The document discusses key components of financial statements including the income statement, balance sheet, and financing. It defines the income statement as showing sales minus expenses to equal profit. The balance sheet lists assets, liabilities (debt), and equity. Assets include current assets like cash, and fixed assets like property and equipment. Liabilities include current liabilities like accounts payable and long-term debt. Financing comes from debt like bonds or equity from stockholders.

1. Chapter 2 -Chapter 2 -
Understanding FinancialUnderstanding Financial
Statements, Taxes, and CashStatements, Taxes, and Cash
FlowsFlows
© 2005, Pearson Prentice Hall

2. SALESSALES
-- EXPENSESEXPENSES
= PROFIT= PROFIT
Income StatementIncome Statement

3. SALESSALES
-- EXPENSESEXPENSES
= PROFIT= PROFIT
Income StatementIncome Statement
Revenue

4. Income StatementIncome Statement
SALESSALES
-- EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods Sold

5. Income StatementIncome Statement
SALESSALES
-- EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods Sold
•Operating Expenses

6. Income StatementIncome Statement
SALESSALES
-- EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods Sold
•Operating Expenses
(marketing, administrative)

7. Income StatementIncome Statement
SALESSALES
-- EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods Sold
•Operating Expenses
(marketing, administrative)
•Financing Costs

8. Income StatementIncome Statement
SALESSALES
-- EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods Sold
•Operating Expenses
(marketing, administrative)
•Financing Costs
•Taxes

9. SALESSALES
-- Cost of Goods SoldCost of Goods Sold
GROSS PROFITGROSS PROFIT
-- Operating ExpensesOperating Expenses
OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)
-- Interest ExpenseInterest Expense
EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)
-- Income TaxesIncome Taxes
EARNINGS AFTER TAXES (EAT)EARNINGS AFTER TAXES (EAT)
-- Preferred Stock DividendsPreferred Stock Dividends
-- NET INCOME AVAILABLENET INCOME AVAILABLE
Income StatementIncome Statement

10. SALESSALES
-- Cost of Goods SoldCost of Goods Sold
GROSS PROFITGROSS PROFIT
-- Operating ExpensesOperating Expenses
OPERATING INCOMEOPERATING INCOME (EBIT)(EBIT)
-- Interest ExpenseInterest Expense
EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)
-- Income TaxesIncome Taxes
EARNINGS AFTER TAXES (EAT)EARNINGS AFTER TAXES (EAT)
-- Preferred Stock DividendsPreferred Stock Dividends
-- NET INCOME AVAILABLENET INCOME AVAILABLE
Income StatementIncome Statement

11. SALESSALES
-- Cost of Goods SoldCost of Goods Sold
GROSS PROFITGROSS PROFIT
-- Operating ExpensesOperating Expenses
OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)
-- Interest ExpenseInterest Expense
EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)
-- Income TaxesIncome Taxes
EARNINGS AFTER TAXES (EAT)EARNINGS AFTER TAXES (EAT)
-- Preferred Stock DividendsPreferred Stock Dividends
- NET INCOME AVAILABLE- NET INCOME AVAILABLE
Income StatementIncome Statement

12. Balance SheetBalance Sheet
Total Assets =Total Assets =
Outstanding
Debt
+
Shareholders’
Equity

13. Balance SheetBalance Sheet

14. Balance SheetBalance Sheet
Assets

15. Balance SheetBalance Sheet
Assets Liabilities (Debt) & Equity

16. Balance SheetBalance Sheet
Assets Liabilities (Debt) & Equity
Current AssetsCurrent Assets
CashCash
Marketable SecuritiesMarketable Securities
Accounts ReceivableAccounts Receivable
InventoriesInventories
Prepaid ExpensesPrepaid Expenses
Fixed AssetsFixed Assets
Machinery &Machinery &
EquipmentEquipment
Buildings and LandBuildings and Land
Other AssetsOther Assets
Investments & patentsInvestments & patents
Current LiabilitiesCurrent Liabilities
Accounts PayableAccounts Payable
Accrued ExpensesAccrued Expenses
Short-term notesShort-term notes
Long-Term LiabilitiesLong-Term Liabilities
Long-term notesLong-term notes
MortgagesMortgages
EquityEquity
Preferred StockPreferred Stock
Common Stock (ParCommon Stock (Par
value)value)
Paid in CapitalPaid in Capital
Retained EarningsRetained Earnings

17. AssetsAssets
 Current AssetsCurrent Assets::

18. AssetsAssets
 Current AssetsCurrent Assets: assets that are: assets that are
relatively liquid, and are expected to berelatively liquid, and are expected to be
converted to cash within a year.converted to cash within a year.

19. AssetsAssets
 Current AssetsCurrent Assets: assets that are: assets that are
relatively liquid, and are expected to berelatively liquid, and are expected to be
converted to cash within a year.converted to cash within a year.
 Cash, marketable securities, accountsCash, marketable securities, accounts
receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.

20. AssetsAssets
 Current AssetsCurrent Assets: assets that are: assets that are
relatively liquid, and are expected to berelatively liquid, and are expected to be
converted to cash within a year.converted to cash within a year.
 Cash, marketable securities, accountsCash, marketable securities, accounts
receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.
 Fixed AssetsFixed Assets::

21. AssetsAssets
 Current AssetsCurrent Assets: assets that are: assets that are
relatively liquid, and are expected to berelatively liquid, and are expected to be
converted to cash within a year.converted to cash within a year.
 Cash, marketable securities, accountsCash, marketable securities, accounts
receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.
 Fixed AssetsFixed Assets: machinery: machinery
and equipment, buildings,and equipment, buildings,
and land.and land.

22. AssetsAssets
 Current AssetsCurrent Assets: assets that are: assets that are
relatively liquid, and are expected to berelatively liquid, and are expected to be
converted to cash within a year.converted to cash within a year.
 Cash, marketable securities, accountsCash, marketable securities, accounts
receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.
 Fixed AssetsFixed Assets: machinery and: machinery and
equipment, buildings, and land.equipment, buildings, and land.
 Other AssetsOther Assets::

23. AssetsAssets
 Current AssetsCurrent Assets: assets that are: assets that are
relatively liquid, and are expected to berelatively liquid, and are expected to be
converted to cash within a year.converted to cash within a year.
 Cash, marketable securities, accountsCash, marketable securities, accounts
receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.
 Fixed AssetsFixed Assets: machinery and: machinery and
equipment, buildings, and land.equipment, buildings, and land.
 Other AssetsOther Assets: any asset that is not a: any asset that is not a
current asset or fixed asset.current asset or fixed asset.

24. AssetsAssets
 Current AssetsCurrent Assets: assets that are: assets that are
relatively liquid, and are expected to berelatively liquid, and are expected to be
converted to cash within a year.converted to cash within a year.
 Cash, marketable securities, accountsCash, marketable securities, accounts
receivable, inventories, prepaid expenses.receivable, inventories, prepaid expenses.
 Fixed AssetsFixed Assets: machinery and: machinery and
equipment, buildings, and land.equipment, buildings, and land.
 Other AssetsOther Assets: any asset that is not a: any asset that is not a
current asset or fixed asset.current asset or fixed asset.
 Intangible assets, such as patents andIntangible assets, such as patents and
copyrights.copyrights.

25. FinancingFinancing
 Debt CapitalDebt Capital::

26. FinancingFinancing
 Debt CapitalDebt Capital: financing provided by a: financing provided by a
creditor.creditor.

27. FinancingFinancing
 Debt CapitalDebt Capital: financing provided by a: financing provided by a
creditor.creditor.
 Short-term debtShort-term debt::

28. FinancingFinancing
 Debt CapitalDebt Capital: financing provided by a: financing provided by a
creditor.creditor.
 Short-term debtShort-term debt: borrowed money that: borrowed money that
must be repaid within the next 12must be repaid within the next 12
months.months.

29. FinancingFinancing
 Debt CapitalDebt Capital: financing provided by a: financing provided by a
creditor.creditor.
 Short-term debtShort-term debt: borrowed money that: borrowed money that
must be repaid within the next 12must be repaid within the next 12
months.months.
 Accounts payable, other payables such asAccounts payable, other payables such as
interest or taxes payable, accruedinterest or taxes payable, accrued
expenses, short-term notes.expenses, short-term notes.

30. FinancingFinancing
 Debt CapitalDebt Capital: financing provided by a: financing provided by a
creditor.creditor.
 Short-term debtShort-term debt: borrowed money that: borrowed money that
must be repaid within the next 12must be repaid within the next 12
months.months.
 Accounts payable, other payables such asAccounts payable, other payables such as
interest or taxes payable, accruedinterest or taxes payable, accrued
expenses, short-term notes.expenses, short-term notes.
 Long-term debtLong-term debt::

31. FinancingFinancing
 Debt CapitalDebt Capital: financing provided by a: financing provided by a
creditor.creditor.
 Short-term debtShort-term debt: borrowed money that: borrowed money that
must be repaid within the next 12must be repaid within the next 12
months.months.
 Accounts payable, other payables such asAccounts payable, other payables such as
interest or taxes payable, accruedinterest or taxes payable, accrued
expenses, short-term notes.expenses, short-term notes.
 Long-term debtLong-term debt: loans from banks or: loans from banks or
other sources that lend money forother sources that lend money for
longer than 12 months.longer than 12 months.

32. FinancingFinancing
 Equity CapitalEquity Capital::

33. FinancingFinancing
 Equity CapitalEquity Capital: shareholders’: shareholders’
investment in the firm.investment in the firm.

34. FinancingFinancing
 Equity CapitalEquity Capital: shareholders’: shareholders’
investment in the firm.investment in the firm.
 Preferred StockholdersPreferred Stockholders::

35. FinancingFinancing
 Equity CapitalEquity Capital: shareholders’: shareholders’
investment in the firm.investment in the firm.
 Preferred StockholdersPreferred Stockholders: receive fixed: receive fixed
dividends, and have higher priority thandividends, and have higher priority than
common stockholders in event ofcommon stockholders in event of
liquidation of the firm.liquidation of the firm.

36. FinancingFinancing
 Equity CapitalEquity Capital: shareholders’: shareholders’
investment in the firm.investment in the firm.
 Preferred StockholdersPreferred Stockholders: receive fixed: receive fixed
dividends, and have higher priority thandividends, and have higher priority than
common stockholders in event ofcommon stockholders in event of
liquidation of the firm.liquidation of the firm.
 Common StockholdersCommon Stockholders::

37. FinancingFinancing
 Equity CapitalEquity Capital: shareholders’: shareholders’
investment in the firm.investment in the firm.
 Preferred StockholdersPreferred Stockholders: receive fixed: receive fixed
dividends, and have higher priority thandividends, and have higher priority than
common stockholders in event ofcommon stockholders in event of
liquidation of the firm.liquidation of the firm.
 Common StockholdersCommon Stockholders: residual: residual
owners of a business. They receiveowners of a business. They receive
whatever is left after creditors andwhatever is left after creditors and
preferred stockholders are paid.preferred stockholders are paid.

38. Corporate Income Tax RatesCorporate Income Tax Rates
Since 1993Since 1993
Taxable Income Corporate Tax RateTaxable Income Corporate Tax Rate
$1 - $50,000 15%$1 - $50,000 15%
$50,001 - $75,000 25%$50,001 - $75,000 25%
$75,001 - $100,000$75,001 - $100,000 34%34%
$100,001 - $335,000 39%$100,001 - $335,000 39%
$335,001 - $10,000,000 34%$335,001 - $10,000,000 34%
$10,000,001 - $15,000,000$10,000,001 - $15,000,000 35%35%
$15,000,001 - $18,333,333$15,000,001 - $18,333,333 38%38%
over $18,333,333over $18,333,333 35%35%

39. Free Cash FlowsFree Cash Flows
Free cash flow:Free cash flow: cash flow that is free andcash flow that is free and
available to be distributed to the firm’savailable to be distributed to the firm’s
investors (both debt and equity investors).investors (both debt and equity investors).

40. Free Cash FlowsFree Cash Flows
Cash Flows fromCash Flows from
AssetsAssets =
Cash Flows from
Financing
Cash flows generated
through the firm’s
assets
=
Cash flows paid to - or
received from - the
firm’s investors
(creditors &
stockholders)

41. Calculating Free Cash Flows:Calculating Free Cash Flows:
An Asset PerspectiveAn Asset Perspective
After-tax cash flowAfter-tax cash flow
from operationsfrom operations
lessless
investment in netinvestment in net
operatingoperating
working capitalworking capital
lessless
investments in fixedinvestments in fixed
and other assetsand other assets

42. Calculating Free Cash Flows:Calculating Free Cash Flows:
An Asset PerspectiveAn Asset Perspective
After-tax cash flowAfter-tax cash flow
from operationsfrom operations
lessless
investment in netinvestment in net
operatingoperating
working capitalworking capital
lessless
investments in fixedinvestments in fixed
and other assetsand other assets
Operating income
+ depreciation
- cash tax payments

43. Calculating Free Cash Flows:Calculating Free Cash Flows:
An Asset PerspectiveAn Asset Perspective
After-tax cash flowAfter-tax cash flow
from operationsfrom operations
lessless
investment in netinvestment in net
operatingoperating
working capitalworking capital
lessless
investments in fixedinvestments in fixed
and other assetsand other assets
[Change in current
assets]
-
[change in non-interest
bearing current liabilities]

44. Calculating Free Cash Flows:Calculating Free Cash Flows:
An Asset PerspectiveAn Asset Perspective
After-tax cash flowAfter-tax cash flow
from operationsfrom operations
lessless
investment in netinvestment in net
operatingoperating
working capitalworking capital
lessless
investments in fixedinvestments in fixed
and other assetsand other assets
Change in gross
fixed assets, and
any other assets
that are on the
balance sheet.

45. Calculating Free Cash Flows:Calculating Free Cash Flows:
A Financing PerspectiveA Financing Perspective
Interest payments to creditorsInterest payments to creditors
- change in debt principal- change in debt principal
- dividends paid to stockholders- dividends paid to stockholders
- change in stock- change in stock
= Financing Free Cash Flows= Financing Free Cash Flows

46. Tax Example:Tax Example:

47.  Space Cow Computer has sales ofSpace Cow Computer has sales of $32$32
millionmillion, cost of goods sold at, cost of goods sold at 60%60% ofof
sales, cash operating expenses ofsales, cash operating expenses of $2.4$2.4
millionmillion, and, and $1.4 million$1.4 million in depreciationin depreciation
expense. The firm hasexpense. The firm has $12 million$12 million inin
9.5%9.5% bonds outstanding. The firm willbonds outstanding. The firm will
paypay $500,000$500,000 in dividends to itsin dividends to its
common stock holders.common stock holders.
 Calculate the firm’s tax liability.Calculate the firm’s tax liability.

48. SalesSales $32,000,000$32,000,000
Cost of Goods SoldCost of Goods Sold (19,200,000)(19,200,000)
Operating ExpensesOperating Expenses (2,400,000)(2,400,000)
Depreciation ExpenseDepreciation Expense (1,400,000)(1,400,000)
EBIT or NOIEBIT or NOI 9,000,0009,000,000
Interest ExpenseInterest Expense (1,140,000)(1,140,000)
Taxable IncomeTaxable Income 7,860,0007,860,000

49. IncomeIncome tax ratetax rate tax paymenttax payment
$50,000 x .15 =$50,000 x .15 = $ 7,500$ 7,500
$25,000 x .25 =$25,000 x .25 = 6,2506,250
$25,000 x .34 =$25,000 x .34 = 8,5008,500
$235,000 x .39 =$235,000 x .39 = 91,65091,650
$7,525,000 x .34 =$7,525,000 x .34 = 2,558,5002,558,500
Total Tax paymentTotal Tax payment $2,672,400$2,672,400
short cut:short cut: $7,860,000 x .34 =$7,860,000 x .34 = $2,672,400$2,672,400