TOPIC 3 Financial Statements, Cash Flow, and Taxes

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TOPIC 3Financial Statements, Cash Flow, and Taxes

• Balance sheet
• Income statement
• Statement of retained earnings
• Statement of cash flows
• 5 Questions about cash
• Federal tax system (continued)

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Ratio Analysis Du Pont system Effects of
improving ratios Limitations of ratio
analysis Qualitative factors
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ANNUAL REPORT
Primary PurposeTo communicate with stockholders
and potential investors.
Contains 1. Balance Sheet 2. Income
Statement 3. Statement of Retained
Earnings 4. Statement of Cash Flows Usually
covers several years. Explains what has happened
and why.
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Balance Sheet Assets

• Cash
• A/R
• Inventories
• Total CA
• Gross FA
• Less Dep.
• Net FA
• Total Assets

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OBSERVATIONS ABOUT THE BALANCE SHEET

• Assets listed in order of currency.
• Current versus fixed assets
• Is depreciation a true expense?

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Balance sheet Liabilities and Equity

• Accts payable
• Notes payable
• Accruals
• Total CL
• Long-term debt
• Common stock
• Retained earnings
• Total Equity
• Total L E

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• What is the difference between Equity,
• Stockholders Equity, and New Worth?
• 2. What is Retained Earnings?

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Income statement

• Sales
• COGS
• Other expenses
• EBITDA
• Depr. Amort.
• EBIT
• Interest Exp.
• EBT
• Taxes
• Net income

2004 6,034,000 5,528,000
519,988 (13,988) 116,960 (130,948)
136,012 (266,960) (106,784) (160,176)
2003 3,432,000 2,864,000 358,672 209,328
18,900 190,428 43,828 146,600 58,640
87,960
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BOTTOM OF INCOME STATEMENT
NET INCOME BEFORE PREFERRED DIVIDENDS 117.5
- PREFERRED DIVIDENDS 4.0 NET
INCOME 113.5 - COMMON DIVIDENDS
57.5 ADDITION TO R.E. 56.0 Dividends on
CS are paid after taxes and after PS dividends
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ANOTHER WAY TO MEASURE PERFORMANCE (t 40)
CO. A CO. B
SALES 10 10 - COSTS 7 7 EBIT 3 3
- INTEREST 2 1 EBT 1 2 - TAXES
.4 .8 NET INCOME .6 1.2
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NOPAT (NET OPERATING PROFIT AFTER TAXES) (t
40)
NOPAT EBIT (1 t) FOR CO. A 3 (1 - .4)
1.8 FOR CO. B 3 (1 - .4) 1.8
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Statement of Retained Earnings (2004)
300,000 100,000 40,000 360,000

• Balance of retained
• earnings, 12/31/03
• Add Net income, 2004
• Less Dividends paid
• Balance of retained
• earnings, 12/31/02

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• WHAT WAS THE DIVIDEND
• PAYOUT RATIO?
• WHAT WAS THE RETENTION
• OR PLOWBACK RATIO?

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NET CASH FLOW (Assume sales and expenses are
all cash)

• SALES 10
• COSTS 8
• DEPRECIATION 1
• NET INCOME 1
• HOW MUCH CASH WAS GENERATED?
• DOES NOT NECESSARILY SHOW
• THE AMOUNT OF CASH ON THE BALANCE
• SHEET BECAUSE THE CASH FLOW CAN BE
• USED IN A VARIETY OF WAYS.

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FREE CASH FLOW
THE CASH FLOW ACTUALLY AVAILABLE FOR DISTRIBUTION
TO ALL INVESTORS IN THE COMPANY (STOCKHOLDERS
AND BONDHOLDERS) FREE CASH FLOW NOPAT ALL
NECESSARY INVESTMENTS IN INVESTMENTS IN
WORKING CAPITAL AND FIXED ASSETS
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BALANCE SHEET Left Hand Side shows
investments (or where you put your money)
Right Hand Side shows financing (or
where you get your money)
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ANY INCREASE IN AN ITEM ON THE RIGHT HAND SIDE
and ANY DECREASE IN AN ITEM ON THE LEFT HAND
SIDE INCREASES FINANCING OR PROVIDES FUNDS and
ANY DECREASE IN AN ITEM ON THE LEFT HAND SIDE
e.g., if Accounts Payable increase or
Accounts Receivable decrease additional funds
will be provided ANY INCREASE IN AN ITEM ON THE
LEFT HAND SIDE INCREASES INVESTMENTS OR USES
FUNDS.
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A STATEMENT OF CASH FLOWS SHOWS 1.
OPERATING ACTIVITIES (Includes net income,
depreciation, and changes in current assets
and current liabilities (other than cash
and short-term debt) 2. INVESTING
ACTIVITIES (Includes investments in or
sales of fixed assets) 3. FINANCING
ACTIVITIES (Includes cash raised by
short-term debt, bonds, and stock. Also
includes cash for dividends and buy-backs
of stocks and bonds.
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Statement of Cash Flows (2004)

• OPERATING ACTIVITIES
• Net income
• Add (Sources of cash)
• Depreciation
• Increase in A/P
• Increase in accruals
• Subtract (Uses of cash)
• Increase in A/R
• Increase in inventories
• Net cash provided by ops.

(160,176) 116,960 378,560 353,600 (280,960) (57
2,160) (164,176)
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Statement of Cash Flows (2004)
(711,950) 436,808 400,000 (11,000) 825,808 (
50,318) 57,600 7,282

• L-T INVESTING ACTIVITIES
• Investment in fixed assets
• FINANCING ACTIVITIES
• Increase in notes payable
• Increase in long-term debt
• Payment of cash dividend
• Net cash from financing
• NET CHANGE IN CASH
• Plus Cash at beginning of year
• Cash at end of year

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REVIEW
WHICH STATEMENT (OR CONCEPT) SHOWS

• HOW MUCH CASH DO WE HAVE?
• HOW MUCH CASH DID WE GENERATE
• DURING THE PERIOD?
• WHAT DID WE DO WITH THE CASH
• WE GENERATED?
• HOW MUCH CASH COULD WE DISTRIBUTE
• TO OUR INVESTORS?
• HOW MUCH CASH DID WE ACTUALLY PAY
• TO OUR STOCKHOLDERS?

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Federal Income Tax System
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Corporate and Personal Taxes

• Both have a progressive structure (the higher the
  income, the higher the marginal tax rate).
• Corporations
• Rates begin at 15 and rise to 35 for
  corporations with income over 10 million.
• Also subject to state tax (around 5).
• Individuals
• Rates begin at 10 and rise to 38.6 for
  individuals with income over 307,050.
• May be subject to state tax.

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Tax treatment of various uses and sources of funds

• Interest paid tax deductible for corporations
  (paid out of pre-tax income), but usually not for
  individuals (interest on home loans being the
  exception).
• Interest earned usually fully taxable (an
  exception being interest from a (muni).
• Dividends paid paid out of after-tax income.
• Dividends received taxed as ordinary income for
  individuals (double taxation). A portion of
  dividends received by corporations is tax
  excludable, in order to avoid triple taxation.

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• How easy is it for us to
• pay our bills?
• How easy is it for us to
• pay our bills if our inventory
• is not very liquid?
• Are we carrying the right
• amount of inventory?
• Are we collecting our accounts
• receivable as fast as we should?
• Do we have the right amount of debt?
• Are we earning enough profit?
• How is our stock price?

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What are the five major categories of ratios, and
what questions do they answer?

• Liquidity Can we make required payments?
• Asset management right amount of assets vs.
  sales?
• Debt management Right mix of debt and equity?
• Profitability Do sales prices exceed unit costs,
  and are sales high enough as reflected in PM,
  ROE, and ROA?
• Market value Do investors like what they see as
  reflected in P/E and M/B ratios?

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FOR EACH RATIO YOU SHOULD KNOW

• THE PROBLEM
• DEFINITION OF THE RATIO
• RATIONALE FOR THE RATIO
• HOW TO EVALUATE

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LIQUIDITY RATIOS

• CURRENT RATIO
• Current assets / current liabilities
• QUICK RATIO
• Current assets inventory / current liabilities

When would this ratio be used?
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Comments on current ratio

• Expected to improve but still below the industry
  average.
• Liquidity position is weak.

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ASSET MANAGEMENT RATIOS

• INVENTORY TURNOVER
• Sales / Inventory
• Do we want this ratio to be as high as
• possible?
• AR TURNOVER (DAYS SALES
• OUTSTANDING)
• Accounts receivable / sales per day
• Do we want this ratio to be as low as
• possible?

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Fixed asset and total asset turnover

• FA turnover Sales / Net fixed assets
• TA turnover Sales / Total assets

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What is the inventory turnover vs. the industry
average?
Inv. turnover Sales / Inventories 7,036
/ 1,716 4.10x
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Appraisal of DSO

• The company collects on sales too slowly, and is
  getting worse.
• The company has a poor credit policy.

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DEBT RATIOS

• THE DEBT RATIO (amount of debt)
• Total debt / Total assets
• TIMES INTEREST EARNED (ability to
• service the debt)
• EBIT / Annual Interest

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PROFITABILITY RATIOS

• PROFIT MARGIN
• Net Income / Sales
• 2. RETURN ON ASSETS
• Net Income / assets
• 3. RETURN ON EQUITY
• Net Income / equity

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MARKET VALUE RATIOS

• P/E RATIO
• MARKET/BOOK RATIO
• Market value of the stock per share
• divided by
• book value of the stock per share
• Book value is total equity on the balance
• sheet divided by the number of shares
• outstanding

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DUPONT ANALYSIS
RETURN PROFIT ASSET ON ASSETS MARGIN
X TURNOVER ROA NI/S X S/A
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The Du Pont system

• Also can be expressed as
• ROE (NI/Sales) x (Sales/TA) x (TA/Equity)
• Focuses on
• Expense control (PM)
• Asset utilization (TATO)
• Debt utilization (Eq. Mult.)
• Shows how these factors combine to determine ROE.

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EXTENDED DUPONT EQUATION
RETURN RETURN EQUITY ON EQUITY ON ASSETS
X MULTIPLIER NI/E NI/S X S/A X A/E
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Extended DuPont equation Breaking down Return
on equity

• ROE (Profit margin) x (TA turnover) x (Equity
  multiplier)
• 3.6 x 2 x 1.8
• 13.0

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Appraising profitability with the return on
assets and return on equity

• Both ratios rebounded from the previous year, but
  are still below the industry average. More
  improvement is needed.
• Wide variations in ROE illustrate the effect that
  leverage can have on profitability.

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Why are ratios useful?

• Ratios standardize numbers and facilitate
  comparisons.
• Ratios are used to highlight weaknesses and
  strengths.

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NON-FINANCIAL ASPECTS OF COMPANY EVALUATION

• Number of customers, suppliers, products
• Amount of oversees business
• Competition
• Laws and regulations
• Management

(Possible problem of double counting.
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PROBLEMS OR LIMITATIONS OFRATIO ANALYSIS

• Determining the industry.
• Accounting practices differ.
• Industry average may not be appropriate.
• Ratios may be misleading (for example, high
  current ratio)
• Seasonal changes