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1 Chapter 3 Financial Statements, Cash Flows, and Taxes Learning Objectives 1. Discuss generally accepted accounting principles (GAAP) and their importance to the economy. 2. Know the balance sheet identity, and explain why a balance sheet must balance. 3. Describe how market-value balance sheets differ from book-value balance sheets. 4. Identify the basic equation for the income statement and the information it provides. 5. Explain the difference between cash flows and accounting income. 6. Explain how the four major financial statements discussed in this chapter are related. 7. Discuss the difference between average and marginal tax rates. I. Chapter Outline 3.1 Financial Statements and Accounting Principles A. Annual Reports The annual report is a vehicle by which management communicates with the firm s shareholders and members of the public. Page 1 of 59

2 The annual report has three sections a financial summary related to the past year s performance; information about the company, its products, and its activities; and audited financial statements, including historical financial data. B. Generally Accepted Accounting Principles (GAAP) These are accounting rules and standards that companies need to adhere to when they prepare financial statements and reports. GAAP is prepared by the Financial Accounting Standards Board (FASB) and is authorized by the SEC. C. Fundamental Accounting Principles The Assumption of Arm s-length Transaction Two parties involved in an economic transaction arrive at a decision independently and rationally. The Cost Principle Transactions are recorded at the cost at which they occurred. The Realization Principle Revenue is recognized when transaction is completed, while cash may not be collected until a later time. The Matching Principle Expenses related to generating any revenue are matched. The Going Concern Assumption It is assumed that a company will continue to operate for the predictable future. D. International GAAP Page 2 of 59

3 The International Accounting Standards Board promotes uniform accounting rules and procedures. All European Union firms are expected to comply with International Accounting Standards (IAS), since The SEC does not recognize IAS and requires foreign firms listed on U.S. stock exchanges to use U.S. GAAP. 3.2 The Balance Sheet A. This financial statement identifies all the assets and liabilities of a firm at a point in time. The left-hand side of the balance shows all the assets that the firm owns and uses to generate revenues. The right-hand side represents the liabilities of the firm that is, the money that the firm has borrowed from both creditors and shareholders. In addition to the amount borrowed from suppliers and other creditors, the balance sheet also lists the capital raised from its shareholders. While assets are listed in their order of their liquidity, the liabilities are listed in the order in which they must be paid. Shareholders of the firm s common equity are listed last as they will be paid with whatever remains after paying all other suppliers of funds. B. Current Assets and Liabilities Page 3 of 59

4 All assets that are likely to be converted to cash within a year are considered to be current assets. These include cash and marketable securities, accounts receivables, and inventory. All liabilities that have to be paid within a year are listed as part of the current liabilities. Thus, bank loans and other borrowings with less than a year s maturity, accounts payables, accrued wages, and taxes are included here. The difference between the amount of current assets and current liabilities is called net working capital. C. Net Working Capital Net working capital is a measure of the liquidity of a firm, which is the ability of the firm to meet its obligations as they come due. As expressed in Equation 3.2, net working capital is the difference between total current assets and total current liabilities. D. Accounting for Inventory Inventory, the least liquid of current assets, is reported in one of two different ways on the balance sheet. First in, first out, or FIFO, refers to the practice of recognizing a sale as being made up of inventory that was purchased earlier and having the lowest cost. Last in, last out, or LIFO, calls for the firm to attribute any sale made to the most recently acquired and most expensive inventory. FIFO reporting leads to higher current asset value and higher net income. Page 4 of 59

5 Firms may switch from one to another only under extraordinary circumstances and not frequently. E. Long-Term Assets These are the real assets that the firm acquires to produce its products and generate cash flows. These include land, buildings, plant, and equipment. Intangible assets, such as goodwill, patents, and copyrights, are also listed here. All long-term real assets are depreciated, while intangible assets are amortized. Depreciating assets allows a firm to lower taxable income and reduce taxes. Firms are allowed to depreciate assets using the straight-line method or an accelerated depreciation method that is allowed by the IRS. F. Long-Term Liabilities These consist of the long-term debt of the company. They include bank loans, mortgages, and bonds that have a maturity of one year or longer. G. Equity There are two sources of equity funds common equity and preferred equity. Common equity represents the true ownership of the firm. Page 5 of 59

6 Multiple accounts identify the various sources of equity funds par value, additional paid-in capital, retained earnings, and treasury stock. Par value and paid-in capital represent the outside equity capital raised by the firm by issuing shares. Retained earnings result from the funds that the firm has reinvested in the firm from its earnings. These funds are not cash since they already have been put to work. The treasury stock account reflects the value of the shares that the firm repurchased from investors. The other source of equity capital is preferred stock. It has features that make it a combination of a fixed income security and an equity security. 3.3 Market Value versus Book Value Traditionally, all assets are reported at their historical cost. The balance sheet does not reflect the current market value of the assets, only their acquired cost. Adopting a marking to market approach that is, reporting assets at their current market value provides better information to management and investors. Downside is the difficulty in estimating market values of assets. When both the liabilities and assets of a firm are reported at their current market value, their difference represents the true market value of shareholders equity. Page 6 of 59

7 3.4 The Income Statement and the Statement of Retained Earnings A. The Income Statement The profitability of a firm for any reporting period is measured in the financial statement. The basic identity is shown in Equation 3.3. Revenues represent the value of the products and services sold by the firm, and they include both cash and credit sales. Expenses range from the cost of producing goods for sale and asset utilization costs such as depreciation or amortization. Net income is the difference between the firm s revenues and expenses. B. Depreciation, Amortization, and Other Income Statement Accounts Depreciation is the writing off of the cost of any physical asset like plant or machinery over its lifetime. This is a noncash expense. Depreciation expense reduces a firm s taxable income as well as the firm s taxes, while increasing the cash flow available to shareholders. Firms can use one of two methods of depreciating an asset: the straight-line method and the accelerated depreciation method. Firms are allowed to use one approach for internal purposes and another for tax purposes. Firms prefer the accelerated depreciation method for tax purposes because it allows the firm to write off larger amounts of the cost of an asset over a shorter period. Page 7 of 59

8 Amortization expenses are related to the writing off of the value of intangible assets like goodwill, patents, and licenses. It is also a noncash expense like depreciation. Nonrecurring expenses are associated with the closing down of unprofitable operations or the restructuring of a firm s operations. Extraordinary items refer to income or expenses associated with events that are not expected to happen on a regular basis. C. Bottom-Line Accounts The first bottom-line income figure that would be of interest to shareholders and creditors is earnings before interest, taxes, depreciation, and amortization (EBITDA), which is the earnings generated from operations prior to the recognition of expenses not directly connected to the production of the products. After netting out the expenses related to depreciation and amortization, we arrive at earnings before interest and taxes (EBIT). The next important income line is earnings before taxes (EBT) and represents the taxable income for the period. Finally, subtracting taxes from EBT yields net income, or net income after taxes. This amount tells us the amount available to management to pay dividends, pay off debt, or reinvest in the firm. D. The Statement of Retained Earnings Page 8 of 59

9 This financial statement shows the changes in this account from one period to the next. This account will show changes whenever a firm reports a loss or profit and when a cash dividend is declared. 3.5 Cash Flows A. Net Income versus Cash Flows While accountants focus on net income, shareholders are more interested in net cash flows. Net income and cash flows are not the same because of the presence of noncash revenues and expenses. Equation 3.4 shows how we can derive the net cash flows from operating activities (NCFOA) from net income. A simplified version of Equation 3.4 is used when the only significant non cash items are depreciation and amortization. Equation 3.5 shows this. B. The Statement of Cash Flows This financial statement helps to measure the cash outflows and the cash inflows generated during any period. The statement is broken down into three parts to identify the cash flows resulting from operating activities, investing activities, and financing activities. Page 9 of 59

10 Operating activities: Cash flows result from producing and selling goods and services. Cash inflows result from selling the products and services from the firm. Cash outflows are tied to the purchase of raw materials, inventory, salaries and wages, utilities, rent, interest and other related expenses. Investing activities: Cash inflows and outflows arise out of the acquisition and sale of real assets necessary to operate the business. It can also result from the buying and selling of financial assets such as bonds and stocks, making and collecting loans, and selling and settling insurance contracts. Financing activities: When a firm issues debt or equity securities and borrows money from banks or other lenders, it produces cash inflows. If the firm pays interest or dividends on the investor s funds, or pays off debt or purchases treasury stock, the firm has cash outflows. The sum of the cash flows from these three activities measures the net cash flows of the firm during a given period and is the bottom line of this financial statement. 3.6 Tying the Financial Statements Together The role of the balance sheet includes the following: The balance sheet brings all the financial statements together, summarizing the financing and investment activities of the firm at a point in time. It recognizes the changes in the company s financial position since the last reporting period that result from new activities or discontinued activities. Page 10 of 59

11 It identifies to shareholders the impact on the owners equity account of all the transactions that the firm was involved in since the last reporting period and recognized in the income statement and statement of retained earnings. 3.7 Federal Income Tax A. Corporate Income Tax Rates The federal income tax schedule for the year 2007 is shown in Exhibit 3.6. It is a progressive tax schedule with rates ranging from 15 to 39 percent. This means the higher a firm s taxable income, the higher the tax liability. B. Average versus Marginal Tax Rates The average tax rate is the total taxes paid divided by taxable income for the period. The marginal tax rate is the tax rate that is paid on the last dollar earned or the next dollar earned. C. Tax Treatment of Dividends and Interest Payments The current tax code in the United States allows interest payments on debt issued by firms to be tax deductible. Dividends paid on the firm s preferred stock or common stock is not deductible for tax purposes and is paid from after-tax income. The result is a lower cost of debt financing relative to the cost of equity financing. Page 11 of 59

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13 II. Suggested and Alternative Approaches to the Material This chapter focuses on the four important financial statements that every firm uses to provide information about the financial condition of the company to both management and investors. In addition, there are discussions on the generally accepted accounting principles (GAAP) and International GAAP. The chapter also overviews market value accounting. Many instructors may choose to cover this chapter in detail. This allows the students to better understand the reporting of accounting information before moving on to the analysis of financial statements in Chapter 4. This material becomes even more critical when the majority of students taking the required first course in Finance are not Finance or Accounting majors. Other instructors may choose to skim through the topics in this chapter if they feel that their students are adequately prepared to tackle the topics in the next couple of chapters. Or they can choose to skip this chapter altogether if their students have a strong enough accounting background. This alternative will be especially helpful if this is a second Finance course, and it will allow the instructor to cover other material. Page 13 of 59

14 III. Summary of Learning Objectives 1. Discuss generally accepted accounting principles (GAAP) and their importance to the economy. GAAP are a set of authoritative guidelines that define accounting practices at a particular point in time. Thus, GAAP principles determine the rules for how a company maintains its accounting system and how it prepares financial statements. Accounting standards are important because without them, each firm could develop its own unique accounting practices, which would make it difficult for stakeholders to monitor the firm s true performance or compare the performance of different firms. The result would be a loss of confidence in the accounting system and the financial reports it produces. 2. Know the balance sheet identity, and explain why a balance sheet must balance. A balance sheet provides a summary of a firm s financial position at a particular point in time. The balance sheet identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (shareholders equity) that were used to buy the assets. The balance sheet identity is: Total assets = Total liabilities + Total stockholders equity. Total stockholders equity represents ownership in the firm and is the residual claim of the owners after all other obligations to creditors, employees, and vendors have been paid. The balance sheet must always balance because the owners get what is left over after all creditors have been paid that is, Total stockholders equity = Total assets Total liabilities. 3. Describe how market-value balance sheets differ from book-value balance sheets. Page 14 of 59

15 Book value is the amount a firm paid for its assets at the time of purchase. The current market value of an asset is the amount that a firm would receive for the asset if it were sold on the open market (not in a forced liquidation). Most managers and investors are more concerned about what a firm s assets can earn in the future than about what the assets cost in the past. Thus, balance sheets marked to market are more helpful in showing a company s true financial condition than balance sheets based on historical costs. Of course, the problem with marked-to-market balance sheets is that it is difficult to estimate market values for some assets and liabilities. In addition, there are fears that the management of some firms may be tempted to manipulate the estimates of market value to favorably distort their firm s true financial picture. 4. Identify the basic equation for the income statement and the information it provides. An income statement is a snapshot that provides a picture of the firm s profit or loss for a period of time, usually a month, quarter, or year. The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses that were needed to generate those revenues. The equation for the income statement is: Net income = Revenues - Expenses. If revenues exceed expenses, the firm generates a net profit for the period. If expenses exceed revenues, the firm generates a net loss. Net profit or income is the most comprehensive accounting measure of a firm s performance. 5. Explain the difference between cash flows and accounting income. Page 15 of 59

16 Cash flows represent the movement of cash within the firm. Cash flows are important in finance because the value of any asset stocks, bonds, or a business is determined by the future cash flows generated by the asset. Accounting profits, in contrast, are calculated according to GAAP in order to determine taxes and to report to stakeholders in a consistent manner. Accounting profits include noncash revenues (such as prepaid rent) and noncash expenses (such depreciation), whereas cash flows do not include these items. 6. Explain how the four major financial statements discussed in this chapter are related. The four financial statements discussed in the chapter are the balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. The key financial statement that ties the other three statements together is the statement of cash flows, which summarizes changes in the balance sheet from the beginning of the year to the end. These changes reflect information in the income statement and in the statement of retained earnings. 7. Discuss the difference between the average and marginal tax rates. The average tax rate is total taxes divided by taxable income. It takes into account the taxes paid at all levels of income, and therefore it will be lower than the marginal tax rate, which is the rate that is paid on the last dollar of income earned. However, for very high income earners, these two rates will be close to equal. When companies are making financial decisions, they use the marginal tax rate, because new projects are expected to generate additional cash flows, which will be taxed at the firm s marginal tax rate. Page 16 of 59

17 IV. Summary of Key Equations Equation Description Formula Balance sheet identity Net working capital Income statement identity Net cash flow from operating activities Net cash flow from operating activities Total assets = Total liabilities + Total stockholders equity Net working capital = Total current assets Total current liabilities Net income = Revenues - Expenses NCFOA = Net income Noncash revenues + Noncash expenses NCFOA = Net income + Depreciation and amortization Page 17 of 59

18 V. Before You Go On Questions and Answers Section What types of information does a firm s annual report contain? A firm s annual report is typically divided into three sections: financial tables with an accompanying verbal explanation of the firm s performance over the past year; a corporate public relations section discussing the firm s operations, and the audited financial statements (balance sheet, income statement, statement of cash flows, and statement of retained earnings). 2. What is the realization principle, and why may it lead to a difference in the timing of when revenues are recognized on the books and cash is collected? According to the realization principle, revenue should only be recognized when the earning process is completed and the exchange of goods or services can be determined by an arm s length transaction. Although this principle works in theory, it still does not specify whether this is the point when the goods are ordered, when they are shipped, or when the payment is actually received from the customer. Also, not many purchases are paid for in cash any more. Therefore, even if the transaction is recognized at the point at which the customer receives the goods, the actual cash flow might not occur until days later (depending what the terms are). Section 3.2 Page 18 of 59

19 1. What is net working capital? Why might a low value for this number be considered undesirable? Net working capital is the difference between total current assets and total current liabilities. A low value for this number is undesirable, for it indicates that the company may not have enough cash on hand to cover its immediate expenses. 2. Explain the accounting concept behind depreciation. Depreciation in accounting is a noncash expense that helps to allocate the cost of an item over its expected life. It reflects the estimated decrease in the value of an asset due to wear and tear and obsolescence. 3. What is treasury stock? Treasury stock is the stock that the company purchased back from its investors. These shares do not pay dividends, have no voting rights, and should not be included in sharesoutstanding calculations. Section What is the difference between book value and market value? Page 19 of 59

20 Book value is the price you paid for a particular asset. This price does not change as long as you own the asset. On the other hand, market value is the price at which you can sell an asset today, as it takes into account how much it can earn in the future. 2. What are some objections to the preparation of marked-to-market balance sheets? Marked-to-market balance sheets list the firm s assets and liabilities at their current market prices. Even though a balance sheet constructed with actual market values might paint a more accurate picture of the company s financial situation, current values are difficult to estimate, and a lot of the complicated models are potentially open to abuse. Therefore, as of the present, the norm is to use book values. Section How do you compute net income? Net income is calculated as revenues minus expenses. It is the most comprehensive accounting measure of a company s performance because it reflects the firm s accomplishments (revenues) relative to its efforts (expenses) during a time period. 2. What is EBITDA, and what does it measure? EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBIT is defined as earnings before taxes and interest. The main difference between these two Page 20 of 59

21 figures is that EBITDA shows the income earned purely from operations and reflects how efficiently a firm can manufacture and sell its products without taking into account the cost of the productive asset base. 3. What accounting events trigger changes to the retained earnings account? Two events will trigger changes to the retained earnings account: (1) a firm s report of a net income or loss and (2) the board of directors declaration of a cash dividend. Section What is the difference between accounting profits and net cash flows? Accounting profits and net cash flows are not the same because as accountants prepare the financial statements, they do not simply count the cash coming in and cash going out. The accounting profits are calculated based on the matching principle and other accounting rules that adhere to GAAP, but are not necessarily based on cash transactions. 2. Should a firm only consider depreciation and amortization expenses when calculating the net cash flow? Explain. Depreciation and amortization are taken into account when calculating both the net cash flows and the net income. Both depreciation and amortization get treated as expenses on the income statement, and they are subtracted from revenues to derive net income. When Page 21 of 59

22 calculating net cash flows, depreciation and amortization are added to net income, as both of these are noncash expenses. 3. Explain the difference between financing and investing activities. Investing activities refer to the buying and selling of long-term assets, whereas financing activities refer to those activities where cash is obtained from, or repaid to, creditors or owners (shareholders). Section Explain how the four financial statements are related. The four financial statements are linked together as follows: the ending cash balance from the statement of cash flows is used as the cash balance on the balance sheet, and the net income reported in the income statement is transferred to retained earnings on the balance sheet. So as you can see, the balance sheet is the one financial statement that ties all four statements together. Section Why is it important to consider the consequences of taxes when financing a new project? When financing a new project, it is important to consider the consequences of taxes because ultimately they have a significant impact on company s income. Page 22 of 59

23 2. Which type of tax rate, marginal or average, should be used in analyzing the expansion of a product line, and why? When analyzing the expansion of a product line, the marginal tax rate should be the type to consider because it is the amount paid on an additional dollar of income earned. Since expansion of a product line is expected to generate new cash flows, the company will be taxed based on the additional earnings. Average tax rate is not as relevant when making financing decisions because it is simply the total taxes paid divided by taxable income. 3. What are the tax implications of a decision to finance a project using debt rather than new equity? The difference between debt financing and financing through new equity is in the tax treatment of interest and dividends. While interest payments on debt are tax-deductible business expenses, dividends paid to common or preferred stockholders are not deductible. Page 23 of 59

24 VI. Self-Study Problems 3.1 The going -concern assumption of GAAP implies that the firm: a. is going under and needs to be liquidated at historical cost. b. will continue to operate and its assets should be recorded at historical cost. c. will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value. d. is going under and needs to be liquidated at liquidation value. c One of the key assumptions under GAAP is the going concern assumption, which states that the firm (c) will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value. 3.2 The Ellicott City Ice Cream Company management has just completed an assessment of its assets and liabilities and has come up with the following information. It has total current assets worth $625,000 at book value and $519,000 at market value. In addition, its long-term assets include plant and equipment valued at market for $695,000, while their book value was $940,000. The company s total current liabilities are valued at market for $543,000, while their book value is $495,000. Both the book value and the market value of its long-term debt is $350,000. If the company s total assets are equal to Page 24 of 59

25 a market value of $1,214,000 (book value of $1,565,000), what are the book value and market value of its shareholders equity? The book value and market value are as follow (in thousands of dollars): Book Market Book Market Assets Value Value Liabilities Value Value Total current assets $ 625 $ 519 Total current liabilities $ 495 $ 543 Fixed assets Long-term debt Stockholders equity Total assetss $1,565 $1,214 Total liabilities and $1,565 $1,214 stockholders equity 3.3 Depreciation and amortization expenses are: a. part of current assets on the balance sheet. b. after-tax expenses that reduce a firm s cash flows. c. long-term liabilities that reduce a firm s net worth. d. noncash expenses that cause a firm s after-tax cash flows to exceed its net income. d Depreciation and amortization expenses are (d) noncash expenses that cause a firm s after-tax cash flows to exceed its net income. Page 25 of 59

26 3.4 You are given the following information about Clarkesville Plumbing Company. The company s annual report on December 31, 2008, showed that during the year its revenues totaled $896, current assets $121, current liabilities $107, depreciation expenses $75, costs of goods sold $365, and interest expenses $54. The company is in the 34 percent tax bracket. Calculate its net income by setting up an income statement. Clarkesville s income statement and net income are as follows: Clarkesville Plumbing Company Income Statement as of December 31, 2008 Amount Revenues $ Costs EBITDA $ Depreciation EBIT $ Interest EBT $ Taxes (34%) Net income $ Page 26 of 59

27 3.5 The Huntington Rain Gear Company had $633,125 in taxable income in the year ending September 30, Calculate the company s tax using the tax schedule in Exhibit 3.6. Huntington s tax bill is calculated as follows: Tax rate Income Tax 15% $50,000 $ 7, (75,000 50,000) 6, (100,000 75,000) 8, (335, ,000) 91, (633, ,000) 101,363 Total taxes payable $215,263 Page 27 of 59

28 VII. Critical Thinking Questions 3.1 What is a major reason for the accounting scandals in recent years? How do firms attempt to meet Wall Street analysts projection of earnings? Most people believe that managers short-term focus is driven by Wall Street s demand that companies meet or beat the earnings forecasted by stock analysts. Rather than report the actual earnings of the firm, managers try to meet the market s expectations by starting with the bottom-line number and backing into a sales figure. Thus, the sales may be consistent with the reported earnings figure, but do not represent the true revenue generated by the firm. 3.2 Why are taxes and the tax code important for managerial decision making? Understanding the tax code is critical to finance managers, since most decisions are made on an after-tax basis. Furthermore, taxes affect any valuation analysis and also determine the bottom-line figure that is of concern to shareholders and managers. 3.3 Identify the five fundamental principles of GAAP and explain briefly their importance. The assumption of arm s length transaction assumes that all business transactions between two parties are made rationally from an economic perspective and both parties will make the deal that provides them the best value. The cost principle calls for the recognition of all accounting transactions at historic cost, or the amount paid or received Page 28 of 59

29 when the transaction was concluded at arm s length. The realization principle implies that revenue should be recognized only at the time of the sale. The matching principle dictates that revenue is first recognized and then is matched with the costs incurred in producing the revenue. Finally, the going concern assumption implies that the firm will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value. 3.4 Explain why firms prefer to use accelerated depreciation methods over the straight-line method for tax purposes. When a firm uses accelerated depreciation, the depreciation expense is higher than with the straight-line method. This reduces the taxable income and the amount of tax paid by the firm. As a result of this higher noncash expense, the firm s cash flow is higher. 3.5 What is treasury stock? Why do firms have treasury stock? Any shares repurchased by the company in the open market are recorded as treasury stock in the shareholders equity account in the balance sheet. The most common reason for firms doing this is to reduce the number of shares outstanding in the market when the management believes that its firm s stock is undervalued. This reduction in the number of shares outstanding is expected to boost the share price. 3.6 Define book-value accounting and market- value accounting. Page 29 of 59

30 Book-value accounting implies that all assets and liabilities are recorded and reported at the historical cost when they were acquired. Market-value accounting requires that all assets and liabilities are reported at their current market value. 3.7 Compare and contrast depreciation expense and amortization expense. Depreciation expense is the amount by which a firm s fixed assets are written down in a period during which the assets are utilized for generating cash flows. Amortization is the amount by which intangible assets like goodwill, patents, license, copyrights, and trademarks are written down in any period that they are utilized by the firm to generate benefits. Both depreciation and amortization are noncash expenses that will serve to boost the firm s after-tax cash flows. 3.8 Why are retained earnings not considered an asset of the firm? Retained earnings are part of shareholders equity that has already been utilized by the company. It is a liability of the company and corresponds to a claim by the firm s shareholders. The retained earnings reported on the balance sheet have already been allocated by the company among various assets and hence are not available for current or future uses. New retained earnings have to be generated to provide for new uses! 3.9 How does net cash flow differ from net income and why? Page 30 of 59

31 Net income or profit after taxes is an accounting figure that includes both cash and noncash expenses. In addition, revenues are recognized before they are collected and expenses are recognized before they are paid. Net cash flow, on the other hand, only recognizes cash inflows and cash outflows that have occurred. Accrual-based accounting causes a time lag between the point when revenues and expenses are recorded and the point when the cash flows actually occur What is the statement of cash flows, and what is its role? This financial statement records both the cash inflows and cash outflows for a period of time. Thus, it reports the changes in the cash position of a firm between successive accounting periods. Page 31 of 59

32 VIII. Questions and Problems BASIC 3.1 Balance sheet: Given the following information about the Elkridge Sporting Goods, Inc., construct a balance sheet for the period ending June 30, The firm had cash and marketable securities of $25,135, accounts receivables of $43,758, inventory of $167,112, net fixed assets of $325,422, and other assets of $13,125. It had accounts payables of $67,855, notes payables of $36,454, long-term debt of $223,125, and common stock of $150,000. How much retained earnings does the firm have? Assets Book Value Liabilities Book Value Cash $ 25,135 Accounts payables $ 67,855 Accounts receivable 43,758 Notes payables 36,454 Inventories 167,112 Total current assets $236,005 Total current liabilities $104,309 Net fixed assets 325,422 Long-term debt 223,125 Other assets 13,125 Common stock 150,000 Retained earnings 97,118 Total assets $574,552 Total liabilities and $574,552 stockholders equity Page 32 of 59

33 3.2 Inventory accounting: Differentiate between FIFO and LIFO. FIFO (first in, first out) refers to the practice of firms, when making sales, assuming that the inventory that came in first (at a lower price) is being sold first. LIFO (last in, last out) implies that a firm is selling the higher cost, newer inventory first, leaving the lower cost, older inventory on the balance sheet. 3.3 Inventory accounting: Explain how the choice of FIFO versus LIFO can affect a firm s balance sheet and income statement. FIFO makes sense during times of rising prices because it allows the firm to eliminate the lower priced inventory first, resulting in higher profit margin. This allows the firm to leave higher valued inventory on the balance sheet. During inflationary times, a firm using LIFO would see a lower profit margin and lower values of inventory on the balance sheet. It is important that anyone who is analyzing firms using different accounting methods on inventory recognize the impact on the bottom line (profit margin and net income) and on current assets. 3.4 Market-value accounting: How does the use of market-value accounting help managers? Market-value accounting of both assets and liabilities allows managers to have a truer picture of their company s financial condition and to do a better job of estimating Page 33 of 59

34 cash flows that the assets would generate. However, marking-to-market is not as easy as it sounds because of the difficulties involved in coming up with the correct market value of current assets and liabilities. 3.5 Working capital: Laurel Electronics reported the following information at its annual meetings. The company had cash and marketable securities worth $1,235,455, accounts payables worth $4,159,357, inventory of $7,121,599, accounts receivables of $3,488,121, notes payable worth $1,151,663, and other current assets of $121,455. What is the company s net working capital? Total current assets = $1,235,455 + $3,488,121 + $7,121, ,455 = $11,966,630 Total current liabilities = $4,159,357 + $1,151,663 = $5,311,020 Net working capital = $11,966,630 - $5,311,020 = $6,655, Working capital: The financial information for Laurel Electronics referred to in Problem 3.5 is all book value. Suppose marking-to-market reveals that the market value of the firm s inventory is 20 percent below its book value and its receivables are 25 percent below its book value. The market value of its current liabilities is identical to the book value. What is the firm s net working capital using market values? What is the percent change in net working capital? Page 34 of 59

35 Market value of inventory = $7,121,599 * 0.80 = $5,697,279 Market value of receivables = $3,488,121 * 0.75 = $2,616,091 Total current assets = $1,235,455 + $2,616,091 + $5,697, ,455 = $9,670,280 Total current liabilities = $4,159,357 + $1,151,663 = $5,311,020 Net working capital = $9,670,280 - $5,311,020 = $4,359,260 Percent Change $4,359,260 $6,656,610 $6,656, % 3.7 Income statement: The Oakland Mills Company has disclosed the following financial information in its annual reports for the period ending March 31, It produced sales of $1.45 million, had cost of goods sold to the tune of $812,500, depreciation expenses of $175,000, and interest expenses of $89,575. Assume that the firm has a tax rate of 35 percent. What is the company s net income? Set up an income statement to answer the question. Amount Revenues $1, Costs 812, EBITDA $ 637, Page 35 of 59

36 Depreciation 175, EBIT $ 462, Interest 89, EBT $ 372, Taxes (35%) 130, Net income $ 242, Cash flow: Describe the organization of the statement of cash flows. The statement of cash flows identifies the cash inflows and cash outflows of the firms for a specified period. This allows one to estimate the net cash flows from operations. This financial statement is organized to report the cash flows resulting from the three basic activities in any firm operating, investing, and financing. See Exhibit 3.4 for an example. The cash flows from operations are the results of netting all revenues and expenses that result from the operating activities of the firm. Buying and selling a firm s assets lead to cash flows from investing activities. Cash flows from financing activities arise from the firm borrowing from its investors and/or making payments to its lenders and shareholders. 3.9 Cash flows: During 2008, Towson Recording Company increased its investment in marketable securities by $36,845, funded fixed assets acquisitions of $109,455, and had marketable securities of $14,215 mature. What is the net cash used in investing activities? Page 36 of 59

37 Long-Term Investing Activities Net property, equipment, and other assets $(109,455.00) Net acquisitions and dispositions 0.00 Investments in marketable securities (22,630.00) Net cash used in investing activities $(132,085.00) 3.10 Cash flows: Caustic Chemicals identified the following cash flows as significant in its meeting with analysts. During the year, it had repaid existing debt of $312,080 and raised additional debt capital of $650,000. It also repurchased stock in the open market for a total of $45,250. What is the net cash provided by financing activities? Financing Activities Loan repayment $(312,080) Increase in long-term debt 650,000 Purchase of treasury stock (45,250) Net cash provided by financing activities $ 292, Cash flow: Identify and explain the noncash expenses that a firm may incur. A firm may have several items on its income statement that did not result in any cash outflow to the firm. The two largest are depreciation expenses and amortization Page 37 of 59

38 expenses. Other noncash expenses include deferred taxes, wages, and depletion charges, which is similar to depreciation and used for natural resource assets. Prepaid expenses also fit into this category as they represent expenses to the firm that are yet to be paid out Tax: Define average tax rate and marginal tax rate. The average tax rate is defined as the total taxes paid divided by taxable income. The marginal tax rate, meanwhile, represents the tax rate that is paid on the last dollar of income earned, or the rate that will be paid on the next dollar earned Tax: What is the relevant tax rate to use when making financial decisions? Explain why. Managers need to use the marginal tax rate for making financial decisions. This is because any additional cash flows that result from a firm s new projects will be taxed at the marginal tax rate. Thus, this is the appropriate rate to use Tax: Manz Property Management Company announced that in the year ended June 30, 2008, its earnings before taxes amounted to $1,478,936. Calculate its taxes using Exhibit 3.6. Earnings before tax = $1,478,936 Page 38 of 59

39 Tax rate Income Tax 15% $0 to $50,000 $ 7, ,001 75,000 6, , ,000 8, , ,000 91, ,001 10,000, , ,000,001 15,000, ,000,001 18,333, More than $18,333,333 Total taxes payable $502, INTERMEDIATE 3.15 Balance sheet: Tim Dye, the chief financial officer of Blackwell Automotive, Inc., is putting together this year s financial statements. He has gathered the following information. The firm had a cash balance of $23,015, accounts payable of $163,257, common stock of $313,299, retained earnings of $512,159, inventory of $212,444, goodwill and other assets equal to $78,656, net plant and equipment of $711,256, and short-term notes payable of $21,115. It also has accounts receivables of $141,228 and other current assets of $11,223. What amount of long-term debt does Blackwell Automotive have? Page 39 of 59

40 Liabilities and Stockholders Assets Cash and marketable Equity $ 23,015 Accounts payable and accruals $ 163,257 securities Accounts receivable 141,258 Notes payable 21,115 Inventories 212,444 Other current assets 11,223 Total current assets $ 387,940 Total current liabilities $ 184,372 Net plant and equipment 711,256 Long-term debt 168,022 Goodwill and other assets 78,656 Total liabilities $ 352,394 Common stock 313,299 Retained earnings 512,159 Total common equity $ 825,458 Total assets $1,177,852 Total liabilities and $1,177,852 stockholders equity 3.16 Balance sheet: Refer to the information for Blackwell Automotive in Problem What level of working capital does Blackwell Automotive have? Net working capital = Total current assets Total current liabilities = $387,940 $184,372 = $203,568 Page 40 of 59

41 3.17 Working capital: Mukhopadhya Network Associates has a current ratio of Its current assets are equal to $1,233,265, its accounts payables are $419,357, and its notes payables are $351,663. Its inventory is currently at $721,599. The company plans to raise funds in the short-term debt market and invest the entire amount in additional inventory. How much can their notes payable increase without lowering their ratio of current assets to current liabilities to below 1.50? Let x be the amount raised through notes payables. New current liabilities = $184,372 + x New current assets = $387,940 + x Current assets Current liabilities $387,940 x 1.5 $184,372 x 1.5* ($184,372 x) $387,940 x 1.5x x $387,940 $276, x $111,382 x $111, $222,764 Thus the firm can add up to $222,764 in inventory by raising money through notes payable without changing the ratio of current assets to current liabilities to more than (This ratio of current assets to current liabilities is known as the current ratio and will be discussed in the next chapter.) Page 41 of 59

42 3.18 Market value: Reservoir Bottling Co. reported to shareholders the following information. It has total current assets worth $237,513 at book value and $219,344 at market value. In addition, its long-term assets include plant and equipment valued at market for $343,222, while their book value is $362,145. The company s total current liabilities are valued at market for $134,889, while their book value is $129,175. Both the book value and the market value of its long-term debt is $144,000. If the company s total assets are equal to a market value of $562,566 (book value of $599,658), what is the difference in the book value and market value of its stockholders equity? Book Market Book Market Assets Value Value Liabilities Value Value Total current assets $237,513 $219,344 Total current liabilities $129,175 $134,889 Net fixed assets 362, ,222 Long-term debt 144, ,000 Other assets 0 0 Common stock 326, ,677 Total assets $599,658 $562,566 Total liabilities and $599,658 $562,566 stockholders equity Change in value of equity = $283,677 $326,483 = $(42,806) 3.19 Income statement: Nimitz Rental Company provided the following information to its auditors. For the year ended March 31, 2008, the company had revenues of $878,412, general and administrative expenses of $352,666, depreciation expenses of $131,455, leasing expenses of $108,195, and interest expenses equal to $78,122. If the company s tax rate was 34 percent, what is its net income after taxes? Page 42 of 59

43 Nimitz Rental Company Income Statement as of March 31, 2008 (in $ 000s) Amount Net sales $878,412 Selling and administrative expenses 352,666 Leasing expenses 108,195 EBITDA $417,551 Depreciation 131,455 EBIT $286,096 Interest expense 78,122 EBT $207,974 Taxes (34%) 70,711 Net income $137, Income statement: Sosa Corporation recently reported an EBITDA of $31.3 million and $9.7 million of net income. The company has $6.8 million interest expense, and the corporate tax rate is 35 percent. What was the company s depreciation and amortization expense? Amount Page 43 of 59

44 EBITDA $31,300, Less: Depreciation and amortization 9,576, EBIT $21,723, Interest 6,800, EBT $14,923, Taxes (35%) 5,223, Net income $ 9,700, Income statement: Fraser Corporation has announced that its net income for the year ended June 30, 2008, is $1,353,412. The company had an EBITDA of $ 4,967,855, and its depreciation and amortization expense was equal to $1,112,685. The company s tax rate is 34 percent. What is the amount of interest expense for Fraser Corporation? Amount EBITDA $4,967, Depreciation 1,112, EBIT $3,855, Interest 1,804, EBT $2,050, Taxes (34%) 697, Net income $1,353, Page 44 of 59

45 3.22 Income statement: Carmichael Hobby Shop has an EBITDA of $512,725.20, an EBIT of $362,450.20, and a cash flow of $348, What is the net income after taxes for this firm? Amount Revenues $1,314, Costs 801, EBITDA $512, Depreciation 150, EBIT $362, Interest 62, EBT $300, Taxes (34%) 102, Net income $198, Retained earnings: Columbia Construction Company earned $451,888 during the year ended June 30, After paying out $225,794 in dividends, the balance went into retained earnings. If the firm s total retained earnings were $846,972, what was the level of retained earnings on its balance sheet on July 1, 2007? Columbia Construction Company Retained Earnings for 2008 (in $000s) Page 45 of 59

46 Balance of retained earnings, July 1, 2007 $ 621, Add: Net income, , Less: Dividends to common stockholders (225,794.00) Balance of retained earnings, June 30, 2008 $ 846, Cash flow: Refer to the information given in Problem What is the cash flow for Nimitz Rental? Cash flow from operation = Net income + Depreciation = $137,263 + $131,455 = $268, Tax: Mount Hebron Electrical Company s financial statements indicated that the company had an EBIT of $718,323. Its interest rate on debt of $850,000 was 8.95 percent. Calculate the amount of taxes the company is likely to owe. What are the marginal and the average tax rates for this company? EBIT $718, Interest 76, EBT $642, Page 46 of 59

47 Tax rate Income Tax 15% $0 to $50,000 $ 7, ,001 75,000 6, , ,000 8, , ,000 91, ,001 10,000, , ,000,001 15,000, ,000,001 18,333, More than $18,333,333 Total taxes payable $218, Marginal tax rate = 34% Average tax rate = Total taxes / Taxable income = $218, / $642,248 = 34% ADVANCED 3.26 Income statement: The Centennial Chemical Corp. announced that for the period ending March 31, 2008, it had earned income after taxes worth $5,330,275 on revenues of $13,144,680. The company s costs (excluding depreciation and amortization) amounted Page 47 of 59