CH3 Titman 12e

Chapter 3
Understanding
Financial
Statements,
Taxes, and
Cash Flows
Slide Contents
1.  An Overview of Financial Statements

2.  The Income Statement
3.  The Balance Sheet
4.  The Cash Flow Statement
•  Principles Applied in This Chapter
•  Key Terms
Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-2

Principles Used in This Chapter
•  Principle 1: Money Has a Time Value.

•  Principle 3: Cash Flows Are the Source of
Value.
•  Principle 4: Market Prices Reflect
Information.
•  Principle 5: Individuals Respond to
Incentives.

3.1 AN OVERVIEW OF THE
FIRM S FINANCIAL
STATEMENTS

Basic Financial Statements
The accounting and financial regulatory

authorities mandate the following four types
of financial statements:
1.  Income statement
2.  Balance sheet
3.  Cash flow statement
4.  Statement of shareholder s equity

Basic Financial Statements (cont.)
1.  Income Statement: An income statement

provides the following information for a
specific period of time (for example, a full
year or quarter):
•  Revenue earned,
•  Expenses incurred, and
•  Profit earned.

2.  Balance sheet: Balance sheet contains

information on a specific date (for example,
as of December 31, 2013) of the following:
•  Assets (everything of value the company owns),
•  Liabilities (the firm s debts), and
•  Shareholders equity (the money invested by the
company owners).

3.  Cash flow statement: It reports cash

received and cash spent by the firm over a
period of time.
4.  Statement of shareholder s equity: It

provides a detailed account of the firm s
activities in the following accounts:
Common stock & Preferred stock account,
Retained earnings account, and Changes to
owners equity.

Why Study Financial Statements?
Analyzing a firm s financial statement can help

managers carry out three important tasks:
1.  Assess current performance,
2.  Monitor and control operations, and
3.  Plan and forecast future performance.

Why Study Financial Statements?
(cont.)
•  Distinction between the earnings numbers

that the firm s accountants calculate and the
amount of cash that a firm generates.
•  It is possible for a firm to report positive

accounting earnings while generating
negative cash flows (and vice versa).

What are the Accounting Principles Used
to Prepare Financial Statements?
•  Accountants use the following three

fundamental principles when preparing
financial statements:
1.  The revenue recognition principle,
2.  The matching principle, and
3.  The historical cost principle.

3.2 THE INCOME STATEMENT

An Income Statement
An income statement (also called a profit and

loss statement) measures the amount of
profits generated by a firm over a given time
period (usually a year or a quarter). It can be
expressed as follows:
Revenues (or Sales) – Expenses = Profits

An Income Statement (cont.)
An income statement will contain the

following:
1.  Revenues
2.  Expenses
–  Cost of goods sold, Selling expenses, General
and administrative expense, depreciation &
amortization expense, Interest expense, and
Income tax expense
3.  Net Income
–  Difference between Revenue and all expenses

Table 3.1 H. J. Boswell, Inc.

Evaluating a Firm s per Share
Earnings (EPS) and Dividends
•  Per Share earnings = company s net income

divided by the number of common shares
outstanding.
•  Dividends per share = total dividends paid

divided by the number of common shares
outstanding.

Evaluating a Firm s EPS and
Dividends (for Boswell, Table 3.1)
•  Earnings per share = $204.75m ÷ 90m

= $2.28 per share
•  Dividends per share = $45m ÷ 90m

= $0.50 per share

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
–  Boswell, Inc. earned net income of $204.75

million, of which $45 million was distributed in
dividends and $159.75 million was retained and
reinvested in the firm.

Interpreting Firm Profitability using
the Income Statement
From H.J. Boswell Inc. s income statement

(Table 3-1) we observe that firm has been
profitable. We can identify three different
measures of profit or income:
1.  The gross Profit margin is 25% ($675 million)
2.  The operating profit margin is only 14.2% ($382.5
million)
3.  The net profit margin is only 7.6% ($204.75 million)

the Income Statement (cont.)
1.  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. The markup
percentage equals gross profit divided by cost of
goods sold (=$675m ÷ $2.025m = 33.3%)

2.  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.

3.  The net profit margin

= net profits ÷ sales
= $204.75 million ÷ $2,700 million
= 7.6%
–  Net profit margin indicates the percentage of

revenues left over after all expenses (including
interest and taxes) have been considered.

By monitoring any changes in these margins

and comparing these margins to those of
similar businesses, we can dissect and identify
a firm s performance and identify expenses
that are out of line.

GAAP and Earnings Management
•  While the firms must adhere to GAAP, there

is considerable room for managers to
actively influence the firm s reported
earnings.
•  Managers have an incentive to tamper with

earnings as their pay depends upon it and
because investors pay close attention to
earnings announcements.

GAAP and Earnings Management
An audit by an independent accounting firm

serves as a check and balance to control
management s incentive to disguise the firm s
financial condition.

CHECKPOINT 3.1:
CHECK YOURSELF
Constructing an Income Statement

Reconstruct the firm s income statement
assuming the firm is able to cut its cost of
goods sold by 10% and that the firm pays
taxes at a 40% rate. What is the firm s net
income and earnings per share?
Step 1: Picture the Problem
•  The income statement can be expressed as

follows:
Revenues – Expenses = Net Income
•  We are given information on revenues and

expenses (cost of goods sold, operating
expenses, interest expense and income
taxes) to fill the template given on next
slide.

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

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.

Step 3: Solve
Revenues = $14,549,000,000
Less: Cost of goods sold

= $8,347,500,000
Equals: profit
=$6,201,500,000
Less: Operating/other expenses
=$3,841,000,000
Equals: net
Operating income
=$2,370,500,000
Less: Interest expense
=$74,000,000
Equals: earnings
Before taxes
=$2,291,500,000
Less: Income taxes (40%)
=$916,600,000
Equals:
NET INCOME
=$1,374,900,000

Step 3: Solve (cont.)
Earnings per share:

= net income ÷ number of shares
= $1,374,900,000 ÷ 716,296,296
= $1.92

Step 4: Analyze
The firm is profitable since it earned net

income of $1,374,900,000. The shareholders
were able be earn $1.96 per share.

3.4 THE BALANCE SHEET

The Balance Sheet
The balance sheet provides a snapshot of the

firm s financial position on a specific date. It
is defined by the following equation:
Total Assets = Total Liabilities + Total

Shareholders Equity

The Balance Sheet (cont.)
•  Total liabilities represent the total amount

of money the firm owes its creditors
•  Total shareholders equity refers to the
difference in the value of the firm s total
assets and the firm s total liabilities.
•  Total assets, sum of total shareholders
equity and total liabilities, represents the
resources owned by the firm.

•  In general, GAAP requires that the firm

report assets using the historical costs.
•  Cash and assets held for sale (such as

marketable securities) are an exception to
the rule. These assets are reported using
the lower of their cost or current market
value.

Assets whose value is expected to decline

over time (such as equipment) is reported as
net equipment (equal to historical cost less
the accumulated depreciation). Net value
(also known as accounting or book value)
could be significantly different from the
market value of the asset.

Table 3.2 H. J. Boswell, Inc.

Table 3.2 H. J. Boswell, Inc. (cont.)

Figure 3.1 The Balance Sheet

The balance sheet includes the following main

components:
1.  Assets – It includes current assets and
fixed assets.
2.  Liabilities and Stockholders’ Equity – It
indicates how the firm finances its assets.
It includes current liabilities, long-term
liabilities, and owner’s equity.

•  Current assets consists of firm s cash plus

other assets the firm expects to convert to
cash within 12 months or less, such as
receivables and inventory.
•  Fixed assets are assets that the firm does

not expect to sell within one year. For
example, plant and equipment, land.

•  Current liabilities represent the amount

that the firm owes to creditors that must be
repaid within a period of 12 months or less
such as accounts payable, notes payable.
•  Long-term liabilities refer to debt with

maturities longer than a year such as bank
loans, bonds.

•  The stockholder s equity includes the

following: Par value of common stock + Paid
in Capital + Retained Earnings.
•  We can also express stockholders equity as

follows:
Shareholders' equity = Total Assets – Total Liabilities

Firm Liquidity and Net Working
Capital
Liquidity generally refers to the firm s ability

to covert its current assets into cash so that it
can pay its current liabilities on time. We can
thus measure a firm s liquidity by computing
its net working capital (equal to current
assets less current liabilities).

Firm Liquidity and Net Working
Capital (cont.)
•  If a firm s net working capital is significantly

positive, it is in a good position to pay its
debts on time and is consequently very
liquid.
•  Lenders consider the net working capital as

an important indicator of firm s ability to
repay its loans.

CHECKPOINT 3.2:
CHECK YOURSELF
Constructing a Balance Sheet
Reconstruct the Gap s balance sheet to
reflect the repayment of $1 billion in short-
term debt using a like amount of the firm’s
cash. What is the balance for total assets and
current liabilities?

•  The firm s balance sheet can be expressed

as follows:
Total Shareholders Equity +
Total Liabilities
= Total Assets

Step 1: Picture the Problem (cont.)
Current Assets Current Liabilities
Cash Accounts payable
Accounts Receivable Short-term debt
Inventories Other current liabilities
Other current assets
Total current assets Total current liabilities
Long-term (fixed) assets Long-term Liabilities

Gross PPE Long-term debt
Less: Accumulated depreciation
Net property, plant and equip. Owner’s Equity
Par value of common stock
Other long-term assets Paid-in-capital
Retained earnings
Total long-term assets Total equity
Total Assets Total Liabilities and

Owners’ equity

We are given the account balances so in order

to construct the balance sheet we need to
substitute the appropriate balances into the
template developed in step 1.

Step 3: Solve
Cash 885,000,000 Current 1,128,000,000

Inventories liabilities
Other current 1,615,000,000
assets 809,000,000
Total current 3,309,000,000 Total current 1,128,000,000
assets liabilities
Net Property, 2,523,000,000 Long-term 2,539,000,000
Plant and liabilities
equipment
Other long-term 590,000,000 Common Equity 2,755,000,000
assets
Total Assets $6,422,000,00 Total Liabilities $6,422,000,00
0 and Equity 0

Step 4: Analyze
We can make the following observations from

Gap s Balance sheet:
–  The total assets of $6,422,000,000 is financed
by a combination of current liabilities, long-term
liabilities and owner s equity. Owner s equity
accounts for $2,755,000,000 of the total.
–  The firm has a healthy net working capital of
$2,181,000,000.

Debt and Equity Financing
The right-hand side of the balance sheet

reveals the following two sources of money
used to finance the purchase of the firm s
assets listed on the left-hand side of the
balance sheet.
–  Borrowings (debt financing)
–  firms owners (equity financing)

Debt versus Equity
•  Payment: Payment for debt holders is

generally fixed (in the form of interest);
Payment for equity holders (dividends) is
not fixed nor guaranteed.
•  Seniority: Debt holders are paid before
equity holders in the event of bankruptcy.
•  Maturity: Debt matures after a fixed period
while equity securities do not mature.

Book Values, Historical Costs, and
Market Values
Book values (based on historical cost)

reported in the balance sheet can differ from
market values.
The gap is likely to be higher for fixed assets
relative to current assets for two reasons:
1. Over time, inflation affects the cost of
fixed assets;
2. The firm adjusts the the BV of its fixed
assets downward yearly as it depreciates

3.5 THE CASH FLOW
STATEMENT

The Cash Flow Statement
The Cash Flow Statement is used by firms

to explain changes in their cash balances over
a period of time by identifying all of the
sources and uses of cash for the period
spanned by the statement.

Sources and Uses of Cash
•  A source of cash is any activity that brings

cash into the firm. For example, sale of
equipment.
•  A use of cash is any activity that causes

cash to leave the firm. For example,
payment of taxes.

Table 3-3 H. J.
Boswell, Inc.,
Balance Sheets
and Balance
Sheet Changes

Cash Flow Analysis (cont.)
Why did the cash balance decline by $4.50m?.

See table 3.1 and table below:
Sources of Cash Uses of Cash

Increase in Accounts Increase in Accounts
Payable = $4.50 Receivable $22.50
Increase in long-term debt Increase in inventory =

=$51.75 $148.50
Increase in retained Increase in net plant and
earnings = $159.75 equipment = $40.50
Decrease in short-term
notes = $9
Total Sources of cash = Total Uses of cash =
$216.00 $220.50

Cash Flow Analysis (cont.)
An analysis of H.J. Boswell s operations

reveals the following:
–  The firm used more cash than it generated,
resulting in a deficit of $4.5 million
–  The main source of cash flow was retained
earnings ($159.75m) and long-term debt
($51.75m)
–  The largest use of cash was for acquiring
inventory at $148.5 million.

Cash Flow Analysis Summary
Sources of Cash Uses of Cash

Decrease in an asset Increase in an asset
account account
Increase in a liability Decrease in a liability
account account
Increase in an Decrease in an
owner’s equity owners’ equity
account account

Cash Flow Statement
The basic format for a cash flow statement is

as follows:
Beginning Cash Balance
Plus: Cash Flow from Operating
Activities
Plus: Cash Flow from Investing
Activities
Plus: Cash Flow from Financing
Activities
Equals: Ending Cash Balance
Cash Flow Statement (cont.)
•  Operating activities represent the company s

core business, including sales and expenses.
•  Investing activities include the cash flows

that arise out of the purchase and sale of
long-term assets such as plant and
equipment.

Cash Flow Statement (cont.)
Financing activities represent changes in the

firm s use of debt and equity such as issue of
new shares, the repurchase of outstanding
shares, and the payment of dividends.

Table 3-4 H. J. Boswell, Inc.

Evaluating the Cash Flow Statement
The statement can be used to answer a

number of important questions such as:
–  How much cash did the firm generate from its
operations?
–  How much did the firm invest in plant and
equipment?
–  Did the firm raise additional funds, and if so, how
much and from what sources?
–  Is the firm able to generate positive cash flows?

Quality of Earnings: Evaluating Cash
Flow from Operations
Since reported earnings can sometimes be

misleading, we can combine information from
the firm s income statement and the
statement of cash flows to evaluate the
quality of firm s reported earnings.

Flow from Operations (cont.)
•  A ratio of 1.00 indicates very high quality of

earnings and that the firm s operating cash
flows and net income are in sync with each
other.
•  A low ratio indicates firm s reliance on non-

operating sources of cash to generate net
income that may not be sustainable.

Flow from Operations (cont.)
•  The quality of earnings ratio for Boswell for

2013 = $173.25m ÷ $ 204.75m = 84.6%
•  Boswell s ratio was only 84.6% due to more

credit sales than it collected, increase in
inventories, non-cash depreciation expense,
and increased reliance on accounts payable.

Sustainable Capital Expenditures:
Evaluating Investment Activities
This ratio calculates the extent to which

the firm s operating cash flows can pay for
capital expenditures. Higher ratio will
mean less dependence on capital markets
for financing.

Sustainable Capital Expenditures:
Evaluating Investment Activities (cont.)
•  For Boswell, the capital acquisition ratio is:

= $157.75m ÷ $159.5m = 98.9%
•  Boswell was, on average, able to finance

98.9% of its new expenditures out of the
firm s current-year operations.

CHECKPOINT 3.3:
CHECK YOURSELF
Interpreting the Statement of Cash Flows

Go to http:finance.google.com/finance and get the
cash flow statements for the most recent four-year
period for Exco Resources (XCO). How does their cash
from investing activities compare to their cash flow
from operating activities in 2012.
•  The cash flow statement identifies the net

sources and uses of cash for a specific
period of time into 3 groups: operating
activities, investing activities, and financing
activities.
•  Here we have to compare the cash flow

from operating activities and investment
activities in 2012 for Exco Resources (XCO).

We can compare the cash flow from operating

activities and cash flow from investing
activities by retrieving the cash flow
statement from
http://finance.google.com/finance

Step 3: Solve
Cash flow from operating activities

EXCO had a positive cash flow from operating
activities of $514.78 million in 2012. In 2011,
the cash flow from operating activities was much
lower at $428.54 million. The primary
contributors to the operating cash flows were
adjustments to net income.

Step 3: Solve (cont.)
Cash flow from investing activities:

Cash flow from investing activities were
($426.09) million in 2012. EXCO had invested
heavily in capital expenditures with a total
expense of $536.92 million.

Step 4: Analyze
•  The cash flow statement for 2012 depicts a

profitable firm with positive cash flow from
operations that have been steadily
increasing since 2010. In 2010, cash flow
from operations were only $339.92 million.
•  The firm has been aggressively investing in

fixed assets. However, it has dropped
significantly compared to 2011 ($1,041
million).

Key Terms
•  Accounts receivable
•  Accounts payable
•  Accumulated depreciation
•  Average tax rate
•  Balance sheet
•  Cash flow from operations
•  Cash flow statement

Key Terms (cont.)
•  Cost of goods sold

•  Current assets
•  Current liabilities
•  Depreciation expense
•  Dividends per share
•  Earnings before interest and taxes (EBIT)
•  Earnings per share

Key Terms (cont.)
•  Fixed assets
•  Gross plant and equipment
•  Gross profit margin
•  Income statement
•  Inventories
•  Liquidity
•  Long-term debt

Key Terms (cont.)
•  Marginal tax rate

•  Market value
•  Net operating income
•  Net income
•  Net plant and equipment
•  Net profit margin
•  Net working capital
•  Notes payable

Key Terms (cont.)
•  Operating profit margin

•  Paid-in capital
•  Par value
•  Profits
•  Quality of earnings ratio
•  Retained earnings
•  Revenues

Key Terms (cont.)
•  Source of cash
•  Stockholders equity
•  Taxable income
•  Total assets
•  Total liabilities
•  Total shareholders equity
•  Treasury stock
•  Uses of cash

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Chapter 3

1. An Overview of Financial Statements

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-2

• Principle 1: Money Has a Time Value.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-3

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-4

The accounting and financial regulatory

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-5

1. Income Statement: An income statement

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-6

2. Balance sheet: Balance sheet contains

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-7

3. Cash flow statement: It reports cash

4. Statement of shareholder s equity: It

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-8

Analyzing a firm s financial statement can help

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-9

• Distinction between the earnings numbers

• It is possible for a firm to report positive

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-10

• Accountants use the following three

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-11

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-12

An income statement (also called a profit and

Revenues (or Sales) – Expenses = Profits

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-13

An income statement will contain the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-14

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-15

• Per Share earnings = company s net income

• Dividends per share = total dividends paid

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-16

• Earnings per share = $204.75m ÷ 90m

• Dividends per share = $45m ÷ 90m

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-17

• What can the firm do with the net income?:

– Boswell, Inc. earned net income of $204.75

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-18

From H.J. Boswell Inc. s income statement

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-19

1. The gross profit margin (GPM)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-20

2. The operating profit margin

– The operating profit margin is equal to the ratio

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-21

3. The net profit margin

– Net profit margin indicates the percentage of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-22

By monitoring any changes in these margins

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-23

• While the firms must adhere to GAAP, there

• Managers have an incentive to tamper with

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-24

An audit by an independent accounting firm

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-25

Constructing an Income Statement

• The income statement can be expressed as

• We are given information on revenues and

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-27

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-28

• Given the account balances, constructing

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-29

Less: Cost of goods sold

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-30

1.  An Overview of Financial Statements

•  Principle 1: Money Has a Time Value.

1.  Income Statement: An income statement

2.  Balance sheet: Balance sheet contains

3.  Cash flow statement: It reports cash

4.  Statement of shareholder s equity: It

•  Distinction between the earnings numbers

•  It is possible for a firm to report positive

•  Accountants use the following three

•  Per Share earnings = company s net income

•  Dividends per share = total dividends paid

•  Earnings per share = $204.75m ÷ 90m

•  Dividends per share = $45m ÷ 90m

•  What can the firm do with the net income?:

–  Boswell, Inc. earned net income of $204.75

1.  The gross profit margin (GPM)

2.  The operating profit margin

–  The operating profit margin is equal to the ratio

3.  The net profit margin

–  Net profit margin indicates the percentage of

•  While the firms must adhere to GAAP, there

•  Managers have an incentive to tamper with

•  The income statement can be expressed as

•  We are given information on revenues and

•  Given the account balances, constructing

•  Total liabilities represent the total amount

•  In general, GAAP requires that the firm

•  Cash and assets held for sale (such as

•  Current assets consists of firm s cash plus

•  Fixed assets are assets that the firm does

•  Current liabilities represent the amount

•  Long-term liabilities refer to debt with

•  The stockholder s equity includes the

•  We can also express stockholders equity as

•  If a firm s net working capital is significantly

•  Lenders consider the net working capital as

•  The firm s balance sheet can be expressed

•  Payment: Payment for debt holders is

•  A source of cash is any activity that brings

•  A use of cash is any activity that causes

•  Operating activities represent the company s

•  Investing activities include the cash flows