Session 2: Financial Statements Business Finance BUAD 306 Conson Zhang Chong Shu

Last class: Overview of Corporate Finance These decisions are not independent of each other

Roadmap of this class We want to learn how to evaluate and finance investments/projects What is the money they generate / spend? Where do we find this information? Outline: What are cash flows? Revenues, expenses, taxes Financial statements: balance sheet and income statement How to get from accounting income to cash-flows

What are cash flows? What do owners want to know? How many $ have they put in? How many $ are they getting back? This difference over a period of time is the Cash Flow How to obtain information about Cash Flows? Financial statements of a firm But there is no statement that gives the needed information straight away ... so we have to work!

What are financial statements? Documents collecting financial information of a corporation over a certain period of time Why do they exists? Legal requirements Security Exchange Commission (SEC), Exchanges Why are they needed? To provide information on the state of a firm’s business and financial health to lenders, shareholders Who certifies their accuracy? Accounting firms and FASB rules Do they tell the truth? What if a company lies?

Two major financial statements Balance sheet: a snapshot of the financial condition of a firm at a particular time (usually year’s end) It is a list of the firm’s assets and liabilities The difference is the net worth of the firm, and is known as stockholders’ equity: Equity = Assets – Liabilities Income statement: a summary of the profitability of the firm over a period of time (usually a year) It presents revenues, expenses, and the resulting net earnings (or profits or net income) Net Income = Revenues – Expenses

The balance sheet

The balance sheet Current assets: relatively highly liquid Cash, account receivables & inventory (which we hope to convert in cash within the next 12 months) Fixed assets: relatively less liquid Tangible assets: plants, equipment Intangible assets: trademarks, patents Current liabilities: due in less than 1 year Accounts payable, short-term debt Net Working Capital: Current Assets – Current Liabilities Long-term debt: bank loans, bonds, other debts

Income statement Operating revenues: from the activity of the firm - Operating expenses: from the activity of the firm Cost of goods sold (COGS) Depreciation of capital expenses: The matching principle: revenues are always matched with the costs to producing them Overhead costs: employees, administrative expenses = EBIT: Earnings Before Interest and Taxes - Interest expenses: from short- and long-term debt - Taxes: we will talk about it soon! = Net Income

The example of the book: U.S. Corporation RE = 1,320 + 412 – 103 = 1320 + 309 = past RE + Net Income - Dividends Owners’ Equity = Common Stock (contributed capital) + RE

Value of a financial asset versus accounting Income statement and balance sheet are based on GAAP (Generally Accepted Accounting Principles) Revenues and expenses are recognized only when incurred, even if no cash has exchanged hands yet Assets are shown at historical cost, not current value GAAP rules offer a lot of latitude Still, they are a crucial source of information and a tool for decision making Reported gains or losses (ex. due to changes in GAAP rules) may be unrelated to fundamentals The value of a financial asset depends on its riskiness and cash flows, not accounting

Is Net Income = Cash Flow? NO: the income statement may include items which are not related to cash inflows or outflows Depreciation and items which are not related to day-to-day business operations Interest payments Spending on fixed assets Spending on current assets Plus: taxes must be considered

Taxes Taxes are one of the largest cash outflows of a firm For the fiscal year 2001, Wal-Mart paid $3.5 billion! The tax environment is the set of fiscal rules under which firms make financial decisions We will briefly look at Federal Income Tax System Tax Issues for the Investor Tax Issues for the Corporations

The Federal Income Tax System Progressive on the taxable income Gross income minus well-defined deductions Marginal rate: rate on the last taxable dollar Average rate: total tax paid / taxable income Corporate tax rates under the 1993 Omnibus Budget Reconciliation Act

Some tax issues for the investor Double taxation of dividends: dividends are taxed At the firm level, as part of Net Income At the investor level, as part of his personal income Capital gains versus ordinary income Capital gains derive from price appreciation of an investment Taxes on them are usually lower than on the ordinary income and deferred until the gain is realized Exception of municipal bonds (“munis”), bonds issued by state and local governments Interest is exempt from federal, state, & local taxation

Some tax issues for a corporation Dividend income: If received by another firm, only 30% of it is taxed Tax-exempt investors (pension funds) like dividends Interest payments: interest paid on debt is tax deductible Depreciation: it allows the firm to pay less taxes Corporate loss carry forward: the use of past losses to shield present profits from taxes Consolidation of corporate tax returns: taxation of fully- owned subsidiaries on a consolidated basis

Three steps to get from Income to Cash Flow Calculate Operating Cash Flow (OCF): Adjusting for taxes and depreciation Calculate Net Capital Spending: Adjusting for money reinvested for the long-term Calculate Change in Net Working Capital: Adjusting for money reinvested for the short-term

Step 1: Operating Cash Flows Depreciation does not represent a cash outflow But allows the firm to pay less taxes Which rate? The marginal rate, as any new cash flows will be taxed at that rate Interest expenses are not operating expenses Two methods to compute OCF: OCF = Net Income + Depreciation + Interest Paid OCF = EBIT + Depreciation - Taxes = (Sales – Cost) x (1 – t) + Depreciation x t Depreciation tax shield

Step 1: Operating Cash Flows OCF: Cash flow that results from the firm's day to day activities of producing and selling. OCF = Net sales – Cost of goods Sold – Taxes EBIT = Net sales – Cost of goods Sold – Deprecation Net Income = Net sales – Cost of goods Sold – Deprecation – taxes – interest Therefore, OCF = EBIT + Deprecation – Taxes OCF = Net Income + Deprecation + interest Financial Management

Step 2: Net Capital Spending We need to consider the long-term assets in the firm’s balance sheet over the income period If long-term assets increase For example, the firm purchased new equipment This increase corresponds to a cash outflow If long-term assets decrease For example, the firm sold some buildings This decrease corresponds to a cash inflow Depreciation of assets is not a cash inflow Net Capital Spending (NCS) is given by: NCS = Change in Fixed Assets + Depreciation

Step 3: Change in Net Working Capital We need to consider short-term assets and liabilities in the firm’s balance sheet over the income period Further short-term or long-term borrowing Both current assets and liabilities may increase Other payments (ex. interests) Current assets decrease, current liabilities may decrease Change in Net Working Capital is given by: Change in NWC = NWC – Past NWC

Summing things up Operating Cash Flow (OCF) Minus Net Capital Spending (NCS) Minus Change in Net Working Capital _________________________________________________________________________ = Cash Flow From Assets (CFFA) Where does this money go? CFFA = CF to Creditors (CFC) + CF to Stockholders (CFS) CFC = Interest Paid – Net New Borrowing CFS = Dividends Paid – New Equity raised Positive NCS means outflow of cash When current assets increase more than current liabilities, there is an outflow of cash

An application: U.S. Corporation OCF (I/S) = NCS (B/S & I/S) = Changes in NWC (B/S) = CFFA = CF to Creditors (B/S & I/S) = CF to Stockholders (B/S & I/S) = EBIT + depreciation – taxes = $547 ending net fixed assets – beginning net fixed assets + depreciation = $130 NWC – Past NWC = $330 547 – 130 – 330 = $87 interest expenses – net new borrowing = 70 – (454 – 408) = $24 dividends paid – new equity raised = 103 – (640 – 600) = $63 24 + 63 = $87

The example of the book: U.S. Corporation

The example of the book: U.S. Corporation

The example of the book: U.S. Corporation

The example of the book: U.S. Corporation

The example of the book: U.S. Corporation

Sources and uses of cash Sources: cash inflow when we “sell” something Decrease in asset accounts (except cash) Decrease in accounts receivable, inventory, or net sales of fixed assets Increase in liability or equity accounts Increase in retained earnings, common stock, or long-term debt Uses: Cash outflow when we “buy” something Increase in asset accounts (except cash) Increase in accounts receivable, inventory, or net acquisitions of fixed assets Decrease in liability or equity accounts Decrease in accounts payable or long-term debt

Where to get financial statements? Directly from the corporation Company websites, under investor relationship department From the SEC database (Edgar) http://www.sec.gov/cgi-bin/srch-edgar Form 10K: Previous year’s balance sheet, income statement, statement of cash flow, retained earnings Address, state of incorporation, etc. Business description, market, products, and competition, staff information, strategy and plans for the future, accountant's report

Where do we go from here? What we have done: We learned how to extract cash flows from financial statements Key concepts: cash flows versus income Operating cash flow, capital spending, net working capital What do we do with these cash flows? Valuation of projects, financial assets, firms What do we still need? We need to learn how to analyze financial statements and consider long-run planning … topic of next class