Ch 02
Jan 20, 2012
Ch 2: I.
Financial Statements
a) Balance Sheet
b) Income Statement
II. Taxes
III. Cash Flows
Go over HW Ch. 1 in Connect?
In August 2008, the SEC announced a timetable that would allow some
companies to report under IFRS (intl financial reporting standards: is
principles based system, as opposed to GAAP is rules based system) as
soon as 2010 and require it of all companies by 2014. However, because
make stakeholders have gotten involved and caused controversy, at this
point not set time is given for conversion.
- 'balance sheet' will become 'statement of financial position'
- 'income statement' will become 'statement of comprehensive income'
- 'cash flow statement' will become 'statement of cash flows'.
I. Financial Statements
a) Balance Sheet (statement of financial position (snapshot or picture of
firm at one particular time) = net worth statement for individual
Assets = Liabilities + Owner’s Equity
Investment decisions = Financing decisions
Assets listed in order according to how long it takes to convert to cash
(liquidity)
liquidity is good because chance of financial distress is low
but liquid assets are less profitable earn less returns, (excess cash is not
earning interest and could be invested in a productive asset)
Liabilities listed according to how soon they have to be paid (time to
maturity)
Equity is difference between assets and liabilities
current assets - current debt = net working capital (should be positive)
On Board: Example Balance Sheet for Miller Corporation for 2010&11
Given:
2010 2011
Current assets
Fixed assets
1
Current liabilities
Long-term debt
Assets:
2010 2011
(02 cash =424, A/R= 705, Inv 1300)
Current assets
2205 2429
Fixed assets
7344 7650
Total assets
9549 10,079
Liabilities & Owners’ Equity
2010 2011
Current liabilities 1003 1255
Long-term debt
3106 2085
4109 3340
Equity( 9549-4109) 5440 6,739
Total liabilities & equity 9549 10,079
(note: equity also includes add to retained earnings)
[(How is common equity determined for balance sheet: 4 components:
1. Par value (par value x # of shares outstanding)
2. Capital in excess of par value: (capital surplus, add. paid-in capital)
exists because shares are sold above their par value:
(sales price - par value) #of shares sold.
example:
par value = $1
sales price = $15
# of shares sold = 1000
capital surplus: (15-1) x 1000 = 14,000
par value can only be distributed when company is liquidated
important: 3. retained earnings:
Net income - dividends = retained earnings (CH. 2)
4. Treasury stock = stock repurchased after it was issued, reported at cost]
assets includes acc. depreciation)
right side: financing = capital structure (debt vs. equity) Ch 15
more debt the more leverage: magnifying glass. magnify gains and losses
Balance sheet gives info on liquidity and leverage
important for creditors
However, does not give info on real or market value of firm. $ amounts of
assets are cost not actual market value (according to GAAP).
(Old car cost in 1940: $2000 accounting value would be cost - depreciation
car is depreciated over 10 years has not value today; but in fact worth a
fortune)
2
market value is what we talk about when we try to optimize value of stocks
market value is important for financial manager
but is difficult to estimate
b) Income Statement (Statement of Comprehensive Income)
measures performance over time (a year) a video or film!
Example: Miller Corp. Jan 1 – Dec 31 2011
Sales:
COGS:
Depreciation:
Interest:
Dividends:
Tax rate:
4507
2633
952
196
250
35%
Sales
-COGS
-Depreciation
EBIT (op. earn.)
-Interest
Taxable Income (EBT)
-Taxes (726x.35)
Net Income
two ways to express taxes: % or decimal
35% = .35
35% of $1000= 1000x.35=350
4507 investment decisions
-2633

- 952
922
-196 financing decisions
726

254
472
Dividends
Add. to retained earnings
250
222 (472-250)
3 Noteworthy things on income statement:
1. According to GAAP (general accepted accounting principles): revenue is
shown in income statement when it accrues (time of sale)
& expense figures are matched to point of sale (cost of producing a
product are matched and reported with sale) Actual cash in- and outflow
occurs at different times.
Example cash flow time line?
2. Income statement does not represent actual cash flows
3
One reason: income statement contains non-cash items (depreciation).
3. In finance: concerned with variable and fixed costs, but accountants
treat costs as product (COGS (raw materials and hammer) and period (S,
G&A) both can be fixed and variable
Before we go into cash flows: talk about taxes
II. Taxes
two things in life are certain: death & taxes,
taxes are always changing
important cash outflow
distinguish between average and marginal tax rates
average : total taxes/ total taxable income
marginal : tax rate applicable to next dollar earned
example:
company has total taxable income of $150,000
7500 + 6250 + 8500 + 19500 = 41,750
$50,000 (.15) + 25,000 (.25) + 25,000 (.34) + 50,000 (.39) = $41,750 tax
41,750/150,000 = .2783 or 27.83% = average tax rate
marginal rate: .39
When do we use average and marginal tax rates?
for computing company’s total tax liability: average
for evaluating cash flows generated from a new investment: marginal
(because investment creates cash flows that are taxed above existing
profits) in capital budgeting decisions
III. Cash Flows
Accounting cash flows: on statement of CFs (next chapter)
$ coming in - $ flowing out can be derived from financial statements
“statement of cash flow” looks at sources and uses in detail
(beg. Cash + sources - uses = > Ending cash)
Financial CF (used for capital budgeting: use balance sheet identity for
cash flows:
A
B
C
cash flow from assets = cash flow to creditors + cash flow to stockholders
cash is created through assets and used to pay creditors and owners
How are these cash flows calculated?
4
A. Cash flow from assets (also called Free cash flow:
company is free to distribute cash to investors because it is not needed for
NWC or fixed assets investment) has three components: (CF free to be
distributed to creditors and shareholders)
1. operating cash flows
2. - net capital spending
3. - change in net working capital
operating cash flow
- net capital spending
- change in NWC
=cash flow from assets (a growing company could have a negative cash
flow from assets if it invested in fixed assets for example, i.e. it raised more
money than it paid out)
1. Operating cash flow: tells us whether firm’s cash inflows from
operations covers everyday cash outflows (should be positive for healthy
firm)
EBIT (revenues - costs - dep., we don’t include financing expenses)
+ depreciation (we don’t want to include depr. because its not a cash
outflow)
-taxes (tax has to be included because it is a cash outflow)
= operating cash flow
Miller Corporation 2011:
EBIT
922
+ depreciation
952
-taxes
-254
operating cash flow
1620
2. Net Capital spending
computes what part of operating cash flow is reinvested in the firm
net spending in fixed assets
money spent on fixed assets - money received from sale of fixed assets
ending net fixed assets
-beginning net fixed assets
+end. Depreciation (during the year)
5
=net investment in fixed assets (if negative firm sold more assets than it
purchased)
Miller Corporation:
2011 net fixed assets (net of dep)
-2010 net fixed assets
+ 2011 depreciation)
net cap. spending
7650
-7344
+952
1258
3. Change in net working capital
ending NWC
-beginning NWC
=change in NWC (if positive this is the investment in NWC for the year)
Miller corporation
ending NWC
1174 (2011: 2429-1255) cur. assets-cur. liab.
-beginning NWC 1202 (2010: 2205-1003) cur. assets-cur. liab.
change in NWC
- 28
OCF
1620
-NetCapSp -1258
-chg in NWC +28
CF from Ass. 390
B. Cash flow to creditors
interest paid
-new borrowing
= cash flow to creditors
Miller Corporation:
interest
-net new borrowing
cash flow to creditors
196
-(-1021) (2085-3106) (2011- 2010 long-term debt)
1217
C. Cash flow to shareholders
dividends paid
- net new equity raised (net n equ=- stock repurchased+new stock issues)
=cash flow to shareholders
Rasputin Corp.
dividends
-net new equity raised
cash flow to shareholders
250
2011 equ.-2010 equ. add. to ret.earn. 2011
-1077 (6739-5440=1299 1299- 222=1077)
-827
6
CF to creditors
+ CF to sh. holder
= CF from assets
1217
-827
390
7