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Financial statements, taxes and cash flow Chapter 2.

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Financial statements, taxes and cash flow Chapter 2
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Page 1: Financial statements, taxes and cash flow Chapter 2.

Financial statements, taxes and cash flow

Chapter 2

Page 2: Financial statements, taxes and cash flow Chapter 2.

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

2-2 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 3: Financial statements, taxes and cash flow Chapter 2.

Chapter outline

• The balance sheet• The income statement• Taxes• Cash flow

2-3 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 4: Financial statements, taxes and cash flow Chapter 2.

The balance sheet

• The balance sheet is a snapshot of a firm’s assets and liabilities at a given point in time.

• Assets: The left-hand side:− Current or fixed− In order of decreasing liquidity

• Liabilities and owners’ equity: The right-hand side:– Current or long term– In ascending order of when due to be paid

• Balance sheet identity

Assets = Liabilities + Shareholders’ equity

2-4 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 5: Financial statements, taxes and cash flow Chapter 2.

The balance sheet (cont.) Figure 2.1

2-5 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 6: Financial statements, taxes and cash flow Chapter 2.

The balance sheet (cont.)

• Net working capital– Current assets minus current liabilities– Usually positive for a healthy firm

• Liquidity− Speed and ease of conversion to cash without

significant loss of value− Valuable in avoiding financial distress

• Debt versus equity− Shareholders’ equity = Assets - Liabilities

2-6 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 7: Financial statements, taxes and cash flow Chapter 2.

Oz Company balance sheetTable 2.1

Visit au.finance.yahoo.com for more financial statements and balance sheets

2-7 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 8: Financial statements, taxes and cash flow Chapter 2.

Market value vs book value

• Market value is the price at which assets, liabilities or equity can actually be bought or sold.• The balance sheet provides the book value

of assets, liabilities and equity.• Market value and book value are often very

different. Why?• Which is more important to the decision-

making process?

2-8 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 9: Financial statements, taxes and cash flow Chapter 2.

Battler CompanyExample 2.2

Battler Company

Balance sheets

Book value versus market value

Book Market Book Market

Assets Liabilities and Shareholders’ equity

NWC 400 600 LTD 500 500

NFA 700 1 000 SE 600 1 100

$1 100 $1 600 $1 100 $1 600

2-9 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 10: Financial statements, taxes and cash flow Chapter 2.

The income statement

• The income statement measures performance over a specified period of time (period, quarter, year).

• Report revenues first and then deduct any expenses for the period.

• End result = Net income = ‘Bottom line’– Dividends paid to shareholders– Addition to retained earnings

• Income statement equation:

Net income = Revenue - Expenses

2-10 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 11: Financial statements, taxes and cash flow Chapter 2.

OZ Company income statementTable 2.2

2-11 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 12: Financial statements, taxes and cash flow Chapter 2.

The income statement (cont.)

• AAS and the income statement– The matching principle• Recognise revenue when it is fully earned. • Matching expenses required to generate

revenue to the period of recognition

• Non-cash items– Expenses charged against revenue that do

not affect cash flow.–Most important of these is depreciation.

2-12 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 13: Financial statements, taxes and cash flow Chapter 2.

The income statement (cont.)

• Time and costs– Fixed or variable costs– Not obvious on income statement

• Earnings management–Smoothing earnings–Wriggle room

2-13 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 14: Financial statements, taxes and cash flow Chapter 2.

Example: Work the Web

• Most Australian companies post their annual reports on their websites. Look for them in the investor or shareholder areas.

• Go to companies’ websites and see what kinds of financial reports you can find.

• Example: Virgin Blue

2-14 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 15: Financial statements, taxes and cash flow Chapter 2.

Taxes• The one thing we can rely on with taxes is that they

are always changing.• Tax bill depends on tax code, which can be

amended by political will.• Corporate tax in Australia and New Zealand– Flat rate tax (currently 30%)

• Marginal vs average tax rates– Marginal–the percentage paid on the next dollar

earned– Average–the tax bill/taxable income

• Other taxes

2-15 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 16: Financial statements, taxes and cash flow Chapter 2.

Personal tax rates (2009/2010)Table 2.3

2-16 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 17: Financial statements, taxes and cash flow Chapter 2.

Example: Marginal vs average tax rates

• Bony Bushman has a taxable income in Australia of $96 000. – What is his tax bill?– What is his average tax rate ?– What is his marginal tax rate?

2-17 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 18: Financial statements, taxes and cash flow Chapter 2.

Example: Marginal vs average tax rates

Total 96000 23930

Average tax rate 24.9270833%Marginal tax rate 38%

Personal tax rateTaxable income Rate

$0-6000 Nil6001-35000 15%

35001-80000 30%80001-180000 38%

180001- 45%

Tax calculationTaxable income Tax liability

6000 029000 435045000 1350016000 6080

2-18 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 19: Financial statements, taxes and cash flow Chapter 2.

Taxation of dividends: An imputation system

• Major effect is that the double taxation of company profits is negated.

• Company advises the shareholder of the amount of company tax already paid on the dividend.

• Shareholder then adds this amount of tax to the cash dividend that they have received and pays personal tax on the grossed-up amount.

• Shareholder receives a tax (franking) credit equivalent to the amount of tax paid by the company.

2-19 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 20: Financial statements, taxes and cash flow Chapter 2.

Effect of a $700 dividend fully franked at 30% tax rate—Example 2.5

2-20 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 21: Financial statements, taxes and cash flow Chapter 2.

Cash flow

• Cash flow is some of the most important information that a financial manager can derive from financial statements.

• The difference between the number of dollars that come in and the number that go out.

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

• Cash flow identity

Cash flow from assets = Cash flow to creditors + Cash flow to shareholders

2-21 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 22: Financial statements, taxes and cash flow Chapter 2.

Cash flow (cont.)

• Cash flow from assets = Operating cash flow – Net capital spending – Changes in net working capital.

• Operating cash flow– Cash generated from a firm’s normal business

activities• Capital spending– Money spent on fixed assets less money received from

the sale of fixed assets• Change in net working capital– Net increase in current assets over current liabilities

2-22 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 23: Financial statements, taxes and cash flow Chapter 2.

Cash flow (cont.)• Free cash flow– Different from cash flow from assets– Cash that the firm is free to distribute to creditors

and shareholders because it is not needed for working capital or fixed asset investments

• Cash flow to creditors– A firm’s interest payments to creditors less net

new borrowings• Cash flow to shareholders– Dividends paid out by a firm less net new equity

raised

2-23 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 24: Financial statements, taxes and cash flow Chapter 2.

OZ Company example• OCF (I/S) = EBIT + Depreciation – Taxes = $547• NCS (B/S and I/S) = Ending net fixed assets –

Beginning net fixed assets + Depreciation = $130• Changes in NWC (B/S) = Ending NWC – Beginning

NWC = $330• CFFA = 547 – 130 – 330 = $87• CF to creditors (B/S and I/S) = Interest paid – Net

new borrowings = $24• CF to stockholders (B/S and I/S) = Dividends paid –

Net new equity raised = $63• CFFA = 24 + 63 = $87

2-24 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Megan Maniscalco
Something missing at the very end of the notes pane?
Page 25: Financial statements, taxes and cash flow Chapter 2.

Cash flow summaryTable 2.5

2-25 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 26: Financial statements, taxes and cash flow Chapter 2.

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?

2-26 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 27: Financial statements, taxes and cash flow Chapter 2.

Quick quiz (cont.)

• 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?

2-27 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 28: Financial statements, taxes and cash flow Chapter 2.

Apple Isle example

2-28 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 29: Financial statements, taxes and cash flow Chapter 2.

Apple Isle (cont.)Operating cash flow

2-29 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 30: Financial statements, taxes and cash flow Chapter 2.

Apple Isle (cont.)Cash flow from assets, cash flow to stockholders

and creditors

2-30 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Page 31: Financial statements, taxes and cash flow Chapter 2.

Chapter 2

END

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