Chapter No.

02

Financial Statements, Taxes and Cash Flows.

Learning Objectives

1. Financial statements
2. Accounting value (book value) and market value.
3. Accounting income and cash flows
4. Average and marginal tax rates.
5. How to determine cash flows from a firm’s financial
statements.

Prepared by: Lal Zada, lecturer

Department of Management Sciences, UoB.
The Balance Sheet
A financial statement showing a firm’s accounting value on a
particular date
 Snapshot of a firm
 It organizes and summarizes
◦ What firms owns(its assets)
◦ What firms owes(liabilities)
◦ The difference between the two (Equity)
 How it is organized
◦ Assets: The Left Side
 Current Assets, one year
 Fixed Assets: Tangible and intangible
Liabilities
◦ Current liabilities,
 be paid in one year
◦ Long-term liabilities,
 be paid in more than one year
◦ Written first than equity, Why?

Owner’s Equity
 The difference between total assets and total liability is
called owner’s equity.
 Also called shareholder’s equity, common stock and
common equity
 Assets = Liabilities + Owners’ Equity

Is the balance sheet identity or equation

Net working capital

The difference between current assets and current liability is

called Net Working Capital.
Examining a Balance Sheet

3 things be kept in mind

1. Liquidity: the speed and ease with which an asset can be converted
into cash. Gold, financial securities, inventory, account receivable
2. Has two dimensions

ease of conversion
loss of value
Assets are listed in order of decreasing liquidity

Liquidity is valuable
more liquid means lesser financial distress
less liquid means financial distress
Debt Versus Equity

Two claimants on assets of a firm

1. Creditors: first claim on firm’s cash flows
2. Equity holders: second claim on cash flows

Thus equity holders are entitled to only the residual portion of

the firm which the portion left over after creditors are paid.

The use of debt in a firm’s capital structure is called Financial

leverage

More debt, more financial leverage

Low debt, lesser financial leverage
Market Value versus Book Value

GAAP requires assets to be recorded at historical cost.

Assets are “carried on the books” at what the firm paid for.

Market value of current assets are similar

Because conversion is short

Market value of fixed assets vary

Who uses balance sheets and how?

1. suppliers: interested in size of accounts payables

2. Creditors are interested in liquidity and financial leverage
3. Managers are investors are interested in value of firms
4. Taxing authorities are interest in EBT.

Value of stock or value of firm is called market value.

2nd Financial Statement: The income statement
 Measures performance over a period
 Composed of two things
◦ Revenue
◦ Expenses
◦ The difference is “net income”

Revenue – expenses = Net Income

Balance sheet is a snap shot but income statement is a video recording.

Balance sheet is the stock of water while
Income statement is the rate of flow of water from the fossit t to the
tub.
Revenue is the first thing reported on the income statement.

Expenses are reported after revenue

Financing expenses include interest paid,

Taxes paid are reported separately

Last item is net income

The difference between net income and dividend is retained

earning.
GAAP and the Income Statement

Revenue is shown as it accrues: recognition or realization

principles into practice, but the inflow of cash is not
necessary.
Thus revenue is recognized at the time of sale and not
collection.

Expenses on income statement are recorded on the matching

principle.
To understand this concept, consider two things
1. Understand the recognition principle
2. Match revenue with the cost producing that revenue
Noncash items:
 Expenses charged against revenue that do not directly
affect cash flow, such as depreciation.

 Asset of $5000, 5 years life, and straight line depreciation

 %1000 accounting number, actual cash occurred before

 Another application of matching principle

Taxes
 Largest cash outflow
 ExxonMobil’s pre-tax earning = $71.88 billion
 Taxes paid =$29.86 or 41% of pre-tax earning

 Tax code(amended set of rules) determine the size of tax bill

 We discuss corporate tax and its calculation next

Four Corporate Tax Rates:
1. 15%
2. 25%
3. 34%
4. 35%

The 38 and 39 tax arise because of surcharges applied on top

of 34 and 35 % tax rate

A tax is a tax is a tax

So there are total 6 corporate tax brackets

Average versus Marginal tax rates
 Average Tax Rate: Total taxes paid divided by total taxable

income is average tax rate.

 In other words, it is the percentage of income that goes to

taxes

 Marginal tax rate: The amount of tax payable on the next

dollar earned
Suppose, taxable income is $200,000 and tax bill is $61250.
What is Average Tax Bill ?

=61,250/200,000 = $30.625

Marginal Tax rate is

If we make additional earning of $1, the Tax Rate would be

39%, which is called Marginal Tax Rate

Flat-Tax Rate: the rate which is equal for all income level is
called flat-tax rate
Cash Flow
 Cash flow is the difference between the number of dollars

that came in and the number of dollars the went out of the
firm.
 From the balance sheet identify we know

Cash flow from assets = Cash Flow to Creditors

+ Cash Flow to Shareholders
Called cash flow identity

Cash flow from assets (Cash Generation) is equal to cash flow

to suppliers (cash usage) of capital
Cash Flow From Assets
Three components
Operating Cash Flow
Capital Spending
Net Working Capital
Operating Cash Flows
 Day to day operating and selling activities.
 Revenue – Cost
 Depreciation is excluded<><>not Cash outflow
 Interest <><> financing expense
 Taxes are included <><> because paid in cash
.
Cash flow from operation is important to let us know whether
business meet its everyday cash outflow.

Now, how much is reinvested: Consider it next on fixed asset

Capital Spending
Net Capital spending is the money spent on fixed assets less
money received from the sale of fixed assets.

End of 2008 = $ 1644

Depreciation = $ 65
-----------------------------------
Net Fixed Asset= $1579
But 2009 B.Sheet =$ 1709

1709-1579 = $130 spent on Fixed Assets

Change in Net Working Capital

Net investment

Conclusion: Cash Flow from Assets

Net investment
CASH FLOW TO CREDITORS AND STOCKHOLDERS
 Cash Flow to Creditors: This is the firm’s interest payment

to creditors less net new borrowing.

 Cash Flow to shareholders

Summary of Cash Flow
END OF CHAPTER!