Chapter 2 summary

Expert-Level Study Guide for Chapter 2: Financial Statements, Taxes, and Cash Flow

(Wharton & Harvard-Level, Yet Simple & Effective for A+ Mastery)

🔹 1. Overview of Financial Statements

Financial statements help businesses track performance, financial health, and compliance with regulations. The three key statements are:
1⃣ Balance Sheet → What the company owns (assets) vs. what it owes (liabilities & equity).
2⃣ Income Statement → Shows profits over a period (revenues, expenses, and net income).
3⃣ Cash Flow Statement → Tracks where the company’s cash comes from and where it goes.

📌 Key Concept:
📊 Accounting vs. Finance → Accounting records historical numbers, while Finance focuses on decision-making & valuation using those numbers.

🔹 2. The Balance Sheet (Snapshot of Financial Position)

📌 Definition: The Balance Sheet is a snapshot of a company’s financial position at a specific date. It follows this equation:

Total Assets=Total Liabilities+Shareholders’ Equity\text{Total Assets} = \text{Total Liabilities} + \text{Shareholders’ Equity}Total Assets=Total Liabilities+Shareholders’ Equity

📍 Example: If a company owns $1M in assets and owes $600K in liabilities, its equity is $400K.

📊 Components of the Balance Sheet
🔹 Assets (What the Company Owns)

• Current Assets (Liquid Assets - Cash & Near Cash Items)

  • Cash & Equivalents (e.g., bank deposits)

  • Marketable Securities (e.g., Treasury Bonds, easy to convert to cash)

  • Accounts Receivable (money customers owe the company)

  • Inventory (raw materials, work-in-progress, finished goods)

• Fixed Assets (Long-Term Assets for Operations)

  • Property, Plant, & Equipment (PP&E)

  • Intangible Assets (Patents, Trademarks, Goodwill)

🔹 Liabilities (What the Company Owes)

• Current Liabilities (Short-Term, Due in 1 Year)

  • Accounts Payable (Money Owed to Suppliers)

  • Notes Payable (Short-Term Debt Obligations)

  • Accrued Expenses (Wages, Rent, Taxes Owed but Not Paid Yet)

• Long-Term Liabilities (Debt Due in More Than 1 Year)

  • Bonds Payable

  • Deferred Taxes (Tax Owed in Future Due to Accounting Rules)

🔹 Shareholders' Equity (Owners’ Claim on Assets)

• Common Stock + Capital Surplus → Value of issued shares.

• Retained Earnings → Profits reinvested instead of paid as dividends.

• Treasury Stock → Shares the company repurchased.

📌 Key Financial Concept: Market Value vs. Book Value

• Book Value = What is recorded in accounting records (historical cost).

• Market Value = What someone is willing to pay today (more important in finance).

📍 Example: If a company’s book value of equity is $5M, but its stock price values it at $20M, investors expect strong future earnings growth!

🔹 3. The Income Statement (Profitability Over Time)

📌 Definition: The Income Statement shows how much revenue a company earned and what it spent to generate that revenue, ending with Net Income (Profit).

📊 Key Formula: Net Income = Revenues - Expenses

📊 Structure of the Income Statement
🔹 Revenues (Sales from Business Operations)

• Total Operating Revenues = Total sales earned.

🔹 Expenses (Costs to Generate Sales)

• Cost of Goods Sold (COGS) → Direct costs of production.

• Operating Expenses → Rent, wages, marketing, utilities, etc.

• Depreciation & Amortization → The gradual reduction in value of fixed & intangible assets.

🔹 Earnings Before Interest & Taxes (EBIT)

EBIT=Revenue−Operating Expenses−DepreciationEBIT = \text{Revenue} - \text{Operating Expenses} - \text{Depreciation}EBIT=Revenue−Operating Expenses−Depreciation

🔹 Net Income (Bottom Line Profit After All Costs)

Net Income=EBIT−Interest Expense−Taxes\text{Net Income} = \text{EBIT} - \text{Interest Expense} - \text{Taxes}Net Income=EBIT−Interest Expense−Taxes

📍 Example:
If a company has:

• Revenue = $500K

• COGS = $200K

• Operating Expenses = $150K

• Depreciation = $50K

• Interest Expense = $20K

• Taxes = $30K

Net Income=500K−200K−150K−50K−20K−30K=50K\text{Net Income} = 500K - 200K - 150K - 50K - 20K - 30K = 50KNet Income=500K−200K−150K−50K−20K−30K=50K

🔹 Earnings Per Share (EPS)

EPS=Net IncomeShares Outstanding\text{EPS} = \frac{\text{Net Income}}{\text{Shares Outstanding}}EPS=Shares OutstandingNet Income​

📍 If Net Income = $50K and Shares Outstanding = 10K, then EPS = $5.00

🔹 4. The Cash Flow Statement (Tracking Real Cash Movement)

📌 Definition: The Cash Flow Statement tracks how much cash is coming in and going out of the business. It shows if a company has enough liquidity to survive.

📊 Sections of the Cash Flow Statement
🔹 Operating Activities (Day-to-Day Business Cash Flow)

• Net Income + Depreciation

• Changes in Working Capital (Accounts Receivable, Inventory, Payables, etc.)

🔹 Investing Activities (Buying or Selling Long-Term Assets)

• Buying/selling property, equipment, or investments

🔹 Financing Activities (Raising Capital from Debt or Equity)

• Issuing new stock, borrowing money, repurchasing shares, paying dividends.

📍 Example:
If a company has:

• Operating Cash Flow = $50K

• Investing Cash Flow = -30K (Bought new equipment)

• Financing Cash Flow = +10K (Issued new stock)

Net Cash Flow=50K−30K+10K=30K\text{Net Cash Flow} = 50K - 30K + 10K = 30KNet Cash Flow=50K−30K+10K=30K

🔹 5. Corporate Taxes (How Much Companies Pay in Taxes)

📌 Key Concepts:

• Marginal Tax Rate → Tax rate on the next dollar earned.

• Effective Tax Rate → Total tax bill ÷ Total income.

📊 Corporate Tax Example
If a company earns $90,000, taxes are:

• First $50K taxed at 15% → $7,500

• Next $25K taxed at 25% → $6,250

• Last $15K taxed at 34% → $5,100

Total Taxes=7,500+6,250+5,100=18,850\text{Total Taxes} = 7,500 + 6,250 + 5,100 = 18,850Total Taxes=7,500+6,250+5,100=18,850Effective Tax Rate=18,85090,000=20.94%\text{Effective Tax Rate} = \frac{18,850}{90,000} = 20.94\%Effective Tax Rate=90,00018,850​=20.94%

🔹 6. Key Differences in Financial Statements

📌 Why Do Companies Report Different Numbers?
1⃣ Different Accounting Methods (GAAP vs. IFRS)
2⃣ Depreciation Policies (Straight-Line vs. Accelerated Depreciation)
3⃣ Extraordinary Items (One-Time Events Affecting Profits)
4⃣ Intangible Asset Valuation (Patents, Trademarks, Goodwill Differences)

📍 Example: Tech companies often report higher market values than book values due to future expected growth!

🎯 Summary – What You Must Know for A+

• Balance Sheet = Assets, Liabilities, Equity (Snapshot of financial health)

• Income Statement = Revenues - Expenses = Net Income (Profitability over time)

• Cash Flow Statement = Operating, Investing, Financing Cash Flows (Real cash movement)

• Corporate Taxes = Marginal vs. Effective Tax Rate

• Accounting Differences Impact Financial Reporting!