BUS 650 Week 3 Assignment

Chapter 5

Estimating Cash Flows

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Learning Objectives

A�er studying this chapter, you should be able to:

Describe the cash cycle of a typical firm. Explain the significance and use of different financial statements. Express why accoun�ng profits and cash flows some�mes differ. Show how accoun�ng profits can be transformed into cash flows. Explain how to construct pro forma financial statements. Express how growth impacts a company's cash flows. Show how to es�mate expected value of future cash flows.

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Ch. 5 Introduction

Cash—dollars and cents—is the lifeblood of every business. Companies distribute cash to shareholders in the form of dividends and use cash to pay employees and suppliers, to pay taxes, and to repay loans. For a business to stay healthy, it is cash, not accoun�ng profits, that ma�ers. This may sound like a contradic�on, but many profitable, fast- growing small companies have gone out of business because they lacked sufficient cash to pay their bills. Regardless of its profitability, a firm without enough cash to pay its bills risks going bankrupt. Because cash is so important, we must understand how to es�mate cash flow and how cash circulates through a company.

Profitability is not iden�cal to cash flow. One of the key objec�ves of this chapter is explaining why accoun�ng profits and cash flow can differ. This difference hinges on several of the rules included in the accoun�ng profession's generally accepted accoun�ng principles (GAAP). We begin by describing the cash cycle of a typical company, then we relate this cash cycle to basic accoun�ng concepts and the primary financial statements produced by a company.

Once we understand how accoun�ng profits and cash flows differ, we describe two methods for transla�ng accoun�ng profits into cash flows. We use these techniques to es�mate the future cash flows for a brand-new project or investment. We extend this forecas�ng technique to the crea�on of pro forma (or projected) financial statements. Once you have mastered these techniques—transla�ng accoun�ng data into cash flows, es�ma�ng cash flows for a new investment, and crea�ng projected financial statements for a company—you will have gained a sound introduc�on to tools that are used daily by business people in a variety of fields.

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The business of purchasing materials and selling products creates a cycle of intertwined accoun�ng entries and cash payments and collec�ons.

When customers use credit cards to pay for products, firms wait for the bank that

5.1 The Cash Cycle of a Typical Firm

For managers of small businesses it is par�cularly important to understand and manage the company's cash cycle. In fact, the lack of a cash cushion is one of the primary reasons that small businesses fail. For some of the other reasons, see The New York Times ar�cle "Top 10 Reasons Small Businesses Fail," in the Web Resources sec�on.

We begin this chapter by describing how cash travels through a typical business enterprise. Understanding the cash cycle will help you see why the profits reported on a company's income statement s differ from the actual cash generated by the firm's ac�vi�es.

Simple Cash Cycle

The opera�ons of a typical firm follow:

1. Goods are produced or purchased for resale. 2. Sales are made. 3. Cash from the sales is collected.

Cash expenditures for materials, wages, adver�sing, and so on occur at stages 1 and 2, but only at stage 3 does cash flow into the firm, providing the cash for another cycle of produc�on, sales, and collec�ons. Typically, accoun�ng revenues and expenses are recorded at stage 2. If not managed properly, these seemingly slight �ming differences between the expenditures of cash, and the collec�on of cash, can cause serious problems and even bankruptcy. Figure 5.1 shows a simple cash cycle.

Figure 5.1: Simple cash cycle

In Figure 5.1, the firm buys materials on credit and generates an account payable (A/P). During the manufacturing process, the firm generates addi�onal costs. Produc�on costs include employee wages and benefits, u�lity expenses, and rent. Another cost of produc�on is the wear and tear on, or deprecia�on of, equipment, though this doesn't include any actual cash outlay (we explain the noncash aspect of deprecia�on later in the chapter).

The firm eventually sells the finished products and recognizes revenues and—it hopes—profits. If a credit sale is made, the firm receives no cash at the �me of the sale. Instead, the sale creates an account receivable (A/R), and the firm must wait for the customer to pay the bill before any cash arrives. Profits may be recognized at stage 2, before any cash is actually collected. Thus, accoun�ng profits (or net income) may not represent cash flow.

Complete Cash Cycle

Figure 5.2 shows a somewhat simplis�c cash cycle. It ignores a number of important factors, such as taxes, dividends, cash infusions from the capital markets, maintenance of inventory to avoid stock-outs, and the purchase and sale of produc�ve assets. These are added to the cash cycle diagram presented in Figure 5.2 to give a more complete picture of how cash moves into, out of, and through the firm. As Figure 5.2 shows, taxes and dividends represent cash flowing out of the firm. The company acquires addi�onal cash from the capital markets by selling shares of stock, issuing bonds, or borrowing from financial ins�tu�ons. Because the company must pay its lenders interest and repay the amount borrowed, another cash ou�low is debt service payments (interest and principal). Two arrows represent the sale and purchase of produc�ve assets such as machinery, vehicles, and factories. To remain compe��ve,

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A more complete depic�on of the cash cycle includes tax payments, disbursements to claimants, and asset purchases.

issued the card to pay for the merchandise on behalf of the customer.

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companies upgrade their manufacturing methods with new equipment, selling the machines that no longer fit their produc�on processes.

Figure 5.2: Complete Cash Cycle

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The income statement shows revenues and expenses over the course of the year.

5.2 A Review of Financial Statements

You may have already taken one (or more) accoun�ng courses, but accoun�ng is so important to managerial finance that we want to provide a short review. The review is from a finance perspec�ve, so we will discuss why some accoun�ng items are par�cularly important to financial managers.

Income Statement

The income statement shows a company's revenues and profits over a set �me period, usually a year or a quarter. It is also called a P&L (profits and loss) statement. An income statement always begins with the revenues or sales for the period at the top and then shows the costs incurred to make these sales. The costs listed first are the direct costs associated with the sales, such as materials and manufacturing labor. These items are o�en combined into a single COGS (cost of goods sold) or cost of revenue expense line. Subtrac�ng these direct expenses from revenues gives us the company's gross margin. Next on the statement are indirect costs, which include SG&A (sales, general, and administra�ve) expenses, deprecia�on and amor�za�on expenses, and R&D (research and development) expenses. All of these expenses are considered opera�ng expenses. Subtrac�ng these expenses produces the opera�ng margin or EBIT (earnings before interest and taxes).

The most common non-opera�ng expenses are interest expense and taxes. Subtrac�ng these items from the opera�ng margin gives us the company's net income or net profit. This is the proverbial "bo�om line" that people refer to, as in "What is the bo�om line?" In fact, usually there are a few more lines that show per share informa�on such as earnings per share and dividends per share. Figure 5.3 shows Nike's income statement, using the basic structure we have just discussed.

Figure 5.3: Nike income statement, 2011

Data from Nike annual report to the Securi�es and Exchange Commission, 2011: h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm (h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm)

Companies some�mes modify financial statements to be�er reflect how they do business. In Figure 5.4, we see that Nike Inc. has included an expense line �tled "Demand Crea�on Expense." The notes to the financial statements explain that this expense is for sponsoring athle�c events and athletes. Apparently Nike sees these types of expenses as sufficiently different from standard marke�ng ac�vi�es and has separated them out on their statement. No�ce too that several items refer to Notes. The financial statements reported in a company's Form 10-K (the annual report filed with the SEC) will have very detailed notes about many accoun�ng items. The standard statement shown on corporate financial statements is: "The accompanying notes to consolidated financial statements are an integral part of this statement."

Balance Sheet

The balance sheet shows a company's financial posi�on at a point in �me, for example as of December 31, 2013, or at the end of a business quarter. A balance sheet based on informa�on from December 31st will differ from a balance sheet computed on December 1 or January 31. A balance sheet is a financial "snapshot" of a firm's financial posi�on at a point in �me. Some balance sheet items are changing constantly. Contrast this to the income statement that covers a period of �me. It is a record of the firm's money-making ac�vi�es over a period of �me, such as a year or quarter.

Balance Sheet

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In any company, capital resources are �ed up in various assets. A balance sheet is a momentary record of the assets that needs to be accurately interpreted for types of assets and investments. Why do financial managers need to understand the func�on of balance sheets?

The balance sheet is a snapshot of a firm's assets, liabili�es, and equity on a par�cular date.

The balance sheet is also called the statement of financial posi�on. It shows what the company owns and what it owes. It contains three categories of items: assets, liabili�es, and equity. Assets are tradi�onally shown on the le�-hand side of the balance sheet (or on the top) and liabili�es and equity on the right-hand side (or below the assets). The liabili�es and equity must equal the assets; the two sides have to balance. Assets are listed according to their liquidity, or how quickly they can be turned into cash. Cash and marketable securi�es are extremely liquid, whereas inventory is less so since it must be sold and receivables must be collected before they become cash.

Figure 5.4: Nike consolidated balance sheets

The accompanying notes to consolidated financial statements are an integral part of this statement.

Data from: Nike annual report to the Securi�es and Exchange Commission, 2011 h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm (h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm)

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Office equipment like computers are listed among long-term company assets included in the PP&E category. Can you think of other examples that would go into this category?

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Usually the largest category of long-term assets is plant, property and equipment (PP&E). Plant, property and equipment includes all the long-lived assets that the company owns, such as factories, machines, cars, trucks, and computers. It is reported as the total historical cost of purchasing those items. The next line on the balance sheet is accumulated deprecia�on. This is the sum of all deprecia�on expense associated with these assets since they were purchased. Subtrac�ng accumulated deprecia�on from total PP&E gives us net PP&E. As items are disposed of, their cost and associated accumulated deprecia�on are subtracted from these accoun�ng items. Nike's consolidated balance sheet (Figure 5.4) shows that net PP&E will some�mes be reported instead of separate lines for the total PP&E and accumulated deprecia�on. Net PP&E shows the book value remaining in a company's assets; it is the undepreciated por�on of the assets' historic cost. Land is an excep�on to this deprecia�on treatment. Land is not depreciated and will appear on a company's balance at its historic cost forever.

Liabili�es are listed roughly according to when they must be paid. Current liabili�es, such as accounts payable, wages payable, and taxes payable, are examples of liabili�es due within a year. Some companies report "current por�on of long-term debt," which is the principal repayment on loans or bonds due within one year. Long-term liabili�es include mul�year bank loans, leases, bonds, and mortgages.

The equity component (o�en called shareholders' equity) is the difference between assets (what is owned) and liabili�es (what is owed). The book value of equity is also equal to the historical contribu�ons of shareholders to the firm plus all profits that have been retained on behalf of shareholders. How we account for these contribu�ons is reviewed in the following paragraphs.

The equity sec�on is o�en separated into three line items:

1. Par value 2. Paid-in capital in excess of par 3. Retained earnings

The first two items are the amounts that shareholders have invested into the company. For common stock the par value or face value is the lowest price that the company can sell a share of stock. Not all states require par values, so many issues of common stock do not have a par value. When stocks have a par value, it is usually set very low, for example 1¢ or 10¢ of $1.00. Paid-in capital in excess of par is the amount above the par value that the company collected when it sold stock to investors. If a company sells shares with a $1.00 par value to investors for $15.00 per share, the paid-in capital in excess of par is $14.00 per share.

The final component of the equity sec�on of the balance sheet is retained earnings. This is the historical accumula�on of profits retained in the firm and invested on behalf of shareholders. This is not an account which contains actual cash. It is very important that you understand that retained earnings has nothing to do with how much cash the company has available. All of the money that's been retained has been used to either purchase assets or to repay liabili�es. The only cash the company has is in its cash account on the asset side of the balance sheet. Remember, the right-hand side of the balance sheet informs us about the sources of the firm's financing, whereas the le�- hand side tells us what the firm has done with those funds.

For most profitable firms, retained earnings is posi�ve. However, it is possible for a company to have nega�ve retained earnings if it has lost money (reported nega�ve net income) over several years. For corpora�ons, nega�ve retained earnings or nega�ve shareholders' equity does not mean that shareholders owe the company money. These investors have limited liability and can only lose the amount they invested. For sole proprietorships this is not the case. The sole proprietor is personally responsible for the debts of the business, so nega�ve equity is poten�ally serious since it puts the owner's other assets at risk if legal claims are made against the company.

It is interes�ng to note that some young firms actually have nega�ve equity accounts because they have accumulated nega�ve retained earnings over �me as they develop their products and markets. The fact that these young and not-yet-profitable corpora�ons have posi�ve share prices for their stock illustrates that market value depends on the expected future for the company and not on its past record. Here, then, we have an example of the difference between the financial balance sheet introduced in Chapter 1 and highlighted throughout the text, and the accoun�ng balance sheet that we're reviewing.

The income statement and balance sheet do not stand alone but rather are �ed together by several accounts. For example, deprecia�on expense from the income statement accumulates in the Accumulated Deprecia�on account on the balance sheet. Also from the income statement, net income, less dividends, accumulates in the Retained Earnings account on the balance sheet.

Cash Flow

The cash flow statement breaks cash flow into three categories:

1. Cash flow from opera�ng ac�vi�es 2. Cash flow from financing ac�vi�es 3. Cash flow from inves�ng ac�vi�es

The cash flow statement starts with net income for the period. It then adjusts for cash used in or provided by opera�ng ac�vi�es, such as deprecia�on (a noncash charge) and changes in working capital. Inves�ng ac�vi�es include buying or selling machinery or facili�es, inves�ng in marketable securi�es, and realizing returns from investments in securi�es. Financing ac�vi�es involve paying dividends to shareholders, repurchasing or issuing stock, and borrowing (or repaying) loans. A company with foreign opera�ons will usually have an addi�onal item a�er the financing sec�on that shows the effect of exchange rate fluctua�ons on cash flow. When the cash flow impact of all of these ac�vi�es is summed, it will show the change in cash over the income statement period.

The general rule regarding cash flow is: Increasing an asset account uses cash, and increasing a liability is a source of cash. If a company buys a machine (increasing PP&E), it spends or uses cash. If the company takes out a loan, it receives cash (the loan is a source of cash but increases a liability account such as Bank Loans). Conversely, repaying a loan uses cash, and selling an asset is a source of cash.

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The statements of cash flows consolidates the cash ac�vi�es over the year and classifies the ac�vi�es into opera�ons, financing, and inves�ng categories.

In the Nike statement of cash flows (Figure 5.5), no�ce that the ac�vi�es shown for 2011 reconcile the change in the company's cash posi�on from $3,079 million at the end of 2010 to $1,955 million at the end of 2011, exactly as shown on the balance sheet in Figure 5.4.

Figure 5.5: Nike consolidated statements of cash flows

Data from Nike annual report to the Securi�es and Exchange Commission, 2011: h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm (h�p://www.sec.gov/Archives/edgar/data/320187/000119312511194791/d10k.htm)

As we discuss in detail in Sec�on 5.3, almost every income statement category can have a recorded amount that differs from the actual cash inflows or ou�lows for that category. You may ask why accountants don't simply keep track of cash, instead of using the accrual accoun�ng system. In fact, in response to a growing interest in cash flow informa�on, accoun�ng statements now include a statement of cash flows.

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Everyone is familiar with cash accoun�ng as it's the same system we use to balance our checkbooks. Most corpora�ons however use an accrual accoun�ng system, which is much more complex.

Comstock Images/Ge�y Images

5.3 Why Accounting Profits and Cash Flows Differ

Generally Accepted Accoun�ng Principles (GAAP) prescribe how accountants record business transac�ons and construct financial statements. These accoun�ng rules were designed to provide an objec�ve portrayal of a company's business ac�vi�es and how those ac�vi�es affect the company's financial posi�on. Three accoun�ng principles are par�cularly important to understanding why accoun�ng profits o�en differ from cash flows. These principles deal with

1. The recogni�on of revenue 2. How expenses and revenues are matched 3. Rules regarding how the deprecia�on (i.e., wear-and-tear) of long-lived equipment is shown on the income statement

These principles, especially the matching principle, mean that corporate financial accoun�ng is an accrual accoun�ng system, not a cash accoun�ng system. As we discuss these accoun�ng principles, you will see how accrual accoun�ng differs from cash accoun�ng. Cash accoun�ng is the system you use in your checkbook. At any moment in �me (except for checks that have been wri�en but haven't yet been cashed), the balance shows the cash you have available. As we will see, this is very different from the accoun�ng used in most businesses.

Revenue Recognition

The rules of revenue recogni�on state that revenues are recorded when a transac�on has occurred. There are several defini�ons of transac�on. It may be when the �tle or ownership of an item changes from the seller to the buyer. It may be at the �me of delivery or pickup. In some cases, a transac�on might occur when an order is placed. The actual point at which a sale is considered to have been completed varies, depending on the nature of the contract or agreement between the buyer and the seller, the rights of the buyer to renege from the deal, and so on.

One thing to no�ce about the above defini�ons is that none define a transac�on as occurring when money changes hands. There is a very good reason for this omission. Many sales are made on credit; that is, the buyer delays paying for several weeks or months, or spreads the payments out over �me. If sales were only recorded as the cash arrived, the sales figure for a par�cular period would reflect the cash collected, not the actual sales ac�vi�es during the period. The objec�ve of the GAAP principles is to provide an accurate picture of a company's ac�vi�es, the primary one of which is selling products, not collec�ng cash. Therefore, the accoun�ng rules are designed to focus more on sales and revenue genera�on than on cash collec�on.

Matching Principle

The rules of accoun�ng require that the expenses recorded on the income statement be those associated with the sales recognized during that period. This is referred to as the matching principle. Expenses refer to the cost of producing the items sold, not the actual cash outlays for labor, materials, and so on made during the period. For example, suppose a company manufactures 175 air condi�oners during the month of April but sells 100 of those units in April. On an income statement for the month of April, the expenses would be the cost of producing the 100 units that the company actually sold, not the 175 that it manufactured. The cost of producing the 75 units that were manufactured but not sold in April will appear on future income statements when those units are sold. In the mean�me, the cost of producing those 75 units is recorded as an increase in inventory. If the company paid cash to its employees and suppliers of raw materials for the 175 units produced, the expense shown on the income statement is less than the actual cash outlays the firm made in April. If the recorded expenses are too low, then net income—revenue minus expenses—overstates how much cash the firm has generated during the period.

The matching principle may also cause net income to understate cash flow. For example, suppose the firm sold 100 units in April but paid for the raw materials used to manufacture those units in May. Thus, the cash for the materials was paid in May but was recorded as inventory, and the cost of goods sold expense for the units would appear in April's income statement. In this case, the expense shown for raw materials on April's income statement would be greater than the actual cash outlays made in April for materials, so April's income would be lower than its actual cash flow—holding everything else constant.

The matching principle is designed to give users of financial statements an idea of the firm's ac�vi�es during a specific period of �me. More specifically, the matching principle is designed to show a firm's profitability. By focusing on revenues or sales and then matching expenses to that sales level, the income statement presents informa�on on the profitability of the company's opera�ons.

Depreciation

When business people use the term deprecia�on (or deple�on or amor�za�on, depending on the asset being considered) they are referring to the alloca�on of the cost of a long-lived asset to several accoun�ng periods. A machine, vehicle, computer, or building will usually last for more than one year. When a company invests in an asset that will be used for several years, for accoun�ng purposes it allocates the cost of the asset over several periods as deprecia�on expense. The idea is to match the use (or the consump�on or wearing out) of the asset to the accoun�ng period in which that use occurs. By repor�ng deprecia�on expense on the income statement as the asset is used, accountants a�empt to show the total costs of doing business during that par�cular accoun�ng period. It is important to understand that although the cost of the asset is spread over several years, the purchase was made and paid for when the asset was acquired.

In terms of es�ma�ng cash flows, the alloca�on of deprecia�on means that net income is different than the cash generated during the period. This is most easily shown with an example. Suppose Acme Metal Fabrica�ng Company purchases a computer-aided lathe in January of 2012 for $100,000. The lathe is expected to last for five years, at which �me the company plans on trading it in for a newer model. In 2012, Acme writes a check for $100,000. The en�re cash outlay for the lathe is made in 2012. In the years 2013 through 2016, there are no cash outlays associated with purchasing the lathe, but the company uses the lathe extensively each of those years. To allocate the cost of the lathe over its es�mated useful life, the company's accountant adds a deprecia�on expense of $20,000 to the company's expenses for each of the five years from 2012 through 2016 ($20,000 = $100,000/5).Processing math: 0%

All companies invest in assets that depreciate over �me. Methods of fixed asset deprecia�on are: straight line, units of produc�on, declining balance, and sum of year digits. What are the benefits to financial managers in knowing an asset's deprecia�on value?

Generally Accepted Accoun�ng Principles (GAAP) are rules that can cause accoun�ng profit to differ from cash flow.

When the company buys the lathe, it records an increase in fixed assets of $100,000. Each year when it records its deprecia�on expense, it reduces the value of the asset by the amount of the deprecia�on. In the years 2013 through 2016, the deprecia�on expense has no corresponding cash outlay. Because of this, deprecia�on is o�en called a noncash expense or noncash charge. The noncash expense lowers net income without affec�ng the firm's cash posi�on. Of course, in 2012, when the machine was purchased, there was a cash outlay of $100,000, but an expense for use of the machine of only $20,000 is reported. Therefore, in 2012 the net income overstates the cash flows of the firm, whereas in the following four years it understates the cash flows.

Fixed Asset Deprecia�on

In many cases, deprecia�on is the major factor that causes accoun�ng profits and cash flows to differ. In Chapter 6, we return to the topic of deprecia�on and describe in more detail how to compute deprecia�on expense and how firms benefit from deprecia�on tax deduc�ons.

Income Statements and GAAP

Figure 5.6 shows an income statement for Acme Metal Fabrica�ng Company, highligh�ng the company's opera�ng ac�vi�es during the 2013 fiscal year. Arrows iden�fy the income statement accounts that can cause net income and cash flow to differ. The sales (or revenue) account may not equal the cash collec�ons for the accoun�ng period because of revenue recogni�on rules. The matching principle implies that the actual cash flowing into or out of the firm may differ from the amount reported as cost of goods sold and GA&S expense for that period. GA&S expense reflects costs necessary to operate the business that are not directly �ed to the produc�on of products. Deprecia�on expense, as we just discussed, is a noncash charge that allocates the cost of long-lived assets to the accoun�ng periods during which the asset is used. Therefore, the income statement amount does not reflect actual cash outlays during the accoun�ng period.

Figure 5.6: Acme's income statement and GAAP

Deferred Taxes

Although a detailed discussion is beyond the scope of this text, the amount of taxes reported on company income statements o�en differs from the actual cash payment made to the Internal Revenue Service and/or state taxing agencies. This results in a deferred taxes liability (it can also be an asset, but this is less common). One of the most common examples of this occurs when a company uses accelerated deprecia�on for tax purposes but a nonaccelerated method of deprecia�on, such as straight-line, for its

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repor�ng. This creates a �ming difference between when taxes are paid and when they are reported in financial statements. Eventually the difference reverses itself as accelerated deprecia�on for the asset falls below the amount reported using straight-line.

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A careful examina�on of how the replacement truck will affect earnings and expenses is crucial to maximizing cash flows. Here, that impact is illustrated in the bo�om sec�on of the income statement.

Purchasing new equipment such as a fuel-efficient truck, despite increased deprecia�on and lower net income, can actually increase cash flow. Do you think purchasing the truck would be beneficial?

Associated Press

5.4 Translating Accounting Profits Into Cash Flows

One of the most important tools you will learn in this class is compu�ng the net present value (NPV) of a proposed investment using discount cash flow analysis. As the name suggests NPV relies on cash flows. We will describe two methods for transforming data from a company's income statement into an es�mate of cash flow: a quick-and- dirty method and a more accurate, but somewhat longer, method.

Simple Method

The quick method, which provides a rough es�mate of the cash that the company generated from opera�ons during the accoun�ng period, requires just one step: Add the deprecia�on expense for the period to net income!

Why does this simple computa�on change net income into cash flow? For many firms, deprecia�on is the main reason that cash flow differs from accoun�ng profit or net income. If, for items other than deprecia�on, there is only a small difference between recorded expenses and cash outlays, then correc�ng for deprecia�on gets us very close to cash flow.

This formula (Cash flow from opera�ons = Net income + Deprecia�on) recognizes that deprecia�on is a noncash charge. We know that in the year that a company buys an asset there can be a large cash outlay to pay for the purchase. No�ce, though, that the formula is for "cash flow from opera�ons." The formula tries to give investors an idea of cash flow generated by a company's day-to-day or month-to-month opera�ng ac�vi�es. As later chapters will show, these are the cash flows that investors are most interested in. Thus, ignoring the cash flows associated with an infrequent event is o�en not a serious problem if we are most interested in a firm's opera�ng ac�vi�es.

Now, let's apply what you just learned about the simple method of es�ma�ng cash flows using an example.

Suppose your company is thinking about replacing a truck with a more efficient model. The new truck will do exactly the same job the older truck did, but it will use less fuel and have lower maintenance costs. These savings are es�mated to be $3,000 per year, which will increase earnings before taxes by $3,000. The new truck will generate addi�onal deprecia�on expense of $4,000 per year, which, when combined with the savings, implies that earnings before taxes will actually decrease by $1,000 per year. At a 30% tax rate, net income will decrease by $700! We usually don't make changes that reduce profits, but we need to look at the cash flow implica�ons of the change. Figure 5.7 shows the bo�om sec�on of an income statement that shows these changes.

Figure 5.7: Change and cash flow

Despite net income falling a bit, cash flow increases by $3,300. This is because much of the decrease in net income was due to higher deprecia�on (a noncash charge). When we correct for the added deprecia�on expense, we have an increase in cash flow. In this example, cash flow increased. In the next chapter, we will learn methods to determine if this increase in cash flow jus�fies spending money on the new truck.

Complete Method

If we need an es�mate of a company's overall cash flow, then, in addi�on to opera�ng ac�vi�es, we must consider a firm's inves�ng ac�vi�es (e.g., its purchase and sale of assets or increases and decreases in asset accounts) and its financing ac�vi�es (e.g., changes in its borrowing, stock sales, and dividend decisions). This more precise measure considers changes in all asset and liability accounts. Examples of such balance sheet effects include increased accounts receivable from more credit sales, changes in accounts payable from the delayed (or early) payment for supplies, changes in debt and equity accounts caused by new funds the firm obtained from (or repaid to) banks or investors, and changes to the PP&E account caused by expenditures for (or proceeds from the sale of) long-lived assets. Table 5.1 summarizes the effect on cash flows due to changes in assets and liabili�es.

Table 5.1: Effect on cash flows due to changes in assets and liabili�es

Cash increases when . . . Cash decreases when . . .

Assets decrease Liabili�es or equity decrease

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Being able to accurately es�mate cash flows into the future is essen�al to the success of a corpora�on.

The concept of a reservoir is helpful in illustra�ng cash flow and analogizing how companies decide to divert some of their cash flow money into another account, or "reservoir."

age fotostock/SuperStock

This is a good �me to take a minute to test your understanding of cash flow and its rela�onship with common business ac�vi�es. Answer the ques�ons in the Applying Finance: Cash Flow feature to assess your understanding.

Applying Finance: Cash Flow

Instruc�ons: Does the described ac�on increase (INC) or decrease (DEC) cash flow?

1. Selling a machine? 2. Repaying a bank loan? 3. Purchasing a fleet of delivery vehicles? 4. Making more sales on credit? 5. Accelera�ng the payments to suppliers to take advantage of a cash discount? 6. Building up inventory in prepara�on for high holiday sales? 7. Increasing the money in the Cash & Marketable Securi�es account?

See Appendix B (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/appb#appB) for the answers.

The item in the Applying Finance: Cash Flow feature that might have confused you is 7—"Increasing the money in the Cash & Marketable Securi�es account?" We are measuring cash flow, the money moving between accounts within the company, or the money available to invest or pay bills. If we decide to increase our cash reserves we are taking money from that available pool and se�ng it aside. The flow of usable cash has go�en smaller. Consider a river running through a town. The water in the river is our cash flow. If the town decides to divert some of that water into a reservoir to use during a dry period, the flow in the river has been reduced. The reservoir is analogous to the Cash & Marketable Security account. Having more money in that account is a valuable resource if the company faces a downturn in sales or wants to pursue a great growth opportunity, but building up that reserve (i.e., filling up the reservoir) reduces cash flow (water flowing in the river).

Now, let's look at an example where we need to consider changes in balance sheet items as well as deprecia�on to get a good es�mate of cash flow.

Suppose a company is considering offering a new product. The product will increase earnings before deprecia�on and taxes, as shown in Figure 5.8. The addi�onal sales must be supported by increased working capital investments. The sales will be mostly on credit so accounts receivable will increase (an increase in an asset account uses cash flow), more inventory will be required to avoid stock-outs (an increase in an asset account requires cash ou�low), but there will also be some spontaneous financing from an increase in accounts payable (an increase in a liability account generates cash inflow). The company es�mates that the new product will require a working capital investment equal to 25% of sales.

Figure 5.8: Cash flow es�ma�on

Considering the required investment in working capital changes the annual cash flow significantly. No�ce that in Year 2 the working capital requirement is $17,500. Since $12,500 was invested in Year 1, an addi�onal investment of only $5,000 is required in Year 2. Also note that in Year 4, as sales decline, working capital is released enhancing cash flow. The release of working capital occurs because as sales fall the company provides less credit to customers and needs less inventory to sa�sfy orders.

Had we ignored the working capital investment in this example, our es�mates of cash flow would have been incorrect and could have led to a poor decision about whether or not to introduce this product.

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We will use ACME Inc.'s historical income statements to build a pro forma income statement.

5.5 Pro Forma Financial Statements

Pro forma (or projected) financial statements are powerful tools for the financial manager or analyst. They help the financial manager forecast how changes in policies will affect the company's financial situa�on. For example, how will changing a company's credit policy change the size of its short-term bank loan? One of our students who became an investment banker doing leveraged buyouts of companies says that he used pro forma statements more than any other financial tool. In this sec�on, we first show the mechanics of crea�ng a pro forma income statement and balance sheet, then we discuss where an analyst would get the informa�on required for these statements.

The Pro Forma Income Statement

A fairly standard method for construc�ng pro forma income statements is to use historical percent-of-sales for many categories, supplemen�ng with addi�onal informa�on when it is available. The approach is as follows:

Step 1: Obtain sales es�mates or es�mated sales growth from the previous year.

Step 2: Compute cost of goods sold, as a percent of sales based on historical data. If informa�on is available about possible changes in the cost structure, this can be used to modify the es�mate.

Step 3: Compute gross margin (Sales – Cost of goods sold).

Step 4: Determine general, administra�ve, and sales expense, deprecia�on expense, and other expenses, based on historical pa�erns from previous years, or cost es�mates from other departments.

Step 5: Compute taxable income by subtrac�ng the expenses in Step 4 from the gross margin.

Step 6: Compute taxes using the company-wide rate or rates from tax tables; then subtract taxes from taxable income to arrive at net income.

Now we will demonstrate how to build a pro forma income statement using the steps listed above. We will use ACME Inc.'s income statements for 2011 and 2012 to construct a pro forma income statement for 2013 based on some assump�ons about how the business will perform during 2013. Below we list the assump�ons for 2013, while the historical income statements for the company appear in Figure 5.9.

Assump�ons for 2013:

Sales will increase by 10% in 2013 from 2012 levels. COGS and SG&A will be the average percent of sales they were for the last two years. Deprecia�on expense will increase to $1,800. Interest expense will be $840. The tax rate is 25%. Dividend payout will remain at $650.

Figure 5.9: ACME Inc. historical income statements

Using this data, we can start solving for the informa�on needed to create our pro forma income statement. According to our assump�ons, sales will increase by 10% in 2013, so 1.10 × $48,000 = $52,800. In 2011 and 2012, COGS were 72% of sales. We assume that COGS remains 72% of sales in 2103. SG&A expense was 13% of sales in both 2011 and 2012, so we will use that percent of sales in 2013. With this informa�on, we can begin building the pro forma income statement, as seen in Figure 5.10.

Figure 5.10: ACME Inc. pro forma income statement

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Using our assump�ons for 2013, and the historical income statements, we were able to construct ACME Inc.'s pro forma income statement.

Once a pro forma balance sheet is created, it is important for company managers to work together to discuss the implica�ons of the balance sheet before making major financial decisions.

In Pictures/Corbis

Star�ng with sales, we enter the informa�on we have and then subtract items to get gross margin, EBIT, and taxable income. We compute taxes at 40% and subtract them from taxable income to get net income. We subtract dividends from net income to determine how much money will be reinvested in the firm by adding it to retained earnings on the balance sheet.

The Pro Forma Balance Sheet

Pro forma or projected balance sheets are o�en necessary when analyzing the effect of corporate decisions on the company's financial condi�on. One of the most common uses for pro forma balance sheets is es�ma�ng future financial need, so a company can make arrangements for loans or lines of credit. Some loans require that the borrower maintain financial ra�os at or above a certain level. Therefore, before managers of a company subject to such a loan arrangement ini�ate changes that could affect the company's balance sheet, they would want to construct pro forma balance sheets to ensure that the loan restric�ons are sa�sfied.

Construc�ng a simple pro forma balance sheet usually requires four steps. More complex balance sheets require more steps. The construc�on of the balance sheet depends on having already completed the appropriate pro forma income statement, so the pa�ern given here assumes the income statement is available.

Step 1: Fill in all of the values that don't change, that are known, or that change in a definite manner. These include items such as long-term debt and the common stock accounts.

Step 2: Fill in all values from income statement. These are deprecia�on and retained earnings.

Step 3: Fill in all values that are projected according to company policy or that represent target policy values. These include inventory, accounts receivable, accounts payable, and plant, property, and equipment. Some of

these will change as a percent of sales. O�en the Cash account is set at some minimum based on sales.

Step 4: Add up the asset side of the balance sheet and transfer that total to the liabili�es and equity side. Balance the assets and liabili�es by adjus�ng a plug figure, usually bank loans or notes payable on the liabili�es side of the balance sheet. If the bank loan is nega�ve, make it zero, add up the liabili�es, move that total to total assets, and adjust the asset side with the Cash account taking up whatever slack is necessary to balance things.

We will demonstrate with an example that builds on the pro forma income statement we just completed for ACME Inc. The actual balance sheet for 2012 is shown in Figure 5.11. We will construct the pro forma balance sheet for 2013 using the following assump�ons:

The minimum cash balance is 3% of sales. Working capital accounts (A/R, A/P, and Inventory) will be the same percent of Sales in 2013 as they were in 2012. $4,000 of new PP&E will be purchased in 2013. Other current liabili�es will remain at 2% of sales in 2013. There will be no changes in the Common Stock or Long-term Debt accounts. The plug figure is bank loan.

Figure 5.11: ACME Inc. balance sheet

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The accoun�ng balance sheet is one of the most important sources of tracking business progress.

The pro forma accoun�ng balance sheet will allow ACME Inc.'s management to project business ac�vity into the future.

Now we can complete our pro forma balance sheet. We add the items that we know for 2013, then fill in the asset side of the balance sheet. We work up from the bo�om of the liabili�es side of the balance sheet by first transferring total assets to total liabili�es and equity. We work our way up the liabili�es side un�l there is one item le�. In our example, the last cell will be the Bank Loan account. The Bank Loan account must put the balance sheet in balance so the Bank Loan amount is our plug figure; it is the number that makes things balance. Figure 5.12 shows the completed pro forma balance sheet for ACME Inc.

Figure 5.12: ACME Inc. pro forma balance sheet

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A company's financial situa�on some�mes becomes evident over a period of �me. Some�mes, a company cannot financially sustain rapid growth.

As small businesses grow, they must watch their cash inflow to make sure they do not grow so fast that they have no money to pay their expenses.

Erich Schlegel/Corbis

5.6 How Growth Affects Cash Flow

Many profitable small businesses fail because they grow too fast for the amount of cash they have. One of the authors watched a very profitable small company grow and fail because of the lack of cash. Government agencies hired the company to duplicate and store records such as land �tles, surveying plats, building permits, and other documents that governments generate that might be called on in the future if a dispute or ques�on arises. The owner had enough money to purchase the equipment and have a small cash reserve. Business picked up quickly because local governments had a mandate to store these items, but had neither a system nor the labor to do so. The business was very profitable in an accoun�ng sense, but it failed. The problem was that the government agencies were slow to pay their bills. The owner had to pay his expenses right away but had to wait 90 to 120 days to receive payments from the government agencies. Every �me around the cash cycle, the business accrued a larger bill for expenses than it did cash from customers. The financing gap—the gap between having to disburse cash to suppliers and receiving cash from customers—con�nued to grow with each cash cycle. Figure 5.13 shows a stylized version of the company's financial situa�on.

Figure 5.13: The company's financial situa�on

You can see from the figure that as the company con�nued to grow the cash outlays also grew. The inflows lagged the outlays by three months, so as long as the company kept growing, the net cash flow (inflows- ou�lows) grew. If the cash reserve was only $100,000 or $150,000, you can see that the company could only remain in business for four or five months. Unless the company slowed its growth, the inflows could not catch up with the ou�lows. This is known as nega�ve cash flow. Later in the text, we will discuss how to es�mate a sustainable growth rate.

This par�cular story had a sad end. The owner of the business couldn't get a very large bank loan and decided to make up the funds by not paying the taxes that he had withheld from employees paychecks (This is illegal!). Eventually the tax authori�es caught him, and the business was shut down.

The moral of the story is that it is be�er to turn away some business than fail. And, always pay your taxes.

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Securi�es analysts play an important role in compu�ng expected cash flows and advising investors on investment opportuni�es.

Photographer's Choice/Ge�y Images

5.7 Computing Expected Cash Flows

When we discuss cash flows from investments, we are talking about future or expected cash flows. Inves�ng today generates payoffs in the future. Therefore, when evalua�ng investment opportuni�es, we must try to es�mate each investment's expected cash flows. In finance, we say that investors form expecta�ons about these future payoffs. The best es�mate of an investment's future payoff is called the expected value of future cash flows. The expected value is a weighted average, with the weights being probabili�es. Suppose a security analyst (a person who analyzes stocks and then makes recommenda�ons to clients on whether to buy, hold, or sell the stocks) believes that Chevron Corpora�on (Ticker: CVX), a leading oil producer, will pay a dividend next quarter of between $0.70 and $1.00. More precisely, the analyst thinks that there is a 10% chance the dividend will be $0.70, a 30% chance it will be $0.80, and a 40% it will be $0.90, and a 20% it will be $1.00. The expected value of Chevron's next dividend is computed by mul�plying each of the possible outcomes ($0.70, $0.80, $0.90, and $1.00) �mes its respec�ve probability and then adding up these products. Arithme�cally, the expected dividend is

Expected dividend = 10% × $0.70 + 30% × $0.80 + 40% × $0.90 + 20% × $1.00 = $0.07 + $0.24 + $0.36 + $0.20 = $0.87

The expected value is slightly more than the middle of the value ($0.85) because the analyst assigns a slightly higher probability to the $0.90 outcome. No�ce that the analyst predicts that the dividend will be either $0.70, $0.80, $0.90, or $1.00. Nowhere does the analyst predict a dividend of $0.87. The actual outcome will not be the expected value of $0.87. Although we compute an expected value for a given point in �me (next quarter's dividend, next year's sales, etc.), expected values are long-run averages. If this set of possible outcomes and probabili�es occurred many �mes, the average dividend from those many occurrences would be the expected value, $0.87.

As this example shows, the expected value is a probability weighted average. Each possible outcome is weighted by the likelihood that it will occur; then these weighted outcomes are summed. Mathema�cally, the expected value is expressed as follows:

Where CFi represents one of the possible cash flow levels (e.g., in the Chevron example, CF1 = $0.70) and pi represents the probability of that cash flow level actually

occurring (the probability associated with the $0.70 outcome in the Chevron example is 10%). The probabili�es, π1 through πn must sum to 1.0 or 100%. The sigma, ∑, is a

summa�on sign, which means we add up all of the separate elements created as our counter i goes from 1 to n. The formula for expected value allows for an unlimited number of possible outcomes because n, the last outcome, can be as large as we want it to be.

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Ch. 5 Conclusion

This chapter discussed cash flow. Cash is the lifeblood of a business enterprise. Despite having accoun�ng profits, a business without cash is doomed. Without cash the company cannot pay its employees, its suppliers, its tax bill, or its bankers. Our discussion of cash flow focused on understanding how cash flows into, out of, and through the company. The cash cycle is a valuable tool for thinking about the day-to-day opera�ons of any business. A�er our accoun�ng review, we explained why accoun�ng profits differ from cash flow. The majority of the chapter discussed how to es�mate cash flows from income statement and balance sheet informa�on and how to es�mate the cash flows for a new investment project using pro forma (or projected) income statements. If you have a good understanding of cash flow—its importance and how to es�mate it —and have mastered some of the analy�c tools introduced in this chapter, you have taken a significant first step in learning how to manage a financially healthy business.

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Ch. 5 Learning Resources

Key Ideas

The simple cash cycle is made up of three steps: 1. The purchase of materials and manufacture of goods; 2. The sale of goods; 3. The collec�on of accounts receivable, payment of accounts payable, and purchase of more material.

The complete cash cycle expands on the simple cash cycle. It includes addi�onal steps, such as payment of taxes, disbursements to claimants, and asset purchases. The income statement is important because it shows revenues and expenses over the course of the year. The accoun�ng balance sheet is one of the most important sources of tracking business progress. The statement of cash flows consolidates the cash ac�vi�es over the year and classifies the ac�vi�es into opera�ons, financing, and inves�ng categories. The simple method for transla�ng accoun�ng profits into cash flows is achieved by adding the deprecia�on expense for an accoun�ng period to net income. The complete method for transla�ng accoun�ng profits into cash flows requires the considera�on of a firm's opera�ng, inves�ng, and financing ac�vi�es. Pro forma financial statements help the financial manager forecast how changes in policies will affect the company's financial situa�on. The effects of rapid company growth are not always sustainable. Ou�lows cannot exceed inflows, otherwise the company will fail. The expected value of future cash flows is the best es�mate of an investment's future payoff.

Key Equa�ons

Cri�cal Thinking Ques�ons

1. If a project analysis shows accoun�ng losses (nega�ve net income), does that ensure that the project should not be pursued? Imagine a project with large capital investments and correspondingly large deprecia�on.

2. Suppose two new companies are iden�cal in all ways except that one uses an accelerated deprecia�on method and the other uses the straight-line method. Ini�ally, which company will have the higher profits? Which will have the higher cash flow? Explain your answers using a simple income statement.

3. In a company there are two divisions compe�ng for investment funds. Manager A proposes a project that uses some idle capacity on exis�ng machines. Manager B, her compe�tor, says that Manager A should include deprecia�on expense for that idle machinery in the cash flow es�mates of Manager A's proposal. Will including extra deprecia�on from exis�ng machinery make the project look worse as Manager B hopes?

4. Some financial analysts use EBITDA (Earnings before Interest, Taxes, Deprecia�on and Amor�za�on) as a proxy for cash flow. Would this be a be�er metric of cash flow available to service debt or available to equityholders? It might be helpful to use an income statement to explain your answer.

5. We say, "An increase in an asset account is a use of cash." But the Cash account is an asset account, so how can an increase in the Cash account be a use of cash? 6. Sec�on 5.1 introduced the cash cycle: purchasing materials to produce inventory, making a sale, and finally collec�ng the cash from the sale. One way to think about the cash

cycle is in terms of days. Inventory days tells us how long it takes from buying materials (or items for resale) to selling an item. Receivable days tells us how long it takes to collect cash a�er a sale is made, and Payables days tells us how long we have to pay our suppliers for materials or merchandise. The cash cycle can be seen as Inventory days + Receivable Days – Payables days. If a company has a nega�ve cash cycle that means that it collects cash from a sale before it must pay its suppliers. Is a nega�ve cash cycle good or bad for a company? Is it the same thing as nega�ve cash flow?

Key Terms

Click on each key term to see the defini�on.

balance sheet (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Snapshot of a company's financial posi�on at a moment in �me. The le�-hand side lists assets and the right-hand side lists liabili�es and owners' equity.

cash cycle (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The sequence of ac�vi�es associated with cash moving through the company.

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cash flow (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The amount of money that passes through a corpora�on. Residual cash flow, for example, refers to the amount of money that stockholders have a claim on a�er all other claims have been paid.

deprecia�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

An accoun�ng expense designed to reflect the wear and tear or use of a long-lived asset.

expected cash flow (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The future cash flow from an investment computed by assigning probabili�es to various outcomes.

expected value of future cash flows (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The probability weighted value of an investment, computed by assigning a probability of occurrence to the various possible future values.

financing gap (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The days or dollars that a company must finance with reserves before cash from sales flow into the company.

generally accepted accoun�ng principles (GAAP) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The accoun�ng rules that define how companies construct their financial reports. Designed to provide as accurate as possible a picture of a company's opera�onal ac�vi�es and financial posi�on.

gross margin (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Represents the amount of revenue that is le� a�er costs to cover opera�ng expenses.

income statement (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A record for a period of a company's opera�onal ac�vi�es. Some�mes referred to as a P/L or profit/loss statement because the bo�om line of the report provides profit or loss income informa�on.

matching principle (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The accoun�ng rule that matches expenses for a period to the number of units sold during the period. Designed to help users of financial statements determine whether a firm can earn profits.

nega�ve cash flow (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Cash ou�lows exceed cash inflows. Even profitable companies may experience nega�ve cash flow on occasion.

opera�ng expenses (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Expenses that arise during the ordinary course of running a business. These include salaries paid to employees, research and development costs, legal fees, accountant fees, bank charges, office supplies, electricity bills, business licenses, and more.

opera�ng margin (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The total pre-tax profit a business generated from its opera�ons.

pro forma (or projected) financial statements (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Financial statements for future periods constructed based on historic financial ra�os and assump�ons about how the firm will perform in the future. They are useful tools for analyzing many types of corporate decisions.

revenue recogni�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Accoun�ng rules that explain when a company may recognize a transac�on as a sale. Companies with aggressive accoun�ng strategies recognize revenue as early as possible, while more conserva�ve companies delay un�l they are certain of the amount to be collected.

statement of cash flows (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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An accoun�ng statement that shows cash from opera�ng, inves�ng, and financing ac�vi�es.

Web Resources

To read The New York Times ar�cle "Top 10 Reasons Small Businesses Fail," see: h�p://boss.blogs.ny�mes.com/2011/01/05/top-10-reasons-small-businesses-fail/ (h�p://boss.blogs.ny�mes.com/2011/01/05/top-10-reasons-small-businesses-fail/)

To see Nike's financial report and notes, visit: h�p://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/docs/Nike_2011_10-K.pdf (h�p://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/docs/Nike_2011_10-K.pdf)

Learn more about Ernst & Young's U.S. GAAP vs. IFRS: The Basics here: h�p://www.oglethorpe.edu/faculty/~c_benton/intermediate/documents/ifrsvsusgaapbasicsmarch2010copy.pdf (h�p://www.oglethorpe.edu/faculty/~c_benton/intermediate/documents/ifrsvsusgaapbasicsmarch2010copy.pdf)

For more informa�on on deferred taxes, see: h�p://www.centrec.com/resources/ar�cles/finanalysisfarmranches/deferredtaxes.pdf (h�p://www.centrec.com/resources/ar�cles/finanalysisfarmranches/deferredtaxes.pdf)

EBITDA is some�mes used as a measure of cash flow (see Cri�cal Thinking Ques�on 4). Here is an interes�ng applica�on of EBITDA to company valua�on: h�p://www.inc.com/guides/2010/10/how-to-understand-earnings-or-ebitda.html (h�p://www.inc.com/guides/2010/10/how-to-understand-earnings-or-ebitda.html)

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