Chapter 2: Financial Statements and Cash Flow

Chapter 2: Financial Statements, Taxes, and Cash Flow

• This chapter covers financial statements, taxes, and cash flow for a firm
• Learning objectives include describing the difference between accounting value and market value, accounting income and cash flow, average and marginal tax rates, and determining a firm's cash flow from its financial statements
• The chapter outline includes the balance sheet, income statement, taxes, and cash flow

The Balance Sheet

• A financial statement showing a firm's accounting value on a particular date
• Organizes and summarizes a firm's assets what it owns, liabilities, what it owes, and equity
• Assets are classified as current or fixed
  • Fixed assets have a longer life (e.g., truck, computer or patent)
  • Current assets have a life of less than one year (e.g., inventory, cash, accounts receivable)
• Liabilities are classified as current or long-term
  • Current liabilities have a life of less than one year (e.g., accounts payable)
  • Long-term liabilities are debts not due in the coming year (e.g., a loan)
• Shareholders' equity is the difference between the total value of assets and the total value of liabilities
• Assets = Liabilities + Shareholders' equity
• Net working capital = Current assets - Current liabilities

The Income Statement

• A financial statement summarizing a firm's performance over a period of time (usually quarterly or annually)
• Income statement equation: Revenues - Expenses = Income
• Begins with revenues from principal operations
• Then lists expenses (including financing like interest payments)
• Reports taxes separately
• Last item is net income, often called the "bottom line"
• Presented on a per-share basis (earnings per share (EPS))

Taxes

• Can be a significant cash outflow for firms
• Federal corporate tax rates are currently flat at 21% (established by the Tax Cuts and Jobs Act of 2017)
• Average tax rate = Total taxes paid / Total taxable income
• Marginal tax rate = The tax payable on the next dollar earned
• Marginal tax rates are important for financial decision making as new cash flows are taxed at this rate

Cash Flow

• The difference between cash inflows and outflows
• No single financial statement directly shows cash flow
• Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
• Cash flows from various activities (operating, capital spending, change in NWC) contribute to the firm's overall cash flow
• Operating cash flow = Revenue - Expenses (excluding depreciation & interest) + Depreciation
• Net capital spending = Ending net fixed assets - Beginning net fixed assets + Depreciation
• Change in net working capital = Ending NWC - Beginning NWC
• Cash flow to creditors = Interest paid - Net new borrowing
• Cash flow to stockholders = Dividends paid - Net new equity raised

This quiz focuses on Chapter 2, exploring financial statements, taxes, and cash flow aspects of a firm. It delves into key concepts such as accounting vs. market value, accounting income, and the structure of balance sheets. Test your understanding of these critical financial principles.