Chapter 2 – Financial Statements, Cash Flows, and Taxes

2.1 FINANCIAL STATEMENTS AND REPORTS

 A company’s annual report usually begins with the chair’s description of the firm’s
operating results during the past year and a discussion of new developments that will
affect future operations
 The annual report also presents four basic financial statements: the balance sheet, the
income statement, the statement of retained earnings, and the statement of cash flows
 The financial statements report what has actually happened to assets, earnings, dividend,
and cash flows during the past few years, whereas the written materials attempt to explain
why things turned out the way they did

2.2 THE BALANCE SHEET

 Represents ‘snapshots’ of a company’s financial position on the last day of each fiscal
year
 The left side lists assets, which are the things the company owns
o They are listed in order of liquidity, the length of time it typically takes to convert
them to cash at fair market values
 The right side lists the claims that various groups have assigned against the company’s
value, listed in the order in which they must be paid
 Shareholders come last, for two reasons:
1. Their claim represents ownership (equity) and never needs to be paid off
2. They have a residual claim in the sense that they may receive payments only if the
other claimants have already been paid
 The amounts shown on the balance sheet are often book values since they are based on
the amounts recorded by bookkeepers when assets are purchased, or liabilities are issues
 Book values may be difference from market values, which are the current values as
determined in the marketplace

Assets
 Current assets are assets that are expected to be converted into cash within a year
 All assets are stated in dollars, but only cash represents actual money that can be spent
 Cash equivalents are marketable securities that mature very soon and can be converted
into cash at prices close to their book values
 Other types of marketable securities have a longer time until maturity, and their market
values are less predictable. They are classified as short-term investments
 Inventories shows the dollars a company has invested in raw materials, work-in-process,
and finished goods available for sale
 FIFO vs LIFO:
o During a period of rising prices, by taking out old, low cost inventory, and leaving
in new, high-cost items, FIFO will produce a higher balance sheet inventory
value, but a lower cost of goods sold on the income statement
o If a company uses FIFO during a time of inflation, its balance sheet inventories
are higher, its cost of goods sold is lower, and its reported profits are higher
 Rather than treat the entire purchase price of a long-term asset as an expense in the
purchase year, accountants ‘spread’ the purchase cost over the asset’s useful life
 o The amount they charge each year us called the depreciation expense
 A company can report depreciation either by using the cost model or the revaluation
model

Liabilities and Equity

 Current liabilities are expected to be paid within a year
 Preferred stock is a hybrid between common stock and debt
o In the event of bankruptcy, preferred stock ranks below debt but above common
stock
o The preferred dividend is fixed, so preferred shareholders do not benefit if the
company’s earnings grow
 Most firm do not use much, or any, preferred stock, so ‘equity’ usually means ‘common
equity’ unless the words ‘total’ or ‘preferred’ are included
 Retained earnings are the cumulative amount of earnings that have not been paid out as
dividends
 The sum of common stock and retained earnings is called equity

2.3 THE INCOME STATEMENT

 Income statements can cover any period of time, but they are usually prepared monthly,
quarterly, and annually
 The income statement reflect performance during a period
 Net sales are the revenues less any discounts or returns
 Depreciation and amortization reflect the estimated costs of the assets that wear out in
producing goods and services
 The cost of goods sold (COGS) includes labour, raw material, and other expenses directly
related to the production or purchase of the items or services sold in that period
 Subtracting COGS (including depreciation) and other operating expenses, results in
earnings before interest and taxes (EBIT)
 Many analysts add back depreciation to EBIT to calculate EBITDA, which stands for
earnings before interest, taxes, depreciation, and amortization
 EBITDA is not useful to managers and analysts as free cash flow, so we usually focus on
free cash flow instead
 The net income available to common shareholders, is generally referred to as net income,
although it is also called profit or earnings
 Dividing net income by the number of shares outstanding gives earning per share, which
is often called ‘the bottom line’
 Comprehensive income consists of net income plus other comprehensive income
o While the income statement presents gains and losses from its operations, there
may be other gains and losses that a company must show but have not been
realized
 Unrealized gains and losses are included as other comprehensive income and are reported
either after net income and after EPS, or on a sperate statement called the statement of
comprehensive income

2.4 STATEMENT OF CHANGES IN EQUITY

  Note that ‘retained earnings’ does not represent assets but is instead a claim against assets
 Retained earnings, as reported on the balance sheet, does not represent cash and is not
‘available’ for the payment of dividends or anything else

2.5 NET CASH FLOWS

 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 received or paid in
cash during the year
 Examples of noncash charges are depreciation and amortization
o The items reduce net income but are not paid out in cash, so we add them back to
net income when calculating net cash flow
 Deferred taxes are also noncash charges
o In comes instances, companies are allowed to defer tax payments to a later date
even though the tax payment is reported as an expense on the income statement
 Some revenues may not be collected in cash during the year, and these items must be
subtracted from net income when calculated net cash flow

2.6 STATEMENT OF CASH FLOWS

 The statement of cash flows separates a company’s activities into three categories,
operating, investing, and financing, and summarizes the resulting cash balance

Operating Activities
 Focuses on the amount of cash generated (or lost) by the firm’s operating activities
 The section becomes with the reported net income before paying preferred dividends, and
makes several adjustments, beginning with noncash activities
 Noncash Adjustments:
o Some revenues and expenses reported on the income statement are not received or
paid in cash during the year
o Reported taxes often differ from the taxes that are pair, resulting in a deferred
taxes account
 They can occur in many ways, including the depreciation
 Increases in deferred taxes are added to net income when calculating cash
flow, and decreases are subtracted from the net income
 Changes in Working Capital
o Increases in current assets other than cash decrease cash, whereas decreased in
these amounts increase cash

Investing Activities
 Investing activities include transactions fixed assets or short-term financial investments

Financing Activities
 Include raising cash by issues short-term debt, long-term debt, or stock
 Because dividend payments, stock repurchases, and principal payments on debt rude a
company’s cash, such transactions are included
2.7 FREE CASH FLOW
 The cash flow available for distribution to investors
 The intrinsic value of a company’s operations is determined by the steam of cash flows
that the operations will generate now and, in the future,
 Free cash flows is defined as after-tax operating profits minus the total amount of new
investment in working capital and fixed assets necessary to sustain the business
 The way for managers to make their companies more valuable is to increase cash flow
now and in the future
 FCF is the cash flow available for distribution to all the company’s investors after the
company has made all investments necessary to sustain ongoing operations

Net Operating Profit After Taxes (NOPAT)

 Net income does not always reflect the true performance of a company’s operations or
the effectiveness of its operating managers
 A better measurement is net operating profit after taxes, which is the amount of profit a
company would generate if it had no debt and held no financial loses

Net Operating Working Capital

 Short term assets normally used in a company’s operating activities are called operating
current assets
 Non-operating assets are not included when calculating operating current assets
 Current liabilities that arise in the normal course of operations are called operating
current liabilities
 Net operating working capital is defined as the operating current assets minus operating
current liabilities

Total Net Operating Capital

 Total net operating capital is the sum of NOWC and operating long-term assets
 Total investor-supplied capital is defined as the total stock of funds provided by
investors, such as notes payable, long-term bonds, preferred stock, and common equity

Free Cash Flow vs. Net Cash Flow

 Free cash flow is the cash flow actually available for distribution to investors after the
company has made all the investments in fixed assets and working capital necessary to
sustain ongoing operations

The Uses of FCF

1. Pay interest to debtholders, keeping in minds that the net cost to the company is the after-
tax interest expense
2. Repay debt holders
3. Pay dividends to shareholder
4. Repurchase stock from shareholders
5. Buy short-term investment or other nonoperating assets

FCF and Corprate Value

  FCF is the cash available for distribution to investors
 Therefore, the value of a firm primarily depends on its expected future FCFs

Evaluating FCF, NOPAT, and Operating Capital

 One way to determine whether growth is profitable is by examining the return on
invested capital (ROIC)
o Ration of NOPAT to total operating capital
o If the ROIC exceeds the rate of return required by investors, then a negative FCF
is nothing to worry about
 If ROIC is greater that the required rate of return, then the firm is adding value

2.8 MVA AND EVA

Market Value Added (MVA)
 The primary goal of most firms is to maximize shareholders’ wealth
 Shareholder wealth is maximized by maximizing the difference between the market of
the firm’s stock and the amount of equity capital that was supplied by shareholders
 The higher the MVA, the better the job management is doing for the firm’s shareholders

Economic Value Added (EVA)

 EVA focuses on managerial effectiveness in a given year
 EVA represents the residual income that remains after the cost of all capital has been
deducted
 Measures the extent to which the firm has increased in shareholder value
o If managers focus on EVA, this will help ensure that they operate in a manner that
is consistent with maximizing shareholder wealth

Intrinsic Value, MVA, EVA

 If a company has a history of negative EVAs, then its MVA will probably be negative,
and vice versa
 A company with a history of negative EVA could have a positive MVA, provided
investors expect a turnaround in the future

2.9 TAXES
 Cash flows from an asset consist of usable income plus depreciation, and usable income
means income after taxes
 Taxes play a critical role in many financial decisions

Corporate Income Taxes

 Vary based on size, location, and type of income being earned
 Interest and Dividends Paid by a Corporation
o A firm’s operations can be financed with either debt or equity capital
o The interest paid by a corporation is deducted from its operating income to obtain
its taxable income, but dividends are not deductible
 Interest and Dividend Income Received by a Corporation
 o Interest income received by a corporation is taxed at its regular corporate tax rate,
whereas such income earned by a CCPC is taxed at a higher rate than the CCPC’s
regular tax rate
 Depreciation for Tax Purposes
o A company is allowed to deduct from earnings a portion of its capital assets that
is holds
o This is called Capital Cost Allowance
 Corporate Loss Carryback and Carry forward
o Ordinary corporate operating losses can be carried back to each of the preceding 3
years and forward for the next 20 years and used to offset taxable income on those
years

Personal Taxes
 Individual pay taxes at the federal and provincial level
 Taxable Income
o Defined as gross income less allowable expenses and deductions that are spelled
out in the instructions to the tax forms that individuals must file
o Each taxpayer receives a personal tax credit
 Taxes on Capital Gains and Dividend and Interest Income
o If you sell the asset for more than you originally paid, the profit is called a capital
gain
 Capital gains are taxed at ½ the rate of ordinary income
o If you sell it for less, you suffer a capital loss
o Income received by individuals is normally taxed at the same rate as regular
income