Financial Statements

1. Financial Statements Chapter 2, Fundamentals by Ross et. al. 3040.03/04 notes by A.P. Palasvirta, Ph.D.

2. Balance sheet • balance sheet • Stock statement • Organizing the value of assets (right-hand side) • Different categories at a given time • Short term • Long term • Organizing the methods of financing of the assets (left-hand side) • Different categories at a given time • Short-term • Long-term • Debt • equity 3040.03/04 notes by A.P. Palasvirta, Ph.D.

3. Balance Sheet characteristics • Current Assets • less than a year • easily convertible • secondary mkts • Fixed Assets • more than a year • Lumpy • Total Assets • Current Liabilities • less than a year • Long-term Liabilities • more than a year • fixed obligations • Equity • infinite • variable • Liabilities & Equity 3040.03/04 notes by A.P. Palasvirta, Ph.D.

4. Current Assets • Cash • cash & checking accounts at banks • Marketable Securities • equity & debt securities of other firms • Accounts Receivable • good sold & invoiced but not paid for • Inventories • Both inputs & outputs 3040.03/04 notes by A.P. Palasvirta, Ph.D.

5. Fixed Assets • plant & equip • value of all physical assets of the firm • less depreciation • loss of value due to wear & tear or innovation 3040.03/04 notes by A.P. Palasvirta, Ph.D.

6. Intangible assets ?? • Kinds of assets • value of patents • good guy capital • value of training to employees • management • Valuation ?? • no book value • market value difficult to determine 3040.03/04 notes by A.P. Palasvirta, Ph.D.

7. Current Liabilities • Payables • accounts payable • notes payable • Accruals • wage accruals • tax accruals • interest accruals 3040.03/04 notes by A.P. Palasvirta, Ph.D.

8. Net Working Capital NWC • Current Assets - Current Liabilities • 19X2 $761 - 486 = 275 • 19X1 $707 - 455 = 252 • Liquidity measure • ability to pay current liabilities • Change in NWC 3040.03/04 notes by A.P. Palasvirta, Ph.D.

9. Personal Net Working Capital (example) • Cash, checking • Receivable • Due from employer • Inventories • Food • Gasoline • Home heating oil • Visa bill • Accruals • Electricity • Rent • Cable • cell 3040.03/04 notes by A.P. Palasvirta, Ph.D.

10. Long-term Liabilities • Discount bonds • lump-sum payment at term (prin & int) • Coupon bonds • interest annuity paid at equal intervals • principal repaid at term • Mortgage bonds • annuity paid including (prin & int) • Deferred Tax liabilities 3040.03/04 notes by A.P. Palasvirta, Ph.D.

11. Equity • Preferred Stock • Stockholder equity • Common Stock • value of all stock issued at Par • Capital Surplus • incremental value stock relative to par • Accumulated Retained Earnings • historical sum of retained earnings 3040.03/04 notes by A.P. Palasvirta, Ph.D.

12. Capital Structure(financial leverage) • proportion of debt to equity finance • increased leverage increases default risk • debt - fixed payments, default & loss of control • equity - residual payments, no default • measures of capital structure • debt ratio = total liabilities / total assets • debt to equity ratio = total liabilities / equity 3040.03/04 notes by A.P. Palasvirta, Ph.D.

13. Net working capital • NWC = Current assets (CA) – current liabilities (CL) • CA = Cash + marketable securities + receivables + inventories • CL = Payables + Accruals • Measure of the liquidity health of the firm • Higher positive value means higher ability to pay its obligations • Higher value means firm is investing more in assets that do not earn a return 3040.03/04 notes by A.P. Palasvirta, Ph.D.

14. Personal Net Working Capital (example) • Cash, checking • $204.43 • Receivable • Work = $653.11 • Inventories • Food = $26 • Gasoline = $11 • CA = $894.54 • Visa bill • Min pymt = $40.00 • Accruals • Electricity = $53.72 • Rent = $500.00 • Cable = $45.98 • Cell = $52.87 • Tuition = $650.00 • CL = $1342.57 3040.03/04 notes by A.P. Palasvirta, Ph.D.

15. Liquidity • Speed of conversion • How quickly assets can be coverted to cash • Cash to fixed assets • How quickly liabilities must be converted to cash • Payables to equity (infinite term) • Assets and liabilities ordered by liquidity • Most liquid assets to least liquid • Those most easily converted to cash on top • Those hardest to covert into case on bottom • Most liquid liabilities to least liquid • Those coming due first on top • Those which never become due on bottom 3040.03/04 notes by A.P. Palasvirta, Ph.D.

16. Debt versus equity • Debt holders • Payment schedule fixed by contract • Priority of payment makes debt less risky • Less risk (to debt holders) means lower costs • Interest cost deductible before taxes • Risk to firm managers • Non payment leads to loss of control • Bankruptcy judge controls firm • Managers/owners no longer control assets • Equity • Stockholders get residual • Higher risk, higher expected return 3040.03/04 notes by A.P. Palasvirta, Ph.D.

17. Market Value versus book value • Balance sheet • All items book value • Book values are easy to calculate • Assets are valued at what was paid minus depreciation (for tax purposes) • Liabilities are valued at principal remaining • Equity = total assets – total liabilities • Market value • What you can get in secondary markets • Receivables, inventories, fixed assets • Much harder to calculate because fixed assets may have very small market 3040.03/04 notes by A.P. Palasvirta, Ph.D.

18. Personal Balance sheet (example) • CA = $894.54 • Clothing = $750 • Cell = $150 • Lap top = $1500 • Misc = $650 • Capital = $50,000 • TA = $53,944.54 • CL = $1342.57 • LT Debt = $24,000.00 • Equity = $28,601.97 • TL & E = $53,944.54 3040.03/04 notes by A.P. Palasvirta, Ph.D.

19. income statement • Flow statement • Accounting of cash flows into various categories over a period of time • Positive cash flows (revenues, sales) • Revenues from sales • Income from financial investments • Royalties, rentals, licensing agreements • Negative cash flows (costs, expenses) • Cost of goods sold COGS - variable cost • Labor, inputs • Operating costs – fixed costs • Management, marketing 3040.03/04 notes by A.P. Palasvirta, Ph.D.

20. Income Statement example • Total Operating Revenues (sales) • (cost of goods sold) • variable over short run • (selling & administrative costs) • fixed over short run • (capital cost allowance) CCA • Allowance as depreciation for tax computation • Operating Income • misc income • Revenue from investments, royalties, etc. • Earnings before Interest and Taxes (EBIT) 3040.03/04 notes by A.P. Palasvirta, Ph.D.

21. Income Statement (con’t) • Earnings before Interest and Taxes • (Interest expense on fixed liabilities) • Earnings before Taxes • (Taxes) • Capital cost allowance (CCA) • non-cash item • Net Income (net cash flow) • Retained earnings • Dividends 3040.03/04 notes by A.P. Palasvirta, Ph.D.

22. Net Income • dividends • earnings distributed as a proportional cash flow back to the stock holder • retained earnings • buy assets • current assets, fixed assets • pay liabilities • lines of credit, bank loans, bonds 3040.03/04 notes by A.P. Palasvirta, Ph.D.

23. Financial Cash Flows • Operating Cash Flow • Cash flows to providers of capital • Capital Spending (Fixed assets) • Purchase of new capital • Repair of existing capital • Change in NWC (Current assets) • NWC = CA – CL • Financing for current assets not financed through current liabilities 3040.03/04 notes by A.P. Palasvirta, Ph.D.

24. Operating cash flow • Depreciation is not a cash flow • Deduction for reducing taxable income • Interest expense is not deducted • not an operating expense • finance expense • Operating cash flows should be positive • Support interest payments to debt holders • Support dividend payments to stockholders 3040.03/04 notes by A.P. Palasvirta, Ph.D.

25. Cash flows to Debt holders • Change in debt can be positive or negative • New financing through debt (negative) • Paying off existing debt (positive) • Cash flow to debt holders should be positive • Bond holders do not want to see interest paid through the issue of new debt • Cash flow to debt holders may be negative • Debt used to finance new project • Principal repayment not cash flow to debt holder 3040.03/04 notes by A.P. Palasvirta, Ph.D.

26. Cash flows to equity holders • Change in equity can be positive or negative • financing through new equity issue (negative) • Repurchase of stock (positive) • Should be positive • Stock holders do not want to see their dividend being paid from a new issue of stock • May be negative • New issue being used to finance new project 3040.03/04 notes by A.P. Palasvirta, Ph.D.

27. Capital Spending • Purchases of fixed assets over the year • New projects • Overhaul or maintenance of old machines • Measure of addition of value to the firm over the year 3040.03/04 notes by A.P. Palasvirta, Ph.D.

28. Net working capital • Additions to current assets not financed through additions to current liabilities • Negative value for NWC financing (more sales) • Need more inventories, cash, receivables • But need more long-term financing for these needs • Positive value for NWC financing (less sales) • Need less inventories, cash, receivables • Cash flow returned to firm for use elsewhere 3040.03/04 notes by A.P. Palasvirta, Ph.D.

29. Personal Net Working Capital (example) • Cash, checking • $204.43 • Receivable • Work = $653.11 • Inventories • Food = $26 • Gasoline = $11 • CA = $894.54 • Visa bill • Min pymt = $40.00 • Accruals • Electricity = $53.72 • Rent = $500.00 • Cable = $45.98 • Cell = $52.87 • Tuition = $650.00 • CL = $1342.57 3040.03/04 notes by A.P. Palasvirta, Ph.D.

30. Marginal & average tax rates Marginal Tax rate Tax Average Tax rate Income 3040.03/04 notes by A.P. Palasvirta, Ph.D.

31. Tax rates • Progressive tax rates • Marginal tax rate increases with income • Average tax rate increases with income • Marginal tax rate > average tax rate • Proportional • Marginal and average tax rate constant with income • Regressive • Marginal tax rate decreases with income • Average tax rate decreases with income 3040.03/04 notes by A.P. Palasvirta, Ph.D.

32. Differential taxes • Sources of income • Wages & salaries • Progressive • Taxable income • Less deductions & exclusions • Rental, proprietorships, & partnerships • Deduction of expenses • Capital gains • Progressive • Fraction of full gains • Corporate • Deductions for expenses, tax breaks 3040.03/04 notes by A.P. Palasvirta, Ph.D.

33. Capital cost allowance • Government allowance for the reduction in value of assets over time • Depreciation of assets • Lowers book value of assets on balance sheet • Allows reduction of taxable income • Government sets the CCA rate for classes of assets • Buildings 4% • Motorized equipment 30% • Pollution control equip 50% • Leasehold improvements straight line 3040.03/04 notes by A.P. Palasvirta, Ph.D.

34. Capital cost allowance EXAMPLE • Delivery van initial cost $60,000 3040.03/04 notes by A.P. Palasvirta, Ph.D.

35. Canadian enterprises ltd 3040.05/06 notes by A.P. Palasvirta, Ph.D.

36. Canadian enterprises ltd 3040.05/06 notes by A.P. Palasvirta, Ph.D.

37. Operating cash flow • Operating CF = EBIT + CCA (depreciation) – taxes • CCA is not a real cash flow • Allowance by the government for reduction in the value of assets • Non-cash item • Because of aging • Because of new technologies • Adjustment to reduce taxable income • Interest expense not counted • Operating CF = 694 + 65 – 250 = 509 3040.05/06 notes by A.P. Palasvirta, Ph.D.

38. Time & costs • Cost of goods sold • Variable cost over the short run • Variable with level of production • Labor • Inputs (raw materials) • Energy • Operating costs • Fixed over short run • Management (administrative) • marketing 3040.05/06 notes by A.P. Palasvirta, Ph.D.

39. Capital spending • Investment in fixed assets • Ending FX2006 - FX2005 + CCA = capital spending • Change in fixed assets over the year • Minus the depreciation of the asset during the year • capital spending = 1709-1644 + 65 • Depreciation added just shows that the firm must spend at least 65 to keep the assets at the same book value 3040.05/06 notes by A.P. Palasvirta, Ph.D.

40. Change in NWC • Ending NWC2006 - NWC2005 = ΔNWC • Investment in new net working capital • When sales grow, your requirements for current assets increase • New cash requirements, additional receivables, higher levels of inventories • Some of these assets are financed by increases in current liabilities such as accruals and payables • The difference must be financed by other forms of financing • If sales decrease the ΔNWC will be negative • ΔNWC = 1014 – 684 = 330 3040.05/06 notes by A.P. Palasvirta, Ph.D.

41. Cash flow to creditors • Interest Pd – net new borrowing = Cash flow to creditors • Ending L-T Debt2005 - L-T Debt2006 + Int pd = cash flow to creditors • Bondholders are interest in this being positive • Bondholders do not want new debt to paying interest payments to old debt holders • Cash flow to creditors = 408 – 454 + 70 = 24 • Including S-T debt • 836 – 843 + 70 =63 • Does it make sense to include short term debt? 3040.05/06 notes by A.P. Palasvirta, Ph.D.

42. Cash Flow to Shareholders • Dividends – New Equity = cash flow to shareholders • Ending CS2005 - CS2006 + Div = cash flow to shareholders • Shareholders like bondholders do not want to see the dividend paid by issuing new stock • Capital gain creates for the shareholder • Increase in investment net of depreciation should increase the value of the firm • Price appreciation of stock is at market value not book value, not on balance sheet • CF shareholders = 600 – 640 + 65 = 25 3040.05/06 notes by A.P. Palasvirta, Ph.D.