DES Chapter 3
Financial Statements and
Free Cash Flow
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Cash is King!
Investors care about cash flow.
It is worth going to a lot of trouble to
disentangle cash flow from published
financial statements.
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Annual report has 4 parts1
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Shareholders’ Equity
1And
of course, the footnotes
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GAAP
Statements prepared according to
GAAP are reasonably consistent from
firm-to-firm.
But the standard measures (earnings
per share, net change in cash, net
income, and return on equity) are not
sufficient for valuation purposes.
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Accruals
Part of the problem with GAAP is
accruals
Accrual basis
 Matching principle

When does cash come in and go out,
versus when are these cash flows
recognized?
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The Balance Sheet
Assets
Accounts receivable (AR)—money owed to
ACME by customers who purchased on
credit terms
 Inventory
 Long-term assets, like property, plant and
equipment (PPE).
 Accumulated depreciation—is subtracted
from gross PPE to get net PPE.

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Acme's Balance Sheet:
Assets
Cash
Inventory
Accounts receivable
Total current assets
Gross PPE
Accumulated depreciation
Net PPE
Total assets
2001
37.30
522.14
932.40
1,491.84
2,619.28
754.48
1,864.80
3,356.64
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2002
41.40
579.58
1,034.96
1,655.94
3,031.40
961.47
2,069.93
3,725.87
2003
45.12
631.74
1,128.11
1,804.98
3,443.32
1,187.09
2,256.23
4,061.20
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The balance sheet…
Liabilities and owners’ equity
Accrued expenses
 Short-term debt
 Long-term debt
 Common stock
 Retained earnings

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Acme's Balance Sheet:
Liabilities
2001
Accounts payable
Accrued expenses
Short-term debt
Total current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total common equity
Total liabilities and equity
372.96
186.48
183.19
742.63
1,000.00
1,742.63
500.00
1,114.01
1,614.01
3,356.64
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2002
413.99
206.99
285.90
906.88
1,000.00
1,906.88
600.00
1,218.99
1,818.99
3,725.87
2003
451.24
225.62
381.71
1,058.57
1,000.00
2,058.57
600.00
1,402.63
2,002.62
4,061.20
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The Income Statement
Sales
Expenses
Cost of goods sold (COGS)
 Sales, general, and administrative (SGA)
 Depreciation

Net income and additions to R.E.
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Acme's Income Statement
Sales
Costs of Goods Sold
Sales, General and Administrative
Depreciation
Operating Profit
Interest expense
Earnings Before Taxes
Taxes
Net Income
2001
3,729.60
2,312.35
745.92
186.48
484.85
88.05
396.80
158.72
238.08
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2002
4,139.86
2,566.71
827.97
206.99
538.18
96.49
441.70
176.68
265.02
2003
4,512.44
2,797.71
902.49
225.62
586.62
105.73
480.89
192.36
288.53
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Income statement items
Sales

Only reflects products or services defined
(according to GAAP) as sold, net of items
returned.
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Income statement items…
Expenses

Cost of Goods Sold (COGS)


These are direct costs of producing products or
services that were sold during the period
Sales, general and administrative
expenses (SGA)

Hard to attribute these expenses to a specific
item. E.g. marketing, insurance, salaries of
executives.
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Income statement items…
Expenses continued…

Depreciation


Not a cash expense. Is the recognition of
money that was spent years ago on capital
assets.
Operating profit = Sales – COGS – SGA –
Depreciation.
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Income statement items…
Interest expense

Interest paid on debt.
Earnings before taxes

Operating profit minus interest expense
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Income statement items…
Taxes
Net income

Earnings before taxes minus taxes
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Statement of shareholder's
equity
Net Income
Dividends
Stock issues
Stock repurchases
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Acme's statement of
shareholders' equity
2002
2003
Balance as of December 31 of previous year
Net Income
Dividends on Common Stock
Issuance of Common Stock
Common Stock Repurchases
1,614.01
265.02
(160.04)
100.00
0.00
1,818.99
288.53
(104.88)
0.00
0.00
Balance as of December 31
1,818.99
2,002.62
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Statement of Cash Flows
Because of accrual accounting, not
everything on the income statement
represents a cash flow—the statement of
cash flows corrects for this.
3 parts:



Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Net cash flow
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Cash flow from operating
activities
Sources of cash flow:
Net income
 Depreciation, because it was deducted
from net income, but it really wasn’t a cash
expense, so it is added back in.
 If liabilities go up, it is like borrowing more,
so it is a source of cash—so increases in
accounts payable and increases in
accruals are sources of cash.

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Cash flow from operating
activities
Uses of cash flow

If assets go up, that represents an
expenditure (in order to pay for the asset),
and so cash goes down. So if inventory
increases, it required a use of cash flow to
pay for it, so increases in inventory and
accounts receivable are subtracted.
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Accounts receivable
Accounts receivable deserve a bit more
discussion:

An account receivable represents money
for goods sold that the company has not
yet received. So the company is basically
lending the customer the money for the
goods. It takes cash to make a loan, so if
the company’s accounts receivable
increase, it is a use of cash.
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Cash flow from operating
activities
Net cash from operating activities is the
sum of these items. In 2003, ACME
generated cash of $424.72 million from
its operating activities, despite the fact
that it had net income of only $288.53
million. The difference comes mainly
from depreciation. Asset and liability
changes account for the rest.
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Acme's statement of cash
flows
2002
Operating Activities
Net Income
Depreciation & Amortization
Change in Inventory
Change in Accounts Receivable
Change in Accounts Payable
Change in Accruals
Net cash from operating activities
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2003
265.02
206.99
288.53
225.62
(57.44)
(102.56)
41.03
20.51
373.55
(52.16)
(93.15)
37.25
18.63
424.72
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Investing activities
Companies use their cash to purchase
fixed assets. These purchases show up
here. In 2003 Acme used $411.92
million to purchase fixed assets. This
was a use of cash so it shows up as a
negative number.
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Financing activities
The money (other than that provided by
operations) has to come from
somewhere—this section tells where.
If short-term or long-term debt or common
stock increases, then cash goes up.
 If the company retires debt or repurchases
common stock, then cash goes down.
 Cash goes down when dividends are paid.

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Investing Activities
Investment in PPE
Net cash from investing activities
2002
(412.12)
(412.12)
2003
(411.92)
(411.92)
Financing Activities
Change in short-term debt
Change in long-term debt
Change in common stock
Common dividends
Net cash from financing activities
102.72
0.00
100.00
(160.04)
42.68
95.80
0.00
0.00
(104.89)
(9.09)
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Adding them up…
The sum of cash flow from operations,
investing activities, and financing
activities represents the total change in
cash. If this sum is positive, then the
total amount of cash the company has
goes up. For ACME, cash went up by
$3.72 million in 2003.
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Net cash flow
2002
2003
Net cash from operating activities
373.55
Net cash from investing activities -412.12
Net cash from financing activities
42.76
Net cash flow (net change in cash)
4.10
424.72
-411.92
-9.08
3.72
Starting cash
Ending cash
37.20
41.40
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41.40
45.12
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Acme’s free cash flow
Free cash flow is cash potentially
available for distribution to stockholders
and creditors:
Dividends and stock repurchases
 Interest and principal payments

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Free cash flow calculation
FCF calculated as

NOPAT – investment in operating capital
For 2003:
NOPAT2003 = Operating profit – taxes on o.p.
=$586.62(1 – 0.40) = $351.97
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FCF calculation
Net operating working capital:

NOWC2003 = (cash + inventory + AR) – (AP
+ Accrued expenses) = $1,128.11
Total operating capital in 2003:
= NOWC + net long-term operating capital
(which is PPE for ACME)
 = $1,128.11 + $2,256.23 = $3,384.34
 TOC in 2002 is $3,104.89

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FCF calculation
FCF = NOPAT – net investment in
operating capital
= $351.97 – ($3,384.34 - $3,104.89)
 = $72.52 million

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Acme's Free Cash Flow
2001
484.85
193.94
290.91
Operating profit
Tax on operating profit
NOPAT
Operating current assets
1,491.84
Operating current liabilities
559.44
NOWC
932.40
Total operating capital
2,797.20
Investment in total net operating capital
FCF
2002
538.19
215.28
322.91
1,655.94 1,804.97
620.98
676.86
1,034.96 1,128.11
3,104.89 3,384.34
307.69
279.45
15.22
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2003
586.62
234.65
351.97
72.52
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Uses of FCF
How was this $72.52 million used?
Paid $106 million to debtholders in
interest—but after-tax amount was only
$64 million because it is deductible.
 Paid $105 million in dividends.
 For a total of $169 million, which is quite a
bit more than its FCF of $73 million. It
borrowed the rest, for a total new
borrowing of $169 - $73 = $96 million.

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Financing approach to calculating
FCF
FCF = After-tax interest expense – Net
CF from financing activities
= $63.44 – (-9.08) = $72.52
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Acme’s operating performance
ROIC = NOPATt/Capitalt-1
ROIC2002 = NOPAT2002/Capital2001
= $322.91/$2,797.2
= 11.5%
ROIC2003 = NOPAT2003/Capital2002
= $351.97/$3,104.89
= 11.3%
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Is this good or bad?
If ROIC is greater than the cost of
capital (WACC) then ACME is adding
value. Since WACC is 10%, ROIC
shows that ACME is earning more than
its investors require.
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