Ch 2: Financial Statements, Taxes, and Cash Flow

Income =

Revenues − Expenses

Kaylor Equipment Rental paid $75 in dividends and $511 in interest expense. The addition to retained earnings is $418 and net new equity is $500. The tax rate is 35 percent. Sales are $15,900 and depreciation is $680. What are the earnings before interest and taxes?

Sales $15,900 -cost -depreciation $680 =earnings before int and tax -Interest paid $511 =taxable income -taxes (35%) =net income -dividends $75 =addition to retained earnings $418 Net Income = $75 + 418 = $493 Taxable Income = $493 / (1- .35) = $758.46 EBIT = $758.46 + $511 = $1,269.46

Andre's Bakery has sales of $613,000 with costs of $479,000. Interest expense is $26,000 and depreciation is $42,000. The tax rate is 25 percent. What is the net income?

Sales $613,000 -cost $479,000 -depreciation $42,000 =earnings before int and tax (EBIT) $92,000 -Interest paid $26,000 =taxable income $66,000 -taxes (tax rate 25%) $16,500 =net income $49,500 -dividends n/a =addition to retained earnings n/a Net Income = $49,500

RTF Oil has total sales of $911,400 and costs of $787,300. Depreciation is $52,600 and the tax rate is 34 percent. The firm does not have any interest expense. What is the operating cash flow?

Sales $911,400 -cost $787,300 -depreciation $52,600 =ebit $71,500 -Interest paid n/a =taxable income $71,500 -taxes (34%) $24,310 =net income $47,190 -dividends n/a =addition to retained earnings n/a operating cash flow (ocf) = ebit $71,500 + depreciation $52,600 - taxes $24,310 = $99,790

Generally Accepted Accounting Principles (GAAP)

The common set of standards and procedures by which audited financial statements are prepared. *compliance is reflected when preparing an income statement, showing revenue when it accrues & expenses shown are based on the matching principle (matching revenues with expenses)

income statement

Financial statement summarizing a firm's performance over a period of time. *when examining, consider 1. cash vs non-cash items 2. GAAP 3. time and costs *calculated by, sales -cost -depreciation =EBIT -Int =taxable income x tax rate -taxes due =net income *items listed 1. revenue and expenses are listed first 2. followed by, financing expenses such as interest paid, 3. Taxes paid are reported separately. 4. The last item is net income (the so-called bottom line). Net income is often expressed on a per-share basis and called earnings per share (EPS). * revenue is only recognized, 1. when the value of an exchange of goods or services can be reliably determined 2. when the earnings process is virtually completed

free cash flow

Another name for cash flow from assets *total distributed cash flopw

A firm has $680 in inventory, $2,140 in fixed assets, $210 in accounts receivables, $250 in accounts payable, and $80 in cash. What is the amount of the net working capital?

Inventory $680 +Acct Recv $210 -Accts Payable $250 +Cash $80 =NWC $720 *fixed assets are not included **current assets - current liabilities

Assets =

Liabilities + Shareholders' equity *provide value to the firm

net working capital (NWC)

Current assets less current liabilities NWC = current assets - current liabilities *is positive when current assets exceed current liabilities *increases when inventory is sold for cash at a profit *Based on the definitions of current assets and current liabilities, this means the cash that will become available over the next 12 months exceeds the cash that must be paid over the same period

cash flow to stockholders =

Dividends paid out by a firm less net new equity raised. *calculated by, dividends paid -net new equity raised =cash flow to stockholders

the u.s. tax rate becomes a flat-rate tax in practice at approximately

$18 million *the corporate tax bill is just a flat 35 percent of taxable income if our taxable income is more than $18.33 million. Also, for the many midsize corporations with taxable incomes in the range of $335,000 to $10,000,000, the tax rate is a flat 34 percent

If, Federal marginal tax bracket = 34% State marginal tax bracket = 5% Local marginal tax bracket = 1% How much money will a corporation keep if it makes another $1,000,000 in taxable income?

$600,000 = (1 - .34 - .05 - .01) x $1,000,000

non-cash items

*Expenses charged against revenues that do not directly affect cash flow, such as depreciation. *expenses that directly affect net income but do not directly affect cash flow *accounting income differs from cash flow because an income statement contains noncash items

fixed assets

*left side of balance sheet *tangible: machinery, equipment, vehicles, land, plant *intangible: trademark, patent, accumulated depreciation

balance sheet

Financial statement showing a firm's accounting value as of a specific date. *left side: Total Value of Assets in order of decreasing book value or most liquid to least. *right side: Total Value of Liabilities and Shareholders' Equity *assets are listed in order of the length of time it takes for them to convert to cash in the normal course of business *liabilities are listed in the order in which they would normally be paid.

depreciation

*listed as a non-cash item on the income statement that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting *rather than deducting the cost of equipment as an expense at one time, it is an asset that depreciates value over a period of time *If it is straight-line and the asset is written down to zero over that period, then $5,000/5 = $1,000 will be deducted each year as an expense.2 The important thing to recognize is that this $1,000 deduction isn't cash—it's an accounting number. The actual cash outflow occurred when the asset was purchased. *increases expenses and lowers taxes for tax-paying firms *increases will increase the ocf (operating cash flow)

liabilities

*listed first, on the right side of the balance sheet - includes, long-term bonds, notes payable, and accounts payable *current: like current assets, have a life of less than one year (meaning they must be paid within the year) and are listed before long-term liabilities. ie, money that a firm owes to its suppliers. *long-term: A debt that is not due in the coming year. ie, loans, bonds. Bondholders are long-term creditors

variable costs

*long run business costs *Other costs such as wages to laborers and payments to suppliers *change as the output of the firm changes

fixed costs

*short term costs *costs that will not change due to fixed commitments over a stated period of time

short-run for a firm is the period of time during which

*some costs are fixed and some are variable *output can vary *costs include, 1. property taxes 2. management salaries (generally fixed) 3. rent payments for a warehouse (generally fixed in the short-run) 4. bond interest

net income

*the bottom line Sales -cost -depreciation =earnings before int and tax -Interest paid =taxable income -taxes (tax rate) =net income -dividends =addition to retained earnings *often expressed on a per-share basis and called earnings per share (EPS)

a primary concern for a bank lending funds to a business for the short term

*the liquidity and degree of financial leverage.

Liquidity

*the speed and ease with which an asset can be converted to cash *ie, gold is a relatively liquid asset - a custom manufacturing facility is not *has two dimensions: ease of conversion vs loss of value - Any asset can be converted to cash quickly if we cut the price enough *valuable - The more liquid a business is, the less likely it is to experience financial distress

An increase in the depreciation expense

1. Decrease net income 2. Increase the cash flow from assets

assets listed by most liquid to least

1. cash equivalents 2. accounts receivable 3. inventory 4. plant and equipment

increasing its noncash liquid assets will enable a firm to

1. increase its ability to meet short-term obligations 2. increase its ability to avoid financial distress

three particularly important things to keep in mind when examining a balance sheet:

1. liquidity 2. debt vs equity 3. market value vs book value

two classifications of costs used by financial accountants

1. product costs 2. period costs

differences between the income statement and cash inflows and outflows

1. sales on credit are accounts receivable rather than cash inflows until they are collected, which may be a different period 2. income taxes are often deferred, so the amount on the income statement may not represent the amount of the check to the IRS 3. cost of raw materials purchased on credit are accounts payable rather than cash outflows until they are paid, which may be in a different period

if the federal marginal tax bracket is 34%, state marginal bracket is 5%, and local marginal tax bracket is 1%, the overall marginal tax rate for the company is

40% = (.34 + .05 + .01)

the tax reform act of 1986 and the budget reconciliation act of 1993 created

6 actual tax rates *According to the originators of the current tax rules, there are only four corporate rates: 15 percent, 25 percent, 34 percent, and 35 percent. *The 38 and 39 percent brackets arise because of "surcharges" applied on top of the 34 and 35 percent rates *marginal and average tax rates equalize at a final rate of 35%

revenue

= units sold x sale price *using GAAP to prepare the income statement, shown as it accrues *general rule (the recognition or realization principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined *when the value of an exchange of goods or services can be reliably determined

cash flow to creditors =

A firm's interest payments to creditors less net new borrowing. *calculated by, interest paid -net new borrowing =cash flow to creditors *$100 interest paid -$150 net new borrowing = -$50 cash flow to creditors

marginal tax rate

Amount of tax payable on the next dollar earned. *rate where incremental cash flows are taxed *financial decisions are usually based on new cash flows

Product costs

includes, 1. raw materials, 2. direct labor expense, and 3. manufacturing overhead *reported on the income statement as costs of goods sold, *include both fixed and variable costs

result of a decrease in depreciation expense

increases earnings per share

it is important for accounting standards to become more comparable across countries because

increasing globalization of business makes it necessary to understand financial reporting by firms that follow other accounting standards

period costs

incurred during a particular time period and might be reported as 1. selling, 2. general, and 3. administrative expenses *some of these costs may be fixed and others may be variable ie, the salary of the firms' president is a period cost and most likely fixed (in the short run)

assets are recorded at historical cost, not market value because

it is hard to keep up with the market value changes *For current assets, market value and book value might be somewhat similar because current assets are bought and converted into cash over a relatively short span of time. **In other circumstances, the two values might differ quite a bit. Moreover, for fixed assets, it would be purely a coincidence if the actual market value of an asset (what the asset could be sold for) were equal to its book value.

positive net working capital is important because

it means the firm should sufficient cash to meet its current obligations

GAAP matching principle

states that costs associated with a good or service should be recorded at the same time as the revenue from selling that good or service

cash flow

the difference between the number of dollars that came in and the number that went out sales - expenses *most important item extracted from financial statements

residual value

the portion equity holders are entitled to after creditors are paid including, 1. accounts payable 2. preferred stockholders 3. other debt holders 4. bondholders

market value

the price at which buyers and sellers would trade *goal of the financial manager is to increase the firm's value

GAAP recognition or realization principle

to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.

dividends per share =

total dividens/total shares outstanding

financial leverage

use of debt in a firm's capital structure *The more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage *can greatly magnify both gains and losses *increase the potential rewards for investors *increase the chance of financial distress and business failure

A positive cash flow to stockholders indicates

a dividends paid exceeded the net new equity raised

a positive cash flow to creditors represents

a net cash outflow from the firm

stockholders' equity represents

a residual claim against the book value of the firm's assets. (the book value of the firm's assets less the book value of its liabilities)

statement of cash flows

an official accounting statement that helps to explain the change in cash and cash equivalents

the accounting equation shows that stockholders' equity equals

assets - liabilities

the cash flow identity reflects

cash flow from assets = cash flow to creditors + cash flow to stockholders *cash is either used to produce the product or service, pay creditors or pay out to the owners of the firm *cash flow from the firm's assets equals the total of cash flow to creditors and cash flow to stockholders *a firm generates cash through its various activities

the value of a firm depends on its ability to generate

cash flows

At the beginning of the year, a firm had current assets of $121,306 and current liabilities of $124,509. At the end of the year, the current assets were $122,418 and the current liabilities were $103,718. What is the change in net working capital? -$19,679

change in nwc = nwc = total assets - total liabilities ending current assets $122,418 - ending current liabilities $124,509 = ending nwc $18,700 beginning current assets $121,306 - beginning current liabilities $124,509 = beginning nwc -$3,203 ending nwc $18,700 - beginning nwc -$3,203 = change in nwc $21,903

corporate tax rates

current tax rules include 4 federal tax rates: 15%, 25%, 34%, and 35% and 2 additional brackets are used for 'surcharges' applied on top of the 34 and 35 percent rates *Taxes can be one of the largest cash outflows a firm experiences *the tax code is the result of political forces and is a set of complicated rules that are often amended * the Tax Reform Act of 1986 expanded in the 1993 Omnibus Budget Reconciliation Act, identifies that corporate tax rates are not strictly increasing *38 and 39 percent brackets arise because of "surcharges" applied on top of the 34 and 35 percent rates. A tax is a tax is a tax, however, so there are really six corporate tax brackets

Jensen Enterprises paid $1,300 in dividends and $920 in interest this past year. Common stock increased by $1,200 and retained earnings decreased by $310. What is the net income for the year?

dividends $1,300 + retained earnings (-$310) = Net Income $990 total expenses - total revenue = net income

At the beginning of the year, the long-term debt of a firm was $72,918 and total debt was $138,407. At the end of the year, long-term debt was $68,219 and total debt was $145,838. The interest paid was $6,430. What is the amount of the cash flow to creditors?

Cash flow to creditors = $6,430 - ($68,219 - 72,918) = $11,129

The Daily News had net income of $121,600 of which 40 percent was distributed to the shareholders as dividends. During the year, the company sold $75,000 worth of common stock. What is the cash flow to stockholders?

Cash flow to stockholders = .40($121,600) - $75,000 = -$26,360

operating cash flow (ocf)

Cash generated from a firm's ongoing, normal business activities. EBIT +depreciation -taxes due =OCF *cash flow generated by business activities, excluding financing, capital spending, or changes in NWC

Net Capital Spending

Net fixed cost 2014 -Net fixed cost 2015 =change in net fixed assets +Depreciation exp 2015 =Net Capital Spending

Cash flow from assets (CFFA) =

The total of cash flow available for distribution to creditors and stockholders. *consisting of the following: operating cash flow, capital spending, and change in net working capital. *calculated by, Cash flow to creditors + Cash flow to stockholders or operating cash flow -net capital spending -change in NWC =cash flow from assets

Shareholders' equity = (common equity or owner's equity)

Total Value of Assets (current and fixed) − Total Value of Liabilities (current and long-term)

average tax rate

Total tax bill / total taxable income.

changes in capital spending can be negative when the acquisition of fixed assets is

less than sale of fixed assets

change in net working capital (NWC)

measured as the net change in current assets relative to current liabilities for the period being examined and represents the amount spent on net working capital *decreases will increase the cfa (cash flow from assets), all else equal calculated by, ending NWC -beginning NWC =change in NWC

Nielsen Auto Parts had beginning net fixed assets of $218,470 and ending net fixed assets of $209,411. During the year, assets with a combined book value of $6,943 were sold. Depreciation for the year was $42,822. What is the amount of net capital spending?

net capital spending = ending net fixed assets $209,411 - beginning net fixed assets $218,470 + depreciation $42,822 = net capital spending $33,763

earnings per share =

net income/total shares outstanding

current assets

relatively liquid and include cash and assets that are expected to convert to cash over the next 12 months *includes, inventory and accounts receivable

flat-rate tax

only one tax rate, so the rate is the same for all income levels *with a flat-rate tax, the marginal tax rate is always the same as the average tax rate. *As it stands now, corporate taxation in the United States is based on a modified flat-rate tax, which becomes a true flat rate for the highest incomes. *all income levels are taxed at *the same average rate and *the same marginal rate

a positive operating cash flow indicates that the firm is generating enough cash to

pay operating costs

liabilities side of the balance sheet

primarily reflects managerial decisions about capital structure and the use of short-term debt

Capital spending

refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets).