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Financial Statements, Cash

Flow, and Taxes

The Annual Report
Balance sheet provides a snapshot of a firms
financial position at one point in time.

Income statement summarizes a firms revenues
and expenses over a given period of time.

Statement of cash flows reports the impact of a
firms activities on cash flows over a given period of

Statement of stockholders equity shows how
much of the firms earnings were retained, rather
than paid out as dividends.

Why do We Need Financial Statements?
Creditors and investors need them to make
informed financial decisions about whether to
lend and invest in the company.

Managers need them to operate their
business efficiently.

Taxing authorities (Government) need them
to assess taxes in a reasonable way.
A Typical Balance Sheet
Stockholders Equity

Paid-in capital - money raised from investors; paid-in
capital represents external financing.

Retained earnings that part of the profit which is
not distributed to investors as dividends, but instead is
reinvested in the business; it provides the most
important source of financing for the corporations
growth internal financing.

Stockholders Equity = Paid-in capital + Retained earnings

BS Equation
Stockholders equity represents a residual claim;
Residual is whatever is left from the assets after all the
liabilities are satisfied. This means that stockholders have
a claim after everybody else has been completely

From the the BS equation, we can calculate
stockholders equity as a residual:

Stockholders equity = Total assets - Total liabilities
Working Capital
Current assets are often called working capital

Net working capital = Current assets Current Liabilities

Distinction between free liabilities (accruals and accounts payable)
and interest-bearing liabilities (notes payable)

NOWC = Current assets (Current liabilities Notes Payable)
Income Statement
EBIT (operating profit) = Sales revenues Operating costs

EBITDA = Sales revenues Operating costs except
depreciation and amortization

Depreciation it simply means a loss of value of an asset
because of normal use (in accounting we use the term
wear and tear); similar to depreciation is amortization with
the only difference that it is associated with intangible
assets; firms often used accelerated depreciation for tax
purposes and straight-line depreciation for stockholder

Statement of Stockholders Equity
It simply has 2 main components paid-in capital and
retained earning.
Stockholders Equity: Beg. Balance + in Retained Earnings
= Ending Balance
Net income and dividends jointly give you the change in
retained earnings for the current year.
Retained Earnings: Beg. Balance (accumulated retained
earnings until last year) + Net Income Dividends =
Ending Balance
Paid-in Capital: Beg. Balance + Stock issuance/issue Stock
buyback/repurchase = Ending Balance

Cash Flow Statement
Cash flows from operating activities

Cash flows from investing activities

Cash flows from financing activities

A Typical Cash Flow Statement
I. Operating activities
Net Income 117,5
Depreciation & Amortization 100
Increase in inventories -200
Increase in accounts receivable -60
Increase in accounts payable 30
Increase in accrued wages and taxes 10
Net cash provided by (used in) operating activities -2,5
II. Long-Term Investing Activities
Additions to property, plant and equipment -230
Net cash from (used in) investing activities -230

III. Financing Activities
Increase in notes payable 50
Increase in bonds 170
Payment of dividends to stockholders -57,5
Net cash from (used in) Financing activities 162,5

IV. Summary
Net increase/decrease in cash and cash equivalents (Net sum of I, II and III) -70
Cash & cash equivalents at the beginning of the period 80
Cash & cash equivalents at the end of the period 10
Free Cash Flow
FCF is the amount of cash that could be withdrawn from the firm
without harming its ability to operate and to produce future cash flows.
FCF is equal to whatever is left from the operating profit after you
satisfy the government and then you take care of your short-term
capital needs (operating needs) and long-term capital needs (investment
needs). It is available to satisfy debtholders and stockholders and can be
used to pay down debt, interest, dividends, to repurchase stock (in any
way to satisfy liabilities).

FCF = [(EBIT(1-T)+ Depreciation & Amortization] - [CapEx + NOWC]

EBIT (1-T) = after-tax profit; it is often referred to as NOPAT (net
operating profit after taxes)
Is it possible a rapidly growing business that is very profitable and
produce high CFs to have a negative FCF?

Performance Measures
Market Value Added (MVA) is the difference between the market value
of a firms equity and its book value.

Economic Value Added (EVA) is the excess of NOPAT over capital costs

EVA = NOPAT Annual dollar cost of capital =
= EBIT(1-T) (Total Investor-supplied operating capital * After-tax
percentage cost of capital)

EVA is an estimate of business true economic profit for a given year
and it differs sharply from accounting net income.
Relationship between EVA and MVA
If EVA is positive, then after-tax operating income >
cost of capital needed to produce that income.

Positive EVA on annual basis helps to ensure MVA is

MVA is applicable to entire firm, while EVA can be
calculated on a divisional basis as well.

Individual Taxes
Individual taxes (on wages and salaries, on investment income and on
profits of proprietorships and partnerships) have a progressive
structure (the higher the taxable income, the higher the marginal tax
Taxable income gross income less a set of exemptions and
Marginal tax rate the tax rate on the last unit of income (begin at
10% and rise to 39,6% for 2013)
Average tax rate taxes paid divided by taxable income.
Interest income received by individuals is added to their income for
tax purposes.
Capital gains and losses short-term ones are added to ordinary
income, long-term are treated differently (they are usually taxed at a
lower rate than regular income).
Dividends are classified either as ordinary dividends or as qualified
dividends. Ordinary dividends are taxed at ordinary tax rates for
whatever tax bracket you are in. Qualified dividends are taxed at the
long-term capital gains tax rates of zero percent, 15% or 20% rates.

Tax Rate Example
Taxable Income
You Pay This Amount
on the Base of the
Plus This Percentage on the
Excess over the Base
(Marginal Rate)
$0 to $8 925 0 10,0%
$8 925 to $36 250 892,5 15,0%
$36 250 to $87 850
4 991,25
$87 850 to $183 250 17 891,25 28,0%
$183 250 to $398 350 44 603,25 33,0%
$398 350 to $400 000 115 586,25 35,0%
$400 000 and up 116 163,75 39.6%
If you earn $100,000 per year, how much tax you would owe?
What are you marginal and average tax rates?

You would owe 10% of $8,925, 15% of $27,325 (the difference
between the top and the threshold of the second tax bracket),
25% of $51,600, and 28% of $12,150 (the difference between
your income and the threshold of the third tax bracket).That
calculation results in $21,293, or an effective (not marginal) tax
rate of 21.3%.
Corporate Taxes
Corporate income taxes have a progressive tax structure.
Interest earned: usually fully taxable at regular tax rates (an
exception being interest from a muni).
Dividends received: A portion of dividends (up to 100%
depending on the percentage of ownership) is excluded from
taxable income, while the remaining is taxed at the ordinary
tax rate, the purpose being to avoid triple taxation.
Capital gains - U.S. corporations face the same tax rate on
capital gains as on ordinary income.
Interest paid: tax deductible for corporations (paid out of
pre-tax income).
Dividends are paid out of net income which has already been
taxed at the corporate level, this is a form of double

Corporate Tax Rates
Taxable Income
You Pay This Amount
on the Base of the
Plus This Percentage on
the Excess over the
Base (Marginal Rate)
$0 to $50 000 0 15,0%
$50 000 to $75 000 7 500 25,0%
$75 000 to $100 000
13 750
$100 000 to $335 000 22 250 39,0%
$335 000 to $10 000 000 113 900 34,0%
$10 000 000 to $15 000 000 3 400 000 35,0%
$15 000 000 to $ 18 333 333 5 150 000 38,0%
$18 333 333 and up
6 416 667
Average Tax
Rate at Top
of Bracket
What is the average tax rate at top of each tax bracket?
More Tax Issues
Tax Loss Carry-Back and Carry-Forward since corporate
incomes can fluctuate widely, the Tax Code allows firms to
carry losses back to offset profits in previous years or forward
to offset profits in the future.
2011 2012
Original taxable income $3 000 000 $2 000 000
Carry-back credit -3 000 000 -2 000 000
Adjusted profit $ 0 $ 0
Taxes previously paid (40%) 1 200 000 800 000
Tax refund $ 1 200 000 $ 800 000
Total refund received in 2014: $1 200 000 + $800 000 = $2 000 000
Amount of loss carry-forward available for use in 2014-2034:
2013 loss
$6 000 000
Carry-back losses used $5 000 000
Carry-forward losses still available $1 000 000