Adopted from “Foundations of Finance” – Martin Petty Keown

For TCHE302/TCH302E Classes in FTU only, no further distribution/reproduction allowed.

3.1 Compute a company’s profits as reflected by its income
statement.
3.2 Determine a firm’s financial position at a point in time based
on its balance sheet.
3.3 Measure a company’s cash flows.
3.4 Describe the limitations of financial statements.
It is also known as Profit/Loss Statement
It measures the results of firm’s operation over a specific period.
The bottom line of the income statement shows the firm’s profit or
loss for a period.

Sales − Expenses = Profits

Revenue (Sales)
Money derived from selling the company’s product or service
Cost of Goods Sold (COGS)
The cost of producing or acquiring the goods or services to be sold
Operating Expenses
Expenses related to marketing and distributing the product or service,
general administrative expenses and depreciation expense
Financing Costs
The interest paid to creditors
Tax Expenses
Amount of taxes owed, based upon taxable income
Common-sized income statement restates the income statement
items as a percentage of sales.
Common-sized income statement makes it easier to compare
trends over time and across firms in the industry.
See Table 3.1
The balance sheet provides a snapshot of a firm’s financial
position at a particular date.
It includes three main items: assets, liabilities, and owner-supplied
capital (shareholders’ equity).
Assets (A) are resources owned by the firm.
Liabilities (L) and owner’s equity (E) indicate how those resources are
financed:
A=L+E
The transactions in balance sheet are recorded at cost price, so the book value
of a firm may be very different from its current market value.
Figure 3-2 The Balance Sheet: An Overview
Current assets comprise assets that are relatively liquid, or
expected to be converted into cash within 12 months. Current
assets typically include:
Cash
Accounts Receivable (payments due from customers who buy on credit)
Inventory (raw materials, work in process, and finished goods held for
eventual sale)
Other assets (ex.: Prepaid expenses are items paid for in advance)
Long-Term Assets: Fixed Assets and Other Assets
Fixed Assets
Include assets that will be used for more than one year. Fixed assets typically
include:
Machinery and equipment, buildings, land
Other Assets
Assets that are neither current assets nor fixed assets.
They may include long-term investments and intangible assets such as patents,
copyrights, and goodwill.
Debt (Liabilities)
Money that has been borrowed from a creditor and must be repaid at some
predetermined date.
Debt could be current (must be repaid within twelve months) or long-term
(repayment time exceeds one year).
Short-Term Debt (Current Liabilities)
Accounts payable (Credit extended by suppliers to a firm when it purchases
inventories)
Accrued expenses (Short-term liabilities incurred in the firm’s operations but
not yet paid for)
Short-term notes (Borrowings from a bank or lending institution due and
payable within 12 months)
Long-Term Debt
Borrowings from banks and other sources for more than one year
Equity: Shareholder’s investment in the firm in the form of
preferred stock and common stock. Preferred stockholders enjoy
preference with regard to payment of dividend and seniority at
settlement of bankruptcy claims.
Treasury Stock: Stock that have been repurchased by the company.
Retained Earnings: Cumulative total of all the net income over the
life of the firm, less common stock dividends that have been paid
out over the years.
Note that retained earnings are not equal to hard cash!
Assets (A)
Liabilities (L)
Current Assets
Fixed Assets
Current Liabilities
Total Assets Long-Term Liabilities
Total Liabilities
Owner’s Equity (E)
Preferred Stock
Common Stock
Retained Earnings
Total Owner’s Equity
Total Liabilities + Equity
 Percentage of Percentage
Dollars Dollars
Assets of Assets
Assets December 31, December
December 31, December
2013 31, 2014
2013 31, 2014
Cash $20,268 22.5% $21,675 23.6%
Accounts receivable 4,873 5.4% 4,466 4.9%
Inventory 3,277 3.6% 3,100 3.4%
Other current assets 2,886 3.2% 3,745 4.1%
Total current assets $31,304 34.8% $32,986 35.8%
Gross plant and equipment $25,032 27.8% $26,674 29.0%
Accumulated depreciation (10,065) (11.2%) (12,041) (13.1%)
Net plant and equipment $14,967 16.6% $14,633 15.9%
Long-term investments 11,512 12.8% Blank Blank
 Percentage of Percentage
Dollars Dollars
Assets of Assets
Assets December December
December December
31, 2013 31, 2014
31, 2013 31, 2014
Goodwill, trademarks, and 32,272 35.8% 30,779 33.4%
other intangible assets
Total assets $90,055 100.0% $92,023 100.0%
Liabilities (Debt) and Equity Blank Blank Blank Blank
Accounts payable $9,886 11.0% $9,364 10.5%
Short-term notes payable 17,925 19.9% 22,740 24.7%
Total current liabilities $27,811 30.9% $32,374 35.2%
Long-term debt 29,071 32.3% 29,329 31.9%
Total liabilities $56,882 63.2% $61,703 67.1%
 Percentage of Percentage
Dollars Dollars
Assets of Assets
Assets December 31, December
December 31, December
2013 31, 2014
2013 31, 2014
Stockholders’ equity Blank Blank Blank Blank
Common stock (par value) $1,760 2.0% $1,760 1.9%
Paid-in capital 12,276 13.6% 13,154 14.3%
Retained earnings 61,660 68.5% 63,408 68.9%
Treasury stock (42,523) (47.2%) (48,002) (52.2%)
Total stockholders' equity $33,173 36.8% $30,320 32.9%
Total liabilities and equity $90,055 100.0% $92,023 100.0%
Debt ratio is the percentage of assets that are financed by debt.
Debt ratio is an indication of “financial risk.” Generally, the higher
the ratio, the more risky the firm is, as firms have to pay interest
on debt regardless of the earnings or cash flow situation.
Net Working Capital = Current assets − current liabilities
The larger the net working capital, the better the firm’s ability to repay its
debt.
Net working capital can be positive or zero or negative. It is generally positive.
An increase in net working capital may not always be good news. For example,
if the level of inventory goes up, current assets will increase and thus net
working capital will also increase. However, increasing inventory level may
well be a sign of inability to sell.
Profits in the financial statements are calculated on “accrual basis”
rather than “cash basis” (see next slide for accrual basis
accounting).
Thus, profits are not equal to cash.
Accrual basis is the principle of recording revenues when earned
and expenses when incurred, rather than when cash is received or
paid.
Thus, sales revenue recorded in the income statement includes both cash and
credit sales. Similarly, inventory purchases may not be entirely paid for in
cash as suppliers may extend credit for some of the purchases.
Treatment of long-term assets: Asset acquisitions (that will last
more than one year, such as equipment) are not recorded as an
expense but are written off every year as depreciation expense.
 Sources of Cash Use of Cash
Decrease in an Asset Increase in an Asset
Example: Selling inventories or Example: Investing in fixed assets or
collecting receivables provides cash. buying more inventories uses cash.
Increase in a Liability or Equity Decrease in a Liability or Equity
Example: Borrowing funds or selling Example: Paying off a loan or buying
stock provides the firm with cash. back stock uses cash.
 December December
Changes in Assets Changes Sources Uses
31, 2013 31, 2014

Accounts receivable $4,873 $4,466 ($407) $ 407 Blank

Inventory 3,277 3,100 (177) 177 Blank
Other current assets 2,886 3,745 859 Blank (859)
Gross plant and equipment 25,032 26,674 1,642 Blank (1,642)
Long-term investments 11,512 13,625 2,113 Blank (2,113)
Goodwill, trademarks, and 32,272 30,779 (1,493) 1,493 Blank
other intangible assets
 Changes in Debt and December December
Changes Sources Uses
Equity 31, 2013 31, 2014

Accounts payable $9,886 $9,634 ($252) Blank ($252)

Short-term notes 17,925 22,740 4,815 $4,815 Blank
Long-term debt 29,071 29,329 258 258 Blank
Paid-in capital 12,276 13,154 878 878 Blank
Treasury stock (42,523) (48,002) (5,479) Blank (5,479)
Figure 3-3 The Balance Sheet: An Overview
Cash flows from Operations (ex. Sales revenue, labor expenses)
Cash flows from Investments (ex. Purchase of new equipment)
Cash flows from Financing (ex. Borrowing funds, payment of
dividends)
If we know the cash flows from operations, investments, and
financing, we can understand the firm’s cash flow position better,
that is, how cash was generated and how it was used.
Cash Flow from Operations: Five Steps
Add back depreciation.
Subtract (add) any increase (decrease) in accounts receivable.
Subtract (add) any increase (decrease) in inventory.
Subtract (add) any increase (decrease) in other current assets.
Add (subtract) any increase (decrease) in accounts payable
Add (subtract) any increase (decrease) in other accrued expenses.
Long-term assets include fixed assets and other long-term assets.
A firm may be engaged in acquisition and sale of such assets
leading to cash flows.
Coca-Cola example:

Changes in Long-Term December December

Changes Inflow Outflow
Assets 31, 2013 31, 2014

Gross plant and equipment $25,032 $26,674 $1,642 Blank ($1,642)

Long-term investments 11,512 13,625 2,113 Blank (2,113)
Goodwill, trademarks, and 32,272 30,779 (1,493) $1,493 Blank
other intangible assets
 Cash Inflow: Cash Outflow:
The firm borrows more money (an The firm repays debt (a decrease in
increase in short-term and/or long-term short-term and/or long-term debt).
debt).
Owner(s) invest in the business (an The firm pays dividends to the
increase in stockholders’ equity). owner(s) or repurchases the owners’
stocks (a decrease in equity).
Dividend payments to shareholders Blank ($ 5,350)

Increase in short-term notes Blank 4,815

Increase in long-term debt Blank 258

Issued common stock to shareholders: Blank Blank

Increase in par value $0 Blank

Increase in paid-in capital 878 Blank

Total stock issued Blank $ 878

Repurchased stock (increase in treasury stock) Blank (5,479)

Net cash outflows from financing activities Blank $(4,878)

Since accounting rules give managers discretionary powers, it is
possible that two firms with similar financial performance may
report different results.
There have been several cases of accounting malpractice where
rules have been broken!
Accounts payable
Accounts receivable
Accrual basis accounting
Accounting book value
Accrued expenses
Accumulated depreciation
Additional paid-in-capital
Average tax rate
Balance sheet
Capital gains
Cash
Cash basis accounting
Common size financial statements
Common stock
Common stock holders
Cost of goods sold
Current assets
Current debt
Debt
Debt ratio
Depreciation expense
Dividends per share
Earnings before taxes
Earnings per share
Equity
Financing cash flows
Fixed costs
Fixed assets
Free cash flows
GAAP
Gross fixed assets
Gross profit
Gross profit margin
IFRS
Income statement
Inventories
Liquidity
Long-term debt
Marginal tax rate
Mortgage
Net fixed assets
Net income
Net profit margin
Net working capital
Operating expenses
Operating income
Paid-in capital
Par value
Preferred stockholders
Profit margins
Retained earnings
Semi-variable costs
Short-term notes (debt)
Statement of cash flows
Taxable income
Trade credit
Treasury stock
Variable costs