Intro to Finance - Fall 2024 PDF

Intro to Finance - Fall 2024 Ch2: Financial Statements, Taxes, and Cash Flow Zeyao Luan Rutgers Business School Table of contents 1. The Balance Sheet 2. The Income Statement 3. Taxes 4. Cash Flow 1 The Balance Sheet The Balance Sheet A snaps...

Intro to Finance - Fall 2024 Ch2: Financial Statements, Taxes, and Cash Flow Zeyao Luan Rutgers Business School Table of contents 1. The Balance Sheet 2. The Income Statement 3. Taxes 4. Cash Flow 1 The Balance Sheet The Balance Sheet A snapshot of the firm at a given point of time. What a firm owns Assets What a firm owes Liabilities The difference between the two Equity Balance sheet identity Assets = Liabilities + Stockholders’ Equity How does this hold? 2 The Balance Sheet 3 Assets: The Left Side Fixed assets: a relatively long life. Tangible. E.g. trucks, computers. Intangible. E.g. patents, trademark. Current assets: a life a less than a year. E.g. inventory, cash, accounts receivable. 4 Liabilities: The First Thing On The Right Side Current liabilities: a life of less than a year. E.g. accounts payable. Long-term liabilities: not due in the coming year. E.g. Long-term debt. A load that the firm pays off in five years. Bond: long-term debt. Bondholders: long-term creditors. 5 Owners’ Equity: The Right Side Shareholders’ equity (or common equity, owners’ equity ) This is to reflect that, if the firm were to sell all its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders. The balance sheet ALWAYS balances because the value of the left side always equal to the the value of the right side. 6 Net Working Capital Net working capital: current assets less current liabilities. The amount of cash that will become available over the next 12 months. Positive net working capital usually indicates a healthy firm. 7 Example 2.1: Building the Balance Sheet A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt of $200. What does the balance sheet look like? What is shareholders’ equity? What is net working capital? 8 Example 2.1: Building the Balance Sheet Step 1 : Total assets = current assets + long-term assets $100 + $500 = $600 Step 2 : Total liabilities = current liabilities + long-term liabilities $70 + $200 = $270 Step 3 : Shareholders’ equity = total assets - total liabilities $600 - $270 = $330 9 Example 2.1: Building the Balance Sheet Step 4 : Net working capital = current assets - current current liabilities $100 - $70 = $30 10 Table 2.1: Balance Sheets 11 Table 2.1: Balance Sheets The structure of the assets for a particular firm reflects the line of business the firm is in as well as managerial decisions. E.g. how mush cash and inventory to have on hand? The liabilities side primarily reflects managerial decision about capital structure and the use of short-term debt. E.g. long-term financing ($454 + $2,330 = $2,784), debt-to-equity ratio of long-term financing ($454/$2,330 = 19.48%) 12 Liquidity Liquidity: the speed and ease with which an asset can be converted to cash. Note: any asset can be converted to cash quickly if we cut the price enough. Two dimensions of liquidity Ease of conversion Loss of value A highly liquid asset is one that can be quickly sold without significant loss of value; on the contrary, an illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction. 13 Liquidity Assets are normally listed on the balances sheet in order of decreasing liquidity. Cash → Accounts receivable → Inventory → Fixed assets Liquidity is valuable. The more liquid a business is, the less likely it is to experience financial distress. Liquid assets are generally less profitable to hold. Cash sometimes earn no return at all – they just sit there. Trade-off: advantages of liquidity vs. forgone of potential profits. 14 Debt vs. Equity When a firm borrows money, It usually gives first claim to its cash flow to creditors; Equity holders are entitled to only the residual value, the portion left after creditors are paid. Share holders’ equity = Assets - Liabilities In an accounting sense: share holders’ equity is defined as this residual portion. In an economic sense: if the firms sells its assets and pays its debts, whatever cash is left belongs to the equity holders. Financial leverage The use of debt in a firm’s capital structure. Debt acts as a lever as using it can greatly magnify both gains and losses. 15 Market Value vs. Book Value Book value The values shown on the balance sheet for the firm’s assets (GAAP: historical cost). Accounting rule changes can lead to variation in book values of some certain types of assets. Market value What the assets are actually worth. The market value of an assets depends on its riskiness and cash flows, neither of which are affected by accounting rule changes. Book values and market values are often very different. For managers and investors, it is the market value that matters. 16 The Income Statement The Income Statement The income statement measures performances over some period of time, usually a quarter or a year. Income statement equation Revenues - Expenses = Income You generally report revenues first and then deduct any expenses for the period. 17 The Income Statement Net income is often reported on a per-share basis and called earnings per share (EPS). Retained earnings is added to the cumulative retained earnings account on the balance sheet. EPS? DPS? (200 million shares outstanding.) 18 The Income Statement GAAP: Matching principle Show revenue when it accrues and match the expenses required to generate the revenue. Noncash items A primary reason that accounting income differs from cash flow is that an income statement contains noncash items. E.g. depreciation (straight-line deduction). 19 Taxes Corporate Tax Rate The tax rate schedule was simplified by the Tax Cuts and Jobs Act of 2017. Beginning in 2018, the corporate tax rate is 21 percent, and that rate applies regardless of the level of taxable income. 20 Marginal vs. average tax rates Marginal vs. average tax rates Marginal tax rate – the percentage paid on the next dollar earned Average tax rate – the tax bill / taxable income Flat rate: Marginal rate = Average rate 21 Examples: Marginal vs. average tax rates Given taxable income: $250,000, what is the average tax rate? the marginal tax rate? Graduated income tax structure; Flat 21%. 22 Cash Flow Cash Flow Cash flow The difference between the number of dollar that come in and the number of dollars that went out. Statement of cash flows (Ch03) does not provide us with the same information that we are looking at here. Cash flow identity Cash flow from assets (CFFA) = Cash flow to creditors + Cash flow to stockholders The cash flow from assets is equal to the cash flow paid to suppliers of capital. 23 Cash Flow From Assets (CFFA) Three important components (+) Operating cash flow (OCF) The cash flow that results form the firm’s day-to-day activities of producing and selling. (-) Net capital spending (NCS) The net spending on fixed assets. (-) Changes in net working capital (NWC) The net change in current assets relative to current liabilities for the period being examined. 24 Example: U.S. Corporation in 2018 OCF (I/S) = EBIT + depreciation - taxes = $628 NCS (B/S and I/S) = ending net fixed assets - beginning net fixed assets + depreciation = $130 Changes in NWC (B/S) = ending NWC - beginning NWC = $391 CFFA = 628 - 130 - 391 = $107 Income statement: pp. 18 Balance sheet: pp. 11 25 Example: U.S. Corporation in 2018 CF to Creditors (B/S and I/S) = interest paid - net new borrowing = $24 CF to Stockholders (B/S and I/S) = dividends paid - net new equity raised = $83 CFFA = 24 + 83 = $107 Income statement: pp. 18 Balance sheet: pp. 11 26 Cash Flow Summary 27 Ch02. Financial Statements, Taxes and Cash Flow End of Chapter 28