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From Financial Statements to Economic Cash Flows
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Translating Accounting into Finance (Present Value Cash Flows)
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Financial accounting is the “language of business.” Although this book is not about
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financial statements, you must understand both their logic and their fundamentals.
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They contain the information to calculate the cash flows that ultimately are the value
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corporate income taxes—a necessary NPV input.
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This chapter begins with a simple hypothetical project. Its economics makes comput-
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This chapter also gently introduces some more details about corporate income taxes
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that you need for PV discounting. But how can you make good decisions about which
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financials. (The reported public and unreported tax statements are constructed using the
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regulatory agencies. For example, criminal penalties are GAAP-deductible, but not tax-
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deductible.) Because income taxes are definite costs, you must be able to understand and
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when you want to compute NPV. And, if you become a tax guru, you may even learn how
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require the company to maintain a current ratio greater than 1.5. Even if a change in
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financials on your projects’ cash flows.
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executive compensation is often linked to the numbers reported in them. Moreover,
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(explained below). Companies are also known to actively lobby the accounting standards
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boards at great expense. For example, the accounting standards board adopted a mandatory
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cost nothing. Although this new rule did not ask firms to change projects, it did reduce
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their reported net income (earnings), especially of technology firms. This rule was adopted
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controversial hypothesis. If true, this could lead to all sorts of troublesome consequences.
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positive-NPV projects if these projects would harm their earnings. Does this sound far-
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business developments, followed by the more formal presentation of the firm’s financials. As
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about how much money the firm makes than about how it makes it. Nevertheless, as much as
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Exhibits 14.1-14.3 contain Intel’s financial statements from 2013 to 2015. (The entire annual
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whatever assets are not accounted for by fixed obligations—is called equity. Therefore,
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machine, described in Exhibit 14.4. We shall construct hypothetical financials, and then we shall
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this particular machine should be depreciated over three years, even though it lasts longer.
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Exhibit 14.5: Income Statement and Excerpt of Cash-Flow Statement of Hypothetical Machine. Although I have broken
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depreciation out in this income statement, it is usually part of other components, most likely COGS or SG&A. Fortunately,
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depreciation, and amortization). Next, subtract out depreciation, which is a subject that deserves
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income, also called EBIT (earnings before interest and taxes). Finally, take out interest expense
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at a rate of 10% per year and corporate income tax (which you can compute from the firm’s tax
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the bottom line because of where it appears.
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Note the similarity of this simple project’s income statement to Intel’s income statement from
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Exhibit 14.2. In 2015, Intel had $55 billion in sales. COGS and SG&A (which included some
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depreciation) added up to $21 + $8 ≈ $29 billion. Intel breaks out research and development,
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because it is primarily an R&D company. This accounted for another $12 billion. This left an
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operating income of $14 billion. The next similar expense is interest expense—which here was

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obvious.
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You have already reported most useful information of your project on the income statement. e(
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income statement. Instead, they are reported on the cash-flow statement (also in Exhibit 14.5).
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the cash- ow statement,
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In this case, capital expenditures are $75 in year 1 and $75 in year 2, followed by $0 in all
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subsequent years. Net debt issuing is $50 in year 1, and the debt principal repayment of $50
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This is not to say that project capital expenditures and debt play no role in the income
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statement (IS)—they do, but not one-to-one. Specifically, capital expenditures reduce net income
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more slowly through depreciation:
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income statement:
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depreciation.
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ditures, plus the first $25 depreciation from the second year’s $75 capital expenditures.
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Year Y4: There is no more depreciation from the first year’s capital expenditures. You only have
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The principal on the loan, either its funding or its repayment, plays no role on the income
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statement. However, the interest paid on the loan does go onto the income statement. Here, this
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is $5 per year.
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Doing Finance
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Now, forget accounting for a moment and instead value the machine from a finance perspective.
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Here is the difference
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The firm consists of three components: the machine itself, the tax obligation, and the loan.
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between full ownership and

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levered ownership.
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NPV Project = NPV Machine – NPV Taxes
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NPV Levered Ownership = NPV Machine – NPV Taxes + NPV Loan
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Full project ownership is equivalent to holding both the debt (including all liabilities) and equity
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(the machine), and earning the cash flows due to both creditors and shareholders. Levered equity
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ownership adds the project “loan” to the package. As full project owner (debt plus equity), in
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the first year, you must originally supply $50 more in capital than if you are just a levered equity

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owner, but in subsequent years, as full owner, you then do not need to worry about paying back
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First work out the actual cash flows of the first component, the machine itself. Without the
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taxes and the loan, the machine produces the following:
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component of the rm—the $60 – $75 $60 – $75 $60
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NPVmachine = + +
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machine's actual cash ows,
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without taxes and loan.

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≈ $119.93
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Unfortunately, corporate income tax—the second component—is an actual cost that cannot
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be ignored. Looking at Exhibit 14.5, you see that Uncle Sam collects $14 in the first year, then
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negative-NPV project, which

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$2 twice, then $12, and finally $22 twice. Assume that the stream of tax obligations has the
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must be valued.
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same discount rate (12%) as that of the overall firm. (To value the future tax obligations, you
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need to know the appropriate discount factor. The firm’s cost of capital is conservatively high.
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Exhibit 14.5, Pg.364.

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Unfortunately, we need to delay this issue until Chapter 18.) It is both convenient and customary
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obligations.) With this cost-of-capital assumption, the net present cost of the tax liability is
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NPVtax liability = ≈ $46.77

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NPVproject ≈ $119.93 – $46.77 = $73.16

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NPV Project = NPV Machine – NPV Taxes

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Now consider the third component—the loan. Assume that you are not the “full project
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The loan usually is a

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owner,” but only the “residual levered equity owner,” so you do not extend the loan yourself.
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“zero-NPV” project, unless

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Instead, you would obtain a loan from a (hopefully) perfect capital market. Let us assume
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unusually bad deal on the corporations in competitive financial markets. Your loan that provides $50 and pays interest at a
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loan.
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rate of 10% should thus be zero NPV. (This saves you the effort of having to compute the loan’s
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NPV.)
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NPVloan = $0
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Be my guest, though, and make the effort:
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+$50 –$5 –$5 –$5 –$5 (–$50) + (–$5)
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NPVloan = = $0
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1 2 3 4 5 1.106
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1.10 1.10 1.10 1.10 1.10
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Therefore, the project NPV with the loan, that is, levered equity ownership, is the same as the
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project NPV without the loan. This makes sense: You are not generating or destroying any value
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by borrowing from one bank rather than another. Therefore,
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NPVlevered ownership = $119.93 – $46.77 $0 = $73.16
01

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NPVlevered ownership = NPV Machine – NPV Taxes + NPV Loan
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Although the NPV remains the same, the cash flows to levered equity ownership are different
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Earnings and cash ows are
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from the cash flows to the project. The cash flows (and net income) are shown in Exhibit 14.6.
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often very different.

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Note how different the cash flows and net income are. Net income is highest in years 5 and 6, e(
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but the levered cash flow in year 6 is negative. In contrast, in year 3—the year with the highest
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levered cash flow—net income is lowest.
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Y1 Y2 Y3 Y4 Y5 Y6 Disc Rate NPV
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Cash Flow, Machine w/o Tax –$15 –$15 I 12% $119.93
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+$60 +$60 +$60 +$60
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= Cash Flow, Project, After Tax –$29 –$17 12% $73.16
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For Comparison, Net Income $21 $3 $3 $18 $33 $33
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Exhibit 14.6: Cash Flows and Net Income Summary. PS: Because investors are risk-averse, the discount rate (also called
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the cost of capital or required expected rate of return) is higher for the machine than for the loan.
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Reverse-Engineering Income Accounting into Finance

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If you neither knew the details of this machine nor the cash flow statement, but only the net
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Discounting the net income

7.
income statement, could you compute the correct firm value by discounting the net income?
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would not give you the true

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Discounting net income with a cost of capital of 12% would yield

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project NPV.
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$21 $3 $3 $18 $33 $33

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via net income = 1.121 + 1.122 + 1.123 + 1.124 + 1.12%5 + 1.126 ≈ $70.16
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which is definitely not the correct answer of $73.16. Neither would it be correct to discount the
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net income with a cost of capital of 10%,

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Incorrect NPV $21 $3 $3 $18 $33 $33

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via net income = 1.101 + 1.102 + 1.103 + 1.104 + 1.105 + 1.106 ≈ $75.24
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Instead, you need the cash flows.

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If you needed them, how could you reverse-engineer the correct cash flows for the NPV
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Instead, you must
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analysis from the income statement? You just need to retrace your steps. Start with the net
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reverse-engineer the
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income numbers from Exhibit 14.5. You add back the depreciations, because they were not actual
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economic cash ows from
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the corporate nancials. cash outflows, and you subtract the capital expenditures, because they were actual cash flows.
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ä Income Statement,
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EBIT
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+$35 +$10
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Cash Flow, Project, Before Tax –$15
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=
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I find the formula most intuitive if I think of the “depreciation + capital expenditures” terms as
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undoing the accountants’ smoothing of the cost of machines over multiple periods.
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IMPORTANT
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To take care of long-term accruals in the conversion from net income into cash flows, undo the
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smoothing—add back the depreciation and subtract out the capital expense.
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Next, you need to subtract corporate income taxes (and, again, look at the numbers themselves
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to clarify the signs in your mind; on the CFS, income tax is quoted as a negative, on the IS as a
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reverse-engineering by
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subtracting off taxes. positive—more later). This gives you the following after-tax project cash flow:
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“+” (–)Capital Expenditures +(–$75) +(–$75)

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– (+)Corporate Income Tax –(+$14) –(+$2)
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Cash Flow, Project, After Tax –$29 –$17
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You can also get these numbers through an alternative calculation. Net income already has
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corporate income tax subtracted out, but it also has interest expense subtracted out. You get the
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same cash flow if you start with net income instead of EBIT but add back the interest expense:
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Net Income +$21 +$3

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+ Depreciation +$25 +$50

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“+” (–)Capital Expenditures

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Interest Expense
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= Cash Flow, Project, After Tax –$29 –$17

F
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Investors (equity and debt together) must thus come up with $29 in the first year and $17 in the
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second year. (You can read the cash flows in later years from line 3 of Exhibit 14.6.)
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Sidenote: The formula signs themselves seem ambiguous, because accountants use different sign conven-
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tions in the IS and CFS. For example, because capital expenditures are usually quoted as negative terms
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on the cash-flow statement, in order to subtract capital expenditures, you just add the (negative) number.
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In the formula below, you want to subtract corporate income tax, which appears on the income statement
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(Exhibit 14.5) as a positive. Therefore, you have to subtract the positive. Sigh. . . I try to clarify the meaning
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(and to warn you) with the quotes around the + in the formulas themselves.
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If the project is financed partly by borrowing, then what part of the $29 and $17 can be
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The cash ow to levered
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financed by creditors, and what residual part must be financed by you? In the first year, your
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equity shareholders takes
7.
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creditors provide $50; in the second year, creditors get back $5. Therefore, levered equity
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care of money coming in
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.
actually receives a positive net cash flow of $21 in the first year, and a negative cash flow of from and going out to
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$22 in the second year. Therefore, with the loan financed from the outside, you must add all creditors.
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loan inflows (principal proceeds) and subtract all loan outflows (both principal and interest).
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Therefore, the cash flow for levered equity shareholders is as follows:
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EBIT
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+$35 +$10
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+ +$25 +$50
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– Corporate Income Tax –$14 –$2
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Cash Flow, Project –$29 –$17

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=
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+ Net Debt Issue +$50 $0 e(
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– Interest Expense $0 –$5

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Cash Flow, Levered Equity Ownership –$22
t
= +$21
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Again, net income already has both corporate income tax and interest expense subtracted
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A different way to skin our

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an vo
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F
out, so the same result comes out if you instead use the following formula:
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cat.
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Net Income
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+$21 +$3
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Net Debt Issue $0
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Fi 7. I
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= Cash Flow, Levered Equity Ownership +$21 –$22
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Solid Financial Analysis

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7.
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EBITDA was all the rage among consultants and Wall Street for many years, because it seems both closer to cash flows
t
c
.
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1
e
than EBIT and more impervious to managerial earnings manipulation through accruals. Sadly, discounting EBITDA can be
7
4
or
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on
01
worse than discounting EBIT if capital expenditures are not netted out—which EBITDA users rarely do. (Not subtracting
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p
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either capital expenditures or depreciation is equivalent to assuming that production falls like manna from heaven. EBIT
.
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7
elc iti
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F
may spread capital expenditures over time periods in a strange way, but at least it does not totally forget it!) Sometimes, a
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1
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)
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little bit of knowledge is more dangerous than none.

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In June 2003, a Bear Stearns analyst valued American Italian Pasta, a small NYSE-listed pasta maker. Unfortunately, Herb
lch io
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7.
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h
i
Greenberg from TheStreet.com discovered that he forgot to subtract capital expenditures—instead, he had added them.
or
F
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an vo
o
di
This mistake had increased the value of American Italian Pasta from $19 to $58.49 per share (then trading at $43.65).
l
or , Ju e Fi
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e
Bear Stearns admitted the mistake and came up with a new valuation in which Bear Stearns boosted the estimate of
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or
u
n
the company’s operating cash flows and dropped its estimate of the cost of capital. Presto! The NPV of this company
17 ce
i
or
at
n)
was suddenly $68 per share. How fortunate that Bear Stearns’ estimates were so robust to basic errors. Incidentally,
eF
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American Italian Pasta traded at $30 in mid-2004, just above $20 by the end of 2004, and at around $10 by the end of
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2005.
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TheStreet.com
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Q 14.3. Show that the formulas in this section yield the cash flows in years 3 through 6 in
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Exhibit 14.6.
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.
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Q 14.4. Using the same cash flows as in the NPV analysis in Exhibit 14.6, how would the project
i
lch ion or
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NPV change if you used a 10% cost of capital (instead of 12%) on the tax liability?
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Depreciation Nuances
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I mentioned earlier that you should read depreciation from the cash-flow statement, not from
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ly
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Why you need to get the
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the income statement. I now want to explain a little more about accounting for depreciation.
di
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depreciation number from
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Depreciation can come in three different forms: depreciation, depletion, and amortization.
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the cash- ow statement. (
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They are all “allocated expenses” and not actual cash outflows. The name differences come from
,
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the asset types to which they apply.

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Depreciation comes in
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different forms with Depreciation applies to tangible assets, such as factories.
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different names.
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Depletion applies to natural resources, such as mines.

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Amortization applies to intangible assets, such as patents, copyrights, licenses, franchises,
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and so on. As late as the 1970s, average intangible assets for publicly traded U.S. firms
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categories, including some for which we just had a vague miscellaneous designation in our long
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10-K, 357. 10-Q, 357. A/R, 362. Accelerated depreciation, 361. Accounts payable, 374. Accounts receivable, 374.
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change in A/R, calculating accounts receivable requires simple ad- firm can do this that have not been discussed. For example, a firm
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$225 change in payables, for cash inflows of $325. Finally, in May,
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or
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Cash Flow to Project $6,079 $13.398 $5.022

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depreciation schedule, and though this may be possible a few times,
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if it is done often, it will most surely raise eyebrows.

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cash and short-term investments ($95 billion!) than in debt.)
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End of Chapter Problems

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7. Q 14.22. Consider a $50,000 SUV that you expect to last
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thought of as imaginary presentations, why is a firm not for 10 years. The IRS uses an MACRS 5-year depreciation
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just a firm, and accounting numbers not just “funny num- schedule on cars. It allows depreciating 20% in year 1,
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bers”? That is, what is the most important direct cash-flow 32%, 19.2%, 11.52%, 11.52%, and 5.76% in the following
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influence of accounting in most corporations? 7 years. You can finance this car yourself. You can produce
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Q 14.18. Which statements on the firm’s financial reports

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MACRS works. How would you depreciate $10,000 in this car?

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computer equipment?
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car from the financials.

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50 years when you purchased it for $3 million? (Hint: Use

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of $1,367 million in 2001. How much did PepsiCo actually Accounts Receivable $2,129 $2,142
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terly sales and net income of $100, $200, $300, $200, Income Tax, Payable $64 $183
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$100. One-quarter of all customers pay immediately, while
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Overall Cost of Capital 12%/year Inventories $1,420 $1,424

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t

(4 elch itio por ly 2 nan Ivo th E h, C n),

Translating Accounting into Finance (Present Value Cash Flows)

of the firm. Moreover, without understanding accounting, you cannot understand

at 201 nce o W Ed Cor , Ju e Fi 17.

corporate income taxes—a necessary NPV input.

14.1 Financial Statements

irrelevant numbers? Isn't

what matters the project's

understand financial statements: how it is reported? (Yes and

an Ivo th E , C n), J ate

earnings are—and what they are not.

2. Subsidiaries and corporations report financial statements, designed by accountants for

the corporate financials may be your primary source of information.

(4 elch itio por ly 2 nan Ivo th E h, C n),

financials on your projects’ cash flows.

executive compensation is often linked to the numbers reported in them. Moreover,

at 201 nce o W Ed Cor , Ju e Fi 17.

fails to see through even mechanical accounting computations.

firms’ performances years after their equity issues.

increase the financial image of the firm’s projects.

(4 elch itio por ly 2 nan Ivo th E h, C n),

by a number of policymakers, most prominently the FASB (Financial Accounting Standards

at 201 nce o W Ed Cor , Ju e Fi 17.

You must read some

and quarterly reports.

an Ivo th E , C n), J ate

Assets = Liabilities + Shareholders’ Equity

ä Warning about BV stock numbers,

Sect. 14.7, Pg.380.

Inventory 5,167,000 4,273,000 4,172,000

Other Current Assets 3,053,000 3,018,000 1,649,000

(4 elch itio por ly 2 nan Ivo th E h, C n),

Total Current Assets 40,356,000 27,730,000 32,084,000

Property Plant and Equipment 31,858,000 33,238,000 31,428,000

Intangible Assets 3,933,000 4,446,000

Other Assets 7,735,000 6,505,000 5,489,000

Total Assets 103,065,000 91,900,000 92,358,000

at 201 nce o W Ed Cor , Ju e Fi 17.

Short/Current Long Term Debt 2,634,000 1,596,000 281,000

Other Current Liabilities 2,188,000 2,205,000 2,096,000

Total Current Liabilities 15,667,000 16,011,000 13,568,000

Long Term Debt 20,036,000 12,059,000 13,165,000

Other Liabilities 2,841,000 3,278,000 2,972,000

Deferred LT Liability Charges 2,539,000 3,775,000 4,397,000

Total Liabilities 41,083,000 35,123,000 34,102,000

(Misc Stocks Options Warrants)

an Ivo th E , C n), J ate

Redeemable Preferred Stock - - -

Common Stock 23,411,000 21,781,000 21,536,000

Retained Earnings 37,614,000 33,418,000 35,477,000

Other Stockholder Equity 60,000 666,000 1,243,000

Total Stockholder Equity 61,085,000 55,865,000 58,256,000

Net Tangible Assets 45,820,000 40,558,000 42,593,000

100 pages of notes that explain more detail.

(4 elch itio por ly 2 nan Ivo th E h, C n),

Total Operating Expenses 20,677,000 20,262,000 19,230,000

Operating Income or Loss 14,002,000 15,347,000 12,291,000

Gains on Equity Investments 315,000 411,000 471,000

at 201 nce o W Ed Cor , Ju e Fi 17.

Interest Expense –105,000 43,000 –151,000

Income Before Tax 14,212,000 15,801,000 12,611,000

Income Tax Expense 2,792,000 I 4,097,000 2,991,000