Chapter 2 Understanding Financial

Statements, Taxes, and Cash Flows

2005, Pearson Prentice Hall

Income Statement
SALES
- EXPENSES
= PROFIT

Cost of Goods Sold

Operating Expenses
(marketing, administrative)

Financing Costs
Taxes

SALES
- Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS

SALES
- Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS

Balance Sheet

Total Assets =

Outstanding
Debt
+
Shareholders
Equity

Balance Sheet
Assets
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses

Fixed Assets
Machinery & Equipment
Buildings and Land

Other Assets
Investments & patents

Liabilities (Debt) & Equity

Current Liabilities

Accounts Payable
Accrued Expenses
Short-term notes

Long-Term Liabilities
Long-term notes
Mortgages

Equity

Preferred Stock
Common Stock (Par
value)
Paid in Capital
Retained Earnings

Assets
Current Assets: assets that are
relatively liquid, and are expected to be
converted to cash within a year.
Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.

Assets
Current Assets: assets that are
relatively liquid, and are expected to be
converted to cash within a year.
Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.

Fixed Assets: machinery

and equipment, buildings,
and land.

Assets
Current Assets: assets that are
relatively liquid, and are expected to be
converted to cash within a year.
Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.

Fixed Assets: machinery and

equipment, buildings, and land.
Other Assets: any asset that is not a
current asset or fixed asset.
Intangible assets, such as patents and
copyrights.

Financing
Debt Capital: financing provided by a
creditor.
Short-term debt: borrowed money that
must be repaid within the next 12
months.
Accounts payable, other payables such as
interest or taxes payable, accrued
expenses, short-term notes.

Long-term debt: loans from banks or

other sources that lend money for
longer than 12 months.

Financing
Equity Capital: shareholders
investment in the firm.
Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of
liquidation of the firm.
Common Stockholders: residual
owners of a business. They receive
whatever is left after creditors and
preferred stockholders are paid.

Corporate Income Tax Rates

Taxable Income

Since 1993
Corporate Tax Rate

$1 - $50,000
15%
$50,001 - $75,000
25%
$75,001 - $100,000
34%
$100,001 - $335,000
39%
$335,001 - $10,000,000
34%
$10,000,001 - $15,000,000 35%
$15,000,001 - $18,333,333 38%
over $18,333,333
35%

Free Cash Flows

Free cash flow: cash flow that is free and
available to be distributed to the firms
investors (both debt and equity investors).

Free Cash Flows

Cash Flows from
Assets

Cash flows generated

through the firms
assets

Cash Flows from

Financing

Cash flows paid to - or

received from - the
firms investors
(creditors &
stockholders)

Calculating Free Cash Flows:

An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets

Calculating Free Cash Flows:

An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets

Operating income
+ depreciation
- cash tax payments

Calculating Free Cash Flows:

An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets

[Change in current
assets]

[change in non-interest
bearing current liabilities]

Calculating Free Cash Flows:

An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets

Change in gross
fixed assets, and
any other assets
that are on the
balance sheet.

Calculating Free Cash Flows:

A Financing Perspective
Interest payments to creditors

change in debt principal

dividends paid to stockholders

change in stock
Financing Free Cash Flows

Tax Example:

 Space Cow Computer has sales of $32

million, cost of goods sold at 60% of

sales, cash operating expenses of $2.4
million, and $1.4 million in depreciation
expense. The firm has $12 million in
9.5% bonds outstanding. The firm will
pay $500,000 in dividends to its
common stock holders.
Calculate the firms tax liability.

Sales
Cost of Goods Sold
Operating Expenses
Depreciation Expense
EBIT or NOI
Interest Expense
Taxable Income

$32,000,000
(19,200,000)
(2,400,000)
(1,400,000)
9,000,000
(1,140,000)
7,860,000

Income
tax rate
$50,000 x .15
$25,000 x .25
$25,000 x .34
$235,000 x .39
$7,525,000 x .34
Total Tax payment

=
=
=
=
=

tax payment
$ 7,500
6,250
8,500
91,650
2,558,500
$2,672,400

short cut: $7,860,000 x .34 = $2,672,400