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EXPH 664

EXPH 664. Financials. GAAP Annual Report Maturity Liquidity Market Value Book Value Balance Sheet Assets, Liabilities Owner’s Equity Working Capital. Income Statement E.B.I.T., E.B.T., E.A.T. Payout Ratio Statement of Cash Flows Capital Structure Financial Distress

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EXPH 664

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  1. EXPH 664 Financials

  2. GAAP Annual Report Maturity Liquidity Market Value Book Value Balance Sheet Assets, Liabilities Owner’s Equity Working Capital Income Statement E.B.I.T., E.B.T., E.A.T. Payout Ratio Statement of Cash Flows Capital Structure Financial Distress Marginal Tax Rate Average Tax Rate Capital Gain Asymmetric Terminology

  3. The Annual Report • Narrative description of the company’s activities during the year. • The company’s accounting statements. • The balance sheet • The income statement • The statement of cash flows • Notes to the financial statements • The Auditor’s report. A company’s annual report contains:

  4. Financial Statements • Prepared according to Generally Accepted Accounting Principles (GAAP) • GAAP guidelines established in the U.S. by the Financial Accounting Standards Board (FASB) • Used by the company to: • Communicate with stakeholders outside the company. • Help plan and organize the company’s activities. • Monitor and evaluate the company’s performance. • Used by the Internal Revenue Service to determine the company’s taxes.

  5. The Balance Sheet • Reports the financial position of a company at a particular point in time. • Think of it as a snapshot of the company’s financial position at that time • Shows assets held by the company on the left-hand side. • Shows the liabilities and the stockholders’ equity on the right-hand side. • The balance sheet identity always holds: Assets = Liabilities + Shareholder’s Equity

  6. ? ? Preferred Stock Basic Financial Statements • Balance Sheet Assets = Liabilities + Owner’s Equity Current Assets Cash Inventory A/R Fixed Assets Land Plant Equipment Less:Depreciation Current Liabilities A/P Accruals S-T Debt L-T Liabilities Bonds L-T Bank Debt Mortgages Common Stock Par Value Paid-In Capital Retained Earnings

  7. Both Sides MUST equal Balance Sheets ($ Millions) 1996 1995 1996 1995 Current Assets $400 $348 Current Liabilities $253 $176 Net Fixed Long Term Assets $750 $528 Liabilities $236 $144 Intangible & Other Assets $0 $0 Shareholder’s Equity $661 $556 TOTAL TOTAL LIAB. & ASSETS $1,150 $876 SHAREHOLDER’S $1,150 $876 EQUITY

  8. Current Assets 2005 2004 Cash & Equivalents $ 26 $18 Accounts Receivable $ 234 $210 Inventories $140 $120 Other Assets $0 $0 Total Current Assets $400 $348

  9. Fixed, Intangible & Other Assets 2005 2004 Gross Fixed Assets $1,129 $816 Less Accumulated Depreciation ($379) ($288) Net Fixed Assets $750 $528 Intangible & Other Assets $0 $0 Total Fixed & Other Assets $750 $528

  10. Current Liabilities 2005 2004 Accounts Payable $ 34 $20 Notes Payable $114 $56 Accrued Expenses $105 $100 Total Current Liabilities $253 $176

  11. Long Term Liabilities 2005 2004 Long Term Bonds $ 192 $112 Other, Incl. Deferred Taxes $44 $32 Total Long Term Liabilities $236 $144

  12. Shareholder’s Equity 2005 2004 Preferred Stock $20 $20 Common Stock $329 $272 Retained Earnings $312 $296 Less Treasury Stock $0 ($32) Total Common Equity $641 $536 Total Shareholder’s Equity $661 $556

  13. The Income Statement • Reports revenues, expenses, and profit (or loss) during the year. • Uses an “accrual” basis. • Also reports earnings and dividends on a per share basis.

  14. Retained Earnings Dividends Basic Financial Statements • Income Statement Revenues - Expenses = Net Income Sales Investment Income Gains Interest Received Dividend Received COGS Salaries Depreciation Taxes Other Expenses Interest Paid

  15. Income Statements 2005 2004 Sales $1,080 $840 Cost of Goods Sold $560 $428 Gross Profit $520 $412 Selling & Admin. Expenses $348 $318 Depreciation & Amortization $91 $35 Operating Profit $81 $59 Non Operating Income $4 $6 Earnings Before Interest & Taxes $85 $65 (EBIT)

  16. Income Statements 2005 2004 EBIT $85 $65 Interest Expense $15 $13 Taxable Income $70 $52 Total Income Tax $28 $21 Net Income $42 $31 Preferred Dividends $6 $6 Net Income Available to Common $36 $25

  17. Income Statements 2005 2004 Net Income Available to Common $36 $25 Common Dividends $20 $15 Addition to Retained Earnings $16 $10

  18. Income Statements 2005 2004 Per Share Data: 16.00 15.00 Shares Outstanding (millions) $2.25 $1.68 Earnings per Share $1.25 $1.00 Dividends per Share $29.00 $26.00 Market Price at year-end

  19. The Statement of Cash Flows • Reports how the company’s cash position changed during the year. • Itemizes the company’s cash flows. • Increase (decrease) in an asset consumes (provides) cash. • Decrease (increase) in a liability consumes (provides) cash.

  20. The Statement of Cash Flows 2005 Cash Flow from Operating Activities $108 Cash Flow from Investing Activities ($313) Cash Flow from Financing Activities $213 Net Increase (Decrease) in Cash & Equivalents $8 Cash & Equivalents at beginning of year $18 Cash & Equivalents at end of year $26

  21. Cash Flow from Operating Activities 2005 Net Income $42 Depreciation & Amortization $91 Decrease (Increase) in Accts. Receivable ($24) Decrease (Increase) in Inventories ($20) Increase (Decrease) in Accts. Payable $14 Increase (Decrease) in Accrued Expenses $5 Cash Flow from Operating Activities $108

  22. Cash Flow from Investing Activities 2005 Purchase of Plant & Equipment ($313) Net Cash Flow from Investing Activities ($313)

  23. Cash Flow from Financing Activities 2005 Increase (Decrease) in Notes Payable $58 Issuance (Retirement) of Long Term Debt $80 Increase (Decrease) in Other Long Term Liabilities $12 Issuance (Retirement) of Common Stock $89 Cash Dividends (preferred & common) ($26) Net Cash Flow from Financing Activities $213

  24. Notes to Financial Statements • More information, such as: • Other income, interest expenses, provision for income taxes. • Details of earnings per share calculations. • Inventories, property, plant and equipment, and other assets. • Employee pension and stock option plans. • Business segment information • Five-year summary of financial performance.

  25. Historical Accounting Statements • They do not provide information about future income and cash flows. • Assets and liabilities as reported do not reflect currentmarketvalues. • So the value of the shareholders’ equity is not the amount shown as “shareholders’ equity,” and the value of the company is not the amount shown as “total assets.”

  26. Market versus Book Values of Assets The market value of an asset can differ from its book value for the following reasons: • Accounting depreciation differs from economic depreciation. • Book values ignore the effects of inflation. • Book values ignore the asset’s liquidity. • Intangible assets are highly illiquid.

  27. Market versus Book Values of Liabilities The market value of a liability can differ from its book value for the following reasons: • Book values do not reflect current and expected future economic conditions affecting the liability’s market value. • Book values do not reflect the company’s current and expected future financial health.

  28. Market versus Book Values of Equity • Stockholder’s Equity = Assets - Liabilities • Since the market and book values of assets (and liabilities) are not equal, • The book value of shareholder’s equity does not reflect its market value.

  29. Net Income versus Cash Flow Net income does not measure cash flow because of the “accrual” basis: • Certain cash flows occur before the item is recorded. • Example: depreciation expenses • Certain cash flows occur after the item is recorded: • Example: accrued wages and taxes, sale of merchandise on credit.

  30. Corporate Income Taxes • Federal income tax rate increases with the level of taxable income. • Marginal tax rate = tax rate applied to the last dollar of taxable income. • Average tax rate = total taxes paid / taxable income • Progressive tax system: • Average tax rate is non decreasing in taxable income.

  31. Corporate Capital Gains • Capital Gain (or Loss) is the difference between the selling price of an asset and its tax basis - that is, its net book value. • If the asset has been held for more than 1 year, it is a long-term capital gain (or loss). Otherwise it is a short-term gain (or loss). • Taxes become due only when the asset is sold. • This creates a tax-timing option. • Capital gains tax rate < regular tax rate.

  32. Corporate Interest Expenses & Income • Corporate interest expenses are tax deductible. • This reduces the after-tax cost of interest. • All corporate interest income is taxed as regular income.

  33. Corporate Dividend Payments & Receipts • Dividends to preferred and common stockholders are not tax deductible. • They are paid from after-tax income. • At least 70% of the dividends received by a corporation from another corporation are tax-exempt. • The tax-exempt proportion varies between 70% and 100%, depending on the percentage of ownership of the stock of the paying corporation.

  34. Interest, Dividends, and Taxes Manhattan Steel & Pipe Co. (MSPC) is in the 34% tax bracket. The following information is available for 1996: Interest Expense $10,000 Dividends Paid $10,000 Interest Income $ 8,000 Dividend Income $ 8,000 MSPC is in the 34% tax bracket, and assume that 70% of the dividends received by MSPC are tax exempt.

  35. After-Tax Interest Expense • By paying $10,000 in interest, the company’s taxable income is reduced by $10,000. • Its tax liability is reduced by $10,000(34%) or $3,400. • The after-tax cost of the interest to the company is $10,000 - $3,400 = $6,600. • After-tax interest expense = Before-tax interest expense x (1 - Tax Rate)

  36. After-Tax Dividends • Since dividend payments are not tax deductible, the after-tax amount of dividends paid = the actual amount of dividends paid. • For MSPC, this is $10,000.

  37. After-Tax Interest Income • Since all interest income is taxable at the regular rate, MSPC pays 34% ($8,000) or $2,720 in taxes on the interest income. • The after-tax interest income is thus $8,000 - $2,720 or $5,280. • Alternatively, after-tax interest income = Before-tax interest income x (1 - Tax Rate) • For MSPC, the after-tax interest income is $8,000 x (1 - 0.34) = $5,280.

  38. After-Tax Dividend Income • Since 70% of the dividends received by MSPC are tax exempt, • Taxable dividends = $8,000 x (1 - 0.70) = $2,400 • Taxes on these dividends = $2,400 (34%) or $816. • After-tax dividends = $8,000 - $816 = $7,184. • Effective tax rate on dividend income = 816/8000 = 10.20%

  39. Personal Income Taxes • Progressive tax rates. • Dividend income received from stock ownership is fully taxable. • Interest income received from corporations and individuals is also fully taxable. • Interest income received from most state and local government bonds is exempt from federal income taxes. • Personal capital gains are taxed at a maximum rate of 20%.

  40. Personal Tax-Timing Option Two years ago, Jim Sanders bought 100 shares of the Sunshine Furniture Co. at $85 each. He is considering selling them at their current market price. Assume today is December 27. In each of the following two cases, discuss whether he should sell the stock now, or wait till after the new year (strictly on the basis of taxes). Stock is currently selling for $70 each. • Stock is currently selling for $100 each.

  41. Current Price is $70 per share • Jim will incur a capital loss of $15 per share, or $1,500 in total. • If he sells now, his taxable income this year will be $1,500 lower. • If he sells next year, his taxable income next year will be $1,500 lower (assuming the same sale price). • Sell now to same taxes immediately.

  42. Current Price is $100 per share • Jim will incur a capital gain of $15 per share, or $1,500 in total. • If he sells now, his taxable income this year will be $1,500 higher. • If he sells next year, his taxable income next year will be $1,500 (assuming the same sale price). • Postpone the sale to postpone paying the taxes. • We’ll talk about other considerations later.

  43. Ratios and Ratio Analysis • There are an unlimited number of alternatives. • They are not useful for “picking winners.” • They are useful for understanding the current situation and perhaps how it developed to this point.

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