INTRODUCTION TO BUSINESS

FINANCE

By MK
Review of the Previous Lecture

 Income Statement „
 Generally Accepted Accounting Principles
(GAAP) „
 Non-cash Items „
 Time and Costs „
 Taxes „
 Average vs. Marginal Tax Rate „
 Flat Tax Rate
 Topics under Discussion

 „ Taxes (Cont.) „
 Depreciation as a Tax Shield „
 Financial Cash Flows „
 Cash Flow From Assets „
 Cash Flow to Creditors „
 Cash Flow to Stockholders „
 Cash Flow Statement
Depreciation as a Tax Shield

 „ Although depreciation is not a new source

of funds, it provides the important function of
shielding part of our income from taxes. „

 Again, we take the same two corporations –

one charges off $100,000 in depreciation,
other charges off none.
Depreciation as a Tax Shield

 It can also be computed as: Depreciation x

Tax rate $100,000 x 35% = $35,000

Depreciation as a Tax Shield „

 Corporation A enjoys $35,000 more in cash
flow, since depreciation shielded $100,000
from taxation in Corporation A and saved
$35,000 in taxes, which eventually appeared
in cash flows.
 Financial Cash Flow

 „ In finance, the most important item that can be

extracted from financial statements is the actual
cash flow of the firm. „
 Since there is no magic in finance, it must be the
case that the cash received from the firm’s assets
must equal the cash flows to the firm’s creditors
and stockholders.
Cash Flow from Assets ≡ Cash Flows to creditors +
Cash flow to stockholders
 Cash Flow from Assets

 „ Cash flow from assets involves three

components „
 Operating Cash flow „
 Capital Spending „
 Change in Net Working capital
 Operating Cash Flow

 „ This refers to the cash flow that results from

the firm’s day-to-day activities of producing and
selling „
 Expenses related to firm’s financing of its assets
are not included since they are not operating
expenses „
 Operating Cash Flow

To calculate OCF, we calculate revenues minus costs

(including taxes being paid in cash), but don’t
include „
 depreciation since it is not a cash out flow „
 Interest because it is a financing expense „
OCF is very significant as it tells whether or not the
firm’s cash inflows from its business operations are
sufficient to cover its everyday cash outflows. „
So, a negative operating cash flow is a sign of
trouble.
 Capital Spending

 „ Some portion of the firm’s cash flow is

reinvested in the firm. Capital spending refers
to the net spending on fixed assets
(Purchases of fixed assets less sale of fixed
assets). „ Net Capital Spending could be
negative if the firm sold off more assets than
it purchased. „ Depreciation of the respective
assets is accounted for in this regard.
Change in Net Working Capital

 „ It is the amount spent on Net Working

Capital, and represents the net increase in
current assets over current liabilities.
 Cash Flow to Stockholders

 „ Cash flow to stockholders is calculated as

dividends paid less net new equity raised.
 Summary

 „ Financial Cash Flows „

 Cash Flow From Assets
 „ Cash Flow to Creditors „
 Cash Flow to Stockholders
 Upcoming Topics

 „ Cash Flow Statement „

 Financial Statements Analysis „
 Common Size Analysis „
 Trend Analysis „
 Ratio Analysis