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0. Introduction 1. Financial statements and cash flow
What is finance? • A quick review of balance sheet and income statement. Topics include:
– the balance sheet identity
– market value vs book value
– income statement vs cash flow
What are the two main branches of finance?
• We will also discuss the components of financial cash flows. The fundamental identies are:
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cash flow from assets = cash flow to creditors
+ cash flow to stockholders
cash flow from assets = operating cash flow
– net capital spending
– change in net working capital
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Balance sheet Balance sheet — example
• The balance sheet summarizes the financial position of a firm at a point in time.
U.S. Composite Corporation
Balance sheet
• Assets are on the left, liabilities on the right. Listed in order of decreasing liquidity. 2007 and 2006
($ in millions)
• What do we mean by liquidity?
Assets 2007 2006
— Current assets:
Cash and equivalents 140 107
Accounts receivable 294 270
Inventories 269 280
Other 58 50
Total current assets 761 707
Fixed assets:
Property, plant and equipment 1423 1274
Less accumulated depreciation (550) (460)
Net property, plant and equipment 873 814
Intangible assets and others 245 221
Total fixed assets 1118 1035
Total assets 1879 1742
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Balance sheet
Liabilities and • Current assets (or liabilities) are assets (or liabilities) with an expected time to conversion
Stockholder’s Equity 2007 2006
to cash of one year or less.
Current liabilities:
Accounts payable 213 197 • Accounts receivable are payments due from the firm’s customers.
Notes payable 50 53
Accrued expenses 223 205
Total current liabilities 486 455 • Accounts payable are payments owed to the firm’s suppliers.
Long-term liabilities
Deferred taxes 117 104 • Fixed assets are equal to purchase price less depreciation.
Long-term debt 471 458
Total long-term liabilities 588 562
• Intangible assets include e.g., trademarks and patents.
Stockholder’s equity
Preferred stock 39 39
Common stock ($1 par value) 55 32 • Owners’ equity reflects the price at which shares were originally sold (or repurchased).
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock (26) (20)
• Accrued expenses are costs that have been incurred but not yet paid out, e.g., salaries
Total equity 805 725 and taxes which are only paid out periodically.
Total liabilities and stockholder’s equity 1879 1742
• Deferred taxes are taxes which have been incurred but will not be paid until later.
For example, a company may use an accelerated depreciation schedule for the IRS, but
straightline for its accounting statements.
Notes: —
• The increase in long-term debt reflects the difference between $86 million in new debt and $73
million in retired old debt.
• The increase in treasury stock reflects the repurchase of $6 million in common stock (at market
value).
• The change in common stock reflects the issuance of 23 million shares of stock at par value of
$1 per share.
• The increase in capital surplus reflects the difference between the price the shares were actually
sold for ($1.87) and the par value.
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Balance sheet identity Figure — net working capital
Assets = Liabilities + Shareholders’ equity
How is the balance sheet like a pie?
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Net working capital (NWC) Discussion
• Think of NWC as the balance after totalling
NWC = Current Assets - Current Liabilities
– the cash in your wallet,
• NWC is normally positive in a healthy firm. It measures the short term ability of the firm – the balance in your checking account,
to pay its bills. – bills that come due this month,
– and your paycheck.
• What are the disadvantages of having a lot of NWC (excess liquidity)?
• You need to maintain liquidity, but additional assets might be better off invested in
• A very low (or negative) NWC may indicate either
T-bills or stocks.
– financial weakness, or
– very efficient short-term financial management. • It may not be so bad to have a negative balance in your checking account if it is covered
by a line-of-credit and your cash flows are sufficient to keep you out of trouble.
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Note: This ambiguity is typical of financial statement analysis.
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Balance sheet identity revisited Book value vs. market value
Recall the balance sheet identity: • Accounting statements always deal with book values. These may or may not be closely
correlated to market values.
Assets = Liabilities + Shareholders’ equity
• Why do we even care about book values?
• Good way to think about this is to consider the book vs market values of your car.
It is often more useful to think of this with the current accounts netted out (to reflect
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long-term financing):
Fixed assets + NWC = Long-term debt + Equity
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Book vs market — continued Book vs market — continued
• Market value of equity referred to as market capitalization The market-to-book ratio is often considered as a useful measure of historical performance.
It describes how much value the firm has created.
• Market value of equity plus long-term debt referred to as total capitalization
• Stocks with low market-to-book are referred to as value stocks.
– How might you estimate a firm’s market capitalization?
• Stocks with high market-to-book are referred to as growth stocks.
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– How might you estimate a firm’s total capitalization?
– How might you estimate the market value of the firm’s fixed assets?
– What determines a firm’s market value?
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Book vs market — continued Book vs market — continued
Think about a company which owns a single factory which cost $1 million to build. • You will sometimes hear analysts touting value stocks. The idea is that although the
stock is cheap now, the market value is likely to recover down the road.
• Suppose, as a result of poor management (or other factors), the market value of the
factory is only $500,000. Thus, management has destroyed $500,000 of value. It is a • Other analysts will be touting growth stocks. The idea is that the firm has done well in
value stock. the past, it is likely to continue doing so.
• On the other hand, if the market value of the factory is $2 million, then management has • The relative performance of growth vs value stocks has varied through time. Thus each
succeeded in creating $1 million of value. It is a growth stock. camp is right sometimes (like a clock that is right twice a day).
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Note: Why would anyone pay $2 million for a factory that only cost $1 million to build?
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Income statement Income statement — example
• While the balance sheet is a summary of the firm’s position at a point in time, the income
U.S. Composite Corporation
statement is a summary of change in firm’s financial position over some period of time. Income statement
2007
($in millions)
• The basic idea is
Income = Revenues - Expenses Total operating revenues $2262
Cost of goods sold (1655)
Selling, general, and administrative costs (327)
• Expenses are broken down into several parts: Depreciation (90)
Operating income $190
– product costs Other income 29
EBIT $219
– period costs Interest (49)
Pretax income $170
– depreciation Taxes (84)
Current: $71
– interest
Deferred: $13
– taxes. Net income $86
— Addition to retained earnings $43
Dividends 43
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Net income Example
• Net income is either paid out as a dividend or retained.
Income statement
• The part that is retained is added to “Retained earnings” on the balance sheet.
Revenue 140
– may be held as cash or other liquid assets. COGS 30
– may be used to finance new fixed assets. Depr 0
Interest 10
– may also go toward repurchasing shares or paying down the principal of the firm’s Tax 20
long-term debt. =============
NI 80
Dividend: 30
Addition to RE: 50
Note: The balance sheet must balance!
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Balance Sheet
2008 2009 2008 2009
CA 150 150 CL 100 100
FA 300 350 LTD 175 175
TA 450 500 E 175 225
D+E 450 500
Note: In this example, the firm retained $50 and used it to buy new fixed assets.
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Income statement vs cash flow Income statement vs cash flow — continued
The income statement does not really reflect cash flow. There are several differences: • The income statement also includes non-cash items, e.g., depreciation.
• Revenues are recorded when they accrue (when the sale is made) rather than when the – The cost of fixed investments is not incurred all at once, but rather as they are
cash actually changes hands. depreciated.
– This is related to the matching principle: the benefits of the investment are realized
• Expenses are recorded using the matching principle: the idea is to try to match revenues not all at the time of purchase, but rather over the course of the asset’s lifetime.
up with the costs associated with producing them.
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– Thus, production costs are recognized not when the raw materials are bought or
when they are paid for, but rather when the goods are sold.
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Period costs and product costs Taxes
• Whereas economists are frequently interested in fixed vs variable costs, the income state-
ment uses product costs vs period costs. US corporate tax schedule (federal)
– Product costs are the costs directly associated with production.
Taxable income Tax rate
– Period costs are typically reported as selling, general and administrative costs.
$ 0 - 50,000 15%
50,001 - 75,000 25
• Although these are loosely related to fixed and variable costs, the relationship is not
75,001 - 100,000 34
exact.
100,001 - 335,000 39
— 335,001 - 10,000,000 34
10,000,001 - 15,000,000 35
15,000,001 - 18,333,333 38
18,333,334 + 35
The above schedule reflects marginal rates.
• What is the difference between marginal and average rates?
• Which is usually more relevant for financial decision making?
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Depreciation Financial statements — real world
Discuss later in course... In the real world, financial statements are more complex than the simplified statements we will
typically use in this course.
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See Dell 2005 10-K.
Homework ...
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Cash flow CFFA
Cash flow identity: cash flow from assets = operating cash flow
– net capital spending
cash flow from assets = cash flow to creditors – change in net working capital
+ cash flow to stockholders
OCF = EBIT + Depreciation - Taxes
NCS = ending net fixed assets
Notes: – starting net fixed assets
• The cash flow identity is similar to the balance sheet identity: The left hand side tells the size of + depreciation
the pie; the right hand side tells how it is divided up.
ChNWC = ending NWC - starting NWC
• We will be primarily interested in financial cash flows, not accounting cash flows.
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Notes:
• In OCF, subtract only taxes paid, not including deferred taxes.
• CFFA is also known as free cash flow.
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Discussion Cash flow to creditors and stockholders
• Remember: the cash flows of interest in finance are not the same as what is recorded in the cash flow from assets = cash flow to creditors
accounting “statement of cash flows”. + cash flow to stockholders
• Why is depreciation added into OCF?
– The reason is that EBIT has subtracted depreciation off, but it is a non-cash item. We Cash flow to creditors = interest paid
just need to undo this subtraction.
– net new borrowing
• Note that the accounting definition of OCF is net income + depreciation. This differs from our
definition of cash flow in that interest is deducted. Cash flow to stock holders = dividends paid
– We treat interest as a financing expense. That is, it will be part of the cash flow to – net new equity raised
creditors. The reason for this will be clearer later.
• Why do we treat depreciation as a positive component of cash flow in NCS?
– Again, we are simply correcting for the fact that it was written off in the balance sheet,
but is not a cash item. Note: Remember that financial cash flows are different from the accounting statement of cash flows.
– NCS reflects the amount of cash actually spent to purchase fixed assets this period.
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Example Example — continued
Rocky Flats Mineral Water (RFMW)* Income statement (2005)
(millions of $)
Balance sheet
(millions of $) Net sales 2000
Cost of goods sold 1800
Assets Depreciation 150
2004 2005 EBIT 50
Current assets 300 350 Interest paid 20
Fixed assets 850 900 Taxable income 30
Total assets 1150 1250 Taxes 9
Net income 21
Liabilities and Owners’ Equity
Dividends 6
2004 2005 Addition to retained earnings 15
Current liabilities 200 250
Long-term debt 300 325 —
Owners’ equity 100 110
Retained earnings 550 565
Total liabilities and owners’ equity 1150 1250
* Their motto: “makes your skin glow (in the dark).”
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Example — continued Ethics
Given the balance sheet and income statement above, compute: • Accounting statements are not always as reliable as we might like to think...
• Operating cash flow (OCF) • Managers’ compensation is often dependent on the firm’s performance:
– options
– target-based bonuses.
• Net capital spending (NCS)
• The idea is to align managers’ incentives with those of the firm (recall the agency
problem).
• Change in net working capital (ChNWC)
• But things don’t always work out as desired:
– Managers may be tempted to massage the books to “enhance” performance.
• CFFA – Short-term results can look good, but in the longer term...
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• Cash flow to creditors (CF2Cr)
• Cash flow to share holders (CF2SH)
• Check that CFFA = CF2Cr + CF2SH
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Cendant Enron
Publicly traded firms have to file audited annual reports, but that doesn’t mean that “accounting irregularities” See posted article.
never slip by the auditors. Companies that deliberately manipulate financial statements may benefit in the short
run, but it eventually comes back to haunt them. Cendant Corporation is a good example. —
Cendant was created when CUC International and HFS, Inc. merged in late 1997. The combined company
owns such name brands as Century 21 and Coldwell-Bankers. In April 1998, the combined company announced
that accounting irregularities had been found in the CUC financial statements and earnings would need to be
restated for 1997 and possibly 1995 and 1996 as well. Cendant’s stock price dropped 47 percent the day after
the announcement was made (it was announced after the market closed).
The problems haunted Cendant throughout 1998. In July, it was announced that the problem was much worse
than originally expected and the stock price plummeted again. By the end of July 1998, the stock price had
dropped more than 60 percent below the price before the original announcement. The company also had to take
a $76.4 million charge in the third quarter of 1998 for the costs of investigating the accounting irregularities.
Criminal charges have been filed against several former executives of CUC International and several class action
lawsuits have been filed against Cendant. The stock was trading at about $41 per share prior to the announcement
and dropped as low as $7.50 per share in October 1998. The price still had not recovered by early September
2000, with a closing price on September 1, 2000 of about $13.
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