chp02+fin+statement+cflow+01

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Financial Statement, Cash Flow

and Financial Forecasting

Chapter 2



2-2

ACT3211 FINANCIALMANAGEMENT

Chapter 2 Learning GoalsLG1: Recall the major financial statements that firms must prepare and

provide to the public

LG2: Differentiate between book (or accounting) value and market value

LG3: Explain how taxes influence corporate managers’ and

investors’ decisions

LG4: Differentiate between accounting income and cash flows

LG5: Demonstrate how to use a firm's financial statement to calculate itscash flows

LG6: Observe cautions that should be taken when examining

external financial statements



2-3 ACT3211 FINANCIAL

MANAGEMENT

Introduction

• Corporate managers must issue manyreports to the public. The mostattention is paid to the annual repo rt ,which contains – Balance sheet

– Income statement

– Statement of cash flows

– Statement of retained earnings• These four statements present an

accounting-based picture of the firm’s

financial position.




MANAGEMENT

• While accountants focus on reportingwhat happened in the past, financialmanagers use financial statements to

draw inferences about the future

• Firms must follow Generally Accepted

Accounting Principles (GAAP) whencreating these statements, but they stillhave substantial discretion




MANAGEMENT

Balance Sheet (Statement of FinancialPosition)

• The balance sheet reports a firm’s assets,liabilities, and equity at a particular pointin time.

Assets = Liabilities + Equity

• The left side of a balance sheet lists the

assets of the firm in order of liquidity• The right side of the balance sheet lists

the liabilities in order of maturity. Equity,which never matures, is listed last




MANAGEMENT

Assets

• Assets fit into two major categories:current assets and fixed assets

• Current Assets

– Will normally convert into cash within a year• Cash (and marketable securities)• Accounts receivable• Inventory

• Fixed Assets – Have a useful life exceeding one year

• Net plant and equipment (Gross plant andequipment less accumulated depreciation)

• Less tangible assets, such as patents andtrademarks


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MANAGEMENT

Liabilities

• Lenders provide funds, which becomeliabilities to the firm.

• Current liabilities

– Obligations due within a year• Accruals (accrued wages and accrued taxes)

• Accounts payable

• Notes payable

• Long-term debt – Long-term loans and bonds with maturities of

more than one year



MANAGEMENT

Equity• The difference between total assets and total

liabilities is the stockholders’ (or owners’)equity.

• Types of Equity – Preferred Stock

• Appears as the cash proceeds when the firm sellspreferred stock

– Common Stock and Paid-in-Surplus• Also appear as cash proceeds when common stock is

issued

– Retained Earnings• When managers reinvest earnings rather than pay them

out as dividends, these will be recorded as retainedearnings. The retained earnings account on thebalance sheet represents the cumulative amount

retained over the years.



MANAGEMENT

Managing the Statement of FinancialPosition

• Managers must monitor a number ofissues related to the firm’s balance sheet,including:

– The accounting method used for fixed assetdepreciation

– The level of net working capital

– The liquidity position of the firm

– Whether to finance the firm’s assets withequity or debt

– The difference between the book valuereported on the balance sheet versus the true

market value of the firm



MANAGEMENT

Accounting method for fixed assetdepreciation

• Managers can choose the accounting method they useto record depreciation against their fixed assets.

• For reporting purposes, companies often use thestraight-line method of depreciation

• For tax purposes, firms often use accelerated

depreciation such as MACRS• Why use different methods?

– The straight-line method results in lower depreciationexpenses in the earlier years, resulting in higher income forreporting to shareholders

– MACRS results in higher depreciation expenses in earlieryears, leading to lower income and thus lower taxes.

– A firm will often use multiple methods for calculatingdepreciation for the same assets



MANAGEMENT



MANAGEMENT

Net Working Capital

• Net Working Capital = Current assetsminus current liabilities

• For DPH Tree Farms for 2007:

– NWC = $190 - $110

– NWC = $ 80 million

• Firms monitor net working capital as a

measure of the firm’s ability to pay itsobligations

– In general, a financially healthy firm haspositive NWC



MANAGEMENT

Liquidity

• Liquidity refers to the ability to turn an asset into cashat its fair market value.• Current assets are the most liquid assets

– Cash, marketable securities, accounts receivable, andinventory

– Inventory is the least liquid of the current assets• Fixed assets are less liquid• Liquidity has both good and bad aspects:

– More liquidity means the firm can more easily pay itsobligations and stave off financial distress, i.e. the firm is

less risky – However, liquid assets don’t provide a very high return.Cash offers no return at all.

– Fixed assets are illiquid, but provide for generatingrevenue and profits

– Managers must consider the risk-return tradeoff



MANAGEMENT

Debt vs. Equity Financing

• Financial leverage refers to the extent to which a firmuses debt as a source of financing• Just like a lever magnifies the ability to move objects,

financial leverage magnifies a firms gains and losses – Debtholders have a fixed claim on the firm’s cash flows

(they are paid interest on their securities) – Stockholders have a claim on whatever cash flow is left.

Since the obligation to debt holders is fixed, if the firm doeswell stockholders do very well. If the firm does poorly,stockholders get little or nothing.

– Yet, debt increases the financial risk to the firm. If the firmcan’t make the fixed payments to debtholders, the firmfaces bankruptcy

• Once again, managers face a tradeoff between riskand return as they decide the firm’s capital structure



MANAGEMENT

Book Value versus MarketValue

• A firm’s balance sheet shows book, or historical cost,value according to GAAP

• Under GAAP, the value of assets on the balance sheetshows what the firm paid for them regardless of whatthey may be work today

• In most cases, book values differ widely from marketvalues for the same assets

• For current assets the difference will be small, but forfixed assets the difference is likely huge

• Similarly, stockholders’ equity on the balance sheet is

generally greatly different than the true market value ofthe equity – Book value of equity represents the historical value of

contributed equity, while the market value of equityrepresents the value of the firm in the market, whichdepends on the present value of future cash flows


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Income Statement (Statementof Comprehensive Income)

• Income statements show the totalrevenues and expenses of a firm over aspecific period of time

• The top line of the income statementshows the firm’s revenues

• The statement then shows all of the

various expenses for the firm• The bottom line, or net income,

represents the difference between

revenues and expenses




• The top part of the income statementrepresents the operating incomeportion of the income statement. This

part of the statement is generated byoperating the firm, and results inoperating income or EBIT

• The bottom part of the incomestatement reflects how the firm isfinanced and taxed




• Items reported below the bottom lineinclude:

goutstandinstockcommonof sharestotal

incomenet(EPS)share perEarnings

goutstandinstockcommonof sharesof number

paiddividendsstockcommon(DPS)Share perDividends

goutstandinstockcommonof sharesof number

equityrsstockholdecommon

(BVPS)share perBook value

stock commonsfirm'theof pricemarketthe(MVPS)share perueMarket val




Statement of Cash Flows• The balance sheet is a snapshot of a firm's financial resources and

obligations at a single point in time, and the income statementsummarizes a firm's financial activity over a period of time. These twofinancial statements reflect the accrual basis of accounting required byGAAP to match revenues with the expenses associated with generatingthose revenues

• Actual cash inflows and outflows may occur at very different times thanare reflected in these two financial statements. Also, the incomestatement contains several non-cash entries, notably depreciation

• Therefore, figures on an income statement do not reflect the actual cashflows of the firm. Financial managers and investors are much moreinterested in cash flows than accrual accounting income.



2-22 ACT3211 FINANCIALMANAGEMENT

• The statement of cash flows shows thefirm’s cash flows over a period of time.

• It includes only inflows and outflows ofcash and marketable securities. Itexcludes transactions that do not directlyaffect cash receipts and payments, suchas depreciation and write-offs on baddebts.

• The bottom line of the statement reflectsthe difference between cash sources anduses and equals the change in cash onthe firm’s balance sheet




Sources and Uses of Cash

• Some activities increase cash, and someactivities decrease cash.

• Sources of cash involve increasing

liabilities (or equity) and decreasingassets.

• Uses of cash involve decreasing liabilities(or equity) and increasing assets.

• The statement of cash flows is a cashbasis report on three types of financialactivities: operating activities, investing activities, and financing activities.




Cash Flows from Operations

• The top portion of the statement of cashflows, cash flows from operations,represents items directly associated with

producing and selling the firm’s products. – Net income

– Depreciation

– Working capital accounts other than cash and

short-term debt• Many finance professionals consider this

portion of the statement the mostimportant.




Cash Flows from Investing Activities

• Cash flows associated with buying orselling fixed or other long-term assets

• This section of the statement of cashflows reflects the firm’s investment in

fixed assets




Cash Flows from Financing Activities

• Cash flows from debt and equityfinancing transactions

– Issuing short- or long-term debt

– Issuing stock

– Using cash to pay dividends

– Using cash to pay off debt

– Using cash to buy back stock




• The bottom line of the statement of cash flowsshows the total of cash flows from operation,investing, and financing activities

• This line reconciles to the net change in cashand marketable securities on the balancesheet over the period.

• In the DPH example, the income statementshowed $90 million in net income, but -$1

million in cash flow – This is because net income is accounting-based

income according to GAAP and does notnecessarily reflect the flow of cash




Free Cash Flow

• To maintain cash flows over time, a firmmust continuously replace working capitaland depreciating fixed assets, and

develop new products• Investors are particularly interested in the

cash flows available to pay the firm’s

stockholders and debtholders – After adjustments for investments in working

capital

– After adjustments for investments in fixed

assets




FCF = Operating cash flow – Investment in operating capital

FCF = (EBIT – Taxes + Depreciation) – (∆Gross fixed assets + ∆Netoperating working capital)

• Operating cash flow (OCF) – Firms generate operating cash flow from operations after

they have paid necessary taxes• Investment in operating capital (IOC)

– Firms buy physical capital or earmark funds for eventualequipment replacement to sustain firm operations

– Includes the firm’s investment in fixed assets, current assets,

and spontaneous current liabilities (i.e. accounts payable andaccruals)




Example 2-5




• A positive Free Cash Flow means that the

firm has funds that can be distributed toinvestors

• A negative FCF might mean several things:

– If FCF is negative due to negative OCF it mayindicate that the firm is experiencing operating ormanagerial problems

– FCF might be negative because the firm is

investing heavily in operating capital to supportgrowth

• In this case FCF might be negative while OCF is

positive




Statement of Retained Earnings

• Provides additional detail about thechange in retained earnings during areporting period

• Reconciles net income and dividendspaid with changes in retained earningsfrom one period to the next:

Beginning retained earnings

+ net income for period

- cash dividends paid

= Ending retained earnings




Cautions in Interpreting FinancialStatements

• While firms must follow GAAP in preparing theirfinancial statements, firms have considerablelatitude in using accounting rules

– Firms can “smooth” earnings, for example for

new managers to show growth – Different depreciation methods

– These strategies are called earningsmanagement

• Sarbanes Oxley Act of 2002 was passed in aneffort to prevent deceptive accounting andmanagement practices brought to light in high-profile scandals such as Enron and WorldCom

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