‑ In the U.S. all public Corporations must prepare financial statements according to GAAP (Generally Accepted Accounting Principles)
‑‑ Why: So that investors can compare one company to another intelligently
-- Why you must be familiar with financial statements: because you examine them to assess the status of a company
So, to begin: The Company’s Financial Statements :
The balance sheet (See balance sheet for MicroDrive Corporation on pg 53)
‑‑ The balance sheet describes the company's status as of a particular time
‑‑ Note it must always balance (all assets are claimed by someone)
Assets = Liabilities + Equity
‑‑‑ Note that the firm can add to accounts equally on both sides, or can "trade" among accounts on one side or the other as long as both sides end up being equal
--- example: If MicroDrive sold another $1 million worth of preferred stock, the cash account would increase by $1 million and the Preferred Stock account would increase by $1 million. The Balance sheet would still be in balance
--- example: MicroDrive could issue $174 million worth of common stock and use the proceeds to pay off the $174 million in bonds outstanding. No changes would occur on the asset side of the balance sheet. The balance sheet is still in balance.
The income statement: (see income statement for MicroDrive Corporation, pg 57)
‑ The income statement describes a company's profit and loss during a particular period
‑‑ that is, it shows how much revenue came into the business vs how much in expenses left the business during the period in question
NOTE: The income statement doesn't show funds expended to buy assets or to pay off debts. Those aren't expenses. Expenses are normally things the business obtains that can't be stored, like labor, utility service, etc.
The Statement of Cash Flows (See MicroDrive's Statement of Cash Flows, pg 62)
‑ The statement of cash flows shows how much cash flowed in and out of the business during a particular period
- Basically the statement of cash flows is developed by adding to net income all the cash inflows and outflows that are not shown on the income statement. Most of these are found by comparing balance sheets of two successive dates. The changes in the balance sheet accounts are computed and recorded on the statement of cash flows as follows:
‑‑ An increase in an asset account is a use of funds
‑‑ A decrease in an asset account is a source of funds
‑‑ An increase in a liability or equity account is a source of funds
‑‑ A decrease in a liability or equity account is a use of funds
‑ Note the cash flows on the statement are divided into categories:
(1) cash flows from operations (that is, the firm’s normal activities)
(2) cash flows from investments (that is, long-term expenditures)
(3) cash flows from financing activities (borrowing, issuing stock, paying off debt, and so on)
Related Concepts:
Net Operating Profit After-Tax (NOPAT) (page 65)
- Net Income is often looked upon by managers as an indicator of a firm’s performance. There is a problem with this measure, however, in that it has interest expense subtracted out of it. Interest expense occurs as a result of a company’s borrowing activity, and does not directly have anything to do with the productivity of a firm’s assets. For this reason just looking at net income doesn’t give you a true picture of how well the firm is operating (two firm’s could be operating identically, but if one was using borrowed money and the other was not, they would have different net income figures).
- To get a better idea of how a company is operating, analysts turn to a measure called Net Operating Profit After Tax (NOPAT). This is simply Operating Income, or Earnings Before Interest and Taxes (EBIT), times 1 – the company’s effective income tax rate:
