Reviewing Financial Statements

1. Reviewing Financial Statements Chapter 2 Fin 325, Section 04 - Spring 2010 Washington State University

2. Introduction • Corporate managers must issue many reports to the public. The most attention is paid to the annual report, which contains • Balance sheet • Income statement • Statement of cash flows • Statement of retained earnings • These four statements present an accounting-based picture of the firm’s financial position.

3. Accounting and Finance • While accountants focus on reporting what happened in the past, financial managers use financial statements to determine what should happen now and in the future • Firms must follow Generally Accepted Accounting Principles (GAAP) when creating these statements, but they still have substantial discretion

4. Balance Sheet • The balance sheet reports a firm’s assets (what it owns), liabilities (what it owes), and equity at a particular point in time. Assets = Liabilities + Equity • The left side of a balance sheet lists the assets of the firm in order of liquidity • The right side of the balance sheet lists the liabilities in order of maturity. Equity, which never matures, is listed last

5. Assets • Assets fit into two major categories: current assets and fixed assets • Current Assets • Will normally convert into cash within a year • Cash (and marketable securities) • Accounts receivable • Inventory • Fixed Assets • Have a useful life exceeding one year • Net plant and equipment (Gross plant and equipment less accumulated depreciation) • Less tangible assets, such as patents and trademarks

6. Liabilities • Lenders provide funds, which become liabilities to the firm. • Current liabilities • Obligations due within one year • Accruals (accrued wages and accrued taxes) • Accounts payable • Notes payable • Long-term debt • Long-term loans and bonds with maturities of more than one year

7. Equity • The difference between total assets and total liabilities is the stockholders’ (or owners’) equity. • Types of Equity • Preferred Stock • Common Stock • Retained Earnings • The retained earnings account on the balance sheet represents the cumulative amount retained over the years.

8. Accounting method for fixed asset depreciation • Managers can choose the accounting method they use to record depreciation against their fixed assets. • straight-line method of depreciation • For reporting purposes • reports lower depreciation expenses in the earlier years, resulting in higher income for reporting to shareholders • Accelerated depreciation such as MACRS (modified accelerated cost recovery system) • For tax purposes • results in higher depreciation expenses in earlier years, leading to lower income and thus lower taxes.

9. Balance Sheet Example

10. Net Working Capital • Net Working Capital = Current Assets - Current Liabilities • For DPH Tree Farms for 2008: • NWC = $205 - $120 • NWC = $ 85 million • Firms monitor net working capital as a measure of the firm’s ability to pay its obligations • In general, a financially healthy firm has positive NWC

11. Book Value versus Market Value • A firm’s balance sheet shows book value, or historical cost, according to GAAP • Under GAAP, the value of assets on the balance sheet shows what the firm paid for them regardless of what they may be worth today • For current assets the difference will be small, but for fixed assets the difference is likely huge • Similarly, stockholders’ equity on the balance sheet is generally greatly different than the true market value of the equity • Book value of equity represents the historical value of contributed equity, while the market value of equity represents the value of the firm in the market, which depends on the present value of future cash flows

12. Income Statement • Income statements show the total revenues and expenses of a firm over a specific period of time

13. Income Statement Example Operating Income Finance & Taxes

14. Items reported below the bottom line include:

15. Corporate Income Taxes Firms pay out a large portion of their earnings in taxes (Microsoft paid $4.4 billion in taxes in 2005, or 26 percent of EBT) The tax code is determined by Congress, and so is subject to frequent changes The tax code is extremely complex. But taxes are so important that firms cannot ignore it

16. Tax Code Example The U.S. tax structure is progressive, meaning that the larger the income, the higher the tax rate

17. Average and Marginal Tax Rate Average tax rate: Marginal tax rate - the amount of taxes must pay on the next $1 in income Marginal tax rate is the most relevant rate for financial decision making.

18. Example • Indian Point Kennels earned $16.5 million in taxable income in 2007. Their tax liability can be determined as: Tax liability = Tax on base amount + tax rate (amount over base) Tax liability = $5,150,000 + .38($16,500,000 - $15,000,000) Tax liability = $5,720,000 The average tax rate = $5,720,000/$16,500,000 = 34.67% • The marginal tax rate is 38 percent

19. Interest and Dividend Received • Interest that corporations receive is taxable • Exception: interest on state and local government bonds is exempt from federal taxes • When corporations own stock in another corporation they may receive dividend income. • The tax code exempts 70 percent of this income from taxation. Only the remaining 30 percent is taxed. • This reduces the effect of triple taxation

20. Interest and Dividend Paid • Interest and Dividends Paid by the Corporation • Interest payments appear on the income statement and are deducted from income before calculating taxable income • Dividends, on the other hand, are paid with after-tax income and so are not tax deductible • This tax deductibility of interest makes debt a much cheaper form of financing than equity

21. Statement of Cash Flows The statement of cash flows shows the firm’s cash flows over a period of time. It includes only inflows and outflows of cash and marketable securities. It excludes transactions that do not directly affect cash receipts and payments, such as depreciation and write-offs on bad debts. The bottom line of the statement reflects the difference between cash sources and uses and equals the change in cash on the firm’s balance sheet

22. Sources and Uses of Cash Some activities increase cash, and some activities decrease cash. Sources of cash involve increasing liabilities (or equity) and decreasing assets. Uses of cash involve decreasing liabilities (or equity) and increasing assets. The statement of cash flows is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities.

23. Cash Flows from Operations • Cash flows from operations, represents items directly associated with producing and selling the firm’s products. • Net income • Depreciation • Working capital accounts other than cash and short-term debt • A stable, positive CFs from operations represent a financially healthy and successful firm.

24. Cash Flows from Investing Activities Cash flows associated with buying or selling fixed or other long-term assets This section of the statement of cash flows reflects the firm’s investment in fixed assets (NOT in financial assets)

25. Cash Flows from Financing Activities • Cash flows from debt and equity financing transactions • Issuing short- or long-term debt • Issuing stock (IPOs or SEOs) • Using cash to pay dividends • Using cash to pay off debt • Using cash to buy back stock

26. Cash Flows • The bottom line of the statement of cash flows shows the total of cash flows from operation, investing, and financing activities • To maintain cash flows over time, a firm must continuously replace working capital and depreciating fixed assets, and develop new products • Free cash flows (FCF) are the cash flows available to pay the firm’s stockholders and debt holders.

27. Free Cash Flow FCF = OCF - IOC = Operating Cash Flow – Investment in Operating Capital Operating cash flow (OCF) OCF = EBIT – Taxes + Depreciation Investment in operating capital (IOC) IOC = ∆Gross fixed assets + ∆Net operating working capital FCF = (EBIT – Taxes + Depreciation) – (∆Gross fixed assets + ∆Net operating working capital)

28. A positive Free Cash Flow means that the firm has funds that can be distributed to investors • A negative FCF might mean several things: • If FCF is negative due to negative OCF it may indicate that the firm is experiencing operating or managerial problems • FCF might be negative because the firm is investing heavily in operating capital to support growth • In this case FCF might be negative while OCF is positive

29. Statement of Retained Earnings • Provides additional detail about the change in retained earnings during a reporting period • Reconciles net income and dividends paid with changes in retained earnings from one period to the next: Beginning retained earnings + net income for period - cash dividends paid = Ending retained earnings

30. Cautions in Interpreting Financial Statements • While firms must follow GAAP in preparing their financial statements, firms have considerable latitude in using accounting rules • Firms can “smooth” earnings, for example for new managers to show growth • Different depreciation methods • These strategies are called earnings management • Sarbanes Oxley Act of 2002 was passed in an effort to prevent deceptive accounting and management practices brought to light in high-profile scandals such as Enron and WorldCom