6-1 Chapter 2 Financial Statements, Taxes and Cash Flow Financial Statements, Taxes and Cash Flow 2-1 Dr. Mazharul Islam

6-2 Chapter Objectives u Understand the difference between book value (from the Balance Sheet) and market value. u Understand the difference between net profit (from the Income Statement) and cash flow. u Explain the differences between the average tax rate, the marginal tax rate and the flat rate. u Explain the calculation of cash flow from assets, and cash flow to debt-holders and shareholders. u Understand the difference between book value (from the Balance Sheet) and market value. u Understand the difference between net profit (from the Income Statement) and cash flow. u Explain the differences between the average tax rate, the marginal tax rate and the flat rate. u Explain the calculation of cash flow from assets, and cash flow to debt-holders and shareholders. 2-2 Dr. Mazharul Islam

6-3 u A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity. u Equation: Assets = Liabilities + Owners’/Shareholders’ Equity. u Net working capital = Current Assets – Current Liabilities. The Balance Sheet 2-3 Dr. Mazharul Islam

6-4 Petro Rabighs’ Balance Sheet (Asset Side) a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. c d Current Assets e $1,195 f g Net Fix. Assets $ 701 Total Assets b $2,169 Cash and C.E. $ 90 Acct. Rec. c 394 Inventories 696 Prepaid Exp d 5 Accum. Tax Prepay 10 Current Assets e $1,195 Fixed Assets f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 a 2-4 Dr. Mazharul Islam

6-5 Petro Rabighs’ Balance Sheet (Liability Side) a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. c d d Current Liab. e $ 500 f g g h Total Equity $1,139 Notes Payable $ 290 Acct. Payable c 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equity a,b $2,169 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, Dr. Mazharul Islam

6-6 Market Value versus Book Value u Book value refers the price that never change as long as you own the asset. Example: if you bought a house 10 years ago for 300,000SAR, its book value for your entire period of ownership will remain 300,000SAR u Market value refers the price that could be obtained in the current market place. Example: if the price of that house after 10 years is 350,000SAR then it is called market value. u Book value refers the price that never change as long as you own the asset. Example: if you bought a house 10 years ago for 300,000SAR, its book value for your entire period of ownership will remain 300,000SAR u Market value refers the price that could be obtained in the current market place. Example: if the price of that house after 10 years is 350,000SAR then it is called market value. 2-6 Dr. Mazharul Islam

6-7 u A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Equation:Revenues – Expenses = Profit. u Profit is often expressed on a per-share basis and called earnings per share (EPS). u The difference between net profit and cash dividends is called retained earnings, which is added to the retained earnings account in the Balance Sheet. The Income Statement 2-7 Dr. Mazharul Islam

6-8 Revenue $4 000 Cost of Goods Sold Depreciation 200 EBIT (Earnings Before Interest & Tax ) Interest 200 Taxable Income (EBT) 800 Tax 240 Net Profit (EAT) $560 Dividends 260 Addition to R/E $300 Example—Income Statement of Petro Rabigh 2-8 Dr. Mazharul Islam

6-9 Cash Flow from Assets u Equation: Cash flow from assets = cash flow to debt-holders + cash flow to shareholders. u The cash flow identity or equation states that the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm Dr. Mazharul Islam

6-10 Cash Flow from Assets The total cash flow from assets = operating cash flow – net capital spending on non- current assets- change in net working capital u Operating cash flow: the cash flow that results from day-to-day activities of producing and selling. Earnings before interest and taxes (EBIT) + Depreciation – Taxes OR (Revenue – costs –taxes) u Net capital spending: Ending non-current assets – Beginning non-current assets + Depreciation.. u Change in net working capital (NWC): Ending NWC – Beginning NWC Dr. Mazharul Islam

6-11 Example―Balance Sheet ($000s) Assets (‘000s) Current assets Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment TOTAL ASSETS $ $ $3 220 $ $ $ Dr. Mazharul Islam

6-12 Liabilities and equity (‘000s) Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings Total TOTAL LIABILITIES AND EQUITY $ $ 640 $ $2 170 $3 220 $ $ 870 $ $2 370 $3 690 Example―Balance Sheet ($000s) 2-16 Dr. Mazharul Islam

6-13 Sales (Revenue) $ Cost of goods sold Depreciation60.00 EBIT $ Interest Taxable income Tax Net profit$ Dividends Addition to retained earnings $ Example―Income Statement ($000s) 2-17 Dr. Mazharul Islam

6-14 Operating cash flow: Revenue:$ Costs: $ – Taxes– $ Change in net working capital: Ending net working capital $ ($1490-$870) – Beginning net working capital – $ ($1250-$640) $10.00 Net capital spending: Ending non-current assets $ – Beginning non-current assets – Depreciation Cash flow from assets: $ – $10 – $290 = $ Example―Cash Flow From Assets ($000s) 2-18 Dr. Mazharul Islam

6-15 Cash Flow to Debt-holders and Shareholders u The cash flow to debt-holders includes any interest paid less the net new borrowing. Cash flow to debt-holders = Interest paid – net new borrowing u The cash flow to shareholders includes dividends paid out by a firm less net new equity raised. Cash flow to share-holders = Dividends paid – net new equity 2-14 Dr. Mazharul Islam

6-16 Cash flow to debtholders: Interest paid $ – Net new borrowing– ($450 – $410) $ 0.00 Cash flow to shareholders: Dividends paid$ – Net new equity raised – $ 0.00 ($580 – $580) $52.00 Cash flow to debt-holders and shareholders = $ $52.00 = $52.00 Example―Cash Flow to Debt- holders and Shareholders ($000) 2-19 Dr. Mazharul Islam

6-17 Summary and Conclusions u The book values on an accounting Balance Sheet can be very different from market values. u Cash flow from assets equals cash flow to debt-holders and shareholders. u It is important not to confuse book values with market values, and accounting income with cash flow Dr. Mazharul Islam