Financial Statement, Cash Flow

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Financial Statement, Cash Flow Taxes

• FIL 404
• Prepared by Keldon Bauer

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Financial Statement Fundamentals

• Publicly traded companies must file an annual
  (10-K) report with the SEC.
• The purpose of the 10-K is to report to owners on
  the status of their investment.
• The 10-K report contains both verbal and
  quantitative information about the performance of
  the firm.

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Financial Statement Fundamentals
Financial Sections Include

• Income Statement (usually 3 years)
• Balance Sheet (usually 2 years)
• Statement of Retained Earnings
• Statement of Cash Flows
• Key operating statistics for 5-10 years
• The purpose is both informative and marketing

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Financial Statement Fundamentals
Income Statement (Profit/Loss)

• Statement summarizing revenues and expenses over
  a period
• Owners want to embellish permanent revenues up
  and permanent expenses down
• Watch for window-dressing, etc.

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Financial Statement Fundamentals
Balance Sheet - Overview

• Statement of financial position at a specific
  point in time.
• The philosophy is to demonstrate sources of funds
  and their uses.
• Assets show the uses of funds, adjusted for
  current value.
• Liabilities/Equity show where funds came from

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Financial Statement Fundamentals
Balance Sheet - Assets

• Assets are listed in order of decreasing
  liquidity.
• The closer to the top the more accurate the
  estimate of market value.
• All assets should be listed as lower of cost or
  market
• Adjustments are at managements discretion.

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Financial Statement Fundamentals
Balance Sheet - Liabilities

• Claims against assets
• Equity Assets - Liabilities
• Book liabilities usually equal actual
  liabilities.
• Since the actual value of assets is rarely in
  line with book value, any adjustments to actual
  asset value is picked up by actual equity.

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Effect of Expansion on Assets

• Net fixed assets grows with sales.
• AR grows with sales.
• Inventory moderates.
• Cash seems to be following something else.

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What effect did the expansion have on liabilities
equity?

• CL increased as creditors and suppliers
  financed part of the expansion.
• Note the current maturity of long-term debt.
• Long-term debt has been falling of late.
• The company didnt issue any stock.
• Retained earnings grew.

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Financial Statement Fundamentals
Statement of Cash Flow

• Several ways of presenting cash flow.
• Accountants use both a direct and indirect
  approach
• 10-K must show the indirect approach
• The indirect cash flow starts with net income and
  adjusts income for its effects on cash flow.

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Financial Statement Fundamentals
Statement of Cash Flow

• The indirect statement has three major parts
• Operating cash flows
• Investing cash flows
• Financing cash flows
• The line following financing shows the net change
  in cash position.

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What is free cash flow (FCF)? Why is it
important?

• FCF is the amount of cash available from
  operations for distribution to all investors
  (including stockholders and debtholders) after
  making the necessary investments to support
  operations.
• A companys value depends upon the amount of FCF
  it can generate.

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What are the five uses of FCF?

• 1. Pay interest on debt.
• 2. Pay back principal on debt.
• 3. Pay dividends.
• 4. Buy back stock.
• 5. Buy nonoperating assets (e.g., marketable
  securities, investments in other companies, etc.)

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What are operating current assets?

• Operating current assets (OCA) are the current
  assets needed to support operations.
• Operating current assets include cash,
  inventory, receivables.
• Operating current assets exclude short-term
  investments, because these are not a part of
  operations.

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What are operating current liabilities?

• Operating current liabilities (OCL) are the
  current liabilities resulting as a normal part of
  operations.
• Operating current liabilities include accounts
  payable and accruals.
• Operating current liabilities exclude notes
  payable, because this is a source of financing,
  not a part of operations.

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Important Operating Measures

• Net Operating Working Capital (NOWC)
• NOWC OCA - OCL
• Total Net Operating Capital (TNOC)
• TNOC NOWC Net Fixed Assets
• Net Operating Profit After Tax (NOPAT)
• NOPAT EBIT(1-Tax Rate)
• EBIT Earnings Before Interest and Taxes

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Important Operating Measures

• Free Cash Flow (FCF)
• FCF NOPAT - Net investment in
  operating capital
• Return on Invested Capital (ROIC)
• ROIC NOPAT / TNOC
• Economic Value Added (EVA)
• EVA NOPAT- (WACC)(TNOC)

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Market Value Added

• Market Value Added (MVA)
• Market Value of Firm - Book Value of Firm
• If the market value of debt is close to the book
  value of debt, then MVA is
• MVA Market value of equity book value of
  equity

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Reality Check

• Financial managers know the things we are talking
  about today.
• Many creative methods have been used to either
  mislead or make the ratios you calculate look a
  little better.

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2004 Corporate Tax Rates
Taxable Income Tax on Base Rate on amount above base
0 -50,000 0 15
50,000 - 75,000 7,500 25
75,000 - 100,000 13,750 34
100,000 - 335,000 22,250 39
335,000 - 10M 113,900 34
10M - 15M 3,400,000 35
15M - 18.3M 5,150,000 38
18.3M and up 6,416,667 35
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Features of Corporate Taxation

• Progressive rate up until 18.3 million taxable
  income.
• Below 18.3 million, the marginal rate is not
  equal to the average rate.
• Above 18.3 million, the marginal rate and the
  average rate are 35.

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Features of Corporate Taxes (Cont.)

• A corporation can
• deduct its interest expenses but not its dividend
  payments
• carry-back losses for two years, carry-forward
  losses for 20 years.
• exclude 70 of dividend income if it owns less
  than 20 of the companys stock
• Losses in 2001 and 2002 can be carried back for
  five years.

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Key Features of Individual Taxation

• Individuals face progressive tax rates, from 10
  to 35.
• The rate on long-term (i.e., more than one year)
  capital gains is 15. But capital gains are only
  taxed if you sell the asset.
• Dividends are taxed at the same rate as capital
  gains.
• Interest on municipal (i.e., state and local
  government) bonds is not subject to Federal
  taxation.

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Taxable versus Tax Exempt Bonds

• State and local government bonds (municipals, or
  munis) are generally exempt from federal taxes.

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Breakeven Tax Rate

• At what tax rate would you be indifferent between
  the muni and the corporate bonds?
• Solve for T in this equation
• Muni yield Corp Yield(1-T)
• e.g. 7.00 10.0(1-T)
• T 30.0.

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Implications

• If T gt 30, buy tax exempt munis.
• If T lt 30, buy corporate bonds.
• Only high income, and hence high tax bracket,
  individuals should buy munis.