FMGT 3550 – FDA

Financial Statements, taxes and cash flows – Chapter 2

 FMGT 3550 – FDA

The primary objective of the Corporation is to maximize shareholder wealth in the long run (i.e
maximize the value of the firm or maximize ).

What are the main financial statements and their purpose?

Who are the main users of financial statements?
How can we use financial statements to determine the value of a firm?
Why do we use Free Cash Flows and not earnings?
How do we define Free Cash Flows?

 Review Main Financial Statement: Balance Sheet and Income Statement

 Free Cash flows definition and calculation
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1. Financial statements – financial reporting and accounting standards

A company’s annual report contains, among others, the following:

 Management Discussion and Analysis (MD&A): comments regarding past performance, goals
and strategy, financial statements compliance with regulatory requirement such as accounting
standards.
 Financial Statements
Income statement Balance sheet
Statement of change in equity Statement of cash flows

Since 2011, Canadian publicly listed companies have to use International Financial Reporting
Standards (IFRS). Privately-held companies (private) can opt to use the Canadian Accounting Standard
for Private Enterprise (ASPE). Why would a privately-held company decide to use IFRS instead of
ASPE?
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2. Balance sheet – Statement of Financial Position (review)

The balance sheet shows the financial resources provided by investors at one moment in time (liabilities
and shareholders’ equity) and shows us how these resources have been invested (assets) at one moment
in time (fiscal year-end).

Balance sheet equation: Total assets = Total liabilities + shareholders’ equity

Debtholders have a priority claims over the firm’s cash flows and assets. Shareholders have a residual
claim.

Main issues with the balance sheet

 Assets are recorded at their historical cost.
 Some strategic assets are not reported, such as:
Q. In which order are the Q. In which order are the firm’s liabilities listed?
firm’s assets listed?
Q. Look at Retained Earning balance at the end of 2022. Can
the firm pay out $50m of dividend to its common
shareholders?
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3. Income Statement (review)

The income statement measures the firm performance over a given period of time (fiscal year).

Income statement equation: Revenues – expenses – taxes = Net Income

Net Income – Dividend paid to preferred shareholders = Net Income Available to Common
Shareholders (NIATCS)

Part of the NIATCS can be retained, part of the NIATCS can be distributed to common shareholders
as cash dividend (distribution and dividend policy).

If the firm has issued preferred shares, preferred dividend must be paid before any common share
dividend payments. If a firm passes on the preferred dividend payment it cannot pay a dividend to its
common shareholders.

A firm has no obligation to pay dividend unless the dividend has already been declared by the firm’s
Board of Directors (“Dividends payable”).
 Remember: depreciation is a
non cash expense

Remember: interest payments

are expensed and therefore
tax deductible.
Remember: preferred
dividends (if any) are paid
before common dividends
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Financial analysts consider the net income as a poor measure of a firm financial performance. The
followings are preferred:

Earnings Before Interest Taxes Depreciation and Amortization (EBITDA)

. not affected by non-cash expenses, such as: depreciation
. not affected by the firm’s capital structure (mix of debt and equity used to finance the firm’s assets)
EBITDA = Sales – Cash operating costs

Net Cash Flow = Net Income + Noncash expense – Noncash revenues

Noncash expense equals mainly depreciation and amortization.

Free Cash Flow

Economic value created by the firm during a certain period (usually one year), that is available
for
distribution to investors (shareholders and debtholders). See section 7.
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4. Other Comprehensive Income (OCI) – IFRS only – Not exam material
Records potential gain/losses on investments (financial investments, derivatives) and foreign exchanges
instruments.

5. Statement of Changes in Equity

Records changes in the firm’s shareholders’ equity during a given period (fiscal year):
. Addition to retained earnings
. New stock issues (increase common stock) or stock repurchases
. Dividend payments …
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6. Statement of Cash flows

The Statement of Cash Flows presents the firm’s sources and uses of cash during a given period per type
of activity: Operating activities, Investing activities, Financing activities

 Shows the increase or decrease in cash for the period

 Cash balance at the beginning of the year +/- cash change = Cash at the year end.
FMGT 3550 – FDA
Q. Which of these CFs is
the most important one in
the long run?
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7. Free Cash Flow
Free cash flows (FCF) are the cash flows available for distribution to all the company’s investors after
the company has made all investments necessary to maintain ongoing operations.
(1) FCF = NOPAT – Net investment in Total Net Operating Capital (TNOC)

(2) NOPAT = Net Operating Profit After Taxes = EBIT x (1 – T), with T = tax rate

(3) Net Investment in Total Net Operating Capital

= Investment in NOWC + Investment in net operating long term assets

(4) NOWC = Net Operating Working Capital = Operating current assets – Operating current liabilities

 A/R, inventory, A/P, accruals and some cash are necessary to operate a firm.
 Extra cash or short-term securities are not included in the NOWC calculation
 Short-term bank loan is not a direct result of operations: bank notes payable are not included in NOWC

Investment in NOWC during Year n = NOWC (Year n) – NOWC (Year n-1)

Investment in net operating long term assets (OLTA) during Year n = OLTA (Year n) – OLTA (Year n-1)
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Example: Using the information provided hereafter, calculate Carioca Inc. FCF for 2022.

Carioca Inc.
Income statement - partial - in millions $ - For year ended December 31 st,
2022 2021
Net sales 3,980 3,705
COGS (except depreciation) 2,730 2,600
Depreciation and 130 117
amortization
Other operating expenses 651 646
EBIT (Operating income) 469 342
Less interest expense 114 78
Earnings before tax (EBT) 355 264
Taxes (30%) 106.5 79
Net Income 248.5 185
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Example: Using the information provided hereafter, calculate Carioca Inc. FCF for 2022.
Carioca Inc.
Balance Sheet - partial - in millions $ - As at December 31 st,
2022 2021 2022 2021
Cash & equivalent 13 19 Accounts payable 78 39
Short term investments 1 83 Notes payable 153 78
Accounts receivable 488 410 Accruals 192 169
Inventories 673 540 Total current liabilities 423 286
Total Current assets 1,175 1,052 Long term bonds 780 754

Net PPE 1,220 1,130 Total Liabilities 1,203 1,040

Total Assets Common stocks 221 221

Retained earnings 971 921
Total shareholders’ equity (SE) 1,192 1,142
2,395 2,182 Total Liabilities and SE 2,395 2,182
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NOPAT = EBIT(2022) x ( 1 – T)
NOPAT (2022) =

NOWC = Operating Current Assets – Operating Current Liabilities

NOWC (2022) =

NOWC (2021) =

ΔNOWC = Investment in NOWC during year 2022 =

ΔOLTA = Investment in Operating LT assets in 2022 =

Net investment in total net operating capital (TNOC) in 2022=

FCF (2022) = NOPAT(2022) – Net Investment in TNOC = = $95.30 million

RETURN on INVESTED CAPITAL (ROIC) = NOPAT/TNOC =

Total Net Operating Capital (TNOC) for 2022 = NOWC + Operating LT assets
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A positive FCF can be used for:

. After tax interest payments

. Loans’ repayments

. Dividends’ payment

. Stocks repurchase

. Purchase of short-term investment (STI) or non-operating assets

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FCF allocation Application to Carioca Inc.
. After tax interest have to be paid
-

. Net loans repayment or net new loans +

Or
-
. Dividends paid
-

. New stocks issued or repurchased +

Or
-
. Change in STI (non-operating assets) +
Or
-