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Chapter 2

Chapter 2.docx

Course Code
FIN 300
Michael Inglis

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Chapter 2: Financial Statements: Cash Flow and Taxes
2.1 The Balance Sheet
Balance sheet F/S of accounting val on particular date, snapshot, summarize assets (owns), liabilities (owes), and
equity (diff b/ 2)
left side = right side
Assets = Liabilities + SH equity
in order of liquidity = length of time to convert to cash
ABC Comp
Balance Sheet
Dec 31, 2011
Current Assets
Cash xxx
A/R xxx
Inventory xxx
Total xxx
Fixed Assets
Net, PPE xxx
Total assets xxx
Liabilities and Owners’ Equity
Current Liabilities
A/P xxx
N/P xxx
Total xxx
Long term debt xxx
Owners’ Equity
Common shares xxx
R/E xxx
Total xxx
Total Liabilities and owners’ equity
Assets: The Left-hand Side
reflects line of business
Current asset life less than 1 yr
o convert cash w/in 1 yr
o inventory, A/R
Fixed/ Capital asset long life
o Tangible - truck
o Intangible patent
Liabilities and Owners’ Equity: The Right-hand Side
reflects use of debt
Current liabilities - life less than 1 yr / obligation paid w/in 1 yr
o listed b4 long term liabilities
o A/P
Long term Liability - debt not due w/in 1 yr
o sources for borrowing = bond and bondholders
SH equity - if firm were to sell all of its assets and use $ to pay off debt --> residual val = belong to SH
Net Working Capital
Net working capital = Current Assets - Current Liabilities
+ve = CA > CL = healthy firm

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speed and ease asset converted to cash
ease of conversion vs/ loss of val
high liquidity = converted w/out significant loss of val
illiquid asset - no quickly converted to cash w/out big price reduction
current assets --> order of liquidity = Cash, A/R, Inventory
Fixed assets = illiquid
liquidity is valuable
o more liquid business is = less likely to experience financial distress (difficulty paying debts and
buying assets)
o liquid assets = less profitable to hold
o trade off = advantages of liquidity vs. forgone potential profits
Debt vs. Equity
equity holders entitled to only residual val = $ left after creditors paid --> SH equity = Assets - Liabilities
financial leverage - uses of debt in firm's capital
o greater degree of financial leverage - more debt a firm has (% of assets)
o debt = lever <-- magnify gains and losses
o increases potential reward to SH and financial distress and business failure
Market value vs. Book value
GAAP - std which audited F/S prepared
book value/ historical cost - value on B/S, what the firm paid for asset
o used for reliability
o B/S listed at cost --> cant know the val of the firm
when asset mkt val significantly below book value --> accountant write down assets
huge write offs hand in hand with overstated profits b/c val of assets not exp properly
IFRS - simplify comparison of F/S in diff countries
o increase transparency of financial info --> move closer to mark-to-market accounting rules and
be more competitive in global mkt place
o mark-to-market accounting - accoutning rules using mkt val rather than book val of assets and
market value - val of asset/ firm now
2.2 The Income Statement
Income Statement - summarize performance over period of time
ABC Comp
Income Statement
Dec 31, 2011
Net Sales xxx
COGS xxx
Depreciation exp xxx
Earnings b4 interest and taxes xxx
Interest exp xxx
Income b4 taxes xxx
Tax exp xxx
Net Income xxx
Addition to retained earnings xxx
Dividends xxx
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