Financial Statements,

Cash Flow, and Taxes

Chapter 3

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 Overview

Key Financial Statements

Balance Sheet

Income Statement

Statement of Stockholders’ Equity

Statement of Cash Flows

Free Cash Flow, EVA and MVA

Federal Tax System

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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 cash flows – reports the impact of a
firm’s activities on cash flows over a given period of
time.
 Statement of stockholders’ equity – shows how
much of the firm’s earnings were retained, rather
than paid out as dividends.

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 Overview of D’Leon Inc.

 Snack food company that underwent major

expansion in 2017.
 So far, expansion results have been
unsatisfactory.
• Company’s cash position is weak.
• Suppliers are being paid late.
• Bank has threatened to cut off credit.
 Board of Directors has ordered that changes
must be made!

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 Balance Sheet: Assets

2018 2017
Cash 7,282 57,600
A/R 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less: Dep. 263,160 146,200
Net FA 939,790 344,800
Total Assets 2,866,592 1,468,800

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 Balance Sheet: Liabilities and Equity

2018 2017
Accts payable 524,160 145,600
Accruals 489,600 136,000
Notes payable 636,808 200,000
Total CL 1,650,568 481,600
Long-term debt 723,432 323,432
Common stock 460,000 460,000
Retained earnings 32,592 203,768
Total Equity 492,592 663,768
Total L & E 2,866,592 1,468,800

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 Income Statement

2018 2017
Sales 6,034,000 3,432,000
COGS 5,528,000 2,864,000
Other expenses 519,988 358,672
Total oper. costs excl.
deprec. & amort. 6,047,988 3,222,672
Depreciation and amortization 116,960 18,900
EBIT (130,948) 190,428
Interest expense 136,012 43,828
EBT (266,960) 146,600
Taxes (106,784) 58,640
Net income (160,176) 87,960

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 Other Data

2018 2017
No. of shares 100,000 100,000
EPS -$1.602 $0.88
DPS $0.11 $0.22
Stock price $2.25 $8.50
Lease pmts $40,000 $40,000

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 Statement of Stockholders’ Equity (2018)

Total
Common Stock Retained Stockholders’
Shares Amount Earnings Equity
Balances, 12/31/17 100,000 $460,000 $203,768 $663,768
2018 Net income (160,176)
Cash dividends (11,000)
Addition (subtraction)
to retained earnings (171,176)
Balances, 12/31/18 100,000 $460,000 $ 32,592 $492,592

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 Statement of Cash Flows (2018)

Operating Activities
Net income ($160,176)
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accruals 353,600
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provided by operating activities ($164,176)

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 Statement of Cash Flows Cont’d (2018)

Investing Activities
Additions to property, plant, & equipment ( $711,950 )
Net cash used in investing activities ( $711,950 )
Financing Activities
Increase in notes payable $ 436,808
Increase in long-term debt 400,000
Payment of cash dividends (11,000)
Net cash provided by financing activities $825,808
Summary
Net decrease in cash ($ 50,318)
Cash at beginning of year 57,600
Cash at end of year $ 7,282

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 D’Leon’s Financial Condition from Statement of CFs:
Conclusions

Net cash from operations = -$164,176, mainly

because of negative NI.

The firm borrowed $836,808 to meet its cash

requirements.

Even after borrowing, the cash account fell by

$50,318.

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 Net Working Capital vs. Net Operating Working Capital

 Net Working Capital = Current Assets - Current

Liabilities
 Net Operating Working Capital = Operating
Current Assets - Operating Current Liabilities
 Net Operating Working Capital = (Current
Assets - Excess Cash) - (Current Liabilities -
Notes Payable)

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 D’Leon’s Case

Did the expansion create additional after-tax

operating income?

AT operating income = EBIT(1 – Tax rate)

AT operating income18 = -$130,948(1 – 0.4)
= -$130,948(0.6)
= -$78,569
AT operating income17 = $114,257

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 D’Leon’s Case

What effect did the expansion have on net

operating working capital?

NOWC = (Current Assets – Excess Cash) – (Current Liabilities – Notes

Payable)

NOWC18  ($1,926,802  $7,282)  ($1,650,568  $636,808)

NOWC18  $905,760
NOWC17  $784,800

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 Assessment of the Expansion’s Effect on Operations

2018 2017
Sales $6,034,000 $3,432,000
AT oper. inc. -78,569 114,257
NOWC 905,760 784,800
Net income -160,176 87,960

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 What was the free cash flow (FCF) for 2018?

FCF = [EBIT(1 – T) + Depreciation and amortization] –

[Capital expenditures + NOWC]

FCF18 = [-$130,948(1 – 0.4) + $116,960] –

[($1,202,950 – $491,000) + $120,960]
= -$794,519

Is negative free cash flow always a bad sign?

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 Performance Measures for Evaluating Managers

 Accounting statements are insufficient for

evaluating managers’ performance because they
do not reflect market values.
 Performance Measures
MVA = Difference between market value and book
value of a firm’s common equity.
(P0 x Number of shares) – Book value.
EVA = Estimate of a business’ true economic
profit for a given year.
EBIT(1 – T)–(Total invested capital  Cost of capital)

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 What was D’Leon’s MVA in 2018 and 2017?

MVA18 = ($2.25 x 100,000) – $492,592

= -$267,592

MVA17 = ($8.50 x 100,000) – $663,768

= $186,232

Shareholder wealth has been destroyed!

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 What is the relationship between EVA and MVA?

If
If EVA
EVA is
is positive,
positive, then
then AT
AT operating
operating
income
income > > cost
cost of
of capital
capital needed
needed to
to
produce
produce that
that income.
income.

Positive
Positive EVA
EVA on
on annual
annual basis
basis helps
helps to
to
ensure
ensure MVA
MVA is
is positive.
positive.

MVA
MVA isis applicable
applicable to
to entire
entire firm,
firm, while
while
EVA
EVA can
can be
be calculated
calculated on
on aa divisional
divisional
basis
basis as
as well.
well.

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 Does D’Leon pay its suppliers on time?

 Probably not.
 A/P increased 260%, over the past year, while
sales increased by only 76%.
 If this continues, suppliers may cut off D’Leon’s
trade credit.

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 D’Leon’s Case

Does it appear that D’Leon’s sales price

exceeds its cost per unit sold?

No. The negative after-tax operating income and

decline in cash position shows that D’Leon is
spending more on its operations than it is taking in.

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 D’Leon’s Case

What if D’Leon’s sales manager decided to

offer 60-day credit terms to customers,
rather than 30-day credit terms?

If competitors match terms, and sales remain constant...

• A/R would .
• Cash would .
If competitors don’t match, and sales double...
• Short-run: Inventory and fixed assets  to meet
increased sales. A/R , Cash . Company may have
to seek additional financing.
• Long-run: Collections increase and the company’s cash
position would improve.

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 How did D’Leon finance its expansion?

 D’Leon financed its expansion with external

capital.
 D’Leon issued long-term debt which reduced its
financial strength and flexibility.

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 D’Leon’s Case

Would D’Leon have required external capital if

they had broken even in 2018 (Net income = 0)?

Yes. The company would still have to finance its increase

in assets. Looking to the Statement of Cash Flows, we see
that the firm made an investment of $711,950 in net fixed
assets. Therefore, they would have needed to raise
additional funds.

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 D’Leon’s Case

What happens if D’Leon depreciates fixed assets

over 7 years (as opposed to the current 10
years)?

 No effect on physical assets.

 Fixed assets on the balance sheet would decline.
 Net income would decline.
 Tax payments would decline.
 Cash position would improve.

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 Federal Income Tax System

Individual Taxes

Corporate Taxes

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 Corporate and Personal Taxes

 Both have a progressive structure (the higher

the income, the higher the marginal tax rate).
 Tax rates may change due to new tax legislation
in 2017
 Corporations
• Rates begin at 15% and rise to 35% for
corporations with income over $10 million,
although corporations with income between $15
million and $18.33 million pay a marginal tax
rate of 38%.
• Also subject to state tax (around 5%).

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 Corporate and Personal Taxes

 Individuals
• Rates begin at 10% and rise to 39.6% for single
individuals with incomes over $418,400 and
married couples filing jointly with incomes over
$470,700.
• May be subject to state tax.

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 Tax Treatment of Various Uses and Sources of Funds

 Interest paid: tax deductible for corporations

(paid out of pre-tax income), but usually not for
individuals (interest on home loans being the
exception).
 Interest earned: usually fully taxable (an
exception being interest from a “muni”).
 Dividends paid: paid out of after-tax income.

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 Tax Treatment of Various Uses and Sources of Funds

 Dividends received: most investors pay 15%

taxes.
• Investors in the 10% or 15% tax bracket pay 0%
on qualified dividends.
• Taxpayers in the 39.6% tax bracket pay 20%
taxes on dividends.
• Dividends are paid out of net income which has
already been taxed at the corporate level, this is
a form of “double taxation”.
• A portion of dividends received by corporations is
tax excludable, in order to avoid “triple taxation.”

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 More Tax Issues

 Tax Loss Carry-Back and Carry-Forward – since corporate

incomes can fluctuate widely, the Tax Code allows firms to carry
losses back to offset profits in previous years or forward to
offset profits in the future.

 Capital gains – defined as the profits from the sale of assets not
normally transacted in the normal course of business, capital
gains for individuals are generally taxed as ordinary income if
held for a year or less, and at the capital gains rate if held for
more than a year. Corporations do not receive special capital
gains treatment.

 Most taxpayers pay 15% taxes on long-term capital gains.

 Taxpayers in the 39.6% tax bracket pay 20% taxes on long-
term capital gains.

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 End of Chapter 3

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