lecture 2 cornett_finance_5e_chapter_02_ppt_accessible

Introduction 1
A financial statement provides an accounting-based picture of a firm’s financial position.
An annual report is made up of four basic financial statements.
Balance sheet.
Income statement.
Statement of cash flows.
Statement of retained earnings.

Introduction 2
Reports are used by accountants as a picture of past financial performance.
Finance professionals use financial statements to draw inferences about the future.

Balance Sheet
The balance sheet reports firm’s assets, liabilities and equity at a point in time.
Assets = Liabilities + Equity
Assets of firm appear on left side.
Liabilities and equity appear on right side.
Both assets and liabilities are listed in decreasing order of liquidity, that is, the time and effort needed to convert the accounts to cash.
Equity never matures, and therefore appears last.

Table 2.1 - Balance Sheet for DPH
DPH TREE FARM, INC.
Balance Sheet as of December 31, 2021 and 2020
(in millions of dollars)

Assets
Current assets normally convert to cash within one year.
For example, cash and marketable securities, accounts receivable, and inventory.
Fixed assets have a useful life exceeding one year.
Physical (tangible) assets.
For example, net plant and equipment.
Less tangible, long-term assets.
For example, patents and trademarks.

Liabilities
Liabilities are funds provided to the firm by lenders.
Current liabilities constitute the firm’s obligations due within one year.
For example, accrued wages and taxes, accounts payable, and notes payable.
Long-term debt include those obligations with maturities of more than one year.
For example, long-term loans and bonds with maturities greater than one year.

Stockholders’ Equity
Stockholders’ equity is the difference between a firm’s total assets and total liabilities.
Preferred stock is a hybrid security with characteristics of both long-term debt and common stock.
Common stock and paid-in-surplus is the fundamental ownership claim in public or private company.
Retained earnings are company profits that are kept by the firm rather than distributed to the stockholders as cash dividends.

Managing the Balance Sheet
Managers must monitor a number of issues underlying items reported on their firms’ balance sheets:
Accounting method for fixed asset depreciation.
Level of net working capital.
Liquidity position of the firm.
Method for financing the firm’s assets.
Equity or debt.
Difference between firm’s book value and true market value.

Accounting Method for Fixed Asset Depreciation
Managers can choose the accounting method they use to record depreciation against their fixed assets.
Straight-line method.
Commonly chosen when reporting income to the firm’s stockholders.
MACRS method.
Typically used when computing taxes, as it accelerates depreciation, resulting in lower taxable income, which leads to lower taxes in the early years of a project’s life.

Net Working Capital
Net Working Capital =
Current assets − Current liabilities
Net working capital is measure of the firm’s ability to pay obligations as they come due.
Healthy firms have positive net working capital values.

Liquidity 1
Liquidity refers to two dimensions.
Ease with which the firm can convert an asset to cash.
Degree to which such a conversation takes place at a fair market value.
Current assets remain relatively liquid.
For example, cash.
Fixed assets remain relatively illiquid.
For example, buildings and equipment.

Liquidity 2
Liquidity is double-edged sword.
The good?
The more liquid assets a firm holds, the less likely the firm will be to experience financial distress.
The bad?
Liquid assets generate little or no profits for a firm.
Managers must carefully consider this trade-off.

Debt versus Equity Financing
Financial leverage refers to the extent to which a firm chooses to finance its ventures or assets by issuing debt securities.
Magnifies gains and losses.
Debt holders have a fixed claim on firm’s cash flows (interest paid on securities and principal repayments).
Stockholders claim any cash flows left after debt holders are paid.
Choice of firm’s capital structure represents management’s risk and return preference.

Debt versus Equity Financing

Book Value versus Market Value
In many cases, book values differ widely from market values.
The book (or historical cost) value is the amount the firm paid for the assets.
Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what those assets might be worth today if the firm were to sell them.
The market value is the amount the firm would get if it sold the assets.

Income Statement
The income statement shows the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time.
The top part of the income statement reports the firm’s operating income.
The bottom part of the income statement summarizes the firm’s financial and tax structure.

Income Statement Structure
FIGURE 2.2
The Basic Income
Statement
Net sales
Less: Cost of goods sold
Gross profits
Less: Other operating expenses
Earnings before interest, taxes,
depreciation, and amortization (EBITDA)
Less: Depreciation and amortization
Earnings before interest and taxes (EBIT)
Less: Interest
Earnings before taxes (EBT)
Less: Taxes
Net income before preferred dividends
Less: Preferred stock dividends
Net income available to common stockholders
Operating income
Financing and tax considerations

DPH Tree Farm Income Statement
TABLE 2.2 Income Statement for DPH Tree Farm, Inc.
DPH TREE FARM, INC.
Income Statement Balance Sheet as of December 31, 2021 and 2020
(in millions of dollars)

Income/Firm Value Summary Below the Bottom Line

Corporate Income Taxes 1
Firms taxed on earnings.
U.S. tax code determines corporate tax obligations – overseen by Congress.
Tax rate changes driven by changes in administration or other changes in the business or public environment.
Tax Cut and Jobs Act (TCJA) of 2017.
Permanently lowers corporate taxes from a progressive schedule (where the highest tax rate was 35%) to a flat 21% beginning in 2018.

Corporate Income Taxes 2
Average tax rate.
Percentage of each dollar of taxable income that the firm pays in taxes.
Marginal tax rate.
Amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns.

Corporate Income Taxes

Corporate Income Taxes

Interest and Dividends Received
Interest is taxable with two exceptions.
Interest on state and local government bonds are federally tax-exempt.
One corporation owns stock in another corporation.
50% of dividends received from the other corporation are considered tax exempt.
Taxed on remaining 50% of dividends received at the receiving corporation’s tax rate.

Interest and Dividends Paid
Interest payments appear on the income statement as an expense item.
They are deducted from income before calculating taxable income.
Dividends paid to shareholders by corporations are not tax deductible.
Encourages managers to finance with debt, which is less expensive than using equity.
Due to the deductible nature of interest paid by firm.

Statement of Cash Flows
The statement of cash flows is a financial statement that shows firm’s cash flows over given period of time.
Reports the amounts of cash the firm has generated and distributed during a particular time period.
Bottom line on the statement of cash flows reflects difference between cash sources and uses.
Equal to the change in cash and marketable securities on the firm’s balance sheet over a period of time.

GAAP Accounting Principles
Company accountants use GAAP principles to prepare firm income statements.
Revenue recognition and actual cash outflows incurred with production may occur at a different time than GAAP principles allow.
GAAP principles.
Revenue recognized at the time of sale.
Production and other expenses shown on the income statement as the sales of those goods take place.

Sources and Uses of Cash 1
An activity that increases cash is a cash source.
Increasing liabilities (or equity).
Decreasing noncash assets.
An activity that decreases cash is a cash use.
Decreasing liabilities (or equity).
Increasing noncash assets.

Sources and Uses of Cash 2
Four categories are used to separate cash flows on the statement of cash flows:
Cash flows from operating activities.
Cash flows from investing activities.
Cash flows from financing activities.
Net change in cash and marketable securities.

DPH Tree Farm Statement of Cash Flows
TABLE 2.3 Statement of Cash Flows for DPH Tree Farm, Inc.
DPH TREE FARM, INC.
Statement of Cash Flows for Year Ending December 31, 2021 (in millions of dollars)

Cash Flows from Operations
Cash flows that are the direct result of the production and sale of the firm’s products are cash flows from operations, and include:
Net income (adding back depreciation).
Change in working capital accounts other than cash and operations-related short-term debt.
Positive cash flows from operations is what gives the firm value.

Cash Flows from Investing Activities
Cash flows associated with the purchase or sale of fixed or other long-term assets are cash flows from investing activities.
Shows inflows and outflows from changes in long-term investing activities.

Cash Flows from Financing Activities
Cash flows from financing activities result from debt and equity financing transactions and include:
Issuing short-term debt.
Issuing long-term debt.
Issuing stock.
Using cash to pay dividends.
Using cash to pay off debt.
Using cash to buy back stock.

Net Change in Cash and Marketable Securities
The sum of the cash flows from operations, investing activities, and financing activities is the net change in cash and marketable securities (that is, the bottom line of the statement of cash flows).
Reconciles to the net change in cash and marketable securities account on the balance sheet over period of analysis.
Positive bottom line indicates cash inflows exceeded cash outflows for the period.

Free Cash Flow 1
Free cash flows is the cash actually available for distribution to the investors in the firm after the investments that are necessary to sustain the firm’s ongoing operations are made.

Free Cash Flow 2
Firms generate operating cash flow (OCF) after they have paid necessary operating expenses and taxes.
Net operating profit after taxes (NOPAT) is the net profit a firm earns after taxes, but before any financing costs.
Investment in operating capital (IOC) includes gross investments in fixed assets, current assets, and spontaneous current liabilities.

Free Cash Flow 3
Firms with positive free cash flow (FCF) have funds available for distribution to investors.
Potential implications for firms with negative FCF.
May be experiencing operating or managerial problems.
May be investing heavily in operating capital to support growth.
Note: FCF might be negative while OCF is positive.

Free Cash Flow Equation

Free Cash Flow

Statement of Retained Earnings
The statement of retained earnings reconciles net income earned during a given period and any cash dividends paid with the change in retained earnings over the period.
Advantages of reinvesting.
Less expensive than raising capital from outside sources (equity markets).
Allows the firm to grow by providing additional funds that can be spent on plant and equipment.

Cautions in Interpreting Financial Statements
GAAP standards required for financial statements.
Firms can use earnings management with GAAP accounting rules.
Firms may wish to smooth earnings.
Firms utilize different depreciation methods, making comparison across firms difficult.
Sarbanes-Oxley Act passed in 2002.
Aims to prevent deceptive accounting and management practices.