FIN202- PRINCIPLES OF CORPORATE FINANCE
CHAPTER 3: FINANCIAL STATEMENTS,
CASH FLOWS, AND TAXES
Taught by Que Anh Nguyen - FPT School of Business (FSB)
Original Slides by Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Based on: Parrino, R., KidWell, D., 2019, Fundamentals of Corporate
Finance (4ed)
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OBJECTIVES
1. Discuss generally accepted accounting principles (GAAP) and their importance.
2. Explain the balance sheet identity and why a balance sheet must balance.
3. Describe how market-value balance sheets differ from book-value balance sheets.
4. Identify the basic equation for the income statement and the information it provides.
5. Understand the calculation of cash flows from operating, investing, and financing activities
required in the statement of cash flows.
6. Explain how the four major financial statements discussed in this chapter are related.
7. Identify the cash flow to a firm's investors using its financial statements.
8. Discuss the difference between average and marginal tax rates
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1. Financial Statements and Accounting Principles
1.1. Annual Reports
Annual Report is used by management to communicate with firm’s shareholders
and the public.
Annual Report is comprised of three sections:
✓ Financial tables and summary related to the past year’s performance.
✓ Information about the company, its products, and its activities.
✓ Audited financial statements including historical financial data.
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1. Financial Statements and Accounting Principles
1.2. Generally Accepted Accounting Principles (GAAP)
▪ These are accounting rules and standards that companies need to adhere to when they
prepare financial statements and reports.
▪ Prepared by the Financial Accounting Standards Board (FASB) and authorized by the SEC.
Five Important Accounting Principles
1. The Assumption of Arm’s Length Transaction: Two parties involved in an economic
transaction arrive at a decision independently and rationally.
2. The Cost Principle: Transactions are recorded at the cost at which they occurred.
3. The Realization Principle: Revenue is recognized when transaction is completed,
while cash may not be collected until a later time.
4. The Matching Principle: Revenues are matched with the expenses used to generate
the revenue.
5. The Going Concern Assumption: It is assumed that a company will continue to
operate for the predictable future.
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1. Financial Statements and Accounting Principles
1.2. Generally Accepted Accounting Principles (GAAP)
International GAAP
▪ Uniform accounting rules and procedures promoted by the International Accounting
Standards Board.
▪ All European Union firms are moving toward a “European GAAP”.
▪ Economic and political pressure is building the United States and Europe to develop a
unified accounting system.
▪ Today most international jurisdictions already utilize IFRS or some close variant of those
standards.
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2. The Balance Sheet
This financial statement identifies all the assets and liabilities of a firm at a point in time.
Total assets = Total liabilities + Total stockholders’ equity
Right side:
Left side: all
assets the firm - liabilities from
owns and uses to creditors
generate revenues. - equity from
shareholders.
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2. The Balance Sheet
▪ Assets listed in order of their liquidity.
▪ Liabilities listed in order in which they must be paid.
Total stockholders’ equity = Total assets - Total liabilities
▪ Balance sheet also lists the capital raised from its shareholders.
▪ Shareholders of the firm’s common equity are listed last.
▪ Shareholders will be paid with whatever remains after paying all other suppliers of funds.
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2. The Balance Sheet
2.1. Current Assets and Liabilities
▪ Current assets: all assets likely to be
▪ Current Liabilities: all liabilities that have
converted to cash within a year (or within
to be paid within a year.
an operating cycle).
▪ Bank loans and other borrowings with less
▪ These include cash and marketable
than a year’s maturity, accounts payables,
securities, accounts receivables, and accrued wages and taxes
inventory.
Net working capital = Total current assets - Total current liabilities
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2. The Balance Sheet
2.1. Current Assets and Liabilities
Net working capital example - Diaz Manufacturing
Total current assets = $1,039.8 m
Total current liabilities = $377.8 m
Net working capital = Total current assets -
Total current liabilities
= $1,039.8 m - $377.8 m
= $ 662.0 m
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2. The Balance Sheet
2.1. Current Assets and Liabilities
Inventory Accounting
Inventory (least liquid of current assets) usually reported in one of two ways on BS.
▪ FIFO (First in first out) refers to practice of recognizing a sale as being made up
of inventory purchased earlier.
→ During rising prices, FIFO reporting leads to higher current asset value and higher
net income.
▪ LIFO (Last in first out) calls for firm to attribute any sale made to the most
recently acquired.
Firms may switch from one to another only under extraordinary circumstances and not frequently.
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2. The Balance Sheet
2.2. Long-Term Assets
▪ Long-term assets: Real assets firm acquires to produce its products and generate cash
flows. E.g. land, buildings, plant and equipment.
DEPRECIATION: All long-term real assets that deteriorate with use are
depreciated. → lower taxable income and reduce taxes.
DEPRECIATION EXPENSE vs. ACCUMULATED DEPRECIATION ???
Straight line method or accelerated depreciation method are allowed by IRS.
▪ Intangible assets also listed here, e.g. goodwill, patents, copyrights, etc.
▪ Goodwill is an intangible asset that arises only when a firm purchases another firm. It
measures how much the price paid for the acquired firm exceeds the sum of the values
of acquired firm's individual assets.
AMORTIZATION: the process of writing off expenses for intangible assets
AMORTIZATION EXPENSE vs. ACCUMULATED AMORTIZATION ???
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2. The Balance Sheet
2.3. Long-Term Liabilities & Equity
▪ Long-term liabilities: debt instruments due and payable beyond one year as well as other long-
term obligations of the firm, e.g. bank loans, mortgages, and bonds with a maturity of one year
or longer.
▪ Equity
1. Common Equity: represents the 3. Retained earnings: results from
true ownership of the firm. funds the firm has reinvested from its
Additional paid-in capital is the earnings.
amount of capital received in excess ▪ These funds are not cash–they
of par value. already have been put to work.
2. Preferred Equity: has features that 4. Treasury stock: reflects the value
make it a combination of a fixed of the shares that the firm has
income security and an equity repurchased from investors.
security.
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3. Market Value vs. Book Value
3.1. Balance Sheet Valuation
▪ All assets are traditionally reported at their historical costs.
▪ Balance sheet does not reflect current market value of the assets–only their acquired
costs.
▪ Market value
✓ Better information is provided to management and investors by adopting a marking
to market approach—reporting assets at their current market value.
✓ Downside is the difficulty in estimating market values of asset.
✓ When both liabilities and assets are reported at their current market values, their
difference represents true market value of shareholders’ equity.
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4. The Income Statement & SOE
4.1. The Income Statement
▪ Measures the profitability of a firm for any reporting period.
▪ Revenues represent value of products and services sold by firm–include both cash
and credit sales.
▪ Expenses range from cost of producing goods for sale and asset utilization costs-
depreciation or amortization.
Net income = Revenues – Expenses
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4. The Income Statement & SOE
4.1. The Income Statement
Exhibit 3.2: Diaz Mfg
Income Statements
Revenues = $1,563.7 m
Expenses = $1,445.2 m
Net Income
= Revenues – Expenses
= $1,563.7 m - $1,445.2 m
= $ 118.5 m
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4. The Income Statement & SOE
4.1. The Income Statement
Depreciation & Amortization Expenses
DEPRECIATION: All long-term real assets that deteriorate with use are
depreciated. → lower taxable income and reduce taxes.
Non-cash DEPRECIATION EXPENSE vs. ACCUMULATED DEPRECIATION ???
expense Straight line method or accelerated depreciation method are allowed by IRS.
▪ Firms allowed to use one for internal purposes and another for tax purposes.
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4. The Income Statement & SOE
4.1. The Income Statement
Depreciation & Amortization Expenses
▪ Intangible assets are amortized except for goodwill
▪ Beginning in June 2001, however, goodwill could no longer be
Non-cash amortized. The value of the goodwill on a firm's balance sheet is now
expense subject to an annual impairment test.
▪ If the value of the goodwill has declined (been impaired), management
must expense the amount of the impairment. This expense reduces the
firm's reported net income.
AMORTIZATION: the process of writing off expenses for intangible assets
AMORTIZATION EXPENSE vs. ACCUMULATED AMORTIZATION ???
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4. The Income Statement & SOE
4.1. The Income Statement
▪ Extraordinary Items refer to income or expenses associated with events that are not
expected to happen on a regular basis.
Bottom Line Accounts
Earnings before interest, taxes, depreciation and amortization (EBITDA):
Earnings generated from operations prior to payment of expenses not directly connected
to production of products.
After netting out the expenses related to depreciation and amortization, we arrive at
earnings before interest and taxes (EBIT).
Earnings before taxes (EBT) represents the taxable income for the period.
Subtracting taxes from EBT yields net income or net income after taxes.
→ This amount tells us amount available to management to pay dividends, pay off debt,
or reinvest in firm.
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4. The Income Statement & SOE
4.2. Statement of Retained Earnings
▪ This financial statement shows the changes in the retained earnings account from
one period to the next.
▪ This account will show changes whenever a firm reports a loss or profit and when
a cash dividend is declared.
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5. The Statement of Cash Flows
Net Cash Flow versus Net Income
▪ While accountants focus on net income, shareholders would be more
interested in net cash flows.
▪ These two are not the same, because of the presence of non-cash revenues
and expenses.
The Statement of Cash Flows
▪ Helps to measure cash outflows and cash inflows generated during any period.
▪ Indicates cash flows resulting from: Operating activities, investing activities, and
financing activities.
▪ Sum of cash flows measures net cash flows of firm during a given period.
▪ Net cash flows is the bottom line of this financial statement.
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5. The Statement of Cash Flows
Exhibit 3.4: Diaz Mfg
Statement of Cash Flows for
the Fiscal Year Ending
December 31,
2017 ($ ms)
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5. The Statement of Cash Flows
5.1. CFs from Operating Activities
▪ Cash inflows result from producing and selling goods and services.
▪ Cash outflows are tied to the purchase of raw materials, inventory, salaries
and wages, utilities, rent, interest and other related expenses.
▪ Net cash flow from operating activities (NCFOA) as:
NCFOA = Net income – Noncash revenues + Noncash expenses (3.4)
NCFOA = Net income + Depreciation & Amortization + Changes in working capital (3.5)
Changes in WC
= Δaccounts payable + Δaccrued income taxes - Δaccounts receivable - Δinventory - Δother current assets
sources of cash uses of cash
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5. The Statement of Cash Flows
5.1. CFs from Operating Activities
NCFOA example – Diaz Manufacturing
Net Income = $118.5 m
Depreciation and Amortization = $83.1 m
NCFOA = Net Income + Depreciation and Amortization + Changes in WC
= $118.5 m + $83.1 m + ($24.3 m + $1.2 m + $8.6 m - $37.4 m - $51.1 m)
= $147.2 m
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5. The Statement of Cash Flows
5.2. CFs from Investing Activities
▪ Cash inflows and outflows arise out of the acquisition and selling
of long-term assets necessary to operate the business. investing
activities.
▪ Also result from
▪ Buying and selling financial assets (bonds, stocks).
▪ Making and collecting loans.
▪ Selling and settling insurance contracts.
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5. The Statement of Cash Flows
5.3. CFs from Financing Activities
▪ Cash Inflows–when a firm issues debt or equity securities, or borrows money from
banks or other lenders.
▪ Cash Outflows–if they pay interest or dividends on the investor’s funds, pay off
debt, or purchase treasury stock.
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5. The Statement of Cash Flows
5.4. Tying Together the Financial Statements
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6. Cash Flows to Investors
5.4. Tying Together the Financial Statements
The cash flow to investors include interest payments and the repayment of principal to the firm's debt
holders, as well as distributions of cash to its stockholders in the form of dividends or stock
repurchases.
▪ Cash flow to investors from operating activity (CFOA) = EBIT - Current taxes + Noncash expenses
→ Does NOT include CHANGES IN WC
▪ Cash flow invested in net working capital (CFNWC) = NWC current period − NWC previous period
▪ Cash flow invested in long-term assets (CFLTA) = Long-term assets current period - Long-term assets
previous period
▪ CFI = CFOA - CFNWC - CFLTA
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7. Federal Income Tax
Corporate Income Tax Rates
▪ It is a progressive tax schedule with rates ranging from 15 percent to 39 percent.
→ The higher a firm’s taxable income, the higher the tax liability.
▪ Average tax rate = total taxes paid
divided by taxable income for the period.
▪ Marginal tax rate = tax rate paid on the
last dollar earned or the next dollar
earned.
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7. Federal Income Tax
Unequal Treatment of Dividends and Interest Payments
▪ Current U.S. tax code allows interest payments on debt issued by firms to be tax
deductible.
▪ Dividends paid on firm’s preferred stock or common stock are NOT deductible for tax
purposes–they are paid from after-tax income.
▪ The result is a lower cost of debt financing relative to the cost of equity financing.
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Homework
HOMEWORK:
Q3.1, 3.5, 3.9, 3.10, 3.13 pg. 204; Q3.18 → 3.22, pg. 205,
Q3.28, 3.30, 3.32, pg. 206 (Parrino, R., KidWell, D., 2019, 4ed)
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