amount by which the revenues exceed the variable costs. Out of this sum
come the funds to satisfy various claimants to a return from the firm, and
internal funds that can be used to reduce debt or buy new assets according
to the company’s position after fixed claims are met and the distribution to
the owners is decided.
Depreciation and other noncash charges such as depletion or amorti-
zation of franchises and patents can be a significant source of cash flow.
Depreciation is usually by far the most important of these items. The de-
preciation account is the estimated capital (i.e., fixed assets) used up during
the year. The depreciation charge is based on the cost—not the present
value—of the assets, and the schedule of depreciation charges on an asset
once set initially cannot be varied except under special circumstances. The
level of depreciation charges is important in setting the amount of corpo-
rate profit tax due. It is important in reminding the management that not
all the returns coming in are income; some must be considered a return of
capital, and dividends policies should be set accordingly.
The annual depreciation charges do not, however, set the amount of
fixed assets that will be replaced or new fixed assets purchased. This deci-
sion is based on the forecasted future profitability of the replacement or of
the new assets. If investment in new fixed assets appears worthwhile, avail-
able internal funds or other sources of funds will be found to finance it; if
the new investment in fixed assets does not exceed the amount of deprecia-
tion, then the extra funds can be used for something else.
Earnings before interest and taxes (EBIT), or operating income, repre-
sent the income of the firm after the book charge for depreciation has been
made. After this figure is determined, the effects of many past financial de-
cisions come into play. The amount of interest that will be paid is based on
the amount of interest-bearing debt the firm has incurred, and this influ-
ences the profits tax. The amount available for the common stockholders is
obtained after dividends on the preferred stock is subtracted. These figures
are influenced by decisions on alternate methods of financing the firm. The
pros and cons of these decisions make up a large part of the subject of cor-
poration finance.
The interest expense represents the interest paid by the company on
debt. It is reduced by the amortization of any premium on bonds payable,
and increased by the amortization of bond discounts. Interest expense is
deductible before calculating the corporate income tax. The corporate
profits tax rate is 35 percent, and the tax is calculated after all regular ex-
penses are deducted but before the subtraction of preferred dividends. If,
however, there are no profits, there is no tax liability.
Earnings after taxes or net income is the amount earned on the total eq-
uity of the corporation from regular sources. It is not the dividends paid on
backadmin
(backadmin)
#1