Financial Statements, Taxes and Cash Flow

Financial Statements, Taxes and Cash Flow

Chapter Two Financial Statements, Taxes and Cash Flow 2003 The McGraw-Hill Companies, Inc. All rights 2.2 Key Concepts and Skills Know the difference between book value and market value Know the difference between accounting income and cash flow Know how to determine a firms cash flow

from its financial statements McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.3 Chapter Outline The Balance Sheet The Income Statement Cash Flow McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights

2.4 Balance Sheet The balance sheet is a snapshot of the firms assets and liabilities at a given point in time Assets are listed in order of liquidity Ease of conversion to cash Without significant loss of value Balance Sheet Identity Assets = Liabilities + Stockholders Equity McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights

2.5 The Balance Sheet - Figure 2.1 McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.6 Net Working Capital and Liquidity Net Working Capital Current Assets Current Liabilities Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out

Usually positive in a healthy firm Liquidity Ability to convert to cash quickly without a significant loss in value Liquid firms are less likely to experience financial distress But, liquid assets earn a lower return Trade to find balance between liquid and illiquid assets McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.7 US Corporation Balance Sheet Table 2.1

McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.8 Market Vs. Book Value The balance sheet provides the book value of the assets, liabilities and equity. Market value is the price at which the assets, liabilities or equity can actually be bought or sold. Market value and book value are often very different. Why? Which is more important to the decisionmaking process?

McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.9 Example 2.2 Klingon Corporation KLINGON CORPORATION Balance Sheets Market Value versus Book Value Book Market Book Market Assets Liabilities and Shareholders Equity NWC

NFA McGraw-Hill/Irwin $ 400 700 1,100 $ 600 LTD 1,000 SE 1,600 $ 500 $ 500 600 1,100 1,100 1,600

2003 The McGraw-Hill Companies, Inc. All rights 2.10 Income Statement The income statement is more like a video of the firms operations for a specified period of time. You generally report revenues first and then deduct any expenses for the period Matching principle GAAP say to show revenue when it accrues and match the expenses required to generate the revenue McGraw-Hill/Irwin

2003 The McGraw-Hill Companies, Inc. All rights 2.11 US Corporation Income Statement Table 2.2 McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.12 The Concept of Cash Flow Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements

The statement of cash flows does not provide us with the same information that we are looking at here We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.13 Cash Flow From Assets Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

Cash Flow From Assets = Operating Cash Flow Net Capital Spending Changes in NWC McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.14 Example: US Corporation OCF (I/S) = EBIT + depreciation taxes = $547 NCS ( B/S and I/S) = ending net fixed assets beginning net fixed assets + depreciation = $130 Changes in NWC (B/S) = ending NWC beginning NWC = $330

CFFA = 547 130 330 = $87 CF to Creditors (B/S and I/S) = interest paid net new borrowing = $24 CF to Stockholders (B/S and I/S) = dividends paid net new equity raised = $63 CFFA = 24 + 63 = $87 McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.15 Cash Flow Summary Table 2.5 McGraw-Hill/Irwin

2003 The McGraw-Hill Companies, Inc. All rights 2.16 Example: Balance Sheet and Income Statement Information Current Accounts 1998: CA = 1500; CL = 1300 1999: CA = 2000; CL = 1700 Fixed Assets and Depreciation

1998: NFA = 3000; 1999: NFA = 4000 Depreciation expense = 300 LT Liabilities and Equity 1998: LTD = 2200; Common Equity = 500; RE = 500 1999: LTD = 2800; Common Equity = 750; RE = 750 Income Statement Information EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250

McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.17 Example: Cash Flows OCF = 2700 + 300 1000 = 2000 NCS = 4000 3000 + 300 = 1300 Changes in NWC = (2000 1700) (1500 1300) = 100 CFFA = 2000 1300 100 = 600 CF to Creditors = 200 (2800 2200) = -400 CF to Stockholders = 1250 (750 500) = 1000 CFFA = -400 + 1000 = 600

The CF identity holds. McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights 2.18 Quick Quiz What is the difference between book value and market value? Which should we use for decision making purposes? What is the difference between accounting income and cash flow? Which do we need to use when making decisions? What is the difference between average and marginal

tax rates? Which should we use when making financial decisions? How do we determine a firms cash flows? What are the equations and where do we find the information? McGraw-Hill/Irwin 2003 The McGraw-Hill Companies, Inc. All rights

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