Chapter 2

Financial Statements, Taxes, and Cash Flow

Prepared and Taught by Lecturer: YIN SOKHNG
E-mail: yin_sokheng@yahoo.com Tel: (855) 16889872 / 17989972

Chapter Outline 2.1 The Balance Sheet

2.2 The Income Statement

2.3 Net Working Capital 2.4 Taxes 2.5 Cash Flow

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2.1 The Balance Sheet

Figure 2.1

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US Corporation Balance Sheet ($ in millions) Table 2.1

Assets Current Assets Cash A/R Inventory Total 2006 2007 Liabilities and Equity Current Liabilities Accounts Payable Notes Payable Total Long-term Debt Fixed Assets Net Fixed Assets$1,644 $1,709 Stockholders Equity Common Stock and Paid in Surplus Retained Earnings Total Total Assets $2,756 $3,112 Total Claims 2006 2007

$ 104 455 553 $1,112

$ 160 688 555 $1,403

$ 232 196 $ 428 $ 208

$ 266 123 $ 389 $ 454

$ 600 1,320 $ 1,920 $ 2,756

$ 640 1,629 $ 2,269 $ 3,112

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Balance Sheet Analysis

When analyzing a balance sheet, the financial manager should be aware of three concerns: 1.Accounting liquidity 2.Debt versus equity 3.Value versus cost

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Accounting Liquidity
Refers to the ease and quickness with which assets can be converted to cash. Current assets are the most liquid. Some fixed assets are intangible. Liquid assets frequently have lower rates of return than fixed assets.

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Debt versus Equity

Generally, when a firm borrows it gives the bondholders first claim on the firms cash flow. Thus shareholders equity is the residual difference between assets and liabilities. Assets Liabilities = Stockholders equity

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Value versus Cost

Under GAAP audited financial statements of firms in the U.S. carry assets at cost. Market value is a completely different concept. In fact, managements job is to create a value for the firm that is higher than its cost. Many users of financial statement, including managers and investors, want to know the value of the firm, not its cost
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2.2 The Income Statement

Table 2.2
2007

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Income Statement Analysis

There are three things to keep in mind when analyzing an income statement:
1. GAAP 2. Non Cash Items 3. Time and Costs

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Generally Accepted Accounting Principles

1. GAAP The matching principal of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, even though no cash flow may have occurred

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Income Statement Analysis

2. Non Cash Items Depreciation is the most apparent. No firm ever writes a check for depreciation. Another noncash item is deferred taxes, which does not represent a cash flow.

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Income Statement Analysis

3. Time and Costs In the short run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials. In the long run, all inputs of production (and hence costs) are variable. Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.
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2.3 Taxes
Federal income tax rate increases with the level of taxable income. Marginal vs. average tax rates

Marginal Rate the percentage paid on the next dollar earned Average Rate the tax bill / taxable income
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Corporate Tax Rate

Taxable Income 050,000 50,001-75,000 75,001-100,000 100,001-335,000 335,001-10,000,000 10,000,001-15,000,000 15,000,001-18,333,333 18,333,333+
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Tax rate 15% 25% 34% 39% 34% 35% 38% 35%
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Example: Marginal Vs. Average Rates

Suppose our corporation has a taxable income of $200,000. What is the firms tax liability? What is the average tax rate? What is the marginal tax rate?

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Example: Marginal Vs. Average Rates

The firms tax liabilities 050,000 x 50,000-75,000 x 75,000-100,000 x 100,000-200,000 x 15% = $7,500 25% = $6,250 34% = $8,500 39% = $39,000 $61,250 Average tax rate = 61,250/200,000 = 30.625% If we made one more dollar, the tax rate on that dollar would be 39%, so our marginal is 39%.
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2.4 Net Working Capital (NWC)

Net working capital is current assets minus current liabilities. Net working capital is positive when current assets are greater than current liabilities. Net Working Capital = Current Assets Current Liabilities NWC is usually growing with the firm.
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2.5 Financial Cash Flow

In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm. The cash from received from the firms assets must equal the cash flows to the firms creditors and stockholders. CF(A)= CF(B) + CF(S) CF(A)= OCF NCS Change in NWC
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Table 2.5

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US Corporation Financial Cash Flow ($ in millions)

Cash flow from assets Operating cash flow: EBIT + Depreciation Taxes Change in net working capital: Ending net working capital Beginning net working capital Net capital spending: Ending non-current assets Beginning non-current assets + Depreciation Cash flow from assets: $ + 694 65 212

547

$ 1,014 684 $ + 1,709 1,644 65

$ 330

$ $

130 87

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Cash flow to debtholders and shareholders Cash flow to debtholders: Interest paid $ 70 Net new borrowing 46 Cash flow to shareholders: Dividends paid Net new equity raised

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103 40

$ $

63 87

Cash flow to debtholders and shareholders

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