Income Statements

EBIT

• Summarises earnings before taxes and financing costs

• Earnings Before Interest and Taxes

Non-operating section

Includes all financing costs, such as interest expense.

Amount of taxes levied on income

• Reported in a second section

Bottom line on statement

Net income

When is revenue recognised

• When an exchange of goods or services has occurred

Income is reported when…

• It is earned, even though no cash flow has necessarily occurred.

• e.g. sales are reported at the time goods are sold, even if the goods are sold on credit.

Economic value of items

• Connected to their future incremental cash flows.

• HOWEVER: cash flow does not appear on income statement.

Depreciation

Reflects the accountants estimate of the cost of equipment used up in the production process.

Deferred taxes

Differences between accounting income and true taxable income

if taxable income is less than accounting income in the current year…

• It will be more than accounting income later on

Taxes that are not paid today…

• Will have to be paid in the future

• represent a liability of the firm

Short run

• period when certain equipment, resources and commitments are fixed

• but the time is long enough for the firm to vary its output by using more labour and raw materials.

All firms making decisions in the short run have some fixed costs:

• Costs that will not change because of fixed commitments

• e.g. bond interest, overhead, property taxes

Variable costs

• change as the output of the firm changes

• e.g. raw materials, wages

In the long run…

All costs are variable

Product costs

• The total production costs incurred during a period

Included in product costs

• Variable costs

• Fixed cost

Period costs

• Costs allocated to a time period

Taxes

• one of largest cash outflows for a firm

The tax code

is the result of political, not economic, forces

When making financial decisions

• Important to distinguish between average and marginal tax rates

Average tax rate

• tax bill divided by taxable income

• % of income that goes to pay taxes

Marginal tax rate

• tax you would pay if you earned one more $.

Flat-rate tax

• Rate is the same for all income levels, so marginal tax rate is always the same as the average tax rate.

Net working capital

• Current assets - current liabilities

• positive when current assets are greater than current liabilities.

Change in net working capital

• Firm invests in net working capital

• Usually positive in a growing firm

Value of the firm

• Its ability to generate financial cash flow

Cash flow is not the same as net working capital

Value of a firms assets

Always equal to the combined value of the liabilities and the value of the equity.

CF ( A )

≡

CF ( B ) + CF ( S )

• The cash flows received from the firms assets (operating ativities) must equal the cash flows received from the firms creditors and equity investors.

Operating cash flow

• the cash flow generated by business activities, including sales of goods and services.

• Reflects tax payments, but not financing, capital spending or changes in net working capital.

Net change in fixed assets

= the acquisition of fixed assets - sales of fixed assets

Capital spending

= ending net fixed assets - beginning net fixed assets + depreciation

Cash flows also used for:

• making investments in net working capital

Total outgoing cash flow of the firm

• Can be separated into cash flow paid to creditors and cash flow paid to stockholders.

Creditors paid amount referred to as…

‘debt service’

Important source of cash flow

Sale of new debt

increase in long-term debt

• Net effect of new borrowing and repayment of maturing obligations plus interest expense.

Cash flow paid to creditors

= interest paid - net new borrowing

cash flow of the firm also paid to…

Stockholders

Cash flow to stockholders

= Dividends paid - net new equity raised

= Dividends paid - (stock sold - stock repurchased)

Types of relevant cash flow

1. Operating cash flow

2. Total cash flow of the firm

3. Free cash flow

Operating cash flow

• Earnings before interest + depreciation - taxes

• Usually positive

• Only negative for long time if firm isn’t generating enough cash to pay operating costs.

Total cash flow of firm

• Frequently negative

• Includes adjustments for capital spending and additions to net working capital

• when firm is growing quickly, is higher than operating cash flow.

net income is not…

Cash flow

Free cash flow

• cash that the firm is free to distribute to creditors and stockholders, as its not needed for working capital or fixed asset investments.

By shifting cash flows to a different heading

• companies boost operating cash flows

• these movements don’t affect the total cash flow of the firm.

Cash flow is generated by the firm and paid to creditors and shareholders. can be classified as:

1. Cash flow from operations

2. Cash flow from changes in fixed assets

3. Cash flow from changes in working capital