FIN 300-01, Chapter 2, Financial Statements, Taxes, and Cash Flow

*financial leverage

the use of debt in a firm's capital structure

2.2a: What is the income statement equation?

Revenues - Expenses = Income

2.1d: Explain the difference between accounting value and market value. Which is more important to the financial manager? Why?

The true value of any asset is its market value, which is simply the amount of cash we would get if we actually sold it. In contrast, the values shown on the 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 United States generally show assets at historical cost. In other words, assets are "carried on the books" at what the firm paid for them (minus accumulated depreciation), no matter how long ago they were purchased or how much they are worth today. For financial managers, then, the accounting value of the equity is not an especially important concern; it is the market value that matters.

2.1c: What do we mean by financial leverage?

The use of debt in a firm's capital structure is called financial leverage. The more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage. As we discuss in later chapters, debt acts like a lever in the sense that using it can greatly magnify both gains and losses. So, financial leverage increases the potential reward to shareholders, but it also increases the potential for financial distress and business failure.

2.4c: Why is interest paid not a component of operating cash flow?

This definition of cash flow thus considers interest paid to be an operating expense. Our definition treats it properly as a financing expense. If there were no interest expense, the two definitions would be the same.

cash flow to creditors

a firm's interest payments to creditors less net new borrowing

operating cash flow

cash generated from a firm's normal business activities

balance sheet

financial statement showing a firm's accounting value on a particular date

income statement

financial statement summarizing a firm's performance over a period of time

Generally Accepted Accounting Principles (GAAP)

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

2.2c: Why is accounting income not the same as cash flow?

A primary reason that accounting income differs from cash flow is that an income statement contains noncash items. The general rule (the recognition 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. 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. Expenses shown on the income statement are based on the matching principle. The basic idea here is to first determine revenues as described earlier and then match those revenues with the costs associated with producing them. So, if we manufacture a product and then sell it on credit, the revenue is recognized at the time of sale. The production and other costs associated with the sale of that product would likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some very different times. Thus, as a result of the way revenues and expenses are reported, the figures shown on the income statement may not be at all representative of the actual cash inflows and outflows that occurred during a particular period.

2.4a: What is the cash flow identity? Explain what it says.

Cash flow from assets = Cash flow to creditors + Cash flow to stockholders This is the cash flow identity. What it reflects is the fact that a firm generates cash through its various activities, and that cash either is used to pay creditors or else is paid out to the owners of the firm. We discuss the various things that make up these cash flows next.

2.2b: What are the three things to keep in mind when looking at an income statement?

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

2.3b: Do the wealthiest corporations receive a tax break in terms of a lower tax rate? Explain.

In looking at Table 2.4, notice that the more a corporation makes, the greater is the percentage of taxable income paid in taxes. Put another way, under current tax law, the average tax rate never goes down, even though the marginal tax rate does. As illustrated, for corporations, average tax rates begin at 15 percent and rise to a maximum of 35 percent.

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

In making financial decisions, it is frequently important to distinguish between average and marginal tax rates. Your average tax rate is your tax bill divided by your taxable income, in other words, the percentage of your income that goes to pay taxes. Your marginal tax rate is the extra tax you would pay if you earned one more dollar.

2.1b: What is liquidity? Why is it important?

Liquidity refers to the speed and ease with which an asset can be converted to cash. Liquidity really has two dimensions: ease of conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset, therefore, is one that can be quickly sold without significant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction. Liquidity is valuable. The more liquid a business is, the less likely it is to experience financial distress (i.e., difficulty in paying debts or buying needed assets). Unfortunately, liquid assets are generally less profitable to hold. For example, cash holdings are the most liquid of all investments, but they sometimes earn no return at all—they just sit there. There is, therefore, a trade-off between the advantages of liquidity and forgone potential profits.

2.4b: What are the components of operating cash flow?

Operating cash flow refers to the cash flow that results from the firm's day-to-day activities of producing and selling. Expenses associated with the firm's financing of its assets are not included because they are not operating expenses. 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. We do want to include taxes because taxes are, unfortunately, paid in cash.

2.1a: What is the balance sheet identity?

The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm's equity) at a given point in time.

marginal tax rate

amount of tax payable on the next dollar earned

free cash flow

another name for cash flow from assets

net working capital

current assets less current liabilities

cash flow to stockholders

dividends paid out by a firm less net new equity raised

noncash items

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

*cash flow

the difference between the number of dollars that came in and the number that went out

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

average tax rate

total taxes paid divided by total income