Republic of the Philippines
SORSOGON STATE UNIVERSITY
Sorsogon Campus
Sorsogon City
LEARNING MODULE
FINANCIAL MANAGEMENT
Module 3: FINANCIAL STATEMENTS, CASH FLOW AND TAXES
I. OVERVIEW
A manager’s primary goal is to maximize shareholder value, which is based on the firm’s future cash flows.
But how do managers decide which actions are most likely to increase those flows, and how do investors
estimate future cash flows? The answers to both questions lie in a study of financial statements that publicly
traded firms must provide to investors. Here investors include both institutions (banks, insurance
companies, pension funds, and the like) and individuals like you.
Much of the material in this module deals with concepts you covered in a basic accounting course. However,
the information is important enough to warrant a review. Also, in accounting you probably focused on how
accounting statements are made; the focus here is on how investors and managers interpret and use them.
Accounting is the basic language of business, so everyone engaged in business needs a good working
knowledge of it. It is used to “keep score”; if investors and managers do not know the score, they won’t
know whether their actions are appropriate. If a firm’s managers—whether they work in marketing, human
resources, production, or finance—do not understand financial statements, they will not be able to judge
the effects of their actions, which will make it hard for the firm to survive, much less to have a maximum
value.
II. LEARNING OUTCOMES
After reading and studying this module, you will be able to:
• List each of the key financial statements and identify the kinds of information they provide to
corporate managers and investors.
• Estimate a firm’s free cash flow and explain why free cash flow has such an important effect on firm
value.
• Discuss the major features of the federal income tax system.
III. LEARNING EXPERIENCE
FINANCIAL STATEMENTS AND REPORTS
Annual Report. A report issued annually by a corporation to its stockholders. It contains basic financial
statements as well as management’s analysis of the firm’s past operations and future prospects.
Aside from the verbal section, which is often presented as a letter from the chairperson, the report
provides four basic financial statements:
1. The balance sheet, which shows what assets the company owns and who has claims on those assets as
of a given date—for example, December 31, 2018.
2. The income statement, which shows the firm’s sales and costs (and thus profits) during some past
period—for example, 2018.
3. The statement of cash flows, which shows how much cash the firm began the year with, how much
cash it ended up with, and what it did to increase or decrease its cash.
4. The statement of stockholders’ equity, which shows the amount of equity the stockholders had at the
start of the year, the items that increased or decreased equity, and the equity at the end of the year.
These statements are related to one another, and, taken together, they provide an accounting picture of
the firm’s operations and financial position.
The quantitative and verbal materials are equally important. The firm’s financial statements report what
has actually happened to its assets, earnings, and dividends over the past few years, whereas
management’s verbal statements attempt to explain why things turned out the way they did and what
might happen in the future.
The Balance Sheet
The balance sheet is a “snapshot” of a firm’s position at a specific point in time. Figure 1 below shows the
layout of a typical balance sheet. The left side of the statement shows the assets that the company owns,
and the right side shows the firm’s liabilities and stockholders’ equity, which are claims against the firm’s
assets. As it shows, assets are divided into two major categories: current assets and non-current (fixed or
long-term) assets. Current assets consist of assets that should be converted to cash within one year, and
they include cash and cash equivalents, accounts receivable, and inventory. Long-term assets are assets
expected to be used for more than one year; they include plant and equipment in addition to intellectual
property such as patents and copyrights. Plant and equipment is generally reported net of accumulated
depreciation.
Figure 1. A Typical Balance Sheet
The claims against assets are of two basic types—liabilities (or money the company owes to others) and
stockholders’ equity. Current liabilities consist of claims that must be paid off within one year, including
accounts payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks and
other short-term lenders that are due within one year. Long-term debt includes bonds that mature in more
than a year.
Stockholders’ equity can be thought of in two ways. First, it is the amount that stockholders paid to the
company when they bought shares the company sold to raise capital, in addition to all of the earnings the
company has retained over the years:
Stockholders’ equity = Paid-in capital + Retained earnings
The retained earnings are not just the earnings retained in the latest year— they are the cumulative total
of all of the earnings the company has earned and retained during its life.
Stockholders’ equity can also be thought of as a residual:
Stockholders’ equity = Total assets - Total liabilities
Assets on the balance sheet are listed by the length of time before they will be converted to cash
(inventories and accounts receivable) or used by the firm (fixed assets). Similarly, claims are listed in the
order in which they must be paid: Accounts payable must generally be paid within a few days, accruals must
also be paid promptly, notes payable to banks must be paid within 1 year, and so forth, down to the
stockholders’ equity accounts, which represent ownership and need never be “paid off.”
Notes about the balance sheet:
1. Cash versus other assets. Although assets are reported in dollar/peso terms, only the cash and
equivalents account represent actual spendable money. Accounts receivable represent credit sales that
have not yet been collected. Inventories show the cost of raw materials, work in process, and finished
goods. Net fixed assets represent the cost of the buildings and equipment used in operations minus the
depreciation that has been taken on these assets.
2. Working capital. Current assets are often called working capital because these assets “turn over”; that
is, they are used and then replaced throughout the year. The total of accounts payable, accruals, and
notes payable represent current liabilities on its balance sheet. If we subtract current liabilities from
current assets, the difference is called net working capital:
Net working capital = Current assets - Current liabilities
Current liabilities include accounts payable, accruals, and notes payable to the bank. Financial analysts often
make an important distinction between net working capital (NWC) and net operating working capital
(NOWC). NOWC differs from NWC in two important ways. First, NOWC makes a distinction between cash
that is used for operating purposes and “excess” cash that is being held for other purposes. Thus, when
calculating NOWC, analysts make an estimate of excess cash and subtract this from the company’s current
assets to get the company’s operating current assets. Second, when looking at a company’s current
liabilities, analysts distinguish between its “free” liabilities (accruals and accounts payable) and its interest-
bearing notes payable. These interest-bearing liabilities are typically treated as a financing cost, rather than
an operating cost, which explains why they are not included as part of the company’s operating current
liabilities. Given these two adjustments, NOWC is calculated as follows:
Net Operating Working Capital = Operating current assets – Operating current liabilities
= (Current assets – Excess cash) – (Current liabilities – Notes payable)
3. Total debt versus total liabilities. A company’s total debt includes both its short-term and long-term
interest-bearing liabilities. Total liabilities equal total debt plus the company’s “free” (non-interest
bearing) liabilities.
Total debt = Short-term debt + Long-term debt
Total liabilities = Total debt + (Account payable + Accruals)
4. Other sources of funds. Most companies finance their assets with a combination of short-term debt,
long-term debt, and common equity. Some companies also use “hybrid” securities such as preferred
stock, convertible bonds, and long-term leases. Preferred stock is a hybrid between common stock and
debt, while convertible bonds are debt securities that give the bondholder an option to exchange their
bonds for shares of common stock. In the event of bankruptcy, debt is paid off first, and then preferred
stock. Common stock is last, receiving a payment only when something remains after the debt and
preferred stock are paid off.
5. Depreciation. Most companies prepare two sets of financial statements—one is based on Internal
Revenue Service (IRS) or BIR rules and is used to calculate taxes; the other is based on GAAP and is used
for reporting to investors. Firms often use accelerated depreciation for tax purposes but straight-line
depreciation for stockholder reporting.
6. Market values versus book values. Companies generally use GAAP to deter mine the values reported
on their balance sheets. In most cases, these accounting numbers (or “book values”) are different from
what the assets would sell for if they were offered for sale (or “market values”).
7. Time dimension. The balance sheet is a snapshot of the firm’s financial position at a point in time—for
example, on December 31, 2021. The balance sheet changes every day as inventories rise and fall, as
bank loans are increased or decreased, and so forth.
The Income Statement
Income Statements Reports summarizing a firm’s revenues, expenses, and profits during a reporting period,
generally a quarter or a year. Net sales are shown at the top of the statement; then operating costs,
interest, and taxes are subtracted to obtain the net income available to common shareholders.
A typical stockholder focuses on the reported EPS, but professional security analysts and managers
differentiate between operating and non-operating income. Operating income is derived from the firm’s
regular core business—, from producing and selling food products. Moreover, it is calculated before
deducting interest expenses and taxes, which are considered to be non-operating costs. Operating income
is also called EBIT, or earnings before interest and taxes. Here is its equation:
Operating income (or EBIT) = Sales revenue - Operating costs
Depreciation. The charge to reflect the cost of assets depleted in the production process. Depreciation is
not a cash outlay.
Amortization. A noncash charge similar to depreciation except that it represents a decline in value of
intangible assets.
Because depreciation and amortization are so similar, they are generally lumped together for purposes of
financial analysis on the income statement and for other purposes. They both write off, or allocate, the
costs of assets over their useful lives.
Even though depreciation and amortization are reported as costs on the income statements, they are not
cash expenses—cash was spent in the past, when the assets being written off were acquired, but no cash
is paid out to cover depreciation and amortization. Therefore, managers, security analysts, and bank loan
officers who are concerned with the amount of cash a company is generating often calculate EBITDA, an
acronym for earnings before interest, taxes, depreciation, and amortization.
Although the balance sheet represents a snapshot in time, the income statement reports on operations
over a period of time. Income statements are prepared monthly, quarterly, and annually. The quarterly and
annual statements are reported to investors, while the monthly statements are used internally by managers
for planning and control purposes.
Finally, note that the income statement is tied to the balance sheet through the retained earnings account
on the balance sheet. Net income as reported on the income statement less dividends paid is the retained
earnings for the year. Those retained earnings are added to the cumulative retained earnings from prior
years to obtain the year-end balance for retained earnings. The retained earnings for the year are also
reported in the statement of stockholders’ equity. All four of the statements provided in the annual report
are interrelated.
Statement of Cash Flows
Net income as reported on the income statement is not cash, and in finance, “cash is king.” Management’s
goal is to maximize the price of the firm’s stock, and the value of any asset, including a share of stock, is
based on the cash flows the asset is expected to produce. Therefore, managers strive to maximize the cash
flows available to investors. The statement of cash flows is the accounting report that shows how much
cash the firm is generating. The statement is divided into four sections:
1. Operating activities. This section deals with items that occur as part of normal ongoing operations.
a. Net income. The first operating activity is net income, which is the first source of cash. If all sales
were for cash, if all costs required immediate cash payments, and if the firm were in a static
situation, net income would equal cash from operations. However, these conditions don’t hold, so
net income is not equal to cash from operations. Adjustments shown in the remainder of the
statement must be made.
b. Depreciation and amortization. The first adjustment relates to depreciation and amortization.
Accountants subtract depreciation (it has no amortization expense), which is a noncash charge,
when they calculate net income. Therefore, depreciation must be added back to net income when
cash flow is determined.
c. Increase in inventories. To make or buy inventory items, the firm must use cash. It may receive some
of this cash as loans from its suppliers and workers (payables and accruals), but ultimately, any
increase in inventories requires cash. If the company had reduced its inventories, it would have
generated positive cash.
d. Increase in accounts receivable. If the company chooses to sell on credit when it makes a sale, it
will not immediately get the cash that it would have received had it not extended credit. To stay in
business, it must replace the inventory that it sold on credit, but it won’t yet have received cash
from the credit sale. So, if the firm’s accounts receivable increase, this will amount to a use of cash.
If the firm had reduced its receivables, this would be shown as a positive cash flow. (Once cash is
received for the sale, the accompanying accounts receivable will be eliminated.)
e. Increase in accounts payable. Accounts payable represent a loan from suppliers. If the firm buy
goods on credit, its payables will increase. If the firm had reduced its payables, that would have
required, or used, cash. Note that as firm grows, it will purchase more inventories. That will give rise
to additional payables, which will reduce the amount of new outside funds required to finance
inventory growth.
f. Increase in accrued wages and taxes. The same logic applies to accruals as to accounts payable.
g. Net cash provided by operating activities. All of the previous items are part of normal operations—
they arise as a result of doing business. When we sum them, we obtain the net cash flow from
operations.
2. Investing activities. All activities involving long-term assets are covered in this section. It also includes
the purchase and sale of short-term investments, other than trading securities, and lending and
collecting on notes receivables.
a. Additions to property, plant, and equipment. A firm spent money on fixed assets during the current
year. This is an outflow; therefore, it is shown in parentheses. If it had sold some of its fixed assets,
this would have been a cash inflow.
b. Net cash used in investing activities.
c. Financing activities.
d. Increase in notes payable. A firm borrowed an additional $50 million from its bank this year, which
was a cash inflow. When the firm repays the loan, this will be an outflow.
e. Increase in bonds (long-term debt). A firm borrowed an additional $170 million from long-term
investors this year, issuing bonds in exchange for cash. This is shown as an inflow. When the bonds
are repaid by the firm some years hence, this will be an outflow.
f. Payment of dividends to stockholders. Dividends are paid in cash, and the money that a firm paid
to stockholders is shown as a negative amount.
g. Net cash provided by financing activities. The sum of financing entries is shown here.
3. Summary. This section summarizes the change in cash and cash equivalents over the year.
a. Net decrease in cash. The net sum of the operating activities, investing activities, and financing
activities is shown here.
b. Cash and equivalents at the beginning of the year.
c. Cash and equivalents at the end of the year.
Statement of Stockholders’ Equity
Changes in stockholders’ equity during the accounting period are reported in the statement of
stockholders’ equity. It shows by how much a firm’s equity changed during the year and why this change
occurred.
Note that “retained earnings” represents a claim against assets, not assets per se. Stockholders allow
management to retain earnings and reinvest them in the business, use retained earnings for additions to
plant and equipment, add to inventories, and the like. Companies do not just pile up cash in a bank account.
Thus, retained earnings as reported on the balance sheet do not represent cash and are not “available” for
dividends or anything else.
USES AND LIMITATIONS OF FINANCIAL STATEMENTS
As we mentioned in the opening vignette to this chapter, financial statements provide a great deal of useful
information. You can inspect the statements and answer a number of important questions such as these:
How large is the company? Is it growing? Is it making or losing money? Is it generating cash through its
operations, or are operations actually losing cash?
At the same time, investors need to be cautious when they review financial statements. Although
companies are required to follow GAAP, managers still have a lot of discretion in deciding how and when
to report certain transactions.
Consequently, two firms in exactly the same situation may report financial statements that convey different
impressions about their financial strength. Some variations may stem from legitimate differences of opinion
about the correct way to record transactions. In other cases, managers may choose to report numbers in a
manner that helps them present either higher or more stable earnings over time. As long as they follow
GAAP, such actions are legal, but these differences make it difficult for investors to compare companies and
gauge their true performances. In particular, watch out if senior managers receive bonuses or other
compensation based on earnings in the short run—they may try to boost short-term reported income to
boost their bonuses.
Unfortunately, there have also been cases where managers disregarded GAAP and reported fraudulent
statements. One blatant example of cheating involved WorldCom, which reported asset values that
exceeded their true value by about $11 billion. This led to an understatement of costs and a corresponding
overstatement of profits. Enron is another high-profile example. It overstated the value of certain assets,
reported those artificial value increases as profits, and transferred the assets to subsidiary companies to
hide the true facts. Enron’s and WorldCom’s investors eventually learned what was happening, and the
companies were forced into bankruptcy. Many of their top executives went to jail, the accounting firm that
audited their books was forced out of business, and investors lost billions of dollars.
After the Enron and WorldCom fiascos, Congress in 2002 passed the Sarbanes-Oxley Act (SOX), which
required companies to improve their internal auditing standards and required the CEO and CFO to certify
that the financial statements were properly prepared. The SOX bill also created a new watchdog
organization to help make sure that the outside accounting firms were doing their jobs.
Finally, keep in mind that even if investors receive accurate accounting data, it is cash flows, not accounting
income, that matters most. Similarly, when managers make capital budgeting decisions on which projects
to accept, their focus should be on cash flow.
FREE CASH FLOW
Thus far, we have focused on financial statements as they are prepared by accountants. However,
accounting statements are designed primarily for use by creditors and tax collectors, not for managers and
stock analysts. Therefore, corporate decision makers and security analysts often modify accounting data to
meet their needs. The most important modification is the concept of free cash flow (FCF), defined as “the
amount of cash that could be withdrawn without harming a firm’s ability to operate and to produce future
cash flows.” Here is the equation used to calculate free cash flow:
FCF = [EBIT(1 2-T) + Depreciation and amortization] - [Capital expenditures + ΔNet operating working capital]
The first term represents the amount of cash that the firm generates from its current operations. EBIT (1 -
T) is often referred to as NOPAT, or net operating profit after taxes. Depreciation and amortization are
added back because these are noncash expenses that reduce EBIT but do not reduce the amount of cash
the company has available to pay its investors. The second bracketed term indicates the amount of cash
that the company is investing in its fixed assets (capital expenditures) and operating working capital in order
to sustain ongoing operations. A positive level of FCF indicates that the firm is generating more than enough
cash to finance current investments in fixed assets and working capital. By contrast, negative free cash flow
means that the company does not have sufficient internal funds to finance investments in fixed assets and
working capital, and that it will have to raise new money in the capital markets in order to pay for these
investments.
Most rapidly growing companies have negative FCFs—the fixed assets and working capital needed to
support a firm’s rapid growth generally exceed cash flows from its existing operations. This is not bad,
provided a firm’s new investments are eventually profitable and contribute to its FCF.
Many analysts regard FCF as being the single most important number that can be developed from
accounting statements, even more important than net income. After all, FCF shows how much cash the firm
can distribute to its investors.
MVA and EVA
Items reported on the financial statements reflect historical, in-the-past, values, not current market values,
and there are often substantial differences between the two. Changes in interest rates and inflation affect
the market value of the company’s assets and liabilities but often have no effect on the corresponding book
values shown in the financial statements. Perhaps, more importantly, the market’s assessment of value
takes into account its ongoing assessment of current operations as well as future opportunities. For
example, it cost Microsoft very little to develop its first operating system, but that system turned out to be
worth many billions that were not shown on its balance sheet. For a given level of debt, these increases in
asset value also lead to a corresponding increase in the market value of equity.
The accounting statements do not reflect market values, so they are not sufficient for purposes of
evaluating managers’ performance. To help fill this void, financial analysts have developed two additional
performance measures, the first of which is MVA, or market value added. MVA is simply the difference
between the market value of a firm’s equity and the book value as shown on the balance sheet, with market
value found by multiplying the stock price by the number of shares outstanding.
The higher its MVA, the better the job management is doing for the firm’s shareholders. Boards of directors
often look at MVA when deciding on the compensation a firm’s managers deserve. Note, though, that just
as all ships rise in a rising tide, most firms’ stock prices rise in a rising stock market, so a positive MVA may
not be entirely attributable to management performance .
A related concept, economic value added (EVA), sometimes called “economic profit,” is closely related to
MVA and is found as follows:
Companies create value (and realize positive EVA) if the benefits of their investments exceed the cost of
raising the necessary capital. Total invested capital represents the amount of money that the company has
raised from debt, equity, and any other sources of capital (such as preferred stock).18 The annual dollar
cost of capital is total invested capital multiplied by the after-tax percentage cost of this capital. So, for
example, if the company has raised $1 million in capital, and the current cost of capital is 10%, the annual
dollar cost of capital would be $100,000. The funds raised from this capital are invested in a variety of net
fixed assets and net operating working capital. In any given year, NOPAT is the amount of money that these
investments have generated for the company’s investors after paying for operating costs and taxes—in this
regard it represents the benefits of capital investments.
EVA is an estimate of a business’s true economic profit for a given year, and it often differs sharply from
accounting net income. The main reason for this difference is that although accounting income takes into
account the cost of debt (the company’s interest expense), it does not deduct for the cost of equity capital.
By contrast, EVA takes into account the total dollar cost of all capital, which includes both the cost of debt
and equity capital.
INCOME TAXES
Individuals and corporations pay out a significant portion of their income as taxes, so taxes are important
in both personal and corporate decisions. The details of our tax laws change fairly often, but the basic nature
of the tax system is likely to remain intact. The tax rates are progressive—that is, the higher one’s income,
the larger the percentage paid in taxes. The table below provides the 2018-2022 tax rates that taxpayers
will pay for tax returns.
Taxable income is defined as “gross income less a set of exemptions and deductions.”
Corporate Taxes
Tax Base For Resident and Foreign Companies
A foreign corporation that is duly licensed to engage in trade or business within the Philippines is referred to as a
"resident foreign corporation".
The Philippines adopt the United Nations Model Convention (together with the OECD model) to identify a
permanent establishment.
Tax Rate
Income Tax The rate is 25% on net income but there are some
preferential rates and exemptions (educational
institutions and non-profit
hospitals: 10%)
Corporations with net taxable income up to PHP 5 20%
million and with total assets up to PHP 100 million
Tax on Regional Operating Headquarters (ROHQ) 10% (until 31 December 2021; thereafter, ROHQs will
be taxed at the regular corporate income tax rate)
Minimum corporate income tax (MCIT - beginning in 1% for the period 1 July 2020 to 30 June 2023 (2%
the fourth taxable year of operations). thereafter)
Imposed where the CIT at 25% is less than 2% MCIT on
gross income.
Improperly accumulated earnings tax 10%
IV.SUMMARY
The primary purposes of this module were to describe the basic financial statements, to present background
information on cash flows, to differentiate between cash flow and accounting income, and to provide an overview of
the Philippine income tax system. In the next module, we build on this information to analyze a firm’s financial
statements and to determine its financial health.
V. ASSESSMENT ACTIVITIES: (Posted in Google Classroom)
Prepared by:
MARIA LUISA P. MIRASOL
Assistant Professor II
mirasol.luisa@sorsu.edu.ph
