Chapter 2

Financial Statements, Cash

Flow, and Taxes
Key Financial Statements
Balance Sheet
Income Statement
Statement of Stockholders Equity
Statement of Cash Flows
Free Cash Flow
Federal Tax System
2-1
The Annual Report

Balance sheet provides a snapshot of a firms

financial position at one point in time.
Income statement summarizes a firms
revenues and expenses over a given period of
time.
Statement of stockholders equity shows how
much of the firms earnings were retained,
rather than paid out as dividends.
Statement of cash flows reports the impact of
a firms activities on cash flows over a given
period of time.
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 Balance Sheet: Assets

2008 2007
Assets
Cash $208,323 $102,024
Accounts receivable 690,294 824,979
Inventories 942,374 715,414
$1,642,41
Total current assets $1,840,991
7
Gross fixed assets 317,503 232,179
Less accumulated depreciation 54,045 34,187
Net fixed assets $263,458 $197,992
$1,840,40
Total assets $2,104,449
9
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Balance Sheet: Liabilities and Equity

2008 2007
Short-term Borrow $288,798 $296,149
Accounts payable 636,318 414,611
Accruals 106,748 103,362
Total current liabilities $1,031,864 $814,122
Long-term debt 410,769 372,931
Common stock (100,000 shares) 550,000 550,000
Retained earnings 111,816 103,356
Total equity $661,816 $653,356
$1,840,40
Total liabilities and equity $2,104,449
9

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 Income Statement
2008 2007
Sales $2,325,967 $2,220,607
Cost of goods sold 1,869,326 1,655,827
Other expenses 287,663 273,870
Total operating costs excluding
$2,156,989 $1,929,697
depreciation and amortization

Depreciation and amortization 26,341

25,363
EBIT $143,615 $264,569

Interest expense 13,802

31,422
EBT $112,193 $250,767
Taxes (40%) 44,877 100,307
Net income $67,316 $150,460

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Other Data

2008 2007
EPS $0.67 $1.50
DPS $1.00 $1.42
Book value per share $6.62 $6.53
Stock price $15.60 $21.80
Share outstanding 100,000 100,000
Tax rate 40% 40%

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Did the expansion create additional
after-tax operating income?
Sales increased by $105,330.
AT operating income08 = EBIT(1 Tax
rate)
= $143,615(1 0.4)
= $143,615(0.6)
= $86,169.
AT operating income07 = $158,741.

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What effect did the expansion have
on net working capital?
NWC08= ($208,323 + $690,294 + $942,374)
($636,318 + $106,748) = $1,097,925.

NWC07= ($102,024 + $824,979 + $715,414)

($414,611 + $103,362)= $1,124,444.

NWC = $1,097,925 $1,124,444 = ($26,519).

Net working capital decreased by $26,519.

2-8
 What was the free cash flow (FCF)
for 2008?

Depr. and Capital

FCF EBIT(1 T) NWC
amortization expenditures

FCF08 = EBIT(1 T) Net investment in operating capital

= ($86,169) ($1,097,925 $1,124,444)
= ($86,169 + 26,519 = ($59,650)

Is negative free cash flow always a bad sign?

2-9
What caused Everelites total assets to
increase in 2008?

Everelites note payable and long-term debt

increased to support its increasing inventories

2-10
Does it appear that Everelites sales
price exceeds its cost per unit sold?
NO, the negative after-tax operating income
and decline in cash position shows that
Everelite is spending more on its operations
than it is taking in.

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What if Everelites sales manager decided to
offer 60-day credit terms to customers,
rather than 30-day credit terms?

If competitors match terms, and sales remain

constant...
A/R would .
Cash would .
If competitors dont match, and sales double...
Short-run: Inventory and fixed assets to
meet increased sales. A/R , Cash .
Company may have to seek additional financing.
Long-run: Collections increase and the
companys cash position would improve.

2-12
How did Everelite finance its
expansion?
Everelite financed its expansion with external
capital.
Everelite issued long-term debt which
reduced its financial strength and flexibility.

2-13
Would Everelite have required external
capital if they had broken even in 2008
(Net income = 0)?

YES, the company would still have to finance

its increase in assets. Looking at the
Statement of Cash Flows, we see that the
firm made an investment of $711,950 in net
fixed assets. Therefore, Everelite would have
raised additional funds.

2-14
What happens if Everelite depreciates fixed
assets over 7 years (as opposed to the
current 10 years)?

No effect on physical
assets.
Fixed assets on the balance
sheet would decline.
Net income would decline.
Tax payments would
decline.
Cash position would
improve.
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Federal Income Tax System

2-16
Corporate and Personal Taxes

Both have a progressive structure (the higher

the income, the higher the marginal tax rate).
Corporations
Rates begin at 15% and rise to 35% for
corporations with income over $10 million,
although corporations with income between
$15 million and $18.33 million pay a
marginal tax rate of 38%.
Also subject to state tax (around 5%).
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Corporate and Personal Taxes

Individuals
Rates begin at 10% and rise to 35% for
individuals with income over $349,700.
May be subject to state tax.

2-18
Tax Treatment of Various Uses and
Sources of Funds
Interest paid tax deductible for corporations
(paid out of pre-tax income), but usually not
for individuals (interest on home loans being
the exception).
Interest earned usually fully taxable (an
exception being interest from a muni).
Dividends paid paid out of after-tax income.

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Tax Treatment of Various Uses and
Sources of Funds
Dividends received Most investors pay 15%
taxes.
Investors in the 10% or 15% tax bracket
pay 0% on dividends in 2008-2010.
Dividends are paid out of net income which
has already been taxed at the corporate
level, this is a form of double taxation.
A portion of dividends received by
corporations is tax excludable, in order to
avoid triple taxation.
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More Tax Issues

Tax Loss Carry-Back and Carry-Forward since

corporate incomes can fluctuate widely, the Tax
Code allows firms to carry losses back to offset
profits in previous years or forward to offset profits
in the future.
Capital gains defined as the profits from the sale
of assets not normally transacted in the normal
course of business, capital gains for individuals are
generally taxed as ordinary income if held for less
than a year, and at the capital gains rate if held for
more than a year. Corporations face somewhat
different rules.
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