Financial Statement, Cash Flow and Financial Forecasting

Chapter 2

Chapter 2 Learning Goals
LG1: Recall the major financial statements that firms must prepare and provide to the public LG2: Differentiate between book (or accounting) value and market value LG3: Explain how taxes influence corporate managers¶ and investors¶ decisions

LG4: Differentiate between accounting income and cash flows LG5: Demonstrate how to use a firm's financial statement to calculate its cash flows LG6: Observe cautions that should be taken when examining external financial statements

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Introduction
‡ Corporate managers must issue many reports to the public. The most attention is paid to the annual report, which contains
± Balance sheet ± Income statement ± Statement of cash flows ± Statement of retained earnings

‡ These four statements present an accounting-based picture of the firm¶s financial position. FINANCIAL ACT3211
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‡ While accountants focus on reporting what happened in the past, financial managers use financial statements to draw inferences about the future ‡ Firms must follow Generally Accepted Accounting Principles (GAAP) when creating these statements, but they still have substantial discretion
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Balance Sheet
‡ The balance sheet reports a firm¶s assets, liabilities, and equity at a particular point in time. Assets = Liabilities + Equity ‡ The left side of a balance sheet lists the assets of the firm in order of liquidity ‡ The right side of the balance sheet lists the liabilities in order of maturity. Equity, which never matures, is listed last
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Assets
‡ Assets fit into two major categories: current assets and fixed assets ‡ Current Assets
± Will normally convert into cash within a year
‡ Cash (and marketable securities) ‡ Accounts receivable ‡ Inventory

‡ Fixed Assets
± Have a useful life exceeding one year
‡ Net plant and equipment (Gross plant and equipment less accumulated depreciation) ‡ Less tangible assets, such as patents and trademarks
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Liabilities
‡ Lenders provide funds, which become liabilities to the firm. ‡ Current liabilities
± Obligations due within a year
‡ Accruals (accrued wages and accrued taxes) ‡ Accounts payable ‡ Notes payable

‡ Long-term debt
± Long-term loans and bonds with maturities of more than one year
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Equity
‡ The difference between total assets and total liabilities is the stockholders¶ (or owners¶) equity. ‡ Types of Equity
± Preferred Stock
‡ Appears as the cash proceeds when the firm sells preferred stock

± Common Stock and Paid-in-Surplus
‡ Also appear as cash proceeds when common stock is issued

± Retained Earnings
‡ When managers reinvest earnings rather than pay them out as dividends, these will be recorded as retained earnings. The retained earnings account on the balance sheet represents the cumulative amount ACT3211 retained over the years. FINANCIAL MANAGEMENT

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Managing the Balance Sheet
‡ Managers must monitor a number of issues related to the firm¶s balance sheet, including:
± The accounting method used for fixed asset depreciation ± The level of net working capital ± The liquidity position of the firm ± Whether to finance the firm¶s assets with equity or debt ± The difference between the book value reported on the balance sheet versus the true market value of the firm ACT3211 FINANCIAL
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Accounting method for fixed asset depreciation
‡ Managers can choose the accounting method they use to record depreciation against their fixed assets. ‡ For reporting purposes, companies often use the straight-line method of depreciation ‡ For tax purposes, firms often use accelerated depreciation such as MACRS ‡ Why use different methods?
± The straight-line method results in lower depreciation expenses in the earlier years, resulting in higher income for reporting to shareholders ± MACRS results in higher depreciation expenses in earlier years, leading to lower income and thus lower taxes. ± A firm will often use multiple methods for calculating depreciation for the same assets

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Net Working Capital
‡ Net Working Capital = Current assets minus current liabilities ‡ For DPH Tree Farms for 2007:
± NWC = $190 - $110 ± NWC = $ 80 million

‡ Firms monitor net working capital as a measure of the firm¶s ability to pay its obligations
± In general, a financially healthy firm has positive NWC ACT3211 FINANCIAL
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Liquidity
‡ Liquidity refers to the ability to turn an asset into cash at its fair market value. ‡ Current assets are the most liquid assets
± Cash, marketable securities, accounts receivable, and inventory ± Inventory is the least liquid of the current assets

‡ Fixed assets are less liquid ‡ Liquidity has both good and bad aspects:
± More liquidity means the firm can more easily pay its obligations and stave off financial distress, i.e. the firm is less risky ± However, liquid assets don¶t provide a very high return. Cash offers no return at all. ± Fixed assets are illiquid, but provide for generating revenue and profits ± Managers must consider the risk-return tradeoff ACT3211 FINANCIAL
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Debt vs. Equity Financing
‡ Financial leverage refers to the extent to which a firm uses debt as a source of financing ‡ Just like a lever magnifies the ability to move objects, financial leverage magnifies a firms gains and losses
± Debtholders have a fixed claim on the firm¶s cash flows (they are paid interest on their securities) ± Stockholders have a claim on whatever cash flow is left. Since the obligation to debt holders is fixed, if the firm does well stockholders do very well. If the firm does poorly, stockholders get little or nothing. ± Yet, debt increases the financial risk to the firm. If the firm can¶t make the fixed payments to debtholders, the firm faces bankruptcy

‡ Once again, managers face a tradeoff between risk and return as they decide the firm¶s capital structure
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Book Value versus Market Value
‡ A firm¶s balance sheet shows book, or historical cost, value according to GAAP ‡ Under GAAP, the value of assets on the balance sheet shows what the firm paid for them regardless of what they may be work today ‡ In most cases, book values differ widely from market values for the same assets ‡ For current assets the difference will be small, but for fixed assets the difference is likely huge ‡ Similarly, stockholders¶ equity on the balance sheet is generally greatly different than the true market value of the equity
± Book value of equity represents the historical value of contributed equity, while the market value of equity represents the value of the firm in the market, which depends on the present value of future cash flows
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Income Statement
‡ Income statements show the total revenues and expenses of a firm over a specific period of time ‡ The top line of the income statement shows the firm¶s revenues ‡ The statement then shows all of the various expenses for the firm ‡ The bottom line, or net income, represents the difference between revenues and expenses ACT3211 FINANCIAL
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‡ The top part of the income statement represents the operating income portion of the income statement. This part of the statement is generated by operating the firm, and results in operating income or EBIT ‡ The bottom part of the income statement reflects how the firm is financed and taxed
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‡ Items reported below the bottom line include:
Earnings per share (EPS) ! net income total shares of common stock outstanding

Dividends per Share (DPS) !

common stock dividends paid number of shares of common stock outstanding
common stockholders equity number of shares of common stock outstanding

Book value per share (BVPS) !

Market value per share (MVPS) ! the market price of the firm' s common stock

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Corporate Income Taxes
‡ Firms pay out a large portion of their earnings in taxes (Microsoft paid $4.4 billion in taxes in 2005, or 26 percent of EBT) ‡ The tax code is determined by Congress, and so is subject to frequent changes ‡ The tax code is extremely complex. However, since taxes are so important to firms, we will examine a general ACT3211 FINANCIAL overview of corporate taxation MANAGEMENT

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‡ The U.S. tax structure is progressive, meaning that the larger the income, the higher the tax rate ‡ Tax rates are discussed in terms of marginal tax rate, and average tax rate ‡ The marginal tax rate is the amount of taxes must pay on the next $1 in income. This is the most relevant rate for financial decision making.
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‡ The average tax rate is determined by:
Average tax rate ! tax liability taxable income

‡ The average tax rate incorporates taxes paid on past income and represents a weighted average of rates on the amount of taxable income
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Example
‡ Indian Point Kennels earned $16.5 million in taxable income in 2007. Their tax liability can be determined as:
Tax liability = Tax on base amount + tax rate (amount over base) Tax liability = $5,150,000 + .38($16,500,000 - $15,000,000) Tax liability = $5,720,000

The average tax rate = $5,720,000/$16,500,000 = 34.67%

‡ The marginal tax rate is 38 percent
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‡ Interest that corporations receive is taxable
± Exception: interest on state and local government bonds is exempt from federal taxes

‡ When corporations own stock in another corporation they may receive dividend income.
± The tax code exempts 70 percent of this income from taxation. Only the remaining 30 percent is taxed.
‡ This reduces the effect of triple taxation
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‡ Interest and Dividends Paid by the Corporation
± Interest payments appear on the income statement and are deducted from income before calculating taxable income ± Dividends, on the other hand, are paid with after-tax income and so are not tax deductible ± This tax deductibility of interest makes debt a much cheaper form of financing than equity
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Example 2-4

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Statement of Cash Flows
‡ The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial activity over a period of time. These two financial statements reflect the accrual basis of accounting required by GAAP to match revenues with the expenses associated with generating those revenues Actual cash inflows and outflows may occur at very different times than are reflected in these two financial statements. Also, the income statement contains several non-cash entries, notably depreciation Therefore, figures on an income statement do not reflect the actual cash flows of the firm. Financial managers and investors are much more interested in cash flows than accrual accounting income.

‡

‡

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‡ The statement of cash flows shows the firm¶s cash flows over a period of time. ‡ It includes only inflows and outflows of cash and marketable securities. It excludes transactions that do not directly affect cash receipts and payments, such as depreciation and write-offs on bad debts. ‡ The bottom line of the statement reflects the difference between cash sources and uses and equals the change in cash on the firm¶s balance sheet
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Sources and Uses of Cash
‡ Some activities increase cash, and some activities decrease cash. ‡ Sources of cash involve increasing liabilities (or equity) and decreasing assets. ‡ Uses of cash involve decreasing liabilities (or equity) and increasing assets. ‡ The statement of cash flows is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. ACT3211 FINANCIAL
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Cash Flows from Operations
‡ The top portion of the statement of cash flows, cash flows from operations, represents items directly associated with producing and selling the firm¶s products.
± Net income ± Depreciation ± Working capital accounts other than cash and short-term debt

‡ Many finance professionals consider this portion of the statement the most important.
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Cash Flows from Investing Activities
‡ Cash flows associated with buying or selling fixed or other long-term assets ‡ This section of the statement of cash flows reflects the firm¶s investment in fixed assets

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Cash Flows from Financing Activities
‡ Cash flows from debt and equity financing transactions
± Issuing short- or long-term debt ± Issuing stock ± Using cash to pay dividends ± Using cash to pay off debt ± Using cash to buy back stock

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‡ The bottom line of the statement of cash flows shows the total of cash flows from operation, investing, and financing activities ‡ This line reconciles to the net change in cash and marketable securities on the balance sheet over the period. ‡ In the DPH example, the income statement showed $90 million in net income, but -$1 million in cash flow
± This is because net income is accounting-based income according to GAAP and does not necessarily reflect the flow of cash
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Free Cash Flow
‡ To maintain cash flows over time, a firm must continuously replace working capital and depreciating fixed assets, and develop new products ‡ Investors are particularly interested in the cash flows available to pay the firm¶s stockholders and debtholders
± After adjustments for investments in working capital ± After adjustments for investments in fixed ACT3211 FINANCIAL assets MANAGEMENT

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FCF = Operating cash flow ± Investment in operating capital FCF = (EBIT ± Taxes + Depreciation) ± (¨Gross fixed assets + ¨Net operating working capital)

‡ Operating cash flow (OCF) ± Firms generate operating cash flow from operations after they have paid necessary taxes ‡ Investment in operating capital (IOC) ± Firms buy physical capital or earmark funds for eventual equipment replacement to sustain firm operations ± Includes the firm¶s investment in fixed assets, current assets, and spontaneous current liabilities (i.e. accounts payable and accruals)

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Example 2-5

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‡ A positive Free Cash Flow means that the firm has funds that can be distributed to investors ‡ A negative FCF might mean several things:
± If FCF is negative due to negative OCF it may indicate that the firm is experiencing operating or managerial problems ± FCF might be negative because the firm is investing heavily in operating capital to support growth
‡ In this case FCF might be negative while OCF is positive
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Statement of Retained Earnings
‡ Provides additional detail about the change in retained earnings during a reporting period ‡ Reconciles net income and dividends paid with changes in retained earnings from one period to the next:
Beginning retained earnings + net income for period - cash dividends paid = Ending retained earnings
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Cautions in Interpreting Financial Statements
‡ While firms must follow GAAP in preparing their financial statements, firms have considerable latitude in using accounting rules ± Firms can ³smooth´ earnings, for example for new managers to show growth ± Different depreciation methods ± These strategies are called earnings management ‡ Sarbanes Oxley Act of 2002 was passed in an effort to prevent deceptive accounting and management practices brought to light in highprofile scandals such as Enron and WorldCom
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