1. Financial Statements, Taxes and Cash Flows
MSBC 5060 Chapter 2
Financial Statements,
Taxes and Cash Flows

2. Chapter Outline
2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes 2.4 Net Working Capital 2.5 Cash Flows 2.6 The Statement of Cash Flows 2.7 Cash Flow Management

3. 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

4. Balance Sheet Assets are listed from Most Liquid to Least Liquid
“Net Fixed Assets” is Book Value (LOCOM) net of Accumulated Depreciation
Assets = Liabilities + OE  OE = Assets - Liabilities

5. The balance sheet is a “snap-shot”
What does the company own today?
What does the company owe today?
How much is left for the owners?
called the residual
The LEFT SIDE shows what assets are employed by the firm to do what it does
Cash, Inventory, Factories, Machines, Trucks…
The RIGHT SIDE shows how it paid for the assets
How much is borrowed and for how long
How much is left for the owners
Note: Owner’s Equity is not how much the owners contributed. It is the current residual value.

6. Debt is also called Financial Leverage
Given the equity, what value of assets are employed?
Put up $1m, borrow $1m, Employ $2m in assets
Put up $1m, borrow $2m, Employ $3m in assets
Market Value vs. Book Value:
Market Value of Assets vs. Book Value of Assets
GAAP: LOCOM
Coors in Golden: Land is on books at cost
But what is the market value of that land?
Market Value of Equity vs. Book Value of Equity
Book Value of Equity = Book Value of Assets – Liabilities
Market Value of Equity = # of Shares x Price per Share
What would account for the difference between book and market?
What kind of companies have a relatively high BM? Low BM?

7. Recap: Market Value of Assets Book Value of Assets
Market Value of Equity
Book Value of Equity

8. Income Statement Income Statement Includes:
Operating Expenses (COGS, SG&A, Lights…)
Per-Share numbers
Addition to Retained Earnings on Income Statement
is added to Accumulated Retained Earnings on the Balance Sheet

9. Revenues and Expenses as they Accrue
If a sale is made, book the revenue
Not necessarily receive cash
Sale could be on account - A/R (a current asset)
Non-Cash Expenses
Depreciation = $90
Was the $90 spent this period?
No! It is a portion of the amount spent (when the PPE was purchased) that is allocated to this period
$90 is expensed against this period’s revenue
It lowers this periods taxable income
And therefore lowers this period’s tax expense

10. Question: A firm’s taxable income is $1,000
The firm owns a machine’s with $200 annual depreciation this year.
It paid $2,000 for the machine and is depreciating it straight-line over 10 years
The firm’s tax rate is 35%
What is this year’s tax savings due to depreciation?
(Depreciation)(Tax Rate) = $200(0.35) = $70 Or
Tax Exp without Depreciation = $1,000(0.35) = $350
Tax Exp with Depreciation = ($1,000 - $200)(0.35) = $280
= ($800)(0.35) = $280
Savings = $350 - $280 = $70

11. Firms can engage in “Earnings Management”
Show higher or lower earnings
Used to achieve income smoothing
“Cookie Jar” accounts
LIFO or FIFO
Not necessarily illegal or unethical
See Wikipedia Page

12. Corporate Taxes See Table 2.3 for corporate tax rates
Make sure you can calculate:
Tax Expense
Marginal Tax Rate
Average Tax Rate
See Example 2.4 on page 27
Note textbook typo: Not Example 4.2
If you are calculating the effect of additional income from a new project, which tax rate should you use?
Marginal. Why?

13. Net Working Capital (NWC)
NWC = Current Assets – Current Liabilities

14. NWC = Current Assets – Current Liabilities NWC = $761 – $486 = $275
NWC is a measure of Short-Term Solvency
NWC also used to adjust Sales and Costs from Income Statement to get Cash Flows:
Assume Sales last year was $100
But A/R increased from $20 to $50
How much actual cash was collected?
Only $70
$100 – ($50 - $20) = $100 - $30 = $70
$70 in Cash Sales and $30 in A/R Sales

15. Cash Flows
Cash Flows are Everything!
On CFs are available to pay investors
Not “Sales” or “Income”
We will deal with Cash Flows in a slightly different way than the “Statement of Cash Flows”
In General, the value of a firm (or an individual project) is…
… the Present Value of its Cash Flows!
Net Cash Flows (in any period) = Money In - Money Out
Not Sales
Since some sales are in cash, some sales are on account
Not Net income (aka Earnings )
NI or Earnings is an “accounting profit” or “economic profit”
Not cash available to pay investors
Includes non-cash expenses
Includes accruals (sales, purchases…)
A firm is defined by its assets so we will call this Cash Flows from Assets
We will start with NI and Adjust 

16. OCF = NI + Int Exp + Dep + Deferred Tax = 86 + 90 + 49 + 13 = $238
CFs from Assets
So back to the Income Statement:
OCF = NI + Int Exp + Dep + Deferred Tax = = $238

17. CFs from Assets So we have OCF = $238
But how much of that activity represents CASH transactions?
Sales was $2,262
But how much of those sales were on account?
COGs was $1,655
But was that money actually spent on inventory this year?
Only if it was replaced! (so no change in INV)
And Only if cash was spent (no change in A/P)

18. CFs from Assets A/R from $270 to $294 INV from $280 to $269
So back to the Balance Sheet (just Current Asset for now):
A/R from $270 to $294
$294 – $270 = $24 of OCF was not cash received
INV from $280 to $269
$269 – $280 = -$11 of Inv was not replaced
COGS of $1,655, but only $1,655 - $11 = $1,644 was cash spent

19. CFs from Assets Now just Current Liabilities:
Total Current Liabilities from $455 to $486
$486 – $455 = $31 of Cash assumed spent was not spent
It was “borrowed”

20. CFs from Assets Increases in Current Asset means OCF is too high
Increases in Current Liabilities means OCF is too low
So next step (Still one more after this):
Total CFs = Operating CF – ΔCA + ΔCL
But it is usually written his way:
ΔCA = New CA – Old CA
ΔCL = New CL – Old CL
New NWC = New CA – New CL
Old NWC = Old CA – Old CL
ΔNWC = New NWC – Old NWC
CFs from Assets = Operating CF – ΔNWC

21. CFs from Assets
Recap:
OCF = EBIT + Dep – Taxes = $219 + $90 - $71 = $238
ΔNWC = New NWC – Old NWC
New NWC = $761 - $486 = $275
Old NWC = $707 - $455 = $252
ΔNWC = $275 – $252 = $23
So now CF = OCF - ΔNWC = $238 - $23 = $215
But still not done yet!
We have to consider Net Capital Spending
Cash spent on capital is not available to investors
Distinguish Capital (PPE) from Working Capital

22. CFs from Assets Now just Fixed Assets
NCS = New Total Fixed Assets – Old Total Fixed Assets + Dep
NCS = $1,118 – $1, ($550 – $460)
NCS = $1,118 – $1, $90 = $173

23. CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42
CFs from Assets
Recap:
OCF = EBIT + Dep – Taxes = $219 + $90 - $71 = $238
ΔNWC = New NWC – Old NWC = $275 – $252 = $23
NCS = New TFA – Old TFA + Dep = $1,118 – $1, $90 = $173
So firm generated “cash” of $238 from operations
But $23 of the $238 was either:
Not collected – Assumed revenue was too high
Or more was spent – Assumed costs were too low
Since NWC increased
And $173 of the $238 was spent of PPE
CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42

24. CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42
CFs from Assets
CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42
This is called Cash Flows From Assets
So what happened to the $42 of CF from Assets?
Some CF to bondholder (also called creditors)
Some CF to stockholders
We will show:
CF from Assets = CF to Creditors + CF to Stockholders
Cash IN must equal Cash OUT

25. From the Income Statement:
CFs to Creditors
From the Income Statement:
Interest Expense = $49
This is a CF TO Creditors
From the Balance Sheet:
Net New Long-Term Debt = New – Old
Net New Long-Term Debt = $471 - $458 = $13
This is a CF FROM Creditors
Net CF to Creditors = Int Exp – Net New LT Debt
Net CF to Creditors = $49 – $13 = $36

26. From the Income Statement:
CF to Stockholders
From the Income Statement:
Dividends = $43
This is a CF TO stockholders
From the Balance Sheet:
Net New Treasury Stock = $26 – $20 = $6
$43 + $6 = $49
The firm paid $49 to Stockholders

27. From the Balance Sheet:
CF from Stockholders
From the Balance Sheet:
Change in Common Stock = $55 – $32 = $23
Change in Capital Surplus = $347 - $327 = $20
Together these are value of new stock sold = $43
$23 + $20 = $43
So the firm got $43 from stockholders
Net CF to Stockholders = $49 – $43 = $6

28. Cash In must equal Cash Out
CFs from Assets
Conclusion:
CF to Creditors = $36
CF to Stockholders = $6
CF to Creditors + CF to Stockholders = $36 + $6 = $42
Recall:
CF from Assets = OCF – ΔNWC – NCS = $42
Cash In must equal Cash Out

29. The Accounting Statement of CFs
Back to the Balance Sheet:
Cash increased by $198 - $157 = $41
Why?
What were the firm’s sources and uses of cash?

30. The Accounting Statement of CFs

31. This is roughly equivalent to OCF – ΔNWC = 238 – 23 = 215
We got a different number because:
We did not include interest expense ($49)
We did include changes in cash ($41)
$215 - $49 + $41 = $207

32. Investing Activities = Net Capital Spending = $173
Financing Activities

33. The Accounting Statement of CFs
Net Changes to Cash = $207 – $173 + $7 = $41
This shows the breakdown of how Cash went from $157 to $198
We DO NOT care about the Statement of CFs
We DO care about CFs from Assets
This is cash available to be paid to investors!
That the firm decided to increase the cash account (instead of buying inventory or paying off debt) does not concern us – from a valuation perspective
What does concerns us is the Free CFs generated from the firm’s assets ($42) that are available to be paid to investors
We also care about what happened to the $42 Free CF’s
$36 to creditors and $6 to stockholders

34. The Accounting Statement of CFs
Be sure to appreciate the difference between:
Accounting Statement of Cash Flows used to trace the source of changes in the cash account
Financial “Free Cash Flows” (FCFs) available to compensate investors
The amount, timing and allocation between stockholders and bondholders of these “free cash flows” are relevant for analyzing the company and valuing its stocks and bonds, not the changes to the amount of cash on hand.

35. Earnings and Cash Flow “Management” vs Fraud
Enron
WorldCom

36. What’s Next?
More on Financial Statements
Financial Statement Analysis
Ratios
Profitability Decomposition
Growth and Financing Growth