1 accounting statements and cash flow

7/24/2019 1 Accounting Statements and Cash Flow

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ACCOUNTING STATEMENTS AND CASH FLOWS

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Key concepts and skills

Understand what the balance sheets and income statements tell us

Understand what cash flow statements (both financial and accounting) tell us

Be able to compute the cash flows used for firm valuation: CF from assets, CF to bondholders, CF to stockholders

Understand basic ratio analysis


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Outline

Balance sheet

Income statement

Statement of cash flows

Free cash flow

Financial ratios

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Source of information

Annual reports (companys website)

Wall Street Journal, Financial Times, etc.

Internet Databases: Bloomberg, Compustat, Datastream Yahoo finance, Hoover NYSE (www.nyse.com ), Nasdaq (www.nasdaq.com ),

LSE (www.londonstockexchange.com ), etc. U.S. Securities and Exchange Commission (www.sec.gov ) search for

companies filings: 10 K, 10 Q, DEF 14A, 8K, PREM14A, DEFM14A, S4


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Balance sheet > Example

(in $ millions)2009 and 2008Balance Sheet

U.S. COMPOSITE CORPORATION

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

Current assets: Current Liabilities:Cash and equivalents 140 107 Accounts payable 213 197Accounts receivable 294 270 Notes payable 50 53Inventories 269 280 Accrued expenses 223 205Other 58 50 Total current liabilities 486 455

Total current assets 761 707Long term liabilities:

Fixed assets: Deferred taxes 117 104Property, plant, and equipment 1,423 1,274 Long term debt 471 458Less accumulated depreciation 550 460 Total long term liabilities 588 562

Net property, plant, equipment 873 814Intangible assets and other 245 221 Stockholder's equity:

Total fixed assets 1,118 1,035 Preferred stock 39 39Common stock ($1 per value) 55 32Capital surplus 347 327Accumulated retained earnings 390 347Less treasury stock 26 20Total equity 805 725

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

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Balance sheet > Overview

Accountants snapshot of firms value on a particular date

Stock versus flow?

Main equa on: Assets Liabili es + Stockholders equity

3 key concerns: Accounting liquidity

Debt vs. equity Value vs. cost


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Balance sheet > Analysis

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

1. Accounting liquidity Accounting liquidity refers to the ease and quickness with which

assets can be converted to cash. Current assets are the most liquid. Some fixed assets are intangible. The more liquid a firms assets, the less likely the firm is to

experience problems meeting short term obligations. Liquid assets often have lower returns than fixed assets.

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Balance sheet > Analysis

2. Debt vs. Equity Generally, when a firm borrows it gives the bondholders first claim

on the firms cash flow. Thus shareholders equity is the residual difference between assets

and liabilities.

3. Value vs. Cost Under Generally Accepted Accounting Principles (GAAP), audited

financial statements of firms in the U.S. carry assets at cost. Since 2005, companies in the E.U. use market value of the International Financial Reporting Standards (IFRS).

Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, not historical cost.


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Balance sheet > Check questions

1. Assets How are assets organized on the balance sheet?

What does accounts receivable represent?

If accounts receivable increases (decreases), all else equal, what does this mean?

What does accumulated depreciation represent?

What is the difference between depreciation expense and accumulated depreciation?

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Balance sheet > Check questions

2. Liabilities How are liabilities organized on the balance sheet?

What does accounts payable represent? What are deferred taxes? Why do we have this account?

3. Equity Where does Retained Earnings (RE) come from? Can you go

get money from the RE account? Before you answer that, can you go get money from the long term debt account?

Besides RE, what are the other main equity accounts? What do these accounts represent?


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Income statement > Example

(in $ millions)2009

Income StatementU.S. COMPOSITE CORPORATION

Total operating revenuesCost of goods soldSelling, general, admin expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes

Current: 71Deferred: 13

Net incomeRetained earnings:Dividends:

2,262 1,655

327 90190

29219 49170 84

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The operating section reports revenues and expenses from

principal operations.

The non operating section includes all financing costs.

A separate section reports the amount of taxes levied on income.

Net income is the bottom line.4343

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Income statement > Overview

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

Check question: How does this differ from the timing of the balance sheet?

Stock versus flow?

Key equation: Income Revenues Expenses

2 key concerns: Noncash items Time and costs


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Income statement > Analysis

Things to keep in mind when analyzing an income statement:

1. Non cash items No firm ever writes a check for depreciation. Deferred taxes do not represent a cash flow. Thus, net income is not cash.

2. Time and costs In the short run, certain equipment, resources, and commitments

of the firm are fixed, but the firm can vary such inputs as laborand raw materials.

In the long run, all inputs of production (and costs) are variable. Financial accountants do not distinguish between variable costs

and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.

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Income statement > Calculations & Taxes

Commonly used equations: Gross Profit = Sales Costs of Goods Sold EBITDA = Gross Profit Cash Operating Expenses EBIT = EBDITA Depreciation Amortization

EBT = EBIT Interest NI or EAT = EBT Taxes

Notes on taxes: Marginal vs. average tax rates:

Marginal: the percentage paid on the next dollar earned

Average: the tax bill / taxable incomeWhich tax rate should you use in financial decisions?


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Statement of cash flows > ExampleOperations

Net IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities

Accounts ReceivableInventoriesAccounts PayableAccrued ExpensesNotes PayableOther

Total Cash Flow from Operations

869013

(24)111618(3)

199(8)

Acquisition of fixed assetsSales of fixed assets

Total Cash Flow from Investing

(198)25

(173)

Investing Activities

Financing ActivitiesRetirement of debt (includes notes)Proceeds from long term debt salesDividendsRepurchase of stockProceeds from new stock issue

Total Cash Flow from Financing

(73)

86(43)

437

(6)

Change in Cash (on the balance sheet) 33

Operating activities

Investing activities

Financing activities

The statement of CFs is the addition of CFs from operations, investing & financing activities.

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Statement of cash flows > Overview

The statement of cash flows reconciles the change in cashfrom last year to current year.

This helps explain the change in accounting cash (which forthe U.S. Composite Corp. is $33 million in 2009).

The three components of the statement of cash flows are Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities


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Financial cash flow > Overview

Also known as Free Cash Flow: a measure of how much cash a business generates after accounting

for capital expenditures such as buildings/equipment, working capital can be used for expansion, interests, dividends, debt reduction, equity

etc.

Cash flow FROM assets = Cash flow TO bondholders (creditors, liability holders)

+ Cash flow TO stockholders (equity investors)

FCF = CF(A) = CF (B) + CF (S)

where A = Assets, B = Bondholders, S = Stockholders

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Financial cash flow > Calculate CF(A)

CF(A) = Operating CF Net capital spending Change in net WC

Operating CF = EBIT Taxes + Depreciation

USCC example:EBIT 219Depreciation 90Taxes 71OCF 238

Note: Marginal taxes are used for valuation purpose:

OCF = EBIT (EBIT x marginal tax rate) + Depreciation


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Net capital spending = Acquisition minus sale of fixed assets

= Change in Gross fixed assetsUSCC example:

2008 2009 ChgProperties, plant & equipment 1,274 1,423 149Intangibles and others 221 245 24Total Gross fixed assets 1,495 1,668 173

Or we can get 173 from the investing section of the statement of cash flows!

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Net capital spending = Change in Gross fixed assets

= Change in Net fixed assets + Depreciation

Example:2008 2009 Change

Gross Properties, Plant & Eq 1,000 1,400 400Accumulated Depreciation 200 300 100Net Properties, Plant & Eq 800 1,100 300

Net capital spending = Change in Gross PPE = 400= Change in Net PPE + Depreciation = 300 + 100


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Change in net WC = Net WC (current year) Net WC (prior year)where: Net WC = Current assets Current liabilities (for each year)

USCC example: 2008 2009Current assets 707 761

Current liabilities 455 486Net WC 252 275

Change in net WC = Net WC 2009 Net WC 2008 = 275 252 = 23

Put it all together for CF(A):CF(A) = 238 173 23 = 42

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Financial cash flow > Calculate CF(B)

CF (B) = Interest paid Net new borrowing

Think about this: We are trying to calculate CF to debtholders. So the debtholders receive the interest (thus, we are adding this), and they receive any payoffs (retirement) of debt (thus we add this).

However, if the firm takes on new debt, the debtholders give that to the firm (so we subtract this).

USCC example:Net new borrowing = Long term debt 2009 Long term debt 2008

= 471 458 = 13

CF(B) = 49 13 = 36


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Financial cash flow > Calculate CF(S)

CF (S) = Dividends Net new equity raised

Concept check: If the change is positive, the company issued new stock. If the change is negative, the company may have bought back stock

USCC example:Net new equity = CS, Surplus & Treasury 2009 CS, Surplus & Treasury 2008

= (55 + 347 20) (32 + 327 26) = 37Or from the statement of cash flows!

Net new equity = Equity issues Equity repurchases= 43 6 = 37

CF(S) = 43 37 = 6

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Financial cash flow > Final check

Final check: CF(A) = CF(B) + CF(S)42 = 36 + 6

Takeaway: The cash flow generated by assets must be generated by or given to debt (bond) and equity holders.


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Financial cash flow > Practice

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Estridge and Lougee (2007) Measuring free cash flows for equityvaluation: pitfalls and possible solutions, Journal of Applied Corporate Finance 19, 60 71.


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FCF has no standard definition. Across companies Across accounting standards

Investors often resort to shortcuts like EBITDA and cash earnings (NI + Deprec) but these measures are not FCFs.

FCF measures vary with investors valuation purposes.

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Ratio analysis > Overview

A firm has resources. It converts resources into profits through production and sales of goods and services

Ratios Measure relations between resources and financial flows Show ways in which firms situation deviates from

Its own past (Time trend analysis) Other firms (Peer group analysis) The industry (Industry peer analysis)

Key objective: Standardize financial information for comparisons and evaluations


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Ratio analysis > Types

Financial ratios: Liquidity ratios

Assess ability to cover current obligations

Leverage ratios Assess ability to cover long term debt obligations

Operational ratios: Activity (Turnover) ratios

Assess amount of activity relative to amount of resources used

Profitability ratios Assess profits relative to amount of resources used

Valuation ratios: Assess market price relative to assets or earnings

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Ratio analysis > Types > Financial ratios

Liquidity ratios: Current ratio = Current assets Current liabilities Quick ratio = (Current assets Inventory) Current liabilities Cash ratio = Cash Current liabilities

Leverage ratios: Total debt ratio = Total debt Total assets

Debt equity ratio = Total debt Total equity Equity multiplier = Total assets Total equity Interest coverage (Times interest earned) = EBIT Interest Cash coverage = (EBIT + depreciation) Interest


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Ratio analysis > Types > Operational ratios

Activity (Turnover) ratios: Inventory turnover = Cost of goods sold Inventory Days sales in inventory = 365 Inventory turnover Receivables turnover = Sales Receivables Days sales in receivables= 365 Receivables turnover Total asset turnover = Sales Total assets Days in inventory = Days in period Inventory turnover

Profitability ratios:

Profit margin = Net income Sales Return on assets = Net income Total assets Return on equity = Net income Total equity

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Ratio analysis > Types > Valuation Ratios

Price to earnings ratio (PE ratio)PE ratio = Market price per share Earnings per share

Market to book ratio (M/B)M/B = Market price per share Book value per share


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Ratio analysis > DuPont Identity

ROE = (NI / Sales) x (Sales / TA) x (TA / TE)ROE = Profit margin x Total asset turnover x Equity multiplier

Profit margin is a measure of the firms operating efficiency (i.e. how well it controls costs).

Total asset turnover is a measure of the firms asset use efficiency (i.e. how well it manages its assets).

Equity multiplier is a measure of the firms financial leverage.

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Ratio analysis > Potential problems

There is no underlying theory of which ratios are most relevant.

Benchmarking is difficult for diversified firms.

Globalization and international competition makes comparison

more difficult

because

of

differences

in

accounting

regulations.

Firms use varying accounting procedures.

Firms have different fiscal years.

Extraordinary, or one time, events


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Ratio analysis > Practice

Nissim and Penman (2001) Ratio analysis and equity valuation: Fromresearch to practice, Review of Accounting Studies 6, 109 154.

Ratios are identified as drivers of future residual earnings, free cashflow and dividends. Ratios in current financial statements are thenviewed as information to forecast the future drivers.

To provide historical benchmarks for forecasting, typical values forratios are documented for the period 19631999, along with theircross sectional variation and correlation. The time series behaviorof many of the ratios is also described and their typical long run,

steady state levels are documented.

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Summary

Financial statements provide important informationregarding the value of the firm.

Financial cash flow: CF(A) = CF(B) + CF(S)

Things to keep in mind: Measures of profitability do not take risk or timing of

cash flows into account. Financial ratios are linked to one another.

This review of accounting was necessary in order tounderstand where/how to calculate the firms cash flowused for firm valuation as well as key financial ratios.

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