Net Working Capital and Liquidity

Financial Statements, Taxes, and Cash Flows

Key Concepts and Skills

Ø  Know the difference between book value and market value

Ø  Know the difference between accounting income and cash flow

Ø  Know the difference between average and marginal tax rates

Ø  Know how to determine a firm’s cash flow from its financial statements

Chapter Outline

Ø  The Balance Sheet

Ø  The Income Statement

Ø  Taxes

Ø  Cash Flow

Balance Sheet

Ø   The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time

Ø   Assets are listed in order of decreasing liquidity

l     Ease of conversion to cash

l     Without significant loss of value

Ø   Balance Sheet Identity

l     Assets = Liabilities + Stockholders’ Equity

The Balance Sheet – Figure 2.1

Net Working Capital and Liquidity

Ø    Net Working Capital

l      Current Assets – Current Liabilities

l      Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out

l      Usually positive in a healthy firm

Ø    Liquidity

l      Ability to convert to cash quickly without a significant loss in value

l      Liquid firms are less likely to experience financial distress

l      But liquid assets earn a lower return

l      Trade-off to find balance between liquid and illiquid assets

US Corporation Balance Sheet – Table 2.1

Market Vs. Book Value

Ø   The balance sheet provides the book value of the assets, liabilities, and equity.

Ø   Market value is the price at which the assets, liabilities ,or equity can actually be bought or sold.

Ø   Market value and book value are often very different. Why?

Ø   Which is more important to the decision-making process?

Example 2.2 Klingon Corporation

Income Statement

Ø   The income statement is more like a video of the firm’s operations for a specified period of time.

Ø   You generally report revenues first and then deduct any expenses for the period

Ø   Matching principle – GAAP says to show revenue when it accrues and match the expenses required to generate the revenue

US Corporation Income Statement – Table 2.2


Ø   The one thing we can rely on with taxes is that they are always changing

Ø   Marginal vs. average tax rates

l     Marginal tax rate – the percentage paid on the next dollar earned

l     Average tax rate – the tax bill / taxable income

Ø   Other taxes

Example: Marginal Vs. Average Rates

Ø   Suppose your firm earns $4 million in taxable income.

l     What is the firm’s tax liability?

l     What is the average tax rate?

l     What is the marginal tax rate?

Ø   If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

The Concept of Cash Flow

Ø   Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements

Ø   The statement of cash flows does not provide us with the same information that we are looking at here

Ø   We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

Cash Flow From Assets

Ø  Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

Ø  Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

Example: US Corporation – Part I

Ø   OCF (I/S) = EBIT + depreciation – taxes = $547

Ø   NCS ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130

Ø   Changes in NWC (B/S) = ending NWC – beginning NWC = $330

Ø   CFFA = 547 – 130 – 330 = $87

Example: US Corporation – Part II

Ø   CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24

Ø   CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63

Ø   CFFA = 24 + 63 = $87

Cash Flow Summary Table 2.5

Quick Quiz

Ø    What is the difference between book value and market value?  Which should we use for decision-making purposes?

Ø    What is the difference between accounting income and cash flow? Which do we need to use when making decisions?

Ø    What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

Ø    How do we determine a firm’s cash flows?  What are the equations and where do we find the information?