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Finance 7310

By Holly Lopez,2014-08-07 09:50
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Finance 7310

    Finance 3310

    Lecture Notes

    Lecture 2

Financial Statements, Taxes and Cash Flow

     In finance the primary source of information about a company is usually the financial statements. Thus it is useful to review both the balance sheet and income statement, as well as some related concepts. In our picture of the corporation taxes represent a „drain‟ on corporate cash flows. Hence taxes are important. Finally, it is important to take the „accounting numbers‟ provided in the financial statements and convert them into „finance numbers,‟ which is cash flow.

THE BALANCE SHEET

     The balance sheet represents a „snapshot‟ of the corporation. It lists the assets and liabilities of a company as of a point in time. The balance sheet also conforms to our

    picture of the firm. That is, assets on the left-hand side are equal to liabilities and equity on the right-hand side.

     Assets - are listed in order of liquidity. (Liquidity has to do with the ability to

    convert something to cash without significant loss of value.) Cash is listed first, followed by inventory and accounts receivable, and ending with fixed or long-term assets.

     Liabilities - are listed in order of claim priority. Accounts payable and accrued expenses are listed first, while equity is listed last.

     A classification consistent with the above which is used by accountants is current

    and long-term. Current usually means occurring within one year, while long-term means longer than a year.

     Net working capital (NWC) -

     NWC = Current Assets - Current Liabilities

     It is useful in many instances involving analysis of a corporation to simply subtract current liabilities from both sides of the balance sheet. A simplified balance sheet results as follows:

     NWC Debt

     Long-term Assets Equity

     Total Assets Total Debt and Equity

    Finance 7310: Lecture 2 1

     Notice that this simple balance sheet conforms to our picture of the corporation. The circle, containing assets, is on the left. Total capital, debt and equity, are on the right.

     Debt - debt typically refers to long-term debt, or, depending on the context, to all interest bearing debt.

     Equity - equity actually consists of two accounts: stockholders equity (par value and paid-in-capital) and retained earnings. Retained earnings represents the cumulative earnings of the company since inception that have not been paid out as dividends. Retained earnings is not, in general, the same thing as money in the bank. These retained earnings may have been used for many things, only one of which is building a cash balance.

     Differences in debt and equity: There are a couple of fundamental differences between debt and equity. 1) Debt has a prior claim on corporate cash flows; equity‟s claim is a residual claim. 2) Interest is deductible for tax purposes; dividends are not.

ACCRUAL ACCOUNTING VS. CASH FLOW

     Accrual accounting, which results from the matching principal, results in revenues

    and expenses being recorded in different periods than when the associated cash flows occur. A company may record an expense this year, but the cash outflow may not occur until next year. Both accounts receivable and accounts payable are a result of accrual accounting.

Market Value vs. Book Value

     In general, the market value of either equity or assets is not the same as book value. Book value is based on the cost principle and reflects the cost of a transaction which has

    occurred or is reasonably certain to occur. Book value is an accounting number. Market value, on the other hand, represents the market‟s estimate of the value of assets or equity.

    Market value is forward looking; that is, market value reflects expectations about the future of the company. Market value and book value may differ because:

     • book value does not reflect reputation, brand names, customer loyalty

     • book value does not reflect expected future growth

     • book value does not reflect management talent

     • book value does not reflect the fact the whole is greater than the sum of the parts.

    The Income Statement

Finance 7310: Lecture 2 2

     The income statement measures performance over some period of time. Below is

    a generic income statement:

     Sales

     Cost of sales

     Gross profit

     Operating expenses

     Earnings before interest and taxes (EBIT)

     Interest

     Taxable income

     Taxes

     Net income

    Note that net income is not the same as cash flow. The primary differences relate to accrued revenues and expenses, and to noncash expenses such as depreciation. Frequently, rather than using net income, companies will divide net income by the number of shares outstanding to arrive at earnings per share (EPS).

TAXES

     As we discussed earlier, corporations must pay taxes. Your text indicates the current corporate tax rates in effect. These rates begin at 15% and rise ultimately to 35%. It is important to distinguish average tax rates from marginal tax rates. The average tax

    rate is simply total taxes divided by total taxable income. The marginal rate is the rate on

    an incremental dollar of taxable income. As an example, a company with $150,000 of taxable income would have a marginal rate of 39%. Your text provides an example of marginal and average tax rates. Marginal rates are used in most financial analysis.

CASH FLOW

     We know from the accounting identity:

     Assets = Debt + Equity (where assets = NWC + Fixed assets)

Therefore:

     Cash Flows From Assets = Cash Flows to B/H + Cash Flows to S/H

NOTE: Your text uses cash flow from assets, whereas we are using free cash flow from

    assets. The difference between the two has to do with taxes. Your text subtracts actual Finance 7310: Lecture 2 3

    taxes from EBIT, whereas we are subtracting t x EBIT. The difference between the two tax amounts is the amount of the depreciation tax shield. Our cash flows to Bondholders uses “net interest” rather than total interest expense. Net interest expense = interest

    expense x (1 t).

Begin with free cash flow from assets. Cash flow from assets consists of:

     • operating cash flows

     • Additions to NWC

     • Capital Spending

Operating cash flows consist of:

     EBIT (1 t)

     + Depreciation

    Additions to NWC = Ending Net working capital - beginning net working capital.

Finally, capital spending = ending gross fixed assets - beginning gross fixed assets.

    Some financial statements will not list gross fixed assets and accumulated depreciation separately. Rather, only net fixed assets will be shown. Your text uses financial

    statements and examples where only net fixed assets is listed. In this case, capital spending is found by adding depreciation expense to the change in net fixed assets. That is,

Capital spending = Ending net fixed assets - beginning net fixed assets + depreciation

    Cash flows to bondholders consists of net interest and the change in debt balance.

     Cash flow to B/H

     Net Interest = Interest expense x (1 t)

     ? in Debt

    Note that the ? in debt could be either positive or negative. Increases in debt represent cash flows from B/H‟s, while decreases in debt represent cash flows to B/H‟s. Cash flows

    from B/H‟s would be subtracted from interest in arriving at cash flow to B/H’s.

    Cash flows to stockholders consist of dividends and any net new equity raised. Similar to debt, net new equity can be either positive or negative. If net new equity is positive, implying the firm has sold shares and raised cash, then the cash flow is from S/H‟s and

    would be subtracted from dividends in arriving at cash flow to S/H’s.

    Summarizing all of this:

     CASH FLOWS FROM ASSETS

    Finance 7310: Lecture 2 4

     Operating Cash Flows: Cash Flows to B/H:

     EBIT (1 t) Net Interest

     + Depreciation Net new Debt

     =

     Cash Flows to S/H:

     - Additions to NWC Dividends

     - Capital Spending Net new equity

Example:

    BALANCE SHEET

     2001 2002 2001 2002 Cash 104 160 Accts Payable 232 266 Accts Rec 455 688 Notes Payable 196 123 Inventory 553 555 Current Liab 428 389 Current 1,112 1,403 Long-Term Debt 408 454 Assets

    Net Fixed 1,644 1,709 Common Stock 600 640 Assets

     Retained Earn. 1,320 1,629

     Total Equity Total Assets 2,756 3,112 Total Liab & 2,756 3,112

    Equity

    INCOME STATEMENT

    Net Sales 1,509

    Cost of Sales 750

    Depreciation 65

    EBIT 694

    Interest 70 46.2

    EBT 624

    Tax 212

    Net Income 412

    Finance 7310: Lecture 2 5

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