1. 0 Chapter 2 Financial Statements, Taxes, and Cash Flow

2. 1 Chapter Outline The Balance Sheet The Income Statement Taxes Cash Flow

3. 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

4. 3 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 decreasing liquidity  Ease of conversion to cash without significant loss of value Balance Sheet Identity  Assets = Liabilities + Stockholders’ Equity

5. 4 Figure 2.1

6. 5 U.S. Corporation Balance Sheet – Table 2.1

7. 6 Balance Sheet Analysis When analyzing a balance sheet, the Finance Manager should be aware of three concerns: 1. Accounting liquidity 2. Debt versus equity 3. Value versus cost

8. 7 Accounting Liquidity Refers to the ease and quickness with which assets can be converted to cash — without a significant loss in value Current assets are the most liquid. Some fixed assets are intangible. The more liquid a firm ’ s assets, the less likely the firm is to experience problems meeting short-term obligations. Liquid assets frequently have lower rates of return than fixed assets.

9. 8 Debt versus Equity Creditors generally receive the first claim on the firm ’ s cash flow. Shareholder ’ s equity is the residual difference between assets and liabilities.

10. 9 Market vs. Book Value The balance sheet provides the book value of the assets, liabilities, and equity.  Historical Cost Principle: Under Generally Accepted Accounting Principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost. Market value is the price at which the assets, liabilities, or equity can actually be bought or sold, which is a completely different concept from historical cost.

11. 10 Value versus Cost Market value and book value are often very different. Why? Which is more important to the decision- making process?

12. 11 Klingon Corporation KLINGON CORPORATION Balance Sheets Market Value versus Book Value BookMarketBookMarket AssetsLiabilities and Shareholders’ Equity NWC$ 400$ 600LTD$ 500 NFA 700 1,000Equity6001,100 1,6001,1001,600

13. 12 The Income Statement Measures financial performance over a specific period of time The accounting definition of income is: Revenue – Expenses ≡ Income

14. 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 recognize revenue when it is fully earned and match expenses required to generate revenue to the period of recognition

15. 14 U.S. Corporation Income Statement - Table 2.2

16. 15 American Composite Corporation Income Statement Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Addition to retained earnings $43 Dividends: $43 The operations section of the income statement reports the firm’s revenues and expenses from principal operations. $2,262 1,655 327 90 $190 29 $219 49 $170 84 $86

17. 16 American Composite Corporation Income Statement Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Addition to retained earnings $43 Dividends: $43 $2,262 1,655 327 90 $190 29 $219 49 $170 84 $86 The non-operating section of the income statement includes all financing costs, such as interest expense.

18. 17 American Composite Corporation Income Statement Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Addition to retained earnings $43 Dividends: $43 $2,262 1,655 327 90 $190 29 $219 49 $170 84 $86 Usually a separate section reports the amount of taxes levied on income.

19. 18 American Composite Corporation Income Statement Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Addition to retained earnings $43 Dividends: $43 $2,262 1,655 327 90 $190 29 $219 49 $170 84 $86 Net income is the “bottom line.”

20. 19 Income Statement Analysis There are three things to keep in mind when analyzing an income statement: 1. Generally Accepted Accounting Principles (GAAP) 2. Non-Cash Items 3. Time and Costs

21. 20 GAAP  The matching principal of GAAP dictates that revenues be matched with expenses.  Thus, income is reported when it is earned, even though no cash flow may have occurred.

22. 21 Non-Cash Items  Depreciation is the most apparent. No firm ever writes a check for “ depreciation. ”  Another non-cash item is deferred taxes, which does not represent a cash flow.  Thus, net income is not cash.

23. 22 Time and Costs  In the short-run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials.  In the long-run, all inputs of production (and hence costs) are variable.  Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.

24. 23 Example: Work the Web Publicly traded companies must file regular reports with the Securities and Exchange Commission These reports are usually filed electronically and can be searched at the SEC public site called EDGAR Click on the web surfer, pick a company, and see what you can find!

25. 24 Taxes The one thing about taxes we can rely on is that they will always be changing Marginal vs. average tax rates  Marginal – the percentage paid on the next dollar earned  Average – the tax bill / taxable income Other taxes

26. 25 Corporate Tax Rates Taxable IncomeTax Rate $ 0- 50,00015% 50,001- 75,00025 75,001- 100,00034 100,001- 335,00039 335,001- 10,000,00034 10,000,001- 15,000,00035 15,000,001- 18,333,33338 18,333,334+35

27. 26 Example: Marginal vs. Average Rates Suppose your firm earns $4 million in taxable income.  What is the firm’s tax liability?  What is the average tax rate?  What is the marginal tax rate? If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

28. 27 Example: Marginal vs. Average Rates (1) Taxable Income (2) Marginal Tax Rate (3) Total Tax (3)/(1) Average Tax Rate $ 45,00015%$ 6,75015.00% 70,0002512,50017.86 95,0003420,55021.63 250,000 1,000,000 17,500,000 50,000,000 100,000,000

29. 28 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 accounting 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 who finance the purchase of the assets

30. 29 Table 2.5

31. 30 Financial Cash Flows Three Financial Cash Flows  Cash Flow From Assets  Cash Flow to Creditors  Cash Flow to Stockholders Since there is no magic in finance, it must be the case that the cash flow received from the firm ’ s assets must equal the cash flows to the firm ’ s creditors and stockholders.  Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders, or CF(A)≡ CF(B) + CF(S)

32. 31 Cash Flow From Assets Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC  OCF (I/S) = EBIT + depreciation – taxesI/S  NCS ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation B/S  Changes in NWC (B/S) = ending NWC – beginning NWC

33. 32 Cash Flow to Investors CF to Creditors (B/S and I/S) = interest paid – net new borrowing CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised

34. 33 U.S. Corporation Balance Sheet – Table 2.1

35. 34 U.S. Corporation Income Statement - Table 2.2

36. 35 U.S.C.C. Financial Cash Flow Operating Cash Flow: EBIT $ 694 + Depreciation 65 - Current Taxes - 212 OCF $ 547 Cash Flow From the Assets Operating cash flow$ 547 Capital spending Additions to net working capital Total Cash Flow to Investors Creditor Stockholder Total

37. 36 U.S.C.C. Financial Cash Flow Cash Flow From the Assets Operating cash flow$ 547 Capital spending -130 Additions to net working capital Total Cash Flow to Investors Creditor Stockholder Total Capital Spending Ending net fixed assets $1,709 - Beginning net fixed assets -1,644 + Depreciation 65 Capital Spending $ 130

38. 37 U.S.C.C. Financial Cash Flow Cash Flow From the Assets Operating cash flow$ 547 Capital spending -130 Additions to net working capital-330 Total Cash Flow to Investors Creditor Stockholder Total Change in Net Working Capital ( NWC) Ending NWC $1,014 - Beginning NWC - 684 Change in NWC $ 330

39. 38 U.S.C.C. Financial Cash Flow Cash Flow From the Assets Operating cash flow$ 547 Capital spending -130 Additions to net working capital-330 Total$ 87 Cash Flow to Investors Creditor Stockholder Total

40. 39 U.S.C.C. Financial Cash Flow Cash Flow From the Assets Operating cash flow$ 547 Capital spending -130 Additions to net working capital-330 Total$ 87 Cash Flow to Investors Creditor$ 24 Stockholder Total Cash Flow to Creditors Interest Paid $70 - Net new borrowings 46 Cash flow to creditors 24

41. 40 U.S.C.C. Financial Cash Flow Cash Flow From the Assets Operating cash flow$ 547 Capital spending -130 Additions to net working capital-330 Total$ 87 Cash Flow to Investors Creditor$ 24 Stockholder63 Total Cash Flow to Stockholders Dividends paid $103 - Net new equity raised 40 Cash to Stockholders 63

42. 41 U.S.C.C. Financial Cash Flow Cash Flow From Assets Operating cash flow$ 547 Capital spending -130 Additions to net working capital-330 Total$ 87 Cash Flow to Investors Creditor$ 24 Stockholder63 Total$ 87 The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:

43. 42 Example: Balance Sheet and Income Statement Information Current Accounts  2007: CA = $1,500; CL = $1,300  2008: CA = $2,000; CL = $1,700 Fixed Assets and Depreciation  2007: NFA = $3,000; 2008: NFA = $4,000  Depreciation expense = $300 LT Liabilities and Equity  2007: LTD = $2,200; Common Stock = $500; RE = $500  2008: LTD = $2,800; Common Stock = $750; RE = $750 Income Statement Information  EBIT = $2,700; Interest Expense = $200; Taxes = $1,000; Dividends = $1,250

44. 43 Example: Cash Flows OCF = $2,700 + $300 – $1,000 = $2,000 NCS = $4,000 – $3,000 + $300 = $1,300 Changes in NWC = ($2,000 – $1,700) – ($1,500 – $1,300) = $100 CFFA = $2,000 – $1,300 – $100 = $600 CF to Creditors = $200 – ($2,800 – $2,200) = - $400 CF to Stockholders = $1,250 – ($750 – $500) = $1,000 CFFA = - $400 + $1,000 = $600 The CF identity holds.

45. 44 2.6 The Statement of Cash Flows There is an official accounting statement called the statement of cash flows. This helps explain the change in accounting cash. The three components of the statement of cash flows are:  Cash flow from operating activities  Cash flow from investing activities  Cash flow from financing activities

46. 45 Quick Quiz 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?

47. 46 Comprehensive Problem Current Accounts  2007: CA = $4,400; CL = $1,500  2006: CA = $3,500; CL = $1,200 Fixed Assets and Depreciation  2007: NFA = $3,400; 2006: NFA = $3,100  Depreciation Expense = $400 Long-term Debt and Equity (R.E. not given)  2007: LTD = $4,000; Common stock & APIC = $400  2006: LTD = $3,950; Common stock & APIC = $400 Income Statement  EBIT = $2,000; Taxes = $300  Interest Expense = $350; Dividends = $500 Compute the CFFA