Lll:)IKS Link to previous chapters Chapter 1 introduced the firm' s operating, investing, and financing activities. Chapter 2 introduced the financial statements. Chapters 5 and 6 outlined valuation models that anchor on those financial statements, and Chapt er 7 utilized those models in active investing. This chapter This chapter shows how the three business activities are depicted in the financial stateme nts. It also shows how the statements are redesigned to highlight these activities and to prepare the statements for applying the valuation models in Chapters 5 and 6. Link to next three chapters Chapters 9, 10, and 11 reformulate the statements according to the design developed in this chapter. Link to Web page Build your own financial statement spreadsheet based on the chapter; for assistance visit the text's Web site at www.mhhe.com/ penman5e Viewing the Business Thra h the Financial Statements 0 How are the How are How are How do the cash flows of a operating and operating and financial bus iness financing assets financing statement identified and liabilities income articulate to in the cash fl.ow identified in the identified in the present a statement? balance sheet? income picture of statement? the business? Every share purchase is in fact the purchase of a business. And anyone who buys a business should know that business. This maxim, recognized in Chapter 1, requires the analyst to investigate "what makes the business tick." This might be done through factory visits and interviews with management. But we also observe the business through financial state- ments. Financial statements are the lens on the business, so we need to get a feel for not only how the business operates but also how its operations are represented in financial statements. Then we will understand the story behind the numbers. This chapter builds on the introduction to businesses in Chapter 1 and the introduction to financial statements in Chapter 2. Chapter 2 showed how financial statements depict "stocks" and " flows" and how these articulating stocks and flows tell a story. This chapter shows how the three business activities introduced in Chapter I - financing, investing, and operating activities- are depicted through stocks and flows in the statements. The key ele- ment is the separation of operating and investment activities from financing activities in the
Transcript
Lll:)IKS
Link to previous chapters
Chapter 1 introduced the firm's operating,
investing, and financing activities. Chapter 2
introduced the financial statements. Chapters 5
and 6 outlined valuation models that anchor on
those financial statements, and Chapter 7 utilized those models in active investing.
This chapter
This chapter shows how the three business activities are
depicted in the financial statements. It also shows how the statements are redesigned to highlight these activities and to
prepare the statements for applying the valuation
models in Chapters 5 and 6.
Link to next three chapters
Chapters 9, 10, and 11 reformulate the statements
according to the design developed in this chapter.
Link to Web page
Build your own financial statement spreadsheet based on the chapter;
for assistance visit the text's Web site
at www.mhhe.com/ penman5e
Viewing the Business Thra h the Financial Statements
~ ~ 0 ~ How are the How are How are How do the
cash flows of a operating and operating and financial business financing assets financing statement identified and liabilities income articulate to
in the cash fl.ow identified in the identified in the present a statement? balance sheet? income picture of
statement? the business?
Every share purchase is in fact the purchase of a business. And anyone who buys a business should know that business. This maxim, recognized in Chapter 1, requires the analyst to investigate "what makes the business tick." This might be done through factory visits and interviews with management. But we also observe the business through financial statements. Financial statements are the lens on the business, so we need to get a feel for not only how the business operates but also how its operations are represented in financial statements. Then we will understand the story behind the numbers.
This chapter builds on the introduction to businesses in Chapter 1 and the introduction to financial statements in Chapter 2. Chapter 2 showed how financial statements depict "stocks" and "flows" and how these articulating stocks and flows tell a story. This chapter shows how the three business activities introduced in Chapter I - financing, investing, and operating activities- are depicted through stocks and flows in the statements. The key element is the separation of operating and investment activities from financing activities in the
Chapter 8 Viewing the Business Through the Financial Statements 235
After reading this chapter you should understand:
• How businesses are set up to generate value.
• How the financial statements are organized to reveal value added for shareholders.
• Why reformatting financial statements is necessary for analysis.
• How operating, investing, and financing activities are depicted in reformatted financial statements.
• The four types of cash flows in a business and how they relate to each other.
• How reformulated statements tie together as a set of stocks and flows.
• What operating activities involve.
• What financing activities involve.
• What determines dividends.
• What determines free cash flow.
• How free cash flow is disbursed.
• Why free cash flow is a dividend from operating activities to the financing activities.
• Why free cash flow does not affect the accounting for value added.
After reading t h is chapter you should be able to:
• Apply the tre asurer's rule.
• Lay out the form of reformulated cash flow statements, balance sheet s, and income statements.
• Explain how n et operating assets change over time.
• Explain how n et financial obligations change over time.
• Explain how free cash flow is generated.
• Explain how free cash flow is disposed of.
• Add new acc ounting relations to your set of analyst's tools.
• Calculate ret urn on net operating assets and net borrowing cost from reformulated statements.
• · Build an elementary spreadsheet that sets you up for analyzing the value generation of a business. This spreadsheet can be embellished as you proceed through the rest of the book.
financial statements, for it is the operating and investing activities that typically generate value, not the financing activities.
Chapter 2 introduced the financial statements in the form in which they are presented under GAAP accounting. That form does not quite give the picture we want to draw for valuation purposes. To sharpen our focus, we reformulate the statements in this chapter in a way that aligns the statements with the business activities. This reformulation readies the statements for the analysis in subsequent chapters which uncovers the factors that determine residual earnings and abnormal earnings growth, the primary valuation attributes in Chapters 5 and 6.
The emphasis in the chapter is on design. The redesign of financial statements provides the template for building a spreadsheet program that inputs the financial statements in a way that readies them for analysis. In Chapter 2 the form of the financial statements was given by a set of accounting relations. Here, too, the form of the reformulated financial statements is given by a set of accounting relations. These accounting relations provide the architecture for the spreadsheet program that can, with further embellishments in subsequent chapters, be used to analyze financial statements and value firms. At the end of the chapter you will be given explicit directions for designing the spreadsheet, with Nike, the firm whose financial statements were presented in Chapter 2, as an example.
236 Part Two The Analysis of Financial Statements
BUSINESS ACTIVITIES: THE CASH FLOWS
FIGURE 8.1 Cash Flows between the Firm and Claimants in the Capital Market Cash received from debtholders and shareholders is (temporarily) invested in financial assets. Cash payments to debtholders and shareholders are made by liquidating financial assets. Net financial assets are debt purchased from issuers, net of debt issued to debtholders. Net financial assets can be negative (that is, if debt issued to debtholders is greater than debt purchased).
In Figure 1.1 in Chapter 1 we depicted the transactions between the firm and its shareholders and debtholders. The firm, however, was left as a black box, although we recognized that the firm is engaged in financing activi ties, investing activities, and operating activities. Our aim in this and subsequent chapters is to fill out that box. Figure 8.1 begins to build the picture, to be completed in Figures 8 .2 and 8.3. Figure 8.1 is similar to Figure 1.1 in Chapter I, where cash flows to and from debtholders and shareholders are depicted. The cash flows to and from the debtholders and the firm have been reduced to a net flow, the net debt financing flow, labeled Fin the figure . This involves the net cash flow to bondholders, banks, and other creditors, that is, cash paid to debtholders in interest and principal repayments less cash paid into the firm from borrowing more from these creditors. Similarly, the net dividend to shareholders (din the figure) is cash paid in dividends and stock repurchases less cash contributions to t he firm from shareholders. The transactions between the two claimants and the firm are t he firm'sfinancing activities- debt and equity financing- and these take place in capital markets where the firm and these claimants trade.
Debt financing flows involve payments to and from debt issuers as well as debtholders. A firm always begins with cash contributions from shareholders. Cash is a nonproductive asset so, until it is invested in operations, firms invest this cash in bonds or other interestbearing paper and deposits, referred to as financial assets or sometimes as marketable securities. These financial assets are purchased in the capital market from debt issuersgovernments (T-bills and bonds), banks (interest-bearing deposits), or other firms (corporate
The Firm
Net financi al
assets (NFA)
Capital Markets
Debtholders or
debt issuers
Shareholders
Financing Activities
Key: F =Net cash flow to debtholders and issuers d = Net cash flow to shareholders
FIGURE 8.2 Cash Flows to Claimants and Cash Flows Within the Firm Cash generated from operations is invested in net financial assets (that is, it is used to buy financial assets or to reduce financial liabilities). Cash investment in operations is made by reducing net financial assets (that is, by liquidating financial assets or issuing financial obligations). Cash from operations and cash investment may be negative (such that, for example, cash can be generated by liquidating an operating asset and investing the proceeds in a financial asset).
Chapter 8 Viewing che Business Through the Financial Statements 237
Net operating
assets (NOA)
The Firm
Net financial
assets (NFA)
Capital Markets
Debtholders or
debt issuers
Shareholders
Operating Activities Financing Activities
Key: F =Net cash flow to debtholders and issuers d =Net cash flow to shareholders C = Cash flow from operations I = Cash investment
bonds or commercial paper). They involve a cash payment out of the firm in exchange for the financial assets. Like the issue of debt, the purchase of debt is also a financing activity. It is lending rather than borrowing, but both amount to buying and selling bonds or other financial claims. A firm can be a buyer of debt (of a debt issuer) if it has excess cash or can be an issuer of debt (to a debtholder) if it needs cash. In the first case it holds financial assets and interest and principal repayments flow into the firm. In the second case it has financial obligations or financial liabilities, and interest and principal repayments are paid out of the firm. In the first case, the net debt financing flow, F, is cash paid to buy debt assets less cash received in interest and from the sale of the debt. In the second case, the net debt financing flow, F, is cash paid in interest and to redeem debt obligations less cash received in issuing debt. Thus the net financing flow, F, is the net cash flow from borrowing and lending.
Firms often issue debt and hold debt at the same time. Thus they hold both financial assets and financial obligations. The net debtholding is net financial assets, financial assets minus financial obligations, as depicted in Figure 8.1 , or, if financial obligations are greater than financial assets, net.financial obligations. Correspondingly, the net debt financing flow is the net cash outflow with respect to both borrowing and lending.
Figure 8.2 completes the cash flow picture. Firms typically are not primarily in the business of buying bonds but hold bonds only temporarily to invest idle cash. They invest in operating assets-land, factories, inventories, and so on- that produce products for sale. This is the firm 's investing activities and the cash flows involved are cash investment or cash flow in investment activities, labeled I in the figure. To invest in operating assets, firms
238 Part Two The Analysis of Financial Statements
sell financial assets and buy operating assets with the proceeds. The arrows go both ways in the diagram because firms can also liquidate <Jperating assets (in discontinued operations, for example) and buy financial assets with t:he proceeds. The operating assets, set to work, produce net cash flows (cash inflows from selling products less cash outflows from paying wages, rent, invoices, and so on) and this cash flow is referred to as cash flow from operations. This cash is invested in financial assets by buying debt, or used to reduce the firm 's own debt. Cash from operations is never "left lying around" but is invested in financial assets to earn interest until needed. When needed, financial assets are liquidated to make cash investment in operations. Note that the term "investing activities" means investment in operating assets, not financial assets; indeed, investment in operating assets involves a liquidation of net financial assets.
Cash flow from operations and cash flow fo r investing activities were introduced in Chapter 4. We can now state a very important accounting identity known as the cash conservation equation or the sources and uses of cash equation. The four cash flows in Figure 8.2 always obey the relationship
Free cash flow = Net dividends to shareholders + Net payments to deb tholders and issuers (8.1)
C - I = d+F
That is, cash flow from operations less cash investment in operations always equals the net cash flows paid to debtholders (or issuers) and shareholders. The left-hand side, C - I, is the ji-ee cash flow. If operations generate more cash than is used in investment, free cash flow is positive. If operations produce less cash than is needed for new investment, free cash flow is negative. A positive free cash flow is used either to pay net interest and buy bonds (F) or to pay net dividends (d) . A negative free cash flow requires that a firm either issue bonds (negative F) or issue shares (negatived) to satisfy the cash shortfall. The cash conservation equation is called an identity because it's always true. Cash generated must be disposed of; the sources of cash must be equal to its uses.
You see now how a firm may have financial obligations rather than financial assets (as is often so). Financial obligations are just negative financial assets. If free cash fl.ow is negative, a firm can sell off financial assets to get cash; if these assets are all sold and if the firm chooses not to reduce its net dividend, however, the firm will have to issue debt to get the cash. Thus the firm becomes a net debtor rather than a creditor, a holder of net financial obligations rather than net financial assets. In either case it just trades in the debt market. If free cash flow is positive, the firm buys others' bonds with the cash or buys its own bonds (redeems them), holding net dividends constant. If free cash flow is negative, it sells bonds-either its own bonds or others ' bonds which it holds. This is debt financing activity, and although sometimes it's done with banks (where the firm might have a loan or an interest-bearing deposit), you can think of it as trading in bonds. In doing so, the firm will have to cover any net dividend it wants to pay and, of course, net cash interest also generates or uses cash. The treasurer's rule summarizes this:
If C - I - i > d, then lend or buy down own debt.
If C - I - i < d, then borrow or reduce lending.
Here i is the net interest cash outflow (interest paid minus interest received). Net interest is after tax, as calculated in Chapter 4, because net cash paid is after receiving a tax deduction for interest. See Box 8.1 .
MICROSOFT CORPORATION: POSITIVE FREE CASH FLOW In its second quarter for 2004, Microsoft generated $4,064 million in free cash flow and received $338 mil lion in interest, net of tax, from short-term marketable securities it held. It paid a net $2,270 million in cash out to shareholders, leaving $2, 132 million with which it purchased short-term interest-bearing securities.
In its second quarter for 2005, Microsoft generated $3,200 million in free cash flow and received $242 million in interest, net of tax, for short-term marketable securities it held. In this quarter, the firm paid out a large special net dividend to shareholders of $33,672 million, leaving a cash shortfall. Accordingly, it sold $30,230 million of marketable securities to provide cash for the dividend.
The calculations for the treasurer's trading in debt are as follows (in mi ll ions):
2nd Quarter 2nd Quarter 2004 2005
Cash flow from operations $4,236 $3,377 Cash investment in operations 172 177 Free cash flow 4,064 3,200 Cash interest received (after tax) 338 242 Cash available for shareholders 4,402 3,442
Purchase (sale) of financial assets $2, 132 $(30,230)
GENERAL ELECTRIC CORPORATION: NEGATIVE FREE CASH FLOW During 2002, General Electric generated $34.8 billion in cash flow from operations but made $61.2 billion further investment in operations, including $7. 7 billion of capital expenditure on property, plant, and equipment, $21.6 bil lion in acquisitions, and $18.1 billion investment in financing receivables. Accordingly, its free cash flow was negative to the amount of - $26.4 billion .
As it paid out $8.1 bi llion to shareholders, it had to borrow $40.6 billion to cover this payout, the free cash deficit, and $6.1 bi llion in interest payments on debt.
The calculations for the treasurer's trading in debt are as follows (in millions):
Cash f low from operations Cash investment in operations Free cash flow Interest paid (after tax) Cash avai lable to shareholders
Net dividend: Cash dividend Share repurchases
Net issue of debt
$7, 157 985
$34,848 61,227
(26,379) 6,082
(32,461)
As the treasurer had $57.8 billion of debt to repay, he issued $98.4 bi llion of new debt (for a net debt issue of $40.6 billion).
239
The cash flows in Box 8.1 are summarized in reformulated cash flow statements below (in millions). The reformulated statement distinguishes cash flows associated with operating activities from cash flows associ ated with financing activities. As free cash flow must be paid out either to shareholders or net debtholders, the statement obeys the cash conservation equation: C - I = d + F.
Debt fi nancing flows (F): Net purchase of financial assets 2, 132 (3 0 ,230) Interest on financia l assets (after tax) (338) (242) Net issue of debt (40,603) Interest paid on debt (after tax) 6,082
Total financing f lows (d + F) $4,064 $3,200 $(26,379) - - -
The Reformulated Cash Flow Statement The accountant keeps track of the cash flows in a statement of cash flows. The design of a statement of cash flows that keeps track of the four cash flows in Figure 8.2 is below (items in parentheses are negative amounts):
Debt financing flows: Net purchase of financial assets Interest on financia l assets (after tax) Net issue of debt Interest on debt (after tax)
Total financing flows
xx (XX)
xx (XX) (XX) xx
c J!j__ C-1
d
F d+F
This reformulated statement is a little different from the GAAP statement of cash flows introduced in Chapter 2. It corresponds to the thought process of the treasurer or chief financial officer who is considering financing needs, and we want financial statements that reflect business activities. See Box 8.2.
Chapter 8 Viewing the Business Through the Financial Statements 241
The Reformulated Balance Sheet The cash flows in Figure 8.2 are flows into and out of stocks of net assets depicted by boxes. So a cash investment, for example, is a flow that reduces the stock of net financial assets and increases the stock of operating assets . The balance sheet keeps track of the stock of financial assets and obligations, and so reports the net indebtedness. The balance sheet keeps track of the stock of operating assets as well. Published balance sheets list assets and liabilities, usually classified into current and long-term categories. This division is useful for credit analysis (as we will see in Chapter 20). But for equity analysis, the published statements are better reformulated into operating and financial assets and operating and financial liabilities. Operating assets and liabilities are simply the assets and liabilities used in the business of selling to customers. Financing assets are assets and liabilities used in the financing of the business. The former are involved in trading with customers and suppliers, the latter in trading in capital markets.
A dummy balance sheet that makes the distinction looks like this:
Assets
Operating assets Financial assets
Total assets
OA FA
OA+ FA
Balance Sheet
Liabilities and Equity
Operating I iabilities Financial ob ligations Common stockholders' equity Total claims
OL FO
CSE OL + FO +CSE
Financing items can be assets or obligations (liabilities), as we have discussed. But operating items also can be positive or negative. If they are positive, they are called operating assets (OA). If they are negative, they are called operating liabilities (OL). Accounts receivable is an operating asset because it arises from selling products in operations. Accounts payable is an operating liability because it arises from buying goods and services in operations. So are wages payable, pension liabilities, and other accrued expenses. We will deal with these classifications in more detail when we analyze actual balance sheets in Chapter 10 and reformulate them along the lines of this dummy statement. For now, note that operating liabilities arise as part of operations whereas financial liabilities arise as part of the financing activities to get cash to run the operations.
To distinguish operating and financing activities, it helps to regroup these items in the balance sheet:
Operating Assets
Operating assets Operating liabilities
OA (OL)
Reformulated Balance Sheet
Financial Obligations and Owners' Equity
Financial obligations Financia l assets Net financial obligations Common shareholders' equity
Net operating assets NOA
Net operating assets (NOA)= OA- OL
Net financial assets (NFA) =FA - FO
Common shareholders ' equity (CSE)= NOA+ NFA
FO lEb2 NFO CSE
NFO +CSE
242 Part Two The Analysis of Financial Statements
Usually NFA is negative, in which case it is net financial obligations (NFO):
CSE=NOA -NFO
The difference between operating assets and operating liabilities is the net operating assets (NOA). The difference between financial assets and financial obligations is the net.financial assets (NFA). These are the two boxes in Figure 8.2. IfNFA is negative, we have net.financial obligations (NFO), as in this dummy statement. IfNFA is positive, it is placed on the left-hand side. The book value of common stockholders' equity, CSE, was previously indicated as B. The last two identities under the statement restate the standard balance sheet equation (Assets - Liabilities= Owners' equity) in terms of the two net stocks for operating and financial activities. The owners' equity is seen as an investment in net operating assets and net financial assets, and the investment in net financial assets can be negative.
BUSINESS ACTIVITIES: ALL STOCKS AND FLOWS
FIGURE 8.3 All Stocks and Flows for a Firm Net operating assets employed in operations generate operating revenue (by selling goods and services to customers) and incur operating expenses (by buying inputs from suppliers). Li indicates changes.
The picture in Figure 8.2 is not complete: How does the income statement fit in? Well, firms raise cash from capital markets to invest in financing assets which are then turned into operating assets. But they then use the operating assets in operations. This involves buying inputs from suppliers (of labor, materials, and so on) and applying them with the net operating assets (such as factories, plant, and equipment) to produce goods or services that are sold to customers. Financing activities involve trading in capital markets. Operating activities involve trading with these customers and suppliers in product and input markets. Figure 8.3 completes the picture.
Product and Input Markets
Customers
Suppliers
Net operating
assets (NOA)
The Firm
c
OR - OE=IOI~ ' l - -- , :Ol'-~NOA =:C - /1
Net financial
assets (NFA)
Capital Markets
Debtholders or
debt issuers
Shareholders
_=..i I I
~-~~- ~NFA + NFI = d
Operating Activities
Key: F =Net cash flow to debtholders and issuers d = Net cash flow to shareholders C =Cash flow from operations I = Cash investment
NFA = Net financial assets
Financing Activities
NOA = Net operating assets OR = Operating revenue OE = Operating expense 01 =Operating income
NFI =Net financial income
Chapter 8 Viewing the Business Through rhe Financial Statements 243
Trading with suppliers involves giving up resources, and this loss of value is called operating expense (OE in the figure). The goods and services purchased have value in that they can be combined with the operating assets to yield products or services. These products or services are sold to customers to obtain operating revenue, or value gained (OR in the figure). The difference between operating revenue and operating expense is called operating income: OI =OR - OE. If all goes well, operating income is positive: The firm adds value. lfnot, operating income is negative: The firm loses value.
Figure 8.3 depicts the stocks and flows involved in the three business activitiesfinancing, investing, and operating activities. It is common, however, to refer to the operating and investment activities together as operating activities (as in the figure) , because investment is a matter of buying assets for operations. So analysts distinguish operating activities (which include investing activities) from financing activities (as in the figure) .
The Reformulated Income Statement The income statement summarizes the operating activities and reports the operating income or operating loss. The operating income is combined with the income and expense from financing activities to give the total value added to the shareholder, comprehensive income, or earnings:
Operating revenue Operating expense Operating income Financial expense Financial income Comprehensive income
Reformulated Income Statement
xx (XX)
OR (OE) 01
(NFE) Cl
Both operating income and net financial expense are after tax. (Chapter 10 shows how to calculate the after-tax amounts.) Operating revenues and operating expenses are not cash flows . They are measures of value in and value out as determined by the accountant. To capture that value, the accountant adds accruals to the cash flows , as we saw in Chapter 4. Similarly, interest income and interest expense (and other financing income and expenses) are not necessarily cash flows. As with operating income, the accountant determines what interest income and expense should be by making an accrual: As cash interest on a discount bond (for example) does not represent the effective borrowing cost, the accountant uses the effective interest method to adjust the cash amount. The net amount of effective interest income (on financial assets) and effective interest expense (on financial obligations) is called net financial income (NFI) or, if interest expense is greater than interest income, net financial expense (NFE).
ACCOUNTING RELATIONS THAT GOVERN REFORMULATED STATEMENTS
We now have three reformulated statements . Just as published statements are governed by the accounting relations laid out in Chapter 2, so the reformulated statements are also governed by accounting relations. The cash flow and income statements are statements of flows over a period- operating flows and financing flows- and the balance sheet is a statement of the stocks- operating and financing stocks- at the end of a period. The flows during a period flow into and out of the stocks, as in the diagram, so the changes in the stocks are explained by the flows.
244 Part Two The Analysis of Financial Statements
The flows and the changes in stocks are linked at the bottom of Figure 8.3. These links between stocks and flows are accounting relations. Accounting relations not only govern the form of the statements-how different components relate to each other-but they also describe what drives, or determines, each component. Financial analysis is a question of what drives financial statements, what drives earnings and book values. So the accounting relations we are about to lay out will become analysis tools in subsequent chapters. The accounting relations below also dictate the structure of a financial statement analysis spreadsheet that will provide those tools. We will end this chapter by giving directions for developing such a spreadsheet. The accounting relations, as stated here, look a bit technical, but they will come to life as you apply them in analysis and valuation. Keep your eye on the prize: We are producing tools for discovering the value generation in a business.
The Sources of Free Cash Flow and the Disposition of Free Cash Flow Free cash flow is generated by cash from operations net of cash investment. But we can also depict the generation of free cash flow in terms of the accrual accounting income statements and balance sheets. Moving from left to right in Figure 8.3, we see how free cash flow is generated:
Free cash flow = Operating income - Change in net operating assets (8.2)
C-I= OI-fiNOA
where the Greek delta, fi, indicates changes. Operations generate operating income, and free cash flow is the part of this income remaining after reinvesting some of it in net operating assets. In a sense, free cash flow is a dividend from the operations, the cash from operating profits after retaining some of the profits as assets.
The right-hand side of the figure explains the disposition of free cash flow:
Free cash flow = Change in net financial assets (8.3a) - Net financial income+ Net dividends
C-I=fiNFA-NFI+ d
That is, free cash flow is used to pay net dividends, with the remainder invested in net financial assets, along with net financial income. Box 8.2 provided an example for Microsoft where, in 2004, the firm applied its free cash flow to purchase financial assets (net of interest received) and paid out cash to shareholders. If the firm has net financial obligations,
Free cash flow= Net financial expenses (8.3b) - Change in net financial obligations+ Net dividends
C - I= NFE - fiNFO + d
That is, free cash flow is applied to pay for net financial expenses, reduce net borrowing, and pay net dividends. Box 8.1 provided an example for General Electric, where, in fact, the free cash flow was negative so the firm had to increase its net financial obligations.
The Drivers of Dividends Running all the way from left to right in Figure 8.3, you see how the value created in product and input markets and recorded in the accounting system flows through to the final dividend to shareholders: Operations yield value (operating income) that is invested in net operating assets; excess (or "free") cash from operations is invested in net financial assets, which yield net interest income; then these financial assets are liquidated to pay dividends. If operations need cash (negative free cash flow), financial assets are liquidated or financial obligations are created through borrowing. Alternatively, cash is raised from shareholders
Cha pt er 8 Viewing the Business Through the Financial Statements 245
(a negative dividend) and temporarily invested in financial assets until needed to satisfy the negative free cash flow. And so the world turns.
The last point of this dividend generation is stated by the accounting relation to the right in Figure 8.3:
Net dividends= Free cash flow+ Net financial income - Change in net financial assets
d = C - I+ NFI - ~NFA
(8.4a)
which is a reordering of the free cash flow relation (8.3a). That is, dividends are paid out of free cash flow and interest earned on financial assets and by selling financial assets. If free cash flow is insufficient to pay dividends, financial assets are sold (or financial obligations incurred) to pay the dividend.
If the firm is a net debtor,
Net dividends= Free cash flow - Net financial expenses + Change in net financial obligations
d = C - I - NFE + ~NFO
(8.4b)
which is a reordering of the free cash flow relation (8 .3b). That is, dividends are generated from free cash flow after servicing interest, but also by increasing borrowing. You see why dividends might not be a good indicator of the value generation in a business (at least in the short run): A firm can borrow to generate dividends (at least in the short run).
Dividends in these relations are net dividends, so cash is paid in by shareholders if free cash flow after net interest is less than net borrowing.
The Drivers of Net Operating Assets and Net Indebtedness By reordering these accounting relations we explain changes in the balance sheet. From equation 8.2,
Net operating assets (end)= Net operating assets (beginning) (8.5) + Operating income - Free cash flow
NOA,= NOA,_1 + 011 - (C1 - ! 1)
or
Change in net operating assets = Operating income - Free cash flow
~NOA1 = Olr - (Ci - 11)
Operating income is value added from operations, and that value increases the net operating assets . So, for example, a sale on credit increases both operating revenue and operating assets through a receivable; and purchase of materials on credit or a deferral of compensation increases both operating expense and operating liabilities through an accounts payable or wages payable. (This is just the debits and credits of accounting at work.) Free cash flow reduces net operating assets as cash is taken from operations and invested in net financial assets. Or, expressing the change in NOA as ~NOA= OI - C +I, you see that operating income and cash investment increase NOA, and NOA is reduced by the cash flows from operations that are invested in net financial assets.
Correspondingly, the change in net financial assets is determined by the income from net financial assets and free cash flows, along with dividends:
Net financial assets (end)= Net financial assets (begin) +Net financial income +Free cash flow - Net dividends
NFAr = NFA1- 1 +NH+ (C, - Ii) - dr
(8.6a)
246 Part Two Tl1e Analysis of Financial Statements
or
Change in net financial assets =Net financial income + Free cash flow - Net dividends
t.NFA1 = NFI1 + ( C1 - 11) - d1
The net financial income earned on net financial assets adds to the assets, free cash flow increases the assets (as the cash from operations is invested in financial assets), and the assets are liquidated to pay net dividends. If the firm holds net financial obligations rather than net financial assets,
or
Net financial obligations (end)= Net financial obligation (begin) (8.6b) +Net financial expense - Free cash flow +Net dividends
NF01 =NF0,_1 + NFEr - ( C1 - I,) + d1
Change in net financial obligations= Net financial expense - Free cash flow + Net dividends
t.NF01 = NFE1 - (Cr - Ir)+ d,
That is, interest obligations increase net indebtedness, free cash flow reduces indebtedness, and the firm has to borrow to finance the net dividend.
These accounting relations, remember, tell us what drives the various aspects of the (reformulated) statements. Net operating assets are driven by operating income and reduced by free cash flow, as in equation 8.5. Or, stated differently, NOA is increased by operating revenue, reduced by operating expenses, increased by cash investment, and reduced by cash from operations (which is not "left lying around" but invested in financial assets). The relations for net financial assets and obligations, equations 8.6a and 8.6b, explain what determines the borrowing or lending requirement and so restate the treasurer's rule: The amount of new debt to be purchased (and put on the balance sheet) is determined by the free cash flow after interest and the net dividend.
TYING IT TOGETHER FOR SHAREHOLDERS: WHAT GENERATES VALUE?
Figure 8.4 shows how reformulated statements articulate via accounting relations. It shows the accounting relations governing each statement (within each box) and the stocks and flow relations that explain ending stocks in the balance sheet in terms of beginning balance sheet stocks and the flows over the period. These flows are from the income statement and cash flow statement. Operating income increases net operating assets, and net financial expense increases net financial obligations. The income statement explains where these flows come from. Free cash flow decreases net operating assets and also decreases the net indebtedness. The cash flow statement explains where the free cash flow come from. Dividends are paid out of the net financial obligations- by liquidating financial assets (to get the cash) or by issuing debt. In short, the financial statements track the operating and financing flows of a business and show how they update the stocks of net operating assets, net financial obligations, and (as t.CSE = t.NOA- t.NFO) the change in shareholders' equity.
The stocks and flows relations for NOA and NFO (or NFA) are similar in form to the stocks and flows equation for common stockholders' equity introduced in Chapter 2:
CSEr = CSE,_1 +Comprehensive income - Net dividends1
Chapter 8 Viewing the Business Through the Financial Statements 247
FIGURE 8.4 The Articulation of Reformulated Financial Statements. This figure shows how reformulated income statements, balance sheets, and the cash flow statements report the operating and financing activities of a business, and how the stocks and flows in Figure 8.3 are identified in the financial statements. Operating income increases net operating assets and net financial expense increases net financial obligations. Free cash flow is a "dividend" from the operating activities to the financing activities: Free cash flow reduces net operating assets and also reduces net financial obligations. Net dividends to shareholders are paid out of net financial obligations.
STOCKS Balance Sheet Last Year, t-1
NOA1_
1
-NF01_1
CSE1_
1
Income Statement
Year,t
FLOWS
+ OI - (C-l) t t
+ NFEI- (C-l)t + dt =
d
STOC KS Balance Sheet Current Year, t
NOA,
-NF 01
CSE1
Cash Flow Statement
Year,t
c, =!i._
FCF1
d, +F,
FCF1
That is, common equity is driven by comprehensive income (earnings) and is reduced by net dividends. The expressions for NOA and NFO (in Figure 8.4 and equations 8.5 and 8.6b) also have a driver and a dividend. NOA is driven by operating income and reduced by a "dividend," free cash flow that is paid to the financing activities. And the net financial obligations are driven by the free cash flow received from the operating activities along with the financial expense they themselves incur, and they pay a dividend to the shareholders.
The aim of the accounting system is to track value created for shareholders. The stocks and flows equation for shareholders indeed says this: Owners ' equity is driven by a valueadded measure, comprehensive income, and reduced by net distributions to owners. But common equity is also the net total of stocks in the balance sheet, the difference between net operating assets and net financial obligations:
CSE1 = NOA1 - NF01
So changes in common equity are driven by the drivers that change NOA and NFO. Figure 8.5 depicts how common shareholders' equity is generated by NOA and NFO. Line 1 explains the change in net operating assets from the beginning of a period and line 2 explains the change in net financial obligations. Line 3 explains the change in common equity (for the case of net financial obligations). The difference between the flows for NOA and NFO (line 1 minus line 2) explains the flow for common equity. The change in the common equity is explained by comprehensive income minus net dividends, but it is also explained by the flows that explain the net operating assets and net financial obligations.
248 Part Two The Analysis of Financial Statements
FIGURE 8.5 Change in Common Stockholders' l!.quity Is Explained by Changes (Flows) in Net Operating Assets (NOA) and Net Financial Obligations (NFO). Subtract line 2 from line 1 and you see that free cash flow (C- /)does not affect the change in common stockholders' equity.
You'll notice in this explanation of the change in shareholders' equity that although the free cash flow affects NOA and NFO, free cash flow drops out in the difference between the two when explaining the change in shareholders' equity: Take line 2 from line 1 to get line 3 and free cash flow drops out. The accounting says that free cash flow does not add value to shareholders. Free cash flow is a driver of the net financial position, not the operating activities, and the amount of free cash flow is irrelevant in determining the value of owners' equity. Rather, the profits from operating activities (OI) and financing activities (NFE), which together give earnings, increase or decrease shareholder wealth. Free cash flow is just a dividend of excess cash from the operating activities to the financing activities, not a measure of the value added from selling products. And free cash flows, just like dividends to shareholders, have little to do with value generated.
This makes eminent sense. Both Microsoft and General Electric in Boxes 8.1 and 8.2 have added tremendous value for shareholders. Microsoft has large positive free cash flow. General Electric has large negative free cash flow. But it does not matter. Earnings matter; accrual accounting gets it right.
BUILD YOUR OWN ANALYSIS ENGINE
As we proceed through this part of the text, you will be able to build most features into a spreadsheet that will perform a complete analysis of a firm. In the next part of the book, on valuation, you will be able to combine the analysis spreadsheet with the valuation engines you produced in Chapters 5- 7 to produce a complete analysis and valuation spreadsheet that you can activate to challenge market prices. The Build Your Own Analysis and Valuation Product (BYOAP) guide on the book's Web site gives the full directions for developing the final product, with examples for Nike, Inc. You can, of course, appropriate the spreadsheet for Nike there, but your learning will be considerably enhanced if you build your own spreadsheet progressively as we proceed through the book.
Figure 8.4 gives the summary financial statement numbers that appear in a financial statement analysis and valuation spreadsheet. Of course, we will add more detail as we proceed-the various types of net operating assets, net financial obligations, operating income, and more that make up these totals-but these summary numbers are primary. Figure 8.4 also gives the accounting relations that govern each statement and the articulation between the statements, and these relations govern the spreadsheet. These relations must hold in the spreadsheet, otherwise the analysis and valuation that the spreadsheet sheet delivers will
Summary Financial Statements and the Articulating Accounting Relations for Nike, Inc. 8.3
The 2010 financial statements for Nike, Inc., the athletic footwear manufacturer, are given in Exhibit 2 .1 in Chapter 2. Reformulation of financial statements involves rearranging the statements according to the design in this chapter. We will go into the detail of reformulating Nike's statements in Chapter 10. To add some live numbers to the rather cryptic presentation you have just gone through, the main summary numbers from Nike's reformulated balance sheets and income statement are given below in the same form as Figure 8.4, together with the numbers for the accounting relations that explain how the financial statements articulate.
STOCKS Balance Sheet
2009
NOA NFA
6,346 2,468
FLOWS
+ 1,814-2,646 4 + 2,646 - 740 =
CSE 8,814 + 1,810 740=
Income Statement 2008
01 1,814
NFI (4)
Cl 1,810
STOCKS Balance Sheet
2010
NOA NFA
CSE
5,514 4,370
Cash Flow Statement 2008
FCF 2,646
d 740 F 1,906
2,646
You might ask where the $2,646 million in free cash flow came from. Is it from the cash flow statement? Well, one could extract it from there with the adjustments we made in Chapter 4. However, we have an accounting relation (8.2) that tells us the free cash flow once we have identified operation income (01) and net operating assets (NOA):
C - I = OJ - '1NOA
= 1,814 - (5,514 - 6,346)
= 2,646
You can see how accounting relations are going to be useful as analysis tools: Some numbers have to be input from financial statements, but others just fall out by applying the relations that connect accounting numbers to each other. A spreadsheet will embed many analysis tools such as this, provided you have set it up to obey the accounting relations.
be in error. Put more positively, if the spreadsheet is built on this template, the analyst is secure, knowing that the spreadsheet has integrity in identifying the value generation in a business.
There is, of course, much to be added before we get to a full analysis and valuation product, and the next few chapters will occupy us in building a complete, functional spreadsheet. We now have only the skeleton, to be fleshed out as we proceed. However, Box 8.3 will get you started. It gives the summary numbers in Figure 8.4 from the financial statements for Nike in Chapter 2. Don't be too concerned about how these are identified at the moment- that is the task of the next three chapters. But put the numbers into a spreadsheet and see how they articulate. In so doing, you will see how the spreadsheet provides tools that give insights. Observe the calculation of free cash fl.ow at the bottom of Box 8.3. We
249
250 Part Two The Analysis of Financial Statements
Summary
don't have to calculate free cash flow-a problem we found difficult in Chapter 4-for it is supplied by the press of a button using an accounting relation. We shall see many other features pop out as we proceed, provided we have built a spreadsheet with integrity.
This chapter has laid out the bare bones of how a business works and how business activities are highlighted in reformulated financial statements. The key point for discovering the value generation is the separation of operating (and investing) activities from financing activities. The separation leads to a set of accounting relations that describe the drivers of reformulated statements and connect the statements together. These relations are summarized in the Analyst's Toolkit below, and you should try to commit them to memory. More importantly, you should appreciate what they are saying. Taken as a whole, these relations outline how value is passed from shareholders to the firm in share issues and, with value added, passed back to shareholders. Figures 8.3 and 8.4 summarize this well. Put them firmly in your mind as you continue.
The chapter, indeed, is skeletal and there is much flesh to be added in the following chapters. You have been given the form of the reformulated statements that distinguish the operating and financing activities of the firm, but the form has to be filled out. The distinction between the two types of activities is important for, as we observed in Chapter 3, it is the operating activities that are typically the source of the value generation, so it is these operating activities- and the return on net operating assets (RNOA)- that we will be particularly focused on as we analyze firms. Indeed, as we proceed with financial statement analysis, we will work with reformulated statements, not the published GAAP statements.
The accounting relations that govern the reformulated statements are also tools for the analyst. They explain how to pull the statements apart to get at the drivers. And they explain how to manipulate the statements to express one component in terms of others. The relations are stated in stark, technical terms here, but they, too, will come to life as the analysis develops. As a set, they provide the architecture for a spreadsheet program that can be used to analyze reformulated statements and value firms. You will find yourself referring back to them and, as you do, you will appreciate how the summary of the financial statements in terms of these relations provides a succinct expression of the "story behind the numbers."
Find the following on the Web page for this chapter: statements more in line with the reformulations in this chapter.
• More directions for putting the framework in this chapter into a spreadsheet.
• More demonstration of how the framework works to produce analysis tools.
• A discussion of the FASB and IASB financial statement design project, which aims to report financial
• Your first introduction to the Build Your Own Analysis Product (BYOAP) spreadsheet tool, a complete spreadsheet for a nalysis and valuation that you can build as the book p roceeds.
Chapter 8 ViewinR the Business Through the Financial Statements 251
Key Concepts
Analysis Tools
The treasurer's ru le
financial asset is an asset held to store cash temporarily and which is liquidated to invest in operations or pay dividends. Also called marketable securities. 236
financial expense is an expense incurred on financial obligations. 243
financial income is earnings on financial assets. 243
financial obligation or financial liability is an obligation incurred to raise cash for operations or to pay dividends. 237
net financial expense is the difference between financial expense and financial income. If financial income is greater
Page Key M easures
238 Common stockholders' equity If C - I - i > d, then lend (CSE)
or buy down debt Financial assets (FA) If C - I - i < d, then borrow Financial ob ligations (FO)
or reduce lending Free cash flow Accounting relations Net financial assets (NFA)
th an financial expense, it is referred to as n et financial income. 243
operating asset is an asset used in operations (to generate value from selling p r oducts and services). 241
operating expense is a loss of value from selling products (in operations). 243
operating income is net value added from operations. 243
operating liability is an obligation incurred as part of operations (to generate va lue from selling products and services). 241
operating revenue is value gained from selling products (in operations). 243
Page Acronyms to Remember
BY OAP Bui ld Your Own Analysis 242 Product 236 Cl comprehensive income 237 CSE common shareholders' 238 equity 23 7 FA financia l asset
Cash conservation equation Net financia l obligations (NFO) 237 FO financial obligation C - I = d + F (8 .1) 238 Free cash flow sources
obligation) driver equations 6NFA = NFI + (C - n - d
(8 .6a) 246 6NFO = NFE - (C - n + d
(8.6b) 246
Net financia l expense (NFE) 243 NFA net financial assets Net financia l income (NFI) 243 NFE net financia l expense Net operating assets (NOA) 242 NFI net financial income Operating asset (OA) 241 NFO net financial obligations Operat ing expense (OE) 243 NOA net operating assets Operating income (01) 243 OA operating assets Operat ing liabil ities (OL) 241 OE operat ing expense Operat ing revenue (OR) 243 0 1 operating income
OL operating liabil ities OR operating revenue
252 Part Two The Analysis of Financial Statements
Concept Questions
A Continuing Case: Kimberly-Clark Corporation
A Self-Study Exercise
Kimberly-Clark's financial statements for 2010 are presented in Exhibit 2.2 as part of the the continuing case for Chapter 2. Over the next three chapters, you will be reformulating these statements following the design in this chapter. Then, in Chapters 12 and 13 you will be performing a full analysis of the reformulated statements in preparation for valuing the company in Part Three of the book. This module of the continuing case prepares you for what is to come.
You will be helped by delving into the full 10 -K report for 2010. Download it from the SEC's EDGAR Web site and go through the footnotes to the financial statements. You will be referring to these footnotes constantly over the next few chapters, so get a sense of their layout. The detail is not important at this stage, b ut do familiarize yourself with the broad content. The KMB case for Chapter 2 gives download instructions. If, for some reason, you have difficulty downloading the 10-K, it is on the Web page for chapter 2 on the book's Web site.
THE TREASURER'S RULE Using the cash flow statement for 2010 in Exhibit 2.2 in Chapter 2 and any other information you glean from the 10-K, lay out the sequen ce that concludes with the treasurer's trading in debt, as in Box 8.1.
Now take this information and present it in th e form of a summary cash flow statement (as in Box 8.2) that obeys the equation: Free cash flow = Distributions to shareholders + Distributions to net debtholders. One question y ou will have to resolve is the treatment of the increase in cash and cash equivalents of $78 million over the year.
IDENTIFYING OPERATING ACT IVITIES The rationale for the reformulation of the financ ial statements sketched out in this chapter is to separate operating activities from financing activities. Typically value is generated in operating activities- trading with customers and suppliers- not in financing activities that merely involve passing cash to and from investors. Reformulation sets us up to examine value added. You will carry out a full reformulation of Kimberly-Clark's balance sheet and income statement in Chapter 10. For now, go through the balance sheet and income statement in Exhibit 2.2 and identify those items you think are involved in operations and those involved in financing activities. If you are ambitious, you can follow through and calculate totals for net operating assets, net financial obligations, operating income, and net financial expenses. You could also set up a stocks and flow diagram like the one for Nike in Box 8.3, but you best wait until Chapter 10.
C8. l. Why can free cash flow be regarded as a dividend, that is, as a distribution of value rather than the value created?
C8.2. A firm has positive free cash flow and a net dividend to shareholders that is less than free cash flow. What must it do wi th the excess of the free cash flow over the dividend?
C8 .3. How can a firm pay a dividend with zer o free cash flow?
Chapter 8 Viewing the Business Through the Financial Statements 253
C8.4. Distinguish an operating asset from a financial asset.
C8.5. Distinguish an operating liability from a financial liability.
C8.6. If an analyst has reformulated balance sheets and income statements, she does not need a cash flow statement to calculate free cash flow. True or false?
C8.7. What drives free cash flow?
C8.8. What drives dividends?
C8.9. What drives net operating assets?
C8. l 0. What drives net financial obligations?
C8 .1 l. Free cash flow does not affect common shareholders' equity. True or false?
C8. l 2. Explain why profitable companies sometimes have negative free cash flows (like General Electric in this chapter).
Exercises Drill Exercises
E8.1. Applying the Cash Conservation Equation (Easy} a. A firm generated $143 million in free cash flow and paid a net dividend of$49 million
to shareholders. How much was paid to debtholders and debt issuers? b. A firm paid a dividend to shareholders of $162 million and repurchased stock for
$53 million. There were no share issues. The firm received net cash of$86 million from debt financing transactions. What was its free cash flow?
E8.2. A Question for the Treasurer (Easy} A firm generated $220 million in free cash flow. It paid out $35 million in dividends and there were no share issues or repurchases. It incurred $6 million in net interest expense (after tax). The boss wants to know what happened to the amount left over. Your answer is: a. Impossible to track it. b. It must have been spent on paying down debt or invested in interest-bearing debt. c. It has been invested back into the business operations. d. Most likely some combination of(b) and (c) .
E8.3. What Were the Payments to Shareholders? (Easy} a. A firm generated $410 million in free cash flow and spent $340 million of this paying
net interest and buying down its net debt. What was the net payout to shareholders? b. The same firm issued shares for $50 million and there were no share repurchases. What
was the cash dividend paid to shareholders?
E8.4. Applying the Treasurer's Rule (Medium} a. A firm generated free cash flow of $2,348 million and paid net interest of $23 million
after tax. It paid a dividend of $14 million and issued shares for $54 million. There were no share repurchases. What did the treasurer do with the remaining cash flow and for how much?
b. A firm generated a negative free cash flow of $1,857 million, but the board of directors, understanding that the firm was quite profitable, maintained the dividend of $1 .25 per share on the 840 million shares outstanding. The firm also paid $32 million in net interest (after tax). What are the responses open to the treasurer?
E8.5. Balance Sheet and Income Statement Relations (Easy} a. A firm holding $432 million in interest-bearing financial assets and with financing debt
of $1,891 million, reported shareholders ' equity of $597 million. What were its net financial assets? What were its net operating assets?
b. The same firm reported $108 million in comprehensive income and net financial expense, after tax, of $4 7 million. What was its after-tax operating income?
254 Part Two The Analysis of Financial Statements
ES.6. Using Accounting Relations (Medium) Below are a balance sheet and an income stateme nt that have been reformulated according to the templates laid out in this chapter. Ignore in come taxes.
Balance Sheet
Assets Liabilities and Equity
2012
Operating assets 205.3 Financial assets 45.7
251 .0
Operating revenues Operating expenses Operating income Interest revenues Interest expenses Comprehensive income
a. How much was paid out in net dividends during 2012? b. What is free cash flow for 2012?
ES.7. Using Accounting Relations (Medium)
2012
40.6 120.4 90.0
251.0
134.5 (112.8) ----n-:7
2.5 (9.6)
----;Lf6
2011
34.2 120.4 77.3
231.9
Below are financial statements that have been reformulated using the templates in this chapter. Some items are missing; they are indica ted by capital letters.
Revenues
Operating expenses Cost of sales
Income Statement Six Months to June 30, 2012
Research and development expenses Selling, administrative, and general expenses Other operating expenses, including taxes
Operating income after tax Net financial expenses after tax Interest expense Interest income
Comprehensive income
A
2,453 507
2,423 2,929 B
850
153 c 59
791
Chapter 8 Viewing the Business Through the Financial Statements 255
Cash Flow Statement Six Months Ending June 30, 2012
Cash flow from operations Cash investment Free cash flow
June 2012
G 7,424
18,470 33,088 ---
Net dividends (dividends and share repurchases - share issues) Payment to net debtholders Total financing flows
December 2011
8,747 6,971
H -F-
584 I J K L M
a. Supply the missing numbers using the accounting relations laid out in this chapter. b. What were the total new operating accruals in the first half of 2012? c. How much new net debt was issued during this period?
EB.8. Inferences Using Accounting Relations (Hard) A firm with no financial assets or financial obligations generated free cash flow of $8.4 million in 2009. At the end of 2008 it had a market value of $224 million, or 1.6 times book value. At the end of 2009 it had a market value of $238 million, twice book value.
a. What was the rate of return from investing in the stock of this firm for 2009? b. What were the earnings for this firm for 2009?
Applications
EB.9. Applying the Treasurer's Rule: Microsoft Corporation (Medium) At the end of its June 30, 2008, fiscal year, Microsoft Corporation reported $23.7 billion in short-te1m interest-bearing investments and cash equivalents. The firm had no debt obligations. Subsequently, in September of that year, the firm announced a $40 billion stock repurchase and its intention to raise the annual dividend to 52 cents a share, from 44 cents, or to a total of $4. 7 billion.
Cash flow from operations for fiscal year 2009 was projected to be $23.4 billion, up from $21.6 billion for 2008; interest receipts were expected to be $702 million; and the firm was expected to maintain cash investment at the 2008 level of $3 .2 billion. Cash receipts from the issue of shares to employees were expected to be $2.5 billion. The firm's tax rate is 36 percent.
a. By applying the treasurer's rule, lay out the strategy for Microsoft's treasurer for managing cash flows.
b. Microsoft is actively looking for acquisitions to enhance its presence in the Web search and Web applications area. What would be the effect on the treasurer's plan if Microsoft decided to make a $4.2 billion cash acquisition?
256 Part Two The Analysis of Financial Statements
c. For many years, Microsoft has carried no debt (obligations). At the time of the share repurchase announcement, Microsoft also sai d that it had received authorization from its board of directors for debt financing up to $6 billion. Why would the management seek such authorization at this stage?
Real World Connection Exercises dealing with Microsoft are El.6, E4.14, E6.12, E9.9, El 1.11 , El8.10, and E20.4. Also see Minicases M9.l and Ml3 .2.
ES.10. Accounting Relations for Kimberly-Clark Corporation (Medium) Below are summary numbers from reformulated balance sheets for 2007 and 2006 for Kimberly-Clark Corporation, the paper products company, along with numbers from the reformulated income statement for 2007 (in milli o ns).
Operating income (after tax) Net financial expense (after tax)
a. Calculate the following for 2007 and 2006: (i) Net operating assets. (ii) Net financial obligations. (iii) Shareholders' equity.
b. Calculate free cash flow for 2007.
2007
$ 18,057.0 6,011 .8
382 .7 6,496.4
2.740.1 147.1
2006
$16,796.2 5,927 .2
270 .8 4,395.4
c. Show that the accounting relation for change in net operating assets (equation 8.5 in the chapter) works for Kimberly-Clark.
d. What was the net payment to shareholders (the net dividend) in 2007?
Real World Connection Follow Kimberly-Clark through the continuing c ase at the end of each chapter. Also see Exercises E4.9, E7.16, El 1.10, and El2.6, and Minicases M2.l and M5.3.
