Financial Statements and

Cash FlowCHAPTER 2.1

Key Concepts and Skills• Understand the information provided

by financial statements• Differentiate between book and

market values• Know the difference between average

and marginal tax rates• Know the difference between

accounting income and cash flow• Calculate a firm’s cash flow

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Chapter Outline

• The Balance Sheet• The Income Statement• Taxes• Cash Flow

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1. 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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The Balance Sheet -

A. Liquidity

• 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.

B. Debt versus Equity

• LEVERAGE: use of debt in a firm’s capital is called financial leverage– Highly levered firm – use of more debt in the

capital structure– Less levered firm – use of less debt in the

capital structure

• 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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US Corporation Balance Sheet

C. Market Value versus Book Value

• Under Generally Accepted Accounting Principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost / book value (historical cost)

• Market Value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.

• The balance sheet provides the book value of the assets, liabilities and equity.

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 SE 600 1,100

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

2 The Income Statement• Measures financial performance over a specific period of time (e.g.

sales/year, net income/quarter, etc.)• The accounting definition of income is: Revenue – Expenses = Income• GAAP • Income statement contains Non-Cash Items - Example:

Depreciation• In the income statement – costs , revenues and expenses are not

distinguished as short and long term

Table 2.2

CLASS WORK & HOME WORK

BALANCE SHEET AND INCOME STATEMENT

3. Taxes

• Paid to the Govt. out of the EARNINGS

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

next dollar earned– Average – the tax bill / taxable income

• Other taxes

TAX RATES

TAXABLE INCOME MARGINAL TAX RATE50000 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 38%

15,000,001 -18,333,334 35%

Marginal vs. Average Tax Rates

• Suppose your firm earns $2 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?