CHAPTER 2

F I N A N C I A L S TAT E M E N T S , TA X E S , A N D C A S H F L O W

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 LEARNING OBJECTIVES

• Describe the difference between accounting value (or

book value) and market value

• Describe the difference between accounting income

and cash flow

• Describe the difference between average and marginal

tax rates

• 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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 THE BALANCE SHEET
• The balance sheet is a financial statement showing a firm’s
accounting value on a particular date
• Organizes and summarizes what a firm owns (assets), what a firm
owes (liabilities), and the difference between the two (equity)
• Assets are classified as either current or fixed
• A fixed asset is one that has a relatively long life
• May be tangible (e.g., truck or computer) or intangible (e.g., trademark)
• A current asset has a life of less than one year (e.g., inventory, cash,
accounts receivable)
• Liabilities are the first thing listed on the right side of the balance
sheet and are classified are either current or long-term
• Current liabilities have a life of less than one year, while long-term
liabilities are debts not due in the coming year
• Assets = Liabilities + Stockholders’ Equity
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 THE BALANCE SHEET
• The balance sheet is a financial statement showing a firm’s
accounting value on a particular date
• Organizes and summarizes what a firm owns (assets), what a firm owes
(liabilities), and the difference between the two (equity)
• Assets are classified as either current or fixed
• A fixed asset is one that has a relatively long life
• May be tangible (e.g., truck or computer) or intangible (e.g., patent)
• A current asset has a life of less than one year (e.g., inventory, cash,
accounts receivable)
• Liabilities are the first thing listed on the right side of the balance
sheet and are classified are either current or long-term
• Current liabilities have a life of less than one year (e.g., accounts
payable)
• Long-term liabilities are debts not due in the coming year (e.g., a loan
the firm will pay off in five years)
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 THE BALANCE SHEET (CONTINUED)
• Shareholders equity (i.e., common equity or owners’ equity)
is the difference between the total value of the assets
(current and fixed) and the total value of the liabilities
(current and long-term)
• Balance sheet “balances” because the value of the left side
always equals the value of the right side
• Value of firm’s assets is equal to the sum of its liabilities and
shareholders’ equity

• Balance sheet identity, or equation, must hold:

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CONSTRUCTION OF THE BALANCE SHEET

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 NET WORKING CAPITAL
• Net working capital is the difference between a firm’s
current assets and its current liabilities
• Positive when cash that will become available over the next 12
months (i.e., current assets) exceeds cash that must be paid
over the same period (i.e., current liabilities)
• Usually positive in a healthy firm

• Three particularly important things to keep in mind when

examining a balance sheet:
1. Liquidity
2. Debt versus equity
3. Market value versus book value

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 LIQUIDITY AND
DEBT VERSUS EQUITY
• Liquidity refers to the speed and ease with which an asset can
be converted to cash
• Two dimensions are ease of conversion versus loss of value
• Highly liquid asset is one that can be quickly sold without
significant loss of value, while an illiquid asset is one that cannot
be quickly converted to cash without a substantial price reduction
• Assets are normally listed on the balance sheet in order of
decreasing liquidity, with current assets being relatively liquid
and fixed assets being relatively illiquid
• The more liquid a business, the less likely it is to experience
financial distress
• If a firm borrows money, it usually gives first claim to the
firm’s cash flow to creditors, with equity holders entitled to
only the residual value
• Use of debt in firm’s capital structure is called financial leverage 1-9
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 U.S. CORPORATION
2020 AND 2021 BALANCE SHEETS

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 MARKET VALUE VERSUS BOOK VALUE

• Values on balance sheet for the firm’s assets are book values
and generally are not what the assets are actually worth
• Under generally accepted accounting principles (GAAP),
audited financial statements in the U.S. mostly show assets at
historical cost (i.e., assets are “carried on the book” at what the
firm paid for them, no matter how long ago they were
purchased or how much they are worth today)
• No necessary connection between total assets shown on the
balance sheet and the value of the firm
• For financial managers, accounting value of stock is not
especially important; it is the market value that matters
• Market value of an asset depends on things like its riskiness and
cash flows, neither of which have anything to do with
accounting
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MARKET VALUE VERSUS BOOK VALUE:
AN EXAMPLE

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 THE INCOME STATEMENT
• The income statement is a financial statement summarizing
a firm’s performance over a period of time, usually a quarter
or a year
• Income statement equation is:

• First thing reported on income statement would usually be

revenue and expenses from the firm’s principal operations
• Subsequent parts include, among other things, financing
expenses such as interest paid
• Taxes are reported separately
• Last item is net income (i.e., “the bottom line”)
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 U.S. CORPORATION:
INCOME STATEMENT

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 THE INCOME STATEMENT (CONTINUED)
• A financial manager should keep three things in mind when
looking at an income statement:
1. GAAP
• As a result of the way revenues and expenses are realized, income
statement figures may not be representative of actual cash
inflows/outflows that occurred during a particular period
2. Cash versus noncash items
• Noncash items are expenses charged against revenues that do not
directly affect cash flow, such as depreciation
• Crucial to separate cash flows from noncash accounting entries
3. Time and costs
• Product costs include things such as raw materials, direct labor
expense, and manufacturing overhead
• Period costs are incurred during a particular time period and
might be reported as selling, general, and administrative expenses
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 TAXES
• Taxes can be one of the largest cash outflows a firm experiences
• Size of a company’s tax bill is determined by the tax code, an often
amended set of rules

• Federal corporate tax rates became a flat 21% after the passage
of the Tax Cuts and Jobs Act of 2017
• Tax rates on other forms of business (e.g., proprietorships,
partnerships, and LLCs) did not become flat

• Average tax rate is calculated as total taxes paid divided by total

taxable income, while the marginal tax rate is the amount of
tax payable on the next dollar earned
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PERSONAL TAX RATES AND AN EXAMPLE

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 CASH FLOW
• Cash flow means the different between the number of
dollars that came in and the number of dollars that went out
• No standard financial statement presents this information in
the way that we wish
• Statement of cash flows is a standard financial accounting
statement, but it is concerned with a somewhat different issue
• Cash flow identity says the cash flow from the firm’s assets is
equal to the cash flow paid to suppliers of capital to the firm:

• Cash flow identity reflects the fact that a firm generates cash
through its various activities, and that cash is either used to
pay creditors or paid out to the owners of the firm
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 CASH FLOW FROM ASSETS
• Cash flow from assets is the total of cash flow to creditors and
cash flow to stockholders, consisting of the following three
components:
• Operating cash flow refers to cash generated from a firm’s
normal business activities
• Capital spending refers to the net spending on fixed assets
(purchases of fixed assets less sales of fixed assets)
• Change in net working capital is measured as the net change in
current assets relative to current liabilities for the period being
examined and represents the amount spend on net working
capital
• Cash flow from assets is sometimes called free cash flow,
referring to the cash the firm is “free” to distribute to creditors
and stockholders because it is not needed for working capital or
fixed asset investments
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CASH FLOW FROM ASSETS (CONTINUED)
• Operating cash flow is calculated as revenues minus costs
and tells us whether a firm’s cash inflows from its business
operations are sufficient to cover its everyday cash outflows
• Do not include depreciation or interest in the calculation, but be
sure to include taxes
• Negative operating cash flow is a sign of trouble
• Different calculation used for operating cash flow in accounting
• Net capital spending (i.e., CAPEX) is money spent on fixed
assets less money received from the sale of fixed assets
• Could be negative is the firm sells more assets than it purchases
• Change in net working capital is found by taking the
difference between the beginning and ending net working
capital (NWC) figures
• Often referred to as the “addition to” NWC
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CASH FLOW FROM ASSETS (CONCLUDED)

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 CASH FLOW TO CREDITORS AND
STOCKHOLDERS
• Cash flow to creditors is calculated as a firm’s interest
payments to creditors less net new borrowing
• Sometimes called cash flow to bondholders

• Cash flow to stockholders is calculated as dividends paid out by a

firm less net new equity raised

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 CASH FLOW SUMMARY

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 CASH FLOWS: EXAMPLE 1
• Current Accounts
 2018: CA = 3,625; CL = 1,787
 2017: CA = 3,596; CL = 2,140

• Fixed Assets and Depreciation

 2018: NFA = 2,194; 2017: NFA = 2,261
 Depreciation Expense = 500

• Long-term Debt and Equity

 2018: LTD = 538; Common stock & APIC = 462
 2017: LTD = 581; Common stock & APIC = 372

• Income Statement
 EBIT = 1,014; Taxes = 193
 Interest Expense = 93; Dividends = 460

• Compute the CFFA 1-24

 CASH FLOWS: EXAMPLE 1

• OCF = 1,014 + 500 - 193 = 1,321

• NCS = 2,194 - 2,261 + 500 = 433
• Changes in NWC =
(3,625 - 1,787) - (3,596 - 2,140) = 382
• CFFA = 1,321 - 433 - 382 = 506

• CF to Creditors = 93 - (538 - 581) = 136

• CF to Stockholders = 460 - (462 - 372) = 370
• CFFA = 136 + 370 = 506
• The CF identity holds.

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 SELECTED CONCEPT QUESTIONS

• What is liquidity? Why is it important?

• Explain the difference between book value and market value.
Which is more important to the financial manager? Why?
• What is the income statement equation?
• What is the difference between a marginal and an average
tax rate?
• What is the cash flow identity? Explain what it says.
• What are the components of operating cash flow?

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 COMPREHENSIVE PROBLEM
• Current Accounts
 2018: CA = 4,400; CL = 1,500
 2017: CA = 3,500; CL = 1,200

• Fixed Assets and Depreciation

 2018: NFA = 3,400; 2014: NFA = 3,100
 Depreciation Expense = 400

• Long-term Debt and Equity (R.E. not given)

 2018: LTD = 4,000; Common stock & APIC = 400
 2017: LTD = 3,950; Common stock & APIC = 400

• Income Statement
 EBIT = 2,000; Taxes = 300
 Interest Expense = 350; Dividends = 500

• Compute the CFFA

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 END OF CHAPTER
CHAPTER 2

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