2. Financial Statements and Cash Flows

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1 2. Financial Statements and Cash Flows Key Concepts Financial Statements: Balance Sheet and Income Statement Liquidity Difference between book value and market value Difference between accounting income and cash flow Know how to determine a firm s cash flow from its financial statements 1 1

2 Balance Sheet The balance sheet is a snapshot of the firm s assets and liabilities at a given point in time Assets are listed in order of liquidity Ease (quick & less costly) of conversion to cash Without significant loss of value Balance Sheet Identity Assets = Liabilities + Stockholders Equity 2 The Balance Sheet 3 2

3 Liquidity Liquidity Ability to convert to cash quickly without a significant loss in value Liquid firms are less likely to experience financial distress Then, what is the drawback of carrying excessive amount of liquid asset? Trade to find balance between liquid and illiquid assets 4 Net Working Capital and Liquidity Net Working Capital NWC = Current Assets Current Liabilities Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out Usually positive in a healthy firm 5 3

4 Net Working Capital 6 SKK Corporation - Balance Sheet Cash ( 현금 ) 104 Accounts Payable 160 ( 매입채무 ) Accounts Receivable ( 매출채권 ) 455 Notes Payable 688 ( 지급어음 ) Current Liabilities Inventory ( 유동부채 ) ( 재고자산 ) Current Assets ( 유동자산 ) 1,112 1,403 Fixed Liabilities ( 고정부채 ) Fixed Assets ( 고정자산 ) 1,644 1,709 Owners Equity and Paidin Surplus ( 자본금및자본잉여금 ) Retained Earnings ( 유보이익 ) 1,320 1,629 Equity ( 자기자본 ) 1,920 2,269 Total Assets ( 자산총계 ) 2,756 3,112 Liabilities and Equity ( 부채및자기자본총계 ) 2,756 3,

5 Amazon.com (AMZN) ($Mil.) Which is the proper measure of the fair value of Google Inc. s equity? $949B or $35B? 8 Market Vs. Book Value The balance sheet provides the book value of the assets, liabilities and equity. Market value is the price at which the assets, liabilities or equity can actually be bought or sold. Market value and book value are often very different. Why? Which is more important to the decisionmaking process? 9 5

6 Income Statement The income statement is more like a video of the firm s operations for a specified period of time. You generally report revenues first and then deduct any expenses for the period 10 SKK Corporation - Income Statement 2018 Sales ( 매출 ) 1,509 Cost of Goods Sold ( 매출원가 ) 750 Depreciation ( 감가상각 ) 65 EBIT ( 영업이익 ) 694 Interest Paid ( 지급이자 ) 70 Taxable Income ( 세전이익 ) 624 Taxes ( 법인세 ) 212 Net Income ( 순이익 ) 412 Dividends ( 배당 ) 103 Additions to Retained Earnings ( 유보이익 )

7 The Concept of Cash Flow Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets Cash Inflow vs. Cash Outflow When cash is generated, the cash flow is called cash inflow and (+) sign is used When cash is spent, the cash flow is called cash outflow and ( ) sign is used 12 Cash Flow from Assets Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders Cash Flow from Assets Cash Flow to Creditors = + Cash Flow To Stockholders 13 7

8 Cash Flow From Assets: Composition Operating Cash Flow Cash Flow Investments from in Assets Fixed Assets Investment in NWC Cash Flow From Assets = Operating Cash Flow Net Capital Spending Changes in NWC 14 Part 1: Operating Cash Flows Two popular ways to estimate OCF Top-Down Approach OCF = Sales Costs Tax Bottom-Up Approach OCF = Net Income + Interest + Non-Cash Item * Interests are part of cash flows that belong to investors (creditors) In general, OCF has a positive value Beside the two methods, there is an OCF estimation method called tax shield approach 15 8

9 Part 2 & 3. Estimation of Capital Spending and Net Working Capital Needs Capital spending: investments in fixed assets Net working capital needs: investments in net working capital (NWC = current assets current liabilities) Investments mean cash flows invested CF invested = Outflow or Inflow? Both items generally have negative ( ) values at early stages of investments Cash flows for purchases of fixed assets are cash outflows (negative) and cash flows from sales of fixed assets are cash inflows (+) Cash flows invested to maintain a needed level of net working capital are cash outflows and cash flows withdrawn (from NWC) towards the end of an investment s life are cash inflows (+) 16 Cash Flow to Investors CF to Creditors = interest paid net new borrowing CF to Stockholders = dividends paid net new equity raised CF to Creditors & S.H. = CF from Assets 9

10 Exercise Determine if each of the following transactions involves an inflow or an outflow? Sale of inventory Purchase of land to build a factory building Accounts receivable paid Sale of a machine Increase in net working capital Is this an inflow or outflow to investors? Dividends paid Issue of bonds Share repurchase 18 Example: SKK Corporation Using the SKK Corporation s B/S and I/S, estimate the cash flows from assets, CF to creditors, and CF to shareholders 19 10

11 SKK Corporation (CFFA) OCF (I/S) = Sales costs taxes (top down) = $1509 $ 750 $212 = $547 OCF (I/S) = NI + interest + depreciation (bottom up) = $412 + $70 + $65 = $547 Net Cap. Spending (B/S and I/S) = net fixed assets 2018 net fixed assets depreciation 2018 = $1,709 - $1,644 + $65 = $130 (-) Changes in NWC (B/S) = ending NWC beg. NWC = (CA 2018 CL 2018 ) (CA 2017 CL 2017 ) = ($1,403 $389) ($1,112 $428) = $330 (-) CFFA = OCF NCS in NWC = = $87 20 SKK Corporation (CFC & CFS) CF to Creditors (B/S and I/S) = interest paid net new borrow. = interest paid 2018 (long-term debt 2018 LTD 2017 ) = $70 ($454 $408) = $70 $46 = $24 CF to Stockholders (B/S and I/S) = dividends paid net new equity raised = dividends paid 2018 (com. stock & paid-in surplus 2018 com. stock & paid-in sur ) = $103 ($640 $600) = $63 CFC + CFS = = $87 11

12 Asia Composite Corporation Balance Sheet Current assets: Cash and equivalents $140 $107 Accounts receivable Inventories Other Total current assets $761 $707 Fixed assets: Property, plant, and equipment $1,423 $1,274 Less accumulated depreciation (550) (460) Net property, plant, and equipment Intangible assets and other Total fixed assets $1,118 $1,035 Total assets $1,879 $1,742 Asia C.C. Income Statement Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income 2016 $2,262 1, $ $ $ $86 Addition to retained earnings $43 Dividends: $43 12

13 Asia C.C. Financial Cash Flow Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income $2,262 1, $ $ $ $86 Addition to retained earnings $43 Dividends: $43 Operating Cash Flow: Net Income +Depreciation +Interest Expense +Deferred Taxes OCF Asia C.C. Financial Cash Flow Current assets: Cash and equivalents $140 $107 Accounts receivable Inventories Other Total current assets $761 $707 Fixed assets: Property, plant, and equipment $1,423 $1,274 Less accumulated depreciation (550) (460) Net property, plant, and equipment Intangible assets and other Total fixed assets $1,118 $1,035 Capital Spending Ending net fixed assets - Beginning net fixed assets +Depreciation Total assets $1,879 $1,742 13

14 Asia C.C. Financial Cash Flow Current assets: Cash and equivalents $140 $107 Accounts receivable Inventories Other Total current assets $761 $707 Current liabilities: Accounts payable $213 $197 Notes payable Accrued expenses Total current liabilities $486 $455 Change in NWC NWC 2015 = NWC 2016 = NWC grew to ( ) million in 2016 from ( ) million in This increase of ( ) million is the addition to NWC (investment). Asia C.C. Financial Cash Flow Cash Flow of the Firm Operating cash flow $238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total $42 14