Chapter 3
Financial Statements, Cash
Flow, and Taxes
 Key Financial Statements




Balance Sheet
Income Statement
Statement of Stockholders’ Equity
Statement of Cash Flows
 Free Cash Flow
 Federal Tax System
3-1
The Annual Report




Balance sheet – provides a snapshot of a
firm’s financial position at one point in time.
Income statement – summarizes a firm’s
revenues and expenses over a given period of
time.
Statement of stockholders’ equity – shows
how much of the firm’s earnings were
retained, rather than paid out as dividends.
Statement of cash flows – reports the impact
of a firm’s activities on cash flows over a
given period of time.
3-2
Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2008
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2007
57,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800
3-3
Balance Sheet: Liabilities and Equity
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2008
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2007
145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
1,468,800
3-4
Income Statement
Sales
COGS
Other expenses
Total oper.costs excl.
deprec. & amort.
Depreciation and amortization
EBIT
Interest expense
EBT
Taxes
Net income
2008
$6,034,000
5,528,000
519,988
2007
$3,432,000
2,864,000
358,672
$6,047,988
116,960
($ 130,948)
136,012
($ 266,960)
(106,784)
($ 160,176)
$3,222,672
18,900
$ 190,428
43,828
$ 146,600
58,640
$ 87,960
3-5
Other Data
No. of shares
EPS
DPS
Stock price
Lease pmts
2008
100,000
-$1.602
$0.11
$2.25
$40,000
2007
100,000
$0.88
$0.22
$8.50
$40,000
3-6
Statement of Stockholders’
Equity (2008)
Balances, 12/31/07
2008 Net income
Cash dividends
Addition (subtraction)
to retained earnings
Balances, 12/31/08
Total
Common Stock
Retained Stockholders’
Shares
Amount Earnings
Equity
100,000 $460,000 $203,768
$663,768
(160,176)
(11,000)
100,000
$460,000 $ 32,592
(171,176)
$492,592
3-7
Statement of Cash Flows (2008)
Operating Activities
Net income
Depreciation and amortization
Increase in accounts payable
Increase in accruals
Increase in accounts receivable
Increase in inventories
Net cash provided by operating activities
($160,176)
116,960
378,560
353,600
(280,960)
(572,160)
($164,176)
3-8
Statement of Cash Flows (2008)
Long-Term Investing Activities
Additions to property, plant, & equipment
Net cash used in investing activities
Financing Activities
Increase in notes payable
Increase in long-term debt
Payment of cash dividends
Net cash provided by financing activities
Summary
Net decrease in cash
Cash at beginning of year
Cash at end of year
($ 711,950)
($ 711,950)
$ 436,808
400,000
(11,000)
$ 825,808
($ 50,318)
57,600
$ 7,282
3-9
Conclusions about D’Leon’s Financial
Condition from Its Statement of CFs

Net cash from operations = -$164,176,
mainly because of negative NI.

The firm borrowed $825,808 to meet its cash
requirements.

Even after borrowing, the cash account fell by
$50,318.
3-10
Did the expansion create additional
after-tax operating income?
AT operating income = EBIT(1 – Tax rate)
AT operating income08 = -$130,948(1 – 0.4)
= -$130,948(0.6)
= -$78,569
AT operating income07 = $114,257
3-11
What effect did the expansion have on
net working capital?
NWC = Current assets – (Payables + Accruals)
NWC08 = ($7,282 + $632,160 + $1,287,360)
– ($524,160 + $489,600)
= $913,042
NWC07 = $842,400
3-12
Assessment of the Expansion’s Effect
on Operations
2008
2007
$6,034,000
$3,432,000
AT oper. inc.
-78,569
114,257
NWC
913,042
842,400
-160,176
87,960
Sales
Net income
3-13
What was the free cash flow (FCF) for
2008?
Depr. and   Capital


FCF  EBIT(1  T) 



NWC

amortization expenditures

FCF08 = [-$130,948(1 – 0.4) + $116,960] –
[($1,202,950 – $491,000) + $70,642]
= -$744,201
Is negative free cash flow always a bad sign?
3-14
Does D’Leon pay its suppliers on time?


Probably not.

If this continues, suppliers may cut off
D’Leon’s trade credit.
A/P increased 260%, over the past year, while
sales increased by only 76%.
3-15
Does it appear that D’Leon’s sales price
exceeds its cost per unit sold?

NO, the negative after-tax operating income
and decline in cash position shows that
D’Leon is spending more on its operations
than it is taking in.
3-16
What if D’Leon’s sales manager decided to offer
60-day credit terms to customers, rather than
30-day credit terms?


If competitors match terms, and sales remain
constant...
 A/R would .
 Cash would .
If competitors don’t match, and sales double...
 Short-run: Inventory and fixed assets  to
meet increased sales. A/R , Cash .
Company may have to seek additional
financing.
 Long-run: Collections increase and the
company’s cash position would improve.
3-17
How did D’Leon finance its expansion?


D’Leon financed its expansion with external
capital.
D’Leon issued long-term debt which reduced
its financial strength and flexibility.
3-18
Would D’Leon have required external capital if
they had broken even in 2008 (Net income = 0)?

YES, the company would still have to finance
its increase in assets. Looking to the
Statement of Cash Flows, we see that the
firm made an investment of $711,950 in net
fixed assets. Therefore, they would have
needed to raise additional funds.
3-19
What happens if D’Leon depreciates fixed assets
over 7 years (as opposed to the current 10 years)?





No effect on physical
assets.
Fixed assets on the balance
sheet would decline.
Net income would decline.
Tax payments would
decline.
Cash position would
improve.
3-20
Federal Income Tax System
3-21
Corporate and Personal Taxes


Both have a progressive structure (the higher
the income, the higher the marginal tax rate).
Corporations
 Rates begin at 15% and rise to 35% for
corporations with income over $10 million,
although corporations with income between
$15 million and $18.33 million pay a
marginal tax rate of 38%.
 Also subject to state tax (around 5%).
3-22
Corporate and Personal Taxes

Individuals
 Rates begin at 10% and rise to 35% for
individuals with income over $349,700.
 May be subject to state tax.
3-23
Tax Treatment of Various Uses and
Sources of Funds



Interest paid – tax deductible for corporations
(paid out of pre-tax income), but usually not
for individuals (interest on home loans being
the exception).
Interest earned – usually fully taxable (an
exception being interest from a “muni”).
Dividends paid – paid out of after-tax income.
3-24
Tax Treatment of Various Uses and
Sources of Funds

Dividends received – Most investors pay 15%
taxes.
 Investors in the 10% or 15% tax bracket
pay 0% on dividends in 2008-2010.
 Dividends are paid out of net income which
has already been taxed at the corporate
level, this is a form of “double taxation”.
 A portion of dividends received by
corporations is tax excludable, in order to
avoid “triple taxation”.
3-25
More Tax Issues


Tax Loss Carry-Back and Carry-Forward – since
corporate incomes can fluctuate widely, the Tax
Code allows firms to carry losses back to offset
profits in previous years or forward to offset
profits in the future.
Capital gains – defined as the profits from the
sale of assets not normally transacted in the
normal course of business, capital gains for
individuals are generally taxed as ordinary
income if held for less than a year, and at the
capital gains rate if held for more than a year.
Corporations face somewhat different rules.
3-26