Financial Decision Making for In-House Counsel—Part I Professor Michael Smith Boston University

2 Session Overview Balance sheet Income statement Statement of cash flows Format? Purpose? Measurement?

3 The Balance Sheet Assets = Liabilities + Owners’ Equity Uses of funds Sources of funds Capital structure refers to the relative amounts of debt and equity in a firm’s financing. (Financing) Productive capacity Creditors’ Claims Owners’ Claims “Snapshot” at a point in time

4 Purpose of Balance Sheet Provides investors with information about: –the nature and amounts of the firm’s productive assets. –the firm’s capital structure (relative amounts of debt and equity) and financial risk. –the firm’s financial flexibility and liquidity (how quickly assets and liabilities will generate or consume cash). The information is most useful to creditors: –Little information about the firm’s earnings potential.

5 Balance Sheet Vocabulary Asset: resource owned by a firm whose benefits can be measured with a reasonable degree of precision. Liability: a firm’s debts or obligations, settled over time through the provision of cash, goods, or services. Owners’ equity: the residual claim of owners against the net assets of the firm.

6 Slater & Gordon Balance Sheet Consolidated Statements of Financial Position Assets Cash and cash equivalents 25,27020,056 Receivables 229, ,499 Work in progress 470, ,859 Other current assets 12,403 9,554 Total current assets 737, ,968 Plant and equipment, net 12,96412,219 Intangible assets 130, ,296 Other non-current assets 14,57418,445 Total assets 895, ,928 Liabilities Assorted payables 232, ,930 Total current liabilities 232, ,930 Long-term borrowings 116,864 32,032 Deferred tax liabilities 97,61978,015 Provisions 24,967 9,744 Total liabilities 472, ,721 Equity Contributed equity 233, ,534 Retained profits 189, ,673 Total shareholders’ investment 423, ,207 Total liabilities + equity 895, ,928

7 Accounting Assets Resources whose benefits can be precisely measured: –Cash, inventory, accounts receivable, property, plant and equipment, investments in other firms, intangible assets purchased from another firm, –Reported as assets on the balance sheet Resources whose benefits cannot be precisely measured: –Research and development, advertising, brand names, internally generated intangible assets –Not reported as assets on the balance sheet

8 Goodwill Goodwill arises only from merger & acquisition activity. Goodwill is the premium of price paid over the market value of the identifiable assets purchased net of the market value of the identifiable liabilities assumed.

9 Asset Write-Downs If the market value of a long-term asset is lower than its book value, the company must reduce (write down) the asset on the balance sheet and take a corresponding loss on the income statement. The following terms are synonymous: Asset impairment Write-down Write-off (write-down to 0)

10 Liabilities Examples of obligations reported as liabilities on balance sheets: –Accounts payable, unearned revenue, debt, wages payable, taxes payable, utilities payable, etc. Legal obligations to make payments are not necessarily accounting liabilities: –Some lease contracts Losses related to litigation accrued if sufficiently probable and estimable.

11 Owners’ Equity Additional paid in capital is the cumulative amount of cash generated by primary stock issuances. Retained earnings is the cumulative amount of profits reinvested in the firm. Treasury shares is the cumulative value of shares repurchased by the firm less the value of those shares reissued..

12 Balance Sheet Caveats Almost all asset and liability accounts are based in part on management’s estimates GAAP does not allow the recognition of internally generated intangible assets on the balance sheet. Some liabilities (and the assets financed by them) may not be on the balance sheet.

13 Income Statement Report of profitability for a period of time. Based on the accrual method of accounting Income does not necessarily correspond to operating cash flows in a given year; over time these amounts will reconcile.

14 Purpose of Income Statement Provides investors with information about –earnings generated by the firm in the past fiscal year and its ability to generate wealth in the future. –the various revenues, expenses, gains and losses of the firm The information is most useful to stock investors.

15 Consolidated Statements of Income Revenue 418, ,963 Less expenses: Salaries and employee benefits (200,270) (145,517) Rental ( 22,005) ( 14,095) Advertising and marketing ( 32,786) ( 23,775) Administrative and office ( 36,391) ( 25,018) Consultant fees ( 4,928) ( 2,580) Finance costs ( 8,412) ( 7,653) Bad and doubtful debts ( 6,904) ( 4,531) Depreciation and amortization ( 6,955) ( 4,973) Costs associated with acquisitions ( 4,054) ( 282) Other expenses ( 11,312) ( 8,198) Profit before income tax expense 84,449 61,341 Income tax expense ( 23,344) ( 19,820) Profit for the year 61,105 41,521 Slater & Gordon Income Statement

16 Accrual Accounting: Expenses Matching principle: Expenses are recognized in the period in which the associated revenues (or benefits) are earned, without regard to the timing of cash payments.

17 Accrual Accounting: Revenue Revenue recognition: Revenue is recognized when earned without regard to the timing of cash payments.

18 Revenue Recognition Milestones in Revenue Cycle Conceive product Design product Make product Market product Take order Deliver product Collect cash Revenue is recorded on the income statement in the period in which the product or service is delivered.

19 Example of Revenue Recognition Product bundle, 5 year contract Copier Extended warranty (for years 2 through 5) Annual maintenance (all 5 years) A single price for all elements of the bundle Customer pays cash upfront When can the company record revenue on the income statement?

20 When is Revenue Recognized? Price Annual maintenance Extended warrantyCopier Allocate price to “buckets” Record revenue immediately Record revenue in years 2 through 5 Record revenue in years 1 through 5

21 GAAP and non-GAAP Income GAAP income (earnings) Non-GAAP definitions: –Earnings Before Interest and Taxes (EBIT) GAAP Income + Interest Expense + Tax Expense Neutralizes the effects of different capital structures and different tax rates across companies. –Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) EBIT + Depreciation Expense + Amortization Expense Neutralizes the effects of different accounting choices Useful for valuation Analysts typically also compute these. Some firms compute and disclose these.

22 Consolidated Statements of Income Revenue418, ,963 Less expenses: Salaries and employee benefits (200,270) (145,517) Rental ( 22,005) ( 14,095) Advertising and marketing ( 32,786) ( 23,775) Administrative and office ( 36,391) ( 25,018) Consultant fees ( 4,928) ( 2,580) Finance costs ( 8,412) ( 7,653) Bad and doubtful debts ( 6,904) ( 4,531) Depreciation and amortization ( 6,955) ( 4,973) Costs associated with acquisitions ( 4,054) ( 282) Other expenses ( 11,312) ( 8,198) Profit before income tax expense 84,449 61,341 Income tax expense ( 23,344) ( 19,820) Profit for the year 61,105 41,521 Slater & Gordon: GAAP Earnings GAAP Earnings = 61,105

23 Consolidated Statements of Income Revenue 418, ,963 Less expenses: Salaries and employee benefits (200,270) (145,517) Rental ( 22,005) ( 14,095) Advertising and marketing ( 32,786) ( 23,775) Administrative and office ( 36,391) ( 25,018) Consultant fees ( 4,928) ( 2,580) Finance costs ( 8,412) ( 7,653) Bad and doubtful debts ( 6,904) ( 4,531) Depreciation and amortization ( 6,955) ( 4,973) Costs associated with acquisitions ( 4,054) ( 282) Other expenses ( 11,312) ( 8,198) Profit before income tax expense 84,449 61,341 Income tax expense ( 23,344) ( 19,820) Profit for the year 61,105 41,521 Slater & Gordon EBIT Earnings Before Interest and Taxes = 61, , ,412 EBIT = 92,816

24 Consolidated Statements of Income Revenue 418, ,963 Less expenses: Salaries and employee benefits (200,270) (145,517) Rental ( 22,005) ( 14,095) Advertising and marketing ( 32,786) ( 23,775) Administrative and office ( 36,391) ( 25,018) Consultant fees ( 4,928) ( 2,580) Finance costs ( 8,412) ( 7,653) Bad and doubtful debts ( 6,904) ( 4,531) Depreciation and amortization ( 6,955) ( 4,973) Costs associated with acquisitions ( 4,054) ( 282) Other expenses ( 11,312) ( 8,198) Profit before income tax expense 84,449 61,341 Income tax expense ( 23,344) ( 19,820) Profit for the year 61,105 41,521 Slater & Gordon: EBITDA EBIT = 92,816 Earn. Bef. Int.,Tax, Depr. and Amort.= EBIT + Depreciation and Amortization EBITDA = 92, ,955 = 99,771

25 Statement of Cash Flows Reports cash flows during a period related to the firm’s operating, investing, and financing activities.

26 Purpose of Statement of Cash Flows Does the firm generate enough cash to make its debt payments in the next period? Does the firm generate enough cash to finance growth with internal funds, or will it have to raise money by issuing stock or debt?

27 Classification of Activities on SCF Operating activity –Cash receipts from sales –Cash payments to suppliers –Cash payments to employees Investing activity –Cash payments for property, plant, equipment, intangible assets, acquisitions. –Cash receipts from sales of long-term assets. Financing activity –Cash receipts/payments related to debt –Cash receipts from stock issuances –Cash payments for dividends and stock repurchases

28 Slater & Gordon Statement of Cash Flows Consolidated Statements of Cash Flows ($000s) Operating activities Receipts from customers 442, ,279 Payments to suppliers and employees (375,225) (285,148) Interest received Borrowing costs ( 5,344) ( 6,158) Income tax paid ( 8,006) ( 537) Cash flow from operations 54,435 32,717 Investing activities Payment for software development ( 1,485) ( 1,253) Payment for plant and equipment ( 3,284) ( 1,058) Payment for acquisitions, net ( 120,827) ( 16,467) Cash flow from investing ( 125,596) ( 18,778) Financing activities Proceeds from share issuance, net 0 65,665 Proceeds from employees and related parties 5,127 4,336 Proceeds (payments) from borrowing, net 81,075 ( 57,396) Dividends paid ( 9,907) ( 9,580) Cash flow from financing ( 76,295) 2,025 Change in cash 5,134 15,964 Effect of exchange rate fluctuations on cash held Beginning balance, cash 20,056 3,960 Ending balance, cash 25,270 20,056

29 Takeaways Balance sheet values typically reflect some managerial assumptions and estimates. Internally generated intangible assets are not reported as assets on the balance sheet. Income is measured using the accrual method. Revenue is recorded in the period the firm provides the good or service.