Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

II. Financial Statements

and Long−Term Financial

Planning

3. Working with Financial
   Statements

(^86) © The McGraw−Hill
Companies, 2002
In the best of all worlds, the financial manager has full market value information
about all of the firm’s assets. This will rarely (if ever) happen. So the reason we rely on
accounting figures for much of our financial information is that we are almost always
unable to obtain all (or even part) of the market information that we want. The only
meaningful yardstick for evaluating business decisions is whether or not they create
economic value (see Chapter 1). However, in many important situations, it will not be
possible to make this judgment directly because we can’t see the market value effects of
decisions.
We recognize that accounting numbers are often just pale reflections of economic re-
ality, but they are frequently the best available information. For privately held corpora-
tions, not-for-profit businesses, and smaller firms, for example, very little direct market
value information exists at all. The accountant’s reporting function is crucial in these
circumstances.
Clearly, one important goal of the accountant is to report financial information to the
user in a form useful for decision making. Ironically, the information frequently does
not come to the user in such a form. In other words, financial statements don’t come
with a user’s guide. This chapter and the next are first steps in filling this gap.
CASH FLOW AND FINANCIAL
STATEMENTS: A CLOSER LOOK
At the most fundamental level, firms do two different things: they generate cash and
they spend it. Cash is generated by selling a product, an asset, or a security. Selling a se-
curity involves either borrowing or selling an equity interest (i.e., shares of stock) in the
firm. Cash is spent in paying for materials and labor to produce a product and in pur-
chasing assets. Payments to creditors and owners also require the spending of cash.
In Chapter 2, we saw that the cash activities of a firm could be summarized by a sim-
ple identity:
Cash flow from assets Cash flow to creditors Cash flow to owners
This cash flow identity summarizes the total cash result of all transactions a firm en-
gages in during the year. In this section, we return to the subject of cash flows by taking
a closer look at the cash events during the year that lead to these total figures.
Sources and Uses of Cash
Those activities that bring in cash are called sources of cash. Those activities that in-
volve spending cash are called uses(or applications) of cash. What we need to do is to
trace the changes in the firm’s balance sheet to see how the firm obtained its cash and
how the firm spent its cash during some time period.
To get started, consider the balance sheets for the Prufrock Corporation in Table 3.1.
Notice that we have calculated the change in each of the items on the balance sheets.
Looking over the balance sheets for Prufrock, we see that quite a few things changed
during the year. For example, Prufrock increased its net fixed assets by $149 and its in-
ventory by $29. (Note that, throughout, all figures are in millions of dollars.) Where did
the money come from? To answer this and related questions, we need to first identify
those changes that used up cash (uses) and those that brought cash in (sources).
54 PART TWO Financial Statements and Long-Term Financial Planning

3.1

sources of cash
A firm’s activities that
generate cash.

uses of cash
A firm’s activities in
which cash is spent.
Also called applications
of cash.