Chapter

Financial Statements, Taxes, and Cash Flows

McGraw-Hill/Irwin

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Know the difference between book value and market value Know the difference between accounting income and cash flow Know how to determine a firms cash flow from its financial statements

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Chapter Outline
The Balance Sheet The Income Statement Taxes Cash Flow

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Financial statements
Provide useful information about a companys financial position on financing, investing and operating activities. Help users (investors, suppliers, managers) make better economic decisions. Consist of the Balance sheet, Income Statement, Statement of Retained Earnings and Statement of Cash Flows
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Where to get companys financial statements?

In companys annual report available at
Company website Bursa Malaysias website (for public listed company) Register of Companies (ROC) (for private company)

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 What do we have in annual report besides financial statements?

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Balance Sheet
The balance sheet is a snapshot of the firms assets and liabilities at a given point in time. Summarizing what a firm owns (assets) and what a firms owes (liabilities) Assets are listed in order of liquidity
Ease of conversion to cash Without significant loss of value
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Balance sheet
Assets
Fixed assets-relatively long-life, could be tangible (machine) or intangible (trademark or patent). Current assets- inventory, cash, account receivables (money owed to the firm by its customers).

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Balance sheet
Liabilities
Long-term-long term debt/liabilities Current liabilities account payables, notes payables.

Shareholders equity
Reflect residue value to the shareholders after firm pay off its debts/liabilities. Consists of common stock & paid-in capital, retained earnings
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M. Corporation Balance Sheet

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The Balance Sheet - Figure 2.1

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Class exercise
ABC Inc has the following:
Current assets: $5,000 Fixed assets: $23,000 Current liabilities: $4,300 Long-term debt: $13,000

Questions: (a) what is the shareholders equity account?; (b) how much is net working capital?
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Balance Sheet Analysis

When analyzing a balance sheet, the Finance Manager should be aware of three concerns:
1. 2. 3. 4. Net working capital Accounting liquidity Debt versus equity Value versus cost

Net Working Capital and Liquidity

Net Working Capital
Current Assets Current Liabilities Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out Usually positive in a healthy firm.

Liquidity
Ability to convert to cash quickly without a significant loss in value Liquid firms are less likely to experience financial distress But liquid assets earn a lower return Trade-off to find balance between liquid and illiquid assets

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Debt versus equity

Creditors generally receive the first claim on the firms cash flow. Shareholders equity is the residual difference between assets and liabilities
(Shareholders equity = assets-liabilities)

The use of debt increases the potential reward to shareholders, but also increases the potential for financial distress.
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Market Vs. Book Value

The balance sheet provides the book value of the assets, liabilities and equity. Market value is the price at which the assets, liabilities or equity can actually be bought or sold. Market value and book value are often very different. Why? Which is more important to the decisionmaking process?
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Example 2.2 Klang Corporation

KLANG CORPORATION Balance Sheets Market Value versus Book Value Book Market Book Market Assets Liabilities and Shareholders Equity $ 400 $ 600 LTD $ 500 $ 500 700 1,000 SE 600 1,100 1,100 1,600 1,100 1,600
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NWC NFA

Income Statement
The income statement is more like a video of the firms performance for a specified period of time. You generally report revenues first and then deduct any expenses for the period
(Revenues-Expenses =Income)

Matching principle GAAP say to show revenue when it accrues and match the expenses required to generate the revenue
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M. Corporation Income Statement Table 2.2

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Noncash Items
A primary reason that net income does not equal to cash flow is that an income statement contains noncash items. Depreciation is the most apparent non-cash item. No firm ever writes a check for depreciation The depreciation deduction (from income statement) reflects the application of matching principle in accounting (expense of purchasing is match with the benefits produced from owning it).

Work the Web Example

Publicly traded companies must file regular reports with Bursa Malaysia. These reports are usually filed electronically and can be searched at
http://www.bursamalaysia.com/market/listed-companies/

Click on the web surfer, pick a company and see what you can find!

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Statement of retained earnings

Beginning balance, retained earnings, 2004 RM1,320 + Net Income RM412 -Dividends RM103 Ending balance, retained earnings, 2005 RM1,629 This statement reports how net income and dividends affect a companys financial position during the periods

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Malaysia Corporate tax

Company (small & medium sized companies) with paid up capital not more than RM2.5 million
On first $500,000: 20% Subsequent balance: 25%

Company with paid up capital more than RM2.5 million

Flat rate of 25%

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The Concept of Cash Flow

Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements Cash flow from the firms asset must equal the sum of the cash flow to creditors and cash flow to stockholders. In other words, cash flow from the firms assets is equal to the cash flow paid to suppliers of capital to the firm.
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Cash flow from assets

Cash flow from assets

Cash flow to creditors

Cash flow to shareholders

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Cash flow from assets

Operating cash flow

Net capital spending

Change in NWC

Cash flow from assets

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Operating cash flow

M. Corporation 2005 Operating Cash Flow Earnings before interest and taxes + Depreciation -Taxes Operating Cash flow RM694 65 212 RM547

Note: Operating cash flow indicating whether or not a firms cash inflows from its business operations are sufficient to cover its everyday cash outflows.
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Capital spending
Ending net fixed assets RM1,709 -Beginning net fixed assets 1,644 + Depreciation 65 Net capital spending RM 130 Note: Net capital spending is the money spent on fixed assets less money received from the sale of fixed assets. What does it mean if net capital spending is negative?
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Change in net working capital

Ending NWC -Beginning NWC Change in NWC RM1,014 684 RM 330

Note: Change in NWC refer to the change in firm investment in net current assets (after minus current liabilities)

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Cash flow from assets

Operating cash flow (RM547)

Net capital spending (RM130)

Change in NWC (RM330)

Cash flow from assets (87)

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Cash flow to creditors

M. Corporation 2005 Cash Flow to Creditors Interest paid -Net new borrowing Cash flow to creditors

RM70 46 RM24

Net new borrowing of RM46 is the additional longterm debt raised in 2005 (RM454-RM408, refer M Corporation balance sheet). This amount is considered a cash inflow. Why?
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Cash flow to stockholders

M. Corporation 2005 Cash Flow to Stockholders Dividend paid RM103 -Net new equity raised 40 Cash flow to stockholders RM 63 Net new equity of RM40 is the additional equity raised in 2005 (RM640-RM600, refer M Corporation balance sheet). This amount is considered a cash inflow. Why?
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Cash flow from assets

Cash flow from assets (RM87)

Cash flow to creditors (RM24)

Cash flow to shareholders (63)

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Cash Flow Summary Table 2.5

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