McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.0 Chapter 2 Financial Statements, Taxes and Cash Flow

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.1 Key Concepts and Skills Market Value versus Book Value Average Tax Rates vs. Marginal Tax Rates Accounting Income vs. Cash Flow How to determine a firm’s cash flow from its financial statements

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved The Balance Sheet

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.3 Balance Sheet (Pg 24) The balance sheet is a “snapshot” of the firm’s assets and liabilities at a given point in time Assets (what a firm owns) are listed in order of liquidity on the left side A liquid asset is one that can be quickly converted to cash without significant loss in value. Liabilities (what a firm owes) are listed on the right side Equity ( = Assets – Liabilities) is listed on the right side Balance Sheet Identity (Equation) Assets = Liabilities + Stockholders’ Equity

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.4 Assets: The Left-Hand Side (Pg 24) Assets are classified as either Current or Fixed Current Assets: Life of less than one year – normally convert to cash within 12 months Cash Inventory – purchased and sold within a year Accounts receivable - $ owed to the firm by its customers Fixed Assets Relatively long life (> 12 months) Tangible – Truck or Computer Intangible – Trademark or Patent

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.5 Liabilities: The Right-Hand Side (Pg 24) First thing listed on the right-hand side of the balance sheet Current Liabilities Life of less than one year – must be paid within the year Listed before long-term liabilities Accounts payable – $ the firm owes to its suppliers Long-Term Liabilities Debt not due in the coming year Five year loan (bonds)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.6 Owners’ Equity: The Right-Hand Side (Pg 24) Second thing listed on the right-hand side of the balance sheet Equity: Difference between Assets and Liabilities Total Assets (Current and Fixed) – Total Liabilities (Current and Long Term) = Equity Equity = Residual Value remaining, if all assets were sold and the proceeds were utilized to pay off all debt The Balance Sheet Balances Left-hand side (Assets) = right-hand side (Liabilities + Equity) Assets = Liabilities + Equity

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.7 Net Working Capital (Pg 25) Net Working Capital = Current Assets - Current Liabilities Positive - when current assets exceed current liabilities (healthy firm)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.8 The Balance Sheet Figure 2.1

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.9 Examining the Balance Sheet (Pg 25) Three Important Things to Keep in Mind: Liquidity Debt versus Equity (Capital Structure) Market Value versus Book Value

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.10 Liquidity (Pg 26) Two Dimensions: Speed and ease an asset can be converted to cash Ease of conversion versus loss of value Any asset can be converted to cash quickly if the price is cut enough Liquid Asset – quickly sold w/o a significant loss of value Current Assets: Cash, Accts Rec., Inventory (least liquid) Illiquid Asset – cannot be quickly converted to cash w/o a substantial price reduction Do not convert to cash in the normal course of business Used in the business to generate cash Tangible Fixed Assets: Buildings & Equipment (Custom manufacturing facility) Intangible Assets: Trademark

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.11 Liquidity (Pg 26) Liquidity is Valuable The more liquid a business is, the less likely it is to experience financial distress Financial Distress: Difficulty in paying operating expenses as they come due, debts, or buying needed assets (Inventory, Plant and Equipment) Liquid Assets are Less profitable to hold Cash – may just sit and earn no return Inventory – must turn to bring in revenues, (just in time) Trade-off : Advantages of liquidity vs. forgone potential profits

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.12 Debt versus Equity (Capital Structure)(Pg 26) Debt - acts like a lever > debt as a % of assets > the degree of financial leverage Greatly magnify gains and losses (discussed in later chapters) Increases potential reward to shareholders Take on projects that produce a return in excess of the cost of borrowing w/o additional s/h investment Increases potential for financial distress/business failure Inability to pay debts when due with an unexpected: Downturn in the economy Increased competition New innovations

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.13 Debt versus Equity (Capital Structure)(Pg 26) Creditors - 1 st claim on the firm’s cash flow (AP Vendors, Bank loans, Bond Holders) Equity Holders – entitled to residual “after creditors are paid”

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.14 Market Vs. Book Value Market value and book value are often very different. “Market Value” is the price at which the assets, liabilities or “equity” can actually be bought or sold. The balance sheet provides the “Book (historical) Value” of the assets, liabilities and equity. The goal of financial management is to: Maximize the “Market” Value of the stock, not its book value.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.15 Market Value vs. Book Value (Pg 27) Market Value Amount of cash received if an asset is sold Book Value According (GAAP) Assets are recorded at “Historical” cost What the firm paid for the asset at the time of purchase Remains on the Balance at Historical Cost (Exceptions: Marketable Securities) No matter how long ago they were purchased Or how much they are worth today

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.16 Market Value vs. Book Value (Pg 27) For Current Assets Market Value and Book Value may be similar Bought and converted to cash over a relatively short time For Fixed Assets Market Value and Book Value would (in general) only be similar shortly after acquisition or upon coincidence Railroad land purchased a century or more ago

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.17 US Corporation Balance Sheet – Table 2.1

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.18 Example 2.2 Klingon Corporation In this example “Market” S/H equity is worth almost twice “Book” Value. KLINGON CORPORATION Balance Sheets Market Value versus Book Value BookMarketBookMarket AssetsLiabilities and Shareholders’ Equity NWC$ 400$ 600LTD$ 500 NFA 700 1,000SE6001,100 1,6001,1001,600

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved The Income Statement

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.20 Income Statement (Pg 28) Income Statement - summarizes a firm’s performance “ over a period of time ” (Video) Remember: Balance Sheet is as of “a given point in time” (Snapshot)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.21 Income Statement (Pg 28) Income Statement Equation is: Revenues – Expenses = Income (The bottom line) Revenue and Expenses from current operations Financing Expenses such as interest paid Taxes paid are reported separately Net Income (the so-called bottom line) often expressed on a per-share bases - earnings per share (EPS) Earnings per Share (EPS) = Net Income / # Shares o/s Net Income not distributed to shareholders as dividends is retained by the organization (Retained Earnings)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.22 US Corporation Income Statement – Table 2.2 U.S. CORPORATION 1998 Income Statement ($ In Millions)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.23 Income Statement (Pg 29) Three things to keep in mind: GAAP Cash versus noncash items Time and Costs

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.24 GAAP and the Income Statement Matching principle – GAAP says to show revenue when it accrues (is earned) and match the expenses required to generate the revenue In general revenue is recognized at the time of sale This may not be the same as the time of collection, if credit terms are offered to customers. Actual cash inflows and outflows may occur at very different times (produce, sale, collect) Read Reality Byte: A Bitter Pill For McKesson’s Stockholders Page 30

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.25 Noncash Items (Pg 29) A primary reason that accounting income differs from cash flow is that an income statement contains Noncash Items. Noncash Items: are expenses charged against revenues that do not directly affect cash flow Depreciation is one of the most significant noncash items Actual cash outflow occurs when an asset is purchased An asset with a life greater than one year will be depreciated over the life of the asset (partially expensed each year) Revenues associated with the asset will generally occur over the life of the asset - not all at the time of purchase! Matching – revenues and expenses over the life of the asset

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.26 Time and Costs (Pg 31) Two non-precise time periods In the “Long Run” All business costs are “Variable” There’s time to make changes: Change strategy & the business plan Assets can be sold, debts can be paid, etc. In the “Short Run” Some costs are fixed – must be paid no matter what Property Taxes Other costs are variable Wages to laborers can change Payments to suppliers - reduce / increase purchases Vary output levels

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.27 Time and Costs (Pg 31) Distinction between fixed & variable costs can be important However, the Income Statement doesn’t identify fixed and variable costs Period Costs - Incurred during a particular time period and typically reported as SG&A on the Income Statement May be fixed or variable Company president’s salary – probably fixed in the short run Product Costs – Reported as Cost of Goods Sold (COGS) on the Income Statement Include both fixed and variable costs Raw Materials, Direct Labor Expense, Mfg Overhead

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Taxes

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.29 Taxes Taxes can be one of the largest cash outflows of the firm The size of the tax bill is determined through the tax code

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.30 Average versus Marginal Tax Rates Average Tax Rate: Total tax paid divided by total taxable income. The % of income that goes to pay taxes Marginal Tax Rate: Amount of tax payable on the next dollar earned. The extra tax you would pay if you earned one more dollar. See Corporate Tax Rate Table 2.3, Page 32 Spreadsheet example

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.31 Average versus Marginal Tax Rates The ‘Marginal Tax Rate” is typically the most relevant for financial decision making New cash flows or changes in existing ones will be taxed at the Marginal Rate

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Cash Flow

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.33 Cash Flow Cash Flow is one of the most important pieces of information that a financial manager can derive from financial statements Cash Flow: is the difference between the number of “dollars” that came in and the number that went out

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.34 Cash Flow Remember the Balance Sheet Identity: Assets = Liabilities + Equity Similarly, the Cash Flow Identity: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders The firm generates cash through various activities (utilizing its assets) which is either: Paid creditors or Paid out to the owners / stockholders

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.35 Cash Flow “Cash” is generated from utilizing assets and is paid to those that “finance” the purchase of the assets: Creditors Stockholders

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.36 Cash Flow From Assets Cash Flow from Assets: is the total cash flow to creditors and cash flow to stockholders, consisting of the following: Operating Cash Flow Cash generated from a firm’s normal business activities Cash flow that results from the firm’s day-to-day activities of producing and selling Doesn’t include expenses associated with the firm’s financing of assets Capital Spending – “net” (purchases less sales) spending on fixed assets Changes in New Working Capital Net increase in current assets over current liabilities for the period being examined

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.37 Cash Flow From Assets Operating Cash Flow (OCF) Operating Cash Flow (OCF): Cash generated from a firm’s normal business activities To calculate Operating Cash (OCF): we calculate Revenue minus Costs “Don’t” include depreciation – it’s not a cash outflow “Don’t” include interest – it’s a “financing” expense “Do” include taxes – they are paid in cash Review U.S. Corporation’s Income Statement Table 2.2, Page 29 Spreadsheet Example

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.38 Cash Flow From Assets Capital Spending Net Capital Spending: Money spent on fixed assets less money received from the sale of fixed assets U.S. Corp Balance Sheet (Table 2.1, Pg 26) Ending net fixed assets $1,709 - Beginning net fixed assets (1,644) (End Bal from Prior Yr) + Depreciation (Income Stmt Pg 29) 65 (No Cash involved) Net Investment in fixed assets$ 130 (Net Capital Spending for 2000) Note: Net Capital Spending can be negative if the firm sold off more assets than it purchased

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.39 Cash Flow From Assets Change in Net Working Capital Change in Net Working Capital: The difference between the “Beginning” and “Ending” Net Working Capital (NWC) Example: U.S. Corp Balance Sheet (Table 2.1, Pg 26) Ending Net Working Capital: Current Assets – Current end of 2000 $1,403 – 389 = $1,014 Beginning Net Working Capital: Current Assets – Current end of 1999 $1,112 – 428 = $684 Change in NWC = $1,014 - $684 = $330 Net Working Capital increased by: $330

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.40 Cash Flow From Assets Conclusion U.S. Corporation Cash Flow from Assets Operating Cash Flow$547 (Spreadsheet) - Net Capital Spending (130) (Slide 38) - Change in NWC (330) (Slide 39) Cash Flow from Assets$ 87 The total “Cash Flow from Assets” is given by: Operating Cash Flow Less the amounts invested in: fixed assets and net working capital. Next we’ll see that this $87 Cash Flow from Assets will equal the sum of the firm’s cash flow to creditors and its cash flow to stockholders.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.41 Cash Flow to Creditors and Stockholders Remember: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders The cash flows to creditors and stockholders represent the net payments to creditors and owners during the year. Cash Flow to Creditors: A firm’s interests payments to creditors less net new borrowings. Cash Flow to Stockholders: Dividends paid out by a firm less net new equity raised.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.42 Cash Flow to Creditors and Stockholders Cash Flow to Creditors Cash Flow to Creditors (Bondholders): A firm’s interests payments to creditors less net new borrowings. According to U.S. Corporation’s Income Statement (Table 2.2, Page 29) U.S. Corp paid $70 in interest to creditors According to U.S. Corporation’s Balance Sheet (Table 2.1, Page 26) U.S. Corp’s Long-term debt increased by: $454 – 408 = $46 $70 – $46 = $24 to Creditors

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.43 Cash Flow to Creditors and Stockholders Cash Flow to Stockholders Cash Flow to Stockholders: Dividends paid out by a firm less net new equity raised. According to U.S. Corporation’s Income Statement (Table 2.2, Page 29) U.S. Corp Dividends paid to Stockholders = $103 According to U.S. Corporation’s Balance Sheet (Table 2.1, Page 26) Common Stock and Paid-In Surplus increased by: $640 – $600 = $40 $103 - $40 = $63 to Stockholders

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.44 Cash Flow Summary Table 2.5

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 2.45 Chapter 2: Suggested Homework Know chapter theories, concepts, and definitions Re-read the chapter Review the Power Point Presentation Slides Suggested Homework: The Chapter Review and Self-Test Problem: 2.1, Page 41 (Answers are provided in book: Pages 41, 42, & 43) Critical Thinking and Concepts Review: Review Questions: 1 through 9, Page 43 Questions and Problems: Question 1, Page 44