Chapter 2

Financial
Statements

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Learning Objectives
1. Explain the foundations of the balance sheet and
income statement
2. Use the cash flow identity to explain cash flow.
3. Provide some context for financial reporting.
4. Recognize and view Internet sites that provide
financial information.

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2.1 Financial Statements

Four main financial statements:

Balance sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flow

Our focus..
Interrelationship between the balance sheet and
the income statement
The process by which these statements can be used
to project a firms future cash flows

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2.1 Financial Statements

(continued)
(A) The Balance Sheet
Represents the assets owned by the
company and the claims against those
assets
Based on the accounting identity:
Assets Liabilities + Owners Equity

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(2.1)

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Figure 2.1 Balance sheet

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2.1 (A) Balance Sheet

Has five main sections:
1. Cash account
2.
3.
4.
5.

Where did the $65 million decline come from?

Working capital accounts

Net working capital = Current assets Current liabilities (2.2)

Long-term asset accounts

Plant and equipment; land and buildings

Gross value accumulated depreciation = Net value

Long-term liabilities (debt) accounts

Loans maturing in over one year

Ownership accounts

Shareholders equity
Retained earningsaccumulated total since inception

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2.1 (B) The Income Statement

Shows the expenses and revenues
generated by a firm over a past period,
typically a quarter or a year.
Net income = Revenues expenses

(2.3)

EBIT = Revenues operating expenses (2.4)

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Figure 2.2 Income Statement example

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2.1 (B) The Income Statement

(continued)
Net income is not the same as cash flow
Firm earned an income of $5,642 million
Cash account decreased by 65 million

3 reasons:
Accrual accounting
Noncash expense items --depreciation
Preference to classify interest expense as part of
financial cash flow

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2.2 Cash Flow Identity

The cash flow identity states that the cash flow
on the left-hand side of the balance sheet is
equal to the cash flow on the right-hand side of
the balance sheet.
CASH FLOW FROM ASSETS CASH FLOW TO CREDITORS
+ CASH FLOW TO OWNERS

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Figure 2.5 Cash Flow Identity and

components

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2.2 (A) The First Component:

Cash Flow From Assets
Three components:
Operating cash flow (OCF)
Net capital spending (NCS)
Change in net working capital (NWC)

Cash flow from assets = OCF NCS - NWC

OCF = EBIT + Depreciation Taxes
NCS = End. Net Beg. Net + Depreciation
Fixed Assets
Fixed Assets
NWC=Ending NWC Beginning NWC

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2.2 (A) The First Component:

Cash Flow From Assets (continued)

OCF = EBIT + Depreciation Taxes

Figure 2.3

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2.2 (A) The First Component:

Cash Flow From Assets (continued)
NCS = End. Net
Beg. Net
+ Depreciation
Fixed Assets Fixed Assets

NCS= ($11,961 - $10,788) + $1,406 = $2,579

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2.2 (A) The First Component:

Cash Flow From Assets (continued)
NWC = Ending NWC Beginning NWC

Net working capital for 2007 = $9,130 - $6,860 = $2,270

Net working capital for 2006 = $10,454 - $9,406 = $1,048
Change in NWC = $2,270 - $1,048 = $1,222
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2.2 (A) The First Component:

Cash Flow From Assets (continued)
Putting it all together.
Cash flow from Assets = OCF NCS - NWC
=$7,287-$2,579-$1,222
=$3,486

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2.2 (B) The Second Component:

Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense Net New Borrowing from Creditors
Net New Borrowing = Ending Long-term Liabilities Beginning Long-Term Liabilities

Cash Flow to Creditors = $239 (-$378) $617

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2.2 (C) The Third Component:

Cash Flow To Owners
Cash flow to owners = Dividends - Net new borrowing from owners
= $2,869

$0

= $2,869

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2.2 (C) Putting It All Together: The

Cash Flow Identity
CASH FLOW FROM ASSETS CASH FLOW FROM
CREDITORS + CASH FLOW TO OWNERS

$3,486

$617

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$2,869

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2.3 Financial Performance

Reporting
Annual reports to shareholders
Quarterly (10-Q) and annual (10-K)
reports filed with the SEC
Regulation Fair Disclosure (Reg. FD):
Companies must release all material
information to all investors at the same time.
Notes to the Financial Statements: A wealth of
information about the firm

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2.4 Financial Statements on the

Internet
EDGAR (www.sec.gov/edgar.shtml)
Yahoo! Finance
(http://finance.yahoo.com.)
Many, many more Web sites with rich
stores of information

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 1
Balance Sheet. Chuck Enterprises has

current assets of $300,000, and total assets of

$750,000. It also has current liabilities of
$125,000, common equity of $250,000, and
retained earnings of $85,000. How much longterm debt and fixed assets does the firm have?

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 1 (ANSWER)

Current Assets + Fixed Assets = Total Assets

$300,000+Fixed Assets = $750,000
Fixed Assets = $750,000 - $300,000 = $400,000
Total Assets = Current Liabilities + Long-term debt
+Common equity + Retained Earnings

$750,000 = $125,000 + Long-term debt + $250,000 +

85,000

Long-term debt = $750,000 - $125,000-$250,000 -$85,000

Long-term debt = $290,000

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 2
Income Statement. The Top Class Company
had revenues of $925,000 in 2009. Its operating
expenses (excluding depreciation) amounted to
$325,000, depreciation charges were $125,000,
and interest costs totaled $55,000. If the firm
pays a marginal tax rate of 34 percent, calculate
its net income after taxes.

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 2 (ANSWER)
Revenues
Less operating expenses
= EBITDA
Less depreciation
= EBIT
Less interest expenses
= Taxable Income
Less taxes (34%)
= Net Income after taxes

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$925,000
325,000
600,000
125,000
475,000
55,000
420,000
142,800
277,200

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 3
Retained Earnings: The West Hanover
Clay Co. had, at the beginning of the fiscal
year, November 1, 2009, retained
earnings of $425,000. During the year
ended October 31, 2010, the company
generated net income after taxes of
$820,000 and paid out 35 percent of its
net income as dividends. Construct a
statement of retained earnings and
compute the year-end balance of retained
earnings.
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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 3 (ANSWER)

Statement of Retained Earnings for

the year ended October 31, 2010

Balance of Retained Earnings,

11/1/2009.$425,000
Add: Net income after taxes, 10/31/2010.
$820,000
Less: Dividends paid for year-end
10/31/2010$287,000
Balance of Retained Earnings, 10/31/20120..
$958,000
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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 4

4. Working Capital: D.K. Imports, Incorporated reported

the following information at its last annual meeting:
Cash and cash equivalents = $1,225,000;
Accounts payables = $3,200,000
Inventory = $625,000;
Accounts receivables = $3,500,000;
Notes payables = $1,200,000;
Other current assets = $125,000.
Calculate the companys net working capital.

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 4 (ANSWER)
Net Working Capital = Current Assets - Current
Liabilities
(Cash & Cash Equivalents + Accts. Rec. + Inventory +
other current assets) - (Accounts Payables + Notes
Payables)
($1,225,000+$3,500,000+$625,000+$125,000) ($3,200,000+$1,200,000)
$5,475,000 - $4,400,000
Net Working Capital $1,075,000

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 5

Cash Flow from Operating Activities: The Mid-American

Farm Products Corporation provided the following financial
information for the quarter ending September 30, 2009:
Depreciation and amortization $75,000
Net Income $225,000
Increase in receivables $95,000
Increase in inventory $69,000
Increase in accounts payables $80,000
Decrease in marketable securities $34,000.
What is the cash flow from operating activities generated
during this quarter by the firm?

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ADDITIONAL PROBLEMS WITH

ANSWERS
Problem 5 (ANSWER)
Net Income
$225,000
Add depreciation and amortization
75,000
Add decrease in marketable securities
34,000
Add increase in accounts payables
80,000
Less increase in accounts receivables
95,000
Less increase in inventory
69,000
Cash flow from operating activities

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$250,000

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Figure 2.4

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Figure 2.6

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Figure 2.7

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