financial statements, taxes and cash...

UNDERSTANDING FINANCIAL STATEMENTS AND CASH FLOWP

AR

T T

WO The 2 March 2006 issue of Business Review Weekly

(BRW) carried the headline ‘Profit turns to loss—New

accounting rules are causing big problems’. Equigold, one of

Australia top five goldminers, reported in its half-year accounts

production costs of $335 an ounce and sales figures of $607

an ounce, producing a nice profit and a cash surplus of

$11.2 million. Equigold used forward contracts that gave it a

guaranteed profitable sale price, but the current price of gold

was far higher than its guaranteed price, at $740 an ounce.

New international accounting standards meant that Equigold

Financial Statements,Taxes and Cash Flow 2

had to record a $2 million loss for the half year. Under old

accounting rules they would have recorded a $15 million profit.

Australia was not the only country affected. On 1 January

2004 investors in L’Oréal, the French cosmetics giant,

received quite a shock. The company’s net worth dropped

from €8.1 billion to about €6.3 billion overnight. You would

think a major event had to cause such a drop, and it did. On

that date, more than 7000 companies in Europe, including

L’Oréal, switched to new international accounting standards.

The new standards greatly changed the financial state-

ments of other companies as well. For example, in 2003

Vodafone of the United Kingdom reported a net loss of £9 billion.

But, under the new international accounting standards, the

company would have reported a profit of £6 billion, a difference

of £15 billion.

THERE ARE BASICALLY FOUR THINGS THAT

YOU SHOULD BE CLEAR ON WHEN YOU HAVE

FINISHED STUDYING THIS CHAPTER:

■ The difference between accountingvalue (or ‘book’ value) and marketvalue.

■ The difference between accountingincome and cash flow.

■ The difference between average andmarginal tax rates.

■ How to determine a firm’s cashflow from its financial statements.

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In this chapter, we examine financial statements, taxes and cash flow. Our emphasis isnot on preparing financial statements. Instead, we recognise that financial statements are

frequently a key source of information for financial decisions, so our goal is to brieflyexamine such statements and point out some of their more relevant features. We pay specialattention to some of the practical details of cash flow.

As you read, pay particular attention to two important differences:

1. the difference between accounting value and market value, and

2. the difference between accounting income and cash flow.

These distinctions will be important throughout the book.

21

So, should Equigold have lost $15 million and was L’Oréal actually worth €1.8 billion less

as a result of changes in accounting rules? Did Vodafone actually make £15 billion more? The

answer to these questions is ‘probably not’. This chapter shows that underneath all the

accounting numbers lurks the financial truth. Our job is to uncover that truth by examining that

all-important substance known as cash flow.

2.1 THE BALANCE SHEETThe balance sheet is a snapshot of the financial position of the firm at a particular time. Itis a convenient means of organising and summarising what a firm owns (its assets), whatit owes (its liabilities), and the difference between the two (the firm’s equity). Figure 2.1illustrates how the balance sheet is constructed. The left-hand side lists the assets of thefirm, and the right-hand side lists the liabilities and equity.

balance sheet

Financial statementshowing a firm’saccounting value on aparticular date.

FIGURE 2.1

The balance sheetLeft side: total value ofassets. Right side: totalvalue of liabilities andshareholders’ equity.

Current liabilities

Non current liabilities,including

long-term debt

Shareholders’ equity

NetWorkingCapital

Total Value of Assets Total Value of Liabilitiesand Shareholders’ Equity

Current assets

Non current assets

1. Tangible fixed assets2. Intangible fixed assets

Assets: The Left-Hand Side

Assets are classified as either current or fixed. A fixed asset is one that has a relatively longlife. Fixed assets can either be tangible, such as a truck or a computer, or intangible, suchas a trademark or patent. A current asset has a life of less than one year. This means that theasset will normally convert to cash within twelve months. For example, inventory wouldnormally be purchased and sold within a year and is thus classified as a current asset.

Ross Ch 02 12/7/07 4:16 PM 1

Obviously, cash itself is a current asset. Accounts receivable (money owed to the firm byits customers) is also a current asset.

22 P A R T 2 Understanding Financial Statements and Cash Flow

Liabilities and Owners’ Equity: The Right-Hand Side

The firm’s liabilities are the first thing listed on the right-hand side of the balance sheet.These are classified as either current or long-term. The first items listed are the currentliabilities, which, like current assets, have a life of less than one year (meaning they mustbe paid within the year). Accounts payable (money the firm owes to its suppliers) is oneexample of a current liability.

A debt that is not due in the coming year is classified as a long-term liability. A loanthat the firm will pay off in five years is one such long-term debt. Firms borrow over thelong term from a variety of sources. We will tend to use the terms bonds, and bondholdersor debtholders generically to refer to long-term debt and long-term creditors, respectively.

An excellent site forcompany financialinformation is<http://au.finance.yahoo.com>.

Woolworths has a goodinvestor site at<www.woolworthslimited.com.au>; use the ‘Investors’ link.

Finally, by definition, the difference between the total value of the assets (current andfixed) and the total value of the liabilities (current and long-term) is the shareholders’equity, also called ordinary equity or owners’ equity. This feature of the balance sheet isintended to reflect the fact that, if the firm were to sell all of its assets and use the money topay off its debts, then whatever residual value remained would belong to the shareholders.So, the balance sheet ‘balances’ because the value of the left-hand side always equals thevalue of the right-hand side. That is, the value of the firm’s assets is equal to the sum of itsliabilities and shareholders’ equity:1

Assets = Liabilities + Shareholders’ equity [2.1]

This is the balance sheet identity, or equation, and it always holds because shareholders’equity is defined as the difference between assets and liabilities.

Net Working Capital

As shown in Figure 2.1, the difference between a firm’s current assets and its currentliabilities is called net working capital. Net working capital is positive when current assetsexceed current liabilities, which means that the cash that will become available over thenext twelve months exceeds the cash that must be paid out over that same period. For thisreason, net working capital is usually positive in a healthy firm.

net working capital

Current assets lesscurrent liabilities.

1 The terms owners’ equity, shareholders’ equity, and equity capital are used interchangeably to refer to theequity in a corporation. The term net worth is also used. Variations exist in addition to these.

Table 2.1 shows a simplified balance sheet for the fictitious OZ Company. There arethree particularly important things to keep in mind when examining a balance sheet:liquidity, debt versus equity and market value versus book value.

LiquiditySummary annualfinancial statements(and more) for majorpublic Australian andNew Zealandcompanies can befound at<http://au.finance.yahoo.com>.

Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold isa relatively liquid asset; a custom manufacturing facility is not. Liquidity really has twodimensions: ease of conversion versus loss of value. Any asset can be converted to cashquickly if we cut the price enough. A highly liquid asset is therefore one that can be quicklysold without significant loss of value. An illiquid asset is one that cannot be quicklyconverted to cash without a substantial price reduction.

Assets are normally listed on the balance sheet in order of decreasing liquidity,meaning that the most liquid assets are listed first. Current assets are relatively liquid and

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include cash and those assets that we expect to convert to cash over the next twelvemonths. Accounts receivable, for example, represent amounts not yet collected fromcustomers on sales already made. Naturally, we hope these will convert to cash in thenear future. Inventory is probably the least liquid of the current assets, at least for manybusinesses.

Fixed assets are, for the most part, relatively illiquid. These consist of tangible thingssuch as buildings and equipment that do not convert to cash at all in normal businessactivity (they are, of course, used in the business to generate cash). Intangible assets, suchas a trademark, have no physical existence but can be very valuable. Like tangible fixedassets, they will not ordinarily convert to cash and are generally considered illiquid.

C H A P T E R 2 Financial Statements, Taxes and Cash Flow 23

EXAMPLE 2.1Building the Balance Sheet

A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt of

$200. What does the balance sheet look like? What is shareholders’ equity? What is net working capital?

In this case, total assets are $100 + $500 = $600 and total liabilities are $70 + $200 = $270, so

shareholders’ equity is the difference: $600 – $270 = $330. The balance sheet would thus look like:

Assets Liabilities and Shareholders’ Equity

Current assets $100 Current liabilities $ 70

Net fixed assets 500 Long-term debt 200

Shareholders’ equity 330

Total liabilities and Total assets $600 shareholders’ equity $600

Net working capital is the difference between current assets and current liabilities, or $100 – $70 = $30.

TABLE 2.1

Balance sheets forOZ Company

OZ Company Balance Sheets as at 31 December 2006 and 2007 ($ in millions)

2006 2007 2006 2007

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 104 $ 160 Accounts payable $ 232 $ 266

Accounts receivable 455 688 Notes payable 196 123

Inventory 553 555 Total $ 428 $ 389

Total $ 1112 $1403

Fixed assets

Net fixed assets $1644 $1709 Long-term debt $ 408 $ 454

Owners’ equity

Ordinary Shares 600 640

Retained earnings 1320 1629

Total $1920 $2269

Total liabilities and Total assets $2756 $3112 owners’ equity $2756 $3112

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Liquidity is valuable. The more liquid a business is, the less likely it is to experiencefinancial distress (that is, difficulty in paying debts or buying needed assets). Unfortunately,liquid assets are generally less profitable to hold. For example, cash holdings are the mostliquid of all investments, but they sometimes earn no return at all—they just sit there. Thereis therefore a trade-off between the advantages of liquidity and forgone potential profits.

Debt versus Equity

To the extent that a firm borrows money, it usually gives first claim to the firm’s cash flowto creditors. Equity holders are only entitled to the residual value, the portion left aftercreditors are paid. The value of this residual portion is the shareholders’ equity in the firm,which is just the value of the firm’s assets less the value of the firm’s liabilities:

Shareholders’ equity = Assets – Liabilities

This is true in an accounting sense because shareholders’ equity is defined as this residualportion. More importantly, it is true in an economic sense: if the firm sells its assets andpays its debts, whatever cash is left belongs to the shareholders.

The use of debt in a firm’s capital structure is called financial leverage. The more debta firm has (as a percentage of assets), the greater is its degree of financial leverage. As wediscuss in later chapters, debt acts like a lever in the sense that its use can greatly magnifyboth gains and losses. So, financial leverage increases the potential reward to shareholders,but it also increases the potential for financial distress and business failure.


Market Value versus Book Value

The true value of any asset is its market value, which is simply the amount of cash we wouldget if we sold it. In contrast, the values shown on the balance sheet for the firm’s assets arebook values and generally are not what the assets are actually worth. Under the Australian

Accounting Standards (AAS), audited financial statements in Australia generally show assetsat historical cost. In other words, assets are ‘carried on the books’ at what the firm paid forthem, no matter how long ago they were purchased or how much they are worth today.

For current assets, market value and book value might be somewhat similar, sincecurrent assets are bought and converted into cash over a relatively short span of time. In othercircumstances, they might differ quite a bit. Moreover, for fixed assets, it would be purely acoincidence if the actual market value of an asset (what the asset could be sold for) were equalto its book value. For example a firm may have bought a delivery truck that it is depreciatingover an estimated five-year life. It would be purely by chance if the market value of thedelivery truck at a particular time were identical to the net book value at which it is carried inthe firm’s books. In the case of assets that normally appreciate in value, such as land andbuildings, firms must have these assets periodically revalued so that they are carried in thefirm’s books at close to their market value. (Any such revaluations are recorded in an AssetRevaluation Reserve Account, which forms part of shareholders’ equity.)

Managers and investors will frequently be interested in knowing the market value of thefirm. This information is not on the balance sheet. The fact that many balance sheet assetsare listed at cost means that there is no necessary connection between the total book valueof the firm’s assets and the market value of the firm. Indeed, many of the most valuableassets that a firm might have—good management, a good reputation, talented employees—do not appear on the balance sheet at all. To give one example, one of the most valuableassets for many well-known companies is their brand name. According to one source, thenames ‘Coca-Cola’, ‘Microsoft’ and ‘IBM’ are worth more than US$50 billion dollars.

AustralianAccountingStandards (AAS)

The common set ofstandards andprocedures by whichaudited financialstatements areprepared.

The home page for theAustralian AccountingStandards Board(AASB) is <www.aasb.com.au>.

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Similarly, the owners’ equity figure on the balance sheet and the true market value ofthe equity need not be related. For financial managers the accounting value of the equity isnot an especially important concern; it is the market value that matters. Henceforth,whenever we speak of the value of an asset or the value of the firm, we will normally meanits market value. So, for example, when we say the goal of the financial manager is toincrease the value of the firm to its owners, we mean the market value of the firm’s shares.


EXAMPLE 2.2Market versus Book Values

The Battler Company has fixed assets with a book value of $700 and an appraised market value of

about $1000. Net working capital is $400 on the books, but approximately $600 would be realised if

all the current accounts were liquidated. Battler has $500 in long-term debt, both book value and

market value. What is the book value of the equity? What is the market value?

We can construct two simplified balance sheets, one in accounting (book value) terms and one

in economic (market value) terms:

BATTLER COMPANYBalance Sheets

Market Value versus Book Value

Book Market Book Market

Assets Liabilities and Shareholders’ Equity

Net working capital $ 400 $ 600 Long-term debt $ 500 $ 500

Net fixed assets 700 1000 Shareholders’ equity 600 1100

$1100 $1600 $1100 $1600

In this example shareholders’ equity is actually worth almost twice as much as what is shown on the

books. The distinction between book and market values is important precisely because book values

can be so different from true economic value.

The income statement measures performance over some period of time, usually a quarter,a half-year or a full year. The income statement equation is:

Revenues – Expenses = Income [2.2]

C O N C E P T Q U E S T I O N S

2.1a What is the balance sheet identity?

2.1b What is liquidity? Why is it important?

2.1c What do we mean by financial leverage?

2.1d Explain the difference between accounting value and market value. Which is moreimportant to the financial manager? Why?

2.2 THE INCOME STATEMENTincome statement

Financial statementsummarising a firm’sperformance over aperiod of time.

If you think of the balance sheet as a snapshot, then you can think of the incomestatement as a video recording covering the period between a before and an afterpicture. Table 2.2 gives a simplified income statement for OZ Company.

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The first thing reported on an income statement would usually be revenue and expensesfrom the firm’s principal operations. Subsequent parts include, among other things,financing expenses such as interest paid. Taxes paid are reported separately. The last itemis net income (the so-called ‘bottom line’). Net income is often expressed on a per-sharebasis and called earnings per share (EPS).

As indicated, OZ Company paid cash dividends of $103. The difference between netincome and cash dividends, $309, is the addition to retained earnings for the year. Thisamount is added to the cumulative retained earnings account on the balance sheet. If youlook back at the two balance sheets for OZ Company, you will see that retained earningsdid increase by this amount, $1320 + 309 = $1629.


TABLE 2.2

Income statement forOZ Company

OZ Company2007 Income Statement

($ in millions)

Net sales $1 509

Cost of goods sold 750

Depreciation 65

Earnings before interest and taxes (EBIT) $ 694

Interest paid 70

Taxable income $ 624

Taxes 212

Net income $ 412

Dividends $103

Addition to retained earnings 309

EXAMPLE 2.3 Earnings and Dividends per Share

Suppose OZ Company had 200 million shares outstanding at the end of 2007. Based on the income

statement in Table 2.2, what was EPS? What were dividends per share?

The income statement shows that OZ had a net income of $412 million for the year. Total

dividends were $103 million. Since 200 million shares were outstanding, we can calculate earnings

per share and dividends per share as follows.

Earnings per share = Net income/Total shares outstanding

= $412/200 = $2.06 per share

Dividends per share = Total dividends/Total shares outstanding

= $103/200 = $0.515 per share

When looking at an income statement, the financial manager needs to keep three thingsin mind:

1. Australian Accounting Standards (AAS),

2. cash versus non-cash items, and

3. time and costs.

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AAS and the Income Statement

An income statement prepared using AAS will show revenue when it accrues. This is notnecessarily when the cash comes in. The general rule (the recognition principle) is torecognise revenue when the earnings process is virtually complete and the value of anexchange of goods or services is known or can be reliably determined. In practice thisprinciple usually means that revenue is recognised at the time of sale, which need not bethe same as the time of collection.

Expenses shown on the income statement are based on the matching principle. The basicidea here is to first determine revenues as described above and then match those revenueswith the costs associated with producing them. So, if we manufacture a product and then sellit on credit, the revenue is recognised at the time of sale. The production and other costsassociated with the sale of that product would likewise be recognised at that time. Once again,the actual cash outflows associated with the production and marketing of the product mayhave occurred at very different times. Thus, as a result of the way revenues and expenses arereported, the figures shown on the income statement may not be at all representative of theactual cash inflows and outflows that occurred during a particular period.

R E A L I T Y B Y T E S

Want to know a quick way to lose 56% worth ofshareholder value? It’s easy: just write off about $882

million in goodwill. While this is not recommended, that’sexactly what happened at Southcorp Wines, Australia’s largestand one of the world’s big wine producers, at the end ofJanuary 2002. At the peak of its share trading in 2001,Southcorp’s shares were trading at $8.38. Two years later,after more bad news, their shares were trading at $3.71.

Southcorp’s tale of woe dates back to its acquisition in2001 of Rosemount wines, a privately owned wine company.According to some commentators the acquisition seemed tobe made in heaven. Southcorp acquired the private winemakerfor $1.5 billion by issuing 94 million shares at a value of $5.50each, using $881 million in cash and taking over Rosemont’sdebt, totalling $90 million. Southcorp acquired Rosemountwhen the wine market was at the top of its business cycle,growth outlook was very strong and Australian wines wereselling very well overseas. Many investors thought that thiswas a good acquisition by Southcorp, and its share price waspushed to a peak of $8.38 in 2001.

However, Rosemount wines was a discount winemaker,selling its product under the one brand and buying grapes fromseveral growers. In contrast, Southcorp was a premiumwinemaker, selling under a number of brands, owning its ownvineyards and operating at higher profit margins, as their winestook longer to mature before selling. This mismatch meant thatthe expected synergies between the two companies did notmaterialise, while the firm also suffered as the result of a

A Bitter Pill for Southcorp’s Shareholders

misguided aggressive production campaign designed tocapture market share. The CEO of Southcorp said later in aninterview that they had overproduced by about 1.5 millioncases of wine, leading to excess inventory. This over-production, combined with falling overseas sales, resulted in a‘fire sale’ to reduce inventory levels.

Rumours of problems at Southcorp had been in themarket for a few months, but the real issue came to a headwith the 21 January 2002 profit announcement and write-downof goodwill. To add to its woes the rating agency Standard &Poor’s immediately put the company’s long-term credit ratingof BBB+ onto credit watch. This downgrading by S&P informedinvestors that Southcorp could possibly have problems inmeeting its debt obligations: this was not good news and sothe share price fell.

The ultimate problem was overproduction of wine and anexcessive valuation of goodwill. This story is instructivebecause it emphasises the differences between accountingreports, cash flows and investor expectations. The 2001acquisition was seen as good news initially, but when thecompany revalued its assets and slashed its profit projectionfor the coming year, shareholders sold their shares, ultimatelytrimming the share price to $3.71 in 2002. The share pricecontinued to decline and in 2005 Southcorp became atakeover target of the Fosters group. As this example makesclear, not all acquisitions or increases in production result ingreater profits, and investors recognise the difference whenconfronted with a discrepancy between cash flow and profits.

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Non-Cash Items


non-cash items

Expenses chargedagainst revenues thatdo not directly affectcash flow, such asdepreciation.

A primary reason that accounting income differs from cash flow is that an incomestatement contains non-cash items. The most important of these is depreciation. Supposea firm purchases a fixed asset for $5000 and pays in cash. Obviously, the firm has a $5000cash outflow at the time of purchase. However, instead of deducting the $5000 as anexpense, an accountant might depreciate the asset over a five-year period.

If the depreciation is straight-line and the asset is written down to zero over thatperiod, then $5000/5 = $1000 would be deducted each year as an expense.2 The importantthing to recognise is that this $1000 deduction is not a cash transaction—it is an accountingnumber. The actual cash outflow occurred when the asset was purchased.

The depreciation deduction is simply another application of the matching principle inaccounting. The revenues associated with an asset would generally occur over some lengthof time. The accountant seeks to match the expense of purchasing the asset with thebenefits produced from owning it.

As we will see, for the financial manager the actual timing of cash inflows and outflows iscritical in coming up with a reasonable estimate of market value, so we need to learn how toseparate the cash flows from the non-cash accounting entries. In reality, the difference betweencash flow and accounting income can be pretty dramatic. For example, wine companySouthcorp Limited reported a net loss of $969 million for 2006. Sounds bad, but Southcorp alsoreported a positive operating cash flow of $96 million! The reason the difference is so large isthat Southcorp has particularly big non-cash deductions related to, among other things, thereduction in their valuation of goodwill by $643 million and of brand names by $240 million.

Time and Costs

It is often useful to think of the future as having two distinct parts: the short run and thelong run. These are not precise time periods. The distinction has to do with whether costsare fixed or variable. In the long run, all business costs are variable. Given sufficient time,assets can be sold, debts can be paid, and so on.

If our time horizon is relatively short, however, some costs are effectively fixed—theymust be paid no matter what (office rent, for example). Other costs, such as wages to staffand payments to suppliers, are still variable. As a result, even in the short run, the firm canvary its output level by varying expenditures in these areas.

The distinction between fixed and variable costs is sometimes important to thefinancial manager, but the way costs are reported on the income statement is not a goodguide as to which costs are which. The reason is that, in practice, accountants tend toclassify costs as either product costs or period costs.

Product costs include such things as raw materials, direct labour expense and manu-facturing overhead. These are reported on the income statement as costs of goods sold, but theyinclude both fixed and variable costs. Similarly, period costs are incurred during a particulartime period and might be reported as selling, general and administrative expenses. Once again,some of these period costs may be fixed and others may be variable. The company chiefexecutive’s salary, for example, is a period cost that is probably fixed, at least in the short run.

The balance sheets and income statement we have been using thus far are hypothetical.Our nearby Work the Web box shows how to find actual balance sheets and incomestatements online for almost any company.

2 By ‘straight-line’, we mean that the depreciation deduction is the same every year. By ‘written down to zero’,we mean that the asset is assumed to have no value at the end of five years.

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Most Australian public companies have investor or shareholder areas on theirweb sites, where you can find online copies of their annual reports. We went

to the Virgin Blue web site and then to ‘About Us’ under this section we went to‘Investor Info’ and then clicked on ‘Financials’, where you can download a number of financialreports.

Earnings Management

The way that firms are required by AAS to report financial results is intended to beobjective and precise. In reality there is plenty of ‘wriggle room’, and as a result companieshave significant discretion over their reported earnings. For example, companiesfrequently like to show investors that they have steadily growing earnings. To do this, theymight take steps to overestimate or underestimate earnings at various times to smooth outdips and surges. Doing this falls under the heading of earnings management.



2.2a What is the income statement equation?

2.2b What are the three things to keep in mind when looking at an income statement?

2.2c Why is accounting income not the same as cash flow?

Here is a partial view of what we got.

W O R K T H E W E B

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Taxes can be one of the largest cash outflows that a firm experiences. For example, for thefiscal year 2006 BHP Billiton’s earnings before taxes were about $19 billion. Its tax bill,including all taxes paid worldwide, was a whopping $4.8 billion, or about 26% of its pretaxearnings. The size of the tax bill is determined through the tax code, an often-amended setof rules. In this section, we examine corporate tax rates and how taxes are calculated. Taxesfor partnerships and sole proprietorships are computed using the personal income taxschedules.

If the various rules of taxation seem a little bizarre or convoluted to you, keep in mindthat the tax code is the result of political, not economic, forces. As a result, there is noreason for it to make economic sense.

Corporate Tax Rates


2.3 TAXES

The Australian TaxOffice has a great website at <www.ato.gov.au> and the New Zealandequivalent is<www.ird.govt.nz>.

average tax rate

Total taxes paid dividedby total taxable income.

marginal tax rate

Amount of tax payableon the next dollarearned.

The corporate tax rate in Australia in 2007 is 30%. As it stands now, corporate taxation inAustralia and in New Zealand is a flat-rate tax. In flat-rate tax, there is only one tax rate,and this rate is the same for all income levels. With flat-rate tax, the marginal tax rate isalways the same as the average tax rate (these terms are discussed below). Assume anAustralian company earns income before tax of $2000 for the year. The tax payable by thecompany is 30% of $2000, that is $2000 × 0.30 = $600.

In some other countries, such as the United States, different tax levels apply todifferent levels of corporate income. In these countries, the difference between themarginal tax rate and the average tax rate may be important. Since marginal and averagerates do not apply to Australian and New Zealand corporate tax, we will explain how thesetaxes work for Australian personal income (they do apply to the earnings of soleproprietorships and partnerships).

Average versus Marginal Tax RatesIn making financial decisions, it is frequently important to distinguish betweenaverage and marginal tax rates. Your average tax rate is your tax bill divided by yourtaxable income, in other words, the percentage of your income that goes to pay taxes.Your marginal tax rate is the extra tax you would pay if you earned one more dollar.The percentage tax rates shown in Table 2.3 are all marginal rates. Put another way,the tax rates in Table 2.3 apply to the part of income in the indicated range only, notall income.

TABLE 2.3

Individual tax rates inAustralia for the2006/2007 financialyear

Taxable Income Tax Rate

$0– 6 000 Nil

6 001– 25 000 15%

25 001– 75 000 30%

75 001–150 000 40%

Over 150 000 45%

The difference between average and marginal tax rates can best be illustrated with a simpleexample. Suppose our taxable income is $50 000. What is the tax bill? From Table 2.3, wecan work out our tax bill as:

Ross Ch 02 12/7/07 4:16 PM Page 30

Nil × 6 000 = $015% × (25 000 – 6 000) = $2 850.0030% × (50 000 – 25 000) = $7 500.00

Total tax = $10 350.00

Our total tax is thus $10 350.In our example, what is the average tax rate? We had a taxable income of $50 000 and

a tax bill of $10 350, so the average tax rate is $10 350/50 000 = 20.70%. What is themarginal tax rate? If we made one more dollar, the tax on that dollar would be 30 cents, soour marginal rate is 30%.


EXAMPLE 2.4Deep in the Heart of TaxesBony Bushman has a taxable income of $85 000. What is their tax bill? What is their average tax rate

and marginal tax rate?

From Table 2.3, the tax for the first $6000 is zero; tax for the next 19 000 (6000 to 25 000) is 15%;

tax for the next $50 000 (25 000 to 75 000) is 30%; and the rate applied after that up to $85 000 is 40%.

So Bony Bushman must pay $19 000 × 0.15 + 50 000 × 0.30 + 10 000 × 0.40 = $21 850. The average

tax rate is thus $21 850/85 000 = 25.71%. The marginal rate is 40% since Bony Bushman’s taxes would

rise by 40 cents if they had another dollar in taxable income.

C O N C E P T Q U E S T I O N

2.3 What is the difference between a marginal and an average tax rate?

Taxation of Dividends: Difference between a ClassicalTax System and an Imputation System

Under a classical system of taxation a firm is first taxed on its profits, and the shareholdersare then taxed on any dividends that they receive from the firm. This leads to doubletaxation of corporate profits, with the company profits first being taxed in the company andthen taxed again when any of the after-tax profits are distributed as dividends to theshareholders. This double taxation was removed in Australia in 1987, and 1988 in NewZealand, when both governments changed to what is described as an imputation tax system.

Under an imputation tax system, the company advises the shareholder of the amountof company tax already paid on the dividend the shareholder receives. The shareholderthen adds this amount of tax to the cash dividend that they have received and pay personaltax on the grossed up amount (cash dividend plus company tax). However, they alsoreceive a tax (franking) credit equivalent to the amount of tax paid by the company, whichthey can offset against their taxable income. The effect is that the company tax is negatedand the full amount of profits earned by the company is taxed at the marginal tax rate of theshareholder. Example 2.5 sets out the company treatment of tax and the effect on theindividual shareholder. The important point to note is that this tax system applies only todomestic investors, and overseas investors who own shares in Australian companies arestill effectively taxed under a classical system.

The Australian and New Zealand dividend imputation systems are very similar—visitthe New Zealand Inland Revenue’s web site to see a comparison at <www.idr.govt.nz>.Other countries that have imputation systems are Britain, France, Germany and Italy.

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At this point, we are ready to discuss perhaps one of the most important pieces of financialinformation that can be gleaned from financial statements: cash flow. By cash flow, wesimply mean the difference between the number of dollars that came in and the number thatwent out. For example, if you were the owner of a business, you might be very interestedin how much cash you actually took out of your business in a given year. How to determinethis amount is one of the things we discuss next.

There is no standard financial statement that presents this information in the way thatwe would like. We will therefore discuss how to calculate cash flow for OZ Company andpoint out how the result differs from that of standard financial statement calculations.(There is a standard financial accounting statement called the statement of cash flows, butit is concerned with a somewhat different issue that should not be confused with what isdiscussed in this section.)


EXAMPLE 2.5 Well Diggers, an Australian company, distributes all of its after-tax profits to its shareholders in the form

of a cash dividend. The table below shows the treatment of the cash dividend for different individuals’

marginal tax rates. Shareholders who have a lower marginal tax rate than the company’s tax rate will

effectively receive a tax refund. Shareholders who have a marginal tax rate of 30% will pay no tax on

the cash component of the dividend. Shareholders who have a marginal tax rate above the company

tax rate of 30% will have to pay some additional tax.

Well Diggers Company Profit and Tax

Profit before tax $1000

Australian company tax (30%) $ 300

Profit after tax $ 700

Effect of dividend on individual shareholders at different marginal tax rates

Shareholder Shareholder Shareholder Shareholder 1 2 3 4

Marginal tax rate 15% 30% 40% 45%

Cash dividend from Well Diggers ($) 700 700 700 700

Tax credit ($) 300 300 300 300

Imputed gross income ($) 1000 1000 1000 1000

Individual tax payable ($) 150 300 400 450

Additional tax to pay ($) Nil Nil 100 150

Tax reimbursement ($) 150 Nil Nil Nil

Net overall cash position ($) 850 700 600 550

Under the classical tax system the shareholder would receive the $700 dividend and include that

amount as part of their assessable income and pay tax on the $700 at their marginal tax rate.

2.4 CASH FLOW

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From the balance sheet identity, we know that the value of a firm’s assets is equal tothe value of its liabilities plus the value of its equity. Similarly, the cash flow from thefirm’s assets must equal the sum of the cash flow to creditors and the cash flow toshareholders (or owners, if the business is not a corporation):

Cash flow from assets = Cash flow to creditors + Cash flow to shareholders [2.3]

This is the cash flow identity. What it reflects is the fact that a firm generates cash throughits various activities, and that cash is either used to pay creditors or paid out to the ownersof the firm. We discuss the various items that make up these cash flows next.

Cash Flow from Assets

Cash flow from assets involves three components: operating cash flow, capital spendingand change in net working capital. Operating cash flow refers to the cash flow that resultsfrom the firm’s day-to-day activities of producing and selling. Expenses associated withthe firm’s financing of its assets are not included because they are not operating expenses.


cash flow fromassets

The total of cash flow tocreditors and cash flowto shareholders,consisting of operatingcash flow, capitalspending and changesin net working capital.

operating cash flow

Cash generated from afirm’s normal businessactivities.

In the normal course of events, some portion of the firm’s cash flow is reinvested inthe firm. Capital spending refers to the net spending on fixed assets (purchases of fixedassets less sales of fixed assets). Finally, the change in net working capital is the amountspent on net working capital. It is measured as the change in net working capital over theperiod being examined and represents the net increase in current assets over currentliabilities. The three components of cash flow are examined in more detail below. In all ourexamples, all amounts are in millions of dollars.

Operating Cash Flow To calculate operating cash flow (OCF), we want to calculaterevenue minus costs, but we do not want to include either depreciation, since it is not a cashoutflow, or interest, because it is a financing expense. We do want to include taxes, becausetaxes are, unfortunately, paid in cash.

If we look at Oz Company’s income statement (Table 2.2), we see that earnings beforeinterest and taxes (EBIT) are $694. This is almost what we want, since it does not includeinterest paid. We need to make two adjustments. First, recall that depreciation is a non-cashexpense. To get cash flow, we first add back the $65 in depreciation, since it was not a cashdeduction. The other adjustment is to subtract the $212 in taxes, since these were paid incash. The result is operating cash flow:

OZ Company 2007 Operating Cash Flow

Earnings before interest and taxes $694

+ Depreciation 65

– Taxes 212

Operating cash flow $547

OZ Company thus had a 2007 operating cash flow of $547. Operating cash flow is animportant number because it tells us, on a very basic level, whether a firm’s cash inflowsfrom its business operations are sufficient to cover its everyday cash outflows. For thisreason, a negative operating cash flow is often a sign of trouble.

There is a possibility for confusion when we speak of operating cash flow, as accountingpractice often defines operating cash flow as net income plus depreciation. For OZ Company

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the accounting number would amount to $412 + 65 = $477. The accounting definition ofoperating cash flow differs from ours in one important way: interest is deducted when netincome is computed in our definition. Notice that the difference between the $547operating cash flow we calculated and the accounting number $477 is $70, the amount ofinterest paid for the year. The accounting definition of cash flow thus considers interestpaid to be an operating expense. Our definition treats it properly as a financing expense. Ifthere were no interest expense, the two definitions would be the same.

To finish our calculation of cash flow from assets for OZ Company, we need toconsider how much of the $547 operating cash flow was reinvested in the firm. Weconsider spending on fixed assets first.

Capital Spending Net capital spending is just money spent on fixed assets less moneyreceived from the sale of fixed assets. At the end of 2006 net fixed assets for OZ Company(Table 2.1) were $1644. During the year, we wrote off (depreciated) $65 worth of fixedassets on the income statement. So, if we did not purchase any new fixed assets, net fixedassets would have been $1644 – 65 = $1579 at year’s end. The 2007 balance sheet shows$1709 in net fixed assets, so we must have spent a total of $1709 – 1579 = $130 on fixedassets during the year:

Ending net fixed assets $1709

– Beginning net fixed assets 1644

+ Depreciation 65

Net investment in fixed assets $ 130

This $130 is our net capital spending for 2007.Could net capital spending be negative? The answer is yes. This would happen if the

firm sold off more assets than it purchased. The net here refers to purchases of fixed assetsnet of any sales of fixed assets.

Change in Net Working Capital In addition to investing in fixed assets, a firm willalso invest in current assets. For example, going back to the balance sheet in Table 2.1,we see that at the end of 2007 OZ had current assets of $1403. At the end of 2006current assets were $1112, so, during the year, OZ invested $291 ($1403 – 1112) incurrent assets.

As the firm changes its investment in current assets, its current liabilities will usuallychange as well. To determine the change in net working capital, the easiest approach is justto take the difference between the beginning and ending net working capital (NWC) figures.Net working capital at the end of 2007 was $1014 ($1403 – 389). Similarly, at the end of2006, net working capital was $684 ($1112 – 428). So, given these figures, we have:

Ending NWC $1014

– Beginning NWC 684

Change in NWC $ 330

Net working capital thus increased by $330. Put another way, OZ Company had a netinvestment of $330 in NWC for the year.


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Conclusion Given the figures we have come up with, we are now ready to calculate cashflow from assets. The total cash flow from assets is given by operating cash flow less theamounts invested in fixed assets and net working capital. So, for OZ Company, we have:

OZ Company 2007 Cash Flow from Assets


– Net capital spending 130

– Change in NWC 330

Cash flow from assets $ 87

From the cash flow identity above, this $87 cash flow from assets equals the sum of thefirm’s cash flow to creditors and its cash flow to shareholders. We consider these next.

It would not be at all unusual for a growing corporation to have a negative cash flow.As we shall see below, a negative cash flow means that the firm raised more money byborrowing and issuing shares than it paid out to creditors and shareholders that year.

A Note on ‘Free’ Cash Flow


free cash flow

Another name for cashflow from assets.

cash flow tocreditors

A firm’s interestpayments to creditorsless net new borrowings.

cash flow toshareholders

Dividends paid out by afirm less net new equityraised.

Cash flow from assets sometimes goes by a different name, free cash flow. Of course,there is no such thing as ‘free’ cash (we wish!). Instead, the name refers to cash that thefirm is free to distribute to creditors and shareholders because it is not needed for workingcapital or fixed asset investments. We will stick with ‘cash flow from assets’ as our labelfor this important concept because, in practice, there is some variation in exactly how freecash flow is computed, as different users calculate it in different ways. Nonetheless,whenever you hear the phrase ‘free cash flow’, you should understand that what is beingdiscussed is cash flow from assets or something quite similar.

Cash Flow to Creditors and Shareholders

Cash flows to creditors and shareholders represent net payments to creditors and owners dur-ing the year. They are calculated in a similar way. Cash flow to creditors is interest paid lessnet new borrowing; cash flow to shareholders is dividends paid less net new equity raised.

Cash Flow to Creditors Looking at the income statement in Table 2.2, we see that OZpaid $70 in interest to creditors. From the balance sheets in Table 2.1, long-term debt roseby $46 ($454 – 408). So, OZ Company paid out $70 in interest, but it borrowed anadditional $46. Net cash flow to creditors is thus:

OZ Company 2007 Cash Flow to Creditors

Interest paid $70

– Net new borrowing 46

Cash flow to creditors $24

Cash flow to creditors is sometimes called cash flow to debtholders; we will use theseterms interchangeably.

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Cash Flow to Shareholders From the income statement, dividends paid to share-holders amount to $103. To calculate net new equity raised, we need to look at the ordinaryshares (paid-up capital). This account tells us what funds the company has raised by sellingshares. During the year, this account rose by $40 ($640 – 600), so $40 in net new equitywas raised. Given this, we have:

OZ Company2007 Cash Flow to Shareholders

Dividends paid $103

– Net new equity raised 40

Cash flow to shareholders $ 63

The cash flow to shareholders for 2007 was thus $63.

Conclusion

The last thing that we need to do is to verify that the cash flow identity holds, to be sure thatwe did not make any mistakes. From above, cash flow from assets is $87. Cash flow tocreditors and shareholders is $24 + 63 = $87, so everything checks out. Table 2.5 containsa summary of the various cash flow calculations for future reference.

As our discussion indicates, it is essential that a firm keeps an eye on its cash flow.The following serves as an excellent reminder of why doing so is a good idea, unless thefirm’s owners wish to end up in the poorhouse.


TABLE 2.5

Cash flow summary

I. The cash flow identity

Cash flow from assets = Cash flow to creditors (debtholders)

+ Cash flow to shareholders (owners)

II. Cash flow from assets

Cash flow from assets = Operating cash flow

– Net capital spending

– Change in networking capital (NWC)

where

Operating cash flow = Earnings before interest and tax (EBIT)

+ Depreciation – Taxes

Net capital spending = Ending net fixed assets – Beginning net fixed assets

+ Depreciation

Change in NWC = Ending NWC – Beginning NWC

III. Cash flow to creditors (debtholders)

Cash flow to creditors = Interest paid – Net new borrowing

IV. Cash flow to shareholders (owners)

Cash flow to shareholders = Dividends paid – Net new equity raised

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Quoth the Banker, ‘Watch Cash Flow’Once upon a midnight dreary as I pondered weak and weary Over many a quaint and curious volume of accounting lore,Seeking gimmicks (without scruple) to squeeze through

some new tax loophole,Suddenly I heard a knock upon my door,

Only this, and nothing more.

Then I felt a queasy tingling and I heard the cash a-jingling As a fearsome banker entered whom I’d often seen before.His face was money-green and in his eyes there could be seen Dollar-signs that seemed to glitter as he reckoned up the score.

‘Cash flow’, the banker said, and nothing more.

I had always thought it fine to show a jet black bottom line. But the banker sounded a resounding, ‘No.Your receivables are high, mounting upward toward the sky; Write-offs loom. What matters is cash flow.’

He repeated, ‘Watch cash flow.’

Then I tried to tell the story of our lovely inventory Which, though large, is full of most delightful stuff. But the banker saw its growth, and with a mighty oath He waved his arms and shouted, ‘Stop! Enough!

Pay the interest, and don’t give me any guff!’

Next I looked for noncash items which could add ad infinitum To replace the ever-outward flow of cash, But to keep my statement black I’d held depreciation back, And my banker said that I’d done something rash.

He quivered, and his teeth began to gnash.

When I asked him for a loan, he responded, with a groan,That the interest rate would be just prime plus eight, And to guarantee my purity he’d insist on some security— All my assets plus the scalp upon my pate.

Only this, a standard rate.

Though my bottom line is black, I am flat upon my back, My cash flows out and customers pay slow.The growth of my receivables is almost unbelievable: The result is certain—unremitting woe!And I hear the banker utter an ominous low mutter,

‘Watch cash flow.’Herbert S. Bailey Jr

Source: Reprinted from Publishers Weekly, 13 January 1975, published by R. R. Bowker, a Xerox company.Copyright © 1975 by the Xerox Corporation.

To which we can only add: ‘Amen’.


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An Example: Cash Flows for Apple Isle

This extended example covers the various cash flow calculations discussed in the chapter.It also illustrates a few variations that may arise.

Operating Cash Flow During the year Apple Isle Ltd had sales and cost of goods soldof $600 and $300, respectively. Depreciation was $150 and interest paid was $30. Taxeswere calculated at a straight 30%. Dividends were $30. (All figures are in millions ofdollars.) What was operating cash flow for Apple Isle? Why is this different from netincome?

The easiest thing to do here is to go ahead and create an income statement. We can thenpick up the numbers we need. Apple Isle’s income statement is given below:

APPLE ISLE2007 Income Statement

Net sales $600


Depreciation 150


Interest paid 30

Taxable income $120

Taxes 36

Net income $ 84

Dividends $30

Addition to retained earnings $54

Net income for Apple Isle was thus $84. We now have all the numbers we need. Lookingback to the OZ Company example and Table 2.5, we have:

APPLE ISLE 2007 Operating Cash Flow


+ Depreciation 150

– Taxes 36


As this example illustrates, operating cash flow is not the same as net income, becausedepreciation and interest are subtracted when net income is calculated. If you recall ourearlier discussion, we do not subtract these in computing operating cash flow, becausedepreciation is not a cash expense, and interest paid is a financing expense, not anoperating expense.

Net Capital Spending Suppose beginning net fixed assets were $500 and ending netfixed assets were $750. What was the net capital spending for the year?

From the income statement for Apple Isle, depreciation for the year was $150. Netfixed assets rose by $250. The net spending for the year on fixed assets was therefore $400($750 + 150 – 500).


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Change in NWC and Cash Flow from Assets Suppose Apple Isle started the yearwith $2130 in current assets and $1620 in current liabilities. The corresponding endingfigures were $2260 and $1710. What was the change in NWC during the year? What wascash flow from assets? How does this compare to net income?

Net working capital started out as $510 ($2130 – 1620) and ended up at $550 ($2260– 1710). The change in NWC was thus $40 ($550 – 510). Putting together all theinformation for Apple Isle, we have:

APPLE ISLE 2007 Cash Flow from Assets




Cash flow from assets –$176

Apple Isle had a cash flow from assets of –$176. Net income was positive at $84. Is the factthat cash flow from assets was negative a cause for alarm? Not necessarily. The cash flowhere is negative primarily because of a large investment in fixed assets. If these are goodinvestments, then the resulting negative cash flow is not a worry.

Cash Flow to Creditors and Shareholders We saw that Apple Isle had cash flowfrom assets of –$176. The fact that this is negative means that Apple Isle raised moremoney in the form of new debt and equity than it paid out for the year. For example,suppose we know that Apple Isle did not sell any new equity for the year. What was cashflow to shareholders? To creditors?

Since it did not raise any new equity, Apple Isle’s cash flow to shareholders is justequal to the cash dividend paid:

APPLE ISLE 2007 Cash Flow to Shareholders

Dividends paid $30

– Net new equity 0

Cash flow to stockholders $30

Now, from the cash flow identity, the total cash paid to creditors and shareholders was$176. Cash flow to shareholders is $30, so cash flow to creditors must be equal to –$176 –30 = –$206.

Cash flow to creditors + Cash flow to shareholders = –$176

Cash flow to creditors + $30 = –$176

Cash flow to creditors = –$206

Since we know that cash flow to creditors is –$206 and interest paid is $30 (from theincome statement), we can now determine net new borrowing. Apple Isle must haveborrowed $236 during the year to help finance the fixed asset expansion:


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SUMMARY AND CONCLUSIONS

CHAPTER REVIEW AND SELF-TEST PROBLEM

APPLE ISLE 2007 Cash Flow to Creditors

Interest paid $30


Cash flow to creditors –$206


2.4a What is the cash flow identity? Explain what it says.

2.4b What are the components of operating cash flow?

2.4c Why is interest paid not a component of operating cash flow?

This chapter has introduced you to some of the basics of financial statements, taxes andcash flow. In it we saw that:

1. The book values on an accounting balance sheet can be very different from marketvalues. The goal of financial management is to maximise the market value of theshare price, not its book value.

2. Net income as it is computed on the income statement is not cash flow. A primaryreason is that depreciation, a non-cash expense, is deducted when net income iscomputed.

3. Marginal and average tax rates can be different, and it is the marginal tax rate that isrelevant for most financial decisions.

4. Australia has a flat company tax rate of 30%, while in New Zealand the flat companytax rate is 33%.

5. There is a cash flow identity much like the balance sheet identity. It says that cashflow from assets equals cash flow to creditors and shareholders.

The calculation of cash flow from financial statements is not difficult. Care must be takenin handling non-cash expenses, such as depreciation, and in not confusing operating costswith financing costs. Most of all, it is important not to confuse book values with marketvalues, and accounting income with cash flow.

2.1 Cash Flow for Rasputin Corporation. This problem will give you somepractice working with financial statements and working out cash flow. Based onthe following information for Rasputin Corporation, prepare an income statementfor 2007 and balance sheets for 2006 and 2007. Next, following our OZ Company

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eC H A P T E R 2 Financial Statements, Taxes and Cash Flow 41

examples in the chapter, calculate cash flow from assets for Rasputin, cash flow tocreditors and cash flow to shareholders for 2007. Use a 30% tax rate throughout.You can check your answers below:

2006 2007

Sales $3790 $3990

Cost of goods sold 2043 2137

Depreciation 975 1018

Interest 225 267

Dividends 200 225

Current assets 2140 2346

Net fixed assets 6770 7087

Current liabilities 994 1126

Long-term debt 2869 2956

■ Answer to Chapter Review and Self-Test Problem

2.1 In preparing the balance sheets, remember that shareholders’ equity is theresidual. With this in mind, Rasputin’s balance sheets are:

RASPUTIN CORPORATION Balance Sheets as at 31 December 2006 and 2007

2006 2007 2006 2007

Current assets $2140 $2346 Current liabilities $994 $1103

Net fixed assets 6770 7087 Long-term debt 2869 2956

Equity 5047 5374

Total assets $8910 $9433 Total liabilities and shareholders’ equity $8910 $9433

The income statement is straightforward:

RASPUTIN CORPORATION 2007 Income Statement

Sales $3990


Depreciation 1018

Earnings before interest and taxes $ 835

Interest paid 267

Taxable income $ 568

Taxes (30%) 170

Net income $ 398

Dividends $225

Addition to retained earnings $173

Notice that we have used a flat 30% tax rate. Also notice that the addition to retainedearnings is just net income less cash dividends.

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We can now pick up the numbers we need to get operating cash flow:

RASPUTIN CORPORATION 2007 Operating Cash Flow

Earnings before interest and taxes $ 835

+ Depreciation 1018

– Current taxes 170


Next, we get the capital spending for the year by looking at the change in fixed assets,remembering to account for the depreciation:

Ending fixed assets $7087

– Beginning fixed assets 6770

+ Depreciation 1018

Net investment in fixed assets $1335

After calculating beginning and ending NWC, we work out the difference to get thechange in NWC:

Ending NWC $1243

– Beginning NWC 1146

Change in NWC $97

We now combine operating cash flow, net capital spending and the change in net workingcapital to get the total cash flow from assets:

RASPUTIN CORPORATION 2007 Cash Flow from Assets




Cash flow from assets $ 251

To get cash flow to creditors, notice that long-term borrowing increased by $87 duringthe year and that interest paid was $267. So:

RASPUTIN CORPORATION 2007 Cash Flow to Creditors

Interest paid $267


Cash flow to creditors $180

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Finally, dividends paid were $225. To get net new equity, we have to do some extracalculations. Total equity was up by $327 ($5374 – 5047). Of this increase, $173 wasfrom additions to retained earnings, so $154 in new equity must have been raised duringthe year. Cash flow to shareholders was thus:

RASPUTIN CORPORATION 2007 Cash Flow to Shareholders

Dividends paid $225

– Net new equity 154

Cash flow to shareholders $ 71

As a check, notice that cash flow from assets ($251) does equal cash flow to creditorsplus cash flow to shareholders ($180 + 71 = $251).

CRITICAL THINKING AND CONCEPTS REVIEW2.1 Liquidity. What does liquidity measure? Explain the trade-off a firm faces

between high-liquidity and low-liquidity levels.

2.2 Accounting and Cash Flows. Why is it that the revenue and cost figuresshown on a standard income statement may not be representative of the actualcash inflows and outflows that occurred during a period?

2.3 Book Values versus Market Values. In preparing a balance sheet, why do youthink standard accounting practice focuses on historical cost rather than marketvalue?

2.4 Operating Cash Flow. In comparing accounting net income and operating cashflow, what two items do you find in net income that are not in operating cashflow? Explain what each is and why it is excluded from operating cash flow.

2.5 Book Values versus Market Values. Under standard accounting rules, it ispossible for a company’s liabilities to exceed its assets. When this occurs, theowners’ equity is negative. Can this happen with market values? Why or why not?

2.6 Cash Flow from Assets. Suppose a company’s cash flow from assets wasnegative for a particular period. Is this necessarily a good sign or a bad sign?

2.7 Operating Cash Flow. Suppose a company’s operating cash flow was negativefor several years running. Is this necessarily a good sign or a bad sign?

2.8 Net Working Capital and Capital Spending. Could a company’s change inNWC be negative in a given year? (Hint: yes.) Explain how this might comeabout. What about net capital spending?

2.9 Cash Flow to Shareholders and Creditors. Could a company’s cash flow toshareholders be negative in a given year? (Hint: yes.) Explain how this mightcome about. What about cash flow to creditors?

2.10 Classical tax system and Imputation. What is the difference in the treatmentof dividends under a classical tax system and an imputation system?

2.11 Firm Values. In the half-year results, Equigold recorded a loss of $2 millionrather than a profit of $15 because of new accounting rules that came into effect in2005. Equigold was not alone. Other gold companies had to make significant

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QUESTIONS AND PROBLEMS

charges as well. Poor performance wasn’t the issue. Instead, gold companies wereforced by accounting rule changes to recalculate the value of forward goldcontracts compared with current gold prices.

So, did shareholders in Equigold lose as a result of the accounting rule changes? Theanswer: Probably not. What do you think is the basis for this conclusion?

Use the following information to answer the next two questions:In June 2005 WorldCom, the telecommunications giant, surprised investors when itannounced that it had overstated net income in the previous two years by $3.8 billion.At the centre of the controversy was Scott D. Sullivan, the former CFO. WorldComhad leased telephone lines from local companies with the expectation of resellingthe use of the lines at a higher price. Under accounting rules, these costs shouldhave been reported as an expense on the income statement. Reportedly, however,Mr Sullivan ordered that the costs be treated as money spent to purchase a fixedasset, so they were to be shown on the balance sheet as an asset and subsequentlydepreciated.

2.12 Corporate Ethics. In the wake of this scandal, Mr Sullivan was charged withfraud. Do you think this should be considered fraud? Why? Why was thisunethical?

2.13 Net Income and Cash Flows. How did Mr Sullivan’s reclassification of somecosts as asset purchases affect net income at the time? In the future? How did thisaction affect cash flows? What does this tell you about the importance ofexamining cash flow relative to net income?

1. Building a Balance Sheet. Bellaire Bat Factory Limited has current assets of$3400, net fixed assets of $7100, current liabilities of $1900 and long-term debt of$5200. What is the value of the shareholders’ equity account for this firm? Howmuch is net working capital?

2. Building an Income Statement. Razzo Limited has sales of $425 000, costs of$210 000, depreciation expense of $63 000, interest expense of $38 000 and a taxrate of 30%. What is the net income for this firm?

3. Dividends and Retained Earnings. Suppose the firm in Problem 2 paid out$35 000 in cash dividends. What is the addition to retained earnings?

4. Per-Share Earnings and Dividends. Suppose the firm in Problem 2 had 30 000shares outstanding. What are the earnings per share, or EPS, figure? What are thedividends per share figure?

5. Market Values and Book Values. Klingon Widgets Limited purchased newcloaking machinery three years ago for $5 million. The machinery can be sold to theRomulans today for $4 million. Klingon’s current balance sheet shows net fixedassets of $2 100 000, current liabilities of $750 000 and net working capital of$600 000. If all the current assets were liquidated today, the company would receive$1.25 million cash. What is the book value of Klingon’s assets today? What is themarket value?

6. Calculating Taxes. Galoot Galah, a sole proprietor, had $54 000 in taxable income.Using the rates from Table 2.3 in the chapter, calculate Galoot’s income tax.

Basic(Questions 1–13)

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14. Calculating Total Cash Flows. Faulk Limited shows the following information onits 2007 income statement: sales = $114 000; costs = $61 200; other expenses =$3300; depreciation expense = $9600; interest expense = $8400; taxes = $10 710;dividends = $3840. In addition, you are told that the firm issued $1700 in new equityduring 2007, and redeemed $3600 in outstanding long-term debt.

a. What is the 2007 operating cash flow?

b. What is the 2007 cash flow to creditors?

c. What is the 2007 cash flow to shareholders?

d. If net fixed assets increased by $11 400 during the year, what was the addition toNWC?

15. Using Income Statements. Given the following information for Pierce PizzaLimited, calculate the depreciation expense: sales = $30 000; costs = $19 000;addition to retained earnings = $2100; dividends paid = $900; interest expense =$1430; tax rate = 35%.

16. Preparing a Balance Sheet. Prepare a balance sheet for Tim’s Couch Corp as at 31December 2006, based on the following information: cash = $204 000; patents andcopyrights = $798 000; accounts payable = $605 000; accounts receivable = $226 000;tangible net fixed assets = $4 400 000; inventory = $473 000; notes payable = $193 000;accumulated retained earnings = $3 905 000; long-term debt = $908 000.

7. Tax Rates. In Problem 6, what is the average tax rate? What is the marginal taxrate?

8. Calculating OCF. Lutz Limited has sales of $9620, costs of $4840, depreciationexpense of $1300 and interest expense of $1210. If the tax rate is 30%, what is theoperating cash flow, or OCF?

9. Calculating Net Capital Spending. Rotweiler Obedience School’s 31 December2006 balance sheet showed net fixed assets of $2.8 million, and the 31 December2007 balance sheet showed net fixed assets of $3.1 million. The company’s 2007income statement showed a depreciation expense of $510 000. What was Rotweiler’snet capital spending for 2007?

10. Calculating Additions to NWC. The 31 December 2006 balance sheet of Anna’sTennis Shop Limited showed current assets of $800 and current liabilities of $280.The 31 December 2007 balance sheet showed current assets of $860 and currentliabilities of $415. What was the company’s 2007 change in net working capital, orNWC?

11. Cash Flow to Creditors. The 31 December 2006 balance sheet of Rack O LambLimited showed long-term debt of $1.9 million, and the 31 December 2007 balancesheet showed long-term debt of $2.3 million. The 2007 income statement showed aninterest expense of $420 000. What was the firm’s cash flow to creditors during 2007?

12. Cash Flow to Shareholders. The 31 December 2006 balance sheet of Rack OLamb Limited showed $4 400 000 in the ordinary equity account. The 31 December2007 balance sheet showed $4 730 000 in the same account. If the company paid out$120 000 in cash dividends during 2007, what was the cash flow to shareholders forthe year?

13. Calculating Total Cash Flows. Given the information for Rack O Lamb Limited inProblems 11 and 12, suppose you also know that the firm’s net capital spending for2007 was $760 000, and that the firm reduced its net working capital investment by$135 000. What was the firm’s 2007 operating cash flow, or OCF?

Intermediate(Questions 14–22)

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17. Residual Claims. O’Dowd Limited is obliged to pay its creditors $3800 during the year.

a. What is the value of the shareholders’ equity if assets equal $4500?

b. What if assets equal $3400?

18. Net Income and OCF. During 2007 Belyk Paving Ltd had sales of $2 400 000. Costof goods sold, administrative and selling expenses, and depreciation expenses were$1 440 000, $360 000 and $480 000, respectively. In addition, the company had aninterest expense of $180 000 and a tax rate of 35%. (Ignore any tax loss carry-backor carry-forward provisions.)

a. What is Belyk’s net income for 2007?

b. What is its operating cash flow?

c. Explain your results in a and b.

19. Accounting Values versus Cash Flows. In Problem 18, suppose Belyk Paving Ltdpaid out $480 000 in cash dividends. Is this possible? If no new investments weremade in net fixed assets or net working capital, and if no new shares were issuedduring the year, what do you know about the firm’s long-term debt account?

20. Calculating Cash Flows. Titan Football Manufacturing had the following operatingresults for 2007: sales = $10 980; cost of goods sold = $8100; depreciation expense =$1440; interest expense = $180; dividends paid = $270. At the beginning of the yearnet fixed assets were $7200; current assets were $1800; and current liabilities were$1350. At the end of the year net fixed assets were $7560; current assets were $2790;and current liabilities were $1620. The tax rate for 2007 was 30%.

a. What is net income for 2007?

b. What is the operating cash flow for 2007?

c. What is the cash flow from assets for 2007? Is this possible? Explain.

d. If no new debt was issued during the year, what is the cash flow to creditors?

What is the cash flow to shareholders? Explain and interpret the positive andnegative signs of your answers in a to d.

21. Calculating Cash Flows. Consider the following abbreviated financial statementsfor Cabo Wabo Ltd:

a. What is owners’ equity for 2006 and 2007?

b. What is the change in net working capital for 2007?

c. In 2007 Cabo Wabo purchased $3000 in new fixed assets. How much in fixedassets did Cabo Wabo sell? What is the cash flow from assets for the year? (Thetax rate is 30%.)

d. During 2007, Cabo Wabo raised $900 in new long-term debt. How much long-term debt must Cabo Wabo have paid off during the year? What is the cash flowto creditors?

CABO WABO Ltd CABO WABO LtdPartial Balance Sheets as at 31 December 2006 and 2007 2007 Income Statement

2006 2007 2006 2007 Sales $21 300

Assets Liabilities and Owners’ Equity Costs 10 680

Current assets $1425 $1509 Current liabilities $ 615 $ 903 Depreciation 1 800

Net fixed assets 6600 6900 Long-term debt $3600 4200 Interest paid 324

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2.1 Change in Net Working Capital. Find the most recent abbreviated balance sheetsfor Fosters Brewing Group in the finance section at <http://au.finance.yahoo.com>.Enter the ASX code ‘FGL’ and follow the ‘Financials’ link to the balance sheetdata. Using the two most recent balance sheets, calculate the change in networking capital. What does this number mean?

2.2 Book Values versus Market Values. The home page for Harvey NormanHoldings Ltd can be found at <www.harveynorman.com.au>. Locate the mostrecent annual report, which contains a balance sheet for the company. What is thebook value of equity for Harvey Norman? The market value of a company is thenumber of shares outstanding times the price per share. This information can befound at <http://au.finance.yahoo.com> using the ASX code for Harvey Norman(HVN). What is the market value of equity? Which number is more relevant forshareholders?

2.3 Net Working Capital. Woodside Petroleum Ltd is Australia’s largest publiclytraded oil and gas exploration and production company. Go to the company’shome page at <www.woodside.com.au>, follow the link to the investors’ page andlocate the annual reports. What was Woodside Petroleum’s net working capital forthe most recent year? Does this number seem low to you, given Woodside’scurrent liabilities? Does this indicate that Woodside Petroleum may beexperiencing financial problems? Why or why not?

2.4 Cash Flows to Stockholders and Creditors. Adsteam Marine Ltd is a leadinginternational provider of maritime services, operating in Australia, Europe andAsia. It provides financial information for investors on its web site at<www.adsteam.com.au>. Follow the ‘Investor Relations’ link and find the mostrecent annual report. Using the consolidated statements of cash flows, calculatethe cash flow to shareholders and the cash flow to creditors.

WHAT’S ONTHE WEB?

Ross Ch 02 12/7/07 4:16 PM Page 47

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