1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 3-2 Accounting and Finance Understanding financial accounting is essential to understanding corporate finance. Key Components of the Financials: The Balance Sheet The Income Statement The Statement of Cash Flows

3. 3-3 The Balance Sheet The Balance Sheet is a financial statement that shows the firm’s assets and liabilities at a particular time. Why is it useful? Shareholders’ Equity = Total Assets – Total Liabilities

4. 3-4 The Balance Sheet Current Assets Cash & Securities Receivables Inventories Fixed Assets Tangible Assets Intangible Assets + ___________________ Total Assets Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity ____________________ Total Liabilities & Shareholders’ Equity =

5. 3-5 Assets Assets represent the uses of a firm’s funds i.e. Assets show what the firm “owns” Liquid Assets can be converted easily into cash Current vs. Fixed Assets

6. 3-6 Current Assets: Examples Which of the following assets is typically considered most liquid? Least liquid? Marketable securities Accounts receivable Inventories Which of the following is a current asset? Property that a firm owns A firm’s production equipment Unsold inventories

7. 3-7 Fixed Assets  Tangible Assets  Intangible Assets  Goodwill

8. 3-8 Fixed Assets: Example  Which of the following represent tangible assets? Intangible assets? Property Production Facilities Patents Production Equipment Trademarks Copyrights

9. 3-9 Liabilities Liabilities represent the sources of a firm’s funding. (i.e. Liabilities represent what a firm “owes.”)  Current vs. Long-Term Liabilities Current Assets – Current Liabilities = Net Working Capital

10. 3-10 Liabilities: Example  Which of the following is a current liability? Bond debt that matures in 3 years A bank loan that is due in 24 months An obligation to pay a supplier within 6 months

11. 3-11 Net Working Capital: Example In the balance sheet below, what was the value of net working capital in 2008? 2009?

12. 3-12 Book Values vs. Market Values  GAAP (Generally Accepted Accounting Principles)  Book Value Value of assets or liabilities according to the balance sheet. Values recorded at their historical cost adjusted for depreciation  Market Value The value of assets or liabilities were they to be resold in a market

13. 3-13 Common-Size Balance Sheet All balance sheet items are expressed as a percentage of total assets. Why is this useful?

14. 3-14 Common-Size Balance Sheet: Example Note the changes from 2008 to 2009.

15. 3-15 The Income Statement Income Statement: a financial statement that shows the revenues, expenses, and net income of a firm over a period of time. Why is this useful?

16. 3-16 Common-size Income Statement All items on a common-size income statement are expressed as a percentage of revenues. Why is this useful?

17. 3-17 Income Statement: Example In the income statement below, what was the value of Home Depot’s EBIT in 2009? Common Size Income Statement (right column)

18. 3-18 Profits vs. Cash Flow Differences between profits & cash flow:  Depreciation  Cash vs. accrual accounting

19. 3-19 (1000)0750 Cash Flows: Example Consider a firm that spends $1,000 to produce goods in period 1. In period 2, it sells half of these goods for $750 and collects payment one period later. The firm sells the other half in period 3 for another $750, and collects payment on these sales in period 4. What are the cash flows in each of the 4 periods for the firm? Period:1234 Sales ($)0750 0 -Accounts Receivable07500(750) - Cost of Goods Sold0500 0 - Changes in Inventories1000(500) 0 = Net Cash Flow

20. 3-20 The Statement of Cash Flows The Statement of Cash Flows shows the firm’s cash receipts and cash payments over time. Why is it useful? Free Cash Flow is cash available for distribution to investors after the firm pays for new investments or additions to working capital.

21. 3-21 The Statement of Cash Flows Cash flow from operations + Cash flow from investments + Cash flow from financing ____________________________ Change in cash balance Structure:

22. 3-22 Cash Flow: Example Net income for your firm was $10,000 last year. The depreciation expense was $2,500; accounts receivable increased $1,250; accounts payable increased $800; and inventories increased by $2,000. What was the total cash flow from operations for the period? Net income:10,000 Depreciation: 2,500 Accounts Receivable: (1,250) Accounts Payable: 800 Inventories: (2,000) Cash flow from operations:10,050

23. 3-23 Accounting Practice Most managers say that accounting earnings is the single most important number reported to investors. What implications does this have for the investor?

24. 3-24 Accounting Practice Grey areas for financial managers: Revenue recognition Cookie-jar reserves

25. 3-25 Accounting Practice Additional grey areas for financial managers: Off-balance sheet assets and liabilities Mark-to-market accounting

26. 3-26 Corporate Taxes In the United States, corporations pay tax on their income. US Corporate Tax Rates, 2011

27. 3-27 Corporate Taxes: Example What is the marginal tax rate for a corporation with $60,000 taxable income and an average tax rate of 16.67% if the next-lowest marginal tax rate of 15% covers taxable incomes up to $50,000? ($60,000) * (16.67%) = $10,000 total taxes paid IncomeRateTaxes Paid $0 - $50,00015%$7,500 $50,001 - $60,000?$2,500 Total:$10,000 ($10,000) * (marginal tax rate) = $2,500 Marginal Tax Rate = 25%

28. 3-28 Personal Tax US Personal Tax Rates, 2011

29. 3-29 Personal Tax: Example What is the average tax rate for an individual with a net income of $50,000 and a total tax liability of $10,704.50?

30. 3-30 The Problem of “Double Taxation” When a corporation issues a dividend, each dividend dollar is effectively taxed twice: 1.Each dollar of earnings taxed at corporate rate. 2.Shareholders pay personal income taxes on all dividends received.