Chapter 3.

Financial Statements, Cash Flows, and Taxes

THE ANNUAL REPORT

The annual report contains a verbal section plus four key statements: the balance sheet, income statement,
statement of stockholders' equity, and statement of cash flows. These statements contain a wealth of information
that is used by bankers, stock and bond analysts, and managers. Hence, they are quite important. Spreadsheets
are used both to create and to analyze these statements, as we demonstrate in this model.

In this model, we start with the same balance sheet and income statement that was used in the chapter, but in an
Excel format, and then we show how spreadsheets can be used to analyze the data. The analysis continues to
cover the statement of stockholders' equity, statement of cash flows, and shows how accounting data may be
modified to evaluate managerial performance.

INPUT DATA SECTION: Historical Data Used in the Analysis 2011 2010
Year-end stock price $23.06 $26.00
Shares outstanding (in millions) 50 50
Tax rate 40% 40%
BALANCE SHEET (Section 3-2)
The balance sheet can be thought of as a snapshot in time of a firm's financial position. You can observe the
firm's level of assets and the manner in which they have used debt and equity to fund those assets.

BALANCE SHEETS - Allied Food Products - December 31 2011 2010

(in millions of dollars)
Assets
Cash and equivalents $ 10 $ 80
Accounts receivable 375 315
Inventories 615 415
Total current assets $ 1,000 $ 810
Net plant and equipment 1,000 870
Other assets expected to last more than 1 year - -
Total assets $ 2,000 $ 1,680

Liabilities and Equity

Accounts payable $ 60 $ 30
Accruals 140 130
Notes payable 110 60
Total current liabilities $ 310 $ 220
Long-term bonds 750 580
Total debt $ 1,060 $ 800
Common stock (50,000,000 shares) 130 130
Retained earnings 810 750
Total common equity $ 940 $ 880
Total liabilities and equity $ 2,000 $ 1,680

INCOME STATEMENT (Section 3-3)

The income statement summarizes a firm's revenues and expenses over an accounting period, usually a year. The
"bottom line" of an income statement is the firm's net income. Collectively, the income statement gives an
indication of a firm's operating ability.

INCOME STATEMENTS - Allied Food Products - Years Ending December 31

(in millions of dollars) 2011 2010

Net sales $ 3,000.0 $ 2,850.0

Operating costs except depreciation and amortization 2,616.2 2,497.0
Depreciation and amortization 100.0 90.0
Earnings before interest and taxes (EBIT) $ 283.8 $ 263.0
Less interest 88.0 60.0
Earnings before taxes (EBT) $ 195.8 $ 203.0
Taxes 78.3 81.2
Net income $ 117.5 $ 121.8

Common dividends $ 57.5 $ 53.0

Addition to retained earnings $ 60.0 $ 68.8

PER-SHARE DATA
We can now use the above information to calculate three specific per-share data measures: earnings per share
(EPS), dividends per share (DPS), and book value per share (BVPS). Simply divide the totals by the appropriate
number of shares outstanding. Note that BVPS is calculated by dividing total common equity (common stock plus
retained earnings) by shares outstanding.
2011 2010
Common stock price $ 23.06 $ 26.00
Earnings per share (EPS) $ 2.35 $ 2.44
Dividends per share (DPS) $ 1.15 $ 1.06
Book value per share (BVPS) $ 18.80 $ 17.60

The per-share data give managers and investors a quick look at some items that affect the stock price.

STATEMENT OF CASH FLOWS (Section 3-4)

Information from the balance sheet and income statement can be used to construct the statement of cash flows,
which is shown below for Allied, in millions of dollars.

STATEMENT OF CASH FLOWS - Allied Food Products (2011)

Parentheses indicate net cash outflows, no parentheses indicates net cash inflows.

I. Operating Activities 2011

Net income $ 117.5
Depreciation and amortization 100.0
Increase in inventories (200.0)
Increase in accounts receivable (60.0)
Increase in accounts payable 30.0
Increase in accrued wages and taxes 10.0
Net cash provided by (used in) operating activities $ (2.5)

II. Long-Term Investing Activities

 Additions to property, plant, and equipment $ (230.0)
Net cash used in investing activities $ (230.0)

III. Financing Activities

Increase in notes payable $ 50.0
Increase in bonds outstanding 170.0
Payment of dividends to stockholders (57.5)
Net cash provided by financing activities $ 162.5

IV. Summary
Net decrease in cash and equivalents: (Net sum of I, II, III) $ (70.0)
Cash and equivalents at beginning of the year 80.0
Cash and equivalents at end of the year $ 10.0

STATEMENT OF STOCKHOLDERS' EQUITY (Section 3-5)

The statement of stockholders' equity takes the previous year's balance of retained earnings, adds the current
year's net income, and then subtracts dividends paid to common stockholders. The end result is the new balance
of retained earnings. Allied's statement is shown below, in millions:

STATEMENT OF STOCKHOLDERS' EQUITY - Allied Food Products (2011)

Total
Common Stock (000) Retained Stockholders'
Shares Amount Earnings Equity
Balances, December 31, 2010 50,000 $130.0 $750.0 $880.0
2011 Net income 117.5
Cash dividends (57.5)
Addition to retained earnings $60.0
Balances, December 31, 2011 50,000 $130.0 $810.0 $940.0

FREE CASH FLOW (Section 3-7)

FCF = EBIT(1 – T) + Depr'n – (Capital expenditures + Δ Net operating working capital)

FCF = $170.3 + $100.0 – ( $230.0 + $150.0
FCF = -$109.7
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CORPORATE TAXES (Section 3-9)
Use the Excel function VLOOKUP to find the taxes due on a given amount of corporate income. The
corporate tax table is shown below, with an income statement that's missing the tax liability and net
income to the right. We use VLOOKUP to find the taxes due, after which we find net income.
If a corporation's It pays this Plus this % on Sales
taxable income amount on the excess Costs
is between: the base over the base Taxable income
(1) (2) (3) (4) Taxes
Net income
$0 $50,000 $0 15.0%
$50,000 $75,000 $7,500 25.0%
$75,000 $100,000 $13,750 34.0% Tax on base
$100,000 $335,000 $22,250 39.0% Income over base
$335,000 $10,000,000 $113,900 34.0% Tax rate
$10,000,000 $15,000,000 $3,400,000 35.0% Tax on income over base
$15,000,000 $18,333,333 $5,150,000 38.0% Total taxes
$18,333,333 and up $6,416,667 35.0% Average tax rate

1. You are to fill in the 8 yellow cells. They should end Sales
up looking like the green cells. Costs
2. Put pointer on H11. Then click Formulas > fx. Find and Taxable income
select category Lookup & Reference, and then click Taxes
Net income
VLOOKUP and OK to get the dialog box shown to the right.
Fill it in as indicated. H7 is the number you are looking
up, the taxable income. Highlight A9:D16 and select Tax on base
it to define the area of the lookup table. You want to look Income over base
up a number in the 3rd column. Tax rate
4. Excel looks down Column 1 until it finds the value that's Tax: income over base
just larger than the number in H7, then it backs up one, Total taxes
then it goes to the 3rd column, finds the right number, and Average tax rate
inserts it in H11. You now have the tax on the base income.
5. To find the income over the base, use VLOOKUP again. Put pointer on H12.
Get a new dialog box and fill it in just like the first one, except the third entry is 1 rather
than 3. You now subtract this amount from the firm's taxable income. Do this by editing and entering
entering H7 followed by a minus sign right after the equal sign in H12. The income over base is $15,000.
6. Now look up the marginal tax rate, i.e., the rate on the income over the base. Again, get a
dialog box and fill it out as before, but with a 4 for the index. See the third box to the right.
7. Now just complete the arithmetic and finish the income statement. Note that the marginal
tax rate is 25%, but the average tax rate is only 17.3%.

With the income statement completed, you can change sales and/or costs to see the new results.
For example, change sales (H5) from $315,000 to $400,000 to see the average rate rise from 17.3%
to 27.8%.
orporate income. The
he tax liability and net
nd net income.
$315,000
$250,000
$65,000

$315,000
$250,000
$65,000
$11,250

$53,750

$7,500
$15,000
25.0%
$3,750
$11,250
17.3%

by editing and entering

ome over base is $15,000.
e. Again, get a
to the right.
at the marginal

ee the new results.

ate rise from 17.3%
 Chapter 3. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem
Problem 3-16

Laiho Industries December 31 Balance Sheets

(in thousands of dollars)
2011 2010
Assets
Cash $ 102,850 $ 89,725
Accounts receivable 103,365 85,527
Inventories 38,444 34,982
Total current assets $ 244,659 $ 210,234
Net fixed assets 67,165 42,436
Total assets $ 311,824 $ 252,670

Liabilities and equity

Accounts payable $ 30,761 $ 23,109
Accruals 30,477 22,656
Notes payable 16,717 14,217
Total current liabilities $ 77,955 $ 59,982
Long-term debt 76,264 63,914
Total liabilities $ 154,219 $ 123,896
Common stock 100,000 90,000
Retained earnings 57,605 38,774
Total common equity $ 157,605 $ 128,774
Total liabilities and equity $ 311,824 $ 252,670

a. Sales for 2011 were $455,150,000, and EBITDA was 15% of sales. Furthermore, depreciation and
amortization were 11% of net fixed assets, interest was $8,575,000, the corporate tax
rate was 40%, and Laiho pays 40% of its net income as dividends. Given this information,
construct the firm’s 2011 income statement.

The input information required for the problem is outlined in the "Key Input Data" section below. Using
this data and the balance sheet above, we constructed the income statement shown below.

KEY INPUT DATA: Laiho Industries

(in thousands of dollars)

Sales $455,150
EBITDA as a percentage of sales 15%
Depr. as a % of fixed assets 11%
Tax rate 40%
Interest expense $8,575
Dividend payout ratio 40%

Laiho Industries Income Statement

(in thousands of dollars)
2011
Sales $455,150
Expenses excluding depreciation and amortization 386,878 Found after finding EBITDA
EBITDA $68,273 Found this first
Depreciation and amortization 7,388
 EBIT $60,884
Interest expense 8,575
EBT $52,309
Taxes (40%) 20,924
Net Income $31,386

Common dividends $12,554

Addition to retained earnings $18,831

b. Construct the statement of stockholders' equity for the year ending December 31, 2011,
and the 2011 statement of cash flows.

Statement of Stockholders' Equity

(in thousands of dollars)
Total
Common Retained Stockholders'
Stock Earnings Equity
Balances, December 31, 2010 $90,000 $38,774 $128,774
Common stock issue 10,000 10,000
2011 Net income 31,386
Cash dividends (12,554)
Addition to retained earnings 18,831
Balances, December 31, 2011 $100,000 $57,605 $157,605

Statement of Cash Flows

(in thousands of dollars)

Operating Activities
Net Income $31,386
Depreciation and amortization 7,388
Increase in accounts payable 7,652
Increase in accruals 7,821
Increase in accounts receivable (17,838)
Increase in inventories (3,462)
Net cash provided by operating activities $32,947

Investing Activities
Additions to property, plant, and equipment ($32,117)
Net cash used in investing activities ($32,117)

Financing Activities
Increase in notes payable $2,500
Increase in long-term debt 12,350
Increase in common stock 10,000
Payment of common dividends (12,554)
Net cash provided by financing activities $12,295

Summary
Net increase/decrease in cash $13,125
Cash balance at the beginning of the year 89,725
Cash balance at the end of the year $102,850

c. Calculate 2010 and 2011 net operating working capital (NOWC) and 2011 free cash flow (FCF).
Net Operating Working Capital (must be financed by external sources)
NOWC10 = Current assets − (Current liabilities − Notes payable)
NOWC10 = $210,234 − $45,765
NOWC10 = $164,469

NOWC11 = Current assets − (Current liabilities − Notes payable)

NOWC11 = $244,659 − $61,238
NOWC11 = $183,421

Free Cash Flow

Capital Increase in
FCF11 = EBIT (1 − T) + Depreciation − expenditures + NOWC
FCF11 = $36,531 + $7,388 − $32,117 + $18,952
FCF11 = -$7,150

d. If Laiho increased its dividend payout ratio, what effect would this have on its corporate taxes paid?
What effect would this have on the taxes paid by the company's shareholders?

An increase in the firm's dividend payout ratio would have no effect on its corporate taxes paid because
dividends are paid with after-tax dollars. However, the company's shareholders would pay additional
taxes on the additional dividends they would receive. As of 09/10, dividends are generally taxed at a
maximum rate of 15%; however, this rate is scheduled to rise on January 1, 2011.