Chapter 2:

Financial statements,
cash flow, and taxes

Financial management

Learning Objectives
➢ List each of the key financial statements and identify the
kinds of information they provide to corporate managers and
investors.
➢ Estimate a firm’s free cash flow and explain why free cash
flow has such an important effect on firm value.

2 Faculty of Finance & Banking

2

1
 Contents
1. Financial Statements and Reports

2. Balance sheet

3. Income statement

4. Statement of cash flows

5. Statement of Stockholders’ Equity

6. Free cash flow

7. MVA and EVA

3 Faculty of Finance & Banking

3

1. Financial Statements and Reports

2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA

Financial management

2
 1. Financial Statements and Reports
Annual Report is a report issued annually by a corporation to
its stockholders.

5 Faculty of Finance & Banking

5

1. Financial Statements and Reports

Annual Report contains two types of information:

1. Verbal section (letter from the chairperson)

2. Four basic financial statements

• The balance sheet

• The income statement

• The statement of cash flows

• The statement of stockholders’ equity

6 Faculty of Finance & Banking

6

3
 1. Financial Statements and Reports

2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA

Financial management

2. Balance sheet
A statement of a firm’s financial position at a specific point in
time.

8 Faculty of Finance & Banking

8

4
 2. Balance sheet
A Typical Balance Sheet

9 Faculty of Finance & Banking

9

2. Balance sheet

10 Faculty of Finance & Banking

10

5
 2. Balance sheet

11 Faculty of Finance & Banking

11

2. Balance sheet
Several additional points about the balance sheet should be noted:

1. Cash versus other assets

Only the cash and equivalents = actual spendable money

Accounts receivable = credit sales that have not yet been collected

Inventories = cost of raw materials + work in process + finished goods

Net fixed assets = the cost of the buildings and equipment used in
operations – the depreciation

12 Faculty of Finance & Banking

12

6
 2. Balance sheet
2. Net Working Capital = Current assets – Current liabilities

Net Operating Working Capital (NOWC)

NOWC = Operating current assets – Operating current liabilities

Operating current assets = Current assets – Excess cash

Operating current liabilities = Current liabilities – Interest-bearing

liabilities

13 Faculty of Finance & Banking

13

2. Balance sheet
3. Total debt versus total liabilities

Total debt = Short-term + Long-term interest-bearing liabilities

Total liabilities = Total debt + Non-interest-bearing liabilities

14 Faculty of Finance & Banking

14

7
 2. Balance sheet
4. Other sources of funds

Some companies also use “hybrid” securities such as preferred

stock, convertible bonds, and long-term leases.

15 Faculty of Finance & Banking

15

2. Balance sheet
5. Depreciation

Firms often use

▪ accelerated depreciation for tax purposes

▪ straight-line depreciation for stockholder reporting

16 Faculty of Finance & Banking

16

8
 2. Balance sheet
6. Market values versus book values

The accounting numbers (book values) are different from what

the assets would sell for (market values).

17 Faculty of Finance & Banking

17

1. Financial Statements and Reports

2. Balance sheet

3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA

Financial management

18

9
 3. Income statement
Reports summarizing a firm’s revenues, expenses, and profits
during a reporting period (a quarter or a year).

19 Faculty of Finance & Banking

19

3. Income statement

20 Faculty of Finance & Banking

20

10
 3. Income statement

21 Faculty of Finance & Banking

21

3. Income statement
Operating Income (EBIT) is derived from the firm’s regular
core business.

It is calculated before deducting non-operating costs (interest

expenses and taxes).

22 Faculty of Finance & Banking

22

11
 3. Income statement
Depreciation

The charge to reflect the cost of assets depleted in the production

process. Depreciation is not a cash outlay.

Amortization

A noncash charge similar to depreciation except that it represents a

decline in value of intangible assets (patents, copyrights, trademarks,
and goodwill).

23 Faculty of Finance & Banking

23

3. Income statement
Depreciation and amortization are not cash expenses.

→ Managers, security analysts, and bank loan officers who are

concerned with the amount of cash a company is generating
often calculate EBITDA (Earnings Before Interest, Taxes,
Depreciation, and Amortization).

EBITDA = EBIT + Depreciation and Amortization

24 Faculty of Finance & Banking

24

12
 1. Financial Statements and Reports
2. Balance sheet
3. Income statement

4. Statement of cash flows

5. Statement of Stockholders’ Equity
6. Free cash flow
7. MVA and EVA

Financial management

25

4. Statement of cash flows

Shows how much cash the firm is generating.

26 Faculty of Finance & Banking

26

13
 4. Statement of cash flows
Three components of cash flows:
1. Cash flow from operating activities (CFO) indicates the amount of money
a company brings in from its ongoing, regular business activities
(manufacturing and selling goods or providing a service).
2. Cash flow from investing activities are any cash flows from the acquisition
and disposal of long-term assets and other investments not included in cash
equivalents.
3. Cash flow from financing activities are any cash flows that result in
changes in the size and composition of the contributed equity capital or
borrowings (bonds, stock, dividends).
27 Faculty of Finance & Banking
27

4. Statement of cash flows

28 Faculty of Finance & Banking

28

14
 4. Statement of cash flows
Allied Food Products: Statement of Cash Flows for 2018 (Millions of Dollars)

29 Faculty of Finance & Banking

29

4. Statement of cash flows

Allied Food Products: Statement of Cash Flows for 2018 (Millions of Dollars)

30 Faculty of Finance & Banking

30

15
 1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows

5. Statement of Stockholders’ Equity

6. Free cash flow
7. MVA and EVA

Financial management

31

5. Statement of Stockholders’ Equity

A statement that shows by how much a firm’s equity changed
during the year and why this change occurred.

32 Faculty of Finance & Banking

32

16
 5. Statement of Stockholders’ Equity

33 Faculty of Finance & Banking

33

1. Financial Statements and Reports

2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity

6. Free cash flow

7. MVA and EVA

Financial management

34

17
 6. Free cash flow
Free Cash Flow (FCF) is the amount of cash that could be withdrawn without
harming a firm’s ability to operate and to produce future cash flows.

35 Faculty of Finance & Banking

35

6. Free cash flow

FCF > 0: the firm is generating more than enough cash to
finance current investments in fixed assets and working capital

FCF < 0: the firm does not have sufficient internal funds to
finance investments in fixed assets and working capital

Is negative FCF always a bad sign?

36 Faculty of Finance & Banking

36

18
 1. Financial Statements and Reports
2. Balance sheet
3. Income statement
4. Statement of cash flows
5. Statement of Stockholders’ Equity
6. Free cash flow

7. MVA and EVA

Financial management

37

7. MVA and EVA

Market Value Added (MVA)

The excess of the market value of equity over its book value.

MVA = Market value of equity – Book value of equity

Market value of equity = Stock price x Number of shares

outstanding

38 Faculty of Finance & Banking

38

19
 7. MVA and EVA
Economic Value Added (EVA)

Excess of NOPAT over capital costs.

39 Faculty of Finance & Banking

39

End of Chapter 2

Financial management

40

20