The Balance Sheet (snapshot of the firm)

ASSETS:

 Assets are classified as either current or fixed.

 A current asset has a life of less than one year. This means that the asset will convert to cash within 12
months.
 Fixed assets can be either tangible, such as a truck or a computer, or intangible, such as a trademark or patent.

LIABILITIES AND OWNERS’ EQUITY:

 Are classified as either current or long-term.

 Current liabilities, like current assets, have a life of less than one year (meaning they must be paid within the
year) and are listed before long-term liabilities.
 Assets = liabilities + SHE (common equity or owners equity)
NET WORKING CAPITAL

net working capital = current assets - current liabilities

Note: There are three particularly important things to keep in mind when examining a balance sheet: liquidity, debt
versus equity, and market value versus book value.
LIQUIDITY

 Liquidity refers to the speed and ease with which an asset can be converted to cash without significant loss in
value.
 Assets are normally listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid
assets are listed first.
 Order from most liquidity to the least liquidity (Cash – Account receivable – Inventory)
 Fixed assets are, for the most part, relatively illiquid.
 Liquidity is valuable. The more liquid a business is, the less likely it is to experience financial distress (that is,
difficulty in paying debts or buying needed assets).
 Unfortunately,
 liquid assets are generally less profitable to hold. For example, cash holdings are the most liquid of all
investments, but they sometimes earn no return at all—they just sit there.

DEBT VERSUS EQUITY

 Equity holders are entitled to only the residual value, the portion left after creditors are paid.
 The use of debt in a firm’s capital structure is called financial leverage. The more debt a firm has (as a
percentage of assets), the greater is its degree of financial leverage.

MARKET VALUE VERSUS BOOK VALUE

 The values shown on the balance sheet for the firm’s assets are book values and generally are not what the
assets are actually worth.
 Under Generally Accepted Accounting Principles (GAAP), audited financial statements in the United States
generally show assets at historical cost.
 The balance sheet is potentially useful to many different parties:
o A supplier might look the size of accounts payable to see how promptly the firm pays its bills.
o A potential creditor would examine the liquidity and degree of financial leverage.
o Managers within the firm can track things like the amount of cash and the amount of inventory the
firm keeps on hand.
 Whenever we speak of the value of an asset or the value of the firm, we will normally mean its market value.

The Income Statement

 The income statement measures performance over some period of time, usually a quarter or a year.
 Revenues - Expenses = Income
 Earnings per share = Net income/Total shares outstanding
 Dividends per share = Total dividends/Total shares outstanding

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GAAP AND THE INCOME STATEMENT

 An income statement prepared using GAAP will show revenue when it accrues.
 Expenses shown on the income statement are based on the matching principle.
 The basic idea here is to first determine revenues as described previously and then match those revenues
with the costs associated with producing them.

NONCASH ITEMS

 A primary reason that accounting income differs from cash flow is that an income statement contains
noncash items.
 The most important of these is depreciation.

TIME AND COSTS

 It is often useful to think of the future as having two distinct parts: the short run and the long run.
 Costs are fixed or variable.
 In the long run, all business costs are variable.
 Some costs are effectively fixed—they must be paid no matter what (property taxes, for example)
 Other costs such as wages to laborers and payments to suppliers are still variable.
 The way costs are reported on the income statement is not a good guide to which costs are which.
 The reason is that, in practice, accountants tend to classify costs as either product costs or period costs.
 Product costs include such things as raw materials, direct labor expense, and manufacturing overhead. These
are reported on the income statement as costs of goods sold, but they include both fixed and variable costs.
 Period costs are incurred during a particular time period and might be reported as selling, general, and
administrative expenses.

AVERAGE VERSUS MARGINAL TAX RATES

 The average tax rate is your tax bill divided by your taxable income in other words, the percentage of your
income that goes to pay taxes.
average tax rate = Tax Paid / taxable income
 Marginal tax rate is the rate of the extra tax you would pay if you earned one more dollar.

Work the Web Example

 Publicly traded companies must file regular reports with the Securities and Exchange Commission including
annual and quarterly financial statements.
 These reports are usually filed electronically and can be searched at the SEC public site called EDGAR.
 Click on the web surfer, pick a company, and see what you can find!

Cash Flow
 Cash flow is one of the most important pieces of information that a financial manager can derive from financial
statements.
 We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase
of the assets.
 Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
 Operating Cash Flow (OCF): we want to calculate revenues minus costs, but we don’t want to include
depreciation because it’s not a cash outflow, and we don’t want to include interest because it’s a financing
expense. We do want to include taxes because taxes are (unfortunately) paid in cash.
 Operating Cash Flow OCF (I/S) = EBIT (earnings before interest and taxes) + depreciation – taxes
 Net cash spending (NCS) ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation
 Changes in NWC (B/S) = ending NWC – beginning NWC
 Change in Net Working Capital (Changes in NWC) (B/S) = ending NWC – beginning NWC
 Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders
 Cash Flow From Assets = (CFFA) Operating Cash Flow – Net Capital Spending – Changes in NWC
 Cash flow to creditors = Interest paid – Net new borrowing
 Cash flow to stockholders = Dividends paid – Net new equity raised

 Assets = liabilities + SHE

 Revenues - Expenses = Income

 Earnings per share = Net income/Total shares outstanding

 Dividends per share = Total dividends/Total shares outstanding

 average tax rate = Tax Paid / taxable income

 Cash flow from assets = Cash flow to creditors + Cash flow to stockholders

 Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

 Cash Flow From Assets = (CFFA) Operating Cash Flow – Net Capital Spending – Changes in NWC

 Operating Cash Flow OCF (I/S) = EBIT (earnings before interest and taxes) + depreciation – taxes

 Net Capital spending (NCS) ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation

 Changes in NWC (B/S) = ending NWC – beginning NWC

 Net working capital (NWC) = Current Assets – Current Liabilities

 Cash flow to creditors = Interest paid – Net new borrowing

 Net new borrowing = long debt ending – long debt beginning

 Cash flow to stockholders = Dividends paid – Net new equity raised

 Net new equity raised = Ending Equity – Beginning Equity – Retained earnings