Accounting Statements and Cash Flow

The basic accounting statements used for reporting corporate ac-tivity. The focus of the chapter is the practical details of cash flow. It will becomeobvious to you in the next several chapters that knowing how to determine cash flowhelps the financial manager make better decisions. Students who have had accountingcourses will not find the material new and can think of it as a review with an emphasis onfinance.


The balance sheet is an accountant’s snapshot of the firm’s accounting value on a particu-lar date, as though the firm stood momentarily still. The balance sheet has two sides: on theleft are the assets and on the right are the liabilities and stockholders’ equity. The balancesheet states what the firm owns and how it is financed. The accounting definition that un-derlies the balance sheet and describes the balance is
Assets = Liabilities + Stockholders’ equity

We have put a three-line equality in the balance equation to indicate that it must alwayshold, by definition. In fact, the stockholders’ equity is defined to be the difference betweenthe assets and the liabilities of the firm. In principle, equity is what the stockholders wouldhave remaining after the firm discharged its obligations。

Table 2.1 gives the 20X2 and 20X1 balance sheet for the fictitious U.S. CompositeCorporation. The assets in the balance sheet are listed in order by the length of time it nor-mally would take an ongoing firm to convert them to cash. The asset side depends on thenature of the business and how management chooses to conduct it. Management must makedecisions about cash versus marketable securities, credit versus cash sales, whether to makeor buy commodities, whether to lease or purchase items, the types of business in which toengage, and so on. The liabilities and the stockholders’ equity are listed in the order inwhich they must be paid.

The liabilities and stockholders’ equity side reflects the types and proportions of fi-nancing, which depend on management’s choice of capital structure, as between debt andequity and between current debt and long-term debt.

When analyzing a balance sheet, the financial manager should be aware of three con-cerns: accounting liquidity, debt versus equity, and value versus cost.

Accounting Liquidity

Accounting liquidity refers to the ease and quickness with which assets can be convertedto cash. Current assets are the most liquid and include cash and those assets that will beturned into cash within a year from the date of the balance sheet. Accounts receivable are amounts not yet collected from customers for goods or services sold to them (after ad-justment for potential bad debts). Inventory is composed of raw materials to be used in pro-duction, work in process, and finished goods. Fixed assets are the least liquid kind of as-sets. Tangible fixed assets include property, plant, and equipment. These assets do notconvert to cash from normal business activity, and they are not usually used to pay ex-penses, such as payroll.

Some fixed assets are not tangible. Intangible assets have no physical existence but canbe very valuable. Examples of intangible assets are the value of a trademark or the value ofa patent. The more liquid a firm’s assets, the less likely the firm is to experience problemsmeeting short-term obligations. Thus, the probability that a firm will avoid financial dis-tress can be linked to the firm’s liquidity. Unfortunately, liquid assets frequently have lowerrates of return than fixed assets; for example, cash generates no investment income. To theextent a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitableinvestment vehicles.

Debt versus Equity

Liabilities are obligations of the firm that require a payout of cash within a stipulated timeperiod. Many liabilities involve contractual obligations to repay a stated amount and inter-est over a period. Thus, liabilities are debts and are frequently associated with nominallyfixed cash burdens, called debt service, that put the firm in default of a contract if they arenot paid. Stockholders’ equity is a claim against the firm’s assets that is residual and notfixed. In general terms, when the firm borrows, it gives the bondholders first claim on thefirm’s cash flow.1Bondholders can sue the firm if the firm defaults on its bond contracts.This may lead the firm to declare itself bankrupt. Stockholders’ equity is the residual dif-ference between assets and liabilities:
Assets = Liabilities+Stockholders’ equity

This is the stockholders’ share in the firm stated in accounting terms. The accounting valueof stockholders’ equity increases when retained earnings are added. This occurs when thefirm retains part of its earnings instead of paying them out as dividends.

Value versus Cost

The accounting value of a firm’s assets is frequently referred to as the carrying value or thebook value of the assets.2Under generally accepted accounting principles (GAAP), au-dited financial statements of firms in the United States carry the assets at cost.3Thus theterms carrying value and book value are unfortunate. They specifically say “value,” whenin fact the accounting numbers are based on cost. This misleads many readers of financiastatements to think that the firm’s assets are recorded at true market values. Market value isthe price at which willing buyers and sellers trade the assets. It would be only a coincidenceif accounting value and market value were the same. In fact, management’s job is to createa value for the firm that is higher than its cost.

Many people use the balance sheet although the information each may wish to ex-tract is not the same. A banker may look at a balance sheet for evidence of accountingliquidity and working capital. A supplier may also note the size of accounts payable andtherefore the general promptness of payments. Many users of financial statements, in-cluding managers and investors, want to know the value of the firm, not its cost. This isnot found on the balance sheet. In fact, many of the true resources of the firm do not ap-pear on the balance sheet: good management, proprietary assets, favorable economic con-ditions, and so on.

• What is the balance-sheet equation?
• What three things should be kept in mind when looking at a balance sheet?

1、Bondholders are investors in the firm’s debt. They are creditors of the firm. In this discussion, the termbondholder means the same thing as creditor.
2、Confusion often arises because many financial accounting terms have the same meaning. This presents aproblem with jargon for the reader of financial statements. For example, the following terms usually refer to thesame thing: assets minus liabilities, net worth, stockholders’ equity, owner’s equity, and equity capitalization.
3、Formally, GAAP requires assets to be carried at the lower of cost or market value. In most instances cost islower than market value.


The income statement measures performance over a specific period of time, say, a year.The accounting definition of income is

If the balance sheet is like a snapshot, the income statement is like a video recording of whatthe people did between two snapshots. Table 2.2 gives the income statement for the U.S.Composite Corporation for 20X2.
The income statement usually includes several sections. The operations section reportsthe firm’s revenues and expenses from principal operations. One number of particular im-portance is earnings before interest and taxes (EBIT), which summarizes earnings beforetaxes and financing costs. Among other things, the nonoperating section of the incomestatement includes all financing costs, such as interest expense. Usually a second section reports as a separate item the amount of taxes levied on income. The last item on the in-come statement is the bottom line, or net income. Net income is frequently expressed pershare of common stock, that is, earnings per share.
When analyzing an income statement, the financial manager should keep in mindGAAP, noncash items, time, and costs.

Generally Accepted Accounting Principles

Revenue is recognized on an income statement when the earnings process is virtually com-pleted and an exchange of goods or services has occurred. Therefore, the unrealized appre-ciation in owning property will not be recognized as income. This provides a device forsmoothing income by selling appreciated property at convenient times. For example, if thefirm owns a tree farm that has doubled in value, then, in a year when its earnings from otherbusinesses are down, it can raise overall earnings by selling some trees. The matching prin-ciple of GAAP dictates that revenues be matched with expenses. Thus, income is reportedwhen it is earned, or accrued, even though no cash flow has necessarily occurred (for ex-ample, when goods are sold for credit, sales and profits are reported).

Noncash Items

The economic value of assets is intimately connected to their future incremental cash flows.However, cash flow does not appear on an income statement. There are several noncashitems that are expenses against revenues, but that do not affect cash flow. The most impor-tant of these is depreciation. Depreciation reflects the accountant’s estimate of the cost ofequipment used up in the production process. For example, suppose an asset with a five-year life and no resale value is purchased for $1,000. According to accountants, the $1,000cost must be expensed over the useful life of the asset. If straight-line depreciation is used,there will be five equal installments and $200 of depreciation expense will be incurred eachyear. From a finance perspective, the cost of the asset is the actual negative cash flow in-curred when the asset is acquired (that is, $1,000, not the accountant’s smoothed $200-per-year depreciation expense).

Another noncash expense is deferred taxes. Deferred taxes result from differences be-tween accounting income and true taxable income.4Notice that the accounting tax shownon the income statement for the U.S. Composite Corporation is $84 million. It can be bro-ken down as current taxes and deferred taxes. The current tax portion is actually sent to thetax authorities (for example, the Internal Revenue Service). The deferred tax portion is not.However, the theory is that if taxable income is less than accounting income in the currentyear, it will be more than accounting income later on. Consequently, the taxes that are notpaid today will have to be paid in the future, and they represent a liability of the firm. Thisshows up on the balance sheet as deferred tax liability. From the cash flow perspective,though, deferred tax is not a cash outflow.

Time and Costs

It is often useful to think of all of future time as having two distinct parts, the short run andthe long run. The short run is that period of time in which certain equipment, resources, andcommitments of the firm are fixed; but the time is long enough for the firm to vary its out-put by using more labor and raw materials. The short run is not a precise period of time thatwill be the same for all industries. However, all firms making decisions in the short run have some fixed costs, that is, costs that will not change because of fixed commitments. In realbusiness activity, examples of fixed costs are bond interest, overhead, and property taxes.Costs that are not fixed are variable. Variable costs change as the output of the firm changes;some examples are raw materials and wages for laborers on the production line.

In the long run, all costs are variable.5Financial accountants do not distinguish be-tween variable costs and fixed costs. Instead, accounting costs usually fit into a classifica-tion that distinguishes product costs from period costs. Product costs are the total produc-tion costs incurred during a period—raw materials, direct labor, and manufacturingoverhead—and are reported on the income statement as cost of goods sold. Both variableand fixed costs are included in product costs. Period costs are costs that are allocated to atime period; they are called selling, general, and administrative expenses. One period costwould be the company president’s salary.


Net working capital is current assets minus current liabilities. Net working capital is posi-tive when current assets are greater than current liabilities. This means the cash that will be-come available over the next 12 months will be greater than the cash that must be paid out.The net working capital of the U.S. Composite Corporation is $275 million in 20X2 and$252 million in 20X1:

Current assets Current liabilities Net working capital
($ millions) - ($ millions) = ($ millions)
20X2 $761 - $486 = $275
20X1 707 - 455 = 252

In addition to investing in fixed assets (i.e., capital spending), a firm can invest in net work-ing capital. This is called the change in net working capital. The change in net workingcapital in 20X2 is the difference between the net working capital in 20X2 and 20X1; thatis, $275 million  $252 million  $23 million. The change in net working capital is usu-ally positive in a growing firm.


Perhaps the most important item that can be extracted from financial statements is the ac-tual cash flow of the firm. There is an official accounting statement called the statement ofcash flows. This statement helps to explain the change in accounting cash and equivalents,which for U.S. Composite is $33 million in 20X2. (See Appendix 2B.) Notice in Table 2.1that Cash and equivalents increases from $107 million in 20X1 to $140 million in 20X2.However, we will look at cash flow from a different perspective, the perspective of finance.In finance the value of the firm is its ability to generate financial cash flow. (We will talkmore about financial cash flow in Chapter 7.)

The first point we should mention is that cash flow is not the same as net working cap-ital. For example, increasing inventory requires using cash. Because both inventories andcash are current assets, this does not affect net working capital. In this case, an increase ina particular net working capital account, such as inventory, is associated with decreasingcash flow.

Just as we established that the value of a firm’s assets is always equal to the value ofthe liabilities and the value of the equity, the cash flows received from the firm’s assets (thatis, its operating activities), CF(A), must equal the cash flows to the firm’s creditors, CF(B),and equity investors, CF(S):
CF(A) = CF(B) + CF(S)
The first step in determining cash flows of the firm is to figure out the cash flow from op-erations.As can be seen in Table 2.3, operating cash flow is the cash flow generated by busi-ness activities, including sales of goods and services. Operating cash flow reflects tax pay-ments, but not financing, capital spending, or changes in net working capital.

The total outgoing cash flow of the firm can be separated into cash flow paid to credi-tors and cash flow paid to stockholders. The cash flow paid to creditors represents a re-grouping of the data in Table 2.3 and an explicit recording of interest expense. Creditors arepaid an amount generally referred to as debt service. Debt service is interest payments plusrepayments of principal (that is, retirement of debt).An important source of cash flow is from selling new debt. U.S. Composite’s long-termdebt increased by $13 million (the difference between $86 million in new debt and $73 mil-lion in retirement of old debt.6) Thus, an increase in long-term debt is the net effect of newborrowing and repayment of maturing obligations plus interest expense.

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