SCG Workshop #3: More FSA and some TVM

Agenda Review of Fin Statements The BS and IS The Statement of Cash Flows The Looking at health and profitability

BS Accounts We have 3 types of accounts in the balance sheet: Assets: Resources of the business we will use to generate revenues Liabilities: Money we owe to creditors or “debt-holders” that have funded our business Equity: Money we got from people who bought stock from the company in return for voting power and a share of the profits Assets = Liabilities + Owner’s Equity Value of resources in the business = Money we got from creditors + money we got from shareholders In other words, everything in the business was either bought with money from shareholders or creditors.

The Accounts Within: Assets Cash Accounts Receivable (Short term IOU’S) Investments Land Buildings Equipment “Property, Plant, and Equipment” or PP&E Inventory

The Accounts Within: Liabilities Accounts Payable (short term debt to suppliers) Bank Loans Bonds Payable Unearned Revenue (prepaid sandwiches)

The Accounts Within: Equity Common Stock Preferred Shares Retained Earnings Additional Paid-In Capital Treasury Stock

Exercise AssetsLiabilitiesEquity Companies have a lot of funky names for their accounts, so based on your knowledge of the base accounts and what each category is, what is each account classified under? Cash and Cash Equivalents Certificates of Deposit (CD’s) Raw Materials Construction in Progress Intangible Assets (Patents) Short Term Borrowings Dividends Payable Trade Receivables Earnings Employed in the business Common Stock Held in Treasury

The Income Statement Tells us the revenue generating and expense generating activities of the business over the course of the reporting period (year or quarter)

Two Classifications to Know Revenues: Dollar value of sales a company generates Expenses: Costs associated with generating the revenue. After all expenses have been taken out of our pool of revenue, what’s left is taxed.

Stepping to the side: Depreciation and Amortization, what are they? When you buy a car for $50,000 and try to sell it a year later, you can’t get the same value you paid for it, you get less. Accountants adjust the value of the long term assets the company is holding at the end of every period to reflect what they believe is the new value. We call this “depreciation” for physical assets and “amortization” for intangible assets (like patents)

The Uselessness of the Income Statement Typically, investors don’t use Operating income to a profit measurement, we have EBITDA, EBIT, EBT, and E. Earnings Before Interest Taxes Depreciation and Amortization

How we get to Earnings Revenue -Cost of Goods Sold Gross Profit -Selling, General, and Admin Expense -Other Expenses +Depreciation and Amortization EBITDA -Depreciation and Amortization EBIT -Interest EBT -Taxes Earnings Most of the time, this is the same as Operating Income Most of the time D&A is already looped in with COGS or in Expenses

Statement of Cash Flows Tell us about where we earned and spent cash during the reporting period, as well as our cash balances. Important because a company can earn billions of dollars in revenue but through the usage of accounts receivable, never see a dollar. This can be a problem because you have to pay debts with cash not another IOU. This statement will be our best friend during DCF modeling in a few lessons.

Form of the Statement of Cash Flows Beginning Cash $100 Net Income $ Net Cash Flows from Operations$550 +Net Cash Flows from Investing-$50 +Net Cash Flows from Financing$400 +Net Cash Flows $900 Ending Cash $1000

Idea Behind it: We want to take our net income and add back any cash generating activities, then take back out any cash using activities to find how much cash was generated by the business. We like cash because finance people think accountants can manipulate numbers (they can) so cash gives us the clearest picture of the reality of the business.

Cash Flows from Operating Activities Cash generated or used up from the everyday activities of the business like: Cash collections from Accounts Receivables Cash Sales Cash Expenditures Changes in Current Assets Changes in Current Liabilities Add back Depreciation and Amortization Depreciation and Amortization are already in Net income, so to get to cash, we need to add it back (remember, we don’t actually pay any cash on D&A), it’s an accounting gimmick. Essentially how much cash you take in minus your bills.

Cash Flows from Investing Activities Covers purchases and sales of long-term assets and investments. What we see in the statement: Buying a building is a cash outflow Selling land is a cash inflow Buying Investments is a cash outflow Selling investments is a cash inflow Important to remember that you’re dealing with cash, so buying assets will decrease your cash and vice versa We refer to the acquisition of long-term assets as “Capital Expenditures”

Cash Flows from Financing Covers cash flows that are related to raising capital for the business, both by debt and equity. Paying interest is a cash outflow Paying back principal of a loan is a cash outflow Receiving a loan’s funds is a cash inflow Receiving funds from a issuance of stock is a cash inflow Having a positive number in cash flows from financing means you are taking on more debt or issuing stock faster than you are paying it back.

So if we go back… Beginning Cash $100 Net Income $ Net Cash Flows from Operations$550 +Net Cash Flows from Investing-$50 +Net Cash Flows from Financing$400 +Net Cash Flows $900 Ending Cash $1000 Cash in - Bills Buying/Selling LT Assets Taking in/paying off capital from investors and creditors

How does all this apply to picking better stocks and valuation? Eyes on the prize: This is all leads to DCF modeling and valuation. Although balance sheets and cash flow statements alone can’t tell you how much a company is worth, we can look at it to see if the company is “healthy”.

An Introduction to Present Value Would you rather have $100 today or $110 dollars a year from now?

We have a choice… Today $100 1-Year from Now $110 What if there was a way to figure out how much money in the future is worth in today’s terms… 5% Interest Rate Future Value = Present Value(1+Interest Rate)^(Number of Years) FV= PV*(1+i)^n FV= 100*(1+.05)^(1) FV= $105

How about now? Today $100 5-Years from Now $105 FV=PV*(1+i)^n FV=100*( )^(5) FV=$103.39

Going back to the future We can also do the opposite of calculating future value. We can discount a future value back to the present value to make direct comparisons: FV = PV * (1 + i) ^ n (1 + i) ^ n FV (1 + i) ^ n = PV We also refer to this as the “discount rate”

The previous example: Today $100 5-Years from Now $105 FV (1 + i) ^ n PV = 105 ( ) ^ 5 PV = PV = $101.55

So… A dollar today is worth more than a dollar in the future because we can invest the dollar today and get interest by the time the future comes around. We refer to this as the time-value of money.

But… When will a stranger ever offer me the choice of having $100 now or $105 later? What use do I have for this stuff? We use present value to calculate terminal value and cash flow value of a company in order to form a DCF, and can use it to calculate internal rate of return.