Lecture Essentials of corporate finance (2/e) – Chap 2: Financial statements, taxes and cash flow

Financial statements, taxes
and cash flow
Chapter 2


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 © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-2


Chapter outline
• The balance sheet
• The income statement
• Taxes
• Cash flow

Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-3


The balance sheet
• The balance sheet is a snapshot of a firm’s assets
and liabilities at a given point in time.
• Assets: The left-hand side:
− Current or fixed
− In order of decreasing liquidity
• Liabilities and owners’ equity: The right-hand side:
– Current or long term
– In ascending order of when due to be paid
• Balance sheet identity

Assets = Liabilities + Shareholders’
equity
Copyright ©2011
McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-4


The balance sheet (cont.)
Figure 2.1

Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.

Slides prepared by David E. Allen and Abhay K. Singh

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The balance sheet (cont.)
• Net working capital
– Current assets minus current liabilities
– Usually positive for a healthy firm

• Liquidity
− Speed and ease of conversion to cash
without significant loss of value
− Valuable in avoiding financial distress

• Debt versus equity
− Shareholders’ equity = Assets - Liabilities
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-6


Oz Company balance sheet
Table 2.1

Visit au.finance.yahoo.com for more
financial statements and balance
sheets

Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-7


Market value vs book value
• Market value is the price at which
assets, liabilities or equity can actually
be bought or sold.
• The balance sheet provides the book
value of assets, liabilities and equity.
• Market value and book value are often
very different. Why?
• Which is more important to the
decision-making process?
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-8


Battler Company
Example 2.2
Battler Company
Balance sheets
Book value versus market value

Book

Market

Assets
NWC

400

NFA

700
$1 100

Book

Market

Liabilities and Shareholders’
equity
600 LTD
1 000 SE
$1 600

Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

500

500

600

1 100

$1 100

$1 600

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The income statement
• The income statement measures performance over a
specified period of time (period, quarter, year).
• Report revenues first and then deduct any expenses
for the period.
• End result = Net income = ‘Bottom line’
– Dividends paid to shareholders
– Addition to retained earnings
• Income statement equation:

Net income = Revenue - Expenses
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-10

OZ Company income
statement
Table 2.2

Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-11


The income statement
(cont.)
• AAS and the income statement
– The matching principle
• Recognise revenue when it is fully earned.
• Matching expenses required to generate
revenue to the period of recognition

• Non-cash items
– Expenses charged against revenue
that do not affect cash flow.
– Most important of these is
depreciation.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-12

The income statement
(cont.)
• Time and costs
– Fixed or variable costs
– Not obvious on income statement

• Earnings management
– Smoothing earnings
– Wriggle room
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-13


Example: Work the Web
• Most Australian companies post their
annual reports on their websites. Look
for them in the investor or shareholder
areas.
• Go to companies’ websites and see
what kinds of financial reports you can
find.
• Example: Virgin Blue
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-14


Taxes
• The one thing we can rely on with taxes is that
they are always changing.
• Tax bill depends on tax code, which can be
amended by political will.
• Corporate tax in Australia and New Zealand
– Flat rate tax (currently 30%)

• Marginal vs average tax rates
– Marginal–the percentage paid on the next dollar
earned
– Average–the tax bill/taxable income

• Other taxes
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-15


Personal tax rates (2009/2010)
Table 2.3

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.

Slides prepared by David E. Allen and Abhay K. Singh

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Example: Marginal vs average
tax rates
• Bony Bushman has a taxable income
in Australia of $96 000.
– What is his tax bill?
– What is his average tax rate ?
– What is his marginal tax rate?

Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-17


Example: Marginal vs average
tax rates
Personal tax rate
Taxable income
Rate
$0-6000
Nil
6001-35000
15%
35001-80000

30%
80001-180000
38%
18000145%
Total

Tax calculation
Taxable income Tax liability
6000
0
29000
4350
45000
13500
16000
6080

96000

Average tax
rate
Marginal tax rate
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

23930
24.9270833%
38%
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Taxation of dividends:
An imputation system
• Major effect is that the double taxation of
company profits is negated.
• Company advises the shareholder of the
amount of company tax already paid on
the dividend.
• Shareholder then adds this amount of tax
to the cash dividend that they have
received and pays personal tax on the
grossed-up amount.
• Shareholder receives a tax (franking)
credit equivalent to the amount of tax paid
by the company.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-19


Effect of a $700 dividend fully
franked at 30% tax rate—Example
2.5

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-20


Cash flow
• Cash flow is some of the most important information
that a financial manager can derive from financial
statements.
• The difference between the number of dollars that
come in and the number that go out.
• The statement of cash flows does not provide us with
the same information that we are looking at here.
• Cash flow identity

Cash flow from assets = Cash flow to creditors +
Cash flow to shareholders
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-21


Cash flow (cont.)
• Cash flow from assets = Operating cash flow –
Net capital spending – Changes in net working
capital.
• Operating cash flow
– Cash generated from a firm’s normal business
activities

• Capital spending
– Money spent on fixed assets less money received
from the sale of fixed assets

• Change in net working capital
– Net increase in current assets over current
liabilities
Copyright
©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-22


Cash flow (cont.)
• Free cash flow
– Different from cash flow from assets
– Cash that the firm is free to distribute to
creditors and shareholders because it is not
needed for working capital or fixed asset
investments

• Cash flow to creditors
– A firm’s interest payments to creditors less net
new borrowings

• Cash flow to shareholders
– Dividends paid out by a firm less net new

equity raised
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

2-23


OZ Company example
• 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
• CF to creditors (B/S and I/S) = Interest paid –
Net new borrowings = $24
• CF to stockholders (B/S and I/S) = Dividends
paid – Net new equity raised = $63
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2011
McGraw-Hill
Australia
Pty Ltd
• CFFA
=
24
+

63
=
$87
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
2-24
Slides prepared by David E. Allen and Abhay K. Singh


Cash flow summary
Table 2.5

Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

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