1. 6-1 Chapter 2 Financial Statements, Taxes and Cash Flow Financial Statements, Taxes and Cash Flow 2-1 Dr. Mazharul Islam

2. 6-2 Chapter Objectives u Understand the difference between book value (from the Balance Sheet) and market value. u Understand the difference between net profit (from the Income Statement) and cash flow. u Explain the differences between the average tax rate, the marginal tax rate and the flat rate. u Explain the calculation of cash flow from assets, and cash flow to debt-holders and shareholders. u Understand the difference between book value (from the Balance Sheet) and market value. u Understand the difference between net profit (from the Income Statement) and cash flow. u Explain the differences between the average tax rate, the marginal tax rate and the flat rate. u Explain the calculation of cash flow from assets, and cash flow to debt-holders and shareholders. 2-2 Dr. Mazharul Islam

3. 6-3 u A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity. u Equation: Assets = Liabilities + Owners’/Shareholders’ Equity. u Net working capital = Current Assets – Current Liabilities. The Balance Sheet 2-3 Dr. Mazharul Islam

4. 6-4 Petro Rabighs’ Balance Sheet (Asset Side) a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. c d Current Assets e $1,195 f g Net Fix. Assets $ 701 Total Assets b $2,169 Cash and C.E. $ 90 Acct. Rec. c 394 Inventories 696 Prepaid Exp d 5 Accum. Tax Prepay 10 Current Assets e $1,195 Fixed Assets (@Cost) f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 a 2-4 Dr. Mazharul Islam

5. 6-5 Petro Rabighs’ Balance Sheet (Liability Side) a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. c d d Current Liab. e $ 500 f g g h Total Equity $1,139 Notes Payable $ 290 Acct. Payable c 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equity a,b $2,169 Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 2-5 Dr. Mazharul Islam

6. 6-6 Market Value versus Book Value u Book value refers the price that never change as long as you own the asset. Example: if you bought a house 10 years ago for 300,000SAR, its book value for your entire period of ownership will remain 300,000SAR u Market value refers the price that could be obtained in the current market place. Example: if the price of that house after 10 years is 350,000SAR then it is called market value. u Book value refers the price that never change as long as you own the asset. Example: if you bought a house 10 years ago for 300,000SAR, its book value for your entire period of ownership will remain 300,000SAR u Market value refers the price that could be obtained in the current market place. Example: if the price of that house after 10 years is 350,000SAR then it is called market value. 2-6 Dr. Mazharul Islam

7. 6-7 u A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Equation:Revenues – Expenses = Profit. u Profit is often expressed on a per-share basis and called earnings per share (EPS). u The difference between net profit and cash dividends is called retained earnings, which is added to the retained earnings account in the Balance Sheet. The Income Statement 2-7 Dr. Mazharul Islam

8. 6-8 Revenue $4 000 Cost of Goods Sold 2 800 Depreciation 200 EBIT (Earnings Before Interest & Tax ) 1 000 Interest 200 Taxable Income (EBT) 800 Tax 240 Net Profit (EAT) $560 Dividends 260 Addition to R/E $300 Example—Income Statement of Petro Rabigh 2-8 Dr. Mazharul Islam

9. 6-9 Cash Flow from Assets u Equation: Cash flow from assets = cash flow to debt-holders + cash flow to shareholders. u The cash flow identity or equation states that the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm. 2-12 Dr. Mazharul Islam

10. 6-10 Cash Flow from Assets The total cash flow from assets = operating cash flow – net capital spending on non- current assets- change in net working capital u Operating cash flow: the cash flow that results from day-to-day activities of producing and selling. Earnings before interest and taxes (EBIT) + Depreciation – Taxes OR (Revenue – costs –taxes) u Net capital spending: Ending non-current assets – Beginning non-current assets + Depreciation.. u Change in net working capital (NWC): Ending NWC – Beginning NWC. 2-13 Dr. Mazharul Islam

11. 6-11 Example―Balance Sheet ($000s) Assets (‘000s)20062007 Current assets Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment TOTAL ASSETS $ 90 520 640 $ 1 250 1 970 $3 220 $ 100 620 770 $ 1 490 2 200 $3 690 2-15 Dr. Mazharul Islam

12. 6-12 Liabilities and equity (‘000s)20062007 Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings Total TOTAL LIABILITIES AND EQUITY $ 420 220 $ 640 $ 410 580 1 590 $2 170 $3 220 $ 520 350 $ 870 $ 450 580 1 790 $2 370 $3 690 Example―Balance Sheet ($000s) 2-16 Dr. Mazharul Islam

13. 6-13 Sales (Revenue) $1 420.00 Cost of goods sold960.00 Depreciation60.00 EBIT $400.00 Interest 40.00 Taxable income 360.00 Tax 108.00 Net profit$252.00 Dividends 52.00 Addition to retained earnings $200.00 Example―Income Statement ($000s) 2-17 Dr. Mazharul Islam

14. 6-14 Operating cash flow: Revenue:$ 1420.00 Costs: $ 960.00 – Taxes– 108.00 $352.00 Change in net working capital: Ending net working capital $ 620.00 ($1490-$870) – Beginning net working capital – $ 610.00 ($1250-$640) $10.00 Net capital spending: Ending non-current assets $ 2 200.00 – Beginning non-current assets – 1 970.00 + Depreciation + 60.00 Cash flow from assets: $352.00 – $10 – $290 = $ 52.00 Example―Cash Flow From Assets ($000s) 2-18 Dr. Mazharul Islam

15. 6-15 Cash Flow to Debt-holders and Shareholders u The cash flow to debt-holders includes any interest paid less the net new borrowing. Cash flow to debt-holders = Interest paid – net new borrowing u The cash flow to shareholders includes dividends paid out by a firm less net new equity raised. Cash flow to share-holders = Dividends paid – net new equity 2-14 Dr. Mazharul Islam

16. 6-16 Cash flow to debtholders: Interest paid $ 40.00 – Net new borrowing– 40.00 ($450 – $410) $ 0.00 Cash flow to shareholders: Dividends paid$ 52.00 – Net new equity raised – $ 0.00 ($580 – $580) $52.00 Cash flow to debt-holders and shareholders = $0.00 + $52.00 = $52.00 Example―Cash Flow to Debt- holders and Shareholders ($000) 2-19 Dr. Mazharul Islam

17. 6-17 Summary and Conclusions u The book values on an accounting Balance Sheet can be very different from market values. u Cash flow from assets equals cash flow to debt-holders and shareholders. u It is important not to confuse book values with market values, and accounting income with cash flow. 2-20 Dr. Mazharul Islam