CHAPTER 2 Financial Statements Cash Flow and Taxes

CHAPTER 2 Financial Statements, Cash Flow, and Taxes n n n Balance sheet Income statement Statement of cash flows Accounting income vs. cash flow MVA and EVA Federal tax system 2 -1

The Annual Report n n Balance sheet – provides a snapshot of a firm’s financial position at one point in time. Income statement – summarizes a firm’s revenues and expenses over a given period of time. Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends. Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time. 2 -2

Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets 2002 7, 282 632, 160 1, 287, 360 1, 926, 802 1, 202, 950 263, 160 939, 790 2, 866, 592 2001 57, 600 351, 200 715, 200 1, 124, 000 491, 000 146, 200 344, 800 1, 468, 800 2 -3

Balance sheet: Liabilities and Equity 2002 Accts payable 524, 160 Notes payable 636, 808 Accruals 489, 600 Total CL 1, 650, 568 Long-term debt 723, 432 Common stock 460, 000 Retained earnings 32, 592 Total Equity 492, 592 Total L & E 2, 866, 592 2001 145, 600 200, 000 136, 000 481, 600 323, 432 460, 000 203, 768 663, 768 1, 468, 800 2 -4

Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2002 6, 034, 000 5, 528, 000 519, 988 (13, 988) 116, 960 (130, 948) 136, 012 (266, 960) (106, 784) (160, 176) 2001 3, 432, 000 2, 864, 000 358, 672 209, 328 18, 900 190, 428 43, 828 146, 600 58, 640 87, 960 2 -5

Other data No. of shares EPS DPS Stock price Lease pmts 2002 100, 000 -$1. 602 $0. 11 $2. 25 $40, 000 2001 100, 000 $0. 88 $0. 22 $8. 50 $40, 000 2 -6

Statement of Retained Earnings (2002) Balance of retained $203, 768 earnings, 12/31/01 Add: Net income, 2002 (160, 176) (11, 000) Less: Dividends paid Balance of retained $32, 592 earnings, 12/31/02 2 -7

Statement of Cash Flows (2002) OPERATING ACTIVITIES Net income Add (Sources of cash): Depreciation Increase in A/P Increase in accruals Subtract (Uses of cash): Increase in A/R Increase in inventories Net cash provided by ops. (160, 176) 116, 960 378, 560 353, 600 (280, 960) (572, 160) (164, 176) 2 -8

Statement of Cash Flows (2002) L-T INVESTING ACTIVITIES Investment in fixed assets (711, 950) FINANCING ACTIVITIES Increase in notes payable Increase in long-term debt Payment of cash dividend Net cash from financing 436, 808 400, 000 (11, 000) 825, 808 NET CHANGE IN CASH (50, 318) Plus: Cash at beginning of year Cash at end of year 57, 600 7, 282 2 -9

What can you conclude about D’Leon’s financial condition from its statement of CFs? n n n Net cash from operations = -$164, 176, mainly because of negative NI. The firm borrowed $825, 808 to meet its cash requirements. Even after borrowing, the cash account fell by $50, 318. 2 -10

Did the expansion create additional net operating after taxes (NOPAT)? NOPAT = EBIT (1 – Tax rate) NOPAT 02 = -$130, 948(1 – 0. 4) = -$130, 948(0. 6) = -$78, 569 NOPAT 01 = $114, 257 2 -11

What effect did the expansion have on net operating working capital? NOWC = Current - Non-interest assets bearing CL NOWC 02 = ($7, 282 + $632, 160 + $1, 287, 360) – ( $524, 160 + $489, 600) = $913, 042 NOWC 01 = $842, 400 2 -12

What effect did the expansion have on operating capital? Operating capital = NOWC + Net Fixed Assets Operating Capital 02 = $913, 042 + $939, 790 = $1, 852, 832 Operating Capital 01 = $1, 187, 200 2 -13

What is your assessment of the expansion’s effect on operations? Sales NOPAT NOWC Operating capital Net Income 2002 $6, 034, 000 -$78, 569 $913, 042 $1, 852, 832 -$160, 176 2001 $3, 432, 000 $114, 257 $842, 400 $1, 187, 200 $87, 960 2 -14

What effect did the expansion have on net cash flow and operating cash flow? NCF 02 = NI + Dep = ($160, 176) + $116, 960 = -$43, 216 NCF 01 = $87, 960 + $18, 900 = $106, 860 OCF 02 = NOPAT + Dep = ($78, 569) + $116, 960 = $38, 391 OCF 01 = $114, 257 + $18, 900 = $133, 157 2 -15

What was the free cash flow (FCF) for 2002? FCF = OCF – Gross capital investment - OR FCF 02 = NOPAT – Net capital investment = -$78, 569 – ($1, 852, 832 - $1, 187, 200) = -$744, 201 Is negative free cash flow always a bad sign? 2 -16

Economic Value Added (EVA) EVA = After-tax __ After-tax Operating Income Capital costs = Funds Available __ Cost of to Investors Capital Used = NOPAT – After-tax Cost of Capital 2 -17

EVA Concepts n n 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 takes into account the total cost of capital, which includes the cost of equity. 2 -18

What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2000 and 13% in 2001. EVA 02 = = NOPAT – (A-T cost of capital) (Capital) -$78, 569 – (0. 13)($1, 852, 832) -$78, 569 - $240, 868 -$319, 437 EVA 01 = $114, 257 – (0. 10)($1, 187, 200) = $114, 257 - $118, 720 = -$4, 463 2 -19

Did the expansion increase or decrease MVA? MVA = Market value __ Equity capital of equity supplied During the last year, the stock price has decreased 73%. As a consequence, the market value of equity has declined, and therefore MVA has declined, as well. 2 -20

Does D’Leon pay its suppliers on time? n n n Probably not. A/P increased 260%, over the past year, while sales increased by only 76%. If this continues, suppliers may cut off D’Leon’s trade credit. 2 -21

Does it appear that D’Leon’s sales price exceeds its cost per unit sold? n NO, the negative NOPAT and decline in cash position shows that D’Leon is spending more on its operations than it is taking in. 2 -22

What if D’Leon’s sales manager decided to offer 60 -day credit terms to customers, rather than 30 -day credit terms? n n If competitors match terms, and sales remain constant … n A/R would é n Cash would ê If competitors don’t match, and sales double … n Short-run: Inventory and fixed assets éto meet increased sales. A/R é, Cash ê. Company may have to seek additional financing. n Long-run: Collections increase and the company’s cash position would improve. 2 -23

How did D’Leon finance its expansion? n n D’Leon financed its expansion with external capital. D’Leon issued long-term debt which reduced its financial strength and flexibility. 2 -24

Would D’Leon have required external capital if they had broken even in 2001 (Net Income = 0)? n YES, the company would still have to finance its increase in assets. Looking to the Statement of Cash Flows, we see that the firm made an investment of $711, 950 in net fixed assets. Therefore, they would have needed to raise additional funds. 2 -25

What happens if D’Leon depreciates fixed assets over 7 years (as opposed to the current 10 years)? n n n No effect on physical assets. Fixed assets on the balance sheet would decline. Net income would decline. Tax payments would decline. Cash position would improve. 2 -26

Federal Income Tax System 2 -27

Corporate and Personal Taxes n n n Both have a progressive structure (the higher the income, the higher the marginal tax rate). Corporations n Rates begin at 15% and rise to 35% for corporations with income over $10 million. n Also subject to state tax (around 5%). Individuals n Rates begin at 10% and rise to 38. 6% for individuals with income over $307, 050. n May be subject to state tax. 2 -28

Tax treatment of various uses and sources of funds n n Interest paid – tax deductible for corporations (paid out of pre-tax income), but usually not for individuals (interest on home loans being the exception). Interest earned – usually fully taxable (an exception being interest from a (muni”). Dividends paid – paid out of after-tax income. Dividends received – taxed as ordinary income for individuals (“double taxation”). A portion of dividends received by corporations is tax excludable, in order to avoid “triple taxation”. 2 -29

More tax issues n n Tax Loss Carry-Back and Carry-Forward – since corporate incomes can fluctuate widely, the tax code allows firms to carry losses back to offset profits in previous years or forward to offset profits in the future. Capital gains – defined as the profits from the sale of assets not normally transacted in the normal course of business, capital gains for individuals are generally taxed as ordinary income if held for less than a year, and at the capital gains rate if held for more than a year. Corporations face somewhat different rules. 2 -30