Ch. 3 Financial Statements, Cash Flows & Taxes Financial Statements All businesses should keep careful financial records. 2 Financial Statements However, many businesses do not need to report their financial statements to the public. Proprietorships Partnerships Privately-held corporations 3 1

Financial Statements Publicly-traded companies must keep and publicly report their financial records to shareholders. h Quarterly statements Annual report 4 The 4 Key Financial Statements Balance sheet Income statement Cash-flow statement Statement of retained earnings 5 Generally-Accepted Accounting Principles (GAAP) The rules and procedures that accountants must follow in preparing financial statements 2

GAAP American GAAP: Set by the Financial Accounting Standards Board (FASB) a private accounting organization GAAP in foreign countries: Usually set by government bodies 7 International Financial- Accounting Standards An effort to unify GAAP worldwide American companies can begin using IFAS in 2010 Everyone will use in 5-7 years. 8 Balance Sheet 9 3

Balance Sheet Shows a firm s financial position on a particular date (e.g., 12/31/2009) Like a photograph of a firm s financial status at a particular point in time (e.g., December 31, 2009) 10 Balance Sheet The balance sheet must always balance Balance-sheet equation: Assets = Liabilit bilities ies + equity 11 Balance Sheet Assets: : The physical and financial resources that a business has available to generate income Liabilities: The part of the assets that were financed by debt Equity: : The part of the assets financed by the owners 12 4

Assets = Liabilities + Equity If a business can reduce its assets, it needs less liabilities and equity. If a business invests more capital (or accumulates more profits as retained earnings), it needs less debt. 13 Current assets Assets Cash & marketable securities Accounts receivable Inventory Long-term assets Fixed assets (net of depreciation) 14 Working Capital Current assets current liabilities Also called net working capital 15 5

Liabilities (= Debt) Current liabilities Accounts payable Notes payable Long-term liabilities Loans Bonds 16 Equity = Ownership (stockholders) Common stock Preferred stock Retained earnings 17 Basic Rights of Stockholders Voting for the members of the board of directors and important actions of the board Preemptive right Cash dividends IF declared Net assets in liquidation 18 6

Retained Earnings Accumulated profits Part of the equity account One source of financing assets Retained earnings are NOT cash!!!!!! 19 Income Statement 20 Income Statement A summary of a firm s revenues, expenses and profits (or losses) Like a video of a firm s financial status during a period (e.g., 2010 or January 1-March 31, 2010) 21 7

Revenue -CGS = EBITDA -D&A =EBIT -I = EBT -T = EAT (= net income) 22 Statement of Retained Earnings 23 Statement of Retained Earnings Changes in retained earnings from one period to the next Previous R/E + net income dividends = New R/E 8

Cash Flows 25 Cash Flows Accounting statements are generally on an accrual basis not cash basis. However, financial managers need to know actual cash flows the funds actually flowing into and out of the business. 26 Statement of Cash Flows = Cash inflows Cash outflows Increases in liabilities and equity are sources of cash. Increases in assets are uses of cash. 27 9

Taxes 28 Businesses Pay Many Taxes Local taxes Property taxes Income taxes State taxes Income taxes 29 Businesses Pay Many Taxes Federal taxes Income taxes (0%-39%) Social Security taxes (6.2%) Medicare taxes (1.45%) [S/S + Medicare = 7.65%] 10

Reducing Taxes Exclusion: : Not subject to taxes Deductions: : Reduction of taxable income Credits: : Reduction of taxes due 31 Federal Tax Rates Marginal tax rate: : the tax rate applied to the last dollar of income Average tax rate: (total taxes paid) (total income) 32 Tax Advantage of Debt Our income-tax system favors debt financing over equity financing. Interest payments are obligations-- --& therefore tax deductible. Dividend payments are choices, not obligations--& not tax deductible. 33 11

Personal Federal Taxes Income tax (0%-39.6%) Social Security and Medicare taxes (7.65% + 7.65% = 15.3%) Excise taxes (gas, alcohol, tobacco) Import duties 34 Social Security & Medicare Taxes 35 Social Security & Medicare Paid only on employee core income Wages & salaries Commissions and tips Not on: Stock options Capital gains 36 12

Social Security & Medicare Separate taxes 6.20% Social Security tax 1.45% Medicare tax Total: 7.65% 37 Social Security & Medicare Paid from the very 1 st dollar of earnings There are no exclusions Low income (e.g., high-school kid) Not tax deductible 38 Social Security & Medicare They are paid by both the employee & the employer. 7.65% + 7.65% = 15.30% 39 13

Social Security & Medicare However, S/S is only paid on the 1 st $106,000 of income. Neither tax is applied to cash bonuses and stock options. 40 Federal Taxes Badly Hurt American Business 14