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Financial Statements and Cash Flows

Financial Statements and Cash Flows. RWJ-Chapter 2. Understanding Financial Statements. The crux of investments is to value firms (or stocks) Various models to value common stocks DCF Multiples

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Financial Statements and Cash Flows

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  1. Financial Statements and Cash Flows RWJ-Chapter 2

  2. Understanding Financial Statements • The crux of investments is to value firms (or stocks) • Various models to value common stocks • DCF • Multiples • No matter which model we are going to use, the key inputs we needed are mostly based on a firm’s financial statements • We will learn the basic tools to analyze financial statements

  3. Information for Financial Statements Analysis • 1) Published annual reports • (1) Financial Statements • Balance Sheet (B/S) • Income Statement (I/S) • Statement of Cash Flows • (2) Notes to financial statements • (3) Letters to stockholders • (4) Auditor’s report (independent accountants) • (5) Management’s discussion and analysis • 2) Reports filed with the government

  4. Sources of Information • Annual reports • SEC • EDGAR (http://www.sec.gov/edgar.shtml) • 10K & 10Q reports

  5. Balance Sheet • Balance sheet summarizes the assets owned by a firm • The value of the assets, and the mix (debt and equity) used to finance these assets at a point in time Assets Liabilities & Equity Fixed Assets Current Assets Financial Investments Intangible Assets Current Liabilities Debt (Long-term) Equity Stockholder’s Equity Total Assets Total Liabilities & Equity

  6. Summary of B/S • An accountant’s snapshot of the firm’s accounting value as of a particular date. • The Balance Sheet Identity is: Assets ≡ Liabilities + Stockholder’s Equity • Stockholder’s equity is defined to be the difference between the assets and the liabilities of the firm. Equity is what stockholders would have remaining after the firm discharged its operations. • Liabilities and equity-side reflects the types and proportions of financing, which depend on management’s choice of capital structure, as between debt and equity and current debt and long-term debt.

  7. Assets • Fixed Assets: • Assets that are purchased for long-term use and are not likely to be converted quickly into cash, such as land, buildings, and equipment. • GAAP requires the valuation of historical cost, adjusted for any estimated loss in value from the aging of these assets (Depreciation) • Many firms in the U.S. use straight line depreciation, while Japanese and German firms often use accelerated depreciation • Straight line versus Accelerated Depreciation • Accelerated depreciation leads reported income that is understated.

  8. Example- Straight Line • An asset costs $33,000 has a residual value of $3,000, and expected to last 4 years • (i) Calculate annual depreciation • (ii) what happen if you are able to sell this asset after two year at selling price of $20,000?

  9. Example-Accelerated Depreciation • An asset costs $33,000, and expected to last 5 years • (i) Calculate annual depreciation • (ii) what happen if you are able to sell this asset after two year at selling price of $20,000?

  10. Assets • Current Assets: • Account Receivables: • It represents money owed by entities to the firm on the sale of products on credit • Cash and Marketable Securities: • Cash: One of the few assets for which accountants and financial analysts should agree on the value • Marketable Securities: Investments made by firms in securities or assets of other firms, as well as T-bills or bonds • Inventory • The total amount of goods and/or materials contained in a store or factory at any given time • Closely related to COGS • LIFO vs FIFO

  11. Assets • Intangible Assets: • Patents and Trademarks • Internal • External • Goodwill • By product of acquisitions • When a firm acquires another firm, the purchase price is first allocated to tangible assets, and the excess price is then allocated to any intangible assets • Nothing but excess price by actual price (MV) and book value of the company

  12. Liabilities and Equity • Current Liabilities: • Accounts payable: • It represents credit received from suppliers and other vendors • Short-term Borrowing: • Short-term loans (due in less than a year) to finance the operations or current asset needs of the business • Short-term portion of long-term borrowing • It represents the portion of the long-term debt or bonds that is coming due in the next year • Other short-term liabilities: • It includes wages due to its employees and taxes due to the government

  13. Liabilities and Equity • Long-Term Debt: • Long-term loan from a bank or other financial institutions • Long-term bond issued to financial markets • Other Long-term Liabilities: • Leases, Employee Benefits, Pension Plans, Health Care Benefits • These are long-term obligations that are not captured in the long-term debt items • In the past two decades accountants moved toward quantifying these liabilities and showing them as long-term liabilities • Equity: • It reflects the original proceeds received by the firm when issued the equity • Retained Earnings: • Net Income kept for further investment

  14. U.S. COMPOSITE CORPORATION Balance Sheet 2008 and 2009 (in $ millions) Liabilities (Debt) Assets 2008 2009 and Stockholder's Equity 2008 2009 Current assets: Current Liabilities: Cash and equivalents $104 $160 Accounts payable $232 $266 123 Accounts receivable 455 688 Notes payable 196 Inventories 553 555 Total current liabilities $428 $389 Total current assets $1,112 $1,403 Fixed assets: $1,644 $1,709 Net Property, plant, and equipment Long-term debt 408 454 Stockholder's equity: Common stock and paid in surplus 600 640 1,629 Accumulated retained earnings 1,320 Total equity $1,920 $2,269 Total liabilities and stockholder's equity Total assets $2,756 $3,112 $2,756 $3,112

  15. Balance Sheet Analysis • When analyzing a balance sheet, the financial manager should be aware of three concerns: • (1) Liquidity • (2) Debt versus equity • (3) Value versus cost

  16. Liquidity • Refers to the ease and quickness with which assets can be converted to cash. • Current assets are the most liquid. Fixed assets are the least liquid. • Some fixed assets are intangible. • The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations. • Liquid assets frequently have lower rates of return than fixed assets. For example, cash generates no or little investment income. • To the extent that a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investments.

  17. Value versus Cost • Under GAAP audited financial statements of firms in the U.S. carry assets at cost. • Market value is a completely different concept. • Market value is the price at which willing buyers and sellers trade the assets. It would be only coincidence if accounting value (book value) and market value were the same. • Many users of financial statements want to know the value of the firm, not its cost. • In this class, whenever we mention value, we mean market value, not the cost (or book value). • When we say that the goal of a financial manager is to increase the value of the stock, we mean the market value of the stock.

  18. Income Statement • The income statement measures performance over a specific period of time. • It provides information on the revenues and expenses of the firm, and resulting income made by the firm, during a period • The accounting definition of income is Revenue – Expenses ≡ Income

  19. More Specifically Revenue Cost of Goods Sold (COGS) Gross Profit Operating Expense EBITDA Depreciation & Amortization EBIT (Operating Income) Interest Taxes Net Income (NI) or Earnings Retained Earnings (R/E) Dividends

  20. U.S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) The operations section of the income statement reports the firm’s revenues and expenses from principal operations Net sales $1,509 Cost of goods sold - 750 Depreciation - 65 $694 Earnings before interest and taxes - 70 Interest expense $624 Taxable income - 212 Taxes (34%) $412 Net income Retained earnings: $309 Dividends: $103

  21. U.S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) Net sales $1,509 Cost of goods sold - 750 - 65 Depreciation The non-operating section of the income statement includes all financing costs, such as interest expense. $694 Earnings before interest and taxes - 70 Interest expense $624 Taxable income - 212 Taxes (34%) $412 Net income Retained earnings: $309 Dividends: $103

  22. U.S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) $1,509 Net sales - 750 Cost of goods sold - 65 Depreciation $694 Earnings before interest and taxes - 70 Usually a separate section reports as a separate item the amount of taxes levied on income Interest expense $624 Taxable income - 212 Taxes (34%) $412 Net income Retained earnings: $309 Dividends: $103

  23. U.S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) Net sales $1,509 Cost of goods sold - 750 - 65 Depreciation $694 Earnings before interest and taxes Interest expense - 70 Taxable income $624 Taxes (34%) - 212 Net income $412 Net income is the “bottom line” Retained earnings: $309 Dividends: $103

  24. Income Statement Analysis • There are twothings to keep in mind when analyzing an income statement: • (1) GAAP • (2) Non Cash Items

  25. Generally Accepted Accounting Principles • Recognition principle: Recognize revenue when the earnings process is complete and the value of an exchange of goods or services is known and can be reliably determined. Thus, income is reported when it is earned, even though no cash flow may have occurred. • Midland co. sells goods for $1 million. The goods cost $900,000. So the company will have profit of $100,000. • But the company has not yet collected the cash from the sale. So, the net cash flow is -$900,000.

  26. Non-Cash Items • Depreciation is the most apparent. No firm ever writes a check for “depreciation”. • In practice, the difference between cash flows and accounting income can be quite dramatic. • For example Conseco Corp. reported a net loss of $194 million for 2007. But it also reported a positive cash flow of $ 703 million for the same fiscal year!

  27. Net Working Capital Net Working Capital ≡ Current Assets – Current Liabilities • If the change in NWC is positive, it is a cash outflow. (you are investing more in NWC). If the change in NWC is negative, it is a cash inflow

  28. U.S. COMPOSITE CORPORATION $1014m = $1403- $389 Balance Sheet 2008 and 2009 (in $ millions) $684m = $1112m- $428m Liabilities (Debt) Assets 2008 2009 and Stockholder's Equity 2008 2009 Current assets: Current Liabilities: Cash and equivalents $104 $160 Accounts payable $232 $266 Accounts receivable 455 688 Notes payable 196 123 Inventories 553 555 Total current liabilities $428 $389 Total current assets $1,112 $1,403 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Here we see NWC grow to $1,014 million in 2009 from $684 million in 2008. Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 par value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 This increase of $330 million is an investment of the firm. Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

  29. Financial Cash Flows • In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm. • Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders. CF(A)≡CF(B) + CF(S)

  30. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Operating Cash Flow: EBIT $694 Depreciation $65 Current Taxes ($212) OCF $547 Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130) (Ending net fixed assets minus beginning fixed assets plus dep.) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt $24 Equity 63 Total $87

  31. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 Capital Spending Ending net fixed assets$1,709 Beginning net fixed assets (1644) Depreciation 65 Net Capital Spending $130 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130) (Ending net fixed assets minus beginning net fixed assets plus dep.) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt $24 Equity 63 Total $42

  32. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 NWC grew from $684 million in 2008 to $1014 million in 20X1. This increase of $330 million is the addition to NWC. (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt $24 Equity 63 Total $87

  33. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130) (Ending net fixed assets minus beginning net fixed assets plus dep.) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt $24 Equity 63 Total $87

  34. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130 Cash Flow to Creditors Interest paid$70 Net new borrowing (46) Total 24 Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt $24 (Interest minus net new borrowing) Equity 63 (Dividends minus net new equity raised) Total $87

  35. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130) Cash Flow to Stockholders Dividends $103 Net new equity raised (40) Total $63 Net new equity raised is the change in common stock and paid–in-surplus from B/S. Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt $24 (Interest minus net new borrowing) Equity 63 (Dividends minus net new equity raised) Total $87

  36. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders: plus depreciation minus taxes) Capital spending (130) (Ending net fixed assets minus beginning net fixed assets plus dep.) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt $24 (Interest minus net new borrowing) Equity 63 (Dividends minus net new equity raised) Total $87

  37. Cash Flow Summary

  38. Free Cash Flows (1) This is the cash flows generated by a company’s operating activities and available to all who provided capital to the firm (Debt and Equity Holders) • There are two types of Cash Flows: Current Assets –Current Liabilities

  39. Free Cash Flows (2) “free” cash flows to equity (stock holders), which is derived from after operating free cash flows have been adjusted for debt payments (interest and principal) Current Assets –Current Liabilities

  40. Question: • Which one to use?

  41. Cash Flows Assets Liabilities Cash inflow Cash outflow Cash outflow Cash inflow

  42. Limitations of Financial Ratios • Accounting statements: • A reasonably good job of categorizing the assets owned by a firm • A partial job of assessing the value of these assets • A poor job of reporting uncertainty about asset value • Accounting principles: • The accounting view of asset value is to a great extent grounded in the notion of historical cost, which is the original cost of the asset. Historical cost is the best estimate of the value of an asset. • Conservative approach to estimate the value . • At the end of 2011, book value of Google is $58.1 billion • At the end of 2011, the market value of Google is $211.04 billion (stock price= $645)

  43. Limitations of Financial Ratios • These values are based on specific dates • Capture values of assets and liabilities on a specific date • Ratios using balance sheet may not reflect company’s situation during rest of the year • Example: A company that reports $1 million in cash on last day of fiscal year may have only $100 K two days later after paying salaries and suppliers

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