Chapter 2

Financial Statements,
Taxes, and Cash Flow
McGraw-Hill/Irwin
Copyright 2012 by McGraw-Hill Education (Asia). All rights reserved.
Learning objectives
To discuss about the user and needs of
financial statement.
To explain the components in the income
statement, balance sheet, retained earnings
statement and cash flow statement.
To discuss the preparation of cash flow
statement.
To explain the calculation of tax and
depreciation.
2-1
Financial statements needs
Financial statements users can be classified into 2
types:
Internal users-persons employed by the firm
External users-potential investors, the
Government, lenders, the public etc...
Analyzing a firms financial statement can help
managers carry out three important tasks:
Assess current performance through financial
statement analysis,
Monitor and control operations, and
Forecast future performance.
Balance Sheet
The balance sheet is a snapshot of the
firms 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
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The Balance Sheet
Figure 2.1
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Current assets comprise assets that are relatively
liquid, or expected to be converted into cash within
12 months. Current assets typically include:
Cash
Marketable securityinvestment on short term financial
assets with high liquidity. Example: T-bill.
Accounts Receivable (payments due from customers who
buy on credit)
Inventory (raw materials, work in process, and finished
goods held for eventual sale)
Other assets (ex.: Prepaid expenses are items paid for in
advance)
Balance Sheet Terms: Assets
Fixed Assets Include assets that will be used for
more than one year. Fixed assets typically include:
Machinery and equipment
Buildings
Land

Other Assets Assets that are neither current
assets nor fixed assets. They may include long-term
investments and intangible assets such as patents,
copyrights, and goodwill.
Balance Sheet Terms: Assets
Debt (Liabilities)
Money that has been borrowed from a creditor and
must be repaid at some predetermined date.
Debt could be current (must be repaid within twelve
months) or long-term (repayment time exceeds one
year).
Current Debt:
Accounts payable (Credit extended by suppliers to a firm when it
purchases inventories)
Accrued expenses (Short term liabilities incurred in the firms
operations but not yet paid for)
Short-term notes (Borrowings from a bank or lending institution
due and payable within 12 months)
Long-Term Debt
Borrowings from banks and other sources for more than 1 year

Balance Sheet Terms: Liabilities
Equity: Shareholders investment in the firm in the form of
preferred stock and common stock.
Preferred stock: Preferred stockholders enjoy preference with
regard to payment of dividend and seniority at settlement of
bankruptcy claims.
Retained Earnings: Cumulative total of all the net income over
the life of the firm, less common stock dividends that have been
paid out over the years.
Paid in Capital: (money that a company gets from potential
investors in addition to the stated value of the stock).

Balance Sheet Terms: Equity
Net Working Capital and
Liquidity
Net Working Capital
= Current Assets Current Liabilities
Positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out
Usually positive in a healthy firm
Liquidity
Ability to convert to cash quickly without a significant loss in
value
Liquid firms are less likely to experience financial distress
But liquid assets typically earn a lower return
Trade-off to find balance between liquid and illiquid assets
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Asia-Pacific Corporation
Balance Sheet Table 2.1
2-10
Market Value vs. Book
Value
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 decision-making
process?
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Income Statement
The income statement is more like a video of the
firms 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 show
revenue when it accrues and match the
expenses required to generate the revenue
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Income Statement Terms
Revenue (Sales)
Money derived from selling the companys product or
service
Cost of Goods Sold (COGS)
The cost of producing or acquiring the goods or services
to be sold
Operating Expenses
Expenses related to marketing and distributing the
product or service and administering the business
Financing Costs
The interest paid to creditors
Tax Expenses
Amount of taxes owed, based upon taxable income
Income Statement Examples
2-14
Taxes
The one thing we can rely on with taxes is that they
are always changing
Marginal vs. average tax rates
Marginal tax rate the percentage paid on the next
dollar earned
Average tax rate the tax bill / taxable income
Suppose your firm earns $4 million in taxable
income.
What is the firms tax liability? What is the average tax
rate? What is the marginal tax rate?
If you are considering a project that will increase
the firms taxable income by $1 million, what tax
rate should you use in your analysis?
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The Concept of Cash Flow
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 that
finance the purchase of the assets
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Cash Flow From Assets
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
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Example:
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

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Cash Flow Summary -
Table 2.6
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