Chapter (2) Financial Statements, Cash Flow Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Chapter Outline: Overview of Financial Information. The Annual Report. The Balance sheet. The Income statement. Statement of Retained Earnings. Statement of cash flows. MVA and EVA. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Financial Information—Where Does It Come From? Financial information is the responsibility of management Created by within-firm accountants Creates a conflict of interest because management wants to portray firm in a positive light Published to a variety of audiences Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Users of Financial Information Investors and Financial Analysts Financial analysts interpret information about companies and make recommendations to investors Major part of analyst’s job is to make a careful study of recent financial statements Vendors/Creditors Use financial info to determine if the firm is expected to make good on loans Management Use financial info to pinpoint strengths and weaknesses in operations Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Orientation of Financial Analysis Accounting is concerned with creating financial statements Finance is concerned with using the data contained within financial statements to make decisions The orientation of financial analysis is critical. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Annual Report It is a report issued annually by a corporation to its stockholders. It contains basic financial statements, as well as management’s analysis of the past year’s operations and opinions about the firm’s future prospects. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Balance sheet A statement of the firm’s financial position at a specific point in time. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets 2002 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 2001 57,600 351,200 715,200 1,124,000 491,000 146,200 344,800 1,468,800 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2002 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592 2001 145,600 200,000 136,000 481,600 323,432 203,768 663,768 1,468,800 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The Income statement The Income statement is a statement summarizes a firm’s revenues and expenses over a given period of time, generally a quarter or a year. Reflects performance during the period Income statements can cover any period of time, but they are usually prepared monthly, quarterly and annually Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2002 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176) 2001 3,432,000 2,864,000 358,672 209,328 18,900 190,428 43,828 146,600 58,640 87,960 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Statement of Retained Earnings. It is a statement reporting how much of the firm’s earnings were retained in the business rather than paid out in dividends. A positive number in the retained earnings account indicates only that in the past the firm earned some income Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Statement of Retained Earnings (2002) Balance of retained earnings, 12/31/01 Add: Net income, 2002 Less: Dividends paid earnings, 12/31/02 $203,768 (160,176) (11,000) $32,592 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Statement of Cash Flows: A statement reporting the impact of a firm’s operating, investing, and financing activities on cash flows over an accounting period. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Statement of Cash Flows Summarizes the changes in a company’s cash position The statement separates activities into three categories, plus a summary section: Operating activities Investment activities Financing activities Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Statement of Cash Flows Is used to help answer questions such as: Is the firm generating enough cash to purchase the additional assets required for growth? Is the firm generating any extra cash that can be used to repay debt or to invest in new products? Such information is useful both for managers and investors Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Operating activities Includes: net income, depreciation, changes in current assets other than cash, Changes in current liabilities other than notes payable, Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Investing activities Includes: investments in fixed assets or sales of fixed assets Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Financing activities Includes: Raising cash by selling short-term investments or by issuing short-term debt Long term debt, or stock Also because both dividends paid and cash used to buy back outstanding stock or bonds reduce the company’s cash, such transactions are included here Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Business Cash Flows Cash Flows Rules The following rules can be applied to any business’s financial statements Asset increase  use of cash Asset decrease  source of cash Liability increase  source of cash Liability decrease  use of cash Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Sources and Uses of Cash Sources of cash Uses of cash Dividend payments Net income + depreciation Increase in long-term debt Decrease in long-term debt Increase in equity Cash and cash equivalents Decrease in equity Increases in current liabilities Increases in fixed assets Decreases in fixed assets Decreases in current assets other than cash Increases in current assets other than cash Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Statement of Cash Flows (2002) OPERATING ACTIVITIES Net income Add (Sources of cash): Depreciation Increase in A/P Increase in accruals Subtract (Uses of cash): Increase in A/R Increase in inventories Net cash provided by ops. (160,176) 116,960 378,560 353,600 (280,960) (572,160) (164,176) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Statement of Cash Flows (2002) L-T INVESTING ACTIVITIES Investment in fixed assets FINANCING ACTIVITIES Increase in notes payable Increase in long-term debt Payment of cash dividend Net cash from financing NET CHANGE IN CASH Plus: Cash at beginning of year Cash at end of year (711,950) 436,808 400,000 (11,000) 825,808 (50,318) 57,600 7,282 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Net cash from operations = -$164,176, mainly because of negative NI. What can you conclude about D’Leon’s financial condition from its statement of CFs? Net cash from operations = -$164,176, mainly because of negative NI. The firm borrowed $825,808 to meet its cash requirements. Even after borrowing, the cash account fell by $50,318. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Market Value Added (MVA): The difference between the market value of the firm’s stock and the amount of equity capital investors have supplied. MVA= Market value of stock – Equity capital supplied by shareholders. MVA= (Stock Price) (Shares outstanding) - Total common equity. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Market Value Added (MVA): ($25*50)- (663,768)=586,232 MVA 2002: ($20*50)- (492,592)=507,408 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Economic Value Added (EVA): Value added to shareholders by management during a given year. In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Economic Value Added (EVA): EVA = After-tax __ After-tax Operating Income Capital costs EVA = NOPAT – After-tax Cost of Capital Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Economic Value Added (EVA): Assume the firm’s after-tax percentage cost of capital was 10% in 2001 and 13% in 2002. EVA02 = NOPAT – (A-T cost of capital) (Capital) = -$78,569 – (0.13)($1,852,832) = -$78,569 - $240,868 = -$319,437 EVA01 = $114,257 – (0.10)($1,187,200) = $114,257 - $118,720 = -$4,463 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

End of Chapter 2 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.