Finance Textbook Notes – Chapter 3: The Structure and Interpretation of Accounting Statements


Notes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Subject: Finance
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao
  1. The balance sheet provides a summary of a firm’s financial position (its assets and claims on those assets) as of a particular point in time. The income statement provides the results of the firms operations (its profit or loss) over a specified period of time. The statement of stockholders’ equity provides a reconciliation of the changes in the book value of a firm’s equity over a specified period of time.
  2. The income statement is a “picture” of the changes in equity on the balance sheet (resulting from the firms operations) for a specific period of time. The balance sheet reflects how the firm has invested its earnings and the claims on those assets. The equity statement reconciles changes in book value of equity, inclusive of both operations and other equity activities.
  3. Managers need a cash flow statement because the basic financial statements do not provide enough information about how cash flows have changed over time and how those cash flows have been used in the business.
  4. A firm’s net income is determined by deducting its accounting expenses from its accounting revenues. Many of these may or may not involve an actual cash outlay. Therefore net income is a good proxy for long run cash flow, but not necessarily related to current cash flows.
  5. In general, a cash flow statement begins with net income and then adds/subtracts any non-cash expenses reflected in that figure to arrive at pure cash flows from operations. Cash provided by or used for investing and financing purposes is then derived directly and presented separately. This is usually accomplished by an analysis of the changes in balance sheet captions from one reporting period to the next.
  6. Just because a firm pays no tax, its cash flows do not necessarily equal is net income. The difference between net income and cash flows is affected not by taxes, but by the nature of the companies expenses (cash vs. non-cash) and its investment and financing decisions.
  7. Common size statements are constructed by calculating the percentage of each line item on the statements vs. a “base” (total assets for balance sheet, revenues for income statement).
  8. CSF are useful in that they depict captions as percentages that can be compared over time or against other companies of any size or against industry norms. By creating CSF, financial statements can be compared to one another, and decisions made about corporate performance, regardless of the size of a company. Without them, such comparisons are often difficult and/or meaningless. Such comparisons can flag certain aspects of a company’s financial statements that may be of concern (or praiseworthy) to investors or other interested parties.
  9. Interest payments on debt are deductible, but dividends are not. This may influence firms to finance their operations through debt because the deductibility of the interest reduces the cost of capital to the firm.
  10. The average tax rate is percentage of tax expense to net income. Marginal tax rate is the particular rate at which the firm’s earnings place it in the graduated tax scales. This rate is the highest rate taxed and is on the “top end” or latest net income.
  11. In general, you would include tax benefits for firms whose actions bring about the desired employment.
  12. The lower capital gains tax rate encourages businesses to invest in long-lived capital assets that will ultimately lead to capital gains which are taxed at lower rates than ordinary income. This was though to encourage capital investment which would stimulate economic growth.
  13. See above for capital gains tax rate. ITCs are designed to encourage activities that promote economic growth by offering a tax break on certain expenses. For example, an ITC might be available for certain expenses incurred i/c/w a new investment. They are powerful because they are dollar-for-dollar reductions in tax payable, as opposed to taxable income.

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