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
Ø The Balance Sheet
Ø The Income Statement
Ø Cash Flow
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
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
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
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?