CHAPTER 2

FINANCIAL STATEMENTS,
CASH FLOW, AND TAXES

 Balance sheet
 Income statement
 Statement of cash flows
 Accounting income vs. cash flow
 MVA and EVA
 Federal tax system
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• A manager’s primary goal is to maximize the value of his or
her firm’s stock.
• How does an investor go about estimating future cash flows,
and
• How does a manager decide which actions are most likely to
increase cash flows?

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If a firm’s managers - whether they are in marketing,
personnel, production, or finance - do not understand
financial statements, they will not be able to judge the
effects of their actions, and the firm will not be successful.

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 The Annual Report
• The annual report gives an accounting picture of
the firm’s operations and financial position.
• Two types of information are given in the report.
1. A verbal section, often presented as a letter from the chairman,
that describes the firm’s operating results during the past year
and discusses new developments that will affect future
operations.
2. Four basic financial statements
• the balance sheet,
• the income statement,
• the statement of retained earnings, and
• the statement of cash flows.

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The Annual Report

• Balance sheet – provides a snapshot of a firm’s

financial position at one point in time.
• Income statement – summarizes a firm’s
revenues and expenses over a given period of
time.
• Statement of retained earnings – shows how
much of the firm’s earnings were retained,
rather than paid out as dividends.
• Statement of cash flows – reports the impact of
a firm’s activities on cash flows over a given
period of time.

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 Example
• For illustrative purposes, we shall use data taken from Allied

Food Products, a processor and distributor of a wide variety of

staple foods, to discuss the basic financial statements.

• The company formed in 1978 when several regional firms

merged, Allied has grown steadily, and it has earned a reputation

for being one of the best firms in its industry.

• Allied’s earnings dropped a bit in 2001, to $113.5 million versus

$117.8 million in 2000.

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• Management reported that the drop resulted from losses associated

with a drought and from increased costs due to a three month strike.

• However, management then went on to paint a more optimistic picture

for the future, stating that full operations had been resumed, that
several unprofitable businesses had been eliminated, and that 2002
profits were expected to rise sharply.

• Of course, an increase in profitability may not occur, and analysts

should compare management’s past statements with subsequent

results.
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THE BALANCE SHEET

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• The left-hand side of Allied’s year-end 2001 and 2000
balance sheets, which are given in Table 2-1, shows
the firm’s assets, while the right-hand side shows the
liabilities and equity, or the claims against these assets.
• The assets are listed in order of their “liquidity,” or the
length of time it typically takes to convert them to cash.
• The claims are listed in the order in which they must be
paid:
• Accounts payable must generally be paid within 30
days, notes payable within 90 days, and so on, down to
the stockholders’ equity accounts, which represent
ownership and need never be “paid off.”

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1. Cash versus other assets.
• The assets are all stated in terms of dollars, only cash
represents actual money.
• (Marketable securities can be converted to cash within a
day or two, so they are almost like cash and are reported
with cash on the balance sheet.)
• Receivables are bills others owe Allied.
• Inventories show the dollars the company has invested in
raw materials, work-in-process, and finished goods
available for sale.
• Net plant and equipment reflect the amount of money
Allied paid for its fixed assets when it acquired those
assets in the past, less accumulated depreciation.
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Continued
• Allied can write checks for a total of $10 million (versus
current liabilities of $310 million due within a year).
• The noncash assets should produce cash over time, but
they do not represent cash in hand, and the amount of
cash they would bring if they were sold today could be
higher or lower than the values at which they are carried
on the books.

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2. Liabilities versus stockholders’ equity.
• The claims against assets are of two types
1. Liabilities (or money the company owes)
2. The stockholders’ ownership position.

• Suppose assets decline in value; for example, suppose some of

the accounts receivable are written off as bad debts. Liabilities
and preferred stock remain constant, so the value of the
common stockholders’ equity must decline.
• Therefore, the risk of asset value fluctuations is borne by the
common stockholders.
• Note, however, that if asset values rise (perhaps because of
inflation), these benefits will grow exclusively to the common
stockholders. 2-12
 3. Preferred versus common stock
• Preferred stock is a hybrid, or a cross between common stock
and debt.
• In the event of bankruptcy, preferred stock ranks below debt but
above common stock.
• Also, the preferred dividend is fixed, so preferred stockholders
do not benefit if the company’s earnings grow.

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4. Breakdown of the common equity accounts.
• The common equity section is divided into two accounts
• 1. Common stock
• 2. Retained earnings
• The retained earnings account is built up over time as the firm
“saves” a part of its earnings rather than paying all earnings out
as dividends.
• The breakdown of the common equity accounts is important for
some purposes but not for others.
• For example, a potential stockholder would want to know
whether the company actually earned the funds reported in its
equity accounts or whether the funds came mainly from selling
stock.

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5. Inventory accounting.
• Allied uses the FIFO (first-in, first-out) method to
determine the inventory value shown on its balance sheet
($615 million).
• It could have used the LIFO (last-in, first-out) method.

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6. Depreciation methods.
• Most companies prepare two sets of financial
statements—one for tax purposes and one for reporting to
stockholders.
• Generally, they use the most accelerated method
permitted under the law to calculate depreciation for tax
purposes, but they use straight line, which results in a
lower depreciation charge, for stockholder reporting.

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7. The time dimension.
• The balance sheet may be thought of as a snapshot of
the firm’s financial position at a point in time—for
example, on December 31, 2000.

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 THE INCOME STATEMENT
• Income Statement
• A statement summarizing the firm’s revenues and
expenses over an accounting period, generally a
quarter or a year.
• Depreciation
• The charge to reflect the cost of assets used up in the
production process. Depreciation is not a cash outlay.
• Tangible Assets
• Physical assets such as plant and equipment.

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• Intangible Assets
• Assets such as patents, copyrights, trademarks, and
goodwill.
• Amortization
• A noncash charge similar to depreciation except that it
is used to write off the costs of intangible assets.
• EBITDA
• Earnings before interest, taxes, depreciation, and
amortization.

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THE BALANCE SHEET

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Income Statements

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Statement of Retained Earnings
• A statement reporting how much of the firm’s earnings
were retained in the business rather than paid out in
dividends.
• The figure for retained earnings that appears here is the
sum of the annual retained earnings for each year of the
firm’s history.

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• Firms retain earnings primarily to expand the business,
and this means investing in plant and equipment, in
inventories, and so on, not piling up cash in a bank
account.
• Changes in retained earnings occur because common
stockholders allow the firm to reinvest funds that
otherwise could be distributed as dividends.
• Thus, retained earnings as reported on the balance sheet
do not represent cash and are not “available” for the
payment of dividends or anything else.

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Net Cash Flow
• Net cash flow represents the amount of cash a business
generates for its shareholders in a given year.
Net cash flow = Net income - Noncash revenues + Noncash charges.
Where
Noncash revenues = deferred taxes
Noncash charges = Depreciation and amortization

Net cash flow = Net income + Depreciation and amortization.

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STATEMENT OF CASH FLOWS
• A company mostly generates high cash flow than what it
gives to its shareholders.
• The cash flow may be used in a variety of ways. For
example,
• the firm may use its cash flow to pay dividends,
• to increase inventories,
• to finance accounts receivable,
• to invest in fixed assets,
• to reduce debt, or
• to buy back common stock

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MODIFYING ACCOUNTING DATA FOR
MANAGERIAL DECISIONS
1. OPERATING ASSETS AND OPERATING CAPITAL
• Operating Assets
• The cash and marketable securities, accounts receivable,
inventories, and fixed assets necessary to operate the business.
• Non-operating Assets
• Cash and marketable securities above the level required for
normal operations, investments in subsidiaries, land held for
future use, and other nonessential assets.
• Operating Working Capital
• Current assets used in operations.
• Net Operating Working Capital
• Operating working capital less accounts payable and accruals. It
is the working capital acquired with investor-supplied funds.
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NET OPERATING PROFIT AFTER
TAXES (NOPAT)
• The profit a company would generate if it had no debt and
held no non-operating assets.
NOPAT = EBIT(1 - Tax rate)
NOPAT = $283.8(1 -0.4)
= $283.8(0.6)
= $170.3 million

NOPAT (2000 ?)
EPS (2000 and 2001 ?)

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Free Cash Flow
• The cash flow actually available for distribution to all investors
(stockholders and debt holders) after the company has made all
the investments in fixed assets, new products, and working
capital necessary to sustain ongoing operations.
Free Cash Flow = Operating cash flow - Gross investment
in operating capital

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1. Operating Cash Flow
Equal to NOPAT plus any noncash adjustments, calculated on
an after-tax basis.
Operating cash flow = NOPAT + Depreciation

Operating cash flow = $170.3 + $100

Operating cash flow = $270.3 million.

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2. Net investment in operating capital = operating assets, or
operating capital in previous year - operating assets, or
operating capital in present year
Net investment in operating capital = $1,800 - $1,520
Net investment in operating capital = $280 million.
3. Gross investment
Gross investment = Net investment + Depreciation
Gross investment = $280 + $100 = $380 million.

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Free Cash Flow (FCF)
Free Cash Flow = Operating cash flow - Gross
investment in
operating
capital
= $270.3 - $380
= -$109.7 million.
• FCF = NOPAT - Net investment in operating capital
= $170.3 - $280
= - $109.7 million.

Is a negative free cash flow always bad?

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THE BALANCE SHEET

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 MVA AND EVA
• Since the primary goal of management is to maximize the firm’s
stock price, we need to bring stock prices into the picture.
• Financial analysts have therefore developed two new
performance measures, MVA, or Market Value Added, and EVA,
or Economic Value Added.
• Market Value Added (MVA)
• The difference between the market value of the firm’s stock and
the amount of equity capital investors have supplied.
• MVA = Market value of stock - Equity capital supplied by shareholders
• MVA = (Shares outstanding)(Stock price) -Total common equity.

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 ECONOMIC VALUE ADDED (EVA)
• Value added to shareholders by management during a given
year.
EVA = (Net operating profit after taxes, or NOPAT) – (After-tax
dollar cost of capital used to support operations)
EVA = (EBIT(1- Corporate tax rate)) – ((Total investor-supplied
operating capital)(After-tax percentage cost of capital))

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Federal Income Tax System

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Corporate and Personal Taxes

• Both have a progressive structure (the higher the income,

the higher the marginal tax rate).
• Corporations
• Rates begin at 15% and rise to 35% for corporations
with income over $10 million.
• Also subject to state tax (around 5%).
• Individuals
• Rates begin at 10% and rise to 38.6% for individuals
with income over $307,050.
• May be subject to state tax.

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• Progressive Tax
• A tax system where the tax rate is higher on higher incomes. The
personal income tax in the United States, which goes from 0
percent on the lowest increments of income to 39.6 percent, is
progressive.
• Taxable Income
• Gross income minus exemptions and allowable deductions as
set forth in the Tax Code.
• Marginal Tax Rate
• The tax rate applicable to the last unit of a person’s income.

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• Average Tax Rate
• Taxes paid divided by taxable income.
• For example, if Jill Smith, a single individual, had taxable income of
$35,000, her tax bill would be
• $3,937.50 + ($35,000 - $26,250)(0.28)
• = $3,937.50 + $2,450 = $6,387.50.
• Her average tax rate would be
• = $6,387.50/$35,000 = 18.25% versus a marginal rate of 28 percent.
• If Jill received a raise of $1,000, bringing her income to $36,000, she
would have to pay $280 of it as taxes, so her after-tax raise would be
$720.
• In addition, her Social Security and Medicare taxes would increase by
$76.50, which would cut her net raise to $643.50.
• Bracket Creep
• A situation that occurs when progressive tax rates combine with
inflation to cause a greater portion of each taxpayer’s real income to
be paid as taxes.
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Taxes on Dividend and Interest Income
• Corporations pay dividends out of earnings that have already been taxed,
there is double taxation of corporate income—income is first taxed at the
corporate rate, and when what is left is paid out as dividends, it is taxed again
at the personal rate.

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Capital Gains versus Ordinary Income

• Capital Gain or Loss

• The profit (loss) from the sale of a capital asset for more
(less) than its purchase price.

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CORPORATE INCOME TAXES

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2-49
 Interest and Dividend Income Received by
a Corporation
• Interest income received by a corporation is taxed as ordinary
income at regular corporate tax rates.
• However, 70 percent of the dividends received by one
corporation from another is excluded from taxable income, while
the remaining 30 percent is taxed at the ordinary tax rate.
• Thus, a corporation earning more than $18,333,333 and paying
a 35 percent marginal tax rate would pay only
• (0.30)(0.35) = 0.105 = 10.5%
• of its dividend income as taxes, so its effective tax rate on
dividends received would be 10.5 percent.

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• If this firm had $10,000 in pre-tax dividend income, its after-tax
dividend income would be $8,950:

Reason:

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