Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows

 Chapter Overview

This chapter focuses on accounting and financial statements. Understanding the financial health of a business by reviewing its financial statements is an important function of financial management. The accounting and regulatory authorities mandate the following four types of financial statements: income statement, balance sheet, cash flow statement, and statement of shareholders’ equity.

Financial statement analysis is important for a number of reasons. First, the study of these accounting statements aids in assessing the financial condition of a business. Second, financial statements are a tool for managers to use in monitoring and controlling the firm’s operations. Third, financial planning and forecasting often is done through the medium of financial statements.

 Chapter Outline

3.1 An Overview of the Firm’s Financial Statements

A. The four basic financial statements are: income statement, balance sheet, cash flow statement, and statement of shareholders’ equity.

B. Accountants use three fundamental principles when preparing a firm’s financial statements:1. The revenue recognition principle2. The matching principle3. The historical cost principle

3.2 The Income Statement

A. The income statement can be expressed as: Revenue Expenses Profits.

B. The income statement recognizes both cash and noncash expenses.

C. Firms must adhere to GAAP in constructing the income statement.

D. Corporate executives have an incentive to manage the firm’s earnings through earnings management.

3.3 Corporate Taxes

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9  Titman/Keown/Martin  Financial Management, Eleventh Edition

3.4 The Balance Sheet

A. The balance sheet is defined as: Total Assets Total Liabilities Total Shareholders’ Equity.

B. Total liabilities represent the total amount of money the firm owes to creditors.

C. Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.

D. The balance sheet reflects the book value of the firm’s assets. This is usually not equal to the market value of the firm’s assets.

E. Assets: The lefthand side of the balance sheet shows what the firm owns.a. Total assets current assets fixed assets

F. Sources of Financing: The righthand side of the balance sheet shows where the funds came from to purchase assets.a. Liabilities accounts payable notes payable long-term debtb. Stockholders’ equity par value paid-in capital retained earnings

G. Net working capital is a measure of the firm’s liquidity.a. Working capital current assets current liabilities

3.5 The Cash Flow Statement

A. Change in Cash Balance Ending Cash Balance Beginning Cash Balance.

B. A source of cash is any activity that brings cash into the firm.

C. A use of cash in any activity that causes cash to leave the firm.

D. Sources and uses of cash are classified into three broad categories: operating activities, investment activities, and financing activities.

 Learning Objectives

3-1. Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager.

3-2. Evaluate firm profitability using the income statement.

3-3. Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.

3-4. Use the balance sheet to describe a firm’s investments in assets and the way it has financed them.

3-5. Identify the sources and uses of cash flow for a firm using the firm’s cash flow statement.

 Lecture Tips

1. Have the students complete the Business of Life: Your Personal Balance Sheet and Income Statement. Use this as an introduction to the discussion of financial statements.

2. Describe some of the alternatives to GAAP.

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Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows  10

 Questions for Further Class Discussion

1. What is the significance of a positive net working capital? Of a negative net working capital? Of a zero net working capital?

2. Discuss the ways in which managers can “manage the firm’s earnings.” Should earnings management always be viewed negatively?

 End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

Simple Average Complex

1, 2, 3, 9, 10 4, 5, 7, 8, 11, 12 6, 13, 14, 15

 Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative.Problems: 3-1—3-2, 3-4—3-15

 Internet Resources

http://finance.yahoo.comhttp://money.cnn.comhttp://www.smartmoney.comwww.fool.comwww.google.com/finance

©2011 Pearson Education, Inc. Publishing as Prentice Hall