CHAPTER 2

Financial Statements and Cash

Flows.

1
 The Annual Report Consists of the
balance sheet,
sheet Income Statement
Statement,
Statement of Retained Earnings,
and the Statement of Cash Flows.
 Balance sheet – provides a snapshot of a firm firm’ss
financial position at one point in time.
 Income
o statement
a – summarizes
u a a firm’s revenuesu and
a d
expenses over a given period of time.
 Statement of retained earnings – shows how much of
th fi
the firm’s
’ earnings
i were retained,
t i d ratherth than
th paid id outt
as dividends.
 Statement of cash flows – reports the impact of a firm’sfirm s
activities on cash flows over a given period of time.
2
Balance Sheet: Assets of Fortune Corp.
% Change

2006 2005
Cash ,
7,282 57,600
,
A/R Accounts Receivable 632,160 351,200
Inventories 1,287,360 715,200
Total CA Current Assets 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less: Dep. Depreciation 263,160 146,200
Net FA Fixed Assets 939,790 344,800
T l Assets
Total A 2,866,592 1,468,800
3
Balance sheet: Liabilities and
Equity of Fortune Corp.
2006 2005
Accts payable 524,160 145,600
N t payable
Notes bl 636,808 200,000
Accruals 489,600 136,000
Total CL 1 650 568
1,650,568
Current Liabilities
481 600
481,600
Long-term debt 723,432 323,432
Common
Co o stock
stoc 460 000
460,000 460 000
460,000
Retained earnings 32,592 203,768
Total Equity 492,592
, 663,768
,
Total L & E 2,866,592
Liabilities and Equity
1,468,800
4
Income statement of Fortune Corp.

2006 2005
Sales 6,034,000 3,432,000
COGS Cost of Goods Sold 5 528 000
5,528,000 2 864 000
2,864,000
Other expenses 519,988 358,672
EBITDA Earnings before interest taxes
(13,988) 209,328
depreciation and amortization

Depr. & Amort.

Depreciation and Amortization
116,960 18,900
EBIT Earnings before interest and taxes ((130,948)) 190,428
Interest Exp. expense 136,012 43,828
EBT Earnings before taxes (266,960) 146,600
Taxes (106 784)
(106,784) 58 640
58,640
Net income (160,176) 87,960
5
 Whyy iss Dep.
ep And
d Amort.
o t in Income
co e
statement and balance sheets of
Fortune Corp
Corp. different?
Depreciation in balance sheet is an accumulation of several income
statement depreciations
depreciations.

6
Other data for Fortune Corp.
2006 2005
No. of shares 100 000
100,000 100 000
100,000
EPS Earnings per share -$1.602 $0.88
DPS Dividend per share $0 11
$0.11 $0 22
$0.22
Stock price $2.25 $8.50
Lease pmts Payments $40 000
$40,000 $40 000
$40,000

7
 (
(2006)) Statement of Retained
Earnings for Fortune Corp.
Retained earnings, 31 Dec. 05
(
(See slide
l d 4 Balance
l Sheet)
h ) $203 768
$203,768
Add: Net income, 2006 (Slide
5 income statement) (160,176)
Less: Dividends paid (Slide 7) (11,000)
Retained earnings, 31 Dec. 06
$32,592
$ ,
(See slide 4 Balance Sheet)
8
 Statement of Cash Flows
(2006) for Fortune Corp.
OPERATING ACTIVITIES
Net income (Slide 5 income statement) (160,176)
Add (Sources of cash):
Depreciation (Slide 5) 116,960 -160,176+116,960 net cash flow

Increase in A/P (524 160 145,600

(524,160- 145 600 Slide
Slid 4) 378 560
378,560
Accounts payable

Increase in accruals (489,600- 136,000) 353,600

Subtract (Uses of cash):
Increase in A/R (632,160- 351,200 Slide 3) (280,960)
Accounts receivable

Increase in inventories ((572,160)

, )
Net cash provided by ops. (164,176) Operations
This figure comes from asset-side of balance sheet.
9
 Available Cash balance (2006)
( )
for Fortune Corp.
L-T INVESTMENT ACTIVITIES
Long term Now we include cash from liability side of balance sheet

Investment in fixed assets (slide 3) 1,202,950 - 491,000

(1) (711,950)
FINANCING ACTIVITIES 436,808
436 808
Increase in notes payable (slide 4)
Increase in long-term debt (slide 4) 400,000
Payment of cash dividend (slide 7) (11,000)
Net cash from financing 825,808
825 808
Net Cash provided by Operations
(2)

From slide 9.
(3) (164,176)
------------------------------

NET CHANGE IN CASH (slide 3) (1+2+3) (50 318)

(50,318)
Plus:Cash at beginning of year(slide 3)
57,600
Cash at the end of year (slide 3) 7 282
7,282
10
 What can you conclude about
Fortune’ss financial condition from
Fortune
its statement of CFs ? cash flows

 Cash Flow (out) or Net cash from operations

(slide 9) = -$164,176,
$164,176, mainly because of
negative NI net income

 The firm
Th fi borrowed
b d heavily
h il ($825,808
($825 808 nett cashh
from financing) to meet its cash needs (slide 10)
 Even after borrowing, the cash account fell by
$50,318 (slide 10) .
11
 Did the expansion create additional Net
Operating Profits After Taxes for Fortune
Corp. (NOPAT)?
NOPAT = EBIT (1 – Tax rate)
= Earnings after taxes and before interest.
(slide 5)
NOPAT05 = 190,428(1 – 0.4)
= 190,428(0.6)
= 114,257
Can we do … ?
NOPAT06 = -$130,948(1 – 0.4) = -$78,569
But we don’t pay taxes on losses
Yes, we get a smaller negative number
Why expansion? Sales, COGS, inventories grew
Why we calculate NOPAT when we have NI? (next slide)
12
What is the difference between
NOPAT and Net Income?
 NOPAT is before interest, net income is
after interest.
 NOPAT is theoretical, because this is
not how we pay taxes.
taxes It is useful for
ignoring the effect of debt financing on
profits through a reduction in taxes.
taxes

13
Whatt effect
Wh ff t did th
the expansion
i have
h on NOWC
net operating working capital of Fortune Corp. ?
Current Non-Interest
NOWC = -
assets bearing CL current liabilities

From balance sheet in Slide 3 and 4

NOWC06 = ($7,282 + $632,160 + $1,287,360)

– ( $524,160
$ + $489,600)
$
= $913,042

NOWC05 = $842,400

14
What effect did the expansion have
on operating capital?
Operating capital =NOWC +
Net operating working capital

Net Fixed Assets

From Slide 3
Operating Capital06 = $913,042 + $939,790
= $1,852,832

Operating Capital05 = $1,187,200

15
 Operating capital Can be Calculated
in another way.
Operating capital =Total Liabilities and Equity – Non-Interest
Bearing Liabilities

Since, non-interest bearing liabilities are mainly accruals and

accounts payable (trade payables), they are not capital. Liability
to a subsidiary and other similar non-interest bearing liabilities
may also exist.

From Slide 4
Operating Capital06 = $2,866,592
2 866 592 - 524,160
524 160 - 489,600
489 600
= $1,852,832

Operating Capital05 = $1,187,200

16
What is your assessment of the
expansion’s effect on operations?
2006 2005
Sales $6,034,000 $3,432,000
NOPAT Net operating profits after taxes -$78,569 $114,257
NOWC Net operating working capital $913 042
$913,042 $842 400
$842,400
Operating capital $1,852,832 $1,187,200
Net Income -$160 176
-$160,176 $87 960
$87,960
An extreme discount strategy?

17
What effect did the expansion have on
net cash flow and operating cash flow?
From Slide 5 or 8

NCF06 = NI + Dep = ($160,176) + $116,960

depreciation

= -$43,216
$43,216
NCF05 = $87,960 + $18,900 = $106,860
From Slide 11

OCF06 = NOPAT + Dep

D
net operating profits after taxes

= ($78,569) + $116,960
= $38,391
$38 391
OCF05 = $114,257 + $18,900
= $133,157
$ ,

18
 What is the free cash flow
(FCF) for 2006?
FCF = OCF – Gross capital investment how do I get the second formula from the first one?
or
FCF06 = NOPAT – Net capital investment
Net operating profit after taxes

Net capital investment = This year’s Operating Capital – Last

year’ss Operating Capital
year
From slide 12 get NOPAT = -78,569 and from slide 15 get Net Capital investment

= -$78,569 – ($1,852,832 - $1,187,200)

= -$744,201

Is negative free cash flow always a bad sign?

OCF = NOPAT + Dep. ; Gross Capital investment = Net Capital Investment + Dep.

19
Solution
OCF = NOPAT + Dep
net operating profits after taxes

FCF = NOPAT – Net capital

Net operating profit after taxes

investment
FCF = OCF – Dep – Net capital investment
FCF = OCF – (Net capital investment + Dep)
FCF = OCF – Gross capital investment

20
 Economic Value Added (EVA)
EVA = After-tax __ After-tax
p
Operating g Income Cost of total Capital
p
(before interest)
Stern and Stewart Consulting Firm
= Funds Available __ Cost of total
to Firms Capital Used
= NOPAT Net operating profit after taxes – After
After-tax
tax Cost of Capital
21
 EVA Concepts
 In order to generate positive EVA, a firm has to
more than just cover operating costs
costs. It must
also provide a fair return to those who have
provided the firm with capital.

 EVA takes into account the total cost of capital,

which
hi h includes
i l d both
b th the
th costt off equity
it andd debt.
d bt

 EVA does not g

get inflated byy the debt tax shield.

22
 What is Fortune’s EVA ? Assume Economic value added

the firm
firm’ss after
after-tax
tax cost of capital was
10% in 2005 and 13% in 2006.
EVA06= NOPAT net operating profit after taxes – (% A-T after tax cost of capital)(Operating
Capital) = -$78,569 – (0.13)($1,852,832)
= -$78,569 - $240,868
= -$319,437
Forget about playing with tax shield of debt, forget about playing with paying non-interest paying liabilities late, what value did you create!

EVA05= $114,257 – (0.10)($1,187,200)

= $114,257
$114 257 - $118,720
$118 720
= -$4,463
EVA is an objective finance measure of management performance. The verdict: the management of Fortune performed poorly for two years in the row
and they are getting worse!

23
 Did the expansion
p increase or
decrease MVA ? Market value of assets

MVA = Market value __ Market value of Equity

of equity now capital last year

During the last year, the stock price has decreased

73% As
73%. A a consequence, theth marketk t value
l off
equity has declined, and therefore MVA has
declined,, as well.
Loss in MVA = (2.25 - 8.50) (100,000) = $625,000
Percent loss in MVA ((8.5 – 2.25)) / 8.5 = 73%

24
Does Fortune p
payy its suppliers
pp
on time?
 Probably not.
 A/P increased 260%
260%, over the past
year, while sales increased by only
76%.
76%
 If this continues, suppliers may cut
off Fortune’s trade credit
credit.

25
Does it appear that Fortune’s
Fortune s sales
price exceeds its cost per unit sold?
 Sales do not seem to cover the costs.
 The negative NOPAT and
net operating profit after taxes

decline in cash position shows that

Fortune corp. is spending g more on its
operations than it is taking in.
 Increase price, stop discounting is a
way to improve EVA.

26
 What if Fortune’s sales manager decided
to offer 60
60-day
day credit terms to customers
customers,
rather than 30-day credit terms?
 If competitors match terms, and sales remain
constant …
 A/R
/ wouldld 
accounts receivables

 Cash would 

 If competitors don’t
don t match
match, and sales double …
 Short-run: Inventory and fixed assets  to
meet increased sales. A/R , Cash .
Company may have to seek additional financing.
 Long-run: Collections increase and the
company’ss cash position would improve.
company improve
27
How did Fortune finance its
expansion?
 Fortune financed its expansion with
external capital.
 Fortune issued long-term debt which
reduced its financial strength and
flexibility.

28
Would Fortune have required external
capital if they had broken even in 2006
(Net Income = 0)?

 The company would still have to finance

its increase in assets. Looking at the
Available Cash Balance in slide 10, we
see that the firm made an investment
of $711,950 in net fixed assets.
Therefore, they would have needed to
raise additional funds.

29
What happens if Fortune 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, due to a
reduction in taxes paid.

30
International Financial Reporting
Standards (IFRS)
 IFRS since 2001 and formerly International
Accounting Standards (IAS) between 1973 and 2001.
Mainly followed by Europeans.
 US follows FASB which is issued by US GAAP since
1939.
1939
 FASB and IFRS are converging.
 GAAP Generally accepted accounting principals in the
rest of the world is mostly FASB based.
 Germany uses HGB, German Financial accounting.

31
European Income Statement
INCOME STATEMENT (compare with slide 5)
 NET SALES (What does net mean?)
 Other Operating Income (sold an old fixed asset)
 Total Operating Income
 Raw materials and production input
 Labor cost
 Amortization/depreciation expense (Depr. & Amort.)
 Other expenses
 Total expenses
 Operating profit before financing costs (EBIT)
 Financial Income
 Financial
a c a Expenses
pe ses
 Net financing costs (interest)
 Profit before Tax (EBT)
 Income Tax Expense (Taxes)
 Net Income ((Loss))
Bold items are the same under GAAP and IFRS

32
Income Statement
2006 2005
NET SALES 6,000,000
Other Operating Income 34,000
Total Operating Income 6,034,000
Complete
p
Raw materials and production input
Labor cost
2,528,000
as an
Amortization/depreciation expense
3,000,000
116,960
exercise.
Other expenses 519 988
519,988
Total expenses 6,164,948
Operating profit before financing costs (130,948) EBIT
Financial Income 1000
Financial Expenses 137,012
Net financing costs 136,012
Profit before Tax (266,960) EBT
Income Tax Expense
(106,784)
Net Income (Loss) (160,176)
33
US GAAP vs. EU IFRS (slide 5 & 35)
 In IFRS, Total Operating Income of 6,034,000 is broken down to NET
SALES of 6,000,000 and Other Operating Income of 34,000. In US
GAAP all income was reported under sales as 6,034,000.
 In IFRS costs of 5,528,000 are broken down to Raw materials cost and
production input costs of 2,528,000 and Labor cost of 3,000,000 in
GAAP all variable costs are reported under COGS as 5,528,000.
 In IFRS, EBITDA is not reported. EBIT is reported as operating profit
before financing costs of (130,948) to which amortization and
depreciation of 116,960 may be added to calculate the EBITDA.
 In IFRS interest expense of GAAP is broken down to financial income
and financial cost and then added to show net financing costs.
 The last three entries of IFRS are exactly the same as US-GAAP. EBT is
called Profit before taxes.

34
 Imperial Tobacco Report in IFRS
and GAAP
 Imperial Tobacco
http://www wwwimperialtobacco com/files/financial/results/ir
http://www.wwwimperialtobacco.com/files/financial/results/ir
2006/index.asp?pageid=28
 IFRS shows a less conservative accounting of profits (worse

than GAAP in accounting of pensions, employee benefits,

and amortization of intangible assets)
 IFRS shows a more conservative accounting of equity book

value (better than GAAP in accounting for M&A related

goodwill).

35
IFRS vs. US GAAP Differences
 IFRS vs. US GAAP

36
 Income Statement
 Is called P&L or Profit and Loss Statement or In
German Gewinn und Verlust Rechnung: GUV (geh
uh fau)) or Win and lost accounting g
 A major issue in German accounting system is that
interest income from workers’ pension may be
deducted from labor costs or reported as interest
i
income att the
th di
discretion
ti off th
the fi
firm. S Some fi
firm’s
’
have used this option to show a reduced labor cost
and to artificially increase profits in lean years.
 I th
In the past, t some GGerman fifirms h have added
dd d their
th i
net income from subsidiaries to their total operating
income in order to imply that their own expenses
are a smaller percentage of their revenues
revenues.

37
What Is SG&A
 Selling General and Administrative costs
 It comes after COGS and is subtracted
from Sales

38
Other Common Terminology
Sales
S l Net Sales (Sales – Returns)
COGS Cost of Goods Sold - COGS___
Gross Margin
g (includes only the variable costs)
Other expenses - SG&A Selling General and administrative costs
EBITDA Earnings before interest taxes EBITDA
depreciation and amortization

Depr. & Amort

Depr Amort. Depreciation and Amortization - D&A
EBIT Earnings before interest and taxes EBIT
Interest Exp. Expense - Interest
EBT Earnings before taxes EBT
Taxes - Taxes
Net income Net income

39
Disney’s annual Report
 Would you loan money to Disney?
 Comment on Films as an asset.
asset

 Disney Case

40