Chapter 2 Financial Statements, Taxes and Cash Flow

Financial Leverage Ratio

= Total Assets/Total Equity

Marginal tax rate (MTR)

Amount of tax payable on the next dollar earned.

the value of the firm's assets is equal to the sum of its liabilities and shareholders' equity

Assets = Liabilities + Stockholders' Equity

1.a An Example: Cash Flows for Dole Cola

Net income for Dole was thus $95. We now have all the numbers we need. DOLE COLA 2019 Operating Cash Flow Earnings before interest and taxes $150 + Depreciation 150 − Taxes 25 Operating cash flow $275

2.3 Concept Question

2.3a What is the difference between a marginal and an average tax rate?

cash flow from assets formula

= cash flow to creditors + cash flow to stockholders

Income Statement

A financial statement showing the revenue and expenses for a fiscal period.

cash flow to creditors

A firm's interest payments to creditors less net new borrowing. sometimes called cash flow to bondholders

Assets are classified as either current or fixed.

A fixed asset is one that has a relatively long life. Fixed assets can either be tangible, such as a truck or a computer, or intangible, such as a trademark or patent. A current asset has a life of less than one year.

Earnings Per Share (EPS)

A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the average number of common shares outstanding during the year.

bonds

Certificates of debt that carry a promise to buy back the bonds at a higher price

liabilities are

Current ( 1 year life) or long term ( more than 1 year)

What is the relationship between current assets and current liabilities in a healthy firm?

Current Assets are short term assets whose life us maximum one year. Current assets are used to support the operation of the business ( cash, account receivables, accrued income) Current Liabilities are a type of short term loan to support the operation of the business. The life of a current liability is one year. ( Account Payable, accrued expenses, short term loan) For a healthy firm. the current assets of the business should be twice the value of the current liabilities. current assets/ current liabilities = 2 for a healthy firm

1.d An Example: Cash Flows for Dole Cola

Dole had cash flow from assets of −$165. Net income was positive at $95. Is the fact that cash flow from assets was negative a cause for alarm? Not necessarily. The cash flow here is negative primarily because of a large investment in fixed assets. If these are good investments, then the resulting negative cash flow is not a worry.

1.e An Example: Cash Flows for Dole Cola Cash Flow to Creditors and Stockholders We saw that Dole Cola had cash flow from assets of −$165. The fact that this is negative means that Dole raised more money in the form of new debt and equity than it paid out for the year.

For example, suppose we know that Dole didn't sell any new equity for the year. What was cash flow to stockholders? To creditors? DOLE COLA 2019 Cash Flow to Stockholders Dividends paid $30 − Net new equity 0 Cash flow to stockholders $30

What are the three things to keep in mind when looking at an income statement?

GAAP, cash versus noncash items, and time and costs.

Items on Income Statement

Revenues - Expenses

Book Value

the difference between the cost of a depreciate asset and its related accumulated depreciation

short run

the period of time during which at least one of a firm's inputs is fixed

Balance Sheet

Financial statement showing a firm's accounting value on a particular date. A statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period.

What is liquidity? Why is it important?

How easy it is to turn an item into cash without losing any money ease of conversion versus loss of value.

Income Statement Picture

The first thing reported on an income statement is usually revenue and expenses from the firm's principal operations.

Average Tax Rate (ATR)

Total taxes paid divided by total taxable income.

2.2 Concept questions

What is the income statement equation? What are the three things to keep in mind when looking at an income statement? Why is accounting income not the same as cash flow?

The cash flow identity states that cash flows from _____ should equal cash flows to creditors and equity investors.

assets

fixed assets

assets that are relatively permanent, such as land, buildings, and equipment

What is the cash flow identity?

cash flow from assets = cash flow to creditors + cash flow to stockholders

Net Working Capital (NWC)

current assets - current liabilities

current ration formula

current assets/ current liabilities

Liquidity

the ease with which an asset can be converted into cash

financial leverage

the use of debt in a firm's capital structure

straight line depreciation

(cost - salvage value) / useful life

Balance Sheet assets

-organized in order of liquidity: 1. Current Assets -includes all cash and items expected to be converted into cash in next 12 months A. Cash and Equivalents - money market B. Accounts Receivable - amounts due from customers C. Inventory - cost of raw materials D. Prepaid Expenses - rents, taxes, prepaid advertising 2. Fixed Assets A. Property Plant and Equipment -factories 3. Other Assets A. Intangible Assets -brand names, trademarks, formulas, etc

marginal tax rate example

.10($9,525) = $952.50 .12($38,700 - 9,525) = 3,501.00 .22($82,500 - 38,700) = 9,636.00 .24($100,000 - 82,500) = 4,200.00 Total = $18,289.50

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

Accounting value . book value = how much you purchased the item for Market value the actual price the item is worth

Free Cash Flow

Another name for cash flow from assets.

What is the balance sheet identity?

Assets = Liabilities + Stockholders' Equity

cash flow to stockholders

Dividends paid out by a firm less net new equity raised.

If you make an extra $1,000 in income and your marginal tax rate is 32 percent while your average tax rate is 20 percent, what will you pay in taxes on this extra income?

Extra Income = $1000 Marginal Tax Rate = 30% Amount he pays in taxes Income is calculated by: Tax Payment = Extra income * Marginal Tax Rate $1000*.30= 300 The amount he pays is 300 taxes on the extra income

Why is interest paid not a component of operating cash flow?

Interest is not a component of operating cash flow because it is considered a financing expense, not an operating expense

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?

Look at image So Algernon must pay .10 × $9,525 + .12 × ($38,700 − 9,525) + .22 × ($80,000 − 38,700) = $13,540. The average tax rate is thus $13,540/$80,000 = .1692, or 16.92%. The marginal rate is 22 percent because Algernon's taxes would rise by 22 cents if it earned another dollar in taxable income.

example At the end of 2019, U.S. had current assets of $1,403. At the end of 2018, current assets were $1,112, so, during the year, U.S. invested $1,403 − 1,112 = $291 in current assets.

Net working capital at the end of 2019 was $1,403 − 389 = $1,014. Similarly, at the end of 2018, net working capital was $1,112 − 428 = $684.

Income Statement Equation

Revenues - Expenses = Net Income

What is the income statement equation?

Revenues - Expenses = Net Income

Debt vs. Equity

Shareholders' equity = Assets - Liabilities

Market Value

The amount you could realistically sell an asset for today

cash flow to creditors ( sheet)

U.S. CORPORATION 2019 Cash Flow to Creditors Interest paid $70 − Net new borrowing 46 = Cash flow to creditors $24

Non-cash items

expenses charged against revenues that do not directly affect cash flow, such as depreciation.

Accounting income vs cash flow

is that an income statement contains noncash items. The most important of these is depreciation.

Assets

left-hand side

capital spending

net spending on fixed assets Net capital spending is money spent on fixed assets less money received from the sale of fixed assets.

bondholder

someone who owns bonds and receives the interest payments

SUMMARY AND CONCLUSIONS This chapter has introduced you to some of the basics of financial statements, taxes, and cash flow. In it, we saw that:

1. The book values on an accounting balance sheet can be very different from market values. The goal of financial management is to maximize the market value of the stock, not its book value. 2. Net income, as it is computed on the income statement, is not cash flow. A primary reason is that depreciation, a non cash expense, is deducted when net income is computed. 3. Marginal and average tax rates can be different, and it is the marginal tax rate that is relevant for most financial decisions. 4. After the Tax Cuts and Jobs Act of 2017, the U.S. corporate income tax is a flat 21 percent. 5. There is a cash flow identity much like the balance sheet identity. It says that cash flow from assets equals cash flow to creditors and stockholders.

corporate tax rate

2017, the federal corporate tax rate in the United States became a flat 21 percent. However, tax rates on other forms of business such as proprietorships, partnerships, and LLCs did not become flat.

What are the components of cash flow from assets?

Cash Flow From Assets Operating Cash Flow Capital Spending Change in Working Capital

1.f An Example: Cash Flows for Dole Cola From the cash flow identity, the total cash paid to creditors and stockholders was −$165. Cash flow to stockholders is $30, so cash flow to creditors must be equal to −$165

Cash flow to stockholders is $30, so cash flow to creditors must be equal to −$165 − 30 = −$195: Cash flow to creditors + Cash flow to stockholders = -$165 Cash flow to creditors + $30 = -$165 Cash flow to creditors = -$195

Operating Cash Flow (OCF)

Cash generated from a firm's normal business activities

Because we know that cash flow to creditors is −$195 and interest paid is $30 (from the income statement), we can now determine net new borrowing. Dole must have borrowed $225 during the year to help finance the fixed asset expansion:

DOLE COLA 2019 Cash Flow to Creditors Interest paid $30 − Net new borrowing 225 Cash flow to creditors −$195

1. An Example: Cash Flows for Dole Cola Operating Cash Flow During the year, Dole Cola, Inc., had sales and cost of goods sold of $600 and $300, respectively. Depreciation was $150, and interest paid was $30. Taxes were calculated at a straight 21 percent. Dividends were $30. (All figures are in millions of dollars.) What was operating cash flow for Dole? Why is this different from net income?

Dole Cola 2019 Income Statement Net sales $600 Cost of goods sold -$300 Depreciation -$150 Earnings before interest and taxes = $150 Interest paid -$30 Taxable income = $120 Taxes -$25 Net income = $95 Dividends $30 Addition to retained earnings 65

example example, going back to the balance sheet in Table 2.1, we see that at the end of 2019, U.S. had current assets of $1,403. At the end of 2018, current assets were $1,112, so, during the year, U.S. invested $1,403 − 1,112 = $291 in current assets.

Ending net fixed assets $1,709 − Beginning net fixed assets 1,644 + Depreciation 89 Net investment in fixed assets $154

1.b An Example: Cash Flows for Dole Cola Net Capital Spending Suppose beginning net fixed assets were $500 and ending net fixed assets were $750. What was the net capital spending for the year?

From the income statement for Dole, depreciation for the year was $150. Net fixed assets rose by $250. Dole thus spent $250 along with an additional $150, for a total of $400.

Suppose U.S. Corporation had 200 million shares outstanding at the end of 2019. Based on the income statement in Table 2.2, what was EPS? What were dividends per share?

From the income statement, U.S. Corporation had a net income of $474 million for the year. Total dividends were $165 million. Because 200 million shares were outstanding, we can calculate earnings per share and dividends per share as follows: Earnings per share = Net income/Total shares outstanding = $474/200 = $2.37 per share Dividends per share = Total dividends/Total shares outstanding = $165/200 = $.825 per share

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 (NWC) Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation − Taxes Net capital spending = Ending net fixed assets − Beginning net fixed assets + Depreciation Change in NWC = Ending NWC − Beginning NWC 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

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

Marginal tax is the tax you will pay on your next dollar of income. Average tax is the taxes you have paid divided by your total income. Therefore, your average percentage of your income you pay in taxes will almost always be less than the marginal tax rate of the tax bracket your income falls within.

1.c An Example: Cash Flows for Dole Cola Change in NWC and Cash Flow from Assets Suppose Dole Cola started the year with $2,130 in current assets and $1,620 in current liabilities. The corresponding ending figures were $2,260 and $1,710. What was the change in NWC during the year? What was cash flow from assets? How does this compare to net income?

Net working capital started out as $2,130 − 1,620 = $510 and ended up at $2,260 − 1,710 = $550. The change in NWC was thus $550 − 510 = $40. DOLE COLA 2019 Cash Flow from Assets Operating cash flow $275 − Net capital spending 400 − Change in NWC 40 Cash flow from assets −$165

The accounting value of a firm is equal to what?

Shareholder Equity

Generally Accepted Accounting Principles (GAAP)

The common set of standards and procedures by which audited financial statements are prepared.

Liabilities and Owner's Equity

The right side represents the people who paid for the Assets and their current stake

cash flow from assets

The total of cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and change in net working capital.

Operating Cash Flow

To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don't want to include depreciation because it's not a cash outflow, and we don't want to include interest because it's a financing expense.

2.1 concept question

What is the balance sheet identity? What is liquidity? Why is it important? What do we mean by financial leverage? Explain the difference between accounting value and market value. Which is more important to the financial manager? Why?

2. 4 Concept Questions

What is the cash flow identity? Explain what it says. What are the components of operating cash flow? Why is interest paid not a component of operating cash flow?

Why is accounting income not the same as cash flow?

accounting income is not the same as cash flow b/c an income statement contains Non-cash Items. Non-cash items are expenses charged against revenues that do not directly affect cash flow, such as depreciation. The deduction or depreciation is just an accounting number, its not ACTUAL cash spent. The depreciation deduction is simply another application of the matching principle in accounting

example of current liability

accounts payable

Change in Net Working Capital

the difference between a change in current assets and a change in current liabilities

long run

the period of time in which a firm can vary all its inputs, adopt new technology, and increase or decrease the size of its physical plant

What is the purpose of the income statement?

to measure performance over a set period of time

Example # 1 A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt of $200. What does the balance sheet look like? What is shareholders' equity? What is net working capital?

total assets are $100 + 500 = $600 and total liabilities are $70 + 200 = $270, so shareholders' equity is the difference: $600 − 270 = $330.

Shareholders' Equity

total value of assets - total value of liabilities