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Chapter 2
Financial Statements and
Cash Flow

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Chapter Outline
• The Balance Sheet
• The Income Statement
• Cash Flows

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First: The Balance Sheet

• The balance sheet is a snapshot of the firm’s assets and liabilities at a
given point in time
• Assets: The Left-Hand Side
• Liabilities and Owners’ Equity: The Right-Hand Side
• Balance Sheet Identity or Equation
Assets = Liabilities + Stockholders’ Equity

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The Firm’s Assets, Liabilities and

Shareholders’ Equity

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NET WORKING CAPITAL

Whaling’s Boats reports the following account
balances: inventory of $16,200, equipment of
$36,200, accounts payable of $9,500, cash of
$1,200, and accounts receivable of $12,400. How
much does the firm have in net working capital?
a. $14,500
b.$20,300
c. $39,300
d.$56,500

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Net working capital = Current assets- Current

liabilities
(inventory $16,200 + cash $1,200 + accounts
receivable $12,400) – (accounts payable $9,500)
= $ 20300

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LONG-TERM DEBT

Jensen, Inc., has current assets of $3,600, current

liabilities of $4,800, and total assets of $17,200.
Owner’s equity is $11,000. What is the value of
the long-term debt?
a. $1,400
b.$2,600
c. $5,000
d.$6,200

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The long-term debt = Total assets - Current

liabilities - Owner’s equity
$17,200 - $4,800 - $11,000 = $ 1400

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RETAINED EARNINGS

The Boardwalk Boutique has beginning retained

earnings of $32,600. For the year, the company
suffered a net loss of $1,300 and paid out dividends
of $500. The company also issued $2,500 worth of
new stock. What is the value of the retained earnings
account at the end of the year?
a. $28,300
b.$30,700
c. $30,800
d.$33,300
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Beginning retained earnings $32,600

net loss ($1,300)
dividends ($500)
Ending retained earnings $30800

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U.S. Corporation Balance Sheet

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Thinking Questions

1- What is the relationship between the

decisions made by financial managers and the
values that subsequently appear on the firm’s
balance sheet?
2- What is the difference between the owners’
equity and retained earnings.

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All finance decisions are either investment

decisions or financing decisions.

Investment decisions involve the purchase and sale

of any assets (not just financial assets). Investment
decisions show up on the left-hand side of the
balance sheet.

Financing decisions involve the choice of whether

to borrow money to buy the assets or to issue new
ownership shares. Financing decisions show up on
the right-hand side of the balance sheet.

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Owners’ equity consists of the common stock

account, paid in surplus, retained earnings and
treasury stock.

The firm’s net income belongs to the owners. It

can either be paid out in dividends or reinvested
in the firm.

When it is reinvested in the firm, it becomes

additional equity investment and shows up in the
retained earnings account.

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Second: Income Statement

• The income statement is more like a video of the
firm’s operations for a specified period.
• the income statement reflects investment decisions in
the “top half,” from sales to EBIT. Financing
decisions are reflected in the “bottom half,” from
EBIT to net income and earnings per share.
• You generally report revenues first and then deduct
any expenses for the period

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U.S. Corporation Income Statement

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INCOME STATEMENT

Bernie’s, Inc., has sales of $391,000, costs of

$298,000, depreciation expense of $54,000, and
interest paid of $16,300. The tax rate is 35%. How
much net income did Bernie’s earn for the period?
a. $7,945
b.$8,355
c. $12,655
d.$14,755

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Sales 4391,000
Cost of sales (298,000)
Depreciation ($54,000)
EBIT $39,000
Interest ($16,300)
Taxable income $22,700
Tax ($7,945)
Net income $14,755

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INCOME STATEMENT

Lester’s added $5,040 to retained earnings last year,

which was derived from sales of $88,000. The
company has costs of $62,400, dividends of $2,500,
and interest paid of $1,500. The tax rate is 35%.
What is the amount of the depreciation expense?
a. $11,000
b.$11,600
c. $12,500
d.$13,100

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Sales 88,000
Cost of sales (62,400)
Depreciation ($12,500)
EBIT $13,100
Interest ($1,500)
Taxable income $11,600
Tax ($4,060) NI Taxable Income
Net income $7,540 754065%
??
100%
Retained earnings $5,040
Dividends $2,500

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The financial manager needs to keep three

things in mind

1- Matching principle: GAAP say to show

revenue when it accrues and match the
expenses required to generate the revenue
2- Noncash Items: The largest noncash
deduction for most firms is depreciation. It
reduces a firm’s taxes and its net income.
Noncash deductions are part of the reason that
net income is not equivalent to cash flow.
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3- Time and Costs: Distinguishing between

fixed and variable costs is important, at time,
for estimating cash flows.
Accountants tend to classify costs as either
product costs or period costs
Another important thing to point out is that
what are short run and long run time periods
will vary for different types of businesses.

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Third: The Concept of 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

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Cash Flow Equation

• Cash Flow From Assets (CFFA) = Cash Flow to
Creditors + Cash Flow to Stockholders
• Cash Flow From Assets = Operating Cash Flow – Net
Capital Spending – Changes in NWC
• Operating cash flow = EBIT + depreciation – taxes
• Net capital spending = ending fixed assets –
beginning fixed assets + depreciation
• Changes in NWC = ending NWC – beginning NWC

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Cash Flow to Creditors + Cash Flow to

Stockholders

•Cash flow to creditors = interest paid – net new

borrowing (ending long-term debt – beginning
long-term debt)
• Cash flow to stockholders = dividends paid – net
new equity raised (ending common stock, APIC &
Treasury stock – beginning common stock, APIC &
Treasury stock)

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Cash Flow Summary

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Example 1: U.S. Corporation

• CFFA = OCF – NCS – Change in NWC
• OCF = EBIT + depreciation – taxes
• 694 + 65 – 212 = $547
• NCS = ending net fixed assets – beginning net
fixed assets + depreciation
• 1,709 – 1,644 + 65 = $130
• Changes in NWC = end.NWC – begin. NWC
• (1,403 – 389) – (1,112 – 428)
• 1,014 – 684 = $330
• CFFA = 547 – 130 – 330 = $87

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CF to Creditors + CF to Stockholders
CF to Creditors = interest paid – net new
borrowing
70 – 46 = $24
CF to Stockholders = dividends paid – net
new equity raised
103 – 40 = $63

CF to Creditors & Stockholders

= 24 + 63 = $87
The CF identity holds.
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Example 2 : Balance Sheet and Income Statement
Information
• Current Accounts
• 2015: CA = 1500; CL = 1300
• 2016: CA = 2000; CL = 1700
• Fixed Assets and Depreciation
• 2015: NFA = 3000; 2016: NFA = 4000
• Depreciation expense = 300
• LT Liabilities and Equity
• 2015: LTD = 2200; Common Stock = 500; RE = 500
• 2016: LTD = 2800; Common Stock = 750; RE = 750
• Income Statement Information
• EBIT = 2700; Interest Expense = 200; Taxes = 1000;
Dividends = 1250

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Example 2: Cash Flows

• OCF = 2700 + 300 – 1000 = 2000
• NCS = 4000 – 3000 + 300 = 1300
• Changes in NWC = (2000 – 1700) – (1500 – 1300)
= 100
• CFFA = 2000 – 1300 – 100 = 600
• CF to Creditors = 200 – (2800 – 2200) = -400
• CF to Stockholders = 1250 – (750 – 500) = 1000
• CFFA = -400 + 1000 = 600
• The CF identity holds.

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A Firm has an operating cash flow of $141,200,

depreciation expense of 89,300, and taxes paid of
$76,100. A partial listing of their balance sheet accounts
is as follows:
Beginning Balance Ending Balance
Current assets $146,800 $132,700
Net fixed assets $989,400 $909,400
Current liabilities $121,600 $138,700
Long-term debt $888,000 $862,500
What is the amount of cash flow from assets?
a. $17,500 b. $100,700
c. $144,500 d. $163,100

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CFFA = OCF – NCS – Change in NWC

OCF = 141,200
NCS = ending net fixed assets – beginning net
fixed assets + depreciation
= (909,400 – 989,400) + 89,300 =
(– 80,000) + 89,300 = 9,300
Changes in NWC = end.NWC – begin. NWC
(132,700 – 138,700) – (146,800 – 121,600)
– 6,000 – 25,200 = – 31,200
CFFA = 141,200 – 9,300 + 31,200 = 163,100

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A firm has earnings before interest and taxes of

$133,400 with a net income of $26,640. The taxes
amounted to $37,300 for the year. During the year,
the firm paid out $150,000 to pay off existing debt
and then later borrowed an additional $70,000. What
is the amount of the cash flow to creditors?
a. -$10,540
b.$128,380
c. $149,460
d.$143,940

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CF to Creditors = interest paid – net new borrowing

To calculate interest paid:
EBIT 133,400
Interest (69,460)
Taxable income 63,940
Tax (37,300)
Net income 26,640

Net new borrowing = – 150,000 + 70,000 = – 80,000

CF to Creditors = 69,460 – (– 80,000) = $149,460

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A Company has an operating cash flow of $121,000

and a cash flow to creditors of $38,700 for the past
year. During that time, the firm invested $22,000 in
net working capital and incurred net capital
spending of $36,900. What is the amount of the cash
flow to stockholders for the last year?
a. $23,400
b.$62,100
c. $67,400
d.$97,200

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CFFA = OCF – NCS – Change in NWC

CFFA = 121,000 – 36,900 – 22,000 = 62,100

CFFA = CF to Creditors + CF to Stockholders

62,100 = 38,700 + CF to Stockholders

CF to Stockholders = 62,000 - 38,700 = 23,400

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A Company has compiled the following information:
2015 2016
Sales $3,813 $4,019
Long-term debt 1,555 899
Interest paid 121 143
Common stock 1,500 2,150
Accounts receivable 498 402
Depreciation 306 393
Cash 413 911
Inventory 1,516 1,533
Accounts payable 387 460
Retained earnings 1,700 1,550
Cost of goods sold 2,123 2,609
Net fixed assets 2,715 2,213
Other costs 391 514
Taxes paid 305 126
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For 2016, the cash flow from assets is

__________, the cash flow to creditors is
__________, and the cash flow to stockholders
is:
a. $315; $799; -$484.
b. $533; $799; -$266.
c. $464; $701; -$237.
d.$787; $701; -$86.

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