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

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

3. 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

4. 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!

5. 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?

6. 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

7. The balance sheet

8. 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

9. 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

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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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
= $87

24. The example of the book: U.S. Corporation

25. The example of the book: U.S. Corporation

26. The example of the book: U.S. Corporation

27. The example of the book: U.S. Corporation

28. The example of the book: U.S. Corporation

29. 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

30. Where to get financial statements?
Directly from the corporation
Company websites, under investor relationship department
From the SEC database (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

31. 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