Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Ch 3: Financial Statements, Cash Flow, and
Taxes
Dr. Khaled Obaid
Other
Financial Statements
Balance Sheet
Outline
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Other
Income Statement
Cash Flow Statement
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Financial Statements
I Our objective is to extract the actual cash flows from accounting
statements
I Accountants care about good representation of the economic value of
the firm today (discretion involved in accrual accounting, e.g. account
receivables, depreciate assets)
I Financiers care about actual cash flows generated by the firm that can
be used to pay investors
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Financial Statements
I Four Statement Types
I The balance sheet: provides a snapshot of a firm’s financial
position at one point in time
I The income statement: summarizes a firm’s revenues and
expenses over a given period of time
I The cash-flow statement: reports the impact of a firm’s
activities on cash flows over a given period of time
I The owners’ equity statement: shows how much of the
firm’s earnings were retained, rather than paid out as
dividends. Least important for us
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Key Reports filed with SEC
I EDGAR-electronic repository of corporate financials
I Complete list of SEC forms HERE
I 10-K annual report: contains key financial statements, management
opinions, and discussion of operations (audited)
I 10-Q quarterly report (not audited)
I 8-K current report: is filed by a corporation anytime it needs to report
important news or events (e.g. change to the management team, win
or loss of major customer contract, acquisition, earnings release with
guidance)
I DEF 14A proxy statement: is issued to shareholders to provide
information on matters subject to vote at the company’s annual
shareholder meeting (e.g. board members up for election, executive
compensation)
Other
Financial Statements
Balance Sheet
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Balance Sheet Example
The assets of Allied consist entirely of current assets and net plant and
equipment, and the firm has no excess cash. The firm has total assets of
$2.7 million and net plant and equipment equals $2.3 million. It has notes
payable of $150,000, long-term debt of $748,000, and total common equity
of $1.55 million. The firm does have accounts payable and accruals on its
balance sheet. The firm only finances with debt and common equity, so it
has no preferred stock on its balance sheet.
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Balance Sheet Example
I What is the company’s total debt (debt is part of liabilities, but
specifically for funds raised by borrowing money from another party;
interest bearing)? Total debt = Short-term debt (i.e. notes payable,
commercial paper) + Long-term debt; exclude accrued liabilities,
accounts payalble, and capital leases
I What is the amount of total liabilities and equity? Assets = Liabilities
+ Equity
I What is the balance of current assets on the firm’s balance sheet?
Total assets = Current assets + Net plant and equipment
I What is the balance of current liabilities on the firm’s balance sheet?
Total liabilities and equity = Current liabilities + Long-term debt +
Total common equity
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Solution
> total_debt = 150000+748000
> print(total_debt)
[1] 898000
> total_LandE = 2700000
> print(total_LandE)
[1] 2700000
> current_assets = 2700000-2300000
> print(current_assets)
[1] 4e+05
> current_liabilities = 2700000-748000-1550000
> print(current_liabilities)
[1] 402000
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Balance Sheet Example
I What is the amount of accounts payable and accruals? Current
liabilities = Accounts payable and accruals + Notes payable
I What is the firm’s net working capital (NWC)? Net working capital =
Current assets - Current liabilities
I NWC captures the liquidity of the firm; is the firm able to meet its
immediate obligations?
I What is the firm’s net operating working capital (NOWC)? Net
operating working capital = (Current assets - Excess cash) - (Current
liabilities - Notes payable)
I NOWC captures the capital that is tied up in operating the business;
can the firm continue running its operation?
I Note: Compared to NWC, NOWC makes a distinction between cash
that is used for operating purposes and ‘excess’ cash that is being held
for other purposes. Second, distinguish between its ‘free’ liabilities
(accruals and accounts payable) and its interest-bearing notes payable.
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Solution
> AP=current_liabilities-150000
> print(AP)
[1] 252000
> NWC = current_assets-current_liabilities
> print(NWC)
[1] -2000
> NOWC = current_assets-(current_liabilities-150000)
> print(NOWC)
[1] 148000
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Income Statement
Cash Flow Statement
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Income Statement
NetIncome
I Earnings per share (EPS) = CommonSharesOutstanding
I Diluted EPS means that you are taking into account increase in
number of shares outstanding from dilutive securities such as
convertible preferred stock or bond (can be converted to a common
share) and employee stock options.
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Income Statement Example
Byron Books Inc. recently reported $13 million of net income. Its EBIT
was $32.5 million, and its tax rate was 35%. What was its interest expense?
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Solution
> library('scales')
> interest= 32500000-(13000000/(1-0.35))
> dollar(interest)
[1] "$12,500,000"
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Cash Flow Statement
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Cash Flow Statement Example
Hampton Industries had $61,000 in cash at year-end 2017 and $27,000 in
cash at year-end 2018. The firm invested in property, plant, and equipment
totaling $150,000. Cash flow from financing activities totaled +$150,000.
(i) What was the cash flow from operating activities? (ii) If accruals
increased by $20,000, receivables and inventories increased by $200,000, and
depreciation and amortization totaled $33,000, what was the firm’s net
income?
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Solution
> library('scales')
> cash_op = (27000-61000)-(-150000+150000)
> dollar(cash_op)
[1] "-$34,000"
> NI= cash_op-(20000-200000+33000)
> dollar(NI)
[1] "$113,000"
Free Cash Flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Example
Assume that a company records an additional $100 of revenue this period
due to an increase in pricing (assume no additional costs). How would this
additional revenue affect the three financial statements? Assume 40% tax
rate.
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Solution
I Income statement: revenue increases by $100. Since there is no change
to COGS or SG&A or interest expense, pre-tax also increases by $100.
At a 40% tax rate, taxes are $40, so net income increases by $60
I Cash flow statement: cash from operations increases by $60 due to the
increase in net income. There are no other changes to the cash flow
statement
I Balance sheet: cash is increased by the same $60, so assets also
increase $60. Shareholders’ equity also increases by $60 due to the
additional net income affecting retained earnings
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Example
Assume the same increase in revenue of $100 (again, assume no cost
increases) but now assume that the company has not yet been paid for the
sale and instead has generated a receivable.
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Solution
I Income statement: revenue increases by $100 and net income increases
by $60, so the income statement is exactly the same
I Cash flow statement: cash from operations increases by $60 due to the
increase in net income but now also decreases by $100 due to the
increase in accounts receivable. So the net effect is a decrease in cash
of $40 (taxes paid)
I Balance sheet: cash decreases $40 but accounts receivable increases
$100, so total assets increases by $60. The only change to the right
side of the balance sheet is the increase in retained earnings of $60,
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Free Cash Flows
I Reverse engineer accounting statements to get the true
cash flows
I The cash flow we want to capture is the core, sustainable,
and recurring profitabaility from core operations of the firm
I If you want a lazy way to proxy for this cash flow, some
people often use EBITDA
I Free cash flow: tells us how much cash does the firm
generate that can be passed on to all investors without
harming the firm’s ability to operate
I Used to value entire firm (not just the equity of the firm)
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Free Cash Flows
I Start with EBIT
I First issue, subtract cash taxes to get net operating profit
after taxes
I Second, is depreciation: add back depreciation because it
was not actual cash outflow.
I Third, subtract CAPEX. Capital Expenditure (or CAPEX)
is change in PPE (‘Property, Plant, and Equipment’)
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Working Capital
I Fourth, subtract increase in net operating working capital
I Net Operating Working Capital = (Current assets - Excess
cash) - (Current liabilities - Notes payable)
I This capital is locked in operating the firm (i.e. can not
freely pass it to investors)
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Review
I Free Cash Flow = EBIT(1-TaxRate) + Depreciation CAPEX - Increase in Net Operating Working Capital
I We are basically reversing earning management
I This discretion enables companies to ‘manage’ their
earnings (investors like smooth earnings)
I We do not want ‘managed’ earnings, we want real cash flows
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Performance Measures for Evaluating Managers
I MVA (market value added)= Difference between market
value and book value of common equity. (Price per share x
Number of shares outstanding) - Total common equity. It
measures how much value the firm has accumulated over
time
I EVA (economic value added) = EBIT(1 - T)-(Total
invested capital x Cost of capital). It measures how
profitable an organization has become within a given
period of time
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Free Cash Flows
Example
For 2018, Gourmet Kitchen Products reported $23 million of sales and $18
million of operating costs (including depreciation). The company has $15
million of total invested capital. Its after-tax cost of capital is 10% and its
federal-plus-state income tax rate was 35%. What was the firm’s economic
value added (EVA), that is, how much value did management add to
stockholders’ wealth during 2018?
Other
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement
Solution
> library('scales')
> EVA= (23000000-18000000)*(1-0.35)-(15000000*0.10)
> dollar(EVA)
[1] "$1,750,000"
Free Cash Flows
Other