CHAPTER 3 Financial Statements

1. CHAPTER 3Financial Statements Key Financial Statements Income statements Balance sheet Cash flow statement Profit v Cash Modification to accounting info MVA and EVA Financial Planning & Forecasting

2. Why Financial Statement? • Manager’s goal? • Value = PV of future CF • Q: • How investor estimate future CF? • How manager decide effect of action of CF? • Fin. Statement - interpret & use

3. The annual report • Qualitative: • Chairman - result of past year (why) & new development (f prospect) • Quantitative: • What actually happened to A, earnings and div. • Financial statement: • Income Statement • Balance Sheet • Cash Flow Statement

4. Obj 1: Financial Statements • Income Statement - Return (R, Exp) • Retained earnings - how distribute ret • Balance Sheet - Risk (A, L, E) • Cash Flow - cash in and out

5. Income Statement • Gross profit - did co sell GNS > cost? • Non-cash Exp • Depreciation (share of cost of tangible A) • Amortization (share of cost of ITA) • EBIT - operating profit • Int -financial exp, Tax - 28% • Dividend distribution • EBITDA - amt of cash co generate

6. Balance Sheet • Asset - resources of co (NC, C) • How finance A: • Liability - money form outsider • Equity (Net worth) - money from owner • Q: Why BS show risk?? • Book value per share = TCE/# CS • MV higher: • Asset increase in value • Expect higher future return (growth opportunity)

7. Cash Flow Statement • Operating: • How much cash generated from daily activities of bus (more better) • I: Enough to invest in A for future growth? • F: If not how get money? • Why CF imp? • E/nal - Co’s cash generating ability (Enron) • I/nal - cash planning & forecast

8. Cash planning

9. Obj 2: Profit v Cash • Profit = Cash? • Accrual concept: • Rev recognised when earned • Realization concept: Rev earned when goods has been delivered • Net income is not cash available due to non-cash nature of rev & exp recognized

10. Exercise • My accountant tell me I have made $60,000 profit but my cash balance has actually fallen by $10,000. Why? • State the impact on CF (+,-,NIL). Why? • An increase in accounts receivable • Depreciation of non-current asset • A reduction in accounts payable • Write-off of a bad debt • An issue of ordinary share

11. Obj 3: Modification • Why need modification? • FS prepared for use of creditor & tax collector • Manager & analyst need to modify info for corp d.m and stock valuation • Mgmt’s obj? • Max wealth --> Max SP --> Max CF

12. Obj--> Max CF • But cannot maintain CF if don’t replace FA or develop new product • Thus need to know Free Cash Flow • FCF • CF actually available for payment to investors (shareholders & debtholders) • CF available after investment in FA, new product and WC

13. Free Cash Flow • Free Cash Flow = Opr CF - Opr Asset = (NOPAT +D+A) - (∆TOC+dep) = [EBIT (1-T) + (D+A)] -[∆ (NOWC+net FA)+D] = [EBIT (1-T) + (D+A)] - [∆NOWC + Gross Cap.Exp]

14. Modification needed • Opr CF • NOPAT = Net operating profit after tax = EBIT (1-T) • Opr Asset • NOWC = Net operating working cap = CA - non-int-bearing CL = CA - (AP + accruals) AP & accruals are “free” coz there is no explicit charge by supplier or accruals NOWC: WC acquired with Investor supplied fund

15. Summary of Modification • Obtain investor fund • Invest in Opr Asset • Generate Opr CF • Compare to calculate FCF

16. Exercise • NOPAT = $30m. • Dep & amortization =$10m. • Gross capital exp = $20m. • Increase in NOWC = $10m. Calculate: • Opr CF • FCF • Is negative FCF bad?

17. Market Value Added (MVA) • FS x reflect market value • Historical cost • MVA = MVe - BVe • Represents the difference between money invested since founding and cash that could obtain if sell business

18. Economic Value Added (EVA) • EVA = NOPAT – Annual dollar cost of capital = NOPAT - (Opr Cap * COC) • In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital. • EVA is economic profit • Not like acctg profit coz tia cost of capital • +ve: opr income exceed COC i.e mgmt action add value to shareholders

19. Exercise D’ Leon p. 95 3-16: a-h

20. Financial Forecasting • Financial plan • Financial forecast: • Sales forecast • The AFN Equation • Forecasted (Pro-Forma) FS • Regression & forecast • Modifying ratios

21. Financial Plan • Projected result of entire corporation • Heart: Projected (pro-forma) financial statement • What is projected???

22. Why is it important? • Effect of proposed operating changes • Give info to security analyst to reduce volatility • Establish target for operating managers • Future financing needs • Examine the effect of alternative strategies & operating plan

23. Forecasts • Sales forecast • The AFN equations • Forecasted FS • Regression

24. Sales forecast • Estimate future sales based on past trend • One way: use LOGEST function in Excel • Why important? • Underestimate – loose market share to competitor • Overestimate – invest too much on asset with low return

25. The AFN equation • AFN = Additional funds needed • I.e amt of external capital needed for growth • AFN = Asset - Spontaneous L - R.E = (A*/So)∆S – (L*/So)∆S – MS1(RR) refer p-557 for definition

26. Forecasted FS • AFN – assume that most assets and liabilities increase at the same rate as sales (not true in reality) • Need to prepare Forecasted FS: • Start with initial forecast (increase at sales rate) • Modify the assumptions

27. Steps • First pass: • IS & BS increase at sales increase • Except notes payable, LT debt & common stock – assume constant • BS – x balance (difference = AFN) • AFN must be financed using notes payable, LT debt and C.S in second pass and fwd until balance sheet balances

28. Regression • Increase in assets & liabilities need not be the same as increase in sales • Better forecasting results could be obtained using regression analysis • Use – FORECAST & CORREL function in excel

29. Integrated Case New Word Chemical p. 572