CHAPTER 2

Understanding Financial
Statements, Taxes, and Cash Flows
CHAPTER ORIENTATION
In this chapter, we review the contents and meaning of a firm’s income statement and
balance sheet. We also look very carefully at how to compute a firm’s cash flows from a
finance perspective, which is called free cash flows.

CHAPTER OUTLINE
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:

3.

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

An example of an income statement is provided in Table 2-1 for the
Harley-Davidson Corporation.

9


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.

b.

II

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

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.

3.

Balance sheets for the Harley-Davidson Corporation are presented in
Table 2-2.

Computing a Company’s Taxes
A.

Types of taxpayers

1.

2.

Sole proprietors
a.

Report business income on personal tax returns

b.

Pay taxes at personal tax rate

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.

10


3.

B.


2.

III.

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.

Computing Taxable Income
1.

C.

Corporations

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

Interest expense is tax deductible


b.

Dividend payments are not tax deductible

Depreciation
a.

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

b.

We use straight-line depreciation to reduce complexity.

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

Measuring Free Cash Flows
A.

While an income statement measures a company’s profits, profits are not the
same as cash flows; profits are calculated on an accrual basis rather than a
cash basis.

B.

In measuring cash flows, we could use the conventional accountant’s
presentation called a statement of cash flows. However, we are more
interested in considering cash flows from the perspective of the firm’s
shareholders and its investors, rather than from an accounting view. We will
instead measure the cash flow that is free and available to be distributed to
the firm’s investors, both debt and equity investors, or what we will call
free cash flows.

C.

The cash flows that are generated through a firm’s operations and
investments in assets will always equal its cash flows paid to – or received
from – the company’s investors (both creditors and stockholders).

11


D.


Calculating Free Cash Flows: An Asset Perspective
1.

A firm's free cash flows, from an asset perspective, is the
after-tax cash flows generated from operations less the firm's
investments in assets. It is this same amount that will be
available for distributing to the firm’s investors. That is, a
firm's free cash flows for a given period is equal to:
After-tax cash flow from operations
less
the investment (increase) in net operating working capital
less
investments in fixed assets (plant and equipment) and other
assets.

2.

After-tax cash flows from operations as follows:
Operating income (earnings before interest and taxes)
+
depreciation
=
Earnings before interest, taxes, depreciation and
amortization (EBITDA)
cash tax payments
=
After-tax cash flows from operations

3.


The increase in net operating working capital is equal to the:
change in noninterest - bearing
 change in 

current assets - 
current liabilities


4.

Investments in fixed assets includes the change in gross fixed assets
and any other balance sheet assets not already considered.

12


E.

Calculating Free Cash Flows: A Financing Perspective
1.

Free cash flows from a financing perspective are equal to:
Interest payments to creditors
+
or
-

decrease in debt principal
increase in debt principal


plus dividends paid to stockholders
+
or
-

IV.

decrease in stock
increase in stock

2.

Free cash flow from an asset perspective must equal free cash flow
from a financing perspective.

3.

Free cash flows from a financing perspective are simply the net cash
flows received by the firm’s investors, or if negative, the cash flows
that the investors are paying into the firm. In the latter situation
where the investors are putting money into the firm, it is because the
firm’s free cash flow from assets is negative, thereby requiring an
infusion of capital by the investors.

Financial Statements and International Finance
A.

Many countries have different guidelines for firms to use in preparing
financial statements. For example, a $1 of earnings in the United States is

not the same as 1.10 Euro (the equivalent of a U.S. dollar based on the
exchange rate). The differences are due to the two countries having
different Generally Accepted Accounting Principles which guide their firms’
financial reporting.

B.

As a result of this situation, the International Accounting Standards
Committee (IASC), a private body supported by the worldwide accounting
profession, is trying to develop international financial-reporting standards
that will minimize the problem. In spite of the work to standardize
accounting practices around the world, the U.S. accounting profession has
rejected efforts toward international standards. At this time, foreign
companies seeking to list their shares in the United States must follow U.S.
accounting standards.

13


ANSWERS TO
END-OF-CHAPTER QUESTIONS
2-1.

a.

The balance sheet represents an enumeration of a firm’s resources (assets)
along with its liabilities and owners’ equity at a given date. The income
statement summarizes the net results of the operation of a firm over a
specified time interval.
The primary distinction between these two statements is that the balance

sheet shows the financial condition of a firm at a given date, whereas the
income statement deals with the revenues and expenses of the firm incurred
during a specified period of time.

b.

The conventional cash flow statement as prepared by accountants provides
the information we need to know about what has happened to the firm’s
cash and why. But it does not present it in a way that makes clear the cash
flows the firm’s creditors and investors are providing to or receiving from
the firm. Thus, we choose to reformat the presentation to show the firm’s
free cash flows—the cash available to distribute to the creditors and
investors. We are more interested in considering cash flows from the
perspective of the firm’s shareholders and its investors, rather than from an
accounting view. We instead measure the cash flow that is free and available
to be distributed to the firm’s investors, both debt and equity investors, or
what we will call free cash flows. Thus, what we use is similar to a
conventional cash flow statement presented as part of a company’s financial
statements, but “not exactly.” We also make the distinction between the
cash flows generated by the firm’s assets and the financing free cash flows.

2-2.

Gross profits is 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 taxes.


2-3.

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.

14


2-4

Once preferred shares are sold, dividends are paid or accrued each year based upon
preferred dividends (i.e., the percentage of the preferred stock’s par value paid as
dividends) agreed to at the selling date. However, these dividends affect the income
statement only. Common stock dividends, which may vary from year to year, also
affect the income statement; however, the investment of common shareholders varies
with the net addition to (or reduction from) retained earnings from year to year. The
net addition to retained earnings equals the difference in the period’s net income and
common dividends paid. Thus, the common equity section of the balance sheet (par
value of common stock, paid-in capital and retained earnings) varies from year to
year due to changes in the retained earnings portion of the firm’s common equity.


2.5

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.

2-6.

A firm could have positive cash flows but still be in trouble because it has negative
cash flows from operations. The positive cash flows would then be the result of the
firm reducing its investments in working capital or long-term assets. Such a
situation means that the company is not earning a satisfactory rate of return on its
investments. Another company could have very attractive rates of return on its
assets, but be growing so fast that the large investments in working capital and longterm assets result in negative cash flows. In this latter case, management is simply
investing in the future. As the rate of growth slows, positive cash flows will occur.

2-7.

Examining only the income statement and the balance sheet fails to tell us how the

firm is using its cash, which is a critical issue for any company.

2-8.

Free cash flows from assets equal the cash flows that are generated by the company
that are then distributed to (if positive) or received from (if negative) the firm’s
creditors and investors. It looks at cash flows from the firm’s perspective. Free cash
flows from a financing perspective looks at the cash flows from the investors’
viewpoint. It indicates how the investor received cash in the form of interest,
dividends, debt repayment or stock repurchase and how the investor infused cash in
the form of additional debt or stock purchase. Whatever the company does is the
exact opposite of what the investor receives or pays. That is, if a company
distributes $100 in cash to the investors, then the investors must receive $100 as
well. They have to be equal.

15


SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
2-1A.

Belmond, Inc.
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash
Accounts receivable

Inventory
Total current assets
Gross buildings & equipment
Accumulated depreciation
Net buildings & equipment
Total assets

$ 16,550
9,600
6,500
$ 32,650
$122,000
(34,000)
$ 88,000
$120,650

LIABILITIES AND EQUITY
Liabilities
Current Liabilities
Notes payable
Accounts payable
Total current liabilities
Long-term debt
Total liabilities
Equity
Common stock
Retained earnings
Total equity
Total liabilities and equity


$

600
4,800
$ 5,400
55,000
$ 60,400
$ 45,000
15,250
$ 60,250
$120,650

Belmond, Inc.
Income Statement
For the Year Ended December 31, 2003
Sales
Cost of goods sold
Gross profits
General & admin expense
Depreciation expense
Total operating expense
Operating income (EBIT)
Interest expense
Earnings before taxes
Taxes
Net income

$ 12,800
5,750
$ 7,050

$

850
500
$
$
$
$

16

1,350
5,700
900
4,800
1,440
3,360


2-2A.

Sharpe Mfg. Company
Balance Sheet
December 31, 2003
ASSETS
Cash
Accounts receivable
Inventory
Total current assets
Machinery and equipment

Accumulated depreciation
Net fixed assets
Total assets

$

96,000
120,000
110,000
$ 326,000
$ 700,000
(236,000)
464,000
$ 790,000

LIABILITIES & EQUITY
Liabilities
Current Liabilities
Notes payable
Accounts payable
Total current liabilities
Long-term debt
Total liabilities
Equity
Common stock
Retained earnings
Prior year
Current year
Total equity
Total liabilities and equity


$ 100,000
90,000
$ 190,000
160,000
$ 350,000
$ 320,000
100,000
20,000
$ 440,000
$ 790,000

Sharpe Mfg. Company
Income Statement
For the Year Ended December 31, 2003
Sales
Cost of goods sold
Gross profits
Operating expense
Net income
(Assume no interest accrued or taxes)

17

$ 800,000
500,000
$ 300,000
280,000
$ 20,000



2-3A. Delaney, Inc. - Corporate Income Tax
Sales
Cost of goods sold and
cash operating expenses
Depreciation expense
Operating profit
Interest expense
Taxable Income

$4,000,000
2,400,000
100,000
$1,500,000
150,000
$1,350,000

Tax Liability:
$50,000
25,000
25,000
235,000
1,015,000
$1,350,000

x
x
x
x
x


0.15
0.25
0.34
0.39
0.34

=
=
=
=
=

$7,500
6,250
8,500
91,650
345,100
$459,000

2-4A. Potts, Inc. - Corporate Income Tax
Sales
Cost of goods sold and
cash operating expenses
Operating profit
Interest expense
Taxable Income

$ 6,000,000
5,600,000

$ 400,000
30,000
$ 370,000

Tax Liability:
$50,000
25,000
25,000
235,000
35,000
$370,000

x
x
x
x
x

0.15
0.25
0.34
0.39
0.34

=
=
=
=
=


18

$7,500
6,250
8,500
91,650
11,900
$125,800


2-5A. Pamplin, Inc.
Free cash flows from an asset perspective:
Operating income (EBIT)
Depreciation
EBITDA
Tax expense
Less change in tax payable
Cash taxes
After-tax cash flows from operations
Change in net working capital
Change in current assets:
Change in cash
Change in accounts receivable
Change in inventory
Change in current assets

$ 360,000
200,000
$ 560,000
$ 120,000

$ 120,000
$ 440,000

$ (50,000)
(25,000)
75,000
$
-

Change in noninterest-bearing current debt:
Change in accounts payable
Change in net operating working capital

$ (50,000)
$ (50,000)

Change in long-term assets:
Purchase of fixed assets
Free cash flows - asset perspective

(400,000)
$ (10,000)

Free cash flows from a financing perspective:
Interest expense
$ (60,000)
Less change in interest payable
Interest paid to lenders
Repayment of long-term debt
Increase in short-term debt

Common stock dividends paid to owners
Free cash flows - financing perspective

$ (60,000)
150,000
(80,000)
$ 10,000

Note: The dividends were computed by comparing net income against the change
in retained earnings. Net income was $180,000, but retained earnings increased
only by $100,000; thus the balance was distributed in the form of dividends.
Pamplin, Inc. had an after-tax operating cash flow of $440,000. Additionally,
Pamplin acquired further financing though increasing short-term debt by $150,000.
This cash was mainly used to purchase fixed assets of $400,000. The remainder
was used to decrease payables to suppliers by $50,000, pay interest of $60,000, and
pay dividends back to the investors of $80,000.

19


2-6A. T.P. Jarmon
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes
Plus interest expense
EBIT
Depreciation
EBITDA
Tax expense
$ 27,100

Less change in tax payable
Cash taxes
After-tax cash flows from operations
Step 2: Change in net operating working capital
Change in current assets:
Change in cash
$ (1,000)
Change in accounts receivable
(9,000)
Change in inventory
33,000
Change in prepaid rent
(100)
Change in marketable securities
200
Change in current assets
$ 23,100
Change in noninterest-bearing current debt:
Change in accounts payable
$ 9,000
Change in accrued expenses
(1,000)
Change in noninterest-bearing current debt:
$ 8,000
Change in net operating working capital
Step 3: Change in long-term assets
Purchase of fixed assets
$ 14,000
(Change in net fixed assets + depr. expense)
Change in other assets

Net cash used for investments
Asset free cash flows
Free cash flows from a financing perspective:
Interest paid to investors
$(10,000)
Less change in interest payable
Interest received by investors
Decrease in long-term debt
Decrease in notes payable
Common stock dividends
Financing free cash flows

$ 70,000
10,000
80,000
30,000
$ 110,000
27,100
$ 82,900

$ (15,100)

$ (14,000)
$ 53,800

$ (10,000)
(10,000)
(2,000)
(31,800)
$ (53,800)


T.P. Jarmon had a successful year, generating an after-tax cash flow of $82,900. To
increase cash flow further, noninterest-bearing debt increased by $8,000. Part of
this cash was consumed when current assets were increased by $23,100 (of which
inventory increased by $33,000). Fixed assets of $14,000 were also purchased.
The substantial part of the cash flow, however, was distributed back to the
investors. Debt was decreased, both long-term and short-term, by $12,000. Interest
of $10,000 was also paid on this debt. Finally, investors were paid $31,800 in
dividends.
20


2-7A. Abrams Manufacturing
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Operating Income
Depreciation
EBITDA
Tax expense
$ 16,000
Less change in tax payable
Cash taxes
After-tax cash flows from operations
Step 2: Change in net operating working capital
Change in current assets:
Change in cash
Change in accounts receivables
Change in inventories
Change in prepaid expenses
Change in current assets

Change in noninterest-bearing current debt:
Change in accounts payables
Change in accrued liabilities
Change in noninterest-bearing current debt:
Change in net operating working capital
Step 3: Change in long-term assets
Purchase of fixed assets
Change in other assets
Net cash used for investments
Asset free cash flows

$ 54,000
26,000
$ 80,000
16,000
$ 64,000

$ 11,000
6,000
(12,000)
$ 5,000
$ 5,000
(5,000)
$
$ (5,000)
$ 73,000
$ (73,000)
$ (14,000)

Free cash flows from a financing perspective:

Interest paid to investors
$ (4,000)
Less change in interest payable
Interest received by investors
Decrease in long-term debt (mortgage payable)
Increase in preferred stock
Preferred stock dividends
Common stock dividends
Financing free cash flows

$ (4,000)
(70,000)
120,000
(10,000)
(22,000)
$ 14,000

Abrams generated cash through an after-tax operating profit of $64,000 and issuing
preferred stock of $120,000. This cash was primarily used to pay down debt of
$70,000 and purchase fixed assets of $73,000. Investors also received cash back
through dividends of $32,000 and interest of $4,000. Abrams also increased current
assets in total by $5,000 by increasing cash and accounts receivable while
decreasing inventory.

21


2-8A. J.T. Williams
Williams generated $224,210 in after-tax operating cash flows(including other
income). To further increase cash flow, accounts payable and accrued expenses

were increased by $1,662 and $32,283, respectively. They also increased their
short-term debt by $30,577, increased their long-term debt by $7,018 and issued
more common stock for $61,806. They used the operating cash flow and increased
financing to purchase $58,297 in inventory and other current assets and purchased
$308,336 in fixed assets, investments, and other assets. While Williams generated a
positive after-tax cash flow from operations, investors and creditors infused
$99,401 into the operations to finance the increases in assets. Williams needs to
analyze whether the investors are receiving an acceptable return on their
investments. It should be careful not to become over-capitalized during this time of
rapid growth.
2-9A. Johnson, Inc.
Johnson incurred a loss of $450,571 in after-tax operating cash flows(including
other losses). In addition, interest expense of $87,966 was paid to cover the
company’s current debt. The company increased their cash reserve, inventory and
other current assets by $587,924. Fixed assets, investments, and other assets
increased in net by $1,420,113. To finance this negative free cash flow, Johnson
increased their long-term debt by $1,118,198, increased short-term debt and other
current liabilities by $227,607, and issued more common stock in the amount of
$851,016. Accounts payable to suppliers were also increased by $349,753. While
investors in Internet companies have been satisfied with repeated annual losses,
Johnson should look for ways to decrease debt, produce positive future cash flows,
and provide an acceptable rate of return to its investors.

SOLUTION TO INTEGRATIVE PROBLEM
Davis & Howard had a successful year bringing in positive after-tax cash flows
from operations(including other income) of $174,034. This money was used in part
to increase current assets and fixed assets of $77,100 and $61,873, respectively.
Investments also increased $2,730 and other assets were sold for $9,881. The
noninterest-bearing current debt also increased by $59,062 to help finance the
increase in current assets. However, the increase in current assets was substantially

due to an increase of $57,467 in accounts receivable. Management should take
measures to reduce the average collection period or utilize other tools to maintain
control of this asset. Free cash flows of $101,274 were distributed to investors.
Interest expense of $17,024 was paid for the current debt. Davis & Howard
decreased their debt principal(including long-term debt, other liabilities, and notes
payable) by a total of $27,380. Stockholders were paid dividends of $26,912.
Finally, Davis & Howard used their free cash flows to repurchase common stock
for $29,958.

22


Solutions to Problem Set B
2-1B.

Warner Company
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Gross buildings & equipment
Accumulated depreciation
Net buildings & equipment
Total assets


$ 225,000
153,000
99,300
14,500
$ 491,800
$ 895,000
(263,000)
$ 632,000
$1,123,800

LIABILITIES AND EQUITY
Liabilities
Current Liabilities
Accounts payable
Notes payable
Taxes payable
Accrued expense
Total current liabilities
Long-term debt
Total liabilities
Equity
Common stock
Retained earnings
Total equity
Total liabilities and equity

$ 102,000
75,000
53,000
7,900

$ 237,900
334,000
$ 571,900
$ 289,000
262,900
$ 551,900
$1,123,800

Warner Company
Income Statement
For the Year Ended December 31, 2003
Sales
Cost of goods sold
Gross profits
General & admin expense
Depreciation expense
Total operating expense
Operating income (EBIT)
Interest expense
Earnings before taxes
Taxes

$
$

573,000
297,000
276,000

$ 79,000

66,000
$
$
$
23

145,000
131,000
4,750
126,250
50,500


Net income

$

2-2B.

Sabine Mfg. Company
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash
Accounts receivable
Inventory
Total current assets
Machinery and Equipment
Accumulated depreciation

Net buildings & equipment
Total assets

$

90,000
150,000
110,000
$ 350,000
$ 700,000
(236,000)
$ 464,000
$ 814,000

LIABILITIES AND EQUITY
Liabilities
Current Liabilities
Accounts payable
Short-term notes payable
Total current liabilities
Long-term debt
Total liabilities
Equity
Common stock
Retained earnings
Prior year
Current year
Total equity
Total liabilities and equity


$

90,000
90,000
$ 180,000
160,000
$ 340,000
$ 320,000
84,000
70,000
$ 474,000
$ 814,000

Sabine Mfg. Company
Income Statement
For the Year Ended December 31, 2003
Net Sales
Cost of goods sold
Gross profits
Operating expense
Net income

$
$
$

24

900,000
550,000

350,000
280,000
70,000

75,750


2-3B. Cook, Inc. - Corporate Income Tax
Sales
Cost of goods sold and
cash operating expenses
Depreciation expense
Operating profit
Interest expense
Taxable Income

$ 3,500,000
2,500,000
100,000
$ 900,000
165,000
$ 735,000

Tax Liability:
$50,000
25,000
25,000
235,000
400,000
$735,000


x
x
x
x
x

0.15
0.25
0.34
0.39
0.34

=
=
=
=
=

$

7,500
6,250
8,500
91,650
136,000
$249,900

2-4B. Rose, Inc. - Corporate Income Tax
Sales

Cost of goods sold and
cash operating expenses
Operating profit
Interest expense
Taxable Income

$7,000,000
6,600,000
$400,000
40,000
$ 360,000

Tax Liability:
$50,000
25,000
25,000
235,000
25,000
$ 360,000

x
x
x
x
x

0.15
0.25
0.34
0.39

0.34

=
=
=
=
=

25

$

7,500
6,250
8,500
91,650
8,500
$122,400


2-5B. J.B. Chavez
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes
Plus interest expense
EBIT
Depreciation
EBITDA
Tax expense
$ 108,000

Less change in tax payable
Cash taxes
After-tax cash flows from operations

$ 270,000
60,000
330,000
200,000
$ 530,000
108,000
$ 422,000

Step 2: Change in net operating working capital
Change in current assets:
Change in cash
$ (50,000)
Change in accounts receivable
(20,000)
Change in inventory
50,000
Change in current assets
$ (20,000)
Change in noninterest-bearing current debt:
Change in accounts payable
Change in accrued expenses
Change in noninterest-bearing current debt:

$(135,000)
$(135,000)


Change in net operating working capital
Step 3: Change in long-term assets
Purchase of fixed assets
Change in other assets
Net cash used for investments

$ (115,000)
$ 300,000
$ (300,000)

Asset free cash flows

$

7,000

Free cash flows from a financing perspective:
Interest expense
$ (60,000)
Less change in interest payable
Interest paid to lenders
Increase in notes payable
Common stock dividends
Financing free cash flows

$ (60,000)
115,000
(62,000)
$ (7,000)


After-tax cash flows from operations of $422,000 and an increase in notes payable
of $115,000 were used to pay down the accounts payable by $135,000 and increase
our inventory and fixed assets by $50,000 and $300,000, respectively. Interest of
$60,000 and common stock dividends of $62,000 were paid to investors.
2-6B. RPI, Inc.
26


Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes
Plus interest expense
EBIT
Depreciation
EBITDA
Tax expense
$ 27,100
Less change in tax payable
Cash taxes
After-tax cash flows from operations
Step 2: Change in net operating working capital
Change in current assets:
Change in cash
$
Change in marketable securities
Change in accounts receivable
Change in prepaid rent
Change in inventory
Change in current assets
$

Change in noninterest-bearing current debt:
Change in accounts payable
$
Change in accrued expenses
Change in noninterest-bearing current debt:
$
Change in net operating working capital
Step 3: Change in long-term assets
Purchase of fixed assets
(Change in net fixed assets
+ depreciation expense)
Change in other assets
Net cash used for investments
Asset free cash flows

$

$ 110,000
10,000
120,000
30,000
$ 150,000
27,100
$ 122,900

1,000
200
(4,000)
(100)
43,000

40,100
7,000
(1,000)
6,000
$ (34,100)
34,000
$ (34,000)
$ 54,800

Free cash flows from a financing perspective:
Interest expense
$ (10,000)
Less change in interest payable
Interest paid to lenders
Decrease in notes payable
Decrease in long-term debt
Common stock dividends
Financing free cash flows

27

$ (10,000)
(3,000)
(10,000)
(31,800)
$ (54,800)


RPI had positive after-tax operating cash flows of $122,900. As a result, RPI made
a decision to evenly split the cash flow between distribution to investors and

investing back into the company. Net operating capital increased by $34,100,
mostly in the area of inventory which increased by $43,000. Fixed assets of
$34,000 were also purchased. The asset free cash flow of $54,800 was distributed
back to investors through interest of $10,000, debt repayments of $13,000, and
dividends of $31,800.
2-7B. Cameron Co.
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes
Plus interest expense
EBIT
Depreciation
EBITDA
Tax expense
$ 30,000
Less change in tax payable
Cash taxes
After-tax cash flows from operations

$

72,000
5,000
77,000
26,000
$ 103,000

$

30,000

73,000

Step 2: Change in net operating working capital
Change in current assets:
Change in cash
$ (19,000)
Change in accounts receivable
6,000
Change in prepaid expenses
Change in inventory
(22,000)
Change in current assets
$ (35,000)
Change in noninterest-bearing current debt:
Change in accounts payable
$ (5,000)
Change in accrued liabilities
(5,000)
Change in noninterest-bearing current debt:
$ (10,000)
Change in net operating working capital

$

25,000

Step 3: Change in long-term assets
Purchase of fixed assets
Change in other assets
Net cash used for investments

Asset free cash flows

$ (63,000)
$ 35,000

$

63,000
-

Free cash flows from a financing perspective:
Interest expense
$ (5,000)
Less change in interest payable
Interest paid to lenders
Decrease in mortgage payable
Increase in preferred stock
Preferred stock dividends
Common stock dividends
Financing free cash flows
28

$ (5,000)
(60,000)
70,000
(8,000)
(32,000)
$ (35,000)



Cameron Co. created cash flows through after-tax profits of $73,000 and issuing
$70,000 of preferred stock. Cameron also decreased current assets of $35,000
through inventory and cash. This cash was used to decrease $10,000 in
noninterest-bearing current debt and to purchase $63,000 in fixed assets. Cameron
also eliminated $60,000 in a mortgage payable and distributed $40,000 in
dividends and $5,000 in interest to investors.
2-8B Hilary’s Ice Cream
Hilary’s had a profitable year generating after-tax operating cash flows(including
other losses) of $10,953. However, it should be noted that current assets increased
by $5,038 of which accounts receivable increased by $7,495. This increase was
offset by increasing accounts payable by $5,456. Hilary’s should be concerned
with the substantial increase in payables and the even greater threat of aging
receivables. Hilary’s used some of the above operating cash flow to purchase other
assets for $3,060. The asset free cash flow of $9,688 was distributed to the
investors in the form of $1,634 in interest, $3,822 in long-term debt principal, and
repurchasing $4,593 in common stock. It is possible that Hilary’s thought it wise to
lower long term debt and repurchase stock rather than make investments in further
growth.
2.9B

Retail.com
In need of cash, Retail.com issued common stock for $368,463 and increased
current liabilities by $9,609. This cash was used, in part, to cover an after-tax
operating loss(including other income) of $63,689. Retail.com mainly used the
cash to increase growth by purchasing fixed assets and other investments of
$31,971 and $178,108, respectively. Retail.com also sought to increase their
liquidity by increasing current assets by $84,962, consisting mainly of a $76,680
increase in their cash reserve, which was offset in part by increasing payables by
$4,657. The remainder of the common stock issue was paid back to investors
through a dividend of $23,612. For many years, it has been fairly easy for

innovative Internet companies to raise money through the stock market. It has been
more important to grow quickly than to create profits. In future years, Retail.com
must turn these losses into profits and create true value for their investors.

29