CHAPTER 2
Financial Statements, Cash Flow,
and Taxes
Balance sheet
Income statement
Statement of cash flows
Accounting income vs. cash flow
MVA and EVA
Financial
Statement Analysis
• Financial Statements (Balance Sheet, Income
Statement, Cash flow statement, Statement of
Retained Earnings)
• A Possible Framework for Analysis
Examples of External Uses of
Statement Analysis
• Trade Creditors -- Focus on the liquidity of the
firm.
• Bondholders -- Focus on the long-term cash
flow of the firm.
• Shareholders -- Focus on the profitability and
long-term health of the firm.
Examples of Internal Uses of
Statement Analysis
• Plan -- Focus on assessing the current financial
position and evaluating potential firm
opportunities.
• Control -- Focus on return on investment for
various assets and asset efficiency.
• Understand -- Focus on understanding how
suppliers of funds analyze the firm.
Primary Types of Financial
Statements
Balance Sheet
A summary of a firm’s financial position on a
given date that shows total assets = total
liabilities + owners’ equity.
Income Statement
– A summary of a firm’s revenues and expenses over
a specified period, ending with net income or loss
for the period.
Basket Wonders’ Balance
Sheet (Asset Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a
Cash and C.E. $ 90 a. How the firm stands on a
Acct. Rec.c 394 specific date.
Inventories 696 Prepaid Exp d b. What BW owned.
5 c. Amounts owed by
Accum Tax Prepay 10 customers.
d. Future expense items
Current Assetse $1,195 Fixed already paid.
Assets (@Cost)f 1030 e. Cash/likely convertible to
Less: Acc. Depr. g (329) cash within 1 year.
Net Fix. Assets $ 701 f. Original amount paid.
Investment, LT 50 g. Acc. deductions for wear
Other Assets, LT 223 and tear.
Total Assets b $2,169
Basket Wonders’ Balance
Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290 a. Note, Assets = Liabilities +
Acct. Payablec 94 Equity.
Accrued Taxes d 16 b. What BW owed and
Other Accrued Liab. d 100 ownership position.
Current Liab. e $ 500
c. Owed to suppliers for goods
Long-Term Debt f 530
Shareholders’ Equity and services.
Com. Stock ($1 par) g 200 d. Unpaid wages, salaries, etc.
Add Pd in Capital g 729 e. Debts payable < 1 year.
Retained Earnings h 210 f. Debts payable > 1 year.
g. Original investment.
Total Equity $1,139 h. Earnings reinvested.
Total Liab/Equitya,b $2,169
Additional Paid In Capital
• Assume that a company issues 1 million shares with a par value of
$50 per share. When the shares are purchased by investors,
however, they pay $70 per share - a premium of $20 over par
value. When the capital received from this issue is recorded, $50
million ($50*1 million) will be allocated to a share capital or paid-
in-capital account. The excess $20 million ($20*1 million) will be
allocated to the contributed surplus account as additional paid-in-
capital.
• Additional paid-in-capital = (Issue Price – Par Value) x Number of
Shares Issued
Basket Wonders’ Income
Statement
Basket Wonders Statement of Earnings (in thousands) for Year Ending December
31, 2007a
Sales $ 2,211 a. Measures profitability over a
Cost of Goods Sold b 1,599 time period.
Gross Profit $ 612 b. Received, or receivable, from
SG&A Expenses c 402 customers.
EBITd $ 210 c. Sales comm., adv., officers’
Interest Expensee 59 salaries, etc.
EBT f $ 151
d. Operating income.
Taxes 60
e. Cost of borrowed funds.
NI or EATg $ 91
Cash Dividends 38 f. Taxable income.
Increase in RE $ 53 g. Amount earned for
shareholders.
TABLE 2- 1 Micro Drive Inc.: December 31 Balance Sheets (Millions of Dollars)
ASSETS 2010 2009 LIABILITIES AND EQUITY 2010 2009
Cash and equivalents $ 10 $ 15 Accounts payable $ 60 $ 30
Short-term 0 65 Notes payable 110 60
investments
Accounts receivable 375 315 Accruals 140 130
Inventories 615 415 Total current liabilities $ 310 $ 220
Total current assets $1,000 $ 810 Long-term bonds 754 580
Net plant and 1,000 870 Total liabilities $1,064 $ 800
equipment
Preferred stock (400,000 40 40
shares)
Common stock (50,000,000 130 130
shares)
Retained earnings 766 710
Total common equity $ 896 $ 840
Total assets $2,000 $1,680 Total liabilities and equity $2,000 $1,680
Micro Drive Inc.: Income Statements for Years Ending December 31
2010 2009
Net sales $3,000.0 $2,850.0
Operating costs excluding depreciation and 2,616.2 2,497.0
amortization
Earnings before interest, taxes, depreciation, and $ 383.8 $ 353.0
amortization (EBITDA)
Depreciation 100.0 90.0
Amortization 0.0 0.0
Depreciation and amortization $ 100.0 $ 90.0
Earnings before interest and taxes (EBIT, or operating $ 283.8 $ 263.0
income)
Less interest 88.0 60.0
Earnings before taxes (EBT) $ 195.8 $ 203.0
Taxes (40%) 78.3 81.2
Net income before preferred dividends $ 117.5 $ 121.8
Preferred dividends 4.0 4.0
Net income $ 113.5 $ 117.8
Additional Information
Common dividends $ $ 53.0
57.5
Addition to retained earnings $ 56.0 $ 64.8
Per Share Data
Common stock price $ 23.00 $ 26.00
Earnings per share (EPS) $ 2.27 $ 2.36
Dividends per share (DPS) $ 1.15 $ 1.06
Book value per share (BVPS) $ 17.92 $ 16.80
Cash flow per share (CFPS) $ 4.27 $ 4.16
Market Value vs. Book Value
• The amounts shown on the balance sheets are called
book values because they are based on the amounts
recorded by bookkeepers when assets are purchased
or liabilities are issued.
• Market value is the current price in the market place at
which the assets, liabilities ,or equity can actually be
bought or sold if the corporation wishes to do now.
• Current assets and liabilities generally have book
values and market values that are very close. This is
not necessarily the case with the other assets,
liabilities, and equity of the firm.
• Market values are generally more important for the
decision making process because they are more
reflective of the cash flows that would occur today.
2-13
STATEMENT OF STOCKHOLDERS’ EQUITY
Common stock Retained Total Equity
Earnings
Shares Amount
Balances, Dec. 31, 2009 50 $130.0 $710.0 $840.0
Net income $113.5 $113.5
Cash dividends (57.5) (57.5)
Issuance of common stock 0 0.0
Balances, Dec. 31, 2010 50 $130.0 $766.0 $896.0
STATEMENT OF CASH FLOWS
Operating Activities
Net income before preferred dividends
$117.5
Adjustments:
Noncash adjustments:
Depreciation
100.0
Due to changes in working capital
Increase in accounts receivable (60.0)
Increase in inventories (200.0)
Increase in accounts payable 30.0
Increase in accruals 10.0
Net cash provided (used) by operating activities ($ 2.5)
Investing Activities
Cash used to acquire fixed assets ($230.0)
Sale of short-term investments $ 65.0
Net cash provided (used) by investing activities ($165.0)
Financing Activities
Increase in notes payable $ 50.0
Increase in bonds outstanding 174.0
Payment of preferred and common dividends (61.5)
Net cash provided (used) by financing activities $162.5
Summary
Net change in cash ($ 5.0)
Cash at beginning of year 15.0
Cash at end of year $ 10.0
Free Cash Flow (FCF)
• FCF is the amount of cash available from operations for
distribution to all investors (including stockholders and
debtholders) after making the necessary investments to
support operations.
• The amount of cash that could be withdrawn from a firm
without harming its ability to operate and expand.
• A company’s value depends on the amount of FCF it can
generate. Greater the FCF, more attractive that company is to
investors.
• FCF = NOPAT – Net Investment in Operating Capital
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 Operating current assets
X (1 − Tax rate) − Operating current liabilities
Net operating profit after taxes 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
Total net operating capital this year
− Net investment in operating capital − Total net operating capital last year
Net investment in operating capital
Free cash flow
Income Statement
2010 2011
Sales $3,432,000 $5,834,400
COGS 2,864,000 4,980,000
Other expenses 340,000 720,000
Deprec. 18,900 116,960
Tot. op. costs 3,222,900 5,816,960
EBIT 209,100 17,440
Int. expense 62,500 176,000
EBT 146,600 (158,560)
Taxes (40%) 58,640 (63,424)
Net income $ 87,960 ($ 95,136)
Balance Sheet: Assets
2010 2011
Cash $ 9,000 $ 7,282
S-T invest. 48,600 20,000
AR 351,200 632,160
Inventories 715,200 1,287,360
Total CA 1,124,000 1,946,802
Gross FA 491,000 1,202,950
Less: Depr. 146,200 263,160
Net FA 344,800 939,790
Total assets $1,468,800 $2,886,592
Balance Sheet: Liabilities & Equity
2010 2011
Accts. payable $ 145,600 $ 324,000
Notes payable 200,000 720,000
Accruals 136,000 284,960
Total CL 481,600 1,328,960
Long-term debt 323,432 1,000,000
Common stock 460,000 460,000
Ret. earnings 203,768 97,632
Total equity 663,768 557,632
Total L&E $1,468,800 $2,886,592
Calculation of
FREE CASH FLOWS (FCF)
FCF = NOPAT – Net Investment in Op. Capital
Net Operating Profit after Taxes
(NOPAT)
NOPAT = EBIT(1 - Tax rate)
NOPAT11 = $17,440(1 - 0.4)
= $10,464.
NOPAT10 = $125,460.
What are operating current assets?
• Operating current assets are the CA needed to support
operations.
– Op CA include: cash, inventory, receivables.
– Op CA exclude: short-term investments, because these are not a
part of operations.
• Nonoperating Assets
– Marketable securities
– Ownership of non-controlling interest in another company
• If an asset pays interest, it should not be classified as an
operating asset.
What are operating current
liabilities?
• Operating current liabilities are the CL
resulting as a normal part of operations.
– Op CL include: accounts payable and accruals.
– Op CL exclude: notes payable, because this is a
source of financing, not a part of operations.
Net Operating Working Capital (NOWC)
Difference in C/A & C/L used to operate business.
NOWC = CA - CL
NOWC= (cash+A/R+Inv) - (A/P + Accruals)
All non-interest bearing CA & CL
Net Operating Working Capital
(NOWC)
Operating Operating
NOWC = -
CA CL
NOWC11 = ($7,282 + $632,160 + $1,287,360)
- ($324,000 + $284,960)
= $1,317,842.
NOWC10 = $793,800.
Total Operating Capital =
= NOWC + Net Plant & Equip.
= S/T Op Cap + L/T Op Cap
Total net operating capital (also
called operating capital)
• Operating Capital= NOWC + Net fixed assets.
• Operating Capital 2011
= $1,317,842 + $939,790
= $2,257,632.
• Operating Capital 2010 = $1,138,600.
Free Cash Flow (FCF) for 2011
FCF = NOPAT - Net investment in
operating capital
= $10,464 - ($2,257,632 - $1,138,600)
= $10,464 - $1,119,032
= -$1,108,568.
How do you suppose investors reacted?
Uses of FCF
After-tax interest payment = $105,600
Reduction (increase) in debt = −$1,196,568
Payment of dividends = $11,000
Repurchase (Issue) stock = $0
Purch. (Sale) of ST investments = −$28,600
Total uses of FCF = −$1,108,568
Uses of FCF
Observe that a company does not use FCF to acquire
operating assets, because the calculation of FCF
already takes into account the purchase of operating
assets needed to support growth.
However, many high-growth companies have positive
NOPAT but negative FCF because they are making large
investments in operating assets to support growth.
There is nothing wrong with profitable growth, even if
it causes negative cash flows.
Uses of FCF
• One way to determine whether growth is
profitable is by examining the return on
invested capital (ROIC).
• ROIC = NOPAT/Operating capital
• If ROIC is greater than the rate of return that
investors require (WACC), then the firm is
adding value and a negative free cash flow
caused by high growth is nothing to worry
about.
Market Value Added (MVA)
• Shareholder wealth is maximized by maximizing the
difference between the market value of the firm’s
stock and the amount of equity capital that was
supplied by shareholders. This difference is called
the Market Value Added
• MVA = Market value of stock - Equity capital
supplied by shareholders = shares outstanding x
current market price of the stock – Total common
equity (BV of common stock + retained earnings)
Economic Value Added (EVA)
• Whereas MVA measures the effects of
managerial actions since the very inception of
a company, Economic Value Added (EVA)
focuses on managerial effectiveness in a given
year.
EVA = Net operating profit after taxes (NOPAT)
— After-tax dollar cost of capital used to support operations
= EBIT(1 — Tax rate)— (Total net operating capital)
(WACC)
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
2010 2009
MVA Calculation
Price per share $ 23.0 $ 26.0
Number of shares (millions) 50.0 50.0
MV of equity = Share price × # of shares $1,150.0 $1,300.0
Book value of equity $ 896.0 $ 840.0
MVA = Market value − Book value $ 254.0 $ 460.0
EVA Calculation
EBIT $ 283.8 $ 263.0
Tax rate 40.0% 40.0%
NOPAT = EBIT(1 − T ) $ 170.3 $ 157.8
Total investor-supplied operating capital $1,800.0 $1,455.0
Weighted average cost of capital, WACC (%) 11.0% 10.8%
Dollar cost of capital = Operating capital × 198.0 $ 157.1
WACC
EVA = NOPAT − Dollar cost of capital $27.7 $ 0.7
Handling Corporate Losses and Gains
Corporations that sustain a net operating loss
can carry that loss back (Carryback) 2 years
and forward (Carryforward)
Carryforward 20 years to
offset operating gains in those years.
• Losses are generally carried back first and
then forward starting with the earliest year
with operating gains.
Corporate Losses and
Gains Example
Lisa Miller is examining the impact of an
operating loss at Basket Wonders (BW) in
2003. The following time line shows
operating income and losses. What impact
does the 2007 loss have on BW?
2004 2005 2006 2007
$150,000 $150,000 $100,000 -$500,000
Corporate Losses and Gains Example
The loss can offset the gain in each of the years 2005
and 2006. The remaining $250,000 can be carried
forward to 2008 or beyond.
Impact: Tax refund for federal taxes paid in 2005 and
2006.
2004 2005 2006 2007
$150,000 $150,000 $100,000 -$500,000
-$150,000 -$100,000 $250,000
$150,000 0 0 -$250,000