2-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Two

Financial Statements,

Taxes and Cash Flow

2-2 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

2.1 The Balance Sheet

2.2 The Income Statement

2.3 Taxes

2.4 Cash Flow

Summary and Conclusions

Chapter Organisation

2-3 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Objectives• Understand the difference between book value (from the

Balance Sheet) and market value.• Understand the difference between net profit (from the Income

Statement) and cash flow.• Explain the differences between the average tax rate, the

marginal tax rate and the flat rate.• Explain the calculation of cash flow from assets, and cash flow

to debtholders and shareholders.

2-4 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Balance Sheet• Shows a firm’s accounting value on a particular date.

• Equation:Assets = Liabilities + Shareholders’ Equity.

• Assets are listed in order of liquidity.

• Net working capital = Current Assets – Current Liabilities.

2-5 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Balance Sheet

Current

Assets

Fixed Assets

1.Tangible fixed assets

2.Intangible fixed assets

NetWorking Capital

Current Liabilities

Non-current Liabilities

Shareholders’ Equity

Total Value of AssetsTotal Value of Liabilities

and Shareholders’ Equity

2-6 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Liquidity• The speed and ease with which an asset can be

converted to cash without significant loss of value.

• Current assets are liquid (e.g. debtors, inventory).

• Non-current assets are relatively non-liquid (e.g. building, equipment, goodwill).

• The more liquid a business is, the less likely it is to experience financial distress, but liquid assets are less profitable to hold.

2-7 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Debt versus Equity• Creditors have first claim on a firm’s cash flow; equity

holders have a residual claim.

• This residual claim is represented in the equation:Shareholder’s equity = Assets – Liabilities.

• Financial leverage or ‘gearing’ is the use of debt in a firm’s capital structure.

• Financial leverage increases the potential reward to shareholders, but also increases the potential for financial distress and business failure.

2-8 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Market Value versus Book Value• Generally Accepted Accounting Principles (GAAP)

require audited financial statements to show assets at historical cost or book value.

• Revaluations of assets to fair value are permitted.

• The value of a firm relates to market value, or the price that could be obtained in the current market place.

2-9 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Market Value versus Book Value

ABC Company has non-current assets with a book value of $1,900 but they have an appraised market value of $2,400. Net working capital has a book value of $1,500, but if all current accounts were liquidated, the company would collect $1,800. ABC Company has $2,000 in long-term debt—both book value and market value.

2-10 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Market Value versus Book Value

ABC Company

Book Market Book Market

Assets Liabilities

Net working capital

$1 500 $1 800Long-term debt

$2 000 $2 000

Non-current assets

$1 900 $2 400 Equity $1 400 $2 200

Total $3 400 $4 200 Total $3 400 $4 200

2-11 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Income Statement• Measures a firm’s earnings over a period of time.

• Equation:Revenues – Expenses = Profit.

• Profit is often expressed on a per-share basis and called earnings per share (EPS).

• The difference between net profit and cash dividends is called retained earnings, which is added to the retained earnings account in the Balance Sheet.

2-12 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Income Statement

Revenue $4 000Cost of Goods Sold 2 800Depreciation 200EBIT 1 000Interest 200Taxable Income 800Tax 240Net Profit $560Dividends 260Addition to R/E $300

2-13 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Balance Sheet

Beg End Beg End

Cash $100 $190 A/P $100 $150

A/R 200 260 N/P 200 200

Inv 300 330 C/L $300 $350

C/A $600 $780 NCL $400 $420

NCA $400 $600 Cap 50 60

R/E 250 550

$300 $610

Total $1000 $1380 Total $1000 $1380

2-14 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Approved Accounting Standards and the Income Statement

• The realisation principle is to recognise revenue at the time of sale.

• Costs are recorded according to the matching principle; that is, revenues are identified and costs associated with these revenues are matched and recorded.

• As a result of the way revenues and costs are realised, the figures shown on the Income Statement may not be representative of the cash inflows and outflows that occurred during a period.

2-15 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Non-cash Items• Expenses charged against revenues that do not

directly affect cash flow, such as depreciation, are called ‘non-cash items’.

• The depreciation deduction is another application of the matching principle.

• To effectively estimate market value, cash flows must be separated from non-cash accounting entries.

2-16 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Time and Costs• In the long run, all business costs are variable. In the short

run, some costs are effectively fixed (e.g. rates) and other costs (e.g. payments to suppliers) are variable.

• The distinction between fixed and variable costs is sometimes important to the financial manager but the Income Statement does not provide a good guide.

• This is because accountants tend to classify costs as either product costs (e.g. raw materials and manufacturing overhead) or period costs (reported as selling, general and administrative expenses).

2-17 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Taxes• Can be one of the largest cash outflows that a firm

experiences.

• The size of the tax bill is determined by the Income Tax Assessment Act 1997 (Tax Act).

• The Tax Act is the result of political, not economic, forces.

2-18 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Tax Rates• The average tax rate is the total tax bill divided by

taxable income; that is, the percentage of income that goes in taxes.

• The marginal tax rate is the extra tax paid if one more dollar is earned.

• A flat rate is where there is only one tax rate that is the same for all income levels.

• It is the marginal rate that is relevant for most financial decisions.

2-19 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Personal and Corporate Tax Rates for the Year 2006–2007

Personal rates Taxable income

Marginal tax rate

$0–6 000 Nil

6 001–25 000 15%

25 001–75 000 30%

75 001–150 000 40%

150 001 + 45%

Company rates Private and public companies (other than life assurance companies)

Flat tax rate 30%

2-20 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Tax Rates• An individual has a taxable income of $35,000.

• Total tax liability is $5,850 (based on the 2006–2007 tax scales).

• The average tax rate is 16.7 per cent.

• The marginal tax rate is 30 per cent.

2-21 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Cash Flow from Assets• Equation:

Cash flow from assets = cash flow to debtholders + cash flow to shareholders.

• The cash flow identity or equation states that the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm.

2-22 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Cash Flow from Assets• The total cash flow from assets consists of:

– Operating cash flow—the cash flow that results from day-to-day activities of producing and selling; less

– Capital spending—the net spending on non-current assets; less

– Additions to net working capital (NWC)—the amount spent on net working capital.

2-23 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Cash Flow from Assets

• Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes.

• Net capital spending = Ending non-current assets – Beginning non-current assets + Depreciation.

• Additions to NWC = Ending NWC – Beginning NWC.

2-24 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Cash Flow to Debtholders and Shareholders

• The cash flow to debtholders includes any interest paid less the net new borrowing.

• The cash flow to shareholders includes dividends paid out by a firm less net new equity raised.

2-25 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example―Balance Sheet ($000s)

Assets (‘000s) 2006 2007

Current assets

Cash

Accounts receivable

Inventory

Total

Non-current assets

Net plant and equipment

TOTAL ASSETS

$ 90

520

640

$ 1 250

1 970

$3 220

$ 100

620

770

$ 1 490

2 200

$3 690

2-26 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example―Balance Sheet ($000s)

Liabilities and equity (‘000s) 2006 2007

Current liabilities

Accounts payable

Notes payable

Total

Long-term debt

Shareholders’ equity

Ordinary shares

Retained earnings

Total

TOTAL LIABILITIES AND EQUITY

$ 420

220

$ 640

$ 410

580

1 590

$2 170

$3 220

$ 520

350

$ 870

$ 450

580

1 790

$2 370

$3 690

2-27 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example―Income Statement ($000s)

Sales $1 420.00Cost of goods sold 960.00Depreciation 60.00EBIT $400.00Interest 40.00Taxable income 360.00Tax 108.00Net profit $252.00Dividends 52.00Addition to retained earnings $200.00

2-28 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example―Cash Flow From AssetsOperating cash flow:

EBIT $ 400.00+ Depreciation + 60.00– Taxes – 108.00

$352.00

Change in net working capital:Ending net working capital $ 620.00

– Beginning net working capital 610.00 $ 10.00

Net capital spending:Ending non-current assets $ 2 200.00– Beginning non-current assets – 1 970.00+ Depreciation + 60.00

$290.00

Cash flow from assets: $ 52.00

2-29 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example―Cash Flow to Debtholders and Shareholders

Cash flow to debtholders:Interest paid $ 40.00– Net new borrowing – 40.00 $ 0.00

Cash flow to shareholders:Dividends paid $ 52.00– Net new equity raised 0.00 $52.00

Cash flow to debtholders and shareholders $52.00

2-30 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Summary and Conclusions• The book values on an accounting Balance Sheet

can be very different from market values.• Net profit as it is computed on the Income Statement

is not a cash flow, a primary reason being the deduction of depreciation (a non-cash expense).

• Marginal and average tax rates can be different. However it is the marginal tax rate that is relevant for most financial decisions.

• Cash flow from assets equals cash flow to debtholders and shareholders.

• It is important not to confuse book values with market values, and accounting income with cash flow.