Financial Statement, Cash Flow & Taxes

1. Financial Statement, Cash Flow & Taxes FIL 404 Prepared by Keldon Bauer

2. Financial Statement Fundamentals • Publicly traded companies must file an annual (10-K) report with the SEC. • The purpose of the 10-K is to report to owners on the status of their investment. • The 10-K report contains both verbal and quantitative information about the performance of the firm.

3. Financial Statement Fundamentals Financial Sections Include: • Income Statement (usually 3 years) • Balance Sheet (usually 2 years) • Statement of Retained Earnings • Statement of Cash Flows • Key operating statistics for 5-10 years • The purpose is both informative and marketing

4. Financial Statement Fundamentals • Statement summarizing revenues and expenses over a period • Owners want to embellish permanent revenues up and permanent expenses down • Watch for window-dressing, etc. Income Statement (Profit/Loss):

5. Financial Statement Fundamentals Balance Sheet - Overview: • Statement of financial position at a specific point in time. • The philosophy is to demonstrate sources of funds and their uses. • Assets show the uses of funds, adjusted for current value. • Liabilities/Equity show where funds came from

6. Financial Statement Fundamentals Balance Sheet - Assets: • Assets are listed in order of decreasing liquidity. • The closer to the top the more accurate the estimate of market value. • All assets should be listed as lower of cost or market • Adjustments are at management’s discretion.

7. Financial Statement Fundamentals • Claims against assets • Equity = Assets - Liabilities • Book liabilities usually equal actual liabilities. • Since the actual value of assets is rarely in line with book value, any adjustments to actual asset value is picked up by actual equity. Balance Sheet - Liabilities:

8. Effect of Expansion on Assets • Net fixed assets grows with sales. • AR grows with sales. • Inventory moderates. • Cash seems to be following something else.

9. What effect did the expansion have on liabilities & equity? • CL increased as creditors and suppliers “financed” part of the expansion. • Note the current maturity of long-term debt. • Long-term debt has been falling of late. • The company didn’t issue any stock. • Retained earnings grew.

10. Financial Statement Fundamentals Statement of Cash Flow: • Several ways of presenting cash flow. • Accountants use both a direct and indirect approach • 10-K must show the indirect approach • The indirect cash flow starts with net income and adjusts income for its effects on cash flow.

11. Financial Statement Fundamentals Statement of Cash Flow: • The indirect statement has three major parts: • Operating cash flows • Investing cash flows • Financing cash flows • The line following financing shows the net change in cash position.

12. What is free cash flow (FCF)? Why is it important? • FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. • A company’s value depends upon the amount of FCF it can generate.

13. What are the five uses of FCF? 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

14. What are operating current assets? • Operating current assets (OCA) are the current assets needed to support operations. • Operating current assets include: cash, inventory, receivables. • Operating current assets exclude: short-term investments, because these are not a part of operations.

15. What are operating current liabilities? • Operating current liabilities (OCL) are the current liabilities resulting as a normal part of operations. • Operating current liabilities include: accounts payable and accruals. • Operating current liabilities exclude: notes payable, because this is a source of financing, not a part of operations.

16. Important Operating Measures • Net Operating Working Capital (NOWC): • NOWC = OCA - OCL • Total Net Operating Capital (TNOC): • TNOC = NOWC + Net Fixed Assets • Net Operating Profit After Tax (NOPAT): • NOPAT = EBIT(1-Tax Rate) • EBIT = Earnings Before Interest and Taxes

17. Important Operating Measures • Free Cash Flow (FCF): • FCF = NOPAT - Net investment in operating capital • Return on Invested Capital (ROIC): • ROIC = NOPAT / TNOC • Economic Value Added (EVA): • EVA = NOPAT- (WACC)(TNOC)

18. Market Value Added • Market Value Added (MVA): • Market Value of Firm - Book Value of Firm • If the market value of debt is close to the book value of debt, then MVA is: • MVA = Market value of equity – book value of equity

19. Reality Check • Financial managers know the things we are talking about today. • Many creative methods have been used to either mislead or make the ratios you calculate look a little better.

20. 2004 Corporate Tax Rates

21. Features of Corporate Taxation • Progressive rate up until $18.3 million taxable income. • Below $18.3 million, the marginal rate is not equal to the average rate. • Above $18.3 million, the marginal rate and the average rate are 35%.

22. Features of Corporate Taxes (Cont.) • A corporation can: • deduct its interest expenses but not its dividend payments; • carry-back losses for two years, carry-forward losses for 20 years.* • exclude 70% of dividend income if it owns less than 20% of the company’s stock *Losses in 2001 and 2002 can be carried back for five years.

23. Key Features of Individual Taxation • Individuals face progressive tax rates, from 10% to 35%. • The rate on long-term (i.e., more than one year) capital gains is 15%. But capital gains are only taxed if you sell the asset. • Dividends are taxed at the same rate as capital gains. • Interest on municipal (i.e., state and local government) bonds is not subject to Federal taxation.

24. Taxable versus Tax Exempt Bonds • State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.

25. Breakeven Tax Rate • At what tax rate would you be indifferent between the muni and the corporate bonds? • Solve for T in this equation: Muni yield = Corp Yield(1-T) e.g. 7.00% = 10.0%(1-T) T = 30.0%.

26. Implications • If T > 30%, buy tax exempt munis. • If T < 30%, buy corporate bonds. • Only high income, and hence high tax bracket, individuals should buy munis.