Fundamentals of Corporate
Finance
Colin Firer et al
Chapter 2
Financial Statements, Taxes and Cash Flow
Key Concepts and Skills
• Know the structure of the balance sheet, income and cash flow statements
• Know the difference between book value and market value
• Know the difference between the way in which individuals and corporations are taxed
• Know the difference between average and marginal tax rates
• Know the difference between accounting profits and cash flow
• Know what is free cash flow and how to determine it from a firm’s financial statements
Chapter Outline
• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow
Balance Sheet
• The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time
• Assets are listed in order of liquidity
– From least liquid to most liquid
– Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Identity
– Assets = Liabilities + Shareholders’ Equity
The Balance Sheet - Figure 2.1
The right-hand side lists the assets of the firm. Non-current assets are listed first because they are
the least liquid.
Note that the balance sheet does not list some very valuable assets, such as the people who work
for the firm.
The liabilities and equity (or ownership) components of the firm are listed on the left-hand side. This
indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total
assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is
retained profits. The left-hand side of the balance sheet is a direct result of management’s financing
decisions.
Remember that shareholders’ equity consists of several components and that total equity includes
all of these components not just the “ordinary shares” item. In particular, retained profits belong to
the shareholders
Net Working Capital and Liquidity
• Net Working Capital
– Current Assets – Current Liabilities
– Positive when the cash that will be received over the next 12 months exceeds the
cash that will be paid out
– Usually positive in a healthy firm
• Liquidity
– Ability to convert to cash quickly without a significant loss in value
– Liquid firms are less likely to experience financial distress
– But, liquid assets earn a lower return
– Trade to find balance between liquid and illiquid assets
SA Corporation Balance Sheet – Table 2.2
2007 2008 2007 2008
Equity and Liabilities Assets
Owners’ equity Non-current assets
Share capital R 568 R 640 Net plant & equipment R1 644 R1 709
Retained profit 1 352 1 629
Total equity 1 920 2 269 Current assets
Inventory 553 555
Non-current liabilities Accounts receivable 455 688
Long-term debt 408 454 Cash 104 160
1 112 1 403
Current liabilities
Accounts payable 232 266
Short-term debt 196 123
428 389
Total equity and R2 756 R3 112 Total assets R2 756 R3 112
liabilities
Total equity = total assets – total liabilities = 1920 = 2756 – (408+428)
Market Vs. Book Value
• The balance sheet provides the book value of the assets, liabilities and equity.
• Market value is the price at which the assets, liabilities or equity can actually be bought or
sold.
• Market value and book value are often very different. Why?
• Which is more important to the decision-making process?
• Current assets and liabilities generally have book values and market values that are very
close. This is not necessarily the case with the other assets, liabilities and equity of the firm.
• Assets are listed at historical costs less accumulated depreciation – this may bear little
resemblance to what they could actually be sold for today. The balance sheet also does not
include the value of many important assets, such as human capital. Consequently, the
“Total Assets” line on the balance sheet is generally not a very good estimate of what the
assets of the firm are actually worth.
• Liabilities are listed at face value. When interest rates change or the risk of the firm
changes, the value of those liabilities change in the market as well. This is especially true for
longer-term liabilities.
• Equity is the ownership interest in the firm. The market value of equity (stock price times
number of shares) depends on the future growth prospects of the firm and on the market’s
estimation of the current value of ALL of the assets of the firm.
• The best estimate of the market value of the firm’s assets is market value of liabilities +
market value of equity.
• Market values are generally more important for the decision making process because they
are more reflective of the cash flows that would occur today.
Income Statement
• The income statement is more like a video of the firm’s operations for a specified period of
time.
• You generally report revenues first and then deduct any expenses for the period
• Matching principle – GAAP say to show revenue when it accrues and match the expenses
required to generate the revenue
• Matching principle – this principle leads to non-cash deductions like depreciation. This is
why net profit after tax is NOT a measure of the cash flow during the period.
SA Corporation Income Statement – Table 2.3
Sales R1 509
Cost of sales 750
Depreciation 65
Profit before interest and tax (PBIT) R 694
Interest paid 70
Profit before tax (PBT) R 624
Taxes 244
Net profit after tax (NPAT) R 380
Profit before interest and taxes is often called operating profits or operating income.
Cost of sales would include both the fixed costs and the variable costs needed to generate the
revenues.
Analysts often look at EBITDA (earnings before interest, taxes, depreciation and amortization) as a
measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are
an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes.
It is important to point out that depreciation expense is often figured two different ways, depending
on the purpose of the financial statement. If we are computing the taxes that we will owe, we use
the depreciation schedule provided by SARS. In this instance, the “life” of the asset for depreciation
purposes may be very different from the useful life of the asset. Statements that are prepared for
investors often use a longer life because this will result in a lower depreciation charge. This reduces
the “expense” and thus increases the firm’s reported EPS. This is a good illustration of why it is
important to look at a firm’s cash flow and not just its EPS.
Taxes
• The one thing we can rely on with taxes is that they are always changing
• Marginal vs. average tax rates
– Marginal – the percentage paid on the next rand earned
• Applicable to personal tax rates in SA
• Company tax rate is not stepped
– Average – the tax bill / taxable income
Example: Marginal versus Average Individual Tax Rates
• What are marginal individual tax rates?
• What are average individual tax rates at the top of each bracket?
Taxable Income Marginal Cumulative Average Tax
Tax Rates Tax Liability Rates %
%
R0 - 112 500 18 R20 250 18,0
112 501 - 180 000 25 37 125 20,6
180 001 - 250 000 30 58 125 23,3
250 001 - 350 000 35 93 125 26,6
350 001 - 450 000 38 131 125 29,1
450 001 - 40
Notice that marginal rates rise as high as 40%. Average rates increase
steadily with taxable income e.g. at R1 million taxable income, the
average tax rate is 38,4%
Given the tax rates as shown, what is the average tax rate for an individual with net profit after tax
of R95 500? How much additional tax will you owe if you increase your net profit after tax by R5
000?
Net profit after tax Tax Rate
R 0- 50 000 15%
50 001 - 75 000 25%
75 001 - 100 000 34%
100 001 - 335 000 39%
Ans: Tax = 0,15(R50 000) + 0,25(R25 000) + 0,34(R25 000) +0,39(R126 500 - R100 000) = R32 585;
Average tax rate = R32 585 R126 500 = 0,2576 = 25,76 percent
The Concept of Cash Flow
• Cash flow is one of the most important pieces of information that a financial manager can
derive from financial statements
• The statement of cash flows does not provide us with the same information that we are
looking at here
• We will look at how cash is generated from utilizing assets and how it is paid to those that
finance the purchase of the assets
Cash Flow From Assets
• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Shareholders
• The first equation is how the cash flow from the firm is divided among the investors that
financed the assets.
• Cash Flow From Assets = Operating Cash Flow – Net Capital Spending
– Changes in NWC
• The second equation is the cash flow that the firm receives from its assets. This is an
important equation to remember.
Example: SA Corporation
Cash Flow From Assets = Operating Cash Flow – Net Capital Spending
– Changes in NWC
• OCF (I/S) = PBIT + depreciation – taxes = R515
OCF = 694 + 65 – 244 = 515
• Net capex ( B/S and I/S) = ending net non-current assets – beginning net non-current
assets + depreciation = R130
NCS = 1 709 – 1 644 + 65 = 130
• Changes in NWC (B/S) = ending NWC – beginning NWC = R330
Ending NWC = 1 403 – 389 = 1 014
Beginning NWC = 1 112 – 428 = 684
Changes in NWC = 1 014 – 684 = 330
• CFFA = 515 – 130 – 330 = R55
Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Shareholders
• CF to Lenders (B/S and I/S) = interest paid – net new borrowing = R24
Net New Borrowing = ending LT debt – beginning LT debt = 454 – 408 = 46
CF to lenders = 70 – 46 = 24
• CF to Shareholders (B/S and I/S) = dividends paid – net new equity raised = R31
Net New Equity = 640 – 568 = 72
Dividends = NPAT – change in RP = 380 – (1629-1352) = 380 – 277 = 103
CF to Shareholders = 103 – 72 = 31
• CFFA = 24 + 31 = R55
Cash Flow Summary Table 2.6
I The cash flow identity
Cash flow from assets = Cash flow to lenders + Cash flow to shareholders
II Cash flow from assets
Cash flow from assets = Operating cash flow
- Net capital spending
- Additions to net working capital
where:
Operating cash flow = Profit before interest and taxes (PBIT)
+ Depreciation - Taxes
Net capital spending = Ending net non-current assets - Beginning net non-current assets
+ Depreciation
Additions to net working capital = Ending net working capital - Beginning net working capital
III Cash flow to lenders
Cash flow to lenders = Interest paid - Net new borrowing
IV Cash flow to shareholders
Cash flow to shareholders = Dividends paid - Net new equity raised