CHAPTER 3

Understanding Financial
Statements and Cash Flows
CHAPTER ORIENTATION
In this chapter, we review the contents and meaning of a firm’s income statement and balance
sheet. We also look very carefully at how to compute a firm’s cash flows from a finance
perspective, rather than from an accountant’s view, which in finance speak is called free cash
flows.

CHAPTER OUTLINE

I. Basic Financial Statements

A. The Income Statement

1. The income statement reports the results from operating the business for a
period of time, such as a year.

2. It is helpful to think of the income statement as comprising four types of

activities:

a. Selling the product.

b. The cost of producing or acquiring the goods or services sold.

c. The expenses incurred in marketing and distributing the product or

service to the customer, along with administrative operating
expenses.

d. The financing costs of doing business, for example, interest paid to

creditors and dividend payments to the preferred stockholders.

3. An example of an income statement is provided in Table 3-1 for the

Starbucks Corporation.

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B. The Balance Sheet

1. The balance sheet provides a snapshot of the firm’s financial position at a

specific point in time, presenting its asset holdings, liabilities, and owner-
supplied capital.

a. Assets represent the resources owned by the firm.

1. Current assets—consisting primarily of cash, marketable
securities, accounts receivable, inventories, and prepaid
expenses.
2. Fixed or long-term assets—comprising equipment,
buildings, and land.
3. Other assets—all assets not otherwise included in the firm’s
current assets or fixed assets, such as patents, long-term
investments in securities, and goodwill.

b. The liabilities and owners’ equity indicate how those resources are
financed.
1. The debt consists of such sources as credit extended from
suppliers or a loan from a bank.
2. The equity includes the stockholders’ investment in the firm
and the cumulative profits retained in the business up to the
date of the balance sheet.

2. The balance sheet is not intended to represent the current market value of
the company but rather reports the historical transactions recorded at their
cost.

3. Balance sheets for the Starbucks Corporation are presented in Table 3-2.

C. Measuring Cash Flows

1. While an income statement measures a company’s profits, profits are not

the same as cash flows; profits are calculated on an accrual basis rather
than a cash basis.

2. In measuring cash flows, we could use the conventional accountant’s

presentation called a statement of cash flows. However, we are more
interested in considering cash flows from the perspective of the firm’s
shareholders and its investors, rather than from an accounting view. We
will instead measure the cash flow that is free and available to be
distributed to the firm’s investor, both debt and equity investors, and what
we will call free cash flows. We will then calculate the financing cash

47
 flows, which indicate exactly how the money was distributed or
received from investors.
3. The cash flows that are generated through a firm’s operations and
investments in assets will always equal its financing cash flows, but with
opposite signs—if one is positive (negative), the other one will be negative
(positive).

4. Free Cash Flows:

a. A firm's free cash flows are the after-tax cash flows

generated from operations less the firm's investments
in assets. That is, a firm's free cash flows for a given
period is equal to:

After-tax cash flow from operations

less

investments in operating working capital and

less

investments in fixed assets and other long-term assets.

b. After-tax cash flows from operations are calculated as

follows:

Operating income
+ depreciation
- income taxes
= after-tax cash flows from operations

c. The increase or decrease in operating working capital is equal

to the change in current assets (also called gross working
capital) minus the change in non-interest bearing current
liabilities.

d. The change in gross fixed assets (rather than net fixed assets)
and any other assets that are on the balance sheet not already
considered.

48
5. Financing Cash Flows

a. A firm’s financing cash flows are equal to:

+ increase in interest-bearing debt (cash inflow)

or

- decrease in interest-bearing debt (cash outflow)

+ increase in long-term debt (cash inflow)

or

- decrease in long-term debt (cash outflow)

+ increase in common stock (cash inflow)

or

- decrease in common stock (cash outflow)

- interest expense (cash outflow)

- dividend payments (cash outflow)

6. To conclude, financing cash flows, if positive, are simply the net

cash flows received from the firm’s investors, or if negative, the cash
flows paid to investors. In the first situation, where the investors are
putting money into the firm, it is because the firm’s free cash flows
are negative, thereby requiring an infusion of capital by the
investors.

49
 ANSWERS TO
END-OF-CHAPTER QUESTIONS

3-1. a. The balance sheet represents an enumeration of a firm’s resources (assets) along
with its liabilities and owners’ equity at a given date. The income statement
summarizes the net results of operation of a firm over a specified time interval.
The primary distinction between these two statements is that the balance sheet
shows the financial condition of a firm at a given date, whereas the income
statement deals with the revenues and expenses of the firm incurred during a
specified period of time.

b. The conventional cash flow statement as prepared by accountants provides the

information we need to know about what has happened to the firm’s cash and why.
But it does not present it in a way that makes clear the cash flows that are being
provided by or contributed to the firm by the lenders and investors. Thus, we
choose to reformat the presentation to show the firm’s free cash flows—the cash
free to distribute to the investors. We are more interested in considering cash
flows from the perspective of the firm’s shareholders and its investors, rather than
from an accounting view. We instead measure the cash flow that is available to be
distributed to the firm’s investors, both debt and equity investors. Thus, what we
use is similar to a conventional cash flow statement presented as part of a
company’s financial statements.

3-2. Gross profit is sales less the cost of producing or acquiring the firm’s product or service.
Operating profits is the gross profits less the operating expenses, which consist of
distributing the product or service to the customer (namely, marketing expenses) and any
general and administrative expenses in operating the business. Net income is operating
profits less financing costs (interest expenses and preferred stock dividends) and less
income taxes.

3-3. Interest expense is the cost of borrowing money from a banker or another lender. There
typically is a fixed interest rate so that the interest expense in computed as the interest rate
times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then
our interest expense will be $60,000.

While interest is paid for the use of debt capital, dividends are paid to the firm’s
stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred
stockholder gets a constant dividend each year. Common stockholders, on the other hand,
usually receives dividends only if management decides to pay a dividend instead of
reinvesting the firm’s profits. However, typically once a dividend has been paid to common
stockholders, management is reluctant to decrease it or pass up paying a dividend.

3-4. Once preferred shares are sold, dividends are paid or accrued each year based upon
preferred dividends (i.e., the percentage of the preferred stock’s par value paid in
dividends) agreed to at the selling date. However, these dividends affect the income
statement only. Common stock dividends, which may vary from year to year, also affect

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 the income statement; however, the investment of common shareholders varies with the net
addition to (or reduction from) retained earnings from year to year. The net addition to
retained earnings equals the difference in the period’s net income and common dividends
paid. Thus, the common equity section of the balance sheet (par value of common stock,
paid-in capital and retained earnings) varies from year to year due to changes in the
retained earnings portion of the firm’s common equity.

3-5. Net working capital is the firm’s gross working capital (current assets) less its
short-term debt. It represents a firm’s investments in short-term assets less its
short-term financing. As a business becomes larger, additional amounts of
working capital will normally be required.

Operating working capital is the firm’s current assets less its non-interest bearing
current liabilities (rather than all of its current liabilities).

3-6. A firm could have positive cash flows but still be in trouble because it has negative cash
flows from operations. The positive cash flows would then be the result of the firm
reducing its investments in working capital or long-term assets. Such a situation means
that the company is not earning a satisfactory rate of return on its investments. Another
company could have very attractive rates of return on its assets but be growing so fast that
the large investments in working capital and long-term assets result in negative cash flows.
In this latter case, management is simply investing in the future. As quickly as the growth
is reduced, positive cash flows will occur.

3-7. Examining only the income statement and the balance sheet fails to tell us how the firm is
using its cash, which is a critical issue for any company.

3-8. Free cash flows equal the cash flows that are generated by the company that are then
distributed to (if positive) or received from (if negative) the firm’s lenders and investors. It
looks at cash flows from the firm’s perspective. Financing cash flows looks at the cash
flows from the investors’ viewpoint. They indicate how the investor received (paid in)
cash, from interest, dividends, lending more or less to the company, or buying or selling
stock. But whatever the company does is the exact opposite of what the investor receives
or pays. That is, if a company distributes $100 in cash to the investors, then the investors
must receive $100 as well. They have to equal.

51
 SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

3-1. Belmond, Inc.

Balance Sheet
ASSETS
Cash $ 16,550
Accounts receivable 9,600
Inventory 6,500
Total current assets $ 32,650
Buildings and equipment 122,000
Accumulated Depreciation 34,000
Net buildings and equipment $ 88,000
Total assets $120,650
LIABILITIES AND EQUITY
Liabilities
Notes payable $ 600
Accounts payable 4,800
Total current liabilities $ 5,400
Long-term debt 55,000
Total liabilities $ 60,400
Equity
Common stock $ 45,000
Retained earnings 15,250
Total equity $ 60,250
Total liabilities and equity $120,650

Belmond, Inc.
Income Statement
Sales $ 12,800
Cost of goods sold 5,750
Gross profits $ 7,050
General & admin expense $ 850
Depreciation expense 500
Total operating expense $ 1,350
Operating income (EBIT) $ 5,700
Interest expense 900
Earnings before taxes $ 4,800
Taxes 1,440
Net income $ 3,360

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a. Net working capital = current assets – current debt = $32,650 - $5,400 = $27,250
Operating working capital = current assets – non-interest bearing current liabilities
= $32,650 - $4,800 = $27,850
Debt ratio = total debt /total assets = $60,400/$120,650 = 0.50 or 50%

b. Common-sized income statement

Sales $12,800 100.0%

Cost of Goods sold 5,750 44.9%
Gross Profit 7,050 55.1%
General & Admin expenses 850 6.6%
Depreciation expense 500 3.9%
Total operating expense 1,350 10.5%
Operating income (EBIT) 5,700 44.5%
Interest expense 900 7.0%
Earnings before taxes 4,800 37.5%
Taxes (40%) 1,440 11.3%
Net Income $3,360 26.3%

Common-sized balance sheet

Cash 16,550 13.7%

Accounts receivable 9,600 8.0%
Inventory 6,500 5.4%
Total current assets 32,650 27.1%
Buildings and equipment 122,000 101.1%
Accumulated Depreciation 34,000 -28.2%
Net buildings and equipment 88,000 72.9%
Total assets 120,650 100.0%

Accounts payable 4,800 4.0%

Notes payable 600 0.5%
Total current liabilities 5,400 4.5%
Long-term debt 55,000 45.6%
Total Liabilities 60,400 50.1%
Common Stock 45,000 37.3%
Retained earnings 15,250 12.6%
Total equity 60,250 49.9%
Total liabilities and equity 120,650 100.0%

53
 To interpret the finding for the common-sized income statement, you want to look at the
gross profits, operating profits, and net income as a percentage of sales. These are called
“profit margins”, which tell management how they are doing in generating profits on sales.
For the common-sized balance sheet, you want to look at current assets and fixed assets
as a percentage of total assets, to see where the firm is investing in assets on a relative
basis. When looking at liabilities and equity, see how much of your financing comes from
debt and how much from equity.
It is good to compare your firm’s numbers with a peer group.

3-2 Free Cash Flows

Operating income $75

Depreciation expense 12
Income taxes (17)
After-tax cash flows from operations 70
Increase in current assets (50)
Increase in non-interest bearing current
liabilities 35
Increase in operating working capital. (15)
Change in gross fixed assets* (35)
Firm’s Free Cash Flows $20

* The change in gross fixed assets is equal to the change in net fixed assets ($23) plus the
depreciation expense for the year of $12, resulting in a change in gross fixed assets of $35.

Financing Cash Flows:

Interest expense ($25)

Increase in common stock 20
Dividend (15)
Financing Cash Flows ($20)

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3-3. Warner Company
Balance Sheet

ASSETS
Cash $ 225,000
Accounts receivables 153,000
Inventories 99,300
Prepaid expenses 14,500
Total current assets $ 491,800
Gross buildings & equipment $ 895,000
Accumulated depreciation 263,000
Net fixed assets 632,000
Total assets $1,123,800

LIABILITIES & EQUITY

Liabilities
Notes payable $ 75,000
Accounts payable 102,000
Taxes payable 53,000
Accrued expenses 7,900
Total current liabilities $ 237,900
Long-term debt 334,000
Total liabilities $ 571,900
Equity
Common stock $ 289,000
Retained earnings 262,900
Total equity $ 551,900
Total liabilities and equity $1,123,800

Warner Company
Income Statement

Sales $ 573,000
Cost of goods sold 297,000
Gross profits $ 276,000
General & admin. expense $ 79,000
Depreciation expense 66,000
Total operating expense $ 145,000
Operating income (EBIT) $ 131,000
Interest expense 4,750
Earnings before taxes $ 126,250
Taxes 50,500
Net income $ 75,750

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a. Net working capital = current assets – current debt = $491,800 - $237,900 =
$253,900
Operating working capital = current assets – non-interest bearing current liabilities
= $491,800 – (102,000 + 53,000 + 7,900) = $328,900
Debt ratio = total debt /total assets = $571,900/$1,123,800 = 0.51or 51%

b. Common-sized income statement

Sales $573,000 100.0%
Cost of Goods sold 297,000 51.8%
Gross Profits 276,000 48.2%
General & Admin expenses 79,000 13.8%
Depreciation expense 66,000 11.5%
Total operating expense 145,000 25.3%
Operating income (EBIT) 131,000 22.9%
Interest expense 4,750 0.8%
Earnings before taxes 126,250 22.0%
Taxes (40%) 50,500 8.8%
Net Income $75,750 13.2%

Common-sized balance sheet

Cash 225,000 20.0%
Accounts receivable 153,000 13.6%
Inventory 99,300 8.8%
Prepaid expenses 14,500 1.3%
Total current assets 491,800 43.8%
Gross Buildings and equipment 895,000 79.6%
Accumulated Depreciation 263,000 -23.4%
Net fixed assets 632,000 56.2%
Total assets 1,123,800 100.0%

Notes payable 75,000 6.7%

Accounts payable 102,000 9.1%
Taxes payable 53,000 4.7%
Accrued expenses 7,900 0.7%
Total current liabilities 237,900 21.2%
Long-term debt 334,000 29.7%
Total Liabilities 571,900 50.9%
Common Stock 289,000 25.7%
Retained earnings 262,900 23.4%
Total equity 551,900 49.1%
Total liabilities and equity 1,123,800 100.0%

56
 The common-sized income statement provides insightful information in terms of profits
per sales dollars. These are numbers that managers watch closely on a monthly basis, if
not on a daily basis. A student is well advised to understand margins, whether she is in
finance, marketing, or any business major.

The common-sized balance sheet shows how the firm’s assets have been allocated and
how the assets have been financed in terms of debt versus equity.

3-4. Westlake Corporation generated a positive cash flow from operations ($855), but even a
greater amount was used to invest in additional working capital ($439) and in fixed assets
($1,064), which resulted in a negative free cash flow overall. Thus, the firm required its
investors to make up the difference, which they did by loaning money to the company and
buying more stock.
3-5
Free Cash Flows:

Operating income $215

Depreciation expense 20
Income taxes (45)
After-tax cash flows from operations $190
Increase in current assets ($135)
Increase in non-interest bearing current
liabilities 0
Increase in operating working capital (135)
Increase in gross fixed assets (55)
Free Cash Flows $0

Financing Cash Flows:

Interest expense ($50)

Increase in common stock 27
Increase in interest-bearing debt 48
Dividend (25)
Financing Cash Flows $0

3-6. The Maness Corporation had three sources of cash flows that contributed to its
distributing money to the investor. It had positive cash flows from operations, and the
firm was being downsized by reducing its fixed assets. It had higher operating working
capital. Whether it is a good decision to reduce the asset base depends on the rate of
return being earned on the assets being released to the firm’s investors. We will learn
more about this decision later in our studies of finance.

57
3.7. Pamplin, Inc.

a. Net working capital = current assets – current debt = $1,200 - 300 = $900
Operating working capital = current assets – non-interest bearing current liabilities
= $1,200 – 150 = $1,050
Debt ratio = total debt /total assets = $900/$2,600 = 0.346 or 34.6%

b. Common-sized income statement

Sales $1,450 100.0%
Cost of goods sold 850 58.6%
Gross profit 600 41.4%
Operating expenses 40 2.8%
Depreciation 200 13.8%
Net operating income 360 24.8%
Interest expense 64 4.4%
Net income before taxes 296 20.4%
Taxes (40%) 118 8.1%
Net income $178 12.3%

Common-sized balance sheet

Assets:
Cash $150 5.8%
Accounts Receivable 425 16.3%
Inventory 625 24.0%
Current assets 1,200 46.2%
Plant and equipment 2,600 100.0%
Less: accumulated depreciation (1,200) -46.2%
Net plant and equipment 1,400 53.8%
Total assets $2,600 100.0%

Liabilities and Equity: 2008

Accounts payable $150 5.8%
Notes payable--current (9%) 150 5.8%
Current liabilities 300 11.5%
Bonds 600 23.1%
Owners’ equity
Common stock 900 34.6%
Retained earnings 800 30.8%
Total owners’ equity 1,700 65.4%
Total liabilities and owners’ equity $2,600 100.0%

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 c. Free cash flows and financing cash flows

Free Cash Flows:

Operating income $360
Depreciation 200
Income taxes (118)
After-tax cash flows from operations 442
Increase in current assets 0
Increase in accounts payable (50)
Change in operating working capital (50)
Increase in gross fixed assets (400)
Free Cash Flows ($8)

Financing Cash Flows:

Interest expense ($64)
Increase in short-term interest bearing debt $150
Dividend* (78)
Financing Cash Flows $8

*Note: The dividends were computed by comparing net income to the change in retained
earnings. Net income was $178, but retained earnings increased only by $100; thus the
balance was distributed in the form of dividends.

3-8. T.P. Jarmon

a. Net working capital = current assets – current debt = $138,300 – 75,000 =

$63,300
Operating working capital = current assets – non-interest bearing current liabilities
= $138,300 – (57,000 + 5,000) = $76,300
Debt ratio = total debt /total assets = $225,000/$408,300 = 0.551 or 55.1%

59
b. Common-sized income statement

Sales 600,000 100.0%

Cost of goods sold 460,000 76.7%
Gross profit 140,000 23.3%
Less: Operating and interest expenses:
General and administration 30,000 5.0%
Interest 10,000 1.7%
Depreciation 30,000 5.0%
Total Operating and interest expenses 70,000 11.7%
Earnings before taxes 70,000 11.7%
Less: Taxes 27,100 4.5%
Net income available to common 42,900 7.2%
stockholders
Less: Cash dividends 31,800 5.3%
Change in Retained earnings 11,100 1.9%

Common-sized balance sheet

Cash $14,000 3.4%

Marketable Securities 6,200 1.5%
Receivables 33,000 8.1%
Inventory 84,000 20.6%
Prepaid expenses 1,100 0.3%
Total current assets 138,300 33.9%
Net fixed assets 270,000 66.1%
Total assets $408,300 100.0%

2008
Accounts payable $57,000 14.0%
Accruals 5,000 1.2%
Notes payable 13,000 3.2%
Total current liabilities 75,000 18.4%
Long-term debt 150,000 36.7%
Common stock 183,300 44.9%
Total liabilities and equity $408,300 100.0%

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c. Free cash flows and financing cash flows

Step 1: after-tax cash flows from operations

Operating Income (EBIT) $80,000
Depreciation expense 30,000
Tax expense (27,100)
After-tax cash flows from operations 82,900

Step 2: change in operating working capital

Change in current assets 23,100
Change in accounts payable 9,000

Change in accruals (1,000)

Change in operating working capital (15,100)

Step 3: Change in long-term assets

Net cash used for investments (14,000)

Free Cash Flows $53,800

Financing Cash Flows:

Interest paid to investors (10,000)

Less change in interest payable 0
Interest received by investors (10,000)
Plus decrease in long-term debt (10,000)
Plus decrease in short-term debt (2,000)
Common stock dividends (31,800)
Financing Cash Flows: ($53,800)

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3-9. Abrams Manufacturing
Abrams Mfg. Company Cash Flows
For the Year Ended December 31, 2006:
Step 1: After-tax cash flows from operations
Operating income (EBIT) $54,000
Depreciation expense 26,000
Income taxes (16,000)
After-tax cash flows from operations $64,000

Step 2: Compute the change in operating working capital:

Increase in current assets ($5,000)
Change in non-interest bearing current debt 0
Change in operating working capital (5,000)

Step 3: Compute the change in fixed assets and other assets:

Purchase of fixed assets (73,000)

Free cash flows (sum of above three steps) ($14,000)

Financing Cash Flows:

Interest expense ($4,000)
Repayment of long-term debt (70,000)
Increase in preferred stock 120,000
Preferred stock dividends (10,000)
Common stock dividends (22,000)
Financing cash flows $14,000

3-10. Erin Corporation

Cash flow pattern:

1 The firm generated positive cash flows from operations, but more than used
it to grow the business, requiring additional funds from investors.
2 The firm generated positive cash flows from operations and by decreasing its
working capital. It used this money to invest in fixed assets and to return
money to investors.
3 The firm generated cash by lowering its investment in working capital and
used this cash to cover a negative cash flow from operations and to invest in
long-term assets. Investors had to invest money in the business to cover the
negative cash flows from operations and the investment in long-term assets.
4 The company had negative cash flows from operations and also grew the
business by investing in working capital and long-term assets. Investors had
to cover the short fall in cash. This firm is either a startup that has not
reached breakeven or it’s a “dog”.

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 SOLUTION TO MINI CASE
NOTE: If you want to use more recent financial data for Toyota and General Motors? Go to the
home page for Foundations of Finance at www.prenhall.com/keown , and you can access the
most recent financials.

a. Common-sized income statement

Toyota
Common-Sized Income Statement 2004 2005
Sales $163,637 100.0% $172,749 100.0%
Cost of goods sold 120,262 73.5% 129,100 74.7%
Gross profit 43,375 26.5% 43,649 25.3%
Selling, general, and administrative 19,438 11.9% 18,095 10.5%
expenses
Depreciation and amortization 9,177 5.6% 9,291 5.4%
Operating profit 14,760 9.0% 16,263 9.4%
Interest expense 196 0.1% 177 0.1%
Nonoperating income 2,269 1.4% 2,244 1.3%
Special Items 608 0.4% (1,297) -0.8%
Taxable Income 17,441 10.7% 17,033 9.9%
Income Taxes 6,446 3.9% 6,126 3.5%
Net income 10,995 6.7% 10,907 6.3%

General Motors
Common-Sized Income Statement 2004 2005
Sales $190,812 100.0% $190,215 100.0%
Cost of goods sold 144,179 75.6% 155,264 81.6%
Gross profit 46,633 24.4% 34,951 18.4%
Selling, general, and administrative 20,394 10.7% 22,734 12.0%
expenses
Depreciation and amortization 14,152 7.4% 15,769 8.3%
Operating profit 12,087 6.3% (3,552) -1.9%
Interest expense 11,980 6.3% 15,768 8.3%
Nonoperating income 3,407 1.8% 2,984 1.6%
Special Items (1,620) -0.8% (109) -0.1%
Taxable Income 1,894 1.0% (16,445) -8.6%
Income Taxes (911) -0.5% (5,878) -3.1%
Net income 2,805 1.5% (10,567) -5.6%

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 Common-sized balance sheet

Toyota
Common-Sized Balance Sheet 2004 2005
Assets:
Cash & equivalents $21,258 10.2% $19,466 8.6%
Accounts receivables 43,063 20.7% 47,166 20.8%
Inventories 10,250 4.9% 12,168 5.4%
Other current assets 9,150 4.4% 9,105 4.0%
Total current assets 83,721 40.1% 87,905 38.8%
Gross plant, property & equipment 126,429 60.6% 130,916 57.8%
Accumulated depreciation 75,765 36.3% 76,948 34.0%
Net plant, property & equipment 50,664 24.3% 53,968 23.8%
Investments 64,728 31.0% 77,296 34.1%
Intangibles 0 0.0% 0 0.0%
Other assets 9,424 4.5% 7,435 3.3%
Total assets $208,537 100.0% $226,604 100.0%

Liabilities:
Accounts payable $16,173 7.8% $17,290 7.6%
Notes payable 20,712 9.9% 22,179 9.8%
Accrued expenses 10,723 5.1% 12,006 5.3%
Short-term notes 13,036 6.3% 13,444 5.9%
Other current liabilities 11,245 5.4% 11,692 5.2%
Total current liabilities 71,889 34.5% 76,611 33.8%
Long term notes 40,186 19.3% 46,698 20.6%
Other long-term liabilities 19,079 9.1% 19,070 8.4%
Total Liabilities 131,154 62.9% 142,379 62.8%
Common stock 3,757 1.8% 3,697 1.6%
Paid-in capital 4,685 2.2% 4,616 2.0%
Retained earnings 8,941 33.1% 75,912 33.5%
Common equity 77,383 37.1% 84,225 37.2%
Total liabilities and equity $208,537 100.0% $226,604 100.0%

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 General Motors
Common-Sized Balance Sheet 2004 2005
Assets:
Cash & equivalents $35,993 7.5% $32,142 6.8%
Accounts receivables 180,195 37.6% 199,407 41.9%
Inventories 32,181 6.7% 36,219 7.6%
Other current assets 10,794 2.3% 8,877 1.9%
Total current assets 259,163 54.0% 276,645 58.1%
Gross plant, property & equipment 124,988 26.1% 130,226 27.4%
Accumulated depreciation 49,904 10.4% 51,825 10.9%
Net plant, property & equipment 75,084 15.7% 78,401 16.5%
Investments 30,614 6.4% 23,891 5.0%
Intangibles 12,089 2.5% 9,097 1.9%
Other assets 102,653 21.4% 88,044 18.5%
Total assets $479,603 100.0% $476,078 100.0%

Liabilities:
Accounts payable $28,830 6.0% $29,913 6.3%
Notes payable 0 0.0% 0 0.0%
Accrued expenses 21,103 4.4% 65,614 13.8%
Short-term notes 93,105 19.4% 83,747 17.6%
Other current liabilities 0 0.0% 3,759 0.8%
Total current liabilities 143,038 29.8% 183,033 38.4%
Long term notes 207,174 43.2% 203,598 42.8%
Other long-term liabilities 101,665 21.2% 74,850 15.7%
Total Liabilities 451,877 94.2% 461,481 96.9%
Common stock 942 0.2% 943 0.2%
Paid-in capital 15,241 3.2% 15,285 3.2%
Retained earnings 11,543 2.4% (1,631) -0.3%
Common equity 27,726 5.8% 14,597 3.1%
Total liabilities and equity $479,603 100.0% $476,078 100.0%

b. In measuring profits to sales, we have three levels of profits that can be meaningfully
compared to sales: Gross profits, operating profits (operating income), and net income.
These comparisons are shown below:

Toyota GM
Gross profits/sales 26.5% 24.4%
Operating profits/sales 9.0% 6.3%
Net Income/sales 6.7% 1.5%
Thus, no matter how we look at profits, in 2005 Toyota generated significantly more
profits per dollar of sales. How they did this will be considered in Chapter 4.

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c. There are also significant differences in:
− GM has 42 percent of its assets invested in accounts receivables, compared to 21
percent for Toyota.
− Investments: Toyota has 29% greater than GM
− Other assets: GM has 15% greater than Toyota
− Accrued expenses: GM has 11.7% greater than Toyota
− Long term notes: GM has 22.2% greater than Toyota
− Retained earnings: Toyota has 34.1% greater than GM
d. Free cash flows

Step 1: Compute after-tax cash flows from

operations Toyota General Motors
Operating income $16,263 ($3,552)
Depreciation and impairment of assets 9,291 15,769
Income taxes (6,126) 5,878
Decrease in tax payable and deferred taxes 0 0
Income taxes (6,126) 5,878
After-tax cash flows from operations 19,428 18,095
Extraordinary items (1,297) (109)
Non-operating income 2,244 2,984

Step 2: Change in operating working capital

Change in current assets:
Cash & equivalents (1,792) (3,851)
Accounts receivables 4,103 19,212
Inventories 1,918 4,038
Other current assets (45) (1,917)
Change in current assets: 4,184 17,482
Change in non-interest bearing current debt:
Accounts payable 1,117 1,083
Accrued expenses 1,283 44,511
Other current liabilities 447 3,759
Change in non-interest bearing debt: 2,847 49,353
Change in operating working capital 1,337 (31,871)
Step 3: Change in long-term assets
Purchase of fixed assets 4,487 5,238
Change in investments 12,568 (6,723)
Change in intangibles 0 (2,992)
Change in other assets (1,989) (14,609)
Net cash used for investments 15,066 (19,086)

Free cash flows $3,972 $71,927

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 GM and Toyota had similar cash flows from operations, but GM did so in spite of an
operating loss, which was offset by adding back much more depreciation and by a tax
refund due to its losses. GM decreased its investments in working capital and long-term
assets while Toyota grew its investments. GM used its reductions in investments to cover
its losses.
e. No solution provided
f. No solution provided

ALTERNATIVE PROBLEMS AND SOLUTIONS

ALTERNATIVE PROBLEMS
3-1A. (Review of Basic Financial Statements) Prepare a balance sheet and income statement at
December 31, 2008 for the Sabine Mfg. Co. from the scrambled list of items below.
Ignore income taxes and interest expense.

Accounts receivable $150,000

Machinery and equipment 700,000
Accumulated depreciation 236,000
Notes payable—current 90,000
Net sales 900,000
Inventory 110,000
Accounts payable 90,000
Long-term debt 160,000
Cost of goods sold 550,000
Operating expenses 280,000
Common stock 320,000
Cash 90,000
Retained earnings—prior year ?
Retained earnings—current year ?
3-2A. (Measuring Cash Flows) Given the information that follows, compute the free cash flows
and financing cash flows for the J.B. Chavez Corporation for the year ended December
31, 2008.
J.B. Chavez Corporation, Balance Sheet
at 12/31/07 and 12/31/08 ($000)
Assets
12/31/07 12/31/08
Cash $225 $175
Accounts receivable 450 430
Inventory 575 625
Current assets $1250 $1230
Plant and equipment $2200 $2500
Less: Accumulated depreciation (1000) (1200)
Net plant and equipment $1200 $1300
Total assets $2450 $2530

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 Liabilities and Owners’ Equity
12/31/07 12/31/08
Accounts payable $250 $115
Notes payable-current (9%) 0 115
Current liabilities $250 $230
Bonds $600 $600
Owners’ equity
Common stock $300 $300
Paid-in capital 600 600
Retained earnings 700 800
Total owners’ equity $1600 $1700
Total liabilities and owners’ equity $2450 $2530

J.B. Chavez Corporation, Income Statement

for the year ending 12/31/07 and 12/31/08

2007 2008
Sales $1250 $1450
Cost of goods sold 700 875
Gross profit $550 $575
Operating expenses 30 45
Depreciation 220 200
Net operating income $300 $330
Interest expense 50 60
Net income before taxes $250 $270
Taxes (40%) 100 108
Net income $150 $162

3-3A. (Measuring Cash Flows) (a) Compute the free cash flows and financing cash flows for
Cramer, Inc., for the year 2008. What were the firm’s primary sources and uses of cash?

2007 2008
Cash $76,000 $82,500
Receivables 100,000 91,000
Inventory 168,000 163,000
Prepaid expenses 11,500 13,500
Total current assets $355,500 $350,000
Gross fixed assets 325,500 450,000
Accumulated depreciation (94,500) (129,000)
Patents 61,500 52,500
Total assets $648,000 $723,500

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 2007 2008
Accounts payable $123,000 $93,500
Short-term notes payable 97,500 105,000
Current liabilities $220,500 $198,500
Mortgage payable 150,000 —
Preferred stock — 231,000
Common stock 225,000 225,000
Retained earnings 52,500 69,000
Total liabilities and equity $648,000 $723,500

Additional Information:
1. The only entry in the accumulated depreciation account is the depreciation expense
for the period.
2. The only entries in the retained earnings account are for dividends paid in the
amount of $20,000 and for the net income for the year.
3. Expenses include a $9,000 amortization of patents and $7,500 in interest expenses.
4. The income statement for 2008 is as follows:

Sales (all credit) $190,000

Cost of goods sold 86,000
Gross profit $104,000
Operating expenses 43,500
Provisions for taxes 24,000
Net income $36,500

(Cost of goods sold included depreciation expense of $34,500)

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SOLUTIONS FOR ALTERNATIVE PROBLEMS

3-1A.
Instructor’s Note: This is a rudimentary exercise, which can be used to review the form
and content of the income statement and balance sheet quickly.

Sabine Mfg. Co.

Balance Sheet
December 31, 2008
(000’s)

Cash $90 Accounts Payable $90

Accounts Receivable 150 Notes Payable—Current 90
Inventory 110 Current Liabilities $180
Total Current Assets $350 Long-Term Debt $160
Machinery Equipment $700 Common Stock $320
Accum. Depreciation (236) Retained Earnings
Net Machinery & Equip. $464 Prior Years 84a
Current Year Addition 70
Total Owners’ Equity $474
Total Liabilities and
Total Assets $814 Owners’ Equity $814
Total Assets $814 Total Retained Earnings $154
Total Debt & Comm. Stk. -660 Net Income -70
Total Retained Earnings $154 Prior Retained Earnings $84

Sabine Mfg. Co.

Income Statement
For the Year Ending, December 31, 2008
(000s)

Net Sales $900

Cost of Goods Sold 550
Gross Profit $350
Operating Expenses 280
Net Income $ 70

Thus, the current Addition to Retained Earnings for 2008 = $70

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3-2A. J.B. Chavez Corporation
Cash Flows
For Year Ended December 31, 2008

Free Cash Flows-

Operating income (EBIT) $ 330
Depreciation 200
Income taxes (108)
After-tax cash flows from operations $ 422

Decrease in current assets $ 20

Decrease in non-interest bearing current debt (135)
Change in operating working capital $ (115)
(current assets – non-interest bearing current debt)
Purchase of fixed assets (300)
Free Cash Flows $ 7

Financing Cash Flows--

Interest $ (60)
Increase in interest bearing current debt 115
Common stock dividends (62)
Financing Cash Flows $ (7)

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3-3A. Cramer, Inc.
Cash Flows
For Year Ended December 31, 2008

Given the information provided in this problem, it is necessary to begin with net income,
instead of operating income, to compute cash flows from operations. We then add back
interest expense along with depreciation and amortization to find the after-tax cash flows
from operations.

Free Cash Flows-

Net income $ 36,500
Depreciation expense 34,500
Amortization of goodwill 9,000
Interest expense 7,500
After-tax cash flows from operations $ 87,500

Decrease in current assets $ 5,500

Decrease in non-interest bearing current debt: (29,500)
Increase in operating working capital $ (24,000)
(current assets – non-interest bearing current debt)
Purchase of fixed assets (124,500)
Free Cash Flows $ (61,000)

Financing Cash Flows

Interest expense ($ 7,500)
Increase in interest bearing current debt 7,500
Common stock dividends ( 20,000)
Repayment of mortgage (150,000)
Issue preferred stock 231,000
Financing Cash Flows $ 61,000

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