Cash Flows Financial Statements

							              AD 311 Business Finance
                    Attila Odabasi
             Lec 2: Financial Statements,
               Taxes, and Cash Flows




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             Main Points
 Know the difference between book value
  and market value
 Know the difference between accounting
  income and cash flow
 Know the difference between average and
  marginal tax rates
 Know how to determine a firm’s cash flow
  from its financial statements
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             Chapter Outline
 The Balance Sheet
 The Income Statement
 Taxes
 Cash Flow



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    Financial Statements and Cash Flows

 Much of the information about businesses comes in the
    form of standard financial statements published in annual
    and quarterly reports.
   They are prepared according to rules established by the
    accounting profession, and it is therefore important to
    understand what those rules are.
   Financial analysts sometimes disagree with how
    accountants measure certain key financial variables.
   Most fundamental disagreement is about how to measure
    the values of assets and liabilities.

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  Functions of Financial Statements
 They provide
      info to the owners and creditors (O&Cs) of the
       firm about the company’s current status and
       past financial performance.
      A convenient way for O&Cs to set
       performance targets and to impose
       restrictions on the managers of the firm.
      Convenient templates for financial planning.

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                  Balance Sheet
 A firm’s balance sheet shows its assets (what it
  owns) and its liabilities (what it owes) at a point
  in time
 Assets are listed in order of liquidity
      Liquidity means:
      Ease of conversion to cash
      Without significant loss of value
   The values of assets and liabilities are
    measured at historical acquisiton costs in
    accordance with GAAP.

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The Balance Sheet - Figure 2.1




                                 2-7
    Net Working Capital and Liquidity
 Net Working Capital
    Current Assets – Current Liabilities
    Positive when the cash that will be received over the
     next 12 months exceeds the cash that will be paid out
    Usually positive in a healthy firm
 Liquidity
    Positive NWC firms are assumed to be liquid.
    Liquid firms are less likely to experience financial
     distress
    But, liquid assets earn a lower return
    Try to find balance between liquid and illiquid assets

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                      B/S (in mio’s)
               2006   2007   Diff                     2006     2007      Diff

Cash & S-T     100    120     20 AP                    60,0     72,0    12,0
Inv
AR              50     60     10 S-T Debt              90,0    184,6    94,6
Inventories    150    180     30 Total CL             150,0    256,6   106,6

 Total CA      300    360     60 L-T Debt             150,0    150,0     0,0
                                 (@12%)
PP&E           400    490     90 Stockholder          300,0    313,4    13,4
                                 Eq.
Accum. Depr    100    130     30 Paid-in Capital      200,0    200,0     0,0

Net PP&E       300    360     60 Retained Earn.       100,0    113,4    13,4

Total Assets   600    720    120 Total Liabilities    600,0    720,0
                                    Price per share           2,72
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             Market Vs. Book Value
 The balance sheet provides the book
  value of the assets, liabilities and equity.
 Market value is the price at which the
  assets, liabilities or equity can actually be
  bought or sold.
 Market value and book value are often
  very different. Why?
 Which is more important to the decision-
  making process?
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             Example: MV vs BV

                 Balance Sheets 2007
             Market Value versus Book Value
             Book Market           Book       Market
             Assets              Liabilities and
                              Shareholders’ Equity
     NWC      $ 103,4 $ 103,4 LTD      $150    $ 150
     NFA         360   590,6 SE        313,4     544
               463,4   694,0           463,4   694,0
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     Market Value vs Book Value
 Shareholders are the ones that benefit from increases in
   the market value of a firm’s assets. They are also the
   ones that bear the losses of a decrease in market value.
   Consequently, managers need to consider the impact of
   their decisions on the market value of assets, not on
   their book value.

 Suppose that the MV of assets declined to $500 (a
   change of -90,6$) and the market value of liabilities
   remained unchanged. What would happen to the market
   value of equity? It would decrease to 544 – 90,6 =
   453,4.

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     Market Value vs Book Value
 MV/BV = 544 / 313,4 = 1,73 (before)
 MV/BV = 453,4 / 313,4 = 1,45 (after)
 The market-to-book ratio, which compares the
   market value of equity to the book value of
   equity, is often used by analysts as a measure of
   valuation for a stock. It is generally a bad sign if
   a company’s market-to-book ratio approaches
   1.00 (meaning market value = book value).

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             Income Statement
 Summarizes the profitability of the firm over a
  period of time (a year?).
 Income, profit, and earnings all mean the same
  thing – the difference between revenues and
  expenses.
 You generally report revenues first and then
  deduct any expenses for the period.
 Matching principle – GAAP say to show revenue
  when it accrues and match the expenses
  required to generate the revenue
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             The Income Statement
   Shows the financial performance of a firm over a year
   Structure:
      Net Sales
      - Operating Costs
      = EBITDA
      - Depreciation
      = EBIT (Operating Income)
      - Interest payments
      = EBT
      - Taxes
      -Dividend to preferred stocks (if any)
      =NI (Net income, profit, earnings)
   EPS = NI / Number of shares outstanding

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     Basitleştirilmiş Gelir Tablosu
   Satışlar (brüt)
   -Satış iade ve indirimleri
   =Net Satışlar
   - Satılan Malın Maliyeti (amortisman hariç)
   = Brüt satış karı/zararı
   - Satış giderleri
   - Yönetim giderleri
   - Ar-Ge giderleri
   = EBITDA
   - Amortisman gideri
   = Faiz Vergi Öncesi Kar (FVÖK) : EBIT, Faaliyet Geliri
   - Faiz
   + Diğer Gelirler
   - Diğer Giderler
   = Vergi öncesi kar (VÖK) : EBT, Bilanço Kar/Zararı
   - Ödenecek Vergi ve Fonlar
   = Dönem Net KArı/Zararı


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   Income Statement for 2007 (in mio’s)
Sales Revenue                      200,0
Cost of Goods sold                 (80,0)
Gen., selling & admin              (30,0)
Depreciation                       (30,0)
Operating Income - EBIT             60,0
Interest Expense (12%)             (18,0) On L.T. Debt
Taxable Income - EBT                42,0
Income tax                         (14,7)
Net Income                          27,3
Earning per share         27,3/200= 0,136
Allocation of NI
Dividends                           13,9
Change in RE                        13,4
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   How to Calculate the Income Tax
              in USA?
Corp. Taxable Income     Tax
  At Least     But <     Rate            Tax Calculation
$          0 $  50,000   15%                .15x(Inc > 0)
      50,000    75,000   25%    $ 7,500 + .25x(Inc > 50,000)
      75,000   100,000   34%       13,750 + .34x(Inc > 75,000)
    100,000    335,000   39%       22,250 + .39x(Inc > 100,000)
    335,000 10,000,000   34%      113,900 + .34x(Inc > 335,000)
10,000,000 15,000,000    35%    3,400,000 + .35x(Inc > 10,000,000)
15,000,000 18,333,333    38%    5,150,000 + .38x(Inc > 15,000,000)
18,333,333               35%    6,416,667 + .35x(Inc > 18,333,333)
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 The income tax in the example:
 What is the firm’s tax liability?
 What is the average tax rate?
 What is the marginal tax rate?
 Taxable inc.= 42m, tax?
 For the first 18,33m:5,15+0,38(3,33) = 6,42m
 For the rest: (42 – 18,33)x 0,35 = 8,28m
 Tax liability =                       14,70m tax
 Average tax rate = 14,7 / 42 = 0,35
 Marginal tax rate = 0,35

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             Free Cash Flow Concept
 Cash flow: we simply mean the difference
  between the number of dollars that came in and
  the number that went out.
 Firms generate cash flows by operating their
  assets and the cash generated is spent on:
      Expenses (current period)
      Assets that will be expensed in the future
 Surplus funds or free cash flows belong to firm’s
   owners or creditors. Companies do not have
   money themselves!
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             Cash Flow From Assets
 Cash Flow From Assets =
     Operating Cash Flow
     – Net Capital Spending
     – Changes in NWC
 Cash Flow From Assets (CFFA) =
     Cash Flow to Creditors
     + Cash Flow to Stockholders
 This is called cash flow identity.
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          FCF – S.T. Debt Part of Operations
After Tax Cash Flow from Operations                      $75,3
Operating Income, EBIT                            60,0
+ Depreciaiton                                   +30,0
- Tax                                            -14,7


-Investments in net operating working capital            +$46.6
Ending Net Working Capital                      +103.4
-Beginning NWC                                  -150.0

-Investments in fixed and other assets                   -$90,0
Ending Net Fixed Assets                         +360,0
- Beginning Netixed Assets                      -300,0
+ Depreciation                                   +30,0
=Free Cash Flow to Firm                                  +31.9
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      Free Cash Flow - Financing
Cash Flow to/from Creditors              +$18.0
Interest payments to creditors    +18
- Net new borrowing                0.0


Cash Flow to Shareholders                +$13,9


Dividends paid to stockholders   +13,9
- Net new equity raised            0,0
=   Financing Free Cash Flows            $+31.9

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 Following slides are optional for this
   lecture.




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             Statement of Cash Flows
 Statement that shows all of the cash that
  flowed into and out of the firm during a
  period of time. Differs from the income
  statement, which shows the firm’s
  revenues and expenses.
 It focuses attention on what is happening
  to the firm’s cash position over time.
 It is not influenced by accrual accounting
  decisions.
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              Sources and Uses
 Activities that bring in cash are called sources of
  cash.
 Sources:
    Cash inflow – occurs when we “sell” something
    Decrease in asset account
    Increase in liability or equity account
 Activities that involve spending cash are called
  uses (or applications) of cash.
 Uses:
    Cash outflow – occurs when we “buy” something
    Increase in asset account
    Decrease in liability or equity account
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Organization of the Statement of Cash Flow

 Organizes cash flows into three sections:
 Operating Activity – includes net income and
   changes in most current accounts
     +Net Income
     +Depreciation
     +Decrease in C/A accounts (except cash)
     +Increase in C/L accounts (except Notes payable)
     - Increase in C/A accounts (except Cash)
     - Decrease in C/L accounts (except Notes payable)

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                            Contn’d
 Investment Activity – includes changes in fixed assets
     +Ending net fixed assets
     -Beginning net fixed assets
     +Depreciation

 Financing Activity – includes changes in notes payable,
   long-term debt and equity accounts as well as dividends

     +/- Change in Notes payable
     +/- Change in Long term debt
     +/- Change in Common stock
     - Dividends


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      Cash Flow Statement for 2003
Cash Flow from Operating Activities           $29,3
Net Income                            +27,3
+ Depreciaiton                        +30,0
- Increase in AR                      -10,0
- Increase in inventories             -30,0
+ Increase in AP                      +12,0

Cash Flow from Investing Activities           -$90
- Investment in plant and equipment   -90,0

Cash Flow from Financing Activities           +80,7
+ Increase in S-T Debt                +94,6
- Dividends paid                      -13,9
Net cash flow                                 $20
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