Professional Documents
Culture Documents
Understanding Financial
Statements, Taxes, and Cash Flows
CHAPTER ORIENTATION
In this chapter, we review the contents and meaning of a firm’s income statement and
balance sheet. We also look very carefully at how to compute a firm’s cash flows from a
finance perspective, which is called free cash flows.
CHAPTER OUTLINE
I. Basic Financial Statements
A. The Income Statement
1. The income statement reports the results from operating the business
for a period of time, such as a year.
2. It is helpful to think of the income statement as comprising five types
of activities:
a. Selling the product
b. The cost of producing or acquiring the goods or services sold
c. The expenses incurred in marketing and distributing the
product or service to the customer along with administrative
operating expenses
d. The financing costs of doing business: for example, interest
paid to creditors and dividend payments to the preferred
stockholders
e. The taxes owed based on a firm’s taxable income
3. An example of an income statement is provided in Table 2-1 for the
Harley-Davidson Corporation.
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B. The Balance Sheet
1. The balance sheet provides a snapshot of the firm’s financial position
at a specific point in time, presenting its asset holdings, liabilities, and
owner-supplied capital.
a. Assets represent the resources owned by the firm
(1) Current assets - consisting primarily of cash,
marketable securities, accounts receivable, inventories,
and prepaid expenses
(2) Fixed or long-term assets – comprising equipment,
buildings, and land
(3) Other assets – all assets not otherwise included in the
firm’s current assets or fixed assets, such as patents,
long-term investments in securities, and goodwill
b. The liabilities and owners’ equity indicate how the assets are
financed.
(1) The debt consists of such sources as credit extended
from suppliers or a loan from a bank.
(2) The equity includes the stockholders’ investment in the
firm and the cumulative profits retained in the business
up to the date of the balance sheet.
2. The balance sheet is not intended to represent the current market
value of the company, but rather reports the historical transactions
recorded at their costs.
3. Balance sheets for the Harley-Davidson Corporation are presented in
Table 2-2.
II Computing a Company’s Taxes
A. Types of taxpayers
1. Sole proprietors
a. Report business income on personal tax returns
b. Pay taxes at personal tax rate
2. Partnerships
a. The partnership reports income but does not pay taxes
b. Each partner reports his or her portion of income and pays the
corresponding taxes.
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3. Corporations
a. Corporation reports income and pays taxes
b. Owners do not report these earnings except when all or part of
the profit is paid out as dividends.
c. Our focus is on corporate taxes.
B. Computing Taxable Income
1. Taxable income is based on gross income less tax-deductible
expenses
a. Interest expense is tax deductible
b. Dividend payments are not tax deductible
2. Depreciation
a. Modified accelerated cost recovery system used for computing
depreciation for tax purposes
b. We use straight-line depreciation to reduce complexity.
C. Computing Taxes Owed
1. Taxes paid are based on corporate tax structure.
2. Tax rates used to calculate tax liability are marginal tax rates, or the
rate applicable to the next dollar of income.
3. Average tax rate is calculated by dividing taxes owed by the firm’s
total income
4. Marginal tax rate is used in financial decision making
III. Measuring Free Cash Flows
A. While an income statement measures a company’s profits, profits are not the
same as cash flows; profits are calculated on an accrual basis rather than a
cash basis.
B. In measuring cash flows, we could use the conventional accountant’s
presentation called a statement of cash flows. However, we are more
interested in considering cash flows from the perspective of the firm’s
shareholders and its investors, rather than from an accounting view. We will
instead measure the cash flow that is free and available to be distributed to
the firm’s investors, both debt and equity investors, or what we will call free
cash flows.
C. The cash flows that are generated through a firm’s operations and
investments in assets will always equal its cash flows paid to – or received
from – the company’s investors (both creditors and stockholders).
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D. Calculating Free Cash Flows: An Asset Perspective
1. A firm's free cash flows, from an asset perspective, is the
after-tax cash flows generated from operations less the firm's
investments in assets. It is this same amount that will be
available for distributing to the firm’s investors. That is, a
firm's free cash flows for a given period is equal to:
After-tax cash flow from operations
less
the investment (increase) in net operating working capital
less
investments in fixed assets (plant and equipment) and other
assets.
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E. Calculating Free Cash Flows: A Financing Perspective
1. Free cash flows from a financing perspective are equal to:
Interest payments to creditors
+ decrease in stock
or
- increase in stock
2. Free cash flow from an asset perspective must equal free cash flow
from a financing perspective.
3. Free cash flows from a financing perspective are simply the net cash
flows received by the firm’s investors, or if negative, the cash flows
that the investors are paying into the firm. In the latter situation
where the investors are putting money into the firm, it is because the
firm’s free cash flow from assets is negative, thereby requiring an
infusion of capital by the investors.
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ANSWERS TO
END-OF-CHAPTER QUESTIONS
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2-4 Once preferred shares are sold, dividends are paid or accrued each year based upon
preferred dividends (i.e., the percentage of the preferred stock’s par value paid as
dividends) agreed to at the selling date. However, these dividends affect the income
statement only. Common stock dividends, which may vary from year to year, also
affect the income statement; however, the investment of common shareholders varies
with the net addition to (or reduction from) retained earnings from year to year. The
net addition to retained earnings equals the difference in the period’s net income and
common dividends paid. Thus, the common equity section of the balance sheet (par
value of common stock, paid-in capital and retained earnings) varies from year to
year due to changes in the retained earnings portion of the firm’s common equity.
2.5 Net working capital is the firm’s liquid assets (current assets) less its short-term debt.
Accountants include all short-term debt when computing net working capital;
however, in computing free cash flows, we only subtract the noninterest-bearing
debt, such as accounts payables and accruals. With this latter method, we are only
considering the assets and liabilities that are changing as a result of the normal
operating cycle of the business—beginning with the time inventory is purchased on
credit to the time the firm collects the cash from its customer.
Gross working capital is the sum of current assets, while net working capital is the
difference between current assets and current liabilities.
As already suggested, we have both interest-bearing debt and noninterest-bearing
debt. The former is debt where the lender is paid interest for providing us the
money. Noninterest-bearing debt charges no interest because the “lender” is really a
supplier or an employee to whom we owe money, but they are not requiring the firm
to pay interest.
2-6. A firm could have positive cash flows but still be in trouble because it has negative
cash flows from operations. The positive cash flows would then be the result of the
firm reducing its investments in working capital or long-term assets. Such a situation
means that the company is not earning a satisfactory rate of return on its investments.
Another company could have very attractive rates of return on its assets, but be
growing so fast that the large investments in working capital and long-term assets
result in negative cash flows. In this latter case, management is simply investing in
the future. As the rate of growth slows, positive cash flows will occur.
2-7. Examining only the income statement and the balance sheet fails to tell us how the
firm is using its cash, which is a critical issue for any company.
2-8. Free cash flows from assets equal the cash flows that are generated by the company
that are then distributed to (if positive) or received from (if negative) the firm’s
creditors and investors. It looks at cash flows from the firm’s perspective. Free cash
flows from a financing perspective looks at the cash flows from the investors’
viewpoint. It indicates how the investor received cash in the form of interest,
dividends, debt repayment or stock repurchase and how the investor infused cash in
the form of additional debt or stock purchase. Whatever the company does is the
exact opposite of what the investor receives or pays. That is, if a company distributes
$100 in cash to the investors, then the investors must receive $100 as well. They
have to be equal.
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SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
2-1A. Belmond, Inc.
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash $ 16,550
Accounts receivable 9,600
Inventory 6,500
Total current assets $ 32,650
Gross buildings & equipment $122,000
Accumulated depreciation (34,000)
Net buildings & equipment $ 88,000
Total assets $120,650
LIABILITIES AND EQUITY
Liabilities
Current Liabilities
Notes payable $ 600
Accounts payable 4,800
Total current liabilities $ 5,400
Long-term debt 55,000
Total liabilities $ 60,400
Equity
Common stock $ 45,000
Retained earnings 15,250
Total equity $ 60,250
Total liabilities and equity $120,650
Belmond, Inc.
Income Statement
For the Year Ended December 31, 2003
Sales $ 12,800
Cost of goods sold 5,750
Gross profits $ 7,050
General & admin expense $ 850
Depreciation expense 500
Total operating expense $ 1,350
Operating income (EBIT) $ 5,700
Interest expense 900
Earnings before taxes $ 4,800
Taxes 1,440
Net income $ 3,360
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2-2A. Sharpe Mfg. Company
Balance Sheet
December 31, 2003
ASSETS
Cash $ 96,000
Accounts receivable 120,000
Inventory 110,000
Total current assets $ 326,000
Machinery and equipment $ 700,000
Accumulated depreciation (236,000)
Net fixed assets 464,000
Total assets $ 790,000
Sales $ 800,000
Cost of goods sold 500,000
Gross profits $ 300,000
Operating expense 280,000
Net income $ 20,000
(Assume no interest accrued or taxes)
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2-3A. Delaney, Inc. - Corporate Income Tax
Sales $4,000,000
Cost of goods sold and
cash operating expenses 2,400,000
Depreciation expense 100,000
Operating profit $1,500,000
Interest expense 150,000
Taxable Income $1,350,000
Tax Liability:
Sales $ 6,000,000
Cost of goods sold and
cash operating expenses 5,600,000
Operating profit $ 400,000
Interest expense 30,000
Taxable Income $ 370,000
Tax Liability:
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2-5A. Pamplin, Inc.
Note: The dividends were computed by comparing net income against the change in
retained earnings. Net income was $180,000, but retained earnings increased only
by $100,000; thus the balance was distributed in the form of dividends.
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2-6A. T.P. Jarmon
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes $ 70,000
Plus interest expense 10,000
EBIT 80,000
Depreciation 30,000
EBITDA $ 110,000
Tax expense $ 27,100
Less change in tax payable -
Cash taxes 27,100
After-tax cash flows from operations $ 82,900
Step 2: Change in net operating working capital
Change in current assets:
Change in cash $ (1,000)
Change in accounts receivable (9,000)
Change in inventory 33,000
Change in prepaid rent (100)
Change in marketable securities 200
Change in current assets $ 23,100
Change in noninterest-bearing current debt:
Change in accounts payable $ 9,000
Change in accrued expenses (1,000)
Change in noninterest-bearing current debt: $ 8,000
Change in net operating working capital $ (15,100)
Step 3: Change in long-term assets
Purchase of fixed assets $ 14,000
(Change in net fixed assets + depr. expense)
Change in other assets -
Net cash used for investments $ (14,000)
Asset free cash flows $ 53,800
Free cash flows from a financing perspective:
Interest paid to investors $(10,000)
Less change in interest payable -
Interest received by investors $ (10,000)
Decrease in long-term debt (10,000)
Decrease in notes payable (2,000)
Common stock dividends (31,800)
Financing free cash flows $ (53,800)
T.P. Jarmon had a successful year, generating an after-tax cash flow of $82,900. To
increase cash flow further, noninterest-bearing debt increased by $8,000. Part of this
cash was consumed when current assets were increased by $23,100 (of which
inventory increased by $33,000). Fixed assets of $14,000 were also purchased. The
substantial part of the cash flow, however, was distributed back to the investors.
Debt was decreased, both long-term and short-term, by $12,000. Interest of $10,000
was also paid on this debt. Finally, investors were paid $31,800 in dividends.
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2-7A. Abrams Manufacturing
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Operating Income $ 54,000
Depreciation 26,000
EBITDA $ 80,000
Tax expense $ 16,000
Less change in tax payable -
Cash taxes 16,000
After-tax cash flows from operations $ 64,000
Step 2: Change in net operating working capital
Change in current assets:
Change in cash $ 11,000
Change in accounts receivables 6,000
Change in inventories (12,000)
Change in prepaid expenses -
Change in current assets $ 5,000
Change in noninterest-bearing current debt:
Change in accounts payables $ 5,000
Change in accrued liabilities (5,000)
Change in noninterest-bearing current debt: $ -
Change in net operating working capital $ (5,000)
Step 3: Change in long-term assets
Purchase of fixed assets $ 73,000
Change in other assets -
Net cash used for investments $ (73,000)
Asset free cash flows $ (14,000)
Free cash flows from a financing perspective:
Interest paid to investors $ (4,000)
Less change in interest payable -
Interest received by investors $ (4,000)
Decrease in long-term debt (mortgage payable) (70,000)
Increase in preferred stock 120,000
Preferred stock dividends (10,000)
Common stock dividends (22,000)
Financing free cash flows $ 14,000
Abrams generated cash through an after-tax operating profit of $64,000 and issuing
preferred stock of $120,000. This cash was primarily used to pay down debt of
$70,000 and purchase fixed assets of $73,000. Investors also received cash back
through dividends of $32,000 and interest of $4,000. Abrams also increased current
assets in total by $5,000 by increasing cash and accounts receivable while decreasing
inventory.
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2-8A. J.T. Williams
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Solutions to Problem Set B
2-1B. Warner Company
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash $ 225,000
Accounts receivable 153,000
Inventory 99,300
Prepaid expenses 14,500
Total current assets $ 491,800
Gross buildings & equipment $ 895,000
Accumulated depreciation (263,000)
Net buildings & equipment $ 632,000
Total assets $1,123,800
Warner Company
Income Statement
For the Year Ended December 31, 2003
Sales $ 573,000
Cost of goods sold 297,000
Gross profits $ 276,000
General & admin expense $ 79,000
Depreciation expense 66,000
Total operating expense $ 145,000
Operating income (EBIT) $ 131,000
Interest expense 4,750
Earnings before taxes $ 126,250
Taxes 50,500
Net income $ 75,750
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2-2B. Sabine Mfg. Company
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash $ 90,000
Accounts receivable 150,000
Inventory 110,000
Total current assets $ 350,000
Machinery and Equipment $ 700,000
Accumulated depreciation (236,000)
Net buildings & equipment $ 464,000
Total assets $ 814,000
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2-3B. Cook, Inc. - Corporate Income Tax
Sales $ 3,500,000
Cost of goods sold and
cash operating expenses 2,500,000
Depreciation expense 100,000
Operating profit $ 900,000
Interest expense 165,000
Taxable Income $ 735,000
Tax Liability:
Sales $7,000,000
Cost of goods sold and
cash operating expenses 6,600,000
Operating profit $400,000
Interest expense 40,000
Taxable Income $ 360,000
Tax Liability:
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2-5B. J.B. Chavez
After-tax cash flows from operations of $422,000 and an increase in notes payable
of $115,000 were used to pay down the accounts payable by $135,000 and increase
our inventory and fixed assets by $50,000 and $300,000, respectively. Interest of
$60,000 and common stock dividends of $62,000 were paid to investors.
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RPI had positive after-tax operating cash flows of $122,900. As a result, RPI made
a decision to evenly split the cash flow between distribution to investors and
investing back into the company. Net operating capital increased by $34,100,
mostly in the area of inventory which increased by $43,000. Fixed assets of $34,000
were also purchased. The asset free cash flow of $54,800 was distributed back to
investors through interest of $10,000, debt repayments of $13,000, and dividends of
$31,800.
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Cameron Co. created cash flows through after-tax profits of $73,000 and issuing
$70,000 of preferred stock. Cameron also decreased current assets of $35,000
through inventory and cash. This cash was used to decrease $10,000 in noninterest-
bearing current debt and to purchase $63,000 in fixed assets. Cameron also
eliminated $60,000 in a mortgage payable and distributed $40,000 in dividends and
$5,000 in interest to investors.
2.9B Retail.com
In need of cash, Retail.com issued common stock for $368,463 and increased current
liabilities by $9,609. This cash was used, in part, to cover an after-tax operating
loss(including other income) of $63,689. Retail.com mainly used the cash to
increase growth by purchasing fixed assets and other investments of $31,971 and
$178,108, respectively. Retail.com also sought to increase their liquidity by
increasing current assets by $84,962, consisting mainly of a $76,680 increase in their
cash reserve, which was offset in part by increasing payables by $4,657. The
remainder of the common stock issue was paid back to investors through a dividend
of $23,612. For many years, it has been fairly easy for innovative Internet
companies to raise money through the stock market. It has been more important to
grow quickly than to create profits. In future years, Retail.com must turn these
losses into profits and create true value for their investors.
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