corporate finance chapter 3.docx

corporate finance chapter 3.docx

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corporatefinancechapter3

Chapter3

FinancialStatements,CashFlows,andTaxes

LearningObjectives

1.Discussgenerallyacceptedaccountingprinciples（GAAP）andtheirimportancetotheeconomy.

2.Knowthebalancesheetidentity,andexplainwhyabalancesheetmustbalance.

3.Describehowmarket-valuebalancesheetsdifferfrombook-valuebalancesheets.

4.Identifythebasicequationfortheincomestatementandtheinformationitprovides.

5.Explainthedifferencebetweencashflowsandaccountingincome.

6.Explainhowthefourmajorfinancialstatementsdiscussedinthischapterarerelated.

7.Discussthedifferencebetweenaverageandmarginaltaxrates.

I.ChapterOutline

3.1FinancialStatementsandAccountingPrinciples

A.AnnualReports

∙Theannualreportisavehiclebywhichmanagementcommunicateswiththefirm’sshareholdersandmembersofthepublic.

∙Theannualreporthasthreesections—afinancialsummaryrelatedtothepastyear’sperformance;informationaboutthecompany,itsproducts,anditsactivities;andauditedfinancialstatements,includinghistoricalfinancialdata.

B.GenerallyAcceptedAccountingPrinciples（GAAP）

∙Theseareaccountingrulesandstandardsthatcompaniesneedtoadheretowhentheypreparefinancialstatementsandreports.

∙GAAPispreparedbytheFinancialAccountingStandardsBoard（FASB）andisauthorizedbytheSEC.

C.FundamentalAccountingPrinciples

∙TheAssumptionofArm’s-LengthTransaction—Twopartiesinvolvedinaneconomictransactionarriveatadecisionindependentlyandrationally.

∙TheCostPrinciple—Transactionsarerecordedatthecostatwhichtheyoccurred.

∙TheRealizationPrinciple—Revenueisrecognizedwhentransactioniscompleted,whilecashmaynotbecollecteduntilalatertime.

∙TheMatchingPrinciple—Expensesrelatedtogeneratinganyrevenuearematched.

∙TheGoingConcernAssumption—Itisassumedthatacompanywillcontinuetooperateforthepredictablefuture.

D.InternationalGAAP

∙TheInternationalAccountingStandardsBoardpromotesuniformaccountingrulesandprocedures.

∙AllEuropeanUnionfirmsareexpectedtocomplywithInternationalAccountingStandards（IAS）,since2007.

∙TheSECdoesnotrecognizeIASandrequiresforeignfirmslistedonU.S.stockexchangestouseU.S.GAAP.

3.2TheBalanceSheet

A.Thisfinancialstatementidentifiesalltheassetsandliabilitiesofafirmatapointintime.

∙Theleft-handsideofthebalanceshowsalltheassetsthatthefirmownsandusestogeneraterevenues.

∙Theright-handsiderepresentstheliabilitiesofthefirm—thatis,themoneythatthefirmhasborrowedfrombothcreditorsandshareholders.

∙Inadditiontotheamountborrowedfromsuppliersandothercreditors,thebalancesheetalsoliststhecapitalraisedfromitsshareholders.

∙Whileassetsarelistedintheirorderoftheirliquidity,theliabilitiesarelistedintheorderinwhichtheymustbepaid.

∙Shareholdersofthefirm’scommonequityarelistedlastastheywillbepaidwithwhateverremainsafterpayingallothersuppliersoffunds.

B.CurrentAssetsandLiabilities

∙Allassetsthatarelikelytobeconvertedtocashwithinayearareconsideredtobecurrentassets.Theseincludecashandmarketablesecurities,accountsreceivables,andinventory.

∙Allliabilitiesthathavetobepaidwithinayeararelistedaspartofthecurrentliabilities.Thus,bankloansandotherborrowingswithlessthanayear’smaturity,accountspayables,accruedwages,andtaxesareincludedhere.

∙Thedifferencebetweentheamountofcurrentassetsandcurrentliabilitiesiscallednetworkingcapital.

C.NetWorkingCapital

∙Networkingcapitalisameasureoftheliquidityofafirm,whichistheabilityofthefirmtomeetitsobligationsastheycomedue.

∙AsexpressedinEquation3.2,networkingcapitalisthedifferencebetweentotalcurrentassetsandtotalcurrentliabilities.

D.AccountingforInventory

∙Inventory,theleastliquidofcurrentassets,isreportedinoneoftwodifferentwaysonthebalancesheet.

∙Firstin,firstout,orFIFO,referstothepracticeofrecognizingasaleasbeingmadeupofinventorythatwaspurchasedearlierandhavingthelowestcost.

∙Lastin,lastout,orLIFO,callsforthefirmtoattributeanysalemadetothemostrecentlyacquiredandmostexpensiveinventory.

∙FIFOreportingleadstohighercurrentassetvalueandhighernetincome.

∙Firmsmayswitchfromonetoanotheronlyunderextraordinarycircumstancesandnotfrequently.

E.Long-TermAssets

∙Thesearetherealassetsthatthefirmacquirestoproduceitsproductsandgeneratecashflows.Theseincludeland,buildings,plant,andequipment.

∙Intangibleassets,suchasgoodwill,patents,andcopyrights,arealsolistedhere.

∙Alllong-termrealassetsaredepreciated,whileintangibleassetsareamortized.Depreciatingassetsallowsafirmtolowertaxableincomeandreducetaxes.

∙Firmsareallowedtodepreciateassetsusingthestraight-linemethodoranaccelerateddepreciationmethodthatisallowedbytheIRS.

F.Long-TermLiabilities

∙Theseconsistofthelong-termdebtofthecompany.

∙Theyincludebankloans,mortgages,andbondsthathaveamaturityofoneyearorlonger.

G.Equity

∙Therearetwosourcesofequityfunds—commonequityandpreferredequity.

∙Commonequityrepresentsthetrueownershipofthefirm.

∙Multipleaccountsidentifythevarioussourcesofequityfunds—parvalue,additionalpaid-incapital,retainedearnings,andtreasurystock.

∙Parvalueandpaid-incapitalrepresenttheoutsideequitycapitalraisedbythefirmbyissuingshares.

∙Retainedearningsresultfromthefundsthatthefirmhasreinvestedinthefirmfromitsearnings.Thesefundsarenotcashsincetheyalreadyhavebeenputtowork.

∙Thetreasurystockaccountreflectsthevalueofthesharesthatthefirmrepurchasedfrominvestors.

∙Theothersourceofequitycapitalispreferredstock.Ithasfeaturesthatmakeitacombinationofafixedincomesecurityandanequitysecurity.

3.3MarketValueversusBookValue

Traditionally,allassetsarereportedattheirhistoricalcost.

∙Thebalancesheetdoesnotreflectthecurrentmarketvalueoftheassets,onlytheiracquiredcost.

∙Adoptingamarkingtomarketapproach—thatis,reportingassetsattheircurrentmarketvalue—providesbetterinformationtomanagementandinvestors.

∙Downsideisthedifficultyinestimatingmarketvaluesofassets.

∙Whenboththeliabilitiesandassetsofafirmarereportedattheircurrentmarketvalue,theirdifferencerepresentsthetruemarketvalueofshareholders’equity.

3.4TheIncomeStatementandtheStatementofRetainedEarnings

A.TheIncomeStatement

∙Theprofitabilityofafirmforanyreportingperiodismeasuredinthefinancialstatement.ThebasicidentityisshowninEquation3.3.

∙Revenuesrepresentthevalueoftheproductsandservicessoldbythefirm,andtheyincludebothcashandcreditsales.

∙Expensesrangefromthecostofproducinggoodsforsaleandassetutilizationcostssuchasdepreciationoramortization.

∙Netincomeisthedifferencebetweenthefirm’srevenuesandexpenses.

B.Depreciation,Amortization,andOtherIncomeStatementAccounts

∙Depreciationisthewritingoffofthecostofanyphysicalassetlikeplantormachineryoveritslifetime.Thisisanoncashexpense.

∙Depreciationexpensereducesafirm’staxableincomeaswellasthefirm’staxes,whileincreasingthecashflowavailabletoshareholders.

∙Firmscanuseoneoftwomethodsofdepreciatinganasset:

thestraight-linemethodandtheaccelerateddepreciationmethod.Firmsareallowedtouseoneapproachforinternalpurposesandanotherfortaxpurposes.

∙Firmsprefertheaccelerateddepreciationmethodfortaxpurposesbecauseitallowsthefirmtowriteofflargeramountsofthecostofanassetoverashorterperiod.

∙Amortizationexpensesarerelatedtothewritingoffofthevalueofintangibleassetslikegoodwill,patents,andlicenses.Itisalsoanoncashexpenselikedepreciation.

∙Nonrecurringexpensesareassociatedwiththeclosingdownofunprofitableoperationsortherestructuringofafirm’soperations.

∙Extraordinaryitemsrefertoincomeorexpensesassociatedwitheventsthatarenotexpectedtohappenonaregularbasis.

C.Bottom-LineAccounts

∙Thefirstbottom-lineincomefigurethatwouldbeofinteresttoshareholdersandcreditorsisearningsbeforeinterest,taxes,depreciation,andamortization（EBITDA）,whichistheearningsgeneratedfromoperationspriortotherecognitionofexpensesnotdirectlyconnectedtotheproductionoftheproducts.

∙Afternettingouttheexpensesrelatedtodepreciationandamortization,wearriveatearningsbeforeinterestandtaxes（EBIT）.

∙Thenextimportantincomelineisearningsbeforetaxes（EBT）andrepresentsthetaxableincomefortheperiod.

∙Finally,subtractingtaxesfromEBTyieldsnetincome,ornetincomeaftertaxes.Thisamounttellsustheamountavailabletomanagementtopaydividends,payoffdebt,orreinvestinthefirm.

D.TheStatementofRetainedEarnings

∙Thisfinancialstatementshowsthechangesinthisaccountfromoneperiodtothenext.

∙Thisaccountwillshowchangeswheneverafirmreportsalossorprofitandwhenacashdividendisdeclared.

3.5CashFlows

A.NetIncomeversusCashFlows

∙Whileaccountantsfocusonnetincome,shareholdersaremoreinterestedinnetcashflows.

∙Netincomeandcashflowsarenotthesamebecauseofthepresenceofnoncashrevenuesandexpenses.

∙Equation3.4showshowwecanderivethenetcashflowsfromoperatingactivities（NCFOA）fromnetincome.AsimplifiedversionofEquation3.4isusedwhentheonlysignificantnoncas