Finance 3310

Financial Statements & Cash Flow

Lecture 2

In finance the primary source of information about a company is usually the financial statements. Thus it is useful to review both the balance sheet and income statement, as well as some related concepts. In our picture of the corporation taxes represent a `drain' on corporate cash flows. Hence taxes are important. Finally, it is important to take the `accounting numbers' provided in the financial statements and convert them into `finance numbers,' which are cash flow.

T2.2

THE BALANCE SHEET

The balance sheet represents a `snapshot' of the corporation. It lists the assets and liabilities of a company as of a point in time. The balance sheet also conforms to our picture of the firm. That is, assets on the left-hand side are equal to liabilities and equity on the right-hand side. (See T2.8 for sample balance sheet.)

• Assets - are listed in order of liquidity. (Liquidity has to do with the ability to convert something to cash without significant loss of value.) Cash is listed first, followed by inventory and accounts receivable, and ending with fixed or long-term assets.

• Liabilities - are listed in order of claim priority. Accounts payable and accrued expenses are listed first, while equity is listed last.

A classification consistent with the above which is used by accountants is current and long-term. Current usually means occurring within one year, while long-term means longer than a year.

• Net working capital (NWC) -

NWC = Current Assets - Current Liabilities

It is useful in many instances involving analysis of a corporation to simply subtract current liabilities from both sides of the balance sheet. A simplified balance sheet results as follows:

Notice that this simple balance sheet conforms to our picture of the corporation. The circle, containing assets, is on the left. Total capital, debt and equity, are on the right.

• Debt - debt typically refers to long-term debt, or, depending on the context, to all interest bearing debt.

• Equity - equity actually consists of two accounts: stockholders equity (par value and paid-in-capital) and retained earnings. Retained earnings represents the cumulative earnings of the company since inception which have not been paid out as dividends. Retained earnings is not, in general, the same thing as money in the bank. These retained earnings may have been used for many things, only one of which is building a cash balance.

Differences in debt and equity: There are a couple of fundamental differences between debt and equity. 1) Debt has a prior claim on corporate cash flows; equity's claim is a residual claim. 2) Interest is deductible for tax purposes; dividends are not.

T2.3

Accrual Accounting vs. Cash Flow

Accrual accounting, which results from the matching principal, results in revenues and expenses being recorded in different periods than when the associated cash flows occur. A company may record an expense this year, but the cash outflow may not occur until next year. Both accounts receivable and accounts payable are a result of accrual accounting.

Market Value vs. Book Value

In general, the market value of either equity or assets is not the same as book value. Book value is based on the cost principle and reflects the cost of a transaction which has occurred or is reasonably certain to occur. Book value is an accounting number. Market value, on the other hand, represents the market's estimate of the value of assets or equity. Market value is forward looking; that is, market value reflects expectations about the future of the company. Market value and book value may differ because:

• book value does not reflect the value of reputation, brand names, customer loyalty

• book value does not reflect expected future growth

• book value does not reflect management talent

• book value does not reflect the fact the whole is greater than the sum of the parts.

The Income Statement

The income statement measures performance over some period of time. (See T2.9 for a sample income statement.) Below is a generic income statement:

Sales

Cost of sales

Gross profit

Operating expenses

Earnings before interest and taxes (EBIT)

Interest

Taxable income

Taxes

Net income

Note that net income is not the same as cash flow. The primary differences relate to accrued revenues and expenses, and to noncash expenses such as depreciation. Frequently, rather than using net income, companies will divide net income by the number of shares outstanding to arrive at earnings per share (EPS).

T2.4, T2.5

TAXES

As we discussed earlier, corporations must pay taxes. T2.4 indicates the current corporate tax rates in effect. These rates begin at 15% and rise ultimately to 35%. It is important to distinguish average tax rates from marginal tax rates. The average tax rate is simply total taxes divided by total taxable income. The marginal rate is the rate on an incremental dollar of taxable income. As an example, a company with $150,000 of taxable income would have a marginal rate of 39%. T2.5 provides an example of marginal and average tax rates. Marginal rates are used in most financial analysis.

T2.7 (examples: T2.6, T2.8-10)

CASH FLOW

We know from the accounting identity:

Assets = Debt + Equity (where assets = NWC + Fixed assets)

Therefore:

Cash Flows From Assets = Cash Flows to B/H + Cash Flows to S/H

Begin with cash flow from assets. Cash flow from assets consists of:

• Operating cash flows

• Additions to NWC

• Capital Spending

 

Operating cash flows consist of:

EBIT

+ Depreciation

- Taxes

 

Additions to NWC = Ending Net working capital - beginning net working capital.

Finally, Capital spending = ending gross fixed assets - beginning gross fixed assets.

Some financial statements will not list gross fixed assets and accumulated depreciation separately. Rather, only net fixed assets will be shown. Your text uses financial statements and examples where only net fixed assets are listed. In this case, capital spending is found by adding depreciation expense to the change in net fixed assets. That is,

Capital spending = Ending net fixed assets - beginning net fixed assets + depreciation

Cash flows to bondholders consists of interest and the change in debt balance.

Cash flow to B/H

• Interest
• Change in Debt

Note that the change in debt could be either positive or negative. Increases in debt represent cash flows from B/H's, while decreases in debt represent cash flows to B/H's. Cash flows from B/H's would be subtracted from interest in arriving at netcash flow to B/H's.

Cash flows to stockholders consists of dividends and any net new equity raised. Similar to debt, net new equity can be either positive or negative. If net new equity is positive, implying the firm has sold shares and raised cash, then the cash flow is from S/H's and would be subtracted from dividends in arriving at cash flow to S/H's.

Summarizing all of this:

Problems:

Chpt 1: 1, 3, 5 - 13. (consider 10 & 11)

Self-Test Problem 2.1

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