Topic 2 . Financial Statements and Cash Flow

1. Topic 2 . Financial Statements and Cash Flow Prof. dr. A Paškevičius

2. Financial Statements and Cash Flow 2.1 The Balance sheet 2.2 The Income Statement 2.3 Cash flow 2.4 Cash Flow and Financial Statements

3. The Balance Sheet The balance sheet is a financial statement showing the firm’s accounting value on a particular date • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time • Assets are listed in order of liquidity • Ease of conversion to cash • Without significant loss of value • Balance Sheet Identity • Assets = Liabilities + Stockholders’ Equity

4. The Balance Sheet

5. The Balance Sheet A fixed asset is one that has a relatively long life. A current asset will convert to cash within 12 months. Shareholders' equity, or common equity reflects the fact that, if the firm were to sell all of its assets and use the money to payoff its debts, then whatever residual value remained would belong to the shareholders.

6. The Balance Sheet 3 Components: • Assets = Liabilities + Shareholders' equity • This is the balance sheet identity, or equation, and it always holds because shareholders' equity is defined as the difference between assets and liabilities. What is shareholders' equity? What is net working capital?

7. The Balance Sheet 3 Components: • Assets = Liabilities + Shareholders' equity • This is the balance sheet identity, or equation, and it always holds because shareholders' equity is defined as the difference between assets and liabilities. What is shareholders' equity? What is net working capital? 1000 – (150+200) =650 400 -150 = 250

8. The Balance Sheet

9. The Balance Sheet Key concepts • Liquidity • Net Working Capital • Debt versus Equity, financial leverage • Market Value versus Book Value

10. Liquidity Liquidity refers to (is an indicator of) the speed and cost (loss of value and conversion cost) with which an asset can be converted to cash. Ability to convert to cash quickly without a significant cost Assets appear on the balance sheet in descending order of liquidity. Interest and principal payments on debt have to be paid before cash may be paid to stockholders. Liquid firms are less likely to experience financial distress The more liquid assets provide lower returns. Trade-off to find balance between liquid and illiquid assets

11. Net Working Capital • Net Working Capital =Current Assets – Current Liabilities • Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out • Usually positive in a healthy firm

12. Debt versus Equity, financial leverage • The more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage. • Debt acts like a lever in the sense that using it can greatly magnify both gains and losses. • Advantage: financial leverage increases the potential reward to shareholders • Disadvantage: it also increases the potential for financial distress and business failure.

13. Market Value versus Book Value • The values shown on the balance sheet for assets are book values. They generally are not what the assets are actually worth. • Under Generally Accepted Accounting Principles (GAAP), financial statements generally show assets at historical cost. • I.e. assets are "carried on the books" at what the firm paid for them, no matter how long ago they were purchased or how much they are worth today. • Market value is the price at which the assets, liabilities or equity can actually be bought or sold. • For current assets, market value and book value is similar • For fixed assets not similar • For example, a railroad

14. 2.2 INCOME STATEMENT • When a balance sheet is a snapshot, then anincome statement is as a video recordingcovering the period between a before and an after picture. • Components • Revenues (We recognize revenue when it is earned, not when the cash is received) • Expenses • Cash and non-cash • Operating and non-operating • Net Income • Earnings per share • Dividend

15. 2015 Income Statement (mln €) Corporation had 200 million shares outstanding at the end of 2014. Based on this income statement, • What was EPS? • What were dividends per share? Earnings per share = Net income/Total shares outstanding = 412/200 = 2.06 € per share Dividends per share = Total dividends/Total shares outstanding = 103/200 = 0.515 € per share

16. Non-cash Items / Non-cash expenses A primary reason that accounting income differs from cash flow is that an income statement contains non-cash items. The most important of these is depreciation. If the depreciation is straight-line and the asset is written down to zero over that period, then the equal portion will be deducted each year as an expense. • By "straight-line," we mean that the depreciation deduction is the same every year. • By "written down to zero," we mean that the asset is assumed to have no value at the end of five years

17. Non-cash items and cash flow 1509 – 750- 50 = 709 • This 1,000 deduction isn't cash- it is only an accounting number. • The actual cash outflow occurred when the asset was purchased (purchase price 5000). • The depreciation deduction is an application of the matching principle in accounting. • The revenues associated with an asset would generally occur over some length of time. So, the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.

18. Operating and non-operatingBreak-even point The future could have two distinct parts: the short run and the long run. In short run, some costs are • fixed- they must be paid (property taxes, salaries to management). • variable -other costs such as wages and payments to suppliers. In the short run, the firm can vary its output level by varying expenditures in these areas. The distinction between fixed and variable costs is important.

19. 2.3 CASH FLOW • The owner of a business is very interested in how much cash he actually took out of his business in a given year. • Accounting methods give an estimate of the economic value of transactions • In Finance, the main concern is the timing of cash flows. • Since the income statement includes non-cash items, we will have to adjust it to get information on cash flows • Balance sheet activity plays an important role in the determination of the cash balance (e.g.) • Collections on accounts receivable • Borrowing on accounts payable

20. The cash flow identity Cash flow tocreditors (bondholders) Cash flow tostockholders(owners) This is based upon the balance sheet identity: Assets = Liabilities + Equity Cash flow from assets = + The cash flow from the firm's assets is equal to the cash flow paid to suppliers of capital to the firm, i.e. either to pay creditors or pay out to the owners of the firm

21. Cash flow from assets Cash flow from assets Operating cash flow (OCF) Net capital spending Changes in net working capital (NWC) _ _ Ending NWC EBIT Ending net fixed assets Beginning NWC Depreciation - + Beginning net fixed assets - Taxes - Depreciation +

22. Cash flow to creditors and stockholders Cash flow from assets Cash flow to creditors Cash flow to stockholders Dividends paid Interest paid Net new equity raised Net new borrowing _ _

23. Cash Flowsummary Operating cash flow (OCF) Net capital spending Changes in net working capital (NWC) _ _ Cash flow from assets Cash flow to creditors Cash flow to stockholders

24. T2.6 Cash Flow Summary • I. Cash flow from assets Cash flow from assets = Operating cash flow – Net capital spending – Additions to net working capital (NWC) where Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes Net capital spending = Ending net fixed assets – Beginning net fixed assets + Depreciation Change in NWC = Ending NWC – Beginning NWC • IICash flow to creditors Cash flow to creditors = Interest paid – Net new borrowing • III.Cash flow to stockholders Cash flow to stockholders = Dividends paid – Net new equity raised

25. 2015 Income statement

26. Balance sheets

27. 2.3 Operating Cash Flow

28. Net capital spending

29. Change in NWC

30. Cash flow from assets

31. Cash Flow to creditors Cash flow to stockholders

32. Cash Flowsummary Operating cash flow 547 Net capital spending 130 Changes in net working capital 330 _ _ Cash flow from assets 87 Cash flow to creditors 24 Cash flow to stockholders 63

33. Cash Flows for DOLE COLA During the year, Dole Cola, Inc., had sales and cost of goods sold of $600 and $300, respectively. Depreciation was $150 and interest paid was $30. Taxes were calculated at a straight 34 percent. Dividends were $30. (All figures are in millions of dollars.) • Create an income statement Beginning net fixed assets were $500 and ending net fixed assets were $750. Dole Cola started the year with $2,130 in current assets and $1,620 in current liabilities, and that the corresponding ending figures were $2,260 and $1,710. • What was operating cash flow for Dole? • Why is this different from net income?

34. Dole Cola income statement

35. 2.4 Dole Cola balance sheet

36. Cash flow from assets Operating cash flow Change in NWC Cash flow from assets Net capital spending

37. Cash flow to stockholders Cash Flow to creditors

38. Cash Flowsummary Operating cash flow 259 Net capital spending 400 Changes in net working capital 40 _ _ Cash flow from assets -181 Cash flow to creditors -211 Cash flow to stockholders 30

39. 2.4 Cash Flow and Financial Statements Balance Sheet

40. 2.4 Cash Flow and Financial Statements

41. 2.4 Cash Flow and Financial Statements

42. 2.4 Cash Flow and Financial Statements 2004 Income Statement

43. 2.4 Cash Flow and Financial Statements 2004 Statement of Cash Flow

44. 2.4 Cash Flow and Financial Statements 2004 Statement of Cash Flow

45. 2.4 Cash Flow and Financial Statements Statement of Cash Flow • Operating activities + Net income + Depreciation + (–) Any decrease (increase) in current assets (except cash) + (–) Increase (decrease) in accounts payable • Investment activities + Beginning fixed assets – Ending fixed assets – Depreciation • Financing activities + (–) Increase (decrease) in notes payable + (–) Increase (decrease) in long-term debt + Increase in common stock – Dividends paid