Financial Statements and Cash Flows

Contents
Balance sheet statement and its managerial applications;
Income statement and its managerial applications;
The concept of cash flow from assets (free cash flow).

Balance Sheet reflects the financial position of a firm
By “financial position” we mean:
Assets
Liabilities
Stockholders’ (Shareholders’, Owners’) Equity

Liabilities are obligations of the entity to outside parties (“creditors”):
Result from past transactions (purchase through credit, cash borrowing, etc.)
Are sources of financing for assets
Elements of balance sheet
Assets are economic resources which are owned by a business:
Result from past transactions (inventory, machinery purchases etc.)
Are expected to benefit future operations.
Owners’ Equity indicates the amount of financing provided by owners of the business
Contributed
Retained earnings

Characteristics of Balance Sheet
There is a relationship between balance sheet elements:
Assets = Liabilities + Stockholders’ Equity
This is also called the “basic accounting equation” or the “balance sheet equation” or the “balance sheet identity”
2) Balance Sheet provides a “snapshot” of a firm’s financial position
it’s prepared at a particular moment of time
it provides summarized information

Format of the Balance Sheet
AAA Corp.
Balance Sheet
As of December 31, 2008
(in thousands of dollars)

Exercise 1
Prepare a balance sheet for AAA Corp. as of December 31, 2008, based on the following information: cash = $150 000; patents and copyrights = $840 000; accounts payable = $224 000; accounts receivable = $241 000; tangible net fixed assets = $4 700 000; inventory = $400 000; accumulated retained earnings = $4 213 000; long-term debt = $1 894 000.

What can be derived from the Balance Sheet
1) The proportion of current assets to current liabilities which provides an estimate of firm’s liquidity.

Liquidity
The term “liquidity” has at least two meanings:
asset liquidity - ease and speed with which asset can be converted into cash
firm liquidity – its capability to pay off all its short-term liabilities in due course.

The assessment of firm’s liquidity
ABC Corp.
Balance Sheet
As of December 31, 2008
(in thousands of dollars)

Exercise 1I
XYZ company has the following assets and liabilities:
cash = $2,000, manufacturing equipment = $13,500,
inventory=$2,400, accounts receivable=$5,000, accounts payable = $4,000, short-term debt = $3,000.
Calculate: 1) shareholders’ equity
2) working capital in accounting and
economic sense

Exercise 1I
Shareholders’ equity = 13,500+2,000+2,400+5,000-4,000-3,000=15,900
Working capital in accounting sense=2,000+2,400+5,000-4,000-3,000=2,400
Working capital in economic sense=2,000+2,400+5,000-4,000=5,400

Working capital
Working capital (WC) is a difference between firm’s current assets and current liabilities
Working capital and net working capital are generally considered to be synonyms.

Working capital
WC = Current assets – Current liabilities
Accounts receivable
Inventory
Cash (required for operations)
Excess cash and marketable securities
Payments to suppliers
Accrued taxes
Accrued wages
Short-term debt

Another way to assess firm’s liquidity

What can be derived from the Balance Sheet
2) The proportion in which debt and equity are distributed in the company.

The income statement
provides an assessment of firm’s performance over a particular period of time
The income statement equation is:
Revenues – Expenses = Income
Revenues and expenses are shown in the income statement on the matching principle

The Income Statement
ABC Corp.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars)

How the Income Statement relates to the Balance Sheet…

Accounting income and cash flow
basically, they are not the same thing
The main reasons why accounting income differs from cash flow are:
revenues and expenses are shown on the income statement at the time they accrue (not necessarily the time when cash exactly flows in and out)
income statement contains noncash items (most notably, depreciation)

Сash flow from assets (free cash flow)
It’s the cash flow generated by the company which is not invested into its assets and is, therefore, free to distribution to its creditors and shareholders.
It consists of three parts:
1) Operating cash flow
2) Net investment in fixed assets
3) Changes in working capital

Cash flow from assets (free cash flow)
Operating cash flow
Net investment in fixed assets
Change in working capital
= Cash flow from assets (Free cash flow)
Cash flow from assets = cash flow to creditors + cash flow to shareholders

Operating cash flow
Sales
Cost of goods sold
Depreciation
Selling, General and Administrative expenses
= Operating profit (Earnings before Interest and Taxes)
Taxes
+ Depreciation
= Operating cash flow

Net investment in fixed assets
Ending net fixed assets
Beginning net fixed assets
+ Depreciation
= Net investment in fixed assets

Changes in working capital
Ending working capital
Beginning working capital
= Change in working capital

Cash flow to creditors
Interest paid
New net borrowing
= Cash flow to creditors