Ch. 2 Financial Statements,
Cash Flows and Taxes
Goals
• To understand financial Statements
• To understand how to calculate cash flows
• To understand how to measure the
performance
• To understand taxes
1. Financial Statement & Reports
• Two types of information in annual reports
• 1) Letter describing the operating results
during the past years
• 2) 4 Financial Statements: balance sheet,
income statement, statement of retained
earnings and statement of cash flows
2. Balance sheet:
• A statement of the firm’s financial position
at a specific point in time
• It measures asset (what a company own)
and claims on assets ( what it owes)
• Items is listed in order of liquidity or the
length of time
• Ex) Table 2-1
Asset
Liability and Equity
Cash and equivalents
Accounts payable
Short term investments
Notes payable
Accounts receivable
Accruals
Inventory
Total current assets
Net plants and equipment
Total assets
Total current liabilities
Long term bonds
Total liabilities
Preferred stock
Common stock
Retained earnings
Total common equity
Total liabilities and equity
Something in B/S:
- Liquidity
- Debt versus Equity (Source of Financing):
Claims in Bankruptcy
Financial Distress
- Common equity = common stock +
retained earnings
- Market Value versus Book Value
Book value explain the current market
value? Ex) Good Management or
reputation
Market value is more concern
- Accounting Rules:
Inventory (FIFO & LIFO) – cost of goods sold
Depreciation Methods (Accelerated
or straight line)
- Net worth = asset - liabilities
3. Income Statement:
A statement summarizing the firm’s revenue
and expenses over a period
Ex)
Something in I/S
- Matching with GAAP: not matching with
the actual cash flows
- Depreciation and amortization are not
actual cash outlay
Sales
Operating Cost except depreciation & amortization
EBITDA
Depreciation & Amortuization
other operating expenses
EBIT
Less interest
EBT
Taxes (40%)
Net Income before preferred dividends
Preferred dividends
Net Income
Dividends to common
Addition to retained earnings
- EBITDA is commonly used among
managers, analysts and bank loan officers
- Net cash flow =
Net income – noncash revenues+
noncash charge =
Net income +depreciation and
amortization
3. Statement of retained earnings:
A statement reporting how much of the
firm’s earnings were retained in the
business rather than paid out in dividends
4. Statement of Cash Flows:
A statement reporting the impact of a firm’s
operating, investing and financing
activities on cash flows over a period
5. Modifying Accounting data for investors and
managerial decisions
The cash flow generated through operations
determines the firm’s value.
1) Operating Cash Flow =
EBIT (1- tax rate) +Depreciation and Amortization
2) Here, EBIT(1- tax rate) is called NOPAT (net
operating profit after taxes). It is a profit that a
firm would generate if it has no debt and held
only operating assets.
• NOPAT is better performance measurement due
to different debts and interest charges
• Comparing changes of NOPAT to those of EPS
reveals impact of interests
3) Net operating working capital
= operating current asset – operating current
liabilities
= (cash + A/R + Inventories) – (A/P + Accruals)
• It indicates the level of liquidity in business.
• (here, AP and accrued taxes and wages are free
due to no fees. They are not provided by
investors)
4) Total net operating capital = net operating
working capital + operating long term asset (net
plant and equipment)
•Change of total net operating capital = net
investment in operating capital
•Ex) relationship among working capitals and net
income or sales
• - lower increase of sales/net income, compared
to higher increase total net operating capital
indicates something wrong. Cash management
problem? Inventory problem? Why?
5) Free cash flow (FCF):
• cash flow actually available for distribution to all
investors after investments in fixed assets, new products
and working capital necessary to sustain ongoing
operations
• It will determine the value of a company’s operations
FCF (free cash flow)
=NOPAT – net investment in operating capital
=(NOPAT + Depreciation) – (Net investment in operating
capital +Depreciation)
= Operating cash flow – Gross investment in operating
capital
How to use FCF?
• Pay interest
• Repay debt-holders
• Pay dividends
• Repurchase stock
• Buy short term investments or non-operating
assets
6. Performance Evaluation
Negative FCF is Bad?
• High growth firms with positive NOPAT
tend to have negative FCF
• However it is a bad sign if both NOPAT
and FCF were negative.
• One way to measure this issue is ROIC
(return on invested capital).
1) ROIC = NOPAT / Total net operating
capital. If ROIC is greater than WACC, firm
is adding value.
2) Market value added (MVA):
Performance Measurement with stock price
information
MVA
= market value of stock – equity capital supplied
by shareholders
= (shares outstanding × stock price) – total
common equity
• The difference between the market value of the
firm’s stock and the amount of equity capital
investors have supplied
• Based on the belief that maximizing the
difference will maximize the stock price
• But it measures the management’s performance
during the whole period
• Another MVA = (market value + market value of
debt and preferred stock) – Total investorsupplied capital. Here total investor-supplied
capital is summation of equity, debt and
preferred stock.
3) Economic value added (EVA):
• Value added to shareholders by management
during the given year. It is a measurement
typically used for an incentive compensation
program.
• EVA
• = NOPAT – after-tax dollar cost of capital used
to support operations
• = EBIT(1-tax rate)-(Total net operating
capital)(after tax cost of capital)
• = (Total net operating capital) × (ROIC – WACC)
6. Federal Income Tax System
• Corporate income is generally taxed by the
federal government at the rate of 15% to 35%,
depending taxable incomes. Also most state
governments impose income tax on corporations
( typically around 5%). Thus a large firm usually
pay around 40%.
• Individuals are taxed by the federal government
at the rate of 10% to 35%. Also some states
impose state taxes. Pension accounts are not
taxed until the money is withdrawn.
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Taxable income of $65,000.
Tax amount = 7500 + 0.25*(65000-50000)
=11250
Here 25% is a marginal tax rate.
11250/65000 is an average tax rate.
• For a business, interest payment is considered
as expense and reduce taxable incomes. But
for individuals, it is not (exception: home loans).
• Interests earned from state and local
government debts are exempt from federal
taxes.
• Dividends paid is not tax deductible.
• Dividend received by the individuals are taxed
as capital gains. But 70% of dividends received
by corporations from others could be deducted
in order to minimize triple taxation – dividend
paying corporation, dividend receiving
corporation, and shareholders of dividend
receiving corporation.
• Due to this character (70% deduction),
investment on stocks rather than on bonds
is preferred by corporations.
• Before 1987, corporate long term capital
gains were taxed at lower rates than
corporate ordinary income. But under
current law, corporations’ capital gains are
taxed at the same rates as their operating
income.
• Tax loss carry-back and carry-forward:
Ordinary corporate operating losses can
be carried back to prior 2 years and
forward for the next 20 years if necessary.
The loss is applied first to the earliest year,
then to the next earliest year, and so on,
until losses have been used up.
• If a corporation intentionally does not pay
dividend in order to help shareholders not
to pay tax on dividend, it is a violation.
Improper accumulation to avoid payment
of dividends. It is subject to penalty rate.
• Consolidated corporate tax return: if a
corporation owns 80% or more of another
corporation’ stock, then it can aggregate
income and file one consolidated tax
return. The losses of one company cane
be used to offset the profits of other
company.
• Taxes on Oversea Income: As long as
foreign earnings are reinvested oversea,
no tax is due and infinite.
• But when repatriated, it is subject for taxation –
difference between what is paid in foreign
countries and in US.
• S corporation is taxed like a personal taxation.
• About personal tax:
- Tax rate is progressive. That is, depending on
incomes, tax rate increases.
- Capital gain resulting from holding investment
more than 1 year, this capital gain is called long
term capital gains and taxed at a lower rate
(around 15%).