Chapter 2: Corporate Finance

FIN3403: Corporate FinanceChapter 2: Financial Statements, Taxes, and Cash FlowThe Balance SheetThe balance sheet is a snapshot of the firm. It is a convenient means of organizing andsummarizing what a firm owns (its assets). what firm owes (its liabilities). and thedifference between the two (the firm's equity) at given point of timeAssets: The Left-Hand SideAssets are classified as either current or fixed.A fixed asset is one that has a relatively long life. Fixed assets can either be tangible, (pnys) (cal)such as a truck or a computer, or intangible, such as a trademark or patent.A current asset has a life of less than one year. This means that the asset will normallyconvert to cash within 12 months.Liabilities and Owner's Equity: The Right-Hand SideA debt that is not due in the upcoming year is classified as a long-term liability.Finally, by definition, the difference between the total value of the assets (current andfixed) and the total value of the liabilities (current and long-term) is the shareholdersequity, also called common equity or owner's equity.So, the balance sheet "balances" because the value of the left-hand side always equals thevalue of the right-hand side. That is, the value of the firm's assets is equal to the sum ofits liabilities and shareholders' equity.Assets = Liabilities + Shareholder's equity(aresidual claim against the Firm's total assets)This is the balance sheet identity, or equation, and it always holds because shareholders'equity is defined as the difference between assets and liabilities.Net Working CapitalThe difference between a firm's current assets and its current liabilities is called networking capital. (-)Net working capital is positive when current assets exceed current liabilities.Based on the definitions of current assets and current liabilities, this means that the cashthat will become available over the next 12 months exceeds the cash that must be paidover that same period. For this reason, net working capital is usually positive in a healthyfirm.There are three particularly important things to keep in mind when examining a balancesheet: liquidity, debt versus equity, and market value versus book value.LiquidityLiquidity refers to the speed and ease with which an asset can be converted to cash.Liquidity really has two dimensions: lease of conversion versus loss of value.Any asset can be converted to cash quickly if we cut the price enough.A highly liquid asset, therefore, is one that can be quickly sold without significant loss ofvalue.An illiquid asset is one that cannot be quickly converted to cash without a substantialprice reduction. FIN3403: Corporate FinanceChapter 2: Financial Statements, Taxes, and Cash FlowAssets are normally listed on the balance sheet in order of decreasing liquidity, meaningthat the most liquid assets are listed first.Current assets are relatively liquid and include cash and those assets that we expect toconvert to cash over the next 12 monthsAccounts receivable, for example, represent amounts not yet collected from customers on(From casiest to nardest) sales already made. Naturally, we hope these will convert to cash in the near future.1. cash equivalentInventory is probably the least liquid of the current assets, at least for many businesses.2. accounts receivableFixed assets are, for the most part, relatively illiquid. These consists of tangible things3. inventorysuch as buildings and equipment that don't convert to cash at all in normal business4. plani and equipmentactivity (they are, of course, used in the business to generate cash).Intangible assets, such as trademarks, have no physical existence but can be veryvaluable. Like tangible fixed assets, they won't ordinarily convert to cash and aregenerally considered illiquid.Debt versus EquityThe use of debt in a firm's capital structure is called financial leverage. The more debtfirm has (as a percentage of assets), the greater is its degree of financial leverage.Market Value versus Book ValueThe true value of any asset is its market value, which is the amount of cash we would getif we actually sold it.an inc balanceFor current assets, market value and book value might be somewhat similar becausesheet, book valuecurrent assets are bought and converted into cash over a relatively short span of time. Inis presented)other circumstances, they might differ quite a bit.Moreover, for fixed assets, it would be purely a coincidence if the actual market value ofan asset (what the asset could be sold for) were equal to its book value.For example, a railroad might own enormous tracts of land purchased a century or moreago. What the railroad paid for that land could be hundreds or thousands of times lessthan what it is worth today.The balance sheet would nonetheless show the historical cost. There are exceptions tothis practice.BOOK value)The Income StatementThe Income statement measures performance over some period of time, usually a quarteror a year.The last item is net income (the so-called bottom line). Net Income often is expressed ona per-share basis and called earnings per share (EPS).GAAP and the Income StatementThe general rule (the recognition principle) is to recognize revenue when the earningsprocess is virtually complete and the value of an exchange of goods or services is knownor can be reliably determined. In practice, this principle usually means that revenue isrecognized at the time of sale, which need not be the same as the time of collection. FIN3403: Corporate FinanceChapter 2: Financial Statements, Taxes, and Cash FlowNoncash ItemsA primary reason that accounting income differs from cash flow Is that an incomestatement contains noncash itemsSuppose a firm purchases a fixed asset for $5,000 and pays in cash. Obviously, the firmhas a $5,000 cash outflow at the time of purchase. However, instead of deducting the$5,000 as an expense, an accountant might depreciate the asset over a five-year period.If the depreciation is straight-line and the asset is written down to zero over that period,then $5,000/5 = $1,000 would be deducted each year as an expense. The important thingto recognize Is that this $1,000 deduction isn't cash - it's an accounting number. Theactual cash outflow occurred when the asset was purchased.The depreciation deduction is another application of the matching principle inaccounting. The revenues associated with an asset would generally occur over somelength of time. So, the accountant seeks to match the expense of purchasing the asset withthe benefits produced from owning it.Time and CostsIt is often useful to think of the future as having two distinct parts: the shirt run and thelong run. These are not precise time periods. The distinction has to do with whether costsare fixed or variable. In the long run, all business costs are variable. Given sufficienttime, assets can be sold, debts can be paid, and so on.If our time horizon is relatively short, however, some costs are effectively fixed - theymust be paid no matter what (e.g., property taxes). Other costs, such as wages to laborersand payments to suppliers, are still variable. As a result, even in the short run, the firmcan vary its output level by varying expenditures in these areas.variable costsThe distinction between fixed and variable costs is important, at times, to the financialchanges as themanager, but the way costs are reported on the income statement is not a good guide as towhich coast are which. The reason is that, in practice, accountants tend to classify costsoutput 01 the Firmas either product costs or period costs.changes.Product costs include such things as raw materials, direct labor expense, andmanufacturing overhead. These are reported on the income statement as costs of goodssold, but they include both fixed and variable costs. Similarly, period costs are incurredduring a particular time period and might be reported as selling, general, andadministrative expenses. Once again, some of these period costs may be fixed and othersmay be variable. The company president's salary is a period cost and is probably fixed, atleast in the short run.Earnings ManagementFor example, corporations frequently like to show investors that they have steadilygrowing earnings. To do this, they might take steps to overstate or understate earnings atvarious times to smooth out dips and surges. Doing so is called earnings management,and it is a controversial practice. FIN3403: Corporate FinanceChapter 2: Financial Statements, Taxes, and Cash FlowTaxesCorporate Tax RatesAfter the passage of the Tax Cuts and Jobs Act of 2017, the federal corporate tax rate inthe United States became a flat 21 percent. However, tax rates on other forms of businesssuch as proprietorships, partnerships, and LLCs did not become flat.To illustrate some important points about taxes for such entities, we take a look atpersonal tax rates.Average versus Marginal Tax RatesYour average tax rate is your tax bill divided by your taxable income; in other words, thepercentage of your income that goes to pay taxes. Your marginal tax rate is the extra taxthat would pay if you earned one more dollar.Cash FlowAt this point, we are ready to discuss perhaps one of the most important pieces offinancial information that can be gleaned from financial statements: cash flow.By cash flow, we mean the difference between the number of dollars that came in and thenumber that went out.From the balance sheet identity, we know that the value of a firm's assets is equal to thevalue of its liabilities plus the value of its equity. Similarly, the cash flow from the firm'sassets must equal the sum of the cash flow to creditors and the cash flow to stockholders(or owners, if the business is not a corporation):Cash flow from assets = Cash flow to creditors + Cash flow to stockholdersCash Flow from AssetsCash flow from assets involves three components: operating cash flow, capital spending,and change in net working capital.Operating cash flow refers to the cash flow that results from the firm's day to dayactivities of producing and selling. Expenses associated with the firm's financing of itsassets are not included because they are not operating expenses.Operating cash flow is an important number because it tells us, on a very basic level,whether or not a firm's cash inflows from its business operations are sufficient to coverits everyday cash outflows. For this reason, a negative operating cash flow is often a signof trouble.Capital SpendingNet capital spending is money spent on fixed assets less money received from the sale offixed assets.Ending net fixed assets$1,709(-) Beginning net fixed assets1,644Depreciation89Net investment in fixed assets$154 FIN3403: Corporate FinanceChapter 2: Financial Statements, Taxes, and Cash FlowA Note on "Free" Cash FlowCash flow from assets sometimes goes by a different name, free cash flow. Of course,there is no such thing as "free" cash (we wish!). Instead, the name refers to cash that thefirm is free to distribute to creditors and stockholders because it is not needed forworking capital or fixed asset investments.Cash Flow to Creditors and StockholdersCash flow to creditors is interest paid less net new borrowing: cash flow to stockholdersis dividends paid less net new equity raised.Interest paid$70(-) Net new borrowing46Cash flow to creditors$24