1. DES Chapter 3 1 Financial Statements and Free Cash Flow

2. DES Chapter 3 2 Cash is King! Investors care about cash flow. It is worth going to a lot of trouble to disentangle cash flow from published financial statements.

3. DES Chapter 3 3 Annual report has 4 parts 1 Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity 1 And of course, the footnotes

4. DES Chapter 3 4 GAAP Statements prepared according to GAAP are reasonably consistent from firm-to-firm. But the standard measures (earnings per share, net change in cash, net income, and return on equity) are not sufficient for valuation purposes.

5. DES Chapter 3 5 Accruals Part of the problem with GAAP is accruals Accrual basis Matching principle When does cash come in and go out, versus when are these cash flows recognized?

6. DES Chapter 3 6 The Balance Sheet Assets Accounts receivable (AR)—money owed to ACME by customers who purchased on credit terms Inventory Long-term assets, like property, plant and equipment (PPE). Accumulated depreciation—is subtracted from gross PPE to get net PPE.

7. DES Chapter 3 7 Acme's Balance Sheet: Assets 2007 2008 2009 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

8. DES Chapter 3 8 The balance sheet… Liabilities and owners’ equity Accrued expenses Short-term debt Long-term debt Common stock Retained earnings

9. DES Chapter 3 9 Acme's Balance Sheet: Liabilities 200720082009

10. DES Chapter 3 10 The Income Statement Sales Expenses Cost of goods sold (COGS) Sales, general, and administrative (SGA) Depreciation Net income and additions to R.E.

11. DES Chapter 3 11 Acme's Income Statement 2007 2008 2009 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 186.48 206.99 225.62 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

12. DES Chapter 3 12 Income statement items… Sales Only reflects products or services defined (according to GAAP) as sold, net of items returned. Expenses Cost of Goods Sold (COGS) These are direct costs of producing products or services that were sold during the period Sales, general and administrative expenses (SGA) Hard to attribute these expenses to a specific item. E.g. marketing, insurance, salaries of executives.

13. DES Chapter 3 13 Income statement items… Expenses continued… Depreciation Not a cash expense. Is the recognition of money that was spent years ago on capital assets. Operating profit = Sales – COGS – SGA – Depreciation. Interest expense Interest paid on debt. Earnings before taxes Operating profit minus interest expense Taxes Net income Earnings before taxes minus taxes

14. DES Chapter 3 14 Statement of shareholder's equity Net Income Dividends Stock issues Stock repurchases

15. DES Chapter 3 15 Acme's statement of shareholders' equity 2008 2009 Balance as of December 31 of previous year 1,614.01 1,818.99 Net Income 265.02 288.53 Dividends on Common Stock (160.04) (104.88) Issuance of Common Stock 100.00 0.00 Common Stock Repurchases 0.00 Balance as of December 31 1,818.99 2,002.62

16. DES Chapter 3 16 Statement of Cash Flows Because of accrual accounting, not everything on the income statement represents a cash flow—the 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

17. DES Chapter 3 17 Cash flow from operating activities Sources of cash flow: Net income Depreciation, because it was deducted from net income, but it really wasn’t a cash expense, so it is added back in. If liabilities go up, it is like borrowing more, so it is a source of cash—so increases in accounts payable and increases in accruals are sources of cash.

18. DES Chapter 3 18 Cash flow from operating activities Uses of cash flow If assets go up, that represents an expenditure (in order to pay for the 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.

19. DES Chapter 3 19 Accounts receivable Accounts receivable deserve a bit more discussion: An account receivable represents money for goods sold that the company has not yet received. So the company is basically lending the customer the money for the goods. It takes cash to make a loan, so if the company’s accounts receivable increase, it is a use of cash.

20. DES Chapter 3 20 Cash flow from operating activities Net cash from operating activities is the sum of these items. In 2009, 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.

21. DES Chapter 3 21 Acme's statement of cash flows 2008 2009 Operating Activities Net Income 265.02 288.53 Depreciation & Amortization 206.99 225.62 Change in Inventory (57.44) (52.16) Change in Accounts 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

22. DES Chapter 3 22 Investing activities Companies use their cash to purchase fixed assets. These purchases show up here. In 2009 Acme used $411.92 million to purchase fixed assets. This was a use of cash so it shows up as a negative number.

23. DES Chapter 3 23 Financing activities The 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.

24. DES Chapter 3 24 20082009

25. DES Chapter 3 25 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 2009.

26. DES Chapter 3 26 Net cash flow 20082009 Net cash from operating activities373.55424.72 Net cash from investing activities-412.12-411.92 Net cash from financing activities42.76-9.08 Net cash flow (net change in cash)4.103.72 Starting cash37.2041.40 Ending cash41.4045.12

27. DES Chapter 3 27 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

28. DES Chapter 3 28 Free cash flow calculation FCF calculated as NOPAT – investment in operating capital For 2009: NOPAT 2009 = Operating profit – taxes on o.p. =$586.62(1 – 0.40) = $351.97

29. DES Chapter 3 29 FCF calculation Net operating working capital: NOWC 2009 = (cash + inventory + AR) – (AP + Accrued expenses) = $1,128.11 Total operating capital in 2009: = NOWC + net long-term operating capital (which is PPE for ACME) = $1,128.11 + $2,256.23 = $3,384.34 TOC in 2008 is $3,104.89

30. DES Chapter 3 30 FCF calculation FCF = NOPAT – net investment in operating capital = $351.97 – ($3,384.34 - $3,104.89) = $72.52 million

31. DES Chapter 3 31 Acme's Free Cash Flow 2007 2008 2009 Operating profit 484.85 538.19 586.62 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

32. DES Chapter 3 32 Uses of FCF How was this $72.52 million used? Paid $106 million to debtholders in interest—but after-tax amount was only $64 million because it is deductible. Paid $105 million in dividends. For a total of $169 million, which is quite a bit more than its FCF of $73 million. It borrowed the rest, for a total new borrowing of $169 - $73 = $96 million.

33. DES Chapter 3 33 Financing approach to calculating FCF FCF = After-tax interest expense – Net CF from financing activities = $63.44 – (-9.08) = $72.52

34. DES Chapter 3 34 Acme’s operating performance ROIC = NOPAT t /Capital t-1 ROIC 2008 = NOPAT 2008 /Capital 2007 = $322.91/$2,797.2 = 11.5% ROIC 2009 = NOPAT 2009 /Capital 2008 = $351.97/$3,104.89 = 11.3%

35. DES Chapter 3 35 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.