CHAPTER 2

FINANCIAL STATEMENTS,
TAXES, AND CASH FLOW

Lecturer
Dr. Le Thanh Huyen
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills
• Know the difference between book
value and market value
• Know the difference between
accounting income and cash flow
• Know the difference between average
and marginal tax rates
• Know how to determine a firm’s cash
flow from its financial statements

2-2
 Chapter Outline
• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow

2-3
 The financial statements
• The Annual Report
 Verbal Section
– Usually a letter from the chairman
 Financial Statements / Recording business
activity / Financial reports
– The Income Statement
– The Balance Sheet
– Statement of Cash Flows
– Statement of Retained Earnings
4
 2.1.Balance Sheet
• The balance sheet is a snapshot of the
firm’s assets and liabilities at a given
point in time
• Assets are listed in order of decreasing
liquidity
– Ease of conversion to cash
– Without significant loss of value
• Balance Sheet Identity
– Assets = Liabilities + Stockholders’ Equity

2-5
The Balance Sheet
 2.1.Balance Sheet
• Assets

 Assets represent the firm’s investment are

classified as either short-term (current) or long-
term
 Current asstes generally include items that will be
liquidated and thus converted into cash within one
year
 Long-term, or fixed, assets include investment
that help generate cash flows over longer period
7
 2.1.Balance Sheet
• Debt
 Debt represents the loan the firm has outstanding,
and it generally is divided into 2 categories – short-
term debt and long-term debt
 Short – term debt (current liabilities) represent debt
that is due within 1 year – that is, these debts are
paid off within 12 months. Current liabilities
includes accounts payable (amount owed to
suppliers), accruals (amount owed to employees
and government) and notes payable (amount owed
to bank).
 Long-term debt includes the bonds and similar debt
instruments that the firm has issued that are paid off
over a period longer8 than 1 year
 2.1.Balance Sheet
• Equity
 Equity represents stockholders’ ownership, does
not to be “paid off”
 The common stock account shows the amount that
stockholders paid to company when the company
issued stock to raise funds.
 The retained earning account effectively represents
the total amount of income that the firm has saved
and reinvested in assets since the firm started
business.

9
US Corporation Balance Sheet –
Table 2.1

Place Table 2.1 (US Corp Balance Sheet)

here

2-10
Net Working Capital

2-11
Net Working Capital

2-12
Net Working Capital

2-13
 Net Working Capital

• Net Working Capital

– Formula NWC = Current Assets – Current Liabilities
– Positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out
– Usually positive in a healthy firm

2-14
Net Working Capital and Liquidity
– Ability to convert to cash
quickly without a
significant loss in value
– Liquid firms are less
likely to experience
financial distress
– But liquid assets typically
earn a lower return
– Trade-off to find balance
between liquid and
illiquid assets
2-15
Liquidity

2-16
Unilate Textiles: Dec. 31 Balance
Sheets ($ millions, except per share data)
2009 2008
Percent of Percent
Amount Total Amount of Total
Assets Assets
Assets
Cash and equivalents $ 15.0 1.8% $ 40.0 5.4%
Accounts receivables 180.0 21.3 160.0 21.3
Inventory 270.0 32.0 200.0 26.7
Total current assets $465.0 55.0%b $400.0 53.3%b
Net plant and equipment a 380.0 45.0 350.0 46.7
Total assets $845.0 100.0% $750.0 100.0%
Liabilities and Equity
Accounts payable $ 30.0 3.6% $ 15.0 2.0%
Accruals 60.0 7.1 55.0 7.3
Notes payable 40.0 4.7 35.0 4.7
Total current liabilities $130.0 15.4% $105.0 14.0%
Long–term bonds 300.0 35.5 255.0 34.0
Total liabilities (debt) $430.0 50.9% $360.0 48.0%
Common stock (25,000,000 shares) 130.0 15.4 130.0 17.3
Retained earnings 285.0 33.7 260.0 34.7
Total common equity $415.0 49.1% 390.0 52.0
Total liabilities and equity $845.0 100.0% $750.0 100.0%

Book value per share = (Common equity)/Shares

17 $16.60 $15.60
Market value per share (stock price) $23.00 $25.00
 Unilate Textiles: Dec. 31 Balance
Sheets ($ millions, except per share data)
Additional information: 2009 2008
Net working capital = Current assets – Current liabilities $335.0 $295.0
Net worth = Total assets – Total liabilities 415.0 390.0

Breakdown of net plant and equipment account:

Gross plant and equipment $680.0 $600.0
Less: Accumulated depreciation (300.0) 250.0
Net plant and equipment $380.0 $350.0

18
Debt versus Equity

2-19
2.1.3. 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.
• Market value and book value are often very
different. Why?
• Which is more important to the decision-
making process?

2-20
2.1.3. Market Value vs. Book
Value
• Roles of information in Balance sheet
- Supplier
- Creditor
- Investor/owner
- Manager
• Weaknesses of information in Balance sheet
- Do not express the true value of the firm
(human capital, true value of the stock,…)

2-21
 Example 2.2 Klingon
Corporation
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book Market Book Market
Assets Liabilities and
Shareholders’ Equity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 SE 600 1,100
1,100 1,600 1,100 1,600

2-22
 2.2. Income Statement
• The income statement is more like a video of
the firm’s operations for a specified period of
time.
• You generally report revenues first and then
deduct any expenses for the period
• The income statement equation:
Revenues – Expenses = Income

2-23
 2.2. Income Statement
• Information reported on an income
statement:
- Revenues
- Expenses
- Taxes
- Net income
- Dividend, Addition to retained earnings

2-24
US Corporation Income
Statement – Table 2.2

Insert new Table 2.2 here (US Corp Income

Statement)

2-25
2.2. Income Statement

2-28
 2.2. Income Statement
• Noncash items
A primary reason that accounting income differs
from cash flow is that an income statement
contains noncash items. (Eg: depreciation)
• Time and cost
In the long run, all business costs are variable
In the short run, some costs are effectively fixed
The distinction between fixed and variable costs
is important, at times, to the financial manager,
but the way costs are reported on the income
statement is not a good guide to which costs
are which

2-32
The Income Statement
(?) Should identical firms report
the same net income?

33
 Work the Web Example
• Publicly traded companies must file
regular reports with the Securities and
Exchange Commission
• These reports are usually filed
electronically and can be searched at the
SEC public site called EDGAR
• Click on the web surfer, pick a company,
and see what you can find!

2-34
2.3. Statements of cash flows
The Concept of Cash Flow
•Cash flow is one of the most important pieces of
information that a financial manager can derive
from financial statements
•The statement of cash flows does not provide us
with the same information that we are looking at
here
•Statement of cash flows is concerned with a
somewhat different issue from what is discussed
in this section.
•We will look at how cash is generated from
utilizing assets and how it is paid to those that
finance the purchase of the assets
2-44
 Cash Flow From Assets
• There components:
- Operating cash flow
- Capital spending
- Change in net working capital
• Cash flow from assets sometimes
goes by a different name, free cash
flow.

2-45
 Cash Flow From Assets
• Cash Flow From Assets (CFFA) = Cash
Flow to Creditors + Cash Flow to
Stockholders
• Cash Flow From Assets = Operating
Cash Flow – Net Capital Spending –
Changes in NWC

2-46
 Cash Flow From Assets
• Operating cash flow (OCF) refers to the
cash flow that results from the firm’s day-to-
day activities of producing and selling.
• Expenses associated with the firm’s financing
of its assets are not included because they are
not operating expenses.  OCF doesn't
include interest
• OCF doesn't include depreciation because it’s
not a cash outflow
• OCF includes taxes because taxes are paid in
cash

2-47
Cash Flow From Assets
Example:

2-48
 Cash Flow From Assets
• OCF tells us whether a firm’s cash inflows
from its business operations are sufficient to
cover its everyday cash outflows
• The accounting definition of operating cash
flow differs from that is taught in this subject
 Interest

2-49
 Cash Flow From Assets
• Capital spending refers to the net spending on
fixed assets (purchases of fixed assets less
sales of fixed assets).
• Net capital spending is just money spent on
fixed assets less money received from the sale
of fixed assets.

• Could net capital spending be negative?

2-50
 Cash Flow From Assets
• Change in net working capital is measured as
the net change in current assets relative to
current liabilities for the period being
examined and represents the amount spent on
net working capital.
• Formula NWC = Current Assets – Current
Liabilities

2-51
 Cash Flow From Creditors and Stockholders

• Cash flow to creditors

• Cash flow to stockholders

2-52
Cash Flow summary

2-53
Example: Cash flows for Dole Coca

2-54
 Example: Cash flows for Dole Coca
1. Operating cash flow
OCF = EBIT + Depreciation – Taxes = 150 + 150 - 41 = $259
2. Net capital spending
Suppose beginning net fixed assets were $500 and ending net fixed
assets were $750. What was the net capital spending for the year?
Depreciation: $150 ; Net fixed assets rose by $250.
Dole thus spent $250 along with an additional $150, for a total of
$400.
3. Change in NWC
Suppose Dole Cola started the year with $2,130 in current assets and
$1,620 in current liabilities, and the corresponding ending figures
were $2,260 and $1,710. What was the change in NWC during the
year? What was cash flow from assets? How does this compare to
net income?
Net working capital started out as $2,130 - 1,620 = $510 and ended
up at $2,260 - 1,710 - $550.
The addition to NWC was thus $550 - 510 = $40.

2-55
Example: Cash flows for Dole Coca

Suppose we know that Dole didn’t sell any new equity for the year.
What was cash flow to stockholders? To creditors?

Cash flow to creditors + Cash flow to stockholders = -$181

Cash flow to creditors + $30 = -$181
Cash flow to creditors = -$211

2-56
 Quick Quiz
• What is the difference between book value and
market value? Which should we use for decision-
making purposes?
• What is the difference between accounting
income and cash flow? Which do we need to use
when making decisions?
• What is the difference between average and
marginal tax rates? Which should we use when
making financial decisions?
• How do we determine a firm’s cash flows? What
are the equations, and where do we find the
information?

2-57
 Ethics Issues

• Why is manipulation of financial statements

not only unethical and illegal, but also bad for
stockholders?

2-58
 Comprehensive Problem
• Current Accounts
– 2009: CA = 4,400; CL = 1,500
– 2008: CA = 3,500; CL = 1,200
• Fixed Assets and Depreciation
– 2009: NFA = 3,400; 2008: NFA = 3,100
– Depreciation Expense = 400
• Long-term Debt and Equity (R.E. not given)
– 2009: LTD = 4,000; Common stock & APIC = 400
– 2008: LTD = 3,950; Common stock & APIC = 400
• Income Statement
– EBIT = 2,000; Taxes = 300
– Interest Expense = 350; Dividends = 500
• Compute the CFFA

2-59
 Mối liên hệ giữa các báo cáo
tài chính doanh nghiệp
Báo cáo kết quả kinh doanh

Doanh thu, chi phí,

Tài sản, nợ và Tài sản, nợ và
Bảng cân lợi nhuận Bảng cân
Vốn chủ sở Vốn chủ sở
đối kế toán đối kế toán
hữu tại thời hữu tại thời
đầu kỳ Dòng tiền vào, cuối kỳ
điểm đầu kỳ điểm cuối kỳ
dòng tiền ra

Báo cáo lưu chuyển tiền tệ

Đầu kỳ 1 kỳ kinh doanh Cuối kỳ

End of Chapter

2-61