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Fin440 Chapter 2

This document provides an overview of key concepts related to financial statements, taxes, and cash flows. It discusses the differences between book and market values, accounting income and cash flow, and average and marginal tax rates. It outlines how to read a balance sheet and income statement, and how to determine a firm's cash flow from its financial statements using various equations that draw information from the balance sheet and income statement. The goal is to understand how to analyze and interpret these key financial concepts and statements.

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53 views21 pages

Fin440 Chapter 2

This document provides an overview of key concepts related to financial statements, taxes, and cash flows. It discusses the differences between book and market values, accounting income and cash flow, and average and marginal tax rates. It outlines how to read a balance sheet and income statement, and how to determine a firm's cash flow from its financial statements using various equations that draw information from the balance sheet and income statement. The goal is to understand how to analyze and interpret these key financial concepts and statements.

Uploaded by

sajedul
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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2

Financial Statements, Taxes, and


Cash Flows

1
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

2
Chapter Outline
 The Balance Sheet
 The Income Statement
 Taxes
 Cash Flow

3
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

4
The Balance Sheet - Figure 2.1

5
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 earn a lower return
 Trade-off to find balance between liquid and illiquid assets

6
US Corporation Balance Sheet –
Table 2.1

7
Market 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?

8
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 $ 500 LTD $ 500 $ 500


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

9
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

10
US Corporation Income Statement
– Table 2.2

11
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

12
US Corporate Tax Table

13
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?

14
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

15
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

16
Example: US 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

17
Example: US 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

18
Cash Flow Summary Table 2.5

19
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?

20
2
End of Chapter

21

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