CHAPTER 6.

1:
Understanding Financial Statements
_Principles of Finance_
 Learning Objectives
• Use of the balance sheet, the income statement, and the
statement of cash flows by managers.

• Calculation of depreciation.

• How depreciation affects cash flow.

• How taxes affect a firm’s value.

• Calculation of marginal and average tax rates.

The Firm’s Financial Statements
• Annual Report includes:
✓ Income Statement

✓ Balance Sheet

✓ Statement of Cash Flows

✓ Accompanying Notes
The Firm’s Financial Statements
✓Income statement – how much money you made last year?
✓ Revenue, expense, profits over a year or quarter.

✓Balance sheet – What’s your current financial situation? a snap shot on

a specific date of

✓ Assets (value of what the firm owns),

✓ Liabilities (value of firm’s debts), and

✓ Shareholder’s equity (the money invested by the company owners)

✓Cash flow statement – How did the cash come and go?
✓ cash received and cash spent by the firm over a period of time
Income Statement
Revenues - Expenses = Net Income
Sales COGS
Investment Income Salaries Depreciation Exp.
Gains Taxes
Interest Received Other Expenses
Dividends Received Interest Paid
Income Statement
• Net Income = Dividends + Retained Earnings
Income Statement
 Income Statement
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)

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Sample Income Statement

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 The Example Company
Income Statement
For the Years Ended December 31, 2010 and 2011

2011 2010
Revenues:
Sales $100 $ 85
Other revenue 30 15
Total revenues $130 $100

Expenses:
Cost of goods sold $ 62 $ 58
Operating & admin. 16 12
Income tax 20 18
Total expenses $ 98 $ 88

Net Income $ 32 $ 12
Statement of Retained Earnings

An additional financial
statement that identifies
Beginning retained earnings changes in retained
+ Net income earnings from one
accounting period to the
– Dividends paid next.
= Ending retained earnings

Net income results in: Dividends result in:

Increase in net assets Decrease in net assets
Increase in retained earnings Decrease in retained
Increase in owners’ equity earnings
Decrease in owners’ equity
 Balance Sheet
Assets = Liabilities + Owners’ Equity
Current Assets Current Liabilities Owners’ Equity
Cash A/P Common Stock Capital in Excess of Par
Inventory Accruals Retained Earnings
A/R S-T Debt
Fixed Assets Long Term Liabilities
Land Bonds
Plant & Equip L-T Bank Debt
Less: Accum. Dep. Mortgages
Preferred Stock
Balance Sheet
Balance Sheet
Sample Balance Sheet
Assets Liabilities
Cash $ 40 Accounts payable $ 50
Accounts receivable 100 Notes payable 150
Land 200 $200
Owners’ Equity
Total assets $340
Capital stock $100
Retained earnings 40
$140
Must Total liabilities
Equal and owners’ equity $340
Cash Flow Statement
Cash Inflows – Cash Outflows = Change in Cash

From Operations From Investing From Financing

• Cash Sales (+) • Sale of Fixed Assets (+) • Sale of Stock (+)
• Collection of A/R (+) • Purchase of Fixed Assets (-) • Issue L-T Debt or NP (+)
• Decrease Inventory (+) • Purchase of other Firms (-) • Buy Back Stock (-)
• Payments to Suppliers (-) • Repay Debt (-)
• Salaries (-) • Pay Dividends (-)
• Increase in A/R (+) • Pay Interest (-)
• Decrease in Payables (-)
• Decrease in Accruals (-)
Statement of Cash Flows

Operating Investing Financing

CASH Activities Activities Activities
INFLOWS

CASH
OUTFLOWS

Operating Investing Financing

Activities Activities Activities
 The Example Company
Statement of Cash Flows
December 31, 2011

Cash Flows From Operating Activities:

Receipts 48
Payments (43) 5

Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)

Cash Flows Used By Financing Activities:

Receipts 10
Payments (6) 4

Net Cash Flow 5

 Cash Flow Statement
Cash--Op. Act. $ 973,000
Cash--Inv. Act. (1,188,000)
Cash--Fin. Act. 245,000
Net increase $ 30,000
Beg. cash 80,000
End. cash $ 110,000 Balance
Sheet 12/31/11

Balance Sheet 12/31/10 Cash $ 110,000

Income Statement Other 4,975,000
Cash $ 80,000
Revenues $12,443,000 Total $5,085,000
Other 4,550,000
Expenses 11,578,400
Total $4,630,000
Net income $ 864,600 Liabilities $2,860,400
Cap. stock 1,000,000
Liabilities $2,970,000
R/E 1,224,600
Cap. stock 900,000 Stmt of Retained Earnings
Total $5,085,000
R/E 760,000 R/E 12/31/10 $ 760,000
Total $4,630,000 Net income 864,600
Dividends (400,000)
R/E 12/31/11 $1,224,600
Market vs. Book value of Assets
✓Book Value is recorded initially at cost.

✓Changes in book value (depreciation) follow specified accounting

rules.

✓Factors that determine the disparity between market and book:

• Time since acquisition (More time, more difference)

• Inflation (Higher inflation, more difference)

• Tangible vs. Intangible assets (Intangible assets, more difference)

Market vs. Book value of Liabilities
✓As with assets, the market value of liabilities may diverge from the
book value, but the relationship is less complex.

✓The main factor that determines the difference between market

and book values for liabilities of a healthy firm is the time until
the liability must be paid off.

✓At maturity, the market value = book value

Market vs. Book value of Equity
✓Total Market Value of Equity is the market price per share
times the number of shares outstanding.

✓Book Value of Equity reflects the changes in other asset and

liability accounts since it is the account that can change to
enforce the balance sheet identity.
Depreciation
✓Accounting depreciation is the allocation of an asset’s initial
cost over time.

✓Allowable depreciation expense is determined by established

accounting rules.
Calculation of Depreciation
✓ Depreciable basis

✓ Total amount to be depreciated over the accounting life of the asset.

✓ Equal to cost of the asset plus any setup and delivery costs.

✓ Straight line depreciation

✓ Basis divided by accounting life with equal amounts of depreciation

allocated to each time period

✓ MACRS (Modified Accelerated Cost Recovery System)

✓ Specified percentage charged each year

Example of MACRS Depreciation
• Assume equipment purchased for $ 9,000 and the cost of delivery and
installation was $1,000. Accounting life = 3 years. Depreciated over 4 years
due to the half-year convention.

Total depreciable basis = $10,000.

Three Year MACRS Schedule

Year Percent X Basis Deduction
1 33.3% $10,000 $3,330
2 44.5% 4,450
3 14.8% 1,480
4 7.4% 740
Federal Income Taxation
✓Marginal and Average Tax Rates

Marginal = Tax Rate on the next dollar of income.

Average = Taxes paid divided by taxable income.

✓Progressive Tax System

Average tax rate increases with the level of taxable income.
Marginal tax rate is greater than the average tax rate. (The current
corp. tax rate schedule is not strictly progressive.)
 Corporate Taxes
✓A firm’s income tax liability is calculated using its taxable income and the
tax rates on corporate income.

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Federal Income Taxation
Corp. Tax Calculation
2005-2017 Corp. Tax Rates

Over But not over Tax is Of amount over

$0 $50,000 15% $0
50,000 75,000 $7,500 + 25% 50,000
75,000 100,000 13,750 + 34% 75,000
100,000 335,000 22,250 + 39% 100,000
335,000 10,000,000 113,900 + 34% 335,000
10,000,000 15,000,000 3,400,000 + 35% 10,000,000
15,000,000 18,333,333 5,150,000 + 38% 15,000,000
18,333,333 ____ 35% 0
Example of Tax Calculation
✓Computed tax for a corporation with Taxable Income of
$160,000?
 Differential Tax Treatments between
Interest and Dividends
✓Interest paid on corporate debt is a tax-deductible expense.

✓Dividends paid to common and preferred stockholders is not tax

deductible.

✓Dividends received by a corporation from another corporation

have at least a 70% exclusion from taxable income.
Dividend Income for Corporations
✓Corp “B” owns 100 shares of Common Stock in Corp “A”

✓Corp “A” pays a $2/share dividend to shareholders.

✓70% or $140 is Tax Free

✓30% or $60 is Taxable

✓Corp “B” pays a marginal tax rate of 25%

$60 x .25 = $15 in Federal Taxes on dividend income

Quiz
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.

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Quiz
Constructing a Balance Sheet
Construct a balance sheet for Gap, Inc. (GPS) using the following list
of jumbled accounts for January 31, 2009. Identify the firm’s total
assets and net working capital:

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