Chapter 3

Understanding
Financial
Statements,
Taxes, and
Cash Flows
Slide Contents

• Learning Objectives
1. An Overview of the Firm’s Financial Statements
2. The Income Statement
3. Corporate Taxes
4. The Balance Sheet
5. The Cash Flow Statement
• Principles Applied in This Chapter
• Key Terms

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 3.1 AN OVERVIEW OF THE
FIRM’S FINANCIAL
STATEMENTS

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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

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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 quarterly):
• Revenue earned,
• Expenses incurred, and
• Profit earned.

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Basic Financial Statements (cont.)

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).

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Basic Financial Statements (cont.)

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.

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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.

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 3.2 THE INCOME STATEMENT

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Table 3.1 H. J. Boswell, Inc.

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Computing Taxable Income

The table reveals the following:

– Tax rates range from 15% to 39%

– Tax rates are progressive i.e. corporations with

higher profits tend to pay more taxes.

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 3.4 THE BALANCE SHEET

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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 the following equation:

Total Assets = Total Liabilities + Total Equity

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 The Capital Budgeting Decision

Current Current
Assets Liabilities

Long-Term
Debt
Fixed Assets

What long-term
investments Shareholders
should the firm
’ Equity
choose?

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 Corporate Finance

Analizing

Financing Finance Div. Investing

Evaluating

Planning / Forecasting

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 The Capital Structure Decision

Current Current
Assets Liabilities

Long-Term
Debt
Fixed Assets How should the
firm raise funds
for the selected
investments?
Shareholders
’ Equity

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50
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Table 3.2 H. J. Boswell, Inc.

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

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Figure 3.1 The Balance Sheet

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The Balance Sheet (cont.)

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.

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The Balance Sheet (cont.)

• 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.

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The Balance Sheet (cont.)

• 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 Balance Sheet (cont.)

• 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

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