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FINC3131 Business Finance

FINC3131 Business Finance. Chapter 3: Income Statements Balance Sheets Cash Flow Statement. Importance of Financial Statements. Form the basis for understanding the financial position of a business

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FINC3131 Business Finance

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  1. FINC3131Business Finance Chapter 3: Income Statements Balance Sheets Cash Flow Statement

  2. Importance of Financial Statements • Form the basis for understanding the financial position of a business • Provide information regarding the financial policies and strategies and insight into future performance • 10-K and 10-Q

  3. Income Statement Overview 1 • Also called • earnings statement • profit & loss statement • Matches revenues & expenses over a period of time, e.g., past fiscal quarter or year • ‘Flow’ measure statement • Each value on an income statement represents cumulative amount of that item through the accounting period • Profit vs. Cash flow • Seldom the same

  4. Income Statement Overview 2 Income Statement Company Name For the time period ending date • Net Sales • - Cost of Goods Sold • Operating Expenses • Depreciation • = Operating Profit • - Interest Expense • = Profit Before Taxes • - Taxes • = Net Income • Operating income • Earnings before interest & taxes (EBIT) • Earnings before taxes (EBT) • Earnings • Net profit

  5. Income Statement Items 1 • Net sales = Gross sales – (returns & allowances) • Cost of Goods Sold (COGS) include raw material and labor costs

  6. Income Statement Items 2 • Operating expenses • Include management salaries, advertising expenditures, repairs & maintenance, R&D, general & administrative expenses, lease payments. • Interest expense • Cost of borrowing money • Taxes • Federal, state and/or local levels • Net income • ‘bottom line’ of income statement • Base profit earned during accounting period

  7. Income Statement Items 3 • Earnings per common share (EPS) Net income available to common shareholders # common shares outstanding indicator of firm’s current performance

  8. Income Statement Items 3 • Companies with complex capital structures, which means existence of convertible securities (such as bonds convertible into common stock) and stock options, must calculate two amounts for earnings per share: basic and diluted.

  9. Where does Net Income go? NI = Retained Earnings + Dividend Payout Common Dividends per share (DPS) common stock dividends paid # common shares outstanding

  10. Dell’s Income Statement • Where to find?

  11. Example Prepare a multi-step income statement for the ABC company for the year ending Dec 31, 2006, given the information below: Advertising expenditures 68,000 Cost of goods sold 2,433,000 Depreciation 78,000 Gross sales 3,210,000 Interest expenses 64,000 Lease payment 52,000 Management salary 240,000 Material purchase 2,425,000 R&D expenditures 35,000 Repair and maintenance costs 22,000 Returns and allowances 48,000 Taxes 51,000

  12. Solution

  13. Overview of Balance Sheet • Show what a company owns vs. owes at a specific point in time. • Categorizes company’s resources as: • Assets • Liabilities • Owner’s equity • Balance sheet identity: Total Assets = Total Liabilities + Shareholders’ Equity

  14. Balance Sheet Overview Assets Liabilities and Owners Equity Cash Marketable securities Accounts Receivable Inventories Total Current Assets Gross Fixed Assets (less Accum. Depreciation) Net Fixed Assets Other long-term investments such as stock and bonds Total Assets Notes Payable Accounts Payable Accrued Expenses Current Portion of LTD Total Current Liabilities Long term (L.T.) Debt Total Liabilities Preferred Stock Common Stock Retained Earnings Total Liabilities and equity S.T. Funds Liquidity L.T. Capital Assets Claims on Assets

  15. Balance Sheet Items: Current Assets 1 Current asset : • Easily converted into cash within a year • Cash • Most liquid asset; frequently represented by demand deposits • Marketable Securities: e.g. short-term T-bills • Accounts Receivable (A/R) Occurs because company sells products/services on credit

  16. Balance Sheet Items: Current Assets 2 • Inventory • Raw materials, work in process (WIP), finished goods • Different valuation methods: FIFO, LIFO, average cost Total current assets = Cash + Marketable Securities + A/R + Inventory

  17. Balance Sheet Items: Long-term assets 1 Fixed assets • Equipment, buildings, vehicles, computers etc • Permanent nature; needed for business operations • Reported at book value = original historical cost – allowable depreciation • Gross fixed assets (GFA): original cost of assets • Accumulated depreciation (AD) • Straight-line • Accelerated cost recovery • Net fixed assets (NFA) = gross fixed assets – accumulated depreciation Example: GFA, AD, NFA.

  18. Balance Sheet Items: Long-term assets 2 • Total assets = Current assets + long-term assets • Assets (LHS of balance sheet) must be financed by a combination of liabilities and owner’s equity (RHS of balance sheet) • firms should try to finance assets with the lowest cost funds available. Not only is it important for a firm’s financial managers to focus on assets, they must focus on the structure and composition of liabilities and net worth as well.

  19. Balance Sheet Items:Liabilities & Equity 1 • Current liabilities • Notes payable • Accounts payable • Accrued expenses (accruals) • Current portion of long-term debt • 1+2+3+4 = total current liabilities • Long-term debt • Liabilities with maturities in excess of 1 year

  20. Balance Sheet Items:Liabilities & Equity 2 • Total liabilities • = current liabilities + L.T. debt • Preferred stock • Like debt: Pays fixed periodic dollar amount • Like equity: If payment is not made, company is not in default • Preferred dividends are usually cumulative; no voting rights

  21. Balance Sheet Items:Liabilities & Equity 3 • Common stock • Common stock at par • No. of shares outstanding = common stock book value Par value per share • Additional paid-in capital (capital surplus) • Additional money generated when company sold stock • Retained earnings • Cumulative total of all net income reinvested into the company • Annual addition to retained earnings = net income – dividends paid Example: RE, NI, dividend, annual RE

  22. Balance Sheet Items:Liabilities & Equity 4 • Common Shareholders’ equity = common stock at par + additional paid-in capital + retained earnings • Common equity also known as: • Net worth, owners’ equity or book value of firm’s equity • What is the market value of the firms’ equity?

  23. Market Value Added (MVA) • Market Value of Equity 2010: • (100,000)($6.00) = $600,000. • Book Value of Equity 2010: • $557,632. • MVA = $600,000 - $557,632 = $42,368.

  24. Balance Sheet Items:Liabilities & Equity 5 Total liabilities and equity = total liabilities + preferred stock (if any) + shareholders’ equity • Must equal total assets

  25. Dell’s Balance Sheet • Where to find?

  26. example From the following accounts, prepare a balance sheet for the BCD company for the year ending Dec 31, 2006: Gross fixed assets 284,950 Inventory 136,500 Accrued expenses 11,850 Accumulated depreciation 82,310 Notes payable 32,570 Preferred stock 8,000 Retained earnings 89,280 Current portion of L-T debt 4,080 Long-term debt 134,300 Accounts receivable 105,770 Additional paid-in capital 71,600 Accounts payable 50830 Common stock ($0.20 par) 60,000 Cash ?

  27. Solution

  28. example • What does the balance sheet summarize for a business enterprise? • Operating results for period • Financial position at a point in time • Financing and investment activities for a period • Profit or loss at a point in time

  29. Effect of Debt vs. Equity Financing on Return

  30. Manipulating financial data Examples: • Adjusting credit terms to affect net sales • Switching inventory valuation methods • Choice of depreciation method: straight-line method smoothes earnings • Discretionary expense items such as R&D

  31. Example (million)

  32. Questions 1. Was the company profitable? 2. Did the company indeed receive 20 million cash as profit in its bank account?

  33. Learning Objectives of Statement of Cash Flows • Understand difference between net profit and net cash flow. • Construct statement of cash flows using indirect method. • Use the statement of cash flows to analyze a company.

  34. Net profit firm performance under accrual method of accounting Easily manipulated Net cash flow firm performance in terms of ability to generate cash Harder to manipulate Net profit vs. net cash flow Net profit does not equal net cash flow

  35. Statement of Cash Flows • Provides information about cash inflows and outflows during an accounting period • Focuses on CASH. • Has THREE sections: • Cash flow from Operating Activities (OCF) • Cash flow from Investing Activities (ICF) • Cash flow from Financing Activities (FCF )

  36. Useful Tip Cash flow from Operating Activities + Cash flow from Investing Activities + Cash flow from Financing Activities = CHANGE in cash account for the period!

  37. Another Useful Tip No matter which section you are doing (operating, investing or financing), • IF the change is a cash INFLOW, you add that change. + • IF the change is a cash OUTFLOW, you subtract that change. - inflow: decreases in assets or increases in liabilities or equity. outflow: increases in assets or decreases in liabilities or equity.

  38. Cash flows from operating activities IS means Income Statement

  39. Cash flows from operating activities 3 Asset accounts related: • Accounts receivable • Inventories Liability accounts related: • Accounts payable • Accruals Warning: Notes payable NOT included! Belongs to financing activities.

  40. Cash flows from operating activities 4

  41. Cash flows from investing activities 1 • Investing activities: • Buying or selling productive assets (plant & equipment) • Buying or selling financial securities that expire after 1 year (e.g., stock of other companies, bonds)

  42. Cash flows from investing activities 2

  43. Cash flows from investing activities 3 • Investing activities refer to changes on the lower left-hand side of balance sheet • Warning: we want changes in GROSS fixed assets. We don’t want the changes in net fixed assets! • BUT, if gross fixed assets not reported in balance sheet, ….?

  44. Useful relationships 1) Change in gross fixed assets = change in net fixed assets + depreciation 2) Depreciation (on IS) = change in accumulated depreciation (on BS)

  45. Balance Sheet Overview Assets Liabilities and Owners Equity Cash Marketable securities Net A/R Inventories Total Current Assets Gross Fixed Assets (less Accum. Depreciation) Net Fixed Assets Other long-term assets such as stocks and bonds Total Assets Notes Payable Accounts Payable Accrued Expenses Current Portion of LTD Total Current Liabilities Long term (L.T.) Debt Total Liabilities Preferred Stock Common Stock Retained Earnings Total Liabilities and equity S.T. Funds Liquidity L.T. Capital Assets Claims on Assets

  46. Cash flows from financing activities 1 Financing activities: • Loans from creditors (long-term, short-term) • Repayment of principal • Sale or repurchase of stock (common or preferred) from firm’s equity holders • Payment of dividends

  47. Cash flows from financing activities 2

  48. Cash flows from financing activities 3 Financing activities refer to: • Items on lower right-hand side of balance sheet (long-term debt, equity) • Changes in notes payable (short-term bank loans). Useful relationship: Dividends paid = net income – change in retained earnings

  49. Dell’s Statement of Cash Flow • Where to find?

  50. Solve Assignment 3.1

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