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Principles of Corporate finance
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Chapter 3 - Accounting and FinanceAfter studying this chapter, you should be able to:
3.1 Interpret the information contained in the balance sheet, income statement, and
statement of cash flows.
3.2 Distinguish between market and book values
3.3 Explain how income differs from cash flow
3.4 Understand the essential features of the taxation of corporate and personal income
3.1 The Balance Sheet
The financial statements show the firm’s balance sheet, the income statement, and a
statement of cash flows. The balance sheet is a financial statement that shows the firm’s
assets and liabilities at a particular time.
- The assets - representing the uses of the funds raised - are listed on the left-hand
side of the balance sheet.
- The liabilities - representing the sources of that funding - are listed on the right.
The accounted puts the most liquid assets at the top of the list and works down to the least
liquid.
Current assets, table 3.1:
- Cash and marketable securities
- Receivables; these payments are due soon, and therefore the balance sheet showed
the unpaid bills or accounts receivable as a current asset.
- Inventories; these may be (1) raw materials and ingredients that the firm bought from
suppliers, (2) work in progress, and (3) finished products waiting to be shipped from
the warehouse.
- Other current assets; items that don’t fit into neat categories.
→ All the assets in the balance of table 3.1 are likely to be used or turned into
cash in the near future, they are therefore described as current assets.
Fixed assets, table 3.1:
→ Longer-lived or fixed assets include items such as buildings, equipment, and
vehicles.
Right-hand portion of the balance sheet, table 3.1, which shows where the money to buy its
assets came from:
→ The accountant starts by looking at the company’s liabilities that is, the money
owned by the company. First come those liabilities that are likely to be paid off
most rapidly.
Current liabilities, table 3.1
- Accounts payable; goods that have been delivered but not yet paid for
⇒ The difference between the assets and the liabilities represents the amount of
the shareholders’ equity.
Book Values and Market Values
, Items in the balance sheet are valued according to generally accepted accounting
principles, GAAP. These state that assets must be shown in the balance sheet at their
historical cost adjusted for depreciation. Book values are therefore ‘backward-looking’
measures of value. They are based on the past cost of the asset, not its current market price
or value to the firm.
Market values of assets and liabilities do not generally equal their book valued. Book values
are based on historical or original values. Market values measure current values of assets
and liabilities.
The difference between the market values of assets and liabilities is the market value of
shareholders’ equity claim. The stock price is simply the market value of shareholders’ equity
divided by the number of outstanding shares.
3.2. The Income Statement
Earnings before interest and taxes = EBIT = total revenues - costs - depreciation.
Income versus Cash Flow
1. Depreciation; when the accountant prepares the income statement, they start with
the cash payments but then divides these payments into two groups = current
expenditures (such as wages) and capital expenditures (such as the purchase of new
machinery).
To calculate the cash produced by the business, it is necessary to add the
depreciation charge (which is not a cash payment) back to accounting profits and to
subtract the expenditure on new capital equipment (which is a cash payment).
2. Cash versus accrual accounting; the practice of matching revenues and expenses is
known as accrual accounting
3.3. The Statement of Cash Flows
The firm’s cash flow can be quite different from its net income. These differences can arise
for at least two reasons:
1. The income statement does not recognize capital expenditures as expenses in the
year that the capital goods are paid for. Instead, it spreads those expenses over time
in the form of an annual deduction for depreciation.
2. The income statement uses the accrual method of accounting, which means that
revenues and expenses are recognized when sales are made, rather than when the
cash is received or paid out.
The statement of cash flows shows the firm’s cash inflows and outflows from operations as
well as from its investments and financing activities.
Table 3.4:
1. The cash flow from operations; this starts with net income but adjust that figure for
those parts of the income statement that do not involve cash coming in or going out.
(Therefore it adds back the allowance for depreciation).
2. The cash that HD has invested in plant and equipment or in the acquisition of new
businesses
3. The final section reports cash flows from financing activities such as the sale of new
debt of stock.
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