Principles of Finance

• Prof. Abdelgader M.A Abdalla

• School of Management Studies University of

Khartoum – Sudan
• 2023

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 Lecture 3

• Understanding Financial Statements and Cash

Flows

• 2023

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 Objectives
• Understanding the makeup of the basic financial
statements: income statement and balance sheet.

• Understanding the difference between book value and

market value.

• Understanding the difference between accounting

income and cash flow

• Measuring cash flows from the financial statements

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 Income Statement

SALES
- EXPENSES
= PROFIT

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 Income Statement

Revenue
SALES
- EXPENSES
= PROFIT

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 Income Statement

SALES •Cost of Goods Sold

- EXPENSES
= PROFIT

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 Income Statement

SALES •Cost of Goods Sold

•Operating Expenses
- EXPENSES
= PROFIT

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 Income Statement

SALES •Cost of Goods Sold

•Operating Expenses
- EXPENSES (marketing, administrative)

= PROFIT

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 Income Statement

SALES •Cost of Goods Sold

•Operating Expenses
- EXPENSES (marketing, administrative)
•Financing Costs
= PROFIT

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 Income Statement

SALES •Cost of Goods Sold

•Operating Expenses
- EXPENSES (marketing, administrative)
•Financing Costs
= PROFIT
•Taxes

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 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
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 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
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 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
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 Balance Sheet

Outstanding
Debt
Total Assets = +
Shareholders’
Equity

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 Balance Sheet
Assets Liabilities (Debt) & Equity
Current Assets Current Liabilities
Cash Accounts Payable
Marketable Securities Accrued Expenses
Short-term notes
Accounts Receivable
Inventories
Long-Term Liabilities
Long-term notes
Prepaid Expenses Mortgages
Fixed Assets Equity
Machinery & Equipment Preferred Stock
Buildings and Land Common Stock (Par value)
Other Assets Paid in Capital
Retained Earnings
Investments & patents

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 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts receivable,
inventories, prepaid expenses.

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 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts receivable,
inventories, prepaid expenses.
• Fixed Assets: machinery
and equipment, buildings,
and land.

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 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts receivable,
inventories, prepaid expenses.
• Fixed Assets: machinery and equipment,
buildings, and land.
• Other Assets: any asset that is not a current
asset or fixed asset.
– Intangible assets, such as patents and copyrights
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 Financing
• Debt Capital: financing provided by a
creditor.
• Short-term debt: borrowed money that must
be repaid within the next 12 months.
– Accounts payable, other payables such as interest
or taxes payable, accrued expenses, short-term
notes.
• Long-term debt: loans from banks or other
sources that lend money for longer than 12
months.
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 Financing
• Equity Capital: shareholders’ investment in
the firm.
• Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of liquidation
of the firm.
• Common Stockholders: residual owners of a
business. They receive whatever is left after
creditors and preferred stockholders are paid

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 Market Vs. Book Value
• The balance sheet provides the book value of the assets,
liabilities and equity.

• Market value is 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?
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 Cash flows

• Profits are not the same as cash flows.

• We are interested in calculating cash

flows from the perspectives of the firm’s
investors rather than from an accounting
view.

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 Profit Vs. Cash flow
Particular Profit Cash flow
Sales 2000 2000
-cost of goods sold 1000 1000
- administrative and selling 200 200
expenses

- Depreciation 500 0
= EBT 300 800
Tax 40% 120 120
= Net profit/cash flow 180 680

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 Cash flows
• Cash flows that are generated through a firm’s
assets equal to its cash flows paid to – or
received from- the company’s investors (both
creditors and stockholders)

• Cash flow from assets = cash flow to creditors

+ cash flow to stockholders

• It is called free cash flows

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 Free Cash Flows
Free cash flow: cash flow that is free and available
to be distributed to the firm’s investors (both
debt and equity investors).

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 Free Cash Flows
Cash Flows from Cash Flows from
Assets (CFA) = Financing

Cash flows Cash flows paid to - or

generated through
the firm’s assets
= received from - the firm’s
investors (creditors &
stockholders)
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 Calculating Free Cash Flows:
An Asset Perspective

After-tax cash flow

from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
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 Calculating Free Cash Flows:
An Asset Perspective

Operating income
After-tax cash flow + depreciation
from operations - cash tax payments
(OCF)
less
investment in net
operating
working capital
less
investments in fixed
and other assets
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 Calculating Free Cash Flows:
An Asset Perspective

After-tax cash flow

from operations
[Change in current
less assets]
investment in net -
[change in non-interest
operating
bearing current liabilities]
working capital NCWC
less
investments in fixed
and other assets
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 Calculating Free Cash Flows:
An Asset Perspective

After-tax cash flow

from operations
less
investment in net Change in gross
operating fixed assets, and
working capital any other assets
less that are on the
balance sheet.
investments in fixed NCS
and other assets
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 Calculating Free Cash Flows:
A Financing Perspective

CF to creditors = Interest payments to creditors-

change in debt principal
CF to common stockholders= dividends paid to
stockholders
- change in stock

= Financing Free Cash Flows

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 Free Cash flows: an asset perspective

• Cash Flow From Assets (CFA) =

OCF – NCS – CNWC,

where;
• OCF= Operating Cash Flow. (I/S)
• NCS = Net Capital Spending ( B/S and I/S
• CNWC = Changes in NWC (B/S)

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 Free Cash flows: Financing perspective

• CF to Creditors ((I/S and B/S ) = interest paid –

net new borrowing

• CF to Stockholders (I/S and B/S ) = dividends

paid – net new equity raised
• Cash flows from assets = cash flows from
financing.

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 Example
• See attached example
• Calculate the followings for US Corporation
2005:
– Cash flows from assets
– Cash flows to stockholders
– Cash flows to creditors

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Corporation Income Statement

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Corporation Balance Sheet

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 Solution
• OCF = EBIT+ Depreciation- tax expenses
• OCF = 694+65-212= 547
• NCS = ending fixed assets – beginning fixed assets +
depreciation
• NCS = 1709– 1644 + 65 = 130
• Change NWC= ending net working capital – beginning net
working capital
• CNWC = (1403-389) – (1112-428) = 330
• CFA = 547-130-330 = 87

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 Solution
• Cash flows to stockholders= dividends paid – net new
equity raised
• Cash flows to stockholders = 103- (640-600)= 63
• Cash flows to creditors= interest paid –net new
borrowing
• Cash flows to creditors = 70–(454-408)= 24
• CFA = Cash flows to stockholders + Cash flows to
creditors
• 87= 63+ 24

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