Chapter 3: Financial Statements, Cash Flows, and Taxes
I.
Balance Sheet Model of the Firm
Board of Directors
Debt
Assets
Shareholders
Debtholders
Management
Equity
The Balance Sheet: The book value of a company’s assets, liabilities and
owners’ equity at a specific point in time. A “snapshot in time”
Total Value of Assets
Total Value of Liabilities
and Shareholders’ Equity
Net
Working
Capital
Current Assets
Current liabilities
Long-term debt
Fixed assets
1. Tangible fixed
assets
2. Intangible fixed
assets
Assets
Shareholders’ equity
=
Liabilities +
Shareholders’ Equity
Shareholders’ Equity:
Preferred stock: Shares outstanding at par (stated) value
Common stock: Shares outstanding at par
plus additional paid-in capital
plus retained earnings
Fin 335: Chapter 3, page 1
A.
Assets
The balance sheet always shows the book value of assets and liabilities, not
their market value.
These assets and liabilities appear in order from most liquid to least liquid.
Current assets
-
Short-term assets
Part of “working capital”
Exists to support the daily operations of the firm
Expected to be turned into cash within a year
a.
Cash
b.
Short-term securities (money market)
c.
Accounts receivable
d.
Notes receivable (short-term portion only)
e.
Inventory
f.
Prepaid expenses
Fixed assets
-
Long-term assets (life > 1 year)
Financial investments: Long-term financial investments
Capital investments: exists to generate growth and future cash
flows
Tangible Fixed Assets: PP&E (Property, plant, and equipment)
(less: depreciation)
Intangible Fixed Assets: patents, trademarks, goodwill, etc.
(less: amortization)
a.
b.
c.
d.
e.
f.
g.
Long –term investments
Capital leases (long-term, contractual lease obligations)
Investments in subsidiaries
Long-term prepaid expenses (pension funding)
PPE
Land
Intangibles
Fin 335: Chapter 3, page 2
B.
Liabilities
Current liabilities
-
Short-term liabilities
Also part of “working capital”
Net Working Capital = current assets minus current liabilities
Expected to be paid within a year
Includes interest on long-term debt that is due in the current
period
a.
b.
c.
d.
Accounts payable
Notes payable (short-term portion only)
Accrued salaries and wages payable
Income taxes payable
Long-term liabilities
C.
Long-term debt of all types (notes and bonds)
Capital leases, pension obligations, deferred taxes
Part of the corporation’s capital structure (along with equity)
Owners’ equity
Preferred stock
Example:
Shares outstanding at par value
Par value (stated value) is important
Dividend is quoted as a percent of par value
Seahawk Corporation Public Offering
8 ½ % preferred stock selling at $25 par value
Pays annual dividends of $2.125
Common stock
-
Shares outstanding at par
Par value per share is often $.01 and is meaningless
Plus: additional paid-in capital
Plus: retained earnings
Fin 335: Chapter 3, page 3
D.
Equity versus Debt
Long-term debt plus equity make up the capital structure of the firm. This
is how the firm finances its operations in order to generate value and wealth
for the common stockholders.
Owners’ Equity:
Common stockholders (owners) have a residual claim on the assets of the
firm. In case of bankruptcy liquidation they get what is left over after
everyone else is paid off.
Common stockholders also receive dividends and have a claim on the
money reinvested in the company that is not paid out in dividends each year
(retained earnings).
However, nothing goes to common stockholders until the other two major
claimholders are paid: preferred stockholders and debt holders.
Preferred stockholders (also owners) have a claim that is senior to
common stockholders, but subordinate to debt holders.
Preferred stockholders also receive dividends on their investment in the
company, and these dividends must be paid before common stock holders
receive anything.
Bond holders receive interest on the money they have loaned the company.
The bond holders’ interest must be paid before the preferred stockholders
and common stockholders receive anything.
In order of priority of claim: First: bondholders, then preferred
stockholders, and finally common stockholders.
Since common stockholders are lowest in priority, they have the highest risk
and therefore are expected to receive the highest rate of return.
Highest risk = highest expected return = Common Stock
Lowest risk = lowest expected return = Debt
From the investor’s point of view, the common stock is the highest risk, debt
is lowest, and preferred stock is in the middle.
Fin 335: Chapter 3, page 4
II.
The Income Statement
The income statement shows revenues and expenses of a company over a
specific period of time.
Revenues - Expenses = Income
Consolidate statements show the revenues and expenses for all businesses
that a company may be involved in.
Common sizes statements express each item as a percentage of sales (for the
income statement) or assets (for the balance sheet)
Pyramid Equipment Company
Income Statement for Year Ending December
31 (in thousands)
Net Sales
Labor & materials (COGS)
Depreciation
Selling, general, and administrative expenses
Total operating costs
Net Operating Income (or EBIT)
Less interest expense
Interest on notes payable
Interest on mortgage bonds
Interest on debentures
Total interest charges
Earnings before taxes
Taxes (at 40%)
Net Income before preferred dividends
Preferred dividends
Net income available to common stockholders
Dividends to common stockholders
Addition to retained earnings
Raw
Data
($)
Common
Size
Data (%)
2012
2012
6,750
5,400
120
55
5,575
1,175
100.00
80.00
1.78
.81
82.59
17.41
22
85
128
235
940
376
564
24
540
340
200
.33
1.26
1.90
3.48
13.93
5.57
8.36
.36
8.00
5.00
2.96
Fin 335: Chapter 3, page 5
A.
Three areas of activity on the Income Statement
-
Operating activities: Daily operating revenues and expenses
Investment activities: changes in PPE, others business purchase/sales
Financing activities: Long-term debt & equity financing
B.
Revenues & expenses
-
Follows GAAP rules based on the accrual concept of accounting
Accrual accounting recognizes expenses and revenues when the
service (sale or purchase) occurs, not when the payment occurs
C.
Taxes
-
Corporations pay taxes at the corporate income tax rate
This means that dividends received by individuals are taxed twice!
To avoid triple taxation, dividends received from other corporations
are largely exempt from taxation for a corporation
D.
Corporate Tax Rate: Average versus Marginal Tax Rates
E.
1.
Average tax rate:
Total taxes paid
Total taxable income
2.
Marginal tax rate: amount of tax payable on the next
dollar earned
Market Value vs. Book Value
Book value of common stock is the value as shown on the balance
sheet. Book value per share would be calculated as follows:
Total Common Equity
Number of Shares
=
book value of a share
of common stock
The market value of a share of stock is the price in the market, i.e.,
what stock sells for right now.
Fin 335: Chapter 3, page 6
III.
The Cash Flow Statement
The Cash Flow Statement (CFS) is separated into three areas of activity:
-
Operating activities: Net income, depreciation, changes in net working capital,
other than cash and short-term debt
Investment activities: Purchase & sales of fixed assets
Financing activities: Long-term and short-term debt & equity financing
STATEMENT of CASH FLOWS
(Indirect Method)
NET INCOME

+ depreciation and amortization

+ deferred expenses

+(-) decreases (increases) in accounts receivable

+(-) decreases (increases) in inventory
OPERATING

+(-) increases (decreases) in accounts payable
ACTIVITIES

+(-) increases (decreases) in current liabilities
=
NET CASH PROVIDED BY OPERATING ACTIVITIES
_____




=
- additions to Plant, Property,
and Equipment (PPE)
- business acquisitions
INVESTING
+ sales of PPE
ACTIVITIES
+ sales of businesses, etc
NET CASH PROVIDED BY INVESTING ACTIVITIES
______






=
- payment of dividends
- reductions in long-term debt (bonds outstanding)
+ increase in long-term debt (bonds outstanding)
FINANCING
+ sale of common/preferred stock
ACTIVITIES
+ sale of treasury stock
- repurchase of common stock
NET CASH PROVIDED BY FINANCING ACTIVITIES
_______
Change in Cash = the sum of the cash flow from each of these activities
Example:
Suppose
Then
Summary:
Cash flow from operating activities = ($40)
Cash flow from investing activities = ($250)
Cash flow from financing activities = $270
Net change in cash is:
($20)
Net change in cash
Cash at the beginning of the year
Cash at the end of the year
($20)
$180
$160
Fin 335: Chapter 3, page 7