Chapter 3
Financial Statements, Cash Flow, and Taxes
Learning Objectives
After reading this chapter, students should be able to:
u Briefly explain the history of accounting and financial statements, and how financial statements are used.
u List the types of information found in a corporation’s annual report.
u Explain what a balance sheet is, the information it provides, and how assets and claims on assets are arranged on a balance sheet.
u Explain what an income statement is and the information it provides.
u Differentiate between net cash flow and accounting profit.
u Identify the purpose of the statement of cash flows, list the factors affecting a firm’s cash position that are reflected in this statement, and identify the three categories of activities that are separated out in this statement.
u Specify the changes reported in a firm’s statement of retained earnings.
u Discuss what questions can be answered by looking through the financial statements, and explain why investors need to be cautious when they review financial statements.
u Discuss how certain modifications to the accounting data are needed and used for corporate decision making and stock valuation purposes. In the process, explain the terms: net operating working capital, total operating capital, NOPAT, operating cash flow, and free cash flow; and explain how each is calculated.
u Define the terms Market Value Added (MVA) and Economic Value Added (EVA), explain how each is calculated, and differentiate between them.
u Explain why financial managers must be concerned with taxation, and list some of the most important elements of the current tax law, such as the differences between the treatment of dividends and interest paid and interest and dividend income received.
Chapter 3: Financial Statements, Cash Flow, and Taxes Learning Objectives 49
Lecture Suggestions
The goal of financial management is to take actions that will maximize the value of a firm’s stock. These actions will show up, eventually, in the financial statements, so a general understanding of financial statements is critically important.
Note that Chapter 3 provides a bridge between accounting, which students have just covered, and financial management. Unfortunately, many non-accounting students did not learn as much as they should have in their accounting courses, so we find it necessary to spend more time on financial statements than we would like. Also, at Florida and many other schools, students vary greatly in their knowledge of accounting, with accounting majors being well-grounded because they have had more intense introductory courses and, more importantly, because they are taking advanced financial accounting concurrently with finance. This gives the accountants a major, and somewhat unfair, advantage over the others in dealing with Chapters 3 and 4 on exams. We know of no good solution to this problem, but what we do is pitch the coverage of this material to the non-accountants. If we pitch the lectures (and exams) to the accountants, they simply blow away and demoralize our non-accountants, and we do not want that. Perhaps Florida has more of a difference between accounting and non-accounting students, but at least for us there really is a major difference.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 3, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 2 OF 58 DAYS (50-minute periods)
Chapter 3: Financial Statements, Cash Flow, and Taxes Learning Objectives 49
Answers to End-of-Chapter Questions
3-1 The four financial statements contained in most annual reports are the balance sheet, income statement, statement of retained earnings, and statement of cash flows.
3-2 Accountants translate physical quantities into numbers when they construct the financial statements. The numbers shown on balance sheets generally represent historical costs. When examining a set of financial statements, one should keep in mind the physical reality that lies behind the numbers, and the fact that the translation from physical assets to numbers is far from precise.
3-3 Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or invest in, managers need financial statements to operate their businesses efficiently, and taxing authorities need them to assess taxes in a reasonable way.
3-4 No, because the $20 million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million would be an investment in all of the firm’s assets.
3-5 The balance sheet shows the firm’s financial position on a specific date, for example, December 31, 2005. It shows each account balance at that particular point in time. For example, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on December 31, 2005. The income statement, on the other hand, reports on the firm’s operations over a period of time, for example, over the last 12 months. It reports revenues and expenses that the firm has incurred over that particular time period. For example, the sales figures reported on the income statement for the period ending December 31, 2005, would represent the firm’s sales over the period from January 1, 2005, through December 31, 2005, not just sales for December 31, 2005.
3-6 Investors need to be cautious when they review financial statements. While companies are required to follow GAAP, managers still have quite a lot of discretion in deciding how and when to report certain transactions. Consequently, two firms in exactly the same operating situation may report financial statements that convey different impressions about their financial strength. Some variations may stem from legitimate differences of opinion about the correct way to record transactions. In other cases, managers may choose to report numbers in a way that helps them present either higher earnings or more stable earnings over time. As long as they follow GAAP, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances.
Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. Indeed, a number of high-profile executives have faced criminal charges because of their misleading accounting practices.
3-7 The emphasis in accounting is on the determination of accounting income, or net income, while the emphasis in finance is on net cash flow. Net cash flow is the actual net cash that a firm generates during some specified period. The value of an asset (or firm) is determined by the cash flows generated. Cash is necessary to purchase assets to continue operations and to pay dividends. Thus, financial managers should strive to maximize cash flows available to investors over the long run.
Although companies with relatively high accounting profits generally have a relatively high cash flow, the relationship is not precise. A business’s net cash flow generally differs from net income because some of the expenses and revenues listed on the income statement are not paid out or received in cash during the year.
Most other companies have little if any noncash revenues, but this item can be important for construction companies that work on multi-year projects, report income on a percentage of completion basis, and then are paid only after the project is completed. Also, if a company has a substantial amount of deferred taxes, which means that taxes actually paid are less than that reported in the income statement, then this amount could also be added to net income when estimating the net cash flow. The relationship between net cash flow and net income can be expressed as:
Net cash flow = Net income + Non-cash charges – Non-cash revenues.
The primary examples of non-cash charges are depreciation and amortization. These items reduce net income but are not paid out in cash, so we add them back to net income when calculating net cash flow. Likewise, some revenues may not be collected in cash during the year, and these items must be subtracted from net income when calculating net cash flow. Typically, depreciation and amortization represent the largest non-cash items, and in many cases the other non-cash items roughly net to zero. For this reason, many analysts assume that net cash flow equals net income plus depreciation and amortization.
3-8 Operating cash flow arises from normal, ongoing operations, whereas net cash flow reflects both operating and financing decisions. Thus, operating cash flow is defined as the difference between sales revenues and operating expenses paid, after taxes on operating income. Operating cash flow can be calculated as follows:
Operating cash flow = EBIT (1 – T) + Depreciation and amortization
= NOPAT + Depreciation and amortization.
Note that net cash flow can be calculated as follows:
Net cash flow = Net income + Depreciation and amortization.
Thus, the difference between the two equations is that net cash flow includes after-tax interest expense.
3-9 NOPAT is the profit a company would generate if it had no debt and held only operating assets. Net income is the profit available to common stockholders; thus, both interest and taxes have been deducted. NOPAT is a better measure of the performance of a company’s operations than net income because debt lowers income. In order to get a true reflection of a company’s operating performance, one would want to take out debt to get a clearer picture of the situation.
3-10 Free cash flow is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets, new products, and operating working capital necessary to sustain ongoing operations. It is defined as net operating profit after taxes (NOPAT) minus the amount of net investment in operating working capital and fixed assets necessary to sustain the business. It is the most important measure of cash flows because it shows the exact amount available to all investors (stockholders and debtholders). The value of a company’s operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit.
3-11 Yes. Negative free cash flow is not necessarily bad. It depends on why the free cash flow was negative. If free cash flow was negative because NOPAT was negative, this is definitely bad, and it suggests that the company is experiencing operating problems. However, many high-growth companies have positive NOPAT but negative free cash flow because they must invest heavily in operating assets to support rapid growth. There is nothing wrong with a negative cash flow if it results from profitable growth.
3-12 Double taxation refers to the fact that corporate income is subject to an income tax, and then stockholders are subject to a further personal tax on dividends received. Income could even be subject to triple taxation; therefore, corporations that receive dividend income can exclude some of the dividends from its taxable income. This provision in the Tax Code minimizes the amount of triple taxation that would otherwise occur.
3-13 Because interest paid is tax deductible but dividend payments are not, the after-tax cost of debt is lower than the after-tax cost of equity. This encourages the use of debt rather than equity. This point is discussed in detail in later chapters: “The Cost of Capital” and “Capital Structure and Leverage.”
Solutions to End-of-Chapter Problems
3-1 NI = $3,000,000; EBIT = $6,000,000; T = 40%; Interest = ?
Need to set up an income statement and work from the bottom up.
EBIT $6,000,000
Interest 1,000,000
EBT $5,000,000 EBT =
Taxes (40%) 2,000,000
NI $3,000,000
Interest = EBIT – EBT = $6,000,000 – $5,000,000 = $1,000,000.
3-2 EBITDA = $7,500,000; NI = $1,800,000; Int = $2,000,000; T = 40%; DA = ?
EBITDA $7,500,000
DA 2,500,000 EBITDA – DA = EBIT; DA = EBITDA – EBIT
EBIT $5,000,000 EBIT = EBT + Int = $3,000,000 + $2,000,000
Int 2,000,000 (Given)
EBT $3,000,000
Taxes (40%) 1,200,000
NI $1,800,000 (Given)
3-3 NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ?
NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000.
3-4 NI = $50,000,000; R/EY/E = $810,000,000; R/EB/Y = $780,000,000; Dividends = ?
R/EB/Y + NI – Div = R/EY/E
$780,000,000 + $50,000,000 – Div = $810,000,000
$830,000,000 – Div = $810,000,000
$20,000,000 = Div.
3-5 Statements b and d will decrease the amount of cash on a company’s balance sheet. Statement a will increase cash through the sale of common stock. This is a source of cash through financing activities. On one hand, Statement c would decrease cash; however, it is also possible that Statement c would increase cash, if the firm receives a tax refund.
3-6 Ending R/E = Beg. R/E + Net income - Dividends
$278,900,000 = $212,300,000 + Net income - $22,500,000
$278,900,000 = $189,800,000 + Net income
Net income = $89,100,000.
3-7 a. From the statement of cash flows the change in cash must equal cash flow from operating activities plus long-term investing activities plus financing activities. First, we must identify the change in cash as follows:
Cash at the end of the year $25,000
– Cash at the beginning of the year – 55,000
Change in cash -$30,000
The sum of cash flows generated from operations, investment, and financing must equal a negative $30,000. Therefore, we can calculate the cash flow from operations as follows:
CF from operations + CF from investing + CF from financing = D in cash
CF from operations - $250,000 + $170,000 = -$30,000
CF from operations = $50,000.
b. To determine the firm’s net income for the current year, you must realize that cash flow from operations is determined by adding sources of cash (such as depreciation and amortization and increases in accrued liabilities) and subtracting uses of cash (such as increases in accounts receivable and inventories) from net income. Since we determined that the firm’s cash flow from operations totaled $50,000 in part a of this problem, we can now calculate the firm’s net income as follows:
NI + + - =
NI + $10,000 + $25,000 – $100,000 = $50,000
NI – $65,000 = $50,000
NI = $115,000.
3-8 EBIT = $750,000; DEP = $200,000; AMORT = 0; 100% Equity; T = 40%; NI = ?; NCF = ?; OCF = ?
First, determine net income by setting up an income statement: