Ch. 2 Financial statement, Taxes and Cash flows

1. Balance sheet Summarizing what a firm owns (assets) and what a firm owes (liabilities) Asset = Liability + Equity Table ) Asset side: current and fixed assets - current asset: assets convertible to cash in a year - fixed asset: tangible and intangible assets

2) Liabilities Current liabilities: liabilities have a life of less than a year. Long term liabilities: life of more than a year. 3) Shareholder’s equity = assets – liabilities 4) Net working capital = current asset – current liabilities. Cash available after current liabilites.

Three important things when examining a balance sheet (1) Net working capital: current asset – current liability. It means cash that will be available for over next 12 months. Positive for healthy firms. (2) Liquidity: The speed and ease with which an asset can be converted to cash. Ease of conversion versus forgone potential profits. (3) Debts versus equity: Credit holders have first claims to the firm’s cash flow and then equity holders. Financial leverage and Potential financial stress. (4) Market value versus book value: Market value means a current price in the market. Book value means the original purchasing price (historical cost). Under GAAP, balance sheet is written at book value (historical cost) and does not reflect the quality of management, reputation, etc. In finance, we mainly focus on market value.

2. Income statement It shows the performance over some period of time. Revenue – expenses = income. 1) GAAP Recognition or realization principle: revenue is recognized when the earning process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. It means revenue is recognized at the time of sale. Matching principle: the amount of sales must be matched with the amount of costs generating products. E.g) sale on credit. Revenue will be recognized. Expense is also recognized though actual cash flow does not happen.

2) Noncash items: Expenses charged against revenue that do not directly affect cash flow such as depreciation. E.g) Purchased a machine (5 year life span) at $5000. Cash outflow happened when purchased. But in accounting, the purchasing price will be spread over 5 years as a depreciation( expense). Income statement may not represent cash flow to the firm due to noncash item. E.g) Conseco reported a net loss of $194 million but its cash inflow was $703 million.

Earnings per share = net income/ total shares outstanding Dividends per share = total dividends / total shares outstanding

3. Taxes One of major cash outflows of companies is tax payment. 1) Corporate Tax rates effective in 2007: Table 2.3 Average tax rate: total taxes paid divided by total taxable income. Marginal tax rate: amount of tax payable on the next dollar earned.

E.g) your firm is supposed to have a taxable income of $200,000. What is total tax? Average tax rate? Marginal tax rate?

Tax=0.15*50, *(75, ,000)+0.34*(100,000-75,000)+0.39*(200, ,000)=61,250 Average tax rate = 61,250/200,000=30.625% Marginal tax rate = 39% Average tax rate increases from 15% to 35% as taxable income increases. If taxable income for a corporation is more than $18.33 million, the tax rate is a flat 35%. If taxable income for a mid size firm is between $335,000 to $10,000,000, tax rate is a flat 34%.

4. Cash flow - Cash flow: difference between cash in and cash out. - Cash flow identity: Cash flow from asset = cash flow to creditors + cash flow to stock holders. 1) Cash flows from assets (free cash flows)= operating cash flow – net capital expenditure – change in net working capital (1) Operating cash flow (OCF): cash flows from daily business activities except for financing activities. It tells us whether business itself generates cash enough to cover cash outflows. OCF = Earning before interest and taxes + Depreciation – Taxes. E.g) Using a previous example of income statement, OCF = =547

(2) Net capital expenditure: net spending on fixed assets. Simply difference between money spent on fixed assets and sales of fixed assets. - Net capital expenditure = Ending net fixed asset – beginning net fixed assets + Depreciation E.g) Using a previous example of balance sheet, =130 (3) Change in net working capital: net change in current asset relative to current liabilities. -Net working capital (NWC) = current assets – current liabilities. -Change in NWC = Ending NWC – Beginning NWC. E.g) Using a previous example of balance sheet, ( ) in 2007 – ( ) in 2006 = 330

(4) Cash flow from assets (free cash flow) = operating cash flow – net capital expenditure – change in net working capital = = 87. 2) Cash flow to creditors: net payment to creditors = Interest paid – net new borrowing (in long term debts) E.g) using the previous balance sheet and income statement, Cash flow to creditors = 70 – ( ) = 24

3) Cash flow to stockholders: net payment to stockholders = dividend paid – net new equity raised ( in common stock and paid-in surplus account) = 103 – ( ) = 63. 4) Cash flow identity Cash flow from asset = cash flow from creditors + cash flow from stock holders 87 =