Corporate Finance

Thirteenth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 2:
Financial Statements and Cash Flow

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 Key Concepts and Skills
• Understand the information provided by financial
statements.
• Differentiate between book and market values.
• Know the difference between average and marginal
tax rates.
• Know the difference between accounting income and
cash flow.
• Calculate a firm’s cash flow.

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 Financial statements
• Reports that provide information on the firm’s conditions
and activities.
1. Balance Sheet
2. Income Statement
3. Statement of Cash Flows

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 2.1 The Balance Sheet
• Summarizes what a firm owns (its assets), what a firm
owes (its liabilities) and the difference between the two
(the firm’s equity).
• The Balance Sheet Identity is:

Assets º Liabilities + Stockholders' equity

• Equity: shareholders are entitled to what remains of the

firm after debt holders are paid.

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 The Balance Sheet of the U.S. Composite
Corporation
The assets are listed in order by the length of time it would normally take
a firm with ongoing operations to convert them into cash.
Clearly, cash is much more liquid than property, plant, and equipment.

The liabilities and the stockholder’s equity are listed in the order in which
they would typically be paid over time.
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 Balance Sheet Analysis
When analyzing a balance sheet, the financial manager
should be aware of three concerns:
1. Accounting Liquidity.
2. Debt versus equity.
3. Value versus cost.

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 Net Working Capital
Net Working Capital (NWC) ≡ Current Assets – Current
Liabilities
NWC > 0 means that liquid assets in the short term can pay
accounts due within the short term => healthy firms.

Change in Net Working Capital

= NWC of this year – NWC of last year

NWC usually grows with the firm.

Change in NWC is usually positive in a growing firm.

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 Liquidity
Liquidity refers to the ease and quickness with which assets
can be converted to cash—without a significant loss in
value.
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less likely the firm is to
experience problems meeting short-term obligations.
Liquid assets frequently have lower rates of return than fixed
assets.
IS LIQUIDITY GOOD?

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 Debt versus Equity
Liabilities: obligations of the firm that require a payout of
cash within a stipulated time period.
Bondholders/creditors generally receive the first claim on the
firm’s cash flow.
Stockholders’ equity is the residual difference between
assets and liabilities.
Stockholder’s Equity ≡ Assets – Liabilities
We call the use of debt : financial leverage.
financial leverage ratio = total debt / total asset

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 Book value and market value
Book value:
• The accounting value of a firm’s assets is frequently
referred to as the book value (carrying value).
• What the firm originally paid for its assets (less
depreciation), or the original face value of its debt => cost.
Market value:
• Market value is the price at which assets, liabilities, or
equity can be bought or sold in the market.
• Some information of the value of firm may not be found on
the balance sheet (good management,…)
• In general, we take the value of a firm or a asset as its
market value.

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 2.2 The Income Statement
• Measures financial performance over a specific period of
time, recording the revenues and expenses of the firm.
• The accounting definition of income is:

Revenue - Expenses º Income

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 The Income Statement of the U.S.
Composite Corporation - I
The operations
section of the
income statement
reports the firm’s
revenues and
expenses from
principal operations.

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 The Income Statement of the U.S.
Composite Corporation - II
The nonoperating
section of the
income statement
includes all
financing costs,
such as interest
expense.

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 The Income Statement of the U.S.
Composite Corporation - III
Usually a separate
section reports the
amount of taxes
levied on income.

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 The Income Statement of the U.S.
Composite Corporation - IV
Net income is the
“bottom line.”

• Suppose there are 29m shares

outstanding.
• EPS?
• DPS?

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 Income Statement Analysis
There are three things to keep in mind when analyzing an
income statement:
1. Generally Accepted Accounting Principles (GAAP)
2. Noncash Items.
3. Time and Costs.

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 GAAP
Revenue is recognized on an income statement when the
earnings process is virtually completed and an exchange of
goods or services has occurred.

The matching principle of GAAP dictates that revenues be

matched with expenses.

Thus, income is reported when it is earned or accrued, even

though no cash flow has necessarily occurred.

When goods are sold for credit, sales and profits are
reported.

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 Noncash Items
Non-cash items:
• Expenses against revenues
• Do not affect cash flow
• Depreciation: reflects the accountant’s estimate of the cost
of equipment used up in the production process.
• Deferred taxes: result from differences between
accounting income and true taxable income (a liability)

Non-cash expenses may reduce net income, but do not

actually represent a cash outflow.

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 Taxes
Taxes can be one of the largest cash outflows that a firm
experiences (in the U.S).

Average tax rates vs. Marginal tax rates

• Average: tax bill / taxable income: the percentage of your
income that goes to pay taxes
• Marginal: the percentage paid on the next dollar earned

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 2.3 Taxes
TAXABLE INCOME TAX RATE
$ 0~50,000 15%

50,001~75,000 25

75,001~100,000 34

100,001~335,000 39

335,001~10,000,000 34

10,0OO,001~15,000,000 35

15,000,001~18,333,333 38

18,333,334+ 35

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2.3 Taxes

Suppose a firm has a taxable income of $200,000

Tax bill: .15(50,000)
+ .25(75,000 – 50,000)
+ .34(100,000 – 75,000)
+ .39(200,000 – 100,000)
= $61,250
Average rate: 61,250 / 200,000 = 30.625%
Marginal rate: 39%
The marginal tax rate is more relevant for financial decision
making
• Any new cash flows will be taxed at the marginal tax rate

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 2.5 Cash Flow of the Firm
• The difference between the number of dollars coming in
and the number of dollars going out is the cash flow of
the firm

• The cash flow received from the firm’s assets (operating

activities), CF(A), must equal the cash flows to the firm’s
creditors, CF(B), and stockholders, CF(S):

CF (A) º CF (B) + CF (S)

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 Cash flow from assets

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 The Accounting Statement of Cash Flows

• There is an official accounting statement called the

statement of cash flows.
• Summarizes a firm’s uses and sources of cash over a
period
• The three components of the statement of cash flows are:
• operating activities.
• investing activities.
• financing activities.

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 U.S. Composite Corporation Cash Flow
from Operating Activities
Calculate cash flow Operations
from operating Net income $ 86
activities: Depreciation 90
Deferred taxes 9
1. Start with net income Change in assets and liabilities
(in income statement), Accounts receivable −24
Inventories 11
2. Add back non-cash
Accounts payable 35
expenses (depreciation,
Cash flow from operating activities $207
deferred taxes)
3. Adjust for changes in
current assets and
liabilities (other than cash
and notes payable).

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 U.S. Composite Corporation Cash Flow
from Investing Activities
Cash flow from investing
activities involves
changes in capital assets: Acquisition of fixed assets −$198
Sales of fixed assets 25
acquisition of fixed assets Cash flow from investing activities −$173
and sales of fixed assets
(i.e., net capital
expenditures).

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 U.S. Composite Corporation Cash Flow
from Financing Activities
Retirement of long-term debt
Cash flow from −$73
Proceeds from long-term debt sales 86
financing activities:
Dividends −43
Cash flows to and from Repurchase of stock −6
creditors and owners Proceeds from new stock issue 43

include changes in Cash flow from financing activities $ 7

equity and debt.

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