Financial Statements, Taxes, and Cash Flow | Corporate Finance | CMA Exam | CPA Exam BEC |Chapter 2

These lectures cover analysis of balance sheet, income statement, corporate taxes and cash flow analysis as  related to introduction to corporate finance course

Balance Sheet | Corporate Finance

Income Statement | Corporate Finance

Corporate Taxes | Cooperate Finance

Cash Flow Analysis | Corporate Finance

 

The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm’s equity) at a given point in time.

Assets are classified as either current or fixed. A fixed asset is one that has a relatively long life. Fixed assets can be either tangible, such as a truck or a computer, or intangible, such as a trademark or patent. A current asset has a life of less than one year. This means that the asset will convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year and is thus classified as a current asset. Obviously, cash itself is a current asset. Accounts receivable (money owed to the firm by its customers) are also current assets.
ssets are classified as either current or fixed. A fixed asset is one that has a relatively long life. Fixed assets can be either tangible, such as a truck or a computer, or intangible, such as a trademark or patent. A current asset has a life of less than one year. This means that the asset will convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year and is thus classified as a current asset. Obviously, cash itself is a current asset. Accounts receivable (money owed to the firm by its customers) are also current assets.

Net working capital is positive when current assets exceed current liabilities. Based on the definitions of current assets and current liabilities, this means the cash that will become available over the next 12 months exceeds the cash that must be paid over the same period. For this reason, net working capital is usually positive in a healthy firm.
The structure of the assets for a particular firm reflects the line of business the firm is in and also managerial decisions about how much cash and inventory to have and about credit policy, fixed asset acquisition, and so on.

Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively liquid asset; a custom manufacturing facility is not. Liquidity actually has two dimensions: ease of conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one that can be quickly sold without significant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction.

Assets are normally listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid assets are listed first. Current assets are relatively liquid and include cash and assets we expect to convert to cash over the next 12 months. Accounts receivable, for example, represent amounts not yet collected from customers on sales already made. Naturally, we hope these will convert to cash in the near future. Inventory is probably the least liquid of the current assets, at least for many businesses.

Fixed assets are, for the most part, relatively illiquid. These consist of tangible things such as buildings and equipment that don’t convert to cash at all in normal business activity (they are, of course, used in the business to generate cash). Intangible assets, such as a trademark, have no physical existence but can be very valuable. Like tangible fixed assets, they won’t ordinarily convert to cash and are generally considered illiquid.

Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively liquid asset; a custom manufacturing facility is not. Liquidity actually has two dimensions: ease of conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one that can be quickly sold without significant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction.

Assets are normally listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid assets are listed first. Current assets are relatively liquid and include cash and assets we expect to convert to cash over the next 12 months. Accounts receivable, for example, represent amounts not yet collected from customers on sales already made. Naturally, we hope these will convert to cash in the near future. Inventory is probably the least liquid of the current assets, at least for many businesses.

Fixed assets are, for the most part, relatively illiquid. These consist of tangible things such as buildings and equipment that don’t convert to cash at all in normal business activity (they are, of course, used in the business to generate cash). Intangible assets, such as a trademark, have no physical existence but can be very valuable. Like tangible fixed assets, they won’t ordinarily convert to cash and are generally considered illiquid.

The income statement measures performance over some period of time, usually a quarter or a year. The income statement equation is:
Revenues minus expenses equal to net income.
The first thing reported on an income statement would usually be revenue and expenses from the firm’s principal operations. Subsequent parts include, among other things, financing expenses such as interest paid. Taxes paid are reported separately. The last item is net income (the so-called bottom line). Net income is often expressed on a per-share basis and called earnings per share (EPS).

The first thing reported on an income statement would usually be revenue and expenses from the firm’s principal operations. Subsequent parts include, among other things, financing expenses such as interest paid. Taxes paid are reported separately. The last item is net income (the so-called bottom line). Net income is often expressed on a per-share basis and called earnings per share (EPS).
GAAP AND THE INCOME STATEMENT
An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. The general rule (the recognition or realization principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.
Expenses shown on the income statement are based on the matching principle. The basic idea here is to first determine revenues as described previously and then match those revenues with the costs associated with producing them. So, if we manufacture a product and then sell it on credit, the revenue is realized at the time of sale. The production and other costs associated with the sale of that product will likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some different time.

As a result of the way revenues and expenses are realized, the figures shown on the income statement may not be at all representative of the actual cash inflows and outflows that occurred during a particular period.

NONCASH ITEMS
A primary reason that accounting income differs from cash flow is that an income statement contains noncash items. The most important of these is depreciation. Suppose a firm purchases an asset for $5,000 and pays in cash. Obviously, the firm has a $5,000 cash outflow at the time of purchase. However, instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a five-year period.
TIME AND COSTS
It is often useful to think of the future as having two distinct parts: the short run and the long run. These are not precise time periods. The distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on.

If our time horizon is relatively short, however, some costs are effectively fixed—they must be paid no matter what (property taxes, for example). Other costs such as wages to laborers and payments to suppliers are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas.

The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs.

TIME AND COSTS
It is often useful to think of the future as having two distinct parts: the short run and the long run. These are not precise time periods. The distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on.

If our time horizon is relatively short, however, some costs are effectively fixed—they must be paid no matter what (property taxes, for example). Other costs such as wages to laborers and payments to suppliers are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas.

The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs.

Taxes can be one of the largest cash outflows a firm experiences.

The size of a company’s tax bill is determined by the tax code, an often amended set of rules. In this section, we examine corporate tax rates and how taxes are calculated. If the various rules of taxation seem a little bizarre or convoluted to you, keep in mind that the tax code is the result of political, not economic, forces. As a result, there is no reason why it has to make economic sense.

Normally the marginal tax rate is relevant for financial decision making. The reason is that any new cash flows will be taxed at that marginal rate. Because financial decisions usually involve new cash flows or changes in existing ones, this rate will tell us the marginal effect of a decision on our tax bill.

By cash flow, we simply mean the difference between the number of dollars that came in and the number that went out. For example, if you were the owner of a business, you might be very interested in how much cash you actually took out of your business in a given year.

various things that make up these cash flows next.

CASH FLOW FROM ASSETS
Cash flow from assets involves three components: operating cash flow, capital spending, and change in net working capital. Operating cash flow refers to the cash flow that results from the firm’s day-to-day activities of producing and selling. Expenses associated with the firm’s financing of its assets are not included because they are not operating expenses.
Operating Cash Flow
To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don’t want to include depreciation because it’s not a cash outflow, and we don’t want to include interest because it’s a financing expense. We do want to include taxes because taxes are (unfortunately) paid in cash.
Capital Spending
Net capital spending is just money spent on fixed assets less money received from the sale of fixed assets.