Chapter 2 - Chapter 2 - Understanding Financial Understanding Financial

Statements, Taxes, and Cash Statements, Taxes, and Cash FlowsFlows

09/02/0809/02/08

Income StatementIncome Statement

SALESSALES

- - EXPENSESEXPENSES

= PROFIT= PROFIT

•Cost of Goods Sold•Operating Expenses (marketing, administrative)•Financing Costs•Taxes

SALESSALES

- - Cost of Goods SoldCost of Goods Sold

GROSS PROFITGROSS PROFIT

- - Operating ExpensesOperating Expenses

OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)

- - Interest ExpenseInterest Expense

EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)

- - Income TaxesIncome Taxes

EARNINGS AFTER TAXES (EAT)EARNINGS AFTER TAXES (EAT)

- - Preferred Stock DividendsPreferred Stock Dividends

- - NET INCOME AVAILABLENET INCOME AVAILABLE

TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS

Income StatementIncome Statement

Three Important IssuesThree Important Issues

Operating income is not affected by Operating income is not affected by how the firm is financedhow the firm is financed

Interest is tax deductibleInterest is tax deductible Positive net income does not Positive net income does not

necessarily mean it has any cashnecessarily mean it has any cash

Balance SheetBalance Sheet

Total Assets =Total Assets =

OutstandingDebt

+Shareholders’

Equity

Balance SheetBalance SheetAssets Liabilities (Debt) & Equity

Current AssetsCurrent Assets CashCash

Marketable SecuritiesMarketable Securities

Accounts ReceivableAccounts Receivable

InventoriesInventories

Prepaid ExpensesPrepaid Expenses

Fixed AssetsFixed Assets Machinery & EquipmentMachinery & Equipment

Buildings and LandBuildings and Land

Other AssetsOther AssetsInvestments & patentsInvestments & patents

Current LiabilitiesCurrent Liabilities Accounts PayableAccounts Payable Accrued ExpensesAccrued Expenses Short-term notesShort-term notesLong-Term LiabilitiesLong-Term Liabilities Long-term notes Long-term notes MortgagesMortgagesEquityEquity Preferred Stock Preferred Stock Common Stock (Par Common Stock (Par value)value) Paid in CapitalPaid in Capital Retained EarningsRetained Earnings

AssetsAssets Current AssetsCurrent Assets: assets that are : assets that are

relatively liquid, and are expected to be relatively liquid, and are expected to be converted to cash within a year.converted to cash within a year. Cash, marketable securities, accounts Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.

Fixed AssetsFixed Assets: machinery and : machinery and equipment, buildings, and land.equipment, buildings, and land.

Other AssetsOther Assets: any asset that is not a : any asset that is not a current asset or fixed asset.current asset or fixed asset. Intangible assets, such as patents and Intangible assets, such as patents and

copyrights.copyrights.

FinancingFinancing Debt CapitalDebt Capital: financing provided by a : financing provided by a

creditor. creditor. Short-term debtShort-term debt: borrowed money that : borrowed money that

must be repaid within the next 12 must be repaid within the next 12 months. months. Accounts payable, other payables such as Accounts payable, other payables such as

interest or taxes payable, accrued interest or taxes payable, accrued expenses, short-term notes.expenses, short-term notes.

Long-term debtLong-term debt: loans from banks or : loans from banks or other sources that lend money for other sources that lend money for longer than 12 months.longer than 12 months.

FinancingFinancing Equity CapitalEquity Capital: shareholders’ : shareholders’

investment in the firm. investment in the firm. Preferred StockholdersPreferred Stockholders: receive fixed : receive fixed

dividends, and have higher priority than dividends, and have higher priority than common stockholders in event of common stockholders in event of liquidation of the firm.liquidation of the firm.

Common StockholdersCommon Stockholders: residual : residual owners of a business. They receive owners of a business. They receive whatever is left after creditors and whatever is left after creditors and preferred stockholders are paid. preferred stockholders are paid.

Common EquityCommon Equity

In balance sheetIn balance sheet

common equity = common stock (par common equity = common stock (par value + paid-in capital – treasury stock) value + paid-in capital – treasury stock) + retained earnings+ retained earnings

Common EquityCommon Equity Example Example

12/31/0112/31/01 12/31/0212/31/02

Common (par value) 3,000 3,200Common (par value) 3,000 3,200

Paid in capital 350,000 380,000Paid in capital 350,000 380,000

Retained earnings 1,800,000 ?Retained earnings 1,800,000 ?

Treasury stock Treasury stock 420,000420,000 480,000480,000

Total common equity 1,733,000 ?Total common equity 1,733,000 ?

Dividend Paid 2002: 70,000Dividend Paid 2002: 70,000

2002 net income: 570,0002002 net income: 570,000

Free Cash FlowsFree Cash Flows

Free cash flow:Free cash flow: cash flow that is free and cash flow that is free and available to be distributed to the firm’s available to be distributed to the firm’s investors (both debt and equity investors).investors (both debt and equity investors).

Free Cash FlowsFree Cash Flows

Cash Flows from Cash Flows from AssetsAssets = Cash Flows from

Financing

Cash flows generated through the firm’s

assets=

Cash flows paid to - or received from - the

firm’s investors (creditors & stockholders)

Calculating Free Cash Flows:Calculating Free Cash Flows:An Asset PerspectiveAn Asset Perspective

After-tax cash flow After-tax cash flow from operationsfrom operations

lessless

investment in net investment in net operating operating working capitalworking capital

lessless

investments in fixed investments in fixed and other assetsand other assets

Operating income + depreciation - cash tax payments

Calculating Free Cash Flows:Calculating Free Cash Flows:An Asset PerspectiveAn Asset Perspective

After-tax cash flow After-tax cash flow from operationsfrom operations

lessless

investment in net investment in net operating operating working capitalworking capital

lessless

investments in fixed investments in fixed and other assetsand other assets

[Change in current assets]-

[change in non-interest bearing current liabilities]

Calculating Free Cash Flows:Calculating Free Cash Flows:An Asset PerspectiveAn Asset Perspective

After-tax cash flow After-tax cash flow from operationsfrom operations

lessless

investment in net investment in net operating operating working capitalworking capital

lessless

investments in fixed investments in fixed and other assetsand other assets

Change in gross fixed assets, and any other assets that are on the balance sheet.

Calculating Free Cash Flows:Calculating Free Cash Flows:A Financing PerspectiveA Financing Perspective

Interest payments to creditorsInterest payments to creditors

- change in debt principal- change in debt principal

- dividends paid to stockholders- dividends paid to stockholders

- change in stock- change in stock

= Financing Free Cash Flows= Financing Free Cash Flows

TaxesTaxes

Marginal tax rate: the tax rate that Marginal tax rate: the tax rate that would be applied to the next dollar of would be applied to the next dollar of taxable incometaxable income

Average tax rate: taxes owned by a firm Average tax rate: taxes owned by a firm divided by the firm’s taxable incomedivided by the firm’s taxable income

Always marginalAlways marginal

Corporate Income Tax RatesCorporate Income Tax RatesSince 1993Since 1993

Taxable Income Corporate Tax RateTaxable Income Corporate Tax Rate

$1 - $50,000 15%$1 - $50,000 15%$50,001 - $75,000 25%$50,001 - $75,000 25%$75,001 - $100,000 $75,001 - $100,000 34% 34%$100,001 - $335,000 39%$100,001 - $335,000 39%$335,001 - $10,000,000 34%$335,001 - $10,000,000 34%$10,000,001 - $15,000,000$10,000,001 - $15,000,000 35% 35%$15,000,001 - $18,333,333$15,000,001 - $18,333,333 38% 38%over $18,333,333over $18,333,333 35% 35%

Corporate Income Tax RatesCorporate Income Tax Rates

ExampleExample

(1) find the taxable income(1) find the taxable income

(2) Suppose we have a taxable income of (2) Suppose we have a taxable income of 90,00090,000

50,000 * 15% = 7,50050,000 * 15% = 7,500

(75,000 – 50,000) * 25% = 6,250(75,000 – 50,000) * 25% = 6,250

(90,000 – 75,000) * 34% = 5,100(90,000 – 75,000) * 34% = 5,100

tax : 7,500 + 6,250 + 5,100 = 18,850tax : 7,500 + 6,250 + 5,100 = 18,850

Space Cow Computer has sales of Space Cow Computer has sales of $32 $32 millionmillion, cost of goods sold at , cost of goods sold at 60%60% of of sales, cash operating expenses of sales, cash operating expenses of $2.4 $2.4 millionmillion, and , and $1.4 million$1.4 million in in depreciation expense. The firm has depreciation expense. The firm has $12 $12 millionmillion in in 9.5%9.5% bonds outstanding. bonds outstanding. The firm will pay The firm will pay $500,000$500,000 in dividends in dividends to its common stock holders.to its common stock holders.

Calculate the firm’s tax liability.Calculate the firm’s tax liability.