Financial statements, taxes and
cash flow
Chapter 2
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
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Chapter outline
• The balance sheet
• The income statement
• Taxes
• Cash flow
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The balance sheet
• The balance sheet is a snapshot of a firm’s assets and
liabilities at a given point in time.
• Assets: The left-hand side:
− Current or fixed
− In order of decreasing liquidity
• Liabilities and owners’ equity: The right-hand side:
– Current or long term
– In ascending order of when due to be paid
• Balance sheet identity
Assets = Liabilities + Shareholders’ equity
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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The balance sheet (cont.)
Figure 2.1
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The balance sheet (cont.)
• 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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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Oz Company balance sheet
Table 2.1
Visit au.finance.yahoo.com for more
financial statements and balance sheets
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Market value vs book value
• Market value is the price at which assets,
liabilities or equity can actually be bought
or sold.
• The balance sheet provides the book value
of assets, liabilities and equity.
• Market value and book value are often very
different. Why?
• Which is more important to the decisionmaking process?
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Battler Company
Example 2.2
Battler Company
Balance sheets
Book value versus market value
Book
Market
400
NFA
700
$1 100
Market
Liabilities and Shareholders’
equity
Assets
NWC
Book
600 LTD
1 000 SE
$1 600
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500
500
600
1 100
$1 100
$1 600
2-9
The 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
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
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OZ Company income statement
Table 2.2
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The income statement (cont.)
• AAS and the income statement
– The matching principle
• Recognise revenue when it is fully earned.
• Matching expenses required to generate
revenue to the period of recognition
• Non-cash items
– Expenses charged against revenue that do
not affect cash flow.
– Most important of these is depreciation.
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The income statement (cont.)
• Time and costs
– Fixed or variable costs
– Not obvious on income statement
• Earnings management
–Smoothing earnings
–Wriggle room
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Example: Work the Web
• Most Australian companies post their
annual reports on their websites. Look for
them in the investor or shareholder areas.
• Go to companies’ websites and see what
kinds of financial reports you can find.
• Example: Virgin Blue
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Taxes
• The one thing we can rely on with taxes is that they
are always changing.
• Tax bill depends on tax code, which can be
amended by political will.
• Corporate tax in Australia and New Zealand
– Flat rate tax (currently 30%)
• Marginal vs average tax rates
– Marginal–the percentage paid on the next dollar
earned
– Average–the tax bill/taxable income
• Other taxes
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Personal tax rates (2009/2010)
Table 2.3
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Example: Marginal vs average tax
rates
• Bony Bushman has a taxable income in
Australia of $96 000.
– What is his tax bill?
– What is his average tax rate ?
– What is his marginal tax rate?
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Example: Marginal vs average tax
rates
Personal tax rate
Taxable income
Rate
$0-6000
Nil
6001-35000
15%
35001-80000
30%
80001-180000
38%
18000145%
Total
Average tax rate
Marginal tax rate
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Tax calculation
Taxable income
Tax liability
6000
0
29000
4350
45000
13500
16000
6080
96000
23930
24.9270833%
38%
2-18
Taxation of dividends:
An imputation system
• Major effect is that the double taxation of
company profits is negated.
• Company advises the shareholder of the
amount of company tax already paid on the
dividend.
• Shareholder then adds this amount of tax to
the cash dividend that they have received and
pays personal tax on the grossed-up amount.
• Shareholder receives a tax (franking) credit
equivalent to the amount of tax paid by the
company.
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Effect of a $700 dividend fully franked
at 30% tax rate—Example 2.5
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Cash flow
• Cash flow is some of the most important information that
a financial manager can derive from financial statements.
• The difference between the number of dollars that come
in and the number that go out.
• The statement of cash flows does not provide us with the
same information that we are looking at here.
• Cash flow identity
Cash flow from assets = Cash flow to creditors + Cash
flow to shareholders
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Cash flow (cont.)
• Cash flow from assets = Operating cash flow – Net
capital spending – Changes in net working capital.
• Operating cash flow
– Cash generated from a firm’s normal business
activities
• Capital spending
– Money spent on fixed assets less money received from
the sale of fixed assets
• Change in net working capital
– Net increase in current assets over current liabilities
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Cash flow (cont.)
• Free cash flow
– Different from cash flow from assets
– Cash that the firm is free to distribute to creditors
and shareholders because it is not needed for
working capital or fixed asset investments
• Cash flow to creditors
– A firm’s interest payments to creditors less net
new borrowings
• Cash flow to shareholders
– Dividends paid out by a firm less net new equity
raised
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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OZ Company example
• 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 borrowings = $24
• CF to stockholders (B/S and I/S) = Dividends paid –
Net new equity raised = $63
• CFFA = 24 + 63 = $87
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Cash flow summary
Table 2.5
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Quick quiz
• 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?
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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Quick quiz (cont.)
• 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?
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Apple Isle example
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Apple Isle (cont.)
Operating cash flow
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Apple Isle (cont.)
Cash flow from assets, cash flow to stockholders
and creditors
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Chapter 2
END
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