Ch. 2

Chapter 2: Financial Statements, Taxes and Cash Flow

Key Concepts and Skills Know

  • Book Value vs. Market Value:

    • Book value: The value of the company's assets, liabilities, and equity reported on the balance sheet.

    • Market value: The actual price at which assets, liabilities, or equity would sell in the market.

  • Accounting Income vs. Cash Flow: Understanding the fundamental differences between these concepts, which impact analysis and decision-making.

  • Average vs. Marginal Tax Rates:

    • Marginal tax rate: The tax rate applied to the next dollar earned.

    • Average tax rate: The total tax bill divided by taxable income.

  • Determining Cash Flow from Financial Statements: A focus on extracting cash flow data to inform financial analysis.

Chapter Outline

  • 2.1 The Balance Sheet

  • 2.2 The Income Statement

  • 2.3 Taxes

  • 2.4 Cash Flow

2.1 The Balance Sheet

  • Definition: The balance sheet provides a snapshot of the firm’s assets and liabilities at a specific point in time, stated as of a certain date.

    • Illustration of a sample balance sheet to show its structure and components.

Components of the Balance Sheet

  • Total Value of Assets: Signals all assets a company owns.

  • Total Value of Liabilities and Shareholders' Equity: Represents all obligations and equity stake of shareholders.

  • Net Working Capital (NWC):

    • Defined as Current Assets minus Current Liabilities.

    • Commonly positive for a financially healthy firm, indicating good liquidity.

Liquidity

  • Definition: The speed and ease with which assets can be converted to cash without substantial value loss.

  • Importance: Helps avoid financial distress.

Debt vs. Equity

  • Equation: Shareholders’ equity is calculated as:
    extShareholders′Equity=extAssets−extLiabilitiesext{Shareholders' Equity} = ext{Assets} - ext{Liabilities}

2.2 The Income Statement

  • Definition: Measures the firm's performance over a designated period (could be period, quarter, year).

  • Structure: Reports revenues followed by expenses with the end result being the Net Income, also referred to as the “bottom line”.

  • Income Statement Equation:
    extNetIncome=extRevenue−extExpensesext{Net Income} = ext{Revenue} - ext{Expenses}

U.S. Corporation Income Statement Example (2016)

  • Key Figures:

    • Net sales: $103 million

    • Cost of goods sold: $309 million

    • Depreciation: $1,509 million

    • Earnings before Interest and Taxes (EBIT): $750 million

    • Interest Paid: $65 million

    • Taxable Income: $694 million

    • Taxes: $70 million

    • Net Income: $624 million

    • Dividends: $212 million

    • Addition to Retained Earnings: $412 million

2.3 Taxes

  • Marginal vs. Average Tax Rates:

    • Marginal: Percentage of tax on the upcoming dollar earned.

    • Average: Your total tax bill divided by taxable income.

  • Application: When assessing a project that may raise taxable income by a specific amount (e.g., $1 million), use the marginal tax rate for analysis.

Corporate Tax Rates Table


  • Ranges of taxable income and corresponding tax rates:

    Taxable Income

    Tax Rate


    $0 - $50,000

    15%


    $50,001 - $75,000

    25%


    $75,001 - $100,000

    34%


    $100,001 - $335,000

    39%


    $335,001 - $10,000,000

    34%


    $10,000,001 - $15,000,000

    35%


    $15,000,001 - $18,333,333

    38%


    $18,333,334+

    35%

    Example: Marginal vs. Average Rates Calculation

    • Scenario: If a firm's taxable income is $4 million, what are the tax liabilities, average tax rate, and marginal tax rate?

      • Steps to Calculate Tax Liability:

      • Surpass each tax bracket to calculate the total tax liability step-wise.

      • Cumulative amounts lead to the total.

    Tax Calculation Breakdown Example

    • Total Tax Calculation Steps based on brackets:

      • $50,000 * 15% = $7,500

      • ($75,000 - $50,000) * 25% = $6,250

      • ($100,000 - $75,000) * 34% = $8,500

      • ($335,000 - $100,000) * 39% = $91,650

      • ($4,000,000 - $335,000) * 34% = $1,246,100

    • Total Tax Liability: 1,360,0001,360,000

    • Average Rate: rac{ ext{Total Tax Liability}}{ ext{Taxable Income}} = rac{1,360,000}{4,000,000} = 34 ext{%}

    • Marginal Rate: Consistent across the last calculation bracket for $4 million income = 34%.

    2.4 The Concept of Cash Flow

    • Definition: Cash flow is fundamental information extracted from financial statements, representing cash generated from utilizing assets and subsequently paid to those financing asset purchases.

    Cash Flow From Assets (CFFA) Equation

    • Formula:
      extCFFA=extOperatingCashFlow(OCF)−extNetCapitalSpending(NCS)−extChangesinNetWorkingCapital(extΔNWC)ext{CFFA} = ext{Operating Cash Flow} (OCF) - ext{Net Capital Spending} (NCS) - ext{Changes in Net Working Capital} ( ext{ΔNWC})

    Components Breakdown

    • Operating Cash Flow (OCF): Calculated as:
      extOCF=extEBIT+extDepreciation−extTaxesext{OCF} = ext{EBIT} + ext{Depreciation} - ext{Taxes}

    • Net Capital Spending (NCS):
      extNCS=extEndingNetFixedAssets−extBeginningNetFixedAssets+extDepreciationext{NCS} = ext{Ending Net Fixed Assets} - ext{Beginning Net Fixed Assets} + ext{Depreciation}

    • Changes in NWC (ΔNWC):
      extΔNWC=extEndingNWC−extBeginningNWC=(extCurrentAssets−extCurrentLiabilities<em>extcurrent)−(extCurrentAssets−extCurrentLiabilities</em>extprevious)ext{ΔNWC} = ext{Ending NWC} - ext{Beginning NWC} = ( ext{Current Assets} - ext{Current Liabilities}<em>{ ext{current}}) - ( ext{Current Assets} - ext{Current Liabilities}</em>{ ext{previous}})

    Example Calculation: U.S. Corporation Cash Flow

    • CFFA Calculation Steps:

      • Identify OCF from EBIT and subtract depreciation and taxes.

      • Calculate NCS and ΔNWC from corresponding asset values for two time periods.

      • Carry out complete CFFA calculation to summarize cash flows.

    End of Chapter 2