1. Chapter 2 Financial Statements, Taxes, and Cash Flow Copyright © 2012 McGraw-Hill Education. All rights reserved.

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 Understand the different point of view between accounting and finance 2-2

3. Chapter Outline The Balance Sheet The Income Statement Taxes Cash Flow Accounting versus Finance 2-3

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 2-4

5. The Balance Sheet - Figure 2.1 2-5

6. Net Working Capital and Liquidity Net Working Capital (NWC) –= 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 typically earn a lower return –Trade-off to find balance between liquid and illiquid assets 2-6

7. US Corporation Balance Sheet – Table 2.1 Place Table 2.1 (US Corp Balance Sheet) here 2-7

8. Debt versus Equity -If the firm sells its assets and pays its debts, whatever cash is left belongs to the shareholders. -The use of debt in a firm’s capital structure is called “financial leverage”. -Financial leverage increases the potential reward to shareholders but it also increases the potential for financial distress and business failure.

9. Market Value vs. Book Value The balance sheet provides the book value of the assets, liabilities, and equity.(historical cost) 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. For current assets they might be similar because current asset a are bought and converted into cash over a relatively short span of time. For fixed assets, it would be a coincidence. The market value of an asset depends on things like its riskiness and cash flows. 2-9

10. Market Value vs. Book Value Which is more important to the decision- making process? Managers and investors will frequently be interested in knowing the value of the firm. This information is not on the balance sheet. (assets are listed at cost, most of the valuable assets a firm might have don’t appear on the balance sheet at all, the true value of the stock is reflected in the stockholders’ equity).

11. Market Value vs. Book Value For financial mangers, the accounting value of the stock is not an especially important concern; it is the market value that matters. Hence, the distinction between book and market values is important precisely because book values can be so different from the true economic value.

12. Example 2.2 Klingon Corporation KLINGON CORPORATION Balance Sheets Market Value versus Book Value BookMarketBookMarket AssetsLiabilities and Shareholders’ Equity NWC$ 400$ 600LTD$ 500 NFA 700 1,000SE6001,100 1,6001,1001,600 2-12

13. 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 2-13

14. US Corporation Income Statement – Table 2.2 Insert new Table 2.2 here (US Corp Income Statement) 2-14

15. Income Statement When looking at an income statement, the financial manger needs to keep 3 things in mind: 1) GAAP and the income statement (recognition or realization principle: to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. It is the time of sale not collection)

16. Income Statement 2) Non cash items: “Expenses charged against revenues that do not directly affect cash flow, such as depreciation.” Matching principle in accounting: the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.

17. Income Statement 3) Time and costs: The distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on.

18. Taxes The one thing we can rely on with taxes is that they are always changing (largest cash outflows the firm may experience) Marginal vs. average tax rates –Marginal tax rate – the percentage paid on the next dollar earned –Average tax rate – the tax bill / taxable income 2-18

19. Taxes Other taxes Interest and dividend income is either taxed at a flat rate or added to the general income and tax at the margin. The longer the holding period of the investment the lower the applicable tax rate. The idea is to discourage short-term trading activities which are generally blamed for heightened financial market volatility.

20. 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 2-20

21. The Concept of Cash Flow “means the difference between the number of dollars that came in and the number that went out.” Cash flow identity: Cash flow from assets = Cash flow to creditors + Cash flow from to stockholders

22. Cash Flow From Assets Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC 2-22

23. Cash Flow From Assets 1) Operating Cash Flow (OCF): “ Cash generated from a firm’s normal business activities.” [Revenues – Costs ] Include: taxes ( paid in cash) Does not include: depreciation (not cash outflow) and interest (financing expense) A negative OCF is often a sign of trouble.

24. Cash Flow From Assets 2) Capital Spending: money spend on fixed assets less money received from the sale of fixed assets. It can be negative if the firm sold off more assets than it purchased.

25. Cash Flow From Assets 3) Change in Net Working Capital: investing in current assets ( current liabilities will usually change as well.) Change in NWC = Ending NWC – Beginning NWC

26. Cash Flow From Assets Cash Flow From Assets = Operating cash flow – the amounts invested in fixed assets and net working capital A negative cash flow means that the firm raised more money by borrowing and selling stock than it paid out to creditors and stockholders during the year

27. Cash Flow Summary - Table 2.6 2-27

28. Accounting versus Finance: A Different Point of View A profitable project should generate a return in excess of the cost of capital needed to pursue it. Only investments above that rate will create value and lead to an increase in the company’s share price. Cost of capital is the weighted average of its capital components, i.e. the cost of equity, the cost of debt and the respective weights.

29. Accounting versus Finance: A Different Point of View Cost of equity: The cost of debt is indicated in the income statement in form of the interest expense, which reduces a company’s taxable income. The only indication of a cash flow to shareholders is given in the income statement in form of the dividend payment. However, the dividend payment s are discretionary because they determined by the financial management based on cash availability and investment policy.

30. Accounting versus Finance: A Different Point of View From the accountant’s view the equity is costless while the financial manager sees it more costly than debt for a variety of reasons: 1- Equity is junior to debt in the event of bankruptcy. 2- The level of cash flow uncertainty during the investment period is higher for equity as neither the dividend size nor timing is known in advance opposite to corporate bond.

31. Accounting versus Finance: A Different Point of View 3- the price fluctuation of stock prices (volatility) is more pronounced than that of bonds prices. The combination of these factors makes a stock investment significantly more risky than a bond investment. As a consequence, equity investors would require a higher return to compensate for the higher level of risk.

32. Accounting versus Finance: A Different Point of View It is important to understand that the investor’s required rate of return is the cost of capital to the company. Therefore, a company’s cost of equity is inherently more costly than its cost of debt. To determine the profitability of a project, it is crucial for the financial manger to incorporate both the cost of debt and the cost of equity.

33. Accounting versus Finance: A Different Point of View Timing of cash flows: the matching principle is a poor guide for the financial manager in determining a company’s cash flow needs. “ The time difference between cash in and outflows” is known as the cash cycle. As the length of the cash cycle affects a company’s financing costs, maximizing shareholders’ wealth mandates the financial manager to keep these financing costs to a minimum.

34. Accounting versus Finance: A Different Point of View Cash flows vs. net profit: from the accounting point of view, a company’s success measure is the net income. The financial manager, however, is more interested in cash flows, i.e., the size and timing of the cash flows as well as the risk associated with them. Net income is not an accurate reflection of the cash in and outflows of a company as it contains non- cash items such as depreciation.

35. Accounting versus Finance: A Different Point of View It also does not incorporate the time value of money concept that states that money loses value over time. The value of the future cash inflow in today’s money is not only a function of time but also of risk. The higher the risk associated with a cash flow, the lower its present value.

36. Accounting versus Finance: A Different Point of View Tax rates: financial mangers determine the profitability of a particular project based on its expected net cash flow effect, i.e., the change in the company’s cash flows after taxes. The tax rate applied to the cash flows of any new project will be determined by the level of taxable income already generated and the corresponding tax bracket.

37. Accounting versus Finance: A Different Point of View Characterization of cost: accountants commonly classify cost as a periodic charge or as selling, general and administrative expenses, which is the combined cost of operating a company. From a financial manager’s point of view, however, it makes more sense to classify costs as being either fixed or variable in nature.

38. Accounting versus Finance: A Different Point of View This distinction enables financial managers to make value maximizing production decisions by determining the optimal level of production or the most advantageous operating leverage.

39. Accounting versus Finance: A Different Point of View Asset value: as a financial mangers are focused on cash flows they make investment decisions primarily based on market values. When buying an asset, the buyer’s cash outflow is determined by its market value and not the book value. Accordingly, the decision to sell an asset is determined by the cash inflow that can be reasonably expected based on its current market value.

40. End of Chapter 2-40