Financial Statements and Cash Flow
Created by David Moore, PhD
Reference Material: Chapter 2 and 3 of Textbook
Key Concepts
Note: This lesson is largely a review of key accounting concepts.
- Fundamentals of Accounting
- Financial Reporting
- Financial Statements
- Income statement
- Balance Sheet
- Cash Flow Statement
- Free Cash Flow (New Concept)
Fundamentals of Accounting
What is Accounting?
Accounting is the standard language of business. i.e. must speak business
- Set of rules for measuring a firm's financial performance
- GAAP: Generally Accepted Accounting Principles
- FASB: Financial Accounting Standards Board
- Accounting is used to make corporate and investment decisions
Accounting Assumptions
- Accounting entity: a company is a separate "living" entity
- Going concern: a company is assumed to remain in existence indefinitely
- Measurement: must be quantifiable in a monetary unit
- Periodicity: in US must file one(1) annual(10K) and three(3) quarterly(10Q) reports
Accounting Principles
- Historical Cost
- Revenue Recognition
- Matching Principle
- Full Disclosure
Accrual Exercise
- 4/15/2019: "Ain't First Your Last"(AFYL) purchases running shoes from Nike
- 8/20/2019: AFYL receives online credit card order for the shoes
- 8/29/2019: Shoes are shipped to customer
- 10/20/2019: AFYL receives cash for selling shoes
When should you record revenue? Expense?
Constraints
- Estimate and Judgment
- Materiality
- Consistency
- Conservatism
Overview
"The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it.
To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company's securities are a good investment.
Only through the steady flow of timely, comprehensive and accurate information can people make sound investment decisions."
-SEC
Periodic Reports
10K
- Filed Annually
- Much more detail
- Audited
- Primary document for analyst
10Q
- Filed Quarterly
- Less detail
- Reviewed but not audited
More on the 10K
See Example
- General Business Info
- MD&A, financial info
- Disclosure
- Exhibit
Other Reporting
- 8k: Disclosure of material event ex. acquisition
- Form 14A (DEF 14A): Known as proxy statement. Filed before annual meeting. Details on board members and executives.
- S-1: Registration statement prior to IPO
- S-4: Registration of securities, business combinations
Full list of SEC forms
Sources of Financial Information
Library Resources
Library Business Databases
- Business Insights Global:news and company's background information.
- Business Source Complete: good resource for company's background information and industry
- Lexis Nexis Company Dossier: news and company's background information.
- Mergent Online: industry ratios and company financials
- Morningstar Investment Research Center: company financials
Income Statement (I/S)
Financial statement depicting operating performance of a company over a specified period of time
- Analyst use:components and drivers of performance
- Tells us about: growth prospects, cost structure, profitability
- Other names: Consolidated statement of earnings, Profit & Loss Statement, Statement of Revenue and Expenses
Revenue
Proceeds from the sale of goods and services produced or offered by the company.
- Must be from operations (excludes interest income, legal settlement)
- Revenue recognition: WHEN EARNED and MEASURABLE
- Multiple deliverables: iPhone example
- Long Term Projects: Percentage of Completion or Completed Contract ex. Boeing
Extra: When should expenses be recorded? Why?
Why accrual?
- More accurate description of a company's operating results
What's problem though?
Does not reflect cash!!
Revenue Manipulation
- Allocation of revenue can be subjective; "Wiggle room"
- Footnotes become important
- TSAI example
Back to I/S
Cost of Goods Sold (COGS)
Direct cost of manufacture or procurement of a good or service that the company sells to generate revenue
- Includes: inventory (merchandise or manufactured), shipping/delivery, depreciation
- DOES NOT include: overhead, marketing and admin, R&D
- Don't forget Matching Principle
Back to I/S
Selling, General & Administrative
Operating expenses not included in cost of goods sold
- "Support" (Indirect) Expense: anything that supports goods and service but not directly related
- Store lease for retail space, sales people/cashiers, IT and office support, selling equipment, exec salaries, legal expenses
Back to I/S
Research & Development
Expenses from activities directed at developing new products or procedures.
- Can be included in SG&A
- Separate line item if large
- Research-intensive industries: healthcare, technology, energy
Back to I/S
Depreciation
Allocating the cost of a tangible asset over its useful life and is used to account for declines in (book/historical) value.
- Matching Principle!
- Ex. Plant, buildings, machinery, computer software and hardware. (Land is NOT depreciated)
- Depreciation usually included in COGS or SG&A (direct or indirect to revenue)
- Identified on Cash-flow statement
- Non-cash expense
Methods of Depreciation
- Straight-line
- Asset depreciated evenly over useful life
- Used by majority of companies
Annual Depreciation Expense=$\frac{Original Cost- Salvage Value}{Useful Life}$
- Accelerated
- Declining balance, Sum of years digits, Units of production
Back to I/S
Amortization
Allocation of the cost of intangible assets over the number of years that these assets are expected to help generate revenue for the company
- Similar to depreciation (often lumped together)
- Applies to acquired intangible assets
- Internally generated intangible assets are expensed as they are incurred
- Remember: historical costs! Does Coke recognize/amortize trademark?
- Non-cash expense
Back to I/S
D&A Ask Yourself
- Is useful life indefinite? (Yes=Stop)
- Is it less than one year? (Yes = expense)
- Is it tangible? (Yes= Depreciate)
- Is it internally generated? (Yes= Expense as incurred No=Amortize)
Net Interest Expense
Payments made on company's outstanding debt net any income received from interest on cash holdings and investments.
- Interest is a financing (not operating) expense.
- Reduces tax burden
Back to I/S
Tax Expense
Tax liability reported on income statement.
- Tax expense DOES NOT EQUAL actual cash taxes paid
- Tax expense: GAAP ("book rules")
- Taxes paid: Country's tax code ("tax rules")
Back to I/S
Net Income
Final measure of profitability. "Bottom line"
- AKA: Net earnings or Net profit
Back to I/S
Other Expenses
- Stock Based Compensation(SBC):Recognized as expense.
- Other operating expenses/income: Identified when large, otherwise embedded. ex. Gain/loss on sale or legal settlement, restructuring, inventory write-down
- Other non-operating expense/income: Usually netted together. Ex. gain/loss in value on investment (not related to operations)
Shares Outstanding
$Shares Outstanding= Shares Issued - Treasury Stock$
- Outstanding: Unit of ownership.
- Basic: Includes only the actual shareholders
- Diluted: includes the impact of dilutive securities (can be converted into common stock, ex., options, convertible stock/debt)
- Treasury: Issued but subsequently repurchased, no longer outstanding.
Items Below NI
- EPS
- Common profitability ratio: how much of total current period profits belong to each shareholder
- Shares outstanding: Use basic or diluted. Weighted average throughout period.
- Diluted EPS favored. More "real"
$EPS=\frac{NI}{Shares Outstanding}$
- Dividends
- Distribution of profits to shareholders
EBIT and EBITDA
EBIT
- Earnings before interest and taxes
- "Operating income"
- Tied to core operations of business
- Listed on I/S
EBITDA
- Earnings before interest, taxes, depreciation, and amortization
- Adds back in non-cash expense
- More "real" depiction of core profits
- EBITDA not directly on I/S
Balance Sheet B/S
Reports a company's assets (resources) and liabilities and shareholder's equity (how resources were funded) at a particular point in time.
Assets=Liabilities+Equity
- Historical costs and Conservatism!
- B/S reflects book value(BV): can differ from Market value (MV)
Double Entry Accounting
Every transaction can be viewed as having two sides: 1) Use of funds and 2) Source of funds
Debit (Use of Funds) |
Credit (Sources of Funds) |
Increases in Assets |
Decrease in Assets |
Decreases in Liabilities and Equity |
Increases in Liabilities and Equity |
How we track movements on B/S
D(ebit)U(se)C(redit)S(ource)
Link between I/S and B/S
Retained Earnings is the link:
- Income(revenue) increases retained earnings on B/S.
- Expenses decrease retained earnings on B/S
Assets
Companies resources or use of funds
To qualify as an asset:
- A company must own the resource
- The resource must be of value
- The resource must have quantifiable, measurable cost
Back to B/S
Liabilities and Equity
Companies sources of funds
What the company owes to others(liabilities)
- Must be measurable
- Its occurrence must be probable
- Transaction from which obligation arises has taken place
Equity is sourced through:
- Equity investment (think stock)
- Retained Earnings
Back to B/S
Cash and Marketable Securities
- Extremely liquid assets
- Cash equivalents. Example U.S. Treasury bills
- Marketable securities: debt or equity investment. Can be separate line item
Back to B/S
Accounts Receivable
Cash owed, but not yet received, to the company from a completed (delivered) sale
- Example: Credit card sales.
Schrute farm sold $1000 worth of beets at the local farmer's market. They collected $600 in cash and the remainder is on credit card (to be collected in 30 days). What accounts are effected and how?
Back to B/S
Inventory
Direct costs associated with production and procurement of goods waiting to be sold.
- Inventory cycles out of B/S into I/S as COGS
- Hits income statement when revenue is recognized (matching!)
Beginning Inventory
+Purchases of New Inventory
-Cost of Goods Sold
=Ending Inventory
Inventory costing
- FIFO: First in, First Out
- LIFO: Last in, First out
- Must disclose LIFO reserve if using LIFO
- LIFO Inventory (COGS) +LIFO Reserve = FIFO Inventory (COGS)
- Average cost
Write down
- Remember can't mark up!
- Must mark down if if MV falls below historical cost
- Loss recognized as "other (non)operating expense"
- Example: Food goes bad in a restaurant
Back to B/S
Prepaid Expenses
Prepaid for a service that has not been received.
- Example: Insurance, rent, utilities
- Asset created due to right for future service
- Not recognized on I/S until received.
Back to B/S
Plant Property & Equipment (Fixed Assets)
Long-term, tangible, assets vital to business operations and not easily converted into cash.
- New purchases of PP&E called capital expenditures (CAPEX)
- PP&E cycles out of B/S into I/S as depreciation
- PP&E is reported net of accumulated depreciation
- Must be written down
- Gain/loss on asset sale recorded on I/S
$Beg. PP&E+Capex-Depreciation-Sales/Write offs=End PP&E$
Back to B/S
Intangible assets & Goodwill
Intangible Asset
- Non-physical and acquired
- Link to I/S through amortization
- Similar to PP&E
- Examples: Customer lists, licenses, franchises, patents, trademarks
Goodwill
- Amount by which purchase price exceeds fair market value in an acquisition
- Accounting plug
- Not amortized but rather tested annually
- Loss of value (impairment) expensed on I/S
- Time Warner write down
Back to B/S
Accounts Payable
Amounts owed by the company to suppliers for prior purchases or services
What happens to B/S if Schrute farm purchases $10,000 worth of phosphorus on credit to be paid in 90 days. Was cash impacted?
Back to B/S
Accrued Expenses
Expenses that have already been incurred but not yet paid.
- Are accrued expenses recognized on I/S?
- Examples: Wages, Insurance, taxes, dividends, litigation costs
Back to B/S
Deferred (unearned) Revenue
Revenue received for services (goods) not yet provided.
- Long-term liability if revenue expected to be recognized in more than a year.
- Unwind when revenue earned
- Examples: Gift cards, sports/theater tickets, iPhone
Back to B/S
Short-term Debt
- Debt obligations owed within 12-months
- Includes portion of long-term debt which is due within the year
Back to B/S
Long-term Debt
- Debt with a maturity greater than one-year
- Often sizeable
Back to B/S
Common Stock (APIC)
Book value of equity
Two components (due to old conventions)
- Common stock par value: Nominal value to issued share
- Additional paid in capital (APIC): Excess value of share issued over par value
- Reported together.
- Example Google par value $0.01 and APIC is $84.99
Back to B/S
Retained Earnings
Cumulative earnings over a companies entire existence.
$Beg.RE+NI-Dividends=EndRE$
Back to B/S
Finance leases
- Economic Ownership
- Lease treats underlying asset as PP&E and lease as debt obligation
- Lease value/liability is PV of lease payments
- Asset is depreciated; Lease liability accrues interest; Reduce liability with lease payment
- I/S reduced by depreciation and interest expense(decreases over life of lease)
Operating Lease
- No economic ownership
- Initial impact the same
- I/S reduced by lease payment
- Loss of value (impairment) expensed on I/S
Excel Example
Other Equity
- Preferred stock: special rights and priority over common stock
- Treasury stock; Issued common stock that has been reacquired by the company. Contra equity account
- Other comprehensive income(loss): Income(loss) not directly recognized on I/S. Ex. foreign currency transactions
Lastly! What does B/S tell us about 3 major corporate finance questions?
Issue with I/S and B/S
I/S Cash issues
- Revenue and Expenses are accrued
- Depreciation(and amortization) are non-cash expense (so are Stock based compensation and write-downs)
- Cash spent on investments only appears on B/S
- Cash cost of financing for debt on I/S but not for equity
Cash Flow Statement (CFS)
Summarizes sources and uses of cash over a specified period
- Reconciles NI to a company's actual change in cash
- Most companies follow the indirect method: accrual based
- Identifies period-over-period change for every B/S line item that affects cash
- Not perfect; we will use I/S to estimate Free cash flow
Three sections of CFS
- Cash flow from Operations: captures CA, CL, and D&A
- Cash flow from Investing: captures Long-term assets
- Cash flow from Financing: captures long term liabilities and equities
Cash Flow from Operations
Adjust NI for non-cash items, working capital and cash from non-operating activities
Working Capital (CA and CL)
|
A |
L |
+ |
Cash Out |
Cash In |
- |
Cash In |
Cash Out |
Non-cash items include D&A, impairment, SBC
Disney Example
Cash Flow from Investing (CFI)
Tracks additions and reductions to fixed assets.
-CAPEX
-Purchases of Intangibles
+Asset sales
+(-)Sale(Purchase) of debt/equity security$
Disney Example
Cash Flow from Financing (CFF)
Tracks changes in companies sources of debt and equity.
+(-) Issuance (repayment) of debt
+(-) Common stock issued (repurchased)
- Dividends
Disney Example
Cash Flow
Difference between number of dollars that came in and number of dollars that came out.
Cash flow identity:
$\text{Cash flow from assets}=$
$\text{Cash flow to creditors}+\text{Cash flow to stockholders}$
Cash Flow from Assets (CFFA)
$\text{CFFA}=\text{Cash Flow to Creditors}+\text{Cash Flow to Stockholder}$
$\text{CF}_{\text{Assets}}=\text{OCF}-\text{NCS}-\Delta\text{NWC}$,
where:
$\text{OCF}=\text{Operating Cash Flow}$
$\text{NCS}=\text{Net Capital Spending}$
$\Delta\text{NWC}=\text{Change in Net Working Capital}$
Operating Cash Flow (OCF)
OCF=EBIT +Depreciation-Taxes
Revenue |
|
Net Sales |
+ |
1,509 |
Expenses |
|
Cost of Goods Sold |
- |
750 |
Depreciation |
- |
65 |
Earnings Before Interest and Taxes (EBIT) |
Revenue - Operating Expenses |
694 |
Interest Paid |
- |
70 |
Taxable Income |
EBIT - Interest Paid |
624 |
Taxes |
Taxable Income $\times$ Tax Rate |
131 |
Net Income (NI) |
Taxable Income - Taxes |
493 |
OCF=694 +65-131=628
Net Capital Spending (NCS)
NCS$_t$=Fixed Assets$_t$-Fixed Assets$_{t-1}$+Depreciation
Assets |
2017 |
2016 |
Liabilities |
2017 |
2016 |
Current Assets |
|
|
Current Liabilities |
|
|
Cash |
1,500 |
1,300 |
Accounts Payable |
600 |
800 |
Accounts Receivable |
500 |
800 |
Notes Payable |
300 |
150 |
Inventory |
750 |
1000 |
|
|
|
Total |
2,750 |
3,100 |
Total |
900 |
950 |
Fixed Assets |
|
|
|
|
Property Plant and Equipment |
5,000 |
4,500 |
Long-term Debt |
3,500 |
3,200 |
NCS=5000-4500+65=565
Change in Net Working Capital($\Delta$NWC)
NWC$_t$=Current Assets$_t$ - Current Liabilities$_t$
$\Delta$NWC$_t$=NWC$_t$-NWC$_{t-1}$
Assets |
2017 |
2016 |
Liabilities |
2017 |
2016 |
Current Assets |
|
|
Current Liabilities |
|
|
Cash |
1,500 |
1,300 |
Accounts Payable |
600 |
800 |
Accounts Receivable |
500 |
800 |
Notes Payable |
300 |
150 |
Inventory |
750 |
1000 |
|
|
|
Total |
2,750 |
3,100 |
Total |
900 |
950 |
Fixed Assets |
|
|
|
|
Property Plant and Equipment |
5,000 |
4,500 |
Long-term Debt |
3,500 |
3,200 |
$\Delta$NWC=(2,750-900)-(3,100-950)=-300
Cash Flow From Assets
CFFA=Cash Flow to Creditors+Cash Flow to Stockholder
CF$_{Assets}$=OCF-NCS-$\Delta$NWC
CF$_{Assets}$=628-565-(-300)=363
Cash Flow to Creditors
CFFA=Cash Flow to Creditors+Cash Flow to Stockholder
CF$_{Creditors}$=Interest Paid - Net New Borrowing
CF$_{Creditors}$=Interest Paid - (Long Term Debt$_t$ - Long term Debt$_{t-1}$)
Balance Sheet |
|
|
|
Income Statement |
|
Liabilities |
2017 |
2016 |
|
Net Sales |
1509 |
Current Liabilities |
|
|
|
Cost of Goods Sold |
750 |
Accounts Payable |
600 |
800 |
|
Depreciation |
65 |
Notes Payable |
300 |
150 |
|
EBIT |
694 |
|
|
|
|
Interest paid |
70 |
Total |
900 |
950 |
|
Taxable Income |
624 |
|
|
|
|
Taxes |
131 |
Long-term Debt |
3,500 |
3,200 |
|
Net Income |
493 |
CF$_{Creditors}$=70-(3,500-3,200)=-230
Cash Flow to Shareholders
CFFA=Cash Flow to Creditors+Cash Flow to Stockholder
CF$_{Stockholders}$=Dividends Paid-Net New Equity Issuance
CF$_{Stockholders}$=Dividends Paid-(Common Stock$_t$ - Common Stock$_{t-1}$)
Balance Sheet |
|
|
|
Income Statement |
|
|
2017 |
2016 |
|
EBIT |
694 |
Shareholder's Equity |
|
|
|
Interest paid |
70 |
Common Stock |
1,000 |
1,300 |
|
Taxable Income |
624 |
Retained Earnings |
2,350 |
2,150 |
|
Taxes |
131 |
Total |
3,350 |
3,450 |
|
Net Income |
493 |
|
|
|
|
|
|
|
|
|
|
Dividends |
293 |
|
|
|
|
Retained Earnings |
200 |
CF$_{Stockholders}$=293-(1,000-1,300)=593
Does it balance?
CFFA=Cash Flow to Creditors+Cash Flow to Stockholder
CF$_{Assets}$=363
CF$_{Creditors}$=-230
CF$_{Stockholders}$=593
$363=-230+593$
$363=363$
Summary
Cash Flow Identity
CF$_{Assets}$=CF$_{Stockholders}$+CF$_{Creditors}$
Cash Flow from Assets
CF$_{Assets}$=OCF-NCS-$\Delta$NWC, where:
OCF=EBIT+Depreciation-Taxes
NCS=Net Fixed Assets$_t$-Net Fixed Assets$_{t-1}$+Depreciation
$\Delta$NWC=NWC$_t$-NWC$_{t-1}$=(CA$_t$-CL$_t$)-(CA$_{t-1}$-CL$_{t-1}$)
Cash Flow to Creditors
CF$_{Creditors}$=Interest Paid-Net New Borrowing=Interest Paid-(Long Term Debt$_t$-Long Term Debt$_{t-1})$
Cash Flow to Stockholders
CF$_{Stockholders}$=Dividends Paid-Net New Equity Raised
=Dividends Paid-(Common Stock$_t$-Common Stock$_{t-1}$)
Cash Flow Problem
Sales=600
CGS=300
Depreciation=150
Interest=30
Taxes=21% (round to nearest integer)
Dividends=30
Beg NFA=500 End NFA=750, NFA=Net Fixed Assets
Beg CA=2130 End CA=2260 Beg CL=1620 End CL=1710
No new equity
What is CF to creditor and net new borrowing?
CF$_C$=-195 Net New Borrowing=225
Key Learning Outcomes
- Accounting principles, assumptions, and constraints
- Financial reporting (when, why, and how)
- Three financial statements
- How they are made and interact with each other
- Cash Flow