Financial Statement, Cash Flow and Financial Forecasting

Chapter 2

Chapter 2 Learning Goals

LG1: Recall the major financial statements that firms must prepare and provide to the public LG2: Differentiate between book (or accounting) value and market value LG3: Explain how taxes influence corporate managers and investors decisions

LG4: Differentiate between accounting income and cash flows

LG5: Demonstrate how to use a firm's financial statement to calculate its cash flows LG6: Observe cautions that should be taken when examining external financial statements

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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 firms financial position. ACT3211 FINANCIAL
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 While accountants focus on reporting what happened in the past, financial managers use financial statements to draw inferences about the future Firms must follow Generally Accepted Accounting Principles (GAAP) when creating these statements, but they still have substantial discretion
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Balance Sheet (Statement of Financial Position)

The balance sheet reports a firms assets, liabilities, 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
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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
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Liabilities
Lenders provide funds, which become liabilities to the firm. Current liabilities
Obligations due within a 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
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Equity
The difference between total assets and total liabilities is the stockholders (or owners) equity. Types of Equity
Preferred Stock
Appears as the cash proceeds when the firm sells preferred stock

Common Stock and Paid-in-Surplus

Also appear as cash proceeds when common stock is issued

Retained Earnings
When managers reinvest earnings rather than pay them out as dividends, these will be recorded as retained earnings. The retained earnings account on the balance sheet represents the cumulative amount ACT3211 FINANCIAL retained over the years. MANAGEMENT

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Managing the Statement of Financial Position

Managers must monitor a number of issues related to the firms balance sheet, including:
The accounting method used for fixed asset depreciation The level of net working capital The liquidity position of the firm Whether to finance the firms assets with equity or debt The difference between the book value reported on the balance sheet versus the true market value of the firm ACT3211 FINANCIAL
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Accounting method for fixed asset depreciation

Managers can choose the accounting method they use to record depreciation against their fixed assets. For reporting purposes, companies often use the straight-line method of depreciation For tax purposes, firms often use accelerated depreciation such as MACRS Why use different methods?
The straight-line method results in lower depreciation expenses in the earlier years, resulting in higher income for reporting to shareholders MACRS results in higher depreciation expenses in earlier years, leading to lower income and thus lower taxes. A firm will often use multiple methods for calculating depreciation for the same assets

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Net Working Capital

Net Working Capital = Current assets minus current liabilities For DPH Tree Farms for 2007:
NWC = $190 - $110 NWC = $ 80 million

Firms monitor net working capital as a measure of the firms ability to pay its obligations
In general, a financially healthy firm has positive NWC ACT3211 FINANCIAL
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Liquidity
Liquidity refers to the ability to turn an asset into cash at its fair market value. Current assets are the most liquid assets
Cash, marketable securities, accounts receivable, and inventory Inventory is the least liquid of the current assets

Fixed assets are less liquid Liquidity has both good and bad aspects:
More liquidity means the firm can more easily pay its obligations and stave off financial distress, i.e. the firm is less risky However, liquid assets dont provide a very high return. Cash offers no return at all. Fixed assets are illiquid, but provide for generating revenue and profits Managers must consider the risk-return tradeoff ACT3211 FINANCIAL
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Debt vs. Equity Financing

Financial leverage refers to the extent to which a firm uses debt as a source of financing Just like a lever magnifies the ability to move objects, financial leverage magnifies a firms gains and losses
Debtholders have a fixed claim on the firms cash flows (they are paid interest on their securities) Stockholders have a claim on whatever cash flow is left. Since the obligation to debt holders is fixed, if the firm does well stockholders do very well. If the firm does poorly, stockholders get little or nothing. Yet, debt increases the financial risk to the firm. If the firm cant make the fixed payments to debtholders, the firm faces bankruptcy

Once again, managers face a tradeoff between risk and return as they decide the firms capital structure
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Book Value versus Market Value

A firms balance sheet shows book, or historical cost, value 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 work today In most cases, book values differ widely from market values for the same assets 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
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Income Statement (Statement of Comprehensive Income)

Income statements show the total revenues and expenses of a firm over a specific period of time The top line of the income statement shows the firms revenues The statement then shows all of the various expenses for the firm The bottom line, or net income, represents the difference between revenues and expenses ACT3211 FINANCIAL
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 The top part of the income statement represents the operating income portion of the income statement. This part of the statement is generated by operating the firm, and results in operating income or EBIT The bottom part of the income statement reflects how the firm is financed and taxed
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 Items reported below the bottom line include:

Earnings per share (EPS) net income total shares of common stock outstanding

Dividends per Share (DPS)

common stock dividends paid number of shares of common stock outstanding

common stockholders equity number of shares of common stock outstanding

Book value per share (BVPS)

Market value per share (MVPS) the market price of the firm's commonstock

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Statement of Cash Flows

The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial activity over a period of time. These two financial statements reflect the accrual basis of accounting required by GAAP to match revenues with the expenses associated with generating those revenues Actual cash inflows and outflows may occur at very different times than are reflected in these two financial statements. Also, the income statement contains several non-cash entries, notably depreciation Therefore, figures on an income statement do not reflect the actual cash flows of the firm. Financial managers and investors are much more interested in cash flows than accrual accounting income.

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 The statement of cash flows shows the firms 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 firms balance sheet
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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. ACT3211 FINANCIAL
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Cash Flows from Operations

The top portion of the statement of cash flows, cash flows from operations, represents items directly associated with producing and selling the firms products.
Net income Depreciation Working capital accounts other than cash and short-term debt

Many finance professionals consider this portion of the statement the most important.
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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 firms investment in fixed assets

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Cash Flows from Financing Activities

Cash flows from debt and equity financing transactions
Issuing short- or long-term debt Issuing stock Using cash to pay dividends Using cash to pay off debt Using cash to buy back stock

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 The bottom line of the statement of cash flows shows the total of cash flows from operation, investing, and financing activities This line reconciles to the net change in cash and marketable securities on the balance sheet over the period. In the DPH example, the income statement showed $90 million in net income, but -$1 million in cash flow
This is because net income is accounting-based income according to GAAP and does not necessarily reflect the flow of cash
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Free Cash Flow

To maintain cash flows over time, a firm must continuously replace working capital and depreciating fixed assets, and develop new products Investors are particularly interested in the cash flows available to pay the firms stockholders and debtholders
After adjustments for investments in working capital After adjustments for investments in fixed ACT3211 FINANCIAL assets MANAGEMENT

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FCF = Operating cash flow Investment in operating capital FCF = (EBIT Taxes + Depreciation) (Gross fixed assets + Net operating working capital)

Operating cash flow (OCF) Firms generate operating cash flow from operations after they have paid necessary taxes Investment in operating capital (IOC) Firms buy physical capital or earmark funds for eventual equipment replacement to sustain firm operations Includes the firms investment in fixed assets, current assets, and spontaneous current liabilities (i.e. accounts payable and accruals)

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Example 2-5

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 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 ACT3211 FINANCIAL
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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
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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 highprofile scandals such as Enron and WorldCom
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