CHAPTER 2
Financial Statements, Cash
Flows, and Taxes
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Key Concepts and Skills
 Know the difference between book value and market
value
 Know the difference between accounting income and
cash flow
 Know the difference between average and marginal tax
rates
 Know how to determine a firm’s cash flow from its
financial statements
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The Balance Sheet
The balance sheet presents the accounting value of assets and
source of money used to purchase those assets at a particular
time.
Assets: The left-hand side
 Fixed asset has a long life (more than one year): tangible asset
(land, machinery,…), and intangible asset (trademark, patent).
 Current asset has a life less than one year such as cash, inventory.
Liabilities and Owners’ Equity: The right-hand side
 Current liabilities, such as account payable, represent obligations
requiring cash payment within the next year.
 Long-term liabilities are debt obligations due beyond one year.
 The difference between the accounting value of the assets and
the liabilities is the shareholders’ equity, representing the
original contribution plus the earning retained in the business.
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The Balance Sheet
Current
Liabilities
Current Assets
Net
Working
Capital
Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible
Total value of assets
Shareholders’
Equity
Total value of the
firm to investors
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Net Working Capital
Net working capital is the difference between a firm’s
current assets and its current liabilities. Net working
capital is positive when current assets exceed current
liability.
Example: A firm has current assets $100, net fixed assets
of $500, short-term debt of $70, and long-term debt of
$200. What does the balance sheet look like? What is
shareholder’s equity? What is net working capital?
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Net Working Capital
 In this case, total assets are $100 + 500 = 600 and
liabilities are $70 + 200 = 270, so shareholders’ equity
is the difference: 600 – 270 = 330. The balance sheet
would look like:
Assets
Liabilities & Equity
Current assets $100 Current liabilities
$70
Net fixed assets 500 Long-term debt
200
Shareholders’ equity
330
Total assets
$600 Total liability & equity $600
Net working capital is 100 – 70 = 30
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Liquidity
Liquidity refers to the speed and ease with which an
asset can be converted to cash.
It is also important to point out that more liquid assets
also provide lower return. Consequently, too much
liquidity can be just as detrimental to shareholder
wealth maximization as too little liquidity.
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Debt versus Equity
Interest and principal payments on debt have to be paid
before cash may be paid to stockholders. The
company’s gains and losses are magnified as the
company increases the amount of debt in the capital
structure. This is why we call the use of debt financial
leverage.
Owner’s Equity = Assets - Liabilities
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Book Values and Market Values
 Market values of assets and liabilities do not generally
equal their book values. Book values are based on historical
or original values. Market values measure current values of
assets and liabilities.
 The stock price is simply the market value of shareholders’
equity divided by the number of outstanding shares.
Example: The Klingon Corporation has fixed assets with a
book value of $700 and an appraised market value of about
$1,000. Net working capital is $400 on the books, but
approximately $600 would be realized if all the current
accounts were liquidated. Klingon has $500 in long-term
debt, both book value and market value. What is the book
value of the equity? What is the market value?
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Book Values and Market Values
We can construct two simplified balance sheets, one in
accounting (book value) terms and one in economic
(market value) terms:
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Income Statement
The income statement is a financial statement that measures
the profitability of the firm over a time period.
Revenues – Expenses = Income
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Earnings and Dividends per Share
 Suppose U.S. had 200 million shares outstanding at
the end of 2008. Based on the income statement in the
previous slide, what was EPS? What were dividends
per share?
 Earnings per share = Net income/Total shares
outstanding
= $412/200 = $2.06 per share
 Dividends per share = Total dividends/Total shares
outstanding
=$103/200 = $.515 per share
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GAAP and the Income Statement
An income statement prepared using GAAP will show
revenue when it accrues. This is not necessarily when the
cash comes in.
 Noncash Items
The largest non-cash deduction from most firms is
depreciation. It reduces a firm’s taxes and its net income.
Non-cash deductions are part of the reason that net
income is not equivalent to cash flow.
 Time and Costs
We need to plan for both short-run cash flows and longrun cash flows. In the short run, some costs are fixed
regardless of the output and other costs are variable. In the
long run, all costs are variable. It is important to identify
these costs when doing a capital budgeting analysis.
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Corporate Tax Rate
 It’s important to point out that corporations pay a flat
rate on their income. Income tax in Cambodia is 20%.
 Taxes paid to government affect cash flow available for
shareholder.
 Corporate Taxes
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Average versus Marginal Tax Rates
 Average tax rate: Total tax paid divided by total taxable income.
 Marginal tax rate: Amount of tax payable on the next dollar
earned.
Suppose our corporation has a taxable income of $200,000, What is
the tax bill? What is average tax rate? Marginal tax rate?
Average tax rate: $61,250/$200,000 = 30.625%
Marginal tax rate: Marginal rate is 39% if it had another dollar
taxable income.
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CASH FLOW
 Provides a summary of cash flows over the period
concern, typically the year just ended.
 Cash Flow from Assets
Cash flow from assets = Cash Flow to Creditor + Cash
Flow to Stockholders
Cash Flow from Assets involves three components:
operating cash flow, capital spending, and change in
net working capital.
 Operating Cash Flow:
It refers to the cash flow that results from the firm’s
day-to-day activities of producing and selling.
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 Capital Spending
It is just money spend on fixed assets less money from sale of
fixed assets.
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Change in net working capital
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 Cash flow to creditors
A firm’s interest payments to creditors deduct net new
borrowing
 Cash flow to stockholders
Dividends paid out by a firm less new equity raised.
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End of Chapter 2
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Greene Co. shows the following information on its 2008
income statement: sales = $138,000; costs = $71,500; other
expenses =$4,100; depreciation expense = $10,100; interest
expense = $7,900; taxes =$17,760; dividends = $5,400. In
addition , you're told that the firm issued $2,500 in new
equity during 2008, and redeemed $3,800 in outstanding
long-term debt.
Instructions:
a. What is the 2008 operating cash flow?
b. What is the 2008 cash flow to creditors?
c. What is the 2008 cash flow to stockholders?
d. If net fixed assets increased by $17,400 during the year,
what was the addition to NWC?
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Net income was negative because of the tax
deductibility of depreciation and interest expense.
However, the actual cash flow from operations was
positive because depreciation is a non-cash expense
and interest is a financing expense, not an operating
expense.
A firm can still pay out dividends if net income is
negative; it just has to be sure there is sufficient cash
flow to make the dividend payments.
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