Agenda

1. Agenda • Minicase Ch 1 • Chapter 2 • Chapter 3 2-0

2. Chapter 2 • Book value and market value • Accounting income and CF • Average and marginal tax rates • How to determine a firm’s CF from its financial statements 2-1

3. Balance Sheet • What does the Balance Sheet do? • What does this mean? A = L + SE

4. Balance Sheet • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time • Assets are listed in order of decreasing liquidity • Ease of conversion to cash • Without significant loss of value • Balance Sheet Identity • Assets = Liabilities + Stockholders’ Equity 2-3

5. The Balance Sheet - Figure 2.1 2-4

6. Net Working Capital and Liquidity • Net Working Capital • = Current Assets – Current Liabilities • Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out • Usually positive in a healthy firm • Liquidity • Ability to convert to cash quickly without a significant loss in value • Liquid firms are less likely to experience financial distress • But liquid assets typically earn a lower return • Trade-off to find balance between liquid and illiquid assets 2-5

7. US Corporation Balance Sheet – Table 2.1 2-6

8. Market Value vs. Book Value • The balance sheet provides the book value of the assets, liabilities, and equity. • Market value is the price at which the assets, liabilities ,or equity can actually be bought or sold. • Market value and book value are often very different. Why? • Which is more important to the decision-making process? 2-7

9. Ch 2 Problem 1 Find the value of Shareholders’ Equity and of Net Working Capital… To find owner’s equity, we must construct a balance sheet : Balance Sheet CA $5,100 CL $4,300 NFA 23,800 LTD 7,400 OE ?? TA $28,900 TL & OE $28,900 We know that total liabilities and owner’s equity (TL & OE) must equal total assets of $28,900. We also know that TL & OE is equal to current liabilities plus long-term debt plus owner’s equity, so owner’s equity is: OE = $28,900 – 7,400 – 4,300 = $17,200 NWC = CA – CL = $5,100 – 4,300 = $800

10. Ch 2 Problem 5 Find the Book Value and the Market Value of assets… To find the book value of current assets, we use NWC = CA – CL Rearranging to solve for current assets, we get: CA = NWC + CL = $380,000 + 1,400,000 = $1,480,000 Market Value of Current Assets is given ($1.6 million).

11. Income Statement • What does the Income Statement do? • What does “matching” achieve, and why is it important?

12. Income Statement • The income statement is a summary of the firm’s finances for a specified period of time. • You generally report revenues first and then deduct any expenses for the period • Matching principle – GAAP says to show revenue when it accrues and match the expenses required to generate the revenue 2-11

13. US Corporation Income Statement – Table 2.2 Insert new Table 2.2 here (US Corp Income Statement) 2-12

14. Ch 2 Problem 2 Find the Net Income…

15. Ch 2 Problems 3 • If they had paid a cash dividend of $73,000, what would happen to Retained Earnings? • What is Retained Earnings? • Net income = Dividends + Addition to retained earnings • Addition to retained earnings = Net income – Dividends = $171,600 – 73,000 = $98,600

16. Ch 2 Problem 4 • Find the EPS and Dividends Per Share… • EPS = Net income / Shares = $171,600 / 85,000 = $2.02 per share • DPS = Dividends / Shares = $73,000 / 85,000 = $0.86 per share

17. Taxes • What is the difference between the Marginal Tax Rate and the Average Tax Rate? • Why is this important to know?

18. Taxes • The one thing we can rely on with taxes is that they are always changing • Marginal vs. average tax rates • Marginal tax rate – the percentage paid on the next dollar earned • Average tax rate – the tax bill / taxable income • Other taxes 2-17

19. Corporate Tax Rate Schedule EXAMPLE: What if a company has before tax earnings of $250,000? Average tax rate = 32.3% Marginal tax rate (on the next $85,000) = 39%

20. Example: Marginal Vs. Average Rates • Suppose your firm earns $4 million in taxable income. • What is the firm’s tax liability? • What is the average tax rate? • What is the marginal tax rate? • If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis? 2-19

21. Ch 2 Problem 6 & 7 Find Renata Co.’s 2009 Income Tax Expense = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($236K – 100K) = $75,290 The average tax rate is the total tax paid divided by net income, so: Average tax rate = $75,290 / $236,000 = 31.90% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%.

22. Cash Flows • Why is CF important? • What if you have a business model with no cash flows? • What are the types of CFs, and what is the significance of each?

23. Cash Flows • CF is one of the most important pieces of information that a financial manager can derive from financial statements • The statement of CFs does not provide us with the same information that we are looking at here • We will look at how cash is generated from utilizing assets • We will examine how cash is paid to those that finance the purchase of assets 2-22

24. CF Summary From which financial statement does each piece of information come from? 2-23

25. US Corporation Balance Sheet – Table 2.1 2-24

26. US Corporation Income Statement – Table 2.2 Insert new Table 2.2 here (US Corp Income Statement) 2-25

27. Example: US Corporation – Part I • OCF (I/S) = EBIT + depreciation – taxes = $547 • NCS (B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130 • Changes in NWC (B/S) = ending NWC – beginning NWC = $330 • CFFA = OCF – NCS – ΔNWC =547 – 130 – 330 = $87 2-26

28. Example: US Corporation – Part II • CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24 • CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63 • CFFA = CF to Creditors + CF to Stockholders= 24 + 63 = $87 • CFFA = OCF – NCS – ΔNWC =547 – 130 – 330 = $87 • OCF – NCS – ΔNWC = CF to Creditors + CF to Stockholders 2-27

29. Example: Balance Sheet and Income Statement Information • Current Accounts • 2009: CA = 3625; CL = 1787 • 2008: CA = 3596; CL = 2140 • Fixed Assets and Depreciation • 2009: NFA = 2194; 2008: NFA = 2261 • Depreciation Expense = 500 • Long-term Debt and Equity • 2009: LTD = 538; Common stock & APIC = 462 • 2008: LTD = 581; Common stock & APIC = 372 • Income Statement • EBIT = 1014; Taxes = 368 • Interest Expense = 93; Dividends = 285 2-28

30. Example: CFs • OCF = 1,014 + 500 – 368 = 1,146 • NCS = 2,194 – 2,261 + 500 = 433 • Changes in NWC = (3,625 – 1,787) – (3,596 – 2,140) = 382 • CFFA = 1,146 – 433 – 382 = 331 • CF to Creditors = 93 – (538 – 581) = 136 • CF to Stockholders = 285 – (462 – 372) = 195 • CFFA = 136 + 195 = 331 • The CF identity holds 2-29

31. Ch 2 Problem 8 Find OCF… First, we need the income statement Income Statement Sales $27,500 Costs 13,280 Depreciation 2,300 EBIT $11,920 Interest 1,105 Taxable income $10,815 Taxes (35%) 3,785 Net income $ 7,030 OCF = EBIT + Depreciation – Taxes = $11,920 + 2,300 – 3,785 = $10,435

32. Ch 2 Problem 9 • Find NCS (Net Capital Spending)… • Net capital spending = NFAend – NFAbeg + Depreciation • Net capital spending = $4,200,000 – 3,400,000 + 385,000 • Net capital spending = $1,185,000

33. Ch 2 Problem 10 • Find ΔNWC (Change in Net Working Capital)… • ΔNWC = NWCend – NWCbeg • ΔNWC = (CAend – CLend) – (CAbeg – CLbeg) • ΔNWC = ($2,250 – 1,710) – ($2,100 – 1,380) • ΔNWC = $540 – 720 = –$180

34. Ch 2 Problem 11 • Find CF to Creditors… • CF to creditors = Interest paid – Net new borrowing • CF to creditors = Interest paid – (LTDend – LTDbeg) • CF to creditors = $170,000 – ($2,900,000 – 2,600,000) • CF to creditors = –$130,000

35. Ch 2 Problem 12 • Find CF to Stockholders… • CF to stockholders = Dividends paid – Net new equity • CF to stockholders = Dividends paid – [(Commonend + APISend) – (Commonbeg + APISbeg)] (APIS is the additional paid-in surplus) • CF to stockholders = $490,000 – [($815,000 + 5,500,000) – ($740,000 + 5,200,000)] • CF to stockholders = $115,000

36. Ch 2 Problem 13 Find OCF (Operating Cash Flow)… First, we need CFFA (Cash Flow From Assets) CFFA = CF to creditors + CF to stockholders= –$130,000 + 115,000 = –$15,000 Since CFFA = –$15,000 and OCF – ΔNWC – Net capital spending Therefore –$15,000 = OCF – (–$85,000) – 940,000 Rearranging to find –$15,000 – 85,000 + 940,000 = OCF OCF = $840,000

37. Chapter 3 • Statement of Cash Flows, and sources and uses of cash • Standardizing financial statements for comparison purposes • Important financial ratios • Problems and pitfalls in financial statement analysis 3-36

38. Financial Statement Analysis

39. Statement of Cash Flows • What is the purpose of the Statement of Cash Flows? • What are the three sections, and why is it divided that way? 3-38

40. Statement of Cash Flows • Statement that summarizes the sources and uses of cash • Changes divided into three major categories • Operating Activity – includes net income and changes in most current accounts • Investment Activity – includes changes in fixed assets • Financing Activity – includes changes in notes payable, long-term debt, and equity accounts, as well as dividends 3-39

41. Sources and Uses of Cash • Sources • Cash inflow – occurs when we “sell” something…always? • Decrease in asset account (Sample B/S) • Accounts receivable, inventory, and net fixed assets • Increase in liability or equity account • Accounts payable, other current liabilities, and common stock • Uses • Cash outflow – occurs when we “buy” something…always? • Increase in asset account • Cash and other current assets • Decrease in liability or equity account • Notes payable and long-term debt 3-40

42. Sample Balance Sheet Numbers in millions of dollars 3-41

43. Sample Income Statement Numbers in millions of dollars, except EPS & DPS 3-42

44. Sample Statement of Cash Flows Numbers in millions of dollars 3-43

45. Why Evaluate Financial Statements? • Internal uses • Performance evaluation – compensation and comparison between divisions • Planning for the future – guide in estimating future cash flows • External uses • Creditors • Suppliers • Customers • Stockholders 3-44

46. Standardized Financial Statements • Common-Size Balance Sheets • Compute all accounts as a percent of total assets • Common-Size Income Statements • Compute all line items as a percent of sales • Standardized statements make it easier to compare financial information, particularly as the company grows • They are also useful for comparing companies of different sizes, particularly within the same industry 3-45

47. Ch 3 Problem 13, 14 & 15 How did we get here? What does it really tell us?

48. Ratio Analysis • Ratios allow for better comparison through time or between companies • Ratios are used both internally and externally • Consider what each ratio is trying to measure and why that information is important • Avoid creating rounding issues! 3-47

49. Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios 3-48

50. Computing Liquidity Ratios • Current Ratio = CA / CL 2,256 / 1,995 = 1.13 times • Quick Ratio = (CA – Inventory) / CL (2,256 – 301) / 1,995 = .98 times • Cash Ratio = Cash / CL 696 / 1,995 = .35 times • NWC to Total Assets = NWC / TA (2,256 – 1,995) / 5,394 = .05 • Interval Measure = CA / average daily operating costs 2,256 / ((2,006 + 1,740)/365) = 219.8 days B/S I/S 3-49