FIN 300


Financial Statements and Cash Flow

Lecture 2

Financial Statements



  • Record of financial activities and positions
  • Mandatory filings for public corporations
  • SEC EDGAR
  • Very important source of information

Topics Covered

Chapter 2



  • Balance Sheet
  • Income Statement
  • Taxes
  • Cash Flow

Balance Sheet


  • Snapshot of the firm's assets and liabilities
  • Assets are any valuable resource
  • Liabilities are any obligation (debts, etc.)


Assets = Liabilities + Shareholder's Equity

Assets Liabilities 
Current Assets Current Liabilities 
 Cash1,500 Accounts Payable600
 Accounts Receivable500 Notes Payable300
 Inventory750  
Total2,750Total900
Fixed Assets   
 Property Plant and Equipment5,000Long-term Debt3,500
  Shareholders' Equity 
   Common stock and paid-in surplus1,000
   Retained Earnings2,350
   Total3,350
Total Assets7,750Total Liabilities + Shareholders' Equity7,750

Liquidity

  • Convert asset to cash without much cost
  • Liquidity management is important
  • Opportunity Cost
  • Tradeoff decisions required

Net Working Capital

  • NWC = Current Assets - Current Liabilities
  • From our example:

    • Current Assets = 2,750
    • Current Liabilities = 900
    • Net Working Capital = 2,750 - 900 = 1,850

Debt vs. Equity


  • Debt is paid before Equity
  • Equity holders are residual claimants
  • Tradeoff decisions required
  • Leverage increases risk and expected return

Market vs. Book Value


  • Shareholders' Equity = Assets - Liabilities
  • Market Value is whatever people will pay
  • Managers often compensated according to market value

Summary



  • The Balance Sheet is a snapshot of the firm's assets and liabilities
  • Total Assets = Total Liabilities + Shareholers' Equity
  • Net Working Capital
    • = Current Assets - Current Liabilities

Taxes

  • Corporations pay taxes on income
  • The tax code is complicated
  • See IRS document for excessive details
      FYI only (Don't study this!)
  • Understand marginal vs average tax rate:
      Tax rate increases as income increases
Over-But not over-Tax is:Of the amount over --
050,00015%0
50,00075,0007,500 + 25%50,000
75,000100,00013,750 + 34%75,000
100,000335,00022,250 + 39%100,000
335,00010,000,000113,900 + 34%335,000
10,000,00015,000,0003,400,000 + 35%10,000,000
15,000,00018,333,3335,150,000 + 38%15,000,000
18,333,333...35%0
See WSJ article on Apple, Cash, and Taxes.

Income Statement


  • A summary of revenues and expenses
  • Calculation of Net Income
  • Net Income $\neq$ Cash Flows
    • Accounting Standards
    • Recognition and matching
  • Provides information about business activities
    • Over a specific time period
    • Yearly or quarterly
Hypothetical Firm
Year 2016
Revenue 
Net Sales+
Expenses 
Cost of Goods Sold-
Depreciation-
Earnings Before Interest and Taxes (EBIT)Revenue - Operating Expenses
Interest Paid-
Taxable IncomeEBIT - Interest Paid
TaxesTaxable Income $\times$ Tax Rate
Net Income (NI)Taxable Income - Taxes
Hypothetical Firm Example
Year 2016
Revenue 
Net Sales10,000
Expenses 
Cost of Goods Sold5,000
Depreciation500
Earnings Before Interest and Taxes (EBIT)4,500
Interest Paid100
Taxable Income4,400
Taxes (34%)1,496
Net Income (NI)2,904
Dividends: 1,150
Addition to Retained Earnings: 1,754

Income Statement


  • A summary of revenues and expenses

  • Calculation of Net Income

    • EBIT = Revenue - Operating Expenses
    • Taxable Income = EBIT - Interest Paid
    • Taxes = Taxable Income $\times$ Tax Rate
    • Net Income = Earnings Before Taxes - Taxes




Cash Flow


Topics Covered



  • Cash Flow Identity
    • - Cash Flow From Assets
    • - Cash Flow to Creditors
    • - Cash Flow to Stockholders

Cash Flow Identity



Cash Flow From Assets  =          Cash Flow to Creditors
+ Cash Flow to Sockholders


Dollars that go in/out of the firm equal the total dollars to/from the creditors and stockholders.

Cash Flow from Assets


  • This is the net amount of cash that is coming out of (or into) the business
  • Not necessarily positive


$\text{CF}_{\text{Assets}} = \text{OCF} - \text{NCS} - \Delta\text{NWC} $

OCF: Operating Cash Flow
NCS: Net Capital Spending
$\Delta$NWC: Change in Net Working Capital

Operating Cash Flow


  • Related to Net Income
    • (with some adjustments for interest, depreciation, etc.)
  • Cash from the firm's day-to-day operations

Operating Cash Flow = EBIT + Depreciation - Taxes

We can get all this information from the income statement.


$\text{CF}_{\text{Assets}} = \text{OCF} - \text{NCS} - \Delta\text{NWC} $

OCF: Operating Cash Flow
NCS: Net Capital Spending
$\Delta$NWC: Change in Net Working Capital

Net Capital Spending


Net Capital Spending = Fixed Assets$_2$ - Fixed Assets$_1$
+ Depreciation


  • Tells us how much was invested in fixed capital
  • Fixed Assets on the Balance Sheet
  • Depreciation on the Income Statement

2-Period Balance Sheet Example
Assets (Year 1) Assets (Year 2) 
Current Assets(...)Current Assets(...)
Fixed Assets1,500Fixed Assets1,800
Total (...)Total (...)


Fixed Assets$_1$ = $\$1,500$
Fixed Assets$_2$ = $\$1,800$

Finishing the Example

Net Capital Spending = Fixed Assets$_2$ - Fixed Assets$_1$
+ Depreciation


Assume Depreciation is $\$500$.
Net Capital Spending $= \$1,800 - \$1,500 + \$500 = \$800$


We add back depreciation because it was not an actual cash outflow.


$\text{CF}_{\text{Assets}} = \text{OCF} - \text{NCS} - \Delta\text{NWC} $

OCF: Operating Cash Flow
NCS: Net Capital Spending
$\Delta$NWC: Change in Net Working Capital

Change in Net Working Capital


  • Net Working Capital = Current Assets - Current Liabilities
  • $\Delta$Net Working Capital
    • Look at balance sheet over two periods
  • $\Delta NWC = NWC_2-NWC_1$

    • $(CA_2-CL_2)-(CA_1-CL_1)$

Summary

$\text{CF}_{\text{Assets}} = \text{OCF} - \text{NCS} - \Delta\text{NWC} $

OCF = EBIT + Depreciation - Taxes
NCS = $\Delta$Fixed Assets + Depreciation
$ \Delta NWC$ = $NWC_2-NWC_1$

Cash Flow Identity



Cash Flow From Assets  =          Cash Flow to Creditors
+ Cash Flow to Stockholders


Cash Flow to Creditors

  • Represents the cash going to/from the debt holders

Cash Flow to Creditors    =                 Interest Paid
- Net New Borrowing

Net New Borrowing    =         Longterm Debt$_2$
- Longterm Debt$_1$

Example

  • Interest Paid = 100
  • Longterm Debt$_1$ = 3,000
  • Longterm Debt$_2$ = 2,900
  • Cash Flow to Creditors = ?
  • CF to Creditors = Interest Paid - Net New Borrowing
  • Net New Borrowing = Longterm Debt$_2$ - Longterm Debt$_1$

Solution:

Net New Borrowing = 2,900 - 3,000 = -100

Cash Flow to Creditors = 100 - (-100) = 200

Cash Flow Identity



Cash Flow From Assets  =          Cash Flow to Creditors
+ Cash Flow to Stockholders


Cash Flow to Stockholders


  • Cash going to/from stockholders

Cash Flow to Stockholders    =                 Dividends Paid
- Net New Equity Raised

Net New Equity Raised    =         CSPS$_2$ - CSPS$_1$

CSPS : "Common Stock and Paid-in Surplus"

Example

  • Dividends Paid = 200
  • CSPS$_1$ = 3,000
  • CSPS$_2$ = 3,200
  • Cash Flow to Stockholders = ?
  • CF to Stockholders = Dividends Paid - Net New Equity Raised
  • Net New Equity Raised = CSPS$_2$ - CSPS$_1$

Solution:

Net New Equity Raised = 3,200 - 3,000 = 200

Cash Flow to Stockholders = 200 - 200 = 0

Summary


  • CF$_{Assets}$ = CF$_{Creditors}$ + CF$_{Stockholders}$
  • CF$_{Assets}$ = OCF - NCS - $\Delta$NWC
  • CF$_{Creditors}$ = Interest Paid - Net New Borrowing
  • CF$_{Stockholders}$ = Dividends Paid - Net New Equity Raised