Chapter 2

Financial Statements,
Taxes, and Cash Flow

Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.

McGraw-Hill/Irwin
 Key Concepts and Skills
• Know the difference between book
value and market value
• Know the difference between
accounting income and cash flow
• Know the difference between
average and marginal tax rates
• Know how to determine a firm’s cash
flow from its financial statements

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 Chapter Outline
• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow

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 Balance Sheet
• The balance sheet is a snapshot of the
firm’s assets and liabilities at a given point
in time
• Assets are listed in order of decreasing
liquidity
– Ease of conversion to cash
– Without significant loss of value
• Balance Sheet Identity
– Assets = Liabilities + Stockholders’ Equity

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The Balance Sheet –
Figure 2.1

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 Net Working Capital and
Liquidity
• Net Working Capital
– = Current Assets – Current Liabilities
– Positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out
– Usually positive in a healthy firm
• Liquidity
– Ability to convert to cash quickly without a significant loss in
value
– Liquid firms are less likely to experience financial distress
– But liquid assets typically earn a lower return
– Trade-off to find balance between liquid and illiquid assets

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 Asia-Pacific Corporation
Balance Sheet – Table 2.1

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 Market Value vs. Book
Value
• The balance sheet provides the book
value of the assets, liabilities, and equity.
• Market value is the price at which the
assets, liabilities ,or equity can actually be
bought or sold.
• Market value and book value are often
very different. Why?
• Which is more important to the decision-
making process?

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 Example 2.2 Klingon
Corporation
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book Market Book Market
Assets Liabilities and
Shareholders’ Equity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 SE 600 1,100
1,100 1,600 1,100 1,600

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 Income Statement
• The income statement is more like a
video of the firm’s operations for a
specified period of time.
• You generally report revenues first and
then deduct any expenses for the period
• Matching principle – GAAP says to show
revenue when it accrues and match the
expenses required to generate the
revenue

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 Asia-Pacific Corporation
Income Statement – Table 2.2

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 Taxes
• The one thing we can rely on with taxes is
that they are always changing
• Marginal vs. average tax rates
– Marginal tax rate – the percentage paid on
the next dollar earned
– Average tax rate – the tax bill / taxable
income
• Other taxes

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Corporate Tax Rates
Around the World

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 Example: Marginal Vs.
Average Rates
• Suppose your firm earns $4 million in
taxable income.
– What is the firm’s tax liability?
– What is the average tax rate?
– What is the marginal tax rate?
• If you are considering a project that will
increase the firm’s taxable income by $1
million, what tax rate should you use in
your analysis?

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 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
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 Cash Flow From Assets
• Cash Flow From Assets (CFFA) =
Cash Flow to Creditors + Cash Flow
to Stockholders
• Cash Flow From Assets = Operating
Cash Flow – Net Capital Spending –
Changes in NWC

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 Example: Asia-Pacific
Corporation – Part I
• OCF (I/S) = EBIT + depreciation – taxes =
$547

• NCS ( B/S and I/S) = ending net fixed

assets – beginning net fixed assets +
depreciation = $130

• Changes in NWC (B/S) = ending NWC –

beginning NWC = $330

• CFFA = 547 – 130 – 330 = $87

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 Example: Asia-Pacific
Corporation – Part II
• CF to Creditors (B/S and I/S) = interest
paid – net new borrowing = $24
• CF to Stockholders (B/S and I/S) =
dividends paid – net new equity raised
= $63
• CFFA = 24 + 63 = $87

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Cash Flow Summary -
Table 2.6

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 Example: Balance Sheet and
Income Statement Information
• Current Accounts
– 2011: CA = 3625; CL = 1787
– 2010: CA = 3596; CL = 2140
• Fixed Assets and Depreciation
– 2011: NFA = 2194; 2008: NFA = 2261
– Depreciation Expense = 500
• Long-term Debt and Equity
– 2011: LTD = 538; Common stock & APIC = 462
– 2010: LTD = 581; Common stock & APIC = 372
• Income Statement
– EBIT = 1014; Taxes = 368
– Interest Expense = 93; Dividends = 285

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 Example: Cash Flows
• OCF = 1,014 + 500 – 368 = 1,146
• NCS = 2,194 – 2,261 + 500 = 433
• Changes in NWC = (3,625 – 1,787) – (3,596 –
2,140) = 382
• CFFA = 1,146 – 433 – 382 = 331
• CF to Creditors = 93 – (538 – 581) = 136
• CF to Stockholders = 285 – (462 – 372) = 195
• CFFA = 136 + 195 = 331
• The CF identity holds.

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 Quick Quiz
• What is the difference between book value
and market value? Which should we use for
decision-making purposes?
• What is the difference between accounting
income and cash flow? Which do we need to
use when making decisions?
• What is the difference between average and
marginal tax rates? Which should we use
when making financial decisions?
• How do we determine a firm’s cash flows?
What are the equations, and where do we
find the information?

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 Ethics Issues

• Why is manipulation of financial

statements not only unethical and illegal,
but also bad for stockholders?

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 Comprehensive Problem
• Current Accounts
– 2011: CA = 4,400; CL = 1,500
– 2010: CA = 3,500; CL = 1,200
• Fixed Assets and Depreciation
– 2011: NFA = 3,400; 2010: NFA = 3,100
– Depreciation Expense = 400
• Long-term Debt and Equity (R.E. not given)
– 2011: LTD = 4,000; Common stock & APIC = 400
– 2010: LTD = 3,950; Common stock & APIC = 400
• Income Statement
– EBIT = 2,000; Taxes = 300
– Interest Expense = 350; Dividends = 500
• Compute the CFFA

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End of Chapter

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