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TOWSON FIN 331 - Financial Statements, Cash Flow, and Taxes

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Chapter3. Financial Statements, Cash Flow, and Taxes* Financial Statements (p.55 – p.56) prepared based on GAAP guidelinesAside) Accounting is a historical report based on events occurred, it is based on a accrual method,different from cash flow based approach. Accounting is good for past events, but often fails to capture future contingencies (contingent claims (=off balance sheet activities) like derivatives, insurance, etc)=> financial crisis like sub-prime (credit default swap=mortgage loan insurance, AIG protecting banks) .Balance Sheet (p.57 – p.61): Assets = Liability (=Debt) + EquityOr A=L + last year end’s Equity + Change in Equity this year- B/S shows uses & sources of funding, how much short-term & long-term assets and debt you may have, => Get information like “enough short-term (=liquid) assets for short-term liability” “too much debt”?Aside) ALM (Asset Liability Management)? Bill Gates, well endowed, but still borrow? Why? –liquidity issue, risk diversification, leverage effect, etc.Stock concept=what you have at a particular point in time. Snapshot of the firm’s financial position at a point in time (e.g., as of Dec. 31, 2009).The structure of B/S (based on the liquidity) Current Assets (Cash, Marketable securities like stocks and bonds, A/R, Inventory) Net (Long-term) Fixed Assets (Net plant and equipment, etc)--- Current Liability (A/P, Accruals, Notes Payable, etc) Long-term LiabilityEquity (Paid-in-capital, Retained Earnings)Aside) Current vs. Long-term? 1yearIncome Statement (p.61 – p.63): Flow concept recording changes, shows “how profitable”, (Net) sales = revenue- CGS (the book example p.62 does not have this! This is not good.)------------ Gross Margin=Gross Profit- Operating expenses (administrative, salary, rent, etc) including depreciation & amortization------------ EBIT- Interest Expenses----------- EBT ($150)-Taxes (33.3%)?----------- (Net) Earnings=Net Income => shareholder’s money ($100)- Dividends (35%? $35)-----------Addition to retained earnings ($65?), (if R/E end of last year=$70, then what is R/E now? $135)(EX. Can you determine NE, once I provide all these numbers? If I give you all the numbers including NE, can you back-figure (Net) Sales?)Example1: Div=$55, R/E at the end of this year=780, R/E at the end of last year=710, what is the NE this year? $125Example2: Even if a firm has a high R/E, it could still borrow.Example3: If the R/E does not change, what happened?Aside 1) Note that some people are also interested in EBITDA=EBIT+D/A(noncash exp)Aside2) Shareholders are the residual claimants=are the last to claim on the income and/or assets of the business. Other stakeholders get their shares first.Aside3) Margin (based on your selling price, sales, rev) vs. mark up (based on your cost),$80+$20 = $100, margin ratio=20%, mark up ratio=25% Note that mark-up is higher than margin ratio.Aside4) Working capital=Current Assets, Net working capital=CA-CL, Working capital management=management of CAs and CLs.Aside5) Market value=Market capitalization vs book value, EPS, DPS, BPS =Equity/#shsStatement of Cash Flows (p.63 – p.67) = Cash (and equivalents(MMA, CP=commercial paper, T Bills)) at the end of the last year from the B/S + Δcash for this year= Cash at the end of this year.  3 channels: 1) operating cash flows, 2) (long-term) investment activities (buying and selling long-term assets (fixed, securities, lending)), 3) financing (funding) activities * This shows everything about CASH (do we have enough cash, where is the cash from, etc)1) Operating cash flows=Net earnings + D/A – ΔCA + ΔCL (Do not include investing in Marketable Securities and Notes payable, why?) (EX, NE=$100, DA=$30, and no change in CA & CL, Operating cash flow?)2) Cash flows from investment activities= - ΔNet fixed assets-Δinvesting in Marketable securities and Lending (loan) 3) Financing activities=Issuing stocks (common, preferred) + ΔNotes payable + ΔLong-term liability - Dividends4) => Net change in cash for this year = 1)+2)+3)Aside) Can get information about “enough cash to repay debt or invest in new products,” “enough internal funds or need to issue new shares”Example1: If net sales=90, cash exp=69, DA=7, $30 debt with a 10% annual interest rate,what is the net operating cash flow at 40% tax rate? $13.6Example2:operating cash flows for MSFTStatement of Retained Earnings or Statement of Stockholders’ EquityPrevious period ending retained earnings (2009 12/31 B/S)+ this period addition to retained earnings (from 2010 I/S) = this period ending retained earnings (2010 12/31 B/S)Aside1) Statement of Stockholders’ Equity (p.67): Just add Paid in capital to the Statement of Retained Earnings. Aside2) A=L+E, A=L + previous period-end Equity + ΔEquity = L + previous period-end E + Addition to R/E = L + previous period-end E + (NE-Dividend)That is, A = L + old E+ (NE - Dividend)where NE=Sales(Rev) – CGS – Expenses – Interest – Taxes  A + CGS + Exp + Interest + Taxes + Div = L + previous period-end E + Sales(Rev)Any increase (decrease) in LHS item appears in the debit (credit) columnAny increase (decrease) in RHS item appears in the credit (debit) column* Free Cash Flow (p.68 – p.70) – concept and measurement= Amount of cash that can be withdrawn without affecting firm’s ability to continue operating at the “on course” capacity (generating the same cash flows, now and the future, as planned) Aside) Where do we have money coming from? From the sales minus expenses (should exclude D/A, as they are non-cash expenses). Where do we use money in business? Two types of money spending : capital expenditure (upkeeps, etc + expanding by purchasing new machines, etc) and operating expenditure (salary, rent, etc). Now, how much money do we have extra (=free) cash after taking care of these cash needs?Aside) My personal experience, Be careful as you may lose the limited liability protection.= EBIT*(1-T) – ΔNet Fixed Assets –ΔWorking CapitalNote that ΔNet Fixed Assets = Capital Expenditure – D/A (this period) = EBIT*(1-T) + D/A – {Capital Expenditure + ΔWorking Capital} p.68Aside) Capital Expenditure=D/A + ΔNet Fixed AssetsΔWorking Capital=ΔCA-ΔCL = EBIT*(1-T) – ΔNet Fixed Assets –ΔCA + ΔCL, (Note: do not include Notes Payable)Example1: Given EBIT=785, Tax rate=30%, Δ(Net) Fixed Assets=-200, ΔWorking Capital=-250,How much free cash flow (FCF) did the company generate this


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