Financial Statements, Cash Flows, and Taxes Chapter 2 Financial Statements, Cash Flows, and Taxes

Key Concepts and Skills Know the difference between book value and market value Know the difference between accounting income and cash flow Know the difference between average and marginal tax rates Know how to determine a firm’s cash flow from its financial statements

The Balance Sheet The balance sheet presents the accounting value of assets and source of money used to purchase those assets at a particular time. Assets: The left-hand side Fixed asset has a long life (more than one year): tangible asset (land, machinery,…), and intangible asset (trademark, patent). Current asset has a life less than one year such as cash, inventory. Liabilities and Owners’ Equity: The right-hand side Current liabilities, such as account payable, represent obligations requiring cash payment within the next year. Long-term liabilities are debt obligations due beyond one year. The difference between the accounting value of the assets and the liabilities is the shareholders’ equity, representing the original contribution plus the earning retained in the business.

Total value of the firm to investors The Balance Sheet Current Assets Current Liabilities Net Working Capital Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity There is often a mismatch between the timing of cash inflows and cash outflows during operating activities. Furthermore, the amount and timing of operating cash flows are not known with certainty. The financial managers must attempt to manage the gaps in cash flow. From a balance-sheet perspective, short-term management of cash flow is associated with a firm’s net working capital. Net working capital is defined as current assets minus current liabilities. From a financial perspective, the short-term cash flow problem comes from the mismatching of cash inflows and outflows. It is the subject of short-term finance. Total value of the firm to investors Total value of assets

Net Working Capital Net working capital is the difference between a firm’s current assets and its current liabilities. Net working capital is positive when current assets exceed current liability. Example: A firm has current assets $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 shareholder’s equity? What is net working capital?

Net Working Capital In this case, total assets are $100 + 500 = 600 and liabilities are $70 + 200 = 270, so shareholders’ equity is the difference: 600 – 270 = 330. The balance sheet would look like: Assets Liabilities & Equity Current assets $100 Current liabilities $70 Net fixed assets 500 Long-term debt 200 Shareholders’ equity 330 Total assets $600 Total liability & equity $600 Net working capital is 100 – 70 = 30

Liquidity Liquidity refers to the speed and ease with which an asset can be converted to cash. It is also important to point out that more liquid assets also provide lower return. Consequently, too much liquidity can be just as detrimental to shareholder wealth maximization as too little liquidity.

Debt versus Equity Interest and principal payments on debt have to be paid before cash may be paid to stockholders. The company’s gains and losses are magnified as the company increases the amount of debt in the capital structure. This is why we call the use of debt financial leverage. Owner’s Equity = Assets - Liabilities

Book Values and Market Values Market values of assets and liabilities do not generally equal their book values. Book values are based on historical or original values. Market values measure current values of assets and liabilities. The stock price is simply the market value of shareholders’ equity divided by the number of outstanding shares. Example: The Klingon Corporation has fixed assets with a book value of $700 and an appraised market value of about $1,000. Net working capital is $400 on the books, but approximately $600 would be realized if all the current accounts were liquidated. Klingon 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?

Book Values and Market Values We can construct two simplified balance sheets, one in accounting (book value) terms and one in economic (market value) terms:

Income Statement The income statement is a financial statement that measures the profitability of the firm over a time period. Revenues – Expenses = Income

Earnings and Dividends per Share Suppose U.S. had 200 million shares outstanding at the end of 2008. Based on the income statement in the previous slide, what was EPS? What were dividends per share? Earnings per share = Net income/Total shares outstanding = $412/200 = $2.06 per share Dividends per share = Total dividends/Total shares outstanding =$103/200 = $.515 per share

GAAP and the Income Statement An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. Noncash Items The largest non-cash deduction from most firms is depreciation. It reduces a firm’s taxes and its net income. Non-cash deductions are part of the reason that net income is not equivalent to cash flow. Time and Costs We need to plan for both short-run cash flows and long-run cash flows. In the short run, some costs are fixed regardless of the output and other costs are variable. In the long run, all costs are variable. It is important to identify these costs when doing a capital budgeting analysis.

Corporate Tax Rate It’s important to point out that corporations pay a flat rate on their income. Income tax in Cambodia is 20%. Taxes paid to government affect cash flow available for shareholder. Corporate Taxes

Average versus Marginal Tax Rates Average tax rate: Total tax paid divided by total taxable income. Marginal tax rate: Amount of tax payable on the next dollar earned. Suppose our corporation has a taxable income of $200,000, What is the tax bill? What is average tax rate? Marginal tax rate? Average tax rate: $61,250/$200,000 = 30.625% Marginal tax rate: Marginal rate is 39% if it had another dollar taxable income.

CASH FLOW Provides a summary of cash flows over the period concern, typically the year just ended. Cash Flow from Assets Cash flow from assets = Cash Flow to Creditor + Cash Flow to Stockholders Cash Flow from Assets involves three components: operating cash flow, capital spending, and change in net working capital. Operating Cash Flow: It refers to the cash flow that results from the firm’s day-to-day activities of producing and selling.

Capital Spending It is just money spend on fixed assets less money from sale of fixed assets.

Change in net working capital

Cash flow to creditors A firm’s interest payments to creditors deduct net new borrowing Cash flow to stockholders Dividends paid out by a firm less new equity raised.

End of Chapter 2

Greene Co. shows the following information on its 2008 income statement: sales = $138,000; costs = $71,500; other expenses =$4,100; depreciation expense = $10,100; interest expense = $7,900; taxes =$17,760; dividends = $5,400. In addition , you're told that the firm issued $2,500 in new equity during 2008, and redeemed $3,800 in outstanding long-term debt. Instructions: a. What is the 2008 operating cash flow? b. What is the 2008 cash flow to creditors? c. What is the 2008 cash flow to stockholders? d. If net fixed assets increased by $17,400 during the year, what was the addition to NWC?

Net income was negative because of the tax deductibility of depreciation and interest expense. However, the actual cash flow from operations was positive because depreciation is a non-cash expense and interest is a financing expense, not an operating expense. A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient cash flow to make the dividend payments.