2-0Chapter

OutlineThe

Balance

SheetThe

IncomeStatementNet

WorkingCapitalFinancial

Cash

FlowSummary

and

Conclusions2-1Sources

of

InformationAnnual

reportsWall

Street

JournalInternetNYSE

()Nasdaq

()Text

(www.m/cj)SECEDGAR10K&

10Qreports2-22.1

The

Balance

SheetAn

accountant’s

snapshot

of

the

firm’saccountingvalue

as

of a

particular

date.The

Balance

Sheet

Identity

is:When

analyzing

a

balance

sheet,

the

financial

managershould

be

aware

of

three

concerns:

accountingliquidity,debt

versus

equity,

and

value

versus

cost.2-3The

Balance

Sheet

of

the

U.S.

Composite

CorporationU.S.

COMPOSITE

CORPORATIONBalance

Sheet20X2

and20X1(in

$millions)Assets20X220X1Current

assets:Cash

andequivalents$140$107Accounts

receivable294270Inventories269280Other

58

50Total

current

assets$761$707Fixed

assets:Property,

plant,

and

equipment

$1,423$1,274Less

accumulated

depreciation

-550 -460Net

property,

plant,

andequipment

873814Intangible

assets

and

other

245

221Total

fixedassets

$1,118

$1,035Total

assets

$1,879

$1,742Liabilities

(Debt)and

Stockholder's

Equity

20X2

20X1Current

Liabilities:Accounts

payable

$213

$197Notes

payable

50

53Accrued

expenses

223

205Total

current

liabilities

$486

$455Long-term

liabilities:Deferred

taxes

$117

$104Long-term

debt

471

458Total

long-term

liabilities

$588

$562Stockholder's

equity:Preferred

stock

$39

$39Common

stock

($1

pervalue)

55

32Capital

surplus

347

327Accumulated

retained

earnings

390

347Less

treasury

stock -26 -20Total

equity

$805

$725Total

liabilities

and

stockholder's

equity

$1,879

$1,742The

assets

are

listed

in

order

bythe

length

of

time

itnormallywould

take

a

firm

withongoingoperations

to

convert

them

intocash.Clearly,

cash

is

much

moreliquid

than

property,

plant

andequipment.2-4Balance

Sheet

AnalysisWhen

analyzing

a

balance

sheet,

thefinancial

manager

should

be

aware

ofthreeconcerns:Accounting

liquidityDebt

versus

equityValue

versus

cost2-5Accounting

LiquidityRefers

to

the

ease

and

quickness

withwhichassets

can

be

converted

tocash.Current

assets

are

the

most

liquid.Some

fixed

assets

are

intangible.The

more

liquid

a

firm’s

assets,

the

less

likelythe

firm

is

to

experience

problems

meetingshort-term

obligations.Liquid

assets

frequently

have

lower

rates

ofreturn

than

fixedassets.2-6Debt

versus

EquityGenerally,

when

a

firm

borrows

it

gives

thebondholders

first

claim

on

the

firm’s

cashflow.Thus

shareholder’s

equity

is

the

residualdifference

between

assets

and

liabilities.2-7Value

versus

CostUnder

GAAP

audited

financial

statementsoffirms

in

the

U.S.

carry

assets

at

cost.Market

value

is

a

completelydifferentconcept.2-82.2

The

IncomeStatementThe

income

statement

measures

performanceover

a

specific

period

of

time.The

accounting

definition

of

income

is2-9U.S.C.C.

Income

StatementU.S.

COMPOSITE

CORPORATIONIncome

Statement20X2(in

$millions)Total

operating

revenuesCost

ofgoodssoldSelling,

general,

and

administrative

expensesDepreciationOperating

incomeOther

incomeEarnings

before

interest

and

taxesInterest

expensePretax

incomeTaxesCurrent:

$71Deferred:$13Net

income

$86

Retained

earnings:$43Dividends:$43Theoperationssection

of

theincome

statementreports

thefirm’srevenues

andexpensesfromprincipaloperations$2,262-1,655-327 -90

$190

29$219 -49$170-842-10U.S.

COMPOSITE

CORPORATIONIncome

Statement20X2 -90

DepreciationOperating

incomeOther

income$190

29Earnings

before

interest

and

taxes$219Interest

expense -49Pretax

income$170TaxesCurrent:

$71Deferred:$13-84Net

income

$86

Retained

earnings:$43Dividends:$43(in

$millions)The

non-operating

Total

operating

revenues$2,262Cost

ofgoodssold-1,655section

of

the

Selling,

general,

and

administrative

expenses-327income

statementincludesallfinancing

costs,such

as

interestexpense.U.S.C.C.

Income

Statement2-11U.S.

COMPOSITE

CORPORATIONIncome

Statement20X2Earnings

before

interest

and

taxesInterest

expensePretax

incomeTaxesCurrent:

$71Deferred:$13Net

incomeRetained

earnings:Dividends:(in

$millions)Total

operating

revenues$2,262Cost

ofgoodssold-1,655Selling,

general,

and

administrative

expenses-327Depreciation -90

Operating

income$190Other

income

29$43$43Usually

a

separatesection

reports

as

aseparate

itemtheamount

of

taxeslevied

onincome.$219 -49$170-84

$86

U.S.C.C.

Income

Statement2-12U.S.

COMPOSITE

CORPORATIONIncome

Statement20x2(in

$millions)Total

operating

revenues$2,262Cost

ofgoodssold-1,655Selling,

general,

and

administrative

expenses-327Depreciation -90

Operating

income$190Other

income

29Earnings

before

interest

and

taxes$219Interest

expense -49Net

income

is

the

Pretax

income$170“bottom

line”.

TaxesCurrent:

$71Deferred:$13-84Net

income

$86

Retained

earnings:$43Dividends:$43U.S.C.C.

Income

Statement2-13Income

Statement

AnalysisThere

are

three

things

to

keep

in

mind

whenanalyzing

an

income

statement:GAAPNon

Cash

ItemsTime

andCosts2-14Generally

Accepted

Accounting

Principles1.

GAAPThe

matching

principal

of

GAAP

dictatesthat

revenues

be

matched

withexpenses.Thus,

income

is

reported

when

it

isearned,even

though

no

cash

flow

may

haveoccurred2-15Income

Statement

Analysis2.

Non

Cash

ItemsDepreciation

is

the

most

apparent.

No

firm

everwrites

a

check

for“depreciation”.Another

noncash

item

is

deferred

taxes,

whichdoes

not

represent

a

cashflow.2-16Income

Statement

Analysis3.

Time

and

CostsIn

the

short

run,

certain

equipment,

resources,

andcommitments

of

the

firm

are

fixed,

but

the

firm

canvary

such

inputs

as

labor

and

rawmaterials.In

the

long

run,

all

inputs

of

production

(and

hencecosts)

are

variable.Financial

accountants

do

not

distinguish

betweenvariable

costs

and

fixed

costs.

Instead,accountingcosts usually

fit

into

a

classification

thatdistinguishes

product

costs

from

periodcosts.2-172.3

Net

Working

CapitalNWC

is

usually

growing

with

thefirm.2-18The

Balance

Sheet

of

the

U.S.C.C.20X2

and20X1(in

$millions)U.S.

COMPOSITE

CORPORATIONBalance

SheetLiabilities

(Debt)Assets20X220X1and

Stockholder's

Equity20X220X1Current

assets:Current

Liabilities:Cash

andequivalents$140$107Accounts

payable$213$197Accounts

receivable294270Notes

payable5053Inventories269280Accrued

expenses

223205

5850$455OtherTotal

current

assets$761$707Long-term

liabilities:Fixed

assets: Deferred

taxes $117

$104Property,

plant,

and

equipment

$1,423

$1,274

Long-term

debt 471

458Less

accumulated

depreciation

-550

-460 Total

long-term

liabilities $588

$562Net

property,

plant,and

equipment

873

814Intangible

assets

and

other 245

221

Stockholder's

equity:Total

fixedassets

$1,118

$1,035 Preferred

stock

$39

$39Common

stock

($1

parvalue)

55

32Capital

surplus

347

327Accumulated

retained

earnings

390

347Less

treasury

stock -26 -20Total

equity

$805

$725Total

assets

$1,879

$1,742 Total

liabilities

and

stockholder's

equity

$1,879

$1,742Total

current

liabilities

$486Here

we

see

NWC

grow

to$275

million

in

20X2

from$252

million

in20X1.$23million$275m

=

$761m-$486mThis

increase

of

$23

million

isan

investment

of

the

firm.$252m

=

$707-$4552-192.4

Financial

CashFlowIn

finance,

the

most

important

item

that

canbe

extracted

from

financial

statements

is

theactual

cash

flow

of

thefirm.Since

there

is

no

magic

in

finance,

it

must

bethe

case

that

the

cash

from

received

from

thefirm’s

assets must

equal

the

cash

flows

to

thefirm’s

creditors

andstockholders.2-20Financial

Cash

Flow

of

the

U.S.C.C.U.S.

COMPOSITE

CORPORATIONFinancial

Cash

Flow20X2(in

$millions)$238-173 -23

$42$366Cash

Flow

of

the

FirmOperating

cash

flow(Earnings

before

interest

and

taxesplus

depreciation

minus

taxes)Capital

spending(Acquisitions

of

fixed

assetsminus

sales

of

fixedassets)Additions

to

net

working

capitalTotalCash

Flow

of

Investors

in

the

FirmDebt(Interest

plus

retirement

of

debtminus

long-termdebt

financing)Equity(Dividends

plus

repurchase

ofequity

minus

new

equityfinancing)

Total

$42Operating

Cash

Flow:EBIT

$219Depreciation

$90Current

Taxes

($71)

OCF

$2382-21Financial

Cash

Flow

of

the

U.S.C.C.U.S.

COMPOSITE

CORPORATIONFinancial

Cash

Flow20X2(in

$millions)$238-173 -23

$42$366Cash

Flow

of

the

FirmOperating

cash

flow(Earnings

before

interest

and

taxesplus

depreciation

minus

taxes)Capital

spending(Acquisitions

of

fixed

assetsminus

sales

of

fixedassets)Additions

to

net

working

capitalTotalCash

Flow

of

Investors

in

the

FirmDebt(Interest

plus

retirement

of

debtminus

long-termdebt

financing)Equity(Dividends

plus

repurchase

ofequity

minus

new

equityfinancing)

Total

$42Capital

SpendingPurchase

of

fixedassets$198Sales

of

fixedassets(25)Capital

Spending$1732-22Financial

Cash

Flow

of

the

U.S.C.C.U.S.

COMPOSITE

CORPORATIONFinancial

Cash

Flow20X2(in

$millions)$238-173-23

$42$366Cash

Flow

of

the

FirmOperating

cash

flow(Earnings

before

interest

and

taxesplus

depreciation

minus

taxes)Capital

spending(Acquisitions

of

fixed

assetsminus

sales

of

fixedassets)Additions

to

net

working

capitalTotalCash

Flow

of

Investors

in

the

FirmDebt(Interest

plus

retirement

of

debtminus

long-termdebt

financing)Equity(Dividends

plus

repurchase

ofequity

minus

new

equityfinancing)

Total

$42NWC

grew

from

$275million

in

20X2

from$252

million

in20X1.This

increase

of

$23million

is

the

addition

toNWC.2-23Financial

Cash

Flow

of

the

U.S.C.C.U.S.

COMPOSITE

CORPORATIONFinancial

Cash

Flow20X2(in

$millions)$238-173-23$42$366Cash

Flow

of

the

FirmOperating

cash

flow(Earnings

before

interest

and

taxesplus

depreciation

minus

taxes)Capital

spending(Acquisitions

of

fixed

assetsminus

sales

of

fixedassets)Additions

to

net

working

capitalTotalCash

Flow

of

Investors

in

the

FirmDebt(Interest

plus

retirement

of

debtminus

long-termdebt

financing)Equity(Dividends

plus

repurchase

ofequity

minus

new

equityfinancing)

Total

$422-24Financial

Cash

Flow

of

the

U.S.C.C.U.S.

COMPOSITE

CORPORATIONFinancial

Cash

Flow20X2(in

$millions)$238-173 -23

$42$366Cash

Flow

of

the

FirmOperating

cash

flow(Earnings

before

interest

and

taxesplus

depreciation

minus

taxes)Capital

spending(Acquisitions

of

fixed

assetsminus

sales

of

fixedassets)Additions

to

net

working

capitalTotalCash

Flow

of

Investors

in

the

FirmDebt(Interest

plus

retirement

of

debtminus

long-termdebt

financing)Equity(Dividends

plus

repurchase

ofequity

minus

new

equityfinancing)

Total

$42Cash

Flow

toCreditorsInterest

$49Retirement

of

debt

73

Debt

service

122Proceeds

from

new

debtsalesTotal(86)362-25Financial

Cash

Flow

of

the

U.S.C.C.U.S.

COMPOSITE

CORPORATIONFinancial

Cash

Flow20X2(in

$millions)$238-173 -23

$42$366Cash

Flow

of

the

FirmOperating

cash

flow(Earnings

before

interest

and

taxesplus

depreciation

minus

taxes)Capital

spending(Acquisitions

of

fixed

assetsminus

sales

of

fixedassets)Additions

to

net

working

capitalTotalCash

Flow

of

Investors

in

the

FirmDe