Net Income, cash flows, reduced balance sheet and WCR (Working Capital Requirements) 1

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1 Madera Inc (Working Capital Requirements) 1 Pablo Fernandez. Professor of Finance. IESE Business School. University of Navarra. fernandezpa@iese.edu Isabel Fernandez Acin. University of Navarra. ifernandez.28@alumni.unav.es Alberto Ortiz. Research Assistant. IESE Business School University of Navarra. AOrtiz@iese.edu xppidepmp500 Previous version: October 17, 2017 A version in Spanish of this document may be donloaded in: (Beneficio, flujos, balance reducido y RNC. Madera Inc) The net income of a company in a given year is an arbitrary number which depends on several decisions on the accounting of expenses and revenues. By contrast, each cash flow (money going out of the cash of the company into someone's pocket: shareholders, debt owners...) is a single number not subject to any particular criterion. The case of Madera Inc. is presented and different flows are calculated. The Equity Cash Flow (ECF) is the money which comes out of the cash and gets into the pockets of the shareholders. The FCF (Free Cash Flow) is the hypothetical ECF if the company had no debt. The Capital Cash flow is the Debt Cash Flow plus the Equity Cash Flow. The Debt Cash Flow consists of the sum of the interest plus the repayment of principal (or less the increase in principal). The reduced balance sheet and the WCR ( Working Capital Requirements ) are also calculated. They allow us to interpret more easily and quicker the accounting statements. The following questions arise: Does the dividend come from the net income? Where are the retained earnings and the reserves? What is the depreciation? 1. Financial statements of Madera Inc. 2. Accounting cash flow, equity cash flow, debt cash flow, free cash flow and capital cash flow 3. Transformation of accounting into collections and payments 4. Analysis of the collection from clients, payments to suppliers and Inventory 4.1. Collection period 4.2. Payment period 4.3. Days of Inventory 4.4. Gross Margin of the company 4.5. Linking payments, collections, inventory and gross margin 5. The reduced balance. WCR ( Working Capital Requirements ). Exhibit 1. Reduced balance sheet for 12 US companies Exhibit 2. Synonyms and confusion of terms Exhibit 3. Balance sheet and P&L of Coca Cola, Pepsico, IBM, Microsoft, Google, and GE 1 We thank Xili Wu and Nicholas A. Lash their invaluable help in this chapter Ch44-1

2 1. Financial statements of Madera Inc. Madera Inc. is an intermediary of multiple wooden items: beams, frames, floors, doors, furniture... It does not manufacture any product. It presents very similar sales every month. Table 1 shows the balance sheet and income statement of Madera Inc. Table 1. Balance Sheet and Income Statement of Madera Inc. (Million $) Income Statement Balance Sheet Net Sales Cash and Equivalents Cost of Sales* Receivables Net Gross Margin Inventory Labor Current Assets Depreciation Gross Fixed Assets Other Expenses Accumulated Depreciation Operating Expenses Fixed Assets (Net) Interest expenses (14%) Total Assets Extraordinary Profit (1) Earnings before Taxes Payable Bank Taxes (30%) Taxes Payable Net Income Payable Other Expenses Dividends Accounts payable Short-term payable * Beginning inventory Long-term payable Purchases Shareholders Equity Ending inventory Total Equity & Liabilities Cost of Sales (1) 2011: The Company withdrew assets with a book value of 15 (gross fixed assets = 25, accumulated depreciation = 10) 2012: The Company sold at year-end assets by 60 million with a book value of 28 (gross = 40; Acc. Dep. = 12) Madera Inc. pays the taxes generated in one year in the following year. 2. Accounting cash flow, equity cash flow, free cash flow and capital cash flow According to the definitions of flows, Table 2 shows the magnitude of several flows: accounting cash flow = net income + depreciation ECF = equity cash flow = money which comes out of the box and gets into the pockets of the shareholders DCF = debt cash flow = money which comes out of the box to banks and owners of financial debt CCF = capital cash flow = equity cash flow + debt cash flow FCF = free cash flow = equity cash flow if the company did not have debt Table 2. Fundamental flows for Madera Inc. (Million $) Net Income Depreciation = Accounting Cash Flow ECF = dividends 5 10 Interest expenses repayment of long-term debt increase in short-term debt with the Bank DCF CCF = ECF + DCF FCF = ECF if D = Table 3 is constructed to calculate the FCF (ECF if D = 0). It is Table 1 without financial debt. Ch44-2

3 Tabla 3. Hypothetical balance Sheet and income statement of Madera Inc. with D = 0 (Million $) (Accounts that change in bold) Income Statement Balance Sheet Net Sales Cash and Equivalents Cost of Sales* Receivables Net Gross Margin Inventory Labor Current Assets Depreciation Gross Fixed Assets Other Expenses Accumulated Depreciation Operating Expenses Fixed Assets (Net) Interest expenses Total Assets Extraordinary Profit (1) Earnings before Taxes Payable Bank Taxes (30%) Taxex Payable Net Income Payable Other Expenses Dividends Accounts payable Short-term payable * Beginning inventory Long-term payable Purchases Shareholders Equity Ending inventory Total Equity & Liabilities Cost of Sales Transformation of accounting into collections and payments Table 4 expresses the accounts in 2011 as collections and payments. In the last row, you can see that the collections (inflows into cash and equivalents ) were million and the outflows were million: therefore, cash and equivalents decreased by 4 million. Table 4. Collections and Payments in 2011 (Million $) 2011 Concept Money in Money out Net Sales Collections from clients = sales - Receivables Cost of Sales Payments to suppliers = purchases - Acc. payable Labor 261 Payments to employees 261 Depreciation 28 Other Expenses 430 Payments of other expenses = (POE) 414 Interest expenses 69 Payment of interest expenses 69 Extraordinary Profit -15 Sales of assets 0 Taxes (30%) 9 Payments of taxes = 9 - (TaxP) 9 Net Income 21 Dividends 5 Payment of dividends 5 Cash and Equivalents Receivables Inventory Gross Fixed Assets (GFA) Payment of fixed assets = GFA Payable Bank More short-term payable 40 Taxes Payable (TaxP) 9 9 Payable Other Expenses (POE) Accounts payable Long-term payable Repayment of long-term payable 10 Shareholders Equity Sum Table 5 expresses the accounts in 2012 as collections and payments. In the last row, you can see that the collections (inflows into cash and equivalents ) were million and the outflows were million: therefore, cash and equivalents decreased by 2 million. Ch44-3

4 Table 5. Collections and Payments in 2012 (Million $) 2012 Concept Collections Payments Net Sales Collections from clients=sales - Receivables Cost of Sales Payments to suppliers=purchases - Acc. payable Labor 345 Payments to employees 345 Depreciation 39 Other Expenses 568 Payments of other expenses = (POE) 545 Interest expenses 72 Payment of interest expenses 72 Extraordinary Profit 32 Sales of assets 60 Taxes (30%) 24 Payment of taxes = 9- (TaxP) 9 Net Income 56 Dividends 10 Payment of dividends 10 Cash and Equivalents Receivables Inventory Gross Fixed Assets (GFA) Payment of fixed assets = GFA Payable Bank More short-term payable 15 Taxes Payable (TaxP) 9 24 Payable Other Expenses (POE) Accounts payable Long-term payable Repayment of long-term payable 10 Shareholders Equity Sum We should not forget that in the box of the company (cash and equivalents) there are only money inflows and outflows (collections and payments), as shown in Figure 1: Figure 1. Madera Inc. Cash inflows and outflows in 2012 In 2012: º More short-term debt 15 Sale of Assets 60 Collections from clients Cash Payable Treasury 9 Payment of dividends 10 Repayment of LT Debt 10 Payment of Fixed Assets 27 Payment of Interest exp. 72 Payment to Employees 345 Payment Other.Expenses 545 Payment to Suppliers Questions about Figure 1 and Table 2: Does the dividend come from the net income? Where are the retained earnings? Is the depreciation a flow? Could you say that dividends are paid with the increase in short-term debt? What is the depreciation? The accounting cash flow, is really a cash flow? Ch44-4

5 4. Analysis of the collection from clients, payments to suppliers and Inventory 4.1. Collection period The "sales" of a company are the sum of the invoices that the company has issued in a year. The "accounts receivable" are the sum of the invoices that the company has issued and has not yet collected. Both can be easily connected. The traditional way is to calculate how many days of "sales" are in the "accounts receivable". If sales are uniform (no seasonality), Average Daily Sale = Sales / 365. And the receivables entail ["Accounts Receivable" / Daily Average Sale] days of sale. These days of sales are called "Collection period" Collection period (in days) = ["Accounts Receivable" / Daily Average Sale] In the case of Madera Inc: (a) Net Sales (b) Daily Sales 6,13 7,38 9,76 (c) Accounts Receivable (c) / (b) Collection period 45,8 44,6 45, Payment period The "purchases" of a company are the sum of the invoices that the company has received from its suppliers in a year. "Suppliers" or "Accounts payable" are the sum of the invoices that the company has received and not yet paid. Both can be esily connected. The usual way is to calculate how many days of "purchases" are in the "accounts payable". If purchases are uniform (no seasonality), Average Daily Purchase = Purchases / 365. And payables entail ["Accounts Payable" / Daily Average Purchase] days of purchase. These days of purchase are referred to as "Payment period " Payment period (in days) = ["Accounts Payable" / Daily Average Purchase] In the case of Madera Inc: (a) Purchases (b) Daily Purchases 4,71 5,24 7,24 (c) Accounts payable (c) / (b) Payment period 40,3 40,5 47, Days of Inventory The "cost of sales" of a company is the output from the inventory or "stock" that the company writes down in a year. The "stock" or "inventories" are the sum of the cost of the goods that the company keep in order to sell at a given time. The usual way to link the two amounts is to calculate how many days of "cost of sales" are in the "Inventory". If no seasonality, Daily Cost of Sales = Cost of sales / 365. And the "Inventory" entail ["Inventory" / Daily Cost of Sales] days of sale. These days of sales are called "days of Inventory". Days of Inventory = ["Inventory" / Daily Cost of Sales] In the case of Madera Inc: (a) Cost of Sales (b) Daily Cost of Sales (c) Ending inventory (c) / (b) Days of Inventory Ch44-5

6 4.4. Gross Margin of the company The following table shows that in 2012 the cost of sales was on average 69.9% of sales. Put another way, the wood for which the company paid $69.9 was sold on average for $100 (or what is the same: the wood for which Madera Inc. paid $100 was sold for $143) Cost of Sales / Sales 70.5% 69.1% 69.9% Sales / Cost of Sales Linking payments, collections, inventory and gross margin Figure 2 shows a simplified diagram about the business of Madera Inc. according to the days obtained above. On day 0, the purchase of wood that reaches the warehouse (Inventory) accompanied by an invoice (accounts payable) for $100 is performed. The supplier is paid on day 47.6 and the wood is in Inventory until the day 88.1, in which the sale occurs. The sale is to send the wood to the customer accompanied by an invoice for $143 to be paid (on average) 45 days later (the day 133.1). The two most important figures in this diagram are: a) The gap of 85.5 days between the payment of $100 and the collection $143 b) The margin: Madera charges $143 for goods that have a cost of $100 (43%) Figure 2. Diagram of [money in] - [money out] in days Figure 3. Diagram of [money in] - [money out] in days Figure 3 shows the simplified scheme with data of We can see that in 2012 Madera Inc. delayed payments to suppliers on average 7.1 days. 5. The reduced balance. The WCR ( Working Capital Requirements ). For quick analysis of the balance sheet it is common to simplify it as follows: a) In Liabilities, we just keep two accounts: shareholders equity and financial debt (both short and long-term). b) In Assets, we just use three accounts: cash and equivalents, fixed assets and a new account thar allows us to balance or fit the reduced balance. This new account is often called WCR (Working Capital Requirements). Therefore, Ch44-6

7 WCR = Shareholders Equity + Financial Debt Fixed Assets Cash WCR = Ebv + D NFA Cash In the case of Madera Inc, WCR = Accounts Receivable + Inventory Taxes Payable Payable (Other Expenses) - Accounts payable Reduced balance Sheet of Madera Inc. are shown in Table 6. Table 6. Reduced balance Sheet of Madera Inc. (Million $) Cash and equivalents Debt WCR Shareholders Equity (Ebv) Net Fixed Assets (NFA) Subtotal Subtotal Complete Balance Sheet Cash and equivalents Payable Bank Receivables-Net Taxes Payable Inventory Payable Other Expenses Gross Fixed Assets Accounts payable Accumulated Depreciation Long-term payable Net Fixed Assets Shareholders Equity Total Assets Total Equity & Liabilities In the reduced balance sheet, it holds that: Cash + WCR + NFA = D + Ebv And therefore: Cash + WCR + NFA = D + Ebv In most companies 2, Ebv = Net income Dividends repurchase of shares = net income - ECF The Equity Cash Flow can be drawn from accounting and connected with net income: ECF = net income - Cash - WCR - NFA + D In the case of Madera Inc: ECF = net income - Cash - WCR - NFA + D (-2) (-40) (-4) (-10) +30 Figura 4. Reduced balance sheet of Madera Inc ($millions) 2 When there are no capital increases, direct charges to reserves... Ch44-7

8 Exhibit 1. Reduced balance sheet for 12 US companies. Assets Ch44-8

9 Exhibit 1 (continue). Reduced balance sheet for 12 US companies. Equity and Liabilities Ch44-9

10 Exhibit 2. Synonyms and confusion of terms The WCR (Working Capital Requirements) are also often called: WC (Working Capital) NCA (Net Current Assets) In addition, some people includes cash, short-term financial debt... And to complicate the understanding, the term WC (working capital) can refer to three different quantities: a) The WCR (Working Capital Requirements) b) The WCR (Working Capital Requirements) + Cash c) Current Assets Current Liabilities, that is equal to: Shareholders Equity + Long-Term Financial Debt - NFA The term WC (Working Capital) is sometimes used as a synonym for WCR, WCR + Cash, and sometimes refers to the magnitude in the figure: Long-term debt + Shareholders Equity - NFA = Current Assets Current Liabilities WCR = Shareholders Equity + Financial Debt Fixed Assets Cash WCR = Ebv + D NFA D Ch44-10

11 Exhibit 3. Balance sheet and P&L of Coca Cola, Pepsico, IBM, Microsoft, Google, and General Electric ($ million) THE COCA-COLA COMPANY (KO) Cash Short Term Investments Receivables (Net) Inventories - Total Prepaid Expenses Other Current Assets Current Assets Total Investment In Unconsolidated Subsidiaries Other Investments Property Plant & Equipment - Net Property Plant & Equipment - Gross (Less) Accumulated Depreciation Other Assets Total Assets Accounts Payable ST Debt & Current Portion of LT Debt Accrued Payroll Income Taxes Payable Other Current Liabilities Current Liabilities - Total Long Term Debt Deferred Taxes Other Liabilities Total Liabilities Minority Interest Common Equity Common Stock Capital Surplus Other Appropriated Reserves Retained Earnings Unrealized Foreign Exchange Gain(Loss) Unrealized Gain on Marketable Securities (Less) Treasury Stock Total Shareholders Equity Total Liabilities & Shareholders Equity Common Shares Outstanding Net Sales or Revenues Cost of Goods Sold Selling, General & Admin Expenses Depreciation, Depletion & Amortization Other Operating Expenses Operating Income Extraordinary Credit - Pretax Extraordinary Charge - Pretax Non-Operating Interest Income Interest Expense On Debt Other Income/Expense - Net Interest Capitalized Pretax Income Income Taxes Minority Interest Ch44-11

12 Equity In Earnings Net Income to Common Shareholders PEPSICO, INC. (PEP) BALANCE SHEET Cash Short Term Investments Receivables (Net) Inventories - Total Other Current Assets Current Assets - Total Long Term Receivables Investment In Unconsolidated Subsidiaries Other Investments Property Plant & Equipment - Net Property Plant & Equipment - Gross (Less) Accumulated Depreciation Other / Intangible Assets Total Assets Accounts Payable ST Debt & Current Portion of LT Debt Accrued Payroll Income Taxes Payable Dividends Payable Other Current Liabilities Current Liabilities - Total Long Term Debt Provision for Risks & Charges Deferred Taxes Other Liabilities Total Liabilities Minority Interest Preferred Stock Common Equity Common Stock Capital Surplus Other Appropriated Reserves Retained Earnings Unrealized Foreign Exchange Gain(Loss) Unrealized Gain on Marketable Securities (Less) Treasury Stock Total Shareholders Equity Total Liabilities & Shareholders Equity Common Shares Outstanding Net Sales or Revenues Operating Expenses - Total Cost of Goods Sold Selling, General & Admin Expenses Depreciation, Depletion & Amortization Operating Income Extraordinary Credit - Pretax Extraordinary Charge - Pretax Non-Operating Interest Income Interest Expense On Debt Other Income/Expense - Net Interest Capitalized Ch44-12

13 Pretax Income Income Taxes Minority Interest Equity In Earnings Net Income to Common Shareholders INTERNATIONAL BUSINESS MACHINES CORPORATION (IBM) BALANCE SHEET Cash Short Term Investments Receivables (Net) Inventories - Total Other Current Assets Current Assets - Total Long Term Receivables Investment In Unconsolidated Subsidiaries Other Investments Property Plant & Equipment - Net Property Plant & Equipment - Gross (Less) Accumulated Depreciation Other Assets Total Assets Accounts Payable ST Debt & Current Portion of LT Debt Accrued Payroll Income Taxes Payable Other Current Liabilities Current Liabilities - Total Long Term Debt Provision for Risks & Charges Deferred Income Deferred Taxes Other Liabilities Total Liabilities Minority Interest Common Equity Common Stock Capital Surplus Other Appropriated Reserves Retained Earnings Unrealized Foreign Exchange Gain(Loss) Unrealized Gain on Marketable Securities (Less) Treasury Stock Total Shareholders Equity Total Liabilities & Shareholders Equity Common Shares Outstanding Net Sales or Revenues Operating Expenses - Total Cost of Goods Sold Selling, General & Admin Expenses Depreciation, Depletion & Amortization Depreciation Amortization of Intangibles Other Operating Expenses Operating Income Extraordinary Credit - Pretax Extraordinary Charge - Pretax Ch44-13

14 Non-Operating Interest Income Interest Expense On Debt Other Income/Expense - Net Interest Capitalized Pretax Income Income Taxes After Tax Other Income/Expense Discontinued Operations Net Income to Common Shareholders MICROSOFT CORPORATION (MSFT) BALANCE SHEET Cash Short Term Investments Receivables (Net) Inventories - Total Other Current Assets Current Assets - Total Investment In Unconsolidated Subsidiaries Other Investments Property Plant & Equipment - Net Property Plant & Equipment - Gross (Less) Accumulated Depreciation Other Assets Tangible Other Assets Intangible Other Assets Total Assets Accounts Payable ST Debt & Current Portion of LT Debt Accrued Payroll Income Taxes Payable Dividends Payable Other Current Liabilities Current Liabilities - Total Long Term Debt Provision for Risks & Charges Deferred Income Deferred Taxes Other Liabilities Total Liabilities Common Equity Common Stock Retained Earnings Unrealized Foreign Exchange Gain(Loss) Unrealized Gain on Marketable Securities Total Shareholders Equity Total Liabilities & Shareholders Equity Common Shares Outstanding Net Sales or Revenues Operating Expenses - Total Cost of Goods Sold Selling, General & Admin Expenses Depreciation, Depletion & Amortization Depreciation Amortization of Intangibles Amortization of Deferred Charges Ch44-14

15 Operating Income Extraordinary Credit - Pretax Extraordinary Charge - Pretax Non-Operating Interest Income Interest Expense On Debt Other Income/Expense - Net Pretax Income Income Taxes Equity In Earnings Net Income to Common Shareholders GOOGLE BALANCE SHEET Cash Short Term Investments Receivables (Net) Inventories - Total Other Current Assets Current Assets - Total Other Investments Property Plant & Equipment - Net Property Plant & Equipment - Gross Buildings Construction Work In Progress PP&E - Other (Less) Accumulated Depreciation Other Assets Deferred Charges Intangible Other Assets Total Assets Accounts Payable ST Debt & Current Portion of LT Debt Accrued Payroll Income Taxes Payable Other Current Liabilities Current Liabilities - Total Long Term Debt Provision for Risks & Charges Deferred Income Deferred Taxes Other Liabilities Total Liabilities Common Equity Common Stock Capital Surplus Other Appropriated Reserves Retained Earnings Unrealized Foreign Exchange Gain(Loss) Unrealized Gain on Marketable Securities Total Shareholders Equity Total Liabilities & Shareholders Equity Common Shares Outstanding Net Sales or Revenues Operating Expenses - Total Cost of Goods Sold Selling, General & Admin Expenses Depreciation, Depletion & Amortization Ch44-15

16 Depreciation Amortization of Intangibles Operating Income Extraordinary Credit - Pretax Extraordinary Charge - Pretax Non-Operating Interest Income Interest Expense On Debt Other Income/Expense - Net Pretax Income Income Taxes Current Domestic Income Tax Current Foreign Income Tax Deferred Domestic Income Tax Deferred Foreign Income Tax Discontinued Operations Net Income to Common Shareholders GENERAL ELECTRIC BALANCE SHEET Cash Short Term Investments Receivables (Net) Inventories - Total Raw Materials Finished Goods Progress Payments & Other Other Current Assets Current Assets - Total Long Term Receivables Investment In Unconsolidated Subsidiaries Other Investments Property Plant & Equipment - Net Property Plant & Equipment - Gross Land Buildings Machinery & Equipment Rental/Lease Property PP&E - Other PP&E Under Capitalized Leases (Less) Accumulated Depreciation Other Assets Deferred Charges Tangible Other Assets Intangible Other Assets Total Assets Accounts Payable ST Debt & Current Portion of LT Debt Dividends Payable Other Current Liabilities Current Liabilities - Total Long Term Debt Provision for Risks & Charges Deferred Taxes Deferred Taxes - Credit Deferred Taxes - Debit Other Liabilities Total Liabilities Minority Interest Ch44-16

17 Common Equity Common Stock Capital Surplus Other Appropriated Reserves Retained Earnings Unrealized Foreign Exchange Gain(Loss) Unrealized Gain on Marketable Securities (Less) Treasury Stock Total Shareholders Equity Total Liabilities & Shareholders Equity Common Shares Outstanding Net Sales or Revenues Operating Expenses - Total Cost of Goods Sold Selling, General & Admin Expenses Depreciation, Depletion & Amortization Depreciation Amortization of Intangibles Other Operating Expenses Operating Income Extraordinary Credit - Pretax Extraordinary Charge - Pretax Non-Operating Interest Income Interest Expense On Debt Other Income/Expense - Net Pretax Income Income Taxes Minority Interest Equity In Earnings After Tax Other Income/Expense Discontinued Operations Net Income Before Extra Items/Preferred Div Extr Items & Gain(Loss) Sale of Assets Net Income Before Preferred Dividends Preferred Dividend Require Net Income to Common Shareholders Ch44-17