Financial Statements

Fall 2022
Lecture 2

Chiyoung Cheong
Financial Statements and Cash Flow
(Chapter 2)

Our emphasis is on determining a firm’s cash flow from its

financial statements (not on preparing financial statements)
Keep in mind: Cash flow is a company’s lifeblood .

Other objectives:
Know the difference between book value and market value
Know the difference between accounting income and cash flow

2
Financial Statements
• There are four main financial reports:
• Balance Sheet
• Income Statement
• Cash Flow Statement
• Owners’ Equity (Ignored by us)

We use information in these statements to estimate

Operating and Free Cash Flows

2-3
 Difference between
Accounting and finance perspectives
• Accounting is transactions based, not cash flow based.

• Very simple example: You invest $1,000 today in some safe investment. You know for sure that
you will receive $3,000 in one year.
Accounting Perspective: You have earned $2,000 today. You are earning nothing next year.
Accounting entry: +$2,000 today.
Finance Perspective: You are losing $1,000 today. You are gaining $3,000 tomorrow.
Finance entry: –$1,000 today
+$3,000 next year. (Note: future payments will be reduced for possible
non-payment risk, time value of money, etc.)
The Balance Sheet
• A snapshot of the firm’s assets and liabilities
at a given point in time (“as of …”)
• Assets
− Left-hand side (or upper portion)
− In order of decreasing liquidity
• Liabilities and Owners’ Equity
• Right-hand side (or lower portion)
• In ascending order of when due to be paid
• Balance Sheet Identity
▪ Assets = Liabilities + Stockholders’ Equity
The Balance Sheet
Figure 2.1
Total Value of Assets Total Value of Liabilities
and Shareholders' Equity

Net
Working Current Liabilities
Current Assets Capital

Long Term Debt

Fixed Assets

1. Tangible
2. Intangible Shareholder Equity
The Balance Sheet
• Net working capital
• Current Assets minus Current Liabilities
• Usually positive for a healthy firm
• Liquidity
− Speed and ease of conversion to cash without
significant loss of value
− Valuable in avoiding financial distress
• Debt versus Equity
− Shareholders’ equity = Assets - Liabilities
Balance Sheet

8
Market vs. Book Value
• Book value = the balance sheet value of the
assets, liabilities, and equity.
• Market value = true value; the price at
which the assets, liabilities, or equity can
actually be bought or sold.
• Market value and book value are often very
different. Why?
• Which is more important to the decision-making
process?
Klingon Corporation
Example 2.2
 Income Statement
• The income statement measures performance
over a specified period of time (period,
quarter, year).
• Report revenues first and then deduct any
expenses for the period
• End result = Net Income = “Bottom Line”
• Dividends paid to shareholders
• Addition to retained earnings
• Income Statement Equation:
• Net Income = Revenue - Expenses
U.S. Corporation Income Statement
The Concept of Cash Flow
• Cash flow = one of the most important
pieces of information that can be derived from
financial statements
• The accounting Statement of Cash Flows does
not provide the same information that we are
interested in here
• Our focus: how cash is generated from
utilizing assets and how it is paid to those
who finance the asset purchase.
Cash Flow From Assets
• Cash Flow From Assets (CFFA)
= Operating Cash Flow (OCF)
– Net Capital Spending (NCS)
– Changes in NWC (ΔNWC)

• Cash Flow From Assets (CFFA)

= Cash Flow to Creditors (CF/CR)
+ Cash Flow to Stockholders (CF/SH)
 Example: U.S. Corporation
Balance Sheet U.S. Corporation
Assets Liabiities & Owners' Equity
2009 2010 2009 2010 Income Statement
Current Assets Current Liabilities Net sales $1,509
Cash $104 $160 Accounts Payable $232 $266
Accounts Receivable 455 688 Notes Payable 196 123
Cost of goods sold 750
Inventory 553 555 Total $428 $389 Depreciation 65
Total $1,112 $1,403
Earnings before interest and taxes $694
Fixed Assets
Net Fixed assets $1,644 $1,709 Long-term debt $408 $454 Interest Paid 70
Owners' equity Taxable income $624
Common stock and
paid-in surplus 600 640
Taxes 212
Retained earnings 1,320 1,629 Net Income $412
Total $1,920 $2,269
Dividends $103
Total Liabilties &
Total assets $2,756 $3,112 Owners Equity $2,756 $3,112 Addition to retained earnings $309

• CFFA = OCF – NCS - ΔNWC

OCF = EBIT + depreciation – taxes

NCS = ending net FA– beginning net FA + depreciation

ΔNWC = ending NWC – beginning NWC

• CFFA =
 Example: U.S. Corporation
U.S. Corporation
Balance Sheet
Assets Liabiities & Owners' Equity U.S. Corporation
2009 2010 2009 2010 Income Statement
Current Assets Current Liabilities Net sales $1,509
Cash $104 $160 Accounts Payable $232 $266
Cost of goods sold 750
Accounts Receivable 455 688 Notes Payable 196 123
Inventory 553 555 Total $428 $389 Depreciation 65
Total $1,112 $1,403 Earnings before interest and taxes $694
Fixed Assets Interest Paid 70
Net Fixed assets $1,644 $1,709 Long-term debt $408 $454 Taxable income $624
Owners' equity
Taxes 212
Common stock and
paid-in surplus 600 640 Net Income $412
Retained earnings 1,320 1,629 Dividends $103
Total $1,920 $2,269 Addition to retained earnings $309
Total Liabilties & Owners
Total assets $2,756 $3,112 Equity $2,756 $3,112

• CFFA = CF/CR + CF/SH

CF/CR = interest paid – net new borrowing

CF/SH = dividends paid – net new equity

• CFFA =
Accounting numbers are not cash flows
We’ll use cash flows instead of earnings or net
income
• To go from accounting earnings (EBIT) to cash flows,
we must:
– Add back non-cash expenses, such as
depreciation and amortization,
– Deduct net investment in long-term assets (aka
capital expenditures)
– Deduct net investment in working capital
(inventory, accounts receivable and payable)
Accounting treatment of capital
expenditures and depreciation
• Investment in long-term assets (capital expenditures) are not treated as
accounting expenses. But they do cause immediate cash outflows:
therefore, we deduct capital expenditures
• Accounting assumes capital expenditures) are incurred gradually across
years of use (depreciation), not when they are actually made!
• Since depreciation is not an actual cash expense, it does not reduce the
cash flows.
• However, depreciation reduces taxable income and taxes. Therefore we
add depreciation back.
Investment in Working capital
• Accounting records operating revenues and operating
expenses when these are incurred.
• Accountants record a sale when it's done, not when it is
paid for! The difference goes to accounts receivable.
• Accountants record an operating expenditure when it is
incurred, not when it is paid for! The difference goes to
accounts payable.
• The differences between when operating revenues and
operating expenses are incurred and when they are actually
paid for are captured by the change in working capital.
• Change in Working Capital =change in current assets –
change in current liabilities
• increase in working capital reduces cash flows in that
year
• decrease in working capital increases cash flows in that
year
Calculating Cash Flow From Assets
(Free Cash Flows)
Sales /Revenues
– Cash Operating Expenses (COSG and SSG&A)
EBITDA or Operating Income
– non-cash expenses (e.g., depreciation)
EBIT or Net Operating Income (Note: We ignore interest payments)
– Income Taxes
Net Operating Profits after Taxes (NOPAT or NOI×(1-tax rate))
+ Depreciation
Operating Cash Flows
– Change in non-cash working capital
– Capital expenditures
– Change in other assets net
Cash Flow From Assets
Investment