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Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows. Slide Contents. Learning Objectives An Overview of the Firm’s Financial Statements The Income Statement Corporate Taxes The Balance Sheet The Cash Flow Statement Principles Applied in This Chapter Key Terms.
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Chapter 3Understanding Financial Statements, Taxes, and Cash Flows
Slide Contents • Learning Objectives • An Overview of the Firm’s Financial Statements • The Income Statement • Corporate Taxes • The Balance Sheet • The Cash Flow Statement • Principles Applied in This Chapter • Key Terms
Learning Objectives • Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager. • Evaluate firm profitability using the income statement. • Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.
Learning Objectives (cont.) • Use the balance sheet to describe a firm’s investments in assets and the way it has financed them. • Identify the sources and uses of cash for a firm using the firm’s cash flow statement.
Principles Used in This Chapter • Principle 1: Money Has a Time Value. • Principle 3: Cash Flows Are the Source of Value. • Principle 4: Market Prices Reflect Information. • Principle 5: Individuals Respond to Incentives.
Basic Financial Statements The accounting and financial regulatory authorities mandate the following four types of financial statements: • Income statement • Balance sheet • Cash flow statement • Statement of shareholder’s equity
Basic Financial Statements (cont.) • Income Statement: An income statement provides the following information for a specific period of time (for example, a full year or quarterly): • Revenue earned, • Expenses incurred, and • Profit earned.
Basic Financial Statements (cont.) • Balance sheet: Balance sheet contains information on a specific date (for example, as of December 31, 2013) of the following: • Assets (everything of value the company owns), • Liabilities (the firm’s debts), and • Shareholders’ equity (the money invested by the company owners).
Basic Financial Statements (cont.) • Cash flow statement: It reports cash received and cash spent by the firm over a period of time. • Statement of shareholder’s equity: It provides a detailed account of the firm’s activities in the following accounts: Common stock & Preferred stock account, Retained earnings account, and Changes to owners’ equity.
Why Study Financial Statements? Analyzing a firm’s financial statement can help managers carry out three important tasks: • Assess current performance, • Monitor and control operations, and • Plan and forecast future performance.
Why Study Financial Statements? (cont.) • This chapter discusses the distinction between the earnings numbers that the firm’s accountants calculate and the amount of cash that a firm generates. • It is possible for a firm to report positive accounting earnings while generating negative cash flows (and vice versa).
What are the Accounting Principles Used to Prepare Financial Statements? • Accountants use the following three fundamental principles when preparing financial statements: • The revenue recognition principle, • The matching principle, and • The historical cost principle.
An Income Statement An income statement (also called a profit and loss statement) measures the amount of profits generated by a firm over a given time period (usually a year or a quarter). It can be expressed as follows: Revenues (or Sales) – Expenses = Profits
An Income Statement (cont.) An income statement will contain the following: • Revenues • Expenses • Cost of goods sold, Selling expenses, General and administrative expense, depreciation & amortization expense, Interest expense, and Income tax expense • Net Income • Difference between Revenue and all expenses
Evaluating a Firm’s per Share Earnings (EPS) and Dividends • Per Share earnings = company’s net income divided by the number of common shares outstanding. • Dividends per share = total dividends paid divided by the number of common shares outstanding.
Evaluating a Firm’s EPS and Dividends (for Boswell, Table 3.1) • Earnings per share = $204.75m ÷ 90m = $2.28 per share • Dividends per share = $45m ÷ 90m = $0.50 per share
Connecting the Income Statement and the Balance Sheet • What can the firm do with the net income?: Pay dividends to shareholders, and/or Reinvest in the firm • Boswell, Inc. earned net income of $204.75 million, of which $45 million was distributed in dividends and $159.75 million was retained and reinvested in the firm.
Interpreting Firm Profitability using the Income Statement From H.J. Boswell Inc.’s income statement (Table 3-1) we observe that firm has been profitable. We can identify three different measures of profit or income: • The gross Profit margin is 25% ($675 million) • The operating profit margin is only 14.2% ($382.5 million) • The net profit margin is only 7.6% ($204.75 million)
Interpreting Firm Profitability using the Income Statement (cont.) • The gross profit margin (GPM) = gross profits ÷ sales = $675 million ÷ $2,700 million = 25% • GPM indicates the firm’s “mark-up” on its cost of goods sold per dollar of sales. The markup percentage equals gross profit divided by cost of goods sold (=$675m ÷ $2.025m = 33.3%)
Interpreting Firm Profitability using the Income Statement (cont.) • The operating profit margin = net operating income ÷ sales = $382.5 million ÷ $2,700 million = 14.17% • The operating profit margin is equal to the ratio of net operating income or EBIT divided by firm’s sales.
Interpreting Firm Profitability using the Income Statement (cont.) • The net profit margin = net profits ÷ sales = $204.75 million ÷ $2,700 million = 7.6% • Net profit margin indicates the percentage of revenues left over after all expenses (including interest and taxes) have been considered.
Interpreting Firm Profitability using the Income Statement (cont.) By monitoring any changes in these margins and comparing these margins to those of similar businesses, we can dissect and identify a firm’s performance and identify expenses that are out of line.
GAAP and Earnings Management • While the firms must adhere to GAAP, there is considerable room for managers to actively influence the firm’s reported earnings. • Managers have an incentive to tamper with earnings as their pay depends upon it and because investors pay close attention to earnings announcements.
GAAP and Earnings Management An audit by an independent accounting firm serves as a check and balance to control management’s incentive to disguise the firm’s financial condition.
Constructing an Income Statement Reconstruct the firm’s income statement assuming the firm is able to cut its cost of goods sold by 10% and that the firm pays taxes at a 40% rate. What is the firm’s net income and earnings per share? CHECKPOINT 3.1:CHECK YOURSELF
Step 1: Picture the Problem • The income statement can be expressed as follows: Revenues – Expenses = Net Income • We are given information on revenues and expenses (cost of goods sold, operating expenses, interest expense and income taxes) to fill the template given on next slide.
Step 1: Picture the Problem (cont.) Revenues Less: Cost of goods sold Equals Gross profit Less: Operating expenses Equals: net Operating income Less: Interest expense Equals: earnings Before taxes Less: Income taxes Equals: NET INCOME
Step 2: Decide on a Solution Strategy • Given the account balances, constructing the income statement will entail substituting the appropriate balances into the template of step 1.
Step 3: Solve Revenues = $14,549,000,000 Less: Cost of goods sold = $8,347,500,000 Equals: profit =$6,201,500,000 Less: Operating/other expenses =$3,841,000,000 Equals: net Operating income =$2,370,500,000 Less: Interest expense =$74,000,000 Equals: earnings Before taxes =$2,291,500,000 Less: Income taxes (40%) =$916,600,000 Equals: NET INCOME =$1,374,900,000
Step 3: Solve (cont.) Earnings per share: = net income ÷ number of shares = $1,374,900,000 ÷ 716,296,296 = $1.92
Step 4: Analyze The firm is profitable since it earned net income of $1,374,900,000. The shareholders were able be earn $1.96 per share.
Corporate Taxes A firm’s income tax liability is based on its taxable income and the tax rates on corporate income.
Computing Taxable Income The table reveals the following: • Tax rates range from 15% to 39% • Tax rates are progressive i.e. corporations with higher profits tend to pay more taxes.
Marginal and Average Tax Rates • Marginal tax rate is the tax rate that the company will pay on its next dollar of taxable income. • Average tax rate is total taxes paid divided by the taxable income.
Marginal and Average Tax Rates Example: What is the average and marginal tax liability for a firm reporting $100,000 as taxable income.
Marginal and Average Tax Rates • Average tax rate • = Total tax liability ÷ Total taxable income • = $22,250 ÷ $100,000 • = 22.25% • Marginal tax rate • = 39% as the firm will have to pay 39% on its next dollar of taxable income i.e. if its taxable income increases from $100,000 to $100,001.
Dividend Exclusion for Corporate Shareholders The dividend received by corporate stockholders are partially exempt from taxation. The rationale is to avoid double taxation at the corporate level. The percentage of exempt taxes is based on the degree of ownership of the firm.
Dividend Exclusion for Corporate Shareholders Example What will be the taxable income if firm A receives $100,000 in dividends from firm B.
The Balance Sheet The balance sheet provides a snapshot of the firm’s financial position on a specific date. It is defined by the following equation: Total Assets = Total Liabilities + Total Shareholders Equity
The Balance Sheet (cont.) • Total liabilities represent the total amount of money the firm owes its creditors • Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities. • Total assets, sum of total shareholders’ equity and total liabilities, represents the resources owned by the firm.
The Balance Sheet (cont.) • In general, GAAP requires that the firm report assets using the historical costs. • Cash and assets held for sale (such as marketable securities) are an exception to the rule. These assets are reported using the lower of their cost or current market value.
The Balance Sheet (cont.) Assets whose value is expected to decline over time (such as equipment) is reported as “net equipment”(equal to historical cost less the accumulated depreciation). Net value (also known as accounting or book value) could be significantly different from the market value of the asset.
