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Chapter No 2
Financial Statements,
Taxes,
and Cash Flow
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Key Concepts and Skills
Know the difference between book
value and market value
Know the difference between average
and marginal tax rates
Know how to determine a firms cash
flow from its financial statements
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Chapter Outline
The Balance Sheet
The Income Statement
Taxes
Cash Flow
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Definitions
Balance sheet provides a snapshot of a firms
financial position at one point in time.
Income statement summarizes a firms
revenues and expenses over a given period of
time.
Statement of retained earnings shows how
much of the firms earnings were retained, rather
than paid out as dividends.
Statement of cash flows reports the impact of a
firms activities on cash flows over a given period
of time.
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The Balance Sheet
The balance sheet is a snapshot of the
firms assets and liabilities at a given
point in time.
Assets are listed in order of decreasing
liquidity
Ease of conversion to cash without
significant loss of value
Balance Sheet Identity
Assets = Liabilities + Stockholders Equity
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Figure 2.1
U.S. Corporation Balance Sheet
Table 2.1
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Market vs. Book Value
The balance sheet provides the book value
(initial) of the assets, liabilities, and equity.
Market value is 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?
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Klingon Corporation
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book
Market
Assets
NWC
NFA
$ 400
700
1,100
Book
Market
Liabilities and Shareholders
Equity
$ 600 LTD
1,000 Equity
1,600
$ 500
$ 500
600
1,100
1,100
1,600
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Income Statement
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It is the summary of performance of a specified
period
The income statement is more like a video of
the firms operations for a specified period of
time
You generally report revenues first and then
deduct expenses for the period
Matching principle Generally Accepted
Accounting Principle (GAAP) says to recognize
revenue when it is fully earned and match
expenses required to generate revenue to the
period of recognition
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U.S. Corporation Income Statement
- Table 2.2
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Example: Work the Web
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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 Electronic
Data Gathering, Analysis, and Retrieval
system (EDGAR)
Click on the web surfer, pick a company,
and see what you can find!
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Taxes
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A tax is a financial charges imposed
upon a taxpayer (an individual or legal
entity) by a state.
The one thing about taxes we can rely on
is that they will always be changing
Marginal vs. average tax rates
Marginal the percentage paid on the next
dollar earned
Average the tax bill / taxable income
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The Concept of Cash Flow
Cash flow is one of the most important
pieces of information that a financial
manager can derive from financial
statements
The statement of cash flows does not provide
us with the same information that we are
looking at here
We will look at how cash is generated from
utilizing assets and how it is paid to those
who finance the purchase of the assets
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Cash Flow From Assets
Cash Flow From Assets (CFFA) = Cash
Flow to Creditors + Cash Flow to
Stockholders
Cash Flow From Assets = Operating
Cash Flow Net Capital Spending
Changes in NWC
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CFFA
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Operating Cash Flow: Refers to the cash flow
that results from the firms day to day activities of
producing and selling.
Capital Spending: Refers to net spending on
fixed assets (purchases of fixed assets- sales of
fixed assets).
Change in the Networking Capital: is
measured net change in current assets relative
to current liabilities to the period.
Cash Flow to the Creditors and Stockholders: It
represent the net payments to creditors and
owners during the period.
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Example: U.S. Corporation
OCF (I/S) = EBIT + depreciation taxes = $547
NCS ( B/S and I/S) = ending net fixed assets
beginning net fixed assets + depreciation = $130
Changes in NWC (B/S) = ending NWC beginning
NWC = $330
CFFA = 547 130 330 = $87
CF to Creditors (B/S and I/S) = interest paid net
new borrowing = $24
CF to Stockholders (B/S and I/S) = dividends paid
net new equity raised = $63
CFFA = 24 + 63 = $87
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Table 2.5
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Example: Balance Sheet and
Income Statement Information
Current Accounts
2007: CA = $1,500; CL = $1,300
2008: CA = $2,000; CL = $1,700
Fixed Assets and Depreciation
2007: NFA = $3,000; 2008: NFA = $4,000
Depreciation expense = $300
LT Liabilities and Equity
2007: LTD = $2,200; Common Stock = $500; RE = $500
2008: LTD = $2,800; Common Stock = $750; RE = $750
Income Statement Information
EBIT = $2,700; Interest Expense = $200; Taxes = $1,000;
Dividends = $1,250
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Example: Cash Flows
OCF = $2,700 + $300 $1,000 = $2,000
NCS = $4,000 $3,000 + $300 = $1,300
Changes in NWC = ($2,000 $1,700) ($1,500
$1,300) = $100
CFFA = $2,000 $1,300 $100 = $600
CF to Creditors = $200 ($2,800 $2,200) =
- $400
CF to Stockholders = $1,250 ($750 $500) =
$1,000
CFFA = - $400 + $1,000 = $600
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Comprehensive Problem
Current Accounts
2007: CA = $4,400; CL = $1,500
2006: CA = $3,500; CL = $1,200
Fixed Assets and Depreciation
2007: NFA = $3,400; 2006: NFA = $3,100
Depreciation Expense = $400
Long-term Debt and Equity (R.E. not given)
2007: LTD = $4,000; Common stock & APIC = $400
2006: LTD = $3,950; Common stock & APIC = $400
Income Statement
EBIT = $2,000; Taxes = $300
Interest Expense = $350; Dividends = $500
Compute the CFFA
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