Understanding Financial Statements,

Taxes, and Cash Flows

ORIENTATION
Here we review the contents and meaning of a firm’s income statement and balance sheet. We also look
very carefully at how to compute a firm’s cash flows from a finance perspective, which is called free cash
flows.

OUTLINE
I. Basic Financial Statements
A. The Income Statement
1. The income statement reports the results from operating the business for a period of
time, such as a year.
2. It is helpful to think of the income statement as comprising five types of activities:
a. Selling the product
b. The cost of producing or acquiring the goods or services sold
c. The expenses incurred in marketing and distributing the product or service
to the customer along with administrative operating expenses
d. The financing costs of doing business: for example, interest paid to
creditors and dividend payments to the preferred stockholders
e. The taxes owed based on a firm’s taxable income
3. An example of an income statement is provided in Table 2-1 for the Harley-
Davidson Corporation.

B. The Balance Sheet

1. The balance sheet provides a snapshot of the firm’s financial position at a specific
point in time, presenting its asset holdings, liabilities, and owner-supplied capital.
a. Assets represent the resources owned by the firm
(1) Current assets - consisting primarily of cash, marketable securities,
accounts receivable, inventories, and prepaid expenses
(2) Fixed or long-term assets – comprising equipment, buildings, and
land
 (3) Other assets – all assets not otherwise included in the firm’s current
assets or fixed assets, such as patents, long-term investments in
securities, and goodwill
b. The liabilities and owners’ equity indicate how the assets are financed.
(1) The debt consists of such sources as credit extended from suppliers
or a loan from a bank.
(2) The equity includes the stockholders’ investment in the firm and the
cumulative profits retained in the business up to the date of the
balance sheet.
2. The balance sheet is not intended to represent the current market value of the
company, but rather reports the historical transactions recorded at their costs.
3. Balance sheets for the Harley-Davidson Corporation are presented in Table 2-2.
II Computing a Company’s Taxes
A. Types of taxpayers
1. Sole proprietors
a. Report business income on personal tax returns
b. Pay taxes at personal tax rate
2. Partnerships
a. The partnership reports income but does not pay taxes
b. Each partner reports his or her portion of income and pays the
corresponding taxes.
3. Corporations
a. Corporation reports income and pays taxes
b. Owners do not report these earnings except when all or part of the profit is
paid out as dividends.
c. Our focus is on corporate taxes.
B. Computing Taxable Income
1. Taxable income is based on gross income less tax-deductible expenses
a. Interest expense is tax deductible
b. Dividend payments are not tax deductible
2. Depreciation
a. Modified accelerated cost recovery system used for computing depreciation
for tax purposes
b. We use straight-line depreciation to reduce complexity.
C. Computing Taxes Owed
1. Taxes paid are based on corporate tax structure.
2. Tax rates used to calculate tax liability are marginal tax rates, or the rate applicable
to the next dollar of income.
 3. Average tax rate is calculated by dividing taxes owed by the firm’s total income
4. Marginal tax rate is used in financial decision making
III. Measuring Free Cash Flows
A. While an income statement measures a company’s profits, profits are not the same as cash
flows; profits are calculated on an accrual basis rather than a cash basis.
B. In measuring cash flows, we could use the conventional accountant’s presentation called a
statement of cash flows. However, we are more interested in considering cash flows from
the perspective of the firm’s shareholders and its investors, rather than from an accounting
view. We will instead measure the cash flow that is free and available to be distributed to
the firm’s investors, both debt and equity investors, or what we will call free cash flows.
C. The cash flows that are generated through a firm’s operations and investments in assets
will always equal its cash flows paid to – or received from – the company’s investors (both
creditors and stockholders).
D. Calculating Free Cash Flows: An Asset Perspective
1. A firm's free cash flows, from an asset perspective, is the after-tax cash
flows generated from operations less the firm's investments in assets. It is
this same amount that will be available for distributing to the firm’s
investors. That is, a firm's free cash flows for a given period is equal to:
After-tax cash flow from operations
less
the investment (increase) in net operating working capital
less
investments in fixed assets (plant and equipment) and other assets.

2. After-tax cash flows from operations as follows:

Operating income (earnings before interest and taxes)

+ depreciation
= Earnings before interest, taxes, depreciation and amortization
(EBITDA)
- cash tax payments
= After-tax cash flows from operations

3. The increase in net operating working capital is equal to the:

 change in  change in noninteres t - bearing 
current assets  -  current liabilitie s 


4. Investments in fixed assets includes the change in gross fixed assets and any other
balance sheet assets not already considered.
 E. Calculating Free Cash Flows: A Financing Perspective
1. Free cash flows from a financing perspective are equal to:

Interest payments to creditors

+ decrease in debt principal

or
- increase in debt principal

plus dividends paid to stockholders

+ decrease in stock
or
- increase in stock

2. Free cash flow from an asset perspective must equal free cash flow from a
financing perspective.
3. Free cash flows from a financing perspective are simply the net cash flows received
by the firm’s investors, or if negative, the cash flows that the investors are paying
into the firm. In the latter situation where the investors are putting money into the
firm, it is because the firm’s free cash flow from assets is negative, thereby
requiring an infusion of capital by the investors.

IV. Financial Statements and International Finance

A. Many countries have different guidelines for firms to use in preparing financial statements.
For example, a $1 of earnings in the United States is not the same as 1.10 Euro (the
equivalent of a U.S. dollar based on the exchange rate). The differences are due to the two
countries having different Generally Accepted Accounting Principles which guide their
firms’ financial reporting.
B. As a result of this situation, the International Accounting Standards Committee (IASC), a
private body supported by the worldwide accounting profession, is trying to develop
international financial-reporting standards that will minimize the problem. In spite of the
work to standardize accounting practices around the world, the U.S. accounting profession
has rejected efforts toward international standards. At this time, foreign companies
seeking to list their shares in the United States must follow U.S. accounting standards.