Chapter 2: Financial Statements, Cash Flows, and Taxes

Question 1

List the types of information found in a corporation’s annual report.

Answer 1

• Presents the balance sheet, income statement, statement of stockholders equity and statement of cash flows.
• Quantitative and qualitative written materials also.
  o Financial statements report what has actually happened to assets, earnings, dividends, and cash flows whereas the written materials attempt to explain why things turned out the way they did.

Question 2

Explain what a balance sheet is, the information it provides, and how assets and claims on assets are arranged on a balance sheet. Understand and be able to explain the accounts on a basic balance sheet.

Answer 2

• Statement of the firm’s financial position at a specific point in time. Assets on left, liabilities and equity/claims against the assets on the right.
• Assets are listed in order of liquidity (how long it’ll take to convert to cash) most liquid first.
• Claims (accounts/notes payable) are listed in order In which they must be paid.
• General order: cash/cash equivalents, marketable securities/short term investments, AR, inventories, Property/plat/equipment, prepaid expenses (insurance, rent, etc
• Liabilities: accounts/notes payable, accruals, long term bonds
• Equity: preferred/common stock, retained earnings

Question 3

Understand the difference between assets and liabilities, and the definition of “equity” on the balance sheet.

Answer 3

• Assets are what you own that is expected to turn into cash within a year.
  o Accounts receivable – amount of sales that haven’t been paid yet. During inflation, older purchases of material have lower costs. So companies using FIFO report lower COGS on the income statement than LIFO, but report higher remaining inventory. Results  inventories are higher on balance sheet, COGS is lower, profits are higher.
• Liabilities – expected to pay back within a year
  o Accounts payable, notes payable and accruals.
  o Accrual accounting method- what most companies use. Match revenues to periods when they are earned and expenses to when the effort to make income happened.
• Equity- common equity unless “total” or “prefered” are included.
  o When a company sells shares of stock, records the proceeds in common stock account.
  o Retained earnings = earnings that haven’t been paid out as dividends.
  o Common equity/ equity = common stock + retained earnings
  o Equity is net worth

Question 4

Explain what an income statement is and the information it provides. Understand and be able to explain the accounts on a basic income statement.

Answer 4

• Shows the firms revenues and expenses over an accounting period. Net sales are at the top of each statement and after subtracting various costs and income taxes you get the net income available to common stockholders. The bottom of the statement reports earnings and dividends per share. Includes:
  o Net sales: revenue – discount/returns
  o COGS: labor, raw material, expenses related to purchase sold in that period.
  o Depreciation – straight line and other method. Amortization- intangible assets like patents, trademarks.
  o EBITDA= EBIT + depreciation
  o Pre tax income: EBIT – interest expense
  o Net income = revenues – expenses, taxes, preferred dividends
  o Earnings per share (EPS)/ bottom line = net income/# of shares outstanding

Question 5

Specify the changes reported in a firm’s statement of retained earnings.

Answer 5

• Has info about a firm’s retained earnings along with the net income and amounts distributed to stockholders in the form of dividends.
• Can appear as a separate statement
• Retained earnings does not represent assets, but is a claim against assets.

Question 6

Understand and be able to explain and use each section of a firm’s statement of cash flows.

Answer 6

• Even if there’s a big net income, the amount of cash reported may be the same or lower because companies can use their net income in different ways. Statement of cash flows – separates a company’s activities into: operating, investing and financing. And then summarizes the resulting cash balance.
  o Operating: not all revenues/expenses are paid in cash. Most common: depreciation. Net income before preferred dividends, noncash adjustments (depreciation) working capital (investment in current assets)
  o Investing: transactions involving fixed assets or short term financial investments.
  o Financing: raising cash by issuing short/long term debt, or stock. Negative cash flow because it reduces company cash
• Helps answer: is the firm generating enough cash to purchase more assets required for growth? Is the firm generating extra cash to repay debt or invest in new products?

Question 7

Distinguish the differences between accounting profit (net income), net cash flow, and free cash flow.

Answer 7

• Accounting profit (net income) – net income available for distribution to common shareholders. some of the revenues/expenses shown in acct profits may not have been received/paid out in cash during the year.
• Net cash flow – sum of net income + noncash adjustments
  o Noncash adjustments: depreciation and amortization
• Free cash flow (FCF) – amount of cash available from operations for distribution to all investors after making the necessary investments to support operations.
  o Company’s value depends on the amount of FCF it can generate.
  o NOPAT (net operating profit after taxes) – investment in total net operating capital
  o Uses: pay interest on debt, pay dividends, buy back stock, buy nonoperating assets
• Calculating FCF:
  o Step 1: (earnings before interest and tax) x (1 – tax rate) = net operating profit after taxes
  o Step 2: operating current assets – operating current liabilities = net operating working capital
  o Step 3: net operating working capital + operating long-term assets = total net operating capital
  o Step 4: total net operating capital this year – total net operating capital last year = net investment in operating capital
  o STEP 5: net operating profit after taxes – net investment in operating capital = free cash flow

Question 8

Understand and be able to calculate Net Operating Working Capital, Total Net Operating Capital, Total Investor-Supplied Capital and Net Investment in Operating Capital.

Answer 8

• Net operating working capital: operating current assets – operating current liabilities
  o Operating current assets are the current assets used to support operations, such as cash, accounts receivable, and inventory. Does not include short term investments.
  o Operating current liabilities are current liabilities that are a natural consequence of the firm’s operations like accounts payable and accruals. Does not include notes payable or other short-term debt that charges interest.
• Total Net Operating Capital- net operating working capital + operating long term assets
  o Operating long term assets: net plant and equipment.
  o Equal to the net amount of investor supplied operating capital
• Total investor supplied capital = notes payable + long term bonds + preferred stock + common equity
  o Amount of financing that investors provided to the company.
• Net investment in operating capital = change in total net operating capital from the previous year. Represents the net amount the company spent on operating capital that year.

Question 9

Be able to calculate EPS, DPS, BVPS, EBIT, EBITDA, net cash flow (NCF), free cash flow (FCF), NOPAT, MVA, EVA, ROIC, and Capital Requirement Ratio (CR). Be able to explain each one, how it is calculated and how it is used.

Answer 9

• EPS (earnings per share) = net income available to common stockholders/ common shares outstanding
• DPS (dividends per share) = dividends paid to common stockholders / common shares outstanding
• BVPS (book value per share) = total common equity/ common shares outstanding
• EBIT (earnings before interest and taxes) = sales – COGS and other operating expenses
• EBITDA (earnings before interest, taxes, depreciation and amortization) = EBIT + Depreciation. Measure of financial strength.
• NCT (net cash flow) = net income + noncash adjustments
• FCF (free cash flow) – see #7
• NOPAT (net operating profit after taxes) = EBIT (1 – tax rate). Amount of profit a company would generate if it had no debt and financial assets.
• MVA (market value added) = (shares outstanding) (stock price) OR market value of stock – equity capital supplied by shareholders
  o Measure of shareholder wealth
• EVA (economic value added) =. NOPAT – (WACC) (Capital)
  o Estimate of a business’ true economic profit for the year (capital is subtracted making it different than accounting profit)
• ROIC (return on invested capital) = NOPAT/ operating capital
  o Provides a measure of how well the company is operating because it excludes the impact of financial leverage
• CR (capital requirement ratio) = total operating capital/sales
  o Measures how much total net operating must be tied up to make dollars of sales

Question 10

Understand tax loss carry-back and -forward, capital gains, and what “double taxation” means from the textbook.

Answer 10

• Tax loss carry forward: prior cumulative operating losses can be carried forward indefinitely and may be used to offset up to 80% of the taxable income for a certain year.
• Tax loss carry back: not allowed anymore.
  o Purpose: to avoid penalizing corporations whose incomes fluctuate substantially from year to year.
• Capital gains- when an asset is sold for more than its book value. Taxed the same as operating income.
  o Capital loss is when the opposite happens.
• Double taxation: corporate earnings may be subject to double taxation – earnings of the corporation are taxed at the corporate level and then earnings are paid out as dividends and taxed again as income to the stockholders.

Question 11

depreciation
amortization
improper accumulation

Answer 11

1. life expectancy of a tangible asset
2. noncash charge to show a decrease in value of an intangible asset
3. retention of earnings by a business for the purpose of enabling stockholders to avoid personal income taxes on dividends.

Question 12

what is operating capital and why is it important

Answer 12

current assets - current liabilities.

it is capital available to conduct operations of the firm.

Question 13

difference between NOPAT and net income

Answer 13

NOPAT is a measure of the company if it had no debt and held no financial assets. Net income takes in to account the debt. NOPAT is a better measure because it doesn’t take in to affect the debt that gives true reflection of the company.