Chapter 2

Financial Statements,
Cash Flow, and Taxes

 PhD, Phan Hong Mai

 School of Banking and Finance
 National Economics University
 hongmai@neu.edu.vn
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 Key Concepts and Skills

 Know how to prepare financial statements

 Know the difference between book value and
market value, between accounting income and
cash flow, between average and marginal tax
rates
 Know how to determine a firm’s cash flow from
its financial statements

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Chapter Outline

Introduction of Financial Statements

2.1 The Balance Sheet
2.2 The Income Statement
2.3 Cash Flows
2.4 The Statement of Cash Flows Chapter 3

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Introduction of Financial Statements

Financial statements (financial reports):

 Formal records of the financial activities and
position of a business, person, or other entity.
 Reported assets, liabilities, equity, income,
expenses and cash flow… which are directly
related to an organization's financial position.

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Introduction of Financial Statements

 The objective of financial statements: provide

information about the financial position,
performance and changes in financial position
of an enterprise that is useful to a wide range
of users in making economic decisions.
 Financial statements should be:
 Understandable
 Relevant
 Reliable
 Comparable
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Introduction of Financial Statements

 Financial statements may be used by users for

different purposes:
 Owners and managers: to make important
business decisions that affect its continued
operations.
 Employees: to make collective bargaining
agreements (CBA) with the management, in
the case of labor unions or for individuals in
discussing their compensation, promotion and
rankings.
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Introduction of Financial Statements

 Prospective investors: to assess the

viability of investing in a business.
 Financial institutions (banks and other
lending companies): to decide whether to
grant a company with fresh working capital or
extend debt securities (such as a long-term
bank loan or debentures) to finance
expansion and other significant expenditures.

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Introduction of Financial Statements
Four basic financial statements:
 Balance sheet – provides a snapshot of a firm’s
financial position at one point in time.
 Income statement – summarizes a firm’s
revenues and expenses over a given period of time.
 Statement of stockholders’ equity – shows
how much of the firm’s earnings were retained,
rather than paid out as dividends.
 Statement of cash flows – reports the impact of
a firm’s activities on cash flows over a given period
of time.
 -> Notes to financial statements. 2-8
 2.1 The Balance Sheet

 Show a firm’s accounting value on a particular

date.
 A convenient mean of organizing and
summarizing what a firm owns (its assets),
what a firm owes (its liabilities) and the
difference between the two (its equity) at a
given point.

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2.1 The Balance Sheet
Total value of liabilities
and shareholders’ equity

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 2.1 The Balance Sheet
 Assets – the left side of the balance sheet:
classified as Current assets and Fixed assets and
listed in order of decreasing liquidity.
 Current assets: have a life of less than one year
-> convert to cash within 12 months.
They can be

 Fixed assets: have a life of more than one year

-> not convert to cash quickly. They can be
Tangible fixed assets (plant, equipment,
property…) and Intangible fixed assets
(trademark, patent…) 2-11
 2.1 The Balance Sheet
 Liabilities and Shareholdes’ equity – the
right side of the balance sheet: classified as
Current liabilities, Long-term debt, and
Shareholdes’ equity and listed in order of
decreasing payment priority.
 Current liabilities: have a life of less than
one year -> must be paid within 12 months.
They can be Accounts payable, Notes payable…
 Long-term debts: not due in the coming year.
They can be long-term loan, bonds…

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 2.1 The Balance Sheet

 Shareholders’ equity (Common equity/

Stockholders’ equity/ Owners’ equity): the total
amount of ownership investment in one firm.
 It is the difference between the total value of
the assets and the total value of the liabilities.

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 2.1 The Balance Sheet

 Assets = Liabilities + Equity

 Equity = Assets - Liabilities
-> if the firm sell all its assets and use the money
to pay off its debts, the residual value belongs to
shareholders.

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2.1 The Balance Sheet

$ 1,920 = $ 2,756 – (428+408)

 2.1 The Balance Sheet

 The structure of assets reflects the line of

business which the firm is in and also managerial
decisions (about how much cash and inventory to
have, about credit policy, fixed asset
acquisition…).
 The structure of liabilities and shareholders’
equity reflects managerial decisions about capital
structure and the use of short-term debt.

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 2.1 The Balance Sheet

Capital budgeting

Capital structure

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 2.1 The Balance Sheet

 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 (over the same period).
 Usually positive in a healthy firm.

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2.1 The Balance Sheet

NWC 2011 = $1,112 – 428 = $684

NWC 2012 = $1,403 – 389 = $1,014
 2.1 The Balance Sheet

 Example 2.1 – Building the balance sheet

A firm has current assets of $200, net fixed
assets of $700, short-term debt of $170, and
long-term debt of $240.
What does the balance sheet look like? What
is shareholders’ equity? What is net working
capital?

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 2.1 The Balance Sheet

 Liquidity: refers to the speed and ease with

which an asset can be convert to cash. A highly
liquid asset can be quickly sold without
significant loss of value. An illiquid asset is one
that cannot be quickly converted to cash without
a substantial price reduction.
 There is a trade-off between the advantages of
liquidity and forgone potential profits. Liquid
firms are less likely to experience financial
distress but liquid assets typically earn a lower
return.
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2.1 The Balance Sheet

9.35%
Receivable 40.92%
49.73%

Current assets: 40.35%

Fixed assets: 59.65%
 2.1 The Balance Sheet

 Debt & Equity:

 The use of debt in a firm’s capital structure
is called financial leverage. The more
debt a firm has, the greater is its degree
of financial leverage.
 Financial leverage increases the potential
reward to shareholders, but it also
increases the potential for financial
distress and business failure.
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2.1 The Balance Sheet

51.20%

48.80%

Total liabilities: 30.33%

Total equity: 69.67%
 2.1 The Balance Sheet

 Book value & Market 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.

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 2.1 The Balance Sheet

 Assets are listed at historical costs less

accumulated depreciation.
 It also does not include the value of many
important assets, such as human capital.
-> “Total Assets” is generally not a very good
estimate of what the assets of the firm are actually
worth.
 Liabilities are listed at face value. When interest
rates change or the risk of the firm changes, the
value of them change in the market as well.
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 2.1 The Balance Sheet

 Equity is the ownership interest in the firm. The

market value of equity depends on:
 the future growth prospects of the firm.
 the market’s estimation of the current value of
all of the assets of the firm.

-> Market values are generally more important for

the decision making process because they are
more reflective of the cash flows that would
occur today.
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 2.1 The Balance Sheet

 Example 2.2 – Market value & Book value

The Klingon Corporation has net fixed assets
with a book value of $500 and an appraised
market value of about $750. Current assets is
$200 on the books, but approximately $300
would be realized if all the current accounts
were liquidated. Klingon has $400 in long-term
debt, both book value and market value. What
is the book value of the equity? What is the
market value?
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2.2 The Income Statement

 Summarizing a firm’s performance over a

period of time.
 It is more like a video of the firm’s operations
for a specified period of time.

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 2.2 The Income Statement

 Report revenue first when it accrues (not

necessarily when the cash comes in) –
Recognition Principle.
 Then, match those revenues with the expenses
required to generate them – Matching Principle.
Expenses can be Cost of Goods Sold, Depreciation,
Selling and Administrative expenses, Interest
paid…
-> Revenues and Expenses generally differ from Cash
Inflows and Cash Outflows.

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 2.2 The Income Statement

 Income = Revenues – Expenses

 There are some noncash items (Depreciation,
Provision…) are subtracted when calculate
Income.
-> Income generally differs from Net Cash Flow.

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2.2 The Income Statement

EBIT = $1,509 – 750 – 65 =

= Earnings before taxes EBT $694 - 70 =

$624 x 34% =
= Earnings after taxes EAT $624 - 212 =

$ 412
2.2 The Income Statement

 Income Tax: A certain percentage of income

that firms have to pay regularly to the
Government.
 The tax rates can be changed that depends
on the tax brackets regulated by the
Government.

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 2.2 The Income Statement

 Average tax rate: = the tax bill/taxable income

 Marginal tax rate: the percentage
paid on the next dollar earned
 Average tax rates vary widely across different
companies and industries.

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 2.2 The Income Statement
 Example 2.3 – Average & Marginal tax rate
Suppose your firm earns $200,000 in taxable income.
-> What is the firm’s tax liability? What is the
average tax rate? And What is the marginal tax rate?
Taxable income Tax rate
0 – 50,000 15%
50,001 – 75,000 25%
75,001 - 100,000 34%
100,001 – 335,000 39%
335,001 – 10,000,000 34%
…….. ……. 2-35
 2.3 Cash Flows

 Cash flows refer to how cash is generated from

utilizing assets and how it is paid to those that
finance the purchase of the assets.
 The cash flows received from the firm’s assets
must equal the cash flows to the firm’s creditors
and stockholders.

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(Net) CF from assets = (Net) CF to creditors + (Net) CF to owners

C=D+E+F
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C–D–E=F
 2.3 Cash Flows

(Net) CF from assets

= (Net) CF to creditors + (Net) CF to owners

 A negative cash flow from assets means that the

firm raised more money by borrowing and selling
stock than it paid out to creditors and
stockholders during the year.

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 2.3 Cash Flows

 Cash flow from

assets involves
operating cash flow
(OCF), net capital
spending, and
change in net
working capital.

(Net) CF from assets = OCF - Net capital spending

- Change in NWC
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2.3 Cash Flows

 Operating cash flow (OCF) refers to the

cash flow that results from the firm’s day-to-
day activities of producing and selling.
 OCF is calculated by subtracting costs from
revenues, but not include depreciation
(noncash item), interest (financing expense)
and include taxes as well (unfortunately,
taxes are paid in cash).

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2.3 Cash Flows
U.S. Corporation Income Statement in 2012
CIF
COF
Non-cash

CF to creditors

COF

OCF = CIF – COF = EBIT + Depreciation - Taxes

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2.3 Cash Flows

 OCF is not the same Net income because

Depreciation and Interest are subtracted out.
Depreciation is not a cash. And Interest is not an
operating expense, it is a financing expense.
 OCF reflects whether a firm’s cash inflows from
its business operations are sufficient to cover its
everyday cash out flows. -> a negative OCF is
often a sign of trouble.

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2.3 Cash Flows
U.S. Corporation Income Statement in 2012

OCF = $694 + 65 – 212 = $547 2-43

2.3 Cash Flows

 Net capital spending refers to the net

spending on fixed assets (purchases of fixed
assets less sales of fixed assets).
 Net capital spending or net capital
expenditures can be negative if the firm sold
off more assets than it purchased.

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 2.3 Cash Flows

Ending = Beginning + Purchasing – Selling – Depreciation

net net fixed fixed
fixed fixed assets assets
assets assets
Net CAPEX

-> Net CAPEX = Ending – Beginning + Depreciation

net fixed net fixed
assets assets

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2.3 Cash Flows

Depreciation = $65

Net CAPEX = $1,709 – 1,644 + 65 = $ 130

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2.3 Cash Flows

 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 spent on net working capital.

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 2.3 Cash Flows

Ending = Beginning + Increase – Decrease

NWC NWC in NWC in NWC

Change in NWC

-> Change in NWC = Ending NWC – Beginning NWC

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2.3 Cash Flows

NWC 2011 = $1,112 – 428 = $684

NWC 2012 = $1,403 – 389 = $1,014

Change in NWC = $1,014 – 684 = $330

-> (Net) CF from assets = $547 – 130 – 330 = $87
 2.3 Cash Flows

 The cash flows to creditors and

stockholders represent the net payments to
creditors and owners during the year.

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 2.3 Cash Flows

CF to = Interest + Capital – New

creditors paid repayment borrowing

CF to = Interest – New – Capital

creditors paid borrowing repayment

Net new borrowing

CF to = Interest – Net new

creditors paid borrowing 2-51
2.3 Cash Flows

Net new = Ending debts – Beginning debts

Borrowing

CF to = Interest – (Ending – Beginning)

Creditors paid debts debts

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2.3 Cash Flows

Interest paid = $70

Net new borrowing =
$454 – 408 = $46

Cash flow to creditors = $70 – 46 = $24 2-53

 2.3 Cash Flows

CF to = Dividends + Capital – New equity

stockholders paid repayment raised

CF to = Dividends – New equity – Capital

stockholders paid raised repayment

Net new equity raised

CF to = Dividends – Net new equity
stockholders paid raised
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 2.3 Cash Flows

Net new = Ending equity – Beginning equity

Equity raised

CF to = Dividends – (Ending – Beginning)

stockholders paid equity equity

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2.3 Cash Flows

Dividends paid = $103

Net new equity raised
= $640 – 600 = $40

Cash flow to stockholders = $103 – 40 = $63

-> (Net) CF to creditors + (Net) CF to stockholders
= $24 + 63 = $87 = (Net) CF from assets
2.3 Cash Flows
2.4 Statement of Cash Flows

 Statement of Cash Flows:

A summary of the actual incomings
and outgoings of cash in a firm
over a period.
 It answers the questions: Where the money
came from? And where it went (will go)?
 It can be prepared by two methods (indirect
and direct method).

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2.4.1 Statement of Cash Flows
(indirect method)

 Changes divided into three major categories:

 Operating Activity – includes net income
and changes in most current accounts
 Investment Activity – includes changes in
fixed assets
 Financing Activity – includes changes in
notes payable, long-term debt and equity
accounts as well as dividends

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2.4.1 Statement of Cash Flows
(indirect method)

 Operating Activities: Use the following

guidelines to adjust for changes in working
capital:
 Add depreciation.
 Deduct the increases in accounts receivable.
 Add increases in accounts payable.
 Deduct increases in inventory.

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2.4.1 Statement of Cash Flows
(indirect method)
 Investment Activities:
 Cash inflows: liquidate fixed assets…
 Cash outflows: purchase/produce/acquire
fixed assets…
 Financing Activities:
 Cash inflows: increase in short-term and
long-term borrowing, sale stock/bond…
 Cash outflows: pay dividends, repurchase
stock, repay loan…
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 2.4.1 The Statement of Cash Flows (indirect method)
Cash, beginning of 2012 $104 Investment Activities
62
Operating Activities Fixed assets acquisitions -$130
Net Income $412
Net CF from Investment -$130
Cash effect of changes in: Activities
Depreciation 65 Financing Activities
Accounts Receivable -233
Repay notes payable -$73
Inventory -2
Increase in long-term debt 46
Accounts Payable 34
Net CF from Operating $276 Sale stock 40
activities Pay dividends -103
Net CF from Financing -$90
Activities
Net increase in cash = $276 – 130 – 90 = $56
Cash, end of 2012 = $104 + 56 = $160
2.4.2 Statement of Cash Flows
(direct method)

 Summarizes the sources and uses of cash, uses

the information on from the balance sheet and
the income statement.
 Activities that bring in cash are called sources
of cash.
 Activities that involve spending cash are called
uses of cash.

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2.4.2 The Statement of Cash Flows (direct method)
Cash, beginning of 2012 $104
Sources of cash Uses of cash
Operations: Working capital:
Net Income $412 Accounts receivable $233
Depreciation 65 Inventory 2
Repay notes payable 73
Working capital:
Accounts Payable $34 Fixed assets acquisitions $130
Long-term financing: Pay Dividends $103
Increase in long-term debt $46 Total uses of cash $541
Sale stock 40
Net addition to cash $56
Total sources of cash $597 Cash, end of 2012 $160
 Summary and Conclusions
 The book values on an accounting balance sheet
can be very different from market values. The goal
of financial management is to maximize the market
value of the stock.
 Net income on the income statement is not cash
flow.
 Marginal and average tax rates can be different.
Marginal tax rate is relevant for most financial
decisions.
 CF from assets equals CF to creditors and owners.
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 HOMEWORKS

 Concepts review: 1, 2, 3, 4, 5.
 Questions and Problems: 5, 6, 7, 8, 9,
10, 14, 15, 16, 17, 22

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