Financial Statements, Taxes, and Cash
Flows
CHAPTER TWO
Key Concepts and Skills
 Know the difference between book value and market value
 Know the difference between accounting income and cash
flow
 Know the difference between average and marginal tax rates
 Know how to determine a firm’s cash flow from its financial
statements
Chapter Outline
 The Balance Sheet
 The Income Statement
 Taxes
 Cash Flow
Balance Sheet
 The balance sheet is a snapshot of the firm’s 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
The Balance Sheet - Figure 2.1
Net Working Capital and Liquidity
 Net Working Capital

Current Assets – Current Liabilities

Positive when the cash that will be received over the next 12 months exceeds the cash
that will be paid out

Usually positive in a healthy firm
 Liquidity

Ability to convert to cash quickly without a significant loss in value

Liquid firms are less likely to experience financial distress

But liquid assets earn a lower return

Trade-off to find balance between liquid and illiquid assets
Building the balance sheet
 A firm has current assets of 100 SR, net fixed assets of
500 SR, short-term debt of 70 SR and long-term debt of
200 SR. what does the balance sheet look like? What is
shareholder’s equity? What is net working capital?
Ex 1 Page 41
 Penguin Pucks, Inc., has current assets of 5,100 $, net
fixed assets of 23,800 $ , current liabilities of 4,300$, and
long-term debt of 7,400 $. What is the value of the
shareholder’s equity account for this firm? How much is
net working capital?
Ex 16 page 42
 Prepare a 2009 balance sheet for Bertinelli Crop. Based
on the following information cash= 195,000 $ ; patents
and copy rights = 780,000 $ ; accounts payable= 405,000
$; accounts receivable= 137,000$ ; tangible net fixed assts
= 2,800,000 $; inventory= 264,000 ; notes payable=
160,000$ ; accumulated retained earnings= 1,934,000 $;
long-term debt= 1,195,300.
Market Vs. Book Value
 The balance sheet provides the book value 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?
 Which is more important to the decision-making process?
Income Statement
 The income statement is more like a video of the firm’s
operations for a specified period of time.
 You generally report revenues first and then deduct any
expenses for the period
 Matching principle – GAAP says to show revenue when it accrues
and match the expenses required to generate the revenue
Ex 15 Page 42
 Given the following information for Rosato Pizza Co.,
calculate the depreciation expense : sales= 41,000 $ ,
costs 19,500 $ , addition to retained earnings 5,100$ ,
dividend paid 1,500 $ , interest expense 4,500$, tax rate
35 percent.
US Corporation Income Statement – Table 2.2
Taxes
 The one thing we can rely on with taxes is that they are
always changing
 Marginal vs. average tax rates

Marginal tax rate – the percentage paid on the next dollar
earned

Average tax rate – the tax bill / taxable income
 Other taxes
Table 2.3
Corporate Tax Rates
Taxable income
Tax Rate
0- 50.000
%15
50.001- 75.000
25
75.001- 100.000
34
100.001 -335.000
39
335.001- 10.000.000
34
10.000.001 - 15.000.000
35
15.000.001- 18.333.333
38
18.333.334 +
35
EXAMPLES
 Suppose our corporation has a taxable income of 200,000
$ what is the tax bill?
 If the taxable income was 60.000 $ what is the tax bill?
 If the taxable income was 1.000.000$ what is the tax bill?
EXAMPLE 2.4
 ALGERNON, Inc. has a taxable income of 85.000 $. What
is the average tax rate? Its marginal tax rate?
EX 6&7 Page 41
 The Renata Co. had 236.000 $ in 2009 taxable income.
Using the rates from table 2.3 in the chapter, calculate
the company’s 2009 income taxes?
 What is the average tax rate? What is the marginal tax
rate?
Ex 18 Page 43
 (Refer to table 2.3) Corporation Growth has 88.000 $ in
taxable income, and corporation Income has 8.800.000 $
in taxable income.
A. What is the tax bill for each firm?
B. Suppose both firms have identified a new project that
will increase taxable income by 10.000$. How much in
additional taxes will each firm pay ?Why is this amount
the same?
The Concept of Cash Flow
 Cash flow is one of the most important pieces of
information that a financial manager can derive from
financial statements
 The statement of cash flows does not provide us with the
same information that we are looking at here
 We will look at how cash is generated from utilizing assets
and how it is paid to those that finance the purchase of the
assets
CASH FLOW FROM ASSETS

Cash Flow From Assets (CFFA) = Cash Flow to Creditors +
Cash Flow to Stockholders  CASH FLOW IDENTITY
1.
Operating Cash Flow (OCF)
2.
Capital Spending
3.
Change in Net Working Capital (NWC)
Assets
2008
U.S. CORPORATION
2008 AND 2009 Balance Sheets
($ in millions)
Liabilities and Owner’ s Equity
2009
2008
2009
Current Assets
Cash
Current liabilities
104
160
Accounts payable
232
266
Accounts receivable
455
668
Notes payable
196
123
Inventory
553
555
total
428
389
Total
1.112
1.403
1.644
1.709
Long-term debt
408
454
Common stocks and
paid-in surplus
600
640
Retained earnings
1320
1629
Total
1920
2269
Total liabilities and
owner’s equity
2756
3112
Fixed Assets
Net plant and
equipment
Owner’s equity
Total Assets
2756
3112
OCF
U.S CORPORATION
2009 Operating Cash Flow
EBIT
694
+ Depreciation
65
- Taxes
212
Operating Cash Flow
547
OCF = EBIT + DEP - TAXES
Capital Spending
Ending Net Fixed Assets
1709
- Beginning net fixed assets
1644
+ Depreciation
65
Net Capital Spending
130
Capital Spending = Ending net fixed assets - Beginning net fixed assets + Dep
•
If the firm didn’t purchase any new fixed assets
Capital Spending = Beginning net fixed assets - Dep
Change in Net Working Capital
Ending NWC
1014
- Beginning NWC
684
Change in NWC
330
Change in NWC = Ending NWC – Beginning NWC
Cash Flow From Assets
U.S CORPORATION
2009 Cash Flow From Assets
Operating Cash Flow
547
- Net capital spending
130
- Change in NWC
330
Cash Flow From Assets
87
Cash Flow From Assets = OCF– Net Capital Spending – Changes in NWC
Free Cash Flow
 Another name for cash flow from assets
 “Free” …… ??
Ex 8 Page 41
 So Long, Inc., has sales of 27500 $, costs of 13.280 $,
depreciation expense of 2.300 $ , and interest expense
of1.150 $. If the tax rate is 35 percent, what is the
operating cash flow, or OCF?
Ex 9 Page 41
 Earnhardt Driving School’s 2008ba;ance sheet showed net
fixed assets of 3.4 $ million, and the 2009 balance sheet
showed net fixed assets of 4.2 $ million. The company’s
2009 income statement showed a depreciation expense
of 385.000 $. What was net capital spending for 2009?
Ex 10 Page 42
 The 2008 balance sheet of Saddle Creek, Inc., showed
current assets of 2.100 $ and current liabilities of 1.380 $.
The 2009 balance sheet showed current assets of 2.250$
and current liabilities of 1.710 $. What was the company’s
2009 change in net working capital, or NWC?
EX 25 Page 44 (HW)
Sales
Depreciation
Cost of goods sold
Other expenses
Interest
Cash
Accounts receivable
Short-term notes payable
Long-term debt
Net fixed assets
Accounts payable
Inventory
Dividends
2008
7,233
1,038
2,487
591
485
3,792
5,021
732
12,700
31,805
3,984
8,927
882
2009
8,085
1,085
2,942
515
579
4,041
5,892
717
15,435
33,921
4,025
9,555
1,011
Tax rate
%34
%34
Cash Flow to Creditors & Stockholders
 It is the net payment to creditors and owners during the
year
U.S CORPORATION
2009 Cash Flow to Creditors
Interest paid
70
- Net new borrowing
46
Cash to creditors
24
Cash to creditors = Interest paid – Net new borrowing
Cash Flow to Creditors & Stockholders
U.S COROPORATION
2009 Cash Flow to Stockholders
Dividend paid
103
- Net new equity raised
40
Cash flow to stockholders
63
Cash flow to stockholders= dividend paid – New equity raised
Cash Flow Summary Table 2.5
Ex 11 Page 42
 The 2008 Balance sheet of Maria’s Tennis shop Inc,.
Showed long-term debt of 2.6 million. And the 2009
Balance sheet Showed long-term debt of 2.9 million. The
2009 Income statement showed an interest expense of
170.000. what was the firm’s cash flow to creditors?
Ex 12 Page 42
 The 2008 Balance sheet of Maria’s Tennis shop Inc,.
Showed 740.000 in the common stock account and 5.2
million in the additional paid-in surplus accounts . The
2009 balance sheet showed 815,000 and 5.5 million in
the same two accounts, respectively. If the company paid
out 490,000 in cash dividends during 2009, what was the
cash flow to stockholders for the year?
Example: Balance Sheet and Income Statement Information
 Current Accounts

2007: CA = 3625; CL = 1787

2006: CA = 3596; CL = 2140
 Fixed Assets and Depreciation

2007: NFA = 2194; 2006: NFA = 2261

Depreciation Expense = 500
 Long-term Debt and Equity

2007: LTD = 538; Common stock & APIC = 462

2006: LTD = 581; Common stock & APIC = 372
 Income Statement

EBIT = 1014; Taxes = 368

Interest Expense = 93; Dividends = 285
Example: Cash Flows
 OCF = 1,014 + 500 – 368 = 1,146
 NCS = 2,194 – 2,261 + 500 = 433
 Changes in NWC = (3,625 – 1,787) – (3,596 – 2,140) = 382
 CFFA = 1,146 – 433 – 382 = 331
 CF to Creditors = 93 – (538 – 581) = 136
 CF to Stockholders = 285 – (462 – 372) = 195
 CFFA = 136 + 195 = 331
 The CF identity holds.
EX 26 Page 44
calculate : CFFA, CF to creditors, and CF to stock holders
Sales
Depreciation
Cost of goods sold
Other expenses
Interest
Cash
Accounts receivable
Short-term notes payable
Long-term debt
Net fixed assets
Accounts payable
Inventory
Dividends
2008
7,233
1,038
2,487
591
485
3,792
5,021
732
12,700
31,805
3,984
8,927
882
2009
8,085
1,085
2,942
515
579
4,041
5,892
717
15,435
33,921
4,025
9,555
1,011
Tax rate
%34
%34
Review
 What is the difference between book value and market value?
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?
 What is the difference between average and marginal tax rates?
Which should we use when making financial decisions?
 How do we determine a firm’s cash flows? What are the
equations and where do we find the information?