INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Chapter 3

Financial Statements, Cash

Flow, and Taxes

Key Financial Statements

• Balance Sheet
• Income Statement
• Statement of Stockholders’ Equity
• Statement of Cash Flows
Free Cash Flow
Federal Tax System
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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

The Annual Report

• Balance sheet – provides a snapshot of a firm’s

financial position at one point in time.
• Income statement – summarizes a firm’s
revenues and expenses over a given period of
time.
• Statement of cash flows – reports the impact of
a firm’s activities on cash flows over a given
period of time.
• Statement of stockholders’ equity – shows how
much of the firm’s earnings were retained,
rather than paid out as dividends.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Overview of D’Leon Inc.

• Snack food company that underwent major

expansion in 2014.
• So far, expansion results have been
unsatisfactory.
 Company’s cash position is weak.
 Suppliers are being paid late.
 Bank has threatened to cut off credit.
• Board of Directors has ordered that changes
must be made!

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Balance Sheet: Assets

2015 2014
Cash 7,282 57,600
A/R 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less: Dep. 263,160 146,200
Net FA 939,790 344,800
Total Assets 2,866,592 1,468,800

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Balance Sheet: Liabilities and Equity

2015 2014
Accts payable 524,160 145,600
Accruals 489,600 136,000
Notes payable 636,808 200,000
Total CL 1,650,568 481,600
Long-term debt 723,432 323,432
Common stock 460,000 460,000
Retained earnings 32,592 203,768
Total Equity 492,592 663,768
Total L & E 2,866,592 1,468,800

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Income Statement

2015 2014
Sales $6,034,000 $3,432,000
COGS 5,528,000 2,864,000
Other expenses 519,988 358,672
Total oper. costs excl.
deprec. & amort. $6,047,988 $3,222,672
Depreciation and amortization 116,960 18,900
EBIT ( $ 130,948) $ 190,428
Interest expense 136,012 43,828
EBT ($ 266,960) $ 146,600
Taxes (106,784 ) 58,640
Net income ( $ 160,176) $ 87,960
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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Other Data

2015 2014
No. of shares 100,000 100,000
EPS -$1.602 $0.88
DPS $0.11 $0.22
Stock price $2.25 $8.50
Lease pmts $40,000 $40,000

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Statement of Stockholders’
Equity (2015)

Total
Common Stock Retained Stockholders’
Shares Amount Earnings Equity
Balances, 12/31/14 100,000 $460,000 $203,768 $663,768
2015 Net income (160,176)
Cash dividends (11,000)
Addition (subtraction)
to retained earnings (171,176)
Balances, 12/31/15 100,000 $460,000 $ 32,592 $492,592

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Statement of Cash Flows (2015)

Operating Activities
Net income ($160,176)
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accruals 353,600
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provide d by operating activities ($164,176)

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Statement of Cash Flows (2015)

Long-Term Investing Activities

Additions to property, plant, & equipment ($711,950)
Net cash used in investing activities ($711,950)
Financing Activities
Increase in notes payable $ 436,808
Increase in long-term debt 400,000
Payment of cash dividends (11,000)
Net cash provided by financing activities $ 825,808
Summary
Net decrease in cash ($ 50,318)
Cash at beginning of year 57,600
Cash at end of year $ 7,282
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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Conclusions about D’Leon’s Financial Condition

from Its Statement of CFs

• Net cash from operations = -$164,176, mainly

because of negative NI.
• The firm borrowed $836,808 to meet its cash
requirements.
• Even after borrowing, the cash account fell by
$50,318.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Did the expansion create additional

after-tax operating income?

AT operating income = EBIT(1 – Tax rate)

AT operating income15 = -$130,948(1 – 0.4)

= -$130,948(0.6)
= -$78,569

AT operating income14 = $114,257

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

What effect did the expansion have on net

operating working capital?

NOWC  Current
  Current  Notes 
assets  liabilities payable

NOWC15  ($7,282 $632,160 $1,287,360)

 ($1,650,568 $636,808)
 $913,042

NOWC14  $842,400

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Assessment of the Expansion’s Effect on

Operations

2015 2014
Sales $6,034,000 $3,432,000
AT oper. inc. -78,569 114,257
NOWC 913,042 842,400
Net income -160,176 87,960

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

What was the free cash flow (FCF) for 2015?

FCF  EBIT(1 T) 
Depr.and   Capital 
   NOWC
 amortization expenditures 

FCF15 = [-$130,948(1 – 0.4) + $116,960] –

[($1,202,950 – $491,000) + $70,642]
= -$744,201

Is negative free cash flow always a bad sign?

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Performance Measures for Evaluating Managers

• Accounting statements insufficient for

evaluating managers’ performance because
they do not reflect market values.
• Performance Measures
MVA = Difference between market value and
book value of a firm’s common equity.
(P0 x Number of shares) – Book value.
EVA = Estimate of a business’ true economic
profit for a given year.

EBIT(1 T)  Totalinvested Costof

capital
 capital
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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

What was D’Leon’s MVA in 2015 and 2014?

MVA15 = ($2.25 x 100,000) – $492,592

= -$267,592

MVA14 = ($8.50 x 100,000) – $663,768

= $186,232

Shareholder wealth has been destroyed!

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

What is the relationship between EVA and MVA?

• If EVA is positive, then AT operating income >

cost of capital needed to produce that income.
• Positive EVA on annual basis helps to ensure
MVA is positive.
• MVA is applicable to entire firm, while EVA can
be calculated on a divisional basis as well.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Does D’Leon pay its suppliers on time?

• Probably not.
• A/P increased 260%, over the past year, while
sales increased by only 76%.
• If this continues, suppliers may cut off D’Leon’s
trade credit.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Does it appear that D’Leon’s sales price

exceeds its cost per unit sold?

• NO, the negative after-tax operating income

and decline in cash position shows that D’Leon
is spending more on its operations than it is
taking in.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

What if D’Leon’s sales manager decided to offer 60-day

credit terms to customers, rather than 30-day credit terms?

• If competitors match terms, and sales remain

constant...
 A/R would .
 Cash would .
• If competitors don’t match, and sales double...
 Short-run: Inventory and fixed assets  to meet
increased sales. A/R , Cash . Company
may have to seek additional financing.
 Long-run: Collections increase and the
company’s cash position would improve.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

How did D’Leon finance its expansion?

• D’Leon financed its expansion with external

capital.
• D’Leon issued long-term debt which reduced its
financial strength and flexibility.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Would D’Leon have required external capital if they

had broken even in 2015 (Net income = 0)?

• YES, the company would still have to finance

its increase in assets. Looking to the
Statement of Cash Flows, we see that the firm
made an investment of $711,950 in net fixed
assets. Therefore, they would have needed to
raise additional funds.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

What happens if D’Leon depreciates fixed assets

over 7 years (as opposed to the current 10 years)?

• No effect on physical assets.

• Fixed assets on the balance sheet would
decline.
• Net income would decline.
• Tax payments would decline.
• Cash position would improve.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Federal Income Tax System

• Individual Taxes
• Corporate Taxes

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Corporate and Personal Taxes

• Both have a progressive structure (the higher

the income, the higher the marginal tax rate).
• Corporations
 Rates begin at 15% and rise to 35% for
corporations with income over $10 million,
although corporations with income between $15
million and $18.33 million pay a marginal tax rate
of 38%.
 Also subject to state tax (around 5%).

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Corporate and Personal Taxes

• Individuals
 Rates begin at 10% and rise to 39.6% for single
individuals with incomes over $406,750 and
married couples filing jointly with incomes over
$457,600.
 May be subject to state tax.

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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

Tax Treatment of Various Uses and Sources of Funds

• Interest paid: tax deductible for corporations

(paid out of pre-tax income), but usually not for
individuals (interest on home loans being the
exception).
• Interest earned: usually fully taxable (an
exception being interest from a “muni”).
• Dividends paid: paid out of after-tax income.

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Tax Treatment of Various Uses and Sources of Funds

• Dividends received: most investors pay 15%

taxes.
 Investors in the 10% or 15% tax bracket pay 0%
on qualified dividends.
 Taxpayers in the 39.6% tax bracket pay 20%
taxes on dividends.
 Dividends are paid out of net income which has
already been taxed at the corporate level, this is
a form of “double taxation”.
 A portion of dividends received by corporations
is tax excludable, in order to avoid “triple
taxation.”
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 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM

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.
• Capital gains – defined as the profits from the sale of
assets not normally transacted in the normal course of
business, capital gains for individuals are generally taxed
as ordinary income if held for a year or less, and at the
capital gains rate if held for more than a year. Corporations
face somewhat different rules.
• Most taxpayers pay 15% taxes on long-term capital gains.
• Taxpayers in the 39.6% tax bracket pay 20% taxes on
long-term capital gains.
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