BUAD-6200 || Corporate Finance || Chapter 2

University of Toledo || College of Business and Innovation

BUAD-6200: Corporate Finance

Lecture- (Chapter-02)
Accounting Statements and Cash Flow

1
1

Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Taxes
2.4 Net Working Capital
2.5 Financial Cash Flow
2.6 The Accounting Statement of Cash Flows

BUAD-6200 || Corporate Finance || Chapter 2

University of Toledo || College of Business and Innovation

Key Concepts and Skills

Understand the information provided by financial

2
2

statements
Differentiate between book and market values
Know the difference between average and marginal tax
rates
Know the difference between accounting income and
cash flow
Calculate a firms cash flow

BUAD-6200 || Corporate Finance || Chapter 2

University of Toledo || College of Business and Innovation

2.1 The Balance Sheet

An accountants snapshot of the firms

accounting value as of a particular date.

The Balance Sheet Identity is:

Assets Liabilities + Stockholders Equity

When analyzing a balance sheet, the financial

manager should be aware of three concerns:

accounting liquidity, debt versus equity, and
value versus cost.

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3

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

The Balance Sheet of the U.S. Composite

Corporation
U.S. Composite Corporation
Balance Sheet 20X2 and 20X1 (in $ millions)

Assets

20X2

20X1

Current assets
Cash and equivalents

$107

Accounts receivable

294

270

Notes payable

Inventories

269

280

Accrued expenses

58

50

$761

$707

Total current assets

Fixed assets
Property, plant, and
equipment
Less accumulated
depreciation
Net property, plant, and
equipment
Intangible assets and other
Total fixed assets

20X
2

20X1

$213

$197

50

53

223

205

$48
6

$455

$117

$104

471

485

$58
8

$562

$39

$39

55

32

347

327

Current Liabilities
$140

Other

4
4

Liabilities (Debts) and

Stockholders Equity

Accounts payable

Total current liabilities

Long-term Liabilities
Deferred taxes

$1,42
3

$1,274

Long-term debt

-550

-460

873

814

Stockholders equity

245

221

Preferred stock

$1,11
8

$1,035

Total long-term liabilities

Common stock ($1 per value)

Capital surplus

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

The Balance Sheet of the U.S. Composite

Corporation
U.S. Composite Corporation
Balance Sheet 20X2 and 20X1 (in $ millions)
Assets

20X2

20X1

$140

$107

Accounts receivable

294

270

Inventories

269

280

58

50

$761

$707

Current assets
Cash and equivalents

Other
Total current assets
Fixed assets
Property, plant, and
equipment

$1,423

$1,274

-550

-460

Net property, plant, and

equipment

873

814

Intangible assets and

other

245

221

Total fixed assets

$1,118

$1,035

Less accumulated
depreciation

5
5

The assets are listed

in order by the length
of time it normally
would take a firm with
ongoing operations to
convert them into
cash.
Clearly, cash is much
more liquid than
property, plant and
equipment.

BUAD-6200 || Corporate Finance || Chapter 2

University of Toledo || College of Business and Innovation

Balance Sheet Analysis

When analyzing a balance sheet, the financial

manager should be aware of three concerns:

Accounting liquidity
Debt versus equity
Value versus cost

6
6

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

1. Accounting Liquidity
Refers to the ease and quickness 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.
[which implies lower probability of financial distress. Later
on we will see the negative consequences of
financial distress]

Liquid assets frequently have lower rates of return than

fixed assets.

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7

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

2. 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.

3. Value versus Cost

Under GAAP audited financial statements of firms in the

U.S. carry assets at cost.

Market value is a completely different concept. [However,
in finance, what matters the most is the market value!]

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8

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

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

9
9

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

U.S.C.C. Income Statement

U.S. Composite Corporation
Income Statement 20X2 (in $ millions)
The operations section of
the income statement
reports the firms
revenues and expenses
from principal operations

Total operating revenues

$2,262

Cost of goods sold

-1,655

Selling, general, and administrative

expenses
Depreciation

-327
-90

Operating income

$190

Other income

29

Earnings before interest and

taxes
Interest expense

$219
-49

Pretax income

$170

Taxes

-84

Current: $71
Deferred: $13
Net income
10
10

Balance
Sheet

Retained earnings
Income
Financial
Statement
Cash
Flow
Dividends

$86
Accounting
Statement

$43
$43

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

U.S.C.C. Income Statement

U.S. Composite Corporation
Income Statement 20X2 (in $ millions)
Total operating revenues

$2,262

Cost of goods sold

-1,655

Selling, general, and administrative

expenses
Depreciation

-90

Operating income

The non-operating section

of the income statement
includes all financing
costs, such as interest
expense.

-327

$190

Other income

29

Earnings before interest and

taxes
Interest expense

$219
-49

Pretax income

$170

Taxes

-84

Current: $71
Deferred: $13
Net income
11
11

Balance
Sheet

Retained earnings
Income
Financial
Dividends Cash Flow
Statement

$86
Accounting
Statement

$43
$43

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

U.S.C.C. Income Statement

U.S. Composite Corporation
Income Statement 20X2 (in $ millions)
Total operating revenues

$2,262

Cost of goods sold

-1,655

Selling, general, and administrative

expenses
Depreciation

-90

Operating income

$190

Other income

29

Earnings before interest and

taxes

Usually a separate section

reports as a separate
item the amount of taxes
levied on income

-327

Interest expense

$219
-49

Pretax income

$170

Taxes

-84

Current: $71
Deferred: $13
Net income

12
12

Balance
Sheet

Retained earnings
Income
Financial
Dividends Cash Flow
Statement

$86
Accounting
Statement

$43
$43

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

U.S.C.C. Income Statement

U.S. Composite Corporation
Income Statement 20X2 (in $ millions)
Total operating revenues

$2,262

Cost of goods sold

-1,655

Selling, general, and administrative

expenses
Depreciation

-327
-90

Operating income

$190

Other income

29

Earnings before interest and

taxes
Interest expense

$219
-49

Net income is the bottom

Pretax income
line.

$170

Taxes

-84

Current: $71
Deferred: $13
Net income
13
13

Balance
Sheet

IncomeRetained earnings
Financial
Statement
Cash Flow
Dividends

$86
Accounting
Statement

$43
$43

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

Income Statement Analysis

There are three things to keep in mind when

analyzing an income statement:

GAAP
Non Cash Items
Time and Costs

1.

GAAP(Generally Accepted Accounting

Principals)

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

14
14

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

BUAD-6200 || Corporate Finance || Chapter 2

University of Toledo || College of Business and Innovation

Income Statement Analysis

2. Non Cash Items
Depreciation is the most apparent. No firm ever writes a check
for depreciation.
(NOTE: Although depreciation is related to non-cash item associated with
tangible assets, the other important non-cash item is the amortization
associated with intangible assets such as patents etc.)

Another noncash item is deferred taxes, which does not

represent a cash flow.

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 labor and raw materials.
In the long run, all inputs of production (and hence costs) are
variable.
Balance
Income
Financial
Accounting
15
15
Sheet
Statement
Cash
Flow
Statement
Financial accountants do not distinguish between
variable

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

2.3 Taxes
The one thing we can rely on with taxes is

that they are always changing

Marginal vs. average tax rates
Marginal the percentage paid on the next dollar

earned
Average the tax bill / taxable income

Other taxes

16
16

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

Marginal versus Average Rates

Suppose your firm earns $4 million in taxable

income.

What is the firms tax liability?

What is the average tax rate?
What is the marginal tax rate?

If you are considering a project that will

increase the firms taxable income by $1

million, what tax rate should you use in your
analysis?

17
17

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

2.4 Net Working Capital

Net Working Capital Current Assets Current
Liabilities
NWC is usually growing with the firm.
Be advised: You need to be quite comfortable with net

working capital concept because later on in NPV

analysis you will need to use it extensively.

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18

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD-6200 || Corporate Finance || Chapter 2

The Balance Sheet of the U.S.C.C.

(Numbers are from Table 2.1, text, p. 22)

U.S. Composite Corporation

Balance Sheet 20X2 and 20X1 (in $ millions)
Assets

20X2

20X1

Current assets

20X2

20X1

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

$275m=$761m-$486m
19
19

Liabilities (Debt)
and
Stockholders
Equity

$252m=$707m-$455m

Here we see NWC grow to $275 million in 20X2 from 252 million in 20X1
Balance
Income
Financial
Accounting
($23 million).
Sheet
Statement
Cash Flow
Statement
The increase of $23 million is an investment of the firm (This is a cash

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

2.5 Financial Cash Flow

(This section is important for Chapter-6 and the Case!)

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)
To understand this better, we can use the Balance Sheet
20
20

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Financial Cash Flow of the U.S.C.C.

U.S. Composite Corporation
Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm

Operating Cash Flow

Operating cash flow (Earnings before

interest and taxes plus depreciation
minus taxes)

$238

EBIT

Capital spending (Acquisitions of fixed

assets minus sales of fixed assets)

(173)

Depreciation

$90

Additions to net working capital

(23)

Current
Taxes

($71)

Total

$42

OCF

$238

Cash Flow of Investors in the

Firm
Debt (Interest plus retirement of debt
minus long-term debt financing)
Equity (Dividends plus repurchase of
equity minus new equity financing)
21
21

$219

Total

Balance
Sheet

Income
Statement

36
6
Financial$42
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Financial Cash Flow of the U.S.C.C.

U.S. Composite Corporation
Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm
Operating cash flow (Earnings before
interest and taxes plus depreciation
minus taxes)

$238

Capital spending (Acquisitions of fixed

assets minus sales of fixed assets)

(173)

Additions to net working capital

(23)

Total

$42

Capital
Spending
Purchase of fixed
assets

$198

Sales of fixed
assets

(25)
$173

Cash Flow of Investors in the

Firm
Debt (Interest plus retirement of debt
minus long-term debt financing)

22
22

Equity (Dividends plus repurchase of

equity minus new equity financing)
Income
Total Balance
Sheet
Statement

36
6
Financial
$42
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Financial Cash Flow of the U.S.C.C.

U.S. Composite Corporation
Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm
Operating cash flow (Earnings before
interest and taxes plus depreciation
minus taxes)

$238

Capital spending (Acquisitions of fixed

assets minus sales of fixed assets)

(173)

Additions to net working capital

Total

Cash Flow of Investors in the

Firm
Debt (Interest plus retirement of debt
minus long-term debt financing)
Equity (Dividends plus repurchase of
equity minus new equity financing)

$42 This increase of $23

million is the addition to
NWC.
36
6

$42

Total
23
23

NWC grew from $275

million in 20X2 from $252
(23) million in 20X1

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Financial Cash Flow of the U.S.C.C.

U.S. Composite Corporation
Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm
Operating cash flow (Earnings before
interest and taxes plus depreciation
minus taxes)

$238

Capital spending (Acquisitions of fixed

assets minus sales of fixed assets)

(173)

Additions to net working capital

(23)

Total

$42

Cash Flow of Investors in the

Firm
Debt (Interest plus retirement of debt
minus long-term debt financing)
Equity (Dividends plus repurchase of
equity minus new equity financing)

$42

Total
24
24

36

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Financial Cash Flow of the U.S.C.C.

U.S. Composite Corporation
Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm
Operating cash flow (Earnings before
interest and taxes plus depreciation
minus taxes)

$238

Capital spending (Acquisitions of fixed

assets minus sales of fixed assets)

(173)

Cash Flow to Creditors

Additions to net working capital

(23)

Total

$42

Cash Flow of Investors in the

Firm
Debt (Interest plus retirement of debt
minus long-term debt financing)
Equity (Dividends plus repurchase of
equity minus new equity financing)
Total
25
25

Balance
Sheet

Income
Statement

Interest
Retirement of
debt
Debt service
Proceeds from
new debt sales

36

Total

$42

Financial
Cash Flow

Accounting
Statement

$49
73

122
(86)
36

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Financial Cash Flow of the U.S.C.C.

U.S. Composite Corporation
Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm
Operating cash flow (Earnings before
interest and taxes plus depreciation
minus taxes)

$238

Capital spending (Acquisitions of fixed

assets minus sales of fixed assets)

(173)
(23)

Total

$42

Cash Flow of Investors in the

Firm

Equity (Dividends plus repurchase of

equity minus new equity financing)
Total
26
26

Dividends
Repurchase of stock

Additions to net working capital

Debt (Interest plus retirement of debt

minus long-term debt financing)

Cash Flow to
Stockholders

Cash to Stockholders
Proceeds from new
stock issue

36

Total

Income
Statement

Financial
Cash Flow

6
49
(43)
$6

$42
Balance
Sheet

$43

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Financial Cash Flow of the U.S.C.C.

U.S. Composite Corporation
Financial Cash Flow 20X2 (in $ millions)
Cash Flow of the Firm
Operating cash flow (Earnings before
interest and taxes plus depreciation
minus taxes)
Capital spending (Acquisitions of fixed
assets minus sales of fixed assets)
Additions to net working capital

Total

$238

The cash from received

(173) from the firms assets
must equal the cash
(23) flows to the firms
creditors and
stockholders:
$42

CF(A)

Cash Flow of Investors in the

Firm
Debt (Interest plus retirement of debt
minus long-term debt financing)

27
27

Equity (Dividends plus repurchase of

equity minus new equity financing)
Balance
Income
Total
Sheet
Statement

36

=CF(B)+CF(S)

6
Financial
$42
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

2.6 The Accounting Statement of Cash

Flows
There is an official accounting statement called the

statement of cash flows.

This helps explain the change in accounting cash, which
for U.S. Composite is $33 million in 20X2.
The three components of the statement of cash flows
are
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities

28
28

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

U.S.C.C. Cash Flow from Operating

Activities
U.S. Composite Corporation
Cash Flow from Operating Activities 20X2 (in $ millions)
Operations
To calculate cash flow
from operations, start
with net income, add
back noncash items like
depreciation and adjust
for changes in current
assets and liabilities
(other than cash)

Net Income

$86

Depreciation

90

Deferred Taxes

13

Changes in Assets and Liabilities

Accounts Receivable

(24)

Inventories

11

Accounts Payable

16

Accrued Expenses

18

Other

(8)

Total Cash Flow from

Operations
29
29

Balance
Sheet

Income
Statement

Financial
Cash Flow

$202
Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

U.S.C.C. Cash Flow from Operating

Activities
U.S. Composite Corporation
Cash Flow from Investing Activities 20X2 (in $ millions)
Cash flow from investing
activities involves changes in
capital assets: acquisition of
fixed assets and sales of
fixed assets (i.e. net capital
expenditures)

30
30

Balance
Sheet

Acquisition of fixed assets

Sales of Fixed assets

25

Total Cash Flow from Investing

Activities

Income
Statement

Financial
Cash Flow

$(198)

Accounting
Statement

$(173)

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

U.S.C.C. Cash Flow from Financing

Activities
U.S. Composite Corporation
Cash Flow from Financing Activities 20X2 (in $ millions)
Cash flows to and from
creditors and owners
include changes in equity
and debt

31
31

Balance
Sheet

Retirement of debt (includes notes)

(73)

Proceeds from long-term debt sales

86

Changes in notes payable

(3)

Dividends

(43)

Repurchase of stock

(6)

Proceeds from new stock issue

43

Total Cash Flow from Financing

$4

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

U.S.C.C. Statement of Cash Flow

The statement of
cash flows is the
addition of cash
flows from
operations cash
flows from investing
activities, and cash
flows from financing
activities

Operations
Net Income

$86

Depreciation

90

Deferred Taxes

13

Changes in Assets and Liabilities

Accounts Receivable

(24)

Inventories

11

Accounts Payable

16

Accrued Expenses

18

Other

(8)

Total Cash Flow from Operations

$202

Acquisition of fixed assets

$(198)

Sales of Fixed assets

25

Total Cash Flow from Investing Activities

$(173)

Financing Activities

32
32

Balance
Sheet

Retirement of debt (includes notes)

(73)

Proceeds from long-term debt sales

86

Changes in notes payable

Income
Dividends
Statement

Repurchase of stock

Financial
Cash Flow

Accounting
Statement

(3)
(43)
(6)

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Statement of Cash Flows versus Cash Flow

from the Firm
Since interest paid is deducted as an expense

when net income is calculated (and not

deducted under financing activities) there is a
difference between cash flow from operations
and total cash flow to the firmthe difference
is interest expense.

33
33

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement

University of Toledo || College of Business and Innovation

BUAD6200 || Corporate Finance || Chapter 2

Quick Quiz
What is the difference between book value and market

value? Which should we use for decision making

purposes?

What is the difference between accounting income and

cash flow? Which do we need to use when making

decisions?

What is the difference between average and marginal

tax rates? Which should we use when making financial

decisions?

How do we determine a firms cash flows? What are the

equations, and where do we find the information?

34
34

Balance
Sheet

Income
Statement

Financial
Cash Flow

Accounting
Statement