6-1 Chapter 2 Financial Statements, Taxes and Cash Flow Financial Statements, Taxes and Cash Flow 2-1

6-2 Chapter Objectives u Understand the difference between book value (from the Balance Sheet) and market value. u Understand the difference between net profit (from the Income Statement) and cash flow. u Explain the differences between the average tax rate, the marginal tax rate and the flat rate. u Explain the calculation of cash flow from assets, and cash flow to debt-holders and shareholders. u Understand the difference between book value (from the Balance Sheet) and market value. u Understand the difference between net profit (from the Income Statement) and cash flow. u Explain the differences between the average tax rate, the marginal tax rate and the flat rate. u Explain the calculation of cash flow from assets, and cash flow to debt-holders and shareholders. 2-2

6-3 u A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity. u Equation: Assets = Liabilities + Owners’/Shareholders’ Equity. u Net working capital = Current Assets – Current Liabilities. The Balance Sheet 2-3

6-4 Petro Rabighs’ Balance Sheet (Asset Side) a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. c d Current Assets e $1,195 f g Net Fix. Assets $ 701 Total Assets b $2,169 Cash and C.E. $ 90 Acct. Rec. c 394 Inventories 696 Prepaid Exp d 5 Accum. Tax Prepay 10 Current Assets e $1,195 Fixed Assets f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 a 2-4

6-5 Petro Rabighs’ Balance Sheet (Liability Side) a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. c d d Current Liab. e $ 500 f g g h Total Equity $1,139 Notes Payable $ 290 Acct. Payable c 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equity a,b $2,169 Petro Rabighs’ Balance Sheet (thousands) Dec. 31,

6-6 Market Value versus Book Value u Book value refers the price that never change as long as you own the asset. Example: if you bought a house 10 years ago for 300,000SAR, its book value for your entire period of ownership will remain 300,000SAR u Market value refers the price that could be obtained in the current market place. Example: if the price of that house after 10 years is 350,000SAR then it is called market value. u Book value refers the price that never change as long as you own the asset. Example: if you bought a house 10 years ago for 300,000SAR, its book value for your entire period of ownership will remain 300,000SAR u Market value refers the price that could be obtained in the current market place. Example: if the price of that house after 10 years is 350,000SAR then it is called market value. 2-6

6-7 u A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Equation:Revenues – Expenses = Profit. u Profit is often expressed on a per-share basis and called earnings per share (EPS). u The difference between net profit and cash dividends is called retained earnings, which is added to the retained earnings account in the Balance Sheet. The Income Statement 2-7

6-8 Revenue $4 000 Cost of Goods Sold Depreciation 200 EBIT (Earnings Before Interest & Tax ) Interest 200 Taxable Income (EBT) 800 Tax 240 Net Profit (EAT) $560 Dividends 260 Addition to R/E $300 Example—Income Statement of Petro Rabigh 2-8

6-9 u Can be one of the largest cash outflows that a firm experiences. u The size of the tax bill is determined by the Income Tax Assessment Act. u The Tax Act is the result of political, not economic, forces. TaxesTaxes 2-9

6-10 u The average tax rate is the total tax bill divided by taxable income; that is, the percentage of income that goes in taxes. u The marginal tax rate is the extra tax paid if one more dollar is earned. u A flat rate is where there is only one tax rate that is the same for all income levels. u It is the marginal rate that is relevant for most financial decisions. Tax rates 2-10

6-11 Tax System in Saudi Arabia

6-12 Cash Flow from Assets u Equation: Cash flow from assets = cash flow to debt-holders + cash flow to shareholders. u The cash flow identity or equation states that the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm.

6-13 Cash Flow from Assets The total cash flow from assets = operating cash flow – net capital spending on non- current assets- addition to net working capital u Operating cash flow: the cash flow that results from day-to-day activities of producing and selling. Earnings before interest and taxes (EBIT) + Depreciation – Taxes. u Net capital spending: Ending non-current assets – Beginning non-current assets + Depreciation.. u Additions to net working capital (NWC): Ending NWC – Beginning NWC.

6-14 Cash Flow to Debt-holders and Shareholders u The cash flow to debt-holders includes any interest paid less the net new borrowing. u The cash flow to shareholders includes dividends paid out by a firm less net new equity raised.

6-15 Example―Balance Sheet ($000s) Assets (‘000s) Current assets Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment TOTAL ASSETS $ $ $3 220 $ $ $3 690

6-16 Liabilities and equity (‘000s) Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings Total TOTAL LIABILITIES AND EQUITY $ $ 640 $ $2 170 $3 220 $ $ 870 $ $2 370 $3 690 Example―Balance Sheet ($000s)

6-17 Sales $ Cost of goods sold Depreciation60.00 EBIT $ Interest Taxable income Tax Net profit$ Dividends Addition to retained earnings $ Example―Income Statement ($000s)

6-18 Operating cash flow: EBIT $ Depreciation – Taxes– $ Change in net working capital: Ending net working capital $ – Beginning net working capital $ Net capital spending: Ending non-current assets $ – Beginning non-current assets – Depreciation $ Cash flow from assets: $ Example―Cash Flow From Assets ($000s)

6-19 Cash flow to debtholders: Interest paid $ – Net new borrowing( )– 40.00$ 0.00 Cash flow to shareholders: Dividends paid$ – Net new equity raised ( ) 0.00$52.00 Cash flow to debtholders and shareholders$52.00 Example―Cash Flow to Debt- holders and Shareholders ($000)

6-20 Summary and Conclusions u The book values on an accounting Balance Sheet can be very different from market values. u Net profit as it is computed on the Income Statement is not a cash flow, a primary reason being the deduction of depreciation (a non-cash expense). u Marginal and average tax rates can be different. However it is the marginal tax rate that is relevant for most financial decisions. u Cash flow from assets equals cash flow to debt-holders and shareholders. u It is important not to confuse book values with market values, and accounting income with cash flow.