CP

338 CHAPTER 9 Financial Statements, Cash Flow, and Taxes

Amanager’s primary goal is to maximize the value of his or her firm’s stock. Value is

based on the stream of cash flows the firm will generate in the future. But how does an

investor go about estimating future cash flows, and how does a manager decide which

actions are most likely to increase cash flows? The answers to both questions lie in a

study of the financial statements that publicly traded firms must provide to investors.

Here “investors” include both institutions (banks, insurance companies, pension

funds, and the like) and individuals. Thus, this chapter begins with a discussion of

what the basic financial statements are, how they are used, and what kinds of financial

information users need.

The value of any business asset—whether it is a financialasset such as a stock or a

bond, or a real (physical) assetsuch as land, buildings, and equipment—depends on the

usable, after-tax cash flows the asset is expected to produce. Therefore, the chapter

also explains the difference between accounting income and cash flow. Finally, since it

is after-taxcash flow that is important, the chapter provides an overview of the federal

income tax system.

Much of the material in this chapter reviews concepts covered in basic accounting

courses. However, the information is important enough to go over again. Accounting

is used to “keep score,” and if a firm’s managers do not know the score, they won’t

know if their actions are appropriate. If you took midterm exams but were not told

how you were doing, you would have a difficult time improving your grades. The

same thing holds in business. If a firm’s managers—whether they are in marketing,

personnel, production, or finance—do not understand financial statements, they will

not be able to judge the effects of their actions, and the firm will not be successful. Al-

though only accountants need to know how to makefinancial statements, everyone in-

volved with business needs to know how to interpretthem.

Financial Statements and Reports

Of the various reports corporations issue to their stockholders, the annual reportis

probably the most important. Two types of information are given in this report. First,

there is a verbal section, often presented as a letter from the chairman, that describes

the firm’s operating results during the past year and discusses new developments that

will affect future operations. Second, the annual report presents four basic financial

statements—the balance sheet,the income statement,the statement of retained earnings,

and the statement of cash flows.Taken together, these statements give an accounting pic-

ture of the firm’s operations and financial position. Detailed data are provided for the

two or three most recent years, along with historical summaries of key operating sta-

tistics for the past five or ten years.^1

The quantitative and verbal materials are equally important. The financial state-

ments report what has actually happenedto assets, earnings, and dividends over the past

few years, whereas the verbal statements attempt to explain why things turned out the

way they did.

For illustrative purposes, we use data on MicroDrive Inc., a producer of disk

drives for microcomputers. Formed in 1982, MicroDrive has grown steadily and has

earned a reputation for being one of the best firms in the microcomputer components

industry. MicroDrive’s earnings dropped a bit in 2002, to $113.5 million versus $117.8

For an excellent example of

a corporate annual report,

take a look at 3M’s annual

report found at http://

http://www.mmm.com.Search for

“annual report” to find the

latest report. A source for

links to the annual reports of

many companies is http://www.

annualreportservice.com.

(^1) Firms also provide quarterly reports, but these are much less comprehensive. In addition, larger firms file
even more detailed statements, giving breakdowns for each major division or subsidiary, with the Securities
and Exchange Commission (SEC). These reports, called 10-K reports,are made available to stockholders
upon request to a company’s corporate secretary. Finally, see http://www.edgarscan.comfor an online
source of these reports, available in spreadsheets.
The textbook's web site
contains an Excelfile that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 09
Tool Kit.xls,and we encour-
age you to open the file and
follow along as you read the
chapter.

334 Financial Statements, Cash Flow, and Taxes