Financial Statement, Cash Flow and Financial Forecasting
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Transcript of Financial Statement, Cash Flow and Financial Forecasting
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Financial Statement, Cash Flow
and Financial Forecasting
Chapter 2
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2-2ACT3211 FINANCIALMANAGEMENT
Chapter 2 Learning GoalsLG1: Recall the major financial statements that firms must prepare and
provide to the publicLG2: Differentiate between book (or accounting) value and market value
LG3: Explain how taxes influence corporate managers and
investors decisions
LG4: Differentiate between accounting income and cash flows
LG5: Demonstrate how to use a firm's financial statement to calculate itscash flows
LG6: Observe cautions that should be taken when examining
external financial statements
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While accountants focus on reportingwhat happened in the past, financialmanagers use financial statements to
draw inferences about the future
Firms must follow Generally Accepted
Accounting Principles (GAAP) whencreating these statements, but they stillhave substantial discretion
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Balance Sheet
The balance sheet reports a firms assets,liabilities, and equity at a particular pointin time.
Assets = Liabilities + Equity
The left side of a balance sheet lists the
assets of the firm in order of liquidity The right side of the balance sheet lists
the liabilities in order of maturity. Equity,which never matures, is listed last
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Assets
Assets fit into two major categories:current assets and fixed assets
Current Assets
Will normally convert into cash within a year Cash (and marketable securities) Accounts receivable Inventory
Fixed Assets Have a useful life exceeding one year
Net plant and equipment (Gross plant andequipment less accumulated depreciation)
Less tangible assets, such as patents andtrademarks
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ACT3211 FIN
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Equity
The difference between total assets and totalliabilities is the stockholders (or owners)equity.
Types ofEquity
Preferred Stock Appears as the cash proceeds when the firm sellspreferred stock
Common Stock and Paid-in-Surplus Also appear as cash proceeds when common stock is
issued
Retained Earnings When managers reinvest earnings rather than pay them
out as dividends, these will be recorded as retainedearnings. The retained earnings account on thebalance sheet represents the cumulative amount
retained over the years.
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ACT3211 FIN
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Managing the Balance Sheet
Managers must monitor a number ofissues related to the firms balance sheet,including:
The accounting method used for fixed assetdepreciation
The level of net working capital
The liquidity position of the firm
Whether to finance the firms assets withequity or debt
The difference between the book valuereported on the balance sheet versus the true
market value of the firm
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ACT3211 FIN
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Accounting method for fixed asset
depreciation Managers can choose the accounting method they useto record depreciation against their fixed assets.
For reporting purposes, companies often use thestraight-line method of depreciation
For tax
purposes, firms often use accelerateddepreciation such as MACRS Why use different methods?
The straight-line method results in lower depreciationexpenses in the earlier years, resulting in higher income forreporting to shareholders
MA
CRS results in higher depreciation expenses in earlieryears, leading to lower income and thus lower taxes.
A firm will often use multiple methods for calculatingdepreciation for the same assets
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ACT3211 FIN
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Net Working Capital
Net Working Capital = Current assetsminus current liabilities
For DPH Tree Farms for 2007:
NWC = $190 - $110
NWC = $ 80 million
Firms monitor net working capital as a
measure of the firms ability to pay itsobligations
In general, a financially healthy firm haspositive NWC
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ACT3211 FIN
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Liquidity Liquidity refers to the ability to turn an asset into cash
at its fair market value. Current assets are the most liquid assets
Cash, marketable securities, accounts receivable, andinventory
Inventory is the least liquid of the current assets Fixed assets are less liquid Liquidity has both good and bad aspects:
More liquidity means the firm can more easily pay itsobligations and stave off financial distress, i.e. the firm is
less risky However, liquid assets dont provide a very high return.
Cash offers no return at all. Fixed assets are illiquid, but provide for generating
revenue and profits Managers must consider the risk-return tradeoff
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ACT3211 FIN
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Debt vs. Equity Financing Financial leverage refers to the extent to which a firm
uses debt as a source of financing Just like a lever magnifies the ability to move objects,
financial leverage magnifies a firms gains and losses Debtholders have a fixed claim on the firms cash flows
(they are paid interest on their securities) Stockholders have a claim on whatever cash flow is left.
Since the obligation to debt holders is fixed, if the firm doeswell stockholders do very well. If the firm does poorly,stockholders get little or nothing.
Yet, debt increases the financial risk to the firm. If the firmcant make the fixed payments to debtholders, the firmfaces bankruptcy
Once again, managers face a tradeoff between riskand return as they decide the firms capital structure
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ACT3211 FIN
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Income Statement
Income statements show the totalrevenues and expenses of a firm over aspecific period of time
The top line of the income statementshows the firms revenues
The statement then shows all of the
various expenses for the firm The bottom line, or net income,
represents the difference between
revenues and ex
penses
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ACT3211 FIN
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The top part of the income statementrepresents the operating incomeportion of the income statement. Thispart of the statement is generated byoperating the firm, and results inoperating income orEBIT
The bottom part of the incomestatement reflects how the firm isfinanced and taxed
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CT3211 FINA
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Items reported below the bottom lineinclude:
goutstandinstockcommonofsharestotal
incomenet(EPS)shareperEarnings !
goutstandinstockcommonofsharesofnumber
paiddividendsstockcommon(DPS)ShareperDividends !
goutstandinstockcommonofsharesofnumber
equityrsstockholdecommon(BVPS)shareperBook value !
stockcommonsfirm'theofpricemarketthe(MVPS)shareperueMarket val !
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Corporate Income Taxes
Firms pay out a large portion of theirearnings in taxes (Microsoft paid $4.4billion in taxes in 2005, or 26 percent of
EBT) The tax code is determined by
Congress, and so is subject to frequentchanges
The tax code is extremely complex.However, since taxes are so importantto firms, we will examine a general
overview of corporate taxation
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The U.S. tax structure is progressive,meaning that the larger the income, thehigher the tax rate
Tax rates are discussed in terms ofmarginal tax rate, and average tax rate
The marginal tax rate is the amount of
taxes must pay on the next $1 inincome. This is the most relevant ratefor financial decision making.
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ACT3211 FINANCIALMANAGEMENT
The average tax rate is determined by:
The average tax rate incorporatestaxes paid on past income and
represents a weighted average of rateson the amount of taxable income
incometaxable
liabilitytaxratetaxAverage !
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ACT3211 FINANCIALMANAGEMENT
Example
Indian Point Kennels earned $16.5 millionin taxable income in 2007. Their taxliability can be determined as:
Tax liability = Tax on base amount + tax rate (amount over base)Tax liability = $5,150,000 + .38($16,500,000 - $15,000,000)
Tax liability = $5,720,000
The average tax rate = $5,720,000/$16,500,000
= 34.67%
The marginal tax rate is 38 percent
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ACT3211 FINANCIALMANAGEMENT
Interest that corporations receive is
taxable Exception: interest on state and local
government bonds is exempt from federaltaxes
When corporations own stock inanother corporation they may receivedividend income. The tax code exempts 70 percent of this
income from taxation. Only the remaining30 percent is taxed.
This reduces the effect oftriple taxation
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ACT3211 FINANCIALMANAGEMENT
Interest and Dividends Paid by the
Corporation Interest payments appear on the income
statement and are deducted from incomebefore calculating taxable income
Dividends, on the other hand, are paidwith after-tax income and so are not taxdeductible
This tax deductibility of interest makesdebt a much cheaper form of financingthan equity
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Example 2-4
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ACT3211 FINANCIALMANAGEMENT
Statement of Cash Flows The balance sheet is a snapshot of a firm's financial resources andobligations at a single point in time, and the income statement
summarizes a firm's financial activity over a period of time. These twofinancial statements reflect the accrual basis of accounting required byGAAP to match revenues with the expenses associated with generatingthose revenues
Actual cash inflows and outflows may occur at very different times thanare reflected in these two financial statements. Also, the incomestatement contains several non-cash entries, notably depreciation
Therefore, figures on an income statement do not reflect the actual cashflows of the firm. Financial managers and investors are much moreinterested in cash flows than accrual accounting income.
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ACT3211 FINANCIALMANAGEMENT
The statement of cash flows shows thefirms cash flows over a period of time.
It includes only inflows and outflows of
cash and marketable securities. Itexcludes transactions that do not directlyaffect cash receipts and payments, suchas depreciation and write-offs on baddebts.
The bottom line of the statement reflectsthe difference between cash sources anduses and equals the change in cash onthe firms balance sheet
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ACT3211 FINANCIALMANAGEMENT
Sources and Uses of Cash
Some activities increase cash, and someactivities decrease cash.
Sources of cash involve increasing
liabilities (or equity) and decreasingassets.
Uses of cash involve decreasing liabilities(or equity) and increasing assets.
The statement of cash flows is a cashbasis report on three types of financialactivities: operating activities, investingactivities, and financing activities.
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ACT3211 FINANCIALMANAGEMENT
Cash Flows from Operations
The top portion of the statement of cashflows, cash flows from operations,represents items directly associated with
producing and selling the firms products. Net income
Depreciation
Working capital accounts other than cash and
short-term debt Many finance professionals consider this
portion of the statement the mostimportant.
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ACT3211 FINANCIALMANAGEMENT
Cash Flows from InvestingActivities
Cash flows associated with buying orselling fixed or other long-term assets
This section of the statement of cashflows reflects the firms investment infixed assets
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ACT3211 FINANCIALMANAGEMENT
Cash Flows from FinancingActivities
Cash flows from debt and equityfinancing transactions
Issuing short- or long-term debt
Issuing stock
Using cash to pay dividends
Using cash to pay off debt
Using cash to buy back stock
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ACT3211 FINANCIALMANAGEMENT
The bottom line of the statement of cash flowsshows the total of cash flows from operation,investing, and financing activities
This line reconciles to the net change in cashand marketable securities on the balancesheet over the period.
In the DPH example, the income statementshowed $90 million in net income, but -$1million in cash flow This is because net income is accounting-based
income according to GAAP and does notnecessarily reflect the flow of cash
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ACT3211 FINANCIALMANAGEMENT
Free Cash Flow
To maintain cash flows over time, a firmmust continuously replace working capitaland depreciating fixed assets, and
develop new products
Investors are particularly interested in thecash flows available to pay the firms
stockholders and debtholders After adjustments for investments in working
capital
After adjustments for investments in fixed
assets
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ACT3211 FINANCIALMANAGEMENT
FCF = Operating cash flow Investment in operating capitalFCF = (EBIT Taxes + Depreciation) (Gross fixed assets + Netoperating working capital)
Operating cash flow (OCF) Firms generate operating cash flow from operations after
they have paid necessary taxes Investment in operating capital (IOC)
Firms buy physical capital or earmark funds for eventualequipment replacement to sustain firm operations
Includes the firms investment in fixed assets, current assets,
and spontaneous current liabilities (i.e. accounts payable andaccruals)
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ACT3211 FINANCIALMANAGEMENT
Example 2-5
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ACT3211 FINANCIALMANAGEMENT
A positive Free Cash Flow means that the
firm has funds that can be distributed toinvestors
A negative FCF might mean several things:
If FCF is negative due to negative OCF it mayindicate that the firm is experiencing operating ormanagerial problems
FCF might be negative because the firm isinvesting heavily in operating capital to supportgrowth
In this case FCF might be negative while OCF is
positive
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ACT3211 FINANCIALMANAGEMENT
Statement of Retained Earnings
Provides additional detail about thechange in retained earnings during areporting period
Reconciles net income and dividendspaid with changes in retained earningsfrom one period to the next:
Beginning retained earnings
+ net income for period
- cash dividends paid
= Ending retained earnings
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ACT3211 FINANCIALMANAGEMENT
Cautions in Interpreting FinancialStatements
While firms must follow GAAP in preparing theirfinancial statements, firms have considerablelatitude in using accounting rules
Firms can smooth earnings, for example for
new managers to show growth Different depreciation methods
These strategies are called earningsmanagement
Sarbanes Oxley
Act of 2002 was passed in aneffort to prevent deceptive accounting and
management practices brought to light in high-profile scandals such as Enron and WorldCom