ch 3 - financial statements, cash flow

8/13/2019 Ch 3 - Financial Statements, Cash Flow

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CHAPTER 3Financial Statements, CashFlow, and Taxes

Balance sheetIncome statement

Statement of cash flows Accounting income vs. cash flowMVA and EVAFederal tax system


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The Annual ReportBalance sheet provides a snapshot of afirms financial position at one point in time.

Income statement summarizes a firmsrevenues and expenses over a given periodof time.Statement of retained earnings shows how

much of the firms earnings were retained,rather than paid out as dividends.Statement of cash flows reports theimpact of a firms activities on cash flows

over a given period of time.


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Balance Sheet: AssetsCash

A/RInventories

Total CAGross FALess: Dep.

Net FATotal Assets

20027,282

632,1601,287,3601,926,802

1,202,950263,160939,790

2,866,592

200157,600

351,200715,200

1,124,000

491,000146,200344,800

1,468,800


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Balance sheet:

Liabilities and Equity Accts payable

Notes payable AccrualsTotal CL

Long-term debt

Common stockRetained earnings

Total EquityTotal L & E

2002524,160

636,808489,6001,650,568

723,432460,000

32,592492,592

2,866,592

2001145,600

200,000136,000481,600323,432460,000203,768663,768

1,468,800


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Income statementSummarizes a firms revenues andexpenses over a given period of time.Reflects performance during the periodIncome statements can cover anyperiod of time, but they are usuallyprepared monthly, quarterly andannually


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Statement of Retained

EarningsShows how much of the firms earningswere retained, rather than paid out asdividends

A positive number in the retainedearnings account indicates only that inthe past the firm earned some income


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Statement of Retained

Earnings (2002)Balance of retained

earnings, 12/31/01 Add: Net income, 2002Less: Dividends paid

Balance of retainedearnings, 12/31/02

$203,768(160,176)(11,000)

$32,592


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Statement of Cash FlowsIs used to help answer questions suchas:

Is the firm generating enough cash topurchase the additional assets required forgrowth?Is the firm generating any extra cash thatcan be used to repay debt or to invest innew products?

Such information is useful both formanagers and investors


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Sources of cash Uses of cash

Net income + depreciation

Increase in long-term debt

Increase in equity

Increases in current liabilities

Decreases in fixed assets

Decreases in current assetsother than cash

Dividend payments

Increases in current assetsother than cash

Decrease in long-term debt

Decrease in equity

Increases in fixed assets

Cash andcash

equivalents


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Statement of Cash FlowsSummarizes the changes in acompanys cash position The statement separates activities intothree categories, plus a summarysection:

Operating activitiesInvestment activitiesFinancing activities


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Operating activitiesIncludes:

net income,depreciation,changes in current assets and liabilities otherthan cash,

short-term investments andshort term debt


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Investing activitiesIncludes:

investments in fixed assetsor sales of fixed assets


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Financing activitiesIncludes:

Raising cash by selling short-term investmentsor by issuing short-term debtLong term debt, or stock

Also because both dividends paid and cash

used to buy back outstanding stock or bondsreduce the companys cash, such transactionsare included here


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Statement of Cash Flows

(2002)L-T INVESTING ACTIVITIESInvestment in fixed assets

FINANCING ACTIVITIESIncrease in notes payableIncrease in long-term debtPayment of cash dividendNet cash from financing

NET CHANGE IN CASHPlus: Cash at beginning of yearCash at end of year

(711,950)

436,808400,000(11,000)825,808

(50,318)57,600

7,282


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What can you conclude aboutDLeons financial condition from

its statement of CFs?Net cash from operations = -$164,176,mainly because of negative NI.

The firm borrowed $825,808 to meetits cash requirements.

Even after borrowing, the cashaccount fell by $50,318.


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Modifying Accounting Data for

Managerial DecisionsWe have to divide total assets in twocategories

Operating assets which consist of theassets necessary to operate the businessNon-operating assets which would

include cash and short term investmentsabove the level required for normaloperations, land held for future use


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Operating assets are further

divided intoOperating current assets

Are the current assets that are used tosupport operations, such as cash, accountsreceivable, inventory

They do not include short-term investments

Long-term operating assetsSuch as plant and equipmentThey do not include any long-term investmentsthat pay interest or dividends


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Operating Current Liabilities Are the current liabilities that occur as anatural consequence of operations

Such as accounts payable and accrualsThey do not include notes payable or anyother short-term debts that charge interest


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What effect did the expansion have

on net operating working capital?NOWC = Current - Non-interestassets bearing CL

NOWC02 = ($7,282 + $632,160 + $1,287,360) ( $524,160 + $489,600)

= $913,042

NOWC01 = $842,400


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Did the expansion create additionalnet operating profit after taxes

(NOPAT)?NOPAT = EBIT (1 Tax rate)

It is the after-tax profit a companywould have if it had no debt and noinvestments in nonoperating assets

Because it excludes the effects offinancing decisions, it is a bettermeasure of operating performance thanis net income


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Did the expansion create additionalnet operating profit after taxes

(NOPAT)?NOPAT = EBIT (1 Tax rate)

NOPAT02 = -$130,948(1 0.4)= -$130,948(0.6)= -$78,569

NOPAT01 = $114,257


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What is your assessment of the

expansions effect on operations?

Sales

NOPATNOWCOperating capital

Net Income

2002$6,034,000

-$78,569$913,042

$1,852,832

-$160,176

2001$3,432,000

$114,257$842,400

$1,187,200

$87,960


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What effect did the expansion have on

net cash flow and operating cash flow?NCF02 = NI + Dep = ($160,176) + $116,960

= -$43,216

NCF01 = $87,960 + $18,900 = $106,860

OCF02 = NOPAT + Dep

= ($78,569) + $116,960= $38,391

OCF01 = $114,257 + $18,900

= $133,157


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What was the free cash flow

(FCF) for 2002?FCF = OCF Gross capital investment

FCF = (NOPAT + Dep) - Gross capital investmentGross investment in operating capital =

Net investment + Depreciation- OR

FCF = NOPAT Net investment in operating capital


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What was the free cash flow

(FCF) for 2002?FCF02 = NOPAT Net investment in oper. capital

= -$78,569 ($1,852,832 - $1,187,200)= -$744,201

Is negative free cash flow always a bad sign?


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Economic Value Added (EVA)Is an estimate of the value created bymanagement during the yearIt differs substantially from accountingprofit because no charge for the use ofequity capital is reflected in accounting

profit


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Economic Value Added (EVA)EVA = After-tax __ After-tax

Operating Income Capital costs

= Funds Available __ Cost of

to Investors Capital Used

= NOPAT After-tax Cost of Capital


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EVA

EVA = Net operating profit after taxes (NOPAT)- After-tax dollar cost of capital used to

support operations

EVA = EBIT (1

Tax rate) (Total Net Operating Capital)(WACC)


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EVA ConceptsIn order to generate positive EVA, afirm has to more than just coveroperating costs.

It must also provide a return to thosewho have provided the firm with capital.

EVA takes into account the total costof capital, which includes the cost ofequity.


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What is the firms EVA? Assume thefirms after -tax percentage cost of capital

was 10% in 2000 and 13% in 2001.EVA 02 = NOPAT (A-T cost of capital) (Total Net Op. Cap.)

= -$78,569 (0.13)($1,852,832)

= -$78,569 - $240,868= -$319,437

EVA 01

= $114,257 (0.10)($1,187,200)= $114,257 - $118,720= -$4,463


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Market Value Added (MVA)MVA = Market value __ Equity capital

of equity suppliedby shareholders

= (Shares outstanding)(Stock price) Totalcommonequity


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Did the expansion increase or

decrease MVA?MVA = Market value __ Equity capital

of equity supplied

During the last year, the stock price hasdecreased 73%. As a consequence, the

market value of equity has declined,and therefore MVA has declined, aswell.


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Does DLeon pay its suppliers

on time?Probably not.

A/P increased 260%, over the pastyear, while sales increased by only76%.If this continues, suppliers may cutoff DLeons trade credit.


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Does it appear that DLeons sales

price exceeds its cost per unit sold?NO, the negative NOPAT and declinein cash position shows that DLeon is

spending more on its operations thanit is taking in.


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What if DLeons sales manager decidedto offer 60-day credit terms to customers,

rather than 30-day credit terms?If competitors match terms, and sales remainconstant

A/R wouldCash would

If competitors dont match, and sales double Short-run: Inventory and fixed assets to

meet increased sales. A/R , Cash .Company may have to seek additional financing.Long-run: Collections increase and thecompanys cash position would improve.


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How did DLeon finance its

expansion?DLeon financed its expansion withexternal capital.

DLeon issued long -term debt whichreduced its financial strength andflexibility.


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Would DLeon have required externalcapital if they had broken even in 2001

(Net Income = 0)? YES, the company would still have tofinance its increase in assets.

Looking to the Statement of CashFlows, we see that the firm made aninvestment of $711,950 in net fixed

assets.Therefore, they would have needed toraise additional funds.


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What happens if DLeon depreciatesfixed assets over 7 years (as opposed to

the current 10 years)?No effect on physicalassets.Fixed assets on thebalance sheet woulddecline.Net income woulddecline.

Tax payments woulddecline.Cash position wouldimprove.


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Federal Income Tax System


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Corporate and Personal TaxesBoth have a progressive structure (the higher theincome, the higher the marginal tax rate).Corporations

Rates begin at 15% and rise to 35% for corporationswith income over $10 million.

Also subject to state tax (around 5%).Individuals

Rates begin at 10% and rise to 38.6% for individualswith income over $307,050.May be subject to state tax.


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Tax treatment of various uses

and sources of fundsInterest paid tax deductible for corporations(paid out of pre-tax income), but usually not forindividuals (interest on home loans being theexception).Interest earned usually fully taxable (anexception being interest from a (muni). Dividends paid paid out of after-tax income.Dividends received taxed as ordinary incomefor individuals (double taxation). A portion ofdividends received by corporations is taxexcludable, in order to avoid triple taxation.


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More tax issuesTax Loss Carry-Back and Carry-Forward sincecorporate incomes can fluctuate widely, the taxcode allows firms to carry losses back to offset

profits in previous years or forward to offsetprofits in the future.Capital gains defined as the profits from thesale of assets not normally transacted in the

normal course of business, capital gains forindividuals are generally taxed as ordinaryincome if held for less than a year, and at thecapital gains rate if held for more than a year.Corporations face somewhat different rules.

ch 3 - financial statements, cash flow

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