Understanding Financial Statements, Taxes, and Cash Flows Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows

Basic Financial Statements Following four types of financial statements are mandated by the accounting and financial regulatory authorities: Income statement Balance sheet Cash flow statement Statement of shareholder’s equity

Basic Financial Statements (cont.) Income Statement: An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months): Revenue, Expenses, and Profit.

Basic Financial Statements (cont.) Balance sheet: Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2010) Assets (value of what the firm owns), Liabilities (value of firm’s debts), and Shareholder’s equity (the money invested by the company owners, or Assets - Liabilities).

Basic Financial Statements (cont.) Cash flow statement: Reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months).

Basic Financial Statements (cont.) Statement of shareholder’s equity: It provides a detailed account of the firm’s activities in the following accounts over a period of time (for example, last six months): Common stock account, Preferred stock account, Retained earnings account, and Changes to owner’s equity.

Why Study Financial Statements? Analyzing a firm’s financial statement can help managers carry out three important tasks: Assess current performance through financial statement analysis, Monitor and control operations, and Forecast future performance.

What are the Accounting Principles Used to Prepare Financial Statements? The following three fundamental principles are adhered to by accountants when preparing financial statements: The revenue recognition principle, The matching principle, and The historical cost principle. An understanding of these basic principles allows us to be a more informed user of financial statements.

The revenue recognition principle: What are the Accounting Principles Used to Prepare Financial Statements? (cont.) The revenue recognition principle: It states that the revenue should be included in the firm’s income statement for the period in which: Its goods and services were exchanged for cash or accounts receivable; or The firm has completed what it must do to be entitled to the cash.

The matching principle: What are the Accounting Principles Used to Prepare Financial Statements? (cont.) The matching principle: Expenses are matched with the revenues they helped produce. For example, employees’ salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid.

The historical cost principle: What are the Accounting Principles Used to Prepare Financial Statements? (cont.) The historical cost principle: Most assets and liabilities are reported in the firm’s financial statements at historical cost i.e. the price the firm paid to acquire them. The historical cost generally does not equal the current market value of the assets or liabilities.

An Income Statement An income statement is also called a profit and loss statement. An income statement measures the amount of profits (net income) generated by a firm over a given time period (usually a year or a quarter).

An Income Statement (cont.) Income statement can be expressed as follows: Revenues – Expenses = Profits (net income)

An Income Statement (cont.) An income statement will contain the following basic elements: Revenues Expenses Cost of goods sold, Interest expenses, SGA (selling, general and administrative) expense, depreciation expense, Income tax expense Profits Gross profit, net operating income (also known as EBIT), earnings before taxes (EBT), and net income

An Income Statement (cont.) Sales Minus Cost of Goods Sold = Gross Profit Minus Operating Expenses Selling expenses General and Administrative expenses Depreciation and Amortization Expense = Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT) Minus Income taxes = Net income (EAT) EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes

Sample Income Statement

Evaluating a Firm’s EPS and Dividends We can use the income statement to determine the earnings per share (EPS) and dividends. EPS = Net income÷ Number of shares outstanding

Evaluating a Firm’s EPS and Dividends (cont.) Example 1: A firm reports a net income $90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)? EPS = Net income ÷ Number of shares = $90 million ÷ $35 million = $2.57

Evaluating a Firm’s EPS and Dividends (cont.) We can determine the dividends paid by the firm to each shareholder by dividing the total amount of dividend (reported on the income statement) by the total number of shares outstanding. Dividends per share = Dividends ÷ Number of shares

Evaluating a Firm’s EPS and Dividends (cont.) Example 2: A firm reports dividend payment of $20 million on its income statement and has 35 million shares outstanding. What will be the dividends per share? Dividends per share = Dividends ÷ Number of shares = $20 million ÷ $35 million = $0.57

Connecting the Income Statement and the Balance Sheet What can the firm do with the net income?: Pay dividends to shareholders, and/or Reinvest in the firm

Connecting the Income Statement and the Balance Sheet (cont.) Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm? Amount retained = Net Income – Dividends = $90m - $20m = $70m The firm’s balance on retained earnings will increase by $70 million on the balance sheet.

GAAP and Earnings Management While firms must adhere to a set of accounting principles, GAAP (Generally Accepted Accounting Principles), there is considerable room for managers to influence the firm’s reported earnings. Managers have an incentive to tamper with reported earnings - their pay depends upon it!

Corporate Taxes A firm’s income tax liability is calculated using its taxable income and the tax rates on corporate income. See the table on next slide for corporate tax rates.

Corporate tax rates

Corporate tax rates The table reveals the following: Tax rates range from 15% to 39% Tax rates are progressive i.e. larger corporations with higher profits will tend to pay more taxes compared to smaller firms with lower profits. Note: In addition to federal taxes, a firm may face State and City taxes.

Marginal and Average Tax Rates While analyzing the tax consequences of a new business venture, the appropriate tax rate is the marginal tax rate. Marginal tax rate is the tax rate that the company will pay on its next dollar of taxable income. Average tax rate is total taxes paid divided by the taxable income.

Marginal and Average Tax Rates What is the average and marginal tax liability for a firm reporting $100,000 as taxable income. Taxable Income Marginal tax rate Incremental Tax Liability Cumulative Tax Liability Average Tax Rate $50,000 15% 7,500 $75,000 25% 6,250 13,750 $100,000 34% 8,500 22,250 22.25%

Marginal and Average Tax Rates = Total tax liability ÷ Total taxable income = $22,250 ÷ $100,000 = 22.25% Marginal tax rate = 39% as the firm will have to pay 39% on its next dollar of taxable income i.e. if its taxable income increases from $100,000 to $100,001.

Dividend Exclusion for Corporate Shareholders Dividends received by corporate stockholders are partially exempt from taxation. The rationale is to avoid double taxation at the corporate level. The percentage of exempt taxes is based on the degree of ownership of the firm. Note dividends for non-corporate investors, like you and me, are not exempt from taxation – they are actually double-taxed.

Dividend Exclusion for Corporate Shareholders What will be ABC’s taxable income if firm ABC receives $200,000 in dividends from firm XYZ? The taxable income will depend on the degree of ownership of XYZ by ABC. See next slide.

Dividend Exclusion for Corporate Shareholders (cont.) Ownership Interest Dividend Exclusion Dividend Income Taxable Dividend Income Less than 20% 70% $200,000 $60,000 20% to 79% 75% $50,000 80% or more 100% $0

The Balance Sheet The balance sheet provides a snapshot of the firm’s financial position on a specific date. The balance sheet is defined by the following equation: Total Assets = Total Liabilities + Total Shareholder’s Equity

The Balance Sheet (cont.) Total assets represents the resources owned by the firm. Total liabilities represent the total amount of money the firm owes its creditors Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.

The Balance Sheet (cont.) The balance sheet includes the following main components: Assets – Found on the left-hand side of the balance sheet. It includes current assets and fixed assets. Sources of financing – Found on the right-hand side of the balance sheet. It includes current liabilities, long-term liabilities, and owner’s equity.

The Balance Sheet (cont.) In general, GAAP requires that the firm report assets on its balance sheet at their historical costs. Cash and assets held for sale (such as marketable securities) are an exception to the rule. These assets are reported using the lower of their cost or current market value.

The Balance Sheet (cont.) Assets whose value is expected to decline over time (such as equipment) are reported as “net assets” which are equal to the historical cost minus accumulated depreciation. Note, the net asset value reported on balance sheet could be significantly different from the market value of the asset.

The Balance Sheet (cont.) Current assets consists of firm’s cash plus other assets the firm expects to convert to cash within 12 months or less, such as receivables and inventory. Fixed (Long-term) assets are assets that the firm does not expect to sell within one year. For example, plant and equipment, land.

The Balance Sheet (cont.) Current liabilities: amount owed to creditors due within 12 months or less Examples: Accounts Payable, Notes Payable. Long-term liabilities: debt with maturities longer than a year Examples: Bank loans, Bonds.

The Balance Sheet (cont.) The stockholder’s equity is broken down into two components: The amount the company received from selling stock to investors (Common/Preferred Stock). Retained Earnings

The Balance Sheet (cont.) We can also express stockholders’ equity as follows: Shareholders' equity = Total Assets – Total Liabilities

Firm Liquidity and Net Working Capital Liquidity refers to the speed with which an asset can be converted to cash without loss of value. For example, a firm’s bank account is perfectly liquid. Other types of assets (A/R, Inventory, PP&E), are less liquid as they are more difficult to sell and convert to cash.

Firm Liquidity and Net Working Capital We can thus measure a firm’s liquidity by computing: net working capital = current assets – current liabilities

Firm Liquidity and Net Working Capital (cont.) If a firm’s net working capital is significantly positive, it is in a good position to pay its debts. Lenders consider net working capital as an important indicator of firm’s ability to repay its loans.

The Balance Sheet

Debt and Equity Financing The right-hand side of the balance sheet reveals the sources of money used to finance the purchase of the firm’s assets listed on the left-hand side of the balance sheet. It shows how much was borrowed (debt financing) and how much was provided by firm’s owners (equity financing, through the sale of equity or retention of prior year’s earnings).

Debt versus Equity Payment: Payment for debt holders is generally fixed (in the form of interest); Payment for equity holders (dividends) is neither fixed nor guaranteed. Seniority: Debt holders are paid before equity holders in the event of bankruptcy. Maturity: Debt matures after a fixed period while equity securities do not mature.

The Cash Flow Statement The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash.

Sources and Uses of Cash Source of cash is any activity that brings cash into the firm. For example, making sales. Use of cash is any activity that causes cash to leave the firm. For example, payment of taxes.

Cash Flow Statement The format for a traditional cash flow statement is as follows: Beginning Cash Balance + or -: Cash Flow from Operating Activities + or -: Cash Flow from Investing Activities + or -: Cash Flow from Financing Activities Equals: Ending Cash Balance

Cash Flow Statement (cont.) Operating activities represent the company’s core business including sales and expenses. Basically any activity that affects net income for the period. Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment. Financing activities represent changes in the firm’s use of debt and equity such as issue of new shares, payment of dividends.

Balance Sheet for H.J. Boswell, Inc.

H.J. Boswell, Inc. Statement of Cash Flows

Cash Flow Analysis (cont.) An analysis of H.J. Boswell’s operations reveals the following for 2010: The firm used more cash than it generated, resulting in a deficit of $4.5 million The primary source of cash flow was operating activities followed by long-term debt ($51.75 million) The largest use of cash was for acquiring inventory at $148.5 million.