Financial Statements, Taxes, and Cash Flow

Key Concepts and Skills Chapter 2 Financial Statements, Taxes, and Cash Flow Chapter Outline • • • • The Balance Sheet The Income Statement Taxes Cash Flow • 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 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 Figure 2.1 U.S. Corporation Balance Sheet – Table 2.1 1-1 Market vs. Book Value Klingon Corporation • The balance sheet provides the book value of the assets, liabilities, and equity. • Market value is the price at which the assets, liabilities, or equity can actually be bought or sold. • Market value and book value are often very different. Why? • Which is more important to the decisionmaking process? KLINGON CORPORATION Balance Sheets Market Value versus Book Value Income Statement Book Market Assets NWC NFA $ 400 700 1,100 Book Market Liabilities and Shareholders’ Equity $ 600 LTD 1,000 Equity 1,600 $ 500 $ 500 600 1,100 1,100 1,600 U.S. Corporation Income Statement - Table 2.2 • 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 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! 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 1-2 Example: Marginal vs. Average Rates The Concept of Cash Flow • 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? • Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements • The 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 Cash Flow From Assets Example: U.S. Corporation • 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? • Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders • Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC Table 2.5 • OCF (I/S) = EBIT + depreciation – taxes = $547 • NCS ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130 • Changes in NWC (B/S) = ending NWC – beginning NWC = $330 • CFFA = 547 – 130 – 330 = $87 • CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24 • CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63 • CFFA = 24 + 63 = $87 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 1-3 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. 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? 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 1-4