Understanding Financial Statements and Cash Flows PDF

INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Adapted from Chapter 3 of Eugene Brigham’s Book Entitled: Essentials of Financial Management 4th Edition “Understanding Financial Statements with Cash Flow Statement” , and Tax...

INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Adapted from Chapter 3 of Eugene Brigham’s Book Entitled: Essentials of Financial Management 4th Edition “Understanding Financial Statements with Cash Flow Statement” , and Taxes Key Financial Statements Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows Free Cash Flow Federal Tax System 3-1 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM The Annual Report Balance sheet – provides a snapshot of a firm’s financial position at one point in time. Income statement – summarizes a firm’s revenues and expenses over a given period of time. Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time. Statement of stockholders’ equity – shows how much of the firm’s earnings were retained, rather than paid out as dividends. 3-2 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM To Illustrate: An Overview of Rebismo Inc. A Snack food company that underwent major expansion in 2020. So far, expansion results have been unsatisfactory. ▪ Company’s cash position is weak. ▪ Suppliers are being paid late. ▪ Bank has threatened to cut off credit. Board of Directors has ordered that changes must be made! 3-3 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Balance Sheet: Assets 2020 2019 Cash 7,282 57,600 A/R 632,160 351,200 Inventories 1,287,360 715,200 Total CA 1,926,802 1,124,000 Gross FA 1,202,950 491,000 Less: Dep. 263,160 146,200 Net FA 939,790 344,800 Total Assets 2,866,592 1,468,800 3-4 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Balance Sheet: Assets, Liabilities and Equity 2020 2019 Accts payable 524,160 145,600 Accruals 489,600 136,000 Notes payable 636,808 200,000 Total CL 1,650,568 481,600 Long-term debt 723,432 323,432 Common stock 460,000 460,000 Retained earnings 32,592 203,768 Total Equity 492,592 663,768 Total L & E 2,866,592 1,468,800 3-5 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Balance Sheet: Assets, Liabilities and Equity 2020 2019 2020 2019 Accts payable 524,160 145,600 Cash 7,282 57,600 Accruals 489,600 136,000 A/R 632,160 351,200 Notes payable 636,808 200,000 Inventories 1,287,360 715,200 Total CL 1,650,568 481,600 Total CA 1,926,802 1,124,000 Long -term debt 723,432 323,432 Gross FA 1,202,950 491,000 Common stock 460,000 460,000 Less: Dep. 263,160 146,200 Retained earnings 32,592 203,768 Net FA 939,790 344,800 Total Equity 492,592 663,768 Total Assets 2,866,592 1,468,800 Total L & E 2,866,592 1,468,800 3-6 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Income Statement 2020 2019 Sales $6,034,000 $3,432,000 COGS 5,528,000 2,864,000 Other expenses 519,988 358,672 Total oper. costs excl. deprec. & amort. $6,047,988 $3,222,672 Depreciation and amortization 116,960 18,900 EBIT ($ 130,948) $ 190,428 Interest expense 136,012 43,828 EBT ($ 266,960) $ 146,600 Taxes - US based (40% tax exempt due to loss) 106,784 58,640 Net income (loss) ($ 160,176) $ 87,960 Note: EBIT means Earnings Before Interest expense and Taxes EBT means Earnings Before Taxes 3-7 Net Loss despite the increase in Sales? Yes and you can find out later in the analysis why.  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM *Earnings per share or EPS is an important financial measure, which indicates Other Data the profitability of a company. It is calculated by dividing the company's net income after interest & taxes by the total number of outstanding shares. 2020 2019 No. of shares 100,000 100,000 EPS* ((160,176)/100,000) -$1.602 $0.88 DPS (Deposit Pension Scheme) $0.11 $0.22 Stock price $2.25 $8.50 Lease payments $40,000 $40,000 Deposit Pension Scheme or DPS is an installment based savings deposit (on monthly basis) for individual customer. In this account a customer deposit a certain amount of money for a certain period. And on maturity an agreed amount will be paid to the customer. At the same time the applicant must choice a tenor and the amount of monthly deposit. Relationship 1: Employees provide services to the employer and, in return, they receive wages. Relationship 2: Employers make contributions to the pension trust. Relationship 3: Funds are used from the pension trust to pay the employee in the future and, sometimes, employees can also make contributions to the trust. 3-8  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Other Data 2020 2019 2020 2019 No. of shares 100,000 100,000 Sales $6,034,000 $3,432,000 EPS* ((160,176)/100,000) -$1.602 $0.88 COGS 5,528,000 2,864,000 DPS (Deposit Pension Scheme) $0.11 $0.22 Other expenses 519,988 358,672 Stock price $2.25 $8.50 Total oper. costs excl. Lease payments $40,000 $40,000 deprec. & amort. $6,047,988 $3,222,672 *Earnings per share or EPS is an important Depn. & amortization 116,960 18,900 financial measure, which indicates the profitability of a company. EBIT ($ 130,948) $ 190,428 Interest expense 136,012 43,828 It is calculated by dividing the company's net income after interest and taxes by the EBT ($ 266,960) $ 146,600 total number of outstanding shares. Taxes- US based (40% tax 106,784 58,640 exempt due to loss) Net income (loss) ($ 160,176) $ 87,960 3-9 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Statement of Stockholders’ Equity (2020) Total Common Stock* Retained Stockholders’ Shares Amount Earnings Equity Balances, 12/31/19 100,000 $460,000 $203,768 $663,768 2020 Net income (loss) (160,176) Cash dividends (11,000) Addition (subtraction) to retained earnings (171,176) Balances, 12/31/20 100,000 $460,000 $ 32,592 $492,592 *$4.60 price per share 3-10  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Total Statement of Stockholders’ Equity (12/31/20) Common Stock* Retained Stockholders’ Shares Amount Earnings Equity Balances, 12/31/19 100,000 $460,000 $203,768 $663,768 2020 Net income (loss) (160,176) Cash dividends Decided by BOD (11,000) Addition (subtraction) to retained earnings (171,176) Balances, 12/31/20 100,000 $460,000 $ 32,592 $492,592 *$4.60 price per share Movement of RE is down 2020 2019 2020 2019 Sales $6,034,000 $3,432,000 Accts payable 524,160 145,600 COGS 5,528,000 2,864,000 Accruals 489,600 136,000 Other expenses 519,988 358,672 Notes payable 636,808 200,000 Total oper. costs excl. Total CL 1,650,568 481,600 deprec. & amort. $6,047,988 $3,222,672 Long -term debt 723,432 323,432 Depn. & amortization 116,960 18,900 Common stock 460,000 460,000 EBIT ($ 130,948) $ 190,428 Interest expense 136,012 43,828 Retained earnings 32,592 203,768 EBT ($ 266,960) $ 146,600 Total Equity 492,592 663,768 Taxes- US based (40% tax 106,784 58,640 Total L & E 2,866,592 1,468,800 exempt(loss) Net income due to loss) ($ 160,176) $ 87,960 3-11  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Statement of Cash Flows (2020) Examples of sources and uses of cash Phrases used in Stt. of CFs: according to the cash flow viewpoint is Current assets & liabilities: as follows: Provided by operating Sources of cash: (Add to Funds) activities Decreases in assets (other than cash) Non-current assets: Increases in liabilities Used in investing activities Increases in equity Uses of cash: (Deduct to Funds) Non-current liabilities & Increases in assets (other than cash) dividends payment: Decreases in liabilities Provided by financing Decreases in equity activities Note: Cash flow viewpoint – Professor’s viewpoint ☺ 3-12  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM 2020 2019 Statement of Cash Flows (2020) Sales $6,034,000 $3,432,000 Operating Activities COGS 5,528,000 2,864,000 1. Net income (loss) as of 12/31/20 ($160,176) Other expenses 519,988 358,672 Total oper. costs excl. 2. Depreciation and amortization 116,960 deprec. & amort. $6,047,988 $3,222,672 3. Increase in accounts payable 378,560 Depn. & amortization 116,960 18,900 EBIT ($ 130,948) $ 190,428 4. Increase in accruals 353,600 Interest expense 136,012 43,828 5. Increase in accounts receivable (280,960) EBT ($ 266,960) $ 146,600 Taxes- US based (40%) 106,784 58,640 6. Increase in inventories (572,160) Net income (loss) ($ 160,176) $ 87,960 Net cash provided by operating ($164,176) activities Examples of sources and uses of cash according to the cash flow viewpoint is as follows: Sources of cash: (Add to Funds) Decreases in assets (other than cash) Increases in liabilities Increases in equity Uses of cash: (Deduct to Funds) Increases in assets (other than cash) Decreases in liabilities Decreases in equity 3-14 3-13  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Statement of Cash Flows (2020) Long -Term Investing Activities Examples of sources and uses of Additions to property, plant, & equipment ($ 711,950 ) cash according to the cash flow Net cash used in investing activities ($ 711,950 ) viewpoint is as follows: Sources of cash: Financing Activities Decreases in assets (other than Increase in notes payable $ 436,808 cash) Increase in longterm - debt 400,000 Increases in liabilities Payment of cash dividends (BOD allowed/given) (11,000) Increases in equity Net cash provided by financing activities $ 825,808 Uses of cash: Summary Increases in assets (other than Net decrease in cash (825,808 - 711,950 - 164,176 ) ($ 50,318) cash) Cash at beginning of year 57,600 Decreases in liabilities Cash at end of year $ 7,282 Decreases in equity 3-14  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Conclusions about Rebismo’s Financial Condition (As derived from its Statement of Cash Flows) Net cash from operations = ($164,176), mainly because of negative NI. The firm borrowed $836,808 to meet its cash requirements. That is $436,808 & $400,000, increase in Notes Payable & Long-Term Debt, respectively. Even after borrowing*, the cash account fell by $50,318. ($825,808 Financing* - $711,950 Investing - $164,176 Operating). 3-20 3-15 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Did the expansion create additional after-tax (AT) operating income? AT operating income = EBIT(1 – Tax rate) AT operating income20 = - $130,948 (1 – 0.40) = - $130,948 (0.60) = - $78,569 - No AT operating income19 = $190,428 (1 – 0.40) = $190,428 (0.60) = $114,257 3-16  Important Formulas to Remember AT operating income = EBIT(1 – Tax rate) 3-22  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM What effect did the expansion have on net operating working capital (NOWC)? Current Current Notes 𝑵𝑶𝑾𝑪 = − − or assets liabilities payable NOWC = Total Current Assets - Total Current Liabilities* *TCL must exclude Notes Payable because it is a Financing activity rather than operating. 𝑵𝑶𝑾𝑪𝟐𝟎 = $𝟕, 𝟐𝟖𝟐 + $𝟔𝟑𝟐, 𝟏𝟔𝟎 + $𝟏, 𝟐𝟖𝟕, 𝟑𝟔𝟎 − ($𝟏, 𝟔𝟓𝟎, 𝟓𝟔𝟖 − $𝟔𝟑𝟔, 𝟖𝟎𝟖) = $1,926,802 - $1,013,760 = $𝟗𝟏𝟑, 𝟎𝟒𝟐 NOWC in 2020 is higher (better) 𝑵𝑶𝑾𝑪𝟏𝟗 = $𝟓𝟕, 𝟔𝟎𝟎 + $𝟑𝟓𝟏, 𝟐𝟎𝟎 + $𝟕𝟏𝟓, 𝟐𝟎𝟎 − ($𝟒𝟖𝟏, 𝟔𝟎𝟎 − $𝟐𝟎𝟎, 𝟎𝟎𝟎) = $1,124,000 - $ 281,600 𝑵𝑶𝑾𝑪𝟏𝟗 = $𝟖𝟒𝟐, 𝟒𝟎𝟎 However, in terms of current ratio it is lower in 2020 @ 1.90 compared to 3.99 in 2019 which is attributed significant increase in total current liabilities in 2020.  Important Formulas to Remember AT operating income = EBIT(1 – Tax rate) Current Current Notes 𝑵𝑶𝑾𝑪 = − − assets liabilities payable 3-24 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Summary of Assessment of the Expansion’s Effect on Operations 2020 2019 Sales $ 6,034,000 $ 3,432,000 AT operating income -78,569 114,257 NOWC 913,042 842,400 Net income -160,176 87,960 3-25  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM What was the free cash flow (FCF) for 2020?  Depr. and   Capital  FCF = EBIT(1 − T) + − +  NOWC  amortizati on expenditures  FCF20 = [-$130,948 (1 - 0.40) + $116,960] - [($1,202,950 – $491,000) + $70,642*] = (-$78,568.80 + $116,960) - ( $711,950 + $70,642) = $38,391.20 - $782,592 = - $744,200.80 or $744,201 Free cash flow is actually the net cash that is left after paying off all the expenses. *$913,042 – 842,400 = $70,642 A company with negative cash flow doesn't Is negative free cash flow always a bad sign? signify that it is bad because new companies usually spend a lot of cash. They do investments getting high rate of return due to which they run out of cash at hand. Have you heard?...that “High risks, high return” ☺  Important Formulas to Remember AT operating income = EBIT(1 – Tax rate) Current Current Notes 𝑵𝑶𝑾𝑪 = − − assets liabilities payable  Depr. and   Capital  FCF = EBIT(1 − T) + − +  NOWC  amortizati on expenditures  OR FCF = (EBIT + Damot) – ( Capit + Now) ☺ 3-27  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Performance Measures for Evaluating Managers/Executives Accounting statements are insufficient for evaluating managers’ performance because they do not reflect market values. Performance Measures: MVA and EVA --------------------------------------------------------------------------------------------------------------------- MVA = Difference between market value and book value of a firm’s common equity. (By: EB) Market value added (MVA) is a calculation that shows the Difference between The market value of a company and the capital contributed by all investors, both bondholders and shareholders. In other words, it is the market value of debt and equity minus all capital claims held against the company. The Formula is: MVA = (P0 x Number of shares) – Book value of CE INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Performance Measures for Evaluating Managers EVA = Estimate of a business’ true economic profit for a given year. Economic value added (EVA) - is a measure of a company's financial performance based on the residual wealth calculated by: deducting its Cost of Capital from its Operating profit, adjusted for taxes on a cash basis. The Formula is: EVA = EBIT(1 − T) − Total invested  Cost of    capital capital   EVA = EBIT (1-T) – (TIC x Cost of Capital in %) EVA = Operating Profit after Tax minus Cost of Capital  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM What was Rebismo’s MVA in 2020 and 2019? Other Data: (Given) 2020 2019 No. of shares 100,000 100,000 EPS* ((160,176)/100,000) -$1.602 $0.88 DPS (Deposit Pension Scheme) $0.11 $0.22 Stock price $2.25 $8.50 Lease payments $40,000 $40,000 MVA = (P0 x Number of shares) – Book value of Common stock + RE MVA20 = ($2.25 x 100,000) - ($460,000 + $32,592) = $225,000 - $492,592 = - $267,592 MVA19 = ($8.50 x 100,000) - ($460,000 + $203,768) = $850,000 - $663,768 = $186,232 Conclusion: The Shareholder’s wealth has been destroyed! (as a result of the decision to underwent business expansion) 3-30  Important Formulas to Remember AT operating income = EBIT(1 – Tax rate) Current Current Notes 𝑵𝑶𝑾𝑪 = − − assets liabilities payable  Depr. and   Capital  FCF = EBIT(1 − T) + − +  NOWC  amortizati on expenditures  or FCF = (EBIT + Damot) – ( Capit + Now) ☺ MVA = (P0 x Number of shares) – Book value EVA = EBIT(1 − T) − Total invested  Cost of   capital capital  Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building. Cost of capital encompasses the cost of both equity and debt, weighted according to the company's preferred or existing capital structure. 3-31  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM What is the relationship between EVA and MVA? MVA = (P0 x Number of shares) – (Book value of common stock + Ret. Earnings) MVA20 = - $267,592 and MVA19 = $186,232 Total invested  Cost of  EVA = EBIT(1 − T) −  capital   capital  EVA20 = Note: To be further discussed in future topics involving WACC. What is the relationship between EVA and MVA? Theoretically: If EVA is positive, then AT operating income > Cost of capital needed to produce that income. Hence, this is acceptable/favorable. Positive EVA on annual basis helps to ensure MVA is positive. MVA is applicable to entire firm, while EVA can be calculated on a divisional basis as well since assessment may be confined to a certain capital investment. 3-33  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Does Rebismo pays its suppliers on time? Probably not. A/P increased 260%, over the past year, while sales increased by only 76%. Calculation: [(CY – PY)/ PY] x 100% If this continues, suppliers may cut off Rebismo’s trade credit. 3-34  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Does it appear that Rebismo’s sales price exceeds its cost per unit sold? NO, the negative after-tax operating income and decline in cash position shows that Rebismo is spending more on its operations than it is taking in. 3-35  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM What if Rebismo’s sales manager decided to offer 60-day credit terms to customers, rather than 30-day credit terms? If competitors match terms, and sales remain constant... ▪ A/R would . ▪ Cash would . If competitors don’t match, and sales double... ▪ Short-run: Inventory and fixed assets  to meet increased sales. A/R , Cash . Company may have to seek additional financing. ▪ Long-run: Collections increase and the company’s cash position would improve. 3-36  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM How did Rebismo finance its expansion? Rebismo financed its expansion with external capital. Rebismo issued long-term debt which reduced its financial strength and flexibility. 3-37  INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM Would Rebismo have required external capital if they had broken even in 2020 (Net income = 0)? YES, the company would still have to finance its increase in assets. Looking to the Statement of Cash Flows, we see that the firm made an investment of $711,950 in net fixed assets. Therefore, they would have needed to raise additional funds. 3-38 INTRO BAL SHEET INCOME STMT STMT/STK EQ STMT/CFs FREE CF FED TAX SYSTEM What happens if Rebismo depreciates fixed assets over 7 years (as opposed to the current 10 years)? No effect on physical assets. Fixed assets on the balance sheet would decline. Net income would decline. Tax payments would decline. Cash position would improve. 3-39 -End of FS, CFS and Taxes- 3-63