Ch.

2 - Understanding Financial
Statements, Taxes, and Cash Flows

2002, Prentice Hall, Inc.

Income Statement

SALES
- EXPENSES

= PROFIT

Income Statement
Revenue

SALES
- EXPENSES

= PROFIT

Income Statement

SALES
- EXPENSES

= PROFIT

Income Statement

SALES
- EXPENSES

= PROFIT

Cost of Goods Sold

Income Statement

SALES
- EXPENSES

= PROFIT

Cost of Goods Sold

Operating Expenses

Income Statement

SALES
- EXPENSES

= PROFIT

Cost of Goods Sold

Operating Expenses
(marketing, administrative)

Income Statement

SALES
- EXPENSES

= PROFIT

Cost of Goods Sold

Operating Expenses
(marketing, administrative)

Financing Costs

Income Statement

SALES
- EXPENSES

= PROFIT

Cost of Goods Sold

Operating Expenses
(marketing, administrative)

Financing Costs
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

Total Assets

Outstanding
Debt
+
Shareholders
Equity

Balance Sheet

Balance Sheet
Assets

Balance Sheet
Assets

Liabilities (Debt) & Equity

Balance Sheet
Assets
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses

Fixed Assets
Machinery & Equipment
Buildings and Land

Other Assets
Investments & patents

Liabilities (Debt) & Equity

Current Liabilities
Accounts Payable
Accrued Expenses
Short-term notes

Long-Term Liabilities
Long-term notes
Mortgages

Equity
Preferred Stock
Common Stock (Par value)
Paid in Capital
Retained Earnings

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
$1 - $50,000
$50,001 - $75,000
$75,001 - $100,000
$100,001 - $335,000
$335,001 - $10,000,000
$10,000,001 - $15,000,000
$15,000,001 - $18,333,333
over $18,333,333

Corporate Tax Rate

15%
25%
34%
39%
34%
35%
38%
35%

Free Cash Flows

Free cash flow: cash flow that is free and
available to be distributed to the firms
investors (both debt and equity investors)

Free Cash Flows

Firms Operating
Free cash flows

Cash flows generated

through the firms
operations and
investments in assets

Firms Financing
Free cash flows

Cash flows paid to - or

received by - the
firms investors
(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
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets

Operating income
+ depreciation
- cash tax payments

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

[Change in current
assets]

[change in non-interest
bearing current liabilities]

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

Change in gross fixed

assets, and any other
assets that are on the
balance sheet.

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 firms tax liability.

Sales
Cost of Goods Sold
Operating Expenses
Depreciation Expense
EBIT or NOI
Interest Expense
Taxable Income

$32,000,000
(19,200,000)
(2,400,000)
(1,400,000)
9,000,000
(1,140,000)
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