1. Financial Statements and Cash Flows
RWJ-Chapter 2

2. Understanding Financial Statements
The crux of investments is to value firms (or stocks)
Various models to value common stocks
DCF
Multiples
No matter which model we are going to use, the key inputs we needed are mostly based on a firm’s financial statements
We will learn the basic tools to analyze financial statements

3. Information for Financial Statements Analysis
1) Published annual reports
(1) Financial Statements
Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (independent accountants)
(5) Management’s discussion and analysis
2) Reports filed with the government

4. Sources of Information
Annual reports
SEC
EDGAR (
10K & 10Q reports

5. Balance Sheet Balance sheet summarizes the assets owned by a firm
The value of the assets, and the mix (debt and equity) used to finance these assets at a point in time
Assets
Liabilities & Equity
Fixed Assets
Current Assets
Financial Investments
Intangible Assets
Current Liabilities
Debt (Long-term)
Equity
Stockholder’s Equity
Total Assets
Total Liabilities & Equity

6. Summary of B/S
An accountant’s snapshot of the firm’s accounting value as of a particular date.
The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity
Stockholder’s equity is defined to be the difference between the assets and the liabilities of the firm. Equity is what stockholders would have remaining after the firm discharged its operations.
Liabilities and equity-side reflects the types and proportions of financing, which depend on management’s choice of capital structure, as between debt and equity and current debt and long-term debt.

7. Assets
Fixed Assets:
Assets that are purchased for long-term use and are not likely to be converted quickly into cash, such as land, buildings, and equipment.
GAAP requires the valuation of historical cost, adjusted for any estimated loss in value from the aging of these assets (Depreciation)
Many firms in the U.S. use straight line depreciation, while Japanese and German firms often use accelerated depreciation
Straight line versus Accelerated Depreciation
Accelerated depreciation leads reported income that is understated.

8. Example- Straight Line
An asset costs $33,000 has a residual value of $3,000, and expected to last 4 years
(i) Calculate annual depreciation
(ii) what happen if you are able to sell this asset after two year at selling price of $20,000?
33-3/4=7,500
33,000- (2x7500)=18,000 (this your BV)…. Your profit is =2000 tax=2000x0.30=600

9. Example-Accelerated Depreciation
An asset costs $33,000, and expected to last 5 years
(i) Calculate annual depreciation
(ii) what happen if you are able to sell this asset after two year at selling price of $20,000?
Recovery year
Applicable
Percentage 1
0.200 2
0.320 3
0.192 4
0.1152 5 6
0.0576
1) 33,000* 0.20=6600
2) 33,000* 0.32=10,560
3) 33,000* 0.192=6,336
4) 33,000*0.1152= 3,802
5) 33,000*0.1152=3802

10. Assets Current Assets: Account Receivables:
It represents money owed by entities to the firm on the sale of products on credit
Cash and Marketable Securities:
Cash: One of the few assets for which accountants and financial analysts should agree on the value
Marketable Securities: Investments made by firms in securities or assets of other firms, as well as T-bills or bonds
Inventory
The total amount of goods and/or materials contained in a store or factory at any given time
Closely related to COGS
LIFO vs FIFO
When home depot sells products to building contractors and gives them a few weeks to make their payment. It is creating account receivables
FIFO COGS is based on the cost of material bought earliest in the period LIFO the latest in the period
If high inflation which gives you higher net income (FIFO) which one has tax advantage (LIFO). Two exactly two companies how should we take care of LIFO and FIFO (footnote: LIFO reserve)

11. Assets Intangible Assets: Patents and Trademarks Internal External
Goodwill
By product of acquisitions
When a firm acquires another firm, the purchase price is first allocated to tangible assets, and the excess price is then allocated to any intangible assets
Nothing but excess price by actual price (MV) and book value of the company
Only externally bought patents are assumed to be asset and amorized up to 40 years
Internal, you write the costs anyway

12. Liabilities and Equity
Current Liabilities:
Accounts payable:
It represents credit received from suppliers and other vendors
Short-term Borrowing:
Short-term loans (due in less than a year) to finance the operations or current asset needs of the business
Short-term portion of long-term borrowing
It represents the portion of the long-term debt or bonds that is coming due in the next year
Other short-term liabilities:
It includes wages due to its employees and taxes due to the government

13. Liabilities and Equity
Long-Term Debt:
Long-term loan from a bank or other financial institutions
Long-term bond issued to financial markets
Other Long-term Liabilities:
Leases, Employee Benefits, Pension Plans, Health Care Benefits
These are long-term obligations that are not captured in the long-term debt items
In the past two decades accountants moved toward quantifying these liabilities and showing them as long-term liabilities
Equity:
It reflects the original proceeds received by the firm when issued the equity
Retained Earnings:
Net Income kept for further investment

14. (in $ millions)
2008 and 2009
Balance Sheet
U.S. COMPOSITE CORPORATION
Liabilities (Debt)
Assets
2008
2009
and Stockholder's Equity
2008
2009
Current assets:
Current Liabilities:
Cash and equivalents
$104
$160
Accounts payable
$232
$266
Accounts receivable
455
688
Notes payable
196
123
Inventories
553
555
Total current liabilities
$428
$389
Total current assets
$1,112
$1,403
Fixed assets:
Net Property, plant, and equipment
$1,644
$1,709
Long-term debt
408
454
Stockholder's equity:
Common stock and paid in surplus
600
640
Accumulated retained earnings
1,320
1,629
Total equity
$1,920
$2,269
Total assets
$2,756
$3,112
Total liabilities and stockholder's equity
$2,756
$3,112

15. Balance Sheet Analysis
When analyzing a balance sheet, the financial manager should be aware of three concerns:
(1) Liquidity
(2) Debt versus equity
(3) Value versus cost

16. Liquidity
Refers to the ease and quickness with which assets can be converted to cash.
Current assets are the most liquid. Fixed assets are the least liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations.
Liquid assets frequently have lower rates of return than fixed assets. For example, cash generates no or little investment income.
To the extent that a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investments.

17. Value versus Cost
Under GAAP audited financial statements of firms in the U.S. carry assets at cost.
Market value is a completely different concept.
Market value is the price at which willing buyers and sellers trade the assets. It would be only coincidence if accounting value (book value) and market value were the same.
Many users of financial statements want to know the value of the firm, not its cost.
In this class, whenever we mention value, we mean market value, not the cost (or book value).
When we say that the goal of a financial manager is to increase the value of the stock, we mean the market value of the stock.

18. Revenue – Expenses ≡ Income
Income Statement
The income statement measures performance over a specific period of time.
It provides information on the revenues and expenses of the firm, and resulting income made by the firm, during a period
The accounting definition of income is
Revenue – Expenses ≡ Income

19. More Specifically Revenue Cost of Goods Sold (COGS) Gross Profit
Operating Expense
EBITDA
Depreciation & Amortization
EBIT (Operating Income)
Interest
Taxes
Net Income (NI) or Earnings
Retained Earnings (R/E)
Dividends

20. U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
The operations section of the income statement reports the firm’s revenues and expenses from principal operations
Net sales
$1,509
Cost of goods sold
- 750
Depreciation
- 65
$694
Earnings before interest and taxes
Interest expense
- 70
Taxable income
$624
Taxes (34%)
- 212
Net income
$412
Retained earnings: $309
Dividends: $103

21. U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
Net sales
$1,509
Cost of goods sold
- 750
- 65
Depreciation
The non-operating section of the income statement includes all financing costs, such as interest expense.
$694
Earnings before interest and taxes
- 70
Interest expense
$624
Taxable income
- 212
Taxes (34%)
Net income
$412
Retained earnings: $309
Dividends: $103

22. U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
$1,509
Net sales
- 750
Cost of goods sold
- 65
Depreciation
$694
Earnings before interest and taxes
Usually a separate section reports as a separate item the amount of taxes levied on income
- 70
Interest expense
$624
Taxable income
- 212
Taxes (34%)
$412
Net income
Retained earnings: $309
Dividends: $103

23. U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
Net sales
$1,509
Cost of goods sold
- 750
- 65
Depreciation
$694
Earnings before interest and taxes
Interest expense
- 70
Taxable income
$624
Taxes (34%)
- 212
Net income
$412
Net income is the “bottom line”
Retained earnings: $309
Dividends: $103

24. Income Statement Analysis
There are two things to keep in mind when analyzing an income statement:
(1) GAAP
(2) Non Cash Items

25. Generally Accepted Accounting Principles
Recognition principle: Recognize revenue when the earnings process is complete and the value of an exchange of goods or services is known and can be reliably determined. Thus, income is reported when it is earned, even though no cash flow may have occurred.
Midland co. sells goods for $1 million. The goods cost $900,000. So the company will have profit of $100,000.
But the company has not yet collected the cash from the sale. So, the net cash flow is -$900,000.

26. Non-Cash Items
Depreciation is the most apparent. No firm ever writes a check for “depreciation”.
In practice, the difference between cash flows and accounting income can be quite dramatic.
For example Conseco Corp. reported a net loss of $194 million for But it also reported a positive cash flow of $ 703 million for the same fiscal year!

27. Working Capital ≡ Current Assets – Current Liabilities
Net Working Capital
Working Capital ≡ Current Assets – Current Liabilities
If the change in NWC is positive, it is a cash outflow. (you are investing more in NWC). If the change in NWC is negative, it is a cash inflow

28. This increase of $330 million is an investment of the firm.
(in $ millions)
2008 and 2009
Balance Sheet
U.S. COMPOSITE CORPORATION
$1014m = $1403- $389
Liabilities (Debt)
Assets
2008
2009
and Stockholder's Equity
2008
2009
Current assets:
Current Liabilities:
Cash and equivalents
$104
$160
Accounts payable
$232
$266
Accounts receivable
455
688
Notes payable
196
123
Inventories
553
555
$684m = $1112m- $428m
Total current liabilities
$428
$389
Total current assets
$1,112
$1,403
Long-term liabilities:
Fixed assets:
Here we see NWC grow to $1,014 million in 2009 from $684 million in 2008.
Deferred taxes
$117
$104
Property, plant, and equipment
$1,423
$1,274
Long-term debt
471
458
Less accumulated depreciation
-550
-460
Total long-term liabilities
$588
$562
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Stockholder's equity:
Total fixed assets
$1,118
$1,035
Preferred stock
$39
$39
Common stock ($1 par value) 55 32
Capital surplus
347
327
Accumulated retained earnings
390
347
This increase of $330 million is an investment of the firm.
Less treasury stock
-26
-20
Total equity
$805
$725
Total assets
$1,879
$1,742
Total liabilities and stockholder's equity
$1,879
$1,742

29. Financial Cash Flows
In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.
Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)

30. U.S. COMPOSITE CORPORATION
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Operating Cash Flow:
EBIT $694
Depreciation $65
Current Taxes ($212)
OCF $547
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
(Ending net fixed assets
minus beginning fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
$24
Equity 63
Total
$87

31. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
Capital Spending
Ending net fixed assets $1,709
Beginning net fixed assets (1644)
Depreciation
Net Capital Spending $130
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
(Ending net fixed assets
minus beginning net fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
$24
Equity 63
Total
$42

32. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
NWC grew from $684 million in 2008 to $1014 million in 20X1.
This increase of $330 million is the addition to NWC.
plus depreciation minus taxes)
Capital spending
(130)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
$24
Equity 63
Total
$87

33. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
(Ending net fixed assets
minus beginning net fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
$24
Equity 63
Total
$87

34. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130
Cash Flow to Creditors
Interest paid $70
Net new borrowing (46)
Total 24
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
$24
(Interest minus net new borrowing)
Equity 63
(Dividends minus net new equity raised)
Total
$87

35. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
Cash Flow to Stockholders
Dividends $103
Net new equity raised (40)
Total $63
Net new equity raised is the change in common stock and paid–in-surplus from B/S.
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
$24
(Interest minus net new borrowing)
Equity 63
(Dividends minus net new equity raised)
Total
$87

36. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:
Capital spending
(130)
(Ending net fixed assets
minus beginning net fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
$24
(Interest minus net new borrowing)
Equity 63
(Dividends minus net new equity raised)
Total
$87

37. Cash Flow Summary

38. Free Cash Flows There are two types of Cash Flows:
(1) This is the cash flows generated by a company’s operating activities and available to all who provided capital to the firm (Debt and Equity Holders)
𝑂𝐹𝐶𝐹=𝐸𝐵𝐼𝑇−𝑇𝑎𝑥+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛−𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙−∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠
Current Assets –Current Liabilities

39. Free Cash Flows
(2) “free” cash flows to equity (stock holders), which is derived from after operating free cash flows have been adjusted for debt payments (interest and principal)
𝐹𝐶𝐹=𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛−𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
+𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒−𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝐷𝑒𝑏𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙−∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠
Current Assets –Current Liabilities

40. Question:
Which one to use?

41. Cash Flows Assets Liabilities Cash inflow Cash outflow Cash outflow

42. Limitations of Financial Ratios
Accounting statements:
A reasonably good job of categorizing the assets owned by a firm
A partial job of assessing the value of these assets
A poor job of reporting uncertainty about asset value
Accounting principles:
The accounting view of asset value is to a great extent grounded in the notion of historical cost, which is the original cost of the asset. Historical cost is the best estimate of the value of an asset.
Conservative approach to estimate the value .
At the end of 2011, book value of Google is $58.1 billion
At the end of 2011, the market value of Google is $ billion (stock price= $645)

43. Limitations of Financial Ratios
These values are based on specific dates
Capture values of assets and liabilities on a specific date
Ratios using balance sheet may not reflect company’s situation during rest of the year
Example: A company that reports $1 million in cash on last day of fiscal year may have only $100 K two days later after paying salaries and suppliers