Financial Statements and Cash Flow

1. Chapter 2 Financial Statements and Cash Flow

2. 2.1 The Balance Sheet • An accountant’s snapshot of the firm’s accounting value at a specific point in time • The Balance Sheet Identity is: • Assets ≡ Liabilities + Stockholder’s Equity

3. U.S. Composite Corporation Balance Sheet The assets are listed in order by the length of time it would normally take a firm with ongoing operations to convert them into cash. Clearly, cash is much more liquid than property, plant, and equipment. 2012 2011 2012 2011 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 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 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

4. Balance Sheet Analysis • When analyzing a balance sheet, the Finance Manager should be aware of three concerns: • Liquidity • Debt versus equity • Value versus cost

5. Liquidity • Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value • Current assets are the most 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.

6. Debt versus Equity • Creditors generally receive the first claim on the firm’s cash flow. • Shareholder’s equity is the residual difference between assets and liabilities.

7. Value versus Cost • Under Generally Accepted Accounting Principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost. • Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.

8. 2.2 The Income Statement • Measures financial performance over a specific period of time • The accounting definition of income is: Revenue – Expenses ≡ Income

9. U.S.C.C. Income Statement Total operating revenues $2,262 The operations section of the income statement reports the firm’s revenues and expenses from principal operations. Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 29 Other income Earnings before interest and taxes $219 Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86 Addition to retained earnings $43 Dividends: $43

10. U.S.C.C. Income Statement Total operating revenues $2,262 The non-operating section of the income statement includes all financing costs, such as interest expense. Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 29 Other income Earnings before interest and taxes $219 Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86 Addition to retained earnings: $43 Dividends: $43

11. U.S.C.C. Income Statement Total operating revenues $2,262 Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 29 Other income Earnings before interest and taxes $219 Usually a separate section reports the amount of taxes levied on income. Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86 Addition to retained earnings: $43 Dividends: $43

12. U.S.C.C. Income Statement Total operating revenues $2,262 Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Interest expense 49 Net income is the “bottom line.” Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43

13. GAAP • The matching principle of GAAP dictates that revenues be matched with expenses. • Thus, income is reported when it is earned, even though no cash flow may have occurred.

14. Depreciation • Simply put, taxable income equals revenue minus expenses • Wherever possible, we want to legally decrease how much we owe in taxes – without decreasing our income • This means that ideally, every expense that a corporation has will be subtracted from revenue as soon as possible

15. Depreciation • However, prior to the new tax law that was passed in Dec. 2017, capital expenses could not be subtracted from revenue in the year they were expensed • Capital Expenses – Big ticket items that last for more than one year – like plant and equipment

16. Depreciation • The new tax law allows corporations to fully expense (subtract the expense from income) all capital expenditures in the year they are purchased • However, the new tax law only allows this through 2022. • From 2022 – 2026, this allowance is to be phased out • Starting in 2027, capital expenses will need to be depreciated again

17. Depreciation • Since you will probably be working for more than a few years, it is worthwhile for you to learn how BOTH methods work: Depreciation and Immediate Expensing

18. Depreciation • Under depreciation, capital expenses have to be depreciated over their expected life according to specific rules • In our class, we will not focus on the rules • We will simply say that under the rules of depreciation, capital expenses are depreciated over the life of the project on a straight-line basis with a salvage value of $0

19. Depreciation • Example: You purchase a piece of equipment that makes widgets. You plan to use it for 10 years (the life of the project). The equipment cost $1 million which was paid at time 0. • When we use depreciation, we will say that the value of the equipment goes down by 10% per year over its 10-year expected life.

20. Depreciation • This means that you cannot list the $1 million cash outflow as an expense to be subtracted from revenue in time 0 • Instead, you list $100,000 as depreciation in each year (1-10) that the equipment is used • Instead of reducing taxable income by $1 million in year 0, you reduce taxable income by $100,000/year in years 1-10

21. Depreciation • Though we will only look at straight-line depreciation in this course, there have been (and probably will be) alternative depreciation schedules that allow a corporation to accelerate the depreciation process • When available, it is generally preferable to depreciate capital expenses as rapidly as possible to save on taxes sooner

22. Immediate Expensing • Immediate expensing is advantageous for the corporation because it allows the company to reduce taxable income immediately. • The total amount of taxes paid is the same under immediate expensing and depreciation, but under depreciation, those taxes are paid sooner.

23. Immediate Expensing • Prior Example: You purchase a piece of equipment at a cost of $1 million which was paid at time 0. • Instead of subtracting $100,000 from income (depreciation) per year for the next 10 years, you subtract the entire $1 million from income at time 0 (immediate expensing).

24. Immediate Expensing • We will assume that the corporation had revenues of more than $1 million in the year the equipment was purchased • So the after-tax cost of the equipment is ($1 million) (1-t) where “t” is the corporation’s marginal tax rate (usually 21%). $790,000 in this example

25. Non-Cash Items on the Income Statement • Depreciation is the most apparent. No firm ever writes a check for “depreciation.” • Another non-cash item is deferred taxes, which does not represent a cash flow. • Thus, net income is not cash.

26. 2.3 Taxes • The one thing we can rely on with taxes is that they are always changing • Marginal vs. average tax rates • Marginal – the percentage paid on the next dollar earned • Average = the tax bill / taxable income • Other taxes

27. 2.4 Net Working Capital • Net Working Capital ≡ Current Assets – Current Liabilities • NWC usually grows with the firm

28. $252m = $707- $455 $23 million $275m = $761m- $486m U.S.C.C. Balance Sheet 2012 2011 2012 2011 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Here we see NWC grow to $275 million in 2012 from $252 million in 2011. Fixed assets: Deferred taxes $117 $104 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 This increase of $23 million is an investment of the firm. Accumulated retained earnings 390 347 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. 2.5 Financial Cash Flow • 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 paid to the firm’s creditors and stockholders. CF(A)≡CF(B) + CF(S)