0. Statement of Cash Flows Analysis

1. Agenda
Recap of the Balance Sheet
Debt vs. Equity
What is the Statement of Cash Flows
Cash Flow from Operations
Cash Flow from Investing Activities
Cash Flow from Financing Activities
Why it is Important
Microsoft Case Study

2. Called a balance sheet because it balances
What is it?
Snapshot of a company’s financial condition at a specific point in time
Called a balance sheet because it balances
Everything a company has (assets) is either owed to someone else (Liabilities) or belongs to the firm’s owners (Equity)

3. The stuff that a company has
Assets
The stuff that a company has
Assets vary in liquidity
Liquidity – how quickly an asset can be converted to cash
Most Liquid
Least Liquid
Cash and Cash Equivalents
Accounts Receivable
Inventory & Surplus
Short-term investments
Long-term investments
Property, Plant, and Equipment
Intangibles (including goodwill)
Land
Current Assets
Long-Term Assets

4. Current Long-term Debt Deferred Revenue Long-term Debt
Liabilities
Types of Liabilities
Accounts Payable
Interest Payable
Short-term Debt
Current Long-term Debt
Deferred Revenue
Long-term Debt
Pension Obligations
Current Liabilities
Long-Term Liabilities

5. Owner’s Equity – If the company is a sole proprietorship
What is Equity
The difference between a companies Assets and Liabilities
The “book value” of a company
Two Different Types of Equity
Owner’s Equity – If the company is a sole proprietorship
Stockholder’s Equity – If a company is a corporation
Includes:
Retained Earnings
Additional Paid-In Capital
Common Stock
Preferred Stock

6. Putting it all together
Assets = Liabilities + Equity
BCI & Company buys a factory for $1 Billion, using some of its own cash and $400 Million of money it borrowed from the bank
What happens to the balance sheet?
$600M cash decrease
$1000M PP&E increase
TOTAL: Assets up $400M
Assets
Liabilities
$400M borrowed
TOTAL: Liabilities up $400M

7. Putting it all together
Assets = Liabilities + Equity
BCI & Company delivers its service for $8000. The customer paid only $1000, promising to pay the remaining in monthly installments
What happens to the balance sheet?
$1000 cash increase
$7000 accounts receivable increase
TOTAL: Assets up $8000
Assets
Equity
$8000 increase in retained earnings
TOTAL: Equity up $8000

8. Debt vs. Equity Financing
Balance Sheet
Debt vs. Equity Financing
A company can raise money to acquire assets by:
Taking on Debt
Issuing Equity
So which is the better option?
Each comes with pros and cons

9. Debt vs. Equity Financing
Balance Sheet
Debt vs. Equity Financing

10. * Leverage also works in the other direction!
Balance Sheet
THE POWER OF LEVERAGE
Suppose BCI & Co has $100 in Equity (thus $100 in assets) and will make a 20% return this year
Scenario 1: No Leverage
Return accrues to Equity for $120
Return on Equity is $20%
Scenario 2: With Leverage
BCI & Co takes on a $100 loan, for total assets of $200
A 20% return increases total assets to $240
Equity = Assets – Liabilities = $240 - $100 = $140
Return on Equity is 40%
* Leverage also works in the other direction!

11. Statement of Cash Flows
What is the Statement of Cash Flows?
Definition: Summarizes all of the inflows and outflows of cash from ongoing operations and from external investments over an accounting period
Basically, the cash flow statement “corrects” everything that was recorded on an accrual accounting basis so that you know how much actual cash is coming in and going out of a business
What is the point of this?
To give a true representation of the cash flows of a business

12. Statement of Cash Flows
How do you calculate your cash flows?
Start with Net Income from the Income Statement & then make “corrections”
Categorize these corrections by recording the changes in cash flow from:
Operations
Investing
Financing
Cash Flow from Operations
Net Income
(+) Depreciation and Amortization
(+/-) Changes in Working Capital
Cash Flow from Investing Activities
(-) Capital Expenditures
(+/-) Investments
Cash Flow from Financing Activities
(-) Dividends
(+/-) Sale/Purchase of Stock
(+/-)Net borrowings
= Net change in cash

13. Statement of Cash Flows
Cash Flows from Operations
Cash Flow from Operations
Net Income
(+) Depreciation and Amortization
(+/-) Changes in Working Capital
We start with Net Income
We add back D&A because it is a non-cash expense
Remember, D&A is the allocation of PP&E expenses over a set period of time
Then we adjust for changes in working capital
Working capital = Current assets – current liabilities
The cash a business requires for day-to-day operations
E.g. if inventory increased, then we used cash to purchase it
E.g. if accounts receivable decreased, then we received cash

14. Statement of Cash Flows
Cash Flows from Investing
Cash Flow from Investing Activities
(-) Capital Expenditures
(+/-) Investments
These are cash flows related to either a company’s capital stock or investments in financial markets
Capital Expenditures
Purchase or sale of capital assets (PP&E)
This is what depreciation adjusts for
Investments
General investments, such as purchase/sale of another company’s stock or debt

15. Statement of Cash Flows
Cash Flows from Financing
Cash Flow from Financing Activities
(-) Dividends
(+/-) Sale/Purchase of Stock
(+/-)Net borrowings
These are cash flows related to a company raising capital and repaying investors
Dividends
These are not on the income statement so you have to subtract these cash payments out
Sale/Purchase of Stock
When a company issues stock to raise money or does a share buyback
Net Borrowings
Companies also issue debt to raise money, but they eventually need to pay back the principal

16. Statement of Cash Flows
Why is the Statement of Cash Flows Important
The cash flow statement gives investors a good idea of:
Gives us best sense of liquidity
Demonstrates changes in assets, liabilities, and equity
Improved comparability of firm’s operating performance by eliminating subjectivity
Remember, ultimately, every company’s goal is to generate cash flow
CASH IS KING

17. Statement of Cash Flows
Case Study

18. Common Cents’ assets of $5 will be added
The Balance Sheet
Microsoft Case Study
When you pay a premium for a company, the premium is recorded as “Goodwill” on a balance sheet
Example
If BCI & Co. pays $10 for “Common Cents Investment Group” with a book value of $5, what happens to BCI & Co.’s balance sheet?
Assets
Cash will decrease $10
Common Cents’ assets of $5 will be added
Goodwill will increase $5 to balance out the transaction

19. The Balance Sheet
Microsoft Case Study

20. The Balance Sheet
Microsoft Case Study

21. Income Statement and Balance Sheet Review
Microsoft Case Study
Goodwill impairment charge from Balance Sheet on the Income Statement

22. Income Statement and Balance Sheet Review
Microsoft Case Study
We have learned that the Statement of Cash Flows shows the cash position of a company
Does the write down of Goodwill affect the cash position of Microsoft?
Remember how you calculate a company’s change in cash
Cash Flow from Operations
Net Income
(+) Depreciation and Amortization
(+/-) Changes in Working Capital
Cash Flow from Investing Activities
(-) Capital Expenditures
(+/-) Investments
Cash Flow from Financing Activities
(-) Dividends
(+/-) Sale/Purchase of Stock
(+/-)Net borrowings
= Net change in cash

23. Income Statement and Balance Sheet Review
Microsoft Case Study
What will you do with a Goodwill Impairment on the Statement of Cash Flows?
Add back the Goodwill Impairment
Subtract the Goodwill Impairment
No adjustment needs to be made
When Goodwill is impaired, on the Income Statement it is subtracted out so this needs to be added back to Net Income
If Goodwill is impaired by $100, what will be the net change in cash? (Assuming a 40% Tax Rate)
Increase Cash by $100
Decrease Cash by $100
No Impact on Cash
Decrease Cash by $60
Increase Cash by $40
Plz help

24. Income Statement and Balance Sheet Review
Microsoft Case Study

25. Income Statement and Balance Sheet Review
Microsoft Case Study
Goodwill impairment charge from Balance Sheet on the Income Statement

26. Income Statement and Balance Sheet Review
How are the Statements Linked Together
You are in an interview for a financial services firm and a BSD1 Managing Director asks you the following question:
A company with $100 of Goodwill on their balance sheet realizes that it is actually worth $0 and writes it down. What happens to their financial statements?
Income Statement
Reduces Pre-Tax Income by $100 as a result of a Goodwill Impairment Charge
Decreases Net Income by $60 (assuming a 40% tax rate)
Statement of Cash Flows
Net income is down by $60 as shown above
Goodwill Impairment increases cash by $100
Ending cash balance is up by $40
Balance Sheet
Cash is up $40
Goodwill is down $100
Total Assets are down by $60
Retained earnings (equity) is down by $60
BALANCED
1 Liar’s Poker Reference

27. How the Financial Statements are Linked Together

28. Income Statement and Balance Sheet Review
How are the Statements Linked Together

29. How the Statements are Linked Together
How are the Statements Linked Together
Income Statement
Revenues minus expenses to get Net Income
Cash Flow Statement
Net Income becomes top line of the Cash Flow Statement
Add back non-cash charges like D&A, and make adjustments for changes in working capital to get Cash Flow from Operations
Take into account all Investing and Financing activities, and end up with Net Change in Cash
Balance Sheet
Assets: Cash equals beginning cash balance plus Net Change in Cash, any changes to PP&E from CapEx
Liabilities: Any changes from Investing/Financing Activities
Equity: Net Income enters as Retained Earnings
Make sure you’re balanced! (Assets = Liabilities + Equity)

30. Suppose D&A increases by $100 (Assume a tax rate of 40%)
How the Statements are Linked Together
Example #1
Suppose D&A increases by $100 (Assume a tax rate of 40%)
Walk me through the 3 financial statements
Anybody want to give it a try?
Income Statement
D&A expense increase by $100
Tax expense reduced by $40 (=$100*40%, we no longer have to pay this since our profit dropped)
Net Income down by $60
Cash Flow Statement
Start with Net Income of -$60
Add back D&A of $100 since it was a non-cash expense
Cash up $40 (this is what you saved on taxes)
Balance Sheet
Assets (-$60): Cash up $40, PP&E down $100 due to D&A
Equity (-$60): Retained Earnings down $60

31. Suppose a company buys $100 plant with cash on Dec. 31
How the Statements are Linked Together
Example #1
Suppose a company buys $100 plant with cash on Dec. 31
(Assume a tax rate of 40%)
Assume a useful life of 5 years
Walk me through the 3 financial statements this year and next year
Anybody want to give it a try?

32. How the Statements are Linked Together
Example #2
Suppose a company buys $100 plant with cash on Dec. 31
(Assume a tax rate of 40%)
Assume a useful life of 5 years
This Year
Income Statement
No effect, buying PP&E (CapEx) is not tax deductible
Cash Flow Statement
Start with Net Income of $0 at top
Cash flow from investing activities (CapEx) falls by $100
Net Change in Cash is -$100
Balance Sheet
Assets (No Change): Cash down $100, PP&E up $100
Liabilities and Equity (No Change): Purchase was only cash

33. How the Statements are Linked Together
Example #2
Suppose a company buys $100 plant with cash on Dec. 31
(Assume a tax rate of 40%)
Assume a useful life of 5 years
Next Year
Income Statement
D&A expense of $20 (= $100/5)
Tax Expense reduced by $8 (=$20*40%, we no longer have to pay this since our profit dropped)
Net Income down by $12
Cash Flow Statement
Start with Net Income of -$12 at top
Add back D&A of $20 since it was a non-cash expense
Cash up $8 (this is what you saved on taxes)
Balance Sheet
Assets (-$12): Cash up $8, PP&E down $20 due to D&A
Equity (-$12): Retained Earnings down $12

34. Suppose a company buys $100 plant using debt financing on Dec. 31
How the Statements are Linked Together
Example #3
Suppose a company buys $100 plant using debt financing on Dec. 31
Assume a tax rate of 40%
Assume a useful life of 5 years
Assume a 10% interest rate
Walk me through the 3 financial statements this year and next year
Anybody want to give it a try?

35. How the Statements are Linked Together
Example #3
Suppose a company buys $100 plant using debt financing on Dec. 31
Assume a tax rate of 40%
Assume a useful life of 5 years
Assume a 10% interest rate
This Year
Income Statement
No effect, buying PP&E (CapEx) is not tax deductible
Cash Flow Statement
Start with Net Income of $0 at top
Cash flow from Investing Activities (CapEx) falls by $100
Cash flow from financing activities (debt) increases by $100
Net change in cash is $0
Balance Sheet
Assets (+$100): PP&E up $100
Equity (+$100): Took on $100 of debt

36. Example #3 Next Year D&A expense of $20 (=$100/5 yrs)
How the Statements are Linked Together
Example #3
Suppose a company buys $100 plant using debt financing on Dec. 31
Assume a tax rate of 40%
Assume a useful life of 5 years
Assume a 10% interest rate
Next Year
Income Statement
D&A expense of $20 (=$100/5 yrs)
Interest Expense of $10 (= $100/10 yrs)
Tax Expense reduced by $12 (= ($20+$10)*40%
Net Income down by $18
Cash Flow Statement
Start with Net Income of -$18 at top
Add $20 of D&A because it was non-cash, don’t add interest
Cash up $2
Balance Sheet
Assets (-$18): Cash up $2, PP&E down $20 due to D&A
Equity (-$18): Retained Earnings down $18
Liabilities (No Change): We still owe back the $100 debt

37. How the Statements are Linked Together
Accounting: The Big Picture
You can memorize every single line item, but it is most important that you understand the big picture.
As investors, the financial statements are the way a business communicates to us how it operates, its financial health, and ultimately helps us determine whether or not the business can sustainably make money.
Now that we can speak “the language of finance”, Next up…
Valuations
Celebrate finishing accounting at the cookout Wednesday