FOF IM CHAPTER 03 - 6th - CHAPTER 3 Understanding Financial...

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CHAPTER 3 Understanding Financial Statements and Cash Flows CHAPTER ORIENTATION In this chapter, we review the contents and meaning of a firm’s income statement and balance sheet. We also look very carefully at how to compute a firm’s cash flows from a finance perspective, rather than from an accountant’s view, which in finance speak is called free cash flows. CHAPTER OUTLINE I. Basic Financial Statements A. The Income Statement 1. The income statement reports the results from operating the business for a period of time, such as a year. 2. It is helpful to think of the income statement as comprising four types of activities: a. Selling the product. b. The cost of producing or acquiring the goods or services sold. c. The expenses incurred in marketing and distributing the product or service to the customer, along with administrative operating expenses. d. The financing costs of doing business, for example, interest paid to creditors and dividend payments to the preferred stockholders. 3. An example of an income statement is provided in Table 3-1 for the Starbucks Corporation. 46
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The Balance Sheet 1. The balance sheet provides a snapshot of the firm’s financial position at a specific point in time, presenting its asset holdings, liabilities, and owner- supplied capital. a. Assets represent the resources owned by the firm. 1. Current assets—consisting primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses. 2. Fixed or long-term assets—comprising equipment, buildings, and land. 3. Other assets—all assets not otherwise included in the firm’s current assets or fixed assets, such as patents, long- term investments in securities, and goodwill. b. The liabilities and owners’ equity indicate how those resources are financed. 1. The debt consists of such sources as credit extended from suppliers or a loan from a bank. 2. The equity includes the stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet. 2. The balance sheet is not intended to represent the current market value of the company but rather reports the historical transactions recorded at their cost. 3. Balance sheets for the Starbucks Corporation are presented in Table 3-2. C. Measuring Cash Flows 1. While an income statement measures a company’s profits, profits are not the same as cash flows; profits are calculated on an accrual basis rather than a cash basis. 2. In measuring cash flows, we could use the conventional accountant’s presentation called a statement of cash flows . However, we are more interested in considering cash flows from the perspective of the firm’s shareholders and its investors, rather than from an accounting view. We will instead measure the cash flow that is free and available to be distributed to the firm’s investor, both debt and equity investors, and what we will call free cash flows . We will then calculate the financing cash flows
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FOF IM CHAPTER 03 - 6th - CHAPTER 3 Understanding Financial...

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