Chapter 2
FINANCIAL STATEMENTS AND CASH FLOW
SLIDES
CHAPTER WEB SITES
Section Web Address
2.1 Key Concepts and Skills
2.2 Chapter Outline
2.3 Sources of Information
2.4 The Balance Sheet
2.5 U.S. Composite Corporation Balance Sheet
2.6 Balance Sheet Analysis
2.7 Liquidity
2.8 Debt versus Equity
2.9 Value versus Cost
2.10 The Income Statement
2.11 U.S.C.C. Income Statement
2.12 U.S.C.C. Income Statement
2.13 U.S.C.C. Income Statement
2.14 U.S.C.C. Income Statement
2.15 Income Statement Analysis
2.16 GAAP
2.17 Non-Cash Items
2.18 Time and Costs
2.19 Taxes
2.20 Marginal versus Average Rates
2.21 Net Working Capital
2.22 U.S.C.C. Balance Sheet
2.23 Cash Flow of the Firm
2.24 U.S.C.C. Financial Cash Flow
2.25 U.S.C.C. Financial Cash Flow
2.26 U.S.C.C. Financial Cash Flow
2.27 U.S.C.C. Financial Cash Flow
2.28 U.S.C.C. Financial Cash Flow
2.29 U.S.C.C. Financial Cash Flow
2.30 U.S.C.C. Financial Cash Flow
2.31 The Statement of Cash Flows
2.32 U.S.C.C. Cash Flow from Operations
2.33 U.S.C.C. Cash Flow from Investing
2.34 U.S.C.C. Cash Flow from Financing
2.35 U.S.C.C. Statement of Cash Flows
2.36 Cash Flow Management
2.37 Quick Quiz
2.1 finance.yahoo.com
money.cnn.com
www.sec.gov
www.fasb.org
www.ifrs.org
2.3 www.irs.gov
CHAPTER ORGANIZATION
2.1 The Balance Sheet
Liquidity
Debt versus Equity
Value versus Cost
2.2 The Income Statement
Generally Accepted Accounting Principles
Noncash Items
Time and Costs
2.3 Taxes
Corporate Tax Rates
Average versus Marginal Tax Rates
2.4 Net Working Capital
2.5 Cash Flow of the Firm
2.6 The Accounting Statement of Cash Flows
Cash Flow from Operating Activities
Cash Flow from Investing Activities
Cash Flow from Financing Activities
2.7 Cash Flow Management
ANNOTATED CHAPTER OUTLINE
Slide 2.0 Chapter 2 Title Slide
Slide 2.1 Key Concepts and Skills
Slide 2.2 Chapter Outline
Slide 2.3 Sources of Information This slide contains hyperlinks to commonly
used sources of financial data.
1. The Balance Sheet
Slide 2.4 The Balance Sheet
The balance sheet provides a snapshot of the firm’s financial position at a specific
point in time. Thus, it is commonly referred to as a “stock” statement, whereas the
income statement would be considered a “flow” statement since it covers a period
of time.
The balance sheet identity is: Assets ≡ Liabilities + Stockholder’s Equity
Slide 2.5 U.S. Composite Corporation Balance Sheet
Assets: The Left-Hand Side
Assets are divided into several categories. Make sure that students recall the
difference between current and fixed assets, as well as tangible and intangible
assets.
Assets are listed in order of how long it typically takes for the specific asset to be
converted to cash, with those taking the shortest time being listed first.
Liabilities and Equity: The Right-Hand Side
This portion of the balance sheet represents the sources of funds used to finance
the purchase of assets.
Lecture Tip: It may be helpful to review slides 4 through 7 from Chapter
1, which highlight the general composition of a balance sheet.
Since sources and uses must equal, the balance sheet is an equality:
Assets = Liabilities + Stockholder’s Equity
Lecture Tip: Students sometimes find it difficult to see the relationship
between the decisions made by financial managers and the values that
subsequently appear on the firm’s balance sheet. One way to help them
see the “big picture” is to emphasize that all finance decisions are either
investment decisions or financing decisions. Investment decisions involve
the purchase and sale of any assets (not just financial assets). Investment
decisions show up on the left-hand side of the balance sheet. Financing
decisions involve the choice of whether to borrow money to buy the assets
or to issue new ownership shares. Financing decisions show up on the
right-hand side of the balance sheet.
Slide 2.6 Balance Sheet Analysis
There are three primary concerns that need to be addressed when analyzing a
balance sheet: liquidity, debt versus equity, and market value versus historical
cost.
A. Liquidity
Slide 2.7 Liquidity
Liquidity is a measure of how easily an asset can be converted to cash. Since
assets are listed in ascending order of how long it takes to be converted to cash,
they are, by definition, listed in descending order of liquidity (i.e., most liquid
listed first). Liability order, however, reflects time to maturity.
It is important to point out to students that liquidity has two components: (1) how
long it takes to convert to cash and (2) the value that must be relinquished to
convert to cash quickly. Any asset can be converted to cash quickly if you are
willing to lower the price enough.
It is also important to point out that owning more liquid assets makes it easier to
meet short-term obligations; however, they also provide lower returns.
Consequently, too much liquidity can be just as detrimental to shareholder wealth
maximization as too little liquidity.
Lecture Tip: Discuss the cash that Apple has on its Balance Sheet. At one point, it
was estimated that Apple had more cash on hand than the U.S. Government.
Should Apple keep this much cash?
Lecture Tip: Some students get a little confused when they try to understand that
excessive cash holdings can be undesirable. Occasionally, they leave an
accounting principles class with the belief that a large current ratio is, in and of
itself, a good thing. Short-term creditors like a company to have a large current
ratio, but that doesn’t mean that excess cash is good for the firm.
You may wish to mention that a cash balance is a use of funds and, therefore,
has an opportunity cost. Ask what a company could do with cash if it were not
sitting idle. It could be paid to stockholders, invested in
productive assets, or used to reduce debt. Students need to understand that a
change in a firm’s cash account is not the same as cash flow, regardless of what
the “Statement of Cash Flows” may imply.
B. Debt versus Equity
Slide 2.8 Debt versus Equity
Interest and principal payments on debt have to be paid before cash may
be paid to stockholders. The company’s gains and losses are magnified as
the company increases the amount of debt in the capital structure. This is
why we call the use of debt financial leverage.
The balance sheet identity can be rewritten to illustrate that owners’ equity
is just what is left after all debts are paid.
Owners’ Equity = Assets – Liabilities
Therefore, equity holders are referred to as residual claimants.
Lecture Tip: You may find it useful at this point to spend a few minutes
reinforcing the concepts of owners’ equity and retained earnings. The
students should recall that owners’ equity consists of the common stock
account, paid-in surplus, retained earnings and treasury stock. It is
important to remind students that the firm’s net income belongs to the
owners. It can either be paid out in dividends or reinvested in the firm.
When it is reinvested in the firm, it becomes additional equity investment
and shows up in the retained earnings account.
C. Value versus Cost
Slide 2.9 Value versus Cost
Under current accounting standards, financial statements are reported on
an historical cost (i.e., book value) basis. However, book values are
generally not all that useful for making decisions about the future because
of the historical nature of the numbers.
Also, some of the most important assets and liabilities do not show up on
the balance sheet. For example, the people that work for a firm can be very
valuable assets, but they are not included on the balance sheet. This is
especially true in service industries.
Lecture Tip: Accounting, or historical, costs are not very important to
financial managers, while market values are. Some students have
difficulty recognizing that the passage of time and changing circumstances
will almost always mean that the price an asset would fetch if sold today
is quite different from its book value. Sometimes an example or two of
familiar instances are enough to make the point. For example, pointing
out the differences between market values and historical costs of used cars
and houses may help.
Some students recognize the difference between book values and
market values, but do not understand why market values are the more
important numbers for decision-making. The simplest answer is that
market value represents the cash price people are
willing and able to pay. After all, it is cash that must ultimately be paid or
received for investments, interest, principal, dividends and so forth. The
key, particularly in later chapters, is to recognize that market values are a
better measure of opportunity costs.
2. The Income Statement
Slide 2.10 The Income Statement
As mentioned earlier, the income statement measures flows over a period of time.
Specifically, it measures revenues collected relative to the costs associated with
those revenues (matching principle). The difference between these two is the
firm’s income. Thus, the income statement takes the following form:
Revenue – Expenses = Income
Slide 2.11 –
Slide 2.14 U.S.C.C. Income Statement
This series of slides walks through the various sections of the income statement,
pointing out that the general operation of the business is reflected in the top
portion, with non-operating impacts (including taxes) being reflected in the lower
portion.
The “bottom line” is net income, which provides a measure of the overall earnings
of the firm.
Lecture Tip: Previously, it was noted that investment decisions are
reflected on the left-hand side of the balance sheet, and financing
decisions are reflected on the right-hand side of the balance sheet. You
could also point out that the income statement reflects investment
decisions in the “top half,” from sales to EBIT. Financing decisions are
reflected in the “bottom half,” from EBIT to net income and earnings per
share.
Slide 2.15 Income Statement Analysis
As with the balance sheet, there are things to remember when trying to interpret
the income statement: GAAP, non-cash items, and timing.
A. Generally Accepted Accounting Principles
Slide 2.16 GAAP
Remember that GAAP require that we recognize revenue when it is
earned, not when the cash is received, and we match costs to revenues
(i.e., the matching principle). Thus, income is reported when it is earned,
not when cash is actually generated from the transaction. Consequently,
net income is NOT cash flow.
A recent development is the integration of International Financial
Reporting Standards (IFRS) with GAAP policies (see section below).
B. Non-Cash Items