CHAPTER 4. FINANCIAL STATEMENTS

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1 CHAPTER 4. FINANCIAL STATEMENTS Accounting standards require statements that show the financial position, earnings, cash flows, and investment (distribution) by (to) owners. These measurements are reported, respectively, by the following statements: balance sheet, income statement, statement of cash flows, and statement of changes in equity. These statements can be constructed in a variety of different ways and levels of detail. An important consideration is that the financial framework of the firm should compliment the physical performance measures of the firm. A typical indicator used as a measure of the firm s financial health is its cash position. Cash flows are an important, but often misleading, indicators of the financial health of a firm. Two necessary conditions for long-term survival in any firm are profitability and feasibility. Profitability is defined as the difference between a firm s revenues and its expenses. Feasibility is the solvency or short-term ability of the firm to meet its obligations when they become due. If a firm is not both profitable and feasible over time, it cannot survive. In the short run, a firm can be feasible but not profitable. For a limited time, the firm can generate cash flows to remain solvent by borrowing, refinancing existing debt, selling inventory, liquidating capital assets, increasing accounts payable, or depleting its capital base. Unfortunately, these techniques are only temporary solutions and don t substitute for long-run profitability. Focusing on only the firm s "cash position" can, and has, led to devastating results for firms. An appropriately constructed set of financial statements will allow a firm to monitor both profitability and solvency and diagnose any difficulties the firm has in these areas. Chapter 4 54 Spring 2003

2 Balance Sheet A balance sheet is a listing of a firm s assets, debt claims, and equity claims at a particular point in time. People are usually taught to think of it as a "snap shot" of the firm on a given date. As a result, it is important to know the date for which the balance sheet was constructed. Table 2.4 presents year-end balance sheets for the hypothetical HiQuality Nursery company, which might be organized as sole proprietorship, partnership, or corporation. The underlying principal for any balance sheet is the fundamental accounting equation: Assets / Liabilities + Equity. In other words, every dollar of the firm s assets must be financed either by a liability (debt borrowed by the firm) or equity claim (capital supplied by the firm s owners), or some combination of the two. This principal results in the separation of assets from liabilities and equity on the balance sheet. We can check the above equality by noting that the total value of assets at the bottom of the balance sheet is equal to the total value of liabilities and equity for each year. Chapter 4 55 Spring 2003

3 Table 4.1 Year-End Balance Sheets for HiQuality Nursery HiQuality Nursery Balance Sheets ($000) Year ASSETS Cash and Mkt Securities Accounts Receivable Inventory $ 600 1,200 5,200 $ 930 1,640 3,750 $1,200 1,560 3,150 CURRENT ASSETS 7,000 6,320 5,910 Prop, Plant, and Equip Other Assets 2, , , LONG TERM ASSETS 3,400 3,680 3,980 TOTAL ASSETS 10,400 10,000 9,890 LIABILITIES Notes Payable Current Portion LTD Accounts Payable Accrued Liabilities 1, , , , , , CURRENT LIABILITIES 6,600 5,958 5,370 TOTAL LONG TERM DEBT 1,985 2,042 2,560 TOTAL EQUITY 1,815 2,000 1,960 TOTAL DEBT AND EQUITY 10,400 10,000 9,890 The firm s assets and liabilities are typically listed in order of liquidity or payment. For example, current assets are expected to be liquidated within the next year and are listed above long- Chapter 4 56 Spring 2003

4 term assets, which are not expected to be liquidated during the upcoming year. Likewise, current liabilities are debts due within the upcoming year and are listed above long-term liabilities, which are debts that will not come due during the next year. Equity, which represents residual ownership of the firm s assets, has no fixed due date and is consequently listed last. Items within each category on the balance sheet are also listed in order of liquidity or payment. Assets Assets represent the resources available to the firm to be used to generate earnings and includes everything owned that has value. Current assets are represented by cash and near-cash assets that are expected to be liquidated during the next year. Current assets are typically assets whose liquidation will not significantly disrupt the operation of the firm. Besides cash, current assets often include marketable securities, accounts receivable, notes receivable, and inventories. Marketable securities are interest bearing deposits which are low risk in terms of principal balance and can easily be converted to cash if needed. Accounts receivable are sales that have been made but not collected from customers. Notes receivable are debt payments due to the firm during the upcoming year. Finally, inventories represent the value of inputs used in production or manufacturing of goods that have not been sold. Inventories are often the least liquid of the current assets and their value is often not known until the assets are sold. Noncurrent long-term assets are assets that yield service over a period of time and are expected to remain in the firm beyond the upcoming year. Liquidation of fixed assets typically would Chapter 4 57 Spring 2003

5 disrupt the operations of the firm. Fixed assets include such items as machinery, equipment, automobiles, breeding stock, contracts, long-term notes receivable, and real estate. Book Value versus Market Value Assets are recorded at a value equal to their acquisition costs. Many fixed assets wear out or lose value over time. This loss in value is accounted for by depreciating, or lowering the acquisition cost, of the assets over time. The value of each asset on the balance sheet (acquisition cost - accumulated depreciation) is called the asset s book value. A difficulty with financial statement analysis is that an asset s book value almost always differs significantly from the asset s market value which is what the firm can actual get if it sells the asset. In order to understand why book value is not equal to market value, let s think about what determines market value. We ll show this more formally later, but it turns out that the value of an asset generally depends on the following three characteristics of the future cash flows the asset is expected to generate: 1. the size and/or number of expected future cash flows; 2. the timing of expected future cash flows; and 3. the risk and variability of future cash flow. In general, the larger the size and/or number of expected future cash flows, the larger the assets market value will be. Likewise, the sooner you expect to get the cash flows, the higher the market value of the asset (think about the time value of money concept). Finally, everything else held constant, the greater the risk or variability of an asset s future cash flows, the lower the market value Chapter 4 58 Spring 2003

6 of the asset. Hopefully, these ideas make some intuitive sense to you; if not, don t worry. We will revisit these concepts in detail later. One final note on market value. In some cases, an asset s value may not be solely based on the future cash flows an asset will generate; the asset may provide other nonmonetary services. For example, you might be able to purchase a $50,000 house that has a higher level of expected future after-tax cash flows than the $100,000 house you are also considering; that is, you think you can make more (or spend less) money by investing in the $50,000 house; however, you might buy the $100,000 house because it will be a nicer place to live and you are willing to sacrifice some of your wealth to increase your living standard. In other words, the house you live in is both an investment and a consumption good. As we discussed in Chapter 1, whenever you mix management and ownership, you can get results that aren t solely based on value maximization. Liabilities and Equity Liabilities are obligations to repay debt that has been incurred. Current liabilities are normally paid during the upcoming year. These typically include accounts payable, current principal and interest payments, and accrued expenses. Accounts payable are expenditures that have been made, to purchase inputs used in production, for example, but not paid yet. Current principal and interest, often called notes payable, are the short-term debt obligations and/or the portion of longterm debt obligations that are due during the upcoming year. Accrued expenses are expenses that have been incurred through the operation of the firm but are not due for payment yet. Examples of accrued expenses include taxes payable and salary and wages payable. Noncurrent or long-term Chapter 4 59 Spring 2003

7 liabilities are obligations that will be payable sometime after the upcoming year. These are usually long-term notes payable, mortgages, or bond obligations. Equity, or net worth, is always the difference between the total book value of assets and the total liabilities of the firm. The value of the equity is an estimate of what owners of the firm would have left after selling all the assets and paying all liabilities. Therefore, this is a major item of concern in financial statements. In a corporation, the firm owns the assets and shareholders own shares of stock in the corporation. In large corporations whose shares are traded on organized exchanges, the value of the stock can differ substantially from the book value of the stock. Why do you think this is the case? The equity portion of the balance sheet looks different for a corporation than for a partnership or sole proprietorship, simply because of the nature of the equity. Corporations report equity in terms of the amount of initial value of the different types of stock that the shareholders own. Similarly, withdrawals are reported as dividends in corporate reporting. Income Statement The balance sheet provides useful information about a firm s financial situation at a single point in time. Nevertheless, it doesn t tell you much about a firm s performance over time. Looking at the change in retained earnings on the balance sheet from one period to the next gives a clue as to whether the firm earned a profit, or realized a loss, but that is all the information that is discernable about a firm s profit-loss situation from the balance sheet. An income statement breaks a firm s revenues and expenses into different components that determine the firm s profitability. Table 4.2 Chapter 4 60 Spring 2003

8 shows the 1996 and 1997 income statements for HiQuality Nursery. Unlike the balance sheet which is a picture of the firm s assets at a particular point in time, the income statement is a record of what has happened to the firm s operations between two points in time in terms of profits and losses. Total revenue is made up the gross receipts or sales that are generated by the firm during the accounting period. Expenses during the period are then deducted from total revenue to determine the firm s profitability during the period. Cost of goods sold reflect the direct cost to the firm to produce, manufacture, or purchase the goods that were sold to generate the firm s revenue. Cost of goods sold is typically the largest expense in most businesses. Operating expenses, or overhead, represent the costs of operating and administrating the business beyond those expense items included in the cost of goods sold. These expenses typically include such things as sales expenses, administrative expenses, general office expenses, rents, salaries, and utilities. Depreciation is the accounting measure of the decline in the value of the firm s fixed assets during the period and can be thought of as the cost to replace the long-term assets used up during the period. Earnings before interest and taxes (EBIT) represents the firm s profits from operations. In other words, this is the profit the firm generates before paying the interest costs of the firm s debt financing and the tax obligations of the firm. Subtracting interest expenses from EBIT gives the firm s earnings before taxes (EBT) which is the firm s profits after paying all expenses except taxes; EBT is sometimes called profit before taxes. Chapter 4 61 Spring 2003

9 Table 4.2 Income Statement for HiQuality Nursery HiQuality Nursery Income Statements ($000) Year Net Sales Cost of Sales Operating Expenses Depreciation EARNING BEFORE INTEREST AND TAXES Interest EARNINGS BEFORE TAXES Taxes NET INCOME AFTER TAXES 1997 $40,000 28,000 11, $38,000 25,600 11, Subtracting the firm s tax liabilities from EBT gives the firm s net income after taxes (NIAT), which is the firm s profit after taxes and is generally what we think about when we talk about a firm s profits. This is the amount of profit the firm generated during the accounting period after paying all expenses including the debt servicing costs and taxes. NIAT is also the profit that is available to be reinvested in the firm or withdrawn by the owners. Subtracting the amount of cash withdrawn by the owner(s) from NIAT leaves the amount of profits reinvested in the firm, which is called retained earnings. It is important to note that retained earnings is the link between the income statement and Chapter 4 62 Spring 2003

10 the balance sheet. The amount of retained earning during the accounting period must equal the difference between the retained earnings on the balance sheet at the end of the period and the retained earnings at the beginning of the accounting period; that is, the change in retained earnings between the two periods. Net Working Capital Net working capital (NWC) is defined as current assets minus current liabilities and provides a measure of the firm s liquidity. If NWC is positive then the assets which are expected to be converted to cash during the upcoming year will likely be sufficient to meet the liabilities due during the upcoming year. HiQuality Nursery s net working capital is positive each year, suggesting the firm was capable of meeting short term debt obligations by using only the assets expected to be liquidated during the upcoming year. Year Current Assets - Current Liabilities = Net Working Capital 1995 $5,910,000 $5,370,000 $540, $6,320,000 $5,958,000 $362, $7,000,000 $6,600,000 $400,000 Typically, you would like to see a positive NWC in a firm. A firm s investment (or deinvestment) in working capital can be measured by the change in NWC during the year. HiQuality Nursery s change in NWC during 1997 is measured by taking the difference between its 1997 and 1996 NWC; in other words NWC = $400,000 - $362,000 = $38,000 (the symbol denotes "change" in the specified Chapter 4 63 Spring 2003

11 variable, in this case, NWC). This suggests that HiQuality has increased investment in NWC. Normally you would like to see NWC increase over time in a growing firm. Changes in Owners Equity Because of the importance of measuring equity, a detailed statement of the reasons for changes in equity is sometimes reported. The statement of changes in owner s equity reports the same information as contained in the balance sheet but provides detail on the reasons underlying the change in equity. The equity position in a business can change as the result of profit or losses from the firm s operations, withdrawals by the firm s owners, and/or new equity contributions by owners. The statement of changes in owners equity generally takes on the following structure: NIAT - Dividends + capital contributions - repurchase of equity capital Change in equity Financial Cash Flow The firm s balance sheet shows its financial position at a point in time, while the income statement gives a measure of the firm s profits over time. Nevertheless, we have mentioned several times that an equally important measure is the firm s after-tax cash flow (ATCF). NIAT differs from a firm s cash flow because NIAT includes a number of non-cash items and because cash inflows and outflows also occur from nonoperating sources. For example, depreciation is generally a major expense item on the income statement for most firms. This is, however, a noncash cash accounting Chapter 4 64 Spring 2003

12 expense; in other words, no cash was spent even though there is an expense on the income statement. Clearly, NIAT underestimates a firm s cash flows from operations by at least the amount of depreciation expense. Remember that the balance sheet requires that Assets = Liabilities + Equity. Similarly it must be the case that the cash flows from a firm s assets (CF a ) must equal the cash flows to the firms creditors (CF c ) and equity holders (CF e ): CF a = CF c + CF e The Statement of Cash Flows identifies the sources and uses of cash during the period between two balance sheets. It replaces a similar statement called the Sources and Uses of Funds Statement as a result of changes in the Generally Accepted Accounting Principles (GAAP) in The general structure of the Statement of Cash Flows is cash flows from operations + cash flows from investment activities + cash flows from financing activities change in cash position This format separates cash flows into the three major management areas: 1) operation management, 2) asset management, and 3) financial management. The cash flows from operations are associated with the management of the firm s operations and reflect the cash flows generated by the firm in producing and delivering its goods and services. The cash flows from investment activities come from the purchase and sale of capital assets that occur as a result of the firm s asset management Chapter 4 65 Spring 2003

13 strategies. The cash flows from financing activities result from borrowing new debt, repayment of old debt, raising new equity capital, and returning capital to owners as a result of the firm s financial management practices. The primary purpose of the Statement of Cash Flows is to detail the sources of cash flows in order to assess the firm s ability to generate future cash flows, meet obligations, pay dividends, and obtain future financing. The Statement isolates the difference between income from operations and cash flows, as well as the effects of the firm s investment and financing activities. Table 4.3 Shows the Statement of Financial Cash Flow for the HiQuality Nursery Company. Chapter 4 66 Spring 2003

14 Table 4.3 Financial Cash Flow HiQuality Nursery HiQuality Nursery Statement of Cash Flows ($000) Year CASH FLOWS FROM OPERATIONS Net Income Depreciation Expense Change in Acct. Rec. Change in Inventory Change in Current Liabilities Net Cash from Operations CASH FLOWS FROM INVESTMENTS Net cash from investments CASH FLOWS FROM FINANCING ACTIVITIES Payment of LTD Payment of dividends Net cash from financing CHANGE IN CASH POSITION 1997 $ $ Chapter 4 67 Spring 2003

15 The cash flow generated by the firm s assets is often called the cash flow from operations and is equal to the firm s NIAT plus depreciation expense less the change in accounts receivable and inventory plus the change in current liabilities. HiQuality s operating cash flows are: NIAT + Depreciation Expense - Change in Accounts Receivable - Change in Inventory + Change in Current Liabilities Net Cash Flow From Operations Adding depreciation expense to NIAT adjusts the firm s profit for noncash expenses and converts profits to an after-tax cash flows basis. Increasing (decreasing) accounts receivable or inventory uses (generates) cash and decreases (increases) the cash flow from operations. Likewise, an increase (decrease) in current liabilities generates (uses) cash, increasing (decreasing) the cash flows from operations. The cash flows from investments focuses on the reinvestment in and/or sale of the firm s longterm assets. Purchasing fixed assets uses cash flow, while the sale of fixed assets generates cash flow for the firm. For example, if you go out and sell your car, you generate some cash inflow. If you then turn around and purchase a new car, you will have spent cash creating a cash outflow. The net cash from investments is equal to amount of long term assets purchased less the amount sold. The cash outflow from investment can be calculated as the beginning long-term assets less depreciation expense less ending long-term assets. Beginning LT Assets - Depreciation Expenses - Ending LT Assets Net Cash Outflow from Investments Chapter 4 68 Spring 2003

16 The depreciation expense is the amount of assets used up during the period through operations. The change in long-term assets represents the actual change in long-term assets during the period and will differ from the depreciation expense if assets have been purchased or sold during the period. Cash flows from financing activities reflect cash flows from long-term debt and/or equity financing. The net cash flow from financing activities is equal to the change in long-term debt less the amount of withdrawals plus the amount of new equity capital less the amount of equity capital repurchased: Change in long-term debt - Amount of dividends + Amount of new equity capital - Amount of equity repurchased Net Cash flow from financing Increasing (decreasing) long-term borrowing increases (decreases) available cash. The payment of dividends uses cash while a new equity contributions provides additional cash. Repurchasing equity from same owners would require the use of cash and decrease cash flow. Cash Versus Accrual Accounting Another factor which causes actual cash flows to differ from profit measures and accounting cash flow is the use of accrual accounting. Accrual accounting recognizes revenues in the period they are earned and expenses in the period they are incurred. For example, you might sell corn in December 1997 but not receive cash for it until January In this case you earned your revenue Chapter 4 69 Spring 2003

17 in 1997, even though you didn t receive cash for it until Accrual accounting doesn t care about the timing of actual cash inflows and outflows. An alternative available to many small businesses is to use a cash accounting system for tax reporting purposes. Cash accounting recognizes revenues and expenses in the period in which they are received. Using a cash accounting system in our corn example above, you would not count the revenue from the corn sale until the cash was received in 1994 even though the grain was sold in Cash accounting allows firms to make some adjustments to revenues and expenses which allows them to manage their tax liability to some extent. Accrual accounting, on the other hand, provides a more accurate reflection of the firm s profitability and gives a better picture of the firm s situation for monitoring and control purposes. As a result, many small businesses use cash accounting for tax purposes and accrual accounting for management purposes. It should be noted that businesses in which inventories are held are required by the IRS to use an accrual based accounting system. However, most types of farm businesses are excluded from this requirement and are allowed to use the cash basis of accounting for tax purposes. It is usually not difficult to adjust financial statements from cash accounting to accrual accounting; and this should be done for businesses that use a cash accounting system for tax purposes in order to provide better information on the financial performance of the firm. Chapter 4 70 Spring 2003