Practical financial managment 7e LASHER chapter 2

Accounts ReceivableMost sales are on credit Seller receives a promise of later payment, rather than immediate cash The seller records an account receivable as an asset Net income may n

Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes

The Nature of Financial Statements

Numerical representations of a firm’s activities for an accounting period

– A picture of activities within the firm and between the firm and the outside

– But can be counterintuitive

Accounts Receivable

Most sales are on credit

Seller receives a promise of later

payment, rather than immediate cash

The seller records an account receivable

as an asset

Net income may not = cash flow

Proration of an asset’s cost over its

service life

Can be straight lined or accelerated

Cost recorded on the income statement does not = cash spent

The Nature of Financial Statements

Three Financial Statements

– Income statement

– Balance sheet

– Statement of cash flows

Generated from the income statement and balance sheet

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The Accounting System

A firm’s financial books are a collection

of records in which money transactions are recorded

– Double entry system

– Accounting periods and closing the books– Implications

– Stocks and flows

Table 2-1 A Typical Income Statement

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The Income Statement

Sales

Cost and Expenses

– Costs of Goods Sold

The Income Statement

Earnings Before Tax, and Tax

Net Income

Terminology:

– Income = profit = earnings

– Profit before tax (PBT)

– Profit after tax (PAT)

– Earnings before tax (EBT)

– Earnings after tax (Net Income)

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Earnings

– Also called net income

– Paid out as dividends or retained in business

Retained Earnings (RE)

– Each year earnings not paid as dividends become an addition to equity

– Retained earnings account is cumulative

earnings not paid out as dividends

The Balance Sheet

Lists everything a company owns and

owes at a moment in time

– All sources and uses of money must be

The Balance Sheet

Two equal sides

Assets = liabilities + equity

Assets and liabilities are arranged in

order of decreasing liquidity

Liquidity – ease with which an asset becomes or

a liability requires cash

Table 2-2 A Conventional Balance Sheet Format

are liquid investments

held instead of cash

– Short-term, modest

return, low risk

Accounts Receivable Uncollected credit sales – Bad Debt Reserve:

some credit sales will never be paid

– Write Off: Remove bad debt from gross and reserve leaving net unchanged

Concept Connection Example 2-1 Writing Off a Large Uncollectable Receivable

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Gross accounts receivable $5,650

Bad-debt reserve (290)

Net accounts receivable $5,360

Need to Write Off $435,000

Reserve 290,000

Expense $145,000

Reestablish Reserve (5%) 260,750

Profit Reduction $405,750

Assets

Inventory - product held for sale in the normal course of business

– Work-In-Process Inventories (WIP)

Value added as inventory moves through production

– The Inventory Reserve

Some inventory is unusable - balances reported net of reserve

– Writing Off Bad Inventory

Missing, damaged, or obsolete items removed from gross and reserve leaving net unchanged

– Become cash within a year

– Include cash, accounts receivable and inventory

Depreciation

– Spreads asset’s cost over its estimated useful life

Financial Statement Representation

– Appears as an expense or cost

– Accumulated depreciation appears on balance sheet reflecting a wearing out of the asset

Table 2-3 Fixed Asset Depreciation

Disposing of a Used Asset

The Life Estimate

Tax Depreciation and Tax Books

– Government allows different depreciation schedules for tax purposes and financial reporting purposes

Concept Connection Example 2-2 Selling a Fixed Asset

Accounting Cash Flow

– Require cash within one year

– Payable and accruals are classified as current

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Figure 2-1 A Payroll Accrual

Working Capital

Total current assets = gross working capital

Net Working Capital = Current Assets ─ Current Liabilities

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Long Term Liabilities

Long Term Debt

– The most significant non-current liability

– Leverage

A business partially financed with debt is leveraged

Fixed Financial Charges

– Interest must be paid regardless of profitability

Concept Connection Example 2-3

Leverage

A business is financed with equity of $100,000Net Income = $15,000

Return on equity = 15% ($15,000/$100,000)

Calculate return on equity if $50,000 borrowed

at an after tax interest rate of 10%

Concept Connection Example 2-3

Leverage

Borrowing levers return on equity up from 15% to 20%

– The sum of long-term debt and equity

Total Liabilities and Equity

– Sum of the right-hand side of the balance sheet

– Must equal total assets

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Equity Accounts Illustration

Three Separate Accounts

Direct Investment by owners paying for stock

Par value and paid in excess accounts

Net Income and Retained Earnings

Beginning Equity

+ Net Income

– Dividends + New Stock Sold = Ending Equity

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The Tax Environment

Taxing Authorities and Tax Bases

Income taxWealth taxConsumption tax

Sales tax

Income Taxes—The Total Effective Tax Rate (TETR)

Total effective tax rate (TETR) is the combined state and federal rate

– State tax is deductible from income when

calculating federal tax

TETR = Tf + Ts (1 – Tf)

where

Tf = federal tax rate

Ts = state tax rate

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Progressive Tax Systems, Marginal and Average Rates

Progressive tax system

Brackets

Marginal and average tax rates

Capital Gains and Losses

Two major types of income

– Ordinary income

– Capital gains or loss and dividends

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The Tax Treatment of Capital Gains

and Losses

Capital gains historically taxed at lower rates

Holding period must be > 1 year for

favorable tax treatment

Income Tax Calculations

Income taxes are paid by households and corporations according to the same basic principles

– Tax is levied on a base of taxable income

But rate schedules for corporations and households are very different as are the rules for calculating taxable income

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Table 2-4 Personal Tax Schedules - 2012

Concept Connection Example 2-4

Calculating Personal Taxes

The Harris family had the following income in 2012:

Salaries: Joe $55,000

Sue 52,000

Interest on savings acct 2,000

Interest on IBM bonds 800

Interest on Boston Bonds 1,200

Dividends - Gen Motors 600

Concept Connection Example 2-4 Calculating Personal Taxes

In 2012 the Harris family:

Sold property for $50,000, paid $53,000 years earlier

Sold stock for $14,000, paid $12,000 years earlier

Paid $12,000 interest on home mortgage

Paid $1,800 in real estate taxes

Had $3,500 withheld from pay for state income tax

Contributed $1,200 to charity

Have two children

Exemption rate is $3,800 per person

Calculate taxable income and tax liability.

What are marginal and average tax rates?

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Concept Connection Example 2-4 Calculating Personal Taxes

Ordinary income: Deductions:

Salaries $107,000 Mortgage interest $12,000

Interest 2,800 Taxes 5,300

$109,800 Charity 1,200

$18,500

Net capital gain or loss:

Loss on property ($3,000) Exemptions:

Gain on stock 2,000$3,800 x 4 = $15,200

Net capital loss ($1,000)

Total Income $108,800 Taxable Income $75,100 (excludes dividends)

Concept Connection Example 2-4 Calculating Personal Taxes

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Use the married filing jointly schedule as follows:

10% of the entire first bracket $17,400 x 10 = $1,740

15% of the amount in the

Total tax liability $10,925

Average tax rate: $10,925/$75,700 = 14.4%

Marginal tax rate = bracket rate = 25%

(15% if dividends or capital gains)

Personal Taxes

Tax Rates and Investment Decisions

– Comparing municipal (muni) and corporate bonds

Interest on muni’s not subject to federal taxes

At same rate muni’s return is higher after taxes

If the rates differ, restate corporate to an after tax yield

Multiply by one minus investor’s marginal tax rate

(1 – marginal tax rate)

Concept Connection Example 2-5

Comparing Taxable and Tax Exempt Returns

The Harris family (25% bracket) has a choice between an IBM bond paying 11% and a

Boston bond paying 9%

Solution:

IBM after tax = 11% x (1 - 25) = 8.25% < Boston = 9%

Therefore prefer the Boston bond if risks are similar

If marginal tax rate is 15%

11% x (1 - 15) = 9.35%

then prefer IBM

High bracket taxpayers tend to be more interested in tax exempt bonds than those with lower incomes

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Corporate tax rates do not consistently

rise as taxable income rises

Table 2-5 Corporate Income Tax

Schedule

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The rate increases from 34% to 39% and 35% to 38% recover the benefit of lower rates on earlier income So a corporation earning more than $18,333,333 pays 35% on all of its income from the

first dollar

Concept Connection Example 2-6

Corporate Income Taxes

Calculate the tax liability for corporations with the following EBTs:

Concept Connection Example 2-6

Corporate Income Taxes

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c We don’t have to go through the calculations in the bottom brackets because we know that the system recovers those benefits to an overall 34% up to $10 million.

$10,000,000 × 34 = $3,400,000

$ 5,000,000 × 35 = $1,750,000

$ 1,000,000 × 38 = $ 380,000 $5,530,000

d Over $18,333,333, the tax is a flat 35% of all income starting from nothing, so the tax on $23,000,000 is

$23,000,000 × 35 = $8,050,000

Corporate Taxes

Taxes and Financing

– The tax system favors debt financing

– Result: A debt-financed firm pays less tax

than an identical equity financed company – But the availability of debt is limited because

it makes the borrowing company risky

Corporate Taxes

Corporate Taxes

Dividends Paid to Corporations

– Dividends paid to another corporation are partially tax exempt

Figure 2-2 Multiple Taxation

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Figure 2-3 Tax Loss Carry Back and

Forward