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STUDY GUIDE: CHAPTER 3

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES


Outline
I.

A firms annual report is the most important report that corporations issue to shareholders and it
contains two types of information.
A. The first is a verbal statement of the companys recent operating results during the past year and
discusses new developments that will affect future operations.
B. The second is a set of quantitative financial statements that report what actually happened to the firms
financial position, earnings, cash flow, and stockholders equity over the past few years.
1. The balance sheet shows what assets the company owns and who has claims on those assets as of a
given date.
2. The income statement shows the firms sales, costs, and profit over a period of time.
3. The statement of cash flows shows how much cash the firm began the year with, how much cash it
ended up with, and what it did to increase or decrease its cash.
4. The statement of stockholders equity shows the amount of equity the stockholders had at the start
of the year, the items that increase or decreased equity, and the equity at the end of the year.
C. The information contained in an annual report can be used to help forecast future earnings and
dividends.

II.

The balance sheet is a statement of the firms financial position at a specific point in time. It shows
the firms assets and the claims against those assets.
A. Assets, found on the left-hand side of the balance sheet, are typically shown in the order of their
liquidity.
1. The balance sheet may be thought of as a snapshot of the firms financial position at a point in time
(for example, the end of the year). The balance sheet changes every day as inventory is increased or
decreased, as fixed assets are added or retired, as bank loans are increased or decreased, and so on.
2. Assets are divided into two major categories: current assets and long-term assets.
3. Current assets include cash and equivalents, accounts receivable, and inventory. Only cash and
equivalents represent actual spendable money.
a. Current assets are often called working capital because these assets turn over. They are used
and then replaced throughout the year.
b. Net working capital is the difference between current assets and current liabilities.
4. Long-term assets are those whose useful lives exceed one year, and they include physical assets
such as plant and equipment and intellectual property such as patents and copyrights.
B. Claims, found on the right-hand side, are generally listed in the order in which they must be paid.
1. Claims against the assets consist of liabilities and stockholders equity:
Assets Liabilities Preferred stock = Common stockholders equity (Net worth)
2. Liabilities are further divided into current liabilities and long-term debt.

Chapter 3

3. Common stockholders equity, or net worth, is capital supplied by common stockholders and
represents ownership. The common equity section of the balance sheet is divided into two
accounts: common stock and retained earnings.
a. The common stock account arises from the issuance of stock to raise capital.
b. Retained earnings are built up over time as the firm saves a part of its earnings rather than
paying all earnings out as dividends.
4. Preferred stock is a hybrid, or a cross between common stock and debt.
C. Companies use generally accepted accounting principles (GAAP) to determine the values reported on
their balance sheets.
1. In most cases, these accounting numbers (referred to as book values) are different from the
corresponding market values.
III.

The income statement summarizes the firms revenues and expenses during a reporting period
(generally a quarter or a year).
A. Earnings per share (EPS) is called the bottom line, denoting that of all the items on the income
statement, EPS is the most important. A typical stockholder focuses on reported EPS.
1. To compare companies operating performances, it is essential to focus on their earnings before
deducting taxes and interest payments.
a. This is called EBIT and is often referred to as operating income.
b. Operating income is derived from the firms regular core business.
2. Depreciation is an annual noncash charge against income that reflects the estimated dollar cost of
the capital equipment and other tangible assets that were used up in the production process.
a. Amortization is similar to depreciation except that it applies to intangible assets, such as
patents, copyrights, trademarks, and good will.
b. Because depreciation and amortization are so similar, they are often lumped together on the
income statement.
3. EBITDA represents earnings before interest, taxes, depreciation, and amortization.
a.

Managers, security analysts, and bank loan officers who are concerned with the amount of
cash a company is generating often calculate EBITDA.

B. Management generally prepares monthly, quarterly, and annual income statements.


1. The quarterly and annual statements are released to investors, while the monthly statements are
used internally for planning and control purposes.
C. The income statement is tied to the balance sheet through the retained earnings account on the balance
sheet.
1. Net income, as reported on the income statement, less dividends paid is the retained earnings for
the year.
2. Those retained earnings are added to the cumulative retained earnings from prior years to obtain
the year-end balance for retained earnings.
3. The retained earnings for the year are also reported in the statement of stockholders equity.

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

IV.

Managements goal is to maximize the price of the firms stock; and the value of any asset, including
a share of stock, is based on the cash flows the asset is expected to produce. Therefore, managers
strive to maximize the cash flows available to investors. The Statement of Cash Flows reports the
impact of a firms operating, investing, and financing activities on cash flows the firm is generating
over an accounting period.
A. The companys cash position as reported on the balance sheet is affected by many factors, including
income, changes in working capital, fixed assets, security transactions, and dividend payments.
B. The statement can be separated into four parts:
1. Operating activities, which includes net income, depreciation, and changes in working capital other
than cash and short-term debt.
2. Investing activities, which includes purchases or sales of fixed assets.
3. Financing activities, which includes raising cash by issuing short-term debt, long-term debt, or
stock, or using cash to pay dividends or to buy back outstanding stock or retiring bonds.
4. Summary, shows the net decrease (increase) in cash from the three activities above, shows the cash
at the beginning of the year, and then calculates the cash at the end of the year.
C. Financial managers generally use this statement, along with the cash budget, when forecasting their
companies cash positions.

V.

The Statement of Stockholders Equity reports changes in the equity accounts between balance sheet
dates and why these changes occurred.
A. The balance sheet account retained earnings represents a claim against assets, not assets per se.
1. Retained earnings as reported on the balance sheet do not represent cash and are not available for
the payment of dividends or anything else.
2. Retained earnings represent funds that have already been reinvested in the firms operating assets.

VI.

Financial statements provide a great deal of useful information. At the same time, investors need to
be cautious when they review financial statements.
A. Companies are required to follow generally accepted accounting principles (GAAP) when reporting
financial statements; however, managers still have a lot of discretion in deciding how and when to
report certain transactions.
1. Two firms in exactly the same situation may report financial statements that convey different
impressions about their financial strength.
2. As long as the financial statements follow GAAP, such actions are legal, but these differences
make it difficult for investors to compare companies and gauge their true performances.
B. After the Enron and WorldCom scandals, Congress passed the Sarbanes-Oxley Act (SOX).
1. It required companies to improve their internal auditing standards.
2. It required the CEO and CFO to certify that the financial statements were properly prepared.
3. It also created a new watchdog organization to help make sure that the outside accounting firms
were doing their jobs.
C. Recently, a serious debate has arisen regarding the appropriate accounting for complicated investments
held by financial institutions.
1.

Currently, regulators and other policy makers are struggling to come up with the best way to
account for and regulate many of these toxic assets.

Chapter 3

VII.

The traditional financial statements are designed primarily for use by creditors and tax collectors,
not for managers and stock analysts. Therefore, corporate decision makers and security analysts
often modify accounting data to meet their needs.
A. Management is not completely free to use the available cash flow however it pleases. The value of a
companys operations depends on all the future expected free cash flows.
1. Free cash flow is defined as the amount of cash that could be withdrawn without harming a firms
ability to operate and to produce future cash flows.
2. Free cash flow is the cash flow actually available for payments to all investors (stockholders and
debtholders) after the company has made the investments in fixed assets, new products, and
working capital required to sustain ongoing operations.
a. Free cash flow is defined as after-tax operating income minus the investments in working
capital and fixed assets necessary to sustain the business.
Depreciation and Capital
Net operating
FCF EBIT(1 T)

amortization expenditures working capital

b. Free cash flow can also be calculated as net operating profit after taxes (NOPAT) less net
investment in operating capital.
3. A positive FCF indicates that the firm is generating more than enough cash to finance its current
investments in fixed assets and working capital.
4. Negative FCF means that the company does not have sufficient internal funds to finance its
investments in fixed assets and working capital, and that it will have to raise new money in the
capital markets in order to pay for these investments.
5. Negative free cash flow is not always bad. If free cash flow is negative because after-tax operating
income is negative, this is bad, because the company is probably experiencing operating problems.
a. Exceptions to this might be startup companies; companies that are incurring significant current
expenses to launch a new product line; or high-growth companies, which will have large
investments in capital that cause low current free cash flow, but that will increase future free
cash flow.
b. Eventually new investments must be profitable and contribute to free cash flow.
6. Many analysts regard FCF as being the single and most important number that can be developed
from accounting statements, even more important than net income.
a. FCF shows how much cash the firm can distribute to its investors.
VIII.

The accounting statements do not reflect market values, so they are not sufficient for purposes of
evaluating managers performance. To help fill this void, financial analysts have developed two
additional performance measures, Market Value Added (MVA) and Economic Value Added (EVA).
A. Shareholders wealth is maximized by maximizing the difference between the market value of a firms
common equity and the book value as shown on the balance sheet. This difference is called the Market
Value Added (MVA).
MVA Market value of commonequity Book valueof commonequity
(Shares outstanding)(Stock price) Totalcommonequity

1. This amount represents the difference between the money a firms stockholders have invested in
the corporation since its founding (including retained earnings) versus the cash they could receive
if they sold the business.
2. The higher its MVA, the better the job management is doing for the firms shareholders.

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

B. Economic Value Added (EVA), sometimes called economic profit, is closely related to MVA.
EVA NOPAT After-tax dollar cost of capital
T otalinvestor-supplied After-tax percentage
EBIT(1 T)

operatingcapital cost of capital

1. Total investor-supplied operating capital equals the sum of net fixed assets and net operating
working capital.
2. EVA is an estimate of a business true economic profit for a given year.
3. EVA differs sharply from accounting net income. Accounting income has no deduction for the
cost of equity whereas this cost is deducted when calculating EVA.
4. If EVA is positive, then after-tax operating income exceeds the cost of the capital needed to
produce that income, and managements actions are adding value for stockholders.
5. Positive EVA on an annual basis will help ensure that MVA is also positive.
6. EVA can be determined for divisions as well as for the company as a whole, so it is useful as a
guide to reasonable compensation for divisional as well as top corporate managers.
IX.

Corporations must pay out a significant portion of their income as taxes, and individuals are also
taxed on their income.
A. Individuals pay taxes on wages and salaries, on investment income, and on the profits of
proprietorships and partnerships.
1. Tax rates are progressive where tax rates are higher on higher income.
a. Rates begin at 10% and rise to 35% on taxable incomes over $372,950.
2. The marginal tax rate is the tax rate applicable to the last unit of a persons income.
3. The average tax rate is calculated as taxes paid divided by taxable income.
4. Capital gain (loss) is the profit (loss) from the sale of a capital asset (one not normally bought and
sold in the course of business) for more (less) than its purchase price.
a. A short-term capital gain is added to ordinary income, such as wages and interest, and then is
taxed at the same rate as ordinary income.
b. A long-term capital gain is taxed at a lower rate than an individuals ordinary income. The top
rate on long-term capital gains in 2010 is 15%. The asset must be held for more than one year
to qualify as long term.
c. On December 17, 2010, President Obama signed a bill extending the lower capital gains tax
rate through 2012.
5. Interest earned is taxable income.
a. An important exception is that interest on most state and local government debt is exempt from
federal taxes.
b. State and local bonds are often called munis, or municipal bonds, and individuals in high tax
brackets generally purchase them.
6. Dividends received by an individual are taxed at the same rate as capital gains, 15%.
a. This rate has also been extended through 2012.
7. Generally, individuals cannot deduct interest payments. However, interest on home loans is
deductible within limits.

Chapter 3

Self-Test
Definitional Questions
1. Of all its communications with shareholders, a firms ________ report is generally the most important.
2. The income statement reports the results of operations during the past year, the most important item being
__________ per share.
3. The _________ sheet lists the firms assets as well as claims against those assets.
4. Typically, assets are listed in order of their ___________, while liabilities are listed in the order in which they
must be paid.
5. Assets are divided into two major categories: _________ assets and ______-______ assets.
6. Claims against assets consist of _____________ and stockholders ________.
7. _________ liabilities are obligations that are due to be paid off within a year, and include accounts payable,
accruals (the total of accrued wages and accrued taxes), and notes payable to banks that are due within one
year.
8. Assets Liabilities Preferred stock = _____ worth, or common _______________ equity.
9. ___________ stock is a hybrid, or a cross between common stock and debt.
10. The two accounts that normally make up the common equity section of the balance sheet are common _______
and retained __________.
11. __________ earnings as reported on the balance sheet represent income earned by the firm in past years that
has not been paid out as dividends.
12. Retained earnings are generally reinvested in operating ________ and are not held in the form of cash.
13. Companies use generally accepted ____________ principles to determine the values reported on their balance
sheets.
14. The accounting numbers on the balance sheet are referred to as ______ values and, in most cases are different
from the corresponding ________ values.
15. The Statement of ______ Flows reports the impact of a firms operating, investing, and financing activities on
cash flows the firm is generating over an accounting period.
16. The four parts of the Statement of Cash Flows are cash flows associated with ___________ activities,
___________ activities, ___________ activities, and summary.
17. The ________ stock account arises from the issuance of stock to raise capital.
18. The Statement of _______________ Equity reports changes in the equity accounts between balance sheet dates
and why these changes occurred.
19. The traditional financial statements are designed primarily for use by ___________ and tax collectors, not for
__________ and stock analysts.
20. ______ cash flow is the cash flow actually available for payments to all investors (stockholders and
debtholders) after the company has made the investments in fixed assets, new products, and working capital
required to sustain ongoing operations.
21. A(n) _____________ tax system is one in which tax rates are higher at higher levels of income.
22. Interest received on ___________ bonds is generally not subject to federal income taxes. This feature makes
them particularly attractive to investors in ______ tax brackets.

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

23. ___________ received by an individual are taxed at the same rate as long-term capital gains to help reduce the
effects of the double taxation on them.
24. In order to qualify as a long-term capital gain or loss, ________ not normally bought and sold in the course of
business must be held for more than _____ year(s).
25. Interest payments paid by a corporation are tax ____________, while dividend payments are not.
26. The Tax Code permits a corporation (that meets certain restrictions) to be taxed at the owners personal tax
rates. This type of corporation is called a(n) ___ corporation.
27. The __________ tax rate is the tax rate applicable to the last unit of a persons income.
28. A long-term capital gain is taxed at a _______ tax rate than an individuals ordinary income.
29. Generally, individuals ________ deduct interest from taxable income; however, an exception is interest on
______ loans.
30. If a corporation owns 80% or more of another corporations stock, it can aggregate income and file one
______________ tax return.
31. Shareholders wealth is maximized by maximizing the difference between the market value of a firms
common equity and the book value as shown on the balance sheet. This difference is called ________ Value
Added.
32. __________ Value Added is an estimate of a business true economic profit for a given year.
33. If EVA is positive, then after-tax operating income exceeds the cost of the _________ needed to produce that
income, and managements actions are adding _______ for stockholders.
34. _____ can be determined for divisions as well as for the company as a whole, while _____ must be applied to
the entire corporation.

Conceptual Questions
1. The fact that some intercorporate dividends received by a corporation are excluded from taxable income has
encouraged debt financing over equity financing.
a. True
b. False
2. Which of the following statements is correct?
a. In order to avoid double taxation and to escape the frequently higher tax rate applied to capital gains,
stockholders generally prefer to have corporations pay dividends rather than to retain their earnings and
reinvest the money in the business. Thus, earnings should be retained only if the firm needs capital very
badly and would have difficulty raising it from external sources.
b. Under our current tax laws, when investors pay taxes on their dividend income, they are being subjected to
a form of double taxation.
c. The fact that a percentage of the interest received by one corporation, which is paid by another corporation,
is excluded from taxable income has encouraged firms to use more debt financing relative to equity
financing.
d. If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a taxdeductible expense, this would probably encourage companies to use more debt financing than they
presently do, other things held constant.
e. A corporations payments for capitalinterest and dividend paymentsare tax deductible; therefore, the
government does not encourage companies to use one form of financing over the other.

Chapter 3

Answers
Definitional Questions
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.

annual
earnings
balance
liquidity
current; long-term
liabilities; equity
Current
Net; stockholders
Preferred
stock; earnings
Retained
assets
accounting
book; market
Cash
operating; investing; financing
common

18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.

stockholders
creditors; managers
Free
progressive
municipal; high
Dividends
assets; one
deductible
S
marginal
lower
cannot; home
consolidated
Market
Economic
capital; value
EVA; MVA

Conceptual Questions
1. b. Debt financing is encouraged by the fact that interest payments paid by corporations are tax
deductible while dividend payments are not.
2. b. To avoid double taxation, stockholders would prefer that corporations retain more earnings
because long-term capital gains are generally taxed at a maximum rate of 15% and are paid only
when the stock is sold.