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CHAPTER 3Financial Statements, Cash Flow, and Taxes

Key Financial Statements Balance sheet Income statements Statement of retained earnings Statement of cash flows

Accounting income vs. cash flow

Federal tax system

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The annual report Balance sheet – provides a snapshot of a

firm’s financial position at one point in time.

Income statement – summarizes a firm’s revenues and expenses over a given period of time.

Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends.

Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.

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Balance sheet: Assets

CashA/RInventories

Total CAGross FALess: Dep.

Net FATotal Assets

20057,282

632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592

200457,600

351,200 715,2001,124,000

491,000 146,200 344,8001,468,800

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Balance sheet: Liabilities and EquityAccts payableNotes payableAccruals

Total CLLong-term debtCommon stockRetained earnings

Total EquityTotal L & E

2005524,160

636,808 489,6001,650,568

723,432460,000

32,592 492,5922,866,592

2004145,600200,000

136,000481,600323,432460,000

203,768 663,7681,468,800

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Income statement

SalesCOGSOther expenses

EBITDADepr. & Amort.

EBITInterest Exp.EBTTaxesNet income

20056,034,000

5,528,000 519,988

(13,988) 116,960(130,948) 136,012(266,960) (106,784) (160,176)

20043,432,0002,864,000 358,672

209,328 18,900

190,428 43,828

146,600 58,640

87,960

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Other data

No. of sharesEPSDPSStock priceLease pmts

2005100,000-$1.602

$0.11$2.25

$40,000

2004100,000

$0.88$0.22$8.50

$40,000

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Statement of Retained Earnings (2005)Balance of retained

earnings, 12/31/04Add: Net income,

2005Less: Dividends

paidBalance of retained

earnings, 12/31/05

$203,768

(160,176)

(11,00

0)

$32,592

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Statement of Cash Flows (2005)OPERATING ACTIVITIES

Net incomeAdd (Sources of cash):

DepreciationIncrease in A/PIncrease in accruals

Subtract (Uses of cash):Increase in A/RIncrease in inventories

Net cash provided by ops.

(160,176)

116,960378,560353,600

(280,960)(572,160)(164,176)

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Statement of Cash Flows (2005)L-T INVESTING ACTIVITIES

Investment in fixed assetsFINANCING ACTIVITIES

Increase 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)

57,6007,282

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What can you conclude about D’Leon’s financial condition from its statement of CFs? Net cash from operations = -

$164,176, mainly because of negative NI.

The firm borrowed $825,808 to meet its cash requirements.

Even after borrowing, the cash account fell by $50,318.

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Did the expansion create additional net operating after taxes (NOPAT)?NOPAT = EBIT (1 – Tax rate)

NOPAT05 = -$130,948(1 – 0.4)= -$130,948(0.6)= -$78,569

NOPAT04 = $114,257

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NOWC = Operating - Non-interest

current assets bearing CL

NOWC05 = ($7,282 + $632,160 + $1,287,360) – ($524,160 + $489,600)

= $913,042

NOWC04 = $842,400

What effect did the expansion have on net operating working capital?

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What effect did the expansion have on operating capital?Operating capital = NOWC + Net Fixed

Assets

Operating Capital05 = $913,042 + $939,790

= $1,852,832

Operating Capital04 = $1,187,200

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What is your assessment of the expansion’s effect on operations? SalesNOPATNOWCOperating

capitalNet Income

2005 $6,034,000

-$78,569$913,042

$1,852,832-$160,176

2004 $3,432,00

0$114,257$842,400$1,187,20

0$87,960

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What effect did the expansion have on net cash flow and operating cash flow?NCF05 = NI + Dep = ($160,176) +

$116,960 = -$43,216

NCF04 = $87,960 + $18,900 = $106,860OCF05 = NOPAT + Depreciation and

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

OCF04 = $114,257 + $18,900 = $133,157

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What was the free cash flow (FCF) for 2005?

NOWC esexpenditur

Capital - onamortizatiandDepr T)-(1 EBIT FCF

FCF05 = [-$130,948(1 – 0.4) + $116,960] – [($1,202,950 – $491,000) + $70,642]= -$744,201

Is negative free cash flow always a bad sign?

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Economic value added (EVA)

EVA = NOPAT – Annual dollar cost of capital

In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital.

EVA takes into account the total cost of capital, which includes the cost of equity.

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What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2004 and 13% in 2005.EVA05 = NOPAT – (A-T cost of capital)

(Capital)= -$78,569 – (0.13)($1,852,832)= -$78,569 – $240,868= -$319,437

EVA04 = $114,257 – (0.10)($1,187,200)= $114,257 – $118,720= -$4,463

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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 has decreased 73%. As a consequence, the market value of equity has declined, and therefore MVA has declined, as well.

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Does D’Leon pay its suppliers on time? Probably not. A/P increased 260%, over the

past year, while sales increased by only 76%.

If this continues, suppliers may cut off D’Leon’s trade credit.

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Does it appear that D’Leon’s sales price exceeds its cost per unit sold? NO, the negative NOPAT and

decline in cash position shows that D’Leon is spending more on its operations than it is taking in.

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What if D’Leon’s sales manager decided to offer 60-day credit terms to customers, rather than 30-day credit terms?

If competitors match terms, and sales remain constant … A/R would é Cash would ê

If competitors don’t match, and sales double … Short-run: Inventory and fixed assets é to

meet increased sales. A/R é, Cash ê. Company may have to seek additional financing.

Long-run: Collections increase and the company’s cash position would improve.

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How did D’Leon finance its expansion? D’Leon financed its expansion with

external capital. D’Leon issued long-term debt

which reduced its financial strength and flexibility.

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Would D’Leon have required external capital if they had broken even in 2005 (Net Income = 0)? YES, the company would still have

to finance its increase in assets. Looking to the Statement of Cash Flows, we see that the firm made an investment of $711,950 in net fixed assets. Therefore, they would have needed to raise additional funds.

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What happens if D’Leon depreciates fixed assets over 7 years (as opposed to the current 10 years)? No effect on physical

assets. Fixed assets on the

balance sheet would decline.

Net income would decline.

Tax payments would decline.

Cash position would improve.