FINANCIAL STATEMENTS & CASH

FLOW CALCULATION

SESSION 02
FA C I L I TAT O R : D R . A B I D M E H M O O D
 LEARNING OBJECTIVES
• Describe the difference between accounting value (or book value) and market value.

• Describe the difference between accounting income and cash flow.

• Describe the difference between average and marginal tax rates.

• Determine a firm’s cash flow from its financial statements.

 CHAPTER OUTLINE
• The Balance Sheet.

• The Income Statement.

• Taxes.

• Cash Flow.
 THE BALANCE SHEET 1

The balance sheet is a financial statement showing a firm’s accounting value on a particular date.
• Organizes and summarizes what a firm owns (assets), what a firm owes (liabilities), and the difference
between the two (equity).

Assets are classified as either current or fixed:

• A fixed asset is one that has a relatively long life.
• May be tangible (for example, truck or computer) or intangible (for example, trademark).
• A current asset has a life of less than one year (for example, inventory, cash, accounts receivable).
Liabilities are the first thing listed on the right side of the balance sheet and are classified are either
current or long-term.
• Current liabilities have a life of less than one year, while long-term liabilities are debts not due in the
coming year.
• Long-term liabilities are debts not due in the coming year (for example, a loan the firm will pay off in
five years).
• Assets = Liabilities + Stockholders’ Equity.
 THE BALANCE SHEET 3

Shareholders equity (that is, common equity or owners’ equity) is the difference
between the total value of the assets (current and fixed) and the total value of the
liabilities (current and long-term).
Balance sheet “balances” because the value of the left side always equals the value of
the right side.
• Value of firm’s assets is equal to the sum of its liabilities and shareholders’ equity.

Balance sheet identity, or equation, must hold:

Assets = Liabilities + Shareholders’ equity
CONSTRUCTION OF THE BALANCE SHEET

Access the text alternative for slide images.

 NET WORKING CAPITAL

Net working capital is the difference between a firm’s current assets and its current
liabilities.
• Positive when cash that will become available over the next 12 months (that is, current assets)
exceeds cash that must be paid over the same period (that is, current liabilities).
• Usually positive in a healthy firm.

Three particularly important things to keep in mind when examining a balance sheet:
1. Liquidity.
2. Debt versus equity.
3. Market value versus book value.
 LIQUIDITY AND DEBT VERSUS EQUITY
Liquidity refers to the speed and ease with which an asset can be converted to cash.
• Two dimensions are ease of conversion versus loss of value.
• Highly liquid asset is one that can be quickly sold without significant loss of value, while an
illiquid asset is one that cannot be quickly converted to cash without a substantial price
reduction.
• Assets are normally listed on the balance sheet in order of decreasing liquidity, with current
assets being relatively liquid and fixed assets being relatively illiquid.
• The more liquid a business, the less likely it is to experience financial distress.

If a firm borrows money, it usually gives first claim to the firm’s cash flow to creditors, with equity
holders entitled to only the residual value.
• Use of debt in firm’s capital structure is called financial leverage.
 U.S. CORPORATION 2020 AND 2021 BALANCE SHEETS
U.S. CORPORATION
2020 and 2021 Balance Sheets (in $ millions)
Assets Liabilities and owners’ Equity
2020 2021 2020 2021
Current assets Current liabilities
Cash $ 104 $ 221 Accounts payable $ 232 $ 266
Accounts 455 688 Notes payable 196 123
receivable
Inventory 553 555 Total $ 428 $ 389
Total $1,112 $1,464
Fixed assets
Net plant and $1,644 $1,709 Long-term debt $ 408 $ 454
equipment
Owners’ equity
Common stock and paid-in surplus $ 600 $ 640
Retained earnings 1,320 1,690
Total $1,920 $2,330
Total assets $2,756 $3,173 Total liabilities and owners’ equity $2,756 $3,173
 MARKET VALUE VERSUS BOOK VALUE
Values on balance sheet for the firm’s assets are book values and generally are not what
the assets are actually worth.
• Under generally accepted accounting principles (GAAP), audited financial statements in the
U.S. mostly show assets at historical cost (that is, assets are “carried on the book” at what the
firm paid for them, no matter how long ago they were purchased or how much they are worth
today).
• No necessary connection between total assets shown on the balance sheet and the value of
the firm.

For financial managers, accounting value of stock is not especially important; it is the
market value that matters.
• Market value of an asset depends on things like its riskiness and cash flows, neither of which
have anything to do with accounting.
 MARKET VALUE VERSUS BOOK VALUE: AN EXAMPLE
The Klingon Corporation has net fixed assets with a book value of $700 and an appraised market value of about $1,000.
Net working capital is $400 on the books, but approximately $600 would be realized if all the current accounts were
liquidated. Klingon has $500 in long-term debt, both book value and market value. What is the book value of the equity?
What is the market value? We can construct two simplified balance sheets, one in accounting (book value) terms and one
in economic (market value) terms:
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Assets Liabilities and Shareholders’ Equity
Book Market Book Market
Net working capital $ 400 $ 600 Long-term debt $ 500 $ 500
Net fixed assets 700 1,000 Shareholders’ equity 600 1,100
$1,100 $1,600 $1,100 $1,600

In this example, shareholders’ equity is actually worth almost twice as much as what is shown on the books. The distinction
between book and market values is important precisely because book values can be so different from true economic value.
 THE INCOME STATEMENT 1

The income statement is a financial statement summarizing a firm’s performance over a period of
time, usually a quarter or a year.
Income statement equation is:

Revenues – Expenses = Income

First thing reported on income statement would usually be revenue and expenses from the firm’s
principal operations.
• Subsequent parts include, among other things, financing expenses such as interest paid.
• Taxes are reported separately.
• Last item is net income (that is, “the bottom line”).
U.S. CORPORATION: INCOME STATEMENT
U.S. CORPORATION
2021 Income Statement (in millions)
Net sales $1,509
Cost of goods sold 750
Depreciation 65
Earnings before interest and taxes $ 694
Interest paid 70
Taxable income $ 624
Taxes (21%) 131
Net income $ 493
Dividends $ 123
Addition to retained earnings 370
 THE INCOME STATEMENT 2

A financial manager should keep three things in mind when looking at an income statement:
1. GAAP.
• As a result of the way revenues and expenses are realized, income statement figures may not be
representative of actual cash inflows/outflows that occurred during a particular period.

2. Cash versus noncash items.

• Noncash items are expenses charged against revenues that do not directly affect cash flow,
such as depreciation.
• Crucial to separate cash flows from noncash accounting entries.
3. Time and costs.
• Product costs include things such as raw materials, direct labor expense, and manufacturing
overhead.
• Period costs are incurred during a particular time period and might be reported as selling, general,
and administrative expenses.
 TAXES
Taxes can be one of the largest cash outflows a firm experiences.
• Size of a company’s tax bill is determined by the tax code, an often amended set of rules.

Federal corporate tax rates became a flat 21% after the passage of the Tax Cuts and Jobs
Act of 2017.
• Tax rates on other forms of business (for example, proprietorships, partnerships, and L LCs) did
not become flat.

Average tax rate is calculated as total taxes paid divided by total taxable income, while the
marginal tax rate is the amount of tax payable on the next dollar earned.
 PERSONAL TAX RATES AND AN EXAMPLE
Taxable Income Tax Rate
$ 0 to 9,875 10%
9,875 to 40,125 12
40,125 to 85,525 22
85,525 to 163,300 24
163,300 to 207,350 32
207,350 to 518,400 35
518,400+ 37

Deep in the Heart of Taxes

Algernon, a small proprietorship owned by an unmarried individual, has a taxable income of $80,000. What is its tax bill? What
is its average tax rate? Its marginal tax rate? From Table 2.3, we see that the tax rate applied to the first $9,875 is 10 percent; the
rate applied to the next $30,250 is 12 percent; and the rate applied after that up to $80,000 is 22 percent. So Algernon must pay.
10 × $9,875 + .12 × $30,250 + .22 × ($80,000 − 40,125) = $13,390. The average tax rate is thus

$13, 390 / $80, 000 .1674, or 16.74 percent. The marginal rate is 22 percent because
Algernon’s taxes would rise by 22 cents if it had another dollar in taxable income.
 CASH FLOW
Cash flow means the difference between the number of dollars that came in and the number of
dollars that went out.
No standard financial statement presents this information in the way that we wish.
• Statement of cash flows is a standard financial accounting statement, but it is concerned with a somewhat
different issue.

Cash flow identity says the cash flow from the firm’s assets is equal to the cash flow paid to suppliers
of capital to the firm:
Cash flow from assets = Cash flow to creditors + Cash flow to stockholders

Cash flow identity reflects the fact that a firm generates cash through its various activities, and
that cash is either used to pay creditors or paid out to the owners of the firm.
 CASH FLOW FROM ASSETS 1

Cash flow from assets is the total of cash flow to creditors and cash flow to stockholders,
consisting of the following three components:
• Operating cash flow refers to cash generated from a firm’s normal business activities.
• Capital expenditure (spending) refers to the net spending on fixed assets (purchases of fixed assets less
sales of fixed assets).
• Change in net working capital is measured as the net change in current assets relative to current
liabilities for the period being examined and represents the amount spend on net working capital.

Cash flow from assets is sometimes called free cash flow, referring to the cash the firm is “free” to
distribute to creditors and stockholders because it is not needed for working capital or fixed asset
investments.
 CASH FLOW FROM ASSETS 2

Operating cash flow is calculated as revenues minus costs and tells us whether a firm’s cash inflows from its
business operations are sufficient to cover its everyday cash outflows.
• Do not include depreciation or interest in the calculation, but be sure to include taxes.
• Negative operating cash flow is a sign of trouble.
• Different calculation used for operating cash flow in accounting.

Net capital spending (that is, CAPEX) is money spent on fixed assets less money received from the sale of
fixed assets.
• Could be negative is the firm sells more assets than it purchases.
Change in net working capital is found by taking the difference between the beginning and ending net
working capital (N W C) figures.
• Often referred to as the “addition to” N W C.
 U.S. CORPORATION 2020 AND 2021 BALANCE SHEETS
U.S. CORPORATION
2020 and 2021 Balance Sheets (in $ millions)
Assets Liabilities and owners’ Equity
2020 2021 2020 2021
Current assets Current liabilities
Cash $ 104 $ 221 Accounts payable $ 232 $ 266
Accounts 455 688 Notes payable 196 123
receivable
Inventory 553 555 Total $ 428 $ 389
Total $1,112 $1,464
Net Working $684 $1075 Change in NWC $391
Capital
Fixed assets
Net plant and $1,644 $1,709 Long-term debt $ 408 $ 454
equipment
Owners’ equity
Common stock and paid-in $ 600 $ 640
surplus
Retained earnings 1,320 1,690
Total $1,920 $2,330
Total assets $2,756 $3,173 Total liabilities and owners’ $2,756 $3,173
equity
 CASH FLOW FROM ASSETS 3

U.S. CORPORATION
2021 Income Statement (in millions)
Net sales $1,509
U.S. CORPORATION
Cost of goods sold 750 2021 Cash Flow from Assets
Depreciation 65 Operating cash flow $628
Earnings before interest $ 694 – Net capital spending 130
and taxes
Interest paid 70 – Change in NWC 391
Taxable income $ 624 Cash flow from assets $107
Taxes (21%) 131
Net income $ 493
Dividends $ 123
Addition to retained 370
earnings
 CASH FLOW TO CREDITORS AND STOCKHOLDERS
Cash flow to creditors is calculated as a firm’s interest payments to creditors less net new borrowing.
• Sometimes called cash flow to bondholders.
U.S. CORPORATION
2021 Cash Flow to Creditors

Interest paid $70

– Net new borrowing 46
Cash flow to creditors $24

Cash flow to stockholders is calculated as dividends paid out by a firm less net new equity raised.

U.S. CORPORATION
2021 Cash Flow to Stockholders

Dividends paid $123

– Net new equity raised 40
Cash flow to stockholders $ 83
 CASH FLOW SUMMARY
I. The cash flow identity
Cash flow from assets = Cash flow to creditors (bondholders)
+ Cash flow to stockholders (owners)
II. Cash flow from assets
Cash flow from assets = Operating cash flow
− Net capital spending
− Change in net working capital (N W C)
where:
Operating cash flow = Earnings before interest and taxes (E B I T)
+ Depreciation − Taxes
Net capital spending = Ending net fixed assets − Beginning net fixed assets
+ Depreciation
Change in NWC = Ending NWC − Beginning N W C
III. Cash flow to creditors (bondholders)
Cash flow to creditors = Interest paid − Net new borrowing
IV. Cash flow to stockholders (owners)
Cash flow to stockholders = Dividends paid − Net new equity raised
 SELECTED CONCEPT QUESTIONS
• What is liquidity? Why is it important?

• Explain the difference between book value and market value. Which is more important to
the financial manager? Why?

• What is the income statement equation?

• What is the difference between a marginal and an average tax rate?

• What is the cash flow identity? Explain what it says.

• What are the components of operating cash flow?