1. Financial Statements, Cash Flow, and Taxes
Chapter 2
Financial Statements, Cash Flow, and Taxes

2. Copyright © 2014 by Nelson Education Ltd.

3. Financial Statements and Reports
A company’s annual report describes the operating results from the past year and new plans for the coming year with four financial statements:
Balance sheet
Income statement
Statement of changes in equity
Statement of cash flows
Copyright © 2014 by Nelson Education Ltd.

4. The Balance Sheet
Also referred to as the statement of financial position
Provides a snapshot of the firm’s financial position at a particular point in time
Shows assets on the left side or at the top and liabilities/equity (i.e. claims against assets) on the right side or at the bottom
Records with book values when assets are purchased or liabilities are issued
Copyright © 2014 by Nelson Education Ltd.

5. Balance Sheet: Assets 2013 2012 Cash and equivalents 10 15
Short-term investments 65
Accounts receivable
375
315
Inventories
615
415
Total current assets
$1,000
$810
Net plant and equipment
1,000
870
Total assets
$2,000
$1,680
Copyright © 2014 by Nelson Education Ltd.

6. Implications on Assets
All assets are stated in dollars.
Only cash represents the actual money that can be spent.
Some marketable securities mature very soon and are called “cash equivalents” and are included with cash.
Other marketable securities have a longer time until maturity and are called “short-term investments.”
Copyright © 2014 by Nelson Education Ltd.

7. Implications on Assets (cont’d)
Accounts receivable (A/R) is the amount of sales the customers have not yet paid for.
Inventory shows the dollars the firm has invested in raw materials, work-in-process, and finished goods available for sale (FIFO vs. LIFO).
Long-term assets can be reported either as gross/book value and accumulated depreciation or as net amount (the book value less accumulated depreciation).
Copyright © 2014 by Nelson Education Ltd.

8. Balance Sheet: Liabilities and Equity
2013
2012
Accounts payable 60 30
Notes payable
110
Accruals
140
130
Total current liabilities
$310
$220
Long-term bonds
754
580
Total liabilities
$1,064
$800
Preferred stock (400,000 shares) 40
Common stock (50,000,000 shares)
Retained earnings
766
710
Total common equity
$896
$840
Total liabilities and equity
$2,000
$1,680
Copyright © 2014 by Nelson Education Ltd.

9. Implications on Liabilities and Equity
Accounts payable (A/P) is an obligation the firm has to pay its suppliers for its purchases.
Notes payable represents loans the firm must repay within a year.
Accruals are the amount of taxes and wages the firm has yet to pay in a year.
Long-term bonds reflect a claim held by investors other than shareholders.
Copyright © 2014 by Nelson Education Ltd.

10. Implications on Liabilities and Equity (cont’d)
Preferred stock is a hybrid between common stock and debt.
Common stock account records the proceeds the firm received from selling shares of stock in the past.
Retained earnings are the cumulative amount of earnings not paid out as dividends.
The sum of common stock and retained earnings is called “common equity,” or simply “equity,” representing the assets net of the liabilities, or net worth.
Copyright © 2014 by Nelson Education Ltd.

11. The Income Statement
Show a firm’s performance over a period of time, such as a month, a quarter, or a year
EBITDA (earnings before interest, taxes, depreciation, and amortization) results from subtracting operating costs from net sales.
Depreciation and amortization are annual charges reflecting the estimated costs of the long-term assets used up each year.
Copyright © 2014 by Nelson Education Ltd.

12. The Income Statement (cont’d)
Neither depreciation nor amortization is paid in cash.
EBITDA can be a better measure of financial strength than net income.
EBITDA is not as important as FCF.
Net income (NI, also called profit or earnings) is revenue less expenses, taxes, and preferred dividends (before paying common dividends).
EPS (earnings per share) is net income divided by the number of shares outstanding, also called “the bottom line.”
Copyright © 2014 by Nelson Education Ltd.

13. The Income Statement (cont’d)
2013
2012
Net sales
3,000.0
2,850.0
Op. costs excluding depre. & amort.
2,616.2
2,497.0
EBITDA
$383.8
$353.0
Depre. & amort.
100.0
90.0
EBIT (operating income)
$283.8
$263.0
Int. expense
88.0
60.0
Earnings before taxes (EBT)
$195.8
$203.0
Taxes (40%)
78.3
81.2
Net income before preferred dividends
$117.5
$121.8
Preferred dividends
4.0
Net Income (NI)
$113.5
$117.8
Copyright © 2014 by Nelson Education Ltd.

14. Stock Price and Other Data
2013
2012
Common stock price
$23.00
$26.00
# of shares
50,000,000
Earnings per share (EPS)
$2.27
$2.36
Dividends per share (DPS)
$1.15
$1.06
Book value per share (BVPS)
$17.92
$16.80
Cash flow per share (CFPS)
$4.27
$4.16
Copyright © 2014 by Nelson Education Ltd.

15. What Happened to Sales and Net Income?
Sales increased by over $150 million.
Total operating costs shot up.
Interest expenses also went up.
Net income was down.
The firm paid less tax as a result.
Copyright © 2014 by Nelson Education Ltd.

16. Net Cash Flow (NCF)
Net cash flow ≠ accounting profit, as some revenues and expenses are not received or paid in cash.
NCF = NI – Noncash revenues + Noncash charges
Examples of noncash revenues/charges:
Depreciation and amortization (largest)
Deferred tax payments
Revenue not collected in cash
NCF = NI + Depreciation and amortization because other noncash items net out to zero

17. Statement of Cash Flows
Summarizes the changes in a firm’s cash position
Separates the firm’s activities into three categories
Operating activities
Investing activities
Financing activities

18. Constructing Statement of Cash Flows
Start with net income from the income statement.
Adjust net income to reflect noncash revenues (subtracting) and expenses (adding).
Calculate the changes for every account on the nearest two years’ balance sheets.
An increase in a noncash asset account decreases cash, while a decrease in such an account increases cash.
An increase (decrease) in any liability or equity account increases (decreases) cash.
Dividend payment and share buyback reduce cash.

19. Statement of Cash Flows: 2013
Operating Activities
Net Income
$117.5
Adjustments:
Depreciation
100.0
Change in A/R
(60.0)
Change in inventories
(200.0)
Change in A/P
30.0
Change in accruals
10.0
Net cash provided by op. act.
($2.5)

20. Statement of Cash Flows: 2013 (cont’d)
Investing Activities
Cash used to acquire FA
(230.0)
Change in S-T investment
65.0
Net cash provided by inv. act.
($165.0)

21. Statement of Cash Flows: 2013 (cont’d)
Financing Activities
Change in notes payable
50.0
Change in long-term debt
174.0
Payment of cash dividends
(61.5)
Net cash provided by fin. act.
$162.5

22. Summary of Statement of Cash Flows 2013
Net cash provided by op. act.
(2.5)
Net cash provided by inv. act.
(165.5)
Net cash provided by fin. act.
162.5
Net change in cash
($5.0)
Cash at beginning of year
15.0
Cash at end of year
$10.0

23. What Can You Conclude from the Statement of Cash Flows?
The firm is not generating cash flow in its operating activities.
Net CF from operations = –$2.5 million because of reduced net income and big increases in working capital.
The firm spent $230 million on fixed assets.
The firm borrowed heavily and sold bonds to meet its cash requirements.
Even after borrowing, the cash account fell by $5 million.

24. Modifying Accounting Data for Managerial Decisions
Unlike accountants, who are concerned with recording transactions and focus on the firm’s net income, financial managers and analysts emphasize the stream of cash flows that the firm will generate now and in the future.
More specifically, they focus on free cash flows (FCF), the cash flow available for distribution to all investors after making all investments necessary to sustain ongoing operations.

26. Net Operating Profit After Taxes (NOPAT)
NOPAT = EBIT(1 – Tax rate) = Operating income × ( 1 – Tax rate)
NOPAT2013 = $283.8 × (1 – 0.4)
= $170.3 million
NOPAT2012 = $157.8 million

27. Net Operating Working Capital (NOWC)
NOWC = Operating current assets – Operating current liabilities
NOWC2013 = ($10 + $375 + $615)
– ($60 + $140)
= $800 million
Use (Cash + A/R + inventories) – (A/P + accruals) to try NOWC2012.

28. Operating Current Assets
Operating current assets are the current assets needed to support operations.
Op CA include: cash, inventory, receivables
Op CA exclude: short-term investments because these are not a part of operations

29. Operating Current Liabilities
Operating current liabilities are the current liabilities resulting as a normal part of operations.
Op CL include: accounts payable and accruals
Op CL exclude: notes payable because this is a source of financing, not a part of operations

30. Total Net Operating Capital (Also Called Operating Capital)
Total net operating capital = NOWC + operating long-term assets
Operating long-term assets include land, buildings, factories, equipment, and so on.
(TN)OC2013 = $800 + $1,000 = $1,800 million
(TN)OC2012 = $585 + $870 = $1,455 million

31. Alternative to Calculating Total Net Operating Capital
Total net operating capital = Funds provided by all investors (banks, bondholders, preferred stock and common equity) – any amount tied up in short-term investments
For MicroDrive, at year-end 2012: total net operating capital = ($60 + $580 + $40 + $840) – $65 = $1,520 – $65 = $1,455 million

32. Net Investment in Operating Capital
Change in total net operating capital between two years:
During 2013, MicroDrive made:
Net investment in operating capital = (TN) OC 2013 – (TN) OC 2012 = $1,800 – $1,455 = $345 million

33. Free Cash Flow (FCF) vs. Net Cash Flow (NCF)
NCF is not the amount of cash flow that management is completely free to use.
FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.
FCF = NOPAT – Net investment in operating capital
MicroDrive’s FCF in 2013 = $170.3 – $345 = –$174.7 million
A company’s value depends upon the amount of FCF it can generate.

34. Five Uses of FCF
1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay cash dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

35. Alternative To Calculating FCF
FCF = Operating cash flow (OCF) – gross investment in operating capital
OCF = NOPAT + depreciation
Gross investment in operating capital = net investment in op. capital + depreciation
FCF = ($ $100) – ($345 + $100)
= $270.3 – $445.0
= -$174.7 million (same as before)
= NOPAT – Net investment in op. capital

36. Evaluating FCF, NOPAT, and Operating Capital
Is a negative free cash flow always bad?
Not necessarily; it depends on why the free cash flow is negative.
If FCF is negative because NOPAT is negative, it is a bad sign.
There is nothing wrong with a high-growth profitable (positive NOPAT) firm having a negative FCF because of making large investments in operating assets to support growth.

37. Return on Invested Capital (ROIC)
A performance measure indicating how much NOPAT is generated by each dollar of operating capital. It is one way to determine whether growth is profitable.
ROIC = NOPAT / operating capital
ROIC2013 = $170.3 / $1,800 = 9.46%
Is this enough to cover the firm’s cost of capital?

38. The Firm’s Cost of Capital Is 11%. Did the Growth Add Value?
No. The ROIC of 9.46% is less than the WACC of 11%. Investors did not get the return they require.
Note: High growth usually causes negative FCF (due to investment in capital), but that is fine if ROIC > WACC.
Firm had high growth, negative FCF, but a high ROIC.

39. Market Value Added (MVA) and Economic Value Added (EVA)
The two performance measures developed to incorporate stock prices into traditional accounting data and modified data
MVA measures the effects of managerial actions since the very inception of a firm.
EVA focuses on managerial effectiveness in a given year.

40. Market Value Added (MVA)
A measure of the difference between the total market value of a firm and its total book value
MVA = Market value of the firm – Book value of the firm
Market value = (# shares of stock)(price per share) + Market value of debt
Total book value = Total common equity + Value of debt

41. MVA (cont’d)
If the market value and book value of debt are close, then MVA is:
MVA = Market value of equity – book value of equity
MVA = (Shares outstanding)(Stock price) – total common equity
MVA = Total market value (stock + debt) – total investors supplied capital
Copyright © 2014 by Nelson Education Ltd.

42. Market value of equity in 2010: Book value of equity 2010:
2010 Imperial Oil MVA (Assume Market Value of Debt = Book Value of Debt)
Market value of equity in 2010:
$34.2 billion
Book value of equity 2010:
$11.2 billion
MVA2010 = $34.2 – $11.2 = $23 billion

43. Economic Value Added (EVA)
An estimate of a business’s true economic profit for the year
It differs from accounting profit.
EVA represents the residual income remaining after the cost of all capital (both debt and equity) has been deducted.
Accounting profit does not take a charge for equity capital.
EVA measures the extent to which the firm has increased shareholder value.

44. EVA (WACC = 11% for 2013)
EVA = NOPAT – (WACC)(Capital) EVA = (Operating capital)(ROIC – WACC) EVA2013 = $170.3 – (0.11)($1,800) = $170.3 – $198.0 = –$27.7 million EVA2013 = $1,800 × ( – 0.11) = $1,800 × (–0.0154)

45. EVA (cont’d)
EVA in 2013 was negative primarily because the amount of capital rose more sharply than NOPAT and the cost of this additional capital pulled EVA down.
EVA is typically used to evaluate managerial performance as part of an incentive compensation program.

46. Taxes
The value of a firm depends on the stream of after-tax cash flows.
Interest income and dividends are taxed in investors’ hands.
Taxes affect both corporations’ and investors’ decision making.
For example, firms prefer to use more debt than equity while investors are in favour of equity investment.

47. Key Features of the Tax Code
Corporate Taxes
Rate vary with firm size, location, and type of income being earned.
Individual Taxes
Rate are progressive.

48. Corporate Income Taxes

49. Features of Corporate Taxes
A corporation can:
deduct its interest expenses but not its dividend payments
carry back losses for the preceding 2 years and carry forward losses for 20 years*
Exclude 70% of dividends if received from another corporation, while the remaining 30% is taxed at the ordinary tax rate.
*The loss treatment is to avoid penalizing corporations whose incomes fluctuate substantially from year to year.

50. Carryback and amount available for Carryforward

51. Key Features of Individual Taxation
Individuals face progressive tax rates.
Individuals are taxed on investment income as well as earned income, but with a few exceptions and modifications.
The length of time that the capital asset is held determines the tax treatment. If held for <1 year, then gain or loss is added to the other ordinary income. If held for >1 year, it is taxed at a lower rate.