Chapter 2 Financial Statements PDF

CHAPTER 2 F I N A N C I A L S TAT E M E N T S , TA X E S , A N D C A S H F L O W Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  LEARNING OBJECTIVES Describe the difference between...

CHAPTER 2 F I N A N C I A L S TAT E M E N T S , TA X E S , A N D C A S H F L O W Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  LEARNING OBJECTIVES Describe the difference between accounting value (or book value) and market value Describe the difference between accounting income and cash flow Describe the difference between average and marginal tax rates Determine a firm’s cash flow from its financial statements 1-2 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  CHAPTER OUTLINE The Balance Sheet The Income Statement Taxes Cash Flow 1-3 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  THE BALANCE SHEET The balance sheet is a financial statement showing a firm’s accounting value on a particular date Organizes and summarizes what a firm owns (assets), what a firm owes (liabilities), and the difference between the two (equity) Assets are classified as either current or fixed A fixed asset is one that has a relatively long life May be tangible (e.g., truck or computer) or intangible (e.g., patent) A current asset has a life of less than one year (e.g., inventory, cash, accounts receivable) Liabilities are the first thing listed on the right side of the balance sheet and are classified are either 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 the firm will pay off in five years) 1-4 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  THE BALANCE SHEET (CONTINUED) Shareholders equity (i.e., common equity or owners’ equity) is the difference between the total value of the assets (current and fixed) and the total value of the liabilities (current and long-term) Balance sheet “balances” because the value of the left side always equals the value of the right side Value of firm’s assets is equal to the sum of its liabilities and shareholders’ equity Balance sheet identity, or equation, must hold: 1-5 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. CONSTRUCTION OF THE BALANCE SHEET 1-6 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  NET WORKING CAPITAL Net working capital is the difference between a firm’s current assets and its current liabilities Positive when cash that will become available over the next 12 months (i.e., current assets) exceeds cash that must be paid over the same period (i.e., current liabilities) Usually positive in a healthy firm Three particularly important things to keep in mind when examining a balance sheet: 1. Liquidity 2. Debt versus equity 3. Market value versus book value 1-7 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  1-8 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  LIQUIDITY AND DEBT VERSUS EQUITY Liquidity refers to the speed and ease with which an asset can be converted to cash Two dimensions are ease of conversion versus loss of value Highly liquid asset is one that can be quickly sold without significant loss of value, while an illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction Assets are normally listed on the balance sheet in order of decreasing liquidity, with current assets being relatively liquid and fixed assets being relatively illiquid The more liquid a business, the less likely it is to experience financial distress (that is, difficulty in paying debts or buying needed assets). If a firm borrows money, it usually gives first claim to the firm’s cash flow to creditors, with equity holders entitled to only the residual value Use of debt in firm’s capital structure is called financial leverage 1-9 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  U.S. CORPORATION 2020 AND 2021 BALANCE SHEETS 1-10 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  MARKET VALUE VERSUS BOOK VALUE Values on balance sheet for the firm’s assets are book values and generally are not what the assets are actually worth Under generally accepted accounting principles (GAAP), audited financial statements in the U.S. mostly show assets at historical cost (i.e., assets are “carried on the book” at what the firm paid for them, no matter how long ago they were purchased or how much they are worth today) No necessary connection between total assets shown on the balance sheet and the value of the firm For financial managers, accounting value of stock is not especially important; it is the market value that matters Market value of an asset depends on things like its riskiness and cash flows, neither of which have anything to do with accounting 1-11 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. MARKET VALUE VERSUS BOOK VALUE: AN EXAMPLE 1-12 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  THE INCOME STATEMENT The income statement is a financial statement summarizing a firm’s performance over a period of time, usually a quarter or a year Income statement equation is: First thing reported on income statement would usually be revenue and expenses from the firm’s principal operations Subsequent parts include, among other things, financing expenses such as interest paid Taxes are reported separately Last item is net income (i.e., “the bottom line”) Net income is often expressed on a per-share basis and called earnings per share (EPS). 1-13 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  U.S. CORPORATION: INCOME STATEMENT 1-14 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  1-15 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  THE INCOME STATEMENT (CONTINUED) A financial manager should keep three things in mind when looking at an income statement: 1. GAAP As a result of the way revenues and expenses are realized, income statement figures may not be representative of actual cash inflows/outflows that occurred during a particular period 2. Cash versus noncash items Noncash items are expenses charged against revenues that do not directly affect cash flow, such as depreciation Crucial to separate cash flows from noncash accounting entries 3. Time and costs The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs. 1-16 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. THE INCOME STATEMENT (CONTINUED) Product costs include things such as raw materials, direct labor expense, and manufacturing overhead Period costs are incurred during a particular time period and might be reported as selling, general, and administrative expenses 1-17 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  TAXES Taxes can be one of the largest cash outflows a firm experiences Size of a company’s tax bill is determined by the tax code, an often amended set of rules Federal corporate tax rates became a flat 21% after the passage of the Tax Cuts and Jobs Act of 2017 Tax rates on other forms of business (e.g., proprietorships, partnerships, and LLCs) did not become flat Average tax rate is calculated as total taxes paid divided by total taxable income, while the marginal tax rate is the amount of tax payable on the next dollar earned 1-18 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. PERSONAL TAX RATES AND AN EXAMPLE 1-19 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  TAXES Normally the marginal tax rate is relevant for financial decision making. The reason is that any new cash flows will be taxed at that marginal rate. Because financial decisions usually involve new cash flows or changes in existing ones, this rate will tell us the marginal effect of a decision on our tax bill. 1-20 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  CASH FLOW Cash flow means the different between the number of dollars that came in and the number of dollars that went out No standard financial statement presents this information in the way that we wish Statement of cash flows is a standard financial accounting statement, but it is concerned with a somewhat different issue Cash flow identity says the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm: Cash flow identity reflects the fact that a firm generates cash through its various activities, and that cash is either used to pay creditors or paid out to the owners of the firm 1-21 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  CASH FLOW FROM ASSETS Cash flow from assets is the total of cash flow to creditors and cash flow to stockholders, consisting of the following three components: Operating cash flow refers to cash generated from a firm’s normal business activities Capital spending refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets) Change in net working capital is measured as the net change in current assets relative to current liabilities for the period being examined and represents the amount spend on net working capital Cash flow from assets is sometimes called free cash flow, referring to the cash the firm is “free” to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments 1-22 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. CASH FLOW FROM ASSETS (CONTINUED) Operating cash flow is calculated as revenues minus costs and tells us whether a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows Do not include depreciation (because it’s not a cash outflow) or interest in the calculation (because it’s a financing expense), but be sure to include taxes (because taxes are paid in cash) Negative operating cash flow is a sign of trouble Different calculation used for operating cash flow in accounting Net capital spending (i.e., CAPEX) is money spent on fixed assets less money received from the sale of fixed assets Could be negative is the firm sells more assets than it purchases Change in net working capital is found by taking the difference between the beginning and ending net working capital (NWC) figures Often referred to as the “addition to” NWC 1-23 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. CASH FLOW FROM ASSETS (CONTINUED) 1-24 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. CASH FLOW FROM ASSETS (CONTINUED) U.S. Corporation had a 2021 operating cash flow of $628. Operating cash flow is an important number because it tells us, on a very basic level, whether a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows. For this reason, a negative operating cash flow is often a sign of trouble. There is an unpleasant possibility of confusion when we speak of operating cash flow. In accounting practice, operating cash flow is often defined as net income plus depreciation. For U.S. Corporation, this would amount to $493 + 65 = $558. The accounting definition of operating cash flow differs from ours in one important way: Interest is deducted when net income is computed. Notice that the difference between the $628 operating cash flow we calculated and this $558 is $70, the amount of interest paid for the year. This definition of cash flow thus considers interest paid to be an operating expense. Our definition treats it properly as a financing expense. If there were no interest expense, the two definitions would be the same. 1-25 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. CASH FLOW FROM ASSETS (CONTINUED) 1-26 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  CASH FLOW FROM ASSETS (CONTINUED) Net working capital thus increased by $391. Put another way, U.S. Corporation had a net investment of $391 in NWC for the year. This change in NWC is often referred to as the “addition to” NWC. 1-27 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. CASH FLOW FROM ASSETS (CONCLUDED) Conclusion Given the figures we’ve come up with, we’re ready to calculate cash flow from assets. The total cash flow from assets is given by operating cash flow less the amounts invested in fixed assets and net working capital. So, for U.S. Corporation, we have: 1-28 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  CASH FLOW TO CREDITORS AND STOCKHOLDERS Cash flow to creditors is calculated as a firm’s interest payments to creditors less net new borrowing Sometimes called cash flow to bondholders Cash flow to stockholders is calculated as dividends paid out by a firm less net new equity raised 1-29 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  CASH FLOW TO CREDITORS AND STOCKHOLDERS The last thing we need to do is to verify that the cash flow identity holds to be sure we didn’t make any mistakes. From the previous section, we know that cash flow from assets is $107. Cash flow to creditors and stockholders is $24 + 83 = $107, so everything checks out. 1-30 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  CASH FLOW SUMMARY 1-31 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  SELECTED CONCEPT QUESTIONS What is liquidity? Why is it important? Explain the difference between book value and market value. Which is more important to the financial manager? Why? What is the income statement equation? What is the difference between a marginal and an average tax rate? What is the cash flow identity? Explain what it says. What are the components of operating cash flow? 1-32 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.  END OF CHAPTER CHAPTER 2 1-33 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.