CHAPTER 2

Financial Statements
and Cash Flow
FIN 6301: Financial Management
Instructor: Dr. Hiro Nishi

The University of Texas at Dallas

Naveen Jindal School of Management

LEARNING OBJECTIVES

1. Understand how a firm’s balance sheet

is structured.

2. Understand how a firm prepares an

income statement.

3. Be able to distinguish between cash

flows and revenues (expenses).

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 BALANCE SHEET

BALANCE SHEET
The balance sheet provides a “snapshot” of a
firm’s financial position as of a specific date
(ex. December 31, 2020).

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BALANCE SHEET
ASSETS (A) LIABILITIES (L)
о Cash о Accounts payable
о Marketable securities о Short-term liabilities
(e.g., interest, taxes)
о Accounts receivable
о Short-term notes
о Inventories
о Long-term Liabilities
о Fixed Assets

EQUITY (E)
о Preferred Stock
о Common Stock
о Retained Earnings
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BALANCE SHEET

Liquidity
• Speed and ease of conversion to cash
without significant loss of value
• Valuable in avoiding financial distress

Securities (Ex: Apple stock) A baby diaper machine

Liquid Illiquid
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NET WORKING CAPITAL
ASSETS (A) LIABILITIES (L)
о Cash о Accounts payable
о Marketable securities о Short-term liabilities
(e.g., interest, taxes)
о Accounts receivable
о Short-term notes
о Inventories
о Long-term Liabilities
о Fixed Assets

Net working capital (NWC)

= a firm’s current assets – Current liabilities

NET WORKING CAPITAL

• In general, the larger the NWC, the better the
firm’s ability to repay its debt.
í Usually positive for a healthy firm (but can
be negative or zero).

• An increase in net working capital may NOT

always be good news.
í If the level of inventory goes up, net
working capital will also increase.
í Increasing inventory level may indicate
inability to sell. 7
BOOK VS. MARKET VALUE
Book value
• The value of the assets, liabilities and equity
on the balance sheet.
• Transactions are recorded at historical costs.

$50K ĺ $40K ĺ $30K ĺ $20K

Market value
• The price, at which the assets, liabilities or
equity can be bought or sold today

BOOK VS. MARKET VALUE

Book value and market value can be quite
different.
• The current market price of common stock is
unlikely to be the same as the price when the
firm sold new stock.

Example:
• Nishi Tofu, Co. sold its stock at $20/share 5
years ago
• Stock is trading at $42/share today.

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 INCOME STATEMENT

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INCOME STATEMENT
The income statement measures the
performance of a firm over a specific period of
time (ex. year, quarter).
• Report revenues first and then deduct any
expenses for the period
• End result = Net Income = “Bottom Line”
i. Dividends paid to shareholders
ii. Addition to retained earnings

Revenue – Expenses = Net Income

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 INCOME STATEMENT
Nishi Tofu Co. Income Statement (in $mm)

Operating section: Total operating revenues $2,262

Cost of goods sold 1,655
shows the firm’s
Selling, general, and administrative expenses 327
revenues & expenses
Depreciation 90
from its operations
Operating income $190
Other income 29

Earnings before interest and taxes $219

Non-operating Interest expense 49
section: Earnings before taxes $170
includes all financing Current taxes 71
costs Deferred taxes 13

Net income $86

Addition to retained earnings $43

Dividends $43
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GAAP & INCOME STATEMENT

GAAP Matching Principle
• Recognizes revenue when earned (time of
sales)
- Not when cash comes in (= collection)

• Matches expenses required to generate

revenue to the period of recognition
- Including expenses that do not affect cash
flow
- Example: Depreciation (see the next page)
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WHAT IS DEPRECIATION?
Depreciation: Allocation of an expense on a long-
term asset over the expected life of the asset.

Example:
Nishi Tofu Co. buys a certain machine for $1
million and paid in cash. The firm plans to use it
for the next 5 years.
• $1 million/5 years = $200,000 expense/year
• The depreciation expense appears as an
expense in the income statement.
• Note: The firm spends $0 cash after the initial
year.
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EXAMPLE #1
Black & Scholes Co. reported the following
results in its income statement. What is the
firm’s gross profit?
What is the operating income (EBIT)?
• Sales = $1,500,000
• Cost of Goods Sold = $980,000
• Administrative Expenses = $90,000
• Marketing Expenses = $120,000
• Depreciation Expense = $95,000
• Interest Expense = $45,000
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EXAMPLE #1 (CONT.)

Sales 1,500,000
Cost of Goods Sold 980,000
Gross Profit $520,000


Administrative Expenses 90,000

Marketing Expenses 120,000
Depreciation Expense 95,000
Operating Income $215,000


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EXAMPLE #2
Given the information from the previous
questions, calculate the earnings before taxes
(EBT) of the firm. In other words, what is the
firm’s taxable income?

The firm’s operating income minus

Interest Expense 45,000

Taxable Income $170,000


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 CASH FLOW OF THE FIRM

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“ACCOUNTING” CASH FLOW

“Statement of Cash Flows”
1. Cash flows from Operations
• Ex. Sales revenue, labor expenses
2. Cash flows from Investing
• Ex. Purchase of new equipment
3. Cash flows from Financing
• Ex. Borrowing funds, payment of dividends
This statement does not provide the
information that we are interested in finance.
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“FINANCIAL” CASH FLOW

Provide cash
Operations!
Investors Firm
(Liabilities &
(Assets)
Equity)

Gives cash back

1. How cash is spent for and generated from the

firm’s operations
2. How cash is received from and paid to those,
who finance the assets (e.g., shareholders) 20

“FINANCIAL” CASH FLOW

1. Cash generated from utilizing assets
= Operating Cash Flow (OCF) Cash "inflow"

– Net Capital Spending (NCS)

Cash "outflow"
– Changes in NWC (ǻNWC)

2. Cash paid to investors

= Cash Flow to Creditors (CF-CR)
+ Cash Flow to Stockholders (CF-SH)
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OPERATING CASH FLOW
Nishi Tofu Co. Income Statement (in $mm)
Sales 2,262
Cost of goods sold 1,655
Other expenses 327
Depreciation 90
Other income 29
EBIT 219
Interest 49
Taxable income 170
Current taxes 84 71
Deferred taxes 13
Net income 86

OCF = EBIT + Depreciation – Current taxes

= 219 + 90 – 71 = $238 $ 225
84 22
OCF = Net income + Depreciation + Interest
= 86 + 90 + 49 = 225

NET CAPITAL SPENDING

Nishi Tofu Co. Balance Sheets (in $mm)
2019 2020 2019 2020

Cash 157 198 Accounts payable 455 486

Accounts receivables 270 294

Inventory 280 269 Deferred taxes 104 117

Total 707 761 Long-term debt 458 471

Retained earnings 347 390

Net fixed assets 1,035 1,118 Common stock 378 415

Total assets 1,742 1,879 Total liabilities & equity 1,742 1,879

NCS = Ending Net FA – Beginning Net FA

+ Depreciation
= 1,118 – 1,035 + 90 = $173 23
ǻ IN NET WORKING CAPITAL
Nishi Tofu Co. Balance Sheets (in $mm)
2019 2020 2019 2020

Cash 157 198 Accounts payable 455 486

Accounts receivables 270 294

Inventory 280 269 Deferred taxes 104 117

Total 707 761 Long-term debt 458 471

Retained earnings 347 390

Net fixed assets 1,035 1,118 Common stock 378 415

Total assets 1,742 1,879 Total liabilities & equity 1,742 1,879

ǻNWC = Ending NWC – Beginning NWC

= (761 – 486) – (707 – 455) = $23
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IN-CLASS EXERCISE #1
Below is Nishi Tofu Co.’s Income Statement (in
$thousand). What is the operating cash flow during
the year?

Sales 35,000
Cost of goods sold 18,000
Other expenses 8,000
Depreciation 4,000
EBIT 5,000
Interest 2,000
Taxable income 3,000
Current taxes (21%) 630
Deferred taxes -
Net income 2,370
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CASH FLOW FROM ASSETS

Cash generated from utilizing assets

= Operating Cash Flow (OCF)

– Net Capital Spending (NCS)
– Changes in NWC (ǻNWC)
= 238 – 173 – 23 = $42

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CASH FLOW TO CREDITORS

Nishi Tofu Co. Balance Sheets (in $mm)
2019 2020 2019 2020

Cash 157 198 Accounts payable 455 486

Accounts receivables 270 294

Inventory 280 269 Deferred taxes 104 117

Total 707 761 Long-term debt 458 471

Retained earnings 347 390

Net fixed assets 1,035 1,118 Common stock 378 415

Total assets 1,742 1,879 Total liabilities & equity 1,742 1,879

CF/CR = Interest Paid – Net New Borrowing

= 49 – (471 – 458) = $36
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CASH FLOW TO STOCKHOLDERS
Nishi Tofu Co. Balance Sheets (in $mm)
2019 2020 2019 2020

Cash 157 198 Accounts payable 455 486

Accounts receivables 270 294

Inventory 280 269 Deferred taxes 104 117

Total 707 761 Long-term debt 458 471

Retained earnings 347 390

Net fixed assets 1,035 1,118 Common stock 378 415

Total assets 1,742 1,879 Total liabilities & equity 1,742 1,879

CF-SH = Dividends Paid – Net New Equity

= 86 – (390 – 347) – (415 – 378)
= $6 28

IN-CLASS EXERCISE #2
Below is Nishi Tofu Co.’s Income Statement (in $thousand).
What is the cash flow to stockholders during the year?
Sales 35,000
Cost of goods sold 18,000
Other expenses 8,000
Depreciation 4,000
EBIT 5,000 2018 2019 2018 2019
Interest Cash 2,000 5,000 4,800 Accounts payable 4,200 4,100
Accounts receivables
Taxable income 3,000 3,500 3,600
Current taxesInventory
(21%) 630 5,500 5,700 Deferred taxes 105 105
Total
Deferred taxes - 14,000 14,100 Long-term debt 20,000 21,000
Net income 2,370 Common stock 21,295 21,845
Net fixed assets 35,000 36,500 Retained earnings 3,400 3,550
Total assets 49,000 50,600 Total liabilities & equity 49,000 50,600

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CASH PAID TO INVESTORS

Cash paid to investors

= Cash Flow to Creditors (CF-CR)

+ Cash Flow to Stockholders (CF-SH)

= 36 + 6 = $42

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APPENDIX: ASSETS
Current assets comprise assets that are
relatively liquid (expected to be converted into
cash within 12 months). Current assets typically
include:
• Cash, including marketable securities
• Accounts Receivable = Payments due from
customers who buy on credit
• Inventory (ex. raw materials, work in process,
and finished goods held for eventual sale)
• Other assets (ex. prepaid expenses are items
paid for in advance, such as insurance
premium)
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APPENDIX: ASSETS
Long-term assets comprise the following:

• Fixed Assets
í Assets that will be used for more than one
year (ex. machinery, buildings, land, etc.)
í Less accumulated depreciation

• Other Assets
í Assets that are neither current assets nor
fixed assets. Typically intangible assets, such
as patents and copyrights.

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APPENDIX: LIABILITIES
Current Liabilities
• Accounts payable = Credit extended by
suppliers to a firm for inventories, etc.
• Accrued expenses = Short-term liabilities
incurred in the firm’s operations but not yet paid
for (ex. wages, interest, taxes)
• Short-term notes = Borrowings from a bank or
lending institution due and payable within 12
months

Long-term Liabilities
• Borrowings from banks and other sources for
more than one year
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APPENDIX: EQUITY
Equity
• Shareholder’s investment in the firm in the form of
preferred stock and common stock
i. Par value = An arbitrary value (usually $1) for
each share prior to its being offered for sale
ii. Paid in capital = The amount above the par
value paid for stock issued by the firm
Treasury Stock
• Stock repurchased by the firm
Retained Earnings
• Cumulative total of all the net income over the life of
the firm, less common stock dividends that have
been paid out over the years (see page 30 – 32).
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