accounts receivable. • Inventory increased by $148.50 million indicating use of cash to procure inventory. • Equipment increased by $175.50 million indicating use of cash to invest in equipment. • In general, • An increase in an asset account = use of cash • A decrease in an asset account = source of cash FIN3000, Liuren Wu