CHAPTER 2
FINANCIAL STATEMENTS, TAXES AND CASH FLOW
CHAPTER 2 QUIZ
CHAPTER ORGANIZATION
2.1
THE BALANCE SHEET
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Assets: The Left-Hand Side – Current assets are the value of cash, accounts receivable,
inventories, marketable securities and other assets that could be converted to cash in less than 1
year. Fixed assets are long-lived property owned by a firm that is used by a firm in the
production of its income. Tangible fixed assets include real estate, plant, and equipment.
Intangible fixed assets include patents, trademarks, and customer recognition. Listed in the order
of their liquidity; reverse order of their profitability.
Liabilities and Owners’ Equity: The Right-Hand Side – Current liabilities are amounts owed for
salaries, interest, accounts payable and other debts due within 1 year. Long-term liabilities are
amounts owed for leases, bond repayment, and other items due after 1 year. Listed in the order of
their maturity (current to long-term).
Shareholders’ Equity - Balance sheet item that includes the book value of ownership in the
corporation. It includes common stock, paid-in surplus, and retained earnings.
The firm’s net income belongs to the owners. It can either be paid out in dividends or reinvested
in the firm. When it is reinvested in the firm, it becomes additional equity investment and shows
up in the retained earnings account. Investment decisions involve the purchase and sale of any
assets (not just financial assets). Investment decisions show up on the left-hand side of the
balance sheet. Financing decisions involve the choice of whether to borrow money to buy the
assets or to issue new ownership shares. Financing decisions show up on the right-hand side of
the balance sheet.
Balance Sheet Identity: Assets = Liabilities + Shareholders’ (Owner’s) Equity
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Net Working Capital - The difference between a firm’s current assets and its current liabilities.
Liquidity - Assets appear on the balance sheet in descending order of liquidity. Liability order
reflects time to maturity. It is important to point out that liquidity has two components: how long
it takes to convert to cash, and the value that must be relinquished to convert to cash quickly.
Any asset can be converted to cash quickly if you are willing to lower the price enough. It is also
important to point out that more-liquid assets also provide lower returns. Consequently, too
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much liquidity can be just as detrimental to shareholder wealth maximization as too little
liquidity. Trade-off between liquidity and profitability.
Debt versus Equity - Interest and principal payments on debt have to be paid before cash may be
paid to stockholders. The company’s gains and losses are magnified as the company increases
the amount of debt in the capital structure. This is why we call the use of debt financial leverage.
Shareholders’ Equity = Assets - Liabilities
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2.2
Market Value versus Book Value - Book values are generally not all that useful for making
decisions about the future because of the historical nature of the numbers. Also, some of the most
important assets and liabilities don’t show up on the balance sheet. For example, the people that
work for a firm can be very valuable assets, but they aren’t included on the balance sheet. This is
especially true in service industries. Accounting, or historical costs, are not very important to
financial managers, while market values are. After all, it is cash that must ultimately be paid or
received for investments, interest, principal, dividends, and so forth.
THE INCOME STATEMENT
Measures performance over a period of time. Revenues – Expenses = Income
EBIT = Earnings before interest and taxes: A financial measure defined as revenues less cost of goods sold and
selling, general, and administrative expenses. In other words, operating and nonoperating profit before the
deduction of interest and income taxes.
EBITDA = Earnings before interest, taxes, depreciation, and amortization: A financial measure defined as
revenues less cost of goods sold and selling, general, and administrative expenses. In other words, operating and
nonoperating profit before the deduction of interest and income taxes. Depreciation and amortization expenses
are not included in the costs. EBITDA measures the cash earnings that may be applied to interest and debt
retirement.
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2.3
GAAP and the Income Statement - GAAP requires that we recognize revenue when it is earned,
not when the cash is received, and we match costs to revenues. This introduces noncash
deductions such as depreciation and amortization. Consequently, net income is NOT the same as
cash flow.
Noncash Items - The largest noncash deduction for most firms is depreciation. It reduces a firm’s
taxes and its net income (but increases cash flow). Noncash deductions are part of the reason that
net income is not equivalent to cash flow.
Time and Costs - We need to plan for both short-run cash flows and long-run cash flows. In the
short-run, some costs are fixed regardless of output, and other costs are variable. In the long run,
all costs are variable. It is important to identify these costs when doing a capital budgeting
analysis. Product costs include raw materials, direct labor expense, and manufacturing overhead.
They are reported on the income statement as cost of goods sold. Period costs are reported as
selling, general, and administrative expenses.
Earnings Management - According to Healy and Wahlen (1999), "Earnings Management" occurs
when managers use judgement (“creative accounting”) in financial reporting and in structuring
transactions to alter financial reports to either mislead some stakeholders about the underlying
economic performance of a company or to influence contractual outcomes that depend on
reported accounting numbers.
TAXES
Tax Information For Businesses - http://www.irs.gov/businesses/index.html
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Corporate Tax Rates - Corporations do not pay a flat rate on their income, but rates are not
strictly increasing either.
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Average versus Marginal Tax Rates
The average rate rises to the marginal rate at $50 million of taxable income. The “surcharges” at
39% and 38% offset the initial lower marginal rates.
Example: Suppose taxable income is $150,000. What is the average tax rate and the marginal tax
rate?
.15(50,000) =
.25(25,000) =
.34(25,000) =
.39(50,000) =
Total
7,500
6,250
8,500
19,500
41,750
Average tax rate = 41,750 / 150,000 = 27.83%
Marginal tax rate = 39%
For purposes of computing a company’s total tax liability, the average tax rate is the correct rate to apply
to before-tax profits. However, in evaluating the cash flows that would be generated from a new
investment, the marginal tax rate is the appropriate rate to use. This is because the new investment will
generate cash flows that will be taxed in addition to the company’s existing profit.
2.4
CASH FLOW
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Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Stockholders
CFFA = Operating cash flow – net capital spending – changes in net working capital
Operating cash flow = EBIT + depreciation – taxes
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Net capital spending = ending fixed assets – beginning fixed assets + depreciation
Changes in NWC = ending NWC – beginning NWC
CFFA = Operating cash flow – net capital spending – changes in net working capital
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Cash Flow to Creditors and Stockholders
Cash flow to creditors = interest paid – net new borrowing = interest paid – (ending long-term
debt – beginning long-term debt)
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Cash flow to stockholders = dividends paid – net new equity raised = dividends paid – (ending
common stock, additional paid-in-capital, & Treasury stock – beginning common stock,
additional paid-in-capital, & Treasury stock)
It is important to point out that changes in retained earnings are not included in “net new equity
raised.”
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Cash flow summary
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