Ch. 2 - Understanding Financial Statements, Taxes, and Cash Flows

, Prentice Hall, Inc.

SALES - EXPENSES = PROFIT

Income Statement

SALES - EXPENSES = PROFIT

Income Statement

Revenue

Income Statement

SALES - EXPENSES = PROFIT

Income Statement

SALES - EXPENSES = PROFIT

•Cost of Goods Sold

Income Statement

SALES - EXPENSES = PROFIT

•Cost of Goods Sold•Operating Expenses

Income Statement

SALES - EXPENSES = PROFIT

•Cost of Goods Sold•Operating Expenses (marketing, administrative)

Income Statement

SALES - EXPENSES = PROFIT

•Cost of Goods Sold•Operating Expenses (marketing, administrative)•Financing Costs

Income Statement

SALES - EXPENSES = PROFIT

•Cost of Goods Sold•Operating Expenses (marketing, administrative)•Financing Costs•Taxes

SALES- Cost of Goods Sold GROSS PROFIT- Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT)- Income Taxes EARNINGS AFTER TAXES (EAT)- Preferred Stock Dividends- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

Income Statement

SALES- Cost of Goods Sold GROSS PROFIT- Operating Expenses OPERATING INCOME (EBIT)- Interest Expense EARNINGS BEFORE TAXES (EBT)- Income Taxes EARNINGS AFTER TAXES (EAT)- Preferred Stock Dividends- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

Income Statement

SALES- Cost of Goods Sold GROSS PROFIT- Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT)- Income Taxes EARNINGS AFTER TAXES (EAT)- Preferred Stock Dividends- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

Income Statement

Balance Sheet

Total Assets =

OutstandingDebt

+Shareholders’

Equity

Balance Sheet

Balance SheetAssets

Balance SheetAssets Liabilities (Debt) & Equity

Balance SheetAssets Liabilities (Debt) & Equity

Current Assets Cash Marketable Securities Accounts Receivable Inventories

Prepaid Expenses

Fixed Assets Machinery & Equipment Buildings and Land

Other AssetsInvestments & patents

Current Liabilities Accounts Payable Accrued Expenses Short-term notesLong-Term Liabilities Long-term notes MortgagesEquity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings

Assets• Current Assets:

Assets• Current Assets: assets that are relatively

liquid, and are expected to be converted to cash within a year.

Assets• Current Assets: assets that are relatively

liquid, and are expected to be converted to cash within a year.– Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.

Assets• Current Assets: assets that are relatively

liquid, and are expected to be converted to cash within a year.– Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.• Fixed Assets:

Assets• Current Assets: assets that are relatively

liquid, and are expected to be converted to cash within a year.– Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.• Fixed Assets: machinery and equipment, buildings, and land.

Assets• Current Assets: assets that are relatively

liquid, and are expected to be converted to cash within a year.– Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.• Fixed Assets: machinery and equipment,

buildings, and land.• Other Assets:

Assets• Current Assets: assets that are relatively

liquid, and are expected to be converted to cash within a year.– Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.• Fixed Assets: machinery and equipment,

buildings, and land.• Other Assets: any asset that is not a current

asset or fixed asset.

Assets• Current Assets: assets that are relatively

liquid, and are expected to be converted to cash within a year.– Cash, marketable securities, accounts

receivable, inventories, prepaid expenses.• Fixed Assets: machinery and equipment,

buildings, and land.• Other Assets: any asset that is not a current

asset or fixed asset.– Intangible assets such as patents and copyrights.

Financing• Debt Capital:

Financing• Debt Capital: financing provided by a

creditor.

Financing• Debt Capital: financing provided by a

creditor. • Short-term debt:

Financing• Debt Capital: financing provided by a

creditor. • Short-term debt: borrowed money that

must be repaid within the next 12 months.

Financing• Debt Capital: financing provided by a

creditor. • Short-term debt: borrowed money that

must be repaid within the next 12 months. – Accounts payable, other payables such as

interest or taxes payable, accrued expenses, short-term notes.

Financing• Debt Capital: financing provided by a

creditor. • Short-term debt: borrowed money that

must be repaid within the next 12 months. – Accounts payable, other payables such as

interest or taxes payable, accrued expenses, short-term notes.

• Long-term debt:

Financing• Debt Capital: financing provided by a

creditor. • Short-term debt: borrowed money that

must be repaid within the next 12 months. – Accounts payable, other payables such as

interest or taxes payable, accrued expenses, short-term notes.

• Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

Financing• Equity Capital:

Financing• Equity Capital: shareholders’ investment in

the firm.

Financing• Equity Capital: shareholders’ investment in

the firm. • Preferred Stockholders:

Financing• Equity Capital: shareholders’ investment in

the firm. • Preferred Stockholders: receive fixed

dividends, and have higher priority than common stockholders in event of liquidation of the firm.

Financing• Equity Capital: shareholders’ investment in

the firm. • Preferred Stockholders: received fixed

dividends, and have higher priority than common stockholders in event of liquidation of the firm.

• Common Stockholders:

Financing• Equity Capital: shareholders’ investment in

the firm. • Preferred Stockholders: received fixed

dividends, and have higher priority than common stockholders in event of liquidation of the firm.

• Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

Corporate Income Tax RatesSince 1993

Taxable Income Corporate Tax Rate

$1 - $50,000 15%$50,001 - $75,000 25%$75,001 - $100,000 34%$100,001 - $335,000 39%$335,001 - $10,000,000 34%$10,000,001 - $15,000,000 35%$15,000,001 - $18,333,333 38%over $18,333,333 35%

Free Cash Flows

Free cash flow: cash flow that is free and available to be distributed to the firm’s investors (both debt and equity investors)

Free Cash FlowsFirm’s Operating

Free cash flows = Firm’s Financing Free cash flows

Cash flows generated through the firm’s

operations and investments in assets

=Cash flows paid to - or

received by - the firm’s investors

(creditors & stockholders)

Calculating Free Cash Flows:An Operating Perspective

After-tax cash flow from operations

lessinvestment in net

operating working capital

lessinvestments in fixed

and other assets

Calculating Free Cash Flows:An Operating Perspective

After-tax cash flow from operations

lessinvestment in net

operating working capital

lessinvestments in fixed

and other assets

Operating income + depreciation - cash tax payments

Calculating Free Cash Flows:An Operating Perspective

After-tax cash flow from operations

lessinvestment in net

operating working capital

lessinvestments in fixed

and other assets

[Change in current assets]-

[change in non-interest bearing current liabilities]

Calculating Free Cash Flows:An Operating Perspective

After-tax cash flow from operations

lessinvestment in net

operating working capital

lessinvestments in fixed

and other assets

Change in gross fixed assets, and any other assets that are on the

balance sheet.

Calculating Free Cash Flows:A Financing Perspective

Interest payments to creditors

- change in debt principal

- dividends paid to stockholders

- change in stock

= Financing Free Cash Flows

Tax Example:

• Space Cow Computer has sales of $32 million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders.• Calculate the firm’s tax liability.

Sales $32,000,000Cost of Goods Sold (19,200,000)Operating Expenses (2,400,000)Depreciation Expense (1,400,000)EBIT or NOI 9,000,000Interest Expense (1,140,000)Taxable Income 7,860,000

Income tax rate tax payment $50,000 x .15 = $ 7,500 $25,000 x .25 = 6,250 $25,000 x .34 = 8,500 $235,000 x .39 = 91,650 $7,525,000 x .34 = 2,558,500Total Tax payment $2,672,400

short cut: $7,860,000 x .34 = $2,672,400