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Corporate Finance
Chapter Two
Ross Westerfield Jaffe 2
Sixth Edition

Financial Statements and

Cash Flow

Anwar Zahid
Lecturer
Independent University, Bangladesh (IUB)
McGraw-Hill Ryerson 2003 McGrawHill Ryerson Limited
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2.1 The Balance Sheet

An accountants snapshot of the firms accounting
value as of a particular date.

The Balance Sheet Identity is:

Assets Liabilitie s Stockholde r' s Equity

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The Balance Sheet of the
Canadian Composite Corporation
CANADIAN COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 The assets are listed in 20X2
order20X1
and Stockholder's Equity
Current assets: Current Liabilities:
Cash and equivalents $140 $107 by the length of time it $213 $197
Accounts payable
Accounts receivable
Inventories
294
269
270
280
normally would take a firm
Notes payable
Accrued expenses
50
223
53
205
Other 58 50 with ongoing operations$486
Total current liabilities to $455
Total current assets $761 $707
convert them into cash.
Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Clearly, cash is much more
Common stock ($1 per value) 55 32
Capital surplus 347 327
liquid than property, plant and
Accumulated retained earnings 390 347
equipment.
Less treasury stock
Total equity
-26
$805
-20
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

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Balance Sheet Analysis

When analyzing a balance sheet, the

financial manager should be aware of three
concerns:
1. Liquidity
2. Debt versus equity
3. Value versus cost

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Liquidity

Refers to the ease and speed with which

assets can be converted to cash.
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firms 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.

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Debt versus Equity

Generally, when a firm borrows it gives the

bondholders first claim on the firms cash
flow.
Thus shareholders equity is the residual
difference between assets and liabilities.

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Value versus Cost

Under GAAP audited financial statements of

firms carry assets at historical cost adjusted
for depreciation.
Market value is a completely different
concept. It is the price at which willing
buyers and sellers trade the assets.

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2.2 The Income Statement

The income statement measures performance

over a specific period of time.
The accounting definition of income is
Revenue Expenses Income

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

The operations Cost of goods sold - 1,655
section of the Selling, general, and administrative expenses - 327
Depreciation - 90
income statement
Operating income $190
reports the firms Other income 29
revenues and Earnings before interest and taxes $219
Interest expense - 49
expenses from Pretax income $170
principal Taxes - 84
operations Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

The non- Cost of goods sold - 1,655
operating section Selling, general, and administrative expenses - 327
Depreciation - 90
of the income
Operating income $190
statement includes Other income 29
all financing costs, Earnings before interest and taxes $219
Interest expense - 49
such as interest Pretax income $170
expense. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Usually a separate Interest expense - 49
section reports as a Pretax income $170
Taxes - 84
separate item the Current: $71
amount of taxes Deferred: $13
levied on income. Net income $86
Retained earnings: $43
Dividends: $43

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20x2
(in $ millions)

Total operating revenues $2,262

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Interest expense - 49
Net income is the Pretax income $170
bottom line. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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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. Non Cash Items
3. Time and Costs

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Generally Accepted Accounting Principles

1. GAAP
The matching principal of GAAP dictates that
revenues be matched with expenses. Thus,
income is reported when it is earned, even
though no cash flow may have occurred.
For example,when goods are sold for credit,
sales and profits are reported.

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Income Statement Analysis

2. Non Cash Items

These are expenses that do not affect cash flow
directly.
Depreciation is the most apparent. No firm ever
writes a cheque for depreciation.
Another noncash item is deferred taxes, which
does not represent a cash flow.

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Income Statement Analysis

3. Time and Costs

In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can
vary such inputs as labour and raw materials.
In the long run, all inputs of production (and hence
costs) are variable.
Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that
distinguishes product costs from period costs.

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2.3 Net Working Capital

NWC = CURRENT ASSETS
CURRENT LIABILITIES
NWC is +ve when current assets are greater
than current liabilities.
A firm can invest in NWC. This is called
change in NWC .
The change in NWC is usually +ve in a
growing firm.

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The Balance Sheet of the C.C.C.

CANADIAN COMPOSITE CORPORATION
Balance Sheet
$252m = $707- $455 20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117 to $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 $275 million in 20X2 from
Total long-term liabilities$588 $562
Net property, plant, and equipment
Intangible assets and other
873
245
814
221
$252 million in 20X1.
Stockholder's equity:
Total fixed assets $1,118 $1,035
$23 million
Preferred stock
Common stock ($1 par value)
$39
55
$39
32
Capital surplus 347 327
$275m = $761m- $486m Accumulated retained earnings 390 347
This increase of $23 million is
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 an investment of the firm.
Total liabilities and stockholder's equity $1,879 $1,742

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2.4 Financial Cash Flow

In finance, the most important item that can

be extracted from financial statements is the
actual cash flow of the firm.
Since there is no magic in finance, it must be
the case that the cash received from the
firms assets must equal the cash flows to the
firms creditors and stockholders.

CF ( A ) CF ( B ) CF ( S )

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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow CF (Asset) = CF (Creditors) + CF(equity)
20X2 42 = 36 + 6
(in $ millions)

Cash Flow of the Firm Operating Cash Flow:

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes) EBIT $219
Capital spending -173
(Acquisitions of fixed assets Depreciation $90
minus sales of fixed assets)
Additions to net working capital -23 Current Taxes ($71)
Total $42
Cash Flow of Investors in the Firm OCF $238
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital Spending
Capital spending -173 Purchase of fixed assets $198
(Acquisitions of fixed assets
minus sales of fixed assets) Sales of fixed assets (25)
Additions to net working capital -23
Total $42 Capital spending $173
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
NWC grew to $275
Capital spending -173 million in 20X2 from
(Acquisitions of fixed assets
minus sales of fixed assets) $252 million in 20X1.
Additions to net working capital -23
Total $42 This increase of $23
Cash Flow of Investors in the Firm million is the addition to
Debt $36
(Interest plus retirement of debt NWC.
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending -173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital -23
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Cash Flow to Creditors
Capital spending -173
(Acquisitions of fixed assets Interest $49
minus sales of fixed assets)
Additions to net working capital -23 Retirement of debt 73
Total $42
Cash Flow of Investors in the Firm Debt service 122
Debt $36
(Interest plus retirement of debt Proceeds from new debt
minus long-term debt financing)
Equity 6 sales (86)
(Dividends plus repurchase of
equity minus new equity financing) Total 36
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238
(Earnings before interest and taxes Cash Flow to Stockholders
plus depreciation minus taxes)
Capital spending -173 Dividends $43
(Acquisitions of fixed assets
minus sales of fixed assets) Repurchase of stock 6
Additions to net working capital -23
Cash to Stockholders 49
Total $42
Cash Flow of Investors in the Firm Proceeds from new stock issue
Debt $36 (43)
(Interest plus retirement of debt
minus long-term debt financing) Total $6
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238 The cash received from
(Earnings before interest and taxes
plus depreciation minus taxes)
the firms assets must
Capital spending -173 equal the cash flows to the
(Acquisitions of fixed assets
minus sales of fixed assets)
firms creditors and
Additions to net working capital -23 stockholders:
Total $42
Cash Flow of Investors in the Firm CF ( A)
CF ( B ) CF ( S )
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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2.5 Summary and Conclusions

Financial statements provide important

information regarding the value of the firm.
A financial manager should be able to
determine cash flow from the financial
statements of the firm.
Knowing how to determine cash flow helps
the financial manager make better decisions.

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