PART £ ‘ Financial Statements, Cash Flow, and Taxes Analysis of Financial Statements Time Value of MoneyFinancial Statements, Cash Flow, and Taxes Unlocking the Valuable Information in Financial Statements In Chapter 1, we said that managers should ‘make decisions that enhance long-term share- holder value, and they should be less concerned about shore inting measures such as earnings per share, With that important point in ‘ming, you might reasonably wonder why are we now going to talk about ting and financial statements. The simple answer is finan cial statements convey a lot of useful informa jon that helps corporate managers assess the companys strengths and and gauge the expected impact of various pro- posals. Good managers must have a sold Understanding of the key financial statements. Outsiders also rely heavily on financial st ments when deciding whether they want to buy the company’s stock, lend money to the coms into a long-term business relationship with the company. ny, OF ent At first glance, financial statements can be ‘overwhelming—but if we know what we are looking for, we can quickly learn a great deal about a company after a quick review of its financial statements, Looking at the balance sheet we can see how large a company Is, the types of assets it holds, and how it finances those assets, Looking at the income stateme! we can see if the companys sales increased or declined and whether the company made a ‘fit. Glancing at the statement of cash flows, we can see if the company made any new investments, if it raised funds through fina ng, repurchased debt or equity, or paid dividends For example in early 2014, Staroucks released ts fist quarter financial statements. The news was good. The company eamed $5407 millon inthe first quarter of its fiscal year—a year earlierChapter 3. Financial Statements, Cash Flow, and Taxes 57 ithad earned $4322 milion, and four years eatir it had eamed only $643 millon, Starbucks also announced a 5% increase in samestore sales, and its Income statement showed that ‘operating costs grew less than revenues. Reviewing the ccompany/s annual report for 2013, at the end of its fiscal year (September 29, 2013), Starbucks showed total assets of $115 billion and total liabilities of $70 billion on its balance sheet Finally, looking atthe staternent of cashflows, we see that Starbucks’ cash position more than doubled. During the year, cash and cash equivalents jumped from $1.19 billion to §258 billion. This increase occurred because the cash generated from its operations and the issuance of new debt far exceeded the amount of cash that was used to make new investments, jeay dividends, and repurchase stock \While we can Jeam a lot from a quick tour ofthe financial statements, a good financial analyst does not just accept these numbers at face value, The analyst digs deeper to see what’ really driving the numbers and uses his or her intuition and knowledge of the industry to help assess the company’s future direction, Keep in mind that just because a company reports great numbers doesn't mean that you should buy the stock In the case of Starbucks, its stock price did rise after it announced its better than-expected financial numbers for the first quarter. However, as is always the case, analysts have rmixed feelings about the stock’: future direction, i's these types of disagreements that make finance interesting, and as always, time will tell whether the optimists (the bulls) or the pessimists (the bears) are correct. Putting THINGS IN PERSPECTIVE ‘A manager's primary goal is to maximize shareholder value, which is based on the firm's future cash flows. But how do managers decide which actions are most likely to increase those flows, and how do investors estimate future cash flows? The answers to both questions lie in a study of financial statements that publicly traded firms must provide to investors. Here investors include both institutions (banks, insurance companies, pension funds, and the like) and individuals like you. Much of the material in this chapter deals with concepts you covered in a basic accounting course. However, the information is important enough to warrant a review. Also, in accounting you probably focused on how accounting statements are made; the focus here is on how investors and managers interpret and use them. Accounting is the basic language of business, so everyone engaged in business needs a good working knowledge of it. It is used to “keep score”; and if investors and managers do not know the score, they won't know whether their actions are appropriate. if you took midterm exams but were not told your scores, you would have a difficult time knowing whether you needed to improve. The same idea holds in business. Ifa firm's managers—whether they work in marketing, human resources, production, or finance—do not understand financial statements, they will not be able to judge the effects of their actions, which will make it hard for the firm to survive, much less to have a maximum value. When you finish this chapter you should be able to: + List each of the key financial statements and identify the kinds of information they provide to corporate managers and investors. + Estimate a firm's free cash flow and explain why free cash flow has such an important ‘effect on firm value. + Discuss the major features of the federal income tax system.38. Part 2. Fundamental Concepts in Financial Management Annual Report A report issued annually by a corporation to its stockholders. t contains baie nancial statements ‘as well as managements analysis ofthe firm's past ‘operations and future prospects. 3-11 Financial Statements aND RerorTs The annual report is the most important report that corporations issue to stod holders, and it contains two types of information.” First, there is a verbal section, often presented as a letter from the chairperson, which describes. the firm’s operating results during the past year and discusses new developments that will affect future operations. Second, the report provides these four basic financial statements: 1. The balance sheet, which shows what assets the company owns and who has claims on those assets as of a given date—for example, December 31, 2015. 2. The income statement, which shows the firm’s sales and costs (and thus profits) during some past period—for example, 2015, 3. The statement of cash flows, which shows how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash, 4. ‘The statement of stockholders’ equity, which shows the amount of equity the stockholders had at the start of the year, the items that increased or decreased ‘equity, and the equity at the end of the year. ‘These statements are related to one another; and taken together they provide an accounting picture of the firm’s operations and financial position. The quantitative and verbal materials are equally important. The firm’s finan- ial statements report what has actually happened to its assets, earnings, and divi- dends over the past few years, whereas management's verbal statements attempt to explain why things tumed out the way they did and what might happen in the future For discussion purposes, we use data for Allied Food Products, a processor and distributor of a wide variety of food products, to illustrate the basic financial statements. Allied was formed in 1984, when several regional firms merged; it has grown steadily while earning a reputation as one of the best firms in its industry. Allied’s earnings dropped from $121.8 million in 2014 to $117.5 million in 2015. Management reported that the drop resulted from losses asso- ciated with a drought as well as increased costs due to a three-month strike. However, management then went on to describe a more optimistic picture for the future, stating that full operations had been resumed, that several unprofit- able businesses had been eliminated, and that 2016 profits were expected to rise sharply. Of course, an increase in profitability may not occur; and analysts should compare management's past statements with subsequent results. In any event, the information contained in the annual report can be used to help forecast ‘future earnings and dividends. Therefore, investors are very interested in this report. We should note that Allied’s financial statements are relatively simple and straightforward; we also omitted some details often shown in the statements. Allied finances with only debt and common stock—it has no preferred stock, convertibles, or complex derivative securities, Also, the firm has made no acquisi- tions that resulted in goodwill that must be carried on the balance sheet. Finally, all of its assets are used in its basic business operations; hence, no non-operating assets must be pulled out when we evaluate its operating performance. We deliberately chose such a company because this is an introductory text; as such, ‘Firms also provide quarterly reports, but these are much less comprehensive than the annual report In addition, larger firms fle even more detailed statements with the Securities and Exchange Commission (SEC), giving breskdowns for etch major division or subsidiary. These reports, called 10K reports, are made available to stockholders upon request 9a company’s corporate secretary. In this chapter, we focus on annual dats—balance sheets atthe ends of yeats and income statements for ‘enfize years rather than for shorter time periodsChapter 3 Financial Statements, Cash Flow, and Taxes 59 Global Accounting Standards: Will It Ever Happen? For the past decade, global accounting standards seemed all ‘but certain. In 2005, the EU required the adoption of Interna- tional Financial Reporting Standards (IFRS), and in 2007, the SEC eliminated the requirement for companies reporting under IFRS to reconcile their financial statements to US. Generally Accepted Accounting Principles (GAAP). To date, 120 countries have adopted IFRS. However, on July 13, 2012, the SEC staff issued a report that failed to recommend IRS for US. adoption. Even though the ultimate decision will be up to the SEC commission, this report will play an important role in its decision The effor to intemationalize accounting standards began in 1973 with the formation of the International Accounting Stan- dards Committee, However, in 1998, it became apparent that 2 fulltime rule-making body with global representation was neces- sary; so the International Accounting Standards Board (IASB) was fstablished. The IASB was charged with the responsibilty for creating a set of IFRS. The "convergence’ process began in ear- nest in September 2002 with the "Norwalk Agreement” in which the Financial Accounting Standards Board (FASB) and IASB. undertook a short-term project to remove individual differences between the FASB's US. GAAP and IFRS and agreed to coordinate their activities. The process was meant to narrow gaps between the two standards, with the intention of making the transition for, companies simpler and less expensive. ‘Obviously, the globalzation of accounting standards Is a huge fendeavor—one that involves compromises between the IASB. and FASB. However, in recent yeats the momentum behind this {goal has diminished. Despite the best of intentions, progress toward consolidation was slowed by the 2007-2008 financial crisis and the resulting global recession. In addition, the leasing and financial instruments impaltment projects progressed slowly, and the chairs of both the FASB and IASB let theie positions. It has become apparent that the cost to companies, both large and small, for switching from GAAP to IFRS will be significant. Finally, the SEC has been given the task of implementing the Dodd~ Frank financial reform lav—fimiting is ability to focus on adopt ing global accounting standards, The United States 's an important economy, and without its participation it will be dificult to truly have global accounting standards. Although this report is a setback, many CFOs and accounting professionals still expect the SEC to come out with fan American version of IFRS to coexist with GAAP. The FASB and IASB remain committed to improving US. GAAP and IFRS and achieving their convergence. Global accounting standards are probably inevitable—it's just a question of time Source: Lee Berton “All Accountants Soon May Speak the Same Language,” The Wall Street Journal, August 29, 1995, p. ATS; James Turley (CEO, Ernst & Young), "Mind the GAAP," The Wall Street Journal November 9, 2007, p. A18; David M. Katz "The Path to Global Standards?" (CFO.com,Janvaty 28, 2017; “Global Accounting Standards: Closing the GAAP,” The Economist (economist. com), vol. 404, July 21, 2012; Joe Adler, "Is Effort to Unify Accounting Regimes Falling Apart,” Amercan Banker, Vol. 177, o. 145, July 30, 2012: Kathleen Hoffelder, “SEC Report Backs Away from Convergence," CFO Magazine (cfo.com/magazine), September 1, 2012; Ken Tysiag Stil in Flax: Future of IFRS in US. Remains Unclear after SEC Report,” Journal of Accountancy (ournalofaccountancy.com), September 2012: and Tammy Whitehouse, “Ten Years on, Convergence Movement Starting to Wane," Compliance Week (complianceweek com), October 2, 2012 we want to explain the basics of financial analysis, not wander into arcane accounting matters that are best left to accounting and security analysis courses. We do point out some of the pitfalls that can be encountered when trying to interpret accounting statements, but we leave it to advanced courses to cover the intricacies of accounting, What is the annual report, and what two types of information does it provide? What four financial statements are typically included in the annual report? Why is the annual report of great interest to investors?Part 2. Fundamental Concepts in Financial Management Balance Sheet A statement ofa firm's financial postion at @ spectc pot in time, 3-2 The Batance SHEET ‘The balance sheet is a “snapshot” of a firm’s position at a specific point in time. Figure 3.1 shows the layout of a typical balance sheet. The left side of the statement shows the assets that the company owns, and the right side shows the firm’s liabilities and stocklolders’ equity, which are claims against the firm's assets. As Figure 3.1 shows, assets are divided into two major categories: current assets and fixed, or long-term, assets. Current assets consist of assets that should bbe converted to cash within one year, and they include cash and cash equivalents, accounts receivable, and inventory.” Long-term assets are assets expected to be used for more than one year; they include plant and equipment in addition to intellectual property such as patents and copyrights. Plant and equipment is generally reported net of accumulated depreciation. Allied’s long-term assets consist entirely of net plant and equipment, and we often refer to them as “net fixed assets.” ‘Note: This s the typical yout ofa balance sheet for ane year. When balance sheets for two or more yeats are shown, assets are ltd inthe top section labilties and equty, in the bottom section. See Table 31 for an sation, “Allied and most other companies hold some curtency in addition to a bank checking account. They may also hold shorcterm interest-bearing secures that can be sold and thus converted to cash Immediately with a simple telephone call Theee securities are calle “cash equivalents” and they are generally included with checking aecount balances or financial reporting purposes. Ifa company ‘vns stocks or other marketable securities that t regards as shor erm investments, thee items wil be shown separately onthe Balance sheet. Allied does not hold any marketable securities other than cash ‘equivalentsChapter 3 Financial Statements, Cash Flow, and Taxes ‘The claims against assets are of two basic types—liabilities (or money the company owes to others) and stockholders’ equity. Current liabilities consist of claims that must be paid off within one year, including accounts payable, accruals (total of acerued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due within one year. Long-term debt includes bonds that mature in more than a year. Stockholders’ equity can be thought of in two ways. First, itis the amount that stockholders paid to the company when they bought shares the company sold to raise capital, in addition to all of the earnings the company has retained over the years” ‘Stockholders’ equity — Paid-in capital ~ Retained earnings The retained earnings are not just the earnings retained in the latest year—they are the cumulative total of all of the earnings the company has earned and retained during its life. Stockholders’ equity can also be thought of as a residual: Stockholders’ equity ~ Total assets — Total liabilities If Allied had invested surplus funds in bonds backed by subprime mortgages and the bonds’ value fell below their purchase price, the true value of the firm's assets would have declined. The amount of its liabilities would not have changed—the firm would still owe the amount it had promised to pay its creditors. Therefore, the reported value of the common equity must decline. The accountants would make a series of entries, and the result would be a reduction in retained earnings—and thus in common equity. In the end, assets would equal liabilities and equity, and the balance sheet would balance. This example shows why common stock is more risky than bonds—any mistake that management makes has a big impact on the stock- holders. Of course, gains from good decisions also go to the stockholders; so with risk come possible rewards. ‘Assets on the balance sheet are listed by the length of time before they will be converted to cash (inventories and accounts receivable) or used by the firm (fixed assets). Similarly, claims are listed in the order in which they must be paid: Accounts payable must generally be paid within a few days, accruals must also be paid promptly, notes payable to banks must be paid within one year, and so forth, down to the stockholders’ equity accounts, which represent ownership and need never be “paid off.” 3-24 Attiep’s BALANCE SHEET Table 3.1 shows Allied’s year-end balance sheets for 2015 and 2014, From the 2015 statement, we sce that Allied had $2 billion of assets—half current and. half long term. These assets were financed with $310 million of current liabilities, $750 million of long-term debt, and $940 million of common equity. Comparing the balance sheets for 2015 and 2014, we see that Allied’s assets grew by $320 million and its liabilities and equity necessarily grew by that same amount. Assets must, of course, equal liabilities and equity; otherwise, the balance sheet does not balance Several additional points about the balance sheet should be noted 1. Cash versus other assets. Although assets are reported in dollar terms, only the cash and equivalents account represents actual spendable money. Accounts receivable represent credit sales that have not yet been collected. Inventories show the cost of raw materials, work in process, and finished goods. Net fixed 50n allied’s balance shee, we simply show a common stock line representing the "paid-in" capital of stockholders when they purchased common shares of stock, Stockholders’ Equity It represents the amount that stockholders paid the ‘company wien shares were purchased and the ‘amount of earings the company has retained since ts origination Retained Earnings They represent the ‘cumulative total of el earings kept by the company during is fife 6