Professeur André Farber Théorie Financière 2005-2006 3. Tableau de financement et planning financier Professeur André Farber

Financial statements and cash flows Objectives for this session Leverage: when is it good? Statement of cash flows Linking accounting numbers and cash flows Financial planning Tfin 2005 03 Cash flows

Levers of Performance Tfin 2005 03 Cash flows

Summarized (managerial) balance sheet Liabilities Stockholders' equity (SE) Interest-bearing debt (D) Assets Fixed assets (FA) Working capital requirement (WCR) Cash (Cash) FA + WCR + Cash = SE + D Working capital requirement : definition + Accounts receivable + Inventories + Prepaid expenses - Account payable - Accrued payroll and other expenses Interest-bearing debt: definition + Long-term debt + Current maturities of long term debt + Notes payable to banks Tfin 2005 03 Cash flows

Net Working Capital Net working capital can be understood in two ways: as an investment to be funded: Current Assets - Current Liabilities as a source of financing=Stockholders' equity + LT debt - Fixed Assets Fixed Assets Stockholder’s equity Current ratio: a measure of NWC Current ratio = Current assets / Current liabilites Net working capital = Current assets - Current liabilites Current ratio > 1  NWC > 0 Net Working Capital Long term debt Current Assets Current liabilities Tfin 2005 03 Cash flows

Net Working Capital vs Working Capital Requirement Summarized balance sheet identity: FA + WCR + CASH = SE + LTD + STD can be written as: WCR + (CASH - STD) = (SE + LTD - FA)  WCR + NLB = NWC Net Working Capital Working Capital Requirement Net Liquid Balance Tfin 2005 03 Cash flows

Return on invested capital Return on assets (net)= Net income / Total assets Advantage: fits with DuPont system ROE = ROA x Equity multiplier Limitation: Net income = EBIT - Interest expense - Taxes Depends on capital structure: 1. Interest expense: function of interest-bearing debt 2. Interest expense : tax deductible Preferred measure: Return on Invested Capital (ROIC) NB: ROIC = ROA (gross) (1 - Tax rate) = ROE of a all equity financed firm Tfin 2005 03 Cash flows

ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE) Financial leverage Financial leverage magnifies ROE only when ROA (gross) is greater than the interest rate on debt. Balance sheet: TA = SE + D Income statement: NI = EBIT - INT- TAX Interest expense INT = r D (Interest expense = Interest rate x Interest-bearing debt) Taxes TAX = (EBIT - r D) Tc (Taxes = Taxable income x Tax rate) Remember : ROIC = ROAgross (1 - Tc) ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE) Tfin 2005 03 Cash flows

Sources of Cash Inflow and Cash Outflow Operating Activities Sales of goods and services Investing Activities Sale of fixed assets Sales of LT financial assets Financing Activities Issuance of stocks and bonds LT and ST borrowing CASH Operating Activities Purchase of supplies Selling, general and administrative expenses Tax expenses Investing Activities Capital expenditures and acquisitions LT financial investments Financing Activities Repurchage of stocks and bonds Repayment of debt Dividend payment CF from operating activities CF from investing activities CF from financing activities Tfin 2005 03 Cash flows

Farber.com: a fable Starting a local version of Amazon.com Initial balance sheet t = 0 Cash 100 Book Equity 100 Operations year 1: Sell 2 books @ €100 each Buy 2 books @ € 50 each Income statement year 1: Revenue 200 Expenses 100 Net Income 100 But….cash account = 0 What happened? Tfin 2005 03 Cash flows

Farber.com: what happened…. Final balance sheet t = 1 Cash 0 Book Equity 200 Account Receivable 200 Statement of cash flows: reconciles the two views Direct method: + Cash collected from customers 0 - Cash payment to suppliers + 100 = Cash flow from operations - 100 Indirect method: Net Income +100 -Working Capital Requirement + 200 = Cash flow from operations -100 No payment from clients Initial Capital + Retained Earnings Tfin 2005 03 Cash flows

Farber.com: additional complications Initial balance sheet t = 0 Cash 100 Book Equity 100 Operations year 1: Borrow and buy 2d hand computer @ €200 Sell 1 books @ €100 each Buy 2 books @ € 50 each Income statement year 1: Revenue 100 Cost of goods sold 50 Depreciation 100 Interest 10 Net Income -60 Final cash account -10 Straight-line depreciation 2 years Tfin 2005 03 Cash flows

Farber.com: details Final balance sheet t = 1 Cash -10 Book Equity 40 Account Receivable 100 Debt 200 Inventories 50 Fixed Assets 100 Total 240 Total 240 Statement of cash flows: direct method Cash collection from customers 0 (=REV - AR) -Cash payment to suppliers 100 (=CGS+ INV) -Cash paid for interest 10 Cash flow from operating activities -110 Cash flow from investing activities -200 (= FA+Dep) Cash flow from financing activities +200 Change in cash -110 Tfin 2005 03 Cash flows

Farber.com: statement of cash flows - indirect method Net Income -60 +Depreciation +100 -Working Capital Requirement + 150 = Cash flow from operations -110 Cash flow from investing activities -200 Debt +200 Cash flow from financing activities +200 Change in cash -110 Tfin 2005 03 Cash flows

Notations Income statement REV Revenue CGS Cost of goods sold SGA Selling, general and administrative expenses Dep Depreciation EBIT Earnings before interest and taxes Int Interest expenses TAX Taxes Tc Tax rate NI Net income Balance sheet FA Fixed assets, net AR Accounts receivable INV Inventories CASH Cash & cash equivalents SE Equity capital LTD Long term debt AP Accounts payable STD Short-term borrowing Statement of retained income DIV Dividendes Tfin 2005 03 Cash flows

Income statement and balance sheet EBIT = REV - CGS - SGA - Dep TAX = Tc (EBIT - Int) NI = EBIT - Int - TAX Balance sheet equation FA + AR + INV + CASH = SE + LTD + AP + STD Working capital requirement: WCR  AR + INV - AP =(Current assets - CASH) - (Current liabilities - STD) Summarised balance sheet: FA + WCR + CASH = SE + D (D = LTD + STD) Tfin 2005 03 Cash flows

Cash flow statement : indirect method FA + WCR + CASH = SE + D FA = AQ - Dep AQ = Acquisitions - Disposals (investing & divesting) SE = NI - DIV + K K = New issuance of capital (NI + Dep - WCR) - (AQ) + (K + D -DIV) = CASH Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities = + + Tfin 2005 03 Cash flows

Statement of cash flows: direct method + Cash collection from customers - Cash payment to suppliers and employees - Cash paid for interest - Cash paid for taxes = Cash flow from operating activities + Cash flow from investing activities + Cash flow from financing activity = CASH REV - AR CGS + INV + SGA - AP Int TAX (REV-CGS-SGA-Int-TAX)- WCR -AQ K + D - DIV NI+Dep-WCR (NI + Dep - WCR) + (-AQ) + (K + D - DIV) = CASH Tfin 2005 03 Cash flows

Free Cash Flow Free Cash Flow = Cash flow from operating activities + Cash flow from investing activities Calculating free cash flows of all equity firm: Free Cash Flow = EBIT(1-TC) + Dep - WCR - AQ Statement of cash flows for all-equity firm: Free Cash Flow = DIV - K + Cash Tfin 2005 03 Cash flows

Financial Forecasting EBITDA -Depreciation =EBIT -Taxes +Net Income Income Statement Statement of Cash Flows CF from operating activities CF from investing activities CF from financing activities Update Balance Sheet Tfin 2005 03 Cash flows

Financial Planning Based on ∆Revenues Assumptions on key ratios relating Revenues to: Gross margin: m = EBITDA /Revenues Working capital requirement: w =  WCR /  Revenues Net fixed assets: a =  NFA /  Revenues Financial policy: Payout ratio p = DIV/Net Income Depreciation d = Depreciation / Fixed Assets-1 Environment: Tax rate TC Cost of debt i Tfin 2005 03 Cash flows

Data Revenues year 0: 2,000 Growth rate year 1: 25% Balance sheet end year 0 Gross margin: m = 30% WCR: w = 20% Net fixed assets: a = 30% Payout ratio p = 50% Depreciation d = 10% Tax rate TC = 40% Cost of debt i = 10% Net Fixed Assets 600 Working Capital Requirement 400 Cash Total Assets 1,000 Book Equity Debt (financial) Total Liabilities + Stockholders’ equity Tfin 2005 03 Cash flows

Step 1: Income statement Year 0 Year 1 Sales 2,000 2,500 Rev-1 (1+g) EBITDA 750 m × Rev Depreciation 60 d × NFA-1 EBIT 690 Interests 40 i × D-1 Taxes 260 Net Income 390 Tfin 2005 03 Cash flows

Step 2: Statement of Cash Flows Year 0 Year 1 Net Income 390 From Income Stat. Depreciation 60 ∆WCR 100 w ×  Revenues CF from operations 350 ∆NFA 150 a ×  Revenues CF from investing -210 Div 195 p × Net Income Stock Issues/buy back Assumption ∆Debt 55 Plug CF from financing -140 ∆Cash Tfin 2005 03 Cash flows

Step 3: Update balance sheet Year 0 Year 1 Net Fixed Assets 600 750 NFA-1 + Inv – Dep Working Capital 400 500 WCR-1 +  WCR Cash Cash-1 +  Cash 1,000 1,250 Book Equity 795 BEq-1+SI + NI – DIV Debt 455 D-1 +  D Tfin 2005 03 Cash flows

The Full Model Tfin 2005 03 Cash flows

Sustainable growth What growth rate can a company achieve without requirement additional external equity?  Assets = (a+w)  Revenues  Assets =  Book Equity +  Debt =  Book Equity +   Book Equity = Net Income (1 – Payout)(1 + ) = (Revenues) (Profit Margin)(1-Payout)(1+ ) g =  Revenues / Revenues = (Profit Margin)(1 – Payout)(1+ ) / (a+w) Tfin 2005 03 Cash flows

Sustainable Growth: example Back to previous example: a+w = 0.30 Net Profit margin = 15% Payout ratio = 50%  = Debt /  Book Equity = 2/3 g = [15% (1 - 0.50) (1+2/3) ] / 0.30 = 41.67% Tfin 2005 03 Cash flows