Ch.

2 - Understanding Financial
Statements, Taxes, and Cash Flows

, Prentice Hall, Inc.

 Income Statement

SALES
- EXPENSES
= PROFIT
 Income Statement

Revenue
SALES
- EXPENSES
= PROFIT
 Income Statement

SALES
- EXPENSES
= PROFIT
 Income Statement

•Cost of Goods Sold

SALES
- EXPENSES
= PROFIT
 Income Statement

•Cost of Goods Sold

SALES
•Operating Expenses
- EXPENSES
= PROFIT
 Income Statement

•Cost of Goods Sold

SALES
•Operating Expenses
- EXPENSES (marketing, administrative)

= PROFIT
 Income Statement

•Cost of Goods Sold

SALES
•Operating Expenses
- EXPENSES (marketing, administrative)
•Financing Costs
= PROFIT
 Income Statement

•Cost of Goods Sold

SALES
•Operating Expenses
- EXPENSES (marketing, administrative)
•Financing Costs
= PROFIT •Taxes
 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
 Balance Sheet

Outstanding
Debt
Total Assets = +
Shareholders’
Equity
Balance Sheet
 Balance Sheet
Assets
 Balance Sheet
Assets Liabilities (Debt) & Equity
 Balance Sheet
Assets Liabilities (Debt) & Equity
Current Assets Current Liabilities
Cash Accounts Payable
Accrued Expenses
Marketable Securities Short-term notes
Accounts Receivable Long-Term Liabilities
Inventories Long-term notes
Prepaid Expenses Mortgages
Fixed Assets Equity
Preferred Stock
Machinery & Equipment Common Stock (Par value)
Buildings and Land Paid in Capital
Other Assets Retained Earnings
Investments & patents
 Assets
• Current Assets:
 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
• Fixed Assets:
 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
• Fixed Assets: machinery
and equipment, buildings,
and land.
 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
• Fixed Assets: machinery and equipment,
buildings, and land.
• Other Assets:
 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
• Fixed Assets: machinery and equipment,
buildings, and land.
• Other Assets: any asset that is not a current
asset or fixed asset.
 Assets
• Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
– Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
• Fixed Assets: machinery and equipment,
buildings, and land.
• Other Assets: any asset that is not a current
asset or fixed asset.
– Intangible assets such as patents and copyrights.
 Financing
• Debt Capital:
 Financing
• Debt Capital: financing provided by a
creditor.
 Financing
• Debt Capital: financing provided by a
creditor.
• Short-term debt:
 Financing
• Debt Capital: financing provided by a
creditor.
• Short-term debt: borrowed money that
must be repaid within the next 12 months.
 Financing
• Debt Capital: financing provided by a
creditor.
• Short-term debt: borrowed money that
must be repaid within the next 12 months.
– Accounts payable, other payables such as
interest or taxes payable, accrued expenses,
short-term notes.
 Financing
• Debt Capital: financing provided by a
creditor.
• Short-term debt: borrowed money that
must be repaid within the next 12 months.
– Accounts payable, other payables such as
interest or taxes payable, accrued expenses,
short-term notes.
• Long-term debt:
 Financing
• Debt Capital: financing provided by a
creditor.
• Short-term debt: borrowed money that
must be repaid within the next 12 months.
– Accounts payable, other payables such as
interest or taxes payable, accrued expenses,
short-term notes.
• Long-term debt: loans from banks or other
sources that lend money for longer than 12
months.
 Financing
• Equity Capital:
 Financing
• Equity Capital: shareholders’ investment in
the firm.
 Financing
• Equity Capital: shareholders’ investment in
the firm.
• Preferred Stockholders:
 Financing
• Equity Capital: shareholders’ investment in
the firm.
• Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of liquidation
of the firm.
 Financing
• Equity Capital: shareholders’ investment in
the firm.
• Preferred Stockholders: received fixed
dividends, and have higher priority than
common stockholders in event of liquidation
of the firm.
• Common Stockholders:
 Financing
• Equity Capital: shareholders’ investment in
the firm.
• Preferred Stockholders: received fixed
dividends, and have higher priority than
common stockholders in event of liquidation
of the firm.
• Common Stockholders: residual owners of
a business. They receive whatever is left
after creditors and preferred stockholders
are paid.
 Corporate Income Tax Rates
Since 1993
Taxable Income Corporate Tax Rate

$1 - $50,000 15%
$50,001 - $75,000 25%
$75,001 - $100,000 34%
$100,001 - $335,000 39%
$335,001 - $10,000,000 34%
$10,000,001 - $15,000,000 35%
$15,000,001 - $18,333,333 38%
over $18,333,333 35%
 Free Cash Flows
Free cash flow: cash flow that is free and
available to be distributed to the firm’s
investors (both debt and equity investors)
 Free Cash Flows
Firm’s Operating Firm’s Financing
Free cash flows = Free cash flows

Cash flows generated Cash flows paid to - or

through the firm’s
operations and
= received by - the
firm’s investors
investments in assets (creditors &
stockholders)
 Calculating Free Cash Flows:
An Operating Perspective

After-tax cash flow

from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
 Calculating Free Cash Flows:
An Operating Perspective
Operating income
After-tax cash flow + depreciation
from operations - cash tax payments
less
investment in net
operating
working capital
less
investments in fixed
and other assets
 Calculating Free Cash Flows:
An Operating Perspective

After-tax cash flow

from operations
[Change in current
less
investment in net -
assets]

[change in non-interest
operating
bearing current liabilities]
working capital
less
investments in fixed
and other assets
 Calculating Free Cash Flows:
An Operating Perspective

After-tax cash flow

from operations
less
investment in net Change in gross fixed
operating assets, and any other
assets that are on the
working capital
balance sheet.
less
investments in fixed
and other assets
 Calculating Free Cash Flows:
A Financing Perspective

Interest payments to creditors

- change in debt principal

- dividends paid to stockholders

- change in stock

= Financing Free Cash Flows

Tax Example:
• Space Cow Computer has sales of $32
million, cost of goods sold at 60% of
sales, cash operating expenses of $2.4
million, and $1.4 million in
depreciation expense. The firm has $12
million in 9.5% bonds outstanding.
The firm will pay $500,000 in dividends
to its common stock holders.
• Calculate the firm’s tax liability.
Sales $32,000,000
Cost of Goods Sold (19,200,000)
Operating Expenses (2,400,000)
Depreciation Expense (1,400,000)
EBIT or NOI 9,000,000
Interest Expense (1,140,000)
Taxable Income 7,860,000
 Income tax rate tax payment
$50,000 x .15 = $ 7,500
$25,000 x .25 = 6,250
$25,000 x .34 = 8,500
$235,000 x .39 = 91,650
$7,525,000 x .34 = 2,558,500
Total Tax payment $2,672,400

short cut: $7,860,000 x .34 = $2,672,400