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CHAPTER 2
Understanding Financial
Statements, Taxes, and Cash Flows
CHAPTER ORIENTATION
In this chapter, we review the contents and meaning of a firm’s income statement and balance sheet. We also look very carefully at how to compute a firm’s cash flows from a finance perspective, which is called free cash flows.
CHAPTER OUTLINE
I. Basic Financial Statements A. The Income Statement
- The income statement reports the results from operating the business for a period of time, such as a year.
- It is helpful to think of the income statement as comprising five types of activities: a. Selling the product b. The cost of producing or acquiring the goods or services sold c. The expenses incurred in marketing and distributing the product or service to the customer along with administrative operating expenses d. The financing costs of doing business: for example, interest paid to creditors and dividend payments to the preferred stockholders e. The taxes owed based on a firm’s taxable income
- An example of an income statement is provided in Table 2-1 for the Harley-Davidson Corporation.
B. The Balance Sheet
- The balance sheet provides a snapshot of the firm’s financial position at a specific point in time, presenting its asset holdings, liabilities, and owner-supplied capital. a. Assets represent the resources owned by the firm (1) Current assets - consisting primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses (2) Fixed or long-term assets – comprising equipment, buildings, and land (3) Other assets – all assets not otherwise included in the firm’s current assets or fixed assets, such as patents, long-term investments in securities, and goodwill b. The liabilities and owners’ equity indicate how the assets are financed. (1) The debt consists of such sources as credit extended from suppliers or a loan from a bank. (2) The equity includes the stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet.
- The balance sheet is not intended to represent the current market value of the company, but rather reports the historical transactions recorded at their costs.
- Balance sheets for the Harley-Davidson Corporation are presented in Table 2-2. II Computing a Company’s Taxes A. Types of taxpayers
- Sole proprietors a. Report business income on personal tax returns b. Pay taxes at personal tax rate
- Partnerships a. The partnership reports income but does not pay taxes b. Each partner reports his or her portion of income and pays the corresponding taxes.
D. Calculating Free Cash Flows: An Asset Perspective
- A firm's free cash flows, from an asset perspective , is the after-tax cash flows generated from operations less the firm's investments in assets. It is this same amount that will be available for distributing to the firm’s investors. That is, a firm's free cash flows for a given period is equal to: After-tax cash flow from operations less the investment (increase) in net operating working capital less investments in fixed assets (plant and equipment) and other assets.
- After-tax cash flows from operations as follows: Operating income (earnings before interest and taxes) + depreciation = Earnings before interest, taxes, depreciation and amortization (EBITDA) - cash tax payments = After-tax cash flows from operations
- The increase in net operating working capital is equal to the: current assets change in
- (^) currentliabilitie s changeinnoninterest- bearing
- Investments in fixed assets includes the change in gross fixed assets and any other balance sheet assets not already considered.
E. Calculating Free Cash Flows: A Financing Perspective
- Free cash flows from a financing perspective are equal to:
- Free cash flow from an asset perspective must equal free cash flow from a financing perspective.
- Free cash flows from a financing perspective are simply the net cash flows received by the firm’s investors, or if negative, the cash flows that the investors are paying into the firm. In the latter situation where the investors are putting money into the firm, it is because the firm’s free cash flow from assets is negative, thereby requiring an infusion of capital by the investors. IV. Financial Statements and International Finance A. Many countries have different guidelines for firms to use in preparing financial statements. For example, a $1 of earnings in the United States is not the same as 1.10 Euro (the equivalent of a U.S. dollar based on the exchange rate). The differences are due to the two countries having different Generally Accepted Accounting Principles which guide their firms’ financial reporting. B. As a result of this situation, the International Accounting Standards Committee (IASC), a private body supported by the worldwide accounting profession, is trying to develop international financial-reporting standards that will minimize the problem. In spite of the work to standardize accounting practices around the world, the U.S. accounting profession has rejected efforts toward international standards. At this time, foreign companies seeking to list their shares in the United States must follow U.S. accounting standards. Interest payments to creditors plus dividends paid to stockholders
- decrease in debt principal or
- increase in debt principal
2-4 Once preferred shares are sold, dividends are paid or accrued each year based upon preferred dividends (i.e., the percentage of the preferred stock’s par value paid as dividends) agreed to at the selling date. However, these dividends affect the income statement only. Common stock dividends, which may vary from year to year, also affect the income statement; however, the investment of common shareholders varies with the net addition to (or reduction from) retained earnings from year to year. The net addition to retained earnings equals the difference in the period’s net income and common dividends paid. Thus, the common equity section of the balance sheet (par value of common stock, paid-in capital and retained earnings) varies from year to year due to changes in the retained earnings portion of the firm’s common equity. 2.5 Net working capital is the firm’s liquid assets (current assets) less its short-term debt. Accountants include all short-term debt when computing net working capital; however, in computing free cash flows, we only subtract the noninterest-bearing debt, such as accounts payables and accruals. With this latter method, we are only considering the assets and liabilities that are changing as a result of the normal operating cycle of the business—beginning with the time inventory is purchased on credit to the time the firm collects the cash from its customer. Gross working capital is the sum of current assets, while net working capital is the difference between current assets and current liabilities. As already suggested, we have both interest-bearing debt and noninterest-bearing debt. The former is debt where the lender is paid interest for providing us the money. Noninterest-bearing debt charges no interest because the “lender” is really a supplier or an employee to whom we owe money, but they are not requiring the firm to pay interest. 2-6. A firm could have positive cash flows but still be in trouble because it has negative cash flows from operations. The positive cash flows would then be the result of the firm reducing its investments in working capital or long-term assets. Such a situation means that the company is not earning a satisfactory rate of return on its investments. Another company could have very attractive rates of return on its assets, but be growing so fast that the large investments in working capital and long-term assets result in negative cash flows. In this latter case, management is simply investing in the future. As the rate of growth slows, positive cash flows will occur. 2-7. Examining only the income statement and the balance sheet fails to tell us how the firm is using its cash, which is a critical issue for any company. 2-8. Free cash flows from assets equal the cash flows that are generated by the company that are then distributed to (if positive) or received from (if negative) the firm’s creditors and investors. It looks at cash flows from the firm’s perspective. Free cash flows from a financing perspective looks at the cash flows from the investors’ viewpoint. It indicates how the investor received cash in the form of interest, dividends, debt repayment or stock repurchase and how the investor infused cash in the form of additional debt or stock purchase. Whatever the company does is the exact opposite of what the investor receives or pays. That is, if a company distributes $100 in cash to the investors, then the investors must receive $100 as well. They have to be equal.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
2-1A. Belmond, Inc. Balance Sheet December 31, 2003 ASSETS Current assets Cash $ 16, Accounts receivable 9, Inventory 6, Total current assets $ 32, Gross buildings & equipment $122, Accumulated depreciation (34,000) Net buildings & equipment $ 88, Total assets $120, LIABILITIES AND EQUITY Liabilities Current Liabilities Notes payable $ 600 Accounts payable 4, Total current liabilities $ 5, Long-term debt 55, Total liabilities $ 60, Equity Common stock $ 45, Retained earnings 15, Total equity $ 60, Total liabilities and equity $120, Belmond, Inc. Income Statement For the Year Ended December 31, 2003 Sales $ 12, Cost of goods sold 5, Gross profits $ 7, General & admin expense $ 850 Depreciation expense 500 Total operating expense $ 1, Operating income (EBIT) $ 5, Interest expense 900 Earnings before taxes $ 4, Taxes 1, Net income $ 3,
2-3A. Delaney, Inc. - Corporate Income Tax
2-5A. Pamplin, Inc. Free cash flows from an asset perspective: Operating income (EBIT) $ 360, Depreciation 200, EBITDA $ 560, Tax expense $ 120, Less change in tax payable - Cash taxes $ 120, After-tax cash flows from operations $ 440, Change in net working capital Change in current assets: Change in cash $ (50,000) Change in accounts receivable (25,000) Change in inventory 75, Change in current assets $ - Change in noninterest-bearing current debt: Change in accounts payable $ (50,000) Change in net operating working capital $ (50,000) Change in long-term assets: Purchase of fixed assets (400,000) Free cash flows - asset perspective $ (10,000) Free cash flows from a financing perspective: Interest expense $ (60,000) Less change in interest payable - Interest paid to lenders $ (60,000) Repayment of long-term debt - Increase in short-term debt 150, Common stock dividends paid to owners (80,000) Free cash flows - financing perspective $ 10, Note: The dividends were computed by comparing net income against the change in retained earnings. Net income was $180,000, but retained earnings increased only by $100,000; thus the balance was distributed in the form of dividends. Pamplin, Inc. had an after-tax operating cash flow of $440,000. Additionally, Pamplin acquired further financing though increasing short-term debt by $150,000. This cash was mainly used to purchase fixed assets of $400,000. The remainder was used to decrease payables to suppliers by $50,000, pay interest of $60,000, and pay dividends back to the investors of $80,000.
2-7A. Abrams Manufacturing Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Operating Income $ 54, Depreciation 26, EBITDA $ 80, Tax expense $ 16, Less change in tax payable - Cash taxes 16, After-tax cash flows from operations $ 64, Step 2: Change in net operating working capital Change in current assets: Change in cash $ 11, Change in accounts receivables 6, Change in inventories (12,000) Change in prepaid expenses - Change in current assets $ 5, Change in noninterest-bearing current debt: Change in accounts payables $ 5, Change in accrued liabilities (5,000) Change in noninterest-bearing current debt: $ - Change in net operating working capital $ (5,000) Step 3: Change in long-term assets Purchase of fixed assets $ 73, Change in other assets - Net cash used for investments $ (73,000) Asset free cash flows $ (14,000) Free cash flows from a financing perspective: Interest paid to investors $ (4,000) Less change in interest payable - Interest received by investors $ (4,000) Decrease in long-term debt (mortgage payable) (70,000) Increase in preferred stock 120, Preferred stock dividends (10,000) Common stock dividends (22,000) Financing free cash flows $ 14, Abrams generated cash through an after-tax operating profit of $64,000 and issuing preferred stock of $120,000. This cash was primarily used to pay down debt of $70,000 and purchase fixed assets of $73,000. Investors also received cash back through dividends of $32,000 and interest of $4,000. Abrams also increased current assets in total by $5,000 by increasing cash and accounts receivable while decreasing inventory.
2-8A. J.T. Williams Williams generated $224,210 in after-tax operating cash flows(including other income). To further increase cash flow, accounts payable and accrued expenses were increased by $1,662 and $32,283, respectively. They also increased their short-term debt by $30,577, increased their long-term debt by $7,018 and issued more common stock for $61,806. They used the operating cash flow and increased financing to purchase $58,297 in inventory and other current assets and purchased $308,336 in fixed assets, investments, and other assets. While Williams generated a positive after-tax cash flow from operations, investors and creditors infused $99, into the operations to finance the increases in assets. Williams needs to analyze whether the investors are receiving an acceptable return on their investments. It should be careful not to become over-capitalized during this time of rapid growth. 2-9A. Johnson, Inc. Johnson incurred a loss of $450,571 in after-tax operating cash flows(including other losses). In addition, interest expense of $87,966 was paid to cover the company’s current debt. The company increased their cash reserve, inventory and other current assets by $587,924. Fixed assets, investments, and other assets increased in net by $1,420,113. To finance this negative free cash flow, Johnson increased their long- term debt by $1,118,198, increased short-term debt and other current liabilities by $227,607, and issued more common stock in the amount of $851,016. Accounts payable to suppliers were also increased by $349,753. While investors in Internet companies have been satisfied with repeated annual losses, Johnson should look for ways to decrease debt, produce positive future cash flows, and provide an acceptable rate of return to its investors.
SOLUTION TO INTEGRATIVE PROBLEM
Davis & Howard had a successful year bringing in positive after-tax cash flows from operations(including other income) of $174,034. This money was used in part to increase current assets and fixed assets of $77,100 and $61,873, respectively. Investments also increased $2,730 and other assets were sold for $9,881. The noninterest-bearing current debt also increased by $59,062 to help finance the increase in current assets. However, the increase in current assets was substantially due to an increase of $57,467 in accounts receivable. Management should take measures to reduce the average collection period or utilize other tools to maintain control of this asset. Free cash flows of $101,274 were distributed to investors. Interest expense of $17,024 was paid for the current debt. Davis & Howard decreased their debt principal(including long-term debt, other liabilities, and notes payable) by a total of $27,380. Stockholders were paid dividends of $26,912. Finally, Davis & Howard used their free cash flows to repurchase common stock for $29,958.
2-2B. Sabine Mfg. Company Balance Sheet December 31, 2003 ASSETS Current assets Cash $ 90, Accounts receivable 150, Inventory 110, Total current assets $ 350, Machinery and Equipment $ 700, Accumulated depreciation (236,000) Net buildings & equipment $ 464, Total assets $ 814, LIABILITIES AND EQUITY Liabilities Current Liabilities Accounts payable $ 90, Short-term notes payable 90, Total current liabilities $ 180, Long-term debt 160, Total liabilities $ 340, Equity Common stock $ 320, Retained earnings Prior year 84, Current year 70, Total equity $ 474, Total liabilities and equity $ 814, Sabine Mfg. Company Income Statement For the Year Ended December 31, 2003 Net Sales $ 900, Cost of goods sold 550, Gross profits $ 350, Operating expense 280, Net income $ 70,
2-3B. Cook, Inc. - Corporate Income Tax
- Sales $4,000,
- cash operating expenses 2,400, Cost of goods sold and
- Depreciation expense 100,
- Operating profit $1,500,
- Interest expense 150,
- Taxable Income $1,350, - $50,000 x 0.15 = $7, Tax Liability: - 25,000 x 0.25 = 6, - 25,000 x 0.34 = 8, - 235,000 x 0.39 = 91, - 1,015,000 x 0.34 = 345, - $1,350,000 $459,
- Sales $ 6,000, 2-4A. Potts, Inc. - Corporate Income Tax
- cash operating expenses 5,600, Cost of goods sold and
- Operating profit $ 400,
- Interest expense 30,
- Taxable Income $ 370, - $50,000 x 0.15 = $7, Tax Liability: - 25,000 x 0.25 = 6, - 25,000 x 0.34 = 8, - 235,000 x 0.39 = 91, - 35,000 x 0.34 = 11, - $370,000 $125,
- Sales $ 3,500,
- cash operating expenses 2,500, Cost of goods sold and
- Depreciation expense 100,
- Operating profit $ 900,
- Interest expense 165,
- Taxable Income $ 735, - $50,000 x 0.15 = $ 7, Tax Liability: - 25,000 x 0.25 = 6, - 25,000 x 0.34 = 8, - 235,000 x 0.39 = 91, - 400,000 x 0.34 = 136, - $735,000 $249,
- Sales $7,000, 2-4B. Rose, Inc. - Corporate Income Tax
- cash operating expenses 6,600, Cost of goods sold and
- Operating profit $400,
- Interest expense 40,
- Taxable Income $ 360, - $50,000 x 0.15 = $ 7, Tax Liability: - 25,000 x 0.25 = 6, - 25,000 x 0.34 = 8, - 235,000 x 0.39 = 91, - 25,000 x 0.34 = 8, - $ 360,000 $122,
Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes $ 110, Plus interest expense 10, EBIT 120, Depreciation 30, EBITDA $ 150, Tax expense $ 27, Less change in tax payable - Cash taxes 27, After-tax cash flows from operations $ 122, Step 2: Change in net operating working capital Change in current assets: Change in cash $ 1, Change in marketable securities 200 Change in accounts receivable (4,000) Change in prepaid rent (100) Change in inventory 43, Change in current assets $ 40, Change in noninterest-bearing current debt: Change in accounts payable $ 7, Change in accrued expenses (1,000) Change in noninterest-bearing current debt: $ 6, Change in net operating working capital $ (34,100) Step 3: Change in long-term assets Purchase of fixed assets $ 34, (Change in net fixed assets
- depreciation expense) Change in other assets - Net cash used for investments $ (34,000) Asset free cash flows $ 54, Free cash flows from a financing perspective: Interest expense $ (10,000) Less change in interest payable - Interest paid to lenders $ (10,000) Decrease in notes payable (3,000) Decrease in long-term debt (10,000) Common stock dividends (31,800) Financing free cash flows $ (54,800)
RPI had positive after-tax operating cash flows of $122,900. As a result, RPI made a decision to evenly split the cash flow between distribution to investors and investing back into the company. Net operating capital increased by $34,100, mostly in the area of inventory which increased by $43,000. Fixed assets of $34, were also purchased. The asset free cash flow of $54,800 was distributed back to investors through interest of $10,000, debt repayments of $13,000, and dividends of $31,800. 2-7B. Cameron Co. Free cash flows from an asset perspective: Step 1: Compute after-tax cash flows from operations Earnings before taxes $ 72, Plus interest expense 5, EBIT 77, Depreciation 26, EBITDA $ 103, Tax expense $ 30, Less change in tax payable - Cash taxes 30, After-tax cash flows from operations $ 73, Step 2: Change in net operating working capital Change in current assets: Change in cash $ (19,000) Change in accounts receivable 6, Change in prepaid expenses - Change in inventory (22,000) Change in current assets $ (35,000) Change in noninterest-bearing current debt: Change in accounts payable $ (5,000) Change in accrued liabilities (5,000) Change in noninterest-bearing current debt: $ (10,000) Change in net operating working capital $ 25, Step 3: Change in long-term assets Purchase of fixed assets $ 63, Change in other assets - Net cash used for investments $ (63,000) Asset free cash flows $ 35, Free cash flows from a financing perspective: Interest expense $ (5,000) Less change in interest payable - Interest paid to lenders $ (5,000) Decrease in mortgage payable (60,000) Increase in preferred stock 70, Preferred stock dividends (8,000) Common stock dividends (32,000) Financing free cash flows $ (35,000)
