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Understanding Financial Statements: Balance Sheet, Income Statement, and Cash Flows

Learn about the balance sheet, income statement, and statement of cash flows in accounting and finance. Understand the definitions, main items, common-size balance sheet, market value vs. book value, and the impact of taxes on cash flows.

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Understanding Financial Statements: Balance Sheet, Income Statement, and Cash Flows

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  1. Chapter 3 Accounting and Finance Topics Covered 3.1 The Balance Sheet 3.2 The Income Statement 3.3 The Statement of Cash Flows 3.4 Accounting Practice & Malpractice (Excluded) 3.5 Taxes

  2. The Balance Sheet Definition Financial statement that show the value of the firm’s assets and liabilities at a particular point in time (from an accounting perspective).

  3. Balance Sheet PepsiCo Balance Sheet (December 31, 2006) $Millions

  4. Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets = The Balance Sheet The Main Balance Sheet Items

  5. The Balance Sheet • Common-Size Balance Sheet • All items in the balance sheet are expressed as a percentage of total assets.

  6. Common Size Balance Sheet

  7. Market Value vs. Book Value Book Valuesare determined by GAAP Market Valuesare determined by current values • Generally Accepted Accounting Principles (GAAP) • Procedures for preparing financial statements. Equity and Asset “Market Values” are usually higher than their “Book Values”

  8. Market Value vs. Book Value Example According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion. Q: What is the market value of your assets? A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion.

  9. Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil Market Value vs. Book Value Example (continued) Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil

  10. The Income Statement Definition Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from an accounting perspective).

  11. The Income Statement Pepsico Income Statement (year end 2006) Net Sales 35,753 COGS -15,762 Selling, Gen.&Admin. expenses -11,530 Depreciation expense -1,406 EBIT 7,055 Net interest expense 66 Taxable Income 6,989 Income Taxes 1,347 Net Income 5,642

  12. The Income Statement Earnings Before Income & Taxes (EBIT) EBIT = Total Revenues - costs – deprecation = 35,753 – 27,292 – 1,406 = $ 7,055 million

  13. The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time.

  14. Cash Flows • Free Cash Flow (FCF) • Cash available for distribution to investors after firm pays for new investments or additions to working capital FCF = EBIT - taxes + depreciation - change in net working capital - capital expenditures

  15. Taxes • Taxes have a major impact on financial decisions Marginal Tax Rate is the tax that the individual pays on each extra dollar of income. Average Tax Rate is the total tax bill divided by total income.

  16. Taxes Example - Taxes and Cash Flows can be changed by the use of debt. Firm A pays part of its profits as debt interest. Firm B does not. Firm A Firm B EBIT 100 100 Interest 40 0 Pretax Income 60 100 Taxes (35%) 21 35 Net Income 39 65

  17. Taxes FOOD FOR THOUGHT - If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow) Firm A Firm B EBIT 100 100 Interest 40 0 Pretax Income 60 100 Taxes (35%) 21 35 Net Income 39 65 ?

  18. Taxes FOOD FOR THOUGHT - If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow) Firm A Firm B Net Income 39 65 ? + Interest 40 0 Net Cash Flow 79 65

  19. Corporate Tax Rates

  20. Personal Tax Rates

  21. Personal Tax Rates Ex:Ifyour total income is $40,000, What is yourtaxbillaccordingtothemarginaltaxrates? What is youraveragetax rate? a. Taxbill= (0.1x8025)+[0.15x(32250-8025)]+ [0.25x(40000-32250)]=$6343.75 b. Averagetax rate = Tax Bill / Total Income = 6343.75 / 40000=0.159=15.9%

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