13
Chapter 2
Financial Statements
LEARNING OBJECTIVES (Slide 2-2)
1. Explain the foundations of the balance sheet and income statement.
2. Use the cash flow identity to explain cash flow.
3. Provide some context for financial reporting.
4. Recognize and view Internet sites that provide financial information.
IN A NUTSHELL….
Although many business students find accounting to be rather boring and dry as a subject,
it is important to remind them that accounting is the official “language” of finance. It
provides managers and business owners with vital information via financial statements,
which can be used to assess the current health of the business, figure out where it has
been, how it is doing, and chalk up a planned route for its future performance.
In this chapter, we review the basic financial statements: the income statement, the
balance sheet, and the cash flow statement. However, unlike a formal course in
accounting, which trains students to actually prepare financial statements, the material in
this chapter mainly helps students read financial statements and understand how they are
linked together in calculating the cash flow of a company.
The value of a firm depends on the present value of its future cash flows. Thus, it is
imperative that students learn how to estimate the cash flows of a firm. Accounting
income that is reported in financial statements is typically not the same as the cash flow
of a firm because most firms use accrual accounting principles for recording revenues
and expenditures. Under accrual accounting, firms may recognize revenues at the time of
sale, even if cash is received at a later date. Similarly, the expenses recorded over a
period may not be the same as the actual payments made because firms are billed in units
of calendar time, i.e., monthly or quarterly, while the actual usage and payment may
follow a different pattern. As a result, accounting statements do not accurately reflect the
actual cash inflows and outflows that have occurred over a period of time. The cash
balance shown on the balance sheet is a true reflection of the cash available to a firm, and
the change in cash balance points out the net result of the cash receipts and payments that
14 Brooks ◼ Financial Management: Core Concepts, 4e
have occurred. Thus, by preparing a statement of cash flows, a manager can track the
sources and uses of cash from the operations, investment, and financing activities of the
firm and understand what has caused the cash balance to change from the prior period.
necessary to examine the performance of a firm.
LECTURE OUTLINE (Slide 2-3)
2.1 Financial Statements
The focus of the discussion in this section should be on the interrelationships among the
four financial statements— the income statement, the balance sheet, the statement of
retained earnings, and the statement of cash flow—and on the process by which these
end of the Lecture Outline.
The Balance Sheet: a firm’s current and fixed assets are listed, as well as the liabilities
and owner’s equity accounts that were used to finance those assets. Thus, the total assets
figure has to equal the sum of total liabilities and owner’s equity of a firm. J.F. & Sons’
balance sheet for the recent two years is shown below, along with the annual changes in
each account item.
(Slides 2-4 to 2-7)
J.F. & Sons’ Balance Sheet at the end of This Year and Last Year
Assets
This Year
Last Year
Change
Cash
318,000
1,000,000
–682,000
Accounts Receivable
180,000
180,000
Inventory
50,000
50,000
Total Current Assets
548,000
1,000,000
452,000
0
Gross Plant and Equipment
200,000
200,000
Land and Buildings
400,000
400,000
Truck
25,000
25,000
Less accumulated Dep.
–125,000
125,000
Chapter 2 ◼ Financial Statements 15
Net Fixed Assets
500,000
500,000
0
TOTAL ASSETS
1,048,000
1,000,000
48,000
Liabilities & Owner’s Equity
Accounts payable
100,000
0
100,000
Accruals
0
Deferrals
0
Total Current Liabilities
100,000
0
100,000
Bank Debt
500,000
500,000
Capital
500,000
500,000
Retained Earnings
–52,000
–52,000
Owner’s Equity
448,000
500,000
–52,000
0
TOTAL LIABILITIES & OWNER’S
EQUITY
1,048,000
1,000,000
48,000
The Balance Sheet has five sections:
• Cash account, which shows a decline of $682,000. An analysis of the Statement
of Cash Flows will help determine why.
• Working capital accounts, which show the current assets and current liabilities
that directly, support the operations of the firm. The difference between current
assets (CA) and current liabilities (CL) is a measure of the net working capital
(NWC) or absolute liquidity of a firm. For J.F. & Sons;
• Long-term capital assets accounts, which show the gross and net book values of
the long-term assets that the firm has invested into since its inception. The
accumulated depreciation figure shows how much of the original value of the
assets has already been expensed as depreciation.
16 Brooks ◼ Financial Management: Core Concepts, 4e
• Long-term liabilities (debt) accounts, which include all the outstanding loans that
the firm has taken on for periods greater than one year. As part of the loan is paid
• Ownership Accounts include the capital contributed by the owners (common stock
account) and the retained earnings of the firm since its inception. The sum of both
these components is known as owner’s equity or stockholders’ equity on the
Note: It is important to stress the point to students that the retained earnings figure
is an accumulated total of the undistributed earnings of a company since its
inception and that it is not cash available for future expenses or investment, since it
has already been used in the business
The Income Statement: shows the expenses and income generated by a firm over a past
period, typically over a quarter or a year. It can be thought of as a video recording of
expenses and revenues. Revenues are listed first, followed by cost of goods sold,
depreciation, and other operating expenses to calculate Earnings before Interest and
(Slides 2-8 to 2-10)
J. F. & Sons’ Annual Income Statement
Revenues
300,000
Cost of Goods Sold
150,000
Wages
20,000
Utilities
5,000
Other Expenses
2,000
Earnings Before Depreciation, Interest, Taxes
123,000
less Depreciation
125,000
Earnings Before Interest & Taxes
–2,000
less Interest
50,000
Earnings Before Taxes
–52,000
Taxes
0
Net Income (Loss)
–52,000
Chapter 2 ◼ Financial Statements 17
J.F. & Sons had earned an operating income of –$2,000 during their first year and after
accounting for interest they would show a loss of $52,000; thus, no taxes would be paid.
Now, the net loss of $52,000 is not the same as their change in cash balance (– 682,000)
because of three reasons: accrual accounting, non-cash expense items, and interest being
treated as a financing rather than an operating expense item.
• Issue 1: Generally accepted accounting principles (GAAP). Based on GAAP,
firms typically recognize revenues at the time of sale, even if cash is not received
in the same accounting period. Similarly, firms are billed for expenses that may
correspond to a later period. This is known as accrual-based accounting. Thus,
the yearly net income figure could be different from the change in cash balance
• Issue 2: Non-cash expense items. Some expenses shown on the income
statement (e.g., depreciation of $125,000) are actually annual charges (20%)
being shown based on the initial year expense of $625,000 for acquiring the truck,
the plant and equipment, and the land and buildings.
J.F. & Sons’ Cash Account details for the year ended December 31, 20XX
Debit
Credit
Owner’s Capital
500,000
Plant & Equipment
200,000
Bank Loan
500,000
Land & Bldg
400,000
Revenues
120,000
Inventory
100,000
Truck
25,000
Wages
20,000
Utilities
5,000
Other Expenses
2,000
Interest Expense
50,000
Ending Balance
318,000
• Issue 3: Classifying interest expense as part of the financing decision. In
finance, there is a preference to separate operating decisions (investment-related)
from financing decisions. Thus, interest expense is not deducted as part of
operating cash flow.
Thus, we can calculate J.F. & Sons’ operating cash flow (OCF) by adding back
depreciation and interest expense to its net income, i.e.,
Thus, although the firm is showing a negative net income (loss) of – $52,000 its cash
flow from operations of $123,000 is positive and considerably higher.
Statement of Retained Earnings is considered to be the fourth financial statement that
firms prepare and report. It shows how the net income for the past period was allocated
between dividends (if any) and retained earnings. For J.F. & Sons, the net loss of $52,000
Chapter 2 ◼ Financial Statements 19
Net New Borrowing = Ending Long-term Liabilities – Beginning Long-term
Liabilities
For J.F. & Sons,
Operating Cash Flow = – $2000 + $125,000 – 0 = $123,000
Net Capital Spending = $500,000 – 0 + $125,000 = $625,000
Change in Net Working Capital = $448,000 – $1,000,000 = – 552,000
were any dividends paid)
Hence, the cash flow identity holds,
i.e., Cash Flow from Assets = $50,000 = Cash Flow to Creditors and Owners
The Statement of Cash Flows, or the Sources and Uses of Cash Statement, as it is often
called, is compiled by taking information from the Income Statement and the Balance
Sheet and organizing it into three sections: cash flow from operating activities, cash flow
from investment activities, and cash flow from financing activities, so as to reflect the
change in the ending cash balance of the firm during that reporting period (quarter or
year). So the three sections of the cash flow identity explained above are related to the
three sections of the statement of cash flows in the following manner:
Note: Remind students that based on the accounting identity and double-entry
accounting principles explained earlier, an increase in an asset (except cash) would
result in a use of cash, while a decrease (sale) of an asset would result in a source of
cash. Similarly, an increase in a liability or owners’ equity would bring in cash while
a decrease would take away cash.
20 Brooks ◼ Financial Management: Core Concepts, 4e
J. F. & Sons’ Statement of Cash Flow
Operating Cash Flow
EBIT
–2,000
Depreciation
125,000
Increase in Inventory (Use)
–50,000
Increase in Accounts Receivable (Use)
–180,000
Increase in Accounts Payable (Source)
100,000
Cash Flow from Operating Activities
–7,000
Investment Cash
Flow
Invested in Plant & Equipment (Use)
–200,000
Invested in a Truck (Use)
–25,000
Land & Buildings (Use)
–400,000
Cash Flow from Investment Activities
–625,000
Financing Cash Flow
Interest Paid
–50,000
Cash flow from financing activities
–50,000
Net Sources (Uses) or Change in Cash Account
–682,000
Beginning Cash Balance
1,000,000
Net Cash Flow during current year
–682,000
Ending Cash Balance
318,000
Chapter 2 ◼ Financial Statements 21
Cash flow from operating activities would include the firm’s operating cash flow
calculated as follows:
Operating Cash Flow (OCF) = EBIT + Depreciation – Taxes as well as the changes in
the current assets (except cash) and current liabilities of the firm for that reporting period.
Cash flow from investing activities includes the cash used/generated in
purchasing/disposing fixed assets and other investments. For J.F. & Sons, given that this
has been its first year of operations, a fairly large use of cash ($625,000) has resulted
from the purchase of its plant, equipment, land, buildings, and a delivery truck.
Note: Since we have already added back depreciation for the year ($125,000) as part
of the sources of funds from operations, we account for the change in gross value of
Cash flow from financing activities includes the payment of interest, dividends,
reduction of the principal balance on debt, repurchase of stock, floating of new issues of
stock and/or bonds and increase/decrease in treasury stock. For J.F. & Sons, this past
year, the only cash flow from financing in the payment of interest of $50,000 on its
outstanding loan.
Free Cash Flow is another term used in conjunction with the cash flow from assets of a
firm. It refers to the cash available to pay the creditors and owners once the firm has
made the investments in working capital and capital assets necessary for continuing and
growing the business. The timing and amount of free cash flow generated by a firm is
critical to its valuation.
2.3 Financial Performance Reporting (Slide 2-22)
Publicly traded companies provide current and potential shareholders financial
performance information, company highlights, and management perspectives by
compiling annual reports. In addition, they are required to file quarterly (10-Q) and
Chapter 2 ◼ Financial Statements 23
A Comprehensive Example to show how the three
statements are prepared from the ledger entries
Let’s say that J.F. & Sons decide to start a business by contributing $500,000 of their
own money and borrowing $500,000 from a bank (10-year note) at the rate of
10%, per year. It is the last week in December.
During the first quarter of the following year, they complete the following transactions:
Amount
Transaction
200,000
Bought Equipment
400,000
Bought Land & Bldg
100,000
Paid Cash for Raw Materials
100,000
Bought Raw Materials on Credit
25,000
Bought Truck for cash
By the end of the year, they have made the following transactions as well…
First Year transactions
Sales
300,000
[40% (Cash); 60% (Credit)]
CGS
150,000
Assume 50% of Sales
Wages
20,000
Utilities
5,000
Other Exp
2,000
Interest
50,000
Selling & Adm.
Exp.
50,000
Depreciation
120,000
20% of Fixed Assets
Let’s start by preparing the journal entries:
Journal Entries
Debit
Credit
1)
Cash
500,000
Owner’s Equity
500,000
2)
Cash
500,000
Bank Loan
500,000
24 Brooks ◼ Financial Management: Core Concepts, 4e
Journal Entries
Debit
Credit
3)
Plant & Equipment
200,000
Cash
200,000
4)
Land & Bldg
400,000
Cash
400,000
5)
Inventory
100,000
Cash
100,000
6)
Inventory
100,000
Accounts Payable
100,000
7)
Truck
25,000
Cash
25,000
8)
Cash
120,000
Revenues
120,000
9)
Accounts Receivable
180,000
Revenues
180,000
10)
Cost of Goods Sold
150,000
Inventory
150,000
11)
Wages
20,000
Cash
20,000
12)
Utilities
5,000
Cash
5,000
13)
Other Exp.
2,000
Cash
2,000
Chapter 2 ◼ Financial Statements 25
Journal Entries
Debit
Credit
14)
Interest Exp.
50,000
Cash
50,000
15)
Selling & Adm. Exp.
50,000
Cash
50,000
16)
Depreciation
120,000
Accumulated Dep.
120,000
Now, keeping in mind the accounting identity
i.e., cash flow generated from the investment in assets is paid back to creditors and the
owners; we can prepare the Income Statement, the Balance Sheet, and the Statement of
Cash Flows for the year.
Questions
1. In what type of accounting system must debits always equal credits? What is the
accounting identity? What is the connection between “debits always equal
credits” and the accounting identity?
Debits must always equal credits in a double-entry bookkeeping (accounting) system.
2. What is the difference between a current asset and a long-term asset? What is
the difference between a current liability and a long-term liability? What is the
difference between a debtor’s claim and an owner’s claim?
A current asset is cash or items such as accounts receivable and inventory that would
26 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
paid off in future business cycles or years. A debtor’s claim is a liability and has a
fixed dollar amount to the claim. An owner’s claim is a residual claim, and this claim
is for all the remaining value of the company once the debtors are satisfied.
3. Why is the term residual claimant applied to a shareholder (owner) of a
business?
The term “residual claimant” is applied to a shareholder because the value of their
claim is what is left over from the company assets once the creditors’ claims have
4. What is the difference between net income and operating cash flow?
To arrive at net income, companies record non-cash expense items and record revenue
5. What is the purpose of the statement of retained earnings?
6. Why do financial notes accompany the annual report? Give an example of a
financial note from an annual report. (Look up the annual report of a company
on its website and read its financial notes.)
Notes to the financial statements help explain many of the details necessary to gain a
7. What are the three components of the cash flow from assets?
8. What does an increase in net working capital mean with regard to cash flow?
9. How does a company return money to debt lenders? How do you determine how
much was returned over the past year?
Companies return money to debt lenders by paying the interest (cost of the borrowed
28 Brooks ◼ Financial Management: Core Concepts, 4e
ANSWER
a. The Balance Sheets for the two years are:
Assets: 2016 2017
Current Assets
Cash $1,300 $1,090
Accounts Receivable $2,480 $2,690
Long-Term Assets:
Plant, Prop. & Equip $8,400 $9,200
Liabilities
Current Liabilities
Accounts Payable $1,800 $2,060
Long-Term Liabilities
Owner’s Equity
Common Stock $4,990 $4,990
b. The Working Capital Accounts are Cash, Accounts Receivable, Inventory, and
Accounts Payable.
c. The Net Working Capital for 2016 and 2017:
Net Working Capital = Cash + Accounts Receivable + Inventory – Accounts
Payable
