1. MSBC 5060 Chapter 2 Financial Statements, Taxes and Cash Flows 1

2. Chapter Outline 2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes 2.4 Net Working Capital 2.5 Cash Flows 2.6 The Statement of Cash Flows 2.7 Cash Flow Management 2

3. Key Concepts and Skills Know the difference between book value and market value Know the difference between accounting income and cash flow Know the difference between average and marginal tax rates Know how to determine a firm’s cash flow from its financial statements 3

4. Balance Sheet Assets are listed from Most Liquid to Least Liquid “Net Fixed Assets” is Book Value (LOCOM) net of Accumulated Depreciation Assets = Liabilities + OE  OE = Assets - Liabilities 4

5. 5 The balance sheet is a “snap-shot” – What does the company own today? – What does the company owe today? – How much is left for the owners? called the residual The LEFT SIDE shows what assets are employed by the firm to do what it does – Cash, Inventory, Factories, Machines, Trucks… The RIGHT SIDE shows how it paid for the assets – How much is borrowed and for how long – How much is left for the owners – Note: Owner’s Equity is not how much the owners contributed. It is the current residual value.

6. 6 Debt is also called Financial Leverage – Given the equity, what value of assets are employed? – Put up $1m, borrow $1m, Employ $2m in assets – Put up $1m, borrow $2m, Employ $3m in assets Market Value vs. Book Value: 1.Market Value of Assets vs. Book Value of Assets GAAP: LOCOM Coors in Golden: Land is on books at cost But what is the market value of that land? 2.Market Value of Equity vs. Book Value of Equity Book Value of Equity = Book Value of Assets – Liabilities Market Value of Equity = # of Shares x Price per Share What would account for the difference between book and market? What kind of companies have a relatively high BM? Low BM?

7. 7 Recap: Market Value of Assets Book Value of Assets Market Value of Equity Book Value of Equity

8. Income Statement Income Statement Includes: – Operating Expenses (COGS, SG&A, Lights…) – Per-Share numbers Addition to Retained Earnings on Income Statement is added to Accumulated Retained Earnings on the Balance Sheet 8

9. 9 Revenues and Expenses as they Accrue – If a sale is made, book the revenue – Not necessarily receive cash – Sale could be on account - A/R (a current asset) Non-Cash Expenses – Depreciation = $90 – Was the $90 spent this period? – No! It is a portion of the amount spent (when the PPE was purchased) that is allocated to this period – $90 is expensed against this period’s revenue – It lowers this periods taxable income And therefore lowers this period’s tax expense

10. 10 Question: A firm’s taxable income is $1,000 The firm owns a machine’s with $200 annual depreciation this year. – It paid $2,000 for the machine and is depreciating it straight- line over 10 years The firm’s tax rate is 35% What is this year’s tax savings due to depreciation? (Depreciation)(Tax Rate) = $200(0.35) = $70 Or Tax Exp without Depreciation = $1,000(0.35) = $350 Tax Exp with Depreciation = ($1,000 - $200)(0.35) = $280 = ($800)(0.35) = $280 Savings = $350 - $280 = $70

11. 11 Firms can engage in “Earnings Management” – Show higher or lower earnings – Used to achieve income smoothing – “Cookie Jar” accounts – LIFO or FIFO – Not necessarily illegal or unethical See Wikipedia PageWikipedia Page

12. 12 Corporate Taxes See Table 2.3 for corporate tax rates Make sure you can calculate: – Tax Expense – Marginal Tax Rate – Average Tax Rate See Example 2.2 on page 27 If you are calculating the effect of additional income from a new project, which tax rate should you use? Marginal. Why?

13. 13 Net Working Capital (NWC) NWC = Current Assets – Current Liabilities

14. 14 NWC = Current Assets – Current Liabilities NWC = $761 – $486 = $275 NWC is a measure of Short-Term Solvency NWC also used to adjust Sales and Costs from Income Statement to get Cash Flows: Assume Sales last year was $100 But A/R increased from $20 to $50 How much actual cash was collected? $100 – ($50 - $20) = $100 - $30 = $70 $70 in Cash Sales and $30 in A/R Sales

15. 15 Cash Flows Cash Flows are Everything! We will deal with cash flows in a slightly different way than the “Statement of Cash Flows” In General, the value of a firm (or an individual project) is… … the Present Value of its Cash Flows! Net Cash Flows (in any period) = Money In - Money Out Not Sales – Since some sales are in cash, some sales are on account Not Net income (aka Earnings ) – NI or Earnings is an “accounting profit” or “economic profit” – Not cash available to pay investors – Includes non-cash expenses – Includes accruals (sales, purchases…) A firm is defined by its assets so we will call this Cash Flows from Assets We will start with NI and Adjust 

16. CFs from Assets So back to the Income Statement: OCF = NI + Int Exp + Dep + Deferred Tax = 86 + 90 + 49 + 13 = $238 16

17. CFs from Assets So we have OCF = $238 But how much of that activity represents cash transactions? Sales was $2,262 – But how much of those sales were on account? COGs was $1,655 – But was that money actually spent on inventory this year? – Only if it was replaced! (so no change in INV) – And Only if cash was spent (no change in A/P) 17

18. CFs from Assets So back to the Balance Sheet (just Current Asset for now): A/R from $270 to $294 – $294 – $270 = $24 of OCF was not cash received INV from $280 to $269 – $269 – $280 = -$11 of Inv was not replaced – COGS of $1,655, but only $1,655 - $11 = $1,644 was cash spent 18

19. CFs from Assets Now just Current Liabilities: Total Current Liabilities from $455 to $486 – $486 – $455 = $31 of Cash assumed spent was not spent – It was “borrowed” 19

20. CFs from Assets Increases in Current Asset means OCF is too high Increases in Current Liabilities means OCF is too low So next step (Still one more after this): Total CFs = Operating CF – ΔCA + ΔCL But it is usually written his way: ΔCA = New CA – Old CA ΔCL = New CL – Old CL New NWC = New CA – New CL Old NWC = Old CA – Old CL ΔNWC = New NWC – Old NWC CFs from Assets = Operating CF – ΔNWC 20

21. CFs from Assets Recap: OCF = EBIT + Dep – Taxes = $219 + $90 - $71 = $238 ΔNWC = New NWC – Old NWC New NWC = $761 - $486 = $275 Old NWC = $707 - $455 = $252 ΔNWC = $275 – $252 = $23 So now CF = OCF - ΔNWC = $238 - $23 = $215 But still not done yet! We have to consider Net Capital Spending – Cash spent on capital is not available to investors Distinguish Capital (PPE) from Working Capital 21

22. CFs from Assets Now just Fixed Assets NCS = New Total Fixed Assets – Old Total Fixed Assets + Dep NCS = $1,118 – $1,035 + ($550 – $460) NCS = $1,118 – $1,035 + $90 = $173 22

23. CFs from Assets Recap: OCF = EBIT + Dep – Taxes = $219 + $90 - $71 = $238 ΔNWC = New NWC – Old NWC = $275 – $252 = $23 NCS = New TFA – Old TFA + Dep = $1,118 – $1,035 + $90 = $173 So firm generated “cash” of $238 from operations But $23 of the $238 was either: – Not collected – Assumed revenue was too high – Or more was spent – Assumed costs were too low – Since NWC increased And $173 of the $238 was spent of PPE CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42 23

24. CFs from Assets CF = OCF – ΔNWC - NCS = $238 - $23 - $173 = $42 This is called Cash Flows From Assets So what happened to the $42 of CF from Assets? Some CF to bondholder (also called creditors) Some CF to stockholders We will show: CF from Assets = CF to Creditors + CF to Stockholders Cash IN must equal Cash OUT 24

25. CFs from Assets Bondholders From the Income Statement: – Interest Expense = $49 – This is a CF TO bondholders From the Balance Sheet: – Net New Long-Term Debt = New – Old – Net New Long-Term Debt = $471 - $458 = $13 – This is a CF FROM bondholders Net CF to Creditors = Int Exp – Net New LT Debt Net CF to Creditors = $49 – $13 = $36 25

26. CFs from Assets CF to Stockholders From the Income Statement: – Dividends = $43 – This is a CF TO stockholders From the Balance Sheet: – Net New Treasury Stock = $26 – $20 = $6 – This is a CF TO stockholders CF TO Stockholders = $43 + $6 = $49 26

27. CF from Stockholders From the Balance Sheet: – Change in Common Stock = $55 – $32 = $23 – Change in Capital Surplus = $347 - $327 = $20 – Together these are value of new stock sold = $43 CF FROM stockholders = $43 Net CF to Stockholders = $49 – $43 = $6 27

28. CFs from Assets Conclusion: CF to Creditors = $36 CF to Stockholders = $6 CF to Creditors + CF to Stockholders = $36 + $6 = $42 Recall: CF from Assets = OCF – ΔNWC – NCS = $42 Cash In must equal Cash Out 28

29. The Accounting Statement of CFs Back to the Balance Sheet: Cash increased by $140 - $107 = $33 Why? What were the firm’s sources and uses of cash? 29

30. The Accounting Statement of CFs 30

31. This is roughly equivalent to OCF – ΔNWC = 238 – 23 = 215 We got a different number before because we did not include interest expense ($49) We did include change in Notes Payable (-$3) We did include changes in cash ($33) $202 + $49 - $3 - $33 = $215 31

32. Investing Activities = Net Capital Spending = $173 Financing Activities includes Changes to Notes Payable 32

33. The Accounting Statement of CFs Net Changes to Cash = $202 – $173 + $4 = $33 This shows the breakdown of how Cash went from $107 to $140 We DO NOT care about the Statement of CFs We DO care about financial CFs from Assets That the firm decided to increase the cash account (instead of buying inventory or paying off debt) does not concern us – from a valuation perspective What does concerns us is the Free CFs generated from the firm’s assets ($42) that are available to be paid to investors We also care about what happened to the $42 Free CF’s – $36 to creditors and $6 to stockholders 33

34. The Accounting Statement of CFs Be sure to appreciate the difference between: 1.Accounting cash flows used to trace the source of changes in the cash account 2.Financial “free cash flows” available to compensate investors – The amount, timing and allocation between stockholders and bondholders of these “free cash flows” are relevant for analyzing the company and valuing its stocks and bonds, not the changes to the amount of cash on hand. 34

35. Earnings and Cash Flow “Management” vs Fraud Enron WorldCom 35

36. What’s Next? More on Financial Statements Financial Statement Analysis Ratios Profitability Decomposition Growth and Financing Growth 36