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Chapter 2

Financial Statements

Taxes and Cash Flow

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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Key Concepts and Skills

Know the difference between bookvalue and market value

Know the difference betweenaccounting income and cash flow

Know the difference betweenaverage and marginal tax rates

Know how to determine a firms cash

flow from its financial statements

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Chapter Outline

The Balance Sheet

The Income Statement

Taxes Cash Flow

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Balance Sheet

The balance sheet is a snapshot of thefirms assets and liabilities at a givenpoint in time

Assets are listed in order of decreasingliquidity Ease of conversion to cash

Without significant loss of value

Balance Sheet Identity Assets = Liabilities + Stockholders Equity

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The Balance SheetFigure 2.1

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Net Working Capitaland Liquidity

Net Working Capital = Current AssetsCurrent Liabilities

Positive when the cash that will be received over the next 12months exceeds the cash that will be paid out

Usually positive in a healthy firm Liquidity

Ability to convert to cash quickly withouta significant loss in value

Liquid firms are less likely to experience financial distress

But liquid assets typically earn a lower return Trade-off to find balance between liquid and illiquid assets

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US Corporation Balance SheetTable 2.1

Place Table 2.1 (US Corp Balance Sheet)

here

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Market Value vs. BookValue

The balance sheet provides the bookvalue of the assets, liabilities, and equity.

Market value is the price at which the

assets, liabilities, or equity can actually bebought or sold.

Market value and book value are oftenvery different. Why?

Which is more important to the decision-making process?

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Example 2.2Klingon Corporation

KLINGON CORPORATION

Balance Sheets

Market Value versus Book Value

Book Market Book Market

Assets Liabilities and ShareholdersEquity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 SE 600 1,100

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

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Income Statement

The income statement is more like avideo of the firms operations for a

specified period of time.

You generally report revenues first andthen deduct any expenses for the period

Matching principleGAAP says to showrevenue when it accrues and match theexpenses required to generate therevenue

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US Corporation IncomeStatementTable 2.2

Insert new Table 2.2 here (US Corp IncomeStatement)

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Work the Web Example

Publicly traded companies must fileregular reports with the Securities andExchange Commission

These reports are usually filedelectronically and can be searched at theSEC public site called EDGAR

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

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http://www.sec.gov/edgar/searchedgar/webusers.htm

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Taxes

The one thing we can rely on with taxes isthat they are always changing

Marginal vs. average tax rates

Marginal tax ratethe percentagepaid on the next dollar earned

Average tax ratethe tax bill / taxableincome

Average tax rates vary widely across differentcompanies and industries

Other taxes

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http://www.irs.gov/

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Example: Marginal vs.Average Rates

Suppose your firm earns $4 million intaxable income. What is the firms tax liability?

What is the average tax rate? What is the marginal tax rate?

If you are considering a project thatwill increase the firms taxable income

by $1 million, what tax rate should youuse in your analysis?

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The Concept of Cash Flow

Cash flow is one of the most importantpieces of information that a financialmanager can derive from financialstatements

The statement of cash flows does notprovide us with the same informationthat we are looking at here

We will look at how cash is generatedfrom utilizing assets and how it is paid tothose that finance the purchase of theassets

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Cash Flow From Assets

Cash Flow From Assets (CFFA) =Cash Flow to Creditors + Cash Flowto Stockholders

Cash Flow From Assets = OperatingCash FlowCapital SpendingChanges in NWC

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Example: US CorporationPart I

OCF (I/S) = EBIT + depreciationtaxes = $547

CS (B/S and I/S) = ending net fixed

assetsbeginning net fixed assets +depreciation = $130

Changes in NWC (B/S) = ending

NWCbeginning NWC = $330

CFFA = 547130330 = $87

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Example: US CorporationPart II

CF to Creditors (B/Sand I/S) = interestpaidnet new borrowing = $24

CF to Stockholders (B/Sand I/S) =

dividends paidnet new equity raised= $63

CFFA = 24 + 63 = $87

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Cash Flow Summary -Table 2.6

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Example: Balance Sheet andIncome Statement Info

Current Accounts 2012: CA = 3625; CL = 1787 2011: CA = 3596; CL = 2140

Fixed Assets and Depreciation 2012: NFA = 2194; 2011: NFA = 2261 Depreciation Expense = 500

Long-term Debt and Equity 2012: LTD = 538; Common stock & APIC = 462 2011: LTD = 581; Common stock & APIC = 372

Income Statement EBIT = 1014; Taxes = 368 Interest Expense = 93; Dividends = 285

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Example: Cash Flows

OCF = 1,014 + 500368 = 1,146

NCS = 2,1942,261 + 500 = 433

Changes in NWC = (3,6251,787)

(3,5962,140) = 382 CFFA = 1,146433382 = 331

CF to Creditors = 93(538581) = 136

CF to Stockholders = 285(462372) = 195

CFFA = 136 + 195 = 331 The CF identity holds.

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Quick Quiz

What is the difference between book valueand market value? Which should we use fordecision-making purposes?

What is the difference between accounting

income and cash flow? Which do we need touse when making decisions?

What is the difference between average andmarginal tax rates? Which should we usewhen making financial decisions?

How do we determine a firms cash flows?What are the equations, and where do wefind the information?

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Ethics Issues

Why is manipulation of financialstatements not only unethical and illegal,but also bad for stockholders?

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Comprehensive Problem

Current Accounts 2012: CA = 4,400; CL = 1,500

2011: CA = 3,500; CL = 1,200

Fixed Assets and Depreciation 2012: NFA = 3,400; 2011: NFA = 3,100

Depreciation Expense = 400 Long-term Debt and Equity (R.E. not given)

2012: LTD = 4,000; Common stock & APIC = 400

2011: LTD = 3,950; Common stock & APIC = 400

Income Statement EBIT = 2,000; Taxes = 300

Interest Expense = 350; Dividends = 500

Compute the CFFA and CF to creditors andstockholders

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End of Chapter

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