Understanding Financial Statements and Cash Flows


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Understanding Financial Statements and Cash Flows

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