1 / 67

CHAPTER FOUR The Financial Statements of Banks and Some of Their Closest Competitors

CHAPTER FOUR The Financial Statements of Banks and Some of Their Closest Competitors. The purpose of this chapter is to acquaint the reader with the content,structure and purpose of bank financial statements and to help managers understand how information from bank financial

jackson-pearson
Download Presentation

CHAPTER FOUR The Financial Statements of Banks and Some of Their Closest Competitors

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. CHAPTER FOURThe Financial Statements of Banks and Some of Their Closest Competitors The purpose of this chapter is to acquaint the reader with the content,structure and purpose of bank financial statements and to help managers understand how information from bank financial statements can be used as tools to reveal how well their banks are performing.

  2. Financial Statement, Cash Flow and Financial Forecasting LG1: Recall the major financial statements that firms must prepare and provide to the public LG2: Differentiate between book (or accounting) value and market value LG3: Explain how taxes influence corporate managers’ and investors’ decisions LG4: Differentiate between accounting income and cash flows LG5: Demonstrate how to use a firm's financial statement to calculate its cash flows LG6: Observe cautions that should be taken when examining external financial statements

  3. Introduction • Corporate managers must issue many reports to the public. The most attention is paid to the annual report, which contains • Balance sheet • Income statement • Statement of cash flows • Statement of retained earnings • These four statements present an accounting-based picture of the firm’s financial position. ACT3211 FINANCIAL MANAGEMENT

  4. While accountants focus on reporting what happened in the past, financial managers use financial statements to draw inferences about the future • Firms must follow Generally Accepted Accounting Principles (GAAP) when creating these statements, but they still have substantial discretion ACT3211 FINANCIAL MANAGEMENT

  5. Balance Sheet • The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time. Assets = Liabilities + Equity • The left side of a balance sheet lists the assets of the firm in order of liquidity • The right side of the balance sheet lists the liabilities in order of maturity. Equity, which never matures, is listed last ACT3211 FINANCIAL MANAGEMENT

  6. Assets • Assets fit into two major categories: current assets and fixed assets • Current Assets • Will normally convert into cash within a year • Cash (and marketable securities) • Accounts receivable • Inventory • Fixed Assets • Have a useful life exceeding one year • Net plant and equipment (Gross plant and equipment less accumulated depreciation) • Less tangible assets, such as patents and trademarks ACT3211 FINANCIAL MANAGEMENT

  7. Liabilities • Lenders provide funds, which become liabilities to the firm. • Current liabilities • Obligations due within a year • Accruals (accrued wages and accrued taxes) • Accounts payable • Notes payable • Long-term debt • Long-term loans and bonds with maturities of more than one year ACT3211 FINANCIAL MANAGEMENT

  8. Equity • The difference between total assets and total liabilities is the stockholders’ (or owners’) equity. • Types of Equity • Preferred Stock • Appears as the cash proceeds when the firm sells preferred stock • Common Stock and Paid-in-Surplus • Also appear as cash proceeds when common stock is issued • Retained Earnings • When managers reinvest earnings rather than pay them out as dividends, these will be recorded as retained earnings. The retained earnings account on the balance sheet represents the cumulative amount retained over the years. ACT3211 FINANCIAL MANAGEMENT

  9. Managing the Balance Sheet • Managers must monitor a number of issues related to the firm’s balance sheet, including: • The accounting method used for fixed asset depreciation • The level of net working capital • The liquidity position of the firm • Whether to finance the firm’s assets with equity or debt • The difference between the book value reported on the balance sheet versus the true market value of the firm ACT3211 FINANCIAL MANAGEMENT

  10. Accounting method for fixed asset depreciation • Managers can choose the accounting method they use to record depreciation against their fixed assets. • For reporting purposes, companies often use the straight-line method of depreciation • For tax purposes, firms often use accelerated depreciation such as MACRS • Why use different methods? • The straight-line method results in lower depreciation expenses in the earlier years, resulting in higher income for reporting to shareholders • MACRS results in higher depreciation expenses in earlier years, leading to lower income and thus lower taxes. • A firm will often use multiple methods for calculating depreciation for the same assets ACT3211 FINANCIAL MANAGEMENT

  11. ACT3211 FINANCIAL MANAGEMENT

  12. Net Working Capital • Net Working Capital = Current assets minus current liabilities • For DPH Tree Farms for 2007: • NWC = $190 - $110 • NWC = $ 80 million • Firms monitor net working capital as a measure of the firm’s ability to pay its obligations • In general, a financially healthy firm has positive NWC ACT3211 FINANCIAL MANAGEMENT

  13. Liquidity • Liquidity refers to the ability to turn an asset into cash at its fair market value. • Current assets are the most liquid assets • Cash, marketable securities, accounts receivable, and inventory • Inventory is the least liquid of the current assets • Fixed assets are less liquid • Liquidity has both good and bad aspects: • More liquidity means the firm can more easily pay its obligations and stave off financial distress, i.e. the firm is less risky • However, liquid assets don’t provide a very high return. Cash offers no return at all. • Fixed assets are illiquid, but provide for generating revenue and profits • Managers must consider the risk-return tradeoff ACT3211 FINANCIAL MANAGEMENT

  14. Debt vs. Equity Financing • Financial leverage refers to the extent to which a firm uses debt as a source of financing • Just like a lever magnifies the ability to move objects, financial leverage magnifies a firms gains and losses • Debtholders have a fixed claim on the firm’s cash flows (they are paid interest on their securities) • Stockholders have a claim on whatever cash flow is left. Since the obligation to debt holders is fixed, if the firm does well stockholders do very well. If the firm does poorly, stockholders get little or nothing. • Yet, debt increases the financial risk to the firm. If the firm can’t make the fixed payments to debtholders, the firm faces bankruptcy • Once again, managers face a tradeoff between risk and return as they decide the firm’s capital structure ACT3211 FINANCIAL MANAGEMENT

  15. Book Value versus Market Value • A firm’s balance sheet shows book, or historical cost, value according to GAAP • Under GAAP, the value of assets on the balance sheet shows what the firm paid for them regardless of what they may be work today • In most cases, book values differ widely from market values for the same assets • For current assets the difference will be small, but for fixed assets the difference is likely huge • Similarly, stockholders’ equity on the balance sheet is generally greatly different than the true market value of the equity • Book value of equity represents the historical value of contributed equity, while the market value of equity represents the value of the firm in the market, which depends on the present value of future cash flows ACT3211 FINANCIAL MANAGEMENT

  16. Income Statement Income statements show the total revenues and expenses of a firm over a specific period of time The top line of the income statement shows the firm’s revenues The statement then shows all of the various expenses for the firm The bottom line, or net income, represents the difference between revenues and expenses ACT3211 FINANCIAL MANAGEMENT

  17. ACT3211 FINANCIAL MANAGEMENT

  18. ACT3211 FINANCIAL MANAGEMENT

  19. The top part of the income statement represents the operating income portion of the income statement. This part of the statement is generated by operating the firm, and results in operating income or EBIT The bottom part of the income statement reflects how the firm is financed and taxed ACT3211 FINANCIAL MANAGEMENT

  20. Items reported below the bottom line include: ACT3211 FINANCIAL MANAGEMENT

  21. Corporate Income Taxes Firms pay out a large portion of their earnings in taxes (Microsoft paid $4.4 billion in taxes in 2005, or 26 percent of EBT) The tax code is determined by Congress, and so is subject to frequent changes The tax code is extremely complex. However, since taxes are so important to firms, we will examine a general overview of corporate taxation ACT3211 FINANCIAL MANAGEMENT

  22. ACT3211 FINANCIAL MANAGEMENT

  23. The average tax rate is determined by: The average tax rate incorporates taxes paid on past income and represents a weighted average of rates on the amount of taxable income ACT3211 FINANCIAL MANAGEMENT

  24. Interest and Dividends Paid by the Corporation • Interest payments appear on the income statement and are deducted from income before calculating taxable income • Dividends, on the other hand, are paid with after-tax income and so are not tax deductible • This tax deductibility of interest makes debt a much cheaper form of financing than equity ACT3211 FINANCIAL MANAGEMENT

  25. Example 2-4 ACT3211 FINANCIAL MANAGEMENT

  26. Statement of Cash Flows • The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial activity over a period of time. These two financial statements reflect the accrual basis of accounting required by GAAP to match revenues with the expenses associated with generating those revenues • Actual cash inflows and outflows may occur at very different times than are reflected in these two financial statements. Also, the income statement contains several non-cash entries, notably depreciation • Therefore, figures on an income statement do not reflect the actual cash flows of the firm. Financial managers and investors are much more interested in cash flows than accrual accounting income. ACT3211 FINANCIAL MANAGEMENT

  27. The statement of cash flows shows the firm’s cash flows over a period of time. It includes only inflows and outflows of cash and marketable securities. It excludes transactions that do not directly affect cash receipts and payments, such as depreciation and write-offs on bad debts. The bottom line of the statement reflects the difference between cash sources and uses and equals the change in cash on the firm’s balance sheet ACT3211 FINANCIAL MANAGEMENT

  28. Sources and Uses of Cash Some activities increase cash, and some activities decrease cash. Sources of cash involve increasing liabilities (or equity) and decreasing assets. Uses of cash involve decreasing liabilities (or equity) and increasing assets. The statement of cash flows is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. ACT3211 FINANCIAL MANAGEMENT

  29. ACT3211 FINANCIAL MANAGEMENT

  30. Cash Flows from Operations • The top portion of the statement of cash flows, cash flows from operations, represents items directly associated with producing and selling the firm’s products. • Net income • Depreciation • Working capital accounts other than cash and short-term debt • Many finance professionals consider this portion of the statement the most important. ACT3211 FINANCIAL MANAGEMENT

  31. Cash Flows from Investing Activities Cash flows associated with buying or selling fixed or other long-term assets This section of the statement of cash flows reflects the firm’s investment in fixed assets ACT3211 FINANCIAL MANAGEMENT

  32. Cash Flows from Financing Activities • Cash flows from debt and equity financing transactions • Issuing short- or long-term debt • Issuing stock • Using cash to pay dividends • Using cash to pay off debt • Using cash to buy back stock ACT3211 FINANCIAL MANAGEMENT

  33. The bottom line of the statement of cash flows shows the total of cash flows from operation, investing, and financing activities This line reconciles to the net change in cash and marketable securities on the balance sheet over the period. ACT3211 FINANCIAL MANAGEMENT

  34. Free Cash Flow • To maintain cash flows over time, a firm must continuously replace working capital and depreciating fixed assets, and develop new products • Investors are particularly interested in the cash flows available to pay the firm’s stockholders and debtholders • After adjustments for investments in working capital • After adjustments for investments in fixed assets ACT3211 FINANCIAL MANAGEMENT

  35. FCF = Operating cash flow – Investment in operating capital FCF = (EBIT – Taxes + Depreciation) – (∆Gross fixed assets + ∆Net operating working capital) • Operating cash flow (OCF) • Firms generate operating cash flow from operations after they have paid necessary taxes • Investment in operating capital (IOC) • Firms buy physical capital or earmark funds for eventual equipment replacement to sustain firm operations • Includes the firm’s investment in fixed assets, current assets, and spontaneous current liabilities (i.e. accounts payable and accruals) ACT3211 FINANCIAL MANAGEMENT

  36. Example 2-5 ACT3211 FINANCIAL MANAGEMENT

  37. A positive Free Cash Flow means that the firm has funds that can be distributed to investors • A negative FCF might mean several things: • If FCF is negative due to negative OCF it may indicate that the firm is experiencing operating or managerial problems • FCF might be negative because the firm is investing heavily in operating capital to support growth • In this case FCF might be negative while OCF is positive ACT3211 FINANCIAL MANAGEMENT

  38. Statement of Retained Earnings • Provides additional detail about the change in retained earnings during a reporting period • Reconciles net income and dividends paid with changes in retained earnings from one period to the next: Beginning retained earnings + net income for period - cash dividends paid = Ending retained earnings ACT3211 FINANCIAL MANAGEMENT

  39. Balance Sheet : Assets ACT3211 FINANCIAL MANAGEMENT

  40. Balance Sheet : Liabilities and Equities ACT3211 FINANCIAL MANAGEMENT

  41. Income Statement ACT3211 FINANCIAL MANAGEMENT

  42. Statement of Retained Earning ACT3211 FINANCIAL MANAGEMENT

  43. Other Data ACT3211 FINANCIAL MANAGEMENT

  44. Statements of Cash Flows: 2008 ACT3211 FINANCIAL MANAGEMENT

  45. Statements of Cash Flows: 2008 ACT3211 FINANCIAL MANAGEMENT

  46. Bank Financial Statements • Report of Condition – Balance Sheet • Report of Income – Income Statement • Sources and Uses of Funds Statement • Statement of Stockholders’ Equity

  47. Report of Condition The Balance Sheet of a Bank Showing its Assets, Liabilities and Net Worth

  48. C + S + L + MA = D + NDB + CA C = Cash Assets S = Security Holdings L = Loans MA = Miscellaneous Assets D = Deposits NDB = Nondeposit Borrowings CA = Capital Accounts

  49. Cash Assets • Account is Called Cash and Deposits Due from Bank • Includes: • Vault Cash • Deposits with Other Banks • Cash Items in Process of Collection • Reserve Account with the Federal Reserve • Sometimes Called Primary Reserves

  50. Security Holdings • Money Market Securities – Secondary Reserves • Investment Securities • Taxable Securities • Nontaxable Securities • Trading Account Securities • Held for Resale Only • Valued at Market Value

More Related