Fundamentals of Corporate Finance

Fundamentals of Corporate Finance, 2/eRobert Parrino, Ph.D.David S. Kidwell, Ph.D.Thomas w. bates, ph.d.

Chapter 3: Financial Statements, Cash Flows, and Taxes

Learning ObjectivesDiscuss Generally accepted accounting principles (GAAP) and their importance to the economy.Explain the balance sheet identity and why a balance sheet must balance.Describe how market-value balance sheets differ from book-value balance sheets.

Learning ObjectivesIdentify the basic equation for the income statement and the information it provides.Understand the calculation of cash flows from operating, investing, and financing activities required in the statement of cash flows.Explain how the four major financial statements discussed in this chapter are related.Learning ObjectivesIdentify the cash flow to a firms investors using its financial statements.Discuss the difference between average and marginal tax rates.

Financial StatementsPurpose of financial statementsProvide stakeholders a foundation for evaluating the financial health of a firmcreditorsemployeesmanagementstockholdersFinancial StatementsPurpose of financial statementsProvide stakeholders a foundation for evaluating the financial health of a firm.customersgeneral Publicregulatorssuppliers

Financial StatementsPurpose of financial statementsEvaluate a firms internal environmentefficiencyeffectivenessrisk level

Financial StatementsPurpose of financial statementsEvaluate a firms interaction with the external environmentcorporate citizenshipsocial responsibilityassessment of the external environmentresponse to the external environmentFinancial StatementsPurpose of financial statementsProvide information about the performance of the firmstakeholders want to compare actual vs. potential performance Financial Statements and Accounting PrinciplesGAAPGenerally Accepted Accounting Principles (GAAP)accounting rules and standards that public companies must adhere to when they prepare financial statements and reportsestablished by the Financial Accounting Standards Board (FASB) and authorized by the Securities and Exchange Commission (SEC)

Financial Statements and Accounting PrinciplesInternational GAAPUniform accounting rules and procedures promoted by the International Accounting Standards BoardFirms in the European Union are moving toward a European GAAPEconomic and political pressure is building in the United States and Europe to develop a unified accounting systemFinancial Statements and Accounting PrinciplesGAAPGuidelines, not rulesFirms have discretion about how their financial information is presented.No two firms are required to have identical statements.Financial Statements and Accounting PrinciplesGAAPGuidelines, not rules.Alternative terms on financial statementsbalance sheet, statement of financial conditionincome statement, statement of operations, profit and loss statement cost-of-goods-sold, cost-of -sales, cost-of-revenue, cost-of-services-soldFinancial Statements and Accounting PrinciplesFive Important Accounting PrinciplesAssumption of Arms Length TransactionParties involved in an economic transaction arrive at a decision independently and rationally.Cost PrincipleAsset values are recorded at the cost for which they were acquired.

Financial Statements and Accounting PrinciplesFive Important Accounting PrinciplesRealization PrincipleRevenue is recognized when a transaction is completed, although cash may be received earlier or later.Matching PrincipleRevenue is matched with the expense incurred to generate it.Financial Statements and Accounting PrinciplesFive Important Accounting PrinciplesGoing Concern AssumptionAssume a company will continue to operate for the predictable future.Financial Statements and Accounting PrinciplesAnnual ReportSummarizes the overall performance of a firm for the most recent fiscal yearInformationthe company, its products, its activities, and its futuresummary of financial performance for the most recent yearaudited financial statements, five-year summary of financial data18The Balance SheetFirm Assets & funding at a point in timeLeft side of a balance shows assets a firm owns and uses to generate revenueRight side of the balance sheet shows sources of the funds used to acquire assets

Diaz Manufacturing Balance Sheets as of December 31

The Balance SheetItem orderAssets listed in order of liquidityLiabilities listed in order in which they are due to be paidStockholders equity listed lastCommon stockholders are entitled to assets remaining after all other providers of funds are paid.

The Balance SheetCurrent AssetsAssets likely to be converted to cash within a year (or one operating cycle)marketable securitiesaccounts receivableinventory

The Balance SheetCurrent LiabilitiesLiabilities scheduled to be paid within a year (or one operating cycle)accounts payable accrued wagesdebt with less than a years maturitytaxesThe Balance SheetNet Working Capital

The Balance SheetNet working capital exampleDiaz Manufacturing Total current assets = $1,039.8 millionTotal current liabilities = $377.8 millionNet working capital = Total current assets - Total current liabilities = $1,039.8 million - $377.8 million = $662.0 millionThe Balance SheetInventory AccountingInventory (least liquid current asset) reported using one of two methodsFIFO (first-in-first-out) assumes merchandise is sold in the order it was acquired by a firm.LIFO (last-in-first-out) assumes merchandise is sold in the reverse of the order it was acquired by a firm.

The Balance SheetInventory AccountingWhen the cost of inventory is increasingFIFO reporting says a firm sold the less expensive inventory and leads tohigher balance in inventorylower cost-of-goods-soldhigher taxable incomehigher income taxeshigher net income

The Balance SheetInventory AccountingWhen the cost of inventory is increasingLIFO reporting says a firm sold the more expensive inventory and leads tolower balance in inventoryhigher cost-of-goods-soldlower taxable incomelower income taxeslower net income

The Balance SheetInventory AccountingWhen the cost of inventory is decreasingFIFO reporting says a firm sold the more expensive inventory and leads tolower balance in inventoryhigher cost-of-goods-soldlower taxable incomelower income taxeslower net income

The Balance SheetInventory AccountingWhen the cost of inventory is decreasingLIFO reporting says a firm sold the less expensive inventory and leads tohigher balance in inventorylower cost-of-goods-soldhigher taxable incomehigher income taxeshigher net income

The Balance SheetInventory AccountingFirms may switch from one inventory accounting method to the other under extraordinary circumstances but not frequently

The Balance SheetLong-Term AssetsReal AssetslandbuildingsequipmentIntangible AssetsgoodwillpatentscopyrightsThe Balance SheetLong-Term AssetsReal assets decline with use and are depreciatedDepreciation expense reduces taxable income and income taxes.Assets are depreciated using either the straight line or accelerated depreciation method.Intangible assets lose value over time and are amortized (equivalent to depreciated)

The Balance SheetLong-Term LiabilitiesLong-term debtbank loansmortgagesbonds with a maturity longer than one year

The Balance SheetEquity Common Stockownership with control in a firmPreferred Stockownership without control in a firmfeatures make it an equity security that resembles debt

The Balance SheetOther Balance Sheet AccountsRetained earningsProfit kept and used to acquire assets.Treasury stockShares of its own stock a firm holds rather than sell them to the public.

Market Value vs. Book Value Recording Asset ValueAssets are traditionally reported at historical cost on a balance sheetBalance sheet amount does not reflect current market value only the acquisition cost

Market Value vs. Book Value Asset ValuationBetter information is provided to management and investors by marking-to-market reporting balance sheet items at current market valuesdifficult to determine market values of assetsThe difference between the market values of assets and liabilities is a realistic estimate of the market value of shareholders equity

The Income StatementIncome Statement: OverviewMeasures the profitability of a firm for a reporting periodRevenue is income from selling products and services for cash or creditExpenses include costs of providing products and services, and asset utilization (depreciation and amortization)

Diaz Manufacturing Income Statements

The Income StatementNet Income exampleDiaz ManufacturingRevenues = $1,563.7 millionExpenses = $1,445.2 millionNet Income = Revenues Expenses = $1,563.7 million - $1,445.2 million = $ 118.5 million

The Income StatementDepreciationThe cost of a physical asset, such as plant or machinery, is written off over its lifetime. This is called depreciation, a non-cash expenseFirms use one of these depreciation methodsstraight-line depreciationaccelerated depreciationFirms may choose to use one for internal purposes and another for tax purposes or for statements released to the public.

The Income StatementAmortizationAmortization expense is related to using intangible assetsgoodwillpatentslicensesLike depreciation, it is a non-cash expense.

The Income StatementExtraordinary Item Income or expense associated with events that are infrequent and abnormalseparated from the results of ordinary incomeshown separately on the income statement

The Income StatementEBITDA and EBITEarnings-before-interest-taxes-depreciation-and-amortization (EBITDA)income from selling goods and services minus the cost of providing themEarnings-before-interest-and-taxes (EBIT) EBITDA minus depreciation and amortization

The Income StatementEBT and NIEarnings-before-taxes (EBT)EBIT minus interest expensetaxable income Net income (NI)EBT minus taxesStatement of Retained EarningsRetained earningsShows cumulative effect of adjustments to shareholders equity resulting from profit, losses, and paying dividendsShows changes in the account for a period based on profit, loss, or dividend paidDiaz Manufacturing Statement of Retained Earnings

Cash FlowsNet Cash Flows versus Net IncomeAccountants focus on net income and shareholders focus on net cash flows. These are not the same because of delays in inflows and outflows, and non-cash revenues and expensesCash FlowsCash Flows to investorsCash flows available to investors from operating activities (CFOA)

Cash FlowsCFOa ExampleDiaz ManufacturingEBIT = $168.4 millionCurrent Taxes = $44.3 millionNon-cash expenses = $83.1 million

Cash FlowsCash Flows to Working CapitalTo compute the net cash flows into or out of working capital

Cash FlowsCFnwc ExampleDiaz ManufacturingNWC 2011 = $662.0 millionNWC 2010 = $342.0 million

Cash FlowsStatement of Cash FlowsSummarizes cash outflows and cash inflows during a periodCash flows result from operating activities, investing activities, and financing activitiesNet cash flows equals cash inflows minus cash outflows

Diaz Manufacturing Statement of Cash Flows

Cash FlowsStatement of Cash Flows organizationOperating Activitiescash inflowssell goods and servicescash outflowsraw materialsinventorysalaries and wagesutilitiesrentCash FlowsStatement of Cash Flows OrganizationInvesting Activitiescash outflows and inflows due tobuying and selling long-term assets such as plant and equipmentbuying and selling bonds and stocks issued by other firmsCash FlowsStatement of Cash Flows organizationFinancing Activitiescash inflowissue debtissue equityborrow moneycash outflowpay interest or dividendsrepay loan principalpurchase treasury stock

Interrelations Among the Financial Statements

Federal Income TaxCorporate Income TaxU.S. has a progressive tax with rates ranging from 15 percent to 39 percenthigher taxable income = higher the tax liability

Corporate Tax Rates for 2010

Federal Income TaxAverage versus Marginal Tax RateAverage tax ratetotal taxes paid divided by taxable income for the periodMarginal tax raterate paid on the last dollar earned or the next dollar that will be earnedFederal Income TaxDividends and Interest are not equalU.S. tax codeallows interest payments on debt to reduce firms taxable incomedoes not allow dividend payments to equity to reduce firms taxable incomedebt financing has a lower cost relative to equity financing