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Financial Statements and Cash Flows
RWJ-Chapter 2
+Understanding Financial Statements
The crux of investments is to value firms (or stocks)
Various models to value common stocks DCF Multiples
No matter which model we are going to use, the key inputs we needed are mostly based on a firm’s financial statements
We will learn the basic tools to analyze financial statements
+Information for Financial Statements Analysis
1) Published annual reports (1) Financial Statements
Balance Sheet (B/S) Income Statement (I/S) Statement of Cash Flows
(2) Notes to financial statements (3) Letters to stockholders (4) Auditor’s report (independent accountants) (5) Management’s discussion and analysis
2) Reports filed with the government
+Sources of Information
Annual reports
SEC EDGAR (http://www.sec.gov/edgar.shtml) 10K & 10Q reports
+Balance Sheet
Balance sheet summarizes the assets owned by a firm
The value of the assets, and the mix (debt and equity) used to finance these assets at a point in time
Assets Liabilities & Equity
Fixed AssetsCurrent AssetsFinancial InvestmentsIntangible Assets
Current LiabilitiesDebt (Long-term)EquityStockholder’s Equity
Total Assets
Total Liabilities & Equity
+Summary of B/S
An accountant’s snapshot of the firm’s accounting value as of a particular date.
The Balance Sheet Identity is:Assets ≡ Liabilities + Stockholder’s Equity
Stockholder’s equity is defined to be the difference between the assets and the liabilities of the firm. Equity is what stockholders would have remaining after the firm discharged its operations.
Liabilities and equity-side reflects the types and proportions of financing, which depend on management’s choice of capital structure, as between debt and equity and current debt and long-term debt.
+Assets
Fixed Assets: Assets that are purchased for long-term use and are not
likely to be converted quickly into cash, such as land, buildings, and equipment.
GAAP requires the valuation of historical cost, adjusted for any estimated loss in value from the aging of these assets (Depreciation)
Many firms in the U.S. use straight line depreciation, while Japanese and German firms often use accelerated depreciation
Straight line versus Accelerated Depreciation Accelerated depreciation leads reported income that is
understated.
+Example- Straight Line
An asset costs $33,000 has a residual value of $3,000, and expected to last 4 years
(i) Calculate annual depreciation
(ii) what happen if you are able to sell this asset after two year at selling price of $20,000?
+Example-Accelerated Depreciation An asset costs $33,000, and expected to last 5 years
(i) Calculate annual depreciation
(ii) what happen if you are able to sell this asset after two year at selling price of $20,000?
Recovery year
Applicable Percentage
1 0.200
2 0.320
3 0.192
4 0.1152
5 0.1152
6 0.0576
+Assets
Current Assets: Account Receivables:
It represents money owed by entities to the firm on the sale of products on credit
Cash and Marketable Securities: Cash: One of the few assets for which accountants and
financial analysts should agree on the value Marketable Securities: Investments made by firms in securities
or assets of other firms, as well as T-bills or bonds Inventory
The total amount of goods and/or materials contained in a store or factory at any given time
Closely related to COGS LIFO vs FIFO
+Assets
Intangible Assets: Patents and Trademarks
Internal External
Goodwill By product of acquisitions When a firm acquires another firm, the purchase price is
first allocated to tangible assets, and the excess price is then allocated to any intangible assets
Nothing but excess price by actual price (MV) and book value of the company
+Liabilities and Equity
Current Liabilities: Accounts payable:
It represents credit received from suppliers and other vendors
Short-term Borrowing: Short-term loans (due in less than a year) to finance the
operations or current asset needs of the business Short-term portion of long-term borrowing
It represents the portion of the long-term debt or bonds that is coming due in the next year
Other short-term liabilities: It includes wages due to its employees and taxes due to
the government
+Liabilities and Equity Long-Term Debt:
Long-term loan from a bank or other financial institutions Long-term bond issued to financial markets
Other Long-term Liabilities: Leases, Employee Benefits, Pension Plans, Health Care Benefits These are long-term obligations that are not captured in the
long-term debt items In the past two decades accountants moved toward quantifying
these liabilities and showing them as long-term liabilities
Equity: It reflects the original proceeds received by the firm when
issued the equity
Retained Earnings: Net Income kept for further investment
+
(in $ millions)2008 and 2009Balance Sheet
U.S. COMPOSITE CORPORATION
Liabilities (Debt)Assets 2008 2009 and Stockholder's Equity 2008 2009
Current assets: Current Liabilities: Cash and equivalents $104 $160 Accounts payable $232 $266 Accounts receivable 455 688 Notes payable 196 123 Inventories 553 555
Total current liabilities $428 $389 Total current assets $1,112 $1,403
Fixed assets: Net Property, plant, and equipment
$1,644$1,709 Long-term debt 408 454
Stockholder's equity:
Common stock and paid in surplus 600 640
Accumulated retained earnings 1,320 1,629
Total equity $1,920 $2,269Total assets $2,756 $3,112Total liabilities and stockholder's equity$2,756 $3,112
+Balance Sheet Analysis
When analyzing a balance sheet, the financial manager should be aware of three concerns:
(1) Liquidity (2) Debt versus equity (3) Value versus cost
+Liquidity
Refers to the ease and quickness with which assets can be converted to cash.
Current assets are the most liquid. Fixed assets are the least liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations.
Liquid assets frequently have lower rates of return than fixed assets. For example, cash generates no or little investment income.
To the extent that a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investments.
+Value versus Cost
Under GAAP audited financial statements of firms in the U.S. carry assets at cost.
Market value is a completely different concept.
Market value is the price at which willing buyers and sellers trade the assets. It would be only coincidence if accounting value (book value) and market value were the same.
Many users of financial statements want to know the value of the firm, not its cost.
In this class, whenever we mention value, we mean market value, not the cost (or book value).
When we say that the goal of a financial manager is to increase the value of the stock, we mean the market value of the stock.
+Income Statement
The income statement measures performance over a specific period of time.
It provides information on the revenues and expenses of the firm, and resulting income made by the firm, during a period
The accounting definition of income is
Revenue – Expenses ≡ Income
+More Specifically
Revenue
Cost of Goods Sold (COGS)
Operating Expense
EBITDA
EBIT (Operating Income)
Gross Profit
Depreciation & Amortization
Interest
TaxesNet Income (NI) or Earnings
Retained Earnings (R/E)
Dividends
+
(in $ millions)2009
Income StatementU.S. COMPOSITE CORPORATION
Net salesCost of goods sold
Depreciation
Earnings before interest and taxes
Interest expenseTaxable incomeTaxes (34%)
Net income Retained earnings: $309 Dividends: $103
The operations section of the income statement reports the firm’s revenues and expenses from principal operations
$1,509- 750
- 65
$694
- 70$624- 212
$412
+
(in $ millions)2009
Income StatementU.S. COMPOSITE CORPORATION
Net salesCost of goods sold
Depreciation
Earnings before interest and taxes
Interest expenseTaxable incomeTaxes (34%)
Net income Retained earnings: $309 Dividends: $103
The non-operating section of the income statement includes all financing costs, such as interest expense.
$1,509- 750
- 65
$694
- 70$624- 212
$412
+
(in $ millions)2009
Income StatementU.S. COMPOSITE CORPORATION
Net salesCost of goods sold
Depreciation
Earnings before interest and taxes
Interest expenseTaxable incomeTaxes (34%)
Net income Retained earnings: $309 Dividends: $103
Usually a separate section reports as a separate item the amount of taxes levied on income
$1,509- 750
- 65
$694
- 70$624- 212
$412
+
(in $ millions)2009
Income StatementU.S. COMPOSITE CORPORATION
Net salesCost of goods sold
Depreciation
Earnings before interest and taxes
Interest expenseTaxable incomeTaxes (34%)
Net income Retained earnings: $309 Dividends: $103
Net income is the “bottom line”
$1,509- 750
- 65
$694
- 70$624- 212
$412
+Income Statement Analysis
There are two things to keep in mind when analyzing an income statement:
(1) GAAP (2) Non Cash Items
+Generally Accepted Accounting Principles
Recognition principle: Recognize revenue when the earnings process is complete and the value of an exchange of goods or services is known and can be reliably determined. Thus, income is reported when it is earned, even though no cash flow may have occurred. Midland co. sells goods for $1 million. The goods cost
$900,000. So the company will have profit of $100,000. But the company has not yet collected the cash from the
sale. So, the net cash flow is -$900,000.
+Non-Cash Items
Depreciation is the most apparent. No firm ever writes a check for “depreciation”.
In practice, the difference between cash flows and accounting income can be quite dramatic. For example Conseco Corp. reported a net loss of $194
million for 2007. But it also reported a positive cash flow of $ 703 million for the same fiscal year!
+Net Working Capital
Working Capital ≡ Current Assets – Current Liabilities
If the change in NWC is positive, it is a cash outflow. (you are investing more in NWC). If the change in NWC is negative, it is a cash inflow
+
(in $ millions)2008 and 2009Balance Sheet
U.S. COMPOSITE CORPORATION
Liabilities (Debt)Assets 2008 2009 and Stockholder's Equity 2008 2009
Current assets: Current Liabilities: Cash and equivalents $104 $160 Accounts payable $232 $266 Accounts receivable 455 688 Notes payable 196 123 Inventories 553 555
Total current liabilities $428 $389 Total current assets $1,112 $1,403
Long-term liabilities:Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment$1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Common stock ($1 par value) 55 32 Capital surplus 347 327
Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725
Total assets $1,879 $1,742Total liabilities and stockholder's equity$1,879 $1,742
Here we see NWC grow to $1,014 million in 2009 from $684 million in 2008.
This increase of $330 million is an investment of the firm.
$684m = $1112m- $428m
$1014m = $1403- $389
+Financial Cash Flows
In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.
Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)
+
(in $ millions)20X2
Financial Cash FlowU.S. COMPOSITE CORPORATION
Cash Flow of the FirmOperating cash flow $547
(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending (130) (Ending net fixed assets
minus beginning fixed assets plus dep.)Additions to net working capital (330)
Total $87
Cash Flow of Investors in the FirmDebt $24
Equity 63
Total $87
Operating Cash Flow:
EBIT $694
Depreciation $65
Current Taxes ($212)
OCF $547
+
(in $ millions)20X2
Financial Cash FlowU.S. COMPOSITE CORPORATION
Cash Flow of the FirmOperating cash flow $547
(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending (Ending net fixed assets
minus beginning net fixed assets plus dep.)Additions to net working capital
Total
Cash Flow of Investors in the FirmDebt
Equity
Total
Capital SpendingEnding net fixed assets$1,709
Beginning net fixed assets (1644)
Depreciation 65
Net Capital Spending $130
(130)
(330)$87
$24
63
$42
+
(in $ millions)20X2
Financial Cash FlowU.S. COMPOSITE CORPORATION
Cash Flow of the FirmOperating cash flow $547
(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending
Additions to net working capital Total
Cash Flow of Investors in the FirmDebt
Equity
Total
NWC grew from $684 million in 2008 to $1014 million in 20X1.
This increase of $330 million is the addition to NWC.
(130)
(330)$87
$24
63
$87
+
(in $ millions)20X2
Financial Cash FlowU.S. COMPOSITE CORPORATION
Cash Flow of the FirmOperating cash flow $547
(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending (Ending net fixed assets
minus beginning net fixed assets plus dep.)Additions to net working capital
Total
Cash Flow of Investors in the FirmDebt
Equity
Total
(130)
(330)$87
$24
63
$87
+
(in $ millions)20X2
Financial Cash FlowU.S. COMPOSITE CORPORATION
Cash Flow of the FirmOperating cash flow $547
(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending
Additions to net working capital Total
Cash Flow of Investors in the FirmDebt
(Interest minus net new borrowing)
Equity (Dividends minus net new equity raised)
Total
Cash Flow to Creditors
Interest paid$70
Net new borrowing (46)
Total 24
(130
(330)$87
$24
63
$87
+
(in $ millions)20X2
Financial Cash FlowU.S. COMPOSITE CORPORATION
Cash Flow of the FirmOperating cash flow $547
(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending
Additions to net working capital Total
Cash Flow of Investors in the FirmDebt
(Interest minus net new borrowing)
Equity (Dividends minus net new equity raised)
Total
Cash Flow to Stockholders
Dividends $103
Net new equity raised (40)
Total $63
Net new equity raised is the change in common stock and paid–in-surplus from B/S.
(130)
(330)$87
$24
63
$87
+
(in $ millions)20X2
Financial Cash FlowU.S. COMPOSITE CORPORATION
Cash Flow of the FirmOperating cash flow $547
(Earnings before interest and taxes plus depreciation minus taxes)
Capital spending (Ending net fixed assets
minus beginning net fixed assets plus dep.)Additions to net working capital
Total
Cash Flow of Investors in the FirmDebt
(Interest minus net new borrowing)
Equity (Dividends minus net new equity raised)
Total
(130)
(330)$87
$24
63
$87
The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:
)()(
)(
SCFBCF
ACF
+Cash Flow Summary
+Free Cash Flows There are two types of Cash Flows:
(1) This is the cash flows generated by a company’s operating activities and available to all who provided capital to the firm (Debt and Equity Holders)
Current Assets –Current Liabilities
+Free Cash Flows
(2) “free” cash flows to equity (stock holders), which is derived from after operating free cash flows have been adjusted for debt payments (interest and principal)
Current Assets –Current Liabilities
+Question: Which one to use?
+Cash Flows
Assets Liabilities
Cash outflow
Cash outflow
Cash inflow
Cash inflow
+Limitations of Financial Ratios Accounting statements:
A reasonably good job of categorizing the assets owned by a firm A partial job of assessing the value of these assets A poor job of reporting uncertainty about asset value
Accounting principles: The accounting view of asset value is to a great extent grounded in
the notion of historical cost, which is the original cost of the asset. Historical cost is the best estimate of the value of an asset.
Conservative approach to estimate the value .
At the end of 2011, book value of Google is $58.1 billion
At the end of 2011, the market value of Google is $211.04 billion (stock price= $645)
+Limitations of Financial Ratios
These values are based on specific dates Capture values of assets and liabilities on a specific date Ratios using balance sheet may not reflect company’s
situation during rest of the year Example: A company that reports $1 million in cash on last
day of fiscal year may have only $100 K two days later after paying salaries and suppliers