Ch 3: Financial Statements, Cash Flow, and Taxes Managerial Finance

The rationale behind the after-tax income exclusion is that when a corporation receives dividends and then pays out its own after-tax income as dividends to its stockholders, the dividends received are subjected to triple taxation:

(1) The original corporation is taxed. (2) The second corporation is taxed on the dividends it receives. (3) The individuals who receive the final dividends are taxed again. This explains the 70% intercorporate dividend exclusion.

Annual report

A report issued annually by a corporation to its stockholders. It contains basic financial statements as well as management's analysis of the firm's past operations and future prospects.

Progressive

A tax system where the tax rate is higher on higher incomes. The personal income tax in the United States, which ranges from 0% on the lowest incomes to 39.6% on the highest incomes, is progressive.

Individuals pay taxes on

wages and salaries, on investment income (dividends, interest, and profits from the sale of securities), and on the profits of proprietorships and partnerships.

Taxable income is defined as

"gross income less a set of exemptions and deductions."

Pretax income needed to pay $1 of dividends =

$1 / (1 - Tax rate)

investors in IRAs face penalties if they withdraw funds before age 59.5 unless there is a qualifying exception—for example, investors in a Roth IRA can withdraw up to

$10,000 from their account to help pay for a first-time home without facing a penalty.

Beginning in 2013, the maximum tax rate on qualified dividends increased to

20% for taxpayers in the 39.6% tax bracket. However, for most taxpayers, the top tax rate on qualified dividends is 15%. Because corporations pay dividends out of earnings that have already been taxed, there is double taxation of corporate income—income is first taxed at the corporate rate; then, when what is left is paid out as dividends, it is taxed again. This double taxation motivated Congress to tax dividends at a lower rate than the rate on ordinary income.

Total debt versus total liabilities

A company's total debt includes both its short-term and long-term interest-bearing liabilities. Total liabilities equal total debt plus the company's "free" (non-interest bearing) liabilities.

Amortization

A noncash charge similar to depreciation except that it represents a decline in the value of intangible assets such as patents, copyrights, trademarks, and goodwill.

EBITDA

An acronym for earnings before interest, taxes, depreciation, and amortization.

Alternative Minimum Tax (AMT)

Created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions. The AMT was created in 1969 because Congress learned that 155 millionaires with high incomes paid no taxes because they had so many tax shelters from items such as depreciation on real estate and municipal bond interest. Under the AMT law, people must calculate their tax under the "regular" system and then under the AMT system, where many deductions are added back to income and then taxed at a special AMT rate. For many years, the AMT was not indexed for inflation, and literally millions of taxpayers found themselves subject to this very complex tax.

Working capital

Current assets are often called working capital because these assets "turn over"; that is, they are used and then replaced throughout the year.

Net working capital

Current assets minus current liabilities.

Dividends per share = DPS =

Dividends paid to common stockholders / common shares outstanding

NOPAT =

EBIT (1 - T)

Operating income

Earnings from operations before interest and taxes (i.e., EBIT). Moreover, it is calculated before deducting interest expenses and taxes, which are considered to be non-operating costs. Operating income is also called EBIT, or earnings before interest and taxes.

Roth IRAs

Individual retirement arrangements in which contributions are not tax-deductible but the future income and capital gains within these accounts are not taxed if the money is withdrawn after age 59 and a half years old.

Traditional IRAs

Individual retirement arrangements in which qualified contributions are tax-deductible and income and capital gains on investments within the account are not taxed until the money is withdrawn after age 59 and a half years old .

Stockholders' Equity

It represents the amount that stockholders paid the company when shares were purchased and the amount of earnings the company has retained since its origination. A statement that shows by how much a firm's equity changed during the year and why this change occurred.

Market value added =

Market value of a firm's equity - book value on the balance sheet

Earnings per share = EPS =

Net income / common shares outstanding

EVA =

Net operating profit after taxes (NOPAT) - Annual dollar cost of capital OR EBIT(1-T) - (Total invested capital x After-tax percentage cost of capital)

Net operating working capital (NOWC) =

Operating current assets - Operating current liabilities OR NOWC = (Current assets - Excess cash) - (Current liabilities - Notes payable)

Net operating working capital (NOWC)

Operating current assets minus operating current liabilities.

Carryback

Ordinary corporate operating losses can be carried backward for 2 years and carried forward for 20 years to offset taxable income in a given year.

Carryforward

Ordinary corporate operating losses can be carried backward for 2 years and carried forward for 20 years to offset taxable income in a given year.

Stockholders' Equity =

Paid-in capital + Retained earnings OR Total assets - Total liabilities

After-tax income =

Pretax income(1-T)

Operating income (or EBIT) =

Sales revenues - Operating costs

After the Enron and WorldCom fiascos, Congress in 2002 passed the

Sarbanes-Oxley Act (SOX), which required companies to improve their internal auditing standards and required the CEO and CFO to certify that the financial statements were properly prepared. The SOX bill also created a new watchdog organization to help make sure that the outside accounting firms were doing their jobs.

Total debt =

Short-term debt + Long-term debt

Statement of Cash Flows

Shows how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash. A report that shows how items that affect the balance sheet and income statement affect the firm's cash flows.

Statement of Stockholders' Equity

Shows the amount of equity the stockholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year.

Income statement

Shows the firm's sales and costs (and thus profits) during some past period—for example, 2018. Reports summarizing a firm's revenues, expenses, and profits during a reporting period, generally a quarter or a year.

Balance sheet

Shows what assets the company owns and who has claims on those assets as of a given date—for example, December 31, 2018. A statement of a firm's financial position at a specific point in time. The left side of the statement shows the assets that the company owns, and the right side shows the firm's liabilities and stockholders' equity, which are claims against the firm's assets.

Average tax rate

Taxes paid divided by taxable income.

S Corporations

The Tax Code allows small businesses that meet certain conditions to be set up as corporations and thus receive the benefits of the corporate form of organization—especially limited liability—yet still be taxed as proprietorships or partnerships rather than as corporations.

Retained earnings

The amount of capital raised beyond which new common stock must be issued. Are not just the earnings retained in the latest year—they are the cumulative total of all of the earnings the company has earned and retained during its life.

free cash flow (FCF)

The amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows.

Depreciation

The charge to reflect the cost of assets depleted in the production process. Depreciation is not a cash outlay.

Capital gain

The profit from the sale of a capital asset for more than its purchase price.

Market value added (MVA)

The excess of the market value of equity over its book value. MVA is simply the difference between the market value of a firm's equity and the book value as shown on the balance sheet, with the market value found by multiplying the stock price by the number of shares outstanding.

Capital loss

The loss from the sale of a capital asset for less than its purchase price.

Net operating profit after taxes (NOPAT)

The profit a company would generate if it had no debt and held only operating assets.

Marginal tax rate

The tax rate applicable to the last unit of a person's income. Marginal rates begin at 10% and rise to 39.6%. Note, though, that when consideration is given to the phase-out of exemptions and deductions, to Social Security and Medicare taxes, and to state taxes, the marginal tax rate may actually exceed 50%.

Book value per share = BVPS =

Total common equity / Common shares outstanding

Total liabilities =

Total debt + (Accounts payable + Accruals)

FCF =

[EBIT (1-T) + Depreciation and amortization] - [Sum of Capital expenditures + Net operating working capital] OR [EBIT x (1 - Tax rate) + Depreciation] - Additional Capital Expenditures - [(Increase in Cash + Increase in Supplies) - (Increase in Accounts payable + Increase in Accruals)]

Capital gains are taxed

and capital losses are not.

Current liabilities include

accounts payable, accruals, and notes payable to the bank.

If a corporation elects to set up as an S corporation, all of its income is reported

as personal income by its stockholders, on a pro-rata basis, and thus is taxed at the stockholders' individual rates. Because the income is taxed only once, this is an important benefit to the owners of small corporations in which all or most of the income earned each year will be distributed as dividends. The situation is similar for LLCs.

Although assets are reported in dollar terms, only the

cash and equivalents account represents actual spendable money.

Finally, keep in mind that even if investors receive accurate accounting data, it is

cash flows, not accounting income, that matter most.

Accounting statements are designed primarily for use by

creditors and tax collectors, not for managers and stock analysts. Therefore, corporate decision-makers and security analysts often modify accounting data to meet their needs.

Certain expenses, including mortgage interest paid, state and local income taxes paid, and charitable contributions, can be

deducted and thus be used to reduce taxable income—but again, high-income taxpayers lose most of these deductions.

Companies create value (and realize positive EVA) if the benefits of their investments

exceed the cost of raising the necessary capital. Total invested capital represents the amount of money that the company has raised from debt, equity, and any other sources of capital (such as preferred stock).

If EVA is positive, then after-tax operating income

exceeds the cost of the capital needed to produce that income, and management's actions are adding value for stockholders. Positive EVA on an annual basis will help ensure that MVA is also positive. Note that whereas MVA applies to the entire firm, EVA can be determined for divisions as well as for the company as a whole, so it is useful as a guide to "reasonable" compensation for divisional as well as top corporate managers.

the fact that interest is a deductible expense has a profound effect on the way businesses are financed—the corporate tax system

favors debt financing over equity financing.

Most companies prepare two sets of

financial statements—one is based on Internal Revenue Service (IRS) rules and is used to calculate taxes; the other is based on GAAP and is used for reporting to investors. Firms often use accelerated depreciation for tax purposes but straight-line depreciation for stockholder reporting.

A positive level of FCF indicates that the firm is

generating more than enough cash to finance current investments in fixed assets and working capital. By contrast, negative free cash flow means that the company does not have sufficient internal funds to finance investments in fixed assets and working capital and that it will have to raise new money in the capital markets in order to pay for these investments.

The firm's financial statements report what has actually

happened to its assets, earnings, and dividends over the past few years, whereas management's verbal statements attempt to explain why things turned out the way they did and what might happen in the future.

The information contained in the annual report can be used to

help forecast future earnings and dividends.

Items reported on the financial statements reflect

historical, in-the-past, values, not current market values, and there are often substantial differences between the two. Changes in interest rates and inflation affect the market value of the company's assets and liabilities but often have no effect on the corresponding book values shown in the financial statements

Looking at the balance sheet we can see

how large a company is, the types of assets it holds, and how it finances those assets. Looking at the income statement, we can see if the company's sales increased or declined and whether the company made a profit. Glancing at the statement of cash flows, we can see if the company made any new investments, if it raised funds through financing, repurchased debt or equity, or paid dividends.

Many analysts regard FCF as being the single most

important number that can be developed from accounting statements, even more important than net income. After all, FCF shows how much cash the firm can distribute to its investors.

A manager's primary goal is to

maximize shareholder value, which is based on the firm's future cash flows.

Income statements are prepared

monthly, quarterly, and annually. The quarterly and annual statements are reported to investors, while the monthly statements are used internally by managers for planning and control purposes.

Claims are listed in the order in which they

must be paid: Accounts payable must generally be paid within a few days, accruals must also be paid promptly, notes payable to banks must be paid within 1 year, and so forth, down to the stockholders' equity accounts, which represent ownership and need never be "paid off."

Interest paid can be deducted from operating income to

obtain taxable income, but dividends paid cannot be deducted.

Although the balance sheet represents a snapshot in time, the income statement reports on

operations over a period of time.

Corporations earn most of their income from

operations, but they may also own securities—bonds and stocks—and receive interest and dividend income. Interest income received by a corporation is taxed as ordinary income at regular corporate tax rates. However, dividends are taxed more favorably: 70% of dividends received are excluded from taxable income, whereas the remaining 30% is taxed at the ordinary tax rate.

A short-term capital gain is taxed at the same rate as

ordinary income. However, long-term capital gains are taxed differently. For most taxpayers, the rate on long-term capital gains is only 15%. Thus, if in 2017, you were in the 35% tax bracket, any short-term capital gains you earned would be taxed just like ordinary income, but your long-term capital gains would only be taxed at 15%.

Stockholders allow management to retain earnings and

reinvest them in the business, use retained earnings for additions to plant and equipment, add to inventories, and the like. Companies do not just pile up cash in a bank account. Thus, retained earnings as reported on the balance sheet do not represent cash and are not "available" for dividends or anything else.

Before 1987, corporate long-term capital gains were taxed at lower rates than corporate ordinary income; so the situation was similar for corporations and individuals. Currently, though, corporations' capital gains are taxed at the

same rates as their operating income.

If you held the asset for a year or less, you will have a

short-term capital gain or loss

Individuals and corporations pay out a

significant portion of their income as taxes, so taxes are important in both personal and corporate decisions.

when the investor is a corporation, the tax factor favors

stock investments.

As you might imagine, over the years Congress has frequently adjusted the

tax code for individuals to promote certain activities. For example, Individual Retirement Accounts (IRAs) have encouraged individuals to save more for retirement.

Depreciation plays an important role in income tax calculations—the larger the depreciation,

the lower the taxable income, the lower the tax bill, and thus the higher the operating cash flow. Congress specifies the life over which assets can be depreciated for tax purposes and the depreciation methods that can be used.

Economic value added (EVA)

xcess of NOPAT over capital costs. EVA is an estimate of a business's true economic profit for a given year, and it often differs sharply from accounting net income. EVA is an estimate of a business's true economic profit for a given year, and it often differs sharply from accounting net income. The main reason for this difference is that although accounting income takes into account the cost of debt (the company's interest expense), it does not deduct for the cost of equity capital. By contrast, EVA takes into account the total dollar cost of all capital, which includes both the cost of debt and equity capital.

while if you held an asset for more than a year,

you will have a long-term capital gain or loss.