Chapter 5 - Financial Statements

Income Statement

determine a firm’s profitability for a specified period

Profitability

revenues less expenses

Firm’s purpose

generate a profit from operations

Nonprofit entities measure success by ___

meeting their objectives

Net Income

Revenues - Expenses

Order of expenses subtracted

Sales - COGS = Gross Profit

Gross Profit - Operating Expenses = Operating Profit

Operating Profit - Interest Expenses = Pre-tax profit

Pre-tax Profit - Income Tax Expenses = Net Income

EBITDA

earnings before interest, taxes, depreciation, and amortization

Proxy for cash from operations

EBIT

known as operating income

reflects the amount of earnings a company generates from its operations

interest expense isn’t deducted because amount of interest a company pays on its debt is a reflection of how much debt it has, and the decision to borrow money is not an operating decision

balance sheet

reflects the accounting equation, basis for double-entry bookkeeping

Assets

liabilities + owner’s equity

resources available to the firm to generate revenues, profits, and cash flow

Liabilities

funds owed to suppliers, banks, employees, and other creditors

Owner’s equity

1) contributed capital (owners or stockholders)

2) earned capital (earnings retained and not distributed)

Moment in time

balance sheet

Period of time

income statement

Left side of a balance sheet

assets(listed in order of liquidity)

cash balances first

broken down between current assets and noncurrent assets

Right side of a balance sheet

liabilities and owner’s equity

liabilities above since if a company goes into liquidation, it goes first

Retained earnings

connection between income statement and balance sheet

owner’s equity and represent earned capital

distributions for dividends taken from this

As a company generates net profits over its lifetime, those

profits ___

flow from the income statement into the retained

earnings account

Matching principles

expenses paid in the same period if no diff between what was incurred as an expense and what was paid in cash

an expense is incurred in one period but is paid for in a subsequent period

Payable

lag between expense recognition and cash payment

Owner’s equity

the investment of the owners in the company

bottom right of balance sheet

source of capital for a firm that is most at risk

if a company does really well, highest return possible

Risk and reward

generate the highest possible return on an investment, one must be willing to accept a higher level of risk

Statements of owner’s equity

shows how the owner’s equity accounts evolved over the year

New sources of funding

• Contributed capital: new investments made by owners, sales of new stock, reissues of treasury restock

• Earned capital: additions to the retained earnings account via net income earned that year

New uses of funding

• Contributed capital: repurchases of owner’s stock

• Earned capital: distributions from retained earnings in form of dividends

Contributed capital

funding provided directly from the owners

Earned capital

funding that was generated by the business and retained rather than distributed to the owners

dividends

Statement of cash flows

income statements created under accrual accounting rules do not reflect cash inflows and outflows

Changes in cash flows over a period

first place where trouble occurs

Firms do not fail because ___

they dont generate profits, they fail because they dont have cash to pay their bills

Three parts of statement of cash flows

Cash from operations: Net income plus noncash accounting

charges plus or minus changes in working capital

Cash for investing activities: Net increases or decreases in

fixed assets or investments

Cash from financing activities: Funding obtained from or repaid to debt holders or equity holders

Operating cash flow

Operating income x (1 - tax rate) = NOPAT

NOPAT + Noncash accounting charges ± changes in working capital = Operating Cash Flow

Free cash flow

cash that is free for distribution to debt or equity holders—in other words, the amount of cash that a firm would generate

independent of how it is financed

operating cash flow - capital expenditures

positive = self-financing

negative = take new debt, issue new stock, cut their dividends, or cut their capital spending programs

Working capital

Accounts receivable

Inventory

Accounts payable

Common-size financial statements

When analyzing financial statements that allow for comparisons between firms of different sizes

When dissecting changes in the composition of income

statement and balance sheet components over time

The alternative would be to try to evaluate absolute dollars, which is a much more difficult process because it lacks perspective.

Income statement percentage of sales

Balance sheet percentage of assets

Accrual accounting

requires that clear cutoffs be established

Public companies must abide by ___

generally accepted accounting principles and securities and exchange commission

Annual Reporting

• Provide general company information

• Discuss risk factors

• Disclose financial statements, accounting policies, and the auditor’s opinion regarding management representations

• Provide management’s discussion and analysis (MD&A) of financial results and performance for the period

What is the difference between gross profit and net income?

Gross Profit is Sales minus Cost of Goods Sold; Net Income is the final "bottom line" profit after all expenses, including operating costs, interest, and taxes, are subtracted

If a balance sheet has $900,000 in assets and $350,000 in equity, what are the liabilities?

550,000

What key element of the income statement flows through to the balance sheet?

Net Income flows from the income statement into the Retained Earnings account on the balance sheet

What useful insights does free cash flow (FCF) provide?

FCF indicates if a firm is self-financing (positive FCF) or needs outside funding (negative FCF) to cover operations and capital spending

Describe how common-size statements are useful

They allow for comparisons between firms of different sizes and help analyze changes in the composition of financial components over time by using percentages rather than absolute dollars

What is the difference between a calendar year and a fiscal year?

Calendar year starts on Jan1 and ends on Dec31

Fiscal year is start and end on other dates based on firm’s business cycle

Ted’s firm reported net income for the current period of $65,750. Is it safe to assume that because Ted’s firm reported such a large net income, it has plenty of cash to fund its operations? Why or why not?

• Reasoning: Under accrual accounting, transactions are recorded when they occur, not necessarily when cash actually moves, creating a timing difference.

• Firms do not fail because they lack profits; they fail because they do not have enough cash to pay their bills.

• A net profit does not automatically mean a firm has cash, just as a net loss does not necessarily mean they are out of cash. To understand the actual movement of funds, one must examine the statement of cash flows