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

2. 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

3. 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

4. The Balance Sheet

5. 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.

6. 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?

7. 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 – ( ) =650
= 250

8. 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

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

10. 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

11. 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

12. 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.

13. 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

14. 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

15. 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 = € per share

16. 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

17. 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 – =
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.

18. 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.

19. 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

20. 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

21. 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 +

22. 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 _ _

23. 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

24. 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

25. 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

26. 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

27. 2.3 Operating Cash Flow Earnings before interest and taxes (EBIT) 694
+ Depreciation
- Taxes
Operating cash flow
694 65
- 212
547

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

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

30. 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

31. 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

32. 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

33. 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?

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 2.4 Cash Flow and Financial Statements
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

43. 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

44. 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

45. 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