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Understanding Financial Statements and Cash Flows

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  • 1. Understanding Financial Statements and Cash Flows Chapter 3
  • 2. Chapter Objectives
    • Compute a company’s profits as reflected by an income statement.
    • Determine a firm’s accounting book value, as presented in a balance sheet.
    • Measure a company’s free cash flows.
  • 3. Basic Financial Statements
    • Income Statement
    • Balance Sheet
    • Statement of Cash Flows
  • 4. Income Statement
    • Also know as Profit/Loss Statement
    • Indicates the amount of profits generated by a firm over a given period of time – Flow value
    • Sales – Costs & Expenses = Profit
  • 5. Income Statement Terminology
    • Revenue (Sales)
      • Money derived from selling the company’s product or service
    • Cost of Goods Sold (COGS)
      • The cost of producing or acquiring the goods or services to be sold
    • Operating Expenses
      • Expenses related to marketing and distributing the product or service and administering the business
    • Financing costs
      • The interest paid to creditors and the dividends paid to preferred stockholders
    • Tax Expenses
      • Amount of taxes owed, based upon taxable income
  • 6. Income Statement Structure
    • Sales
    • Less cost of goods sold
    • = Gross profit
    • Less operating expenses
    • = Operating income
    • Less interest expense
    • = Earnings before taxes
    • Less corporate taxes
    • = Earnings before preferred dividends (Net Income)
    • Less preferred stock dividends
    • = Net income available to common stockholders
  • 7. Starbucks Corporation Income Statement 2003 ($M)
    • Sales $4,076
    • Cost of Goods Sold 3,207
    • Gross Profit $ 869
    • Operating Expenses
      • Marketing expenses and general and
      • Administrative expenses $227
      • Depreciation Expense 206
    • Total Operating Expenses $ 433
    • Operating Profits $ 436
    • Interest Expense 3
    • Earnings before taxes $ 433
    • Income taxes 165
    • Net income $ 268
  • 8. Balance Sheet
    • Examines the firm’s financial position at a specific point in time – Stock value
    • Assets = Liabilities + Owner’s Equity
    • Assets are resources owned by the firm
    • Liabilities and Owner’s equity indicate how those resources were financed
  • 9. Types of Assets
    • Current Assets or gross working capital Comprise assets that are relatively liquid, or expected to be converted into cash within a year.
    • Current Assets typically include:
      • Cash
      • Accounts Receivable
        • payments due from customers who buy on credit
      • Inventory
        • raw materials, work in process, and finished goods held for
        • eventual sale
      • Prepaid expenses
        • expenses paid for in advance
  • 10.
    • Fixed Assets Assets held for more than one year. Typically Include:
      • Machinery
      • Equipment
      • Land and Buildings
    • Other Assets Assets that are not current assets or fixed assets
      • Patents
      • Copyrights
      • Goodwill
    Types of Assets
  • 11.
    • Debt or Liabilities
      • Money that has been borrowed and must be repaid at some predetermined date
      • Debt Capital
        • financing provided by a creditor
        • Current, short-term and long-term
        • Current or short-term debt must be repaid within the next 12 months
    Types of Financing
  • 12.
    • Current Debt – Short Term
      • Accounts Payable
        • Credit extended by suppliers
      • Other Payables
        • Interest and taxes that are owed
      • Accrued expenses
        • Liabilities incurred, but not yet paid
      • Short-term Notes
        • Borrowings from a bank or lending institution due and payable within 12 month
    • Long-Term Debt
      • Loans from banks and issuance of bonds to investors for longer than 12 months
    Debt Capital
  • 13.
    • Equity
      • Includes the shareholder’s investment (Par and Additional paid in capital)
        • Preferred stock
        • Common stock
      • Retained Earnings
        • Cumulative total of all the net income over the life of the firm, less dividends that have been paid out
      • Treasury Stock
        • Stock that was once outstanding and has been repurchased by the company (reduces equity)
    Types of Financing
  • 14. Balance Sheet Layout
    • ASSETS
      • Current Assets
      • Fixed Assets
    • Total Assets
    • LIABILITIES
      • Current Liabilities
      • Long-Term Liabilities
    • Total Liabilities
    • OWNER’S EQUITY
      • Preferred Stock
      • Common Stock
      • Retained earnings
    • Total Owner’s Equity
    • Total liabilities + OE
  • 15. Additional Terms
    • Net Working Capital
      • Current assets (Gross Working Capital) – Current liabilities
    • Accrual Basis Accounting
      • Recording revenues when earned and expenses when incurred, rather than when cash is exchanged
    • Free Cash Flows
      • Cash flow that is free and available to be distributed
      • to the firm’s investors
  • 16. Fundamental Principle of Cash Flows
    • Cash Flows generated through a firm’s assets always equal its Cash Flows paid to or received by the company’s investors (creditors and stockholders)
    • Cash Flows from Assets = Cash Flows from Financing
    • These two perspectives give the same answer
  • 17. Cash Flows from Assets
    • Cash Flow generated by the firm’s assets
    • Free Cash Flow =
    • After-tax cash flow from operations
    • -- less--
    • Changes in net working capital
    • -- less --
    • Changes in long term assets
  • 18. Starbucks Free Cash Flows ($M) After-tax cash flows from operations $477 Less 2003 investments in: Investments in net working capital $ 4 Investments in Long Term Assets 566 Total investments $ 570 Free cash flows $ (93)
  • 19. Cash Flows from Assets
  • 20. After-Tax Cash Flows From Operations
    • Operating Income
    • + Depreciation
    • = Earnings before interest, taxes,
    • depreciation, and amortization
    • - Income taxes
    • = After-tax cash flows from operations
  • 21. Change in Net Working Capital
    • Change in net working capital = (change in current assets) - (change in current liabilities)
    • Increase in net working capital uses up cash
    • Decrease in net working capital frees up cash
  • 22. Change in Long Term Assets
    • Change in gross fixed assets, not net fixed assets (recall net fixed assets = gross fixed assets – accumulated depreciation)
    • A decrease in long-term assets indicates that the firm is selling assets, which is a “source” of cash or increases cash
    • An increase in long-term assets indicates that the firm is purchasing assets, which is a “use” of cash or causes cash to go down
  • 23. Cash Flows from Financing
    • Cash Flows investors provide to and receive from the firm
    • Financing Activities which generate cash include:
      • An increase in debt (a source of cash)
        • Issuing new notes or bonds
      • An increase in equity (another source of cash)
        • Issuing new stock
  • 24. Cash Flows from Financing
    • Financing Activities which decrease cash include:
      • Payment of interest
      • Payment of dividends
      • A decrease in debt (a use of cash)
        • Repays a note or bond
      • A decrease in equity (a use of cash)
        • Repurchase of outstanding stock
  • 25. Cash Flows from Financing
  • 26. What does Cash Flows tell us?
    • Principle 3 – Cash, not profits, is King
    • Positive Cash Flows - good or bad?
      • Depends, is it due to operations or financing?
    • Negative Cash Flows – good or bad?
      • Depends, it is due to operations or investment?