Chapter 2

Financial Statements,Taxes, and Cash Flow

McGraw-Hill/IrwinCopyright © 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.

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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 firm’s 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

firm’s 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 security–investment 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 firm’s 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: Shareholder’s 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

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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 firm’s 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 company’s 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

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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 firm’s tax liability? What is the average tax rate?

What is the marginal tax rate?• If you are considering a project that will increase the firm’s

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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