ch03.ppt

Copyright 2008 John Wiley & Sons
Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Created by
Babu G. Baradwaj, Ph.D.
Lawrence L. Licon, Ph.D.
Chapter 3 – Financial Statements, Cash Flows, and Taxes

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Chapter 3 – Financial Statements, Cash Flows, and Taxes Copyright 2008 John Wiley & Sons
CHAPTER 3
Financial Statements,
Cash Flows, and Taxes

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Quick Links
Financial Statements and Accounting Principles
Market Value vs. Book Value
The Income Statement
Statement of Retained Earnings
Cash Flows
The Balance Sheet
Federal Income Tax
Exhibits

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 Annual Report comprised of three sections:
 Financial summary related to the past
year’s performance
 Information about the company, its
products, and its activities
 Audited financial statements including
historical financial data
 Annual Report – Used by management to
communicate with firm’s shareholders and
public
Financial Statements and
Accounting Principles
Annual Reports

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 Prepared by the Financial Accounting
Standards Board (FASB) and authorized by
the SEC
Generally Accepted Accounting Principles (GAAP)
 These are accounting rules and standards
that companies need to adhere to when they
prepare financial statements and reports

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Five Important Accounting Principles
 The Cost Principle:
Transactions are recorded at the cost
at which they occurred
 The Assumption of Arm’s Length Transaction:
Two parties involved in an economic
transaction arrive at a decision
independently and rationally

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Five Important Accounting Principles
 The Going Concern Assumption:
It is assumed that a company will continue
to operate for the predictable future
 The Matching Principle:
Expenses related to generating any
revenue are matched
 The Realization Principle:
Revenue is recognized when transaction
is completed, while cash may not be
collected until a later time

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International GAAP
 Uniform accounting rules and procedures
promoted by the International Accounting
Standards Board
 All European Union firms required to
comply with International Accounting
Standards (IAS) since 2007
 SEC does not recognize IAS, and requires
foreign firms listed on U.S. stock
exchanges to use U.S. GAAP

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Criticisms of U.S. GAAP
 It can easily be circumvented by sharp
financial managers and accountants
 It is too complicated and detail oriented,
and leaves no room for accountants to
use their judgment

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This financial statement identifies all the assets and
liabilities of a firm at a point in time
 Left side of the balance shows all assets
the firm owns and uses to generate
revenues
 Right side represents the liabilities of the
firm – money that the firm has borrowed
from both creditors and shareholders
The Balance Sheet
Go to Exhibit 3.1

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The Balance Sheet
 Balance sheet also lists the capital raised from
its shareholders
 Shareholders of the firm’s common equity are
listed last
 Will be paid with whatever remains after
paying all other suppliers of funds
 Assets listed in order of their liquidity
 Liabilities listed in order in which they must be
paid

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Current Assets and Liabilities
The Balance Sheet
 Current assets include all assets likely to be
converted to cash within a year (or within an
operating cycle)
 These include cash and marketable
securities, accounts receivables, and
inventory

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The Balance Sheet
Current Assets and Liabilities
 Net Working Capital = Difference between
amount of current assets and current
liabilities
 Current Liabilities include all liabilities that
have to be paid within a year
 Bank loans and other borrowings with
less than a year’s maturity, accounts
payables, accrued wages and taxes

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Inventory Accounting
 FIFO (First in first out) refers to practice of
recognizing a sale as being made up of
inventory purchased earlier and having
lowest cost
 LIFO (Last in last out) calls for firm to
attribute any sale made to the most recently
acquired and most expensive inventory
 Inventory (least liquid of current assets)
reported in one of two ways on balance sheet
The Balance Sheet

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Inventory Accounting
 FIFO reporting leads to higher current asset
value and higher net income
 Firms may switch from one to another only
under extraordinary circumstances and not
frequently
The Balance Sheet

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Long-Term Assets
The Balance Sheet
 Intangible assets also listed here
 Goodwill, patents, copyrights, etc.
 Real assets firm acquires to produce its
products and generate cash flows
 Land, buildings, plant and equipment

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Long-Term Assets
The Balance Sheet
 All long-term real assets are depreciated
 Intangible assets are amortized
 Depreciating assets allow a firm to lower
taxable income and reduce taxes
 Firms are allowed to depreciate assets
using straight line method or accelerated
depreciation method allowed by IRS

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Long-Term Liabilities
The Balance Sheet
 Long-term debt of the company
 Including bank loans, mortgages, and bonds
with a maturity of one year or longer

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Equity – There are two sources of equity funds:
The Balance Sheet
 Preferred Equity:
The other source of equity capital is
preferred stock
Has features that make it a
combination of a fixed income security
and an equity security
 Common Equity:
Common equity represents the true
ownership of the firm

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The Balance Sheet
More Balance Sheet Accounts
 Retained earnings:
Results from funds the firm has
reinvested from its earnings
These funds are not cash–they already
have been put to work
 Treasury stock:
This account reflects the value of the
shares that the firm has repurchased
from investors

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 All assets are traditionally reported at their
historical costs
 Balance sheet does not reflect current
market value of the assets–only their
acquired costs
Asset Valuation

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 Downside is the difficulty in estimating market
values of assets
 When both liabilities and assets are
reported at their current market values,
their difference represents true market
value of shareholders’ equity
Asset Valuation
 Better information is provided to management
and investors by adopting a marking to market
approach—reporting assets at their current
market value

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 Measures the profitability of a firm for any
reporting period
 Revenues represent value of products and
services sold by firm–include both cash and
credit sales
 Expenses range from cost of producing
goods for sale and asset utilization costs-
depreciation or amortization
 Net income = Difference between the firm’s
revenues and expenses
The Income Statement: Overview
Go to Exhibit 3.2

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 The cost of any physical asset, such as plant
or machinery, is written off over its lifetime.
This is called depreciation and is a non-cash
expense
The Income Statement: Depreciation
 Firms use one of these for depreciating
an asset:
Straight line method
Accelerated depreciation method
 Firms allowed to use one for internal purposes
and another for tax purposes

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 Amortization expenses are related to the
writing off of the value of intangible
assets, such as:
 Goodwill, Patents, Licenses, etc.
The Income Statement: Amortization
 It is also a non-cash expense like depreciation

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 Nonrecurring expenses are associated with
the closing down of unprofitable operations,
or restructuring of a firm’s operations
Nonrecurring and Extraordinary Items
 Extraordinary Items refer to income or
expenses associated with events that are
not expected to happen on a regular basis

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 Earnings before interest, taxes, depreciation and
amortization (EBITDA)
 Earnings generated from operations prior to
payment of expenses not directly connected to
production of products
Bottom Line Accounts
 After netting out the expenses related to
depreciation and amortization, we arrive at
earnings before interest and taxes (EBIT)

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 Subtracting taxes from EBT yields net
income or net income after taxes
 This amount tells us amount available
to management to pay dividends, pay
off debt, or reinvest in firm
Bottom Line Accounts
 Earnings before taxes (EBT) represents the
taxable income for the period

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Statement of Retained Earnings
 This account will show changes whenever
a firm reports a loss or profit and when a
cash dividend is declared
 This financial statement shows the
changes in this account (Retained
Earnings) from one period to the next
Go to Exhibit 3.3

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Cash Flows
Net Cash Flow versus Net Income
 While accountants focus on net income,
shareholders would be more interested
in net cash flows
 These two are not the same, because of
the presence of non-cash revenues and
expenses

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Cash Flows
Cash Flow Statement
 Helps to measure cash outflows and cash
inflows generated during any period
 Indicates cash flows resulting from:
 Operating activities, investing activities,
and financing activities
 Sum of cash flows measures net cash
flows of firm during a given period
 It is the bottom line of this financial
statement
Go to Exhibit 3.4

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Cash Flows
Operating Activities
 Cash inflows result from producing and
selling goods and services
 Cash outflows are tied to the purchase of
raw materials, inventory, salaries and
wages, utilities, rent, interest and other
related expenses
Go to Exhibit 3.5

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Cash Flows
 Cash inflows and outflows arise out of the
acquisition and selling of real assets
necessary to operate the business
investing activities
Investing Activities
 Also result from:
 Buying and selling financial assets
(bonds, stocks)
 Making and collecting loans
 Selling and settling insurance contracts

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Cash Flows
 Cash Inflows–when a firm issues debt or
equity securities, or borrows money from
banks or other lenders
 Cash Outflows–if they pay interest or
dividends on the investor’s funds, pay off
debt, or purchase treasury stock
Financing activities

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Federal Income Tax
Corporate Income Tax Rates
 It is a progressive tax schedule with rates
ranging from 15 percent to 39 percent
 The higher a firm’s taxable income, the
higher the tax liability
Go to Exhibit 3.6

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Average versus Marginal Tax Rates
 Average tax rate = total taxes paid divided
by taxable income for the period
 Marginal tax rate = tax rate paid on the
last dollar earned or the next dollar earned
Federal Income Tax

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Federal Income Tax
Dividends and interest payments
 Current U.S. tax code allows interest
payments on debt issued by firms to be tax
deductible
 Dividends paid on firm’s preferred stock or
common stock are not deductible for tax
purposes–they are paid from after-tax
income
 The result is a lower cost of debt financing
relative to the cost of equity financing

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Exhibit 3.1: Diaz Mfg Balance
Sheets

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Exhibit 3.2: Diaz Mfg Income
Statements

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Exhibit 3.3: Diaz Mfg Statement of
Retained Earnings

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Exhibit 3.4: Diaz Mfg Statement of
Cash Flows

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Exhibit 3.5: Interrelations among
the Financial Statements

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Exhibit 3.6: Corporate Tax Rates
for 2007

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