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Chapter 3

Financial
Statements,
Taxes, and Cash
Flows 2-0
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
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Chapter Outline

• The Balance Sheet


• The Income Statement
• Taxes
• Cash Flow

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Balance
sheet

Financial
Statement

Income
statement

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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 liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet
• Assets = Liabilities + Stockholders’ Equity

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The Balance Sheet - Figure 2.1

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Net Working Capital and
Liquidity
• Net Working Capital
• 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
• 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 earn a lower return
• Trade-off to find balance between liquid and illiquid assets

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US Corporation Balance Sheet –
Table 2.1

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Market 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?
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Market Value Book Value

• Value of company • Value of business


according to the stock according to its “book” or
market financial statements
• Changes according to the • No changes in price in
market condition asset owned
• Affects by supply and
demand in the market

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• Book Value > Market Value
 Financial market values the company less than its
stated value or net worth
 Market lost confidence in the ability of the company’s
assets to generate future profits and cash flows

• Market Value > Book Value


 Market assigns higher value to company because
earnings power of the company’s assets
 Almost all consistently profitable companies have
market value greater than book value

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• Book Value = Market Value
 Market perceives company’s assets stated in the
balance sheet will remain neutral

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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
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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
• Matching principle – GAAP say to show
revenue when it accrues and match the
expenses required to generate the revenue

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US Corporation Income Statement –
Table 2.2

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Tax

• Gross income • Tax-deductible expenses


(–) Tax-deductible expenses refers to the operating
Taxable income expenses (marketing,
administrative, depreciation
expenses) and interest
expenses paid on firm’s
outstanding debt
• Sales
(–) Product’s Cost
Gross income

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Corporate Income Tax
Residence Status Non-resident Status

• Management and control • Non-resident companies


is exercised in Malaysia are taxed at following
• Tax rate: 25% while those rates:
with paid-up capital of
RM2.5million or less are
taxed at following rates:
Chargeable 2014 &
Income 2015
The first RM500,000 20%
In excess of 25%
RM500,000 2-16
Residence Status Non-residence status

Type of income 2015


Chargeable 2015
Business income 25%
Income
Royalties 10%
The first 20%
RM500,000 Rental of 10%
moveable
In excess of 25%
properties
RM500,000
Technical or 10%**
management
service fees
Interest 15%***
Dividends Exempt****
Other income 10%

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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

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Cash Flow Summary Table 2.5

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Example: Balance Sheet and
Income Statement Information
• Current Accounts
• 2004: CA = 3625; CL = 1787
• 2003: CA = 3596; CL = 2140
• Fixed Assets and Depreciation
• 2004: NFA = 2194; 2003: NFA = 2261
• Depreciation Expense = 500
• Long-term Debt and Equity
• 2004: LTD = 538; Common stock & APIC = 462
• 2003: LTD = 581; Common stock & APIC = 372
• Income Statement
• EBIT = 1014; Taxes = 368
• Interest Expense = 93; Dividends = 285

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Chapter 2
•End of Chapter