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Chapter 2

• Financial Statements,
Taxes, and Cash Flow

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Chapter Outline

• The Balance Sheet

• The Income Statement
• Taxes
• Cash Flow

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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
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First: The Balance Sheet

• The balance sheet is a snapshot of the firm’s
assets and liabilities at a given point in time
• Assets: The Left-Hand Side
• Liabilities and Owners’ Equity: The Right-
Hand Side
• Balance Sheet Identity or Equation
Assets = Liabilities + Stockholders’ Equity

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Figure 2.1

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NET WORKING CAPITAL

Whaling’s Boats reports the following account
balances: inventory of $16,200, equipment of
$36,200, accounts payable of $9,500, cash of
$1,200, and accounts receivable of $12,400. How
much does the firm have in net working capital?
a. $14,500
b.$20,300
c. $39,300
d.$56,500

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Net working capital = Current assets- Current

liabilities
(inventory $16,200 + cash $1,200 + accounts
receivable $12,400) – (accounts payable $9,500)
= $ 20300

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LONG-TERM DEBT

Jensen, Inc., has current assets of $3,600, current

liabilities of $4,800, and total assets of $17,200.
Owner’s equity is $11,000. What is the value of
the long-term debt?
a. $1,400
b.$2,600
c. $5,000
d.$6,200

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The long-term debt = Total assets - Current

liabilities - Owner’s equity
$17,200 - $4,800 - $11,000 = $ 1400

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RETAINED EARNINGS
The Boardwalk Boutique has beginning retained
earnings of $32,600. For the year, the company
suffered a net loss of $1,300 and paid out dividends
of $500. The company also issued $2,500 worth of
new stock. What is the value of the retained
earnings account at the end of the year?
a. $28,300
b.$30,700
c. $30,800
d.$33,300
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SHAREHOLDERS’ EQUITY

Grunzel Potters, Inc., has net working capital of

$2,100, net fixed assets of $23,600, current
liabilities of $1,800, and long-term debt of $14,700.
What is the value of the shareholders’ equity?
a. $6,800
b. $9,200
c. $11,000
d. $12,800

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Net working capital = Current assets – Current

liabilities
$2,100 = Current assets - $1800
Current assets = $2100 + $1800 = $3900
Total assets = Fixed assets + Current assets
= $23600 + $3900 = $27500
Total liabilities = $1800 + $14700 = $16500
Shareholders’ equity = Total assets - Total liabilities
= $27500 - $16,500 = $11000

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U.S. Corporation Balance Sheet

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Slide 25 Example: U.S. Corporation
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Thinking Questions

1- What is the relationship between the

decisions made by financial managers and the
values that subsequently appear on the firm’s
balance sheet?
2- What is the difference between the owners’
equity and retained earnings.

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There are three important concepts to keep

in mind when examine a balance sheet:

1- Liquidity
2- Debt Versus Equity
3- Market vs. Book Value

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Second: Income Statement

• The income statement is more like a video of the
firm’s operations for a specified period.
• the income statement reflects investment decisions
in the “top half,” from sales to EBIT. Financing
decisions are reflected in the “bottom half,” from
EBIT to net income and earnings per share.
• You generally report revenues first and then deduct
any expenses for the period

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U.S. Corporation Income Statement

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Example: U.S. Corporation Slide 25
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INCOME STATEMENT

Bernie’s, Inc., has sales of $391,000, costs of

$298,000, depreciation expense of $54,000, and
interest paid of $16,300. The tax rate is 35%. How
much net income did Bernie’s earn for the period?
a. $7,945
b.$8,355
c. $12,655
d.$14,755

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Sales 4391,000
Cost of sales (298,000)
Depreciation ($54,000)
EBIT $39,000
Interest ($16,300)
Taxable income $22,700
Tax ($7,945)
Net income $14,755

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INCOME STATEMENT

Lester’s added $5,040 to retained earnings last year,

which was derived from sales of $88,000. The
company has costs of $62,400, dividends of $2,500,
and interest paid of $1,500. The tax rate is 35%.
What is the amount of the depreciation expense?
a. $11,000
b.$11,600
c. $12,500
d.$13,100

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Sales 88,000
Cost of sales (62,400)
Depreciation ($12,500)
EBIT $13,100
Interest ($1,500)
Taxable income $11,600
Tax ($4,060)
Net income $7,540
Retained earnings $5,040
Dividends $2,500

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The financial manager needs to keep

three things in mind
1- Matching principle: GAAP say to show
revenue when it accrues and match the
expenses required to generate the revenue
2- Noncash Items: The largest noncash
deduction for most firms is depreciation. It
reduces a firm’s taxes and its net income.
Noncash deductions are part of the reason that
net income is not equivalent to cash flow.
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3- Time and Costs: Distinguishing between

fixed and variable costs is important, at time,
for estimating cash flows.
Accountants tend to classify costs as either
product costs or period costs

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Third: Marginal vs. average tax rates

• Marginal – the percentage paid on the next
dollar earned
• Average – the tax bill / taxable income
• The average tax rate is the correct rate to
apply to before-tax profits.
• The marginal tax rate is the appropriate
rate to evaluate the cash flows that would
be generated from a new investment,
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Example: Marginal Vs. Average Rates

Suppose taxable income is $150,000. What are the
average tax rate and 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
10,000,001 – 15,000,000 35
15,000,001 – 1,333,333 38
18,333,334 + 35
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•15(50,000) = 7,500
•.25(25,000) = 6,250
•.34(25,000) = 8,500
•.39(50,000) = 19,500
Total 41,750

Average tax rate = 41,750 /

150,000 =27.8%

Marginal tax rate = 39%

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AVERAGE TAX RATE

Holbotton, Inc., owes a total of $11,354 in taxes for

this year. Their taxable income is $51,609. If
Holbotton earns $100 more in income, they will owe
an additional $34 in taxes. What is Holbotton’s
average tax rate on income of $51,709?
a. 21 percent
b.22 percent
c. 34 percent
d.35 percent

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$11,354 taxes for taxable income = $51,609

additional $34 taxes for $100 more in income
Total taxes = = $11,354 + $34 = $11,388
Total taxable income = $51,609 + $100 =
$51,709
Average tax rate on income = $11,388/ $51,709 =
22%

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MARGINAL TAX RATE

Buster’s Brooms owes $36,485 in tax on a taxable

income of $136,500. The company has determined
that they will owe $38,435 in tax if their taxable
income rises to $141,500. What is the marginal tax
rate at this level of income?
a. 15 percent
b. 25 percent
c. 39 percent
d. 38 percent

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$36,485 in tax on a taxable income of $136,500.

$38,435 in tax if their taxable income rises to
$141,500.

The marginal tax rate = (38,435 – 36,485)/

141,500 – 136,500) =
1950/5000 = 39%

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Fourth: The Concept of Cash Flow

• Cash flow is one of the most important

pieces of information that a financial
manager can derive from financial
statements
• We will look at how cash is generated from
utilizing assets and how it is paid to those
that finance the purchase of the assets

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Cash Flow Equation

• Cash Flow From Assets (CFFA) = Cash Flow to
Creditors + Cash Flow to Stockholders
• Cash Flow From Assets = Operating Cash Flow – Net
Capital Spending – Changes in NWC
• Operating cash flow = EBIT + depreciation – taxes
• Net capital spending = ending fixed assets – beginning
fixed assets + depreciation
• Changes in NWC = ending NWC – beginning NWC

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Cash Flow to Creditors + Cash Flow to

Stockholders
•Cash flow to creditors = interest paid – net new
borrowing (ending long-term debt – beginning
long-term debt)
• Cash flow to stockholders = dividends paid – net
new equity raised (ending common stock, APIC &
Treasury stock – beginning common stock, APIC &
Treasury stock)

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Cash Flow Summary

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Example: U.S. Corporation

• CFFA = OCF – NCS – Change in NWC
• OCF = EBIT + depreciation – taxes
• 694 + 65 – 212 = $547
• NCS = ending net fixed assets – beginning net
fixed assets + depreciation
• 1,709 – 1,644 + 65 = $130
• Changes in NWC = end.NWC – begin. NWC
• (1,403 – 389) – (1,112 – 428)
• 1,014 – 684 = $330
• CFFA = 547 – 130 – 330 = $87
U.S. Corporation Income
U.S. Corporation Balance She Statement - Table 2.2
et Table 2.1 36
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CF to Creditors + CF to Stockholders
CF to Creditors = interest paid – net new
borrowing
70 – 46 = $24
CF to Stockholders = dividends paid – net
new equity raised
103 – 40 = $63

CF to Creditors & Stockholders

= 24 + 63 = $87
The CF identity holds.
U.S. Corporation Balance Sheet U.S. Corporation Income
– Table 2.1 Statement - Table 2.2 37
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Example: Balance Sheet and Income
Statement Information
• Current Accounts
– 2005: CA = 1500; CL = 1300
– 2006: CA = 2000; CL = 1700
• Fixed Assets and Depreciation
– 2005: NFA = 3000; 2006: NFA = 4000
– Depreciation expense = 300
• LT Liabilities and Equity
– 2005: LTD = 2200; Common Stock = 500; RE = 500
– 2006: LTD = 2800; Common Stock = 750; RE = 750
• Income Statement Information
– EBIT = 2700; Interest Expense = 200; Taxes = 1000;
Dividends = 1250
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Example: Cash Flows

• OCF = 2700 + 300 – 1000 = 2000
• NCS = 4000 – 3000 + 300 = 1300
• Changes in NWC = (2000 – 1700) – (1500 –
1300) = 100
• CFFA = 2000 – 1300 – 100 = 600
• CF to Creditors = 200 – (2800 – 2200) = -400
• CF to Stockholders = 1250 – (750 – 500) = 1000
• CFFA = -400 + 1000 = 600
• The CF identity holds.

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A Firm has an operating cash flow of $141,200,

depreciation expense of 89,300, and taxes paid of
$76,100. A partial listing of their balance sheet accounts
is as follows:
Beginning Balance Ending Balance
Current assets $146,800 $132,700
Net fixed assets $989,400 $909,400
Current liabilities $121,600 $138,700
Long-term debt $888,000 $862,500
What is the amount of cash flow from assets?
a. $17,500 b. $100,700
c. $144,500 d. $163,100
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CFFA = OCF – NCS – Change in NWC

OCF = 141,200
NCS = ending net fixed assets – beginning net
fixed assets + depreciation
= (909,400 – 989,400) + 89,300 =
(– 80,000) + 89,300 = 9,300
Changes in NWC = end.NWC – begin. NWC
(132,700 – 138,700) – (146,800 – 121,600)
– 6,000 – 25,200 = – 31,200
CFFA = 141,200 – 9,300 + 31,200 = 163,100

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A firm has earnings before interest and taxes of

$133,400 with a net income of $26,640. The taxes
amounted to $37,300 for the year. During the year,
the firm paid out $150,000 to pay off existing debt
and then later borrowed an additional $70,000. What
is the amount of the cash flow to creditors?
a. -$10,540
b.$128,380
c. $149,460
d.$143,940

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CF to Creditors = interest paid – net new borrowing

To calculate interest paid:
EBIT 133,400
Interest (69,460)
Taxable income 63,940
Tax (37,300)
Net income 26,640

Net new borrowing = – 150,000 + 70,000 = – 80,000

CF to Creditors = 69,460 – (– 80,000) = $149,460

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A Company has an operating cash flow of $121,000

and a cash flow to creditors of $38,700 for the past
year. During that time, the firm invested $22,000 in
net working capital and incurred net capital
spending of $36,900. What is the amount of the cash
flow to stockholders for the last year?
a. $23,400
b.$62,100
c. $67,400
d.$97,200

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CFFA = OCF – NCS – Change in NWC

CFFA = 121,000 – 36,900 – 22,000 = 62,100

CFFA = CF to Creditors + CF to Stockholders

62,100 = 38,700 + CF to Stockholders

CF to Stockholders = 62,000 - 38,700 = 23,400

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A Company has compiled the following information:
2005 2006
Sales $3,813 $4,019
Long-term debt 1,555 899
Interest paid 121 143
Common stock 1,500 2,150
Accounts receivable 498 402
Depreciation 306 393
Cash 413 911
Inventory 1,516 1,533
Accounts payable 387 460
Retained earnings 1,700 1,550
Cost of goods sold 2,123 2,609
Net fixed assets 2,715 2,213
Other costs 391 514
Taxes paid 305 126
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For 2006, the cash flow from assets is

__________, the cash flow to creditors is
__________, and the cash flow to stockholders
is:
a. $315; $799; -$484.
b. $533; $799; -$266.
c. $464; $701; -$237.
d.$787; $701; -$86.

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CFFA = OCF – NCS – Change in NWC

OCF = EBIT + depreciation – taxes
=(4,019 - 2,609 - 514 - 393) + 393 – 126
= 503 + 393 – 126 = 770
NCS = ending net fixed assets – beginning net fixed
assets + depreciation
2,213 – 2,715 + 393 = - 109
Changes in NWC = end.NWC – begin. NWC
(2,846 – 460) – (2,427 – 387)
2,386 – 2,040 = 346
CFFA = 770 + 109 – 346 = 533

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CF to Creditors = interest paid – net new borrowing

= 143 – (899 – 1555) = 799
CF to Stockholders = dividends paid – net new
equity raised
EBIT 503
Interest (143)
Taxable income 360
Tax (126)
Net income 234
Retained earnings -150 (1550 - 1700)
Dividends 384
net new equity raised = (2150 – 1500) = 650
CF to Stockholders = 384 – 650 = - 266
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Quick Quiz
• What is the difference between book value
and market value? Which should we use for
decision making purposes?
• What is the difference between accounting
income and cash flow? Which do we need to
use when making decisions?
• What is the difference between average and
marginal tax rates? Which should we use
when making financial decisions?
• How do we determine a firm’s cash flows?
What are the equations and where do we find
the information?
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