RWJ FCF11e Chap 02

CHAPTER 2
FINANCIAL STATEMENTS, TAXES, AND

CASH FLOW
Copyright © 2016 by McGrawHill Global Education LLC. All rights reserved.
KEY CONCEPTS AND SKILLS
• Know the difference between book
value and market value
• Know the difference between

accounting income and cash flow
• Know the difference between

average and marginal tax rates
• Know how to determine a firm’s cash

flow from its financial statements
Copyright © 2016 by McGrawHill Global Education LLC. All rights reserved. 2-2
CHAPTER OUTLINE
• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow
BALANCE SHEET
• The balance sheet is a snapshot of
the firm’s assets and liabilities at a
given point in time
• Assets are listed in order of

decreasing liquidity
 Ease of conversion to cash
 Without significant loss of value
• Balance Sheet Identity

 Assets = Liabilities + Stockholders’ Equity
THE BALANCE SHEET
FIGURE 2.1
NET WORKING CAPITAL
AND LIQUIDITY
• Net Working Capital
 = Current Assets – Current Liabilities
 Positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out
 Usually positive in a healthy firm
• Liquidity
 Ability to convert to cash quickly without
a significant loss in value
 Liquid firms are less likely to experience financial distress
 But liquid assets typically earn a lower return
 Trade-off to find balance between liquid and illiquid assets
U.S. CORPORATION BALANCE
SHEET TABLE 2.1
MARKET VALUE VS. BOOK VALUE
• The balance sheet provides the book value

of the assets, liabilities, and equity.
• Market value is the price at which the

assets, liabilities, or equity can actually be
bought or sold.
• Market value and book value are often very

different. Why?
• Which is more important to the decision-

making process?
EXAMPLE 2.2
KLINGON CORPORATION
INCOME STATEMENT
• The income statement is more like a video

of the firm’s operations for a specified
period of time.
• You generally report revenues first and

then deduct any expenses for the period
• Matching principle – GAAP says to show

revenue when it accrues and match the
expenses required to generate the revenue
U.S. CORPORATION INCOME
STATEMENT – TABLE 2.2
WORK THE WEB EXAMPLE
• Publicly traded companies must file

regular reports with the Securities and
Exchange Commission
• These reports are usually filed

electronically and can be searched at the
SEC public site called EDGAR
• Click on the web surfer, pick a company,

and see what you can find!
TAXES
• The one thing we can rely on with taxes
is that they are always changing
• Marginal vs. average tax rates

 Marginal tax rate – the percentage
paid on the next dollar earned
 Average tax rate – the tax bill / taxable
income
 Average tax rates vary widely across
different companies and industries
• Other taxes
EXAMPLE: MARGINAL VS.
AVERAGE RATES
• Suppose your firm earns $4 million in
taxable income.
 What is the firm’s tax liability?
 What is the average tax rate?
 What is the marginal tax rate?
• If you are considering a project that

will increase the firm’s taxable income
by $1 million, what tax rate should you
use in your analysis?
THE CONCEPT OF CASH FLOW
• Cash flow is one of the most important
pieces of information that a financial
manager can derive from financial
statements
• The statement of cash flows does not

provide us with the same information
that we are looking at here
• We will look at how cash is generated

from utilizing assets and how it is paid
to those that finance the purchase of
the assets
CASH FLOW FROM ASSETS
• Cash Flow From Assets (CFFA) = Cash Flow to

Creditors + Cash
Flow to
Stockholders
• Cash Flow From Assets = Operating Cash Flow

– Net Capital
Spending – Changes
in NWC
EXAMPLE: U.S. CORPORATION –
PART I
• OCF (I/S) = EBIT + depreciation –
taxes = $547
• NCS (B/S and I/S) = ending net fixed
assets – beginning net fixed assets +
depreciation = $130
• Changes in NWC (B/S) = ending

NWC – beginning NWC = $330
• CFFA = 547 – 130 – 330 = $87
EXAMPLE: U.S. CORPORATION –
PART II
• CF to Creditors (B/S and I/S) =
interest paid – net new borrowing
= $24
• CF to Stockholders (B/S and I/S) =

dividends paid – net new equity
raised = $63
• CFFA = 24 + 63 = $87
CASH FLOW SUMMARY - TABLE 2.6
EXAMPLE: BALANCE SHEET AND
INCOME STATEMENT INFO
• Current Accounts
 2015: CA = 3625; CL = 1787
 2014: CA = 3596; CL = 2140
• Fixed Assets and Depreciation

 2015: NFA = 2194; 2014: NFA = 2261
 Depreciation Expense = 500
• Long-term Debt and Equity

 2015: LTD = 538; Common stock & APIC = 462
 2014: LTD = 581; Common stock & APIC = 372
• Income Statement
 EBIT = 1014; Taxes = 368
 Interest Expense = 93; Dividends = 285
EXAMPLE: CASH FLOWS
• OCF = 1,014 + 500 – 368 = 1,146

• NCS = 2,194 – 2,261 + 500 = 433
• Changes in NWC = (3,625 – 1,787) – (3,596 –
2,140) = 382
• CFFA = 1,146 – 433 – 382 = 331
• CF to Creditors = 93 – (538 – 581) = 136

• CF to Stockholders = 285 – (462 – 372) = 195
• CFFA = 136 + 195 = 331
• The CF identity holds.
QUICK QUIZ
• What is the difference between book value
and market value? Which should we use
for decision-making purposes?
• What is the difference between accounting

income and cash flow? Which do we need
to use when making decisions?
• What is the difference between average

and marginal tax rates? Which should we
use when making financial decisions?
• How do we determine a firm’s cash flows?

What are the equations, and where do we
find the information?
ETHICS ISSUES
• Why is manipulation of financial

statements not only unethical and
illegal, but also bad for stockholders?
COMPREHENSIVE PROBLEM
• Current Accounts
 2015: CA = 4,400; CL = 1,500
 2014: CA = 3,500; CL = 1,200
• Fixed Assets and Depreciation

 2015: NFA = 3,400; 2014: NFA = 3,100
 Depreciation Expense = 400
• Long-term Debt and Equity (R.E. not given)

 2015: LTD = 4,000; Common stock & APIC = 400
 2014: LTD = 3,950; Common stock & APIC = 400
• Income Statement
 EBIT = 2,000; Taxes = 300
 Interest Expense = 350; Dividends = 500
• Compute the CFFA

CHAPTER 2
END OF CHAPTER

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CHAPTER 2

FINANCIAL STATEMENTS, TAXES, AND

• Know the difference between

• Know the difference between

• Know how to determine a firm’s cash

• The Balance Sheet

• The Income Statement

• Assets are listed in order of

• Balance Sheet Identity

• The balance sheet provides the book value

• Market value is the price at which the

• Market value and book value are often very

• Which is more important to the decision-

• The income statement is more like a video

• You generally report revenues first and

• Matching principle – GAAP says to show

• Publicly traded companies must file

• These reports are usually filed

• Click on the web surfer, pick a company,

• Marginal vs. average tax rates

• If you are considering a project that

• The statement of cash flows does not

• We will look at how cash is generated

• Cash Flow From Assets (CFFA) = Cash Flow to

• Cash Flow From Assets = Operating Cash Flow

• Changes in NWC (B/S) = ending

• CFFA = 547 – 130 – 330 = $87

• CF to Stockholders (B/S and I/S) =

• Fixed Assets and Depreciation

• Long-term Debt and Equity

• OCF = 1,014 + 500 – 368 = 1,146

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

• What is the difference between accounting

• What is the difference between average

• How do we determine a firm’s cash flows?

• Why is manipulation of financial

• Fixed Assets and Depreciation

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

• Compute the CFFA

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