1. Chapter 2
Financial Statements, Taxes and Cash Flow

2. 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

3. 2.1 The Balance Sheet

4. 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
Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.
Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the IM for a more complete discussion of this issue.

5. 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

6. 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)

7. 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

8. Net Working Capital (Pg 25)
Current Assets - Current Liabilities
Positive - when current assets exceed current liabilities (healthy firm)

9. The Balance Sheet Figure 2.1
The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are direct result of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.)
Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of management’s financing decisions.
Remember that shareholders’ equity consists of several components and that total equity includes all of these components not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders.

10. Examining the Balance Sheet (Pg 25)
Three Important Things to Keep in Mind:
Liquidity
Debt versus Equity (Capital Structure)
Market Value versus Book Value

11. 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

12. 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

13. 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

14. Debt versus Equity (Capital Structure)(Pg 26)
Creditors - 1st claim on the firm’s cash flow
(AP Vendors, Bank loans, Bond Holders)
Equity Holders – entitled to residual “after creditors are paid”

15. Market Vs. Book Value The goal of financial management is to:
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.
Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities and equity of the firm.
Assets are listed at historical costs less accumulated depreciation – this may bear little resemblance to what they could actually be sold for today. The balance sheet also does not include the value of many important assets, such as human capital. Consequently, the “Total Assets” line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth.
Liabilities are listed at face value. When interest rates change or the risk of the firm changes, the value of those liabilities change in the market as well. This is especially true for longer-term liabilities.
Equity is the ownership interest in the firm. The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the market’s estimation of the current value of ALL of the assets of the firm.
The best estimate of the market value of the firm’s assets is market value of liabilities + market value of equity.
Market values are generally more important for the decision making process because they are more reflective of the cash flows that would occur today.

16. Market Value vs. Book Value (Pg 27)
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

17. 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

18. US Corporation Balance Sheet – Table 2.1
The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example.
Here is an example of a simplified balance sheet. Many students make it through business school without ever seeing an actual balance sheet, particularly those who are not majoring in finance or accounting. Later in the chapter, a hot link is provided to the 1999 annual report for McGraw-Hill. If you don’t have access to the internet for your presentation, I encourage you to bring in some annual reports and let the students see the differences between the simplified statements they see in textbooks and the real thing.
This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are.

19. 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
Book
Market
Assets
Liabilities and Shareholders’ Equity
NWC
$ 400
$ 600
LTD
$ 500
NFA
700
1,000 SE
600
1,100
1,600
Shareholders are the ones that benefit from increases in the market value of a firm’s assets. They are also the ones that bear the losses of a decrease in market value. Consequently, managers need to consider the impact of their decisions on the market value of assets, not on their book value. Here is a good illustration:
Suppose that the MV of assets declined to $700 and the market value of long-term debt remained unchanged. What would happen to the market value of equity? It would decrease to 700 – 500 = 200.
The market-to-book ratio, which compares the market value of equity to the book value of equity, is often used by analysts as a measure of valuation for a stock. It is generally a bad sign if a company’s market-to-book ratio approaches 1.00 (meaning market value = book value) because of the GAAP employed in creating a balance sheet. It is definitely a bad sign if the ratio is less than 1.00.
GAAP does provide for some assets to be marked-to-market, primarily those assets for which current market values are readily available due to trading in liquid markets. However, it does not generally apply to long-term assets, where market values and book values are likely to differ the most.

20. 2.1 The Income Statement

21. 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)
Matching principle – this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.

22. 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)

23. US Corporation Income Statement – Table 2.2
U.S. CORPORATION 1998 Income Statement ($ In Millions)
The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example.
Remember that these are simplified income statements for illustrative purposes.
Earnings before interest and taxes is often called operating income.
COGS would include both the fixed costs and the variable costs needed to generate the revenues.
Analysts often look at EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes.
The IM provides a discussion of Cendant and the problems that the company ran into when fraudulent accounting practices were discovered.
It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statement. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the IRS. In this instance, the “life” of the asset for depreciation purposes may be very different from the useful life of the asset. Statements that are prepared for investors often use straight-line depreciation because it will tend to have a lower depreciation charge than MACRs early in the asset’s life. This reduces the “expense” and thus increases the firm’s reported EPS. This is a good illustration of why it is important to look at a firm’s cash flow and not just its EPS.

24. Income Statement (Pg 29) Three things to keep in mind: GAAP
Cash versus noncash items
Time and Costs

25. 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

26. 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

27. 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

28. 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

29. 2.3 Taxes

30. 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

31. 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

32. 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

33. 2.4 Cash Flow

34. 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

35. 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

36. Cash Flow
“Cash” is generated from utilizing assets and is paid to those that “finance” the purchase of the assets:
Creditors
Stockholders

37. 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
The first equation is how the cash flow from the firm is divided among the investors that financed the assets.
The second equation is the cash flow that the firm receives from its assets. This is an important equation to remember. We will come back to it and use it again when we do our capital budgeting analysis. We want to base our decisions on the timing and risk of the cash flows we expect to receive from a project.

38. 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

39. 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) (No Cash involved)
Net Investment in fixed assets $ (Net Capital Spending for 2000)
Note: Net Capital Spending can be negative if the firm sold off more assets than it purchased

40. 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

41. 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.

42. 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.

43. 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

44. 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

45. Cash Flow Summary Table 2.5
This provides a summary for the various cash flow calculations. It is a good place to refer back when working on cash flows in the capital budgeting section.

46. 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