Understanding Financial Statements

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 3
Understanding
Financial
Statements, Taxes,
and Cash Flows
Copyright © 2018, 2014, 2011 Pearson Education,

Copyright © Inc. Education,
2018, 2014, 2011 Pearson All Rights Reserved
Inc. All Rights Reserved
Learning Objectives (1 of 2)
1. Describe the content of the four basic financial
statements and discuss the importance of
financial statement analysis to the financial
manager.
2. Evaluate firm profitability using the income
statement.
3. Estimate a firm’s tax liability using the corporate
tax schedule and distinguish between the
average and marginal tax rate.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Learning Objectives (2 of 2)
4. Use the balance sheet to describe a firm’s
investments in assets and the way it has
financed them.
5. Identify the sources and uses of cash for a firm
using the firm’s cash flow statement.
Principles Used in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 3: Cash Flows Are the Source of Value.
• Principle 4: Market Prices Reflect Information.
• Principle 5: Individuals Respond to Incentives.
3.1 AN OVERVIEW OF THE FIRM’S
FINANCIAL STATEMENTS
Basic Financial Statements (1 of 4)
The accounting and financial regulatory authorities
mandate that firms provide the following four types
of financial statements:
1. Income statement
2. Balance sheet
3. Cash flow statement
4. Statement of shareholders’ equity
1. Income Statement: An income statement
provides the following information for the firm
over a specific period of time (usually a quarter
of a year or a full year):
§ Revenue earned,
§ Expenses incurred, and
§ Profit earned.
2. Balance sheet: Balance sheet contains
information as of the date of its preparation of
the following:
§ Assets (everything of value the company owns),
§ Liabilities (the company’s debts), and
§ Stockholders’ equity (the money invested by the
company owners).
3. Cash flow statement: It reports cash received
and cash spent by the firm over a specific period
of time, usually a quarter of a year or a full year.
4. Statement of shareholder’s equity: It provides a
detailed account of activities in the firm’s
common and preferred stock accounts and its
retained earnings account and of changes to
shareholders’ equity.
Why Study Financial Statements?
Analyzing a firm’s financial statement can help
managers carry out three important tasks:
1. assess the financial condition of the firm
2. monitor and control operations, and
3. financial forecasting and planning.
What are the Accounting Principles
Used to Prepare Financial Statements?
• Accountants use the following three fundamental
principles when preparing financial statements:
1. The revenue recognition principle,
2. The matching principle, and
3. The historical cost principle.
3.2 THE INCOME STATEMENT
An Income Statement (1 of 2)
An income statement (also called a profit and loss
statement) measures the amount of profits
generated by a firm over a given time period
(usually a year or a quarter). It can be expressed as
follows:
Revenues (or Sales) – Expenses = Profits
An Income Statement (2 of 2)
An income statement will contain the following:
1. Revenues
2. Cost of Good Sold
3. Gross Profit
4. Operating Expenses
5. Net Operating Income
6. Interest Expense
7. Earnings Before Taxes
8. Income Taxes
9. Net Income
Table 3.1 H. J. Boswell, Inc. (1 of 2)
Income Statement ($ millions, except per share data) for the Year Ended
December 31, 2016
Sales Blank $2,700.00 Blank
Cost of goods sold Blank (2,025.00) Blank
Gross profit Blank $ 675.00 Blank
Operating expenses: Blank Blank Blank
Selling expense $(90.00) Blank Blank
General and administrative expense (67.50) Blank Blank
Depreciation and amortization expense (135.00) Blank Blank
Total operating expenses Blank (292.50) Blank
Net operating income (EBIT, or earnings before interest Blank $ 382.50 Income from
and taxes) operating
activities
Interest expense Blank (67.50) Cost of debt

financing
Earnings before taxes Blank $ 315.00 Blank
Income taxes Blank (110.25) Cost of corporate income

Taxes
Net income Blank $ 204.75 Income resulting from

operating and financing
activities
Additional information: Blank Blank Blank
Dividends paid to stockholders during Blank $ 45.00 Blank

2016
Number of common shares outstanding Blank 90.00 Blank
Earnings per share (EPS) Blank $ 2.28 Blank
Dividends per share Blank $ 0.50 Blank
Evaluating a Firm’s per Share Earnings
and Dividends
• Per Share earnings = company’s net income
divided by the number of common shares
outstanding.
• Dividends per share = total dividends paid divided
by the number of common shares outstanding.
Evaluating a Firm’s EPS and Dividends
(for Boswell, Table 3.1)
• Earnings per share = $204.75m 90m
= $2.28 per share
• Dividends per share = $45m 90m
= $0.50 per share
Connecting the Income Statement and the
Balance Sheet
• What can the firm do with the net income?: Pay
dividends to shareholders, and/or Reinvest in the
firm
– Boswell, Inc. earned net income of $204.75 million, of
which $45 million was distributed in dividends and
$159.75 million was retained and reinvested in the firm.
Interpreting Firm Profitability using the
Income Statement (1 of 5)
From H.J. Boswell Inc.’s income statement (Table 3-1)
we observe that firm has been profitable. We can
identify three different measures of profit or income:
1. The gross Profit margin is 25% ($675 million)
2. The operating profit margin is only 14.2%
($382.5 million)
3. The net profit margin is only 7.6% ($204.75
million)
1. 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. The markup percentage equals
gross profit divided by cost of goods sold
(= $675m ÷ $2.025m = 33.3%)
2. The operating profit margin
= net operating income ÷ sales
= $382.5 million ÷ $2,700 million
= 14.2%
– The operating profit margin is equal to the ratio of net
operating income or EBIT divided by firm’s sales.
3. The net profit margin
= net profits sales
= $204.75 million $2,700 million
= 7.6%
– Net profit margin indicates the percentage of revenues
left over after all expenses (including interest and
taxes) have been considered.
By comparing these margins to those of similar
businesses, we can dissect a firm’s performance
and identify expenses that are out of line.
GAAP and Earnings Management
• In the United States, while the firms must adhere to
GAAP, there is considerable room for company’s
managers to actively influence the firm’s reported
earnings.
• Managers have an incentive to tamper with earnings
as their pay depends upon it and because investors
pay close attention to earnings announcements.
• An audit by an independent accounting firm serves as
a check and balance to control management’s
incentive to disguise the firm’s financial condition.
CHECKPOINT 3.1: CHECK YOURSELF
Constructing an Income Statement
Reconstruct the firm’s income statement assuming the firm is able to cut its cost of
goods sold by 10% and that the firm pays taxes at a 40% rate. What is the firm’s net
income and earnings per share?
Step 1: Picture the Problem (1 of 2)
• The income statement can be expressed as
follows:
Revenues – Expenses = Net Income
• We are given information on revenues and
expenses (cost of goods sold, operating
expenses, interest expense and income taxes)
to fill the template given on next slide.
Revenues Blank
Less: Cost of goods sold Blank
Blank Equals Gross profit
Less: Operating expenses Blank
Blank Equals: net Operating income
Less: Interest expense Blank
Blank Equals: earnings Before taxes
Less: Income taxes Blank
Blank Equals: NET INCOME
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.
Step 3: Solve (1 of 2)
Revenues = $14,549,000,00 Blank
Less: Cost of goods sold = $8,347,500,000 Blank
Blank Equals: profit = $6,201,500,000
Less: Operating/other expenses = $3,841,000,000 Blank
Blank Equals: net Operating income = $2,370,500,000
Less: Interest expense = $74,000,000 Blank
Blank Equals: earnings Before taxes = $2,291,500,000
Less: Income taxes (40%) = $916,600,000 Blank
Blank Equals: NET INCOME = $1,374,900,000
Earnings per share:
= net income number of shares
= $1,374,900,000 716,296,296
= $1.92
Step 4: Analyze
The firm is profitable since it earned net income of
$1,374,900,000. The shareholders were able be
earn $1.96 per share.
3.3 CORPORATE TAXES
Corporate Taxes
A firm’s income tax liability is calculated using its
taxable income and the tax rates on corporate
income.
Taxable Income Marginal Tax Rate
$0–$50,000 15%
$50,001–$75,000 25%
$75,001–$100,000 34%
$100,001–$335,000 39%
$335,001–$10,000,000 34%
$10,000,001–$15,000,000 35%
$15,000,001–$18,333,333 38%
Over $18,333,333 35%
Computing Taxable Income
The table reveals the following:
– Tax rates range from 15% to 39%
– Tax rates are progressive i.e. corporations with higher
profits tend to pay more taxes.
Marginal and Average Tax Rates (1 of 3)
• Marginal tax rate is the tax rate that the company
will pay on its next dollar of taxable income.
• Average tax rate is total taxes paid divided by the
taxable income.
Example: What is the average and marginal tax
liability for a firm reporting $100,000 as taxable
income.
Taxable Income Marginal Tax Rate Tax Liability Cumulative Tax Average Tax Rate
Liability
$ 50,000 15% $ 7,500 $ 7,500 15.00%
75,000 25% 6,250 13,750 18.33%
100,000 34% 8,500 22,250 22.25%
• 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.
Dividend Exclusion for Corporate
Shareholders (1 of 2)
For corporate stockholders, the dividend received
are at least partially exempt from taxation. The
rationale behind the exclusion is to avoid double
taxation. The percentage of exempt taxes is based
on the degree of ownership of the firm.
Dividend Exclusion for Corporate
Shareholders (2 of 2)
Example What will be the taxable income if firm A receives
$100,000 in dividends from firm B
Ownership Interest Dividend Exclusion Dividend Income Taxable Income
Less than 20% 70% $100,000 $30,000
20% to 79% 75% $100,000 $25,000
80% or more 100% $100,000 $0
3.4 THE BALANCE SHEET
The Balance Sheet (1 of 4)
The balance sheet is a snapshot of the firm’s
financial position on a specific date. It is defined by
the following equation:
Total Assets = Total Liabilities + Total Shareholders Equity
• Total liabilities represent the total amount of
money the firm owes its creditors
• Total shareholders’ equity refers to the
difference in the value of the firm’s total assets
and the firm’s total liabilities.
• Total assets, sum of total shareholders’ equity
and total liabilities, represents the resources
owned by the firm.
• In general, GAAP requires that the firm report
assets using the historical costs.
• Cash and assets held for sale (such as
marketable securities) are an exception to the
rule. These assets are reported using the lower of
their cost or current market value.
• Assets whose value is expected to decline over
time (such as equipment) are adjusted downward
periodically by depreciating the historical cost.
Balance sheet reports the book value (equal to
historical cost less the accumulated depreciation).
• Generally, the book value is not equal to the
current market value of the firm’s assets.
Balance Sheets ($ millions), December 31, 2015 and 2016
Assets Blank Blank Liabilities and Stockholders’ Blank Blank
Equity
Blank 2015 2016 Blank 2015 2016

Cash $ 94.50 $ 90.00 Accounts payable $ 184.50 $ 189.00
Accounts 139.50 162.00 Accrued expenses 45.00 45.00
Receivable
Inventory 229.50 378.00 Short-term notes 63.00 54.00

Other current 13.50 13.50 Total current liabilities $ 292.50 $ 288.00
assets
Total current $ 477.00 $ 643.50 Long-term debt 720.00 771.75

assets
Gross plant 1,669.50 1,845.00 Total liabilities $1,012.50 $1,059.75

and
equipment
Assets Blank Blank Liabilities and Blank Blank
Stockholders’ Equity
Blank 2015 2016 Blank 2015 2016
Less (382.50) (517.50) Common stockholders’ Blank Blank

accumulated equity
depreciation
Net plant and $1,287.00 $1,327.50 Common stock-par value 45.00 45.00
equipment
Total assets $1,764.00 $1,971.00 Paid-in capital 324.00 324.00
Blank Blank Blank Retained earnings 382.50 542.25
Blank Blank Blank Total common $ 751.50 $ 911.25

stockholders’ equity
Blank Blank Blank Total liabilities and $1,764.00 $1,971.00

stockholders’ equity
Legend:
Assets: The Left-Hand Side of the Balance Sheet
Current Assets. Assets that the firm expects to convert to
cash in 12 months or less. Examples include cash, accounts
receivable, inventories, and other current assets.
• Cash. Every firm must have some cash on hand at all
times because cash expenditures can sometimes exceed
cash receipts.
• Accounts receivable. The amounts owed to the firm by its
customers who purchased on credit.
• Inventory. Raw materials that the firm utilizes to

build its products, partially completed items or
work in process, and finished goods held by the
firm for eventual sale.
• Other current assets. All current assets that do
not fall into one of the named categories (cash,
accounts receivable, and so forth). Prepaid
expenses (prepayments for insurance premiums,
for example) are a common example of an asset
in this catch-all category.
Gross Plant and Equipment. The sum of the

original acquisition prices of plant and equipment
still owned by the firm.
Accumulated Depreciation. The sum of all the
depreciation expenses charged against the prior
year’s revenues for fixed assets that the firm still
owns.
Net Plant and Equipment. The depreciated value
of the firm’s plant and equipment.
Liabilities and Stockholders’ Equity: The Right-

Hand Side of the Balance Sheet
Current Liabilities. Liabilities that are due and
payable within a period of 12 months or less.
Examples include the firm’s accounts payable,
accrued expenses, and short-term notes.
• Accounts payable. The credit suppliers extended to the

firm when it purchased items for its inventories.
• Accrued expenses. Liabilities that were incurred in the
firm’s operations but not yet paid. For example, the
company’s employees might have done work for which
they will not be paid until the following week or month. The
wages owed by the firm to its employees are recorded as
accrued wages.
• Short-term notes. Debts created by borrowing from a
bank or other lending source that must be repaid in 12
months or less.
Long-Term Debt. All firm debts that are due and

payable more than 12 months in the future. A
25-year mortgage loan used to purchase land or
buildings is an example of a long-term liability. If the
firm has issued bonds, the portion of those bonds
that is not due and payable in the coming 12
months is also included in long-term debt.
Common Stockholders’ Equity. Common

stockholders are the residual owners of a business.
They receive whatever income is left over after the
firm has paid all of its expenses. In the event the
firm is liquidated, the common stockholders receive
only what is left over—but never lose more than
they invested—after the firm’s other financial
obligations have been paid.
Figure 3.1 The Balance Sheet
Assets: The Left—Hand side of the
Balance Sheet
The left-hand side of the balance sheet lists the
firm’s assets, which are categorized into current and
fixed assets.
Current Assets
Current assets consists 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 Assets
Fixed assets are assets that the firm does not
expect to sell within one year. These include plant
and equipment, land, and other investments that
are expected to be held for an extended period of
time.
Liabilities and Stockholders’ Equity: The
Right-Hand Side of the Balance Sheet (1 of 2)
• This side of the balance sheet indicates how the
firm finances its assets.
• Current liabilities represent 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 liabilities refer to debt with maturities
longer than a year such as bank loans, bonds.
Liabilities and Stockholders’ Equity: The
Right-Hand Side of the Balance Sheet (2 of 2)
• The stockholder’s equity includes the following:
Par value of common stock + Paid in Capital
+ Retained Earnings.
• We can also express stockholders’ equity as
follows:
Stockholders' equity = Total Assets – Total Liabilities
Firm Liquidity and Net Working
Capital (1 of 2)
• The Liquidity of an asset refers to the speed with
which it can be converted to cash without loss of
value.
• We can also think in terms of liquidity of the firm
as a whole – that is, the firm’s ability to regularly
convert its current assets to cash so that it can
pay its bills on time.
• Net Working Capital = Current Assets – Current
Liabilities
Firm Liquidity and Net Working
Capital (2 of 2)
• 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.
Constructing a Balance Sheet
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 net working capital?
• The firm’s balance sheet can be expressed as
follows:
Total Shareholders’ Equity + Total Liabilities = Total Assets
Current Assets Current Liabilities
Cash Accounts payable
Accounts Receivable Short-term debt
Inventories Other current liabilities
Other current assets
Total current assets Total current liabilities
Long-term (fixed) assets Long-term Liabilities
Gross PPE Long-term debt
Less: Accumulated depreciation
Net property, plant and equip. Owner’s Equity
Par value of common stock
Other long-term assets Paid-in-capital
Retained earnings
Total long-term assets Total equity
Total Assets Total Liabilities and
Owners’ equity
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.
Step 3: Solve
Cash 885,000,000 Current liabilities 1,128,000,000
Inventories 1,615,000,000
Other current assets 809,000,000
Total current assets 3,309,000,000 Total current 1,128,000,000

liabilities
Net Property, Plant and 2,523,000,000 Long-term liabilities 2,539,000,000

equipment
Other long-term assets 590,000,000 Common Equity 2,755,000,000
Total Assets $6,422,000,000 Total Liabilities and $6,422,000,000

Equity
Step 4: Analyze
We can make the following observations from Gap’s
Balance sheet:
– The total assets of $6,422,000,000 is financed by a
combination of current liabilities, long-term liabilities
and owner’s equity. Owner’s equity accounts for
$2,755,000,000 of the total.
– The firm has a healthy net working capital of
$2,181,000,000.
Debt and Equity Financing
The right-hand side of the balance sheet reveals the
following two sources of money used to finance the
purchase of the firm’s assets listed on the left-hand
side of the balance sheet.
– Borrowings (debt financing)
– firms owners (equity financing)
Debt versus Equity
• 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.
Book Values, Historical Costs, and Market
Values
• Book values reported in the balance sheet can
differ from market values for three reasons.
– Book values are reflect their historical cost at the time
the asset was acquired, not their current market value.
– Depreciation expense used to reduce value of fixed
assets reflects accounting and tax rules rather than
actual changes in market values.
– Intangible assets are not reflected fully in the firm’s
balance sheet.
3.5 THE CASH FLOW STATEMENT
The Cash Flow Statement
The cash flow statement is a report that firms use to
explain changes in their cash balances over a
specific period of time by identifying all of the
sources and uses of cash for that period.
Change in Cash Balance = Ending Cash Balance - Beginning Cash Balance
Sources and Uses of Cash (1 of 4)
• A source of cash is any activity that brings cash
into the firm. For example, sale of equipment.
• A use of cash is any activity that causes cash to
leave the firm. For example, payment of taxes.
Table 3-3 H. J. Boswell, Inc., Balance Sheets and Balance
Sheet Changes (1 of 2)
Blank 2015 2016 Change
Cash $ 94.50 $ 90.00 $ (4.50)
Accounts receivable 139.50 162.00 22.50
Inventory 229.50 378.00 148.50
Other current assets 13.50 13.50 0.00
Total current assets $ 477.00 $ 643.50 $166.50
Gross plant and equipment 1,669.50 1,845.00 175.50
Less accumulated depreciation (382.50) (517.50) (135.00)
Net plant and equipment $1,287.00 $1,327.50 $ 40.50
Total assets $1,764.00 $1,971.00 $207.00
Table 3-3 H. J. Boswell, Inc., Balance Sheets and Balance
Sheet Changes (2 of 2)
Blank 2015 2016 Change
Accounts payable $ 184.50 $ 189.00 $ 4.50
Accrued expenses 45.00 45.00 0.00
Short-term notes 63.00 54.00 (9.00)
Total current liabilities $ 292.50 $ 288.00 $ (4.50)
Long-term debt 720.00 771.75 51.75
Total liabilities $1,012.50 $1,059.75 $ 47.25
Common stockholders’ equity Blank Blank Blank
Common stock—par value 45.00 45.00 0.00
Paid-in capital 324.00 324.00 324.00
Retained earnings 382.50 542.25 159.75
Total common stockholders’ equity $ 751.50 $ 911.25 $159.75
Total liabilities and stockholders’ equity $1,764.00 $1,971.00 $207.00
Why did the cash balance decline by $4.50m?. See table 3.3
and table below:
Sources of Cash Uses of Cash
Increase in Accounts Increase in Accounts

Payable = $4.50 Receivable $22.50
Increase in long-term debt = $51.75 Increase in inventory = $148.50
Increase in retained Increase in net plant and

earnings = $159.75 equipment = $40.50
Blank Decrease in short-term notes = $9
Total Sources of cash = $216.00 Total Uses of cash = $220.50
An analysis of H.J. Boswell’s operations reveals the
following:
– The firm used more cash than it generated, resulting in
a deficit of $4.5 million
– The main source of cash flow was retained earnings
($159.75m) and long-term debt ($51.75m)
– The largest use of cash was for acquiring inventory at
$148.5 million.
Sources of Cash Uses of Cash
Decrease in an asset account Increase in an asset account
Increase in a liability account Decrease in a liability account
Increase in an owner’s equity account Decrease in an owners’ equity account
Cash Flow Statement Format (1 of 3)
The basic format for a cash flow statement is as
follows:
Beginning Cash Balance
Plus: Cash Flow from Operating Activities
Plus: Cash Flow from Investing Activities
Plus: Cash Flow from Financing Activities
Equals: Ending Cash Balance
• Operating activities represent the company’s core
business, including sales and expenses.
• Investing activities include the cash flows that
arise out of the purchase and sale of long-term
assets such as plant and equipment.
Financing activities represent changes in the firm’s
use of debt and equity such as issue of new shares,
the repurchase of outstanding shares, and the
payment of dividends.
Table 3-4 H. J. Boswell, Inc. (1 of 2)
Ending cash balance for 2015 (beginning cash Blank Blank $94.50
balance for 2016)
Operating activities Blank Blank Blank

Net income $204.75 Blank Blank
Increase in accounts receivable (22.50) Blank Blank
Increase in inventory (148.50) Blank Blank
No change in other current assets 0.00 Blank Blank
Depreciation expense 135.00 Blank Blank
Increase in accounts payable 4.50 Blank Blank
No change in accrued expenses 0.00 Blank Blank
Cash flow from operating activities Blank $ 173.25 Blank
Investing activities Blank Blank Blank
Purchases of plant and equipment (175.50) Blank Blank
Cash flow from investing activities Blank (175.50) Blank
Table 3-4 H. J. Boswell, Inc. (2 of 2)
Ending cash balance for 2015 (beginning cash balance Blank Blank $94.50
for 2016)
Financing activities Blank Blank Blank
Decrease in short-term notes (9.00) Blank Blank
Increase in long-term debt 51.75 Blank Blank
Cash dividends paid to shareholders $ (45.00) Blank Blank
Cash flow from financing activities Blank (2.25) Blank
Increase (decrease) in cash during the year Blank Blank $ (4.50)
Ending cash balance for 2016 Blank Blank $90.00
Evaluating the Cash Flow Statement
The statement can be used to answer a number of
important questions such as:
– How much cash did the firm generate from its
operations?
– How much did the firm invest in plant and equipment?
– Did the firm raise additional funds, and if so, how much
and from what sources?
Quality of Earnings: Evaluating Cash Flow
from Operations (1 of 3)
Since reported earnings can sometimes be
misleading, we can combine information from the
firm’s income statement and the statement of cash
flows to evaluate the quality of firm’s reported
earnings.
Cash Flow from Operations

Quality of Earnings =
Net Income
• A ratio of 1.00 indicates very-high-quality earnings
and that the firm’s operating cash flows and net
income are in sync with each other.
• A low ratio indicates firm’s reliance on non-
operating sources of cash to generate net income
that may not be sustainable.
• The quality of earnings ratio for Boswell
= $173.25m $ 204.75m = 84.6%
• Boswell’s ratio was only 84.6% due to more credit
sales than it collected, increase in inventories,
non-cash depreciation expense, and increased
reliance on accounts payable.
Sustainable Capital Expenditures:
Evaluating Investment Activities (1 of 2)
This ratio calculates the extent to which the firm’s
operating cash flows can pay for capital
expenditures. Higher ratio will mean less
dependence on capital markets for financing.
Cash Flow from Operations

Capital Acquisitions Ratio =
Cash Paid for Capital Expenditures (CAPEX)
Sustainable Capital Expenditures:
Evaluating Investment Activities (2 of 2)
• For Boswell, the capital acquisition ratio is:
= $157.75m $159.5m = 98.9%
• Boswell was, on average, able to finance 98.9%
of its new expenditures out of the firm’s
current-year operations.
Interpreting the Statement of Cash Flows
Go to http:finance.google.com/finance and get the cash flow statements for the most
recent four-year period for Exco Resources (XCO). How does their cash from
investing activities compare to their cash flow from operating activities in 2015.
Step 1: Picture the Problem
• The cash flow statement identifies the net sources
and uses of cash for a specific period of time into
3 groups: operating activities, investing activities,
and financing activities.
• Here we have to compare the cash flow from
operating activities and investment activities in
2012 for Exco Resources (XCO).
We can compare the cash flow from operating
activities and cash flow from investing activities by
retrieving the cash flow statement from
http://finance.google.com/finance
Cash flow from operating activities
EXCO had a positive cash flow from operating
activities of $577.83 million in 2015. In 2011,
the cash flow from operating activities was
much higher at $362.09 million. The primary
contributors to the operating cash flows were
adjustments to net income.
Cash flow from investing activities:
Cash flow from investing activities were
($300.83) million in 2015, compared to
(221.59) in 2014.
Step 4: Analyze
• The cash flow statement for 2015 depicts a
profitable firm with positive cash flow from
operations. However, the cash flow from
operations have been steadily declining since
2012. In 2010, cash flow from operations was
$514.79million.
• The firm has been reducing its investment in
capital expenditure over the years ($325.20 million
in 2015 compared to $536.92 in 2012).
Key Terms (1 of 6)
• Accounts receivable
• Accounts payable
• Accumulated depreciation
• Average tax rate
• Balance sheet
• Cash flow from operations
• Cash flow statement
Key Terms (2 of 6)
• Cost of goods sold
• Current assets
• Current liabilities
• Depreciation expense
• Dividends per share
• Earnings before interest and taxes (EBIT)
• Earnings per share
Key Terms (3 of 6)
• Fixed assets
• Gross plant and equipment
• Gross profit margin
• Income statement
• Inventories
• Liquidity
• Long-term debt
Key Terms (4 of 6)
• Marginal tax rate
• Market value
• Net operating income
• Net income
• Net plant and equipment
• Net profit margin
• Net working capital
• Notes payable
Key Terms (5 of 6)
• Operating profit margin
• Paid-in capital
• Par value
• Profits
• Quality of earnings ratio
• Retained earnings
• Revenues
Key Terms (6 of 6)
• Source of cash
• Stockholders’ equity
• Taxable income
• Total assets
• Total liabilities
• Total shareholders’ equity
• Treasury stock
• Uses of cash
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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson Education,

Interest expense Blank (67.50) Cost of debt

Earnings before taxes Blank $ 315.00 Blank

Income taxes Blank (110.25) Cost of corporate income

Net income Blank $ 204.75 Income resulting from

Additional information: Blank Blank Blank

Dividends paid to stockholders during Blank $ 45.00 Blank

Number of common shares outstanding Blank 90.00 Blank

Earnings per share (EPS) Blank $ 2.28 Blank

Dividends per share Blank $ 0.50 Blank

Less: Cost of goods sold Blank

Blank Equals Gross profit

Less: Operating expenses Blank

Blank Equals: net Operating income

Less: Interest expense Blank

Blank Equals: earnings Before taxes

Less: Income taxes Blank

Blank Equals: NET INCOME

Revenues = $14,549,000,00 Blank

Less: Cost of goods sold = $8,347,500,000 Blank

Blank Equals: profit = $6,201,500,000

Less: Operating/other expenses = $3,841,000,000 Blank

Blank Equals: net Operating income = $2,370,500,000

Less: Interest expense = $74,000,000 Blank

Blank Equals: earnings Before taxes = $2,291,500,000

Less: Income taxes (40%) = $916,600,000 Blank

Blank Equals: NET INCOME = $1,374,900,000

75,000 25% 6,250 13,750 18.33%

100,000 34% 8,500 22,250 22.25%

Ownership Interest Dividend Exclusion Dividend Income Taxable Income

Less than 20% 70% $100,000 $30,000

20% to 79% 75% $100,000 $25,000

80% or more 100% $100,000 $0

Blank 2015 2016 Blank 2015 2016

Inventory 229.50 378.00 Short-term notes 63.00 54.00

Total current $ 477.00 $ 643.50 Long-term debt 720.00 771.75

Gross plant 1,669.50 1,845.00 Total liabilities $1,012.50 $1,059.75

Blank 2015 2016 Blank 2015 2016

Less (382.50) (517.50) Common stockholders’ Blank Blank

Total assets $1,764.00 $1,971.00 Paid-in capital 324.00 324.00

Blank Blank Blank Retained earnings 382.50 542.25

Blank Blank Blank Total common $ 751.50 $ 911.25

Blank Blank Blank Total liabilities and $1,764.00 $1,971.00

• Inventory. Raw materials that the firm utilizes to

Gross Plant and Equipment. The sum of the

Liabilities and Stockholders’ Equity: The Right-

• Accounts payable. The credit suppliers extended to the

Long-Term Debt. All firm debts that are due and

Common Stockholders’ Equity. Common

Total current assets 3,309,000,000 Total current 1,128,000,000

Net Property, Plant and 2,523,000,000 Long-term liabilities 2,539,000,000

Other long-term assets 590,000,000 Common Equity 2,755,000,000

Total Assets $6,422,000,000 Total Liabilities and $6,422,000,000

Change in Cash Balance = Ending Cash Balance - Beginning Cash Balance

Cash $ 94.50 $ 90.00 $ (4.50)

Accounts receivable 139.50 162.00 22.50

Inventory 229.50 378.00 148.50