Financial Statements, Taxes, and Cash Flows

1. Financial Statements, Taxes, and Cash Flows Chapter 2

2. Topics • Financial Statements: • Balance Sheet • Income Statement • The basic difference between accounting value (or “book” value) and market value • The difference between accounting income and cash flow • How to determine a firm’s cash flow from its financial statements • Calculate cash flow • The difference between average and marginal tax rates • Calculate taxes

3. Financial Statements: Balance Sheet and Income Statement • In this class we will not prepare financial statements, we will use them as a source of information • The financial statements we see in this textbook will be condensed and will ignore some accounting customs such as: • Proper Titles • Showing the proper expense: • Interest Expense and Tax Expense will be shown on the Income Statement as Interest Paid and Taxes Paid

4. Balance Sheet (Snapshot In Time):Shows A Firm’s Accounting Value On A Particular Date

5. Balance Sheet Equation • Balance Sheet Equation: A = L + SE Assets = Liabilities + Shareholders’ Equity (Owners’ Equity)* Items owned Amounts owed to creditors Shareholders’ Investment* *See note at bottom of page 23

6. Define: • Asset • Cash, properties, and other things of value owned by an economic unit or business entity • Provides (probable) future economic benefits • Liability • Debts or amounts owed to creditors • (Probable) sacrifice of future economic benefits • In one word: • Debt • Owner’s Equity • The owner’s right to or investment in the business • Assets – Liabilities = Owners’ Equity • A – L = OE

7. What Is The Essence Of Each Side? A = L + SE Owners Stuff used to generate revenues Creditors

8. What Is The Essence Of Each Side? A = L + SE Use of Cash Source of Cash

9. Current assets Asset that will be converted to cash within 12 months, or the normal operating cycle Examples: Cash Accounts Receivable $ owed to firm by customers Fixed assets Asset that has a relatively long life Example: Truck, Building, Patent Current liabilities Debts owed within the year Example: Accounts Payable $ firm owes to suppliers Long-term debt Debt not due within the next year Example: Bonds Shareholders’ Equity A – L = SE Assets (Left Side) and Liabilities (Right Side) And Owners’ Equity (Right Side)

10. Net Working Capital = CA – CL =The Cash That Will Become Available Over The Next 12 Months

11. Handout # 1 • Build a balance sheet. • What is equity? • What is net working capital?

12. Liquidity: How Quickly An Asset Can Be Converted To Cash • Liquidity has two dimensions: • Ease of conversion to cash • Loss of value because you have to sell it quickly • Highly liquid asset: • Quickly sold without significant loss of value (inventory, short-term investments) • Illiquid asset: • Cannot be sold quickly without significant price reduction (machinery) • Items on balance sheet are listed in order of decreasing liquidity (most liquid are first)

13. Liquidity: How Quickly An Asset Can Be Converted To Cash • Liquidity is valuable: • Firm can readily pay bills and buy assets quickly • Liquid assets such as cash tend to be less profitable than illiquid assets such as buildings/trucks and subdivisions of business • To many liquid assets may mean the firm is not investing in profitable assets such as machinery to make products or purchases of other businesses

14. Debt vs. Equity • Creditors get paid first: • Periodic interest payments • In bankruptcy • Shareholders’ Equity = Assets - Liabilities

15. Leverage • The more debt (as a % of assets), the more leverage • Leverage can magnify: • Gains • Losses • More later!

16. The Basic Difference Between Accounting Value (Or “Book” Value) And Market Value • Asset’s: • Market value • The amount of cash we would get if we sold it • You never know for sure until you sell it • Book value • The historical cost that was recorded when the firm purchased the asset • Required under GAAP (Generally Accepted Accounting Principals) • Book value of assets often does not reflect the firm’s most valuable assets such as: • Talented employees/ managers • Customer list • Reputation

17. The Basic Difference Between Accounting Value (Or “Book” Value) And Market Value • Shareholders’ Equity • The market value for a share of stock is virtually always different that its book value • The goal of the financial manager is to maximize the market value for the stock • Thus, the financial manager is more interested in the market value than the book value

19. Income Statement (Video Recording For The Period) (Revenues – Expenses = Net Income) • Shows a firms performance for a period of time • Month • Quarter • Year • Synonyms: • Net Income = Profit = Earnings Net Income does not Necessarily mean “Cash in”

20. Define Revenues (GAAP) • The amounts a business earns • Generally at the point of sale • Examples: • Fees earned for performing services • Sales of merchandise • Rent income, and interest income • May take the form of cash, credit card receipts, or accounts receivable (collect from customer later)

21. Define Expenses (GAAP) • The costs that relate to earning revenue (the costs of doing business) • Examples • Wages • Rent • Interest • Advertising • May be paid in cash, immediately or at a future time (accounts payable)

22. Matching Principle (GAAP) • The principle that the revenue for one time period is matched up or compared with the related expenses for the same time period • First determine the revenues and then match those revenues with the costs associated with producing them!

23. The Difference Between Accounting Income And Cash Flow • GAAP • Accrued items do not have a cash flow associated with them • Noncash Revenues or Expense do not have cash associated with them • Time and Costs: • Product Cost may have both fixed and variables costs associated with them • Period Costs may have both fixed and variables costs associated with them

24. Accrual (GAAP) • Expense meaning of accrual: • Record (recognize) an expense when it has been incurred but not yet recorded in the books • Regardless of when the cash is paid • Revenue meaning of accrual: • Record (recognize) a revenue when it has been earned but not yet recorded in the books • Regardless of when the cash is received Define incur: To come in existence; To bring upon oneself

25. Noncash Items • Revenues or Expense listed on the Income Statement that have no cash flow associated with them for the period • Example: • Depreciation Expense

26. Depreciation • Systematically spreads out the cost of these assets over their useful lives • Matches the expenses for one period to the revenue generated for that same period (Matching Principle) • Example: • Original cash outflow of $10,000 for a truck • You cannot record the whole $10,000 in the first year because the firm will use it for 5 years • Thus, the accountant can take $10,000/5 = $2,000 Depreciation Expense per year • The $2,000 Depreciation Expense listed on the Income Statement is an accounting number, not a cash flow number

27. Time and Costs • Variable cost: • Costs that change in direct proportion to change in volume of activity • Example: • Sales commissions, direct materials, wages, delivery costs • Fixed cost: • Must be paid no matter what • Example: • Rent, depreciation, property taxes, executive salaries • The future: • Short run • Some costs are variable some are fixed • Long run • All costs are variable • Product Costs: • COGS may have both variable and fixed costs • Period Costs: • Selling and administrative costs may be variable and fixed, respectively

28. Cash Flow • Cash in • Cash out • Cash flow ≠ Net Income (Profit or Earnings) • Throughout this textbook and the study of financial management, cash flow will be fundamental • Therefore, we will have to be able to derive cash flow from the information on the balance sheet and the income statement

29. The Concept of Cash Flow • Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements • The statement of cash flows does not provide us with the same information that we are looking at here • We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

30. How To Determine A Firm’s Cash Flow From Its Financial Statements • Cash flow identity: More 

33. Notes On Identities: • Operating cash flow = Cash flow from day to day activities • Don’t include interest payments because that goes to bondholders (it properly is a financing expense – different than accountant CFO) • Add back the noncash expense, depreciation • Taxes are paid in cash • Capital spending = net spending on fixed assets (purchases - sales) • Add depreciation back because the net amount has it subtracted out • Change in NWC • CA – CL in beginning and ending period, then take the difference

34. Notes On Identities: • Net new borrowing = (End long-term debt) – (beg LTD) • Net new equity raised = (End common stock & Paid-in surplus) – (end CS & PIS) • Amounts in calculations can be positive or negative • A negative cash flow from assets may indicate that a firm is buying profitable assets! • A negative amount from change in NWC, could mean that firm is managing inventory or receivables or payables more efficiently! • A negative amount to stockholders could mean that the firm issued an amount of new stock that is more than dividends paid! • Handout #3 

35. Handout #3

36. The Difference Between Average And Marginal Tax Rates (see book table page31) • Average Tax Rates = total taxes/taxable income • Marginal Tax Rates = rate used on the next taxable $

37. Handout #4

38. Marginal Tax Rate • Normally, the marginal tax rate will be relevant for financial decision making • Any new cash flows will be taxed at the marginal rate

39. Summary Slide • Financial Statements: Balance Sheet and Income Statement • Balance Sheet Equation • Net Working Capital = CA – CL =The Cash That Will Become Available Over The Next 12 Months • Liquidity: How Quickly An Asset Can Be Converted To Cash • Debt vs. Equity

40. Summary Slide (cont.) • Leverage • The Basic Difference Between Accounting Value (Or “Book” Value) And Market Value • Define Revenues (GAAP) • Define Expenses (GAAP) • Matching Principle (GAAP) • The Difference Between Accounting Income And Cash Flow • Depreciation

41. Summary Slide (cont.) • Cash Flow • How To Determine A Firm’s Cash Flow From Its Financial Statements • The Difference Between Average And Marginal Tax Rates (see book table page31)