Key concepts from FINANCIAL STATEMENTS Objectives Goal Quick overview of financial statement concepts that are most important for corporate finance This is not an accounting course These concepts will be important for Capital budgeting Project cash flows Capital budgeting often starts with financial statement data Better understand the effects of working capital depreciation taxes Valuation Better understand where key ratios come from e g Market to book ROA ROE leverage BALANCE SHEET STATEMENT The Balance Sheet Lists the firm s Assets Liabilities Provides a snapshot of the firm s financial position at a given point in time The Balance Sheet Identity Assets Liabilities Stockholders Equity Global Corporation Balance Sheet for 2010 and 2009 Current Assets Cash and other marketable securities short term low risk investments easily sold and converted to cash Accounts receivable amounts owed to the firm by customers who have purchased on credit Inventories raw materials work in progress finished goods Other current assets includes items such as prepaid expenses Long Term Assets Assets that produce benefits for more than one year E g buildings machinery etc Many of these assets value is reduced yearly through a deduction called depreciation Depreciation is not a cash expense but a way of recognizing that fixed assets wear out and become less valuable as they get older Liabilities Current Liabilities Accounts payable Amounts owed to suppliers for purchases made on credit Notes payable Short term loans that must be repaid within a year The part of repayment of long term debt that will occur within the year Accrual items Items such as salary or taxes that are owed but have not yet been paid and deferred or unearned revenue Long Term Liabilities Long term debt a loan or debt obligation maturing in more than a year Working Capital Measures of short term capital for running the business and pay bills Net Working Capital Current Assets Current Liabilities Current Assets Current Ratio Current Liabilities Current Assets Inventory Quick Ratio Current Liabilities Book Value vs Market Capitalization Book value of equity o Net worth from an accounting perspective o Assets Liabilities Equity o True economic value of assets may be different from book value Market value of equity market capitalization o Market share price number of shares o Is not directly tied to anything in the financial statements Example Market capitalization Global has 3 6 million shares outstanding and these shares are trading for a price of 10 per share What is Global s market capitalization How does the market capitalization compare to Global s book value of equity What could drive any difference between these values Global s market capitalization is 3 6 million shares 10 share 36 million Market capitalization is significantly higher than Global s book value of equity 22 2 million Examples of Balance Sheet Ratios INCOME STATEMENT The Income Statement Lists the firm s revenues and expenses over a period of time Provides information regarding the profitability of a firm s business Global Corporation s Income Statement Sheet for 2010 and 2009 The top line shows net sales or revenues The bottom line shows net income or earnings Earnings per share EPS Net income reported on a per share basis Net Income 2 0 million EPS 0 556 per share Shares Outstanding 3 6 million shares Fully diluted EPS increases number of shares by Stock options issued to employees Shares issued due to conversion of convertible bonds EBITDA Financial analysts often compute a firm s earnings before interest taxes depreciation and amortization or EBITDA Because depreciation and amortization are not cash flows this subtotal reflects the cash a firm has earned from operations The EBITDA for Global Corporation is 10 4 1 2 11 6 Examples of Income Statement Ratios THE STATEMENT OF CASH FLOWS The Statement of Cash Flows The firm s statement of cash flows uses information from the income statement and balance sheet to determine how much cash the firm has generated how that cash has been allocated Divided into three sections activities Operating activities Investment activities Financing activities The last line of the Statement of Cash Flows combines the cash flows from these three activities to calculate the overall change in the firm s cash balance over the time period Global Corporation s Statement of Cash Flows for 2007 and 2006 Operating activities effect on cash flows Accounts receivable A sale has been recorded as part of net income but the cash has not yet been received from the customer so we adjust the cash flows by deducting the increases in accounts receivable An increase in A R represents additional lending by the firm to its customers and it reduces the cash available to the firm Accounts payable Similarly we add increases in accounts payable Accounts payable represents borrowing by the firm from its suppliers This borrowing increases the cash available to the firm Operating activities effect on cash flows cont Inventory deduct increases to inventory Increases to inventory are not recorded as an expense and do not contribute to net income But the cost of increasing inventory is a cash expense for the firm Depreciation Add back depreciation to net income since it is not a cash outflow but has been deducted as an expense from net income But note depreciation does affect cash flows through its effect on taxes Example Depreciation and taxes Suppose Global Corporations had an additional 1 million depreciation expense in 2010 and Global s tax rate on pretax income is 26 What would be the impact of this expense on Global s earnings How would it impact Global s cash at the end of the year Solution Depreciation and taxes Global s operating income EBIT and pretax income would fall by 1 million EBITDA would be unchanged This reduces Global s tax bill by 26 1 million 0 26 million Net Income would fall by 1 0 26 0 74 million On the cash flow statement we add back the additional depreciation of 1 million because it is not a cash expense Thus cash from operating activities would rise by 0 74 1 0 26 million Global s cash balance at the end of the year would increase by 0 26 million the amount of the tax savings that resulted from the additional depreciation deduction Takeaway Depreciation reduces a firm s taxes and therefore increases the firm s cash flow Financing Activity The last section of the statement of cash flows shows the cash flows from financing activities 1