Corporate Finance, 6th Edition

Chapter 3EARNINGS

Time to put our accounting hat on!

Following our analysis of company cash flows, it is time to consider the issue of how a company creates wealth. In this chapter, we are going to study the income statement to show how the various cycles of a company create wealth.

Section 3.1 ADDITIONS TO WEALTH AND DEDUCTIONS FROM WEALTH

What would your spontaneous answer be to the following questions?

• Does purchasing an apartment make you richer or poorer?
• Would your answer change if you were to buy the apartment on credit?

There can be no doubt as to the correct answer. Provided that you pay the market price for the apartment, your wealth is not affected whether or not you buy it on credit. Our experience as teachers has shown us that students often confuse cash and wealth.

Cash and wealth are two of the fundamental concepts of corporate finance. It is vital to be able to juggle them around and thus be able to differentiate between them confidently.

Consequently, we advise readers to train their minds by analysing the impact of all transactions in terms of cash flows and wealth impacts.

For instance, when you buy an apartment, you become neither richer nor poorer, but your cash decreases. Arranging a loan makes you no richer or poorer than you were before (you owe the money), but your cash has increased. If a fire destroys your house and it was not insured, you are worse off, but your cash position has not changed, since you have not spent any money.

Raising ...