CH 2 k. Financial Statements,

Chapter 2Financial Statements ,Taxes , and CashPART TWO Understanding Financial Statements and Cash FlowChapter 2 + Chapter 3

.. 19/1/2014

Chapter Outline Financial statementThe Balance Sheet Statement.The Income Statement.Cash Flow Statement. Taxes.2-*

2.1 Balance SheetFinancial statementShowing a firms accounting value on a particular date.

The balance sheet Is a snapshot of the firms assets and liabilities at a given point in time.Its represent what the firm own (assets), what the firm owes (liabilities) and the difference between the two (the firms equity).

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The Balance Sheet - Figure 2.1

Balance SheetAssets: The Left-Hand Side of the balance sheet.Assets are listed in order of liquidityEase and quickness of conversion assets to cash Without significant loss of value.

Current and fixed assets:Current assets have a life less than one year, such as: Cash, Account Receivable and Inventory ( least liquid)Fixed assets are whose expected life is greater than one year, can be Tangible assets: have a physical presence, such as computeror intangible asset: non- physical items, such as trademark

Balance SheetLiabilities and owners equity: The right sideThe firms liabilities are the first thing list on the right side of balance sheet. These are classified as current or long-term.

Current liabilities and long-term liability :Current liabilities like current assets, have a life less than one year (meaning that they must be repaid within one year) , such as Accounts payable (money the firm owes to its supplies). long-term liability is the debt that not due in the coming year. A loan that the firm will pay off in more than one year such as long-term debt.

Balance SheetShareholder's equity (common equity or owners equity) Is the difference between the total value of assets (current and fixed) and the total value of liabilities (current and long-term).

This features of the balance sheets is intended to reflects the fact that, if the firm want to sell all of its assets and use the money to pay off all of its debts, then the residual value remained would belong to the shareholder.

Balance Sheet Identity Assets = Liabilities + Stockholders Equity

Balance SheetNet Working Capital (NWC)The difference between the firms current assets and its currents liabilities is called working capital.

Based on the definition of current assets and currents liabilities , the NWC will be positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out over the same period.Usually positive in a healthy firm.

Balance Sheet

A firm has a current assets of $100, net fixed assets of $500, short term debt of $70 and long term debt of $200.what does the balance sheet like? Whats the shareholder equity? Whats the net working capital?

Total assets are $100+ $500 = $600 Total liabilities are $70+ $200 = $270.Shareholder equity is the difference: $600 - $270 = $330.Net working capital is the difference between current assets and current liability, then NWC $100 - $70 = $30.

*Example:

Balance Sheet

Balance Sheet : LiquidityLiquidity is the speed and ease which an asset can be converted to cash or the ability to convert to cash quickly without a significant loss in value. Liquid firms are less likely to experience financial distress, but liquid assets earn a lower return.Trade-off to find balance between liquid and illiquid assets.Remind that that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesnt mean it is liquid.Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns.A highly liquid asset is the one that can be quickly sold without significant loss of value.Illiquid asset is one that cannot be quickly be converted to cash without substantial price reduction. *

Balance Sheet Investment decisions & Financing decisions Investment decisions involve the purchase and sale of any assets (not just financial assets). Investment decisions show up on the left-hand side of the balance sheet.

Financing decisions involve the choice of whether to borrow money to buy the assets or to issue new ownership shares. Financing decisions show up on the right-hand side of the balance sheet.

Balance Sheet : Debt versus equity The use of debt in the firms capital structure is called financial leverage. The more debt a firm has( as a percentage of assets), the greater is its degree of financial leverage.Financial leverage increase the potential reward to shareholders, but also increase the potential for financial distress and business failureAs firm borrow money, its usually gives the first claim of the firms cash flow to creditor.Equity holders are entitled to only residual value, the portion left after creditor are paid. Residual portion means that if the firm sells its assets and pays its debt, whatever cash left belongs to the shareholders.Shareholders equity = Assets liabilities.

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Market Vs. Book ValueThe balance sheet provides the book value of the assets, liabilities and equity. Generally, these book values are not reflected the actual value as they worth.In other words, assets are carried on in the book at what the firm paid for them, no matter how long ago they were purchased or how much they worth today.

Market value is the price at which the assets, liabilities ,or equity can actually be bought or sold today.For current assets, market value and book value might be somewhat similar because current assets are bought and converted into cash over a relatively short span of time.Generally accepted accounting principle (GAAP) is the common set of standards and procedures by which audited financial statements are prepared.

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Market Vs. Book ValueMarket value and book value are often very different. Why?

Which is more important to the decision-making process?

Income Statement

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Income StatementThe income statement is more like a video of the firms operations for a specified period of time.It measures financial performance over a specific period of timeThe accounting definition of income is: Revenue Expenses Income

You generally report revenues first and then deduct any expenses for the period2-*

Income StatementRevenue is the amounts that any business earns. Generally at the point of sale.Examples: fees earned for performing services, Rent income, and interest income.

Expenses is the costs that relate to earning revenue (the costs of doing business).Examples: wages, rent, advertising.

Income StatementMatching principle say to match revenues with the costs associated with production them.

Matching principle is the principle that the revenue for one time period is matched up or compared with the related expenses for the same time period.

First determine the revenues and then match those revenues with the costs associated with producing them.

Income Statement 2-*

Calculating Earning and Dividend per shareSuppose that U.S corporation had 200 million share outstanding at the end of 2009. Based on the income statement in the table what was the earning per share (EPS)? What were dividends per share?

Earning per share (EPS) = Net Income / Total share outstanding = $412 / 200 = $2.06 per share.

Dividends per share = Total Dividends / Total share outstanding = $103 / 200 = 0.515 per share.

Net Income = Profit = Earnings

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Noncash ItemsExpenses charged against revenue that dont directly affect cash flow, such as depreciation.Depreciation, systematically spreads out the cost of these assets over their useful lives.The largest non-cash deduction for most firms is depreciation. It reduces a firms taxes and its net income.Example: Original cash outflow of $10,000 for a truck. You cannot record the whole $10,000 in the first year because the firm will use it for 5 years. Thus, the accountant can take $10,000/5 = $2,000 Depreciation Expense per year.

The $2,000 Depreciation Expense listed on the Income Statement is an accounting number, not a cash flow number.

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Time and CostsFuture have tow distinct part: the short run and the long run.Short run: Some costs are variable and some are fixed. long run: All costs are variable.

Fixed cost: Must be paid no matter what.Example: Rent, depreciation, property taxes, executive salaries.

Variable cost: Costs that change in direct proportion to change in volume of activity.Example: Sales commissions, direct materials, wages, delivery costs.

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2-*TaxesThe one thing we can rely on with taxes is that they are always changing; corporations do not pay a flat rate on their income, but rates are not strictly increasing either.Marginal vs. average tax ratesMarginal the percentage paid on the next dollar earnedAverage the tax bill / taxable income (is the total taxes paid divided by total taxable income)We are concerned with the taxes that we will pay if a decision is made. Consequently, the marginal tax rate is what we should use in our analysis.

Example: Marginal Vs. Average RatesSuppose your firm earns $4 million in taxable income.

What is the firms tax liability?What is the average tax rate?What is the marginal tax rate?

If you are considering a project that will increase the firms taxable income by $1 million, what tax rate should you use in your analysis?2-*

2-*Taxes

2-*Example: Marginal Vs. Average RatesWhat is the firms tax liability?0.15(50,000) + 0.25(75,000 50,000) + 0.34(100,000 75,000) + 0.39(335,000 100,000) + 0.34(4,000,000 335,000) = $1,360,000

What is the average tax rate?$1,360,000 / 4,000,000 = .34 or 34. %.

What is the marginal tax rate?Marginal rate comes from the table and it is 34%

If you are considering a project that will increase the firms taxable income by $1 million, what tax rate should you use in your analysis?

Cash Flow Statement.

The Concept of Cash FlowCash flow is one of the most important pieces of information that a financial manager can derive from financial statements.

We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets.

It must be the case that the cash flow received from the firms assets must equal the cash flows to the firms creditors and stockholders.

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The Concept of Cash FlowCash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders.

Cash Flow to Creditors: is a firms interest payments to creditors less net new borrowings.CF to Creditors = interest paid net new borrowing

Cash Flow to Stockholders: is the dividends paid out by a firm less net new equity raisedCF to Stockholders = dividends paid net new equity raised

Free cash flow: is another name for Cash Flow from assets

The Concept of Cash FlowCash Flow From Assets = Operating Cash Flow (OCF) Net Capital Spending(NCS) Changes in NWC.

OCF = EBIT + depreciation taxesNCS = ending net fixed assets beginning net fixed assets + depreciation.Changes in NWC = ending NWC beginning NWC

Example: US Corporation Part IOCF (I/S) = EBIT + depreciation taxes = $547 = 694 + 65 212 = $547

NCS ( B/S and I/S) = ending net fixed assets beginning net fixed assets + depreciation = $130 = 1709 1644 + 65 = $130

Changes in NWC (B/S) = ending NWC beginning NWC = $330= 1014 684 = $330

CFFA = 547 130 330 = $872-*

Example: US Corporation Part IICF to Creditors (B/S and I/S) = interest paid net new borrowing = $24Net New Borrowing = ending LT debt beginning LT debt = 454 408 = 46CF to creditors = 70 46 = $24

CF to Stockholders (B/S and I/S) = dividends paid net new equity raised = $63Net New Equity = 640 600 = 40 (Be sure to point out that we want equity raised in the capital markets, not retained earnings)CF to Stockholders = 103 40 = $63CFFA = 24 + 63 = $872-*

Cash Flow Summary - Table 2.52-*

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* (expected return) (Risk) .

(reasonable expectations) (assets) (treasury bill) Benchmark .

(slide ) 2.*The Lecture Tip in the IM focuses on helping students see the big picture: all decisions relate to either investment or financing.

Liquidity is a very important concept. Students tend to remember the convert to cash quickly component of liquidity, but often forget the part about without loss of value. Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesnt mean it is liquid.

Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the Lecture Tip in the IM for a more complete discussion of this issue.2.*Matching principle this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.

Similar to a previous Lecture Tip, consider discussing that the top half of the income statement addresses investment decisions, whereas the bottom half deals with financing.

See the IM for a discussion of Global Crossings record profit during the first quarter of 2004.

2.*The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example.

Remember that these are simplified income statements for illustrative purposes.

Earnings before interest and taxes is often called operating income.

COGS would include both the fixed costs and the variable costs needed to generate the revenues.

Analysts often look at EBITDA (earnings before interest, taxes, depreciation, and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes.

The IM provides a discussion of Cendant and the problems that the company ran into when fraudulent accounting practices were discovered.

It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statements. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the IRS. In this instance, the life of the asset for depreciation purposes may be very different from the useful life of the asset. Statements that are prepared for investors often use straight-line depreciation because it will tend to have a lower depreciation charge than MACRs early in the assets life. This reduces the expense, and thus increases the firms reported EPS. This is a good illustration of why it is important to look at a firms cash flow and not just its EPS.2.*Point out that taxes can be a very important component of the decision making process, but that what they learn about tax specifics now could change tomorrow. Consequently, it is important to keep up with the changing tax laws and to utilize specialists in the tax area when making decisions where taxes are involved.

www: Click on the web surfer icon to go to the IRS web site for the most up-to-date tax information.

It is important to point out that we are concerned with the taxes that we will pay if a decision is made. Consequently, the marginal tax rate is what we should use in our analysis.

Point out that the tax rates discussed in the book are just federal taxes. Many states and cities have income taxes as well and those taxes should figure into any analysis that we do.2.*Tax liability:.15(50,000) + .25(75,000 50,000) + .34(100,000 75,000) + .39(335,000 100,000) + .34(4,000,000 335,000) = $1,360,000

Average rate: 1,360,000 / 4,000,000 = .34 or 34% Marginal rate comes from the table and it is 34% also, but they are not always the same.

2.*Tax liability:.15(50,000) + .25(75,000 50,000) + .34(100,000 75,000) + .39(335,000 100,000) + .34(4,000,000 335,000) = $1,356,100

Average rate: 1,356,100 / 4,000,000 = .339025 or 33.9025% Marginal rate comes from the table and it is 34%

Should use the marginal rate with an expected additional 34,000 in taxes and a change in the average rate to 1,390,100 / 4,000,000 = .347525 or 34.7525%2.*Use the information from the balance sheet and income statement presented previously to work through this example. There is a hyperlink on I/S that will take you to that slide. Another one exists on B/S. The arrows on the Income Statement and Balance Sheet slides will bring you back here.

OCF = 694 + 65 212 = 547NCS = 1709 1644 + 65 = 130

Students often have a difficult time understanding why a cash outflow has a positive sign and a cash inflow has a negative sign. Emphasize that we are talking about SPENDING in the net capital spending formula and Investment in NWC. The formula for CFFA takes care of reducing cash flow when NCS is positive and increasing CF when it is negative.

Ending NWC = 1403 389 = 1014Beginning NWC = 1112 428 = 684Changes in NWC = 1014 684 = 330

2.*Use the information from the balance sheet and income statement presented previously to work through this example. There is a hyperlink on I/S that will take you to that slide. Another one exists on B/S. The arrows on the Income Statement and Balance Sheet slides will bring you back here.

Net New Borrowing = ending LT debt beginning LT debt = 454 408 = 46CF to creditors = 70 46 = 24

Net New Equity = 640 600 = 40 (Be sure to point out that we want equity raised in the capital markets, not retained earnings).CF to Stockholders = 103 40 = 63 2.*This provides a summary for the various cash flow calculations. It is a good place to refer back when working on cash flows in the capital budgeting section.*