Chapter 3 Financial Statements, Cash Flow, and Taxes 61If a company has problems, its stock price can fall below its book value. For
example, Countrywide Financial, the largest originator of subprime mort-
gages, saw its stock price fall to $13 versus a book value of $25 when the sub-
prime market blew up in 2007.
- The time dimension. The balance sheet is a snapshot of the! rm’s! nancial
position at a point in time—for example, on December 31, 2008. Thus, we see
that on December 31, 2007, Allied had $80 million of cash; but that balance fell
to $10 million by year-end 2008. The balance sheet changes every day as inven-
tories rise and fall, as bank loans are increased or decreased, and so forth. A
company such as Allied, whose business is seasonal, experiences especially
large balance sheet changes during the year. Its inventories are low just before
the harvest season but high just after the fall crops have been harvested and
processed. Similarly, most retailers have large inventories just before Christ-
mas but low inventories (and high accounts receivable) just after Christmas.
We will examine the effects of these changes in Chapter 4, when we compare
companies’! nancial statements and evaluate their performance.
What is the balance sheet, and what information does it provide?
How is the order in which items are shown on the balance sheet determined?
What was Allied’s net working capital on December 31, 2007? ($650 million)
What items on Allied’s December 31 balance sheet would probably be
di" erent from its June 30 values? Would these di" erences be as large if
Allied were a grocery chain rather than a food processor? Explain. (Invento-
ries, accounts receivable, and accounts payable would experience
seasonal " uctuations; no—less seasonality)SELF^ TEST (^)
3-3 THE INCOME STATEMENT
Table 3-2 shows Allied’s 2007 and 2008 income statements. Net sales are shown at
the top of the statement; then operating costs, interest, and taxes are subtracted to
obtain the net income available to common shareholders. We also show earnings
and dividends per share, in addition to some other data, at the bottom of Table 3-2.
Earnings per share (EPS) is often called “the bottom line,” denoting that of all
items on the income statement, EPS is the one that is most important to stockhold-
ers. Allied earned $2.35 per share in 2008, down from $2.44 in 2007. In spite of the
decline in earnings, the! rm still increased the dividend from $1.06 to $1.15.
A typical stockholder focuses on the reported EPS, but professional security
analysts and managers differentiate between operating and non-operating income.
Operating income is derived from the! rm’s regular core business—in Allied’s
case, from producing and selling food products. Moreover, it is calculated before
deducting interest expenses and taxes, which are considered to be non-operating
costs. Operating income is also called EBIT, or earnings before interest and taxes.
Here is its equation:
Operating income (or EBIT)! Sales revenues # Operating costs (^) 3-1
! $3,000.0 # $2,716.2
! $283.8
This! gure must, of course, match the one reported on the income statement.
Different! rms have different amounts of debt, different tax carry-backs and
carry-forwards, and different amounts of non-operating assets such as marketable
Income Statement
A report summarizing a
firm’s revenues, expenses,
and profits during a
reporting period, generally
a quarter or a year.
Income Statement
A report summarizing a
firm’s revenues, expenses,
and profits during a
reporting period, generally
a quarter or a year.
Operating Income
Earnings from operations
before interest and taxes
(i.e., EBIT).
Operating Income
Earnings from operations
before interest and taxes
(i.e., EBIT).