Chapter 2 Understanding Financial Statements, Taxes, and Cash Flows

2005, Pearson Prentice Hall

Income Statement

SALES
- EXPENSES

= PROFIT

Income Statement

SALES
- EXPENSES

Revenue

= PROFIT

Income Statement

SALES
- EXPENSES

Cost of Goods Sold

= PROFIT

Income Statement

SALES
- EXPENSES

Cost of Goods Sold Operating Expenses

= PROFIT

Income Statement

SALES
- EXPENSES

Cost of Goods Sold Operating Expenses

(marketing, administrative)

= PROFIT

Income Statement

SALES
- EXPENSES

Cost of Goods Sold Operating Expenses

(marketing, administrative)

= PROFIT

Financing Costs

Income Statement

SALES
- EXPENSES

Cost of Goods Sold Operating Expenses

(marketing, administrative)

= PROFIT

Financing Costs Taxes

SALES - Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends

- NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

SALES - Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends

- NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

SALES - Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends

- NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

Balance Sheet
Outstanding Debt + Shareholders Equity

Total Assets =

Balance Sheet

Balance Sheet
Assets

Balance Sheet
Assets

Liabilities (Debt) & Equity

Balance Sheet
Assets Current Assets
Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses

Liabilities (Debt) & Equity

Current Liabilities
Accounts Payable Accrued Expenses Short-term notes

Long-Term Liabilities
Long-term notes Mortgages

Fixed Assets
Machinery & Equipment Buildings and Land

Equity
Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings

Other Assets
Investments & patents

Assets
Current Assets:

Assets
Current Assets: assets that are
relatively liquid, and are expected to be converted to cash within a year.

Assets
Current Assets: assets that are
relatively liquid, and are expected to be converted to cash within a year.
Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Assets
Current Assets: assets that are
relatively liquid, and are expected to be converted to cash within a year.
Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Fixed Assets:

Assets
Current Assets: assets that are
relatively liquid, and are expected to be converted to cash within a year.
Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Fixed Assets: machinery

and equipment, buildings, and land.

Assets
Current Assets: assets that are
relatively liquid, and are expected to be converted to cash within a year.
Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Fixed Assets: machinery and

equipment, buildings, and land. Other Assets:

Assets
Current Assets: assets that are
relatively liquid, and are expected to be converted to cash within a year.
Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Fixed Assets: machinery and

equipment, buildings, and land. Other Assets: any asset that is not a current asset or fixed asset.

Assets
Current Assets: assets that are
relatively liquid, and are expected to be converted to cash within a year.
Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Fixed Assets: machinery and

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

Financing
Debt Capital:

Financing
Debt Capital: financing provided by a
creditor.

Financing
Debt Capital: financing provided by a
creditor. Short-term debt:

Financing
Debt Capital: financing provided by a
creditor. Short-term debt: borrowed money that must be repaid within the next 12 months.

Financing
Debt Capital: financing provided by a
creditor. Short-term debt: borrowed money that must be repaid within the next 12 months.
Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

Financing
Debt Capital: financing provided by a
creditor. Short-term debt: borrowed money that must be repaid within the next 12 months.
Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

Long-term debt:

Financing
Debt Capital: financing provided by a
creditor. Short-term debt: borrowed money that must be repaid within the next 12 months.
Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

Long-term debt: loans from banks or

other sources that lend money for longer than 12 months.

Financing
Equity Capital:

Financing
Equity Capital: shareholders
investment in the firm.

Financing
Equity Capital: shareholders
investment in the firm. Preferred Stockholders:

Financing
Equity Capital: shareholders
investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm.

Financing
Equity Capital: shareholders
investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders:

Financing
Equity Capital: shareholders
investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

Corporate Income Tax Rates

Since 1993 Taxable Income $1 - $50,000 $50,001 - $75,000 $75,001 - $100,000 $100,001 - $335,000 $335,001 - $10,000,000 $10,000,001 - $15,000,000 $15,000,001 - $18,333,333 over $18,333,333 Corporate Tax Rate 15% 25% 34% 39% 34% 35% 38% 35%

Free Cash Flows

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

Free Cash Flows

Cash Flows from Assets

Cash Flows from Financing

Cash flows generated through the firms assets

Cash flows paid to - or received from - the firms investors (creditors & stockholders)

Calculating Free Cash Flows:

An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets

Calculating Free Cash Flows:

An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets
Operating income + depreciation - cash tax payments

Calculating Free Cash Flows:

An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets

[Change in current assets]

[change in non-interest bearing current liabilities]

Calculating Free Cash Flows:

An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets

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

Calculating Free Cash Flows:

A Financing Perspective
Interest payments to creditors
change in debt principal

dividends paid to stockholders

change in stock

Financing Free Cash Flows

Tax Example:

 Space Cow Computer has sales of $32

million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders. Calculate the firms tax liability.

Sales Cost of Goods Sold Operating Expenses Depreciation Expense EBIT or NOI Interest Expense Taxable Income

$32,000,000 (19,200,000) (2,400,000) (1,400,000) 9,000,000 (1,140,000) 7,860,000

Income tax rate tax payment $50,000 x .15 = $ 7,500 $25,000 x .25 = 6,250 $25,000 x .34 = 8,500 $235,000 x .39 = 91,650 $7,525,000 x .34 = 2,558,500 Total Tax payment $2,672,400

short cut: $7,860,000 x .34 = $2,672,400