Review Chapter 2 Financial Statements, Cash Flow, and Taxes

A. A BRIEF HISTORY OF ACCOUNTING AND FINANCIAL STATEMENTS

For some reasons, a need arose for financial statements, for accountants to prepare

those statements, and for auditors to verify the accuracy of the accountants’ work.

The economic system has grown enormously since its beginning, and accounting has

become more complex. However, the original reasons for financial statements still

apply: Bankers and other investors need accounting information to make intelligent

decisions, managers need it to operate their businesses efficiently, and taxing

authorities need it to assess taxes in a reasonable way.

B. FINANCIAL STATEMENTS AND REPORTS

Annual Report is a report issued annually by a corporation to its stockholders. It

contains basic financial statements, as well as management’s analysis of the past

year’s operations and opinions about the firm’s future prospects.

Two types of information are given in this report. First, there is a verbal section, often

presented as a letter from the chairman, that describes the firm’s operating results

during the past year and discusses new developments that will affect future

operations. Second, the annual report presents four basic financial statements — the

balance sheet, the income statement, the statement of retained earnings, and the

statement of cash flows.

The quantitative and verbal materials are equally important. The financial statements

report what has actually happened to assets, earnings, and dividends over the past few

years, whereas the verbal statements attempt to explain why things turned out the way

they did.
The information contained in an annual report is used by investors to help form

expectations about future earnings and dividends.

C. THE BALANCE SHEET

Balance Sheet is a statement of the firm’s financial position at a specific point in time.

The left-hand side of balance sheets shows the firm’s assets, while the right-hand side

shows the liabilities and equity, or the claims against assets. The assets are listed in

order of their “liquidity,” or the length of time it typically takes to convert them to

cash.

D. THE INCOME STATEMENT

Income Statement is a statement summarizing the firm’s revenues and expenses over

an accounting period, generally a quarter or a year. Net sales are shown at the top of

each statement, after which various costs are subtracted to obtain the net income

available to common shareholders, which is generally referred to as net income. These

costs include operating costs, interest costs, and taxes. A report on earnings and

dividends per share is given at the bottom of the income statement. Earnings per share

(EPS) is called “the bottom line,” denoting that of all the items on the income

statement, EPS is the most important.

E. STATEMENT OF RETAINED EARNINGS

Statement of Retained Earnings is a statement reporting how much of the firm’s

earnings were retained in the business rather than paid out in dividends. The figure for

retained earnings that appears here is the sum of the annual retained earnings for each

year of the firm’s history.

“Retained earnings” represents a claim against assets, not assets per se. Moreover,

firms retain earnings primarily to expand the business, and this means investing in

plant and equipment, in inventories, and so on, not piling up cash in a bank account.
Changes in retained earnings occur because common stockholders allow the firm to

reinvest funds that otherwise could be distributed as dividends. Thus, retained

earnings as reported on the balance sheet do not represent cash and are not “available”

for the payment of dividends or anything else.

F. NET CASH FLOW

Net Cash Flow is the actual net cash, as opposed to accounting net income, that a firm

generates during some specified period. Accounting Profit is a firm’s net income as

reported on its income statement.

A business’s net cash flow generally differs from its accounting profit because some

of the revenues and expenses listed on the income statement were not paid in cash

during the year. The relationship between net cash flow and net income can be

expressed as follows:

Net cash flow = Net income - Non cash revenues + Non cash charges.

Many analysts assume that net cash flow equals net income plus depreciation and

amortization:

Net cash flow = Net income + Depreciation and amortization.

Depreciation is a non cash charge, so it must be added back to net income to obtain

the net cash flow. If we assume that all other non cash items (including amortization)

sum to zero, then net cash flow is simply equal to net income plus depreciation.

G. STATEMENT OF CASH FLOWS

Statement of Cash Flows is a statement reporting the impact of a firm’s operating,

investing, and financing activities on cash flows over an accounting period.

Net cash flow represents the amount of cash a business generates for its shareholders

in a given year. However, the fact that a company generates high cash flow does not
necessarily mean that the amount of cash reported on its balance sheet will also be

high.

The company’s cash position as reported on the balance sheet is affected by a great

many factors, including the following:

1. Cash flow

2. Changes in working capital

3. Fixed assets

4. Security transactions

Each of the above factors is reflected in the statement of cash flows, which

summarizes the changes in a company’s cash position. The statement separates

activities into three categories:

1. Operating activities, which includes net income, depreciation, and changes in

current assets and current liabilities other than cash and short-term debt.

2. Investing activities, which includes investments in or sales of fixed assets.

3. Financing activities, which includes cash raised during the year by issuing short-

term debt, long-term debt, or stock. Also, since dividends paid or cash used to buy

back outstanding stock or bonds reduces the company’s cash, such transactions are

included here.

H. MODIFYING ACCOUNTING DATA FOR MANAGERIAL DECISIONS

Certain modifications are used for corporate decision making and stock valuation

purposes. In the following how financial analysts combine stock prices and

accounting data to evaluate and reward managerial performance.

1. OPERATING ASSETS AND OPERATING CAPITAL

To judge managerial performance, we need to compare managers’ ability to generate

operating income (or EBIT) with the operating assets under their control.
The first step in modifying the traditional accounting framework is to divide total

assets into two categories, operating assets, which consist of the cash and marketable

securities, accounts receivable, inventories, and fixed assets necessary to operate the

business, and non operating assets, which would include cash and marketable

securities above the level required for normal operations, investments in subsidiaries,

land held for future use, and the like.

Those current assets used in operations are called operating working capital, and

operating working capital less accounts payable and accruals is called net operating

working capital. Therefore, net operating working capital is the working capital

acquired with investor-supplied funds. Here is a workable definition in equation form:

Net operating working capital = All current assets - All current liabilities that do not

charge interest

2. NET OPERATING PROFIT AFTER TAXES (NOPAT)

A better measurement for comparing managers’ performance is net operating profit

after taxes, or NOPAT, which is the amount of profit a company would generate if it

had no debt and held no non operating assets. Net Operating Profit After Taxes

(NOPAT) is the profit a company would generate if it had no debt and held no non

operating assets. NOPAT is defined as follows:

NOPAT = EBIT (1 - Tax rate).

3. FREE CASH FLOW

Free Cash Flow is the cash flow actually available for distribution to all investors

(stockholders and debt holders) after the company has made all the investments in

fixed assets, new products, and working capital necessary to sustain ongoing

operations.

4. CALCULATING FREE CASH FLOW

Operating Cash Flow is equal to NOPAT plus any non cash adjustments, calculated

on an after-tax basis.

Operating cash flow = NOPAT + Depreciation

The gross investment in operating capital as follows:

Gross investment = Net investment + depreciation

The following algebraically equivalent expression for free cash flow:

FCF = NOPAT - Net investment in operating capital

I. MVA AND EVA

Financial analysts have therefore developed two new performance measures, MVA,

or Market Value Added, and EVA, or Economic Value Added.

1. MARKET VALUE ADDED (MVA)

Shareholder wealth is maximized by maximizing the difference between the market

value of the firm’s stock and the amount of equity capital that was supplied by

shareholders. This difference is called the Market Value Added (MVA):

MVA = Market value of stock - Equity capital supplied by shareholders

= (Shares outstanding)(Stock price) - Total common equity.

2. ECONOMIC VALUE ADDED (EVA)

Whereas MVA measures the effects of managerial actions since the very inception of

a company, Economic Value Added (EVA) focuses on managerial effectiveness in a

given year. The basic formula for EVA is as follows:

EVA = Net operating profit after taxes, or NOPAT - After-tax dollar cost of capital

used to support operations

= EBIT(1 - Corporate tax rate) - (Total investor-supplied operating capital)(After-tax

percentage cost of capital).

J. THE FEDERAL INCOME TAX SYSTEM

The value of any financial asset (including stocks, bonds, and mortgages), as well as

most real assets such as plants or even entire firms, depends on the stream of cash

flows produced by the asset. Cash flows from an asset consist of usable income plus

depreciation, and usable income means income after taxes.

Corporate income is really subject to double taxation. Because of the magnitude of the

tax bite, taxes play a critical role in many financial decisions.

It is important to know the basic elements of the tax system as a starting point for

discussions with tax experts.

1. INDIVIDUAL INCOME TAXES

Individuals pay taxes on wages and salaries, on investment income (dividends,

interest, and profits from the sale of securities), and on the profits of proprietor ships

and partnerships. Our tax rates are progressive — that is, the higher one’s income, the

larger the percentage paid in taxes.

a. Taxes on Dividend and Interest Income

Dividend and interest income received by individuals from corporate securities is

added to other income and thus is taxed at rates going up to about 50 percent. Since

corporations pay dividends out of earnings that have already been taxed, there is

double taxation of corporate income — income is first taxed at the corporate rate, and

when what is left is paid out as dividends, it is taxed again at the personal rate.

b. Capital Gains versus Ordinary Income

Assets such as stocks, bonds, and real estate are defined as capital assets. If you buy a

capital asset and later sell it for more than your purchase price, the profit is called a

capital gain; if you suffer a loss, it is called a capital loss. An asset sold within one

year of the time it was purchased produces a short-term gain or loss and one held for

more than a year produces a long-term gain or loss.

2. CORPORATE INCOME TAXES

a. Interest and Dividend Income Received by a Corporation

Interest income received by a corporation is taxed as ordinary income at regular

corporate tax rates. However, 70 percent of the dividends received by one corporation

from another is excluded from taxable income, while the remaining 30 percent is

taxed at the ordinary tax rate.

b. Interest and Dividends Paid by a Corporation

A firm’s operations can be financed with either debt or equity capital. If it uses debt, it

must pay interest on this debt, whereas if it uses equity, it is expected to pay dividends

to the equity investors (stockholders). The interest paid by a corporation is deducted

from its operating income to obtain its taxable income, but dividends paid are not

deductible. The fact that interest is a deductible expense has a profound effect on the

way businesses are financed — our corporate tax system favors debt financing over

equity financing.

c. Corporate Capital Gains

Before 1987, corporate long-term capital gains were taxed at lower rates than

corporate ordinary income, so the situation was similar for corporations and

individuals. Under current law, however, corporations’ capital gains are taxed at the

same rates as their operating income.

d. Corporate Loss Carry-Back and Carry-Forward

Ordinary corporate operating losses can be carried back (carry-back) to each of the

preceding 2 years and forward (carry-forward) for the next 20 years and used to offset

taxable income in those years.

e. Improper Accumulation to Avoid Payment of Dividends

Corporations could refrain from paying dividends and thus permit their stockholders

to avoid personal income taxes on dividends. To prevent this, the Tax Code contains

an improper accumulation provision that states that earnings accumulated by a

corporation are subject to penalty rates if the purpose of the accumulation is to enable

stockholders to avoid personal income taxes.

f. Consolidated Corporate Tax Returns

If a corporation owns 80 percent or more of another corporation’s stock, it can

aggregate income and file one consolidated tax return; thus, the losses of one

company can be used to offset the profits of another.

3. TAXATION OF SMALL BUSINESSES : S CORPORATIONS

If a corporation elects S corporation status for tax purposes, all of the business’s

income is reported as personal income by its stockholders, on a pro rata basis, and

thus is taxed at the rates that apply to individuals. This is an important benefit to the

owners of small corporations in which all or most of the income earned each year will

be distributed as dividends, because then the income is taxed only once, at the

individual level.

K. DEPRECIATION

Depreciation plays an important role in income tax calculations — the larger the

depreciation, the lower the taxable income, the lower the tax bill, hence the higher the

cash flow from operations. Congress specifies, in the Tax Code, both the life over

which assets can be depreciated for tax purposes and the methods of depreciation that

can be used.