Chapte

r2

Financial Statements, Taxes, and

Cash Flow

2-1

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 2 Study Guide
Section 2.1 Balance Sheet
Snapshot of Firms Assets and Liabilities
Assets: The Left Side
Liabilities and OE: The Right Side
Balance Sheet Identity
Residual Belongs to Shareholders
Net Working Capital
Liquidity
Debt vs. Equity
Market Value vs. Book Value

Section 2.2 Income Statement

GAAP -
Noncash Items
Time and costs

Section 2.3 Corporate Taxes

Average vs. Marginal Tax Rates
Marginal Tax Rate Often Best for Decision Making

Section 2.4 Cash Flow

Not Accounting Cash Flow
Cash Flow from Assets
Operating Cash Flow
Capital Spending
Change in Net Working Capital
Cash Flow to Creditors and Stockholders
Cash Flow Summary (Table 2.6)

10-2
 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

Liquidity is the ease of

conversion to cash
without significant
loss of value
2-3
 Balance Sheet
Balance Sheet Identity:
The residual (what is left over after creditors
are paid) belongs to the stockholders

Total Assets = Total Liabilities +

Stockholders Equity

2-4
 The Balance Sheet
Figure 2.1

2-5
 Net Working Capital
NWC = 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
over the same period

Usually positive in a financially healthy

firm
2-6
 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
2-7
between liquid and illiquid
 US Corporation Balance
Sheet Table 2.1

Place Table 2.1 (US Corp Balance

Sheet) here

2-8
 Debt vs. Equity
Equity is the assets owned by
shareholders
Residual or left-overs from the
creditors
Shareholders equity = Assets -
Liabilities

Debit is borrowing
Financial leverage
Magnifies both gains and losses
Too much debt creates financial
distress
2-9
 Market Value vs. Book
Value
Book values are historical
costs
Market values are the prices
at which assets, liabilities, or
equity can actually be bought
or sold.
The balance sheet provides
the book value of the assets,
2-10
liabilities, and equity.
 Differences Between Market
Values and Book Values
Book values are determined by
accounting rules
Market values are independent of
accounting rules
Current assets have little difference
between book and market values
The value of the firm is not shown on
the balance sheet
Market values are more important to
the decision-making process
2-11
 Income Statement
The income statement is more like a
video (as opposed to a snapshot) of the
firms operations over 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.
2-12
Income statement does not represent
 US Corporation Income
Statement Table 2.2

2-13
 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
Other taxes in addition to federal
taxes
State
2-14 Local (City or Town)
 Corporate Progressive Taxes
8 corporate federal tax rate
categories
6 unique corporate federal tax
brackets

2-15
 Corporate Federal Tax Rates

U.S. corporations pay federal taxes at

a modified flat-rate
Federal tax rate is flat for the highest
2-16
incomes
 Example: Marginal Vs.
Average Rates
Suppose your firm earns $4 million in
taxable income.
What is the firms tax liability? $1,360,000
What is the average tax rate? 34%
What is the marginal tax rate? 34%
Corporate Tax
If you are considering a project that Calculator

will increase the firms taxable income

by $1 million, what tax rate should
you use in your analysis?
The marginal rate should be used
because it is the rate at which new cash
flows will be taxed.
2-17
 Corporate Federal Tax Rates
Each major industry has different tax
incentives provided by the US Government
and as such, may actually pay a different
average tax rate:

2-18
 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
2-19 and how it is paid to those that
 Cash Flow Summary
Table 2.6

2-20
 Cash Flow From Assets

Cash Flow From Assets (CFFA) = Cash

Flow to Creditors + Cash Flow to
Stockholders

CFFA = CF to creditors + CF
to Stockholders

2-21
 Example of CFFA: Part I
Using the U.S. Corporation income
statement (I/S) and balance sheet
(B/S):
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 = CF to creditors + CF to
2-22
Stockholders
 Cash Flow From Assets

Cash Flow From Assets = Operating

Cash Flow Net Capital Spending
Changes in NWC

CFFA = OCF NCS NWC

Therefore:
OCF NCS NWC = CF to creditors
+ CF to Stockholders
2-23
 Example of CFFA: Part II
Again, using the U.S. Corporation income
statement (I/S) and balance sheet (B/S):
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 = OCF NCS - NWC

CFFA = 547 130 330 = $87

2-24
 The Big Picture Problem: Balance Sheet
and Income Statement Information

Current Accounts
2009: CA = 3625; CL = 1787
2008: CA = 3596; CL = 2140
Fixed Assets and Depreciation
2009: NFA = 2194; 2008: NFA = 2261
Depreciation Expense = 500
Long-term Debt and Equity
2009: LTD = 538; Common stock & APIC =
462
2008: LTD = 581; Common stock & APIC =
372
Income Statement
EBIT = 1014; Taxes = 368
Interest Expense = 93; Dividends = 285
2-25
 Task: use the information on the
previous slide to compute the
following:
1. OCF
2. NCS
3. Changes in NWC
4. CFFA
5. CF to Creditors
6. CF to Stockholders
7. CFFA
8. Does the CF identity hold?

2-26
 Cash Flow Problem Answers:

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

NCS = 2,194 2,261 + 500 = 433
Changes in NWC = (3,625 1,787)
(3,596 2,140) = 382
CFFA = 1,146 433 382 = 331
CF to Creditors = 93 (538 581) =
136
CF to Stockholders = 285 (462
372) = 195
CFFA = 136 + 195 = 331
2-27
The CF identity holds!
 Formulas
Total Assets = Total
Liabilities + Stockholders
Equity

CFFA = CF to creditors +
CF to Stockholders

CFFA = OCF NCS -

NWC

2-28