Chapter 2 Financial Statements, Taxes and Cash
Flows
May 07
1
2
Basic Financial Statements
Annual report includes:
™Balance sheet
™Income statement
™Statement of Retained Earnings
™Cash Flows
Financial Statements, Taxes
&
Cash Flows
3
Basic Financial Statements
4
Basic Financial Statements
Net Working Capital = Current Assets
Balance Sheet
– Current Liabilities
Assets = Liabilities + Owner’s Equity
Current Assets
Cash + MS
A/R
Inventory
Current Liabilities
A/P
Notes Payable
Accruals
Fixed Assets
Land
Plant
Equipment
Less:Depreciation
L-T Liabilities
Bonds
Preferred Stock
Common Stock
Par Value
Paid in Capital
Retained Earnings
–
1,230
230
1,000
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total
Assets
$2,530
Accounts Payable
$115
Accruals
115
Current Liabilities
$230
Bonds
$600
Owner’s Equity
Common Stock
$300
Paid-in Capital
600
Retained Earnings
800
Total Owners’ Equity$1,700
Total Liabilities and
Owners Equity
$2,530
Chapter 2 Financial Statements, Taxes and Cash
Flows
May 07
5
Basic Financial Statements
Income Statement
The income statement for the Simsboro Computer
Company:
Revenues - Expenses = Net Income
Sales
Investment Income
Gains
Interest Received
Dividend Received
COGS
Salaries
Depreciation
Taxes
Dividends
Other Expenses
Interest Paid
Basic Financial Statements
Income Statement
Simsboro Computer Company
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
EBIT
$330
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Retained
Earnings
8
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 Accruals
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
600
Net Fixed Assets
$1,300 Paid-in Capital
Total
Assets
$2,530
Retained
Earnings
800
Income Statement
Simsboro Computer Company
Total Owners’ Equity $1,700
Total Liabilities and
Sales
$1,450
Owners Equity
$2,530
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Statement of Retained Earnings
Net Operating Income
$330
Simsboro Computer Company
Interest Expense
60
Net Income Before Taxes
$270
Retained Earnings (Dec 31, 2001)
$738
Taxes (40%)
108
Add: Net Income 2002
162
Net Income
$162
Less: Dividends to Common Stockholders
100
Dividends Paid
100
Balance of Retained Earnings Dec 31, 2002
$800
Addition to Retained Earnings $62
Statement of
Retained Earnings
7
Basic Financial Statements
Revenue
Subtotal
Expenses
Profit
Distribution of Profit
Federal Income Taxation
Marginal / Average Tax Rates
™Marginal = Tax Rate on the next dollar of income.
™Average = Taxes paid, divided by taxable income.
Progressive Tax System
™Average tax rate increases with the level of taxable
income.
™Marginal tax rate is greater than or equal to the
average tax rate.
10
Chapter 2 Financial Statements, Taxes and Cash
Flows
May 07
11
Federal Income Taxation
Tax Computation
Taxable Income
$0 - $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
Tax Rate
15%
25%
34%
39%
34%
35%
38%
35%
1st Bracket
2nd Bracket
3rd Bracket
4th Bracket
18
™Compute Tax for
Corporation with
Taxable Income of
$160,000
Tax Rate
15%
25%
34%
39%
$50,000
$25,000
$25,000
$60,000
Tax Rate
15%
25%
34%
39%
x15% =$ 7,500
x25% =$ 6,250
x34% =$ 8,500
x39% =$23,400
$45,650 Tax
Liability
Comparison of Marginal & Average Rates
Corporate Tax Rates
Taxable Income
$0 - $50,000
$50,001 - $75,000
$75,001 - $100,000
$100,001-$335,000
Taxable Income
$0 - $50,000
$50,001 - $75,000
$75,001 - $100,000
$100,001-$335,000
™Compute Tax for
Corporation with
Taxable Income of
$160,000
Federal Income Taxation
Tax Computation
Example
Corporate Tax Rates
Tax Computation
Example
Corporate Tax Rates
16
Federal Income Taxation
$160,000
50.00%
39%
40.00%
30.00%
28.53%
20.00%
10.00%
Marginal tax rate = 39%
0.00%
50000
Average = Tax Liability = $45,650
Tax Rate Taxable Income $160,000
75000 100,000
335,000
10,000,000 15,000,000 18,333,333
= 28.53%
Average
Marginal
19
Chapter 2 Financial Statements, Taxes and Cash
Flows
Comparison of Marginal & Average Rates
May 07
20
$4,500,000
50.00%
Comparison of Marginal & Average Rates
$12,500,000
50.00%
40.00%
40.00%
34%
34%
30.00%
35%
34%>AVG>35%
30.00%
20.00%
20.00%
10.00%
10.00%
0.00%
21
0.00%
50000
75000 100,000
335,000
10,000,000 15,000,000 18,333,333
Marginal Rate = Average Rate
50000
Average
Marginal
75000 100,000
Taxes on $12,500,000 = .34(10,000,000) = $3,400,000
+ .35(2,500,000) =
Taxes on $4,500,000 = .34(4,500,000) = $1,530,000
The Concept of Cash Flows
10,000,000 15,000,000 18,333,333
335,000
$875,000
$4,275,000
22
Income Statement Measures Accounting Profits
™Does not take into account the actual Cash Flows
Average
Marginal
AVG RATE?
23
Firm’s Cash Flows
Firm’s Cash Flows
from assets
=
Cash Flow to
Investors
=
Cash flows
1. paid to the firm’s
investors
2. or received by the
firm’s investors
™Additional investments in assets
™Payments to investors
™Capital raised from investors
™Cash Flows measure how cash is generated from
utilizing assets and how it is paid to those that
finance the purchase of the assets
™Focus of many of the recent accounting scandals
(AOL, WorldCom)
™Inflating earnings using GAAP, but cannot inflate the
Cash Flow of the firm.
Cash flows generated
through the firm’s
1. operations
2. investments in assets
Chapter 2 Financial Statements, Taxes and Cash
Flows
Cash Flows From Assets
May 07
24
Overview of Calculation
Operating Cash
Flows
Overview of Calculation
Cash flows generated
from the OPERATIONS of
the Firm
less
Change in net
working capital
Change in Net Working
Capital
Change in gross
fixed assets
Cash Flows From Assets
Overview of Calculation
Operating Cash
Flows
Income Statement
Simsboro Computer Company
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Net Operating Income
$330
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
Ending NWC
– Beginning NWC
less
less
Capital Spending
Operating income (EBIT)
+ depreciation
- cash tax payments
Operating Cash
Flows
less
Change in net
working capital
25
Cash Flows From Assets
Capital Spending
26
Ending Net Fixed Assets
– Beginning Net Fixed Assets
+ Depreciation
27
Cash Flows From Assets
Overview of Calculation
Operating income (EBIT)
+ depreciation
- cash tax payments
Change in Net
Working Capital
Ending NWC
– Beginning NWC
NWC 2002
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
$ 330
+ 200
– 108
$ 422
2001 2002
Cash
Accounts Receivable
Inventories
Current Assets
Plant & Equipment
Less:Acc. Depr.
Net Fixed Assets
Total Assets
183
450
500
1133
2150
1000
1150
2283
175
430
625
1230
2500
1200
1300
2530
2001
2002
Accounts Payable
150
Accruals
95
Current Liabilities
245
Bonds
400
Owner’s Equity
Common Stock
300
Paid-in Capital
600
Retained Earnings
738
Total Owners’ Equity 1638
Total Liabilities and
Owners Equity
2283
115
115
230
400
400
700
800
1900
2530
$ 1230
– 230
$ 1000
NWC 2001
$ 1133
– 245
$ 888
∆NWC = $ 112
Chapter 2 Financial Statements, Taxes and Cash
Flows
28
Cash Flows From Assets
Overview of Calculation
Ending Net Fixed Assets
– Beginning Net Fixed Assets
+ Depreciation
Capital Spending
2001 2002
183
450
500
1133
2150
1000
1150
2283
175
430
625
1230
2500
1200
1300
2530
2001
2002
Accounts Payable
150
Accruals
95
Current Liabilities
245
Bonds
400
Owner’s Equity
Common Stock
300
Paid-in Capital
600
Retained Earnings
738
Total Owners’ Equity 1638
Total Liabilities and
Owners Equity
2283
115
115
230
400
$ 1300
– 1150
+ 200
400
700
800
1900
($40)
$ 350
Cash flows generated
from the OPERATIONS of
the Firm
Change in net
working capital
Change in Net Working
Capital
less
$ 422
$ 112
$ 350
Capital Spending
Change in gross
fixed assets
Cash Flow From Assets = $
30
=
Overview of Calculation
Operating Cash
Flows
2530
Firm’s Cash Flows
Firm’s Cash Flows
from assets
29
Cash Flows From Assets
less
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
Accounts Receivable
Inventories
Current Assets
Plant & Equipment
Less:Acc. Depr.
Net Fixed Assets
Total Assets
May 07
Cash Flow to
Investors
(40)
Cash Flows To Investors
Overview of Calculation
Cash Flows to
Creditors
Interest Paid
– Net New Borrowing*
plus
Cash Flows to
Stockholders
Conclusion of Cash Flows From Assets:
™The Firm needed an ADDITIONAL $40 of Cash last
year to sustain operations
™Analyze the effect on the firm’s Investors
Dividends Paid
– Net new Equity Raised**
* If Debt decreases as a result of paying off outstanding
loans then Net New Borrowing will be negative.
** If Common Stock decreases as a result of the firm
repurchasing outstanding shares then Net New Equity
Raised will be negative.
31
Chapter 2 Financial Statements, Taxes and Cash
Flows
May 07
32
Cash Flows To Investors
Overview of Calculation
Overview of Calculation
Interest Paid
– Net New Borrowing
Cash Flows to
Creditors
Income Statement
Simsboro Computer Company
Balance Sheet
Sales
$1,450
Simsboro
Computer Company
Cost of Goods Sold
875
Assets
Liabilities
Gross Profit
$575
2001 2002
2001
Operating Expenses
45
Cash
183 200
175 Accounts Payable
150
Depreciation
Accounts
Receivable
450
430
Accruals
95
Net Operating Income
$330
Inventories
500 60
625 Current Liabilities
245
Interest
Expense
Current
Assets
1133
1230
Bonds
400
Net Income Before Taxes
$270
Plant(40%)
& Equipment
2150 108
2500 Owner’s Equity
Taxes
1000 $162
1200 Common Stock
300
NetLess:Acc.
Income Depr.
Paid-in Capital
600
Net
Fixed
Assets
1150
1300
Dividends Paid
100
Total to
Assets
2283 $62
2530 Retained Earnings
738
Addition
Retained Earnings
Total Owners’ Equity 1638
Total Liabilities and
Owners Equity
2283
$ 60
– 0
$60
2002
115
115
230
400
$0
400
700
800
1900
2530
34
Cash Flows To Investors
Cash Flows to
Stockholders
$ 100
Dividends Paid
– Net new Equity Raised – $200
Income Statement
Simsboro Computer Company
Balance Sheet
Sales
$1,450
Simsboro
Computer Company
Cost of Goods Sold
875
Assets
Liabilities
Gross Profit
$575
2001 2002
2001
Operating Expenses
45
Cash
183 200
175 Accounts Payable
150
Depreciation
Accounts
Receivable
450
430
Accruals
95
Net Operating Income
$330
Inventories
500 60
625 Current Liabilities
245
Interest
Expense
Current
Assets
1133
1230
Bonds
400
Net Income Before Taxes
$270
Plant(40%)
& Equipment
2150 108
2500 Owner’s Equity
Taxes
1000 $162
1200 Common Stock
300
NetLess:Acc.
Income Depr.
Paid-in Capital
600
Net
Fixed
Assets
1150
1300
Dividends Paid
100
Total to
Assets
2283 $62
2530 Retained Earnings
738
Addition
Retained Earnings
Total Owners’ Equity 1638
Total Liabilities and
Owners Equity
2283
Interest Paid
– Net New Borrowing
$60
($100)
2002
115
115
230
400
400
700
800
1900
+$200
2530
35
Firm’s Cash Flows -- Identity
Firm’s Cash Flows
from assets
Overview of Calculation
Cash Flows to
Creditors
33
Cash Flows To Investors
($40)
=
Cash Flow to
Investors
($40)
plus
Cash Flows to
Stockholders
Dividends Paid
– Net new Equity Raised
($100)
Cash Flow To Investors = $
(40)
The Sources of Cash (from the investors) Equals the
Uses of Cash (finance operations)
Although this firm has a Net Income of $162 this year,
over the year an additional $40 was required to keep
the operations going