This study guide covers every topic, concept, and key term from Unit 3 of BBYM's Financial Literacy Curriculum. Unit 3 is where the numbers come alive — you move from the philosophy of why finance matters (Unit 1) and the markets that move money (Unit 2) to the actual documents that tell a business's financial story. Financial statements are the language of business. Every lender, investor, grant committee, and business partner you will ever work with speaks this language. By the end of Unit 3, you will speak it too — fluently enough to build an income statement, compute free cash flow, and calculate your own tax bill with complete confidence.
Part 1 — Core Topics Explained
Detailed explanations of every major concept tested on the Unit 3 assessment
📋 Learning Objectives
By the end of Unit 3, you will be able to:
- Read and interpret all three core financial statements — the Balance Sheet, Income Statement, and Statement of Cash Flows
- Build a complete income statement from revenue to net income, identifying every line: Gross Profit, EBITDA, EBIT, EBT, Taxes, and Net Income
- Calculate NOPAT, Operating Cash Flow (OCF), and Free Cash Flow (FCF) — and explain why FCF is the most important measure for investors
- Explain why depreciation is added back in cash flow calculations even though it is an expense on the income statement
- Apply the progressive federal income tax system: calculate tax owed in multiple brackets, then compute average and marginal tax rates
- Explain the difference between the average tax rate and the marginal tax rate — and why the marginal rate is used in all financial decisions
- Connect these financial tools to reading a W-2, managing a BBYM social enterprise, and building community wealth in Birmingham-Bessemer
1. The Three Core Financial Statements — What Each One Tells You
Every business — from a Birmingham corner store to Amazon — uses three financial statements to tell its financial story. Each answers a different question:
| Statement | Question It Answers | Time Period |
|---|---|---|
| Balance Sheet | What does the firm OWN (assets) and what does it OWE (liabilities)? What is left for shareholders (equity)? | A single POINT in time — a snapshot at the end of a period (e.g., December 31) |
| Income Statement | How much did the firm EARN and SPEND during the period? What was the profit (net income)? | A PERIOD of time — typically one year or one quarter |
| Statement of Cash Flows | Where did cash actually COME FROM and WHERE did it go? Why is cash different from profit? | A PERIOD of time — same period as the income statement |
Critical Timing Distinction — Heavily Tested
The Balance Sheet is like a PHOTOGRAPH — it shows a firm's financial position at one moment in time.
The Income Statement and Statement of Cash Flows are like a MOVIE — they show what happened over a period.
A question that asks "Which statement shows accounts receivable?" (Balance Sheet) vs. "Which shows revenue earned this year?" (Income Statement) is testing whether you understand this timing difference.
The Balance Sheet is like a PHOTOGRAPH — it shows a firm's financial position at one moment in time.
The Income Statement and Statement of Cash Flows are like a MOVIE — they show what happened over a period.
A question that asks "Which statement shows accounts receivable?" (Balance Sheet) vs. "Which shows revenue earned this year?" (Income Statement) is testing whether you understand this timing difference.
2. The Balance Sheet — Assets = Liabilities + Equity
The Balance Sheet rests on the most fundamental equation in all of accounting:
The Accounting Identity — Must ALWAYS Balance
Total Assets = Total Liabilities + Stockholders' Equity
Stockholders' Equity = Total Assets − Total Liabilities
Equity is the RESIDUAL claim — what belongs to shareholders after all debts are paid.
Balance Sheet Structure:
| ASSETS (What We Own) | LIABILITIES + EQUITY (How We Financed It) |
|---|---|
| Current Assets (due/converted within 1 year): Cash & equivalents · Accounts receivable · Inventory · Prepaid expenses |
Current Liabilities (due within 1 year): Accounts payable · Accrued wages and taxes · Short-term notes payable · Current portion of long-term debt |
| Long-Term Assets: Property, Plant & Equipment (PP&E) — net of accumulated depreciation · Intangible assets (patents, goodwill) · Long-term investments |
Long-Term Liabilities: Long-term debt (bonds, mortgages) · Deferred tax liabilities · Pension obligations |
| Total Assets = Sum of all above | Stockholders' Equity: Common stock · Retained Earnings (cumulative net income kept in the business — NOT a cash account) Total Liabilities + Equity = Total Assets ✓ |
What Retained Earnings Is — and Is NOT
Retained Earnings is one of the most misunderstood items on the Balance Sheet. It represents the cumulative total of all past Net Incomes that have been kept in the business rather than paid out as dividends.
It is NOT a pile of cash sitting in a safe. The firm has already deployed those earnings — they were used to buy equipment, pay down debt, build inventory, or fund operations. Retained Earnings is an accounting balance, not a bank account. A firm can have $5 million in Retained Earnings and $0 in cash.
Retained Earnings is one of the most misunderstood items on the Balance Sheet. It represents the cumulative total of all past Net Incomes that have been kept in the business rather than paid out as dividends.
It is NOT a pile of cash sitting in a safe. The firm has already deployed those earnings — they were used to buy equipment, pay down debt, build inventory, or fund operations. Retained Earnings is an accounting balance, not a bank account. A firm can have $5 million in Retained Earnings and $0 in cash.
3. The Income Statement — From Revenue to Net Income
The Income Statement shows what the firm earned and spent over a period of time. Every line flows directly into the next — understanding this cascade is one of the most testable skills in Unit 3.
| Line Item | What It Represents |
|---|---|
| Net Sales (Revenue) | Total dollar value earned from selling goods or services — before ANY deductions. The top line. |
| Less: COGS | Direct costs of producing what was sold: raw materials, direct labor, manufacturing. |
| = Gross Profit | Revenue − COGS. Profit before overhead, D&A, interest, and taxes. Measures core pricing power. |
| Less: Operating Expenses (SG&A) | Selling, general, and administrative expenses — rent, salaries, marketing, utilities. |
| = EBITDA | Gross Profit − Operating Expenses. Proxy for operating cash generation — strips out non-cash charges and financing effects. |
| Less: Depreciation & Amortization | Non-cash charge spreading cost of long-term assets over their useful lives. Reduces taxable income but no cash leaves the firm. |
| = EBIT (Operating Income) | EBITDA − D&A. Profit from operations before financing decisions. Starting point for NOPAT. |
| Less: Interest Expense | Cost of debt — paid to lenders. Subtracted after EBIT to isolate the effect of financing decisions. |
| = EBT | EBIT − Interest. The profit base on which income taxes are calculated. |
| Less: Income Taxes | EBT × Tax Rate. The government's share of pre-tax profit. |
| = Net Income | EBT − Taxes. Final bottom line — profit belonging to shareholders. Can be paid as dividends or kept as Retained Earnings. |
Why EBITDA? Why So Many Different Income Lines?
Gross Profit — measures the efficiency of the firm's core production process. If gross margins are falling, the firm may be losing pricing power or facing rising input costs.
EBITDA — strips out depreciation (non-cash), interest (financing decision), and taxes (government policy) to show pure operating performance. Analysts use EBITDA to compare firms across different countries, tax rates, and capital structures.
EBIT — adds depreciation back in to show the true cost of using long-lived assets. Used in NOPAT calculation.
Net Income — the legally required bottom line. Used for EPS, dividends, and Retained Earnings. But it is an accounting figure — it can be influenced by depreciation method and revenue recognition timing. This is why investors also look at cash flow.
Gross Profit — measures the efficiency of the firm's core production process. If gross margins are falling, the firm may be losing pricing power or facing rising input costs.
EBITDA — strips out depreciation (non-cash), interest (financing decision), and taxes (government policy) to show pure operating performance. Analysts use EBITDA to compare firms across different countries, tax rates, and capital structures.
EBIT — adds depreciation back in to show the true cost of using long-lived assets. Used in NOPAT calculation.
Net Income — the legally required bottom line. Used for EPS, dividends, and Retained Earnings. But it is an accounting figure — it can be influenced by depreciation method and revenue recognition timing. This is why investors also look at cash flow.
4. Depreciation — The Non-Cash Expense That Changes Everything
Depreciation is the systematic allocation of the cost of a long-term asset over its useful life. When a BBYM enterprise buys a $50,000 commercial oven expected to last 10 years, it does not expense the full $50,000 in Year 1. Instead, it records $5,000 of depreciation expense each year for 10 years.
| What Depreciation DOES | What Depreciation Does NOT Do |
|---|---|
| Reduces reported Net Income each year (it is an expense on the income statement) | Reduce the firm's cash balance — no cash actually leaves the bank when depreciation is recorded |
| Reduces Taxable Income — and therefore reduces the tax bill (the Depreciation Tax Shield) | Represent the actual market value decline of the asset — accounting depreciation and real economic depreciation are different |
| Reduces the book value of PP&E on the Balance Sheet (Net PP&E = Gross PP&E − Accumulated Depreciation) | Appear in the cash balance — it is added back when computing OCF because it was never a cash outflow |
| Shows up as a non-cash add-back on the Statement of Cash Flows, Operating Activities section | Affect Free Cash Flow directly — CapEx (actual spending on new assets) is what affects cash |
Depreciation Tax Shield
Tax Shield = Depreciation × Tax Rate
Example: Dep = $18,000, Tax Rate = 25% → Tax Shield = $18,000 × 0.25 = $4,500
Because depreciation is deductible, the firm saves $4,500 in taxes it would otherwise have to pay. The government effectively subsidizes the non-cash expense.
Because depreciation is deductible, the firm saves $4,500 in taxes it would otherwise have to pay. The government effectively subsidizes the non-cash expense.
5. NOPAT and Operating Cash Flow — Linking Profit to Cash
NOPAT (Net Operating Profit After Tax) is the firm's operating profit after paying taxes, but before any interest or financing effects. It measures how much money the firm's operations generate on a purely after-tax basis — as if the company had no debt.
NOPAT and OCF Formulas
NOPAT = EBIT × (1 − Tax Rate)
OCF = NOPAT + Depreciation = EBIT(1−T) + Depreciation
Why add Depreciation back? Depreciation reduced EBIT (and thus NOPAT) on paper, but no cash left the firm. Adding it back restores the true cash generated by operations.
Worked Example — Community Bakery: EBIT = $102,000 | Depreciation = $18,000 | Tax Rate = 25%
NOPAT = $102,000 × (1 − 0.25) = $76,500
OCF = $76,500 + $18,000 = $94,500
The bakery's operations generated $94,500 in actual cash after taxes — even though EBIT was $102,000 before the non-cash depreciation charge.
NOPAT = $102,000 × (1 − 0.25) = $76,500
OCF = $76,500 + $18,000 = $94,500
The bakery's operations generated $94,500 in actual cash after taxes — even though EBIT was $102,000 before the non-cash depreciation charge.
6. Free Cash Flow (FCF) — The Number That Matters Most to Investors
Free Cash Flow is the cash that remains after the firm has funded all its operating needs AND invested in the long-term assets required to sustain future growth. It represents the cash truly available to pay back ALL of the firm's investors — both debt holders and equity holders.
Free Cash Flow Formula
FCF = OCF − Capital Expenditures (CapEx) − Change in NWC (ΔNWC)
Where: OCF = NOPAT + Depreciation = EBIT(1−T) + Dep
CapEx = cash spent purchasing new long-term assets (PP&E)
ΔNWC = increase in Net Working Capital (increase in CA minus CL — cash tied up in operations)
ΔNWC = increase in Net Working Capital (increase in CA minus CL — cash tied up in operations)
Full Worked Example — Bessemer Community Bakery:
Net Sales $320K | COGS $140K | OpEx $60K | Dep $18K | Interest $7K | Tax 25% | CapEx $22K | ΔNWC $8K
Gross Profit = $320K − $140K = $180,000
EBITDA = $180K − $60K = $120,000
EBIT = $120K − $18K = $102,000
EBT = $102K − $7K = $95,000
Taxes = $95K × 25% = $23,750
Net Income = $95K − $23,750 = $71,250
NOPAT = $102K × 0.75 = $76,500
OCF = $76,500 + $18,000 = $94,500
FCF = $94,500 − $22,000 − $8,000 = $64,500
Net Sales $320K | COGS $140K | OpEx $60K | Dep $18K | Interest $7K | Tax 25% | CapEx $22K | ΔNWC $8K
Gross Profit = $320K − $140K = $180,000
EBITDA = $180K − $60K = $120,000
EBIT = $120K − $18K = $102,000
EBT = $102K − $7K = $95,000
Taxes = $95K × 25% = $23,750
Net Income = $95K − $23,750 = $71,250
NOPAT = $102K × 0.75 = $76,500
OCF = $76,500 + $18,000 = $94,500
FCF = $94,500 − $22,000 − $8,000 = $64,500
FCF ($64,500) vs. Net Income ($71,250) — Why They Differ:
Net Income is higher because it does not deduct the $22,000 CapEx or the $8,000 NWC increase. These real cash outflows appear nowhere on the income statement — only on the Balance Sheet (new PP&E) and in the FCF calculation.
For firm valuation: FCF — not Net Income — is what gets discounted in a DCF valuation. A firm is worth the present value of its future free cash flows.
Net Income is higher because it does not deduct the $22,000 CapEx or the $8,000 NWC increase. These real cash outflows appear nowhere on the income statement — only on the Balance Sheet (new PP&E) and in the FCF calculation.
For firm valuation: FCF — not Net Income — is what gets discounted in a DCF valuation. A firm is worth the present value of its future free cash flows.
7. The Statement of Cash Flows — Three Sections
The Statement of Cash Flows reconciles Net Income (accounting profit) to the actual change in the firm's cash balance. Three sections, each telling a different part of the cash story:
| Section | What It Captures | Key Items |
|---|---|---|
| Operating Activities | Cash generated or used by the firm's core day-to-day business — the most important section for evaluating health | Net Income + Depreciation (add back) + changes in AR, inventory, AP, and other working capital |
| Investing Activities | Cash used to acquire or dispose of long-term assets. Negative Investing CF often means a healthy, growing firm investing in future capacity | Purchase of PP&E (CapEx) — negative; Sale of equipment — positive; Acquisitions |
| Financing Activities | Cash raised from — or returned to — the firm's investors: debt holders and equity shareholders | Issuing or repaying debt; Issuing stock; Paying dividends; Repurchasing shares |
Why a Profitable Company Can Still Run Out of Cash
Imagine a BBYM youth enterprise with Net Income of $50,000. It looks profitable. But during the same year it spent $80,000 on new equipment (Investing) and built up $20,000 in inventory (Operating). Its actual cash balance declined by $50,000.
Profit is an accounting concept. Cash is real. A business that cannot pay its bills goes bankrupt — regardless of whether it shows a profit on paper. The most common cause of small business failure is not unprofitability — it is running out of cash while being profitable.
Imagine a BBYM youth enterprise with Net Income of $50,000. It looks profitable. But during the same year it spent $80,000 on new equipment (Investing) and built up $20,000 in inventory (Operating). Its actual cash balance declined by $50,000.
Profit is an accounting concept. Cash is real. A business that cannot pay its bills goes bankrupt — regardless of whether it shows a profit on paper. The most common cause of small business failure is not unprofitability — it is running out of cash while being profitable.
8. The Progressive Federal Income Tax System
The U.S. uses a progressive income tax system — higher income is taxed at higher marginal rates. The key insight: the higher rate applies ONLY to the income within that bracket, NOT to all income.
| Tax Bracket | Rate | Applied To | Tax Owed (on $55,000 income) |
|---|---|---|---|
| Bracket 1 | 10% | First $11,000 | $11,000 × 10% = $1,100 |
| Bracket 2 | 12% | $11,001 – $44,000 ($33,000) | $33,000 × 12% = $3,960 |
| Bracket 3 | 22% | $44,001 – $55,000 ($11,000) | $11,000 × 22% = $2,420 |
| TOTAL TAX — Income: $55,000 | $7,480 | ||
9. Marginal Tax Rate vs. Average Tax Rate — A Critical Distinction
| Marginal Tax Rate | Average Tax Rate |
|---|---|
| The tax rate that applies to the NEXT dollar earned — the rate at the top of your income range | Total taxes paid ÷ Total taxable income — the overall percentage of all income paid as taxes |
| For $55,000 income: Marginal rate = 22% | For $55,000 income: Average rate = $7,480 ÷ $55,000 = 13.6% |
| ALWAYS used in financial decision-making — evaluating a raise, calculating after-tax cost of debt, measuring depreciation tax shield | Useful for understanding overall tax burden, but NOT the rate used in financial decisions |
| Example: $5,000 raise → $5,000 × (1 − 0.22) = $3,900 after-tax | Average rate of 13.6% is lower because the first dollars were taxed at only 10% and 12% |
The Most Common Exam Mistake: Applying Marginal Rate to ALL Income
❌ Wrong: "I earn $55,000 and my marginal rate is 22%, so I owe $55,000 × 22% = $12,100."
✅ Correct: The 22% rate applies ONLY to income above $44,000. Total = $7,480.
Memory trick: Think of your income filling up tax buckets. The 10% bucket fills first, then the 12% bucket, then the 22% bucket. Only the income in each bucket is taxed at that bucket's rate.
❌ Wrong: "I earn $55,000 and my marginal rate is 22%, so I owe $55,000 × 22% = $12,100."
✅ Correct: The 22% rate applies ONLY to income above $44,000. Total = $7,480.
Memory trick: Think of your income filling up tax buckets. The 10% bucket fills first, then the 12% bucket, then the 22% bucket. Only the income in each bucket is taxed at that bucket's rate.
10. Reading a W-2 — Applying Tax Concepts to Your Own Life
A W-2 form is the tax document your employer sends each January showing wages, federal taxes withheld, and Social Security/Medicare contributions. Understanding your W-2 is where all of Unit 3's tax concepts become personal.
| W-2 Box | What It Shows | Tax Concept |
|---|---|---|
| Box 1 | Wages, tips, and other compensation — total taxable income from this employer | This is your taxable income that gets run through the progressive tax brackets |
| Box 2 | Federal income tax withheld — what your employer already sent to the IRS | Compare to actual tax owed to determine refund (overwithheld) or amount due (underwithheld) |
| Box 3 & 5 | Social Security wages and Medicare wages | FICA taxes: 6.2% Social Security + 1.45% Medicare — flat rates, NOT progressive |
| Box 12 | Various benefit codes — Code W = HSA, Code DD = employer health insurance | Often pre-tax — reduce Box 1 taxable income |
| Box 16–17 | State wages and state income tax withheld | State taxes vary — Alabama has its own brackets |
BBYM Personal Finance Connection: Understanding your W-2 means you can verify your employer withheld the correct amount, understand the difference between gross and taxable income (pre-tax 401k, HSA, and health insurance contributions reduce taxable income), and identify when the marginal rate is what actually matters — as when deciding whether to contribute more to a pre-tax retirement account.
11. Net Working Capital and Its Role in Cash Flow
NWC represents the short-term financial cushion that allows a firm to fund daily operations. Changes in NWC directly affect Free Cash Flow.
Net Working Capital Formula
NWC = Current Assets − Current Liabilities
Positive ΔNWC (NWC increased) = cash was USED — a cash outflow
Negative ΔNWC (NWC decreased) = cash was RELEASED — a cash inflow
FCF = OCF − CapEx − ΔNWC → Increasing NWC REDUCES FCF (consumes cash)
Why Growing Businesses Often Have Negative FCF — and Why That Can Be Good:
A fast-growing BBYM social enterprise might show strong Net Income but negative FCF. As the business grows, it needs more inventory (AR rises), pays suppliers before collecting from customers, and invests in new equipment (CapEx). All of these consume cash even as profits rise.
Negative FCF during a growth phase is often a sign of a healthy, expanding business — NOT a dying one. The question to ask: "Is the firm investing in projects that will generate MORE than their cost over time?"
A fast-growing BBYM social enterprise might show strong Net Income but negative FCF. As the business grows, it needs more inventory (AR rises), pays suppliers before collecting from customers, and invests in new equipment (CapEx). All of these consume cash even as profits rise.
Negative FCF during a growth phase is often a sign of a healthy, expanding business — NOT a dying one. The question to ask: "Is the firm investing in projects that will generate MORE than their cost over time?"
12. BBYM Community Wealth Connection
How the Three Statements Apply to BBYM and The Swanson Initiative
Balance Sheet: Shows the community what BBYM owns (equipment, cash, property) and owes (grants to be disbursed, loan obligations). Retained Earnings in a nonprofit context becomes the 'net assets' that fund future programs.
Income Statement: Shows whether BBYM's programs generated enough revenue and grants to cover expenses. Tracking EBIT helps BBYM separate program performance from one-time grant income.
Free Cash Flow: The most important metric for The Swanson Initiative trust fund — how much cash does the initiative generate that can be reinvested in community businesses, scholarships, or cooperative ownership? FCF answers this question in a way that Net Income cannot.
Understanding financial statements is community power: A youth entrepreneur who can read and present these three statements to a CDFI loan officer, a grant committee, or a community board is dramatically more likely to secure funding, earn trust, and build lasting wealth.
Balance Sheet: Shows the community what BBYM owns (equipment, cash, property) and owes (grants to be disbursed, loan obligations). Retained Earnings in a nonprofit context becomes the 'net assets' that fund future programs.
Income Statement: Shows whether BBYM's programs generated enough revenue and grants to cover expenses. Tracking EBIT helps BBYM separate program performance from one-time grant income.
Free Cash Flow: The most important metric for The Swanson Initiative trust fund — how much cash does the initiative generate that can be reinvested in community businesses, scholarships, or cooperative ownership? FCF answers this question in a way that Net Income cannot.
Understanding financial statements is community power: A youth entrepreneur who can read and present these three statements to a CDFI loan officer, a grant committee, or a community board is dramatically more likely to secure funding, earn trust, and build lasting wealth.
Part 2 — Key Terms Defined
Master all 21 terms — they appear on the Unit 3 assessment and form the language of financial literacy
Balance Sheet
A financial statement showing a firm's assets, liabilities, and stockholders' equity at a single point in time. Must always satisfy: Assets = Liabilities + Equity.
Income Statement
A financial statement showing revenues, expenses, and profit over a period of time. Flows from Net Sales to Net Income through multiple intermediate lines (Gross Profit, EBITDA, EBIT, EBT).
Statement of Cash Flows
A financial statement showing the actual movement of cash during a period, divided into three sections: Operating, Investing, and Financing Activities. Reconciles Net Income to the change in cash.
Revenue (Net Sales)
The total dollar amount earned from selling goods or services before any expenses are subtracted. The 'top line' of the income statement.
Cost of Goods Sold (COGS)
Direct costs attributable to producing goods sold — raw materials, direct labor, manufacturing overhead. Subtracted from Revenue to get Gross Profit.
Gross Profit
Revenue minus COGS. Measures how much money is left from sales after covering production costs, before overhead and other expenses.
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization. A widely used proxy for operating cash generation that strips out non-cash charges and financing effects.
EBIT (Operating Income)
Earnings Before Interest and Taxes. EBITDA minus Depreciation and Amortization. The firm's operating profit — starting point for NOPAT and cash flow calculations.
Net Income
The final 'bottom line' after all expenses including interest and taxes. Belongs to shareholders — can be paid as dividends or retained as Retained Earnings.
Retained Earnings
The cumulative total of all past Net Incomes kept in the business rather than paid out as dividends. An equity account on the Balance Sheet — NOT a cash account.
Depreciation & Amortization (D&A)
Non-cash charges that allocate the cost of long-term assets (D) or intangible assets (A) over their useful lives. Reduces taxable income (creating the tax shield) but involves no actual cash payment.
Depreciation Tax Shield
The tax savings generated by the depreciation expense deduction: Depreciation × Tax Rate. The government effectively subsidizes the firm's use of long-term assets.
NOPAT
Net Operating Profit After Tax = EBIT × (1 − Tax Rate). Operating profit after taxes but before any financing effects (interest). Measures the core cash-generating ability of operations.
Operating Cash Flow (OCF)
NOPAT + Depreciation. The actual cash generated by operations after taxes. Depreciation is added back because it reduced NOPAT on paper but was never a cash payment.
Free Cash Flow (FCF)
OCF minus Capital Expenditures minus the change in Net Working Capital. The cash available to pay ALL investors (debt and equity) after funding operations and investment. The most important metric for firm valuation.
Net Working Capital (NWC)
Current Assets minus Current Liabilities. The short-term liquidity buffer. Increasing NWC consumes cash (reduces FCF); decreasing NWC releases cash (increases FCF).
Capital Expenditures (CapEx)
Cash spent on purchasing or improving long-term assets such as PP&E. Not expensed immediately — instead depreciated over time. Directly reduces FCF.
Progressive Tax System
A tax structure where higher income is taxed at higher marginal rates, but each rate applies only to the income within that specific bracket — not to all income.
Marginal Tax Rate
The rate applied to the NEXT dollar of income earned. The rate that determines the financial impact of any additional income, deduction, or tax-related decision. Always use the marginal rate in financial calculations.
Average Tax Rate
Total taxes paid divided by total taxable income. The overall fraction of income paid as taxes. Always less than or equal to the marginal rate in a progressive system.
W-2 Form
The employer-issued tax document showing total wages paid and taxes withheld during the year. Box 1 = taxable wages; Box 2 = federal income tax already withheld.
Part 3 — Formulas & Calculations
Every formula you need, with worked examples. These WILL appear on the Unit 3 assessment.
Income Statement Cascade — Memorize This Order
Complete Income Statement Build — Top to Bottom
(1) Gross Profit = Revenue − COGS
(2) EBITDA = Gross Profit − Operating Expenses
(3) EBIT = EBITDA − Depreciation & Amortization
(4) EBT = EBIT − Interest Expense
(5) Taxes = EBT × Tax Rate
(6) Net Income = EBT − Taxes = EBT × (1 − Tax Rate)
(7) NOPAT = EBIT × (1 − Tax Rate)
(8) OCF = NOPAT + Depreciation
(9) FCF = OCF − CapEx − ΔNWC
Quick Reference — All Formulas
| Formula Name | Formula | What It Measures |
|---|---|---|
| Gross Profit | Revenue − COGS | Core profitability from production/sales before overhead |
| EBITDA | Gross Profit − Operating Expenses | Operating cash generation before D&A, interest, taxes |
| EBIT | EBITDA − Depreciation & Amortization | Operating profit after accounting for asset wear and tear |
| EBT | EBIT − Interest Expense | Profit base for tax calculation |
| Net Income | EBT × (1 − Tax Rate) | Bottom-line accounting profit belonging to shareholders |
| NOPAT | EBIT × (1 − Tax Rate) | Operating profit after taxes, excluding financing effects |
| OCF | NOPAT + Depreciation | Cash generated by operations after taxes |
| FCF | OCF − CapEx − ΔNWC | Cash available to ALL investors after operations and investment |
| NWC | Current Assets − Current Liabilities | Short-term liquidity buffer; changes in NWC affect FCF |
| Depreciation Tax Shield | Depreciation × Tax Rate | Annual tax saving from the depreciation deduction |
| Average Tax Rate | Total Tax Paid ÷ Taxable Income | Overall fraction of income paid as taxes |
| Marginal Tax Rate | Rate on the next dollar earned | Rate used in ALL financial decisions and tax shield calculations |
Progressive Tax Bracket Calculation — Step by Step
Always solve bracket-by-bracket. Never apply the highest rate to all income.
Tax Calculation — $85,000 Taxable Income (Brackets: 10% / 12% / 22%)
Bracket 1: $11,000 × 10% = $1,100
Bracket 2: ($44,000 − $11,000) = $33,000 × 12% = $3,960
Bracket 3: ($85,000 − $44,000) = $41,000 × 22% = $9,020
Total Tax = $1,100 + $3,960 + $9,020 = $14,080
Average Tax Rate = $14,080 ÷ $85,000 = 16.6%
Marginal Tax Rate = 22% (the rate on the last dollar — in the 22% bracket)
After-Tax Income = $85,000 − $14,080 = $70,920
Marginal Tax Rate = 22% (the rate on the last dollar — in the 22% bracket)
After-Tax Income = $85,000 − $14,080 = $70,920
Part 4 — Net Income vs. Free Cash Flow
The most important distinction in Unit 3 — and one of the most important in all of corporate finance
Why They Differ — Side by Side
| Net Income | Free Cash Flow (FCF) |
|---|---|
| An accounting measure: follows GAAP rules for revenue recognition, expense matching, and accrual accounting | A cash measure: counts only actual dollars received and paid, independent of accounting timing choices |
| INCLUDES depreciation as a deduction (reduces income on paper) | Adds depreciation BACK — it was subtracted to get NOPAT but is not a real cash outflow, so it is restored |
| Does NOT deduct Capital Expenditures — CapEx is capitalized and only partially expensed each year via depreciation | DEDUCTS the full CapEx — cash actually left the firm when equipment was purchased, regardless of how it is expensed |
| Does NOT deduct increases in Net Working Capital (AR, inventory build-up are assets, not expenses) | DEDUCTS increases in NWC — cash is consumed when inventory rises or customers are slow to pay |
| Based on EBT (after interest), so it reflects financing decisions | Based on EBIT (before interest), so it is independent of financing — available to BOTH debt and equity holders |
| Used for EPS, dividends, and stockholder reports | Used for firm valuation (DCF analysis), investment decisions, and investor returns analysis |
The FCF Bridge — From Net Income to FCF
FCF Bridge from Net Income (Indirect Method)
Start: Net Income
+ Add: Depreciation & Amortization (non-cash — add back)
−/+ Adj: Changes in NWC (↑ CA = outflow; ↑ CL = inflow)
= Operating Cash Flow (indirect method)
− Less: Capital Expenditures (CapEx)
= Free Cash Flow (FCF)
This is how FCF appears on the actual Statement of Cash Flows. The NOPAT method and this Net Income method produce the same FCF.
Real-World BBYM Example
A Profitable Business Can Fail. A Free-Cash-Flow-Positive Business Survives.
Business A — The Bakery: Net Income = $50,000. But the owner invested $70,000 in a commercial kitchen (CapEx) and extended 60-day credit creating $30,000 in new AR (NWC increase). FCF = $50,000 + $15,000 Dep − $70,000 CapEx − $30,000 ΔNWC = −$35,000.
Business B — The Tutoring Center: Net Income = $28,000. No major CapEx. Customers pay upfront (no AR increase). FCF ≈ $30,000.
Which business is healthier? It depends entirely on context. The Bakery has negative FCF — but if the kitchen investment generates strong returns for years to come, that is a wise investment. The entrepreneur who understands FCF can make this distinction — and so can the CDFI loan officer evaluating their application.
Business A — The Bakery: Net Income = $50,000. But the owner invested $70,000 in a commercial kitchen (CapEx) and extended 60-day credit creating $30,000 in new AR (NWC increase). FCF = $50,000 + $15,000 Dep − $70,000 CapEx − $30,000 ΔNWC = −$35,000.
Business B — The Tutoring Center: Net Income = $28,000. No major CapEx. Customers pay upfront (no AR increase). FCF ≈ $30,000.
Which business is healthier? It depends entirely on context. The Bakery has negative FCF — but if the kitchen investment generates strong returns for years to come, that is a wise investment. The entrepreneur who understands FCF can make this distinction — and so can the CDFI loan officer evaluating their application.
Part 5 — Review & Practice Questions
Answer in your own words — these mirror the Unit 3 assessment and real financial decisions
Write your answer before clicking to reveal. Cover the answer and test yourself!
Conceptual Questions
Q1
Explain the difference between the Balance Sheet and the Income Statement. Which one is a 'snapshot' and which is a 'movie'? Give one specific item that belongs on each statement and explain why it belongs there and not the other.
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The Balance Sheet is the snapshot — it shows the firm's financial position at one specific point in time (e.g., December 31). Accounts Receivable belongs on the Balance Sheet because it represents money owed to the firm at that moment — an asset the firm holds right now, not something earned during a period.
The Income Statement is the movie — it shows what happened over a period of time (e.g., all of 2024). Revenue belongs on the Income Statement because it represents money earned during the year through sales activity — a flow of value over time, not a balance at a single moment.
The Income Statement is the movie — it shows what happened over a period of time (e.g., all of 2024). Revenue belongs on the Income Statement because it represents money earned during the year through sales activity — a flow of value over time, not a balance at a single moment.
Q2
A classmate says: "Depreciation is an expense, so it must reduce cash." Do you agree? Explain why depreciation does not reduce cash — and why it is added back when computing Operating Cash Flow.
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Disagree. Depreciation is a non-cash charge — it reduces reported profit and taxable income, but no money actually leaves the firm when it is recorded. The cash was spent when the asset was originally purchased (CapEx). Depreciation is simply the accounting recognition that the asset's value is being "used up" over time — but that process involves no cash transaction.
This is why depreciation must be added back when computing Operating Cash Flow. Starting from NOPAT (which had depreciation deducted to reach EBIT, then taxed), we restore depreciation because it reduced NOPAT on paper but never reduced the firm's actual cash balance. OCF = NOPAT + Depreciation reflects true cash generation.
This is why depreciation must be added back when computing Operating Cash Flow. Starting from NOPAT (which had depreciation deducted to reach EBIT, then taxed), we restore depreciation because it reduced NOPAT on paper but never reduced the firm's actual cash balance. OCF = NOPAT + Depreciation reflects true cash generation.
Q3
A BBYM youth enterprise reports Net Income of $45,000 and Free Cash Flow of $12,000. Explain two specific reasons why FCF could be so much lower than Net Income. Which number would a lender or investor focus on, and why?
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Two reasons FCF is lower than Net Income:
1. Capital Expenditures: The enterprise may have purchased new equipment (e.g., a $25,000 commercial printer). This cash outflow reduces FCF directly but does not reduce Net Income (only depreciation of that equipment, say $2,500/year, appears on the IS).
2. Increase in Net Working Capital: Growing sales may have increased Accounts Receivable (customers have 30-day credit terms) and inventory — real cash tied up in operations. A $15,000 NWC increase reduces FCF by $15,000 but does not reduce Net Income at all.
A lender or investor would focus on FCF — because it measures actual cash available to pay debt obligations and returns to investors. Net Income is an accounting figure that can be positive even when the firm is running out of cash.
1. Capital Expenditures: The enterprise may have purchased new equipment (e.g., a $25,000 commercial printer). This cash outflow reduces FCF directly but does not reduce Net Income (only depreciation of that equipment, say $2,500/year, appears on the IS).
2. Increase in Net Working Capital: Growing sales may have increased Accounts Receivable (customers have 30-day credit terms) and inventory — real cash tied up in operations. A $15,000 NWC increase reduces FCF by $15,000 but does not reduce Net Income at all.
A lender or investor would focus on FCF — because it measures actual cash available to pay debt obligations and returns to investors. Net Income is an accounting figure that can be positive even when the firm is running out of cash.
Q4
Explain the difference between NOPAT and Net Income. Why does NOPAT start with EBIT (before interest) while Net Income starts with EBT (after interest)?
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NOPAT (EBIT × (1−T)) starts with EBIT — before interest — because it is designed to measure the operating performance of the business independent of how it is financed. NOPAT answers: "How much cash did operations generate, regardless of whether we used debt or equity?" It belongs to ALL investors — both debt holders and equity holders — before any interest payments are made.
Net Income starts with EBT — after interest — because it represents what is left for equity shareholders only, after the firm has already paid its debt holders. Two identical businesses with different debt levels will have different Net Incomes but the same NOPAT.
This is why NOPAT and FCF are used for valuation (firm value is independent of capital structure), while Net Income is used for EPS, dividends, and shareholder-specific metrics.
Net Income starts with EBT — after interest — because it represents what is left for equity shareholders only, after the firm has already paid its debt holders. Two identical businesses with different debt levels will have different Net Incomes but the same NOPAT.
This is why NOPAT and FCF are used for valuation (firm value is independent of capital structure), while Net Income is used for EPS, dividends, and shareholder-specific metrics.
Q5
A student earns $72,000 and is offered a $10,000 raise. Her marginal tax rate is 22% and her average tax rate is 15%. Which rate should she use to calculate how much of the raise she will keep after taxes?
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She should use the marginal tax rate of 22%. The raise is additional income placed on top of her existing $72,000 — it falls in her highest bracket. The average rate of 15% reflects her overall tax burden including the lower-taxed income in her 10% and 12% brackets, but those brackets are already filled by her base salary.
After-tax value of the raise = $10,000 × (1 − 0.22) = $7,800
If she incorrectly used the average rate: $10,000 × (1 − 0.15) = $8,500 — an overestimate of $700. This distinction matters every time she evaluates a bonus, side income, or tax deduction.
After-tax value of the raise = $10,000 × (1 − 0.22) = $7,800
If she incorrectly used the average rate: $10,000 × (1 − 0.15) = $8,500 — an overestimate of $700. This distinction matters every time she evaluates a bonus, side income, or tax deduction.
Calculation Practice
Q6
Build a complete income statement for Community Print Shop: Net Sales $280,000 | COGS $112,000 | Operating Expenses $56,000 | Depreciation $14,000 | Interest $8,000 | Tax Rate 21%. Show every line.
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Gross Profit = $280,000 − $112,000 = $168,000
EBITDA = $168,000 − $56,000 = $112,000
EBIT = $112,000 − $14,000 = $98,000
EBT = $98,000 − $8,000 = $90,000
Taxes = $90,000 × 21% = $18,900
Net Income = $90,000 − $18,900 = $71,100
EBITDA = $168,000 − $56,000 = $112,000
EBIT = $112,000 − $14,000 = $98,000
EBT = $98,000 − $8,000 = $90,000
Taxes = $90,000 × 21% = $18,900
Net Income = $90,000 − $18,900 = $71,100
Q7
Using Community Print Shop above: (a) Calculate NOPAT. (b) Calculate OCF. (c) If CapEx = $20,000 and NWC increased by $6,000, calculate FCF. (d) Explain in one sentence why FCF differs from Net Income.
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(a) NOPAT = $98,000 × (1 − 0.21) = $98,000 × 0.79 = $77,420
(b) OCF = $77,420 + $14,000 = $91,420
(c) FCF = $91,420 − $20,000 − $6,000 = $65,420
(d) FCF is lower than Net Income ($71,100) because FCF deducts the full $20,000 CapEx and $6,000 NWC increase — real cash outflows that never appear on the income statement.
(b) OCF = $77,420 + $14,000 = $91,420
(c) FCF = $91,420 − $20,000 − $6,000 = $65,420
(d) FCF is lower than Net Income ($71,100) because FCF deducts the full $20,000 CapEx and $6,000 NWC increase — real cash outflows that never appear on the income statement.
Q8
Calculate federal income tax for a BBYM student earning $62,000. Brackets: 10% on first $11,000; 12% on $11,001–$44,000; 22% on remainder. Show each bracket. Then compute: (a) Total tax, (b) Average tax rate, (c) Marginal tax rate, (d) After-tax take-home.
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Bracket 1: $11,000 × 10% = $1,100
Bracket 2: ($44,000 − $11,000) = $33,000 × 12% = $3,960
Bracket 3: ($62,000 − $44,000) = $18,000 × 22% = $3,960
(a) Total Tax = $1,100 + $3,960 + $3,960 = $9,020
(b) Average Tax Rate = $9,020 ÷ $62,000 = 14.5%
(c) Marginal Tax Rate = 22% (rate on the last dollar earned — in the 22% bracket)
(d) After-Tax Income = $62,000 − $9,020 = $52,980
Bracket 2: ($44,000 − $11,000) = $33,000 × 12% = $3,960
Bracket 3: ($62,000 − $44,000) = $18,000 × 22% = $3,960
(a) Total Tax = $1,100 + $3,960 + $3,960 = $9,020
(b) Average Tax Rate = $9,020 ÷ $62,000 = 14.5%
(c) Marginal Tax Rate = 22% (rate on the last dollar earned — in the 22% bracket)
(d) After-Tax Income = $62,000 − $9,020 = $52,980
Q9
A firm has: Cash $40,000 | AR $65,000 | Inventory $55,000 | AP $35,000 | Accrued Wages $15,000. Calculate NWC. If AR increases to $85,000 next year (all else equal), what happens to NWC and how does that affect FCF?
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Current Assets = $40,000 + $65,000 + $55,000 = $160,000
Current Liabilities = $35,000 + $15,000 = $50,000
NWC = $160,000 − $50,000 = $110,000
If AR increases to $85,000: New CA = $40K + $85K + $55K = $180,000. New NWC = $180,000 − $50,000 = $130,000.
ΔNWC = $130,000 − $110,000 = +$20,000
Effect on FCF: The $20,000 increase in NWC is a cash outflow — customers owe more money but haven't paid yet. FCF = OCF − CapEx − ΔNWC, so FCF decreases by $20,000. Slower collections tie up real cash.
Current Liabilities = $35,000 + $15,000 = $50,000
NWC = $160,000 − $50,000 = $110,000
If AR increases to $85,000: New CA = $40K + $85K + $55K = $180,000. New NWC = $180,000 − $50,000 = $130,000.
ΔNWC = $130,000 − $110,000 = +$20,000
Effect on FCF: The $20,000 increase in NWC is a cash outflow — customers owe more money but haven't paid yet. FCF = OCF − CapEx − ΔNWC, so FCF decreases by $20,000. Slower collections tie up real cash.
Critical Thinking — BBYM Community Connection
Q10
Read a real nonprofit's IRS Form 990 (available on ProPublica Nonprofit Explorer for any Birmingham-area organization). Identify: (a) total revenue, (b) total expenses, (c) net surplus or deficit, (d) total assets, (e) total liabilities, (f) net assets. Which financial statement does each come from?
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(a) Total revenue — Income Statement (top line, equivalent to Net Sales)
(b) Total expenses — Income Statement (equivalent to COGS + Operating Expenses)
(c) Net surplus or deficit — Income Statement (equivalent to Net Income; nonprofits call it "change in net assets")
(d) Total assets — Balance Sheet (sum of all current and long-term assets)
(e) Total liabilities — Balance Sheet (sum of current and long-term liabilities)
(f) Net assets — Balance Sheet (equivalent to Stockholders' Equity; in nonprofits = assets minus liabilities)
Practical tip: Search "Birmingham" on projects.propublica.org/nonprofits to find local organizations' publicly available Form 990s.
(b) Total expenses — Income Statement (equivalent to COGS + Operating Expenses)
(c) Net surplus or deficit — Income Statement (equivalent to Net Income; nonprofits call it "change in net assets")
(d) Total assets — Balance Sheet (sum of all current and long-term assets)
(e) Total liabilities — Balance Sheet (sum of current and long-term liabilities)
(f) Net assets — Balance Sheet (equivalent to Stockholders' Equity; in nonprofits = assets minus liabilities)
Practical tip: Search "Birmingham" on projects.propublica.org/nonprofits to find local organizations' publicly available Form 990s.
Q11
A BBYM student entrepreneur just received her first full-year financials: Net Income = $38,000, FCF = −$5,000. She is panicking. Explain: (a) Why FCF can be negative despite positive Net Income, (b) What questions you would ask to determine if this is healthy, and (c) What she should present to a CDFI loan officer.
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(a) FCF = OCF − CapEx − ΔNWC. Even with strong NOPAT, if she invested heavily in equipment (CapEx) or grew her accounts receivable and inventory (ΔNWC increase), the cash was consumed. Negative FCF despite positive Net Income means the business is growing and investing — not necessarily failing.
(b) Key questions: Did she make a significant capital investment this year? (If so, is it expected to generate returns?) Did accounts receivable increase — and are those customers reliable? How much of the NWC increase is inventory vs. unpaid invoices? Is this a one-time growth investment or a recurring pattern?
(c) For the CDFI officer, she should present: (1) The income statement showing $38,000 Net Income — proof of profitability, (2) The FCF calculation showing what consumed the cash (CapEx for growth, not operating losses), (3) A forward projection showing when the capital investment will generate positive FCF, and (4) Her accounts receivable aging schedule to show collections are on track.
(b) Key questions: Did she make a significant capital investment this year? (If so, is it expected to generate returns?) Did accounts receivable increase — and are those customers reliable? How much of the NWC increase is inventory vs. unpaid invoices? Is this a one-time growth investment or a recurring pattern?
(c) For the CDFI officer, she should present: (1) The income statement showing $38,000 Net Income — proof of profitability, (2) The FCF calculation showing what consumed the cash (CapEx for growth, not operating losses), (3) A forward projection showing when the capital investment will generate positive FCF, and (4) Her accounts receivable aging schedule to show collections are on track.
Q12
The Swanson Initiative aims to build a community trust fund through BBYM's youth enterprises. Design a simple financial dashboard: (a) which single IS number to track monthly, (b) which Cash Flow number quarterly, (c) which Balance Sheet ratio to monitor, and (d) why you chose each.
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(a) Monthly IS metric: EBIT (Operating Income) — because it measures the enterprise's operating performance before financing decisions. It separates program performance from grant income and tells the trust whether the business model itself is sustainable. Net Income is too easily distorted by one-time items.
(b) Quarterly Cash Flow metric: Free Cash Flow — because FCF is what the Swanson Initiative can actually reinvest. Trust fund contributions should come from FCF, not Net Income. Tracking FCF quarterly ensures distributions don't exceed actual cash generation.
(c) Balance Sheet ratio: Current Ratio (Current Assets ÷ Current Liabilities) — monitors short-term liquidity. A ratio above 1.5 means the enterprise can comfortably meet near-term obligations. If it falls below 1.0, the enterprise may need emergency financing that disrupts trust contributions.
Together these three metrics create a simple, community-accessible dashboard: Is the enterprise profitable at its core (EBIT)? Is it generating real cash (FCF)? Can it pay its bills short-term (Current Ratio)?
(b) Quarterly Cash Flow metric: Free Cash Flow — because FCF is what the Swanson Initiative can actually reinvest. Trust fund contributions should come from FCF, not Net Income. Tracking FCF quarterly ensures distributions don't exceed actual cash generation.
(c) Balance Sheet ratio: Current Ratio (Current Assets ÷ Current Liabilities) — monitors short-term liquidity. A ratio above 1.5 means the enterprise can comfortably meet near-term obligations. If it falls below 1.0, the enterprise may need emergency financing that disrupts trust contributions.
Together these three metrics create a simple, community-accessible dashboard: Is the enterprise profitable at its core (EBIT)? Is it generating real cash (FCF)? Can it pay its bills short-term (Current Ratio)?
Part 6 — Quick Reference Summary
Read this the night before the assessment — the whole unit in one page
Unit 3 in 6 Essential Sentences
Sentence 1
Every business tells its financial story through three statements: the Balance Sheet (snapshot of what it owns and owes at one point in time), the Income Statement (profit earned over a period), and the Statement of Cash Flows (actual cash movement — reconciling profit to the change in cash).
Sentence 2
The income statement flows: Revenue → Gross Profit → EBITDA → EBIT → EBT → Net Income; each line strips away one more layer of costs, and the key to mastering Unit 3 is knowing exactly what is removed at each step.
Sentence 3
Depreciation is a non-cash expense that reduces taxable income (generating a tax shield = Dep × Tax Rate) but does not reduce cash — which is why it must be added back when computing Operating Cash Flow.
Sentence 4
Free Cash Flow (FCF = OCF − CapEx − ΔNWC) is more important than Net Income to investors because it measures actual cash — not accounting profit — and is the basis for all firm valuation; a company can be profitable and still run out of cash if it has large CapEx and working capital needs.
Sentence 5
The U.S. progressive tax system applies different rates only to the income within each bracket — the marginal rate is the rate on the next dollar earned and is the rate used in ALL financial decisions, while the average rate measures the overall tax burden but is lower than the marginal rate.
Sentence 6
Reading your W-2, building an income statement, and calculating FCF are not abstract exercises — they are the core skills that allow a BBYM entrepreneur to present her business to a lender, evaluate whether a growth investment makes sense, and build transparent accountability to her community.
Must-Know Facts for the Assessment
| Question You Will See | The Right Answer |
|---|---|
| Which statement is a 'snapshot' at a point in time? | Balance Sheet |
| Which statements cover a period of time? | Income Statement AND Statement of Cash Flows |
| What is the accounting identity? | Assets = Liabilities + Stockholders' Equity (must always balance) |
| What is Retained Earnings? | Cumulative past Net Income kept in the business — NOT cash |
| What comes after EBIT on the IS? | Subtract Interest → EBT; Subtract Taxes → Net Income |
| Why add depreciation back in OCF? | Depreciation reduced NOPAT on paper but is non-cash — no cash actually left the firm |
| NOPAT formula? | EBIT × (1 − Tax Rate) |
| OCF formula? | NOPAT + Depreciation |
| FCF formula? | OCF − CapEx − ΔNWC |
| Why is FCF < Net Income (usually)? | FCF deducts CapEx and NWC increases that don't appear on the IS |
| What is the Depreciation Tax Shield? | Depreciation × Tax Rate — annual tax saving from the deduction |
| Marginal tax rate for $55K income (22% bracket)? | 22% — the rate on the last dollar earned |
| Average tax rate for $55K income? | $7,480 ÷ $55,000 = 13.6% |
| Which tax rate is used in financial decisions? | Marginal tax rate — ALWAYS |
| Which CF section captures CapEx? | Investing Activities |
| Which CF section captures depreciation add-back? | Operating Activities |