Module 01: Discussion MF

edina

Cornett_Finance_5e_Chapter_02_PPT.pptx

Home >Business & Finance homework help >Financial markets homework help >Module 01: Discussion MF

Reviewing Financial Statements

Finance 5th Edition

Cornett, Adair, and Nofsinger

Introduction

A financial statement provides an accounting-based picture of a firm’s financial position

An annual report is made up of four basic financial statements

Balance sheet

Income statement

Statement of cash flows

Statement of retained earnings

2-‹#›

Introduction (continued)

Reports are used by accountants as a picture of past financial performance

Finance professionals use financial statements to draw inferences about the future

2-‹#›

Balance Sheet

The balance sheet reports firm’s assets, liabilities and equity at a point in time

Assets = Liabilities + Equity

Assets of firm appear on left side

Liabilities and equity appear on right side

Both assets and liabilities are listed in decreasing order of liquidity, that is, the time and effort needed to convert the accounts to cash

Equity never matures, and therefore appears last

2-‹#›

The most liquid assets (called current assets) appear first on the asset side of the balance sheet. The least liquid, called fixed assets, appear last. Similarly, current liabilities – those obligations that the firm must pay within a year – appear first on the right hand side of the balance sheet. Stockholders’ equity, which never matures, appears last on the balance sheet.

Table 2.1 - Balance Sheet for DPH

2-‹#›

Assets

Current assets normally convert to cash within one year

E.g., cash and marketable securities, accounts receivable, and inventory

Fixed assets have a useful life exceeding one year

Physical (tangible) assets

E.g., net plant and equipment

Less tangible, long-term assets

E.g., patents and trademarks

2-‹#›

The value of net plant and equipment is found by taking the difference between gross plant and equipment and the depreciation accumulated against the fixed assets since their purchase.

Liabilities

Liabilities are funds provided to the firm by lenders

Current liabilities constitute the firm’s obligations due within one year

E.g., accrued wages and taxes, accounts payable, and notes payable

Long-term debt include those obligations with maturities of more than one year

E.g., long-term loans and bonds with maturities greater than one year

2-‹#›

Stockholders’ Equity

Stockholders’ equity is the difference between a firm’s total assets and total liabilities

Preferred stock is a hybrid security with characteristics of both long-term debt and common stock

Common stock and paid-in-surplus is the fundamental ownership claim in public or private company

Retained earnings are company profits that are kept by the firm rather than distributed to the stockholders as cash dividends

2-‹#›

Managing the Balance Sheet

Managers must monitor a number of issues underlying items reported on their firms’ balance sheets:

Accounting method for fixed asset depreciation

Level of net working capital

Liquidity position of the firm

Method for financing the firm’s assets

Equity or debt

Difference between firm’s book value and true market value

2-‹#›

Accounting Method for Fixed Asset Depreciation

Managers can choose the accounting method they use to record depreciation against their fixed assets

Straight-line method

Commonly chosen when reporting income to the firm’s stockholders

MACRS method

Typically used when computing taxes, as it accelerates depreciation, resulting in lower taxable income, which leads to lower taxes in the early years of a project’s life.

2-‹#›

Net Working Capital

Net Working Capital =

Current assets - Current liabilities

Net working capital is measure of the firm’s ability to pay obligations as they come due

Healthy firms have positive net working capital values

2-‹#›

Liquidity

Liquidity refers to two dimensions

Ease with which the firm can convert an asset to cash

Degree to which such a conversation takes place at a fair market value

Current assets remain relatively liquid

E.g., cash

Fixed assets remain relatively illiquid

E.g., buildings and equipment

2-‹#›

Highly liquid assets can be sold quickly at their fair market values, while illiquid assets cannot be sold quickly unless the price is reduced far below fair value.

Liquidity (continued)

Liquidity is double-edged sword

The good?

The more liquid assets a firm holds, the less likely the firm will be to experience financial distress

The bad?

Liquid assets generate little or no profits for a firm

Managers must carefully consider this trade-off

2-‹#›

Debt vs. Equity Financing

Financial leverage refers to the extent to which a firm chooses to finance its ventures or assets by issuing debt securities

Magnifies gains and losses

Debt holders have a fixed claim on firm’s cash flows (interest paid on securities and principal repayments)

Stockholders claim any cash flows left after debt holders are paid

Choice of firm’s capital structure represents management’s risk and return preference

2-‹#›

Book Value vs. Market Value

In many cases, book values differ widely from market values

The book (or historical cost) value is the amount the firm paid for the assets

Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what those assets might be worth today if the firm were to sell them

The market value is the amount the firm would get if it sold the assets

2-‹#›

Income Statement

The income statement shows the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time

The top part of the income statement reports the firm’s operating income

The bottom part of the income statement summarizes the firm’s financial and tax structure

2-‹#›

Remember, the balance sheet reports a firm’s position at a specific point in time, while the income statement reports performance over a period of time (e.g., the last year).

Income Statement Structure

2-‹#›

DPH Tree Farm Income Statement

XXX – Add Table 2.2

2-‹#›

Income/Firm Value Summary Below the Bottom Line

2-‹#›

Corporate Income Taxes

Firms taxed on earnings

U.S. tax code determines corporate tax obligations – overseen by Congress

Tax rate changes driven by changes in administration or other changes in the business or public environment

Tax Cut and Jobs Act (TCJA) of 2017

Permanently lowers corporate taxes from a progressive schedule (where the highest tax rate was 35%) to a flat 21% beginning in 2018

2-‹#›

The TCJA of 2017 represents one of the most significant changes to corporate tax laws in more than 30 years.

Corporate Income Taxes (continued)

Average tax rate

Percentage of each dollar of taxable income that the firm pays in taxes

Marginal tax rate

Amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns

2-‹#›

Interest and Dividends Received

Interest is taxable with two exceptions

Interest on state and local government bonds are federally tax-exempt

One corporation owns stock in another corporation

50% of dividends received from the other corporation are considered tax exempt

Taxed on remaining 50% of dividends received at the receiving corporation’s tax rate

2-‹#›

Interest and Dividends Paid

Interest payments appear on the income statement as an expense item

They are deducted from income before calculating taxable income

Dividends paid to shareholders by corporations are not tax deductible

Encourages managers to finance with debt, which is less expensive than using equity

Due to the deductible nature of interest paid by firm

2-‹#›

Statement of Cash Flows

The statement of cash flows is a financial statement that shows firm’s cash flows over given period of time

Reports the amounts of cash the firm has generated and distributed during a particular time period

Bottom line on the statement of cash flows reflects difference between cash sources and uses

Equal to the change in cash and marketable securities on the firm’s balance sheet over a period of time

2-‹#›

GAAP Accounting Principles

Company accountants use GAAP principles to prepare firm income statements

Revenue recognition and actual cash outflows incurred with production may occur at a different time than GAAP principles allow

GAAP principles

Revenue recognized at the time of sale

Production and other expenses shown on the income statement as the sales of those goods take place

2-‹#›

Sources and Uses of Cash

An activity that increases cash is a cash source

Increasing liabilities (or equity)

Decreasing noncash assets

An activity that decreases cash is a cash use

Decreasing liabilities (or equity)

Increasing noncash assets

2-‹#›

Sources and Uses of Cash (continued)

Four categories are used to separate cash flows on the statement of cash flows:

Cash flows from operating activities

Cash flows from investing activities

Cash flows from financing activities

Net change in cash and marketable securities

2-‹#›

DPH Tree Farm Statement of Cash Flows

2-‹#›

Cash Flows from Operations

Cash flows that are the direct result of the production and sale of the firm’s products are cash flows from operations, and include:

Net income (adding back depreciation)

Change in working capital accounts other than cash and operations-related short-term debt

Positive cash flows from operations is what gives the firm value

2-‹#›

Considered to be the most important section of the statement of cash flows by most finance professionals

Cash Flows from Investing Activities

Cash flows associated with the purchase or sale of fixed or other long-term assets are cash flows from investing activities

Shows inflows and outflows from changes in long-term investing activities

2-‹#›

Cash Flows from Financing Activities

Cash flows from financing activities result from debt and equity financing transactions and include:

Issuing short-term debt

Issuing long-term debt

Issuing stock

Using cash to pay dividends

Using cash to pay off debt

Using cash to buy back stock

2-‹#›

Net Change in Cash and Marketable Securities

The sum of the cash flows from operations, investing activities, and financing activities is the net change in cash and marketable securities (i.e., the bottom line of the statement of cash flows)

Reconciles to the net change in cash and marketable securities account on the balance sheet over period of analysis

Positive bottom line indicates cash inflows exceeded cash outflows for the period

2-‹#›

Free Cash Flow

Free cash flows is the cash actually available for distribution to the investors in the firm after the investments that are necessary to sustain the firm’s ongoing operations are made

2-‹#›

Free Cash Flow (continued)

Firms generate operating cash flow (OCF) after they have paid necessary operating expenses and taxes

Net operating profit after taxes (NOPAT) is the net profit a firm earns after taxes, but before any financing costs

Investment in operating capital (IOC) includes gross investments in fixed assets, current assets, and spontaneous current liabilities

2-‹#›

Free Cash Flow (concluded)

Firms with positive free cash flow (FCF) have funds available for distribution to investors

Potential implications for firms with negative FCF

May be experiencing operating or managerial problems

May be investing heavily in operating capital to support growth

Note: FCF might be negative while OCF is positive

2-‹#›

Free Cash Flow Equation

2-‹#›

Statement of Retained Earnings

The statement of retained earnings reconciles net income earned during a given period and any cash dividends paid with the change in retained earnings over the period

Advantages of reinvesting

Less expensive than raising capital from outside sources (equity markets)

Allows the firm to grow by providing additional funds that can be spent on plant and equipment

2-‹#›

Cautions in Interpreting Financial Statements

GAAP standards required for financial statements

Firms can use earnings management with GAAP accounting rules

Firms may wish to smooth earnings

Firms utilize different depreciation methods, making comparison across firms difficult

Sarbanes-Oxley Act passed in 2002

Aims to prevent deceptive accounting and management practices

2-‹#›