Chapter 2

Chapter 02 Financial Statements, Taxes, and Cash Flow

Key Concepts and Skills

• After studying this chapter, you should be able to:

  • Differentiate between accounting value (or "book value") and market value.

  • Distinguish accounting income from cash flow.

  • Explain the difference between average and marginal tax rates.

  • Determine a firm’s cash flow from its financial statements.

Chapter Outline

• 2.1 The Balance Sheet

• 2.2 The Income Statement

• 2.3 Taxes

• 2.4 Cash Flow

The Balance Sheet

Overview

• Definition: A snapshot of the firm’s assets and liabilities at a given point in time (indicating the status “as of …”).

Structure

• Assets (Left-hand side or upper portion):

  • Listed in order of decreasing liquidity.

• Liabilities and Owners’ Equity (Right-hand side or lower portion):

  • Listed in ascending order of the due date.

Balance Sheet Identity

• Equation: Assets = Liabilities + Stockholders’ Equity

  • This reflects the financial structure of a firm.

Key Components

• Total Value of Assets

  • Includes both current assets and fixed assets.

• Net Working Capital (NWC)

  • Definition: Current assets minus current liabilities.

  • Implication: Usually positive for a healthy firm.

• Liquidity

  • Definition: Speed and ease of conversion to cash without significant loss of value.

  • Provides a buffer against financial distress.

• Debt versus Equity

  • Refers to financial leverage. Shareholders’ equity can be calculated as:
    $Shareholders' ext{ } equity = Assets - Liabilities$

U.S. Corporation Balance Sheet Example (as of December 31, 2021 and 2022, in millions)

Market Value vs Book Value

• Book Value: The balance sheet value of the assets, liabilities, and equity.

• Market Value: The true value; the price at which the assets, liabilities, or equity can be bought or sold.

• Importance of Distinction: Market value and book value are often very different. Market value may have more relevance for decision-making purposes.

Income Statement

Overview

• Definition: Measures performance over a specified period of time (could be a period, quarter, or year).

• Structure:

  • Report revenues first, followed by deducting any expenses for the period.

  • Net Income: The end result, referred to as the “bottom line.”

  • Includes dividends paid to shareholders and additions to retained earnings.

• Key Equation:
  $Net ext{ } income = Revenue - Expenses$

U.S. Corporation Income Statement Example (2022, in millions)

Financial Statements - Principles and Definitions

GAAP Matching Principle

• Definition: Recognize revenue when it is fully earned, not when the cash arrives.

• Matching Expenses: Relate incurred expenses to the period of revenue recognition.

Non-Cash Items

• Definition: Expenses charged against revenue that do not impact cash flow.

• Example: Depreciation is the most common non-cash expense.

Taxes

Tax Structure

• Understanding Marginal vs Average tax rates:

  • Marginal Tax Rate: Percentage of tax paid on the next dollar earned.

  • Average Tax Rate: Total taxes paid divided by taxable income.

  • Important: If a project is expected to increase taxable income by $1 million, it is the marginal tax rate that should be used in analyses.

Corporate Tax Rate Example

• Recent Changes: Following the Tax Cuts and Jobs Act of 2017, the federal corporate tax rate in the U.S. is a flat 21% for corporations.

Example: Determining Tax Bill

• For personal taxable income of $125,000:

  • Calculate marginal and average tax rates:

  • Calculated Tax Bill:

  • Calculated as:

  • $0.10 imes 11,600 = 1,160.00$

  • $0.12 imes (47,150 - 11,600) = 4,266.00$

  • $0.22 imes (100,525 - 47,150) = 11,742.50$

  • $0.24 imes (125,000 - 100,525) = 5,784.00$

  • Total Tax:

  • $ext{Total} = 1,160 + 4,266 + 11,742.50 + 5,784 = 23,042.50$

  • Average Tax Rate Calculation:

  • $ext{Average Tax Rate} = rac{23,042.5}{125,000} = 0.1843 ext{ or } 18.43 ext{ \%}$

  • Marginal Tax Rate: The additional tax for earning one more dollar equals 24%.

The Concept of Cash Flow

Overview

• Definition: Cash flow is one of the most crucial pieces of information derived from financial statements.

• Focus: How cash is generated from utilizing assets, and how it is utilized to pay those financing the asset purchase.

Cash Flow from Assets (CFFA) Definition

• $CFFA = Operating ext{ } Cash ext{ } Flow (OCF) - Net ext{ } Capital ext{ } Spending (NCS) - Changes ext{ } in ext{ } NWC ( riangle NWC)$

• Alternatively expressed as:

• $CFFA = Cash ext{ } Flow ext{ } to ext{ } Creditors + Cash ext{ } Flow ext{ } to ext{ } Stockholders$

Example of Cash Flow from Assets, U.S. Corporation

1. Balance Sheet

• Review current and fixed assets along with liabilities and owners' equity.

2. Operating Cash Flow Calculation

• $OCF = EBIT + Depreciation - Taxes = 670 + 89 - 126 = 633$

Net Capital Spending and Changes in Net Working Capital (NWC)

Net Capital Spending Calculation

• $NCS = Ending ext{ } Net ext{ } FA - Beginning ext{ } Net ext{ } FA + Depreciation$

• $= 1,709 - 1,644 + 89 = 154$

Changes in Net Working Capital Calculation

• $riangle NWC = (Ending ext{ } NWC - Beginning ext{ } NWC)$

• $= (1,403 - 389) - (1,112 - 428) = 330$

Overall CFFA Calculation

• Therefore,

• $CFFA = 633 - 154 - 330 = 149$

Cash Flow to Creditors and Stockholders

Cash Flow to Creditors Calculation

• $CF/CR = Interest ext{ } Paid - Net ext{ } New ext{ } Borrowing = 70 - (454 - 408) = 24$

Cash Flow to Stockholders Calculation

• $CF/SH = Dividends ext{ } Paid - Net ext{ } New ext{ } Equity = 165 - (640 - 600) = 125$

Final CFFA Result

• $CFFA = 24 + 125 = 149$

Quick Quiz Review

• Differentiate between book value and market value and their importance.

• Clarify the distinction between accounting income and cash flow.

• Explore average and marginal tax rates and their relevance in financial decision-making.

• Understand how to determine a firm’s cash flows using provided equations and financial statements.

Dole Cola Example

Dole Cola 2025 Income Statement

Operating Cash Flow Calculation for Dole Cola

• $OCF = EBIT + Depreciation - Taxes = 150 + 150 - 25 = 275$

Change in Net Capital Calculation

• Ending Net Fixed Assets = 750,

• Beginning Net Fixed Assets = 500,

• Change in Net Working Capital (2022) = Current Assets - Current Liabilities for 2022 and 2021 leads to a change of 40.

Cash Flow from Assets (CFFA) for Dole Cola

• CFFA = OCF - NCS - $ riangle$NWC

• Ultimately leading to a negative cash flow from assets, identifying financial challenges and resource allocation needs.