BUSINESS AND FAITH INTEGRATION

Understanding financial accounting is essential to understanding corporate finance.

Key Components of the Financials:

· The Balance Sheet

· The Income Statement

· The Statement of Cash Flows

Chapter 3 Outline

· The Balance Sheet

· Assets

· Liabilities

· Book values vs. market values

· The Income Statement

· Profits vs. cash flow

· Depreciation

· Cash vs. accrual accounting

· The Statement of Cash Flows

· Free cash flow

· Accounting practice

· Taxes

· Corporate tax

· Personal tax

· The problem of “double taxation”

The Balance Sheet

The Balance Sheet is a financial statement that shows the firm’s assets and liabilities at a particular time.

Why is it useful?

Shareholders’ Equity = Total Assets – Total Liabilities

Balance sheet – Financial statement that shows the firm’s assets and liabilities at a particular time.

Assets – Represent the uses of the funds raised by the firm.

· Listed on the left-hand side of the balance sheet.

Liabilities – Represent the sources of a firm’s funding.

· Listed on the right-hand side of the balance sheet.

Shareholders’ Equity – Representative of the difference between a firm’s total assets and total liabilities.

The Balance Sheet

Current Liabilities

· Payables

· Short-term Debt

Current Assets

· Cash & Securities

· Receivables

· Inventories

+

Long-term Liabilities

+

+

=

Fixed Assets

· Tangible Assets

· Intangible Assets

Shareholders’ Equity

____________________

___________________

Total Liabilities & Shareholders’ Equity

Total Assets

Fixed Assets

· Tangible Assets

· Intangible Assets

· Goodwill

Tangible Assets – Assets that can be physically seen or touched.

Intangible Assets – Assets that have no physical existence; yet, are still very valuable for a firm.

Goodwill - The difference between actual price paid for the acquisition of a firm and its book value.

· Note: Most of the “intangible assets” on a firm’s balance sheets consist of goodwill.

Fixed Assets: Example

· Which of the following represent tangible assets? Intangible assets?

· Property

· Production Facilities

· Patents

· Production Equipment

· Trademarks

· Copyrights

Tangible Assets: Property, Production Facilities, Production Equipment

Intangible Assets: Patents, Trademarks, Copyrights

Liabilities

Liabilities represent the sources of a firm’s funding.

(i.e. Liabilities represent what a firm “owes.”)

· Current vs. Long-Term Liabilities

· Current Assets – Current Liabilities = Net Working Capital

Current Liabilities – Liabilities that are likely to be paid off within the next 12 months.

Examples: accounts payable, debt due for repayment

Long-Term Liabilities – Liabilities that are not likely to be paid off within the next 12 months.

Net Working Capital – The difference between a firm’s current assets and current liabilities.

Liabilities: Example

Which of the following is a current liability?

· Bond debt that mature in 3 years

· A bank loan that is due in 24 months

· An obligation to pay a supplier within 6 months

Current Liability: Obligation to pay a supplier within 6 months

Net Working Capital: Example

In the balance sheet below, what was the value of net working capital in 2008? 2009?

Book Values vs. Market Values

· GAAP (Generally Accepted Accounting Principles)

· Procedures for preparing financial statements.

· Book Value

· Value of assets or liabilities according to the balance sheet.

· Values recorded at their historical cost adjusted for depreciation.

· Market value

· The values of assets or liabilities were they to be resold in a market.

Note: Market values are usually higher than book values.

Common-Size Balance Sheet

All balance sheet items are expressed as a percentage of total assets.

Why is this useful?

Common-Size Balance Sheet: Example

Note the changes from 2008 to 2009.

The Income Statement

Why is this useful?

Income Statement – Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.

Common-size Income Statement – All items on the income statement are expressed as a percentage of revenues.

EBIT – Earnings Before Interest & Taxes

EBIT = total revenues - costs – depreciation

Common-size Income Statement:

Why is this useful?

Income Statement – Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.

Common-size Income Statement – All items on the income statement are expressed as a percentage of revenues.

EBIT – Earnings Before Income & Taxes

· EBIT = total revenues - costs – depreciation

Income Statement: Example

In the income statement below, what was the value of Home Depot’s EBIT in 2009?

Common Size Income Statement

(right column)

Profits vs. Cash Flow

Differences between profits and cash flow:

Depreciation

· Rather than deducting the cost of an investment entirely when purchased, the accountant makes an annual charge for depreciation on the firm’s books.

· Note: “Profits” account for this depreciation but “Cash Flows” do not

Accrual Accounting – The process of matching revenues and expenses

· Note: When a firm makes a sale in a different period than it collects the proceeds from that sale, profits and cash flows will be unequal.

Cash Flows: Example

Consider a firm that spends $1,000 to produce goods in period 1. In period 2, it sells half of these goods for $750 and collects payment one period later. The firm sells the other half in period 3 for another $750, and collects payment on these sales in period 4.

What are the cash flows in each of the 4 periods for the firm?

The Statement of Cash Flows

Statement of Cash Flows – Financial statement that shows the firm’s cash receipts and cash payments over a period of time.

Free Cash Flow – Cash available for distribution to investors after the firm pays for new investments or additions to working capital.

Structure:

Cash flow from operations

-

+

Cash flow from investments

_______________

Cash flow from financing

Change in cash balance

1. Cash flow from operations – Adjusts net income for the parts of the income statement that do not involve cash actually coming in or going out.

2. Cash flow from investments – Adjusts the figure from (1) to reflect all capital expenditures during the period.

3. Cash flow from financing – Adjusts the figure from (2) to reflect the changes in a firm’s cash flow due to gains (or losses) from financing activities.

Cash Flow: Example

Net income for your firm was $10,000 last year. The depreciation expense was $2,500; accounts receivable increased $1,250; accounts payable increased $800; and inventories increased by $2,000.

What was the total cash flow from operations for the period?

Net income: 10,000

Depreciation: 2,500

Accounts Receivable: (1,250)

Accounts Payable: 800

Inventories: (2,000)

Cash flow from operations: 10,050

Accounting Practice

Most managers say that accounting earnings is the single most important number reported to investors

What implications does this have for the investor?

Grey areas for financial managers:

Revenue recognition - Firms record a sale when it is made, not when the customer actually pays; however the date of sale is not always obvious.

Cookie-jar reserves - Firms sometimes put cash in separate accounts to be used in times of distress to create the illusion of growth even in bad years.

· Example: Freddie Mac

Corporate Taxes

In the United States, corporations pay tax on their income.

US Corporate Tax Rates, 2011

Marginal tax rate – Additional taxes owed per dollar of additional income.

Average tax rate – Total taxes owed divided by total income.

When firms calculate taxable income they are allowed to direct expenses. A few common deductions include:

· Depreciation

· Interest paid to bondholders

Remember: while each additional dollar of revenues results in 35 cents in increased taxes (for large firms), each dollar of expenses reduces taxes by 35 cents.

Corporate Taxes: Example

What is the marginal tax rate for a corporation with $60,000 taxable income and an average tax rate of 16.67% if the next-lowest marginal tax rate of 15% covers taxable incomes up to $50,000?

($60,000) * (16.67%) = $10,000 total taxes paid

($10,000) * (marginal tax rate) = $2,500

Marginal Tax Rate = 25%

Personal Tax

US Personal Tax Rates, 2011

· These tax rates refer to ordinary income (i.e. salary, wages, and interest earnings)

· Note: capital gains are taxed only when gains are realized, at a rate of 15% for most shareholders.

Personal Tax: Example

What is the average tax rate for an individual with a net income of $50,000, a total tax liability of $10,704.50, and a 28% marginal tax rate?

The Problem of “Double Taxation”

When a corporation issues dividend, each dividend dollar is effectively taxed twice:

1. Each dollar of earning taxed at corporate rate.

2. Shareholders pay personal income taxes on all dividends received.

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Taxable Income = $50,000 + $10,704.50

Tax Liability$10,704.50

Average Tax Rate = 17.63%

Taxable Income60,704.50

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