Assignment 1
SiriP
Chapter2.FinancialStatementsandCashFlow1.pptxFinancial Statements Analysis and Financial Models
Chapter 2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
3-‹#›
1
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
Grasp the difference between accounting income and cash flow
Calculate a firm’s cash flow
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4
Note that Slides 4 and 7 from Chapter 1 could be reused here to emphasize the general structure of the balance sheet.
The left-hand side of the balance sheet lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are a direct result of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.)
Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of management’s financing decisions.
Remember that shareholders’ equity consists of several components, and that total equity includes all of these components not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders.
Take Notice! (on the following Balance Sheet)
Assets exactly equal liabilities + equity
Assets are listed in order of liquidity
The amount of time it would take to convert them to cash in an operating business
Obviously cash and A/R are more liquid than property plant and equipment
Liabilities are listed in the order in which they come due
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S. Composite Corporation Balance Sheet (in $ millions)
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Balance Sheet Analysis
When analyzing a balance sheet, the Finance Manager should be aware of three concerns:
Accounting liquidity
Debt versus equity
Value versus cost
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Accounting 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
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
8
Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.
Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the IM for a more complete discussion of this issue.
Debt versus Equity
Creditors generally receive the first claim on the firm’s cash flow.
Shareholders’ equity is the residual difference between assets and liabilities.
Debt and equity have different costs; the relationship between them has an impact on the firm’s profitability.
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Value versus Cost
Under Generally Accepted Accounting Principles (GAAP), financial statements of firms in the U.S. carry assets at historical 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.
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
2.2 The Income Statement
Measures financial performance over a specific period of time
The accounting definition of income is:
Revenue – Expenses ≡ Income
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Income Statement 2017 Operations section (in $ Millions)
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Addition to retained earnings $43
Dividends: $43
The operations section of the income statement reports the firm’s revenues and expenses from principal operations.
$2,262
1,655
327
90
$190
29
$219
49
$170
84
$86
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Income Statement 2017 Non-operating section (in $ Millions)
Total operating revenues
$2,262
Cost of goods sold
1,655
Selling, general, and administrative expenses
327
Depreciation
90
Operating income
$190
Other income
29
Earnings before interest and taxes
$219
Interest expense
49
Pretax income
$170
Taxes
84
Current: $71
Deferred: $13
Net income
$86
Addition to retained earnings: $43
Dividends: $43
The non-operating section of the income statement includes all financing costs, such as interest expense.
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Income Statement 2017 Net Income (in $ Millions)
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings: $43
Dividends: $43
Net income is the “bottom line.”
$2,262
1,655
327
90
$190
29
$219
49
$170
84
$86
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
14
Income Statement Analysis
There are three things to keep in mind when analyzing an income statement:
Generally Accepted Accounting Principles (GAAP)
Noncash Items
Time and Costs
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
GAAP
The matching principal of GAAP dictates that revenues be matched with expenses.
Thus, income and expenses are reported when earned or incurred, even though no cash flow may have occurred.
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Noncash Items
Depreciation is the most apparent non-cash item. No firm ever writes a check for “depreciation.”
Other noncash accounts include uncollected sales on account, unpaid purchases on account and deferred taxes, none of which represent a cash flow.
Thus, net income does not equal cash flow
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Time and Costs
Think of the future as having two parts: short run and long run
In the short run some costs are fixed and others variable:
In the short run equipment and commitments are fixed
Production can only be varied by altering labor and materials
In the long run all costs are variable
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Costs and Purpose
Financial accountants do not distinguish between variable costs and fixed costs
Accounting costs are usually treated as period or product costs
Product Costs: Total production costs
i.e., raw materials, direct labor, manufacturing overhead
Period Costs: Costs allocated to a time period
i.e., selling, general and administrative costs
Such as accountant salaries, office supplies
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
2.3 Taxes
Taxes impact income; important to financial decisions
Taxes come from various sources:
Federal, state, excise
Taxes are always changing
Marginal vs. average tax rates
Marginal – the percentage paid on the next dollar earned
Average = the tax bill / taxable income
Financial decisions are incremental; applicable tax rate is the marginal rate
Other taxes
2-‹#›
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
20
Point out that taxes can be a very important component of the decision making process, but that what they learn about tax specifics now could change tomorrow. Consequently, it is important to keep up with the changing tax laws and to utilize specialists in the tax area when making decisions where taxes are involved.
www: Click on the web surfer icon to go to the IRS web site for the most up-to-date tax information.
It is important to point out that we are concerned with the taxes that we will pay if a decision is made. Consequently, the marginal tax rate is what we should use in our analysis.
Point out that the tax rates discussed in the book are just federal taxes. Many states and cities have income taxes as well, and those taxes should figure into any analysis that we conduct.
Marginal versus Average Tax 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?
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
21
Tax liability:
.15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,360,000
Average rate: 1,360,000 / 4,000,000 = .34 or 34% Marginal rate comes from the table, and it is 34%
We should use the marginal rate with an expected additional 34,000 in taxes.
2.4 Net Working Capital
Net Working Capital ≡
Current Assets – Current Liabilities
NWC usually grows with the firm
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Balance Sheet Net Working Capital
2017
2016
2017
2016
Current assets:
Current Liabilities:
Cash and equivalents
$198
$157
Accounts payable
$486
$455
Accounts receivable
294
270
Inventories
269
280
Total current liabilities
$486
$455
Total current assets
$761
$707
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 equipment
873
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
Here we see NWC grow to $275 million in 2017 from $252 million in 2016.
This increase of $23 million is an investment of the firm.
$23 million
$275m = $761m- $486m
$252m = $707- $455
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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.
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 other words, the cash generated by assets enables the firm to pay its debts and provide a return to shareholders.
Accounting cash flow and financial cash flow are not necessarily equal.
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
24
Remind students that this relation is just an application of the standard balance sheet identity.
U.S.C.C. Financial Cash Flow: OCF
Cash Flow of the Firm
Operating cash flow
$238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
-23
Total
$42
Cash Flow of Investors in the Firm
Debt
$36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
$42
Operating Cash Flow:
EBIT $219
Depreciation $90
Current Taxes -$71
OCF $238
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Financial Cash Flow: Capital Spending
Cash Flow of the Firm
Operating cash flow
$238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
Capital Spending
Purchase of fixed assets $198
Sales of fixed assets -$25
Capital Spending $173
-173
-23
$42
$36
6
$42
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
26
Note that capital spending can also be calculated as:
End NFA – Beg NFA + Depr
= $1,118 - $1,035 + $90 = $173
U.S.C.C. Financial Cash Flow: Net Working Capital
Cash Flow of the Firm
Operating cash flow
$238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
NWC grew to $275 million in 2014 from $252 million in 2013.
This increase of $23 million is the addition to NWC.
-173
-23
$42
$36
6
$42
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Financial Cash Flow: cash Flow to Creditors
Cash Flow of the Firm
Operating cash flow
$238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
Cash Flow to Creditors
Interest $49
Retirement of debt 73
Debt service 122
Proceeds from new debt sales -86
Total $36
-173
-23
$42
$36
6
$42
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
28
Cash flow to creditors can also be calculated as:
Interest paid – Net new borrowing = Interest paid – (End LT Debt – Beg LT Debt)
=$49 – ($471 - $458) = $36
U.S.C.C. Financial Cash Flow: Cash Flow to Stockholders
Cash Flow of the Firm
Operating cash flow
$238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
Cash Flow to Stockholders
Dividends $43
Repurchase of stock 6
Cash to Stockholders 49
Proceeds from new stock issue -43
Total $6
-173
-23
$42
$36
6
$42
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Financial Cash Flow: reconciliation
Cash Flow of the Firm
Operating cash flow
$238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:
-173
-23
$42
$36
6
$42
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
2.5 The 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 $33 million in 2014.
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
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
31
It is extremely important to remind students that accounting cash flow and actual cash flow as calculated earlier are different values.
U.S.C.C. Cash Flow from Operating Activities
To calculate cash flow from operations, start with net income, add back noncash items like depreciation and adjust for changes in current assets and liabilities (other than cash).
Operations
Net Income
Depreciation
Deferred Taxes
Changes in Current Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
$86
90
13
-24
11
31
Total Cash Flow from Operating Activities
$207
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. 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).
Acquisition of fixed assets
Sales of fixed assets
Total Cash Flow from Investing Activities
-$198
25
-$173
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Cash Flow from Financing activities
Cash flows to and from creditors and owners include changes in equity and debt.
Retirement of debt
Proceeds from long-term debt sales
-$73
86
Total Cash Flow from Financing Activities
$4
Dividends
Repurchase of stock
-43
Proceeds from new stock issue
43
-6
Change in notes payable
-3
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
U.S.C.C. Statement of Cash Flows
The statement of cash flows is the addition of cash flows from operations, investing, and financing.
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Quick Quiz
What is the difference between book value and market value? Which should we use for decision making purposes?
What is the difference between accounting income and cash flow? Which do we need to use when making decisions?
What is the difference between average and marginal tax rates? Which should we use when making financial decisions?
How do we determine a firm’s cash flows? What are the equations, and where do we find the information?
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Sources of Information
Financial information is abundant and readily accessible.
The following are some common sources:
Annual reports
Internet
EDGAR
10K & 10Q reports
2-‹#›
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37
This slide contains hyperlinks to the Wall Street Journal, the NYSE, NASDAQ, the publisher (McGraw), yahoo! finance, and the SEC.
)()(
)(
SCFBCF
ACF
