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BCOR 2200 Chapter 2

BCOR 2200 Chapter 2. Financial Statements, Taxes and Cash Flows. Chapter Outline. 2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes 2.4 Cash Flows. Key Concepts and Skills. Understand Financial Statements!! Know the difference between: Book Value and Market Value

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BCOR 2200 Chapter 2

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  1. BCOR 2200Chapter 2 Financial Statements, Taxes and Cash Flows

  2. Chapter Outline 2.1 The Balance Sheet 2.2 The Income Statement 2.3 Taxes 2.4 Cash Flows

  3. Key Concepts and Skills • Understand Financial Statements!! • Know the difference between: Book Value and Market Value Accounting Net Income and a Cash Flow Average Tax Rates and Marginal Tax Rates • Know how to determine a firm’s cash flow from its financial statements

  4. 2.1 Balance Sheet • The balance sheet is a “snap-shot” • What does the company owntoday? • What does the company owetoday? • How much is left for the owners? • called the residual • The LEFT SIDE shows what assets are employed by the firm to do what it does • Cash, Inventory, Factories, Machines, Trucks… • The RIGHT SIDE shows how it paid for the assets • How much is borrowed and for how long • How much is left for the owners • Note: Owner’s Equity is not how much the owners contributed. It is the current residual value.

  5. Balance Sheet and Financial Leverage Debt is also called Financial Leverage • So for some amount of equity… • What amount of assets are employed? Put up $1 million in Equity: • And Borrow $1 million • So Employ $2 million in assets • Or Borrow $2 million • So Employ $3 million in assets • The firm with three million in assets has more Financial Leverage

  6. Balance Sheet Example • Assets are listed from Most Liquid to Least Liquid • What does liquid mean? • “Net Fixed Assets” is Book Value (LOCOM) net of Accumulated Depreciation • Assets = Liabilities + OE  OE = Assets - Liabilities

  7. Market Value vs. Book Value: • Market Value of Assetsvs. Book Value of Assets • GAAP: LOCOM • Coors in Golden: Land is on books at cost • But what is the market value of that land? • Market Value of Equity vs. Book Value of Equity • Book Value of Equity = Book Value of Assets – Liabilities • Market Value of Equity = # of Shares x Price per Share • What would account for the difference between book and market? • What kind of companies have a relatively high Market-to-Book ratio? • What kind of companies have a relatively low Market-to-Book ratio?

  8. Clicker Question: • A firm’s balance sheet shows $50 million in Total Assets and $30 million Total Debt • The firm has 1,000,000 shares of stock outstanding at a price of $25 per share • Which of the following is true? • Book Value Equity is greater than Market Value of Equity • Market Value Equity is greater than Book Value of Equity • Book Value Equity equals Market Value of Equity • There is not enough information to tell.

  9. Clicker Answer: Book Value of Equity = Book value of Assets - Book Value of Debt Book Value of Equity = $50m – $30m = $20m Market Value of Equity = # of shares x Price Market Value of Equity = 1 million x $25 = $25m The Answer is B. The Market Value Equity is greater than Book Value of Equity

  10. 2.2 Income Statement • Revenues and Expenses as they Accrue • If a sale is made, book the revenue • Not necessarily receive cash • Sale could be on account - A/R (a current asset) • Non-Cash Expenses • Depreciation = $65 • Was the $65 spent this period? • No. It is a portion of the amount spent (when the PPE was purchased) that is allocated to this period • $65 is expensed against this period’s revenue • It lowers this periods taxable income • And therefore lowers this period’s tax expense

  11. Income Statement Revenue = Sales - COGS Gross Profit - SG&A EBITDA = Operating Revenue - Depreciation and Amortization EBIT - Interest Expense EBT = Taxable Income - Tax Expense Net Income = Earnings Revenue > Gross Profit > EBITDA > EBIT > EBT > NI

  12. Later we will reorganize some of the items on the Income Statement • We will produce projected Income Statements for a specific project • Called “Pro Forma” Income Statements • Use items associated with Managerial Accounting • We will not breakdown costs into COGS and SG&A • We will breakdown costs into Fixed Costs and Variable Costs But for now, standard Income Statements 

  13. Income Statement Example • Income Statement Includes: • Operating Expenses (COGS, SG&A, Lights…) • Per-Share numbers • Addition to Retained Earnings on Income Statement is accumulated Retained Earnings on the Balance Sheet

  14. Clicker Question: • A firm’s taxable income is $1,000 • The firm owns a machine with $200 annual depreciation this year. • The firm’s tax rate is 35% • What is this year’s tax savings due to depreciation? • $35 • $65 • $100 • $70 • $130

  15. Clicker Answer: • A firm’s taxable income is $1,000 • The firm owns a machine with $200 annual depreciation this year. • The firm’s tax rate is 35% • What is this year’s tax savings due to depreciation? (Depreciation)(Tax Rate) = $200(0.35) = $70 Or Tax Exp with Depreciation = $1,000(0.35) = $350 Tax Exp without Depreciation = ($1,200)(0.35) = $420 Savings = $420 - $350 = $70 Correct Answer is D.

  16. Income Statement Firms can engage in “Earnings Management” • Show higher or lower earnings • Used to achieve income smoothing • “Cookie Jar” accounts • LIFO or FIFO • Not necessarily illegal or unethical • See the Wikipedia Page

  17. 2.3 Corporate Taxes • See Table 2.3 for corporate tax rates • Make sure you can calculate: • Tax Expense • Marginal Tax Rate • Average Tax Rate • See Examples on page 32 • If you are calculating the effect of additional income from a new project, which tax rate should you use? • Marginal. • Why?

  18. 2.4 Cash Flows Cash Flows are Everything! • It is money available to pay investors • We will deal with cash flows differently from the accounting “Statement of Cash Flows” • In General, the value of a firm (or an individual project) is… … the Present Value of its Cash Flows! • In any period… Net Cash Flows = Money In - Money Out

  19. Cash Flows • Not Sales • Since some sales are in cash, some sales are on account • Not Net Income (aka Earnings ) • NI or Earnings is an “accounting profit” not cash • Includes non-cash expenses • Includes accruals (sales, purchases…) • But at first we will start with the Income Statement and Net Income… • Why? • Because NI is closeto what we want (Cash Flows) • It has already been calculated by the accountants…

  20. Net Cash Flows We will figure out two things: • How much cash (at the end of the year) does the firm have available for investors? • Net Cash = “Cash In” minus “Cash Out” • Who gets that cash? • Stockholders or Bondholders

  21. Cash Flow from Assets • A company is defined by its assets • The cash generated by the company avaible to be paid to investors is called CF from Assets CF from Assets = CF from Operations minusCash spent on Capital (aka PPE) minusCash spent on Working Capital • Cash spent on Capital is called Net Capital Spending (NCS) • Cash spent on Working Capital is called Change in Net Working Capital (ΔNWC)

  22. Calculating CF from Operations CF from Operations: CF = Sales – COGS – Int Exp– Tax Exp = 1,509 – 750 – 70 – 212 = $477 But since Interest Expense is not an Operating Expense: CF from Operations= Sales – COGS – Tax Exp = 1,509 – 750 – 212 = $547 or CF from Operations= NI + Dep + IntExp = 412 + 65 + 70 = $547

  23. Calculating Net Capital Spending (NCS) • Net Fixed Assets increased on the Balance Sheet by $65 • $1,709 - $1,644 = $65 • Depreciated Expense on the Income Statement was $65 • Depreciation decreased Net Fixed Assets by $65 • So a net increase of $65 means the company spent $65 + $65 = $130 on Fixed Assets • Money spent on Net Fixed Assets is called Net Capital Spending=$130

  24. Calculating Change in Net Working Capital(ΔNWC) • First start with why ΔNWC matters… Sales = $1,509 COGS = $750 Tax Exp = $212 CF from Ops = Sales – COGS –Tax Exp = $1,509 – $750 – $212 = $547 • A/R increased by $233 (from $455 to $688) • This means that $233 of Sales assumed to be cash was not collected • So CF from Ops is too large by $233 • So we need to reduce CF from Assets by $233 • Inventory increased by $2 (from $553 to $555) • So how much inventory did the company buy? • Since COGS was $750, and inventory increased by $2 • The company bought $750 in inventory to replace what it sold • But we already subtracted $750 from CF from Ops • And it bought another $2, which we account for in ΔNWC • So CF from Ops is too large by $2 • So we need to reduce CF from Assets by $2

  25. Calculating ΔNWC Continued • Accounts Payable and Notes Payable decreased by $39 (from $428 to $389) • This means the company paid-off a net of $39 of short-term debt • So CF from Assets is too large by $39 • Cash increased by $56 (from $104 to $160) • This is cash the company retained, so it is not available to pay to the the investors (the stock and bond holders) • So CF from Assets is too large by $56

  26. Calculating ΔNWC Continued Recap: • Cash increased by $56 • A/R increased by $233 • Inventory increased by $2 • A/P and N/P decreased by $39 • Total = $330 = $56 + $233 + $2 – (-$39)

  27. Calculating ΔNWC Continued Or: New Total Current Assets – Old Total Current Assets = $1,403 - $1,112 = $291 • Current Assets increased by $291 so that cash is not available New Total Current Liab – Old Total Current Liab = $389 - $428 = -$39 • Current Liabilities decreased by $39 so that cash is not available

  28. Calculating ΔNWC Continued ΔNWC= (New Total Current Assets – Old Total Current Assets) – (New Total Current Liab – Old Total Current Liab) ΔNWC= New Total Current Assets–Old Total Current Assets –New Total Current Liab+Old Total Current Liab ΔNWC= (New Total Current Assets– New Total Current Liab) – (Old Total Current Assets–Old Total Current Liab) (Recall: Current Assets – Current Liab = Net Working Capital) ΔNWC= (New Net Working Capital) – (Old Net Working Capital) ΔNWC= (New NWC) – (Old NWC)

  29. ΔNWC= (New NWC) – (Old NWC) New NWC = New Total Current Assets – New Total Current Liab New NWC = $1,403 - $389 = $1,014 Old NWC = Old Total Current Assets – Old Total Current Liab Old NWC = $1,112 - $428 = $684 ΔNWC= (New NWC) – (Old NWC) = $1,014 – $684 = $330

  30. So back to CF from Assets So what was the Total CF generated by the company? In other words: what was the CF from Assets? • CF from Ops = $547 (Inflow) • Net Capital Spending = $130 (Outflow) • ΔNWC = $330 (Outflow) • CF from Assets = CF from Ops – NCS – ΔNWC = $547 - $130 - $330 = $87 So what happened to the $87? • It was paid to the investors • The stockholders and the bondholders • Next Question: • How much of the $87 went to the bondholders? • How much of the $87 went to the stockholders?

  31. CF from Assets = CF to Creditors + CF to Stockholders • How much cash did the Creditors (also called the bondholders) get? • They got the interest expense that was paid • Less any new money lent to the company • CF to Creditors = IntExp – Net New Borrowing • How much cash did the Stockholders get? • The got the dividends paid • Less any new ownership sold by the company • CF to Stockholders = Divs Paid – Net New Equity

  32. Calculating CF to Creditors= IntExp – Net New Borrowing • Interest Expense = $70 • Long Term Debt Increased by $46 (from $408 to $454) • So Bondholders were paid $70 but lent back $46 • CF to Creditors = $70 - $46 = $24

  33. Calculating CF to Stockholders= Divs Paid – Net New Equity • Dividends Paid = $103 • C-Stock & Paid-In Surplus Increased by $40 (from $600 to $640) • So Stockholders were paid $103 but invested an additional $40 • CF to Stockholders= $103 - $40 = $63

  34. CF from Assets = CF to Creditors + CF to Stockholders • CF to Creditors = IntExp – Net New Borrowing = $70 - $46 = $24 • CF to Stockholders = Divs Paid – Net New Equity = $103 - $40 = $63 • CF from Assets = $24 + $63 = $87 Recall the Cash Generated by the Assets: CF from Assets = CF from Ops – NCS – ΔNWC = $547 - $130 - $330 = $87 Cash Generated from Assets = $87 Cash Paid to Investors = $87

  35. Clicker Question: • Over the last year, a firm’s cash flow from operations was $1,000 • It spent $300 on new PPE • It’s change in NWC was $200 • Calculate the firm’s CF from Assets • $1,000 • $900 • $500 • $300 • $200

  36. Clicker Answer: • Over the last year, a firm’s cash flow from operations was $1,000 • It spent $300 on new PPE • It’s change in NWC was $200 • Calculate the firm’s CF from Assets CF from Assets = = CF from Ops – CF from Cap Spending - DNWC CF from Assets = = $1,000 - $300 - $200 = $500 The Answer is C.

  37. Clicker Question: • Last year a firm’s CF from Assets was $500 • It paid dividends $400 • Net Common Stock on the B-S went from $700 to $800 • It paid $300 in Interest Expense • Net Debt on the B-S went from $600 to $700 • Calculate CF to Stockholders. • Calculate CF to Creditors.

  38. Clicker Answer: CF to Stockholders = Divs – Net New Equity = $400 – ($800 – $700) = $400 - $100 = $300 CF to Creditors = IntExp– Net New Borrowing = $300 – ($700 – $600) = $300 – $100 = $200 The Answer is C. Notes: • The firm paid $300 in interest expense but then borrowed another $100. Why not just pay $200 in interest expense and not bother to borrow more? • The firm paid $400 in dividends but then sold $100 in new stock. Why not just pay $300 in dividends and not bother to sell the stock?

  39. Clicker Question: • Last year a firm’s CF from Assets was $500 • It paid dividends $400 • Net Common Stock on the B-S went from $700 to $1,200 • It paid $300 in Interest Expense • Net Debt on the B-S went from $600 to $300 • Calculate CF to Stockholders. • Calculate CF to Creditors.

  40. Clicker Answer: CF to Stockholders = Divs – Net New Equity = $400 – ($1200 – $700) = $400 - $500 = -$100 CF to Creditors = IntExp– Net New Borrowing = $300 – ($300 – $600) = $300 – (-$300) = $600 The Answer is A. Notes: • The firm paid $400 in dividends but then sold $500 in new stock. Therefore the CF to Stockholders was negative $100 • The firm paid $300in interest expense and then paid-off $300 of its outstanding debt. Therefore CF to Creditors was $600

  41. Now (Chapter 2): • We are calculating pastCash Flows • By looking at the financial statements covering pastactivity • The Balance Sheet and the Income Statement • And calculating the cash generated by the firm in the past Later (Chapter 9): • We will calculate projectedCash Flows • By producing pro-forma financial statements over a futureperiod of time • And calculate the cash we think a project (or new business) will generate in the future if we do it The Cash Flow formulas will be slightly different

  42. Recap: Table 2.6, Page 38

  43. What’s Next… Chapters 3: Financial Statement Analysis • Using financial statements and financial ratios to determine: • The Financial “health” of a business • Its ability to repay its debts • It degree of leverage • Its operating efficiency • Its ability to grow

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