Chapter 2 Understanding Financial
Statements, Taxes, and Cash
Flows
09/02/08
Income Statement
SALES
- EXPENSES
= PROFIT
•Cost of Goods Sold
•Operating Expenses
(marketing, administrative)
•Financing Costs
•Taxes
SALES
Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
Three Important Issues
 Operating income is not affected by
how the firm is financed
 Interest is tax deductible
 Positive net income does not
necessarily mean it has any cash
Balance Sheet
Total Assets =
Outstanding
Debt
+
Shareholders’
Equity
Balance Sheet
Assets
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses
Fixed Assets
Machinery &
Equipment
Buildings and Land
Other Assets
Investments & patents
Liabilities (Debt) & Equity
Current Liabilities
Accounts Payable
Accrued Expenses
Short-term notes
Long-Term Liabilities
Long-term notes
Mortgages
Equity
Preferred Stock
Common Stock (Par
value)
Paid in Capital
Retained Earnings
Assets
 Current Assets: assets that are
relatively liquid, and are expected to be
converted to cash within a year.
 Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
 Fixed Assets: machinery and
equipment, buildings, and land.
 Other Assets: any asset that is not a
current asset or fixed asset.
 Intangible assets, such as patents and
copyrights.
Financing
 Debt Capital: financing provided by a
creditor.
 Short-term debt: borrowed money that
must be repaid within the next 12
months.
 Accounts payable, other payables such as
interest or taxes payable, accrued
expenses, short-term notes.
 Long-term debt: loans from banks or
other sources that lend money for
longer than 12 months.
Financing
 Equity Capital: shareholders’
investment in the firm.
 Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of
liquidation of the firm.
 Common Stockholders: residual
owners of a business. They receive
whatever is left after creditors and
preferred stockholders are paid.
Common Equity
 In balance sheet
common equity = common stock (par
value + paid-in capital – treasury stock)
+ retained earnings
Common Equity
 Example
12/31/01 12/31/02
Common (par value) 3,000
3,200
Paid in capital
350,000
380,000
Retained earnings 1,800,000
?
Treasury stock
420,000
480,000
Total common equity 1,733,000
?
Dividend Paid 2002: 70,000
2002 net income: 570,000
Free Cash Flows
Free cash flow: cash flow that is free and
available to be distributed to the firm’s
investors (both debt and equity investors).
Free Cash Flows
Cash Flows from
Assets
Cash flows generated
through the firm’s
assets
=
=
Cash Flows from
Financing
Cash flows paid to - or
received from - the
firm’s investors
(creditors &
stockholders)
Calculating Free Cash Flows:
An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Operating income
+ depreciation
- cash tax payments
Calculating Free Cash Flows:
An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
[Change in current
assets]
-
[change in non-interest
bearing current liabilities]
Calculating Free Cash Flows:
An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Change in gross
fixed assets, and
any other assets
that are on the
balance sheet.
Calculating Free Cash Flows:
A Financing Perspective
Interest payments to creditors
=
-
change in debt principal
-
dividends paid to stockholders
-
change in stock
Financing Free Cash Flows
Taxes
 Marginal tax rate: the tax rate that
would be applied to the next dollar of
taxable income
 Average tax rate: taxes owned by a firm
divided by the firm’s taxable income
 Always marginal
Corporate Income Tax Rates
Since 1993
Taxable Income
$1 - $50,000
$50,001 - $75,000
$75,001 - $100,000
$100,001 - $335,000
$335,001 - $10,000,000
$10,000,001 - $15,000,000
$15,000,001 - $18,333,333
over $18,333,333
Corporate Tax Rate
15%
25%
34%
39%
34%
35%
38%
35%
Corporate Income Tax Rates
 Example
(1) find the taxable income
(2) Suppose we have a taxable income of
90,000
50,000 * 15% = 7,500
(75,000 – 50,000) * 25% = 6,250
(90,000 – 75,000) * 34% = 5,100
tax : 7,500 + 6,250 + 5,100 = 18,850
 Space Cow Computer has sales of $32
million, cost of goods sold at 60% of
sales, cash operating expenses of $2.4
million, and $1.4 million in
depreciation expense. The firm has $12
million in 9.5% bonds outstanding.
The firm will pay $500,000 in dividends
to its common stock holders.
 Calculate the firm’s tax liability.