November 24, 2014

Chapter 3. Financial Statements and Taxes

 Financial statements and reports
 Basic financial statements
 Free cash flow
 MVA and EVA
 Income taxes

Finance managers have to prepare or arrange to prepare financial statements of their company and they have to analyze the financial statements of their customers, suppliers and companies in which they may make short term or long term equity or debt  investments.

 Financial statements and reports
Annual report
A report issued annually to shareholders that contains:
(1) Verbal statements: explain what happened and why; offer future prospects
(2) Financial statements:
Balance sheet
Income statement
Cash flow statement
Shareholder’s equity statement

Importance of financial statements and reports
To investors: provide valuable information regarding the firm
To managers: for internal control and financial planning

 Basic financial statements

(1) Balance sheet: a statement of a firms’ financial position at a point in time
Cash & marketable securities Accounts payable (A/P)
Accounts receivable (A/R) Accrued wages and taxes (Accruals)
Inventory Notes payable
------------------------------------ -------------------------------------
Current assets Current liabilities
+ + Total liabilities
Net fixed assets Long-term debt
+ +
Other assets Shareholders’ equity (c/s and R/E)
------------------------------------ --------------------------------------
Total assets = Total liabilities and equity
Note: Current liabilities + long-term debt = total liabilities
 Shareholder’s equity (Common equity) = total assets - total liabilities
Shareholders’ equity = common stock (c/s) + retained earnings (R/E)
 = paid-in capital + retained earnings
Paid-in capital = market value of stock - par value of stock
Retained earnings are cumulative, assuming no preferred stocks

Working capital: refers to current assets
Net working capital = current assets - current liabilities
Net operating working capital = current assets - (current liabilities - notes

Market value vs. book value
Market value = the actual market price
Book value = (common equity) / (# of shares outstanding)

(2) Income statement: a report summarizing a firm’s revenues, expenses, and
profits during a reporting period
- Operating cost except depreciation and amortization
- Depreciation and amortization
Earnings before interest and taxes (EBIT)
- Interest expenses
Earnings before Tax (EBT)
- Income tax
Net income (NI)
NI can be used for cash dividend and/or retained earnings

Commonly used terms:
Earnings per share (EPS) = NI / number of shares outstanding
Dividend per share (DPS) = cash dividend / number of shares outstanding
Dividend payout ratio = cash dividend / NI
Retention ratio = retained earnings / NI

(3) Cash flow statement: a report showing how things affect the balance sheet and
income statement will affect the firm’s cash flows
Cash flow statement has four sections: operating, long-term investing, financing
activities, and summary on cash flows over an accounting period

(4) Shareholder’s equity statement
Last year’s end balance
Add this year’s R/E = NI - Common stock cash dividend
This year’s end balance

 Free cash flow
Accounting profit vs. cash flow
Accounting profit is a firm’s net income reported on its income statement.
Net cash flow is the actual net cash that a firm generates during a specified period.
Net cash flow = NI + depreciation and amortization
Free cash flow: a mount of cash available for payments to all investors, including
stockholders and debt-holders after investments to sustain ongoing operations
FCF = EBIT*(1-T) + depreciation and amortization – (capital expenditures +

net operating working capital)
 MVA and EVA
MVA stands for market value added, which is the excess of the market value of
equity over its book value - focus
EVA stands for economic value added, which is the excess of net operating profit
after tax (NOPAT) over capital costs
Capital costs = total investor-supplied operating capital*after-tax cost of capital

 Income taxes
Progressive tax rate system: the tax rate is higher on higher income
Taxable income: gross income minus exceptions and allowable deductions as set
forth in the Tax Code or the income that is subject to taxes
Marginal tax rate: the tax rate applicable to the last dollar made
Average tax rate: taxes paid divided by total taxable income
Personal income tax:
Interest income: taxed as ordinary income (up to 39.6% for federal taxes +
additional state taxes)
Dividend income: used to be taxed as ordinary income (currently is taxed at 15%
for most investors and the maximum 20% for wealthy investors)
Capital gains (short-term, less than a year): taxed as ordinary income
Capital gains (long-term, more than a year): taxed at 15% for most investors and
the maximum of 20% for wealthy investors
Capital losses are tax deductible up to $3,000 or to offset capital gains
Alternative Minimum TAX (AMT): created by Congress to make it more difficult
for wealthy individuals to avoid taxes through the use of various deductions
Equivalent pre-tax yield vs. after tax return
Equivalent pre-tax yield = tax-free return / (1 – T)
After tax return = before tax return (1 – T)
Example: suppose your marginal tax rate is 28%. Would you prefer to earn a 6%
taxable return or 4% tax-free return? What is the equivalent taxable yield of the
4% tax-free yield?
Answer: 6%*(1-28%) = 4.32% or 4% / (1-28%) = 5.56%
You should prefer 6% taxable return because you get a higher return after tax,
ignoring the risk

Corporate income tax:

Interest income is taxed as ordinary income
Interest expenses are tax deductible
Dividend income is 70% tax-exempt (70% dividend exclusion)
Dividend paid is not tax deductible
Capital gains are taxed as ordinary income
Capital losses can only offset capital gains (carry back for 3 years or carry
forward for 5 years)
Operating losses can offset taxable income (carry back for 2 years or carry
forward for 20 years)
Deprecation: plays an important role in income tax calculation - the larger the
depreciation, the lower the taxable income, the lower the tax bill
Depreciation methods:
Straight-line method depreciates cost evenly throughout the useful life of the fixed
Double-declining balance method is an accelerated depreciation method that
counts twice as much of the asset’s book value each year as an expense compared
to straight-line depreciation.
Modified accelerated cost recovery system (MACRS) is the current tax
depreciation system in the United States. Under this system, the capitalized cost
(basis) of tangible property is recovered over a specified life by annual deductions
for depreciation. The lives are specified broadly in the Internal Revenue Code.
The Internal Revenue Service (IRS) publishes detailed tables of lives by classes of

No comments:

Post a Comment