Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

I. Overview of Corporate

Finance

2. Financial Statements,
   Taxes, and Cash Flow

© The McGraw−Hill^55

Companies, 2002

CHAPTER

2

Financial Statements, Taxes,

and Cash Flow

In April 2001,General Electric Company (GE) announced it would take a first

quarter charge of $444 million against earnings. General Electric was not alone.

Other companies such as Coca-Cola, Deutsche Bank, Broadcom, Forest Oil, and

7-Eleven were also forced to change their reported earnings. Performance

wasn’t the issue. Instead, a change in accounting rules forced companies to

recalculate the value of certain types of financial instruments.

So, did stockholders in General Electric lose $444 million as a result of

accounting rule changes? Probably not. Understanding why ultimately leads

us to the main subject of this chapter, that all-important substance known as

cash flow.

n this chapter, we examine financial statements, taxes, and cash flow. Our emphasis is

not on preparing financial statements. Instead, we recognize that financial statements

are frequently a key source of information for financial decisions, so our goal is to

briefly examine such statements and point out some of their more relevant features. We

pay special attention to some of the practical details of cash flow.

As you read, pay particular attention to two important differences: (1) the difference

between accounting value and market value, and (2) the difference between accounting

income and cash flow. These distinctions will be important throughout the book.

THE BALANCE SHEET

The balance sheetis a snapshot of the firm. It is a convenient means of organizing and

summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the dif-

ference between the two (the firm’s equity) at a given point in time. Figure 2.1 illustrates

how the balance sheet is constructed. As shown, the left-hand side lists the assets of the

firm, and the right-hand side lists the liabilities and equity.

Assets: The Left-Hand Side

Assets are classified as either current or fixed. A fixed asset is one that has a rela-

tively long life. Fixed assets can be either tangible, such as a truck or a computer, or

I

23

2.1

balance sheet

Financial statement

showing a firm’s

accounting value on a

particular date.