Financial Statements, Taxes, and Cash Flow

Chapter 2

Created by David Moore, PhD

Key Concepts

Note: This chapter is largely a review of key accounting concepts.

  1. Balance sheet
  2. Income statement
  3. Taxes
  4. Cash flow

Financial Statements

Written records that convey the financial activities and conditions of a business or entity
  • Mandatory
  • Public
  • Large set of reporting rules
  • Most useful source of information on public companies.

The Balance Sheet

Balance Sheet

The balance sheet is a snapshot of the firm's assets and liabilities at a given point in time.

Balance Sheet Identity:

  • Assets= Liabilities + Stockholder's Equity

Summarizes what the firm owns (assets), owes (liabilities), and the difference (stockholder's equity).

Assets Liabilities 
Current Assets   Current Liabilities  
 Cash 1,500  Accounts Payable 600
 Accounts Receivable 500  Notes Payable 300
 Inventory 750    
Total 2,750 Total 900
Fixed Assets      
 Property Plant and Equipment 5,000 Long-term Debt 3,500
    Shareholders' Equity  
     Common stock and paid-in surplus 1,000
     Retained Earnings 2,350
     Total 3,350
Total Assets 7,750 Total Liabilities + Shareholders' Equity 7,750
Disney Example

Asset Tangibility


Assets can be tangible (can touch) or intangible (can't touch).

Things to consider

  1. Liquidity
  2. Debt vs Equity
  3. Market Value vs Book Value

Liquidity

Ability to convert to cash quickly without a significant loss in value

Trade off:

  • Liquid firms are less likely to experience financial distress.
  • Liquid assets typically earn a lower return

Debt vs Equity

  • Creditors are paid first; Shareholders get residual.
  • Other term for debt is: Financial leverage
  • Cost and benefits of financial leverage (debt) discussed more in later chapters

Market Value vs Book Value

The balance sheet provides the book value of the assets, liabilities, and equity.

Market value is the price at which the assets, liabilities, or equity can actually be bought or sold.

Tesla

Income Statement

The Income Statement

Summarizes a firm's performance over a period of time.

  • Generally: $\text{Revenue}-\text{Expenses}=\text{Income}$
  • Net Income $\neq$ cash flow
    • GAAP
    • Recognition and matching
    • Non-cash items: Depreciation

Income Statement: Example

Revenue  
Net Sales + 1,509
Expenses  
Cost of Goods Sold - 750
Depreciation - 65
Earnings Before Interest and Taxes (EBIT) Revenue - Operating Expenses 694
Interest Paid - 70
Taxable Income EBIT - Interest Paid 624
Taxes Taxable Income $\times$ Tax Rate 131
Net Income (NI) Taxable Income - Taxes 493
Dividends 293
Retained Earnings 200
Disney Example

Taxes

  • Tax code is complicated
  • This isn't a corporate tax class
  • Marginal vs average tax rate

What kind of taxes are companies paying? Taxes

Foreign Earnings

How are foreign earnings taxed?
Taxes2

Repatriation and Tax Cuts

Taxes2

Corporate Inversion

What is a corporate inversion?
Taxes3
(not)Fun fact: You owe taxes if you own stock in US company even if you don’t sell shares!! (See WSJ article)

Cash Flow

Cash Flow

Difference between number of dollars that came in and number of dollars that came out.

Cash flow identity:

$\text{Cash flow from assets}=$
$\text{Cash flow to creditors}+\text{Cash flow to stockholders}$

Cash Flow from Assets (CFFA)

$\text{CFFA}=\text{Cash Flow to Creditors}+\text{Cash Flow to Stockholder}$

  • Known as free cash flow


$\text{CF}_{\text{Assets}}=\text{OCF}-\text{NCS}-\Delta\text{NWC}$,
where:
$\text{OCF}=\text{Operating Cash Flow}$
$\text{NCS}=\text{Net Capital Spending}$
$\Delta\text{NWC}=\text{Change in Net Working Capital}$

Operating Cash Flow (OCF)

OCF=EBIT +Depreciation-Taxes
Revenue  
Net Sales + 1,509
Expenses  
Cost of Goods Sold - 750
Depreciation - 65
Earnings Before Interest and Taxes (EBIT) Revenue - Operating Expenses 694
Interest Paid - 70
Taxable Income EBIT - Interest Paid 624
Taxes Taxable Income $\times$ Tax Rate 131
Net Income (NI) Taxable Income - Taxes 493
OCF=694 +65-131=628

Net Capital Spending (NCS)

NCS$_t$=Fixed Assets$_t$-Fixed Assets$_{t-1}$+Depreciation

Assets 2017 2016 Liabilities 2017 2016
Current Assets Current Liabilities    
 Cash 1,500 1,300  Accounts Payable 600 800
 Accounts Receivable 500 800  Notes Payable 300 150
 Inventory 750 1000      
Total 2,750 3,100 Total 900 950
Fixed Assets        
 Property Plant and Equipment 5,000 4,500 Long-term Debt 3,500 3,200

NCS=5000-4500+65=565

Change in Net Working Capital($\Delta$NWC)

NWC$_t$=Current Assets$_t$ - Current Liabilities$_t$
$\Delta$NWC$_t$=NWC$_t$-NWC$_{t-1}$

Assets 2017 2016 Liabilities 2017 2016
Current Assets Current Liabilities    
 Cash 1,500 1,300  Accounts Payable 600 800
 Accounts Receivable 500 800  Notes Payable 300 150
 Inventory 750 1000      
Total 2,750 3,100 Total 900 950
Fixed Assets        
 Property Plant and Equipment 5,000 4,500 Long-term Debt 3,500 3,200

$\Delta$NWC=(2,750-900)-(3,100-950)=-300

Cash Flow From Assets

CFFA=Cash Flow to Creditors+Cash Flow to Stockholder

CF$_{Assets}$=OCF-NCS-$\Delta$NWC
CF$_{Assets}$=628-565-(-300)=363

Cash Flow to Creditors

CFFA=Cash Flow to Creditors+Cash Flow to Stockholder
CF$_{Creditors}$=Interest Paid - Net New Borrowing
CF$_{Creditors}$=Interest Paid - (Long Term Debt$_t$ - Long term Debt$_{t-1}$)
Balance Sheet Income Statement
Liabilities 2017 2016 Net Sales 1509
Current Liabilities       Cost of Goods Sold 750
 Accounts Payable 600 800   Depreciation 65
 Notes Payable 300 150   EBIT 694
        Interest paid 70
Total 900 950   Taxable Income 624
        Taxes 131
Long-term Debt 3,500 3,200   Net Income 493

CF$_{Creditors}$=70-(3,500-3,200)=-230

Cash Flow to Shareholders

CFFA=Cash Flow to Creditors+Cash Flow to Stockholder
CF$_{Stockholders}$=Dividends Paid-Net New Equity Issuance
CF$_{Stockholders}$=Dividends Paid-(Common Stock$_t$ - Common Stock$_{t-1}$)
Balance Sheet Income Statement
2017 2016   EBIT 694
Shareholder's Equity       Interest paid 70
 Common Stock 1,000 1,300   Taxable Income 624
 Retained Earnings 2,350 2,150   Taxes 131
 Total  3,350  3,450   Net Income 493
 
        Dividends 293
  Retained Earnings 200

CF$_{Stockholders}$=293-(1,000-1,300)=593

Does it balance?

CFFA=Cash Flow to Creditors+Cash Flow to Stockholder

CF$_{Assets}$=363
CF$_{Creditors}$=-230
CF$_{Stockholders}$=593

$363=-230+593$
$363=363$

Summary

Cash Flow Identity
CF$_{Assets}$=CF$_{Stockholders}$+CF$_{Creditors}$
Cash Flow from Assets
CF$_{Assets}$=OCF-NCS-$\Delta$NWC, where:
OCF=EBIT+Depreciation-Taxes
NCS=Net Fixed Assets$_t$-Net Fixed Assets$_{t-1}$+Depreciation
$\Delta$NWC=NWC$_t$-NWC$_{t-1}$=(CA$_t$-CL$_t$)-(CA$_{t-1}$-CL$_{t-1}$)
Cash Flow to Creditors
CF$_{Creditors}$=Interest Paid-Net New Borrowing=Interest Paid-(Long Term Debt$_t$-Long Term Debt$_{t-1})$
Cash Flow to Stockholders
CF$_{Stockholders}$=Dividends Paid-Net New Equity Raised =Dividends Paid-(Common Stock$_t$-Common Stock$_{t-1}$)

Cash Flow Problem

Sales=600
CGS=300
Depreciation=150
Interest=30
Taxes=21% (round to nearest integer)
Dividends=30
Beg NFA=500 End NFA=750, NFA=Net Fixed Assets
Beg CA=2130 End CA=2260 Beg CL=1620 End CL=1710
No new equity

What is CF to creditor and net new borrowing?
CF$_C$=-195 Net New Borrowing=225

Sources of Financial Information

Key Learning Outcomes

  • Reading financial statements
  • Differentiate: book vs market; financial vs accounting
  • Corporate Taxes and Foreign Earnings
  • Understand and calculate cash flows

Next time

Chapter 3: Financial Ratios