Finance 2000 1 Jessica Gahtan
The balance sheet is a financial statement that shows the value of the firm’s assets and liabilities
at a particular date. Current assets are likely to be used or turned into cash in the near future.
Long-term assets include tangible capital assets or fixed assets such as buildings, equipment,
etc., and investments in associated companies, showing the ownership interest in another
business. There is also goodwill and other intangibles . On the other side of the balance sheet
there are liabilities, and what is left over after liabilities have been paid is shareholders’ equity.
Shareholders’ equity = Total assets – Total liabilities
Book value vs. Market value : Generally accepted accounting principles (GAAP):
procedures for preparing financial statements. Book value: net worth of the firm according to the
balance sheet. This is based on historical cost. The market values of assets and liabilities do not
equal their book values. Book values are based on historical or origina l values. Market values
measure current values of assets and liabilities. The difference between book and market value is
likely to be greatest for shareholders’ equity, since the stock price fluctuates all the time. You can
think of a firm in terms of a “market-value balance sheet.” The market -value balance sheet is
forward looking. It depends on the benefits that investors expect the assets to provide. The
difference between the market values of assets and liabilities is the market value of the
shareholders’ equity claim. The stock price is simply the marke t value of the shareholders’ equity
divided by the number of outstanding shares. You will usually find that shares of stock sell for
more than the book value.
The income statement is a financial statement that shows the revenues, expenses, and net
income of a firm over a period of time.
Three reasons why profits differ from cash flow:
1. To calculate the cash produced by the business it is necessary to add back the depreciation
charge (which is not a cash payment) and to subtract the expenditure on new capital equipment
(which is a cash payment).
2. The cash that the company receives is equal to the sales shown in the income statement less
the increase in unpaid bills (accounts receivable).
3. The cash outflow is equal to the cost of goods sold, which is shown in the income statement,
plus the change in inventories.
Statement of cash flows
Cash flow differs from profits because of depreciation of capital expenditures and accru al
accounting. The statement of cash flows shows the firm’s cash inflows and outflows from
operations as well as from its investment and financing activities.
The first section, operating activities, starts with net income and then adjusts that fifor the
parts of the income statement that don’t affect cash flows. Depreciation is added back, and
adjustments are made for any other non -cash items such as future taxes and accounting gains or
losses on the sale of fixed assets. Any additions to curren t assets or liabilities need to be Finance 2000 2 Jessica Gahtan
subtracted or added from net earnings, as they absorb cash but do not appear in the income
statement. Cash flow provided by operating activities = Net earnings + depreciation + cash from
other income statement adjustments + cash from non -cash working capital
The second section, investing activities, includes purchases of new capital and investments in
other businesses. Cash flow from assets (free cash flow) = cash provided by operating activities
+ cash flow from investments. Free cash flow is the cash flow generated by the firm’s operations,
after investment in working capital and fixed assets. It’s the first two parts of the CF statement.
The third section shows the details of the financing activities during the yea r. It includes debt
payments and new debt, selling of stock, and dividend payments. Increase (decrease) in cash in
the bank = cash flow from assets + cash flow from financing activities
Cash flow from assets, financing flow, and free cash flow
The fundamental cash flow identity is: Cash flow from assets = Cash flow from financing activities
+ Increase (decrease) in cash in the bank. Often called “free cash flow” because the cash flow
from assets is the cash available to pay out to its bondholders and sh areholders. Financing flow:
cash flow to bondholders and shareholders plus increases in cash balances;