Chapter 2
Financial
Statements,
Taxes and
Cash Flow
6-1
2-1
Chapter Objectives
 Understand
the difference between book value
(from the Balance Sheet) and market value.
 Understand
the difference between net profit
(from the Income Statement) and cash flow.
 Explain
the differences between the average
tax rate, the marginal tax rate and the flat rate.
 Explain
the calculation of cash flow from
assets, and cash flow to debt-holders and
shareholders.
6-2
2-2
The Balance Sheet
summary of a firm’s financial position
on a given date that shows total assets =
total liabilities + owners’ equity.
A
 Equation:
Assets = Liabilities + Owners’/Shareholders’ Equity.
working capital = Current Assets –
Current Liabilities.
 Net
6-3
2-3
Petro Rabighs’ Balance
Sheet (Asset Side)
Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014a
Cash and C.E.
$ 90
Acct. Rec.c
394
Inventories
696
Prepaid Exp d
5
Accum. Tax Prepay
10
Current Assetse $1,195
Fixed Assets (@Cost)f 1030
Less: Acc. Depr. g
(329)
Net Fix. Assets $ 701
Investment, LT
50
Other Assets, LT
223
Total Assets b $2,169
6-4
2-4
a. How the firm stands on
a specific date.
b. What BW owned.
c. Amounts owed by
customers.
d. Future expense items
already paid.
e. Cash/likely convertible
to cash within 1 year.
f. Original amount paid.
g. Acc. deductions for
wear and tear.
Petro Rabighs’ Balance
Sheet (Liability Side)
Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014
Notes Payable
Acct. Payablec
Accrued Taxes d
Other Accrued Liab. d
Current Liab. e
Long-Term Debt f
Shareholders’ Equity
Com. Stock ($1 par) g
Add Pd in Capital g
Retained Earnings h
Total Equity
Total Liab/Equitya,b
6-5
2-5
$ 290
94
16
100
$ 500
530
a. Note, Assets =
Liabilities + Equity.
b. What BW owed and
ownership position.
c. Owed to suppliers for
goods and services.
d. Unpaid wages,
200
salaries, etc.
729 e. Debts payable < 1 year.
210 f. Debts payable > 1 year.
$1,139 g. Original investment.
$2,169 h. Earnings reinvested.
Market Value versus
Book Value
 Book
value refers the price that never change
as long as you own the asset. Example: if you
bought a house 10 years ago for 300,000SAR,
its book value for your entire period of
ownership will remain 300,000SAR
 Market
value refers the price that could be
obtained in the current market place. Example:
if the price of that house after 10 years is
350,000SAR then it is called market value.
6-6
2-6
The Income Statement
summary of a firm’s revenues and expenses
over a specified period, ending with net income
or loss for the period.
A
Equation: Revenues – Expenses = Profit.
 Profit
is often expressed on a per-share
basis and called earnings per share (EPS).
 The
difference between net profit and cash
dividends is called retained earnings, which
is added to the retained earnings account in
the Balance Sheet.
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2-7
Example—Income
Statement of Petro Rabigh
Revenue
Cost of Goods Sold
Depreciation
EBIT(Earnings Before Interest & Tax )
Interest
Taxable Income (EBT)
Tax
Net Profit (EAT)
Dividends
Addition to R/E
6-8
2-8
$4 000
2 800
200
1 000
200
800
240
$560
260
$300
Taxes
Can
be one of the largest cash
outflows that a firm experiences.
The
size of the tax bill is
determined by the Income Tax
Assessment Act.
The
Tax Act is the result of
political, not economic, forces.
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2-9
Tax rates
 The
average tax rate is the total tax bill
divided by taxable income; that is, the
percentage of income that goes in taxes.
 The
marginal tax rate is the extra tax paid if
one more dollar is earned.
A
flat rate is where there is only one tax rate
that is the same for all income levels.
 It
is the marginal rate that is relevant for
most financial decisions.
6-10
2-10
Tax System in Saudi Arabia
Types
Tax rate
Personal rates
Company Rate
Foreigner Shareholders
Saudi Shareholders
Both Saudi & Non-Saudi (natural gas sector)
Both Saudi & Non-saudi (production of oil and
Nil
Flat Rate
20%
2.5%
30%
85%
hydrocarbons )
6-11
Cash Flow from Assets
 Equation:
Cash flow from assets = cash flow to
debt-holders + cash flow to shareholders.
 The
cash flow identity or equation states
that the cash flow from the firm’s assets
is equal to the cash flow paid to suppliers
of capital to the firm.
6-12
Cash Flow from Assets
The total cash flow from assets = operating
cash flow – net capital spending on noncurrent assets- addition to net working capital
6-13

Operating cash flow: the cash flow that results from day-to-day
activities of producing and selling. Earnings before interest
and taxes (EBIT) + Depreciation – Taxes.

Net capital spending: Ending non-current assets – Beginning
non-current assets + Depreciation..

Additions to net working capital (NWC): Ending NWC –
Beginning NWC.
Cash Flow to Debt-holders
and Shareholders
The
cash flow to debt-holders
includes any interest paid less
the net new borrowing.
The
cash flow to shareholders
includes dividends paid out by a
firm less net new equity raised.
6-14
Example―Balance Sheet
($000s)
Assets (‘000s)
Current assets
Cash
Accounts receivable
Inventory
Total
Non-current assets
Net plant and equipment
TOTAL ASSETS
6-15
2006
2007
$
90
520
640
$ 1 250
$
100
620
770
$ 1 490
1 970
2 200
$3 220
$3 690
Example―Balance Sheet
($000s)
Liabilities and equity (‘000s)
2006
2007
$
420
220
$ 640
$
Long-term debt
$ 410
$ 450
Shareholders’ equity
Ordinary shares
Retained earnings
Total
TOTAL LIABILITIES AND EQUITY
580
1 590
$2 170
$3 220
580
1 790
$2 370
$3 690
Current liabilities
Accounts payable
Notes payable
Total
6-16
520
350
$ 870
Example―Income Statement
($000s)
Sales
$1 420.00
Cost of goods sold
960.00
Depreciation
60.00
EBIT
$400.00
Interest
40.00
Taxable income
360.00
Tax
108.00
Net profit
$252.00
Dividends
52.00
Addition to retained earnings
$200.00
6-17
Example―Cash Flow From
Assets ($000s)
6-18
Operating cash flow:
EBIT
+ Depreciation
– Taxes
$ 400.00
+ 60.00
– 108.00
$352.00
Change in net working capital:
Ending net working capital
– Beginning net working capital
$ 620.00
610.00
$ 10.00
Net capital spending:
Ending non-current assets
$ 2 200.00
– Beginning non-current assets
– 1 970.00
+ Depreciation
+
60.00
$290.00
Cash flow from assets:
$ 52.00
Example―Cash Flow to Debtholders and Shareholders
($000)
Cash flow to debtholders:
Interest paid
– Net new borrowing (450-410)
Cash flow to shareholders:
Dividends paid
– Net new equity raised (580-580)
$
–
40.00
40.00
$ 0.00
$
52.00
0.00
$52.00
Cash flow to debtholders and shareholders
6-19
$52.00
Summary and Conclusions

The book values on an accounting Balance Sheet can be
very different from market values.

Net profit as it is computed on the Income Statement is
not a cash flow, a primary reason being the deduction of
depreciation (a non-cash expense).

Marginal and average tax rates can be different.
However it is the marginal tax rate that is relevant for
most financial decisions.

Cash flow from assets equals cash flow to debt-holders
and shareholders.

It is important not to confuse book values with market
values, and accounting income with cash flow.
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