Chapter 2 Financial Statements, Taxes, and Cash Flow

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

Chapter Outline The Balance Sheet The Income Statement Taxes Cash Flow!

The 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 liquidity with the most liquid assets being listed first Liquidity is the ease with which an asset can be converted to cash without significant loss in value Inventory is the least liquid current asset

The Balance Sheet (continued) The balance sheet equation Assets = Liabilities + Stockholders’ Equity Assets = Liabilities + Owners’ Equity

Net Working Capital Net working capital = Current assets – current liabilities NWC = CA – CL Net working capital is positive when current assets exceed current liabilities Net working capital is usually positive in a healthy firm

Market Value vs. Book Value Assets are reported on the balance sheet at book value Historical cost, what the firm paid for the assets Required by GAAP Market value is the price at which the assets, liabilities, or equity can be bought or sold Market value and book value often differ

Income Statement The income statement is a view of the firm’s operations over a period of time Revenues are reported when accrued, Expenses are reported when incurred Matching Principle: GAAP requires revenues to be reported when accrued and matched to the expenses incurred to generate the revenues Revenue – Expenses = Income

Taxes Life has two certainties: Death and Taxes Taxes and tax law are always changing

Taxes (continued) Marginal versus average tax rates Marginal: the tax rate paid on the next dollar earned Average: Total taxes paid divided by total taxable income Total taxes paid/total taxable income

Cash Flow Cash flow: The difference between the amount of money that came in and the amount of money that went out Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements The standard financial accounting Statement of Cash Flows addresses a different issue than what we are concerned with

Cash Flow (continued) Cash Flow From Assets (CFFA) = Cash Flow to Creditors plus Cash Flow to Stockholders Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in Net Working Capital

Operating Cash Flow Operating Cash Flow is the cash flow that results from the firm’s day-to-day activities of producing and selling Expenses associated with the financing of assets are not included since they are not operating expenses Example: Interest expense

Operating Cash Flow (continued) Formula: Operating Cash Flow = EBIT + depreciation - taxes

Net Capital Spending Net Capital Spending: Money spent on fixed assets less money received from the sale of fixed assets Formula: Ending net fixed assets minus beginning net fixed assets plus depreciation = Net investment in fixed assets

Change in Net Working Capital To determine the change in net working capital, take the difference between the beginning and ending net working capital (NWC) figures Ending NWC minus Beginning NWC = Change in NWC

Cash flow to creditors A firm’s interest payments to creditors less net new borrowings Also known as cash flow to bondholders Interest paid – net new borrowing = cash flow to creditors

Cash flow to stockholders Cash flow to stockholders is dividends paid out by a firm less net new equity raised Dividends paid - net new equity raised = Cash flow to stockholders

Quiz What is liquidity and why is it important? What is the least liquid current asset? What is the difference between market value and book value? Which should we use for decision making purposes? What is the income statement equation? What is the difference between a marginal and an average tax rate?

Quiz (continued) What is the Operating Cash Flow equation? Why do we add back depreciation? Why is interest paid not a component of operating cash flow?