Owais Husain PhD.



Corporate Finance

Understanding Financial Statements &Taxes

I. Basic Financial Statements

A. The Income Statement

1. The income statement reports the results from operating the business for a period of time, such as a year.

2. It is helpful to think of the income statement as comprising five types of activities:

a. Selling the product

b. The cost of producing or acquiring the goods or services sold

c. The expenses incurred in marketing and distributing the product or service to the customer along with administrative operating expenses

d. The financing costs of doing business: for example, interest paid to creditors and dividend payments to the preferred stockholders

e. The taxes owed based on a firm’s taxable income

Income Statement

SALES - EXPENSES = PROFIT

Sales = Revenue

Expenses = Cost of Goods Sold, Operating Expenses, (marketing, administrative), Financing Costs and Taxes OR

SALES

- Cost of Goods Sold

GROSS PROFIT

- Operating Expenses

OPERATING INCOME (EBIT)

- Interest Expense

EARNINGS BEFORE TAXES (EBT)

- Income Taxes

EARNINGS AFTER TAXES (EAT)

- Preferred Stock Dividends

- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

B. The Balance Sheet

1. The balance sheet provides a snapshot of the firm’s financial position at a specific point in time, presenting its asset holdings, liabilities, and owner-supplied capital.

a. Assets represent the resources owned by the firm

(1) Current assets - consisting primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses

(2) Fixed or long-term assets – comprising equipment, buildings, and land

(3) Other assets – all assets not otherwise included in the firm’s current assets or fixed assets, such as patents, long-term investments in securities, and goodwill

b. The liabilities and owners’ equity indicate how the assets are financed.

(1) The debt consists of such sources as credit extended from suppliers or a loan from a bank.

(2) The equity includes the stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet.

2. The balance sheet is not intended to represent the current market value of the company, but rather reports the historical transactions recorded at their costs.

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II Computing a Company’s Taxes

A. Types of taxpayers

1. Sole proprietors

a. Report business income on personal tax returns

b. Pay taxes at personal tax rate

2. Partnerships

a. The partnership reports income but does not pay taxes

b. Each partner reports his or her portion of income and pays the corresponding taxes.

3. Corporations

a. Corporation reports income and pays taxes

b. Owners do not report these earnings except when all or part of the profit is paid out as dividends.

c. Our focus is on corporate taxes.

B. Computing Taxable Income

1. Taxable income is based on gross income less tax-deductible expenses

a. Interest expense is tax deductible

b. Dividend payments are not tax deductible

2. Depreciation

a. Modified accelerated cost recovery system used for computing depreciation for tax purposes

b. We use straight-line depreciation to reduce complexity.

C. Computing Taxes Owed

1. Taxes paid are based on corporate tax structure.

2. Tax rates used to calculate tax liability are marginal tax rates, or the rate applicable to the next dollar of income.

3. Average tax rate is calculated by dividing taxes owed by the firm’s total income

4. Marginal tax rate is used in financial decision making

Corporate Income Tax Rates

Taxable Income Corporate Tax Rate

$1 - $50,000 15%

$50,001 - $75,000 25%

$75,001 - $100,000 34%

$100,001 - $335,000 39%

$335,001 - $10,000,000 34%

$10,000,001 - $15,000,000 35%

$15,000,001 - $18,333,333 38%

over $18,333,333 35%

Example: Space Cow Computer has sales of $32 million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders.

Calculate the firm’s tax liability.

Solution: Sales $32,000,000

Cost of Goods Sold (19,200,000)

Operating Expenses (2,400,000)

Depreciation Expense (1,400,000)

EBIT or NOI 9,000,000

Interest Expense (1,140,000)

Taxable Income 7,860,000

Tax Calculation:

Income tax rate Tax payment

$50,000 x .15 = $ 7,500

$25,000 x .25 = 6,250

$25,000 x .34 = 8,500

$235,000 x .39 = 91,650

$7,525,000 x .34 = 2,558,500

Total Tax payment $2,672,400

Question 1: What are the differences among gross profits, operating profits and net income?

Answer: Gross profits are sales less the cost of producing or acquiring the firm’s product or service.

Operating profits is the gross profits less the operating expenses, which consist of distributing the product or service to the customer (namely, marketing expenses) and any general and administrative expenses in operating the business.

Net income is operating profits less financing costs (interest expenses and preferred stock dividends) and less income tax.

Question 2: What is the difference between dividend and interest expense?

Answer: Interest expense is the cost of borrowing money from a banker or another lender. There typically is a fixed interest rate so that the interest expense is computed as the interest rate times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then our interest expense will be $60,000.

While interest is paid for the use of debt capital, dividends are paid to the firm’s stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred stockholder gets a constant dividend each year. Common stockholders, on the other hand, usually receive dividends only if management decides to pay a dividend instead of reinvesting the firm’s profits. However, typically once a dividend has been paid to common stockholders, management is reluctant to decrease it or cease paying a dividend.

Question 3: What is Net Working Capital? How it is different from Gross working capital? What is the difference between interest-bearing debt and non-interest bearing debt?

Answer: Net working capital is the firm’s liquid assets (current assets) less its short-term debt. Accountants include all short-term debt when computing net working capital; however, in computing free cash flows, we only subtract the noninterest-bearing debt, such as accounts payables and accruals. With this latter method, we are only considering the assets and liabilities that are changing as a result of the normal operating cycle of the business—beginning with the time inventory is purchased on credit to the time the firm collects the cash from its customer.

Gross working capital is the sum of current assets, while net working capital is the difference between current assets and current liabilities.

As already suggested, we have both interest-bearing debt and noninterest-bearing debt. The former is debt where the lender is paid interest for providing us the money. Noninterest-bearing debt charges no interest because the “lender” is really a supplier or an employee to whom we owe money, but they are not requiring the firm to pay interest.

Question 4: Delaney Inc., sells minicomputers. During the past year, the company’s sales were $4 million. The cost of its merchandise sold came to 2 million, cash operating expenses were $400,000, depreciation expense was $100,000 and the firm paid $150,000 in interest on bank loans. Also, the corporation paid $25,000 in the forms of dividend to its common stock holders. Calculate the corporation’s tax liability.

|Answer: |  |  |

|CORPORATE INCOME TAX |  |  |

| | | | |

|DATA | | | |

|Sales | |$4,000,000 | |

|COGS | |2,000,000 | |

|Gross profit | |2,000,000 | |

|Operating expenses |400,000 | |

|Depreciation expense |100,000 | |

|Interest expense | |150,000 | |

|Taxable income | |$1,350,000 | |

| | | | |

|Tax Liability: |Tax Bracket | | |

|0.15 |0-50,000 |50,000 |7,500 |

|0.25 |50,001-75,000 |75,000 |6,250 |

|0.34 |75,001-100,000 |100,000 |8,500 |

|0.39 |100,001-335,000 |335,000 |91,650 |

|0.34 |335,001-10,000,000 |335,000 |345,100 |

|  |  |: |$459,000 |

|Taxes due | | | |

Question 5: Potts Inc. had sales of $6 million during the past year. The cost of goods sold amounted to $3 million. Operating expenses totaled $2.6 million and interest expenses was $30,000. Determine firm’s tax liability.

Answer:

|DATA | | |

|Sales | |$6,000,000 |

|COGS | |3,000,000 |

|Gross profit | |3,000,000 |

|Operating expenses |2,600,000 |

|Interest expense | |30,000 |

|Taxable income | |$370,000 |

| | | |

| | | |

|Tax Liability: | | |

|0.15 |50,000 |7,500 |

|0.25 |75,000 |6,250 |

|0.34 |100,000 |8,500 |

|0.39 |335,000 |91,650 |

|0.34 |335,000 |11,900 |

|  |Taxes due : |$125,800 |

Question 6: Cook Inc., sells minicomputers. During the past year, the company’s sales were $3.5 million. The cost of the merchandise sold came to $2million and cash operating expenses were $500,000; depreciation expenses was $100,000, and the firm paid $165,000 in interest on bank loans. Also, the corporation paid $25,000 in dividends to its own common stockholders. Calculate the corporation’s tax liability.

Solution: Cook, Inc. - Corporate Income Tax

Sales $ 3,500,000

Cost of goods sold and

cash operating expenses 2,500,000

Depreciation expense 100,000

Operating profit $ 900,000

Interest expense 165,000

Taxable Income $ 735,000

Tax Liability:

$50,000 x 0.15 = $ 7,500

25,000 x 0.25 = 6,250

25,000 x 0.34 = 8,500

235,000 x 0.39 = 91,650

400,000 x 0.34 = 136,000

$735,000 $249,900

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