Chapter 2 Bank Financial Statements and Cash Flow

Chapter 2 Bank Financial Statements and Cash Flow - a ti...

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Unformatted text preview: _ a: ti fir ’3’ ii. 93?: -. mag/gm war/egg W; (vi—3%) Erma CHAPTER 2 FINANCIAL STA T EMEN T S, TAXES, AND CASH FLOW CRITICAL THINKING AND CONCEPTS REVIEW 2.1 Liquidity. What does liquidity measure? Explain the trade-off a firm faces between high-liquidity and low-liquidity levels. Answer: Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It’s desirable for firms to have high liquidity so that they can more safely meet short-term creditor demands. However, liquidity also has an opportunity cost. Firms generally reap higher returns by investing in illiquid, productive assets. It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing needs. 2.2 Accounting and Cash Flows. Why is it that the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and outflows that occurred during a period? Answer: The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it. 2.3 Book Values versus Market Values. In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value? Answer: Historical costs can be objectively and precisely measured, whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between relevance (market values) and objectivity anok values). CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-1 _ __ a: ti fir *5” rt. 93?: -. mag/gm wax/aye We (aw—3%) amt-:2 2.4 Operating Cash Flow. In comparing accounting net income and operating cash flow, what two items do you find in net income that are not in operating cash flows? Explain what each is and why it is excluded in operating cash flows. Answer: Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a financing cost, not an operating cost. 2.5 Book Values versus Market Values. Under standard accounting rules, it is possible for a company's liabilities to exceed its assets. When this occurs, the owners' equity is negative. Can this happen with market values? Why or why not? Answer: Market values can never be negative. Imagine a share of stock selling for —$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 2.6 Cash Flow from Assets. Suppose a company's cash flow fiom assets was negative for a particular period. Is this necessarily a good sign or a bad sign? Answer: For a successfill company that is rapidly expanding, capital outlays would typically be large, possibly leading to negative cash flow fiom assets. In general, what matters is whether the money is spent wisely, not whether cash flow fiom assets is positive or negative. 2.7 Operating Cash Flow. Suppose a company's operating cash flow was negative for several years running. Is this necessarily a good sign or a bad sign? Answer: It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-up, so it depends. 2.8 Net Working Capital and Capital Spending. Could a company's change in NWC be negative in a given year(Hint: Yes.)? Explain how this might come about. What about net capital spending? Answer: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-2 2.9 2.1 2.1 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW g; tifi‘fi’fi. -..'..-9‘ each“ If Esau-I'm «awe/gm fiéfifinfi Effie: (Vi-3%) fififlfi' For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning NWC would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased. Cash Flow to Stockholders and Creditors. stockholder be negative in a given years (Hint2Yes). Explain how this might come about. Could a company's cash flow to What about cash flow to creditors? Answer: If a company raises more money flom selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest, its cash flow to creditors will be negative. 0 Firm Values. Look back at the Ford example we discussed at the beginning of the chapter. Did stockholders in Ford lose $2.7 billion as a result of the accounting changes? What is the basis fiom your conclusion? Use the following information to answer the next two questions: In June 2002, WorldCom, the telecommunications giant, surprised investors when it announced that it had overstated net income in the prior two years by $3.8 billion. At the center of the controversy was Scott D. Sullivan, the former CFO. WorldCom had leased telephone lines fiom local companies with the expectation of reselling the use of the lines at a higher price. Under GAAP, these costs should have been reported as an expense on the income statement. Reportedly, however, Mr. Sullivan ordered that the costs be treated as money spent to purchase a fixed asset, so they were to be shown on the balance sheet as an asset and subsequently depreciated. Answer: The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the company. 1 Corporate Ethics. In the wake of this scandal, Mr. Sullivan was charged with fraud. Do you think this should be considered flaud? Why? Why was this unethical? Answer: The legal system thought it was fiaud. Mr. Sullivan disregarded GAAP procedures, which is fiaudulent. That fiaudulent activity is unethical goes without saying. 2.12 Net Income and Cash Flows. g; his-9‘ each“ If Esau-I'm fifi‘fi’fi. «Z‘rfié‘fim fiéfifinfi Effie: (Vi-3%) filfiflfi' How did Mr. Sullivan's reclassifying some costs as asset purchases affect net income at the time? In the future? How did this action affect cash flows? What does this tell you about the importance of examining cash flow relative to net income? Answer: By reclassifying costs as assets, it lowered costs when the lines were leased. This increased the net income for the company. It probably increased most future net income amounts, although not as much as you might think. Since the telephone lines were fixed assets, they would have been depreciated in the future. This depreciation would reduce the effect of expensing the telephone lines. The cash flows of the firm would basically be unaffected no matter what the accounting treatment of the telephone lines. Solutions to Questions and Problems Basic (Questions 1-13) 1. Building a Balance Sheet. Romo,Inc., has current assets of $1,850, net fixed assets of $8,600, current liabilities of $1,600,and long-term debt of $6,100. What is the value of the shareholders' equity account for this firm? How much is net working capital? Solution: The balance sheet for the company will look like this: Balance sheet Current assets $1,850 Current liabilities $1,600 Net fixed assets 8,600 Long-term debt 6,100 Owner's equity 2,750 Total assets $ 10,450 Total liabilities & Equity $ 10,450 The owner’s equity is a plug variable. We know that total assets must equal total liabilities & owner’s equity. Total liabilities and equity is the sum of all debt and equity, so if we subtract debt fiom total liabilities and owner’s equity, the remainder must be the equity balance, sorOwner’s equity = Total liabilities & equity — Current liabilities — Long-term debt Owner’s equity = $10,450 — 1,600 — 6,100 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-4 =7 75: 553‘ ‘3’ 5'5. 93% -. mag/gm wax/egg W; (vi—3%) elem Owner’s equity = $2,750 Net working capital is current assets minus current liabilities, so: NWC = Current assets — Current liabilities NWC = $1,850 — 1,600 NWC = $250 2. Building an Income Statement. Fyre, Inc., has sales of $625.000, costs of $260.000, depreciation expense of $79,000, interest expense of $43,000, and a tax rate of 35 percent. What is the net income for this firm? Solution: The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract out interest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get: Income Statement Sales $625,000 Costs 260,000 Depreciation 79,000 EBIT $286,000 Interest 43,000 Taxable income $243,000 Taxes 85,050 Net income $i_fl,9_50 3. Dividends and Retained Earnings. Suppose the firm in Problem 2 paid out $60,000 in cash dividends, what is the addition to retained earnings? Solution: The dividends paid plus addition to retained earnings must equal net income, so: Net income = Dividends + Addition to retained earnings Addition to retained earnings = $157,950 — 60,000 Addition to retained earnings = $97,950 4. Per-Share Earnings and Dividends. Suppose the firm in Problem 3 had 40,000 shares of common stock outstanding. What is the earnings per share, or EPS, figure? What is the dividends per share figure? Solution: Earnings per share is the net income divided by the shares outstanding, so: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-5 =7 g: 553‘ ‘3’ 5'5. 93% a mag/gm wax/egg W; (vi—3%) email EPS = Net income / Shares outstanding EPS = $157,950 / 40,000 EPS = $3.95 per share And dividends per share are the total dividends paid divided by the shares outstanding, so: DPS = Dividends / Shares outstanding DPS = $60,000 / 40,000 DPS = $1.50 per share 5. Market Values and Book Values. Klingon Widgets,Inc., purchased new cloaking machinery three years ago for $6 million. The machinery can be sold to the Romulans today for $5.6 million. Klingon's current balance sheet shows net fixed assets of $4.8 million, current liabilities of $780,000, and net working capital of $100,000. If all the current assets were liquidated today, the company would receive $805,000 cash. What is the book value of Klingon's assets today? What is the market value? Solution: To find the book value of assets, we first need to find the book value of current assets. We are given the NWC. NWC is the difference between current assets and current liabilities, so we can use this relationship to find the book value of current assets. Doing so, we find: NWC = Current assets — Current liabilities Current assets = $100,000 + 780,000 = $880,000 Now we can construct the book value of assets. Doing so, we get: Book value of assets Current assets $ 880,000 Fixed assets 4 800 000 Total assets $5,680,0fl1 All of the information necessary to calculate the market value of assets is given, so: Market value of assets Current assets $ 805,000 Fixed assets 5,600,000 Total assets $6,405,000 6. Calculating taxes. The fly Leaf Co. had $315,000 in taxable income. Using the rates fiom Table 2.3 in the chapter, calculate the company's income taxes. Solution: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-6 =7 75: 553‘ ‘3’ 5'5. 93% -. mag/gm flaw/aw W; (aw—55%) amt-Lat: Using Table 2.3, we can see the marginal tax schedule. The first $25,000 of income is taxed at 15 percent, the next $50,000 is taxed at 25 percent, the next $25,000 is taxed at 34 percent, and the next $215,000 is taxed at 39 percent. So, the total taxes for the company will be: Taxes = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($315,000 — 100,000) Taxes = $106,100 7. Tax Rates. In problem 6, what is the average tax rate? What is the marginal tax rate? Solution: The average tax rate is the total taxes paid divided by net income, so: Average tax rate = Total tax / Net income Average tax rate = $106,100 / $315,000 Average tax rate = .3368 or 33.68% The marginal tax rate is the tax rate on the next dollar of income. The company has net income of $315,000 and the 39 percent tax bracket is applicable to a net income of $335,000, so the marginal tax rate is 39 percent. 8. Calculating OCF. Stone Sour, Inc., has sales of $16,550, costs of $5,930, depreciation expense of $1,940, and interest expense of $1,460. If the tax rate is 35%, what is the operating cash flow, or OCF? Solution: To calculate the OCF, we first need to construct an income statement. The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract out interest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get: Income Statement Sales $16,550 Costs 5,930 Depreciation 1,940 EBIT $8,680 Interest M Taxable income $7,220 Taxes (35%) 2,527 Net income M Now we can calculate the OCF, which is: CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-7 _ r ti fir *5” it. 93% w mag/gm waxes W; (gm—3%) 47:62:12 OCF = EBIT + Depreciation — Taxes OCF = $8,680 + 1,940 — 2,527 OCF = $8,093 9. Calculating Net Capital Spending. Rotweiler Obedience School's December 21,2007, balance sheet showed net fixed assets of $1.875 million, and the December 31,2008, balance sheet showed net fixed assets of $2.12 million. The company's 2008 income statement showed a depreciation expense of $220,000. What was Rotweiler Obedience's net capital spending for 2008? Solution: Net capital spending is the increase in fixed assets, plus depreciation. Using this relationship, we find: Net capital spending = NFAend — NFAb,g + Depreciation Net capital spending = $2,120,000 — 1,875,000 + 220,000 Net capital spending = $465,000 10. Calculating Additions to NWC. The December 31,2007, balance sheet of Anna's Tennis Shop, Inc., showed current assets of $840 and current liabilities of $320. The December 31,2008, balance sheet showed current assets of $910 and current liabilities of $335. What was the company's 2008 change in net working capital, or NWC? Solution: The change in net working capital is the end of period net working capital minus the beginning of period net working capital, so: Change in NWC = NWCend — NWCbcg Change in NWC = (CAend — CLend) — (CAMg — CLbeg) Change in NWC = ($910 — 335) — (840 — 320) Change in NWC = $55 11. Cash Flow to Creditors. The December 31, 2007, balance sheet of Butterfly Wings, Inc., showed long-term debt of $1.65 million,and the December 31, 2008, balance sheet showed long-term debt of $1.8 million. The 2008 income statement showed an interest expense of $49,000. What was the firm's cash flow to creditors during 2008? Solution: The cash flow to creditors is the interest paid, minus any new borrowing, so: Cash flow to creditors = Interest paid — Net new borrowing Cash flow to creditors = Interest paid — (LTDend — LTDbeg) CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-8 _ r ti fir *5” ti. 93% a mag/am fiéffing W; (aw—3%) amt: Cash flow to creditors = $49,000 — ($1,800,000 — 1,650,000) Cash flow to creditors = —$101,000 12. Cash Flow to Stockholders. The December 31, 2007, balance sheet of Butterfly Wings,Inc., showed $150,000 in common stock account and $2.9 million in the additional paid-in surplus account. The December 31, 2008, balance sheet showed $160,000 and $3.2 million in the same two accounts, respectively. If the company paid out $70,000 in cash dividends during 2008, what was the cash flow to stockholders for the year? Solution: The cash flow to stockholders is the dividends paid minus any new equity raised. So, the cash flow to stockholders is: (Note that APIS is the additional paid-in surplus.) Cash flow to stockholders = Dividends paid — Net new equity = Dividends paid — (Commonend + APISend) — (Commonb‘,g + APISbeg) = $70,000 — [($160,000 + 3,200,000) — ($150,000 + 2,900,000)] = —$240,000 13. Calculating Total Cash Flows. Given the information for Butterfly Wings,Inc., in problems 11 and 12, suppose you also know that that the firm's net capital spending for 2008 was $760,000, and that the firm reduced its net working capital investment by $135,000. What was the firm's 2008 operating cash flow, or OCF? Solution: We know that cash flow fiom assets is equal to cash flow to creditors plus cash flow to stockholders. So, cash flow fiom assets is: Cash flow fiom assets = Cash flow to creditors + Cash flow to stockholders Cash flow fiom assets = —$101,000 — 240,000 Cash flow fiom assets = —$341,000 We also know that cash flow fiom assets is equal to the operating cash flow minus the change in net working capital and the net capital spending. We can use this relationship to find the operating cash flow. Doing so, we find: Cash flow fiom assets = OCF — Change in NWC — Net capital spending —$341,000 = OCF — (—$135,000) — (760,000) OCF = —$341,000 — 135,000 + 760,000 OCF = $284,000 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-9 =7 75: 553‘ ‘3’ 5'5. 93% q mere/gm agree We (vi—3%) amt-Lat: Intermediate (questi0n14-23 ) 14. Calculating Total Cash Flows. Greene Co. shows the following information on its 2008 income statement; sales=$138,000; costs=$71,500; other expenses=$4,100; depre- ciation expense=$10,100; interest expense=$7,900;taxes=$17,760;dividends=$5,400. In addition, you're told that the firm issued $2,500 in new equity during 2008, and redeemed $3,800 in outstanding long-term debt. a. What is the 2008 operating cash flow? b. What is the 2008 cash flow to creditors? c. What is the 2008 cash flow to stockholders? d. If fixed assets increased by $17,400 during the year, what was the addition to NWC? Solution: a. To calculate the OCF, we first need to construct an income statement. The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract out interest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get: Income Statement Sales $138,000 Costs 71,500 Other Expenses 4, 100 Depreciation 10,100 EBIT $52,300 Interest 7,900 Taxable income $44,400 Taxes 17, 760 Net income $26,640 Dividends $5,400 Addition to retained earnings 21,240 Dividends paid plus addition to retained earnings must equal net income, so: Net income = Dividends + Addition to retained earnings Addition to retained earnings = $26,640 — 5,400= $21,240 So, the operating cash flow is: OCF = EBIT + Depreciation — Taxes OCF = $52,300 + 10,100 — 17,760 = $44,640 CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2-10 93% a mag/gm waxes W; (vi—3%) elem-tr: b. The cash flow to creditors is the interest paid, minus any new borrowing. Since the company redeemed long-term debt, the new borrowing is negative. So, the cash flow to creditors is: Cash flow to creditors = Interest paid — Net new borrowing Cash flow to creditors = $7,900 — (—$3,800) = $11,700 c. The cash flow to stockholders is the dividends paid minus any new equity. So, the cash flow to stockholders is: Cash flow to stockholders = Dividends paid — Net new equity Cash flow to stockholders = $5,400 — 2,500= $2,900 d. In this case, to find the addition to NWC, we need to find the cash flow fiom assets. We can then use the cash flow fiom assets equation to find the change in NWC. We know that cash flow fiom assets is equal to cash flow to creditors plus cash flow to stockholders. So, cash flow fiom assets is: Cash flow fiom assets = Cash flow to creditors + Cash flow to stockholders Cash flow fiom assets = $11,700 + 2,900= $14,600 Net capital spending is equal to depreciation plus the increase in fixed assets, so: Net capital spending = Depreciation + Increase in fixed assets Net capital spending = $10,100 + 17,400= $27,500 Now we can use the cash flow fiom assets equation to find the change in NWC. Doing so, we find: Cash flow ...
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