Financial Management - Section 3 | Financial Statements PDF

Preview

Summary

Financial Statements Pt 2...

Description

Financial Management

3: Financial Statements Pt.2

The Statement of Cash Flows (SCF) Third and most honest of the basic financial statements. Explains cash in and cash out of the company for a given year. Cash flow reveals the true health of a company Not net income Cash Flows are divided into three groups 1. Cash flows from operations (CFO)  measures the net cash impact of operating decisions 2. Cash flows from investing (CFI)  measures the net cash impact of investing decisions 3. Cash flows from financing (CFF)  measures the net cash impact of financing decisions. Sum of these three cash flows = company’s change in cash. They refer to three types of decisions made by managers: 1. Operational decisions  What to product, how to product it, who to use for suppliers 2. Investing activities  Decisions regarding purchase/sale of assets 3. Financing decisions  The issuance of debt and equity  Repayment of depts or repurchase stock  Payment of dividends The categorization of cash flow is flexible and is impacted by the firm's operating environment.

1

Financial Management

3: Financial Statements Pt.2

Standard Form for Statement of Cash Flows Statement of Cash Flows (dated for period ended) _________________________________________ Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing _________________________________________ = Change in Cash + Beginning Cash _________________________________________ = End Cash   

CFO can be dramatically impacted by managerial discretion in the financial reporting process. The three cash flow areas are from operations, investing, and finance While gross cash flows are difficult to manage/manipulate, it is relatively easy to shift cash flows between the activity categories (e.g., shifting between CFO and CFI). Hence, the analyst must still be careful to understand the assumptions/estimates/decisions made in the reported data.

CFO Includes all cash flows related to producing and selling company’s product. CFO and Net Income differ for many reasons:  Revenue, used to calculate net income, is not the same as cash collected from sales due to changes in AR.  An increase in AR means sales associated with increase have been recognized, but cash not yet collected.  Gain/loss from sale of PP&E is included in net income but not part of CFO.  (gain on sale = sale price – book value)  Cash from sale of equipment is associated with investing activities and part of CFI.  Depreciation expense is included in the calculation of net income but does not represent an outflow of cash.  A non-cash expense created for tax purposes  Add depreciation expense back to net income to reflect actual CFO 2

Financial Management  

3: Financial Statements Pt.2

Neither net income nor CFO “accounts” for the change in cash. An increase in an asset account indicates an outflow of cash. Since A/R is an operating account, the $100 increase will decrease CFO by $100.

Calculating CFO Indirect Method: Most commonly used, a bottom-up approach, starting with net income and adjusting for differences between net income and CFO. If there were no non-cash expenses and no changes to any operating balance sheet accounts, net income would equal CFO, although very rare. Simplified Method: Assume no asset disposals and add net income plus depreciation expense to changes in operating accounts from the balance sheet to determine CFO. CFO = NI + Depreciation Expense + Changes in Operating Accounts Increased assets = outflow of cash For assets to increase, cash must have been used to acquire the asset. A decrease in an asset account indicates an inflow of cash. Increases in liability accounts signal an inflow of cash Decreases signify an outflow of cash. If accounts payable increases, more is owed to suppliers. If money is owed to suppliers, less cash was paid out than implied by net income If less cash was paid out, then cash has gone up A decrease in accounts payable indicates cash paid to suppliers. The sum of CFO, CFI, and CFF = The Change in Cash

CFO implications of changes: Operating asset accounts (AR, inventory):  Increase = outflow of cash  Decrease = inflow of cash Operating liability accounts (AP, accrued wages)  Increases = inflow of cash  Decreases = outflow of cash

3

Financial Management

3: Financial Statements Pt.2

Increases in liabilities = increased cash Notes Payable: Frequently included in current liabilities section of balance sheet but considered a financing account –part of CFF. Be sure not to adjust net income for changes in notes payable when calculating CFO 

An increase in an operating asset such as inventory represents an outflow of cash attributable to CFO.

CFI Involves any cash in or out due to investment in or disposal of fixed assets. CFI = Change in Gross PP&E CFI = Change in Net PP&E + Depreciation

PP&E Gross Before accumulated depreciation is deducted PP&E Net After accumulated depreciation is deducted Increase in gross PP&E represents use of cash Had to use cash to purchase more fixed assets. Use of Cash An increase of an asset (including cash) or the decrease of a liability

CFF The net impact from financing and includes cash flows resulting from:  increased borrowing  debt repayments  stock issuance  stock repurchase  dividend payment

4

Financial Management

3: Financial Statements Pt.2

Calculated by comparing appropriate balance sheet accounts from one year to the next.  An increase in a financing account signals a cash inflow  A decrease indicates a cash outflow associated with repaying lenders or repurchasing stock. Financing accounts:  Debt  Notes payable  Equity Dividends paid out are a cash outflow attributable to CFF

Dividends = (OldRE + Net Income) – NewRE Net Income: $1,000 BegRE: $12,200 EndRE: $13,000 Dividends = (oldRE + NI) – newRE Dividends = (12,200 + 1,000) – 13,000 Dividends = $200 ^^represents cash outflow –CFF will be $200 lower

SCF and The Balance Sheet T-Account Balance Sheet Cash Accounts Receivable Accounts Payable Inventory Accrued Wages Current Assets Current Liabilities PP&E

Common Stock Retained Earnings

CFO = Net Income + depreciation expense +/- changes in operating assets (add decreases, subtract increases) +/- changes in operating liability accounts (add increases and subtract decreases)

5

Financial Management 

    

3: Financial Statements Pt.2

Generally speaking, the operating accounts relevant to the calculation of CFO are located at the top of both the asset and financing side of the balance sheet. Conceptualizing the current assets as operating asset accounts and the current liabilities as operating liabilities is useful for building intuition. The bottom of the asset side of the balance sheet (long-term assets) is most closely associated with CFI. CFF comes from the liabilities and equity side of the balance sheet. Change in cash is not considered in the calculation of any of the three cash flow categorizations. Notes payable is an important cash flow variable, it is a financing variable and included in CFF

FCF Free Cash Flow: distributable cash Represents the cash that can be distributed after funding required reinvestment in PP&E as well as increased working capital. FCFF FCF to the Firm – most commonly used in financial analysis The cash distributor to all providers of capital, both debt and equity holders. FCFE FCF to Equity The cash distributable to the equity holders after satisfying all obligations to debt holders. Dividends are the cash distributed to stockholders FCFE is cash distributable to stockholders once required reinvestments are funded Base equation for measuring FCFF: FCFF = EBIT (1-tax rate) + depreciation – CAPEX – increases in NWC Tax rate: Percent of earnings a firm pays in taxes Depreciation Depreciation expense EBIT Earnings before interest and taxes CAPEX Capital expenditure on PP&E; frequently measures as CFI 6

Financial Management

3: Financial Statements Pt.2

NWC Net working capital (current assets – current liabilities) changes EBIT (1-tax rate) is referred to as Net Operating Profit After Taxes (NOPAT) EBIT is used rather than Net Income because FCFF is a measure of cash flows before either creditors or owners are compensated –adding back depreciation since it is a non-cash expense.

FCFE = NI + depreciation – CAPEX – increases in NWC + Increases in debt *increases in debt = new borrowings minus repayments of old debt FCFE measures cash distributable to equity holders after all obligations and required reinvestments are satisfied.    

     

   7

CFO doesn’t allow for required reinvestment. FCFF is nopat (i.e., EBIT x [1-t]) plus depreciation less capex less increases in net working capital. FCFF = Net income+ Depreciation – CAPEX – Increases in NWC + increases in debt is the formula for FCFE. Depreciation expense is added back when calculating Free Cash Flow (FCF) because depreciation expense is a non-cash expense CFO + CFI + CFF = change in cash during the period. An increase in an operating liability (like A/P) will increase CFO. An increase in notes payable will increase CFF. An increase in cash is the result of operations, investment, and financing. Free Cash Flow (FCF) is different from Cash Flows from Operations (CFO) because FCF represents cash flow after required investment In order to understand the health of a company, you must understand how the firm generates and expends cash. The impacts of accrual accounting are seen most in relation to net income. Increase in inventory or accounts receivable and decreases in accounts payable will decrease CFO. Notes payable is a financing item. Depreciation expense is a significant source of difference between net income and CFO because depreciation expense is non-cash expense on

Financial Management

     

   

   

8

3: Financial Statements Pt.2

the income statement associated with the acquisition of long-lived assets. CFI accounts are generally non-current assets (i.e., bottom of the asset side of the balance sheet). Increases in assets consume cash as do decreases in operating liabilities. A decrease in an operating asset represent a cash inflow associated with CFO and is not impacted by tax rate Assuming no asset disposals, CFI is the change in Gross PP&E. CFI is equal to the change in Net PP&E plus depreciation expense. Firms can sustain negative CFO in the short-run buy borrowing, etc. In the long run, the firm will run out of assets to sell and lenders will refuse to lend. A firm cannot sustain negative CFO forever. Increases in operating asset accounts will decrease CFO, but increases in operating liability accounts (i.e., A/P) will increase CFO. An increase in an operating liability such as accounts payable or accrued wages represent an inflow to the firm. Change in retained earnings is accounted in CFO by adding net income and CFF by subtracting dividends paid. Most current asset and current liability accounts are operating accounts; hence, changes are included in the calculation of CFO. However, Operating assets do not include all current assets. Cash is the notable exception. Operating liabilities do not include notes payable (changes in notes payable are included in CFF). Note that there are other exceptions, but they are beyond the scope of this discussion. Assuming no asset disposals, depreciation expense is equal to the change in accumulated depreciation. FCFF can sustainably be distributed to the providers of capital. Common Stock (CS) is a type of equity on the balance sheet which represents equity sold to common shareholders at par value. The calculation of FCFF uses NOPAT instead of Net Income because FCFF is the cash available to both debt holders and equity holders....