Lecture 2 - Financial Statements (Compatibility Mode)

9/17/2016
Financial Statements and Taxes

Key Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholders Equity
Federal Tax System

3-1
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The Annual Report
Balance sheet provides a snapshot of a firms

financial position at one point in time.
Income statement summarizes a firms revenues
and expenses over a given period of time.
Statement of cash flows reports the impact of a
firms activities on cash flows over a given period of
time.
Statement of stockholders equity shows how
much of the firms earnings were retained, rather
than paid out as dividends.
3-2
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The Balance Sheet

Total Assets = Total Liabilities +
Total Shareholders Equity
The Balance Sheet (cont.)
Total assets - resources owned by the firm.
Total shareholders equity - difference in the value

of the firms total assets and the firms total
liabilities.
Total liabilities - total amount of money the firm

owes its creditors
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Assets whose value is expected to decline over time

is reported as net asset which is equal to the
historical cost minus accumulated depreciation.
The Balance
Sheet (cont.)
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Current assets - firms cash plus other assets the firm

expects to convert to cash within 12 months or less,
Fixed assets are assets that the firm does not expect
to sell within one year.
Current liabilities - amount that the firm owes to

creditors; repaid within a period of 12 months or less
Long-term liabilities -debt with maturities longer

than a year
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The stockholders equity is broken down into two

components:
The amount the company received from selling stock to
investors.
Two Components:
Par value - stated or face value a firm puts on each share of
stock.
Paid in capital is the additional amount the firm raised when
it sold the shares.

For example, DLK corporations par value per share is
$2.00 and the firm has 30 million shares outstanding
What is the par value of the firms common equity?

If the stocks were issued to investors for $240 million,
what is the paid in capital?
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Retained earnings - portion of net income that has

been retained from prior years operations.
Stockholders Equity
= Par value of common stock + Paid in Capital +
Retained Earnings
Or:
Shareholders' equity = Total Assets Total Liabilities
Firm Liquidity and Net Working Capital
Liquidity - speed with which an the asset can be

converted to cash without loss of value.
For example, a firms bank account is perfectly liquid.
Net Working Capital = current assets current

liabilities
Note: an important indicator of firms ability to repay its
loans.
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Constructing a Balance Sheet

Construct a balance sheet for Gap, Inc. (GPS)
using the following list of jumbled accounts for
January 31, 2009. Identify the firms total assets
and net working capital:
Current Assets
4,005,000,000.00 Current Liabilities
2,158,000,000.00
Long-Term Liabilities
1,019,000,000.00
Total Liabilities
3,177,000,000.00
Long-Term
Assets
3,559,000,000.00 Common Equity
4,387,000,000.00
Total Assets
7,564,000,000.00 Total Liabilities and Equity
7,564,000,000.00
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Checkpoint 3.2: Check Yourself
Reconstruct the Gaps balance sheet to

reflect the repayment of $1 billion in
short-term debt using a like amount of
the firms cash. What is the balance for
total assets and current liabilities?
Step 1: Picture the Problem
The firms balance sheet can be expressed as follows:

Total Shareholders Equity +
Total Liabilities
= Total Assets
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Sample Balance Sheet

Current Assets
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets
Long-term (fixed) assets
Gross PPE
Less: Accumulated depreciation
Net property, plant and equip.
Other long-term assets
Total long-term assets
Total Assets
Current Liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Long-term Liabilities
Long-term debt
Owners Equity
Par value of common stock
Paid-in-capital
Retained earnings
Total equity
Total Liabilities and

Owners equity
Decide on a Solution Strategy
We are given the account balances so in order to

construct the balance sheet we need to substitute
the appropriate balances into the template shown
earlier.
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Solution:
Cash
Inventories
Other current
assets
756,000,000
1,506,000,000
743,000,000
Current liabilities
1,158,000,000
Total current
assets
3,005,000,000
Total current
liabilities
1,158,000,000
Net Property,
Plant and
equipment
2,993,000,000
Long-term
liabilities
1,019,000,000
Other long-term
assets
626,000,000
Common Equity
4,387,000,000
Total Assets
$6,564,000,000
Total Liabilities
and Equity
$6,564,000,000
Analysis of Balance Sheet
The total assets of
$6,564,000,000 is financed by a
combination of current liabilities, long-term liabilities
and owners equity.
The firm has a healthy net working capital
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Debt and Equity Financing
sources of money used to finance the purchase of

the firms assets
It shows how much was borrowed and how much

was provided by firms owners
Debt versus Equity
Payment
Seniority
Maturity
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Book Values and Market Values
Book values reported in the balance sheet can differ

from market values.
The gap between book value and market value is

likely to be higher for fixed assets relative to current
assets
Income Statement
3-24
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An Income Statement
profit and loss statement.
measures the amount of profits generated by a firm

over a given time period
Equation:
Revenues (or Sales) Expenses = Profits
An Income Statement (cont.)
Basic Elements:
Revenues
Expenses
Cost of goods sold, Interest expenses, SGA (selling, general and

administrative) expense, depreciation expense, Income tax
expense
Profits
Gross profit, net operating income (also known as EBIT),

earnings before taxes (EBT), and net income
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An Income Statement (cont.)
Sales
= Gross Profit
Minus Operating Expenses
Minus Cost of Goods Sold
Selling expenses
General and Administrative expenses
Depreciation and Amortization Expense
= Operating income (EBIT)

Minus Interest Expense
= Earnings before taxes (EBT)
Minus Income taxes
= Net income (EAT)
EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT =
Earnings after taxes
Sample Income Statement
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Evaluating a Firms EPS and Dividends (cont.)

EPS = Net income Number of shares outstanding
Example 1: A firm reports a net income $90 million and
has 35 million shares outstanding, what will be the
earnings per share (EPS)?
EPS = Net income Number of shares
= $90 million $35 million
= $2.57
Evaluating a Firms EPS and Dividends (cont.)

Dividends per share = Net income Number of shares
Example 2: A firm reports dividend payment of $20
million on its income statement and has 35 million
shares outstanding. What will be the dividends per
share?
Dividends per share = Net income Number of

shares
= $20 million $35 million
= $0.57
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Connecting the Income Statement and the

Balance Sheet
What can the firm do with the net income?:
Pay dividends to shareholders, and/or

Reinvest in the firm
Connecting the Income Statement and the

Balance Sheet (cont.)
How much was retained or reinvested by the firm?

Amount retained = Net Income Dividends
= $90m - $20m = $70m
What will happen to the $70m?
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Interpreting Firm Profitability using the Income

Statement
What can we learn from H.J. Boswell Inc.s income

statement (Table 3-1)?

Statement (cont.)
The gross profit margin (GPM)
= gross profits sales
= $675 million $2,700 million
= 25%
mark-up on its cost of goods sold per dollar of sales.
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Statement (cont.)
The operating profit margin
= net operating income sales
= $382.5 million $2,700 million
= 14.17%
ratio of net operating income or EBIT divided by firms sales.

Statement (cont.)
Net profit margin:
= net profits sales
= $204.75 million $2,700 million
= 7.58%
percentage of revenues left after all expenses have been
considered.
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Statement (cont.)
What will the company do with these profit margins?
Constructing an I/S
Constructing an Income Statement
Use the following information to construct an income statement for Gap, Inc.
(GPS). The Gap is a specialty retailing company that sells clothing, accessories,
and personal care products under the Gap, Old Navy, Banana Republic,
Piperlime, and Athleta brand names. Use the scrambled information below to
calculate the firms gross profits, operating income, and net income for the year
ended January 31, 2009. Calculate the firms earnings per share and dividends
per share.
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Checkpoint 3.1: Check Yourself
Reconstruct the Gaps income statement

assuming the firm is able to cut its cost of goods
sold by 10% and where the firm pays taxes at
40% tax rate. What is the firms net income and
earnings per share?
Income Statement Format

Revenues
Less: Cost of goods sold

Less: Operating expenses
Equals Gross
profit
Equals: net
Operating income
Less: Interest expense

Equals: earnings
Before taxes
Less: Income taxes

Equals:
NET INCOME
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Construct the I/S
Revenues = $14,526,000,000
Less: Cost of goods sold
= $8,171,100,000
Less: Operating expenses

=$3,899,000,000
Equals: profit
=$6,354,900,000
Equals: net
Operating income
=$2,455,900,000
Less: Interest expense

=$1,000,000
Less: Income taxes (40%)

=$9,819,600,000
Equals: earnings
Before taxes
=$2,454,900,000
Equals:
NET INCOME
=$1,472,940,000
Earnings and Dividends Computations
Earnings per share:

= net income number of shares
= $1,472,940,000 716,296,296
= $2.06
Dividends per share

= dividends number of shares
= $243,000,000 716,296,296 = $0.34
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Analysis of Income Statement
Is the firm profitable?

Did the shareholders earn from their investments in
the company?
Taxes
3-44
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Federal Income Tax System
Individual Taxes
Corporate Taxes
3-45
Corporate and Personal Taxes
Individuals
Rates begin at 10% and rise to 35% for individuals

with income over $373,650.
May be subject to state tax.
3-46
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Corporate Taxes
A firms income tax liability is calculated using its

taxable income and the tax rates on corporate
income.
See the table on next slide for corporate tax rates.
Corporate tax rates
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Marginal and Average Tax Rates
Marginal tax rate is the tax rate that the company

will pay on its next dollar of taxable income.
Average tax rate is total taxes paid divided by the

taxable income.
Example 3: What is the average and marginal tax

liability for a firm reporting $100,000 as taxable
income.
Taxable
Income
Marginal
tax rate
Incrementa Cumulativ
l Tax
e Tax
Liability
Liability
Average
Tax Rate
$50,000
15%
7,500
7,500
15.00%
$75,000
25%
6,250
13,750
18.33%
$100,000
34%
8,500
22,250
22.25%
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Average tax rate
= Total tax liability Total taxable income

= $22,250 $100,000
= 22.25%
Marginal tax rate
= 39% as the firm will have to pay 39% on its next

dollar of taxable income i.e. if its taxable income
increases from $100,000 to $100,001.
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Lecture 2 - Financial Statements (Compatibility Mode)

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9/17/2016

Financial Statements and Taxes

Federal Tax System

The Annual Report

Balance sheet provides a snapshot of a firms

The Balance Sheet

The Balance Sheet (cont.)

Total assets - resources owned by the firm.

Total shareholders equity - difference in the value

Total liabilities - total amount of money the firm

The Balance Sheet (cont.)

Assets whose value is expected to decline over time

The Balance Sheet (cont.)

Current assets - firms cash plus other assets the firm

The Balance Sheet (cont.)

Current liabilities - amount that the firm owes to

Long-term liabilities -debt with maturities longer

The Balance Sheet (cont.)

The stockholders equity is broken down into two

The Balance Sheet (cont.)

What is the par value of the firms common equity?

The Balance Sheet (cont.)

Retained earnings - portion of net income that has

Shareholders' equity = Total Assets Total Liabilities

Firm Liquidity and Net Working Capital

Liquidity - speed with which an the asset can be

For example, a firms bank account is perfectly liquid.

Net Working Capital = current assets current

Constructing a Balance Sheet

4,005,000,000.00 Current Liabilities

3,559,000,000.00 Common Equity

7,564,000,000.00 Total Liabilities and Equity

Checkpoint 3.2: Check Yourself

Reconstruct the Gaps balance sheet to

Step 1: Picture the Problem

The firms balance sheet can be expressed as follows:

Sample Balance Sheet

Total Liabilities and

Decide on a Solution Strategy

We are given the account balances so in order to

Analysis of Balance Sheet

The total assets of

The firm has a healthy net working capital

Debt and Equity Financing

sources of money used to finance the purchase of

It shows how much was borrowed and how much

Debt versus Equity

Book Values and Market Values

Book values reported in the balance sheet can differ

The gap between book value and market value is

profit and loss statement.

measures the amount of profits generated by a firm

An Income Statement (cont.)

Cost of goods sold, Interest expenses, SGA (selling, general and

Gross profit, net operating income (also known as EBIT),

An Income Statement (cont.)

Minus Cost of Goods Sold

= Operating income (EBIT)

Sample Income Statement

Evaluating a Firms EPS and Dividends (cont.)

Evaluating a Firms EPS and Dividends (cont.)

Dividends per share = Net income Number of

Connecting the Income Statement and the