DES Chapter 3 1

DES Chapter 3

Financial Statements & Free Cash Flow

DES Chapter 3 2

Cash is King!

Investors care about cash flow.

Importance of disentangling cash flows from published financial statements.

DES Chapter 3 3

Annual report has 4 parts1

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Shareholders’ Equity

1And footnotes

DES Chapter 3 4

GAAP

Statements prepared according to GAAP are reasonably consistent from firm-to-firm.

But standard measures (EPS, net change in cash, net income, and ROE) are not sufficient for valuations.

DES Chapter 3 5

Accruals

Accruals creates problems w/ GAAPAccrual basisMatching principle

When does cash come in and go out, versus when are cash flows recognized?

DES Chapter 3 6

The Balance Sheet

AssetsAccounts receivable (AR)—money owed to

ACME by customers who purchased on credit terms

InventoryLong-term asset: property, plant and

equipment (PPE).Accumulated depreciation—subtracted

from gross PPE to get net PPE.

DES Chapter 3 7

Acme's Balance Sheet: Assets

2001 2002 2003 Cash 37.30 41.40 45.12 Inventory 522.14 579.58 631.74 Accounts receivable 932.40 1,034.96 1,128.11

Total current assets 1,491.84 1,655.94 1,804.98 Gross PPE 2,619.28 3,031.40 3,443.32 Accumulated depreciation 754.48 961.47 1,187.09

Net PPE 1,864.80 2,069.93 2,256.23

Total assets 3,356.64 3,725.87 4,061.20

DES Chapter 3 8

The balance sheet…

Liabilities and owners’ equityAccrued expensesShort-term debtLong-term debtCommon stockRetained earnings

DES Chapter 3 9

Acme's Balance Sheet: Liabilities

Accounts payable 372.96 413.99 451.24 Accrued expenses 186.48 206.99 225.62 Short-term debt 183.19 285.90 381.71

Total current liabilities 742.63 906.88 1,058.57 Long-term debt 1,000.00 1,000.00 1,000.00

Total liabilities 1,742.63 1,906.88 2,058.57 Common stock 500.00 600.00 600.00 Retained earnings 1,114.01 1,218.99 1,402.63

Total common equity 1,614.01 1,818.99 2,002.62

Total liabilities and equity 3,356.64 3,725.87 4,061.20

2001 2002 2003

DES Chapter 3 10

The Income Statement

Sales

ExpensesCost of goods sold (COGS)Sales, general, and administrative (SGA)Depreciation

Net income and additions to R.E.

DES Chapter 3 11

Acme's Income Statement

2001 2002 2003 Sales 3,729.60 4,139.86 4,512.44 Costs of Goods Sold 2,312.35 2,566.71 2,797.71 Sales, General and Administrative 745.92 827.97 902.49 Depreciation 186.48 206.99 225.62

Operating Profit 484.85 538.18 586.62 Interest expense 88.05 96.49 105.73

Earnings Before Taxes 396.80 441.70 480.89 Taxes 158.72 176.68 192.36

Net Income 238.08 265.02 288.53

DES Chapter 3 12

Income statement items

SalesReflects only products or services defined

(according to GAAP) as sold, net of items returned.

DES Chapter 3 13

Income statement items…

ExpensesCost of Goods Sold (COGS)

Direct costs of producing products or services sold during period

Sales, general and administrative expenses (SGA)

Hard to attribute these expenses to specific items. E.g. marketing, insurance, salaries of executives.

DES Chapter 3 14

Income statement items…

Expenses continued…Depreciation

Not a cash expense. Using up or allocating of Plant & Equipment (capital assets).

Operating profit = Sales – COGS – SGA – Depreciation.

DES Chapter 3 15

Income statement items…

Interest expense Interest paid on debt.

Earnings before taxesOperating profit minus interest expense

DES Chapter 3 16

Income statement items…

Taxes

Net incomeEarnings before taxes minus taxes

DES Chapter 3 17

Statement of shareholder's equity

Net Income

Dividends

Stock issues

Stock repurchases

DES Chapter 3 18

Acme's statement of shareholders' equity

2002 2003

Balance as of December 31 of previous year 1,614.01 1,818.99 Net Income 265.02 288.53 Dividends on Common Stock (160.04) (104.88) Issuance of Common Stock 100.00 0.00 Common Stock Repurchases 0.00 0.00

Balance as of December 31 1,818.99 2,002.62

DES Chapter 3 19

Statement of Cash Flows

Because of accrual accounting, not everything on income statement represents a cash flow—statement of cash flows corrects for this.3 parts: Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities

Net cash flow

DES Chapter 3 20

Cash flow from operating activities

Sources of cash flow:Net incomeDepreciation, because deducted from net

income, but not really cash expense, so it is added back.

If liabilities go up, it is like borrowing more, so source of cash—so increases in accounts payable and increases in accruals are sources of cash.

DES Chapter 3 21

Cash flow from operating activities

Uses of cash flow If assets go up, represents expenditure (in

order to pay for asset), and so cash goes down. So if inventory increases, it required a use of cash flow to pay for it, so increases in inventory and accounts receivable are subtracted.

DES Chapter 3 22

Accounts receivable

Accounts receivable deserve more discussion:A/R represents money for goods sold that

company has not yet received. So firm is basically lending the customer money for goods. It takes cash to make a loan, so if company’s accounts receivable increase, it is a use of cash.

DES Chapter 3 23

Cash flow from operating activities

Net cash from operating activities is the sum of these items. In 2003, ACME generated cash of $424.72 million from its operating activities, despite the fact that it had net income of only $288.53 million. The difference comes mainly from depreciation. Asset and liability changes account for the rest.

DES Chapter 3 24

Acme's statement of cash flows 2002 2003

Operating Activities Net Income 265.02 288.53 Depreciation & Amortization 206.99 225.62 Change in Inventory (57.44) (52.16) Change in Accounts Receivable (102.56) (93.15) Change in Accounts Payable 41.03 37.25 Change in Accruals 20.51 18.63

Net cash from operating activities 373.55 424.72

DES Chapter 3 25

Investing activities

Companies use cash to purchase fixed assets. These purchases show up here. In 2003 Acme used $411.92 million to purchase fixed assets. This was a use of cash so it shows up as a negative number.

DES Chapter 3 26

Financing activities

Money (other than that provided by operations) has to come from somewhere—this section tells where. If short-term or long-term debt or common

stock increases, then cash goes up. If the company retires debt or repurchases

common stock, then cash goes down.Cash goes down when dividends are paid.

DES Chapter 3 27

Investing Activities Investment in PPE (412.12) (411.92)

Net cash from investing activities (412.12) (411.92) Financing Activities Change in short-term debt 102.72 95.80 Change in long-term debt 0.00 0.00 Change in common stock 100.00 0.00 Common dividends (160.04) (104.89) Net cash from financing activities 42.68 (9.09)

2002 2003

DES Chapter 3 28

Adding them up…

The sum of cash flow from operations, investing activities, and financing activities represents the total change in cash. If this sum is positive, then the total amount of cash the company has goes up. For ACME, cash went up by $3.72 million in 2003.

DES Chapter 3 29

Net cash flow

2002 2003

Net cash from operating activities 373.55 424.72Net cash from investing activities -412.12 -411.92Net cash from financing activities 42.76 -9.08Net cash flow (net change in cash) 4.10 3.72

Starting cash 37.20 41.40Ending cash 41.40 45.12

DES Chapter 3 30

Acme’s free cash flow

Free cash flow is cash potentially available for distribution to stockholders and creditors:Dividends and stock repurchases Interest and principal payments

DES Chapter 3 31

Free cash flow calculation

FCF calculated asNOPAT – investment in operating capital

For 2003:

NOPAT2003 = Operating profit – taxes on o.p.

=$

DES Chapter 3 32

FCF calculation

Net operating working capital:NOWC2003 =

Total operating capital in 2003:= NOWC + net long-term operating capital

= $

TOC in 2002 is $3,104.89

DES Chapter 3 33

FCF calculation

FCF = NOPAT – net investment in operating capital= $

DES Chapter 3 34

Acme's Free Cash Flow 2001 2002 2003 Operating profit 484.85 538.19 586.62 Tax on operating profit 193.94 215.28 234.65 NOPAT 290.91 322.91 351.97 Operating current assets 1,491.84 1,655.94 1,804.97 Operating current liabilities 559.44 620.98 676.86 NOWC 932.40 1,034.96 1,128.11

Total operating capital 2,797.20 3,104.89 3,384.34 Investment in total net operating capital 307.69 279.45 FCF 15.22 72.52

DES Chapter 3 35

Uses of FCF

How was this $72.52 million used?Paid $? to debtholders

Paid $? to stockholders.For a total of $

DES Chapter 3 36

Financing approach to calculating FCF

FCF = After-tax interest expense – Net CF from financing activities

= $

DES Chapter 3 37

Acme’s operating performance

ROIC = NOPATt/Capitalt-1

ROIC2002 = NOPAT2002/Capital2001

= $

= ?%

ROIC2003 = NOPAT2003/Capital2002

= $

= ?%

DES Chapter 3 38

Is this good or bad?

If ROIC is greater than the cost of capital (WACC) then ACME is adding value. Since WACC is 10%, ROIC shows that ACME is earning more than its investors require.