CHAPTER 3: FINANCIAL

STATEMENTS, CASH FLOWS, AND

TAXES

1
ANNUAL REPORT
• The annual report is the most important report that
firms issue to their stockholders and the public
• Summarizes the overall performance of a firm for the
most recent fiscal year
o Tables containing financial information and operations
o Information on the firms products, services, and
contributions
o Audited financial statements: balance sheet, income
statement, statement of retained earnings, and the
statement of cash flows

2
FINANCIAL STATEMENTS &
ACCOUNTING PRINCIPLES (1 OF 2)
• Generally Accepted Accounting Principles (GAAP)
o Accounting rules and standards that public companies must adhere
to when they prepare financial statements and reports
o Established by the Financial Accounting Standards Board (FASB)
and authorized by the Securities and Exchange Commission (SEC)
o Standards make it easier for analysts and management to make
meaningful comparisons of company performance
• GAAP are guidelines, not rules
o Firms have discretion about how their financial information is
presented
o Practical application requires professional judgement

3
FIVE IMPORTANT
ACCOUNTING PRINCIPLES (1
OF 2)
1. Assumption of Arm’s Length Transaction
 Parties involved in an economic transaction arrive at a decision
independently and rationally

2. Cost Principle
 Asset values are recorded at the cost for which they were acquired
(and must be adjusted if they fall in value)
 Investors want current prices and prefer a market value balance
sheet (finance) versus a book value balance sheet (accounting)
3. Realization Principle
• Revenue is recognized when a transaction is completed, although
cash may be received earlier or later

4
FIVE IMPORTANT ACCOUNTING
PRINCIPLES (2 OF 2)
4. Matching Principle
 Revenue is matched with the expense incurred to generate the
expense
5. Going Concern Assumption
 Assumption that a company will continue to operation for the
predictable future

5
STEP BY STEP TO THE BOTTOM LINE
• Earnings-before-interest-taxes-depreciation-and-amortization
(EBITDA)
o Income from selling goods and services minus the cost of
providing them
• Earnings-before-interest-and-taxes (EBIT)
o EBITDA minus depreciation and amortization
• Earnings-before-taxes (EBT)
o EBIT minus interest expense
o Taxable income
• Net income (NI)
o EBT minus taxes

6
CASH FLOW TO INVESTORS (1 OF 3)
• Net Income vs. Cash Flows
o Accountants focus on net income and shareholders focus on net cash
flows, which are not the same because of delays in inflows, outflows,
and non-cash revenues and expenses

• Cash flow available to investors from operating activity

(CFOA)

Equation 3.4

CFOA = EBIT − Current Taxes + Noncash Expenses

7
CASH FLOW TO INVESTORS (2 OF 3)
• Diaz Manufacturing
o EBIT = $168.4 million
o Current Taxes = $44.3 million
o Non-cash expenses = $83.1 million

CFOA = EBIT − Current Taxes+ Noncash Expenses

CFOA = $168.4m − $44.3m + $83.1m
CFOA = $207.2 million

8
CASH FLOW INVESTED IN
WORKING CAPITAL
• CFNWC reflects net cash flows into or out of working
capital
Equation 3.5

CFNWC = NWC current period − NWC previous period

Where NWC = Total current assets − Total current liabilities

9
CFNWC EXAMPLE
• Diaz Manufacturing
o NWC 2014 = $662.0 million
o NWC 2013 = $342.0 million

CFNWC 2014 = NWC 2014 − NWC 2013

CFNWC 2014 = $662.0m − $342.0m
CFNWC 2014 = $320.0 million

10
CASH FLOW INVESTED IN LONG-
TERM ASSETS
• CFLTA reflects changes in the value of long-term
assets (LTA)
o Since depreciation is a non-cash charge, we ignore
accumulated depreciation when calculating the value of
the assets

Equation 3.6

CFLTA = LTA current period − LTA previous period

11
CASH FLOW TO INVESTORS (3 OF 3)
• CFI considers changes in cash flows from operating
activity, net working capital, and investment in
long-term assets

Equation 3.7

CFI = CFOA − CFNWC − CFLTA

12
FEDERAL INCOME TAX (1 OF 2)
• Corporate Income Tax
o The U.S. has a progressive tax with rates ranging from 15% to 39%
o The higher the taxable income, the higher the tax liability

• Average vs. Marginal Tax Rate

o Average Tax Rate is total taxes paid, divided by taxable income for the
period
o Marginal Tax Rate is the rate paid on the last dollar earned or the next
dollar that will be earned

13
FEDERAL INCOME TAX (2 OF 2)
Exhibit 3.6 U.S. Federal Corporate Income Tax Rates for 2016
The federal corporate marginal tax rate varies from 15 to 39 percent. Generally speaking, smaller
companies with lower taxable income have lower tax rates than larger companies with higher taxable
incomes. Smaller businesses are given preferential treatment to encourage new business formation.

(1) (2) (3) (4)

Pay This Amount on Marginal Tax Rate:
Corporations’ Taxable Average Tax Rate
the Base of the Tax Rate on the Excess
Income at Top of Bracket
Bracket Over the Base
$0–$50,000 $ 0 15% 15.0%
50,001–75,000 7,500 25 18.3
75,001–100,000 13,750 34 22.3
100,001–335,000 22,250 39 34.0
335,001–10,000,000 113,900 34 34.0
10,000,001–15,000,000 3,400,000 35 34.3
15,000,001–18,333,333 5,150,000 38 35.0
More than 18,333,333 6,416,667 35 35.0

14
TAX TREATMENT OF DIVIDENDS &
INTEREST
• Dividends and interest are not equal
o The U.S. tax code allows interest payments on debt to
reduce firms’ taxable income
o The tax code does not allow dividend payments to equity
to reduce firms’ taxable income
o Therefore debt financing has a lower cost relative to
equity financing

15