Chapter 2 Financial Statements, Taxes & Cash Flow
I. Five Sections of the Balance Sheet
A. The balance sheet presents a snapshot of the accounting value of assets and the
sources of money used to purchase those assets at a particular time.
B. Assets are usually listed in descending order of liquidity, or the ability to convert to
cash.
1. Cash and marketable securities, accounts receivable, and inventories are
current assets, each of which expect to cycle through cash over the next year.
2. Long-term fixed assets, both tangible assets like plant and equipment and
intangible assets such as patents, trademarks, franchise and goodwill will not be
converted to cash but are expected to generate future cash flows.
C. While the assets depict what is owned, liabilities and equity represent what is owed
or who provided the funding for the assets.
1. Current liabilities, such as accounts payable, represent obligations requiring
cash payment within the next year.
2. Current assets minus current liabilities is net working capital, or the extent to
which current assets are financed with long-term sources of financing.
3. Long-term liabilities are debt obligations due beyond one year.
4. The difference between the accounting value of the assets and the liabilities is
the shareholders’ equity, representing the original capital contribution plus the
earnings retained in the business. See Figure 2.1 & Table 2.1 for examples of the
balance sheet.
THE MAIN BALANCE SHEET ITEMS
Current Assets
Current liabilities
Cash & securities
Payables
Receivables
Short-term debt
Inventories
=
+
+
Fixed Assets
Long-term liabilities
Tangible assets
+
Intangible assets
Shareholder’s Equity
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D. Book Value (BV) and Market Value (MV):
BVs and MVs of assets and liabilities usually are different, because:
1. Books values are stipulated by Generally Accepted Accounting Principles
(GAAP). According to GAAP, assets and liabilities are usually “booked” at their
historical or original cost value.
The BV equity or NW (net worth)
= BV of (assets – liabilities)
= Original cash contributions (or sale of stock)
+ reinvested earnings (or retained earnings.)
2. Market values are what assets and liabilities are worth today: the MV is
measured by the ability to generate future cash flows. Shareholders and managers
are concerned about the market values of their stock, so their focus is on a marketvalue-driven balance sheet.
MV equity (or MVE) = MV of assets – MV of liabilities
Example 1:
See the Example 2.2 (p. 25).
Example 2:
Think about selling your car today, what would be the BV and MV each, would
the two values be the same?
II The Income Statement
A. The income statement is a financial statement listing the revenues, expenses, and net
income of the firm over a period of time. Compared with the balance sheet, it presents a
firm’s financial performance like a video.
B. The income statement indicates where operating profit (EBIT) came from (revenues operating costs - depreciation) and where operating income was distributed (interest to
creditors, taxes to governments, and profits to shareholders).
DPS and EPS
An example of the income statement (Table 2.2, page 26).
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Note: Net Profits (or net income or “bottom line”) versus Cash Flows (CFs):
1. Shareholders and managers are concerned about maximizing shareholder value,
which is oriented toward estimating and generating cash flows.
2. Cash flows and profits from an income statement usually differ because:
(1) Different items are considered in the calculations of profits vs. CFs.
Certain noncash expenses, such as depreciation, are allocated to a specific period
to measure accounting profit. These noncash expenses cause profit to be less than
what operating cash flow actually is and thus noncash expenses must be added
back to profit to estimate cash flow in a period.
In addition, capital expenditures, capitalized and depreciated or expensed over
future periods, incur cash outlays when purchased.
(2) Different timing between CF occurrences and accounting book keeping
activities.
A. Cash accounting versus accrual accounting. Accrual accounting gathers the
revenue earned in the period with the associated expenses incurred in the period.
B. Sales in one period do not mean cash in the same period.
III Accounting for differences:
A. Company managers, outside financial analysts and shareholders, current and
prospective, all have different ways to either present or interpret the financial statements
of the same company. A wise person will never listen to only one party.
B. Valuable intangible assets, are not normally listed on the B/S; certain liabilities (lease,
warrant, pension commitments and stock options), are real variables affecting future cash
flows and are often not listed on the B/S either.
C. Accounting rules are different across countries. The work of the International
Accounting Standards (IAS) Committee toward standardizing accounting conventions
worldwide will enhance the globalization of financial markets.
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IV. Corporate Average versus Marginal Tax Rates
1. Average tax rate = total taxes / total taxable income
2. Marginal tax rate = amount of tax on the next dollar earned.
V. Cash Flow (Table 2.5)
1. Cash flow from assets = OCF – Δ capital spending – Δ NWC
2. Cash flow to creditors = Interest payment - Δ new borrowing
3. Cash flow to stockholders = Dividend payment - Δ new equity raised
4. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
An Example: Cash flow for Dole Cola (pp. 36-38).
12/31/2006 Income Statement
Net Sales
CoGS
Depre.
EBIT
Interest
EBT
Taxes (.34)
Net Income
$600
300
150
150
30
120
41
79
Dividends
REs
$30
49
12/31/2006 and 12/31/2005 Balance Sheet
CAs
FAs
2006
$2260
750
2005
$2130
500
CLs
2006
$1710
Also, the firm did not issue any new stocks in 2006.
1. What is the Cash Flow from Assets in 2006?
2. What is the Cash Flow to Stockholders in 2006?
3. What is the Cash Flow to Creditors in 2006?
4. How much did the firm borrow in 2006?
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2005
$1620
1. What is the Cash Flow from Assets in 2006?
Cash Flow from Assets = OCFs – Net Capital Spending – Net NWC
OCFs = EBIT + Depre – Taxes = 150 + 150 – 41 = 259;
Net Capital Spending = Ending FAs – Beginning FAs + Depre. = 750 – 500 + 150 = 400;
Net NWC = Ending NWC – Beginning NWC = (2260 – 1710) - (2130 – 1620) = 40;
Cash Flow from Assets = 259 – 400 – 40 = -181.
2. What is the Cash Flow to Stockholders in 2006?
Cash Flow to Stockholders = Dividends paid – Net new equity issued
= 30 – 0 = 30.
3. What is the Cash Flow to Creditors in 2006?
Cash Flow to Creditors = Interest paid – Net new debt issued
= 30 - ?
Cash Flow from Assets = Cash Flow to Stockholders + Cash Flow to Creditors
-181
= 30 + (30 - ?)
So, Cash Flow to Creditors = (30 - ?) = -211.
4. How much did the firm borrow in 2006?
-211
= (30 - ?)
241 = ?
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