1. Chapter 3 Financial Statements & Free Cash Flow
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2. Cash is King! Investors care about cash flow.
Importance of disentangling cash flows from published financial statements.
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3. Annual report has 4 parts1
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Shareholders’ Equity
1And footnotes
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4. 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.
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5. Accruals Accruals creates problems w/ GAAP
Accrual basis
Matching principle
When does cash come in and go out, versus when are cash flows recognized?
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6. 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.
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7. 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
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8. The balance sheet… Liabilities and owners’ equity Accrued expenses
Short-term debt
Long-term debt
Common stock
Retained earnings
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9. Acme's Balance Sheet: Liabilities
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
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10. 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.
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11. 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
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12. Income statement items
Sales
Reflects only products or services defined (according to GAAP) as sold, net of items returned.
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13. 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.
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14. 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.
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15. Income statement items…
Interest expense
Interest paid on debt.
Earnings before taxes
Operating profit minus interest expense
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16. Income statement items…
Taxes
Net income
Earnings before taxes minus taxes
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17. Statement of shareholder's equity
Net Income
Dividends
Stock issues
Stock repurchases
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18. 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
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19. 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
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20. 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.
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21. 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.
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22. 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.
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23. Cash flow from operating activities
Net cash from operating activities is the sum of these items. In 2003, ACME generated cash of $ million from its operating activities, despite the fact that it had net income of only $ million. The difference comes mainly from depreciation. Asset and liability changes account for the rest.
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24. 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
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25. Investing activities
Companies use cash to purchase fixed assets. These purchases show up here. In 2003 Acme used $ million to purchase fixed assets. This was a use of cash so it shows up as a negative number.
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26. 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.
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27. 2002
2003
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28. 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 $3.72 million in 2003.
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29. Net cash flow
Net cash from operating activities Net cash from investing activities Net cash from financing activities Net cash flow (net change in cash)
Starting cash Ending cash
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30. Acme’s free cash flow
Free cash flow is cash potentially available for distribution to stockholders and creditors:
Dividends and stock repurchases
Interest and principal payments
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31. Free cash flow calculation
FCF calculated as
NOPAT – investment in operating capital
For 2003:
NOPAT2003 = Operating profit – taxes on o.p. =$
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32. 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
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33. FCF calculation FCF = NOPAT – net investment in operating capital
- NOIC = $
FCF =$
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34. 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
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35. 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 ?
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36. Financing approach to calculating FCF
FCF = After-tax interest expense – Net CF from financing activities
= $
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37. Acme’s operating performance
ROIC = NOPATt/Capitalt-1
ROIC2002 = NOPAT2002/Capital2001
= $
= ?%
ROIC2003 = NOPAT2003/Capital2002
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38. 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.
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