FINC 3310 CHAPTER TWO

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FINC 3310 CHAPTER TWO

• REVIEW OF FINANCIAL STATEMENT BASICS

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Abbreviations, Acronyms, and Symbols used in
these notes

• EBIT earnings before interest and taxes, also
  known as operating income
• CF cash flow
• OCF operating cash flow
• NWC net working capital
• CA current assets
• CL current liabilities

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I. The Balance Sheet
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I. The Balance Sheet

• This is a "point in time" representation of the
  firm's assets, liabilities, and equity.
• The left-hand side accounts are investments that
  reflect carefully considered decisions which
  should produce some pay-off for the corporation.
• The right-hand side accounts reflect the firm's
  sources of financing.

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A POINT TO NOTE The Balance Sheet and Firm Value

• The balance sheet does not reflect market values.
  Why?
• A L do not represent current, but rather
  historical, values (and there is also the
  problem of depreciation)

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The Balance Sheet and Firm Value, continued

• Intangible assets may be excluded. These can
  often be the most important assets of the firm!
  Examples
• Some liabilities are understated or omitted, like
  contingent payouts. Examples
• Consequently, lets start thinking of the
  financial balance sheet

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The Financial Balance Sheet

• Focuses on cash flows
• Records the current values of left-hand side
  investments made by the firm and the current
  value of right-hand side claims
• Is not observable its condition is determined by
  analysis

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The Financial Balance Sheet
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II. The Income Statement
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II. The Income Statement

• The idea of the income statement is to capture
  the "flow" of revenues and costs through the firm
  over a specified period of time
• PROBLEM we want to measure economic income, and
  accounting income does not really do this. In
  accounting terms a firm could be profitable, yet
  be sustaining economic losses.

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Accounting Income and Cash Flow

• THE KEY is cash flow! Shareholders are more
  interested in cash flow than earnings reported.
  What can cause cash flow to be different from
  accounting income?
• cash versus accrual accounting
• non-cash items

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GAAP versus Cash Flow Time Line

• Revenue
• recognized
• and
• matched
• expenses
• Sale of goods
• on credit
• Time
• Pay Payroll Pay Collect
• for raw checks utilities accounts
• goods issued receivable
• Cash flow Cash flow Cash flow Cash flow

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A Few Conclusions about Financial Statements

• We should be somewhat skeptical of reported
  income and earnings per share data, right? But,
  we do have to use these, and understanding how
  the numbers are created helps us be better users
  of the information in the statements.
• Again, think about financial, or valuation
  effects, rather than just accounting statement
  numbers.

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Measuring Cash Flow

• Using the balance sheet identity, we can say
  cash flow has an "identity" also
• Cash flow from assets
• Cash flow to creditors
• Cash flow to shareholders
• This value is often called free cash flow and
  is an important measure of the firms performance
  over time.

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Cash Flow from Assets, or CF(A)(Note that this
departs slightly from the text treatment!)

• Operating Cash Flow
• This is basically Revenue - Expenses
• Do not include depreciation in expenses - this is
  non-cash
• Do not include interest...this is financial
• OCF EBIT(1 t) D
• Capital Spending (looking at changes in fixed
  assets)
• Capital spending (Ending balance - Beginning
  balance) Depreciation

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CF(A) continued

• Additions to NWC
• Ending NWC - Beg NWC DNWC
• Recall NWC CA-CL

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Putting it all together

• CF(A) OCF - Capital Spending - DNWC
• CF(A) can be negative...is this automatically bad?

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The Other Side of the Equation Cash Flows to
Creditors and Stockholders

• Cash Flow to creditorsInterest Paid(1-t) - Net
  new borrowing
• Cash Flow to Stockholders Dividends - Net new
  equity

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Balance Sheet as of December 31( in thousands)

• Assets 2005 2006
• Current assets
• Cash 45 50
• Accounts receivable 260 310
• Inventory 320 385
• Total 625 745
• Fixed assets
• Net plant and equipment 985 1100
• Total assets 1610 1845

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Balance Sheet (concluded)

• Liabilities and equity 2005 2006
• Current liabilities
• Accounts payable 210 260
• Notes payable 110 175
• Total 320 435
• Long-term debt 205 225
• Stockholders equity
• Common stock and paid-in surplus
  290 290
• Retained earnings 795 895
• Total 1085 1185
• Total liabilities and equity 1610 1845

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Income Statement ( in thousands)

• Net sales 710.00
• Cost of goods sold 480.00
• Depreciation 30.00
• Earnings before interest
• and taxes 200.00
• Interest 20.00
• Taxable income 180.00
• Taxes 53.45
• Net income 126.55
• Dividends 26.55

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Cash Flows from Assets

• Operating cash flow
• EBIT(1-t) 140.61
• Depreciation 30.00
• 170.61
• Net capital spending
• Ending net fixed assets 1,100.00
• Beginning net fixed assets 985.00
• Depreciation 30.00
• 145.00
• Change in net working capital
• Ending net working capital 310.00
• Beginning net working capital 305.00
• 5.00
• Cash flow from assets 20.61

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Cash Flows from Assets (concluded)

• Total cash flow to creditors and stockholders
• Cash flow to creditors
• Interest paid(1-t) 14.06
• Net new borrowing 20.00
• -5.94
• Cash flow to stockholders
• Dividends paid 26.55
• Net new equity raised 0.00
• 26.55
• Cash flow to creditors and stockholders 20.61

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III. The Statement of Cash Flows

• We have been considering only aggregated data,
  but now we want to look at the individual "cash
  events" that provide the "total" figures we have
  used. We want to construct a Statement of Cash
  Flows or Statement of Sources Uses of Cash.
  The key is properly identifying the sources and
  uses.

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Sources and Uses of Cash

• increases in assets are uses
• increases in liabilities and equity are sources

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Statement of Cash Flows format

• Operating activities
• Net income
• Depreciation
• Any decrease in current assets (except cash)
• Any increase in current liabilities
• - Any increase in current assets (except cash)
• - Any decrease in current liabilities

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Statement of Cash Flows format, continued

• Investment activities
• Ending fixed assets
• - Beginning fixed assets
• Depreciation
• Financing Activities
• - Change in notes payable
• - Change in long-term debt
• - Change in common stock
• - Dividends

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Statement of Cash Flows

• Operating activities
• Net income 126.55
• Depreciation 30.00
• Increase in payables 50.00
• Increase in receivables 50.00
• Increase in inventory 65.00
• 91.55
• Investment activities
• Ending fixed assets 1,100.00
• Beginning fixed assets 985.00
• Depreciation 30.00
• (145.00)

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Statement of Cash Flows (concluded)

• Financing activities
• Increase in notes payable 65.00
• Increase in long-term debt 20.00
• Dividends 26.55
• 58.45
• Putting it all together
• 91.55 145.00 58.45 5.00