Because learning changes everything.

Chapter 02
Financial Statements,
Taxes, and Cash Flow

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 Key Concepts and Skills
After studying this chapter, you should be able to:
• Differentiate between accounting value (or “book” value)
and market value.
• Distinguish accounting income from cash flow.

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• Explain the difference between average and marginal tax
rates.
• Determine a firm’s cash flow from its financial statements.

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 Chapter Outline
2.1 The Balance Sheet.
2.2 The Income Statement.
2.3 Taxes.
2.4 Cash Flow.

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 The Balance Sheet 1

A snapshot of the firm’s assets and liabilities at a given point

in time (“as of …”).
Assets.
• Left-hand side (or upper portion).

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• In order of decreasing liquidity.
Liabilities and Owners’ Equity.
• Right-hand side (or lower portion).
• In ascending order of when due to be paid.
Balance Sheet Identity.
• Assets = Liabilities + Stockholders’ Equity.

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 The Balance Sheet 2

Access the text alternative for slide images.

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 The Balance Sheet 3

Net working capital.

• Current assets minus current liabilities.
• Usually positive for a healthy firm.

Liquidity.
• Speed and ease of conversion to cash without significant
loss of value.
• Valuable in avoiding financial distress.

Debt versus Equity.

• Shareholders’ equity = Assets − Liabilities.

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 U.S. Corporation Balance Sheet
Table 2.1 Balance sheets for U.S. Corporation.

U.S. Corporation
Balance Sheets as of December 31, 2021 and 2022 (in millions)

2021 2022 2021 2022

Assets Liabilities and Owners’ Equity

Current Assets Current liabilities

Cash $ 104 $ 160 Accounts payable $ 232 $ 266

Accounts 455 688 Notes payable 196 123

Receivable

Inventory 553 555 Total $ 428 $ 389

Total $ 1,112 $ 1,403

Fixed assets

Net fixed $ 1,644 $ 1,709 Long-term debt $ 408 $ 454

assets

Owners’ equity

Common stock and paid-in surplus 600 640

Retained earnings 1,320 1,629

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 Market Versus Book Value
Book value = the balance sheet value of the assets,
liabilities, and equity.
Market value = true value; the price at which the assets,
liabilities, or equity can actually be bought or sold.
• Market value and book value are often very different.
Why?
• Which is more important to the decision-making
process?

Return to Quiz

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 Klingon Corporation 1

Example 2.2 Market versus Book Values

The Klingon Corporation has fixed assets with a book value of
$700 and an appraised market value of about $1,000. Current
assets are $400 on the books, but approximately $600 would be
realized if they were liquidated. Klingon has $500 in long-term
debt, both book value and market value, and no current liabilities
of any kind. What is the book value of the equity? What is the
market value?
We can construct two simplified balance sheets, one in accounting
(book value) terms and one in economic (market value) terms:

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 Klingon Corporation 2

Klingon Corporation
Balance Sheets
Market Value versus Book Value
Book Market Book Market

Assets Liabilities and Shareholders’ Equity

Current assets $ 400 $ 600 Long-term debt $ 500 $ 500
Net fixed assets 700
$1,100
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1,000
$1,600
Shareholders’ equity 600
$1,100
1,100
$1,600

In this example, shareholders’ equity is actually worth almost twice as

much as what is shown on the books. The distinction between book and
market values is important precisely because book values can be so
different from true economic values.

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 Income Statement
The income statement measures performance over a
specified period of time (period, quarter, year).
Report revenues first and then deduct any expenses for the
period.
End result = Net income = “Bottom line.”
• Dividends paid to shareholders.
• Addition to retained earnings.
Income statement equation:
• Net income = Revenue − Expenses.

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 U.S. Corporation Income Statement
Table 2.2 Income statement for U.S. Corporation
U.S. Corporation
2022 Income Statement
(in millions)
Net Sales $1,509
Cost of goods sold 750
Depreciation 89
Earnings before interest and taxes $ 670
Interest paid 70
Taxable income $ 600
Taxes (21%) 126
Net income $ 474
Dividends $165
Addition to retained earnings 309
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 Financial Statements 1

GAAP Matching Principle.

• Recognize revenue when it is fully earned.
• Match expenses required to generate revenue to the period
of recognition.
Noncash Items.
• Expenses charged against revenue that do not affect cash
flow.
• Depreciation = most important.

Return to Quick Quiz

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 Financial Statements 2

Time and Costs.

• Fixed or variable costs.
• Not obvious on income statement.

Earnings Management.
Smoothing earnings.
GAAP leaves “wiggle room.”
Global standardization of accounting.
• GAAP versus IFRS.
• Information about IFRS can be found at this link.

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 Example: Work the Web
Publicly traded companies must file regular reports with
the Securities and Exchange Commission.
These reports are usually filed electronically and can be
searched at the SEC public site called EDGAR.
Click on this link, pick a company, and see what you can
find!

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 Taxes
Marginal versus Average tax rates.
• Marginal – percent tax paid on the next dollar earned.
• Average – total taxes paid divided by taxable income.
• If considering a project that will increase taxable income
by $1 million, which tax rate should you use in your
analysis?
Information about IFRS can be found at this link.

Return to Quick Quiz

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 Corporate Tax Rates
Following the passage of the Tax Cuts and Jobs Act of 2017,
the federal corporate tax rate in the United States became a
flat 21 percent for corporations.

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 Example: Marginal Versus Average Rates
Suppose you are single and your personal taxable income is
$100,000.
What is your tax bill?
What is the average tax rate?
What is the marginal rate?

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 Tax on $100,000

.10($9,950) = $ 995.00
.12($40,525 − 9,950) = 3,669.00
.22($86,375 − 40,525) = 10,087.00
.24($100,000 − 86,375) = 3,270.00
$18,021.00

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 Average & Marginal Tax Rates
The tax bill is $18,021 on $100,000 of taxable income. The
average tax rate is
$18,021/ $100,000 = .1802, or 18.02%.
If you made one more dollar, you would pay 24 cents in tax,
so the marginal tax rate is 24 percent.

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 The Concept of Cash Flow
Cash flow = one of the most important pieces of information
that can be derived from financial statements.
The accounting Statement of Cash Flows does not provide
the same information that we are interested in here.
Our focus: how cash is generated from utilizing assets and
how it is paid to those who finance the asset purchase.

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 Cash Flow from Assets
Cash Flow From Assets (CFFA)
= Operating Cash Flow (OCF)`

− Net Capital Spending (NCS)

− Changes in NWC (ΔNWC ).
Cash Flow From Assets (CFFA)
= Cash Flow to Creditors (CF/CR )
+ Cash Flow to Stockholders (CF/SH ).

Return to Quick Quiz

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 Example: U.S. Corporation 1

Balance Sheet U.S Corporation

Asset Liabilities & Income Statement
s Owners’ Equity
Net sales $
2021 2022 2021 2022 1,509
Current Current Liabilities Cost of goods sold 750
Assets
Depreciation 89
Cash $ $ Accounts $ 232 $ 266
104 160 Payable Earnings before interest $
and taxes 670
Accounts 455 688 Notes Payable 196 123
Receivab Interest paid 70
le Taxable Income $
Inventory 553 555 Total $ 428 $ 389 600

Total $1,112 $1,40 Long-term debt $ 408 $ 454 Taxes (21%) 126
3 Net Income $
Fixed Owners' Equity 474
Assets Dividends $165
Net Fixed $1,644 $1,70 Common 600 640 Addition to retained $309
assets 9 Stock and earnings
paid-in surplus

Retained 1,320 1,629

earnings
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 Example: U.S. Corporation 2

CFFA = OCF – NCS – ΔNWC.

OCF = EBIT + Depreciation – Taxes
= $670 + 89 − 126 = $633
NCS = Ending net FA − Beginning net FA + Depreciation
= $1,709 − 1,644 + 89 = $154
ΔNWC = Ending NWC − Beginning NWC
= ($1,403 − 389) − ($1,112 − 428) = $330
CFFA = 633 − 154 − 330 = $149

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 Example: U.S. Corporation 3

Balance Sheet U.S Corporation

Asset Liabilities & Owners’ Income Statement
s Equity
Net sales $
2021 2022 2021 2022 1,509
Current Current Liabilities Cost of goods sold 750
Assets
Depreciation 89
Cash $ $ Accounts Payable $ $
104 160 232 266 Earnings before interest $
and taxes 670
Accounts 455 688 Notes Payable 196 123
Receivab Interest paid 70
le
Taxable Income $
Inventory 553 555 Total $ $ 600
428 389
Taxes (21%) 126
Total $1,112 $1,40 Long-term debt $ $
Net Income $
3 408 454
474
Fixed Owners' Equity
Dividends $165
Assets
Addition to retained $309
Net Fixed $1,644 $1,70 Common Stock and 600 640
earnings
assets 9 paid-in surplus

Retained earnings 1,320 1,629

Total $1,92 $2,26

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 Example: U.S. Corporation 4

CFFA = CF/CR + CF/SH

CF/CR = interest paid − Net new borrowing
= $70 − ($454 − 408) = $24
CF/SH = Dividends paid − Net new equity
= $165 − ($640 − 600) = $125
CFFA = $24 + $125= $149

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 Table 2.4 1

I. The cash flow II. Cash flow from assets.

identity. Cash flow from assets = Operating cash flow
Cash flow from assets = − Net capital spending
Cash flow to creditors
− Change in net working capital (NW
(bondholders) + Cash flow
C)
to stockholders (owners)
where
Operating cash flow = Earnings before
interest and taxes (EBIT) + Depreciation
− Taxes
Net capital spending = Ending net fixed
assets − Beginning net fixed assets +
Depreciation
Change in NWC = Ending NWC − Beginning NWC

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 Table 2.4 2

IIII. Cash flow to creditors IV. Cash flow to stockholders

(bondholders). (owners).
Cash flow to creditors = Cash flow to stockholders =
Interest paid − Net new Dividends paid − Net new equity
borrowing raised
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 Quick Quiz 1

What is the difference between book value and market

value? (Slide 2.8)
• Which should we use for decision making purposes?

What is the difference between accounting income and cash

flow?
• Which do we need to use when making decisions? (Slide
2.13)

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 Quick Quiz 2

What is the difference between average and marginal tax

rates?
• Which should we use when making financial decisions?
(Slide 2.16)
How do we determine a firm’s cash flows?
• What are the equations and where do we find the
information? (Slide 2.22)

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 Dole Cola Example
Dole Cola
2022 Income Statement
Net Sales $600
Cost of goods sold 300
Depreciation 150
Earnings before interest and $ 150
taxes
Interest paid 30
Taxable income $ 120
Taxes 25
Net income $ 95
Dividends $30
Addition to retained earnings 65

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 Dole Cola Operating Cash Flow
Dole Cola
2022 Operating Cash Flow

Earnings before interest and taxes $150

+ Depreciation 150
− Taxes 25
Operating cash flow $275

Dole Cola
2022 Operating Cash Flow

Ending Net Fixed Assets $750

− Beginning Net Fixed Assets 500
+ Depreciation 150
$400

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 Dole Cola Net Capital Spending & Change in
Net Working Capital
Dole Cola
2022 Operating Cash Flow

Ending Net Fixed Assets $750

− Beginning Net Fixed Assets 500

+ Depreciation 150
$400
Dole Cola
2022 Change in Net Working Capital

2022 Current Assets $2,260

2022 Current Liabilities $1,710

2022 Net Working Capital $ 550
2021 Current Assets $2,130
2021 Current Liabilities $1,620
2021 Net Working Capital $ 510
Change in Net Working Capital $ 40

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 Dole Cola Cash Flow from Assets – Option 1
Dole Cola
2022 Cash Flow from Assets

Operating cash flow $ 275

− Net capital spending 400
− Change in NWC 40
Cash flow from assets −$165

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 Dole Cola CFFA – Option 2
Dole Cola
2022 Change in Net Working Capital

2022 Current Assets $ 2,260

2022 Current Liabilities $1,710
2022 Net Working Capital $ 550
2021 Current Assets $2,130
2021 Current Liabilities $1,620
2021 Net Working Capital $ 510
Change in Net Working Capital $ 40
Dole Cola
2022 Cash Flow from Assets

Operating cash flow $ 275

− Net capital spending 400
− Change in NWC 40
Cash flow from assets −$165

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 Dole Cola Cash Flow to Stockholders &
Creditors
Dole Cola
2022 Income Statement

Net sales $600

Cost of goods sold 300
Depreciation 150
Earnings before interest and $150
taxes
Interest paid 30
Taxable income $120
Taxes 25
Net income $ 95

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 Dole Cola Cash Flow to Creditors
Dole Cola
2014 Cash Flow to Creditors
Interest paid $ 30
− Net new borrowing 225
Cash flow to creditors −$195

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