We willinstead measure the cash flow that is free and available to be distributed tothe firm’s investors, both debt and equity investors, or what we will call free cash flows.. The cash
Trang 1I 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 administrativeoperating expenses
d The financing costs of doing business: for example, interest
paid to creditors and dividend payments to the preferredstockholders
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
Trang 2B 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 thebusiness 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 transactionsrecorded 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
Trang 33 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 makingIII 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’sshareholders and its investors, rather than from an accounting view We willinstead measure the cash flow that is free and available to be distributed tothe 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 receivedfrom – the company’s investors (both creditors and stockholders)
Trang 4D 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'sinvestments in assets It is this same amount that will beavailable for distributing to the firm’s investors That is, afirm's free cash flows for a given period is equal to:
After-tax cash flow from operationsless
the investment (increase) in net operating working capital less
investments in fixed assets (plant and equipment) and otherassets
2 After-tax cash flows from operations as follows:
Operating income (earnings before interest and taxes) + depreciation
= Earnings before interest, taxes, depreciation andamortization (EBITDA)
- cash tax payments
= After-tax cash flows from operations
3 The increase in net operating working capital is equal to the:
bearing-
tnoninteres
in change
4 Investments in fixed assets includes the change in gross fixed assets
and any other balance sheet assets not already considered
Trang 5E Calculating Free Cash Flows: A Financing Perspective
1 Free cash flows from a financing perspective are equal to:
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 flowsthat the investors are paying into the firm In the latter situationwhere the investors are putting money into the firm, it is because thefirm’s free cash flow from assets is negative, thereby requiring aninfusion of capital by the investors
IV Financial Statements and International Finance
A Many countries have different guidelines for firms to use in preparing
financial statements For example, a $1 of earnings in the United States is not the same as 1.10 Euro (the equivalent of a U.S dollar based on the exchange rate) The differences are due to the two countries having different Generally Accepted Accounting Principles which guide their firms’financial reporting
B As a result of this situation, the International Accounting Standards
Committee (IASC), a private body supported by the worldwide accounting profession, is trying to develop international financial-reporting standards that will minimize the problem In spite of the work to standardize accounting practices around the world, the U.S accounting profession has rejected efforts toward international standards At this time, foreign companies seeking to list their shares in the United States must follow U.S accounting standards
Interest payments to creditors
plus dividends paid to stockholders
+ decrease in debt principalor
- increase in debt principal
+ decrease in stockor
- increase in stock
Trang 6ANSWERS TO END-OF-CHAPTER QUESTIONS
2-1 a The balance sheet represents an enumeration of a firm’s resources (assets)
along with its liabilities and owners’ equity at a given date The incomestatement summarizes the net results of the operation of a firm over aspecified time interval
The primary distinction between these two statements is that the balancesheet shows the financial condition of a firm at a given date, whereas theincome statement deals with the revenues and expenses of the firm incurredduring a specified period of time
b The conventional cash flow statement as prepared by accountants provides
the information we need to know about what has happened to the firm’scash and why But it does not present it in a way that makes clear the cashflows the firm’s creditors and investors are providing to or receiving fromthe firm Thus, we choose to reformat the presentation to show the firm’s
free cash flows—the cash available to distribute to the creditors and
investors We are more interested in considering cash flows from theperspective of the firm’s shareholders and its investors, rather than from anaccounting view We 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 Thus, what we use is similar to a
conventional cash flow statement presented as part of a company’s financialstatements, but “not exactly.” We also make the distinction between thecash flows generated by the firm’s assets and the financing free cash flows.2-2 Gross profits is sales less the cost of producing or acquiring the firm’s product or
service Operating profits is the gross profits less the operating expenses, whichconsist of distributing the product or service to the customer (namely, marketingexpenses) and any general and administrative expenses in operating the business.Net income is operating profits less financing costs (interest expenses and preferredstock dividends) and less income taxes
2-3 Interest expense is the cost of borrowing money from a banker or another lender
There typically is a fixed interest rate so that the interest expense is computed as theinterest rate times the amount borrowed If we borrow $500,000 at an interest rate of
12 percent, then our interest expense will be $60,000
While interest is paid for the use of debt capital, dividends are paid to the firm’sstockholders Preferred stock typically has a fixed dividend rate, so that thepreferred stockholder gets a constant dividend each year Common stockholders, onthe other hand, usually receive dividends only if management decides to pay adividend instead of reinvesting the firm’s profits However, typically once adividend has been paid to common stockholders, management is reluctant todecrease it or cease paying a dividend
Trang 72-4 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 asdividends) agreed to at the selling date However, these dividends affect the incomestatement only Common stock dividends, which may vary from year to year, alsoaffect the income statement; however, the investment of common shareholders varieswith the net addition to (or reduction from) retained earnings from year to year Thenet addition to retained earnings equals the difference in the period’s net income andcommon dividends paid Thus, the common equity section of the balance sheet (parvalue of common stock, paid-in capital and retained earnings) varies from year toyear 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-bearingdebt, such as accounts payables and accruals With this latter method, we are onlyconsidering the assets and liabilities that are changing as a result of the normaloperating cycle of the business—beginning with the time inventory is purchased oncredit 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 thedifference between current assets and current liabilities
As already suggested, we have both interest-bearing debt and noninterest-bearingdebt The former is debt where the lender is paid interest for providing us themoney Noninterest-bearing debt charges no interest because the “lender” is really asupplier or an employee to whom we owe money, but they are not requiring thefirm 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 thefirm reducing its investments in working capital or long-term assets Such asituation means that the company is not earning a satisfactory rate of return on itsinvestments Another company could have very attractive rates of return on itsassets, 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 simplyinvesting 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’screditors and investors It looks at cash flows from the firm’s perspective Free cashflows 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 inthe form of additional debt or stock purchase Whatever the company does is theexact opposite of what the investor receives or pays That is, if a companydistributes $100 in cash to the investors, then the investors must receive $100 aswell They have to be equal
Trang 8SOLUTIONS TO END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
2-1A Belmond, Inc.
Balance Sheet December 31, 2003 ASSETS
Current assets
Accounts receivable 9,600
Inventory 6,500
Total current assets $ 32,650
Gross buildings & equipment $122,000
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
Net income $ 3,360
Trang 92-2A Sharpe Mfg Company
Balance Sheet December 31, 2003 ASSETS
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
LIABILITIES & EQUITY
Liabilities
Current Liabilities
Notes payable $ 100,000 Accounts payable 90,000 Total current liabilities $ 190,000 Long-term debt 160,000 Total liabilities $ 350,000 Equity
Common stock $ 320,000Retained earnings
Prior year 100,000 Current year 20,000 Total equity $ 440,000 Total liabilities and equity $ 790,000
Sharpe Mfg Company Income Statement For the Year Ended December 31, 2003
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)
Trang 102-3A Delaney, Inc - Corporate Income Tax
Cost of goods sold and
cash operating expenses 2,400,000Depreciation expense 100,000Operating profit $1,500,000Interest expense 150,000Taxable Income $1,350,000Tax Liability:
$50,000 x 0.15 = $7,50025,000 x 0.25 = 6,25025,000 x 0.34 = 8,500235,000 x 0.39 = 91,6501,015,000 x 0.34 = 345,100
$1,350,000 $459,000
2-4A Potts, Inc - Corporate Income Tax
Cost of goods sold and
cash operating expenses 5,600,000Operating profit $ 400,000Interest expense 30,000Taxable Income $ 370,000Tax Liability:
$50,000 x 0.15 = $7,50025,000 x 0.25 = 6,25025,000 x 0.34 = 8,500235,000 x 0.39 = 91,650 35,000 x 0.34 = 11,900
$370,000 $125,800