Chapter 2
Financial Statements, Cash Flow,
and Taxes
1
Topics in Chapter






Balance sheet
Income statement
Statement of cash flows
Free cash flow
MVA and EVA
Corporate taxes
2
Importance of Financial
Statements



Form the basis for understanding the
financial position of a business
Provide information regarding the
financial policies and strategies and
insight into future performance
10-K and 10-Q
3
Balance Sheet
Assets
Liabilities and Equity
Cash and equivalents
Short-term investments (stocks and bonds)
Accounts Receivable
Inventories
Total current assets
Accounts payable
Notest payable
Current long-term debt
Accruals
Total current liabilities
Net plant and equipment
Intangible assets (R&D, patents)
Long-term investments (stock and bonds)
Total Assets
Long-term debt
Total liabilities
Preferred stock
Common stock
Retained earnings
Total Liabilities and Equity
4
Balance Sheet: Assets
Cash
S-T invest.
AR
Inventories
Total CA
Gross FA
Less: Depr.
Net FA
Total assets
2009
$
9,000
48,600
351,200
715,200
1,124,000
491,000
146,200
344,800
$1,468,800
2010
$
7,282
20,000
632,160
1,287,360
1,946,802
1,202,950
263,160
939,790
$2,886,592
5
Balance Sheet: Liabilities &
Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E
2009
$ 145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
$1,468,800
2010
$ 324,000
720,000
284,960
1,328,960
1,000,000
460,000
97,632
557,632
$2,886,592
6
Changes on liabilities & equity




CL increased as creditors and suppliers
“financed” part of the expansion.
Long-term debt increased to help
finance the expansion.
The company didn’t issue any stock.
Retained earnings fell, due to the year’s
negative net income and dividend
payment.
7
Dell’s Balance Sheet

http://finance.yahoo.com/q/bs?s=DELL
+Balance+Sheet&ann
8
Balance Sheet highlights



Net plant and equipment= gross plant and
equipment– accumulated depreciation
Common stock at par and additional paid-in
(capital surplus)
Retained earnings


Annual addition to retained earnings
= net income – dividends paid
Net worth – common equity
9
Income Statement
Net Sales
Less Cost of Goods Sold (COGS)
Less Operating expenses
EBITDA
Less Depreciation
Less Amortizations
EBIT
Less Interest
EBT
Less Taxes
Net income
10
Income Statement Example
2009
2010
Sales
$3,432,000
$5,834,400
COGS
2,864,000
4,980,000
340,000
720,000
18,900
116,960
3,222,900
5,816,960
209,100
17,440
62,500
176,000
146,600
(158,560)
58,640
(63,424)
87,960
($ 95,136)
Other expenses
Deprec.
Tot. op. costs
EBIT
Int. expense
EBT
Taxes (40%)
Net income
$
11
Dell’s Income Statement

http://finance.yahoo.com/q/is?s=DELL+
Income+Statement&annual
12
MicroDrive Income Statement
Table 2-2
MicroDrive Income Statements for Years Ending December 31
(in millions of dollars)
2010
2009
Net sales
$3,000.0
$2,850.0
Operating costs except depreciation
$2,616.2
$2,497.0
$383.8
$353.0
Depreciation
$100.0
$90.0
Amortization
$0.0
$0.0
Depreciation and amortization
$100.0
$90.0
Earnings before interest and taxes (EBIT)
$283.8
$263.0
INCOME STATEMENT
Earnings before interest, taxes, deprn., and amortization (EBITDA)*
Less interest
$88.0
$60.0
$195.8
$203.0
$78.3
$81.2
$117.5
$121.8
$4.0
$4.0
$113.5
$117.8
Common dividends
$57.5
$53.0
Addition to retained earnings
$56.0
$64.8
Earnings before taxes (EBT)
Taxes
Net Income before preferred dividends
Preferred dividends
Net Income available to common stockholders
*MicroDrive has no amortization charges.
13
Income Statement Highlight

Operating expenses



Include management salaries, advertising expenditures,
repairs & maintenance, R&D, general & administrative
expenses, lease payments, etc.
Earnings per common share (EPS)
Companies that issued convertible securities
(such as bonds convertible into common
stock) and stock options, must calculate two
types of earnings per share: basic and
diluted.
14
Statement of Cash Flows



Provides information about cash inflows
and outflows during an accounting
period
Focuses on CASH.
Has THREE sections:



Cash flow from Operating Activities (OCF)
Cash flow from Investing Activities (ICF)
Cash flow from Financing Activities (FCF )
15
Compute the changes in some
accounts over two periods
Accounts receivables
Which
goes
Notes payable
account item
Depreciation
Fixed assets
Accruals etc …
to
Operating
Investing
Which
section
Financing
?
16
Useful Tip 1
No matter which section you are doing
(operating, investing or financing),
 IF the change of an account leads to a cash
INFLOW, you add that change (+); IF the
change leads to a cash OUTFLOW, you
subtract that change (-)

inflow: decreases in assets or increases in
liabilities or equity.
outflow: increases in assets or decreases in
liabilities or equity.
17
Useful Tip 2
Cash flow from Operating Activities
+ Cash flow from Investing Activities
+ Cash flow from Financing Activities
= CHANGE in cash account
18
Cash flows from
operating activities 1
Net income
+ depreciation
+/- change in A/R
+/- change in Inv.
+/- change in A/P
+/- change in Accruals
19
Cash flows from
operating activities 2
Asset
Liability
Decreases
Add +
(cash inflow)
Subtract (cash outflow)
Increases
Subtract (cash outflow)
Add +
(cash inflow)
20
Cash flows from
investing activities 1

Investing activities:

Buying or selling productive assets
(plant & equipment)

Buying or selling financial securities (e.g.,
stocks and bonds of other companies,)
21
Cash flows from
investing activities 2
Inflows:
Means:
Decrease in gross fixed assets Firm sells long-lived assets such as
gross property, plant and equipment
Decrease in long-term
investments
Firm sells debt or equity securities
of other firms
Outflows:
Increase in gross fixed assets
Firm buys long-lived assets such as
gross property, plant and equipment
Increase in long-term
investments
Firm buys debt or equity securities
of other firms
22
Cash flows from
investing activities 3
Warning: we want changes in GROSS
fixed assets. We don’t want the changes
in net fixed assets!
BUT, if gross fixed assets are not
reported in balance sheet …
23
Cash flows from
investing activities 4
change in gross fixed assets
= change in net fixed assets + depreciation
24
Cash flows from
financing activities 1
+/- changes in N/P
+/- changes in current long-term debt
+/- changes in long-term debt
+/- changes in common and preferred stock
+/- changes in capital surplus
- Payment of dividends
25
Cash flows from
financing activities 2
Inflows:
Means:
•increase in notes payable
•increase in long-term debt
•increase in common stock
Outflows:
Firm borrows money
•decrease in notes payable
•decrease in long-term debt
•decrease in common stock
Firm repays debt
•Payment of dividends
Firm sells equity securities
Firm buys back shares
Firm pays cash to
shareholders
26
Cash Flows Workshop
Solve Assignment 3.1
27
Dell’s Statement of Cash Flow

http://finance.yahoo.com/q/cf?s=DELL
+Cash+Flow&annual
28
Analyzing Statement
of Cash Flows 1
Statement of CF can help you analyze a
company:
1) Relationship between net income and
net cash flow from operations (OCF)



If net income positive, but OCF is negative,
could mean:
Company is growing rapidly
Financial mis-management
29
Analyzing Statement
of Cash Flows 2
2) Net cash flow from investing activities
(ICF)
If negative, company is making
investments


Buying plant & equipment (improve
efficiencies)
Buying another company’s stock (strategic
reasons, e.g., joint venture)
If positive, company is liquidating assets.
Why? Financial distress?
30
Analyzing Statement
of Cash Flows 3
3) Does company have sufficient cash to
pay dividends?
OCF should exceed dividends.
If dividends exceed OCF, why?



Company liquidated assets to pay dividends?
Company issued equity or borrow to pay
dividends?
Neither situation is good.
31
Analyzing Statement
of Cash Flows 4
4) Changes in debt
 Look at cash flow from financing
activities
 substantial increases in debt (either
short-term or long-term)
 Substituting short-term debt for longterm debt may indicate worsening
financial health.
32
What is free cash flow (FCF)?
Why is it important?


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.
A company’s value depends on the
future FCF it can generate.
33
What are the five uses of FCF?
1.
2.
3.
4.
5.
Pay interest on debt.
Pay back principal on debt.
Pay dividends.
Buy back stock (repurchase).
Buy nonoperating assets (e.g.,
marketable securities, investments in
other companies, etc.)
34
Calculating Free Cash Flow in 5 Easy Steps
Step 1
Step 2
Earning before interest and taxes
Operating current assets
X (1 − Tax rate)
− Operating current liabilities
Net operating profit after taxes
Net operating working capital
Step 3
Net operating working capital
+
Operating long-term assets
Total net operating capital
Step 5
Step 4
Net operating profit after taxes
Total net operating capital this year
− Net investment in operating capital
− Total net operating capital last year
Free cash flow
Net investment in operating capital
35
Step1: Net Operating Profit
after Taxes (NOPAT)
NOPAT = EBIT(1 - Tax rate)
=EBIT - Tax
36
Step2: Net Operating Working
Capital (NOWC)
NOWC
=
Operating
CA
Operating
CL
Operating CA = cash and equivalent + inventory +
accounts receivables.
Operating CL = accounts payable + accruals
37
Step 3: Total net operating
capital (or operating capital)
Operating Capital
= NOWC + Net fixed assets.
38
Step 4: net investment in
operating capital
Net investment in operating capital
= operating capital this year
- operating capital last year
39
Step 5: Free Cash Flow (FCF)
FCF
= NOPAT - Net investment in operating capital
Equation (2-6)
40
Alternative FCF equation (2-9)
FCF =
operating cash flow
- gross investment in long-term
operating asset
-
investment in NOWC
Equation (2-9)
41
Is a negative FCF bad?


If –NOPAT leads to a –FCF, then bad.
High growth usually causes negative
FCF (due to investment in capital), but
that’s ok if ROIC > WACC.
ROIC: return on invested capital

ROIC = NOPAT / operating capital
42
Market Value Added (MVA)



MVA = Market Value of the Firm - Book
Value of the Firm
Market Value = (# shares of
stock)(price per share) + Value of debt
Book Value = Total common equity +
Value of debt
43
MVA (Continued)

If the market value of debt is close to
the book value of debt, then
MVA = Market value of equity – book value of equity

This applies when it is hard to find the
market value of debt.
44
MVA (Assume market value of
debt = book value of debt.)

Market Value of Equity 2010:


Book Value of Equity 2010:


(100,000)($6.00) = $600,000.
$557,632.
MVA = $600,000 - $557,632 = $42,368.
45
Economic Value Added (EVA)
EVA
= NOPAT – Operating capital x WACC
= Operating capital x ROIC –
Operating capital x WACC
= Operating capital (ROIC-WACC)
46
MVA and EVA (Table 2-5)
Table 2-5
MVA and EVA for MicroDrive (Millions of Dollars)
2010
2009
$23.0
$26.0
50.0
50.0
$1,150.0
$1,300.0
Book value of equity
$896.0
$840.0
MVA = Market value - Book value
$254.0
$460.0
$283.8
$263.0
40%
40%
$170.3
$157.8
$1,800.0
$1,455.0
Weighted average cost of capital, WACC (%)
11.0%
10.8%
Dollar cost of capital = Operating capital (WACC)
$198.0
$157.1
EVA = NOPAT – Capital cost
-$27.7
$0.7
ROIC = NOPAT/Operating capital
9.46%
10.85%
-1.54%
0.05%
-$27.7
$0.7
MVA Calculation
Price per share
Number of shares (millions)
Market value of equity = Share price (number of shares)
EVA Calculation
EBIT
Tax rate
NOPAT = EBIT (1-T)
Total investor-supplied operating capitala
ROIC – Cost of capital = ROIC – WACC
EVA = (Operating capital)(ROIC – WACC)
47
2009 Corporate Tax Rates
Taxable Income
0 -50,000
50,000 - 75,000
75,000 - 100,000
Tax on Base
0
7,500
13,750
100,000 - 335,000
335,000 - 10M
10M - 15M
22,250
113,900
3,400,000
15M - 18.3M
18.3M and up
5,150,000
6,416,667
Rate on amount
above base
15%
25%
34%
39%
34%
35%
38%
35%
48
Features of Corporate
Taxation

Progressive rate up until $18.3 million
taxable income.


Below $18.3 million, the marginal rate is
not equal to the average rate.
Above $18.3 million, the marginal rate and
the average rate are 35%.
49
After Chapter Homework


Problems: (2-3), (2-4), (2-5), (2-10),
(2-12 abcde), mini case d,e,f,g,h.
Course website: Statement of Cash
Flow assignment 3.2, 3.3.
50