Financial Statements and Cash Flows RWJChapter 2 Understanding

+ Financial Statements and Cash Flows RWJ-Chapter 2

+ Understanding Financial Statements n The crux of investments is to value firms (or stocks) n Various models to value common stocks n DCF n Multiples n No matter which model we are going to use, the key inputs we needed are mostly based on a firm’s financial statements n We will learn the basic tools to analyze financial statements

+ Information for Financial Statements Analysis n 1) Published annual reports n n (1) Financial Statements n Balance Sheet (B/S) n Income Statement (I/S) n Statement of Cash Flows n (2) Notes to financial statements n (3) Letters to stockholders n (4) Auditor’s report (independent accountants) n (5) Management’s discussion and analysis 2) Reports filed with the government

+ Sources of Information n Annual reports n SEC n EDGAR (http: //www. sec. gov/edgar. shtml) n 10 K & 10 Q reports

+ Balance Sheet n Balance sheet summarizes the assets owned by a firm n The value of the assets, and the mix (debt and equity) used to finance these assets at a point in time Assets Fixed Assets Current Assets Financial Investments Intangible Assets Total Assets Liabilities & Equity Current Liabilities Debt (Long-term) Equity Stockholder’s Equity Total Liabilities & Equity

+ Summary of B/S n An accountant’s snapshot of the firm’s accounting value as of a particular date. n The Balance Sheet Identity is: Assets ≡ Liabilities + Stockholder’s Equity n Stockholder’s equity is defined to be the difference between the assets and the liabilities of the firm. Equity is what stockholders would have remaining after the firm discharged its operations. n Liabilities and equity-side reflects the types and proportions of financing, which depend on management’s choice of capital structure, as between debt and equity and current debt and long-term debt.

+ Assets n Fixed Assets: n Assets that are purchased for long-term use and are not likely to be converted quickly into cash, such as land, buildings, and equipment. n GAAP requires the valuation of historical cost, adjusted for any estimated loss in value from the aging of these assets (Depreciation) n Many firms in the U. S. use straight line depreciation, while Japanese and German firms often use accelerated depreciation n Straight line versus Accelerated Depreciation n Accelerated depreciation leads reported income that is understated.

+ Example- Straight Line n An asset costs $33, 000 has a residual value of $3, 000, and expected to last 4 years n (i) Calculate annual depreciation n (ii) what happen if you are able to sell this asset after two year at selling price of $20, 000? (Tax Rate=30%)

+ Example-Accelerated Depreciation n An asset costs $33, 000, and expected to last 5 years n (i) Calculate annual depreciation n (ii) what happen if you are able to sell this asset after two year at selling price of $20, 000? (Tax Rate=30%) Recover y year Applicable Percentage 1 0. 200 2 0. 320 3 0. 192 4 0. 1152 5 0. 1152 6 0. 0576

+ Assets n Current Assets: n n n Account Receivables: n It represents money owed by entities to the firm on the sale of products on credit Cash and Marketable Securities: n Cash: One of the few assets for which accountants and financial analysts should agree on the value n Marketable Securities: Investments made by firms in securities or assets of other firms, as well as T-bills or bonds Inventory n The total amount of goods and/or materials contained in a store or factory at any given time n Closely related to COGS n LIFO vs FIFO

+ Assets n Intangible Assets: n n Patents and Trademarks n Internal n External Goodwill n By product of acquisitions n When a firm acquires another firm, the purchase price is first allocated to tangible assets, and the excess price is then allocated to any intangible assets n Nothing but excess price by actual price (MV) and book value of the company

+ Liabilities and Equity n Current Liabilities: n Accounts payable: n n Short-term Borrowing: n n Short-term loans (due in less than a year) to finance the operations or current asset needs of the business Short-term portion of long-term borrowing n n It represents credit received from suppliers and other vendors It represents the portion of the long-term debt or bonds that is coming due in the next year Other short-term liabilities: n It includes wages due to its employees and taxes due to the government

+ Liabilities and Equity n Long-Term Debt: n n n Other Long-term Liabilities: n n Leases, Employee Benefits, Pension Plans, Health Care Benefits These are long-term obligations that are not captured in the long-term debt items In the past two decades accountants moved toward quantifying these liabilities and showing them as long-term liabilities Equity: n n Long-term loan from a bank or other financial institutions Long-term bond issued to financial markets It reflects the original proceeds received by the firm when issued the equity Retained Earnings: n Net Income kept for further investment

+ U. S. COMPOSITE CORPORATION Balance Sheet 2008 and 2009 (in $ millions) Assets Current assets: Cash and equivalents Accounts receivable Inventories 2008 $104 455 553 2009 $160 688 555 Liabilities (Debt) and Stockholder's Equity Current Liabilities: Accounts payable Notes payable Total current liabilities Total current assets $1, 112 $1, 403 Fixed assets: Net Property, plant, and equipment $1, 644 $1, 709 Long-term debt 2008 2009 $232 196 $266 123 $428 $389 408 454 600 640 1, 320 1, 629 Stockholder's equity: Common stock and paid in surplus Accumulated retained earnings Total assets Total equity $1, 920 $2, 269 $2, 756 $3, 112 Total liabilities and stockholder's equity $2, 756 $3, 112

+ Balance Sheet Analysis When analyzing a balance sheet, the financial manager should be aware of three concerns: n n (1) Liquidity n (2) Debt versus equity n (3) Value versus cost

+ Liquidity n Refers to the ease and quickness with which assets can be converted to cash. n Current assets are the most liquid. Fixed assets are the least liquid. n Some fixed assets are intangible. n The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations. n Liquid assets frequently have lower rates of return than fixed assets. For example, cash generates no or little investment income. n To the extent that a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investments.

+ Value versus Cost n Under GAAP audited financial statements of firms in the U. S. carry assets at cost. n Market value is a completely different concept. n Market value is the price at which willing buyers and sellers trade the assets. It would be only coincidence if accounting value (book value) and market value were the same. n Many users of financial statements want to know the value of the firm, not its cost. n In this class, whenever we mention value, we mean market value, not the cost (or book value). n When we say that the goal of a financial manager is to increase the value of the stock, we mean the market value of the stock.

+ Income Statement n The income statement measures performance over a specific period of time. n It provides information on the revenues and expenses of the firm, and resulting income made by the firm, during a period n The accounting definition of income is Revenue – Expenses ≡ Income

+ More Specifically Revenue Cost of Goods Sold (COGS) Gross Profit Operating Expense EBITDA Depreciation & Amortization EBIT (Operating Income) Interest Taxes Net Income (NI) or Earnings Retained Earnings (R/E) Dividends

+ U. S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) The operations section of the income statement reports the firm’s revenues and expenses from principal operations Net sales Cost of goods sold Depreciation $1, 509 - 750 - 65 Earnings before interest and taxes $694 Interest expense Taxable income Taxes (34%) - 70 $624 - 212 Net income Retained earnings: Dividends: $412 $309 $103

+ U. S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) Net sales Cost of goods sold Depreciation The non-operating section of the income statement includes all financing costs, such as interest expense. Earnings before interest and taxes $1, 509 - 750 - 65 $694 Interest expense Taxable income Taxes (34%) - 70 $624 - 212 Net income Retained earnings: Dividends: $412 $309 $103

+ U. S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) Net sales Cost of goods sold Depreciation Earnings before interest and taxes Usually a separate section reports as a separate item the amount of taxes levied on income $1, 509 - 750 - 65 $694 Interest expense Taxable income Taxes (34%) - 70 $624 - 212 Net income Retained earnings: Dividends: $412 $309 $103

+ U. S. COMPOSITE CORPORATION Income Statement 2009 (in $ millions) Net sales Cost of goods sold Depreciation Earnings before interest and taxes Net income is the “bottom line” $1, 509 - 750 - 65 $694 Interest expense Taxable income Taxes (34%) - 70 $624 - 212 Net income Retained earnings: Dividends: $412 $309 $103

+ Income Statement Analysis There are two things to keep in mind when analyzing an income statement: n n (1) GAAP n (2) Non Cash Items

+ Generally Accepted Accounting Principles n Recognition principle: Recognize revenue when the earnings process is complete and the value of an exchange of goods or services is known and can be reliably determined. Thus, income is reported when it is earned, even though no cash flow may have occurred. n Midland co. sells goods for $1 million. The goods cost $900, 000. So the company will have profit of $100, 000. n But the company has not yet collected the cash from the sale. So, the net cash flow is -$900, 000.

+ Non-Cash Items n Depreciation is the most apparent. No firm ever writes a check for “depreciation”. n In practice, the difference between cash flows and accounting income can be quite dramatic. n For example Conseco Corp. reported a net loss of $194 million for 2007. But it also reported a positive cash flow of $ 703 million for the same fiscal year!

+ Net Working Capital ≡ Current Assets – Current Liabilities n If the change in NWC is positive, it is a cash outflow. (you are investing more in NWC). If the change in NWC is negative, it is a cash inflow

+ U. S. COMPOSITE CORPORATION Balance Sheet 2008 and 2009 (in $ millions) $1014 m = $1403 - $389 Assets Current assets: Cash and equivalents Accounts receivable Inventories 2008 $104 455 553 2009 $160 688 555 Liabilities (Debt) and Stockholder's Equity Current Liabilities: Accounts payable Notes payable Total current liabilities Total current assets 2009 $232 196 $266 123 $428 $389 $1, 112 $1, 403 Fixed assets: Property, plant, and equipment $1, 423 $1, 274 Less accumulated depreciation -550 -460 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Total fixed assets $1, 118 $1, 035 $684 m = $1112 m- $428 m Total assets 2008 $1, 879 $1, 742 Long-term liabilities: Deferred taxes $117 $104 Here we see NWC grow to $1, 014 Long-term debt 471 458 Total long-term liabilities $588 $562 million in 2009 from $684 million in 2008. Stockholder's equity: Preferred stock $39 Common stock ($1 par value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock of $330 million -26 This increase is-20 an Total equity $805 $725 investment of the firm. Total liabilities and stockholder's equity $1, 879 $1, 742

+ Financial Cash Flows n In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm. n Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders. CF(A)≡ CF(B) + CF(S)

+ U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) (130) Capital spending (Ending net fixed assets minus beginning fixed assets plus dep. ) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt Equity Total $24 63 $87 Operating Cash Flow: EBIT Depreciation $694 $65 Current Taxes ($212) OCF $547

+ U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) (130) Capital spending (Ending net fixed assets minus beginning net fixed assets plus dep. ) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt Equity Total $24 63 $42 Capital Spending Ending net fixed assets $1, 709 Beginning net fixed assets (1644) Depreciation Net Capital Spending 65 $130

+ U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending $547 (130) Additions to net working capital Total (330) $87 Cash Flow of Investors in the Firm Debt $24 Equity 63 Total $87 NWC grew from $684 million in 2008 to $1014 million in 20 X 1. This increase of $330 million is the addition to NWC.

+ U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130) (Ending net fixed assets minus beginning net fixed assets plus dep. ) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt Equity Total $24 63 $87

+ U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending $547 (130 Additions to net working capital Total (330) $87 Cash Flow of Investors in the Firm Debt (Interest minus net new borrowing) $24 Equity 63 (Dividends minus net new equity raised) Total $87 Cash Flow to Creditors Interest paid $70 Net new borrowing (46) Total 24

+ U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending $547 (130) Additions to net working capital Total (330) $87 Cash Flow of Investors in the Firm Debt (Interest minus net new borrowing) $24 Equity 63 (Dividends minus net new equity raised) Total $87 Cash Flow to Stockholders Dividends $103 Net new equity raised (40) Total $63 Net new equity raised is the change in common stock and paid –in-surplus from B/S.

+ U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow $547 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (130) (Ending net fixed assets minus beginning net fixed assets plus dep. ) Additions to net working capital (330) Total $87 Cash Flow of Investors in the Firm Debt (Interest minus net new borrowing) $24 Equity 63 (Dividends minus net new equity raised) Total $87 The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:

+ Cash Flow Summary

+ Free Cash Flows n There are two types of Cash Flows: (1) This is the cash flows generated by a company’s operating activities and available to all who provided capital to the firm (Debt and Equity Holders) Current Assets –Current Liabilities

+ Free Cash Flows (2) “free” cash flows to equity (stock holders), which is derived from after operating free cash flows have been adjusted for debt payments (interest and principal) Current Assets –Current Liabilities

+ Question: n Which one to use?

+ Cash Flows Assets Cash outflow Cash inflow Liabilities Cash inflow Cash outflow

+ Limitations of Financial Ratios n n Accounting statements: Ø A reasonably good job of categorizing the assets owned by a firm Ø A partial job of assessing the value of these assets Ø A poor job of reporting uncertainty about asset value Accounting principles: Ø The accounting view of asset value is to a great extent grounded in the notion of historical cost, which is the original cost of the asset. Historical cost is the best estimate of the value of an asset. Ø Conservative approach to estimate the value. n At the end of 2011, book value of Google is $58. 1 billion n At the end of 2011, the market value of Google is $211. 04 billion (stock price= $645)

+ Limitations of Financial Ratios n These values are based on specific dates n Capture values of assets and liabilities on a specific date n Ratios using balance sheet may not reflect company’s situation during rest of the year n Example: A company that reports $1 million in cash on last day of fiscal year may have only $100 K two days later after paying salaries and suppliers