Principals of Managerial Finance

9th Edition

Chapter 3

Financial Statements, Taxes, Depreciation, and Cash Flow

Learning Objectives• Review the format and key components of the

income statement, the balance sheet, the

statement of retained earnings, the statement

of cash flows, and the procedures for

consolidating international financial statements.

• Understand the effect of depreciation and other

non-cash charges on the firm’s cash flows.

Learning Objectives• Determine the amount of depreciation allowed each

year for tax purposes using the modified accelerated

cost recovery system (MACRS).

• Analyze the firm’s cash flows and develop and

interpret the statement of cash flows.

• The income statement provides a financial summary

of a company’s operating results during a specified

period.

• Although they are prepared annually for reporting

purposes, they are generally computed monthly by

management and quarterly for tax purposes.

Financial StatementsThe Income Statement

Financial Statements

• The balance sheet presents a summary of a firm’s

financial position at a given point in time.

• Assets indicate what the firm owns, equity represents

the owners’ investment, and liabilities indicate what

the firm has borrowed.

Financial StatementsThe Balance Sheet

Financial Statements

Financial Statements

• The statement of retained earnings reconciles the net

income earned and dividends paid during the year,

with the change in retained earnings.

Financial StatementsStatement of Retained Earnings

Financial Statements

• The statement of cash flows provides a summary of

the cash flows over the period of concern, typically the

year just ended.

• This statement not only provides insight into a

company’s investment, financing and operating

activities, but also ties together the income statement

and previous and current balance sheets.

Financial StatementsStatement of Cash Flows

Depreciation• Depreciation is the systematic charging of a portion of

the costs of fixed assets against annual revenues over

time.

• Depreciation for tax purposes is determined by using

the modified accelerated cost recovery system

(MACRS).

Depreciation

• Financial managers are much more concerned with

cash flows rather than profits.

• To adjust the income statement to show cash flows

from operations, all non-cash charges should be

added back to net profit after taxes.

• By lowering taxable income, depreciation and other

non-cash expenses create a tax shield and enhance

cash flow.

Depreciation & Cash Flow

Depreciation

• Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation.

• No adjustment is required for expected salvage value.

• For tax purposes, the depreciable life of an asset is determined by its MACRS recovery predetermined period.

• MACRS rates are shown in Table 3.8 on the following slides.

Depreciable Value & Depreciable Life

Depreciation

DepreciationAn Example

Elton Corporation acquired, for an installed cost of $40,000, a machine having a recovery period of 5 years. Using the applicable MACRS rates, the depreciation expense each year is as follows:

Year Cost MACRS Rates Depreciation1 40,000$ 20% 8,000$ 2 40,000$ 32% 12,800$ 3 40,000$ 19% 7,600$ 4 40,000$ 12% 4,800$ 5 40,000$ 12% 4,800$ 6 40,000$ 5% 2,000$

Totals 100% 40,000$

Analyzing the Firm’s Cash FlowsClassifying Sources & Uses of Cash

• The statement of cash flows essentially summarizes the sources and uses of cash during a given period.

Analyzing the Firm’s Cash FlowsInterpreting the Statement of Cash Flows

• The statement of cash flows ties the balance sheet at the beginning of the period with the balance sheet at the end of the period after considering the performance of the firm during the period through the income statement.

• “Net Increase (decrease) in cash and marketable securities should be equivalent to the difference between the cash and marketable securities on the balance sheet at the beginning of the year and the end of the year.