Chapter 2 Financial Statements, Taxes, and Cash Flow

Learning Objectives

• Difference between accounting value and market value:

  • Accounting value (or book value) refers to the value of assets as recorded in financial statements, typically at historical costs.
  • Market value reflects the current worth of the assets based on the market conditions, often influenced by their risk and potential cash flows.

• Difference between accounting income and cash flow:

  • Accounting income is the profit calculated based on the revenues earned and expenses incurred during a specific period, regardless of actual cash movements.
  • Cash flow indicates the actual inflow and outflow of cash, highlighting liquidity.

• Difference between average and marginal tax rates:

  • Average tax rate is the total taxes paid divided by total taxable income, showing the proportion of income paid in taxes.
  • Marginal tax rate is the tax rate applied to the next dollar of income, indicating how tax liability changes with additional income.

• Determining a firm’s cash flow from financial statements:

  • Analyze cash flows using the Statement of Cash Flows, which separates operating, investing, and financing activities.

The Balance Sheet

• Definition: A financial statement displaying the firm's accounting value at a specific date, summarizing what a firm owns (assets), owes (liabilities), and its equity.
• Structure:
  • Assets: Classified into:
  • Current Assets (e.g., cash, inventory, accounts receivable) with a life of less than one year.
  • Fixed Assets (e.g., machinery, buildings) usually have a long life and can be tangible (like vehicles) or intangible (like patents).
  • Liabilities: Further categorized into:
  • Current Liabilities (e.g., accounts payable, due within a year).
  • Long-term Liabilities (e.g., loans, debts payable beyond a year).
  • Equity represents the owner’s claim after liabilities are deducted from assets.
• Equation: Assets = Liabilities + Shareholders’ Equity

Net Working Capital

• Definition: Difference between current assets and current liabilities, indicating liquidity and operational efficiency.
  • Positive net working capital implies that a firm can meet its short-term obligations comfortably.

Liquidity and Debt Versus Equity

• Liquidity: Ability to convert assets to cash without significant loss. Highly liquid assets include cash and receivables, while less liquid might be real estate or specialized equipment.
• Debt vs. Equity:
  • Debt provides a claim for creditors, whereas equity holders receive residual income after debts are paid.
  • Financial leverage can amplify returns but increases risk for equity holders.

Market Value vs. Book Value

• Book Value: Recorded historical cost of assets in financial statements.
• Market Value: The estimated worth of assets in current market conditions, which can vary significantly from book value.
• Example: Klingon Corporation’s net fixed assets have a book value of $700 but a market value of $1,000.
  • Book equity calculation: Total assets - Total liabilities based on historical costs versus actual realizable values.

The Income Statement

• Purpose: Summarizes a firm’s performance over a specific period (monthly, quarterly, or yearly).
• Structure:
  • Calculation: Revenues - Expenses = Income
  • Starts with revenues, lists expenses, and concludes with net income.
• Considerations: Income figures might not represent actual cash flows due to noncash expenses like depreciation.

Taxes

• Corporate Tax Rates: Under current laws, the federal corporate tax rate is a flat 21% due to the Tax Cuts and Jobs Act of 2017.
  • Average Tax Rate = Total taxes / Total taxable income
  • Marginal Tax Rate = The rate applicable to the next dollar of taxable income.
• Example Calculation for tax liabilities based on progressive tax brackets.

Cash Flow

• Definition: The difference between the amount of cash coming in (cash inflows) and the amount going out (cash outflows).
• Cash Flow Identity: Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Stockholders
  • Displays how a firm generates cash and the allocation of that cash either to creditors or owners.

Components of Cash Flow from Assets

1. Operating Cash Flow: Cash generated from core business operations, excluding interest and depreciation but including taxes.
2. Net Capital Spending: Investment in fixed assets minus any sales of fixed assets.
3. Change in Net Working Capital: Measures the change in current assets relative to current liabilities.

• Example of Calculation for cash flow from assets.

Cash Flow to Creditors and Stockholders

• Cash Flow to Creditors: Interest payments minus net new borrowing,
• Cash Flow to Stockholders: Dividends paid minus net new equity raised.

Cash Flow Summary

1. Cash Flow Identity: Recognizes the flow from assets to both creditors and stockholders.
2. Components: Include operating cash flow, net capital spending, and changes in net working capital.
3. Calculation Framework for cash flow to creditors and stockholders.