FIN303
Vicentiu Covrig
Financial statements and
cash flow
(chapter 3)
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FIN303
Vicentiu Covrig
Sources of Information

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Annual reports
Wall Street Journal
Internet
- www.yahoo.com
- www.smartmoney.com
Mergent online
SEC
- EDGAR
- 10K & 10Q reports
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FIN303
Vicentiu Covrig
The Annual Report

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
Balance sheet – provides a snapshot of a firm’s
financial position at one point in time.
Income statement – summarizes a firm’s
revenues and expenses over a given period of
time.
Statement of cash flows – reports the impact of a
firm’s activities on cash flows over a given
period of time.
Statement of stockholders’ equity – shows how
much of the firm’s earnings were retained, rather
than paid out as dividends.
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FIN303
Vicentiu Covrig
Overview of D’Leon Inc.
Snack food company that underwent major
expansion in 2010.
 So far, expansion results have been
unsatisfactory.
- Company’s cash position is weak.
- Suppliers are being paid late.
- Bank has threatened to cut off credit.
 Board of Directors has ordered that
changes must be made!

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FIN303
Vicentiu Covrig
Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2011
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
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2010
57,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800
FIN303
Vicentiu Covrig
Balance Sheet: Liabilities and Equity
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2011
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
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2010
145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
1,468,800
FIN303
Vicentiu Covrig
Income Statement
Sales
COGS
Other expenses
Total oper. costs excl.
deprec. & amort.
Depreciation and amortization
EBIT
Interest expense
EBT
Taxes
Net income
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2011
$6,034,000
5,528,000
519,988
2010
$3,432,000
2,864,000
358,672
$6,047,988
116,960
($ 130,948)
136,012
($ 266,960)
(106,784)
($ 160,176)
$3,222,672
18,900
$ 190,428
43,828
$ 146,600
58,640
$ 87,960
FIN303
Vicentiu Covrig
Other Data
2011
No. of shares
EPS
DPS
Stock price
Lease pmts
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2010
100,000
100,000
-$1.602
$0.88
$0.11
$0.22
$2.25
$8.50
$40,000
$40,000
FIN303
Vicentiu Covrig
Statement of Stockholders’
Equity (2011)
Balances, 12/31/10
2011 Net income
Cash dividends
Addition (subtraction)
to retained earnings
Balances, 12/31/11
Total
Common Stock
Retained Stockholders’
Shares
Amount Earnings
Equity
100,000 $460,000 $203,768
$663,768
(160,176)
(11,000)
100,000
$460,000 $ 32,592
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(171,176)
$492,592
FIN303
Vicentiu Covrig
Did the expansion create additional
after-tax operating income?
AT operating income = EBIT(1 – Tax rate)
AT operating income11 = -$130,948(1 – 0.4)
= -$130,948(0.6)
= -$78,569
AT operating income10 = $114,257
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FIN303
Vicentiu Covrig
What effect did the expansion have on
net operating working capital?
Current
Current
Notes
NOWC  assets   liabilities  payable 


NOWC11  ($7,282  $632,160  $1,287,360)
 ($1,650,568  $636,808)
 $913,042
NOWC10  $842,400
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FIN303
Vicentiu Covrig
Assessment of the Expansion’s Effect
on Operations
2011
Sales
2010
$6,034,000
$3,432,000
AT oper. inc.
-78,569
114,257
NOWC
913,042
842,400
Net income
-160,176
87,960
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FIN303
Vicentiu Covrig
What was the free cash flow (FCF) for
2011?
Depr. and   Capital


FCF  EBIT(1  T) 



NOWC

amortizati on expenditur es

FCF11
= [-$130,948(1 – 0.4) +
$116,960] – [($1,202,950 – $491,000) +
$70,642]
= -$744,201
Is negative free cash flow always a bad
sign?
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FIN303
Vicentiu Covrig
Performance Measures for Evaluating
Managers
•
•
Accounting statements insufficient for evaluating
managers’ performance because they do not reflect
market values.
Performance Measures
MVA = Difference between market value and
book value of a firm’s common equity.
P0 x Number of shares – Book value.
EVA = Estimate of a business’ true economic
profit for a given year.
EBIT(1 – T) –
Investor-supplied Cost of
x
capital
capital
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FIN303
Vicentiu Covrig
What was D’Leon’s MVA in 2010 and
2011?
MVA10 = ($8.50 x 100,000) – $663,768
= $186,232.
MVA11 = ($2.25 x 100,000) – $492,592
= -$267,592.
Shareholder wealth has been destroyed!
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FIN303
Vicentiu Covrig
What is the relationship between EVA
and MVA?
If EVA is positive, then AT operating
income > cost of capital needed to produce
that income.
 Positive EVA on annual basis helps to
ensure MVA is positive.
 MVA is applicable to entire firm, while
EVA can be calculated on a divisional
basis as well.

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FIN303
Vicentiu Covrig
Federal Income Tax System
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FIN303
Vicentiu Covrig
Corporate and Personal Taxes
Both have a progressive structure (the
higher the income, the higher the marginal
tax rate).
 Corporations
- Rates begin at 15% and rise to 35% for

-
corporations with income over $10 million,
although corporations with income between
$15 million and $18.33 million pay a marginal
tax rate of 38%.
Also subject to state tax (around 5%).
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FIN303
Vicentiu Covrig
Tax treatment of various uses and
sources of funds

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Interest paid – tax deductible for corporations (paid
out of pre-tax income), but usually not for individuals
(interest on home loans being the exception).
Interest earned – usually fully taxable (an exception
being interest from a (muni”).
Dividends paid – paid out of after-tax income.
Dividends received – taxed as ordinary income for
individuals (“double taxation”). A portion of
dividends received by corporations is tax excludable,
in order to avoid “triple taxation”.
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FIN303
Vicentiu Covrig
Tax Treatment of Various Uses and
Sources of Funds

Dividends received: most investors pay 15% taxes
through 2012. The rate is scheduled to rise after 2012.
- Investors in the 10% or 15% tax bracket pay 0% on
qualified dividends through 2012.
- Dividends are paid out of net income which has
already been taxed at the corporate level, this is a form
of “double taxation”.
- A portion of dividends received by corporations is tax
excludable, in order to avoid “triple taxation.”
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FIN303
Vicentiu Covrig
Learning objectives
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Annual report; Balance sheet; Income Statement items you see on the slides
You DO NOT need to know the Statement of Cash Flows (3.4)
Free Cash Flow
MVA and EVA (no numerical problems)
Taxes
All the numerical problems on the slides and recommended below from end of
chapter
You need to know to do After Tax Income problems and remember the formula
from page 81
Questions: ST-1, ST-2 a,b,c,d; 3-1 to 3-5; 3-73-9,3-10
Problems: 3-1, 3-2, 3-3, 3-5, 3-8, 3-12
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