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 | |
Cash | 1,500 | Accounts Payable | 600 |
Accounts Receivable | 500 | Notes Payable | 300 |
Inventory | 750 | | |
Total | 2,750 | Total | 900 |
Fixed Assets | | | |
Property Plant and Equipment | 5,000 | Long-term Debt | 3,500 |
| | Shareholders' Equity | |
| | Common stock and paid-in surplus | 1,000 |
| | Retained Earnings | 2,350 |
| | Total | 3,350 |
Total Assets | 7,750 | Total Liabilities + Shareholders' Equity | 7,750 |
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 -- |
0 | 50,000 | 15% | 0 |
50,000 | 75,000 | 7,500 + 25% | 50,000 |
75,000 | 100,000 | 13,750 + 34% | 75,000 |
100,000 | 335,000 | 22,250 + 39% | 100,000 |
335,000 | 10,000,000 | 113,900 + 34% | 335,000 |
10,000,000 | 15,000,000 | 3,400,000 + 35% | 10,000,000 |
15,000,000 | 18,333,333 | 5,150,000 + 38% | 15,000,000 |
18,333,333 | ... | 35% | 0 |
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 Income | EBIT - Interest Paid |
Taxes | Taxable Income $\times$ Tax Rate |
Net Income (NI) | Taxable Income - Taxes |
Hypothetical Firm Example
Year 2016
Revenue | |
Net Sales | 10,000 |
Expenses | |
Cost of Goods Sold | 5,000 |
Depreciation | 500 |
Earnings Before Interest and Taxes (EBIT) | 4,500 |
Interest Paid | 100 |
Taxable Income | 4,400 |
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
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 Assets | 1,500 | Fixed Assets | 1,800 |
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