Chapter 2
Financial Statements,
Taxes, and Cash Flow
Copyright © 2012 McGraw-Hill Education. All rights reserved.
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
• Understand the different point of view
between accounting and finance
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Chapter Outline
•
•
•
•
•
The Balance Sheet
The Income Statement
Taxes
Cash Flow
Accounting versus Finance
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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
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The Balance Sheet - Figure
2.1
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Net Working Capital and
Liquidity
• Net Working Capital (NWC)
– = 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 typically earn a lower return
Trade-off to find balance between liquid and illiquid assets
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US Corporation Balance Sheet
– Table 2.1
Place Table 2.1 (US Corp Balance Sheet)
here
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Debt versus Equity
- If the firm sells its assets and pays its debts,
whatever cash is left belongs to the
shareholders.
- The use of debt in a firm’s capital structure
is called “financial leverage”.
- Financial leverage increases the potential
reward to shareholders but it also increases
the potential for financial distress and
business failure.
Market Value vs. Book Value
• The balance sheet provides the book value of the
assets, liabilities, and equity.(historical cost)
• 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. For current assets they might be similar
because current asset a are bought and
converted into cash over a relatively short span of
time.
For fixed assets , it would be a coincidence.
• The market value of an asset depends on things
like its riskiness and cash flows.
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Market Value vs. Book Value
• Which is more important to the decisionmaking process?
• Managers and investors will frequently be
interested in knowing the value of the firm.
This information is not on the balance
sheet. (assets are listed at cost, most of
the valuable assets a firm might have don’t
appear on the balance sheet at all, the true
value of the stock is reflected in the
stockholders’ equity).
Market Value vs. Book Value
• For financial mangers, the accounting
value of the stock is not an especially
important concern; it is the market value
that matters.
• Hence, the distinction between book
and market values is important precisely
because book values can be so
different from the true economic value.
Example 2.2 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 SE
1,600
$ 500
$ 500
600
1,100
1,100
1,600
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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
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US Corporation Income
Statement – Table 2.2
Insert new Table 2.2 here (US Corp Income
Statement)
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Income Statement
• When looking at an income statement, the
financial manger needs to keep 3 things in
mind:
• 1) GAAP and the income statement
(recognition or realization principle: to
recognize revenue when the earnings
process is virtually complete and the value
of an exchange of goods or services is
known or can be reliably determined. It is
the time of sale not collection)
Income Statement
2) Non cash items: “Expenses charged
against revenues that do not directly affect
cash flow, such as depreciation.”
Matching principle in accounting: the
accountant seeks to match the expense of
purchasing the asset with the benefits
produced from owning it.
Income Statement
3) Time and costs: The distinction has to
do with whether costs are fixed or variable.
In the long run, all business costs are
variable. Given sufficient time, assets can
be sold, debts can be paid, and so on.
Taxes
• The one thing we can rely on with taxes is that
they are always changing (largest cash outflows
the firm may experience)
• Marginal vs. average tax rates
– Marginal tax rate – the percentage paid on the next
dollar earned
– Average tax rate – the tax bill / taxable income
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Taxes
• Other taxes
Interest and dividend income is either taxed
at a flat rate or added to the general income
and tax at the margin.
The longer the holding period of the
investment the lower the applicable tax rate.
The idea is to discourage short-term trading
activities which are generally blamed for
heightened financial market volatility.
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
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The Concept of Cash Flow
• “means the difference between the number
of dollars that came in and the number that
went out.”
• Cash flow identity:
Cash flow from assets = Cash flow to
creditors + Cash flow from to stockholders
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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Cash Flow From Assets
1) Operating Cash Flow (OCF): “ Cash
generated from a firm’s normal business
activities.” [Revenues – Costs ]
• Include: taxes ( paid in cash)
• Does not include: depreciation (not cash
outflow) and interest (financing expense)
• A negative OCF is often a sign of trouble.
Cash Flow From Assets
2) Capital Spending: money spend on fixed
assets less money received from the sale of
fixed assets.
• It can be negative if the firm sold off more
assets than it purchased.
Cash Flow From Assets
3) Change in Net Working Capital: investing
in current assets ( current liabilities will
usually change as well.)
Change in NWC = Ending NWC – Beginning
NWC
Cash Flow From Assets
• Cash Flow From Assets = Operating cash
flow – the amounts invested in fixed assets
and net working capital
• A negative cash flow means that the firm
raised more money by borrowing and
selling stock than it paid out to creditors
and stockholders during the year
Cash Flow Summary Table 2.6
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Accounting versus Finance: A
Different Point of View
• A profitable project should generate a
return in excess of the cost of capital
needed to pursue it.
• Only investments above that rate will create
value and lead to an increase in the
company’s share price.
• Cost of capital is the weighted average of
its capital components, i.e. the cost of
equity, the cost of debt and the respective
weights.
Accounting versus Finance: A
Different Point of View
• Cost of equity: The cost of debt is indicated
in the income statement in form of the interest
expense, which reduces a company’s taxable
income. The only indication of a cash flow to
shareholders is given in the income
statement in form of the dividend payment.
However, the dividend payment s are
discretionary because they determined by the
financial management based on cash
availability and investment policy.
Accounting versus Finance: A
Different Point of View
• From the accountant’s view the equity is costless
while the financial manager sees it more costly
than debt for a variety of reasons:
1- Equity is junior to debt in the event of
bankruptcy.
2- The level of cash flow uncertainty during
the investment period is higher for equity as
neither the dividend size nor timing is known
in advance opposite to corporate bond.
Accounting versus Finance: A
Different Point of View
3- the price fluctuation of stock prices
(volatility) is more pronounced than that of
bonds prices.
• The combination of these factors makes a
stock investment significantly more risky
than a bond investment. As a
consequence, equity investors would
require a higher return to compensate for
the higher level of risk.
Accounting versus Finance: A
Different Point of View
• It is important to understand that the
investor’s required rate of return is the cost
of capital to the company. Therefore, a
company’s cost of equity is inherently
more costly than its cost of debt. To
determine the profitability of a project, it is
crucial for the financial manger to
incorporate both the cost of debt and the
cost of equity.
Accounting versus Finance: A
Different Point of View
• Timing of cash flows: the matching principle
is a poor guide for the financial manager in
determining a company’s cash flow needs.
• “ The time difference between cash in and
outflows” is known as the cash cycle.
• As the length of the cash cycle affects a
company’s financing costs, maximizing
shareholders’ wealth mandates the financial
manager to keep these financing costs to a
minimum.
Accounting versus Finance: A
Different Point of View
• Cash flows vs. net profit: from the
accounting point of view, a company’s
success measure is the net income. The
financial manager, however, is more
interested in cash flows, i.e., the size and
timing of the cash flows as well as the risk
associated with them. Net income is not an
accurate reflection of the cash in and
outflows of a company as it contains noncash items such as depreciation.
Accounting versus Finance: A
Different Point of View
• It also does not incorporate the time value
of money concept that states that money
loses value over time. The value of the
future cash inflow in today’s money is not
only a function of time but also of risk. The
higher the risk associated with a cash flow,
the lower its present value.
Accounting versus Finance: A
Different Point of View
• Tax rates: financial mangers determine the
profitability of a particular project based on
its expected net cash flow effect, i.e., the
change in the company’s cash flows after
taxes.
• The tax rate applied to the cash flows of any
new project will be determined by the level
of taxable income already generated and
the corresponding tax bracket.
Accounting versus Finance: A
Different Point of View
• Characterization of cost: accountants
commonly classify cost as a periodic charge
or as selling, general and administrative
expenses, which is the combined cost of
operating a company. From a financial
manager’s point of view, however, it makes
more sense to classify costs as being either
fixed or variable in nature.
Accounting versus Finance: A
Different Point of View
• This distinction enables financial
managers to make value maximizing
production decisions by determining the
optimal level of production or the most
advantageous operating leverage.
Accounting versus Finance: A
Different Point of View
• Asset value: as a financial mangers are
focused on cash flows they make investment
decisions primarily based on market values.
When buying an asset, the buyer’s cash
outflow is determined by its market value and
not the book value. Accordingly, the decision
to sell an asset is determined by the cash
inflow that can be reasonably expected based
on its current market value.
End of Chapter
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