FINANCIAL STATEMENTS, CASH FLOW, AND TAXES

Financial Management

Financial Statements, Cash Flow and Taxes

Income statement Balance sheet Statement of cash flows Free cash flow MVA and EVA Corporate taxes Personal taxes

The Annual Report

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

How can Financial Statements be used to increase value or make money in Business
Use to evaluate investment opportunities 1. Internal - From within company
i.e.: investments in fixed assets to increase FCFs & value

2. External:
To make informed investment decisions into specific companies

Determinants of Intrinsic Value: Calculating FCF

Sales revenues Operating costs and taxes Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF ... + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

Weighted average cost of capital (WACC)

Market interest rates

Market risk aversion

Cost of debt Cost of equity

Firms debt/equity mix

Firms business risk
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Income Statement
Revenue (Sales)

-Costs (COGS)
-Operating exp - Deprec. exp =EBIT
Earnings b/4 interest & Taxes Earnings b/4 taxes Tax Expense Profit Op Income b/4 taxes Taxable Income

-Int. expense =EBT

-Taxes = Net Income NI / #shs c. stk

=EPS

Earning per share

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Statement of Retained Earnings

Beginning RE
+ NI -Divids Ending RE

Divids / #shs c. stk

=DPS

Balance Sheet
ASSETS= LIABILITIES Current Assets
Cash Accounts Receivable
Inventory Prepaids Marketable Securities

+ OWNERS EQUITY

Current Liabilities
Accounts Payable Accruals (other s/t payables) S/T Notes Payable Common Stock Addtl Paid-in-Cap Prfd. Stock Retained Earnings

Non-Current Assets Non-Current Liabilities

Property Plant Equipment -Accum Deprec
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N/P Mortgage Payable Bonds Payable

The Balance Sheet

Statement of Cash Flows

Is used to help answer questions such as:
Is the firm generating enough cash to purchase the additional assets required for growth? Is the firm generating any extra cash that can be used to repay debt or to invest in new products?

Such information is useful both for managers and investors

Sources of cash
Net income + depreciation Increase in long-term debt Increase in equity Increases in current liabilities Cash and cash equivalents

Uses of cash
Dividend payments Decrease in long-term debt

Decrease in equity

Increases in fixed assets

Decreases in fixed assets

Decreases in current assets other than cash

Increases in current assets other than cash

Statement of Cash Flows

Summarizes the changes in a companys cash position The statement separates activities into three categories, plus a summary section:
Operating activities Investment activities Financing activities

Operating activities
Includes:
net income, depreciation, changes in current assets and liabilities other than cash, short-term investments and short term debt

Investing activities
Includes:
investments in fixed assets or sales of fixed assets

Financing activities
Includes:
Raising cash by selling short-term investments or by issuing short-term debt Long term debt, or stock Also because both dividends paid and cash used to buy back outstanding stock or bonds reduce the companys cash, such transactions are included here

 We have to divide total assets in two categories

Modifying Accounting Data for Managerial Decisions

Operating assets which consist of the assets necessary to operate the business Non-operating assets which would include cash and short term investments above the level required for normal operations, land held for future use

Operating assets are further divided into

Operating current assets
Are the current assets that are used to support operations, such as cash, accounts receivable, inventory
They do not include short-term investments

Long-term operating assets

Such as plant and equipment
They do not include any long-term investments that pay interest or dividends

Operating Current Liabilities

Are the current liabilities that occur as a natural consequence of operations
Such as accounts payable and accruals They do not include notes payable or any other short-term debts that charge interest

Net operating working capital

Is the difference between operating current assets and operating current liabilities

NOWC= (Cash+Accounts receivable+Inventories)

(Accounts payable+Accruals)

What effect did the expansion have on net operating working capital?
NOWC = Current - Non-interest assets bearing CL

What effect did the expansion have on operating capital?

Operating capital = total net operating capital = net operating assets It is the total amount of capital needed to run the business

Operating capital = NOWC + Net Fixed Assets

Net Operating Profit After Tax(NOPAT)

NOPAT = EBIT (1 Tax rate)

It is the after-tax profit a company would have if it had no debt and no investments in nonoperating assets Because it excludes the effects of financing decisions, it is a better measure of operating performance than is net income

Free Cash Flow (to Firm)

Free cash flow (FCF) is the amount of cash flow remaining after a company makes the asset investments necessary to support operations FCF is the amount of cash flow available for distribution to investors

Free cash flows (to Firms)

FCF= cash available for distribution to investors. Greater the FCF, more attractive that company is to investors. Therefore, value of the firm is primarily dependent on its expected future free cash flows!

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What are the five uses of FCF?

1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

Calculating Free Cash Flow in 5 Easy Steps

Step 1 Step 2

Earning before interest and taxes X (1 Tax rate) Net operating profit after taxes

Operating current assets Operating current liabilities Net operating working capital
Step 3

Net operating working capital

Operating long-term assets Total net operating capital

Step 5 Step 4

Net operating profit after taxes Net investment in operating capital

Total net operating capital this year Total net operating capital last year Net investment in operating capital
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Free cash flow

Free Cash Flow (to Firm)

FCF = OCF Gross capital investment
FCF = (NOPAT + Dep) - Gross capital investment Gross investment in operating capital = Net investment + Depreciation - OR FCF = NOPAT Net investment in operating capital

Economic Value Added (EVA)

Is an estimate of the value created by management during the year It differs substantially from accounting profit because no charge for the use of equity capital is reflected in accounting profit

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

EVA
EVA = Net operating profit after taxes (NOPAT) - After-tax dollar cost of capital used to support operations EVA = EBIT (1 Tax rate) (Total Net Operating Capital)(WACC)

EVA Concepts
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.

Market Value Added (MVA)

MVA = Market value __ of equity Equity capital supplied by shareholders

= (Shares outstanding)(Stock price) Total common equity

What happens if a company depreciates fixed assets over 7 years (as opposed to the current 10 years)?
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.

Corporate and Personal Taxes

Both have a progressive structure (the higher the income, the higher the marginal tax rate). Corporations 30% + 3% cess Individuals Rates begin at 10% and rise to 30% + 3% cess

Tax treatment of various uses and sources of funds

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 tax free bond) Dividends paid paid out of after-tax income. Dividends received dividend distribution tax 15% + 5% + 3%

More tax issues

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.