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Chapter 2

Financial Statements, Cash Flow, and Taxes

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Topics in Chapter

Balance sheet Income statement Statement of cash flows Free cash flow MVA and EVA Corporate taxes

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Importance of Financial Statements

Form the basis for understanding the financial position of a business

Provide information regarding the financial policies and strategies and insight into future performance

10-K and 10-Q

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Balance SheetAssets Liabilities and EquityCash and equivalents Accounts payableShort-term investments (stocks and bonds) Notest payableAccounts Receivable Current long-term debtInventories Accruals Total current assets Total current liabilities

Long-term debtNet plant and equipment Total liabilitiesIntangible assets (R&D, patents) Preferred stockLong-term investments (stock and bonds) Common stock

Retained earningsTotal Assets Total Liabilities and Equity

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Balance Sheet: Assets

2009 2010

Cash $ 9,000 $ 7,282

S-T invest. 48,600 20,000

AR 351,200 632,160

Inventories 715,200 1,287,360

Total CA 1,124,000 1,946,802

Gross FA 491,000 1,202,950

Less: Depr. 146,200 263,160

Net FA 344,800 939,790

Total assets $1,468,800 $2,886,592

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Balance Sheet: Liabilities & Equity

2009 2010

Accts. payable $ 145,600 $ 324,000

Notes payable 200,000 720,000

Accruals 136,000 284,960

Total CL 481,600 1,328,960

Long-term debt

323,432 1,000,000

Common stock

460,000 460,000

Ret. earnings 203,768 97,632

Total equity 663,768 557,632

Total L&E $1,468,800 $2,886,592

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Changes on liabilities & equity CL increased as creditors and

suppliers “financed” part of the expansion.

Long-term debt increased to help finance the expansion.

The company didn’t issue any stock.

Retained earnings fell, due to the year’s negative net income and dividend payment.

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Dell’s Balance Sheet

http://finance.yahoo.com/q/bs?s=DELL+Balance+Sheet&ann

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Balance Sheet highlights Net plant and equipment= gross plant

and equipment– accumulated depreciation

Common stock at par and additional paid-in (capital surplus)

Retained earnings Annual addition to retained earnings

= net income – dividends paid Net worth – common equity

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Income StatementNet Sales

Less Cost of Goods Sold (COGS)

Less Operating expenses

EBITDA

Less Depreciation

Less Amortizations

EBIT

Less Interest

EBT

Less Taxes

Net income

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Income Statement Example

2009 2010

Sales $3,432,000 $5,834,400

COGS 2,864,000 4,980,000

Other expenses 340,000 720,000

Deprec. 18,900 116,960

Tot. op. costs 3,222,900 5,816,960

EBIT 209,100 17,440

Int. expense 62,500 176,000

EBT 146,600 (158,560)

Taxes (40%) 58,640 (63,424)

Net income $ 87,960 ($ 95,136)

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Dell’s Income Statement

http://finance.yahoo.com/q/is?s=DELL+Income+Statement&annual

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MicroDrive Income Statement

Table 2-2

MicroDrive Income Statements for Years Ending December 31    

(in millions of dollars)          

          2010 2009

INCOME STATEMENT          

Net sales         $3,000.0 $2,850.0

Operating costs except depreciation     $2,616.2 $2,497.0

Earnings before interest, taxes, deprn., and amortization (EBITDA)* $383.8 $353.0

Depreciation       $100.0 $90.0

Amortization       $0.0 $0.0

Depreciation and amortization     $100.0 $90.0

Earnings before interest and taxes (EBIT)     $283.8 $263.0

Less interest       $88.0 $60.0

Earnings before taxes (EBT)     $195.8 $203.0

Taxes         $78.3 $81.2

Net Income before preferred dividends     $117.5 $121.8

Preferred dividends       $4.0 $4.0

Net Income available to common stockholders   $113.5 $117.8

             

Common dividends       $57.5 $53.0

Addition to retained earnings     $56.0 $64.8

             

*MicroDrive has no amortization charges.      

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Income Statement Highlight Operating expenses

Include management salaries, advertising expenditures, repairs & maintenance, R&D, general & administrative expenses, lease payments, etc.

Earnings per common share (EPS) Companies that issued convertible

securities (such as bonds convertible into common stock) and stock options, must calculate two types of earnings per share: basic and diluted.

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Statement of Cash Flows

Provides information about cash inflows and outflows during an accounting period

Focuses on CASH. Has THREE sections:

Cash flow from Operating Activities (OCF)

Cash flow from Investing Activities (ICF)

Cash flow from Financing Activities (FCF )

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Compute the changes in some accounts over two periods

Which account item

goes to

Which

section ?

Accounts receivables

Notes payable

Depreciation

Fixed assets

Accruals etc …

Operating

Investing

Financing

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Useful Tip 1

No matter which section you are doing (operating, investing or financing),

IF the change of an account leads to a cash INFLOW, you add that change (+); IF the change leads to a cash OUTFLOW, you subtract that change (-)

inflow: decreases in assets or increases in liabilities or equity.outflow: increases in assets or decreases in liabilities or equity.

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Useful Tip 2

Cash flow from Operating Activities+ Cash flow from Investing Activities+ Cash flow from Financing Activities

= CHANGE in cash account

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Cash flows from operating activities 1

Net income + depreciation+/- change in A/R+/- change in Inv.+/- change in A/P+/- change in Accruals

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Cash flows from operating activities 2

Asset Liability

Decreases Add +(cash inflow)

Subtract -(cash outflow)

Increases Subtract -(cash outflow)

Add +(cash inflow)

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Cash flows from investing activities 1

Investing activities: Buying or selling productive assets

(plant & equipment)

Buying or selling financial securities

(e.g., stocks and bonds of other

companies,)

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Cash flows from investing activities 2

Inflows: Means:Decrease in gross fixed assets Firm sells long-lived assets such as

gross property, plant and equipment

Decrease in long-term investments

Firm sells debt or equity securities of other firms

Outflows:Increase in gross fixed assets Firm buys long-lived assets such as

gross property, plant and equipment

Increase in long-term investments

Firm buys debt or equity securities of other firms

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Cash flows from investing activities 3

Warning: we want changes in GROSS fixed assets. We don’t want the changes in net fixed assets!

BUT, if gross fixed assets are not reported in balance sheet …

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Cash flows from investing activities 4

change in gross fixed assets

= change in net fixed assets + depreciation

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Cash flows from financing activities 1

+/- changes in N/P

+/- changes in current long-term debt

+/- changes in long-term debt

+/- changes in common and preferred stock

+/- changes in capital surplus

- Payment of dividends

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Cash flows from financing activities 2

Inflows: Means: •increase in notes payable •increase in long-term debt

Firm borrows money

•increase in common stock Firm sells equity securities

Outflows:•decrease in notes payable•decrease in long-term debt

Firm repays debt

•decrease in common stock Firm buys back shares •Payment of dividends Firm pays cash to

shareholders

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Cash Flows Workshop

Solve Assignment 3.1

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Dell’s Statement of Cash Flow

http://finance.yahoo.com/q/cf?s=DELL+Cash+Flow&annual

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Analyzing Statement of Cash Flows 1

Statement of CF can help you analyze a company:

1) Relationship between net income and net cash flow from operations (OCF) If net income positive, but OCF is

negative, could mean: Company is growing rapidly Financial mis-management

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Analyzing Statement of Cash Flows 2

2) Net cash flow from investing activities (ICF)

If negative, company is making investments Buying plant & equipment (improve

efficiencies) Buying another company’s stock

(strategic reasons, e.g., joint venture)If positive, company is liquidating

assets. Why? Financial distress?

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Analyzing Statement of Cash Flows 3

3) Does company have sufficient cash to pay dividends?

OCF should exceed dividends. If dividends exceed OCF, why? Company liquidated assets to pay

dividends? Company issued equity or borrow to pay

dividends? Neither situation is good.

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Analyzing Statement of Cash Flows 4

4) Changes in debt Look at cash flow from financing

activities substantial increases in debt

(either short-term or long-term) Substituting short-term debt for

long-term debt may indicate worsening financial health.

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What is free cash flow (FCF)? Why is it important?

FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.

A company’s value depends on the future FCF it can generate.

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What are the five uses of FCF?

1. Pay interest on debt.2. Pay back principal on debt.3. Pay dividends.4. Buy back stock (repurchase).5. Buy nonoperating assets (e.g.,

marketable securities, investments in other companies, etc.)

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Earning before interest and taxes

(1 − Tax rate)

Net operating profit after taxes

X

Operating current assets

Operating current liabilities

Net operating working capital

−

Total net operating capital

Operating long-term assets

+

Net operating working capital

Free cash flow

−Net investment in operating capital

Net operating profit after taxes

−

Total net operating capital this yearTotal net operating capital last yearNet investment in operating capital

Calculating Free Cash Flow in 5 Easy StepsStep 1 Step 2

Step 3

Step 4

Step 5

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Step1: Net Operating Profit after Taxes (NOPAT)

NOPAT = EBIT(1 - Tax rate)

=EBIT - Tax

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Step2: Net Operating Working Capital (NOWC)

Operating CA = cash and equivalent + inventory + accounts receivables.

Operating CL = accounts payable + accruals

= -Operating

CAOperating

CLNOWC

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Step 3: Total net operating capital (or operating capital)

Operating Capital= NOWC + Net fixed assets.

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Step 4: net investment in operating capital

Net investment in operating capital= operating capital this year - operating capital last year

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Step 5: Free Cash Flow (FCF)

FCF = NOPAT - Net investment in operating

capital

Equation (2-6)

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Alternative FCF equation (2-9)

FCF =

operating cash flow

- gross investment in long-term operating asset

- investment in NOWC

Equation (2-9)

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Is a negative FCF bad?

If –NOPAT leads to a –FCF, then bad.

High growth usually causes negative FCF (due to investment in capital), but that’s ok if ROIC > WACC.

ROIC: return on invested capital

ROIC = NOPAT / operating capital

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Market Value Added (MVA)

MVA = Market Value of the Firm - Book Value of the Firm

Market Value = (# shares of stock)(price per share) + Value of debt

Book Value = Total common equity + Value of debt

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MVA (Continued)

If the market value of debt is close to the book value of debt, then

MVA = Market value of equity – book value of equity

This applies when it is hard to find the market value of debt.

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MVA (Assume market value of debt = book value of debt.)

Market Value of Equity 2010: (100,000)($6.00) = $600,000.

Book Value of Equity 2010: $557,632.

MVA = $600,000 - $557,632 = $42,368.

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Economic Value Added (EVA)

EVA = NOPAT – Operating capital x WACC= Operating capital x ROIC – Operating capital x WACC= Operating capital (ROIC-WACC)

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MVA and EVA (Table 2-5)Table 2-5

MVA and EVA for MicroDrive (Millions of Dollars)      

          2010 2009

MVA Calculation          

Price per share       $23.0 $26.0

Number of shares (millions)     50.0 50.0

Market value of equity = Share price (number of shares) $1,150.0 $1,300.0

Book value of equity       $896.0 $840.0

MVA = Market value - Book value     $254.0 $460.0

             

EVA Calculation          

EBIT         $283.8 $263.0

Tax rate         40% 40%

NOPAT = EBIT (1-T)       $170.3 $157.8

Total investor-supplied operating capitala   $1,800.0 $1,455.0

Weighted average cost of capital, WACC (%)   11.0% 10.8%

Dollar cost of capital = Operating capital (WACC)   $198.0 $157.1

EVA = NOPAT – Capital cost     -$27.7 $0.7

ROIC = NOPAT/Operating capital     9.46% 10.85%

ROIC – Cost of capital = ROIC – WACC     -1.54% 0.05%

EVA = (Operating capital)(ROIC – WACC)     -$27.7 $0.7

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2009 Corporate Tax Rates

Taxable Income Tax on Base

Rate on amount above base

0 -50,000 0 15%

50,000 - 75,000 7,500 25%

75,000 - 100,000 13,750 34%

100,000 - 335,000 22,250 39%

335,000 - 10M 113,900 34%

10M - 15M 3,400,000 35%

15M - 18.3M 5,150,000 38%

18.3M and up 6,416,667 35%

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Features of Corporate Taxation

Progressive rate up until $18.3 million taxable income. Below $18.3 million, the marginal rate

is not equal to the average rate. Above $18.3 million, the marginal

rate and the average rate are 35%.

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After Chapter Homework

Problems: (2-3), (2-4), (2-5), (2-10), (2-12 abcde), mini case d,e,f,g,h.

Course website: Statement of Cash Flow assignment 3.2, 3.3.