Comprehensive Study Guide: Financial Statements, Taxes, and Cash Flow

Mastering Chapter 2 from Ross, Westerfield, and Jordan

Introduction & Learning Objectives

This guide is your interactive companion to understanding the core concepts of **Financial Statements, Taxes, and Cash Flow**, based on **Chapter 2 of Ross's textbook**. A deep understanding of these topics is crucial for making informed financial decisions.

Learning Objectives (Ross, page 24)

  • Describe the difference between accounting value (book value) and market value.
  • Describe the difference between accounting income and cash flow.
  • Describe the difference between average and marginal tax rates.
  • Determine a firm's cash flow from its financial statements.

1. The Balance Sheet

Core Concepts (Ross, page 25)

The **balance sheet** is a snapshot of a firm's assets, liabilities, and equity at a specific point in time. It is defined by the **balance sheet identity**:

$\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}$
  • **Liquidity:** Assets are listed in order of decreasing liquidity (ease of conversion to cash without loss of value). This is a key measure of a firm's ability to meet its short-term obligations.
  • **Financial Leverage:** The use of debt in a firm's capital structure. More debt magnifies both potential returns and potential losses to shareholders.
  • **Book Value vs. Market Value:** **Book value** is the historical cost of an asset as per GAAP, while **market value** is its true worth today. For financial managers, **market value is what matters**, as the goal is to maximize firm value. This was tested in **Question 1(ii) from the May 2024 exam** on the ROE ratio, which is based on book value.

2. The Income Statement

The Income Statement Equation (Ross, page 30)

The income statement measures performance over a period. It is defined by:

$\text{Revenues} - \text{Expenses} = \text{Income}$

Key takeaways: The income statement relies on GAAP principles like revenue recognition and the matching principle, which means it may not reflect actual cash flows. It also includes **noncash items**, most importantly **depreciation**, which must be added back to find cash flow.

3. Taxes

Average vs. Marginal Tax Rates (Ross, page 34)

The **average tax rate** is your total tax bill divided by your taxable income. The **marginal tax rate** is the tax rate on the next dollar of income. For financial decisions, the **marginal tax rate** is the most relevant because it tells you the tax impact of any new cash flow.

Exam Hint: Be able to calculate both rates. For corporations, the federal tax rate is a flat 21%, but for other business forms, the marginal rate is what matters.

4. Cash Flow

The Cash Flow Identity (Ross, page 35)

The cash flow identity states that the cash generated by a firm's assets must be paid out to its capital providers.

$\text{Cash Flow from Assets} = \text{Cash Flow to Creditors} + \text{Cash Flow to Stockholders}$

Exam Hint: This identity is the foundation for cash flow analysis. Be able to calculate each component and verify that the identity holds.

Component Formula
**Operating Cash Flow** (OCF) EBIT + Depreciation - Taxes
**Net Capital Spending** (NCS) Ending NFA - Beginning NFA + Depreciation
**Change in NWC** (ΔNWC) Ending NWC - Beginning NWC
**Cash Flow from Assets** (CFA) OCF - NCS - ΔNWC
**Cash Flow to Creditors** (CFCR) Interest Paid - Net New Borrowing
**Cash Flow to Stockholders** (CFS) Dividends Paid - Net New Equity Raised

5. Problems & Solutions

Problem Statement: Based on the following information for Mara Corporation, prepare an income statement for 2021 and balance sheets for 2020 and 2021. Next, calculate cash flow from assets, cash flow to creditors, and cash flow to stockholders for Mara for 2021. Use a 21 percent tax rate throughout.

Data: Sales: 2020=$4,203, 2021=$4,507. CGS: 2020=$2,422, 2021=$2,633. Depr: 2020=$785, 2021=$952. Int: 2020=$180, 2021=$196. Div: 2020=$275, 2021=$352. CA: 2020=$2,205, 2021=$2,429. NFA: 2020=$7,344, 2021=$7,650. CL: 2020=$1,003, 2021=$1,255. LTD: 2020=$3,106, 2021=$2,085.

Solution:

Income Statement (2021):

  • Sales: $4,507
  • CGS: $2,633
  • Depreciation: $952
  • EBIT: $4,507 - 2,633 - 952 = $922
  • Interest: $196
  • Taxable Income: $922 - 196 = $726
  • Taxes (21%): $726 * 0.21 = $152
  • Net Income: $726 - 152 = $574
  • Dividends: $352
  • Addition to RE: $574 - 352 = $222

Balance Sheets (2020 & 2021):

Shareholders' Equity (2020) = Assets - Liabilities = (2,205 + 7,344) - (1,003 + 3,106) = $5,440

Shareholders' Equity (2021) = Assets - Liabilities = (2,429 + 7,650) - (1,255 + 2,085) = $6,739

Cash Flow Calculations (2021):

OCF = EBIT + Depr. - Taxes = 922 + 952 - 152 = $1,722

NCS = (End NFA - Beg NFA) + Depr. = (7,650 - 7,344) + 952 = $1,258

ΔNWC = (End CA - End CL) - (Beg CA - Beg CL) = (2,429 - 1,255) - (2,205 - 1,003) = 1,174 - 1,202 = -$28

CFA = OCF - NCS - ΔNWC = 1,722 - 1,258 - (-28) = $492

CF to Creditors = Int. Paid - Net New Borrowing = 196 - (2,085 - 3,106) = 196 - (-1,021) = $1,217

CF to Stockholders = Div. Paid - Net New Equity = 352 - (6,739 - 5,440 - 222) = 352 - 1,077 = -$725

Verification: CFA = CF to Creditors + CF to Stockholders -> 492 = 1,217 + (-725) = 492. The identity holds.

Problem Statement: Christina Jennings has assembled financial records for Sunset Boards for 2020 and 2021 and has asked you to prepare: 1) An income statement, 2) A balance sheet, 3) OCF for each year, 4) CFA for 2021, 5) CF to Creditors for 2021, and 6) CF to Stockholders for 2021.

Solution:

1. Income Statements (2020 & 2021):

Sales - CGS - S&A - Depr = EBIT. EBIT - Int = EBT. EBT - Taxes = NI.

  • 2020: NI = (601,729 - 306,726 - 60,322 - 86,590 - 18,824) * (1-0.21) = $103,454
  • 2021: NI = (733,469 - 387,290 - 78,732 - 97,871 - 21,576) * (1-0.21) = $116,911

2. Balance Sheets (2020 & 2021):

Calculate current assets (CA) and current liabilities (CL) for each year. Shareholders' Equity (SE) = (CA + NFA) - (CL + LTD).

  • 2020: CA = 44,261 + 31,363 + 60,382 = $136,006. CL = 31,423 + 35,654 = $67,077. SE = (136,006 + 382,014) - (67,077 + 192,827) = $258,116
  • 2021: CA = 66,870 + 40,681 + 81,209 = $188,760. CL = 53,181 + 38,929 = $92,110. SE = (188,760 + 465,426) - (92,110 + 210,408) = $351,668

3. Operating Cash Flow (OCF):

OCF = EBIT + Depr - Taxes

  • 2020: OCF = (601,729 - 306,726 - 60,322) + 86,590 - (121,511 * 0.21) = $233,446
  • 2021: OCF = (733,469 - 387,290 - 78,732) + 97,871 - (167,067 * 0.21) = $277,363

4. Cash Flow from Assets (CFA) for 2021:

CFA = OCF - NCS - ΔNWC

NCS = (465,426 - 382,014) + 97,871 = $181,283

ΔNWC = (188,760 - 92,110) - (136,006 - 67,077) = 96,650 - 68,929 = $27,721

CFA = 277,363 - 181,283 - 27,721 = $68,359

5. Cash Flow to Creditors (CFCR) for 2021:

CFCR = Interest Paid - Net New Borrowing = 21,576 - (210,408 - 192,827) = 21,576 - 17,581 = $3,995

6. Cash Flow to Stockholders (CFS) for 2021:

CFS = Dividends Paid - Net New Equity Raised. Net New Equity = New Equity (given) = $23,400. Dividends = 40% of NI = 0.40 * 116,911 = $46,764.

CFS = 46,764 - 23,400 = $23,364