Chapter 3 Learning Objectives Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Distinguish between market and book values. Explain why income differs from cash flow. Understand the essential features of the taxation of corporate and personal income.

Accounting and Finance Understanding financial accounting is essential to understanding corporate finance. Key Components of the Financials: The Balance Sheet The Income Statement The Statement of Cash Flows Chapter 3 Outline The Balance Sheet Assets Liabilities Book values vs. market values The Income Statement Profits vs. cash flow Depreciation Cash vs. accrual accounting The Statement of Cash Flows Free cash flow Accounting practice Taxes Corporate tax Personal tax The problem of “double taxation”

Shareholders’ Equity = Total Assets – Total Liabilities The Balance Sheet The Balance Sheet is a financial statement that shows the firm’s assets and liabilities at a particular time. Why is it useful? Shareholders’ Equity = Total Assets – Total Liabilities Balance sheet – Financial statement that shows the firm’s assets and liabilities at a particular time. Assets – Represent the uses of the funds raised by the firm. Listed on the left-hand side of the balance sheet. Liabilities – Represent the sources of a firm’s funding. Listed on the right-hand side of the balance sheet. Shareholders’ Equity – Representative of the difference between a firm’s total assets and total liabilities.

Total Liabilities & Shareholders’ Equity The Balance Sheet Current Assets Cash & Securities Receivables Inventories Current Liabilities Payables Short-term Debt + + = Long-term Liabilities Fixed Assets Tangible Assets Intangible Assets + Shareholders’ Equity ___________________ ____________________ Total Liabilities & Shareholders’ Equity Total Assets

Assets Assets represent the uses of a firm’s funds i.e. Assets show what the firm “owns” Liquid Assets can be converted easily into cash Liquid Asset – An asset that can be easily converted into cash. Note: The balance sheet places the most liquid assets at the top of the list and concludes with the least liquid asset at the bottom. Current Asset – Assets that are likely to be used or turned into cash in the near future (usually within the next 12 months). Examples include accounts receivable & inventories. Fixed Asset – Assets that will not be used or converted into cash in the near future (usually within the next 12 months). Examples include buildings, equipment, and vehicles. Current vs. Fixed Assets

Current Assets: Examples Which of the following assets is typically considered most liquid? Least liquid? Marketable securities Accounts receivable Inventories Which of the following is a current asset? Property that a firm owns A firm’s production equipment Unsold inventories Liquidity (Most Least): Marketable Securities, Accounts Receivable, Inventories Current Asset: Unsold Inventories

Fixed Assets Tangible Assets Intangible Assets Goodwill Tangible Assets – Assets that can be physically seen or touched. Intangible Assets – Assets that have no physical existence, yet are still very valuable for a firm. Goodwill - The difference between actual price paid for the acquisition of a firm and its book value. Note: most of the “intangible assets” on a firm’s balance sheet consist of goodwill.

Fixed Assets: Example Which of the following represent tangible assets? Intangible assets? Property Production Facilities Patents Production Equipment Trademarks Copyrights Tangible Assets: Property, Production Facilities, Production Equipment Intangible Assets: Patents, Trademarks, Copyrights

Liabilities Current vs. Long-Term Liabilities Liabilities represent the sources of a firm’s funding. (i.e. Liabilities represent what a firm “owes.”) Current vs. Long-Term Liabilities Current Assets – Current Liabilities = Net Working Capital Current Liabilities – Liabilities that are likely to be paid off within the next 12 months. Examples: accounts payable, debt due for repayment Long-Term Liabilities – Liabilities that are not likely to be paid off within the next 12 months. Net Working Capital – The difference between a firm’s current assets and current liabilities.

Liabilities: Example Which of the following is a current liability? Bond debt that matures in 3 years A bank loan that is due in 24 months An obligation to pay a supplier within 6 months Current Liability: Obligation to pay a supplier within 6 months

Net Working Capital: Example In the balance sheet below, what was the value of net working capital in 2008? 2009?

Book Values vs. Market Values GAAP (Generally Accepted Accounting Principles) Book Value Value of assets or liabilities according to the balance sheet. Values recorded at their historical cost adjusted for depreciation Market Value The value of assets or liabilities were they to be resold in a market GAAP – Procedures for preparing financial statements. Book Value – Value of assets or liabilities according to the balance sheet. Values recorded at their historical cost adjusted for depreciation Market Value – The value of assets or liabilities were they resold in a market. Note: Market values are usually higher than book values

Common-Size Balance Sheet All balance sheet items are expressed as a percentage of total assets. Why is this useful? Common-size Balance Sheet - All items in the balance sheet are expressed as a percentage of total assets.

Common-Size Balance Sheet: Example Note the changes from 2008 to 2009. Common-size Balance Sheet - All items in the balance sheet are expressed as a percentage of total assets.

The Income Statement Income Statement: a financial statement that shows the revenues, expenses, and net income of a firm over a period of time. Why is this useful? Income Statement – Financial statement that shows the revenues, expenses, and net income of a firm over a period of time. Common-size Income Statement – All items on the income statement are expressed as a percentage of revenues. EBIT – Earnings Before Income & Taxes EBIT = total revenues - costs – depreciation

Common-size Income Statement All items on a common-size income statement are expressed as a percentage of revenues. Why is this useful? Income Statement – Financial statement that shows the revenues, expenses, and net income of a firm over a period of time. Common-size Income Statement – All items on the income statement are expressed as a percentage of revenues. EBIT – Earnings Before Income & Taxes EBIT = total revenues - costs – depreciation

Income Statement: Example In the income statement below, what was the value of Home Depot’s EBIT in 2009? Common Size Income Statement (right column)

Differences between profits & cash flow: Profits vs. Cash Flow Differences between profits & cash flow: Depreciation Cash vs. accrual accounting Depreciation Rather than deducting the cost of an investment entirely when purchased, the accountant makes an annual charge for depreciation on the firm’s books. Note: “Profits” account for this depreciation but “Cash Flows” do not Accrual Accounting – The process of matching revenues and expenses Note: When a firm makes a sale in a different period than it collects the proceeds from that sale, profits and cash flows will be unequal.

Cash Flows: Example Consider a firm that spends $1,000 to produce goods in period 1. In period 2, it sells half of these goods for $750 and collects payment one period later. The firm sells the other half in period 3 for another $750, and collects payment on these sales in period 4. What are the cash flows in each of the 4 periods for the firm? Period: 1 2 3 4 Sales ($) 750 -Accounts Receivable (750) - Cost of Goods Sold 500 - Changes in Inventories 1000 (500) = Net Cash Flow (1000) 750

The Statement of Cash Flows The Statement of Cash Flows shows the firm’s cash receipts and cash payments over time. Why is it useful? Free Cash Flow is cash available for distribution to investors after the firm pays for new investments or additions to working capital. Statement of Cash Flows – Financial statement that shows the firm’s cash receipts and cash payments over a period of time. Free Cash Flow – Cash available for distribution to investors after the firm pays for new investments or additions to working capital.

The Statement of Cash Flows Structure: Cash flow from operations - Cash flow from investments + Cash flow from operations – Adjusts net income for the parts of the income statement that do not involve cash actually coming in or going out. Cash flow from investments – Adjusts the figure from (1) to reflect all capital expenditures during the period. Cash flow from financing – Adjusts the figure from (2) to reflect the changes in a firm’s cash flow due to gains (or losses) from financing activities. Cash flow from financing ____________________________ Change in cash balance

What was the total cash flow from operations for the period? Cash Flow: Example Net income for your firm was $10,000 last year. The depreciation expense was $2,500; accounts receivable increased $1,250; accounts payable increased $800; and inventories increased by $2,000. What was the total cash flow from operations for the period? Net income: 10,000 Depreciation: 2,500 Accounts Receivable: (1,250) Accounts Payable: 800 Inventories: (2,000) Cash flow from operations: 10,050

What implications does this have for the investor? Accounting Practice Most managers say that accounting earnings is the single most important number reported to investors. What implications does this have for the investor?

Accounting Practice Grey areas for financial managers: Revenue recognition Cookie-jar reserves Revenue recognition - Firms record a sale when it is made, not when the customer actually pays; however the date of sale is not always obvious. Cookie-jar reserves - Firms sometimes put cash in separate accounts to be used in times of distress to create the illusion of growth even in bad years. Example: Freddie Mac

Accounting Practice Additional grey areas for financial managers: Off-balance sheet assets and liabilities Mark-to-market accounting Off-balance sheet assets and liabilities - Firms may hide large amounts of resources in off balance sheet accounts in order to hide potential liabilities (or assets) from the public. Example: Enron Mark-to-market accounting – Many assets and liabilities are valued at their historic cost, not at their current values. This may make it more difficult to accurately value the firm.

In the United States, corporations pay tax on their income. Corporate Taxes In the United States, corporations pay tax on their income. US Corporate Tax Rates, 2011 Marginal tax rate – Additional taxes owed per dollar of additional income. Average tax rate – Total taxes owed divided by total income. When firms calculate taxable income they are allowed to direct expenses. A few common deductions include: Depreciation Interest paid to bondholders Remember: while each additional dollar of revenues results in 35 cents in increased taxes (for large firms), each dollar of expenses reduces taxes by 35 cents.

Corporate Taxes: Example What is the marginal tax rate for a corporation with $60,000 taxable income and an average tax rate of 16.67% if the next-lowest marginal tax rate of 15% covers taxable incomes up to $50,000? ($60,000) * (16.67%) = $10,000 total taxes paid Income Rate Taxes Paid $0 - $50,000 15% $7,500 $50,001 - $60,000 ? $2,500 Total: $10,000 Marginal tax rate – Additional taxes owed per dollar of additional income. Average tax rate – Total taxes owed divided by total income. ($10,000) * (marginal tax rate) = $2,500 Marginal Tax Rate = 25%

Personal Tax US Personal Tax Rates, 2011 These tax rates refer to ordinary income (i.e. salary, wages, and interest earnings) Note: capital gains are taxed only when gains are realized, at a rate of 15% for most shareholders.

Personal Tax: Example What is the average tax rate for an individual with a net income of $50,000, a total tax liability of $10,704.50, and a 28% marginal tax rate?

The Problem of “Double Taxation” When a corporation issues a dividend, each dividend dollar is effectively taxed twice: Each dollar of earnings taxed at corporate rate. Shareholders pay personal income taxes on all dividends received.