1. Financial Statements, Taxes and Cash Flows
MBAC 6060 Chapter 2
Financial Statements,
Taxes and Cash Flows

2. Chapter Outline
2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes 2.4 Net Working Capital 2.5 Cash Flows 2.6 The Statement of Cash Flows 2.7 Cash Flow Management

3. 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

4. 2.1 Balance Sheet Assets are listed from Most Liquid to Least Liquid
“Net Fixed Assets” is Book Value (LOCOM) net of Accumulated Depreciation
Assets = Liabilities + OE  OE = Assets - Liabilities

5. Balance Sheet (Continued 1)
The balance sheet is a “snap-shot”
What does the company own today?
What does the company owe today?
How much is left for the owners?
called the residual
The LEFT SIDE shows what assets are employed by the firm to do what it does
Cash, Inventory, Factories, Machines, Trucks…
The RIGHT SIDE shows how it paid for the assets
How much is borrowed and for how long
How much is left for the owners
Note: Owner’s Equity is not how much the owners contributed. It is the current residual value.

6. Balance Sheet (Continued 2)
Debt is also called Financial Leverage
Given the equity, what value of assets are employed?
Put up $1m, borrow $1m, Employ $2m in assets
Put up $1m, borrow $2m, Employ $3m in assets
Market Value vs. Book Value:
Market Value of Assets vs. Book Value of Assets
GAAP: LOCOM
Coors in Golden: Land is on books at cost
But what is the market value of that land?
Market Value of Equity vs. Book Value of Equity
Book Value of Equity = Book Value of Assets – Liabilities
Market Value of Equity = # of Shares x Price per Share
What would account for the difference between book and market?
What kind of companies have a relatively high BM? Low BM?

7. Review Question:
A firm’s balance sheet shows $50 million in Total Assets and $30 million Total Debt
The firm has 1,000,000 shares of stock outstanding at a price of $25 per share
Which of the following is true?
Book Value Equity is greater than Market Value of Equity
Market Value Equity is greater than Book Value of Equity
Book Value Equity equals Market Value of Equity
There is not enough information to tell.

8. Review Answer: The Answer is B.
Book Value of Equity = Book value of Assets - Book Value of Debt
Book Value of Equity = $50m – $30m = $20m
Market Value of Equity = # of shares x Price
Market Value of Equity = 1 million x $25 = $25m
The Answer is B.
The Market Value Equity is greater than Book Value of Equity

9. 2.2 Income Statement Income Statement Includes:
Operating Expenses (COGS, SG&A, Lights…)
Per-Share numbers
Addition to Retained Earnings on Income Statement
is added to Accumulated Retained Earnings on the Balance Sheet

10. Income Statement (Cont 1)
Revenues and Expenses as they Accrue
If a sale is made, book the revenue
Not necessarily receive cash
Sale could be on account - A/R (a current asset)
Non-Cash Expenses
Depreciation = $90
Was the $90 spent this period?
No! It is a portion of the amount spent (when the PPE was purchased) that is allocated to this period
$90 is expensed against this period’s revenue
It lowers this periods taxable income
And therefore lowers this period’s tax expense

11. Review Question: A firm’s taxable income is $1,000
The firm owns a machine with $200 annual depreciation this year.
The firm’s tax rate is 35%
What is this year’s tax savings due to depreciation?
$35
$65
$100
$70
$130

12. Review Answer: A firm’s taxable income is $1,000
The firm owns a machine’s with $200 annual depreciation this year.
The firm’s tax rate is 35%
What is this year’s tax savings due to depreciation?
(Depreciation)(Tax Rate) = $200(0.35) = $70 Or
Tax Exp without Depreciation = $1,000(0.35) = $350
Tax Exp with Depreciation = ($1,000 - $200)(0.35) = $350
= ($800)(0.35) = $280
Savings = $350 - $280 = $70
Correct Answer is D.

13. Income Statement (Cont 2)
Firms can engage in “Earnings Management”
Show higher or lower earnings
Used to achieve income smoothing
“Cookie Jar” accounts
LIFO or FIFO
Not necessarily illegal or unethical
See Wikipedia Page

14. 2.3 Corporate Taxes See Table 2.4 for sample corporate tax rates
Make sure you can calculate:
Tax Expense
Marginal Tax Rate
Average Tax Rate
See Example 2.2 on page 27
If you are calculating the effect of additional income from a new project, which tax rate should you use?
Marginal. Why?

15. 2.4 Net Working Capital (NWC)
NWC = Current Assets – Current Liabilities

16. 2.4 NWC Continued NWC = Current Assets – Current Liabilities
NWC is a measure of Short-Term Solvency
NWC also used to adjust Sales and Costs from Income Statement to get Cash Flows:
Assume Sales last year was $100
But A/R increased from $20 to $50
How much actual cash was collected?
$100 – ($50 - $20) = $100 - $30 = $70
$70 in Cash Sales and $30 in A/R Sales

17. 2.5 Cash Flows Cash Flows are Everything!
We will deal with cash flows in a slightly different way than the “Statement of Cash Flows”
In General, the value of a firm (or an individual project) is…
… the Present Value of its Cash Flows!
Net Cash Flows (in any period) = Money In - Money Out
Not Sales
Since some sales are in cash, some sales are on account
Not Net income (aka Earnings )
NI or Earnings is an “accounting profit” not cash
Includes non-cash expenses
Includes accruals (sales, purchases…)
We will start with EBIT
Why?
Because EBIT is close to what we Operating Cash Flows
It has already been calculated by the accountants

18. Operating Cash Flows = EBIT + Dep – Taxes = $219 + $90 – $71 = $238
2.5 CFs (Continued 1)
So back to the Income Statement:
Operating Cash Flows = EBIT + Dep – Taxes = $219 + $90 – $71 = $238

19. 2.5 CFs (Continued 2) So we have OCF = $238
But how much of that activity represents cash transactions?
Sales was $2,262
But how much of those sales were on account?
COGs was $1,655
But was that money actually spent on inventory this year?
Only if it was replaced (so no change in INV)
And Only if cash was spent (no change in A/P)

20. 2.5 CFs (Continued 3) A/R from $270 to $294 INV from $280 to $269
So back to the Balance Sheet (just Current Asset for now):
A/R from $270 to $294
$294 – $270 = $24 of OCF was not cash received
INV from $280 to $269
$269 – $280 = -$11 of Inv was not replaced
COGS of $1,655, but only $1,655 - $11 = $1,644 was cash spent

21. Now just Current Liabilities:
2.5 CFs (Continued 4)
Now just Current Liabilities:
Total Current Liabilities from $455 to $486
$486 – $455 = $31 of Cash assumed spent was not spent
It was “borrowed”

22. 2.5 CFs (Continued 5) Increases in Current Asset means OCF is too high
Increases in Current Liabilities means OCF is too low
So next step (Still one more after this):
Total CFs = Operating CF – ΔCA + ΔCL
But it is usually written his way:
ΔCA = New CA – Old CA
ΔCL = New CL – Old CL
New NWC = New CA – New CL
Old NWC = Old CA – Old CL
ΔNWC = New NWC – Old NWC
Total CFs = Operating CF – ΔNWC

23. 2.5 CFs (Continued 6) Recap:
OCF = EBIT + Dep – Taxes = $219 + $90 - $71 = $238
ΔNWC = New NWC – Old NWC
New NWC = $761 - $486 = $275
Old NWC = $707 - $455 = $252
ΔNWC = $275 – $252 = $23
So now CF = OCF - ΔNWC = $238 - $23 = $215
But still not done yet!
We have to consider Net Capital Spending
Distinguish Capital (PPE) from Working Capital

24. 2.5 CFs (Continued 7) Now just Fixed Assets
NCS = New Total Fixed Assets – Old Total Fixed Assets + Dep
NCS = $1,118 – $1, ($550 – $460)
NCS = $1,118 – $1, $90 = $173

25. CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42
2.5 CFs (Continued 8)
Recap:
OCF = EBIT + Dep – Taxes = $219 + $90 - $71 = $238
ΔNWC = New NWC – Old NWC = $275 – $252 = $23
NCS = New TFA – Old TFA + Dep = $1,118 – $1, $90 = $173
So firm generated “cash” of $238 from operations
But $23 of the $238 was either:
Not collected – Assumed revenue was too high
Or more was spent – Assumed costs were too low
Since NWC increased
And $173 of the $238 was spent of PPE
CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42

26. CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42
2.5 CFs (Continued 9)
CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42
This is called Cash Flows From Assets
So what happened to the $42 of CF from Assets?
Some CF to bondholder (also called creditors)
Some CF to stockholders
We will show:
CF from Assets = CF to Creditors + CF to Stockholders
Cash in must equal Cash out

27. From the Income Statement:
2.5 CFs (Continued 10)
Bondholders
From the Income Statement:
Interest Expense = $49
This is a CF TO bondholders
From the Balance Sheet:
Net New Long-Term Debt = New – Old
Net New Long-Term Debt = $471 - $458 = $13
This is a CF FROM bondholders
Net CF to Creditors = Int Exp – Net New LT Debt
Net CF to Creditors = $49 – $13 = $36

28. From the Income Statement:
2.5 CFs (Continued 11)
CF to Stockholders
From the Income Statement:
Dividends = $43
This is a CF TO stockholders
From the Balance Sheet:
Net New Treasury Stock = $26 – $20 = $6
CF TO Stockholders = $43 + $6 = $49

29. From the Balance Sheet:
2.5 CFs (Continued 12)
CF from Stockholders
From the Balance Sheet:
Change in Common Stock = $55 – $32 = $23
Change in Capital Surplus = $347 - $327 = $20
Together these are value of new stock sold = $43
CF FROM stockholders = $43
Net CF to Stockholders = $49 – $43 = $6

30. Cash In must equal Cash Out
2.5 CFs (Continued 13)
Conclusion:
CF to Creditors = $36
CF to Stockholders = $6
CF to Creditors + CF to Stockholders = $36 + $6 = $42
Recall:
CF from Assets = OCF – ΔNWC – NCS = $42
Cash In must equal Cash Out

31. Review Question:
Over the last year, a firm’s cash flow from operations was $1,000
It spent $300 on new PPE
It’s change in NWC was $200
Calculate the firm’s CF from Assets
$1,000
$900
$500
$300
$200

32. Review Answer:
Over the last year, a firm’s cash flow from operations was $1,000
It spent $300 on new PPE
It’s change in NWC was $200
Calculate the firm’s CF from Assets
Total CF from assets =
= CF from Ops – CF from Cap Spending - DNWC
Total CF from Assets =
= $1,000 - $300 - $200 = $500
The Answer is C.

33. 2.6 The Accounting Statement of CFs
This information is summarized in an accounting document
Called the Statement of Cash Flows
Back to the Balance Sheet:
Cash increased by $140 - $107 = $33
Why?

34. 2.6 The Accounting Statement of CFs

35. 2.6 The Accounting Statement of CFs
This is roughly equivalent to OCF – ΔNWC = 238 – 23 = 215
We got a different number before because we did not include interest expense ($49), did include change in Notes Payable (-$3) and changes in cash ($33)
$202 + $49 - $3 - $33 = $215

36. 2.6 The Accounting Statement of CFs
Investing Activities = Net Capital Spending = $173
Financing Activities includes Changes to Notes Payable

37. 2.6 The Accounting Statement of CFs
Net Changes to Cash = $202 – $173 + $4 = $33
This shows the breakdown of how Cash went from $107 to $140
We DO NOT care about the Statement of CFs
We DO care about financial CFs from Assets
That the firm decided to increase the cash account (instead of buying inventory or paying off debt) does not concern us
What does concerns us is the Free CFs earned from the firm’s assets ($42) that are available to be paid to investors
Also what happened to the Free CF’s
$36 to creditors and $6 to stockholders

38. 2.6 The Accounting Statement of CFs
So why did I bother showing you all this stuff about the Accounting Statement of CFs?
To illustrate the difference between:
Financial “free cash flows” available to compensate investors
Accounting cash flows used to trace the source of changes in the cash account

39. 2.7 Earnings and Cash Flow “Management”
Read Examples on page 34
LIFO vs. FIFO
Allocating CFs to operations instead of investing
Capitalizing the light bill
Repos