ISBN: 0-03-028931-9
Chapter 2 Financial Statements, Cash Flow, and Taxes
The primary purposes of this chapter were to describe the basic financial statements, to present some background information on cash flows, and provide an overview of the federal income tax system. This is an outline of a few of the main concepts, please refer to the textbook for more comprehensive coverage.
The four basic statements contained in the annual report are the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. Investors use the information provided in these statements to form expectations about future levels of earnings and dividends, and about the firm's riskiness.
The balance sheet is a financial statement that shows the firm's assets on the left-hand side and liabilities and equity (or claims against assets) on the right-hand side. The balance sheet may be thought of as a snapshot of the firm's financial position at a particular point in time. For that reason, balance sheets are very sensitive to time and can vary greatly depending on the time of the year.
The income statement reports the results of operations over a period of time, and it shows earnings per share as its "bottom line."
The statement of retained earnings shows the change in retained earnings between the balance sheet dates. Retained earnings represent of claim against assets, not assets per se.
The statement of cash flows reports the impact of operating, investing, and financing activities on cash flows over an accounting period. The generation or use of cash can be classified as either operating activities, investing activities, or financing activities.
Net cash flow differs from accounting profit because some of the revenues and expenses reflected in accounting profits may not have been received or paid out in cash during the year. Depreciation is typically the largest non-cash item, so net cash flow is often expressed as net income plus depreciation and amortization. Investors are at least as interested in a firm's projected net cash flow as in reported earnings because it is cash, not paper profit, that is paid out as dividends and plowed back into the business to produce growth.
Net operating working capital is defined as the difference between current assets and those current liabilities on which no interest is charged (generally, accounts payable and accruals). Thus, net working capital is the working capital acquired with investor-supplied funds.
Operating assets are those assets which consist of cash, accounts receivable, inventories, and fixed assets necessary to operate the business.
NOPAT is net operating profit after taxes. It is the after-tax profit a company would have if it had no debt and no investments in financial assets. Since it excludes the effects of financial decision, it is a better measure of operating performance than is net income.
Operating cash flow arises from normal operations, and it is the difference between cash revenues and cash costs, including taxes on operating income. Operating cash flow differs from net cash flow because operating cash flow does not include either interest income or interest expense. It is equal to NOPAT plus any non-cash adjustments.
Free cash flow (FCF) is the amount of cash flow remaining after a company makes the asset investments necessary to support operations. In other words, FCF is the amount of cash flow available for distribution to investors, so the value of a company is directly related to its ability to generate free cash flow. Free cash flow can be found as the operating cash flow less capital expenditures and increases in working capital.
Market Value Added (MVA) represents the difference between the market value of a firm's stock and the amount of equity its investors have supplied. MVA can be determined as being the market value of the firm's stock minus the equity capital supplied by shareholders.
Economic Value Added (EVA) is the difference between after-tax operating profit and the total cost of capital, including the cost of equity capital. EVA is an estimate of the value created by management during the year, and it differs substantially form accounting profit because no charge for the use of equity capital is reflected in accounting profit. EVA can be calculated by subtracting the after-tax dollar cost of capital from the firm's NOPAT.
The value of any asset depends on the stream of after-tax cash flows it produces. Tax rates and other aspects of our tax system are changed by Congress every year or so.
In the United States, tax rates are progressive-the higher one's income, the larger the percentage paid in taxes, up to a point.
Assets such as stocks, bonds, and real estate are defined as capital assets. If a capital asset is sold for more than its cost, the profit is called a capital gain. If the asset is sold for a loss, it is called a capital loss. Assets held for more than a year but less than 18 months provide intermediate-term gains or losses. Assets held for 18 months or longer provide long-term gains or losses.
Operating income paid out as dividends is subject to double taxation: the income is first taxed at the corporate level, and then shareholders must pay personal taxes on their dividends.
Interest income received by a corporation is taxed as ordinary income; however, 70 percent of the dividends received by one corporation from another are excluded from taxable income. The reason for this exclusion is that corporate dividend income is ultimately subjected to triple taxation.
Because interest paid by a corporation is a deductible expense while dividends are not, our tax system favors debt over equity financing.
Ordinary corporate operating losses can be carried back to each of the preceding 2 years and forward for the next 20 years and used to offset taxable income in those years.
S corporations are small businesses, which have the limited liability benefits of the corporate form of organization but are taxed as a partnership or a proprietorship.
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