Ch. 3
Financial Statements,
Cash Flows
&
Taxes
Financial Statements

All businesses should keep
careful financial records.
records
C. M. Korth
2
Financial Statements

However, many businesses do not
need to report their financial
statements to the public.
• Proprietorships
• Partnerships
• Privately
Privately--held corporations
C. M. Korth
3
1
Financial Statements

Publicly-traded companies must
Publiclykeep and publicly report their
financial records to
shareholders.
h
h ld
• Quarterly statements
• Annual report
C. M. Korth
4
The 4 Key Financial
Statements

Balance sheet

Income statement

Cash--flow statement
Cash

Statement of retained earnings
C. M. Korth
5
Generally-Accepted Accounting
GenerallyPrinciples (GAAP
GAAP))

The rules and procedures that
accountants must follow in
preparing financial statements
2
GAAP


American GAAP: Set by the
Financial Accounting
Standards Board (FASB)—
(FASB)—a
private accounting organization
GAAP in foreign countries: Usually
set by government bodies
C. M. Korth
7
International FinancialFinancialAccounting Standards



An effort to unify GAAP worldwide
American companies can begin
using IFAS in 2010
Everyone will use in 5
5--7 years.
C. M. Korth
8
Balance Sheet
C. M. Korth
9
3
Balance Sheet


Shows a firm’s financial position on a
particular date (e.g., 12/31/2009)
Like a photograph of a firm’s
financial status at a particular
point in time (e.g., December 31,
2009)
C. M. Korth
10
Balance Sheet


The balance sheet must always
balance
Balance--sheet equation:
Balance
equation:
Assets = Liabilit
Liabilities
ies + equity
C. M. Korth
11
Balance Sheet



Assets: The physical and financial
Assets:
resources that a business has
available to generate income
Liabilities: The part of the assets
Liabilities:
that were financed by debt
Equity: The part of the assets
Equity:
financed by the owners
C. M. Korth
12
4
Assets = Liabilities + Equity


If a business can reduce its
assets, it needs less liabilities
and equity.
If a business invests more
capital (or accumulates more
profits as retained earnings),
it needs less debt.
C. M. Korth
13
Assets

Current assets
• Cash & marketable securities
• Accounts receivable
• Inventory

Long--term assets
Long
• Fixed assets (net of depreciation)
14
Working Capital

Current assets – current liabilities

Also called net working capital
C. M. Korth
15
5
Liabilities (= Debt)

Current liabilities
• Accounts payable
• Notes p
payable
y

Long--term liabilities
Long
• Loans
• Bonds
16
Equity

= Ownership (stockholders)

Common stock

Preferred stock

Retained earnings
C. M. Korth
17
Basic Rights of Stockholders

Voting for the members of the
board of directors and
important actions of the board

Preemptive right

Cash dividends—
dividends—IF declared

Net assets in liquidation
C. M. Korth
18
6
Retained Earnings

Accumulated profits

Part of the equity account
• One source of financing assets
• Retained earnings are NOT cash!!!!!!
C. M. Korth
19
Income Statement
C. M. Korth
20
Income Statement


A summary of a firm’s revenues,
expenses and profits (or losses)
Like a video of a firm’s financial
status during a period (e.g.,
2010 or January 1
1--March 31,
2010)
C. M. Korth
21
7
Revenue
- CGS
= EBITDA
- D&A
=EBIT
-I
= EBT
-T
= EAT (= net income)
income)
22
Statement
of
Retained Earnings
C. M. Korth
23
Statement of Retained Earnings


Changes in retained earnings
from one period to the next
Previous R/E + net income
– dividends = New R/E
8
Cash Flows
C. M. Korth
25
Cash Flows


Accounting statements are
generally on an accrual basis—
basis—
not cash basis.
basis.
However, financial managers need
to know actual cash flows—
flows—the
funds actually flowing into and
out of the business.
C. M. Korth
26
Statement of Cash Flows



= Cash inflows – Cash outflows
I
Increases
in
i liabilities
li biliti
and
d equity
it
are sources of cash.
Increases in assets are uses of cash.
C. M. Korth
27
9
Taxes
C. M. Korth
28
Businesses Pay Many Taxes

Local taxes
• Property taxes
• Income taxes

State taxes
• Income taxes
C. M. Korth
29
Businesses Pay Many Taxes

Federal taxes
• Income taxes (0%(0%-39%)
• Social Security taxes (6.2%)
• Medicare taxes (1.45%)

[S/S + Medicare = 7.65%]
10
Reducing Taxes



Exclusion:: Not subject to taxes
Exclusion
Deductions: Reduction of taxable
Deductions:
income
income
Credits:: Reduction of taxes due
Credits
C. M. Korth
31
Federal Tax Rates


Marginal tax rate:
rate: the tax rate
applied to the last dollar of income
A
Average
ttax rate:
rate
t :
(total taxes paid) ÷ (total income)
C. M. Korth
32
Tax Advantage of Debt

Our incomeincome-tax system favors debt
financing over equity financing.
• Interest payments are obligations-obligations--&
&
therefore tax deductible.
deductible.
• Dividend payments are choices, not
obligations-obligations
--&
& not tax deductible.
C. M. Korth
33
11
Personal Federal Taxes
Income tax (0%(0%-39.6%)

Social Security and Medicare taxes
(7.65% + 7.65% = 15.3%)


Excise taxes (gas, alcohol, tobacco)

Import duties
34
Social Security
&
Medicare Taxes
C. M. Korth
35
Social Security & Medicare

Paid only on employee core income
• Wages & salaries
• Commissions and tips

Not on:
• Stock options
• Capital gains
36
12
Social Security & Medicare

Separate taxes
• 6.20% Social Security tax
• 1.45%
1 45% Medicare tax

Total: 7.65%
C. M. Korth
37
Social Security & Medicare


Paid from the very 1st dollar of
earnings
There are no exclusions
• Low income (e.g., highhigh-school kid)

Not tax deductible
C. M. Korth
38
Social Security & Medicare

They are paid by both the
employee & the employer.
• 7.65% + 7.65% = 15.30%
C. M. Korth
39
13
Social Security & Medicare


However, S/S is only paid on the
1st $106,000 of income.
Neither tax is applied to cash
bonuses and stock options.
C. M. Korth
40
Federal Taxes
Badly Hurt
American Business
14