314 Chp 3 Notes

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					Understanding Financial Statements
Chapter 3

Financial Statements
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Balance Sheet

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Income Statement
Statement of Cash Flows

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Balance Sheet
  

Provides a firm’s financial position at a specific point in time Assets are resources owned by the firm Liabilities and owner’s equity are how those resources are financed

Total Assets = Liabilities (debt) +

Shareholder’s Equity

Or… A = L+OE

Balance Sheet
Things we own
Assets
Current Assets Cash Accounts Receivable Inventories Prepaid Expenses ST investments Fixed Assets Netted for depreciation Other Assets Patents, goodwill, etc.

How they are financed
Liabilities & Equity
Current Liabilities Accounts payable Notes Payable Accruals Long term Liabilities

Equity
Preferred stock Common stock Retained earnings

Assets

=

Liabilities and Equity

Balance Sheet Terminology
Assets


Current assets or gross working capital comprise of assets that are
relatively liquid, or expected to be converted into cash within 12 months.



Current assets typically include:  Cash  Accounts Receivable
o

payments due from customers who buy on credit raw materials, work in process, and finished goods held for eventual sale Prepaid expenses are those items paid for in advance

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Inventory
o

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Other expenses
o

Balance Sheet Terminology
Assets
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Fixed Assets – Assets held for more than one year. Typically Include:
o o o

Machinery and equipment Buildings Land

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Other Assets – Assets that are not current assets or fixed assets
o o o

Patents Copyrights Goodwill

Balance Sheet Terminology
Debt


Current Liabilities:  Accounts payable
o

Credit extended by suppliers to a firm when it purchases inventories Expenses incurred in the firm’s operations but not yet paid Borrowings from a bank or lending institution payable within 12 mths



Accrued expenses
o

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Short-term notes
o



Long-Term Debt


Loans from banks or bonds issued for longer than 12 months

Balance Sheet Terminology
Equity


Includes the shareholder’s investment
o o

Preferred stock Common stock stock that was once outstanding and has been repurchased by the company cumulative total of all the net income over the life of the firm, less cumulative total common stock dividends that have been paid out



Treasury Stock
o



Retained Earnings
o

Exercise: Sabine Mfg. Co.
Prepare a balance sheet for 2003 from the scrambled list of items below. Accounts receivable Machinery and equipment Notes payable – current Net Income Inventory Accounts payable Long – term debt Accumulated Depreciation Dividend Paid Common stock Cash Retained earnings – prior year Retained earnings – current year $150,000 700,000 90,000 90,000 110,000 90,000 160,000 236,000 20,000 320,000 90,000 ? ?

Sabine Mfg. Co.'s Balance Sheet December 31, 2003 (000s) Cash Accounts Receivable Inventory Total Current Assets Machinery & Equip. Less: Accum. Deprec. Net Mach. & Equip. TOTAL ASSETS Accts. Pay. Notes Pay.-Current Current Liabilities Long Term Debt Total Liabilities

Common Stock Retained Earnings: Total Owners Equity TOTAL LIAB. & EQ.

?? ?? ??

December 31, 2003 (000s) Cash Accounts Receivable Inventory Total Current Assets Machinery & Equip. Less: Accum. Depr. Net Mach. & Equip. TOTAL ASSETS Assets = Liab + Stk + RE Thus, Assets - Liab - Stk = RE Total Assets - Total Debt & C/S = Total R/E Accts. Pay. Notes Pay.-Current Current Liabilities Long Term Debt Total Liabilities Common Stock Retained Earnings: Prior Years Add: Net Income Less: Div. Paid Total R/E Total Owners Equity TOTAL LIAB. & EQ.

Balance Sheet Issues
 


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Leverage (Debt/Equity ratio) Liquidity Composition of Assets (P&E, Goodwill, Receivables) Mark-to-Market: What is the true market value of assets and liabilities? Volatility in marks? Quality of Equity (preferred vs common stock) ALM (asset liability management) Credit risks Currency risks Off B\S exposures Country differences (capital structure, accting, etc.)

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Income Statement
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Profit/Loss Statement (P&L) Indicates the amount of profits generated by a firm over a given period of time Sales – Expenses = Profit



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Income Statement
Money received from operations (Sales) - Direct costs (Cost of goods sold) Gross Profit - Other cash expenses related to operations (Admin) - Depreciation Earnings before interest and taxes (EBIT)

- Interest Taxable Income (Earnings before taxes)
- Taxes Net Income (Accounting profit) - Preferred dividends Net Income available to Common Shareholders

Income Statement Terminology


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Revenue (Sales)  Money derived from selling the company’s product or service Cost of Goods Sold (COGS)  Cost of producing or acquiring the goods or services to be sold Operating Expenses  Expenses related to marketing and distributing the product or service and administering the business Financing Costs  The interest paid to creditors and the dividends paid to preferred stockholders Tax Expenses  Amount of taxes owed, based upon taxable income

Starbucks Income Statement 2003 (US$ Millions)
Sales Cost of Goods Sold Gross Profit Operating Expenses Marketing expenses and general and Administrative expenses $227 Depreciation Expense 206 Total Operating Expenses Operating Profits Interest Expense Earnings before taxes Income taxes Net income $4,076 3,207 $ 869

$ 433 $ 436 3 $ 433 165 $ 268

Income Statement Issues
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Earnings growth Earnings from core operations



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Quality of earnings (i.e. stability, sustainability)
Return on equity or investment

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Statement of Cash Flows
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Changes the picture from accrual to cash
o

Key step in financial analysis



Shows Cash Flows divided into 3 categories:
o o o

Cash flow from operations Cash flow from investments Cash flow from financing activities

Statement of Cash Flows


Cash flows from operations
 

Cash in from our customers Cash out in expenses to support operations

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Cash flows from investing activities
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Purchase plant & equipment, cash goes out to pay for it Sell fixed assets, cash comes in from the sale Buy (cash out) or sell (cash in) short term investments

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Cash flows from financing activities
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Cash comes in if we borrow money as notes or if we issue bonds or stocks Cash goes out as we pay off debt and as we pay out dividends

Free Cash Flows
 

Money available to shareholders (owners) Two Perspectives (note: Asset CF and Financing CF must offset)


Asset
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CF = After Tax CF from Operations
- Additional Investments in NWC (+ if decrease) - Additional Investments in LT assets (+ if decrease)

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Financing
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CF = + Increases in debt and equity financing
- Decreases in debt and equity financing - Compensation to investors (interest and dividends)

Free Cash Flows
FCF =
ATCFO - Increase in NOWC - Increase in LT assets + Decrease in NOWC + Decrease in LT assets

Operating Profit + Depreciation and Amortization =EBITDA Less: Taxes Paid in Cash

Change in CA Less change in non-interest charging current liabilities

Difference between P&E last year and P&E this year

Problem 3 - 4: Westlake Corporation Free Cash Flows Free Cash Flows - Asset Perspective: Operating Income (EBIT) 1020 Depreciation 125 EBITDA 1145 Tax Expense 325 Less: Change in Tax Payable 35 Cash Taxes 290 After Tax Cash Flows from Operations 855 Change in net working capital: Change in current assets: Change in cash 226 Change in accounts receivable 112 Change in inventories 302 Change in current assets 640 Change in non-interest bearing current debt: Change in accounts payable 116 Change in accruals 85 Change in non-int. bearing curr. debt 201 Change in NOWC (net operating W/C) 439 Change in long term assets: Purchase of fixed assets 1064 FCF - Asset Perspective -648 Free Cash Flows - Financing Perspective: Interest paid to investors -231 Less change in interest payable -45 Interest paid to lenders -276 Issue long term debt 550 Increase in short term debt 126 Issue common stock 312 Common stock dividends -64 FCF - Financing Persp. 648

Problem 3-4 Westlake
After-tax cash flows from operations Change in NOWC Change in LT assets Free cash flows

Interest on debt Stock dividends New long term debt New short-term debt New common stock Net

Cash Flow Issues
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Is company producing CF from operations? Is company producing FCF? What does it do with positive FCF:
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Pay interest and dividends Repay debt Repurchase Stock M&A or Invest in marketable securities Build cash balances Issue new debt or equity

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How does it finance negative FCF
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Importance of cash flows
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Key business decisions based on cash flow
o

o

If business generates positive cash flow, what should we do? (invest in new opportunities, pay down debt, increase dividends) If business generates negative cash flow, what is going on? (are we growing?, is this a viable business?)

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Bottom Line: Does our business’ long-term cash return provide a good risk-adjusted return to investors? Efficient use of money
o

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Working capital management

Homework: Chapter 3


Learn key terms

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Study Questions: 3-2, 3-3, 3-8
Study Problems: 3-1, 3-2, 3-3, 3-7

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