Understanding Financial Statements, Taxes, and Cash Flows

Chapter 2 - Chapter 2 - Understanding Financial Understanding Financial

Statements, Taxes, and Cash Statements, Taxes, and Cash FlowsFlows

2005, Pearson Prentice Hall

SALESSALES - - EXPENSESEXPENSES = PROFIT= PROFIT

Income StatementIncome Statement



Revenue



•Cost of Goods Sold



•Cost of Goods Sold•Operating Expenses



•Cost of Goods Sold•Operating Expenses (marketing, administrative)



•Cost of Goods Sold•Operating Expenses (marketing, administrative)•Financing Costs



•Cost of Goods Sold•Operating Expenses (marketing, administrative)•Financing Costs•Taxes

SALESSALES- - Cost of Goods SoldCost of Goods Sold GROSS PROFITGROSS PROFIT- - Operating ExpensesOperating Expenses OPERATING INCOME (EBIT)OPERATING INCOME (EBIT) - - Interest ExpenseInterest Expense EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)- - Income TaxesIncome Taxes EARNINGS AFTER TAXES (EAT)EARNINGS AFTER TAXES (EAT)- - Preferred Stock DividendsPreferred Stock Dividends- - NET INCOME AVAILABLENET INCOME AVAILABLE TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS


SALESSALES- - Cost of Goods SoldCost of Goods Sold GROSS PROFITGROSS PROFIT- - Operating ExpensesOperating Expenses OPERATING INCOMEOPERATING INCOME (EBIT)(EBIT)- - Interest ExpenseInterest Expense EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)- - Income TaxesIncome Taxes EARNINGS AFTER TAXES (EAT)EARNINGS AFTER TAXES (EAT)- - Preferred Stock DividendsPreferred Stock Dividends- - NET INCOME AVAILABLENET INCOME AVAILABLE TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS


SALESSALES- - Cost of Goods SoldCost of Goods Sold GROSS PROFITGROSS PROFIT- - Operating ExpensesOperating Expenses OPERATING INCOME (EBIT)OPERATING INCOME (EBIT) - - Interest ExpenseInterest Expense EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)- - Income TaxesIncome Taxes EARNINGS AFTER TAXES (EAT)EARNINGS AFTER TAXES (EAT)- - Preferred Stock DividendsPreferred Stock Dividends- NET INCOME AVAILABLE- NET INCOME AVAILABLE TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS


Balance SheetBalance Sheet

Total Assets =Total Assets =

OutstandingDebt

+Shareholders’

Equity

Balance SheetBalance Sheet

Balance SheetBalance SheetAssets

Balance SheetBalance SheetAssets Liabilities (Debt) & Equity

Balance SheetBalance SheetAssets Liabilities (Debt) & Equity

Current AssetsCurrent Assets CashCash Marketable SecuritiesMarketable Securities Accounts ReceivableAccounts Receivable InventoriesInventories

Prepaid ExpensesPrepaid ExpensesFixed AssetsFixed Assets Machinery & EquipmentMachinery & Equipment Buildings and LandBuildings and LandOther AssetsOther Assets

Investments & patentsInvestments & patents

Current LiabilitiesCurrent Liabilities Accounts PayableAccounts Payable Accrued ExpensesAccrued Expenses Short-term notesShort-term notesLong-Term LiabilitiesLong-Term Liabilities Long-term notes Long-term notes MortgagesMortgagesEquityEquity Preferred Stock Preferred Stock Common Stock (Par Common Stock (Par value)value) Paid in CapitalPaid in Capital Retained EarningsRetained Earnings

AssetsAssets Current AssetsCurrent Assets::

AssetsAssets Current AssetsCurrent Assets: assets that are : assets that are

relatively liquid, and are expected to be relatively liquid, and are expected to be converted to cash within a year.converted to cash within a year.


relatively liquid, and are expected to be relatively liquid, and are expected to be converted to cash within a year.converted to cash within a year. Cash, marketable securities, accounts Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.



receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses. Fixed AssetsFixed Assets::



receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses. Fixed AssetsFixed Assets: machinery: machinery and equipment, buildings,and equipment, buildings, and land. and land.



receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses. Fixed AssetsFixed Assets: machinery and : machinery and

equipment, buildings, and land.equipment, buildings, and land. Other AssetsOther Assets::




equipment, buildings, and land.equipment, buildings, and land. Other AssetsOther Assets: any asset that is not a : any asset that is not a

current asset or fixed asset.current asset or fixed asset.




equipment, buildings, and land.equipment, buildings, and land. Other AssetsOther Assets: any asset that is not a : any asset that is not a

current asset or fixed asset.current asset or fixed asset. Intangible assets, such as patents and Intangible assets, such as patents and

copyrights.copyrights.

FinancingFinancing Debt CapitalDebt Capital::

FinancingFinancing Debt CapitalDebt Capital: financing provided by a : financing provided by a

creditor. creditor.


creditor. creditor. Short-term debtShort-term debt::


creditor. creditor. Short-term debtShort-term debt: borrowed money that : borrowed money that

must be repaid within the next 12 must be repaid within the next 12 months. months.



must be repaid within the next 12 must be repaid within the next 12 months. months. Accounts payable, other payables such as Accounts payable, other payables such as

interest or taxes payable, accrued interest or taxes payable, accrued expenses, short-term notes.expenses, short-term notes.





Long-term debtLong-term debt::





Long-term debtLong-term debt: loans from banks or : loans from banks or other sources that lend money for other sources that lend money for longer than 12 months.longer than 12 months.

FinancingFinancing Equity CapitalEquity Capital::

FinancingFinancing Equity CapitalEquity Capital: shareholders’ : shareholders’

investment in the firm. investment in the firm.


investment in the firm. investment in the firm. Preferred StockholdersPreferred Stockholders::


investment in the firm. investment in the firm. Preferred StockholdersPreferred Stockholders: receive fixed : receive fixed

dividends, and have higher priority than dividends, and have higher priority than common stockholders in event of common stockholders in event of liquidation of the firm.liquidation of the firm.




Common StockholdersCommon Stockholders::




Common StockholdersCommon Stockholders: residual : residual owners of a business. They receive owners of a business. They receive whatever is left after creditors and whatever is left after creditors and preferred stockholders are paid. preferred stockholders are paid.

Corporate Income Tax RatesCorporate Income Tax RatesSince 1993Since 1993

Taxable Income Corporate Tax RateTaxable Income Corporate Tax Rate

$1 - $50,000 15%$1 - $50,000 15%$50,001 - $75,000 25%$50,001 - $75,000 25%$75,001 - $100,000 $75,001 - $100,000 34% 34%$100,001 - $335,000 39%$100,001 - $335,000 39%$335,001 - $10,000,000 34%$335,001 - $10,000,000 34%$10,000,001 - $15,000,000$10,000,001 - $15,000,000 35% 35%$15,000,001 - $18,333,333$15,000,001 - $18,333,333 38% 38%over $18,333,333over $18,333,333 35% 35%

Free Cash FlowsFree Cash Flows

Free cash flow:Free cash flow: cash flow that is free and cash flow that is free and available to be distributed to the firm’s available to be distributed to the firm’s investors (both debt and equity investors).investors (both debt and equity investors).

Free Cash FlowsFree Cash FlowsCash Flows from Cash Flows from

AssetsAssets = Cash Flows from Financing

Cash flows generated through the firm’s

assets =Cash flows paid to - or

received from - the firm’s investors

(creditors & stockholders)

Calculating Free Cash Flows:Calculating Free Cash Flows:An Asset PerspectiveAn Asset Perspective

After-tax cash flow After-tax cash flow from operationsfrom operations

lesslessinvestment in net investment in net

operating operating working capitalworking capital

lesslessinvestments in fixed investments in fixed

and other assetsand other assets







Operating income + depreciation - cash tax payments







[Change in current assets]-

[change in non-interest bearing current liabilities]







Change in gross fixed assets, and any other assets that are on the balance sheet.

Calculating Free Cash Flows:Calculating Free Cash Flows:A Financing PerspectiveA Financing Perspective

Interest payments to creditorsInterest payments to creditors

- change in debt principal- change in debt principal

- dividends paid to stockholders- dividends paid to stockholders

- change in stock- change in stock

= Financing Free Cash Flows= Financing Free Cash Flows

Tax Example:Tax Example:

Space Cow Computer has sales of Space Cow Computer has sales of $32 $32 millionmillion, cost of goods sold at , cost of goods sold at 60%60% of of sales, cash operating expenses of sales, cash operating expenses of $2.4 $2.4 millionmillion, and , and $1.4 million$1.4 million in depreciation in depreciation expense. The firm has expense. The firm has $12 million$12 million in in 9.5%9.5% bonds outstanding. The firm will bonds outstanding. The firm will pay pay $500,000$500,000 in dividends to its in dividends to its common stock holders.common stock holders.

Calculate the firm’s tax liability.Calculate the firm’s tax liability.

SalesSales $32,000,000$32,000,000Cost of Goods SoldCost of Goods Sold (19,200,000)(19,200,000)Operating ExpensesOperating Expenses (2,400,000)(2,400,000)Depreciation ExpenseDepreciation Expense (1,400,000) (1,400,000)EBIT or NOIEBIT or NOI 9,000,0009,000,000Interest ExpenseInterest Expense (1,140,000)(1,140,000)Taxable IncomeTaxable Income 7,860,000 7,860,000

Income Income tax rate tax rate tax paymenttax payment $50,000 x .15 = $50,000 x .15 = $ 7,500$ 7,500 $25,000 x .25 = $25,000 x .25 = 6,2506,250 $25,000 x .34 = $25,000 x .34 = 8,5008,500 $235,000 x .39 = $235,000 x .39 = 91,650 91,650 $7,525,000 x .34 = $7,525,000 x .34 = 2,558,5002,558,500Total Tax payment Total Tax payment $2,672,400$2,672,400

short cut:short cut: $7,860,000 x .34 = $7,860,000 x .34 = $2,672,400$2,672,400

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Understanding Financial Statements, Taxes, and Cash Flows

Economy & Finance