Understanding Financial Statements & Corporate Finance

1. Session 2:Financial Statements Business Finance BUAD 306 Conson Zhang Chong Shu

2. Last class: Overview of Corporate Finance • These decisions are not independent of each other

3. Roadmap of this class • We want to learn how to evaluate and finance investments/projects • What is the money they generate / spend? • Where do we find this information? • Outline: • What are cash flows? • Revenues, expenses, taxes • Financial statements: balance sheet and income statement • How to get from accounting income to cash-flows

4. What are cash flows? • What do owners want to know? • How many $ have they put in? • How many $ are they getting back? • This difference over a period of time is the Cash Flow • How to obtain information about Cash Flows? • Financial statements of a firm • But there is no statement that gives the needed information straight away ... so we have to work!

5. What are financial statements? • Documents collecting financial information of a corporation over a certain period of time • Why do they exists? Legal requirements • Security Exchange Commission (SEC), Exchanges • Why are they needed? To provide information on the state of a firm’s business and financial health to lenders, shareholders • Who certifies their accuracy? Accounting firms and FASB rules • Do they tell the truth? What if a company lies?

6. Two major financial statements • Balance sheet: a snapshot of the financial condition of a firm at a particular time (usually year’s end) • It is a list of the firm’s assets and liabilities • The difference is the net worth of the firm, and is known as stockholders’ equity: Equity = Assets – Liabilities • Income statement: a summary of the profitability of the firm over a period of time (usually a year) • It presents revenues, expenses, and the resulting net earnings (or profits or net income) Net Income = Revenues – Expenses

7. The balance sheet

8. The balance sheet • Current assets: relatively highly liquid • Cash, account receivables & inventory (which we hope to convert in cash within the next 12 months) • Fixed assets: relatively less liquid • Tangible assets: plants, equipment • Intangible assets: trademarks, patents • Current liabilities: due in less than 1 year • Accounts payable, short-term debt Net Working Capital: Current Assets – Current Liabilities • Long-term debt: bank loans, bonds, other debts

9. Income statement Operating revenues: from the activity of the firm - Operating expenses: from the activity of the firm • Cost of goods sold (COGS) • Depreciation of capital expenses: • The matching principle: revenues are always matched with the costs to producing them • Overhead costs: employees, administrative expenses = EBIT: Earnings Before Interest and Taxes - Interest expenses: from short- and long-term debt - Taxes: we will talk about it soon! = Net Income

10. The example of the book: U.S. Corporation RE = 1,320 + 412 – 103 = 1320 + 309 = past RE + Net Income - Dividends Owners’ Equity = Common Stock (contributed capital) + RE

11. Value of a financial asset versus accounting • Income statement and balance sheet are based on GAAP (Generally Accepted Accounting Principles) • Revenues and expenses are recognized only when incurred, even if no cash has exchanged hands yet • Assets are shown at historical cost, not current value • GAAP rules offer a lot of latitude • Still, they are a crucial source of information and a tool for decision making • Reported gains or losses (ex. due to changes in GAAP rules) may be unrelated to fundamentals • The value of a financial asset depends on its riskiness and cash flows, not accounting

12. Is Net Income = Cash Flow? • NO: the income statement may include items which are not related to cash inflows or outflows • Depreciation and items which are not related to day-to-day business operations • Interest payments • Spending on fixed assets • Spending on current assets • Plus: taxes must be considered

13. Taxes • Taxes are one of the largest cash outflows of a firm • For the fiscal year 2001, Wal-Mart paid $3.5 billion! • The tax environment is the set of fiscal rules under which firms make financial decisions • We will briefly look at • Federal Income Tax System • Tax Issues for the Investor • Tax Issues for the Corporations

14. The Federal Income Tax System • Progressive on the taxable income • Gross income minus well-defined deductions • Marginal rate: rate on the last taxable dollar • Average rate: total tax paid / taxable income Corporate tax rates under the 1993 Omnibus Budget Reconciliation Act

15. Some tax issues for the investor • Double taxation of dividends: dividends are taxed • At the firm level, as part of Net Income • At the investor level, as part of his personal income • Capital gains versus ordinary income • Capital gains derive from price appreciation of an investment • Taxes on them are usually lower than on the ordinary income and deferred until the gain is realized • Exception of municipal bonds (“munis”), bonds issued by state and local governments • Interest is exempt from federal, state, & local taxation

16. Some tax issues for a corporation • Dividend income: • If received by another firm, only 30% of it is taxed • Tax-exempt investors (pension funds) like dividends • Interest payments: • interest paid on debt is tax deductible • Depreciation: it allows the firm to pay less taxes • Corporate loss carry forward: the use of past losses to shield present profits from taxes • Consolidation of corporate tax returns: taxation of fully-owned subsidiaries on a consolidated basis

17. Three steps to get from Income to Cash Flow • Calculate Operating Cash Flow (OCF): • Adjusting for taxes and depreciation • Calculate Net Capital Spending: • Adjusting for money reinvested for the long-term • Calculate Change in Net Working Capital: • Adjusting for money reinvested for the short-term

18. Step 1: Operating Cash Flows • Depreciation does not represent a cash outflow • But allows the firm to pay less taxes • Which rate? The marginal rate, as any new cash flows will be taxed at that rate • Interest expenses are not operating expenses • Two methods to compute OCF: • OCF = Net Income + Depreciation + Interest Paid • OCF = EBIT + Depreciation - Taxes = (Sales – Cost) x (1 – t) + Depreciation x t Depreciation tax shield

19. Step 1: Operating Cash Flows OCF: Cash flow that results from the firm's day to day activities of producing and selling. OCF = Net sales – Cost of goods Sold – Taxes EBIT = Net sales – Cost of goods Sold – Deprecation Net Income = Net sales – Cost of goods Sold – Deprecation – taxes – interest Therefore, OCF = EBIT + Deprecation – Taxes OCF = Net Income + Deprecation + interest

20. Step 2: Net Capital Spending • We need to consider the long-term assets in the firm’s balance sheet over the income period • If long-term assets increase • For example, the firm purchased new equipment • This increase corresponds to a cash outflow • If long-term assets decrease • For example, the firm sold some buildings • This decrease corresponds to a cash inflow • Depreciation of assets is not a cash inflow • Net Capital Spending (NCS) is given by: NCS = Change in Fixed Assets + Depreciation

21. Step 3: Change in Net Working Capital • We need to consider short-term assets and liabilities in the firm’s balance sheet over the income period • Further short-term or long-term borrowing • Both current assets and liabilities may increase • Other payments (ex. interests) • Current assets decrease, current liabilities may decrease • Change in Net Working Capital is given by: Change in NWC = NWC – Past NWC

22. Summing things up Operating Cash Flow (OCF) Minus Net Capital Spending (NCS) Minus Change in Net Working Capital _________________________________________________________________________ = Cash Flow From Assets (CFFA) • Where does this money go? CFFA = CF to Creditors (CFC) + CF to Stockholders (CFS) CFC = Interest Paid – Net New Borrowing CFS = Dividends Paid – New Equity raised Positive NCS means outflow of cash When current assets increase more than current liabilities, there is an outflow of cash

23. An application: U.S. Corporation • OCF (I/S) = • NCS (B/S & I/S) = • Changes in NWC (B/S) = • CFFA = • CF to Creditors (B/S & I/S) = • CF to Stockholders (B/S & I/S) = • CFFA = EBIT + depreciation – taxes = $547 ending net fixed assets – beginning net fixed assets + depreciation = $130 NWC – Past NWC = $330 547 – 130 – 330 = $87 interest expenses – net new borrowing = 70 – (454 – 408) = $24 dividends paid – new equity raised = 103 – (640 – 600) = $63 24 + 63 = $87

24. The example of the book: U.S. Corporation

25. The example of the book: U.S. Corporation

26. The example of the book: U.S. Corporation

27. The example of the book: U.S. Corporation

28. The example of the book: U.S. Corporation

29. Sources and uses of cash • Sources: cash inflow when we “sell” something • Decrease in asset accounts (except cash) • Decrease in accounts receivable, inventory, or net sales of fixed assets • Increase in liability or equity accounts • Increase in retained earnings, common stock, or long-term debt • Uses: Cash outflow when we “buy” something • Increase in asset accounts (except cash) • Increase in accounts receivable, inventory, or net acquisitions of fixed assets • Decrease in liability or equity accounts • Decrease in accounts payable or long-term debt

30. Where to get financial statements? • Directly from the corporation • Company websites, under investor relationship department • From the SEC database (Edgar) • http://www.sec.gov/cgi-bin/srch-edgar • Form 10K: • Previous year’s balance sheet, income statement, statement of cash flow, retained earnings • Address, state of incorporation, etc. • Business description, market, products, and competition, staff information, strategy and plans for the future, accountant's report

31. Where do we go from here? • What we have done: • We learned how to extract cash flows from financial statements • Key concepts: cash flows versus income • Operating cash flow, capital spending, net working capital • What do we do with these cash flows? • Valuation of projects, financial assets, firms • What do we still need? We need to learn how to analyze financial statements and consider long-run planning … topic of next class