Chapter 2:
Financial statements,
cash flow, and taxes
Financial management
Learning Objectives
➢ List each of the key financial statements and identify the
kinds of information they provide to corporate managers and
investors.
➢ Estimate a firm’s free cash flow and explain why free cash
flow has such an important effect on firm value.
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Contents
1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
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1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
Financial management
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1. Financial Statements and Reports
Annual Report is a report issued annually by a corporation to
its stockholders.
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1. Financial Statements and Reports
Annual Report contains two types of information:
1. Verbal section (letter from the chairperson)
2. Four basic financial statements
• The balance sheet
• The income statement
• The statement of cash flows
• The statement of stockholders’ equity
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1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
Financial management
2. Balance sheet
A statement of a firm’s financial position at a specific point in
time.
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2. Balance sheet
A Typical Balance Sheet
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2. Balance sheet
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2. Balance sheet
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2. Balance sheet
Several additional points about the balance sheet should be noted:
1. Cash versus other assets
Only the cash and equivalents = actual spendable money
Accounts receivable = credit sales that have not yet been collected
Inventories = cost of raw materials + work in process + finished goods
Net fixed assets = the cost of the buildings and equipment used in
operations – the depreciation
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2. Balance sheet
2. Net Working Capital = Current assets – Current liabilities
Net Operating Working Capital (NOWC)
NOWC = Operating current assets – Operating current liabilities
Operating current assets = Current assets – Excess cash
Operating current liabilities = Current liabilities – Interest-bearing
liabilities
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2. Balance sheet
3. Total debt versus total liabilities
Total debt = Short-term + Long-term interest-bearing liabilities
Total liabilities = Total debt + Non-interest-bearing liabilities
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2. Balance sheet
4. Other sources of funds
Some companies also use “hybrid” securities such as preferred
stock, convertible bonds, and long-term leases.
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2. Balance sheet
5. Depreciation
Firms often use
▪ accelerated depreciation for tax purposes
▪ straight-line depreciation for stockholder reporting
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2. Balance sheet
6. Market values versus book values
The accounting numbers (book values) are different from what
the assets would sell for (market values).
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1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
Financial management
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3. Income statement
Reports summarizing a firm’s revenues, expenses, and profits
during a reporting period (a quarter or a year).
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3. Income statement
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3. Income statement
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3. Income statement
Operating Income (EBIT) is derived from the firm’s regular
core business.
It is calculated before deducting non-operating costs (interest
expenses and taxes).
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3. Income statement
Depreciation
The charge to reflect the cost of assets depleted in the production
process. Depreciation is not a cash outlay.
Amortization
A noncash charge similar to depreciation except that it represents a
decline in value of intangible assets (patents, copyrights, trademarks,
and goodwill).
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3. Income statement
Depreciation and amortization are not cash expenses.
→ Managers, security analysts, and bank loan officers who are
concerned with the amount of cash a company is generating
often calculate EBITDA (Earnings Before Interest, Taxes,
Depreciation, and Amortization).
EBITDA = EBIT + Depreciation and Amortization
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1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
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4. Statement of cash flows
Shows how much cash the firm is generating.
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4. Statement of cash flows
Three components of cash flows:
1. Cash flow from operating activities (CFO) indicates the amount of money
a company brings in from its ongoing, regular business activities
(manufacturing and selling goods or providing a service).
2. Cash flow from investing activities are any cash flows from the acquisition
and disposal of long-term assets and other investments not included in cash
equivalents.
3. Cash flow from financing activities are any cash flows that result in
changes in the size and composition of the contributed equity capital or
borrowings (bonds, stock, dividends).
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4. Statement of cash flows
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4. Statement of cash flows
Allied Food Products: Statement of Cash Flows for 2018 (Millions of Dollars)
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4. Statement of cash flows
Allied Food Products: Statement of Cash Flows for 2018 (Millions of Dollars)
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1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
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5. Statement of Stockholders’ Equity
A statement that shows by how much a firm’s equity changed
during the year and why this change occurred.
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5. Statement of Stockholders’ Equity
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1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
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6. Free cash flow
Free Cash Flow (FCF) is the amount of cash that could be withdrawn without
harming a firm’s ability to operate and to produce future cash flows.
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6. Free cash flow
FCF > 0: the firm is generating more than enough cash to
finance current investments in fixed assets and working capital
FCF < 0: the firm does not have sufficient internal funds to
finance investments in fixed assets and working capital
Is negative FCF always a bad sign?
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1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA
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7. MVA and EVA
Market Value Added (MVA)
The excess of the market value of equity over its book value.
MVA = Market value of equity – Book value of equity
Market value of equity = Stock price x Number of shares
outstanding
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7. MVA and EVA
Economic Value Added (EVA)
Excess of NOPAT over capital costs.
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End of Chapter 2
Financial management
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