finance 332

Corporate Finance Twelfth Edition Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan / Joe Smolira (digital co-author)

Chapter 2 Financial Statements and Cash Flow

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

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Key Concepts and Skills

Understand the information provided by financial statements Differentiate between book and market values Know the difference between average and marginal tax rates Know the difference between accounting income and cash flow Calculate a firm’s cash flow

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Chapter Outline

2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes 2.4 Net Working Capital 2.5 Cash Flow of the Firm 2.6 The Accounting Statement of Cash Flows 2.7 Cash Flow Management

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Sources of Information

Annual reports Wall Street Journal Internet • NYSE (www.nyse.com) • NASDAQ (www.nasdaq.com) • Textbook (www.mhhe.com) SEC • EDGAR • 10K & 10Q reports

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2.1 The Balance Sheet

An accountant’s snapshot of the firm’s accounting value at a specific point in time The Balance Sheet Identity is:

Assets Liabilities Stockholders’ equity≡ +

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The Balance Sheet of the U.S. Composite Corporation (1 of 2)

The assets are listed in order by the length of time it would normally take a firm with ongoing operations to convert them into cash. Clearly, cash is much more liquid than property, plant, and equipment.

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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

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Liquidity

Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value Current assets are the most 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.

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Debt versus Equity

Bondholders generally receive the first claim on the firm’s cash flow. Stockholders’ equity is the residual difference between assets and liabilities.

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Value versus Cost

Under generally accepted accounting principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost. Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.

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2.2 The Income Statement

Measures financial performance over a specific period of time The accounting definition of income is:

Revenue Expenses Income− ≡

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The Income Statement of the U.S. Composite Corporation - I

The operations section of the income statement reports the firm’s revenues and expenses from principal operations.

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The Income Statement of the U.S. Composite Corporation - II

The nonoperating section of the income statement includes all financing costs, such as interest expense.

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The Income Statement of the U.S. Composite Corporation - III

Usually a separate section reports the amount of taxes levied on income.

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The Income Statement of the U.S. Composite Corporation - IV

Net income is the “bottom line.”

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Income Statement Analysis

There are three things to keep in mind when analyzing an income statement: 1. Generally Accepted Accounting Principles (GAAP) 2. Noncash Items 3. Time and Costs

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GAAP

The matching principle of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, even though no cash flow may have occurred.

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Noncash Items

Depreciation is the most apparent. No firm ever writes a check for “depreciation.” Another noncash item is deferred taxes, which does not represent a cash flow. Thus, net income is not cash.

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Time and Costs

In the short run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials. In the long run, all inputs of production (and hence costs) are variable. Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.

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2.3 Taxes

The one thing we can rely on with taxes is that they are always changing • Tax Cuts and Jobs Act of 2017 • See the IRS website for current information Average versus marginal tax rates

Average the tax bill taxable income= • Marginal: the percentage paid on the next dollar earned Other taxes

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Average versus Marginal Rates

Suppose your firm earns $4 million in taxable income. • What is the firm’s tax liability? • What is the average tax rate? • What is the marginal tax rate? If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

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2.4 Net Working Capital

Net Working Capital Current Assets – Current Liabilities≡

NWC usually grows with the firm.

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The Balance Sheet of the U.S. Composite Corporation (2 of 2)

Access the text alternative for slide images

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2.5 Cash Flow of the Firm

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 CF CFA B S≡ +

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Financial Cash Flow of the U.S. Composite Corporation - I

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Financial Cash Flow of the U.S. Composite Corporation - II

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Financial Cash Flow of the U.S. Composite Corporation - III

NWC grew from $252 million in 2018 to $271 million in 2019. This increase of $19 million is the addition to NWC.

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Financial Cash Flow of the U.S. Composite Corporation - IV

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Financial Cash Flow of the U.S. Composite Corporation - V

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Financial Cash Flow of the U.S. Composite Corporation - VI

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Financial Cash Flow of the U.S. Composite Corporation - VII

The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:

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2.6 The Accounting Statement of Cash Flows

There is an official accounting statement called the statement of cash flows. This helps explain the change in accounting cash, which for U.S. Composite is $41 million in 2019. The three components of the statement of cash flows are: • Cash flow from operating activities • Cash flow from investing activities • Cash flow from financing activities

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U.S. Composite Corporation Cash Flow from Operating Activities

To calculate cash flow from operating activities, start with net income, add back noncash items like depreciation and adjust for changes in current assets and liabilities (other than cash).

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U.S. Composite Corporation Cash Flow from Investing Activities

Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i.e., net capital expenditures).

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U.S. Composite Corporation Cash Flow from Financing Activities

Cash flows to and from creditors and owners include changes in equity and debt.

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U.S. Composite Corporation Statement of Cash Flows

The statement of cash flows is the addition of cash flows from operations, investing activities, and financing activities.

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2.7 Cash Flow Management

Earnings can be manipulated using subjective decisions required under GAAP Total cash flow is more objective, but the underlying components may also be “managed” • Moving cash flow from the investing section to the

operating section may make the firm’s business appear more stable