FINC 3131 Business Finance Chapter 3: Income Statements Balance Sheets Cash Flow Statement 1
Importance of Financial Statements p Form the basis for understanding the financial position of a business p Provide information regarding the financial policies and strategies and insight into future performance p 10 -K and 10 -Q 2
Income Statement Overview p Also called • earnings statement • profit & loss statement p Matches revenues & expenses over a period of time, e. g. , past fiscal quarter or year p ‘Flow’ measure statement • p Each value on an income statement represents cumulative amount of that item through the accounting period Profit vs. Cash flow • Seldom the same 3
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Income Statement Structure Income Statement Company Name For the time period ending date • Earnings before taxes (EBT) Net Sales - Cost of Goods Sold - Operating Expenses - Depreciation and Amort. = Operating Profit - Interest Expense = Profit Before Taxes - Taxes = Net Income • Operating income • Earnings before interest & taxes (EBIT) • Earnings • Net profit 5
EBITDA • Earning before interest tax depreciation and amortization 6
Income Statement Items • Net sales = Gross sales – (returns & allowances) • Cost of Goods Sold (COGS) include raw material and labor costs 7
Income Statement Items p Operating expenses • Include management salaries, advertising expenditures, repairs & maintenance, R&D, general & administrative expenses, lease payments. p Interest expense • Cost of borrowing money p Taxes • Federal, state and/or local levels p Net income • • ‘bottom line’ of income statement Base profit earned during accounting period 8
Income Statement Items p Earnings per common share (EPS) Net income available to common shareholders # common shares outstanding indicator of firm’s current performance 9
Where does Net Income go to? NI = Retained Earnings + Dividend Payout Common Dividends per share (DPS) common stock dividends paid # common shares outstanding 10
Example Levo Inc. ’s latest net income was $2 million, and it has 200, 000 common shares outstanding. The company wants to pay out 40% of its income as dividend. How much is the earnings per share? How much is the dividend per share? 11
Example Prepare a multi-step income statement for the ABC company for the year ending Dec 31, 2006, given the information below: Advertising expenditures Cost of goods sold Depreciation Gross sales Interest expenses Lease payment Management salary Material purchase R&D expenditures Repair and maintenance costs Returns and allowances Taxes 68, 000 2, 433, 000 78, 000 3, 210, 000 64, 000 52, 000 240, 000 2, 425, 000 35, 000 22, 000 48, 000 51, 000 12
Solution Gross Sales Return and Allowance 3, 210, 000 48, 000 Net Sales 3, 162, 000 Cost of Goods Sold 2, 433, 000 Gross Profit 729, 000 Operating Expenses 417, 000 Depreciation EBIT Interest Expense 78, 000 234, 000 64, 000 EBT 170, 000 Tax 51, 000 Net Income 119, 000 13
Example BB Ltd. recently reported an EBITDA of $10 million and net income of $2 million. It had $3 million of interest expense, and its corporate tax rate was 40%. What was its charge for Depreciation and Amortization? 14
IBM’s Income Statement p Where to find? 15
Overview of Balance Sheet p Show what a company owns vs. owes at a specific point in time. p Categorizes company’s resources as: • • • Assets Liabilities Owner’s equity p Balance sheet identity: Total Assets = Total Liabilities + Shareholders’ Equity 16
Balance Sheet Overview Assets Liabilities and Owners Equity Liquidit y Cash Notes Payable Marketable securities Accounts Payable Accounts Receivable Accrued Expenses Inventories Current Portion of LTD Total Current Assets Total Current Liabilities Gross Fixed Assets Long term (L. T. ) Debt (less Accum. Depreciation) Total Liabilities Net Fixed Assets Preferred Stock Other long-term investments Common Stock such as stock and bonds Retained Earnings Total Assets Total Liabilities and equity Assets Claims on Assets S. T. Funds L. T. Capital 17
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Balance Sheet Items: Current Assets 1 Current asset : Ø Easily converted into cash within a year p Cash • Most liquid asset; frequently represented by demand deposits p Marketable Securities: e. g. short-term T-bills p Accounts Receivable (A/R) Occurs because company sells products/services on credit 19
Balance Sheet Items: Current Assets 2 p Inventory • • Raw materials, work in process (WIP), finished goods Different valuation methods: FIFO, LIFO, average cost Total current assets = Cash + Marketable Securities + A/R + Inventory 20
Balance Sheet Items: Long-term assets 1 Fixed assets • • • p p Gross fixed assets (GFA): original cost of assets Accumulated depreciation (AD) • • p Equipment, buildings, vehicles, computers etc Permanent nature; needed for business operations Reported at book value = original historical cost – allowable depreciation Straight-line Accelerated cost recovery Net fixed assets (NFA) = gross fixed assets – accumulated depreciation Example: GFA, AD, NFA. 21
Balance Sheet Items: Long-term assets 2 p Total assets = Current assets + long-term assets p Assets (LHS of balance sheet) must be financed by a combination of liabilities and owner’s equity (RHS of balance sheet) p firms should try to finance assets with the lowest cost funds available. Not only is it important for a firm’s financial managers to focus on assets, they must focus on the structure and composition of liabilities and net worth as well. 22
Balance Sheet Items: Liabilities & Equity 1 p Current liabilities 1. 2. 3. 4. Ø Notes payable Accounts payable Accrued expenses (accruals) Current portion of long-term debt 1+2+3+4 = total current liabilities p Long-term debt 1. Liabilities with maturities in excess of 1 year 23
Balance Sheet Items: Liabilities & Equity 2 p Total liabilities • = current liabilities + L. T. debt p Preferred stock • • • Like debt: Pays fixed periodic dollar amount Like equity: If payment is not made, company is not in default Preferred dividends are usually cumulative; no voting rights 24
Balance Sheet Items: Liabilities & Equity 3 p Common stock • Common stock at par Ø No. of shares outstanding = common stock book value Par value per share • Additional paid-in capital (capital surplus) Ø Additional money generated when company sold stock p Retained earnings • Cumulative total of all net income reinvested into the company • Annual addition to retained earnings = net income – dividends paid Example: RE, NI, dividend, annual RE 25
Balance Sheet Items: Liabilities & Equity 4 p Common Shareholders’ equity = common stock at par + additional paid-in capital + retained earnings p Total asset- total liability = net worth 26
Market Value Added (MVA) Suppose there are 100, 000 shares of common stock, and the stock market price is $6. 00 per share. The book value of these common stock is $550, 000. Market Value: (100, 000)($6. 00) = $600, 000. MVA = $600, 000 - $550, 000 = $50, 000. Or 6 - 550000/100000= $0. 5/share 27
Balance Sheet Items: Liabilities & Equity 5 Total liabilities and equity = total liabilities + preferred stock (if any) + common shareholders’ equity • Must equal total assets 28
IBM’s Balance Sheet p Where to find? 29
example From the following accounts, prepare a balance sheet for the BCD company for the year ending Dec 31, 2006: Gross fixed assets Inventory Accrued expenses Accumulated depreciation Notes payable Preferred stock Retained earnings Current portion of L-T debt Long-term debt Accounts receivable Additional paid-in capital Accounts payable Common stock ($0. 20 par) Cash 284, 950 136, 500 11, 850 82, 310 32, 570 8, 000 89, 280 4, 080 134, 300 105, 770 71, 600 50830 60, 000 ? 30
Solution cash x notes payable 32570 50830 A/R 105770 Accounts payable Incentory 136500 current portion of LT debt Current Asset 242270+x 4080 Accrued expenses 11850 Current liability 99330 long-term debt total liability Gross fixed asset 284950 accumulated dep. 82310 Net fixed asset 202640 134300 233630 common stock 60000 additional paid-in 71600 prefered stock retained earnings 8000 89280 Equity total asset 444, 910+x 228880 Liability and Equity 462510 31
How many new shares issued in 2004? Cash 2004 5, 500 2003 2, 900 Accounts receivable Inventories 4, 000 6, 200 2, 000 9, 000 Total current assets Net fixed assets Total Assets Notes payables Accounts payables Accrued expenses 15, 700 84, 300 100, 000 1, 500 8, 600 700 13, 900 87, 000 100, 900 1, 900 6, 600 900 Total current liabilities Long-term debt 10, 800 37, 500 9, 400 42, 000 Common stock ($2 par value) 12, 000 8, 000 Additional paid-in capital Retained earnings 14, 520 25, 180 9, 500 32, 000 Total liabilities & equity 100, 000 100, 900 32
Effect of Debt vs. Equity Financing on Return assets operating income equity debt r=10% case 1 $12 mil $5 mil case 2 $12 mil $5 mil $12 mil 0 $1 mil $11 mil 5 0 5 1. 5 3. 5 5 1. 1 3. 9 1. 17 2. 73 operating income less: interest Taxable income less: tax (30%) Net Income Return on Equity 3. 5/12=29% 2. 73/1=273% 33
Manipulating financial data Examples: • Adjusting credit terms to affect net sales • Switching inventory valuation methods • Choice of depreciation method: straight-line method smoothes earnings • Discretionary expense items such as R&D 34
Example (million) Net Sales 400 COGS 260 Gross Profit 140 Operating Expenses 70 Operating Income Interest Paid Earnings before taxes Taxes Net Income 70 20 50 30 20 35
Questions 1. Was the company profitable? 2. Did the company indeed receive 20 million cash as profit in its bank account? 36
Learning Objectives of Statement of Cash Flows p Understand difference between net profit and net cash flow. p Construct statement of cash flows using indirect method. p Use the statement of cash flows to analyze a company. 37
Net profit vs. net cash flow Net profit does not equal net cash flow Net profit Net cash flow p firm performance in under accrual terms of ability to method of accounting generate cash p Easily manipulated p Harder to manipulate 38
Statement of Cash Flows p Provides information about cash inflows and outflows during an accounting period p Focuses on CASH. p Has THREE sections: • • • Cash flow from Operating Activities (OCF) Cash flow from Investing Activities (ICF) Cash flow from Financing Activities (FCF ) 39
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Useful Tip Cash flow from Operating Activities + Cash flow from Investing Activities + Cash flow from Financing Activities = CHANGE in cash account for the period! 41
Another Useful Tip No matter which section you are doing (operating, investing or financing), Ø IF the change is a cash INFLOW, you add that change. + Ø IF the change is a cash OUTFLOW, you subtract that change. inflow: decreases in assets or increases in liabilities or equity. outflow: increases in assets or decreases in liabilities or equity. 42
Cash flows from operating activities Net income + Depreciation IS means Income Statemen t + Decrease in any asset account related to IS - Increase in any asset account related to IS Decrease in any liability account related to IS + Increase in any liability account related to IS = Net cash flow from operating activities 43
Cash flows from operating activities 3 Asset accounts related: § § Accounts receivable Inventories Liability accounts related: § § Accounts payable Accruals 44
Cash flows from operating activities 4 Asset Liability Decreases Add (cash inflow) Subtract (cash outflow) Increases Subtract (cash outflow) Add (cash inflow) 45
Cash flows from investing activities 1 p Investing activities: • Buying or selling productive assets (plant & equipment) • Buying or selling financial securities that expire after 1 year (e. g. , stock of other companies, bonds) 46
Cash flows from investing activities 2 Inflows: Means: Decrease in gross fixed assets Firm sells long-lived assets such as gross property, plant and equipment Decrease in long-term investments Firm sells debt or equity securities of other firms Outflows: Increase in gross fixed assets Firm buys long-lived assets such as gross property, plant and equipment Increase in long-term investments Firm buys debt or equity securities of other firms 47
Cash flows from investing activities 3 p Investing activities refer to changes on the lower left-hand side of balance sheet p Warning: we want to find the changes in GROSS fixed assets. We don’t want the changes in net fixed assets! p BUT, if gross fixed assets not reported in balance sheet, …. ? 48
Useful relationships Change in gross fixed assets = change in net fixed assets + depreciation 49
Balance Sheet Overview Assets Liabilities and Owners Equity Cash Notes Payable Marketable securities Accounts Payable Net A/R Accrued Expenses Inventories Current Portion of LTD Total Current Assets Total Current Liabilities Gross Fixed Assets Long term (L. T. ) Debt (less Accum. Depreciation) Total Liabilities Net Fixed Assets Preferred Stock Other long-term assets such Common Stock as Retained Earnings stocks and bonds Total Liabilities and Total Assets equity Assets Claims on Assets 50
Cash flows from financing activities 1 Financing activities: • Loans from creditors (long-term, short-term) • Repayment of principal • Sale or repurchase of stock (common or preferred) from firm’s equity holders • Payment of dividends 51
Cash flows from financing activities 2 Inflows: • increase in notes payable • increase in long-term debt • increase in common stock Outflows: • decrease in notes payable • decrease in long-term debt • decrease in common stock • Payment of dividends Means: Firm borrows money Firm sells equity securities Firm repays debt Firm buys back shares Firm pays cash to shareholders 52
Cash flows from financing activities 3 Financing activities refer to: • Items on lower right-hand side of balance sheet (long-term debt, equity) • Changes in notes payable (short-term bank loans). Useful relationship: Dividends paid = net income – change in retained earnings 53
IBM’s Statement of Cash Flow p Where to find? 54
Solve Assignment 3. 1 on course website. 55
Analyzing Statement of Cash Flows 1 Statement of CF can help you analyze a company: 1) Relationship between net income and net cash flow from operations (OCF) p If net income positive, but OCF is negative, could mean: p Company is growing rapidly p Financial mis-management 56
Analyzing Statement of Cash Flows 2 2) Net cash flow from investing activities (ICF) If negative, company is making investments p Buying plant & equipment (improve efficiencies) p Buying another company’s stock (strategic reasons, e. g. , joint venture) If positive, company is liquidating assets. Why? Financial distress? 57
Analyzing Statement of Cash Flows 3 3) Does company have sufficient cash to pay dividends? OCF should exceed dividends. If dividends exceed OCF, why? p Company liquidated assets to pay dividends? p Company issued equity or borrow to pay dividends? p Neither situation is good. 58
Analyzing Statement of Cash Flows 4 4) Changes in debt p Look at cash flow from financing activities p Big increases in debt (either short-term or long-term) are not good. p Substituting short-term debt for long-term debt may indicate worsening financial health. 59
Homework § § Self-practice problems: 1. Textbook problems (page 86): 3 -2, 3 -3, 3 -4, 3 -8, 3 -9 2. additional cash flow problems on course web Homework assignments to be graded: (listed on the course website) 60
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