UNDERSTANDING BALANCE SHEETS AND INCOME STATEMENTS

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Chapter 2

• UNDERSTANDING BALANCE SHEETS AND INCOME STATEMENTS

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Fin. Statements and the Value Problem

• Market Value vs. Book Value
• Shareholder Equity
• Financial statements report book values
• Investors buy and sell shares at market value
• Do investors care about the accounting book
  value of their equity?
• Equity investors buy shares for future income
  (cash flows)

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Tangible vs. Intangible Assets

• In most cases balance sheets only reflect
  tangible assets
• Machinery, Equipment, Buildings, land etc.
• Intangible assets can also be an important source
  of value
• Patents
• Trademarks
• Copy Rights
• Human Capital

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Economic vs. Accounting income

• Accountants measure revenues only when realized
• What about unrealized gains
• Discovery of a new drug
• Patented technology
• Do investors really wait for revenues to adjust
  the value of an investment?

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The Value Problem Cont.

• Imputed Costs
• The income sheet includes interest expense but no
  return for shareholders.

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Question

• You are responsible for labor relations in your
  company. During heated labor negotiations, the
  general secretary of your largest union claims,
  Look this company has 10 billion in assets, 5
  billion in equity, and profits of 400 million
  last year due largely to the effort of union
  employees. So dont tell me you cant afford our
  wage demands. How would you reply?

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Forecasting Income and Asset Needs

• You have completed CompuStores financial
  statements for the year 2000, you now wish to
  forecast next years income statement and balance
  sheet (pro forma statements).

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• Why might you want to prepare pro formas for
  CompuStores?
• How should you approach this problem?
• Percent of sales?

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• Sales are expected to grow 10
• Gross Profit and components of cost of goods
  sold, expressed as a percentage of sales, should
  be the same as in 2000.
• Selling, general and administrative expenses will
  rise by 4,280,000.
• The licensing fee, depreciation expenses,
  interest payments and corporate tax rates will
  not change.
• Collection of Receivables, payment of payables
  and inventory management should be at the same
  level of efficiency as the previous year.
• Accounts receivable will remain at 12 of the
  years sales
• Accounts payable will remain at 1.85 times
  monthly sales
• inventories will remain at 10 percent of sales
• Prepaid and accrued expenses are not expected to
  change.
• The company will upgrade one of its assembly
  lines at a cost equal to this years depreciation.
• There will be new borrowing or issuance of new
  share of common stock.
• The company wishes to hold as much cash in 2001
  as it did in 2000 and will pay a dividend that
  will allow it to achieve this objective.

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Income Statement First
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Next the Balance Sheet
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The income statement again
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• What did you learn from CompuStores Pro Forma
  statements?
• How can you use Pro Formas strategically (i.e. to
  evaluate startegic change?)
• What would it mean if CompuStore needed more in
  retained earnings than it was able to generate in
  2001?

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The Link Between the Balance Sheets and the
Income Statement.