 Understanding Financial Statements

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Overview
1. An Overview of the Firm’s Financial Statements
2. The Income Statement
3. The Balance Sheet
4. The Cash Flow Statement
5. Statement of Retained Earnings.

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Learning Objectives
1. Understand the content of the 4 basic financial
statements. Focus on
① Income statement
② Balance sheet statement
③ Cash flow statement

2. Evaluate firm profitability using the income

statement.

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Principles Used in This Chapter
 Principle 1: Money Has a Time Value.
 We need to recognize that financial statements do not
adjust for time value of money.
 Principle 2: Cash Flows Are the Source of Value.
 Financial statements provide an important starting point
in determining the firm’s cash flow.
 We should be able to distinguish between reported
earnings and cash flow. It is possible for a firm to report
positive earnings but have no cash!
 Principle 3: Market Prices Reflect Information.
 Firm ’ s financial statements provide important
information that is used by investors in forming
expectations about firm ’ s future prospects and
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Why Study Financial Statements?
1. Assess current performance through financial
statement analysis
 Next chapter provides more tools for the analysis.
2. Monitor and control operations
 Both insiders (such as managers, board of
directors) and outsiders (such as suppliers,
creditors, investors) use the statements to monitor
and control the firm’s operations.
3. Forecast future performance.
 Financial planning models are typically built using
the financial statements
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The Balance Sheet
The balance sheet provides a snapshot of the firm’s
financial position on a specific date. It is defined by:
Total Assets = Total Liabilities + Total Shareholder’s Equity
(asset) = (sources of funding)
 Total assets represents the resources owned by the
firm.
 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.
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Asset value calculation
In general, GAAP requires that the firm report assets on
its balance sheet 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” which is
equal to the historical cost minus accumulated
depreciation.

The net value reported on balance sheet could be

significantly different from the market value of the
asset.
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 Assets and liabilities
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.

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 The stockholder’s equity
Two components:
1. The amount the company received from selling
stock to investors. It may be shown as common
stock in the balance sheet.
OR
 Capital of investor/owners

1. Retained Earnings: the portion of net income

that has been retained (i.e., not paid in dividends)
from prior years operations.

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Three Accounting Principles
1. The Revenue recognition principle: Revenue should be
included in the income statement for the period in which:
 Its goods and services were exchanged for cash or accounts
receivable; or
 The firm has completed what it must do to be entitled to the
cash.
2. The Matching principle: Expenses are matched with the
revenues they helped produce.
 For example, employees’ salaries are recognized when the
product produced as a result of that work is sold, and not
when the wages were paid.
3. The Historical cost principle: Most assets and liabilities are
reported in the financial statements at historical cost, i.e., the
price the firm paid to acquire them. The historical cost
generally does not equal the current market value of the assets
or liabilities.

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An Income Statement
 Sales
 Minus Cost of Goods Sold
 = Gross Profit
 Minus Operating Expenses
 Selling expenses
 General and Administrative expenses
 Depreciation Expense
 = Operating income (EBIT)
 Minus Interest Expense
 = Earnings before taxes (EBT)
 Minus Income taxes
 = Net income (EAT)
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Sample Income Statement

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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.
 Source of cash is any activity that brings cash into the
firm. For example, sale of equipment.
 Use of cash is any activity that causes cash to leave the
firm. For example, payment of taxes.

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