Post on 20-Jan-2016
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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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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
$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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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
$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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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
$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
Cash Flow to Investors
Creditor
Stockholder
Total
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U.S.C.C. Financial Cash Flow
Cash Flow From the Assets
Operating cash flow $ 547
Capital spending -130
Additions to net working capital
Total
Cash Flow to Investors
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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U.S.C.C. Financial Cash Flow
Cash Flow From the Assets
Operating cash flow $ 547
Capital spending -130
Additions to net working capital -330
Total
Cash Flow to Investors
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
Operating cash flow $ 547
Capital spending -130
Additions to net working capital -330
Total $ 87
Cash Flow to Investors
Creditor
Stockholder
Total
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U.S.C.C. Financial Cash FlowCash Flow From the Assets
Operating cash flow $ 547
Capital spending -130
Additions to net working capital -330
Total $ 87
Cash Flow to Investors
Creditor $ 24
Stockholder
Total
Cash Flow to Creditors
Interest Paid $70
- Net new borrowings 46
Cash flow to creditors 24
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U.S.C.C. Financial Cash FlowCash Flow From the Assets
Operating cash flow $ 547
Capital spending -130
Additions to net working capital -330
Total $ 87
Cash Flow to Investors
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
Operating cash flow $ 547
Capital spending -130
Additions to net working capital -330
Total $ 87
Cash Flow to Investors
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