Depreciation and Cash versus Income (2)

• Cash flow from operations measures whether the

basic business is throwing off cash. It ignores the one
time items in other income.
– Is equal to operating income + depreciation

• Net cash flow or total cash flow includes all

extraordinary items. It is the “acid test” for cash: does a
company generate more cash than it consumes.
– Is equal to net income + depreciation + writedowns

• Negative cash flow creates a crisis.

– Vendors tend to stop delivering, and banks call loans.
Depreciation and Cash vs Income – Exam Item #1

• You borrow $3 million for a three year term and combine

it with your equity to buy a business. The business is
essentially debt free before you buy it and has a steady
net income of $0.8 million/year. Depreciation runs at
$0.4 million/year.

• Questions:
– Can you repay the debt? Explain
Depreciation and Cash vs Income – Exam Item #2

• You study three companies:

A B C
Revenue $12.6 $12.6 $12.6
– COGS $8.1 $8.1 $8.1
= Contribution Margin $4.5 $4.5 $4.5
– SG&A excl. Deprec. $2.5 $4.7 $4.7
– Depreciation $3.0 $0.6 $0.6
= Operating Income ($1.0) ($0.8) ($0.8)
+ Other Income ($0.5) - $1.8
= Net Income ($1.5) ($0.8) $1.0
• Question:
– Which one of these companies would you most prefer
to own? Explain.
 Balance Sheets
• A balance sheet is a snapshot of a business’s financial
position at a point in time (usually the last day of the
accounting period).
– Also called a position statement.
statement

• The balance sheet balances a business’s assets against

its liabilities, and owner’s equity:
Assets = Liabilities + Equity

• Assets include current assets and fixed assets.

assets
• Liabilities include current liabilities and long-term
liabilities.
liabilities
• Owner’s equity includes shares and retained earnings.
earnings
 Balance Sheets (2)
• Assets:
– If the asset is useful, it is recorded at book value (the
lesser of original cost minus depreciation or market
value).
• If market value is higher, it is never recognized in
advance of being realized.
– If it is useless or worn out, it is written off.
• depreciation and writedowns
– Accounting is always conservative.
• In times of high inflation, book values deviate from
real values
– Some long-term assets are intangible.
intangible
• Something that can’t be seen or touched but has
value to a company
 Balance Sheet Format

Assets: Liabilities:
Current: Cash Current: Short Term Credit Line
Receivables Accounts Payable
Short Term Notes Accrued Expenses
Inventory Taxes Payable
Prepaid Expenses Curr. Port. Of L-T Debt

Fixed: Land, Bldgs, & Equip Long Term: Long Term Debt
less Accum Depreciation Repayable Grants

Long Term Investments Shareholder’s Equity:

Capital Shares
Goodwill and Intangible Assets Retained Earnings
Sample Balance Sheet #1
Sample Balance Sheet #1 (2)
Sample Balance Sheet #2
 Balance Sheets: General Observations

• Typically use a one year rule for current assets and

liabilities.
• List assets in ascending order of liquidity.
– Cash at top, then receivables, and so on.
• Prepaid expenses are bills paid annually but tracked
monthly or quarterly.
• Fixed assets usually list the purchase value as well as an
accumulated depreciation as a reduction.
– This gives the ability to have a sense of the “age” of
the assets.
• Capital shares (cash injection) are distinguished from
retained earnings (cash retention).
 Goodwill and Intangibles

• Goodwill is the premium you paid to purchase a

company.
– Equivalent to the purchase price minus the book
value of the business.
– Goodwill can be depreciated, just like any other asset.

• Intangible assets can be depreciated as well.

– e.g., patents have a finite lifetime
 Working Capital
• Working capital is the difference between current assets
and current liabilities.
– The extra cost of being in business over and above
fixed assets.
– A good measure of a company's efficiency and its
financial health.
• Working capital ratio is current assets divided by
current liabilities.
• Adequacy of working capital is one key test for the
provision of a short term credit line by a bank.
– A positive working capital means you can pay off your
short-term liabilities.
– A negative working capital means you can’t meet your
short-term liabilities with your current assets.
 Working Capital (2)

• Working capital generally increases with sales level.

– Typically, inventory, payables and receivables are
proportional to sales.
– Failure to recognize this has sunk many a business.

• Inventory and receivables are often measured in terms of days.

– As a ratio of daily sales
– Often in the 30 to 60 days range

• More businesses fail for a lack of available cash than for a lack
of profit.
 Exam Item #3: Working Capital Deficiency
• Imagine a startup “magic box” business with the following
characteristics:
– Your “rich uncle” gave you $500k to see what you could do.
– You and some friends spent two years and $400k doing the
software.
– Your losses to date from two years of prototyping are $95k.
– Your sales strategy is a CM of 50%.
– Material is 90% of COGS, contract labor is 10%.
– You are selling $25k/mo of boxes to larger companies, who
are testing the product. You are at break even.
– One company gives you an order for $1,000,000!!

• Can you supply the order? Explain.

 Example: Goodco versus Badco
• Goodco and Badco have the same income statement for
a one year period:
Revenue 650
Warranty/ Bad Debt 6
Net Revenue 644
COGS 320
Contribution Margin 324
CM, % 49.8%
Retained Earnings, start 125
SG&A
All admin except dep. 220
Net Earnings for the year 46
Depreciation 70
Less: Dividend Paid 16
Operating Income 34
Other Income 12 Retained Earnings, end 155
Net Income 46
 Exam Item #4: Goodco versus Badco (2)
• Badco and Goodco have very different balance sheets
this year.

Goodco Badco Goodco Badco

Assets Liabilities
Current ST Credit 24 174
Current Cash 22 22
Accounts Payable 48 48
Receivables 120 120 Accrued Expenses 9 9
Inventory 88 88 Taxes Payable 2 2
Prepaids 28 28 Cur. Port. of LT Debt 20 20
Total current 258 258 Total current 103 253
Fixed Cost 760 760 Long Term Debt 175 225
Less depreciation 210 210 Shareholders' Equity
Net 550 550 Capital Shares 375 175
Retained Earnings 155 155
Total assets 808 808
Total Liabilities plus Equity 808 808

Which company would you rather own? Explain.