Financial

Statements
and Cash Flow
Part 2
STATEMENT OF CASH FLOWS
2
Operating Activities
• This section deals with items that
occur as part of normal ongoing
operations

4
Net Income

• First source of • Because not all

cash sales went for
• It is not equal to cash, not all costs
cash from require immediate
operations cash payments

5
Depreciation and Amortization

• The first
• Therefore, it must
adjustment
be added back to
• Allied’s net income when
accountants cash flow is
subtracted determined
depreciation, • If EBITDA was
which is a noncash
used, there is no
charge, when they
need for this
calculated net
adjustment
income

6
Increase in Inventories

• To make or buy • but ultimately, any

inventory items, increase in
inventories requires
the firm must use cash
cash. It may
receive some of • Allied increased its
this cash as loans inventories by $200
million in 2008. that
from its suppliers
amount is shown in
and workers parenthesis because
(payables and it is negative
accruals) (outflow)

7
Increase in Accounts Receivable

• If Allied chooses
to sell on credit • Once cash is
when it makes a received for the
sale, it will not sale, the
immediately get accompanying
the cash that it accounts
would have receivable will be
received had it not changed
extended credit

8
Increase in Accounts Payable

• Accounts payable
represent a loan
from suppliers • If Allied paid its
payables, this area
• Since the loan did would have been
not mean an negative
outflow of cash, it
is positive

9
Increase in Accrued Wages and Taxes

• It means that the

firm has yet to pay
• Same logic applies
($10 million) its
to this as well
workers and taxing
authorities

10
Net Cash Provided by Operating Activities

• The net result was

• The sum of all that operations led
operating activities to a $2.5 million
net cash outflow

11
Long-Term Investing
Activities
• All activities involving long-term
assets are covered in this section
• If Allied has sold fixed assets, its
accountants would have reported
it in this section as a positive
amount

12
Additions to Property, Plant, and Equipment

• Allied spent $230

million on fixed
assets during the
current year

13
Net Cash Used in Investing Activities

• The sum of all

long-term
investing activities

14
Financing Activities
• Allied’s financing activities are
shown in this section

15
Increase in Notes Payable

• Allied borrowed
an additional $50 • When the firm
million from its repays the loan, it
bank this year, will become an
which was a cash outflow
inflow

16
Increase in Bonds (Long-Term Debt)

• Allied borrowed
an additional $170
million from long-
term investors this
year, issuing bonds
in exchange for
cash

17
Payment of Dividends to Stockholders

• Dividends are paid

in cash, and that
payment is an
outflow

18
Net Cash Provided by Financing Activities

• These funds were

used to help pay
for the $230
• The sum of all the million deficit
financing entries resulting from the
fixed asset
investment and
operating activities

19
Summary
• Summarizes the change in cash
and cash equivalents over the
year

20
Net Decrease in Cash

• Resulted in a $70
million net
• Net sum of the 3 decrease, mainly
activities due to
expenditures on
new fixed assets

21
Cash and Equivalents at the Beginning of the Year

• The firm began

with $80 million
of cash

22
Cash and Equivalents at the End of the Year

• Allied ended at
$10 million which
is clearly weaker
in cash position
than it was at the
beginning of the
year

23
 A l l i ed’s statement of cash fl ows shoul d be of conce rn to
its managers and i nve stors.
A l thoug h it ’s positi ve, the fi rm can’ t conti nue to have
smaller and s malle r cash posi ti on

In the long run:

• Section 1– needs to show positive operating cash flows
• Section 2– to show expenditures on fixed assets that are about equal to
• Its depreciation changes;
• Some additional expenditures to provide for growth
• Section 3– normally shows some net borrowing in addition to a “reasonable”
amount of dividends
• Section 4– to show a reasonably stable year-to-year cash balance
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STATEMENT OF STOCKHOLDERS’ EQUITY

25
 Note that “retained earnings” represents a claim
against assets, not assets per se

• Stockholders allow management to retain earnings and reinvents them in

the business, use retained earnings for additions to plant and equipment,
add to inventories, and the like
• Thus retained earnings as reported on the balance sheet, do not represent cash
and are not “available” for dividends or anything else

27
Free Cash Flow
28
 Accounti ng statements are designed primarily for
use by creditors and tax collectors, not for
managers and stock analysts

• Therefore, corporate decision makers and security analysts often modify

accounting data to meet their needs

29
Free Cash Flow
• The amount of cash that could be
withdrawn without harming a firm’s
ability to operate and to produce future
cash flows
FCF=
[EBIT(1-tax rate)+depreciation
& amortization]
-
[Capital Expenditures+△Net
Operating Working Capital]

30
EBIT(1-Tax rate)
• NOPAT– net operating profit
after taxes
• The profit a company would
generate if it had no debt and held
only operating assets

31
Depreciation &
Amortization
• Are added back because these are
noncash expenses that reduce
EBIT but do not reduce the
amount of cash the company has
available to pay its investors

32
Capital Expenditures
• Fixed asset investments

33
△Net Operating
Working Capital
• To sustain ongoing operations

34
 Results

Positive FCF (+) Negative FCF (-)

• The firm is generating more than
enough cash to finance current
investments in fixed assets and
working capital (even enough to
build new stores)
• Does not have sufficient internal
funds, and that it will have to raise
new money in the capital markets in
order to pay for these investments
35
Computation

NOPAT or EBIT(1-
• Allied’s 2008 T)
operating income
(EBIT) was = $283.8 (1-0.40)
$283.8 million and = $170.3
the tax rate is 40%
million

36
Computation

△NOWC= NOWC2-
NOWC1
• Depreciation and
amortization in 2008 NOWC
2008 is $100 =1,000-(310-110)
million = $800 million
• Its capital 2007 NOWC
expenditures is =810-(220-60)
$230 million = $650 million
△NOWC= $150 m

37
Computation

FCF= [170.3+100]-
[230+150]
• Allied’s FCF is
FCF 2015= negative, which is
not good
($109.7
million)

38
N ote, tho u gh , that the negati ve FCF i s l argel y att r ib uta bl e
to th e $ 2 30 m il l io n in expendi ture for a n ew p ro c es si ng
pl ant, s o, it wil l not need to purc has e ano the r fi xed as s et
o f the s a me k i nd fo r a few years

• Allied’s financial situation is not as bad as the negative FCF might

suggest
• Having a negative FCF is not that bad, provided a firm’s new investments are
eventually profitable and contribute to its FCF
• Many analyst regard FCF as being the single most important number that can
be developed from accounting statements, even more important than net
income
• Afterall, it shows how much cash the firm can distribute to its investors

39
MVA and EVA
40
 Ch anges i n interest rates and i nfl ati o n aff ec t the mar ket
val ue o f th e co mpa ny ’s as sets a nd l ia bi li ti es b ut oft en
h ave no eff ec t o n the cor res po nd in g b oo k va lu es s how n in
the fi nanc ial stateme nts

Example:
• A firm was started with $1 million of assets at book value (historical cost),
$500,000 of which was provided by bondholders, and $500,000 by
stockholders (50,000 shares purchased at $10 per share)
• However, this firm became very successful; the market value of the firm’s
equity is now worth $19.5 million, and its current stock price is
$19,500,000/50,000
• $390 per share

41
 The accounti ng statements do not refl ect market
values, so they are not suffi cient for purposes of
evaluati ng managers’ performance

To help fill this void, financial analysts have developed two additional
performance measures

1. Market Value Added (MVA)

2. Economic Value Added (EVA)

42
Market Value Added
(MVA)
• The difference between the market
value of a firm’s equity and the
book value as shown on the
balance sheet, with market value
found by multiplying the stock
price by the number of shares
outstanding
• The excess of the market value of
equity over its book value

43
Computation

• For Allied:
MVA
= MV - BV MVA
= $19.5m - $0.5m = 1,153m - 940m
=$19 million = $213 million

MV= 390 x 50,000 MV= 23.06 x

50,000,000
BV= 10 x 50,000
BV= 940

44
 $ 2 1 3 m i l l i o n . W h i c h re p re s e nt s t h e d i ff e re n c e b e t we e n t h e
m o n ey A l l i e d ’s sto c k h o l d e rs h ave i nve ste d i n t h e co r p o rati o n
s i n c e i t s fo u n d i n g – i n c l u d i n g re ta i n e d e a r n i n g s – ve rs u s t h e
ca s h t h ey co u l d re c e i ve i f t h ey s o l d t h e b u s i n e s s

• the higher the MVA, the better the job management is doing for the
firm’s shareholders
• Boards of directors often look at MVA when deciding on the compensation of
a firm’s managers deserve
• Note though, that just as all ships rise in a rising tide, most firms’ stock prices
rise in a rising stock market, so a positive MVA may not be entirely
attributable to management performance

45
Economic Value Added
(EVA)
• a.k.a economic profit
• Excess of NOPAT over capital
costs
• It is an estimate of a business’
true economic profit for a given
year, and it often differs sharply
from accounting net income

46
Economic Value Added
(EVA)
• The main reason for this difference
is that although accounting income
takes into account the cost of debt,
it does not deduct for the cost of
equity capital
• By contrast, EVA takes into
account the total money cost of all
capital, which includes both the
cost of debt and equity capital

47
Economic Value Added
(EVA)
• If positive (+)– after-tax income
exceeds the cost of the capital needed
to produce that income, and
managements’ actions are adding value
to the stockholders
EVA=NOPAT-Annual money cost of
capital or
EVA= EBIT(1-T)-(total invested
capital x After-tax percentage cost of
capital)

48
Fin.
Quiz next meeting