0 chapter 2 financial statements, taxes, and cash flow

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Chapter 2

Financial Statements, Taxes, and Cash Flow

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Chapter Outline

The Balance Sheet The Income Statement Taxes Cash Flow

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Key Concepts and Skills

Know the difference between book value and market value

Know the difference between accounting income and cash flow

Know the difference between average and marginal tax rates

Know how to determine a firm’s cash flow from its financial statements

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The Balance Sheet The balance sheet is a snapshot of the

firm’s assets and liabilities at a given point in time

Assets are listed in order of decreasing liquidity Ease of conversion to cash without significant

loss of value Balance Sheet Identity

Assets = Liabilities + Stockholders’ Equity

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Figure 2.1

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U.S. Corporation Balance Sheet – Table 2.1

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Balance Sheet Analysis

When analyzing a balance sheet, the Finance Manager should be aware of three concerns:

1. Accounting liquidity

2. Debt versus equity

3. Value versus cost

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Accounting Liquidity

Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value

Current assets are the most liquid. Some fixed assets are intangible. The more liquid a firm’s assets, the less likely

the firm is to experience problems meeting short-term obligations.

Liquid assets frequently have lower rates of return than fixed assets.

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Debt versus Equity

Creditors generally receive the first claim on the firm’s cash flow.

Shareholder’s equity is the residual difference between assets and liabilities.

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Market vs. Book Value

The balance sheet provides the book value of the assets, liabilities, and equity. Historical Cost Principle: Under Generally

Accepted Accounting Principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost.

Market value is the price at which the assets, liabilities, or equity can actually be bought or sold , which is a completely different concept from historical cost.

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Value versus Cost

Market value and book value are often very different. Why?

Which is more important to the decision-making process?

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Klingon Corporation

KLINGON CORPORATION

Balance Sheets

Market Value versus Book Value

Book Market Book Market

Assets Liabilities and Shareholders’ Equity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 Equity 600 1,100

1,100 1,600 1,100 1,600

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The Income Statement

Measures financial performance over a specific period of time

The accounting definition of income is:

Revenue – Expenses ≡ Income

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Income Statement

The income statement is more like a video of the firm’s operations for a specified period of time

You generally report revenues first and then deduct any expenses for the period

Matching principle – GAAP says to recognize revenue when it is fully earned and match expenses required to generate revenue to the period of recognition

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U.S. Corporation Income Statement - Table 2.2

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American Composite Corporation Income Statement

Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes Current: $71 Deferred: $13Net income

Addition to retained earnings $43

Dividends: $43

The operations section of the income statement reports the firm’s revenues and expenses from principal operations.

$2,262 1,655

327 90

$190 29

$219 49

$170 84

$86

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Dividends: $43

$2,262 1,655

327 90

$190 29

$219 49

$170 84

$86

The non-operating section of the income statement includes all financing costs, such as interest expense.

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Dividends: $43

$2,262 1,655

327 90

$190 29

$219 49

$170 84

$86

Usually a separate section reports the amount of taxes levied on income.

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Dividends: $43

$2,262 1,655

327 90

$190 29

$219 49

$170 84

$86

Net income is the “bottom line.”

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Income Statement Analysis

There are three things to keep in mind when analyzing an income statement:

1. Generally Accepted Accounting Principles (GAAP)

2. Non-Cash Items

3. Time and Costs

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GAAP The matching principal of GAAP dictates

that revenues be matched with expenses. Thus, income is reported when it is earned,

even though no cash flow may have occurred.

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Non-Cash Items Depreciation is the most apparent. No firm

ever writes a check for “depreciation.” Another non-cash item is deferred taxes,

which does not represent a cash flow. Thus, net income is not cash.

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Time and Costs In the short-run, certain equipment, resources, and

commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials.

In the long-run, all inputs of production (and hence costs) are variable.

Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.

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Example: Work the Web

Publicly traded companies must file regular reports with the Securities and Exchange Commission

These reports are usually filed electronically and can be searched at the SEC public site called EDGAR

Click on the web surfer, pick a company, and see what you can find!

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Taxes

The one thing about taxes we can rely on is that they will always be changing

Marginal vs. average tax rates Marginal – the percentage paid on the next

dollar earned Average – the tax bill / taxable income

Other taxes

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Corporate Tax Rates

Taxable Income Tax Rate

$ 0- 50,000 15%

50,001- 75,000 25

75,001- 100,000 34

100,001- 335,000 39

335,001- 10,000,000 34

10,000,001- 15,000,000 35

15,000,001- 18,333,333 38

18,333,334+ 35

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Example: Marginal vs. Average Rates

Suppose your firm earns $4 million in taxable income. What is the firm’s tax liability? What is the average tax rate? What is the marginal tax rate?

If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

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Example: Marginal vs. Average Rates(1)

Taxable Income

(2)

Marginal

Tax Rate

(3)

Total Tax

(3)/(1)

Average

Tax Rate

$ 45,000 15% $ 6,750 15.00%

70,000 25 12,500 17.86

95,000 34 20,550 21.63

250,000

1,000,000

17,500,000

50,000,000

100,000,000

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The Concept of Cash Flow

Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements

The accounting statement of cash flows does not provide us with the same information that we are looking at here

We will look at how cash is generated from utilizing assets and how it is paid to those who finance the purchase of the assets

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Table 2.5

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Financial Cash Flows

Three Financial Cash Flows Cash Flow From Assets Cash Flow to Creditors Cash Flow to Stockholders

Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders. Cash Flow From Assets (CFFA) = Cash Flow to

Creditors + Cash Flow to Stockholders, or

CF(A)≡ CF(B) + CF(S)

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Cash Flow From Assets

Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC OCF (I/S) = EBIT + depreciation – taxes NCS ( B/S and I/S) = ending net fixed assets –

beginning net fixed assets + depreciation Changes in NWC (B/S) = ending NWC –

beginning NWC

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Cash Flow to Investors

CF to Creditors (B/S and I/S) = interest paid – net new borrowing

CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised

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U.S. Corporation Balance Sheet – Table 2.1

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U.S. Corporation Income Statement - Table 2.2

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U.S.C.C. Financial Cash Flow

Operating Cash Flow:

EBIT $ 694

+ Depreciation 65

- Current Taxes - 212

OCF $ 547

Cash Flow From the Assets

Operating cash flow $ 547

Capital spending

Additions to net working capital

Total


Creditor

Stockholder

Total

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Capital spending -130

Additions to net working capital

Total


Creditor

Stockholder

Total

Capital Spending

Ending net fixed assets $1,709

- Beginning net fixed assets -1,644

+ Depreciation 65

Capital Spending $ 130

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Additions to net working capital -330

Total


Creditor

Stockholder

Total

Change in Net Working Capital (NWC)

Ending NWC $1,014

- Beginning NWC - 684

Change in NWC $ 330

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U.S.C.C. Financial Cash FlowCash Flow From the Assets




Total $ 87


Creditor

Stockholder

Total

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Total $ 87


Creditor $ 24

Stockholder

Total

Cash Flow to Creditors

Interest Paid $70

- Net new borrowings 46

Cash flow to creditors 24

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Total $ 87


Creditor $ 24

Stockholder 63

Total

Cash Flow to Stockholders Dividends paid $103- Net new equity raised 40 Cash to Stockholders 63

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U.S.C.C. Financial Cash FlowCash Flow From Assets




Total $ 87


Creditor $ 24

Stockholder 63

Total $ 87

)()(

)(

SCFBCF

ACF

The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:

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Example: Balance Sheet and Income Statement Information

Current Accounts 2007: CA = $1,500; CL = $1,300 2008: CA = $2,000; CL = $1,700

Fixed Assets and Depreciation 2007: NFA = $3,000; 2008: NFA = $4,000 Depreciation expense = $300

LT Liabilities and Equity 2007: LTD = $2,200; Common Stock = $500; RE = $500 2008: LTD = $2,800; Common Stock = $750; RE = $750

Income Statement Information EBIT = $2,700; Interest Expense = $200; Taxes = $1,000;

Dividends = $1,250

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Example: Cash Flows OCF = $2,700 + $300 – $1,000 = $2,000 NCS = $4,000 – $3,000 + $300 = $1,300 Changes in NWC = ($2,000 – $1,700) – ($1,500 –

$1,300) = $100 CFFA = $2,000 – $1,300 – $100 = $600 CF to Creditors = $200 – ($2,800 – $2,200) = - $400 CF to Stockholders = $1,250 – ($750 – $500) = $1,000 CFFA = - $400 + $1,000 = $600 The CF identity holds.

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2.6 The Statement of Cash Flows

There is an official accounting statement called the statement of cash flows.

This helps explain the change in accounting cash.

The three components of the statement of cash flows are: Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities

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Quick Quiz

What is the difference between book value and market value? Which should we use for decision making purposes?

What is the difference between accounting income and cash flow? Which do we need to use when making decisions?

What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

How do we determine a firm’s cash flows? What are the equations and where do we find the information?

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Comprehensive Problem

Current Accounts 2007: CA = $4,400; CL = $1,500 2006: CA = $3,500; CL = $1,200

Fixed Assets and Depreciation 2007: NFA = $3,400; 2006: NFA = $3,100 Depreciation Expense = $400

Long-term Debt and Equity (R.E. not given) 2007: LTD = $4,000; Common stock & APIC = $400 2006: LTD = $3,950; Common stock & APIC = $400

Income Statement EBIT = $2,000; Taxes = $300 Interest Expense = $350; Dividends = $500

Compute the CFFA

0 chapter 2 financial statements, taxes, and cash flow

Documents

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accounting income

liquid assets

fixed assets

carry assets

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firms operations

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