2. Ch. 2 - Understanding Financial Statements, Taxes, and Cash Flows , Prentice Hall, Inc.

3. Chapter 2 Game Plan ► Overview of Accounting Statements  What are profits?  What is a company’s book value? ► Corporate Taxes ► Free Cash Flow Measurement  How cash flow differs from accounting profits.  (cash flow example info & notes posted under next Wed’s lecture)

4. Principles of the Week ► Principle 4: Cash is king. ► Principle 7: Agency Relationships. How to insure management is acting in the stockholders best interests.

5. SALES SALES - EXPENSES - EXPENSES = PROFIT = PROFIT Income Statement

6. SALES SALES - EXPENSES - EXPENSES = PROFIT = PROFIT Income Statement Revenue

7. Income Statement SALES SALES - EXPENSES - EXPENSES = PROFIT = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative) Financing Costs Taxes

8. SALES SALES - Cost of Goods Sold GROSS PROFIT GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS TO COMMON STOCKHOLDERS Income Statement

9. SALES SALES - Cost of Goods Sold GROSS PROFIT GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS TO COMMON STOCKHOLDERS Income Statement

10. SALES SALES - Cost of Goods Sold GROSS PROFIT GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS TO COMMON STOCKHOLDERS Income Statement

11. Harley-Davidson, Inc. Annual Income Statement Millions of U.S. Dollars 31-Dec-200131-Dec-200031-Dec-1999 Sales--Core Business3,545.03,046.52,585.7 Total Sales3,545.03,046.52,585.7 Cost of Goods Sold2,303.72,018.51,722.3 SG&A Expense578.8513.0447.5 Other Operating Expense0.0 Total Expenses2,882.52,531.52,169.8 Operating Income662.5515.0415.9 Interest Expense, Non-Oper0.0 Other--Net11.033.64.9 Pre-Tax Income673.5548.6420.8 Income Taxes235.7200.8153.6 Income After Taxes437.7347.7267.2 Net Income437.7347.7267.2 Primary EPS1.451.150.88 Dividends Per Share0.120.100.09 Shares to Calculate Primary EPS (millions of shares)302.5302.7304.7

12. Balance Sheet Total Assets = Total Assets = Outstanding Debt + Shareholders’ Equity

13. Balance Sheet Assets Liabilities (Debt) & Equity Current Assets Current Assets Cash Cash Marketable Securities Marketable Securities Accounts Receivable Accounts Receivable Inventories Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Machinery & Equipment Buildings and Land Buildings and Land Other Assets Investments & patents Current Liabilities Accounts Payable Accrued Expenses Short-term notes Long-Term Liabilities Long-term notes Mortgages Equity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings

14. Assets ► Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.

15. Assets  Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

16. Assets ► Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.  Cash, marketable securities, accounts receivable, inventories, prepaid expenses. ► Fixed Assets: machinery and equipment, buildings, and equipment, buildings, and land. and land.

17. Assets ► Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.  Cash, marketable securities, accounts receivable, inventories, prepaid expenses. ► Fixed Assets: machinery and equipment, buildings, and land. ► Other Assets: any asset that is not a current asset or fixed asset.  Intangible assets such as patents and copyrights.

18. Harley-Davidson, Inc. Annual Balance Sheet Millions of U.S. Dollars 31-Dec-200131-Dec-200031-Dec-1999 Assets Cash & Equivalents439.4419.7183.4 Other Short-Term Investments196.00.0 Accounts Receivable775.3629.2542.7 Inventory181.1191.9168.6 Prepayments & Advances34.428.124.9 Other Current Assets39.028.329.4 Total Current Assets1,665.31,297.3949.0 Property Plant & Equipment1,705.41,424.61,236.2 Accum Depr. & Amort.-813.5-670.4-554.4 Property Plant & Equipment, Net891.8754.1681.7 Goodwill/Intangibles49.754.355.4 Other Long-Term Assets511.7330.7425.9 Total Assets3,118.52,436.42,112.1

19. Financing ► Debt Capital: financing provided by a creditor. ► Short-term debt: borrowed money that must be repaid within the next 12 months.  Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes. ► Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

20. Financing ► Equity Capital: shareholders’ investment in the firm. ► Preferred Stockholders: received fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. ► Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

21. Harley-Davidson’s Liabilities Liabilities Accounts Payable194.7169.8137.7 Short-Term Debt0.0 Curr. LT Debt and CLOs217.189.5181.2 Other Current Liabilities304.4238.4199.3 Total Current Liabilities716.1497.7518.2 Long-Term Debt380.0355.0280.0 Deferred Taxes17.815.612.0 Other Long-Term Liabilities248.3162.4140.8 Total Liabilities1,362.21,030.7951.0 Stockholders' Equity Common Stock3.2 Additional Paid in Capital359.2285.4234.9 Retained Earnings1,833.31,431.01,113.4 Treasury Stock-425.5-314.0-188.0 Other Equity-13.90.0-2.4 Total Shareholders' Equity1,756.31,405.71,161.1 Total Liabilities + Shareholders' Equity3,118.52,436.42,112.1 Shares Outstanding302.8302.1302.7

22. Corporate Income Taxes ► Corporate deductions from income: operating expenses, depreciation, interest expense. ► Dividends paid are NOT deductible. ► Interest and capital gain income is fully taxable. ► 30% (in general) of Dividend income is taxable. ► Losses can be carried back 2 years and carried forward up to 20 years

23. Corporate Income Tax Rates Since 1993 Taxable Income Corporate Tax Rate $1 - $50,000 15% $50,001 - $75,000 25% $75,001 - $100,000 34% $100,001 - $335,000 39% $335,001 - $10,000,000 34% $10,000,001 - $15,000,000 35% $15,000,001 - $18,333,333 38% over $18,333,333 35%

24. Tax Example:

25. Corporate Tax Example ► Space Cow Computer has sales of $32 million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders. ► Calculate the firm’s tax liability.

26. Free Cash Flows Free cash flow: cash flow that is free and available to be distributed to the firm’s investors (both debt and equity investors)

27. Free Cash Flows Firm’s Operating Free cash flows = Firm’s Financing Free cash flows Cash flows generated through the firm’s operations and investments in assets = Cash flows paid to - or received by - the firm’s investors (creditors & stockholders)

28. Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets

29. Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Operating income + depreciation - cash tax payments

30. Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets [Change in current assets] - [change in non-interest bearing current liabilities*] *Accounts payable and accruals

31. Calculating Free Cash Flows: An Operating Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Change in gross fixed assets, and any other assets that are on the balance sheet.

32. Calculating Free Cash Flows: A Financing Perspective Interest payments to creditors & Dividends paid to stockholders - change in debt principal - change in debt principal - change in stock - change in stock = Financing Free Cash Flows = Financing Free Cash Flows