Understanding Financial Statements, Taxes, and Cash Flows

1. Understanding Financial Statements, Taxes, and Cash Flows Chapter 3

2. Slide Contents Learning Objectives Principles Used in This Chapter An Overview of the Firm’s Financial Statements The Income Statement Corporate Taxes The Balance Sheet The Cash Flow Statement Key Terms

3. Learning Objectives Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager. Evaluate firm profitability using the income statement. Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.

4. Introduction Use the balance sheet to describe a firm’s investments in assets and the way it has financed them. Identify the sources and uses of cash flow for a firm using the firm’s Cash Flow Statement.

5. Principles Used in This Chapter Principle 1: Money Has a Time Value. We need to recognize that financial statements do not adjust for time value of money.

6. Principles Used in This Chapter (cont.) Principle 3: Cash Flows Are the Source of Value. Financial statements provide an important starting point in determining the firm’s cash flow. We should be able to distinguish between reported earnings and cash flow. It is possible for a firm to report positive earnings but have no cash!

7. Principles Used in This Chapter (cont.) Principle 4: Market Prices Reflect Information. Firm’s financial statements provide important information that is used by investors in forming expectations about firm’s future prospects and subsequently, the market prices.

8. 3.1 An Overview of the Firm’s Financial Statements

9. Basic Financial Statements Following four types of financial statements are mandated by the accounting and financial regulatory authorities: Income statement Balance sheet Cash flow statement Statement of shareholder’s equity

10. Basic Financial Statements (cont.) 1. Income Statement: An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months): Revenue, Expenses, and Profit.

11. Basic Financial Statements (cont.) 2. Balance sheet: Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2010) Assets (value of what the firm owns), Liabilities (value of firm’s debts), and Shareholder’s equity (the money invested by the company owners).

12. Basic Financial Statements (cont.) 3. Cash flow statement: It reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months).

13. Basic Financial Statements (cont.) 4. Statement of shareholder’s equity: It provides a detailed account of the firm’s activities in the following accounts over a period of time (for example, last six months): Common stock account, Preferred stock account, Retained earnings account, and Changes to owner’s equity.

14. What is the Focus of this Chapter? Discuss the basic Content and Format of: Income statement, Balance sheet, and Cash flow statement

15. Why Study Financial Statements? Analyzing a firm’s financial statement can help managers carry out three important tasks: Assess current performance through financial statement analysis, Monitor and control operations, and Forecast future performance.

16. Why Study Financial Statements? (cont.) Financial statement analysis: Financial statement analysis allows us to assess the present financial condition of a firm. Chapter 4 introduces the tools and techniques used to carry out financial statement analysis.

17. Why Study Financial Statements? (cont.) 2. Financial control: Financial statements are used by both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors) to monitor and control the firm’s operations. For example, a creditor may analyze a firm’s financial statements to decide whether or not to renew company’s loan.

18. Why Study Financial Statements? (cont.) 3. Financial forecasting and planning: Financial planning models are typically built using the financial statements. Financial planning is covered in chapter 17.

19. What are the Accounting Principles Used to Prepare Financial Statements? The following three fundamental principles are adhered to by accountants when preparing financial statements: The revenue recognition principle, The matching principle, and The historical cost principle. An understanding of these basic principles allows us to be a more informed user of financial statements.

20. What are the Accounting Principles Used to Prepare Financial Statements? (cont.) The revenue recognition principle: It states that the revenue should be included in the firm’s income statement for the period in which: Its goods and services were exchanged for cash or accounts receivable; or The firm has completed what it must do to be entitled to the cash.

21. What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 2. The matching principle: This principle determines whether specific costs or expenses can be attributed to this period’s revenues. The expenses are matched with the revenues they helped produce. For example, employees’ salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid.

22. What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 3. The historical cost principle: This principle provides the basis for determining the dollar values the firm reports in its balance sheet. Most assets and liabilities are reported in the firm’s financial statements at historical cost i.e. the price the firm paid to acquire them. The historical cost generally does not equal the current market value of the assets or liabilities.

23. 3.2 The Income Statement

24. An Income Statement An income statement is also called a profit and loss statement. An income statement measures the amount of profits generated by a firm over a given time period (usually a year or a quarter).

25. An Income Statement (cont.) Income statement can be expressed as follows: Revenues (or Sales) – Expenses = Profits

26. An Income Statement (cont.) An income statement will contain the following basic elements: Revenues Expenses Cost of goods sold, Interest expenses, SGA (selling, general and administrative) expense, depreciation expense, Income tax expense Profits Gross profit, net operating income (also known as EBIT), earnings before taxes (EBT), and net income

27. An Income Statement (cont.) Sales Minus Cost of Goods Sold = Gross Profit Minus Operating Expenses Selling expenses General and Administrative expenses Depreciation and Amortization Expense = Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT) Minus Income taxes = Net income (EAT) EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes

28. Sample Income Statement

29. Evaluating a Firm’s EPS and Dividends We can use the income statement to determine the earnings per share (EPS) and dividends. EPS = Net income÷ Number of shares outstanding

30. Evaluating a Firm’s EPS and Dividends (cont.) Example 1: A firm reports a net income $90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)? EPS = Net income ÷ Number of shares = $90 million ÷ $35 million = $2.57

31. Evaluating a Firm’s EPS and Dividends (cont.) We can determine the dividends paid by the firm to each shareholder by dividing the total amount of dividend (reported on the income statement) by the total number of shares outstanding. Dividends per share = Dividends÷ Number of shares

32. Evaluating a Firm’s EPS and Dividends (cont.) Example 2: A firm reports dividend payment of $20 million on its income statement and has 35 million shares outstanding. What will be the dividends per share? Dividends per share = Dividends ÷ Number of shares = $20 million ÷ $35 million = $0.57

33. Connecting the Income Statement and the Balance Sheet What can the firm do with the net income?: Pay dividends to shareholders, and/or Reinvest in the firm

34. Connecting the Income Statement and the Balance Sheet (cont.) Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm? Amount retained = Net Income – Dividends = $90m - $20m = $70m The firm’s balance on retained earnings will increase by $70 million on the balance sheet.

35. Interpreting Firm Profitability using the Income Statement What can we learn from H.J. Boswell Inc.’s income statement (Table 3-1)? The firm has been profitable as its revenues exceeded its expenses.

36. Interpreting Firm Profitability using the Income Statement (cont.) 2. The gross profit margin (GPM) = gross profits ÷ sales = $675 million ÷ $2,700 million = 25% GPM indicates the firm’s “mark-up” on its cost of goods sold per dollar of sales.

37. Interpreting Firm Profitability using the Income Statement (cont.) 3. The operating profit margin = net operating income ÷ sales = $382.5 million ÷ $2,700 million = 14.17% The operating profit margin is equal to the ratio of net operating income or EBIT divided by firm’s sales.

38. Interpreting Firm Profitability using the Income Statement (cont.) Net profit margin: = net profits ÷ sales = $204.75 million ÷ $2,700 million = 7.58% Net profit margin indicates the percentage of revenues left after all expenses (including interest and taxes) have been considered.

39. Interpreting Firm Profitability using the Income Statement (cont.) These profit margins (gross profit margin, operating profit margin, and net profit margin) should be closely monitored and compared to previous years and those of competing firms.

40. GAAP and Earnings Management While the firms must adhere to set of accounting principles, GAAP (Generally Accepted Accounting Principles), there is considerable room for managers to influence the firm’s reported earnings. Managers have an incentive to tamper with reported earnings as their pay depends upon it and investors care about it.

41. Checkpoint 3.1 Constructing an Income Statement Use the following information to construct an income statement for Gap, Inc. (GPS). The Gap is a specialty retailing company that sells clothing, accessories, and personal care products under the Gap, Old Navy, Banana Republic, Piperlime, and Athleta brand names. Use the scrambled information below to calculate the firm’s gross profits, operating income, and net income for the year ended January 31, 2009. Calculate the firm’s earnings per share and dividends per share.

42. Checkpoint 3.1

43. Checkpoint 3.1

44. Checkpoint 3.1: Check Yourself Reconstruct the Gap’s income statement assuming the firm is able to cut its cost of goods sold by 10% and where the firm pays taxes at 40% tax rate. What is the firm’s net income and earnings per share?

45. Step 1: Picture the Problem The income statement can be expressed as follows: Revenues – Expenses = Net Income The template on the next slide can be used to solve the equation. We are given information on revenues and expenses (cost of goods sold, operating expenses, interest expense and income taxes) to fill the template.

46. Step 1: Picture the Problem (cont.) Revenues Less: Cost of goods sold Equals Gross profit Less: Operating expenses Equals: net Operating income Less: Interest expense Equals: earnings Before taxes Less: Income taxes Equals: NET INCOME

47. Step 2: Decide on a Solution Strategy Given the account balances, constructing the income statement will entail substituting the appropriate balances into the template of step 1.

48. Step 3: Solve Revenues = $14,526,000,000 Less: Cost of goods sold = $8,171,100,000 Equals: profit =$6,354,900,000 Less: Operating expenses =$3,899,000,000 Equals: net Operating income =$2,455,900,000 Less: Interest expense =$1,000,000 Equals: earnings Before taxes =$2,454,900,000 Less: Income taxes (40%) =$9,819,600,000 Equals: NET INCOME =$1,472,940,000

49. Step 3: Solve (cont.) Earnings per share: = net income ÷ number of shares = $1,472,940,000 ÷ 716,296,296 = $2.06 Dividends per share = dividends ÷ number of shares = $243,000,000 ÷ 716,296,296 = $0.34

50. Step 4: Analyze The firm is profitable since it earned net income of $1,472,940,000. The shareholders were able be earn $2.06 per share. However, the dividends per share were only $0.34 indicating that the difference of $1.72 was reinvested in the corporation.