2 Financial Statements

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Financial Statements, Taxes, andFinancial Statements, Taxes, and

Cash FlowsCash Flows


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Key Concepts and SkillsKey Concepts and Skills

Know the difference between book valueKnow the difference between book valueand market valueand market value

Know the difference between accountingKnow the difference between accountingincome and cash flowincome and cash flow

Know the difference between average andKnow the difference between average andmarginal tax ratesmarginal tax rates

Know how to determine a firms cash flowKnow how to determine a firms cash flowfrom its financial statementsfrom its financial statements


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Chapter OutlineChapter Outline

The Balance SheetThe Balance Sheet

The Income StatementThe Income Statement

TaxesTaxesCash FlowCash Flow


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Balance SheetBalance Sheet

The balance sheet is a snapshot of the firmsThe balance sheet is a snapshot of the firmsassets and liabilities at a given point in timeassets and liabilities at a given point in time

Assets are listed in order of decreasing liquidityAssets are listed in order of decreasing liquidity Ease of conversion to cashEase of conversion to cash Without significant loss of valueWithout significant loss of value

Balance Sheet IdentityBalance Sheet Identity Assets = Liabilities + Stockholders EquityAssets = Liabilities + Stockholders Equity


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The Balance SheetThe Balance Sheet -- Figure 2.1Figure 2.1


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Net Working Capital andNet Working Capital and

LiquidityLiquidity Net Working CapitalNet Working Capital Current AssetsCurrent Assets Current LiabilitiesCurrent Liabilities

Positive when the cash that will be received over the next 12 monthsPositive when the cash that will be received over the next 12 monthsexceeds the cash that will be paid outexceeds the cash that will be paid out

Usually positive in a healthy firmUsually positive in a healthy firm

LiquidityLiquidity Ability to convert to cash quickly without a significant loss in valueAbility to convert to cash quickly without a significant loss in value

Liquid firms are less likely to experience financial distressLiquid firms are less likely to experience financial distress

But liquid assets earn a lower returnBut liquid assets earn a lower return

TradeTrade--off to find balance between liquid and illiquid assetsoff to find balance between liquid and illiquid assets


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US Corporation Balance SheetUS Corporation Balance Sheet

Table2.1

Table2.1


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Market Vs. Book ValueMarket Vs. Book Value

The balance sheet provides the book value ofThe balance sheet provides the book value ofthe assets, liabilities, and equity.the assets, liabilities, and equity.

Market value is the price at which the assets,Market value is the price at which the assets,

liabilities ,or equity can actually be bought orliabilities ,or equity can actually be bought orsold.sold.

Market value and book value are often veryMarket value and book value are often verydifferent. Why?different. Why?

Which is more important to the decisionWhich is more important to the decision--makingmakingprocess?process?


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Example 2.2KlingonExample 2.2Klingon

CorporationCorporationKLINGON CORPORATIONKLINGON CORPORATION

Balance SheetsBalance Sheets

Market Value versus Book ValueMarket Value versus Book Value

BookBook MarketMarket BookBook MarketMarket

AssetsAssets Liabilities and ShareholdersLiabilities and ShareholdersEquityEquity

NWCNWC $ 400$ 400 $ 600$ 600 LTDLTD $ 500$ 500 $ 500$ 500

NFANFA 700700 1,0001,000 SESE 600600 1,1001,100

1,1001,100 1,6001,600 1,1001,100 1,6001,600


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Income StatementIncome Statement

The income statement is more like a video of theThe income statement is more like a video of thefirms operations for a specified period of time.firms operations for a specified period of time.

You generally report revenues first and thenYou generally report revenues first and then

deduct any expenses for the perioddeduct any expenses for the period

Matching principleMatching principle GAAP says to showGAAP says to showrevenue when it accrues and match therevenue when it accrues and match the

expenses required to generate the revenueexpenses required to generate the revenue


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US Corporation Income StatementUS Corporation Income Statement

Table2.2

Table2.2


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TaxesTaxes

The one thing we can rely on with taxes is thatThe one thing we can rely on with taxes is thatthey are always changingthey are always changing

Marginal vs. average tax ratesMarginal vs. average tax rates

Marginal tax rateMarginal tax rate the percentage paid on the nextthe percentage paid on the nextdollar earneddollar earned

Average tax rateAverage tax rate the tax bill / taxable incomethe tax bill / taxable income

Other taxesOther taxes


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Example: Marginal Vs. AverageExample: Marginal Vs. Average

RatesRates Suppose your firm earns $4 million in taxableSuppose your firm earns $4 million in taxable

income.income. What is the firms tax liability?What is the firms tax liability?

What is the average tax rate?What is the average tax rate?

What is the marginal tax rate?What is the marginal tax rate?

If you are considering a project that willIf you are considering a project that willincrease the firms taxable income by $1increase the firms taxable income by $1million, what tax rate should you use in yourmillion, what tax rate should you use in youranalysis?analysis?


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The Concept of Cash FlowThe Concept of Cash Flow

Cash flow is one of the most important pieces ofCash flow is one of the most important pieces ofinformation that a financial manager can deriveinformation that a financial manager can derivefrom financial statementsfrom financial statements

The statement of cash flows does not provide usThe statement of cash flows does not provide uswith the same information that we are looking atwith the same information that we are looking atherehere

We will look at how cash is generated fromWe will look at how cash is generated from

utilizing assets and how it is paid to those thatutilizing assets and how it is paid to those thatfinance the purchase of the assetsfinance the purchase of the assets


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Cash Flow From AssetsCash Flow From Assets

Cash Flow From Assets (CFFA) = CashCash Flow From Assets (CFFA) = CashFlow to Creditors + Cash Flow toFlow to Creditors + Cash Flow toStockholdersStockholders

Cash Flow From Assets = Operating CashCash Flow From Assets = Operating CashFlowFlow Net Capital SpendingNet Capital Spending Changes inChanges inNWC = also termed as Free Cash Flow ofNWC = also termed as Free Cash Flow of

the Firm (FCFF)the Firm (FCFF)


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Example: US CorporationExample: US Corporation Part IPart I

OCF (OCF (I/SI/S) = EBIT + depreciation) = EBIT + depreciation taxes = $547taxes = $547 NCS (NCS ( B/SB/S and I/S) = ending net fixed assetsand I/S) = ending net fixed assets

beginning net fixed assets + depreciation = $130beginning net fixed assets + depreciation = $130

Changes in NWC (Changes in NWC (B/SB/S) = ending NWC) = ending NWC beginning NWC = $330beginning NWC = $330

CFFA = 547CFFA = 547 130130 330 = $87330 = $87


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Example: US CorporationExample: US Corporation Part IIPart II

CF to Creditors (CF to Creditors (B/SB/S andand I/SI/S) = interest paid) = interest paid net new borrowing = $24net new borrowing = $24

CF to Stockholders (CF to Stockholders (B/SB/S andand I/SI/S) = dividends) = dividends

paidpaid net new equity raised = $63net new equity raised = $63 CFFA = 24 + 63 = $87CFFA = 24 + 63 = $87


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Cash Flow Summary Table 2.5Cash Flow Summary Table 2.5


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Example: Balance Sheet andExample: Balance Sheet andIncome Statement InformationIncome Statement Information

Current AccountsCurrent Accounts 2007: CA = 3625; CL = 17872007: CA = 3625; CL = 1787 2006: CA = 3596; CL = 21402006: CA = 3596; CL = 2140

Fixed Assets and DepreciationFixed Assets and Depreciation 2007: NFA = 2194;2006: NFA = 22612007: NFA = 2194;2006: NFA = 2261 Depreciation Expense = 500Depreciation Expense = 500

LongLong--term Debt and Equityterm Debt and Equity 2007: LTD = 538; Common stock & APIC = 4622007: LTD = 538; Common stock & APIC = 462 2006: LTD = 581; Common stock & APIC = 3722006: LTD = 581; Common stock & APIC = 372

Income StatementIncome Statement EBIT = 1014; Taxes = 368EBIT = 1014; Taxes = 368 Interest Expense = 93; Dividends = 285Interest Expense = 93; Dividends = 285


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Example: Cash FlowsExample: Cash Flows

OCF = 1,014 + 500OCF = 1,014 + 500 368 = 1,146368 = 1,146

NCS = 2,194NCS = 2,194 2,261 + 500 = 4332,261 + 500 = 433

Changes in NWC = (3,625Changes in NWC = (3,625 1,787)1,787) (3,596(3,596 2,140) =2,140) =

382382 CFFA = 1,146CFFA = 1,146 433433 382 = 331382 = 331

CF to Creditors = 93CF to Creditors = 93 (538(538 581) = 136581) = 136

CF to Stockholders = 285CF to Stockholders = 285 (462(462 372) = 195372) = 195

CFFA = 136 + 195 = 331CFFA = 136 + 195 = 331 The CF identity holds.The CF identity holds.


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Quick QuizQuick Quiz What is the difference between book value andWhat is the difference between book value and

market value? Which should we use for decisionmarket value? Which should we use for decision--making purposes?making purposes?

What is the difference between accounting incomeWhat is the difference between accounting incomeand cash flow? Which do we need to use whenand cash flow? Which do we need to use whenmaking decisions?making decisions?

What is the difference between average and marginalWhat is the difference between average and marginaltax rates? Which should we use when makingtax rates? Which should we use when makingfinancial decisions?financial decisions?

How do we determine a firms cash flows? What areHow do we determine a firms cash flows? What arethe equations and where do we find the information?the equations and where do we find the information?


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Comprehensive ProblemComprehensive Problem Current AccountsCurrent Accounts

2007: CA = 4,400; CL = 1,5002007: CA = 4,400; CL = 1,500

2006: CA = 3,500; CL = 1,2002006: CA = 3,500; CL = 1,200

Fixed Assets and DepreciationFixed Assets and Depreciation 2007: NFA = 3,400;2006: NFA = 3,1002007: NFA = 3,400;2006: NFA = 3,100

Depreciation Expense =400Depreciation Expense =

400

LongLong--term Debt and Equity (R.E. not given)term Debt and Equity (R.E. not given) 2007: LTD = 4,000; Common stock & APIC = 4002007: LTD = 4,000; Common stock & APIC = 400

2006: LTD = 3,950; Common stock & APIC = 4002006: LTD = 3,950; Common stock & APIC = 400

Income StatementIncome Statement EBIT = 2,000; Taxes = 300EBIT = 2,000; Taxes = 300 Interest Expense = 350; Dividends = 500Interest Expense = 350; Dividends = 500

Compute the CFFACompute the CFFA

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2 Financial Statements