The future starts today,

Chapter 3 : Financial Statements, Cash Flow, and Taxes

not tomorrow.
Lecture : Rizal Yaya, S.E., M.Sc., Ph.D., Ak, CA
 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 firm’s past operations
and future prospects.
 Financial Statements and Reports
Four basic financial statements:
1. The balance sheet, which shows what assets the company owns and who has claims on
those assets as of a given date
2. The income statement, which shows the firm’s sales and costs during some past period.
3. The statement of cash flows, which shows how much cash the firm began the year
with, how much cash it ended up with, and what it did to increase or decrease its cash.
4. The statement of stockholders’ equity, which shows the amount of equity the
stockholders had at the start of the year, the items that increased or decreased equity,
and the equity at the end of the year.
 The Balance Sheet

Balance Sheet is a statement of a firm’s financial position

at a specific point in time

Stockholders’ Equity is the amount that stockholders paid

the company when shares were purchased and the amount
of earnings the company has retained since its origination.
The Balance Sheet
 Stockholders’ Equity

Stockholders’ Equity = Paid-in Capital - Retained Earnings

Stockholders’ Equity = Total Assets - Total Liabilities

 A Allied’s Balance Sheet

Several additional points about the balance sheet should be noted:

1. Cash versus other assets.
2. Working capital
3. Total debt versus total liabilities
4. Other sources of funds
5. Depreciation
6. Market values versus book values.
7. Time Dimension
1. Cash versus Other Assets

Although assets are reported in dollar terms, only The

Cash and equivalents account represents actual spendable
money. Accounts receivable represent credit sales that have
not yet been collected. Inventories show the cost of raw
materials, work in process, and finished goods.
2. Working Capital

Current assets are often called Working Capital because

these assets “turn over”; that is, they are used and then
replaced throughout the year.

Net Working Capital = Current Assets - Current Liabilities

Net Operating Operating Operating

Working Capital (NOWC) = Current Assets - Current Liabilities
2. Working Capital
3. Total Debt versus Total Liabilities

A company’s Total Debt includes both its shortterm and long-term

interest-bearing liabilities. Total Liabilities equal total debt plus the
company’s “free” (non-interest bearing) liabilities.

Total Debt = Short Term Debt + Long Term Debt

Total Liabilities = Total Debt + (Accounts Payable + Accruals)

3. Total Debt versus Total Liabilities
4. Other Sources of Funds.

Most companies (including Allied) finance their assets

with a combination of short-term debt, long-term debt, and
common equity. Some companies also use “hybrid”
securities such as preferred stock, convertible bonds, and
long-term leases.
5. Depreciation

Most companies prepare two sets of financial statements. One is

based on Internal Revenue Service (IRS) rules and is used to
calculate taxes; the other is based on GAAP and is used for
reporting to investors. Firms often use accelerated depreciation for
tax purposes but straight-line depreciation for stockholder reporting.
6. Market Values versus Book Values

Companies generally use GAAP to determine the values

reported on their balance sheets. In most cases, these
accounting numbers (Book Values) are different from what
the assets would sell for if they were offered for sale
(Market Values).
7. Time Dimension

The balance sheet is a snapshot of the firm’s financial

position at a point in time. The balance sheet changes every
day as inventories rise and fall, as bank loans are increased
or decreased, and so forth.
 The Income Statement

Income Statements is reports summarizing a firm’s

revenues, expenses, and profits during a reporting period,
generally a quarter or a year. Operating Income is earnings
from operations before interest and taxes.

Operating Income (or EBIT) = Sales Revenues - Operating Costs

 The Income Statement

Terms contained in The Income Statement:

• Depreciation is the charge to reflect the cost of assets depleted in the
production process. Depreciation is not a cash outlay.
• Amortization is a noncash charge similar to depreciation except that it
represents a decline in value of intangible assets.
• EBITDA is an acronym for earnings before interest, taxes,
depreciation, and amortization
 Statement of Cash Flows

Statement of Cash Flows is a report that shows how items that affect the
balance sheet and income statement affect the firm’s cash flows. There
are four sections in the statement of cash flows.
1. Operating Activities
2. Investing Activities
3. Financing Activities
4. Summary
1. Operating Activities
This section deals with items that occur as part of normal ongoing operations.
Some section of operating activities, such as:
1. Net income
2. Depreciation and amortization
3. Increase in inventories
4. Increase in accounts receivable
5. Increase in accounts payable
6. Increase in accrued wages and taxes
7. Net cash provided by (used in) operating activities
2. Investing Activities

All activities involving long-term assets are covered in this section.

It also includes the purchase and sale of short-term investments,
other than trading securities, and lending and collecting on notes
receivables. Some section of investing activities, such as:
1. Additions to property, plant, and equipment
2. Net cash used in investing activities
3. Financing Activities

All cash activity that comes from increasing the company's capital.
Some section of financing activities, such as:
1. Increase in notes payable
2. Increase in bonds (long-term debt).
3. Payment of dividends to stockholders
4. Net cash provided by financing activities.
4. Summary

This section summarizes the change in cash and cash equivalents

over the year. Some section of summary, such as:
1. Net decrease in cash
2. Cash and equivalents at the beginning of the year
3. Cash and equivalents at the end of the year
 Statement of Stockholders’ Equity

Statement of Stockholders’ Equity is A statement that shows by how

much a firm’s equity changed during the year and why this change
occurred. Note that “retained earnings” represents a claim against assets,
not assets per se. Stockholders allow management to retain earnings and
reinvest them in the business, use retained earnings for additions to plant
and equipment, add to inventories, and the like.
 Uses and Limitations of Financial Statements

Investors need to be cautious when they review financial statements.

Although companies are required to follow GAAP, managers still have a
lot of discretion in deciding how and when to report certain transactions.
Two firms in exactly the same situation may report financial statements
that convey different impressions about their financial strength.
Managers may choose to report numbers in a manner that helps them
present either higher or more stable earnings over time.
 Free Cash Flow

Free Cash Flow (FCF) is the amount of cash that could be withdrawn
without harming a firm’s ability to operate and to produce future cash flows.

 EBIT (1 – T) is often referred to as Net Operating Profit After Taxes (NOPAT) The
profit a company would generate if it had no debt and held only operating assets.
 Net Operating Working Capital (NOWC) is operating current assets minus
operating current liabilities
Free Cash Flow
 MVA and EVA

• Market Value Added (MVA) is the excess of the market value of

equity over its book value.
• Economic Value Added (EVA) is excess of NOPAT over capital costs.
 Income Taxes

A Individual Taxes

B Corporate Taxes
 A Individual Taxes

Terms contained in Individual Taxes:

• The tax rates are progressive. That is, the higher one’s income, the larger
the percentage paid in taxes.
• Marginal Tax Rate is the tax rate applicable to the last unit of a person’s
income.
• Average Tax Rate is taxes paid divided by taxable income.
• Capital Gain is the profit from the sale of a capital asset for more than its
purchase price.
 A Individual Taxes

Terms contained in Individual Taxes:

• Capital Loss is the loss from the sale of a capital asset for less than its
purchase price
• Traditional IRAs is individual retirement arrangements in which qualified
contributions are tax deductible and income and capital gains on
investments within the account are not taxed until the money is
withdrawn after age 59½.
 A Individual Taxes

Terms contained in Individual Taxes:

• Roth IRAs is individual retirement arrangements in which contributions
are not tax deductible but the future income and capital gains within
these accounts are not taxed if the money is withdrawn after age 59½.
• Alternative Minimum Tax (AMT) is created by Congress to make it
more difficult for wealthy individuals to avoid paying taxes through the
use of various deductions.
 B Corporate Taxes

Interest and Dividends Received by a Corporation

The rationale behind this exclusion is that when a corporation receives
dividends and then pays out its own after-tax income as dividends to its
stockholders, the dividends received are subjected to triple taxation:
1) The original corporation is taxed.
2) The second corporation is taxed on the dividends it receives.
3) The individuals who receive the final dividends are taxed again. This
explains the 70% intercorporate dividend exclusion.
 B Corporate Taxes

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. Currently, though, corporations’ capital gains
are taxed at the same rates as their operating income.
 B Corporate Taxes

Corporate Loss Carryback and Carryforward

 Carryback is ordinary corporate operating losses can be carried
backward for 2 years and carried forward for 20 years to offset taxable
income in a given year.
 Carryforward is ordinary corporate operating losses can be carried
backward for 2 years and carried forward for 20 years to offset taxable
income in a given year.
 B Corporate Taxes

Consolidated Corporate Tax Returns

If a corporation owns 80% or more of another corporation’s stock, it can
aggregate income and file one consolidated tax return. This allows the
losses of one company to be used to offset the profits of another. No
business wants to incur losses, but tax offsets make it more feasible for
large, multidivisional corporations to undertake risky new ventures or
ventures that will suffer losses during a developmental period.
 B Corporate Taxes

Taxation of Small Businesses: S Corporations

S Corporation is a small corporation that, under Subchapter S of the
Internal Revenue Code, elects to be taxed as a proprietorship or a
partnership yet retains limited liability and other benefits of the corporate
form of organization. (Regular corporations are called C corporations)
 B Corporate Taxes

Depreciation
Depreciation plays an important role in income tax calculations. The
larger the depreciation, the lower the taxable income, the lower the tax bill,
and thus the higher the operating cash flow. Congress specifies the life over
which assets can be depreciated for tax purposes and the depreciation
methods that can be used.
 B HOMEWORK

Self Test 2 Page 94

Problem 3.1
 SelfTest

1. What is the annual report, and what two types of information

does it provide?
2. What four financial statements are typically included in the
annual report?
3. Why is the annual report of great interest to investors?
 SelfTest
1. What is the balance sheet, and what information does it provide?
2. How is the order in which items are shown on the balance sheet
determined?
3. Explain in words the difference between net working capital and net
operating working capital.
4. Explain in words the difference between total debt and total liabilities.
5. What items on Allied’s December 31 balance sheet would probably be
different from its June 30 values? Would these differences be as large if
Allied were a grocery chain rather than a food processor? Explain.
 SelfTest

1. Why is earnings per share called “the bottom line”?

2. What is EBIT, or operating income? What is EBITDA?
3. Which is more like a snapshot of the firm’s operations—
the balance sheet or the income statement? Explain your
answer.
 SelfTest

1. What is the statement of cash flows, and what are some

questions it answers?
2. Identify and briefly explain the four sections shown in the
statement of cash flows.
3. If during the year a company has high cash flows from its
operations, does this mean that cash on its balance sheet will be
higher at the end of the year than it was at the beginning of the
year? Explain.
 SelfTest

1. What information does the statement of stockholders’ equity

provide?
2. Why do changes in retained earnings occur?
3. Explain why the following statement is true: The retained
earnings account reported on the balance sheet does not
represent cash and is not “available” for dividend payments or
anything else.
 SelfTest

1. Can investors be confident that if the financial statements of

different companies are accurate and are prepared in accordance
with GAAP, the data reported by one company will be
comparable to the data provided by another?
2. Why might different companies account for similar transactions
in different ways?
 SelfTest

1. What is free cash flow (FCF)?

2. Why is FCF an important determinant of a firm’s value?
 SelfTest

1. Define the terms market value added (MVA) and

economic value added (EVA).
2. How does EVA differ from accounting net income?
 SelfTest
1. Explain this statement: Our tax rates are progressive.
2. What’s the difference between marginal and average tax rates?
3. What’s the AMT, and what is its purpose?
4. What’s a muni bond, and how are these bonds taxed?
5. What are long-term capital gains?
6. Are they taxed like other income? Explain.
7. How does our tax system influence the use of debt financing by corporations?
8. What is the logic behind allowing tax loss carrybacks/carryforwards?
9. Differentiate between S and C corporations.