to acquire additional assets or to repay debt. The retained earnings accu-
mulated over time become the earned surplus of the firm. The surplus ac-
count indicates only a historical source for the financing of the firm and
does not represent an existing fund of cash.
The amount earned and paid in dividends on the individual stock-
holder’s share is of more direct importance to him or her than the total
amount earned by the firm. The earnings and trend of dividends on the in-
dividual shares in the long run establish their value in the market.
The earnings per share are obtained by dividing the total earnings avail-
able to the common stock by the number of shares of stock outstanding.
Often the earnings per share are shown once, reflecting the regular, recur-
ring income, and again, including extraordinary income items. An addi-
tional figure, not always available but often useful, is the cash flow per
share. It includes earnings available to the common shareholders plus non-
cash charges divided by the number of shares. This figure shows the gross
funds available per share of stock that may be used to repay debt, acquire
assets, and pay dividends. An interesting possibility is to subtract required
amortization of debt from the cash flow per share and arrive at the figure of
free or disposable cash flow per share. This figure might prove useful in
comparing two firms where earnings are similar but one firm is required to
make payments on the principal of its debt.
Sources and Uses of Funds
The income statement provides a picture of the firm’s operations during
the past year. The bottom line of the income statement is the firm’s net in-
come or after-tax profits. The firm’s sources of cash flow from its opera-
tions are positive net income, having depreciation and other noncash
expenses, and issuing new debt or equity. The firm’s sources of funds must
equal its uses of funds. The firm uses its cash flow to engage in capital ex-
penditures, pay dividends, pursue research and development (R&D) activ-
ities, pay off its debt and/or equity, or reduce its net working capital (its
current assets less its current liabilities). The reader only needs to look at
Johnson & Johnson’s sources and uses of funds in Table 2.5 to be re-
minded that net income is the firm’s primary source of cash flow. Stock-
holders prefer to see the firm’s cash flow derived from profits, not
depreciation, because depreciation is an expense that serves to provide the
firm with cash flow to replenish its capital investment. From Table 2.5, we
find that the statement of cash flows can be divided into three sections:
cash flows from operating activities, cash flows from investing activities,