2-1

TOPIC 3Financial Statements and

Cash Flows

Balance sheet Income statement Statement of retained earnings Statement of cash flows 5 Questions about cash Federal tax system

(continued)

2-2

Ratio Analysis

Du Pont system

Effects of improving ratios

Limitations of ratio analysis

Qualitative factors

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ANNUAL REPORT

Primary Purpose—To communicate with stockholders and potential investors.

Contains: 1. Balance Sheet

2. Income Statement

3. Statement of Retained Earnings

4. Statement of Cash Flows

Usually covers several years.

Explains what has happened and why.

2-4

Balance Sheet: Assets

CashA/RInventories

Total CAGross FALess: Dep.

Net FATotal Assets

20047,282

632,1601,287,3601,926,8021,202,950 263,160 939,7902,866,592

200357,600

351,200 715,2001,124,000

491,000 146,200 344,8001,468,800

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OBSERVATIONS ABOUT THE BALANCE SHEET

1. Assets listed in order of “currency.”

2. Current versus fixed assets

3. Is depreciation a true expense?

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Balance sheet: Liabilities and Equity

Accts payableNotes payableAccruals

Total CLLong-term debtCommon stockRetained earnings

Total EquityTotal L & E

2002524,160

636,808 489,6001,650,568

723,432460,000

32,592 492,5922,866,592

2001145,600200,000

136,000481,600323,432460,000

203,768 663,7681,468,800

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1. What is the difference between Equity, Stockholder’s Equity, and New Worth?

2. What is “Retained Earnings?”

2-8

Income statement

SalesCOGSOther expenses

EBITDADepr. & Amort.

EBITInterest Exp.EBTTaxesNet income

20046,034,000

5,528,000 519,988

(13,988) 116,960(130,948) 136,012(266,960) (106,784) (160,176)

20033,432,0002,864,000 358,672

209,328 18,900

190,428 43,828

146,600 58,640

87,960

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BOTTOM OF INCOME STATEMENT

NET INCOME BEFORE PREFERREDDIVIDENDS $117.5

- PREFERRED DIVIDENDS 4.0

NET INCOME $113.5

- COMMON DIVIDENDS 57.5

ADDITION TO R.E. 56.0

Dividends on CS are paid after taxes and after PS dividends

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ANOTHER WAY TO MEASURE PERFORMANCE

(t = 40%) CO. A CO. BSALES 10 10 - COSTS 7 7= EBIT 3 3 - INTEREST 2 1= EBT 1 2 - TAXES .4 .8= NET INCOME .61.2

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NOPAT(NET OPERATING PROFIT AFTER TAXES)

(t = 40%)

NOPAT = EBIT (1 – t)

FOR CO. A: 3 (1 - .4) = 1.8

FOR CO. B: 3 (1 - .4) = 1.8

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Statement of Retained Earnings (2004)

Balance of retainedearnings, 12/31/03

Add: Net income, 2004

Less: Dividends paid

Balance of retained earnings, 12/31/02

$300,000

100,000 40,000

$360,000

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1. WHAT WAS THE “DIVIDEND PAYOUT RATIO?”

2. WHAT WAS THE “RETENTION” OR “PLOWBACK” RATIO?

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NET CASH FLOW(Assume sales and expenses

are all cash)

SALES $10-COSTS 8-DEPRECIATION 1= NET INCOME 1

HOW MUCH CASH WAS GENERATED?

DOES NOT NECESSARILY SHOW THE AMOUNT OF CASH ON THE BALANCESHEET BECAUSE THE CASH FLOW CAN BE USED IN A VARIETY OF WAYS.

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FREE CASH FLOW

THE CASH FLOW ACTUALLY AVAILABLEFOR DISTRIBUTION TO ALL INVESTORSIN THE COMPANY (STOCKHOLDERS ANDBONDHOLDERS)

FREE CASH FLOW =

NOPAT – ALL NECESSARY INVESTMENTS IN INVESTMENTS IN WORKING CAPITAL AND FIXED ASSETS

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BALANCE SHEET

Left Hand Side shows “investments” (or where you put your money)

Right Hand Side shows “financing” (or where you get your money)

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ANY INCREASE IN AN ITEM ON THE RIGHT HAND SIDE and ANY DECREASEIN AN ITEM ON THE LEFT HAND SIDEINCREASES “FINANCING” OR PROVIDES FUNDS and ANY DECREASE IN AN ITEM ON THE LEFT HAND SIDE

e.g., if Accounts Payable increase—or Accounts Receivable decrease—additional funds will be provided

ANY INCREASE IN AN ITEM ON THE LEFT HAND SIDE INCREASES “INVESTMENTS” OR USES FUNDS.

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A STATEMENT OF CASH FLOWS SHOWS: 1. OPERATING ACTIVITIES

(Includes net income, depreciation, and changes in current assets and current liabilities (other than cash and short-term debt)

2. INVESTING ACTIVITIES (Includes investments in or sales of fixed assets)

3. FINANCING ACTIVITIES (Includes cash raised by short-term debt, bonds, and stock. Also includes cash for dividends and buy-backs of stocks and bonds.

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Statement of Cash Flows (2004)

OPERATING ACTIVITIESNet income

Add (Sources of cash):DepreciationIncrease in A/PIncrease in accruals

Subtract (Uses of cash):Increase in A/RIncrease in inventories

Net cash provided by ops.

(160,176)

116,960378,560353,600

(280,960)(572,160)(164,176)

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Statement of Cash Flows (2004)L-T INVESTING ACTIVITIES

Investment in fixed assets

FINANCING ACTIVITIESIncrease in notes payableIncrease in long-term debtPayment of cash dividendNet cash from financing

NET CHANGE IN CASH

Plus: Cash at beginning of year

Cash at end of year

(711,950)

436,808400,000

(11,000)825,808

(50,318)

57,6007,282

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REVIEWWHICH STATEMENT (OR CONCEPT)SHOWS:

1. HOW MUCH CASH DO WE HAVE?

2. HOW MUCH CASH DID WE GENERATE DURING THE PERIOD?

3. WHAT DID WE DO WITH THE CASH WE GENERATED?

4. HOW MUCH CASH COULD WE DISTRIBUTE TO OUR INVESTORS?

5. HOW MUCH CASH DID WE ACTUALLY PAY TO OUR STOCKHOLDERS?

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Federal Income Tax System

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Corporate and Personal Taxes

Both have a progressive structure (the higher the income, the higher the marginal tax rate).

Corporations Rates begin at 15% and rise to 35% for

corporations with income over $10 million. Also subject to state tax (around 5%).

Individuals Rates begin at 10% and rise to 38.6% for

individuals with income over $307,050. May be subject to state tax.

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Tax treatment of various uses and sources of funds Interest paid – tax deductible for corporations

(paid out of pre-tax income), but usually not for individuals (interest on home loans being the exception).

Interest earned – usually fully taxable (an exception being interest from a (muni”).

Dividends paid – paid out of after-tax income. Dividends received – taxed as ordinary income

for individuals (“double taxation”). A portion of dividends received by corporations is tax excludable, in order to avoid “triple taxation”.