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CHAPTER TWO Financial Statements, Taxes, and Cash Flows.

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1 CHAPTER TWO Financial Statements, Taxes, and Cash Flows

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 Net Working Capital  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 Tax RateTaxable income %

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. A. What is the tax bill for each firm? B. 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 1. Operating Cash Flow (OCF) 2. Capital Spending 3. Change in Net Working Capital (NWC)

21 U.S. CORPORATION 2008 AND 2009 Balance Sheets ($ in millions) s Equity Liabilities and Owner’ Assets Current liabilitiesCurrent Assets Accounts payable Cash Notes payable Accounts receivable total555553Inventory Total Fixed Assets Long-term debt Net plant and equipment Owner’s equity Common stocks and paid-in surplus Retained earnings Total Total liabilities and owner’s equity Total Assets

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

23 Capital Spending 1709 Ending Net Fixed Assets Beginning net fixed assets 65+ Depreciation 130Net 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 1014Ending NWC 684- Beginning NWC 330Change in NWC Change in NWC = Ending NWC – Beginning NWC

25 Cash Flow From Assets U.S CORPORATION 2009 Cash Flow From Assets 547Operating Cash Flow 130- Net capital spending 330- Change in NWC 87Cash 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 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? Ex 9 Page 41

29 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? Ex 10 Page 42

30 EX 25 Page 44 (HW)

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 70Interest paid 46- Net new borrowing 24Cash to creditors

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

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 2009 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, – 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 EX 26 Page 44 calculate : CFFA, CF to creditors, and CF to stock holders

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?


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