Chapter 2

•Financial Statements, Taxes,

and Cash Flows

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills

• Know the difference between book value

and market value
• Know the difference between accounting
income and cash flow
• Know the difference between average and
marginal tax rates
• Know how to determine a firm’s cash flow
from its financial statements
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 Chapter Outline

• The Balance Sheet

• The Income Statement
• Taxes
• Cash Flow

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 Balance Sheet

• The balance sheet is a snapshot of the

firm’s 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

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• The left-hand side lists the assets of the firm.
• Current assets are listed first because they are
the most liquid.
• Fixed assets can include both tangible and
intangible assets, and they are listed at the
bottom because they generally are not very
liquid.
• These are a direct result of management’s
investment decisions. (Please emphasize that
“investment decisions” are not limited to
investments in financial assets.)

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• Note that the balance sheet does not list some
very valuable assets, such as the people who
work for the firm.
• The liabilities and equity (or ownership)
components of the firm are listed on the right-
hand side.
• This indicates how the assets are paid for.

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• Since the balance sheet has to balance,
total equity = total assets – total liabilities.
• The portion of equity that can most easily
fluctuate to create this balance is retained
earnings.
• The right-hand side of the balance sheet is
a direct result of management’s financing
decisions.

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The Balance Sheet - Figure 2.1

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 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-off to find balance between liquid and illiquid assets

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 Building the Balance Sheet

Assets Liabilities and Shareholders’

Equity
Current assets $100 Current liabilities $ 70
Net fixed assets 500 Long term debt 200
Shareholders equity 330

Total assets $600 Total liabilities and $600

Shareholder’s equity

Total assets are $100 + 500 = $600

Total liabilities are $70 + 200 = $270
Shareholders’ equity is the difference: $600 – 270 = $330
Net working capital is the different between current assets and current
liabilities, or $100 – 70 = $30

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US Corporation Balance Sheet –
Table 2.1

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 Liquidity

• Liquidity is a very important concept.

• Students tend to remember the “convert to cash
quickly” component of liquidity, but often forget
the part about “without loss of value.”
• Remind them that we can convert anything to
cash quickly if we are willing to lower the price
enough, but that doesn’t mean it is liquid.
• Also, point out that a firm can be TOO liquid.
Excess cash holdings lead to overall lower
returns.

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 Debt Vs Equity

Shareholders’ equity = Assets – Liabilities

 In accounting sense  shareholders’ equity is defined as
this residual portion.
 In economics sense  if the firm sells its assets and
pays its debt, whatever cash is left belongs to the
shareholders.
 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.
 Debt acts like a lever  financial leverage increases the
potential reward to shareholders, but it also increases the
potential for financial distress and business failure.

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• 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.
• For fixed asset, 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.
• The difference between market value and book
value is important for understanding the impact of
reported gain and losses.
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 Market Vs. Book Value

• The values shown on the balance sheet for

the firm’s asset are book value.
• Generally Accepted Accounting Principles
(GAAP), audited financial statement in US.
• 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.
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• Managers and investors will frequently be interested
in knowing the value of the firm, this information is
not on the balance sheet.
• The fact that balance sheet assets are listed at cost
means that there is no necessary connection
between the total asset shown and the value of the
firm.
• Many of the most valuable assets a firm might have:
good management, good reputation, talented
employee don’t appear on the balance sheet at all.

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 Example 2.2 Klingon
Corporation
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book Market Book Market
Assets Liabilities and
Shareholders’ Equity
NWC $ 400 $ 600 LTD $ 500 $ 500
NFA 700 1,000 SE 600 1,100
1,100 1,600 1,100 1,600
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• Shareholders are the ones that benefit from
increases in the market value of a firm’s assets.
• They are also the ones that bear the losses of a
decrease in market value.
• Consequently, managers need to consider the
impact of their decisions on the market value of
assets, not on their book value. Here is a good
illustration:
• Suppose that the MV of assets declined to $700 and
the market value of long-term debt remained
unchanged. What would happen to the market value
of equity? It would decrease to 700 – 500 = 200.
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• The market-to-book ratio, which compares the market
value of equity to the book value of equity, is often used
by analysts as a measure of valuation for a stock.
• It is generally a bad sign if a company’s market-to-book
ratio approaches 1.00 (meaning market value = book
value) because of the GAAP employed in creating a
balance sheet.
• It is definitely a bad sign if the ratio is less than 1.00.
• GAAP does provide for some assets to be marked-to-
market, primarily those assets for which current market
values are readily available due to trading in liquid
markets.
• However, it does not generally apply to long-term assets,
where market values and book values are likely to differ
the most.
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 Income Statement

• The income statement is more like a video of the

firm’s 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.
• Matching principle – this principle leads to non-cash
deductions like depreciation.
• This is why net income is NOT a measure of the
cash flow during the period.

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The income statement measures performance over
some period of time, usually a quarter or a year.
The income statement equation is:
Revenue – Expenses = Income

Balance sheet as a snapshot

Income statement as a video recording covering
the period between before and after pictures.

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US Corporation Income Statement –
Table 2.2

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 Calculating Earnings and Dividends per
Share

• For the income statement, we see that US had a net

income of $412 million for the year.
• Total dividends were $103 million.
• 200 million shares were outstanding.

Earning per share = Net income/ Total share outstanding

= $412/200
= $2.06 per share
Dividends per share = Total dividends/Total shares outstanding
= $103/200
= $0.515 per share

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 Non Cash Items

• A primary reason that accounting income differs

from cash flow is that an income statement
contains noncash items.
• The most important of these is depreciation.
• Non cash items: expenses charged against
revenues that do not directly affect cash flow
such as depreciation.
• The depreciation is simply another application of
the matching principle in accounting.

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 Time and Cost

• The future as having two distinct parts: the short run and
the long run.
• These are not precise time periods.
• The distinction has to do with whether costs are fixed or
variable.
• In the long run, all business costs are variable.
• Given sufficient assets can be sold, debts can be paid,
and so on.
• In the short run, some costs are fixed, they must be paid
no matter what (property taxes, for example).
• Other cost such as wage to laborers and payments to
suppliers are still variable.
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• The distinction between fixed and variable costs is important.
• The way costs are reported on the income statement is not a
good guide to which costs are which. The reason is
accountants tends to classify cost as either product costs or
period costs.
• Product costs include such things as raw materials, direct
labor expense and manufacturing overheads (in income
statement they reported as costs of good sold, but they include
both fixed and variable costs).
• Period costs are incurred during a particular period and might
be reported as selling, general, and administrative expenses.
Some period cost may be fixed and other may be variable.
• The salary for director for example: is a period cost and is
probably fixed, at least in the short run.
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 Taxes

• Taxes can be one of the largest cash outflows a

firm experiences.
• The size of company’s tax bill is determined
through the tax code, an often amended set of
rules.
• Tax code is the result of political, not economic,
forces.

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 Average Vs marginal Tax Rate

• Average tax rate: tax bill divided by taxable

income (the percentage of income that goes to
pay taxes).
• Marginal tax rate: the rate of the extra tax that
would pay if earned one more dollar.

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 Taxable Income Tax Rate
$ 0 – 50,000 15%
50,001 – 75,000 25%
75,001 – 100,000 34%
100,001 – 335,000 39%
335,001 – 10,000,000 34%
10,000,000 – 15,000,000 35%
15,000,001 – 18,333,333 38%
18,333,334 + 35%

Suppose our corporation has a taxable income $200,000.

.15 ($50,000) $ 7,500
.25 ($75,000 – 50,000) 6,250
.34 ($100,000 – 75,000) 8,500
.39 ($200,000 – 100,000) 39,000
$ 61,250

Our total tax is $61,250

Average tax = $61,250/$200,000 = 30.625%
Marginal tax rate = if we made one dollar, the tax on that dollar would be 39
cents, so our marginal rate is 39%.
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Example: Marginal Vs. Average
Rates
• Suppose your firm earns $4 million in
taxable income.
• What is the firm’s tax liability?
• What is the average tax rate?
• What is the marginal tax rate?
• If you are considering a project that will
increase the firm’s taxable income by $1
million, what tax rate should you use in
your analysis?
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 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
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 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

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 Cash Flow From Assets

• Cash flow from assets involves three components:

operating cash flow, capital spending, and change in net
working capital.
• Operating cash flow refers to the cash flow that results
from the firm’s day to day activities of producing and
selling.
• Capital spending refers to the net spending on fixed
assets (purchases of fixed assets less sales of fixed
asset).
• Change in net working capital is 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.

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 Operating Cash Flow

US CORPORATION
2007 Operating Cash Flow

Earning before interest and taxes

$ 649
65
+ Depreciation
212
- Taxes

Operating Cash Flow

$ 547

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 Capital Spending

US CORPORATION
2007 Net Capital Spending

End net fixed asset

$ 1,709
1,644
- Beginning net fixed assets
65
+ Depreciation

Net Capital Spending

$ 130

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 Change in Net Working Capital

US CORPORATION
Change in Net working Capital
Ending Net Working capital
$ 1,014
684
-Beginning Net Working Capital

Change in Net Working Capital

$ 330

At the balance sheet  At the end 2007 current asset = $1,403 and at
2006 current asset = $1,112
so during the year invested $1,403 - 1,112 = $291 in current asset
Net working capital at the end 2007  $1,403 – 389 = $1,014
Net working capital at the end 2006  $1,112 – 428 = $648

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 Cash Flow from Asset

US CORPORATION
2007 Cash Flow from Assets
Operating Cash Flow
$ 547
130
- Net Capital Spending
330
- Change in NWC

Cash Flow from Asset

$ 87

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 Cash Flow to Creditors and Stockholders

• Cash flow to creditor is interest paid less net new borrowing.

• Cash flow to stockholders is dividends paid less net new equity
raised.
US CORPORATION
2007 Cash Flow to Creditors

Interest paid
$ 70
46
- Net new borrowing

Cash Flow to Creditor

$ 24

Long term debt rose by $454 – 408 = $46.

Corporation paid out $70 in interest but it borrowed an additional $46

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 US CORPORATION
2007 Cash Flow to Stockholder

Dividends paid
$ 103
40
- Net new equity raised

Cash Flow to stockholders

$ 63

Dividends paid to stockholder amounted to $103.

During the year, equity rose by $40, so $40 in net new equity was raised.
The lasting we need to do is to verify that the cash flow identity holds to be
sure we didn’t make any mistake. From the previous section, we know that
cash flow from assets is $87.
Cash flow to creditor and stockholders is $24 + 63 = $87, so everything
checks out.
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Cash Flow Summary Table 2.5

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 Assignment

BOOK VALUE VS MARKET VALUE

The home page for Coca-cola Company can be found at
www.coca-cola.com
Locate the most recent annual report, which contains a balance sheet
for the company. What is the book value of equity for Coca-Cola?
The market value of a company is the number of share of stock
outstanding times the price per share.
This information can be found at www.finance.yahoo.com using the
ticker symbol for Coca-Cola (KO).
What is the market value of equity?
Which number is more relevant for shareholder?
If you have a problem, please contact me at fitri.ismiyanti@gmail.com

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Exercise: Understanding a balance
sheet

The Dinmore Company has total assets of $6.4 million,

current assets of $2.3 million, current liabilities of $2.5
million and total liabilities of $4.2 million.

1. What is the amount of the stockholders’ equity?

2. What is the amount of the net working capital?
3. What is the amount of the long-term assets?
4. What is the amount of the long-term debt

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