Chapter 3 Financial Statements & Free Cash Flow DES Chapter 3

Cash is King! Investors care about cash flow. Importance of disentangling cash flows from published financial statements. DES Chapter 3

Annual report has 4 parts1 Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity 1And footnotes DES Chapter 3

GAAP Statements prepared according to GAAP are reasonably consistent from firm-to-firm. But standard measures (EPS, net change in cash, net income, and ROE) are not sufficient for valuations. DES Chapter 3

Accruals Accruals creates problems w/ GAAP Accrual basis Matching principle When does cash come in and go out, versus when are cash flows recognized? DES Chapter 3

The Balance Sheet Assets Accounts receivable (AR)—money owed to ACME by customers who purchased on credit terms Inventory Long-term asset: property, plant and equipment (PPE). Accumulated depreciation—subtracted from gross PPE to get net PPE. DES Chapter 3

Acme's Balance Sheet: Assets 2001 2002 2003 Cash 37.30 41.40 45.12 Inventory 522.14 579.58 631.74 Accounts receivable 932.40 1,034.96 1,128.11 Total current assets 1,491.84 1,655.94 1,804.98 Gross PPE 2,619.28 3,031.40 3,443.32 Accumulated depreciation 754.48 961.47 1,187.09 Net PPE 1,864.80 2,069.93 2,256.23 Total assets 3,356.64 3,725.87 4,061.20 DES Chapter 3

The balance sheet… Liabilities and owners’ equity Accrued expenses Short-term debt Long-term debt Common stock Retained earnings DES Chapter 3

Acme's Balance Sheet: Liabilities 2001 2002 2003 Accounts payable 372.96 413.99 451.24 Accrued expenses 186.48 206.99 225.62 Short - term debt 183.19 285.90 381.71 Total current liabilities 742.63 906.88 1,058.57 Long 1,000.00 Total liabilities 1,742 .63 1,906.88 2,058.57 Common stock 500.00 600.00 Retained earnings 1,114.01 1,218.99 1,402.63 Total common equity 1,614.01 1,818.99 2,002.62 Total liabilities and equity 3,356.64 3,725.87 4,061.20 DES Chapter 3

The Income Statement Sales Expenses Net income and additions to R.E. Cost of goods sold (COGS) Sales, general, and administrative (SGA) Depreciation Net income and additions to R.E. DES Chapter 3

Acme's Income Statement 2001 2002 2003 Sales 3,729.60 4,139.86 4,512.44 Costs of Goods Sold 2,312.35 2,566.71 2,797.71 Sales, General and Administrative 745.92 827.97 902.49 Depreciation 186.4 8 206.99 225.62 Operating Profit 484.85 538.18 586.62 Interest expense 88.05 96.49 105.73 Earnings Before Taxes 396.80 441.70 480.89 Taxes 158.72 176.68 192.36 Net Income 238.08 265.02 288.53 DES Chapter 3

Income statement items Sales Reflects only products or services defined (according to GAAP) as sold, net of items returned. DES Chapter 3

Income statement items… Expenses Cost of Goods Sold (COGS) Direct costs of producing products or services sold during period Sales, general and administrative expenses (SGA) Hard to attribute these expenses to specific items. E.g. marketing, insurance, salaries of executives. DES Chapter 3

Income statement items… Expenses continued… Depreciation Not a cash expense. Using up or allocating of Plant & Equipment (capital assets). Operating profit = Sales – COGS – SGA – Depreciation. DES Chapter 3

Income statement items… Interest expense Interest paid on debt. Earnings before taxes Operating profit minus interest expense DES Chapter 3

Income statement items… Taxes Net income Earnings before taxes minus taxes DES Chapter 3

Statement of shareholder's equity Net Income Dividends Stock issues Stock repurchases DES Chapter 3

Acme's statement of shareholders' equity 2002 2003 Balance as of December 31 of previous year 1,614.01 1,818.99 N et Income 265.02 288.53 Dividends on Common Stock (160.04) (104.88) Issuance of Common Stock 100.00 0.00 Common Stock Repurchases Balance as of December 31 2,002.62 DES Chapter 3

Statement of Cash Flows Because of accrual accounting, not everything on income statement represents a cash flow—statement of cash flows corrects for this. 3 parts: Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities Net cash flow DES Chapter 3

Cash flow from operating activities Sources of cash flow: Net income Depreciation, because deducted from net income, but not really cash expense, so it is added back. If liabilities go up, it is like borrowing more, so source of cash—so increases in accounts payable and increases in accruals are sources of cash. DES Chapter 3

Cash flow from operating activities Uses of cash flow If assets go up, represents expenditure (in order to pay for asset), and so cash goes down. So if inventory increases, it required a use of cash flow to pay for it, so increases in inventory and accounts receivable are subtracted. DES Chapter 3

Accounts receivable Accounts receivable deserve more discussion: A/R represents money for goods sold that company has not yet received. So firm is basically lending the customer money for goods. It takes cash to make a loan, so if company’s accounts receivable increase, it is a use of cash. DES Chapter 3

Cash flow from operating activities Net cash from operating activities is the sum of these items. In 2003, ACME generated cash of $424.72 million from its operating activities, despite the fact that it had net income of only $288.53 million. The difference comes mainly from depreciation. Asset and liability changes account for the rest. DES Chapter 3

Acme's statement of cash flows 2002 2003 Operating Activities Net Income 265.02 288.53 Depreciation & Amortization 206.99 225.62 Change in Inventory (57.44) (52.16) Change in Account s Receivable (102.56) (93.15) Change in Accounts Payable 41.03 37.25 Change in Accruals 20.51 18.63 Net cash from operating activities 373.55 424.72 DES Chapter 3

Investing activities Companies use cash to purchase fixed assets. These purchases show up here. In 2003 Acme used $411.92 million to purchase fixed assets. This was a use of cash so it shows up as a negative number. DES Chapter 3

Financing activities Money (other than that provided by operations) has to come from somewhere—this section tells where. If short-term or long-term debt or common stock increases, then cash goes up. If the company retires debt or repurchases common stock, then cash goes down. Cash goes down when dividends are paid. DES Chapter 3

2002 2003 DES Chapter 3

Adding them up… The sum of cash flow from operations, investing activities, and financing activities represents the total change in cash. If this sum is positive, then the total amount of cash the company has goes up. For ACME, cash went up by $3.72 million in 2003. DES Chapter 3

Net cash flow 2002 2003 Net cash from operating activities 373.55 424.72 Net cash from investing activities -412.12 -411.92 Net cash from financing activities 42.76 -9.08 Net cash flow (net change in cash) 4.10 3.72 Starting cash 37.20 41.40 Ending cash 41.40 45.12 DES Chapter 3

Acme’s free cash flow Free cash flow is cash potentially available for distribution to stockholders and creditors: Dividends and stock repurchases Interest and principal payments DES Chapter 3

Free cash flow calculation FCF calculated as NOPAT – investment in operating capital For 2003: NOPAT2003 = Operating profit – taxes on o.p. =$ DES Chapter 3

FCF calculation Net operating working capital: NOWC2003 = Total operating capital in 2003: = NOWC + net long-term operating capital = $ TOC in 2002 is $3,104.89 DES Chapter 3

FCF calculation FCF = NOPAT – net investment in operating capital - NOIC = $ FCF =$ DES Chapter 3

Acme's Free Cash Flow 2001 2002 2003 Operating profit 484.85 538.19 586.6 2 Tax on operating profit 193.94 215.28 234.65 NOPAT 290.91 322.91 351.97 Operating current assets 1,491.84 1,655.94 1,804.97 Operating current liabilities 559.44 620.98 676.86 NOWC 932.40 1,034.96 1,128.11 Total operating capital 2,797.20 3,104.89 3,384.34 Investment in total net operating capital 307.69 279.45 FCF 15.22 72.52 DES Chapter 3

Uses of FCF How was this $72.52 million used? Paid $? to debtholders in interest Paid $? to stockholders in dividends. For total of $ which is > FCF $72.52 Rest came from ? DES Chapter 3

Financing approach to calculating FCF FCF = After-tax interest expense – Net CF from financing activities = $ DES Chapter 3

Acme’s operating performance ROIC = NOPATt/Capitalt-1 ROIC2002 = NOPAT2002/Capital2001 = $ = ?% ROIC2003 = NOPAT2003/Capital2002 DES Chapter 3

Is this good or bad? If ROIC is greater than the cost of capital (WACC) then ACME is adding value. Since WACC is 10%, ROIC shows that ACME is earning more than its investors require. DES Chapter 3