1. Financial Statements, Taxes, and Cash Flows
Chapter TWO

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

3. Chapter Outline
The Balance Sheet
The Income Statement
Taxes
Cash Flow

4. 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

5. The Balance Sheet - Figure 2.1

6. Net Working Capital and Liquidity
Current Assets – Current Liabilities
Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out
Usually positive in a healthy firm
Liquidity
Ability to convert to cash quickly without a significant loss in value
Liquid firms are less likely to experience financial distress
But liquid assets earn a lower return
Trade-off to find balance between liquid and illiquid assets

7. Building the balance sheet
A firm has current assets of 100 SR, net fixed assets of 500 SR, short-term debt of 70 SR and long-term debt of 200 SR. what does the balance sheet look like? What is shareholder’s equity? What is net working capital?

8. Ex 1 Page 41
Penguin Pucks, Inc., has current assets of 5,100 $, net fixed assets of 23,800 $ , current liabilities of 4,300$, and long-term debt of 7,400 $. What is the value of the shareholder’s equity account for this firm? How much is net working capital?

9. Ex 16 page 42
Prepare a 2009 balance sheet for Bertinelli Crop. Based on the following information cash= 195,000 $ ; patents and copy rights = 780,000 $ ; accounts payable= 405,000 $; accounts receivable= 137,000$ ; tangible net fixed assts = 2,800,000 $; inventory= 264,000 ; notes payable= 160,000$ ; accumulated retained earnings= 1,934,000 $; long-term debt= 1,195,300.

10. Market Vs. Book Value
The balance sheet provides the book value of the assets, liabilities, and equity.
Market value is the price at which the assets, liabilities ,or equity can actually be bought or sold.
Market value and book value are often very different. Why?
Which is more important to the decision-making process?

11. 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 show revenue when it accrues and match the expenses required to generate the revenue

12. Ex 15 Page 42
Given the following information for Rosato Pizza Co., calculate the depreciation expense : sales= 41,000 $ , costs 19,500 $ , addition to retained earnings 5,100$ , dividend paid 1,500 $ , interest expense 4,500$, tax rate 35 percent.

13. US Corporation Income Statement – Table 2.2

14. Taxes
The one thing we can rely on with taxes is that they are always changing
Marginal vs. average tax rates
Marginal tax rate – the percentage paid on the next dollar earned
Average tax rate – the tax bill / taxable income
Other taxes

15. Table 2.3 Corporate Tax Rates
Taxable income
%15 25 34 39 35 38

16. EXAMPLES
Suppose our corporation has a taxable income of 200,000 $ what is the tax bill?
If the taxable income was $ what is the tax bill?
If the taxable income was $ what is the tax bill?
ALGERNON, Inc. has a taxable income of $. What is the average tax rate? Its marginal tax rate?
EXAMPLE 2.4

17. EX 6&7 Page 41
The Renata Co. had $ in 2009 taxable income. Using the rates from table 2.3 in the chapter, calculate the company’s 2009 income taxes?
What is the average tax rate? What is the marginal tax rate?

18. Ex 18 Page 43
(Refer to table 2.3) Corporation Growth has $ in taxable income, and corporation Income has $ in taxable income.
What is the tax bill for each firm?
Suppose both firms have identified a new project that will increase taxable income by $. How much in additional taxes will each firm pay ?Why is this amount the same?

19. 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 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 that finance the purchase of the assets

20. CASH FLOW FROM ASSETS
Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders  CASH FLOW IDENTITY
Operating Cash Flow (OCF)
Capital Spending
Change in Net Working Capital (NWC)

21. U.S. CORPORATION
2008 AND 2009 Balance Sheets
($ in millions)
s Equity Liabilities and Owner’ Assets
Current liabilities
Current Assets
266
232
Accounts payable
160
104
Cash
123
196
Notes payable
668
455
Accounts receivable
389
428
total
555
553
Inventory
1.403
1.112
Total
Fixed Assets
454
408
Long-term debt
1.709
1.644
Net plant and equipment
Owner’s equity
640
600
Common stocks and paid-in surplus
1629
1320
Retained earnings
2269
1920
3112
2756
Total liabilities and owner’s equity
Total Assets

22. OCF OCF = EBIT + DEP - TAXES U.S CORPORATION 2009 Operating Cash Flow
694
EBIT 65
+ Depreciation
212
- Taxes
547
Operating Cash Flow
OCF = EBIT + DEP - TAXES

23. Capital Spending = Beginning net fixed assets - Dep
1709
Ending Net Fixed Assets
1644
- Beginning net fixed assets 65
+ Depreciation
130
Net Capital Spending
Capital Spending = Ending net fixed assets - Beginning net fixed assets + Dep
If the firm didn’t purchase any new fixed assets
Capital Spending = Beginning net fixed assets - Dep

24. Change in Net Working Capital
1014
Ending NWC
684
- Beginning NWC
330
Change in NWC
Change in NWC = Ending NWC – Beginning NWC

25. Cash Flow From Assets = OCF– Net Capital Spending – Changes in NWC
U.S CORPORATION
2009 Cash Flow From Assets
547
Operating Cash Flow
130
- Net capital spending
330
- Change in NWC 87
Cash Flow From Assets
Cash Flow From Assets = OCF– Net Capital Spending – Changes in NWC

26. Free Cash Flow
Another name for cash flow from assets
“Free” …… ??

27. Ex 8 Page 41
So Long, Inc., has sales of $, costs of $, depreciation expense of $ , and interest expense of1.150 $. If the tax rate is 35 percent, what is the operating cash flow, or OCF?

28. Ex 9 Page 41
Earnhardt Driving School’s 2008ba;ance sheet showed net fixed assets of 3.4 $ million, and the 2009 balance sheet showed net fixed assets of 4.2 $ million. The company’s 2009 income statement showed a depreciation expense of $. What was net capital spending for 2009?

29. Ex 10 Page 42
The 2008 balance sheet of Saddle Creek, Inc., showed current assets of $ and current liabilities of $. The 2009 balance sheet showed current assets of 2.250$ and current liabilities of $. What was the company’s 2009 change in net working capital, or NWC?

30. Short-term notes payable
EX 25 Page 44 (HW)
2008
2009
Sales
7,233
8,085
Depreciation
1,038
1,085
Cost of goods sold
2,487
2,942
Other expenses
591
515
Interest
485
579
Cash
3,792
4,041
Accounts receivable
5,021
5,892
Short-term notes payable
732
717
Long-term debt
12,700
15,435
Net fixed assets
31,805
33,921
Accounts payable
3,984
4,025
Inventory
8,927
9,555
Dividends
882
1,011
Tax rate
34%

31. Cash Flow to Creditors & Stockholders
It is the net payment to creditors and owners during the year
Cash to creditors = Interest paid – Net new borrowing
U.S CORPORATION
2009 Cash Flow to Creditors 70
Interest paid 46
- Net new borrowing 24
Cash to creditors

32. Cash Flow to Creditors & Stockholders
U.S COROPORATION
2009 Cash Flow to Stockholders
103
Dividend paid 40
- Net new equity raised 63
Cash flow to stockholders
Cash flow to stockholders= dividend paid – New equity raised

33. Cash Flow Summary Table 2.5

34. Ex 11 Page 42
The 2008 Balance sheet of Maria’s Tennis shop Inc,. Showed long-term debt of 2.6 million. And the 2009 Balance sheet Showed long-term debt of 2.9 million. The 2009 Income statement showed an interest expense of what was the firm’s cash flow to creditors?

35. Ex 12 Page 42
The 2008 Balance sheet of Maria’s Tennis shop Inc,. Showed in the common stock account and 5.2 million in the additional paid-in surplus accounts . The balance sheet showed 815,000 and 5.5 million in the same two accounts, respectively. If the company paid out 490,000 in cash dividends during 2009, what was the cash flow to stockholders for the year?

36. Example: Balance Sheet and Income Statement Information
Current Accounts
2007: CA = 3625; CL = 1787
2006: CA = 3596; CL = 2140
Fixed Assets and Depreciation
2007: NFA = 2194; 2006: NFA = 2261
Depreciation Expense = 500
Long-term Debt and Equity
2007: LTD = 538; Common stock & APIC = 462
2006: LTD = 581; Common stock & APIC = 372
Income Statement
EBIT = 1014; Taxes = 368
Interest Expense = 93; Dividends = 285

37. Example: Cash Flows OCF = 1,014 + 500 – 368 = 1,146
NCS = 2,194 – 2, = 433
Changes in NWC = (3,625 – 1,787) – (3,596 – 2,140) = 382
CFFA = 1,146 – 433 – 382 = 331
CF to Creditors = 93 – (538 – 581) = 136
CF to Stockholders = 285 – (462 – 372) = 195
CFFA = = 331
The CF identity holds.

38. Short-term notes payable
EX 26 Page 44 calculate : CFFA, CF to creditors, and CF to stock holders
2008
2009
Sales
7,233
8,085
Depreciation
1,038
1,085
Cost of goods sold
2,487
2,942
Other expenses
591
515
Interest
485
579
Cash
3,792
4,041
Accounts receivable
5,021
5,892
Short-term notes payable
732
717
Long-term debt
12,700
15,435
Net fixed assets
31,805
33,921
Accounts payable
3,984
4,025
Inventory
8,927
9,555
Dividends
882
1,011
Tax rate
34%

39. Review
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?