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+ Financial Statements and Cash Flows RWJ-Chapter 2

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Page 1: + Financial Statements and Cash Flows RWJ-Chapter 2

+

Financial Statements and Cash Flows

RWJ-Chapter 2

Page 2: + Financial Statements and Cash Flows RWJ-Chapter 2

+Understanding Financial Statements

The crux of investments is to value firms (or stocks)

Various models to value common stocks DCF Multiples

No matter which model we are going to use, the key inputs we needed are mostly based on a firm’s financial statements

We will learn the basic tools to analyze financial statements

Page 3: + Financial Statements and Cash Flows RWJ-Chapter 2

+Information for Financial Statements Analysis

1) Published annual reports (1) Financial Statements

Balance Sheet (B/S) Income Statement (I/S) Statement of Cash Flows

(2) Notes to financial statements (3) Letters to stockholders (4) Auditor’s report (independent accountants) (5) Management’s discussion and analysis

2) Reports filed with the government

Page 4: + Financial Statements and Cash Flows RWJ-Chapter 2

+Sources of Information

Annual reports

SEC EDGAR (http://www.sec.gov/edgar.shtml) 10K & 10Q reports

Page 5: + Financial Statements and Cash Flows RWJ-Chapter 2

+Balance Sheet

Balance sheet summarizes the assets owned by a firm

The value of the assets, and the mix (debt and equity) used to finance these assets at a point in time

Assets Liabilities & Equity

Fixed AssetsCurrent AssetsFinancial InvestmentsIntangible Assets

Current LiabilitiesDebt (Long-term)EquityStockholder’s Equity

Total Assets

Total Liabilities & Equity

Page 6: + Financial Statements and Cash Flows RWJ-Chapter 2

+Summary of B/S

An accountant’s snapshot of the firm’s accounting value as of a particular date.

The Balance Sheet Identity is:Assets ≡ Liabilities + Stockholder’s Equity

Stockholder’s equity is defined to be the difference between the assets and the liabilities of the firm. Equity is what stockholders would have remaining after the firm discharged its operations.

Liabilities and equity-side reflects the types and proportions of financing, which depend on management’s choice of capital structure, as between debt and equity and current debt and long-term debt.

Page 7: + Financial Statements and Cash Flows RWJ-Chapter 2

+Assets

Fixed Assets: Assets that are purchased for long-term use and are not

likely to be converted quickly into cash, such as land, buildings, and equipment.

GAAP requires the valuation of historical cost, adjusted for any estimated loss in value from the aging of these assets (Depreciation)

Many firms in the U.S. use straight line depreciation, while Japanese and German firms often use accelerated depreciation

Straight line versus Accelerated Depreciation Accelerated depreciation leads reported income that is

understated.

Page 8: + Financial Statements and Cash Flows RWJ-Chapter 2

+Example- Straight Line

An asset costs $33,000 has a residual value of $3,000, and expected to last 4 years

(i) Calculate annual depreciation

(ii) what happen if you are able to sell this asset after two year at selling price of $20,000?

Page 9: + Financial Statements and Cash Flows RWJ-Chapter 2

+Example-Accelerated Depreciation An asset costs $33,000, and expected to last 5 years

(i) Calculate annual depreciation

(ii) what happen if you are able to sell this asset after two year at selling price of $20,000?

Recovery year

Applicable Percentage

1 0.200

2 0.320

3 0.192

4 0.1152

5 0.1152

6 0.0576

Page 10: + Financial Statements and Cash Flows RWJ-Chapter 2

+Assets

Current Assets: Account Receivables:

It represents money owed by entities to the firm on the sale of products on credit

Cash and Marketable Securities: Cash: One of the few assets for which accountants and

financial analysts should agree on the value Marketable Securities: Investments made by firms in securities

or assets of other firms, as well as T-bills or bonds Inventory

The total amount of goods and/or materials contained in a store or factory at any given time

Closely related to COGS LIFO vs FIFO

Page 11: + Financial Statements and Cash Flows RWJ-Chapter 2

+Assets

Intangible Assets: Patents and Trademarks

Internal External

Goodwill By product of acquisitions When a firm acquires another firm, the purchase price is

first allocated to tangible assets, and the excess price is then allocated to any intangible assets

Nothing but excess price by actual price (MV) and book value of the company

Page 12: + Financial Statements and Cash Flows RWJ-Chapter 2

+Liabilities and Equity

Current Liabilities: Accounts payable:

It represents credit received from suppliers and other vendors

Short-term Borrowing: Short-term loans (due in less than a year) to finance the

operations or current asset needs of the business Short-term portion of long-term borrowing

It represents the portion of the long-term debt or bonds that is coming due in the next year

Other short-term liabilities: It includes wages due to its employees and taxes due to

the government

Page 13: + Financial Statements and Cash Flows RWJ-Chapter 2

+Liabilities and Equity Long-Term Debt:

Long-term loan from a bank or other financial institutions Long-term bond issued to financial markets

Other Long-term Liabilities: Leases, Employee Benefits, Pension Plans, Health Care Benefits These are long-term obligations that are not captured in the

long-term debt items In the past two decades accountants moved toward quantifying

these liabilities and showing them as long-term liabilities

Equity: It reflects the original proceeds received by the firm when

issued the equity

Retained Earnings: Net Income kept for further investment

Page 14: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)2008 and 2009Balance Sheet

U.S. COMPOSITE CORPORATION

Liabilities (Debt)Assets 2008 2009 and Stockholder's Equity 2008 2009

Current assets: Current Liabilities: Cash and equivalents $104 $160 Accounts payable $232 $266 Accounts receivable 455 688 Notes payable 196 123 Inventories 553 555

Total current liabilities $428 $389 Total current assets $1,112 $1,403

Fixed assets: Net Property, plant, and equipment

$1,644$1,709 Long-term debt 408 454

Stockholder's equity:

Common stock and paid in surplus 600 640

Accumulated retained earnings 1,320 1,629

Total equity $1,920 $2,269Total assets $2,756 $3,112Total liabilities and stockholder's equity$2,756 $3,112

Page 15: + Financial Statements and Cash Flows RWJ-Chapter 2

+Balance Sheet Analysis

When analyzing a balance sheet, the financial manager should be aware of three concerns:

(1) Liquidity (2) Debt versus equity (3) Value versus cost

Page 16: + Financial Statements and Cash Flows RWJ-Chapter 2

+Liquidity

Refers to the ease and quickness with which assets can be converted to cash.

Current assets are the most liquid. Fixed assets are the least liquid.

Some fixed assets are intangible.

The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations.

Liquid assets frequently have lower rates of return than fixed assets. For example, cash generates no or little investment income.

To the extent that a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investments.

Page 17: + Financial Statements and Cash Flows RWJ-Chapter 2

+Value versus Cost

Under GAAP audited financial statements of firms in the U.S. carry assets at cost.

Market value is a completely different concept.

Market value is the price at which willing buyers and sellers trade the assets. It would be only coincidence if accounting value (book value) and market value were the same.

Many users of financial statements want to know the value of the firm, not its cost.

In this class, whenever we mention value, we mean market value, not the cost (or book value).

When we say that the goal of a financial manager is to increase the value of the stock, we mean the market value of the stock.

Page 18: + Financial Statements and Cash Flows RWJ-Chapter 2

+Income Statement

The income statement measures performance over a specific period of time.

It provides information on the revenues and expenses of the firm, and resulting income made by the firm, during a period

The accounting definition of income is

Revenue – Expenses ≡ Income

Page 19: + Financial Statements and Cash Flows RWJ-Chapter 2

+More Specifically

Revenue

Cost of Goods Sold (COGS)

Operating Expense

EBITDA

EBIT (Operating Income)

Gross Profit

Depreciation & Amortization

Interest

TaxesNet Income (NI) or Earnings

Retained Earnings (R/E)

Dividends

Page 20: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)2009

Income StatementU.S. COMPOSITE CORPORATION

Net salesCost of goods sold

Depreciation

Earnings before interest and taxes

Interest expenseTaxable incomeTaxes (34%)

Net income Retained earnings: $309 Dividends: $103

The operations section of the income statement reports the firm’s revenues and expenses from principal operations

$1,509- 750

- 65

$694

- 70$624- 212

$412

Page 21: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)2009

Income StatementU.S. COMPOSITE CORPORATION

Net salesCost of goods sold

Depreciation

Earnings before interest and taxes

Interest expenseTaxable incomeTaxes (34%)

Net income Retained earnings: $309 Dividends: $103

The non-operating section of the income statement includes all financing costs, such as interest expense.

$1,509- 750

- 65

$694

- 70$624- 212

$412

Page 22: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)2009

Income StatementU.S. COMPOSITE CORPORATION

Net salesCost of goods sold

Depreciation

Earnings before interest and taxes

Interest expenseTaxable incomeTaxes (34%)

Net income Retained earnings: $309 Dividends: $103

Usually a separate section reports as a separate item the amount of taxes levied on income

$1,509- 750

- 65

$694

- 70$624- 212

$412

Page 23: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)2009

Income StatementU.S. COMPOSITE CORPORATION

Net salesCost of goods sold

Depreciation

Earnings before interest and taxes

Interest expenseTaxable incomeTaxes (34%)

Net income Retained earnings: $309 Dividends: $103

Net income is the “bottom line”

$1,509- 750

- 65

$694

- 70$624- 212

$412

Page 24: + Financial Statements and Cash Flows RWJ-Chapter 2

+Income Statement Analysis

There are two things to keep in mind when analyzing an income statement:

(1) GAAP (2) Non Cash Items

Page 25: + Financial Statements and Cash Flows RWJ-Chapter 2

+Generally Accepted Accounting Principles

Recognition principle: Recognize revenue when the earnings process is complete and the value of an exchange of goods or services is known and can be reliably determined. Thus, income is reported when it is earned, even though no cash flow may have occurred. Midland co. sells goods for $1 million. The goods cost

$900,000. So the company will have profit of $100,000. But the company has not yet collected the cash from the

sale. So, the net cash flow is -$900,000.

Page 26: + Financial Statements and Cash Flows RWJ-Chapter 2

+Non-Cash Items

Depreciation is the most apparent. No firm ever writes a check for “depreciation”.

In practice, the difference between cash flows and accounting income can be quite dramatic. For example Conseco Corp. reported a net loss of $194

million for 2007. But it also reported a positive cash flow of $ 703 million for the same fiscal year!

Page 27: + Financial Statements and Cash Flows RWJ-Chapter 2

+Net Working Capital

Working Capital ≡ Current Assets – Current Liabilities

If the change in NWC is positive, it is a cash outflow. (you are investing more in NWC). If the change in NWC is negative, it is a cash inflow

Page 28: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)2008 and 2009Balance Sheet

U.S. COMPOSITE CORPORATION

Liabilities (Debt)Assets 2008 2009 and Stockholder's Equity 2008 2009

Current assets: Current Liabilities: Cash and equivalents $104 $160 Accounts payable $232 $266 Accounts receivable 455 688 Notes payable 196 123 Inventories 553 555

Total current liabilities $428 $389 Total current assets $1,112 $1,403

Long-term liabilities:Fixed assets: Deferred taxes $117 $104

Property, plant, and equipment$1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39

Common stock ($1 par value) 55 32 Capital surplus 347 327

Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725

Total assets $1,879 $1,742Total liabilities and stockholder's equity$1,879 $1,742

Here we see NWC grow to $1,014 million in 2009 from $684 million in 2008.

This increase of $330 million is an investment of the firm.

$684m = $1112m- $428m

$1014m = $1403- $389

Page 29: + Financial Statements and Cash Flows RWJ-Chapter 2

+Financial Cash Flows

In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.

Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.

CF(A)≡ CF(B) + CF(S)

Page 30: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $547

(Earnings before interest and taxes plus depreciation minus taxes)

Capital spending (130) (Ending net fixed assets

minus beginning fixed assets plus dep.)Additions to net working capital (330)

Total $87

Cash Flow of Investors in the FirmDebt $24

Equity 63

Total $87

Operating Cash Flow:

EBIT $694

Depreciation $65

Current Taxes ($212)

OCF $547

Page 31: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $547

(Earnings before interest and taxes plus depreciation minus taxes)

Capital spending (Ending net fixed assets

minus beginning net fixed assets plus dep.)Additions to net working capital

Total

Cash Flow of Investors in the FirmDebt

Equity

Total

Capital SpendingEnding net fixed assets$1,709

Beginning net fixed assets (1644)

Depreciation 65

Net Capital Spending $130

(130)

(330)$87

$24

63

$42

Page 32: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $547

(Earnings before interest and taxes plus depreciation minus taxes)

Capital spending

Additions to net working capital Total

Cash Flow of Investors in the FirmDebt

Equity

Total

NWC grew from $684 million in 2008 to $1014 million in 20X1.

This increase of $330 million is the addition to NWC.

(130)

(330)$87

$24

63

$87

Page 33: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $547

(Earnings before interest and taxes plus depreciation minus taxes)

Capital spending (Ending net fixed assets

minus beginning net fixed assets plus dep.)Additions to net working capital

Total

Cash Flow of Investors in the FirmDebt

Equity

Total

(130)

(330)$87

$24

63

$87

Page 34: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $547

(Earnings before interest and taxes plus depreciation minus taxes)

Capital spending

Additions to net working capital Total

Cash Flow of Investors in the FirmDebt

(Interest minus net new borrowing)

Equity (Dividends minus net new equity raised)

Total

Cash Flow to Creditors

Interest paid$70

Net new borrowing (46)

Total 24

(130

(330)$87

$24

63

$87

Page 35: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $547

(Earnings before interest and taxes plus depreciation minus taxes)

Capital spending

Additions to net working capital Total

Cash Flow of Investors in the FirmDebt

(Interest minus net new borrowing)

Equity (Dividends minus net new equity raised)

Total

Cash Flow to Stockholders

Dividends $103

Net new equity raised (40)

Total $63

Net new equity raised is the change in common stock and paid–in-surplus from B/S.

(130)

(330)$87

$24

63

$87

Page 36: + Financial Statements and Cash Flows RWJ-Chapter 2

+

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $547

(Earnings before interest and taxes plus depreciation minus taxes)

Capital spending (Ending net fixed assets

minus beginning net fixed assets plus dep.)Additions to net working capital

Total

Cash Flow of Investors in the FirmDebt

(Interest minus net new borrowing)

Equity (Dividends minus net new equity raised)

Total

(130)

(330)$87

$24

63

$87

The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:

)()(

)(

SCFBCF

ACF

Page 37: + Financial Statements and Cash Flows RWJ-Chapter 2

+Cash Flow Summary

Page 38: + Financial Statements and Cash Flows RWJ-Chapter 2

+Free Cash Flows There are two types of Cash Flows:

(1) This is the cash flows generated by a company’s operating activities and available to all who provided capital to the firm (Debt and Equity Holders)

Current Assets –Current Liabilities

Page 39: + Financial Statements and Cash Flows RWJ-Chapter 2

+Free Cash Flows

(2) “free” cash flows to equity (stock holders), which is derived from after operating free cash flows have been adjusted for debt payments (interest and principal)

Current Assets –Current Liabilities

Page 40: + Financial Statements and Cash Flows RWJ-Chapter 2

+Question: Which one to use?

Page 41: + Financial Statements and Cash Flows RWJ-Chapter 2

+Cash Flows

Assets Liabilities

Cash outflow

Cash outflow

Cash inflow

Cash inflow

Page 42: + Financial Statements and Cash Flows RWJ-Chapter 2

+Limitations of Financial Ratios Accounting statements:

A reasonably good job of categorizing the assets owned by a firm A partial job of assessing the value of these assets A poor job of reporting uncertainty about asset value

Accounting principles: The accounting view of asset value is to a great extent grounded in

the notion of historical cost, which is the original cost of the asset. Historical cost is the best estimate of the value of an asset.

Conservative approach to estimate the value .

At the end of 2011, book value of Google is $58.1 billion

At the end of 2011, the market value of Google is $211.04 billion (stock price= $645)

Page 43: + Financial Statements and Cash Flows RWJ-Chapter 2

+Limitations of Financial Ratios

These values are based on specific dates Capture values of assets and liabilities on a specific date Ratios using balance sheet may not reflect company’s

situation during rest of the year Example: A company that reports $1 million in cash on last

day of fiscal year may have only $100 K two days later after paying salaries and suppliers