financial statement, cash flow and financial forecasting

8/6/2019 Financial Statement, Cash Flow and Financial Forecasting

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Financial Statement, Cash Flow

and Financial Forecasting

Chapter 2


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

provide to the publicLG2: 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


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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


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Balance Sheet

The balance sheet reports a firms 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


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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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Equity

The difference between total assets and totalliabilities is the stockholders (or owners)equity.

Types ofEquity

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.


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Managing the Balance Sheet

Managers must monitor a number ofissues related to the firms 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 firms assets withequity or debt

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

market value of the firm


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Accounting method for fixed asset

depreciation 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 accelerateddepreciation 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

MA

CRS 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


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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 firms ability to pay itsobligations

In general, a financially healthy firm haspositive NWC


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Liquidity Liquidity refers to the ability to turn an asset into cash

at 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 dont provide a very high return.

Cash offers no return at all. Fixed assets are illiquid, but provide for generating

revenue and profits Managers must consider the risk-return tradeoff


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Debt vs. Equity Financing Financial leverage refers to the extent to which a firm

uses 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 firms 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 firmcant make the fixed payments to debtholders, the firmfaces bankruptcy

Once again, managers face a tradeoff between riskand return as they decide the firms capital structure


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Income Statement

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

The top line of the income statementshows the firms 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 ex

penses


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The top part of the income statementrepresents the operating incomeportion of the income statement. Thispart of the statement is generated byoperating the firm, and results inoperating income orEBIT

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


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Items reported below the bottom lineinclude:

goutstandinstockcommonofsharestotal

incomenet(EPS)shareperEarnings !

goutstandinstockcommonofsharesofnumber

paiddividendsstockcommon(DPS)ShareperDividends !

goutstandinstockcommonofsharesofnumber

equityrsstockholdecommon(BVPS)shareperBook value !

stockcommonsfirm'theofpricemarketthe(MVPS)shareperueMarket val !


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Corporate Income Taxes

Firms pay out a large portion of theirearnings in taxes (Microsoft paid $4.4billion in taxes in 2005, or 26 percent of

EBT) The tax code is determined by

Congress, and so is subject to frequentchanges

The tax code is extremely complex.However, since taxes are so importantto firms, we will examine a general

overview of corporate taxation


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The U.S. tax structure is progressive,meaning that the larger the income, thehigher the tax rate

Tax rates are discussed in terms ofmarginal tax rate, and average tax rate

The marginal tax rate is the amount of

taxes must pay on the next $1 inincome. This is the most relevant ratefor financial decision making.


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The average tax rate is determined by:

The average tax rate incorporatestaxes paid on past income and

represents a weighted average of rateson the amount of taxable income

incometaxable

liabilitytaxratetaxAverage !


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Example

Indian Point Kennels earned $16.5 millionin taxable income in 2007. Their taxliability can be determined as:

Tax liability = Tax on base amount + tax rate (amount over base)Tax liability = $5,150,000 + .38($16,500,000 - $15,000,000)

Tax liability = $5,720,000

The average tax rate = $5,720,000/$16,500,000

= 34.67%

The marginal tax rate is 38 percent


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Interest that corporations receive is

taxable Exception: interest on state and local

government bonds is exempt from federaltaxes

When corporations own stock inanother corporation they may receivedividend income. The tax code exempts 70 percent of this

income from taxation. Only the remaining30 percent is taxed.

This reduces the effect oftriple taxation


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Interest and Dividends Paid by the

Corporation Interest payments appear on the income

statement and are deducted from incomebefore calculating taxable income

Dividends, on the other hand, are paidwith after-tax income and so are not taxdeductible

This tax deductibility of interest makesdebt a much cheaper form of financingthan equity


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Example 2-4


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Statement of Cash Flows The balance sheet is a snapshot of a firm's financial resources andobligations at a single point in time, and the income statement

summarizes 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.


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The statement of cash flows shows thefirms cash flows over a period of time.

It includes only inflows and outflows of

cash 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 firms balance sheet


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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, investingactivities, and financing activities.


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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 firms 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.


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Cash Flows from InvestingActivities

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

This section of the statement of cashflows reflects the firms investment infixed assets


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Cash Flows from FinancingActivities

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


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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 -$1million in cash flow This is because net income is accounting-based

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


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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 thecash flows available to pay the firms

stockholders and debtholders After adjustments for investments in working

capital

After adjustments for investments in fixed

assets


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FCF = Operating cash flow Investment in operating capitalFCF = (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 firms investment in fixed assets, current assets,

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


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Example 2-5


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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 isinvesting heavily in operating capital to supportgrowth

In this case FCF might be negative while OCF is

positive


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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


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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 and

management practices brought to light in high-profile scandals such as Enron and WorldCom

financial statement, cash flow and financial forecasting

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