Financial Statements, Cash Flow, and Taxes

1. Financial Statements, Cash Flow, and Taxes Key Financial Statements Balance sheet Income statements Statement of retained earnings Statement of cash flows Accounting income vs. cash flow Federal tax system

2. 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 retained earnings – 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. Balance Sheet – D’Leon Co.

4. Balance sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

5. Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E

6. Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income

7. Other data No. of shares EPS DPS Stock price Lease pmts

8. Statement of Retained Earnings (2009) Balance of retained earnings, 12/31/08 Add: Net income, 2009 Less: Dividends paid Balance of retained earnings, 12/31/09

9. What is a Source vs. Use? Sources: Decrease Asset Increase Liability Increase Owner’s Equity Uses: Increase Asset Decrease Liability Decrease Owner’s Equity

10. Statement of Cash Flows (2009) OPERATING ACTIVITIES Net income Add (Sources of cash): Depreciation Increase in A/P Increase in accruals Subtract (Uses of cash): Increase in A/R Increase in inventories Net cash provided by ops.

11. Statement of Cash Flows (2009) L-T INVESTING ACTIVITIES Investment in fixed assets FINANCING ACTIVITIES Increase in notes payable Increase in long-term debt Payment of cash dividend Net cash from financing NET CHANGE IN CASH Plus: Cash at beginning of year Cash at end of year

12. What can you conclude 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.

13. Did the expansion create additional net operating profits after taxes (NOPAT)? NOPAT = EBIT (1 – Tax rate) NOPAT09 = -$130,948 (1 – 0.4) = -$130,948 (0.6) = -$78,569* NOPAT08 = $114,257 *note: tax subsidy (recoup tax payments)

14. NWC = Operating - Non-interest current assets bearing CL NWC09 = ($7,282 + $632,160 + $1,287,360) – ($524,160 + $489,600) = $913,042 NWC08 = $842,400 Note: if CA includes marketable securities this amount is not included. Not an operating asset. What effect did the expansion have on net working capital (operating – no financing)?

15. What effect did the expansion have on operating capital? Operating capital = NWC + Net Fixed Assets Operating Capital09 = $913,042 + $939,790 = $1,852,832 Operating Capital08 = $1,187,200 Note: NWC does not include financing

16. What is your assessment of the expansion’s effect on operations? Sales NOPAT NWC Operating capital Net Income

17. What effect did the expansion have on net cash flow and operating cash flow? NCF09 = NI + Dep = ($160,176) + $116,960 = -$43,216 NCF08 = $87,960 + $18,900 = $106,860 OCF09 = NOPAT + Depreciation and amortization = ($78,569) + $116,960 = $38,391 OCF08 = $114,257 + $18,900 = $133,157

18. What was the free cash flow (FCF) for 2009? FCF09 = [-$130,948(1 – 0.4) + $116,960] – [($1,202,950 – $491,000) + $70,642] = -$744,201 NOTE: Capital Expenditures = Diff Net Plant & Equip + Dep. So: FCF = [EBIT (1-t) + Dep – [? Gross fixed assets + ? NWC] Or: FCF = [EBIT (1-t) + Dep – [? net fixed assets + Dep. + ? NWC] Is negative free cash flow always a bad sign?

19. 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.

20. Federal Income Tax System

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%). Individuals Rates begin at 10% and rise to 35% for individuals with income over $319,100. May be subject to state tax.

22. 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. Dividends received – Most investors pay 15% taxes. Investors in the 10% tax bracket pay 5% on dividends. 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”.

23. 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.