Financial Statements,
Taxes and Cash Flow
Chapter Two
Retail Market
Dollar General (NYSE:DG) on Tuesday raised its Family Dollar
(NYSE:FDO) bid by 2% to $9.1 billion, or $80 a share, putting pressure
on the takeover target to abandon its deal with Dollar Tree
(NASDAQ:DLTR).
Family Dollar has not yet backed Dollar General's offers, citing the $500
million break-up fee and antitrust concerns, and is standing by Dollar
Tree's lower $8.5 billion, $74.50-a-share cash-and-stock deal.
But the No. 1 deep discount retailer says it's willing to pay the break-up
fee and divest up to 1,500 stores, up from a previous proposal of 700
stores, to clear regulators' concerns.
View Enlarged Image
"In the event you refuse to engage with us regarding our revised
proposal, we will consider taking our persuasive and superior proposal
directly to your shareholders," Dollar General CEO Rick Dreiling said in
a letter to Family Dollar's board on Tuesday.
Dollar General shares rose 1.2% to 64.73 on the stock market today.
Dollar Tree rose 1.6% to 54.50. Family Dollar, which has been trading
well above either prior offer, rose 0.5%, or 38 cents, to 80.21.
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Family Dollar (FDO) Price…
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Financial Statements and the
Price of Oil
Who do you think would be impacted….???
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3
Weekly Economic Indicators & Events
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Chapter Outline
• The Balance Sheet
• The Income Statement
• Taxes
• Operational Cash Flow and the Cash Flow
Identity
– (Not the Statement of Cash Flows)
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Balance Sheet
• The balance sheet is a
snapshot of the firm’s assets
and liabilities at a given point
in time
Assets = Liabilities + Owners Equity
• Assets are listed in order of
liquidity
– Ease of conversion to cash
– Without significant loss of
value
•
Anything can be sold quickly
at the right price..!
• Balance Sheet Identity
– Assets = Liabilities +
Stockholders’ Equity
• Can a firm be too liquid?
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The Balance Sheet - Figure 2.1
Assets = Liabilities + Stockholders’ Equity
Total Equity = Common Stock + Paid in Capital (Surplus) + Retained Earnings
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Net Working Capital and Liquidity
• Net Working Capital
– Current Assets – Current Liabilities
– Usually positive in a healthy firm
– Cash Flow impact looks at the change in NWC
• Liquidity
–
–
–
–
Ability to convert to cash quickly without a significant loss in value
Liquid firms are less likely to experience financial distress
But, liquid assets earn a lower return
Trade-off to find balance between liquid and illiquid assets
– How much NWC should we have?
•
•
Carry Costs and Short-out become issues for short term financing
Operating Cycle and Cash Cycle should be understood
Chapters 16 and 17 look at understanding the optimal cash position.
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US Corporation Balance Sheet –
Table 2.1
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Real Balance Sheet
• McGraw Hill Balance Sheet
http://www.sec.gov/edgar/searchedgar/webusers.htm
Direct Link to McGraw Hill
(look at Higher Ed Operating Revenue……!!!)
http://www.sec.gov/Archives/edgar/data/64040/000095012307014307/y41302e10vq.htm
See pg 22-23
As of 1-19-16
http://www.sec.gov/Archives/edgar/data/64040/000006404015000026/mhfi-2015930xq3.htm
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Balance Sheet Example
Example Balance Sheet
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Market vs. Book Value
• The balance sheet provides the book value of the assets, liabilities and equity.
• Market value is the price at which the assets, liabilities or equity can actually be
bought or sold.
– How do we calculate market value?
– How do we determine the value of the asset?
– Sometimes assets have to be written down on the books…
• Market value and book value are often very different. Why?
• Long Term Assets vs. Short Term Assets
– Short Term: Book Value ≈ Market Value
– Long Term: Book Value <> Market Value…… (Mortgage Backed)
• Which is more important to the decision-making process?
• What about “Human Capital”? How do we value this valuable asset…?
– Apple Inc.….
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Market vs. Book Value
• Book value = the balance sheet value of the assets, liabilities,
and equity.
• Market value = true value; the price at which the assets,
liabilities, or equity can actually be bought or sold.
– Market Value is more important to the decision-making process.
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Market vs. Book Value S&P 500
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Klingon Corporation
Market-to-Book ratio ------- > Market Value / Book Value
MV is usually greater than 1
Notice that Long-term debt Book value and market value are the same, while NFA and
Equity vary substantially.
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Mark-to-Market Accounting
• Mark the Book Value of Assets to Market Value
– Credit Assets: Bonds, Collateralized Debt Obligations (CDOs)
• Can severely impact Owners’ Equity (Liabilities are fixed)
• BIG impact recently with Financial institutions, i.e.,
– Banks…. Involved with credit write downs.
• In short, there are lag times between when Book values
actually represent market values for an asset.
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Bank of America (BAC)
as of 1-18-13
Market Values can change quickly
• ~ 85% drop in
market price
(per share)
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Dell up on Rumors 1-18-13
(10% price value move)
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Income Statement
• The income statement is more like a video of the firm’s operations for a specified
period of time.
• You generally report revenues first and then deduct any expenses for the period
• End result = Net Income = “Bottom Line”
– Dividends paid to shareholders
– Addition to retained earnings
• Income Statement Equation:
• Net Income = Revenue - Expenses
• Matching principle – GAAP say to show revenue when it accrues and match the
expenses required to generate the revenue
– NOT always a measure of “cash flow” however.
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US Corporation Income
Statement
EBIT = Operating Income
Absorption-based costing as opposed to variable costing
Sales
- Less Variable Expense
Contribution Margin
- Less fixed Expenses
Net Operating Income
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Simple Income Statement
Example Income Statement
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Publicly Traded Companies
• Publicly traded companies must file regular reports with the
Securities and Exchange Commission (SEC)
– 10K, 10Q, 8k,
• These reports are usually filed electronically and can be searched
at the SEC public site called EDGAR
• Click on the web surfer, pick a company and see what you can find!
• Example Potash Inc (chemical and fertilizer)
• Example Apple Computer (computer industry)
• SIC – Standard Industry Code
• NAICS – North American Industry Classification System
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Search Engines….
http://www.baidu.com/
http://www.google.com/
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Taxes
• The one thing we can rely on with
taxes is that they are always
changing and they never go
away……
• Marginal vs. average tax rates
– Marginal – the percentage paid on
the next dollar earned
– Average – the tax bill / taxable
income
• Marginal Rates are used when we
consider investment decisions.
Why?
• Other taxes
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Example: Marginal vs. Average Rates
• Example: Suppose your firm earns $4 million in taxable
income.
– What is the firm’s tax liability?
– What is the average tax rate?
– What is the marginal tax rate?
• If you are considering a project that will increase the firm’s taxable income
by $1 million, what tax rate should you use in your analysis?
• Ford’s (F) tax return is over 6 feet high and requires 50 people to prepare.
The IRS requires a team of auditors just to monitor the return?
– Is this an efficient use of resources? Should we abolish Corporate
Income Tax?
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Same Problem (Excel)
Tax on $4 million
Taxable Income Levels
Tax Rate
Income
Liability
$
-
$
50,000
15%
$
50,000
$
7,500
$
50,001
$
75,000
25%
$
25,000
$
6,250
$
75,001
$
100,000
34%
$
25,000
$
8,500
$
100,001
$
335,000
39%
$
235,000
$
91,650
$
335,001
$
10,000,000
34%
$ 3,665,000
$ 1,246,100
$
10,000,001
$
15,000,000
35%
$
15,000,001
$
18,333,333
38%
$
18,333,334
$ 4,000,000
$ 1,360,000
-
Average Rate =
34%
Marginal Rate =
34%
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Average Tax Rates
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Problems (next time)
• Complete problems:
– Review of financial statements and Tax
•
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1-8 from Chapter 2 of your text…..
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Cash Flow
and
several ways to view cash flow
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Apple set record earnings…
Apple's net profit more than doubled in the first quarter of fiscal 2012 to a record $13.06
billion, while revenue soared to an all-time high of $46.33 billion from $26.74 billion a
year ago…….. ~ 100 Billion in Cash and NO Debt….
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Apple Metrics…
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Samsung Galaxy Upgrade?
Samsung Galaxy Note 4
iPhone 6
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The Concept of Cash Flow
• Cash flow is one of the most important pieces of information that a financial
manager can derive from financial statements
• The Statement of Cash Flows does not provide us with the same information
that we are looking at here
• We will look at how cash is generated from utilizing assets and how it is paid
to those that finance the purchase of the assets
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Cash Flow From Assets
• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders
• Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) – Net Capital Spending –
Changes in NWC
• CFFA is not the same thing as the Cash Flow Statement…..
– Cash Flow Direct Method on Board….
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Cash Flow Model
Cash Flow to Creditors
The cash flow identity
Cash Flow from Assets = Cash flow to creditors + Cash
flow to owners
Cash flow to creditors = Interest – net new debt
= Interest – (Ending LTD – Beg LTD)
1. Cash Flow of Assets (Firm)
Cash Flow to Stockholders (owners)
Cash flow from Assets = OCF – NCS – change NWC
Cash to owners = Dividends – Net new equity
(includes common stock and paid in capital)
OCF = EBIT + Depreciation – tax
NCS = (Ending NFA – Beg NFA) + Depreciation
Change NWC = Ending NWC – Beg NWC
$
$
OCF – change NWC
Assets
(Firm)
$
True Cash Flow
From Operations
Creditors
Free Cash flow
of the Firm
or
Cash flow from
Assets
Stockholders
(Owners)
NCS
(OCF- Change NWC – NCS)
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Cash Flow Model
Cash Flow to Creditors
The cash flow identity
Cash Flow from Assets = Cash flow to creditors + Cash
flow to owners
Cash flow to creditors = Interest – net new debt
= Interest – (Ending LTD – Beg LTD)
1. Cash Flow of Assets (Firm)
Cash flow from Assets = OCF – NCS – change NWC
Cash Flow to Stockholders (owners)
OCF = EBIT + Depreciation – tax
Cash to owners = Dividends – net new equity
(includes common stock and paid in capital)
NCS = Ending NFA – Beg NFA + Depreciation
Change NWC = Ending NWC – Beg NWC
Retained Earnings
Plowback
$
OCF – change NWC
True Cash Flow
From Operations
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$
Assets
(Firm)
$
NCS
Creditors
CFFA
(Free Cash Flow)
Investments &
Other non-operating
Income
Stockholders
(Owners)
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Cash Flow Model with Financial Statements
Cash Flow to Creditors
Cash flow to creditors = Interest – net new debt
= Interest – (Ending LTD – Beg LTD)
Cash Flow to Stockholders (owners)
Cash to owners = Dividends – Net new equity
(includes common stock and paid in capital)
OCF – change NWC
Assets
(Firm)
Free Cash flow
of the Firm
or
Cash flow from
Assets
Creditors
Stockholders
(Owners)
NCS
OCF = EBIT + Depreciation – tax
NCS = Ending NFA – Beg NFA + Depreciation
Change NWC = Ending NWC – Beg NWC
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Cash Flow Summary Table
2.5
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Example: U.S. Corporation
Balance Sheet
Assets
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Fixed assets
Total assets
2009
2010
$104
455
553
$1,112
$160
688
555
$1,403
$1,644
$1,709
$2,756
$3,112
Liabiities & Owners' Equity
2009
Current Liabilities
Accounts Payable
$232
Notes Payable
196
Total
$428
Long-term debt
Owners' equity
Common stock and
paid-in surplus
Retained earnings
Total
Total Liabilties &
Owners Equity
U.S. Corporation
Income Statement
2010
$266
123
$389
$408
$454
600
1,320
$1,920
640
1,629
$2,269
$2,756
$3,112
Net sales
Cost of goods sold
Depreciation
Earnings before interest and taxes
Interest Paid
Taxable income
Taxes
Net Income
Dividends
Addition to retained earnings
$1,509
750
65
$694
70
$624
212
$412
$103
$309
• CFFA = OCF – NCS - ΔNWC
OCF
= EBIT + depreciation – taxes
= $694 + 65 – 212 = $547
NCS
= ending net FA– beginning net FA + depreciation
= $1709 – 1644 + 65 = $130
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ΔNWC
= ending NWC – beginning NWC
= ($1403 – 389) – ($1112 – 428) = $330
CFFA
= 547 – 130 – 330 = $87
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Example: U.S. Corporation
U.S. Corporation
U.S. Corporation
Income Statement
Balance Sheet
Assets
Liabiities & Owners' Equity
2009
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Fixed assets
Total assets
2010
$104
455
553
$1,112
$160
688
555
$1,403
$1,644
$1,709
$2,756
• CFFA
CF/Cr
$3,112
Current Liabilities
Accounts Payable
Notes Payable
Total
Long-term debt
Owners' equity
Common stock and
paid-in surplus
Retained earnings
Total
Total Liabilties & Owners
Equity
2009
2010
$232
196
$428
$266
123
$389
$408
$454
600
1,320
$1,920
640
1,629
$2,269
$2,756
$3,112
Net sales
Cost of goods sold
Depreciation
Earnings before interest and taxes
Interest Paid
Taxable income
Taxes
Net Income
Dividends
Addition to retained earnings
= CF/Cr + CF/Sh
=
$1,509
750
65
$694
70
$624
212
$412
$103
$309
OCF – NCS – ΔNWC = $87
= interest paid – net new borrowing
= $70 – ($454 – 408) = $24
CF/Sh
= dividends paid – net new equity
= $103 – ($640 – 600) = $63
• CFFA
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= $24 + $63 = $87
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Cash Flow Example
Fictious Corp
Balance Sheet
Assets
Cash
1-Jan
100
31-Dec
150
AR
200
250
Inv
300
Current Assets
NFA
Total Assets
1-Jan
100
31-Dec
150
NP
200
200
300
Current Liab
300
350
600
700
LTD
400
420
400
500
CS & PIC
50
60
ARE
250
370
Total Liab
1000
1200
1000
1200
Liabilities
AP
Fictious Corp
Income Statement
Sales
- Costs
- Dep
2000
-1400
-100
EBIT
500
- Int
-100
- Tax
-200
Net Income
Dividends
Retained Earnings
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200
80
120
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Example: Balance Sheet and Income
Statement Information
• Current Accounts
– 1998: CA = 4500; CL = 1300
– 1999: CA = 2000; CL = 1700
• Fixed Assets and Depreciation
– 1998: NFA = 3000; 1999: NFA = 4000
– Depreciation expense = 300
• LT Liabilities and Equity
– 1998: LTD = 2200; Common Equity = 500; RE = 500
– 1999: LTD = 2800; Common Equity = 750; RE = 750
• Income Statement Information
– EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends =
1250
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Example: Cash Flows
• OCF = 2700 + 300 – 1000 = 2000
• NCS = 4000 – 3000 + 300 = 1300
• Changes in NWC = (2000 – 1700) – (1500 – 1300) = 100
• CFFA = 2000 – 1300 – 100 = 600
• CF to Creditors = 200 – (2800 – 2200) = -400
• CF to Stockholders = 1250 – (750 – 500) = 1000
• CFFA = -400 + 1000 = 600
• The CF identity holds.
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Quick Quiz
• What is the difference between book value and market value?
Which should we use for decision making purposes?
• What is the difference between accounting income and cash
flow? Which do we need to use when making decisions?
• What is the difference between average and marginal tax
rates? Which should we use when making financial
decisions?
• How do we determine a firm’s cash flows? What are the
equations and where do we find the information?
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Critical Thinking Questions
• Review questions in class….. Page 44
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Homework Problem Set
• Assign problems and work in-class
examples….
– See FIN 301 Assignment Page
• Read Chapters
– 3 (Financial Statements & Ratios)
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