Topic 2 . Financial Statements and Cash Flow Prof. dr. A Paškevičius

Financial Statements and Cash Flow 2.1 The Balance sheet 2.2 The Income Statement 2.3 Cash flow 2.4 Cash Flow and Financial Statements

The Balance Sheet The balance sheet is a financial statement showing the firm’s accounting value on a particular date The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time Assets are listed in order of liquidity Ease of conversion to cash Without significant loss of value Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity

The Balance Sheet

The Balance Sheet A fixed asset is one that has a relatively long life. A current asset will convert to cash within 12 months. Shareholders' equity, or common equity reflects the fact that, if the firm were to sell all of its assets and use the money to payoff its debts, then whatever residual value remained would belong to the shareholders.

The Balance Sheet Assets = Liabilities + Shareholders' equity 3 Components: Assets = Liabilities + Shareholders' equity This is the balance sheet identity, or equation, and it always holds because shareholders' equity is defined as the difference between assets and liabilities. What is shareholders' equity? What is net working capital?

The Balance Sheet Assets = Liabilities + Shareholders' equity 3 Components: Assets = Liabilities + Shareholders' equity This is the balance sheet identity, or equation, and it always holds because shareholders' equity is defined as the difference between assets and liabilities. What is shareholders' equity? What is net working capital? 1000 – (150+200) =650 400 -150 = 250

The Balance Sheet Assets 2014 2015 Liabilities and Shareholders' Equity Current assets Current liabilities Cash 104 160 Accounts payable 232 266 Accounts receivable 455 688 Notes payable 196 123 Inventory 553 555 Total current liabilities 428 389 Total current assets 1112 1403 Long-term debt 408 454 Fixed assets Shareholders' equity Net plant and equipment 1644 1709 Common stock and paid-in surplus 600 640 Retained earnings 1320 1629 Total shareholders’ equity 1920 2269 Total assets 2756 3112 Total liabilities and shareholders' equity

The Balance Sheet Key concepts Liquidity Net Working Capital Debt versus Equity, financial leverage Market Value versus Book Value

Liquidity Liquidity refers to (is an indicator of) the speed and cost (loss of value and conversion cost) with which an asset can be converted to cash. Ability to convert to cash quickly without a significant cost Assets appear on the balance sheet in descending order of liquidity. Interest and principal payments on debt have to be paid before cash may be paid to stockholders. Liquid firms are less likely to experience financial distress The more liquid assets provide lower returns. Trade-off to find balance between liquid and illiquid assets

Net Working Capital Net Working Capital =Current Assets – Current Liabilities Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out Usually positive in a healthy firm

Debt versus Equity, financial leverage The use of debt in a firm's capital structure is called financial leverage. The more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage. Debt acts like a lever in the sense that using it can greatly magnify both gains and losses. Advantage: financial leverage increases the potential reward to shareholders Disadvantage: it also increases the potential for financial distress and business failure.

Market Value versus Book Value The values shown on the balance sheet for assets are book values. They generally are not what the assets are actually worth. Under Generally Accepted Accounting Principles (GAAP), financial statements generally show assets at historical cost. I.e. assets are "carried on the books" at what the firm paid for them, no matter how long ago they were purchased or how much they are worth today. Market value is the price at which the assets, liabilities or equity can actually be bought or sold. For current assets, market value and book value is similar For fixed assets not similar For example, a railroad

2.2 INCOME STATEMENT Income statement is a financial statement summarizing a firm’s performance over a period of time When a balance sheet is a snapshot, then an income statement is as a video recording covering the period between a before and an after picture. Components Revenues (We recognize revenue when it is earned, not when the cash is received) Expenses Cash and non-cash Operating and non-operating Net Income Earnings per share Dividend

2015 Income Statement (mln € ) Net sales 1509 Costs of goods sold 750 Depreciation 65 Earnings before interest and taxes (EBIT) 694 Interest paid 70 Taxable Income 624 Taxes 212 Net Income 412 Dividends 103 Addition to Retained Earnings 309 Corporation had 200 million shares outstanding at the end of 2014. Based on this income statement, What was EPS? What were dividends per share? Earnings per share = Net income/Total shares outstanding = 412 / 200 = 2.06 € per share Dividends per share = Total dividends/Total shares outstanding = 103 / 200 = 0.515 € per share

Non-cash Items / Non-cash expenses Non-cash items are expenses charged against revenues that do not directly affect cash flow. A primary reason that accounting income differs from cash flow is that an income statement contains non-cash items. The most important of these is depreciation. If the depreciation is straight-line and the asset is written down to zero over that period, then the equal portion will be deducted each year as an expense. By "straight-line," we mean that the depreciation deduction is the same every year. By "written down to zero," we mean that the asset is assumed to have no value at the end of five years

Non-cash items and cash flow Net sales 1509 Costs of goods sold 750 Depreciation 1000 Earnings before interest and taxes (EBIT) (241) Interest paid 50 Taxable Income (291) Taxes Net Income Net Cash flow = 1509 – 750- 50 = 709 This 1,000 deduction isn't cash- it is only an accounting number. The actual cash outflow occurred when the asset was purchased (purchase price 5000). The depreciation deduction is an application of the matching principle in accounting. The revenues associated with an asset would generally occur over some length of time. So, the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.

Operating and non-operating Break-even point Sales (80 units x €100=8.000 8.000 Variable costs (80 units x €80) 6.400 Fixed costs 2.000 Net Income -400 Sales (100 units x € 100) 10.000 Variable costs (100 units x €80 ) 8.000 Fixed costs 2.000 Net Income The future could have two distinct parts: the short run and the long run. In short run, some costs are fixed- they must be paid (property taxes, salaries to management). variable -other costs such as wages and payments to suppliers. In the short run, the firm can vary its output level by varying expenditures in these areas. The distinction between fixed and variable costs is important.

2.3 CASH FLOW Cash flow is the difference between the money that came in and the money that went out. The owner of a business is very interested in how much cash he actually took out of his business in a given year. Accounting methods give an estimate of the economic value of transactions In Finance, the main concern is the timing of cash flows. Since the income statement includes non-cash items, we will have to adjust it to get information on cash flows Balance sheet activity plays an important role in the determination of the cash balance (e.g.) Collections on accounts receivable Borrowing on accounts payable

The cash flow identity This is based upon the balance sheet identity: Cash flow to creditors (bondholders) Cash flow to stockholders (owners) Cash flow from assets = + This is based upon the balance sheet identity: Assets = Liabilities + Equity The cash flow from the firm's assets is equal to the cash flow paid to suppliers of capital to the firm, i.e. either to pay creditors or pay out to the owners of the firm

Changes in net working capital (NWC) Cash flow from assets Cash flow from assets Operating cash flow (OCF) Net capital spending Changes in net working capital (NWC) _ _ Ending NWC EBIT Ending net fixed assets Beginning NWC Depreciation - + Beginning net fixed assets - Taxes - Depreciation +

Cash flow to creditors and stockholders Cash flow from assets Cash flow to creditors Cash flow to stockholders Dividends paid Interest paid Net new equity raised Net new borrowing _ _

Changes in net working capital (NWC) Cash flow to stockholders Cash Flow summary Operating cash flow (OCF) Net capital spending Changes in net working capital (NWC) _ _ Cash flow from assets Cash flow to creditors Cash flow to stockholders

T2.6 Cash Flow Summary I. Cash flow from assets Cash flow from assets = Operating cash flow – Net capital spending – Additions to net working capital (NWC) where Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes Net capital spending = Ending net fixed assets – Beginning net fixed assets + Depreciation Change in NWC = Ending NWC – Beginning NWC II Cash flow to creditors Cash flow to creditors = Interest paid – Net new borrowing III. Cash flow to stockholders Cash flow to stockholders = Dividends paid – Net new equity raised

2015 Income statement Net sales 1509 Costs of goods sold 750 Depreciation 65 Earnings before interest and taxes (EBIT) 694 Interest paid 70 Taxable Income 624 Taxes 212 Net Income 412 Dividends 103 Addition to R/E 309

Balance sheets Assets 2014 2015 Liabilities and Shareholders' Equity Current assets Current liabilities Cash 104 160 Accounts payable 232 266 Accounts receivable 455 688 Notes payable 196 123 Inventory 553 555 Total current liabilities 428 389 Total current assets 1112 1403 Long-term debt 408 454 Fixed assets Shareholders' equity Net plant and equipment 1644 1709 Common stock and paid-in surplus 600 640 Retained earnings 1320 1629 Total shareholders’ equity 1920 2269 Total assets 2756 3112 Total liabilities and shareholders' equity

2.3 Operating Cash Flow Earnings before interest and taxes (EBIT) 694 + Depreciation - Taxes Operating cash flow 694 65 - 212 547

Net capital spending Ending net fixed assets 1.709 - Beginning net fixed assets + Depreciation Net capital spending 1.709 - 1.644 65 130 1.709 - 1.644 65 130

Change in NWC 1014 - 684 330 Ending NWC - Beginning NWC Change in NWC

Cash flow from assets Cash flow from assets Operating cash flow - Net capital spending - (+) Change in NWC Cash flow from assets 547 - 130 - 330 87

Cash flow to stockholders Cash Flow to creditors Interest paid – Net new borrowing Cash flow to creditors 70 - 46 24 Cash flow to stockholders Dividends paid – Net new equity raised Cash flow to stockholders 103 - 40 63

Changes in net working capital Cash flow to stockholders Cash Flow summary Operating cash flow 547 Net capital spending 130 Changes in net working capital 330 _ _ Cash flow from assets 87 Cash flow to creditors 24 Cash flow to stockholders 63

Cash Flows for DOLE COLA During the year, Dole Cola, Inc., had sales and cost of goods sold of $600 and $300, respectively. Depreciation was $150 and interest paid was $30. Taxes were calculated at a straight 34 percent. Dividends were $30. (All figures are in millions of dollars.) Create an income statement Beginning net fixed assets were $500 and ending net fixed assets were $750. Dole Cola started the year with $2,130 in current assets and $1,620 in current liabilities, and that the corresponding ending figures were $2,260 and $1,710. What was operating cash flow for Dole? Why is this different from net income?

Dole Cola income statement Net sales 600 Costs of goods sold 300 Depreciation 150 Earnings before interest and taxes (EBIT) Interest paid 30 Taxable Income 120 Taxes 41 Net Income 79 Dividends Addition to R/E 49

2.4 Dole Cola balance sheet Assets Beg End Liabilities and Shareholders' Equity Current assets 2130 2260 Current liabilities 1620 1710 Net fixed assets 500 750 Long-term debt 200 441 Shareholders' equity Common stock and paid-in surplus Retained earnings 610 659 Total shareholders’ equity 810 859 Total assets 2630 3010 Total liabilities and shareholders' equity

Cash flow from assets Cash flow from assets Operating cash flow Change in NWC Earnings before interest and taxes (EBIT) 150 + Depreciation - Taxes - 41 Operating cash flow 259 Ending NWC 550 - Beginning NWC - 510 Change in NWC 40 Cash flow from assets Net capital spending Ending net fixed assets 750 - Beginning net fixed assets - 500 + Depreciation 150 Net capital spending 400 Operating cash flow 259 Net capital spending 400 Change in NWC 40 Cash flow from assets -181

Cash flow to stockholders Dividends paid 30 – Net new equity raised - 0 Cash flow to stockholders Cash Flow to creditors Interest paid 30 – Net new borrowing - 241 Cash flow to creditors - 211

Changes in net working capital Cash flow to stockholders Cash Flow summary Operating cash flow 259 Net capital spending 400 Changes in net working capital 40 _ _ Cash flow from assets -181 Cash flow to creditors -211 Cash flow to stockholders 30

2.4 Cash Flow and Financial Statements Balance Sheet Assets 2014 2015 Change Current assets Cash 84 98 +14 Accounts receivable 165 188 +23 Inventory 393 422 +29 Total current assets 642 708 +66 Net fixed assets Net plant and equipment 2.731 2.880 +149 Total assets 3.373 3.588 +215

2.4 Cash Flow and Financial Statements Liabilities and Shareholders' Equity 2014 2015 Change Current liabilities Accounts payable 312 344 +32 Notes payable 231 196 -35 Total current liabilities 543 540 -3 Long-term debt 531 457 -74 Shareholders' equity Common stock and paid-in surplus 500 550 +50 Retained earnings 1.799 2.041 +242 Total shareholders’ equity 2.299 2.591 -292 Total liabilities and shareholders' equity 3.373 3.588 +215

2.4 Cash Flow and Financial Statements Sources of cash: Increase in accounts payable 32 Increase in common stock 50 Increase in retained earnings 242 Total sources 324 Uses of cash Increase in accounts receivable 23 Increase in inventory 29 Decrease in notes payable 35 Decrease in long-term debt 74 Net fixed assets acquisitions 149 Total uses 310 Net addition to cash 14

2.4 Cash Flow and Financial Statements 2004 Income Statement Sales 2.311 Costs of goods sold 1.344 Depreciation 276 Earnings before interest and taxes (EBIT) 691 Interest paid 141 Taxable Income 550 Taxes 187 Net Income 363 Dividends 121 Addition to retained earnings 242

2.4 Cash Flow and Financial Statements 2004 Statement of Cash Flow Cash, beginning of year 84 Operating activity Net income + 363 Depreciation + 276 Increase in accounts payable + 32 Increase in accounts receivable 23 Increase in inventory 29 Net cash from operating activity + 619 Investment activity Fixed asset acquisitions 425 Net cash from investment activity

2.4 Cash Flow and Financial Statements 2004 Statement of Cash Flow Financing activity Decrease in notes payable 35 Decrease in long-term debt 74 Dividends paid 121 Increase in common stock + 50 Net cash from financing activity 180 Net increase in cash + 14 Cash, end of the year 98

2.4 Cash Flow and Financial Statements Statement of Cash Flow Operating activities + Net income + Depreciation + (–) Any decrease (increase) in current assets (except cash) + (–) Increase (decrease) in accounts payable Investment activities + Beginning fixed assets – Ending fixed assets – Depreciation Financing activities + (–) Increase (decrease) in notes payable + (–) Increase (decrease) in long-term debt + Increase in common stock – Dividends paid