Lecture Essentials of corporate finance (2/e) – Chapter 2: Financial statements, taxes and cash flow

The topics discussed in this chapter are financial statements, taxes and cash flow. On completion of this chapter students will: Know the difference between book value and market value, know the difference between accounting income and cash flow, know the difference between average and marginal tax rates, know how to determine a firm’s cash flow from its financial statements.

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Financial statements, taxes

and cash flow

Chapter 2

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Key concepts and skills

• Know the difference between book

value and market value

• Know the difference between

accounting income and cash flow

• Know the difference between average

and marginal tax rates

• Know how to determine a firm’s cash

flow from its financial statements

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Chapter outline

• The balance sheet

• The income statement

• Taxes

• Cash flow

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The balance sheet

• The balance sheet is a snapshot of a firm’s assets

and liabilities at a given point in time.

• Assets: The left-hand side:

− Current or fixed

− In order of decreasing liquidity

• Liabilities and owners’ equity: The right-hand side:

– Current or long term

– In ascending order of when due to be paid

• Balance sheet identity

Assets = Liabilities + Shareholders’

equity

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The balance sheet (cont.)

Figure 2.1

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The balance sheet (cont.)

• Net working capital

– Current assets minus current liabilities

– Usually positive for a healthy firm

• Liquidity

− Speed and ease of conversion to cash

without significant loss of value

− Valuable in avoiding financial distress

• Debt versus equity

− Shareholders’ equity = Assets - Liabilities

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Oz Company balance sheet

Table 2.1

Visit au.finance.yahoo.com for more financial statements and balance sheets

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Market value vs book value

• Market value is the price at which

assets, liabilities or equity can actually

be bought or sold.

• The balance sheet provides the book

value of assets, liabilities and equity.

• Market value and book value are often very different Why?

• Which is more important to the

decision-making process?

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Battler Company

Example 2.2

Battler Company

Balance sheets Book value versus market value Book Market Book Market

Assets Liabilities and Shareholders’

equity NWC 400 600 LTD 500 500 NFA 700 1 000 SE 600 1 100

$1 100 $1 600 $1 100 $1 600

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The income statement

• The income statement measures performance over a specified period of time (period, quarter, year).

• Report revenues first and then deduct any expenses for the period.

• End result = Net income = ‘Bottom line’

– Dividends paid to shareholders

– Addition to retained earnings

• Income statement equation:

Net income = Revenue - Expenses

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OZ Company income

statement Table 2.2

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(cont.)

• AAS and the income statement

– The matching principle

• Recognise revenue when it is fully earned

• Matching expenses required to generate revenue to the period of recognition

• Non-cash items

– Expenses charged against revenue

that do not affect cash flow.

– Most important of these is

depreciation

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(cont.)

• Time and costs

– Fixed or variable costs

– Not obvious on income statement

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Example: Work the Web

• Most Australian companies post their

annual reports on their websites Look for them in the investor or shareholder areas.

• Go to companies’ websites and see

what kinds of financial reports you can find.

• Example: Virgin Blue

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• The one thing we can rely on with taxes is that they are always changing.

• Tax bill depends on tax code, which can be

amended by political will.

• Corporate tax in Australia and New Zealand

– Flat rate tax (currently 30%)

• Marginal vs average tax rates

– Marginal–the percentage paid on the next dollar earned

– Average–the tax bill/taxable income

• Other taxes

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Personal tax rates (2009/2010)

Table 2.3

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Example: Marginal vs average

tax rates

• Bony Bushman has a taxable income

in Australia of $96 000

– What is his tax bill?

– What is his average tax rate ?

– What is his marginal tax rate?

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Example: Marginal vs average

tax rates

Total 96000 23930

Average tax

Marginal tax rate 38%

Personal tax rate

Taxable income Rate

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• Shareholder then adds this amount of tax

to the cash dividend that they have

received and pays personal tax on the

grossed-up amount

• Shareholder receives a tax (franking)

credit equivalent to the amount of tax paid

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Effect of a $700 dividend fully

franked at 30% tax rate—Example

2.5

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Cash flow

• Cash flow is some of the most important information

that a financial manager can derive from financial

statements.

• The difference between the number of dollars that

come in and the number that go out.

• The statement of cash flows does not provide us with the same information that we are looking at here.

• Cash flow identity

Cash flow from assets = Cash flow to creditors + Cash flow to shareholders

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Cash flow (cont.)

• Cash flow from assets = Operating cash flow – Net capital spending – Changes in net working capital.

• Operating cash flow

– Cash generated from a firm’s normal business

activities

• Capital spending

– Money spent on fixed assets less money received from the sale of fixed assets

• Change in net working capital

– Net increase in current assets over current

liabilities

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Cash flow (cont.)

• Free cash flow

– Different from cash flow from assets

– Cash that the firm is free to distribute to

creditors and shareholders because it is not

needed for working capital or fixed asset

investments

• Cash flow to creditors

– A firm’s interest payments to creditors less net new borrowings

• Cash flow to shareholders

– Dividends paid out by a firm less net new

equity raised

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• CF to creditors (B/S and I/S) = Interest paid –

Net new borrowings = $24

• CF to stockholders (B/S and I/S) = Dividends

paid – Net new equity raised = $63

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Cash flow summary

Table 2.5

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Quick quiz

• What is the difference between book

value and market value?

– Which should we use for decision-making purposes?

• What is the difference between

accounting income and cash flow?

– Which do we need to use when making

decisions?

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Quick quiz (cont.)

• What is the difference between

average and marginal tax rates?

– Which should we use when making

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Apple Isle example

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Apple Isle (cont.) Operating cash flow

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Apple Isle (cont.)

Cash flow from assets, cash flow to

stockholders and creditors

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Chapter 2

END

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