Financial Statements and Cash Flow The COVID-19 crisis in the early part of 2020 affected Many industries, perhaps none more significantly than the airlines. For the industry as a whole, the International Air Transport Association (IATA) stated that global losses would be about $84 billion in 2020 and an additional $15 billion in 2021. United Airlines, for example, lost about $2 billion in the first quarter of 2020 alone and another $1.6 billion in the second quarter. Cf course, global pandemics aren't the only reason companies report losses. In mid-2020, Shell announced that It would write off $22 billion due to a decrease in the value of its assets, and BP announced a $17.5 billion write-off for the same reason. Both companies attributed the write-offs to an expected reduction in oll and gas prices in the coming decades, along with the transition to cleaner energy sources. S0 did stockholders in the major ‘use of the traffic reduction? Definitely. Did money when the ilines lose money bec! stockholders in Shell and BP lose write-offs were announced? Probably not. Understend- ing why ultimately leads us to the main subject of this ‘chapter: that all-important substance known as cash flow. Please visit us at nwjcorporatefinance.blogspot.com for the latest developments in the world of corporate finance. Se AS 2.1 The Balance Sheet 20 xX Excel ‘Master ‘The balance sheet is an accountant’s snapshot of a firm’s accounting value on a particular date, as though the firm stood momentarily still. The balance sheet has two sides: On the left are the assets and on the right are the liabilities and stockholders’ equity. The balance sheet states what the firm owns and how it is financed. The accounting definition that underlies the balance sheet and describes the balance is: Assets = Liabilities + Stockholders’ equity We have put a three-line equality in the balance equation to indicate that it must always hold, by definition. In fact, the stockholders’ equity is defined to be the difference between the assets and the liabilities of the firm. In principle, equity is what the stockholders ‘would have if the firm were to discharge its obligations. Table 2.1 gives the 2021 and 2022 balance sheet for iti i Corporation, The asses in the balance shet are listed in Saas tenth of tne normally would take an ongoing firm to convert them into cash. The asset side depends8 CHAPTER 2. Financial Statements and Cash Flow Table 2.1 The Balance Sheet of the US. Composite Corporation Pete eet Seen Tiy Current assets: i Current liabilities: Cash and equivalents ‘Accounts payable ‘Accounts receivable Total current liablities loventony Total curent assets $707 S7ey_ “perm Habilties: a Deferred taxes $104 $113 "meperty plan, and angen sg ae art +e ‘Total lor liabilities ‘562 ‘584 ‘equipment $1,274 $1,423 ogee ‘$562 ‘$584 Less accumulated ‘Stockholders’ equity: depreciation 460 _s50 Preferred stock So) S| 30 Na eae Common stock ($1 par value) 32 55 q ‘equipment’ $ 814 $ 873 Capital surplus 327 347 iis ‘Accumulated retained earnings 347 390 Intangible assets and others, 224 245 Less treasury stock’ 20 26 Total fixed assets 035 «| Te Total equity 575 = 5805 Total lbilties and Total assets siociocldere Sty $1742 $1,879 “Longiterm debt ose by $471 mikon ~ 458 millon = $13 millon This the ference between $86 milon new debt and $73 millon in retement of la cet. “Treasury stock rose by $6 millon. Ths rtlects the repurchase of $6 milion of US. Composte’s company stock 'US. Composite reports $43 millon in rew equty. The compary fsued 23 milon shares at @ pce of $1.87. The par valve of commen stock increased by $23 milion, and captal surplus mereased by $20 millon ‘on the nature of the business and how management chooses to conduct it. Management must make decisions about cash versus marketable securities, credit versus cash sales, whether to make or buy commodities, whether to lease or purchase items, the type of business in which to engage, and so on. The liabilities and the stockholders’ equity are listed in the order in which they would typically be paid over time. The liabilities and stockholders’ equity side reflects the types and proportions of voeneely financing, which depend on management's choice of capital structure, Management will seers Jananeia! decide on which combination of debt and equity, and, for debt, which combination of information are shortterm and longterm debt. finance-yahoo.com When analyzing a balance sheet, the financial manager should be aware of three ‘and money.can concerns: liquidity, debt versus equity, and value versus cost. com. LIQUIDITY Liquidity refers to the ease and quickness with which assets can be converted to cash (without significant loss in value). Current assets are the most liquid and include cash and assets that will be turned into cash within a year from the date of the balance sheet. Accounts receivable are amounts not yet collected from customers for goods or services sold to them (after adjustment for potential bad debts). Inventory is composed of raw materials to be used in production, work in process, and finished goods. Fixed assets are the least liquid kind of assets. Tangible fixed assets include property, plant, and equipment.Annual and quarterly financial statements for most public US, corporations can be found in the EDGAR database at www sec.gov. The home page for the Financial Accounting Standards Board (FASB) Is wwwfasb org. 2200 mms PARTI. Overview activity, and they are not us. jormal business These assets do not convert to eash from normal ally used to pay expenses such as payroll Some fixed assets are intangible. Int be very valuable, Examples of intangible assets ae (1 of a patent, The more liquid a firm's assets, the less q fems mecting shortierm obligations. The probebilty (Mt ee srequently have lower tress can be linked to the firm’s liquidity. Unfortunately, lial .s no investment income. To rates of return than fixed assets; for example, cash Bene unity to invest in potentially the extent a firm invests in liquid assets it sacrifices an OPP more profitable investment vehicles. stence but ssets have no physical exist can ingle asses Mjue of a trademark OF the value ly the firm is to experience prob. a firm will avoid financial dis. DEBT VERSUS EQUITY Liabilities are obligations of the firm that require @ P: period. Many liabilities involve contractual obligations t0 FePay © eran tae a interest over a period. Liabilities are debts and are frequently assole) Ni burdens. called deby service, that put the firm in default of a contract © YT A not pi Stockholders’ equity is a claim against the firm's assets that is residual TAY DO AT general terms, when the firm borrows, it gives the bondholders first clan OO Te Nhs cash flow.' Bondholders can sue the firm if the firm defaults on its bond contracts. This nay lead the frm to declare itself bankrupt. Stockholders’ equity isthe difference between assets and liabilities: ayout of cash within a stipulated Stockholders’ equity Assets — Liabiliti ‘This is the stockholders’ share in the firm stated in accounting terms. The accounting value of stockholders’ equity increases when retained earnings are added. This occurs when the firm retains part of its earnings instead of paying them out as dividends. VALUE VERSUS COST ‘The accounting value of a firm’s assets is frequently referred to as the carrying value ot the book value of the assets.’ Under generally accepted accounting principles (GAAP), audited financial statements of firms in the United States carry assets at cost.’ The terms carrying value and book value are misleading and cause many readers of financial state ‘ments to believe the firm's assets are recorded at true market values. Marker value is the price at which willing buyers and sellers would trade the assets. It would be only a coin- “cidence if accounting value and market value were the same. In fact, management's job is to create value for the firm that exceeds its cost. Many people use the balance sheet, but the information each may wish to extract is different. A banker may look at a balance sheet for evidence of accounting liquidity and working capital, while a supplier also may note the size of accounts payable and the general promptness of payments. Many users of financial statements, including managers and investors, want to know the market value of the firm, not its cost. This information is not found on the balance sheet. In fact, many of the true resources of the firm do not "Bonabetion " Bondolders are investors inthe firm's debt. They re creditors ofthe fi same thing as credo. oe Confusion often arses because many Financial accounting terms have the sa refer tothe same ting asses mins ables, net worth, sekhelde’ eu im. In this discussion, the term Bonaholde meas he mewn For ean heft ters a Genel the US. GAAP requie asses tobe cared at the lover of cos or mane epee emu cnn ase oe ar mrt ae ue cn be realy determined teases Rave thFor more information about IFRS, check out the website Coverage online 23 CHAPTER 2 Financial Statements and Cash Flow appear on the balance sheet: good management, proprietary assets, favorable economic Conditions, and so on, Henceforth, whenever we refer to the value of an asset or the value of the firm, we will normally mean its market value. So, when we say the goal of the financial manager is to increase the value of the stock, we usually mean the market value of the stock, not the book value. With the increasing globalization of business, there has been a growing need to make accounting standards more comparable across countries. In recent years, U.S. accounting standards have become more closely tied to International Financial Reporting Standards (IFRS). In particular, the Financial Accounting Standards Board, which is in charge of GAAP policies, and the International Accounting Standards Board, in charge of IFRS polices, have been working toward convergence of policies. Although GAAP and IFRS have become similar in several areas, it appears that a full convergence of accounting Policies is off the table, at least for now. Market Value versus Book Value The Cooney Corporation has fixed assets with a book value of $700 and an appraised market value of about $1,000. Net working capital is $400 on the ‘books, but approximately $600 would be realized if all the current accounts were liquidated. Cooney has $500 in long-term debt, in book value and market value terms. What is the book value of the equity? What is the market value? We can construct two simplified balance sheets, one in accounting (book value) terms and fone in economic (market value) terms: Market Book Net working capital $ 400 $ 600 _Longsterm debt $ 500 Net fixed assets 700 _1,000 Shareholders’ equity 600 $1,100 $1,600 $1,100 In this example, shareholders’ equity is actually worth almost twice as much as what is shown ‘on the books. The distinction between book and market values is important precisely because book values can be so different from market values. The Income Statement The income statement measures performance over a specific period—say a year. The accounting definition of income is: Income Revenue — Expenses If the balance sheet is like a snapshot, the income statement is like a video recording of what the company did between two snapshots. Table 2.2 gives the income statement for the U.S. Composite Corporation for 2022.24 m= PARTI Overview Table 2.2 The income Statement of the US. Composite Corporation ‘Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes (EBIT) Interest expense Pretax income Taxes Current: $15 Deferred: 9 Net income Addition to retained eamings Dividends nd dhidends per share can be calculsted as NOTE, There ace 29 milion shares outstanding. Eamings per share and cvidends ps follows: Net income. Eomings per shave = yergrahisres oulstaniNO $6, 3B = £297 per sce Suen Dividends per share = sear nS ag 38 2 = 5148 por snare The income statement usually includes several sections. The operations section reports the firm’s revenues and expenses from principal operations. One number of par ticular importance is earnings before interest and taxes (EBIT), which summarizes earn- ings before taxes and financing costs. Among other things, the nonoperating section of the income statement includes all financing costs, such as interest expense. Usually a second section reports as a separate item the amount of taxes levied on income. The last item on the income statement is the bottom line, or net income. Net income is frequently expressed per share of common stock~that is, earnings per share, When analyzing an income statement, the financial manager should keep in mind GAAP, noncash items, time, and costs. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Revenue is recognized on an income statement when the earnings process is virtually completed and an exchange of goods or services has occurred, Therefore, the unrealized appreciation from owning property will not be recognized as income. This provides a device for smoothing income by selling appreciated property at convenient times, For example, i the firm owns a tree farm that has doubled in value, then, in a ‘year when its earnings fromCHAPTER 2. Financial Statements and Cash Flow mm 25 other businesses are down, it can raise overall earnings by selling some trees. The matching Principle of GAAP dictates that revenues be matched with expenses. Income is reported when it is earned, or accrued, even though no cash flow has necessarily occurred (eg, sales are reported at the time goods are sold, even if the goods are sold on credit). NONCASH ITEMS ‘The economic value of assets is intimately connected to their future incremental cash flows. However, cash flow does not appear on an income statement. There are several noncash ltems that are expenses against revenues but do not affect cash flow. The most important Of these is depreciation. Depreciation reflects the accountant's estimate of the cost of equip ‘ment used up in the production process. Suppose an asset with a fiveyear life and no resale Value is purchased for $1,000. According to accountants, the $1,000 cost must be expensed over the useful life of the asset. Ifstraightine depreciation is used, there will be five equal installments, and $200 of depreciation expense will be incurred each year. From a finance perspective, the cost of the asset is the actual negative cash flow incurred when the asset acquired (i.e, $1,000, nor the accountant’s smoothed $200-per-year depreciation expense). Another noncash expense is deferred taxes. Deferred taxes result from differences between accounting income and true taxable income.‘ Notice that the accounting tax shown on the income statement for the U.S. Composite Corporation is $24 million. It can be broken down as current taxes and deferred taxes. The current tax portion is actu: ally sent to the tax authorities (e.g, the Internal Revenue Service), while the deferred tax portion is not. However, the theory is that if taxable income is less than accounting income in the current year, it will be more than accounting income later on. Consequently, the taxes that are not paid today will have to be paid in the future, and they represent a liability of the firm. This shows up on the balance sheet as deferred tax liability. From the cash flow perspective, though, deferred tax is not a cash outflow. In practice, the difference between cash flows and accounting income can be quite dramatic, so it is important to understand the difference. For example, in the second quarter of 2020, commercial graphics company Quad/Graphics announced a net loss in accounting income of $15 million. Sounds bad, but the company also reported a positive cash flow of $51 million, a difference of $66 million, TIME AND COSTS It is often useful to visualize all of future time as having two distinct parts, the short run and the Jong run. The short run is the period in which certain equipment, resources, and commitments of the firm are fixed; but the time is long enough for the firm to vary its ‘output by using more labor and raw materials. The short run is not a precise period that will be the same for all industries, However, all firms making decisions in the short run have some fixed costs—that is, costs that will not change because of fixed commitments, Examples of fixed costs are bond interest, overhead, and property taxes. Costs that are not fixed are variable. Variable costs change as the output of the firm changes; some examples are raw materials and wages for laborers on the production line. In the long run, all costs are variable. Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a clas- sification that distinguishes product costs from period costs. Product costs are the total production costs incurred during a period—raw materials, direct labor, and manufacturing, "One statlon in which taxable income may be lower than accounting income i when the fim uses accelerated deprecation expense procedures forthe IRS but uss strghine procedures allowed by GAAP for reporting purposes2.3 e RS. coverage online For a history of Income taxes, listen to tinyurl.com/ yBraqex2, ‘The IRS has a great website at weve irs.gov. PARTI Overview Js sold. Both variabi overhead—and are reported on the income statement as cet ar a aiisaica vf and fed eosts are included in product costs. Period costs ar CORE EE Ln 1 time period: they are called selling, general, and adminis would be the company president’s salary. Taxes Taxes can be one of the largest cash outflows .96 billion. fiscal year 2019, Southwest Airlines’ earnings before taxes Were Soar a tox bill, including all taxes paid worldwide, was a whopping $007 To ae 22 percent of its pretax earnings. Also for fiscal year 2019, Wal in average tax rate of of $20.12 billion, and the company paid $4.92 billion in taxes NN 2b percent, The size ofthe firm's tax bills determined by the tax code, an Nenmende set of rules. In this section, we examine corporate tax rates anc re calculated. If the various rules of taxation seem a little is mind that the tax code is the result of political, not economic, is no reason why it has to make economic sense. CORPORATE AND PERSONAL TAX RATES ; ‘After the passage of the Tax Cuts and Jobs Act of 2017, the federal corporate tax rate in the United States became a flat 21 percent. However, tax rates on other forms of business such as proprietorships, partnerships, and LLCs did not become flat. To illustrate some important points about taxes for such entities, we take a look at personal tax rates in Table 2.3. As shown, in 2021, there are seven tax brackets, ranging from 10 percent to a high of 37 percent, down from 39.6 percent in 2017. a firm experiences. For example, for the bizarre or convoluted to you, keep in forces. As a result, there AVERAGE VERSUS MARGINAL TAX RATES In making financial decisions, it is important to distinguish between average and marginal tax rates, Your average tax rate is your tax bill divided by your taxable income—in other words, the percentage of your income that goes to pay taxes. Your marginal tax rate is the tax you would pay (in percent) if you earned one more dollar. The percentage tax rates shown in Table 2.3 are all marginal rates. Put another way, the tax rates apply to the part of income in the indicated range only, not all income. ‘The difference between average and marginal tax rates can best be illustrated with a simple example. Suppose your personal taxable income is $100,000. What is your tax bill? Using Table 2.3, we can figure your tax bill like this: 10 ($9,950) =$ 995.00 12 ($40,525 — 9,950) = 3,669.00 22 ($86,375 — 40,525) = 10,087.00 24 ($100,000 — 86,375) = _ 3,270.00 $48,021.00 Your total tax is $18,021. In our example, what is your average tax rate? You had a taxable income of $100,000 and a tax bill of $18,021, so your average tax rate is $18,021/$100,000 = .1802, or 18.02%. ‘What is your marginal tax rate? If you made one more dollar, the tax on that dollar would be 24 cents, $0 your marginal rate is 24 percent,Table 2.3 Personal Tax Rates for 2021 (Unmarried Individuals) 2.4 ee AX Master Coverage online CHAPTER 2 Financial Statements and Cash Flow eae eae $ 0-9,950 10% 9,950-40,525, 12 40525-86375 22 86,375-164,925 24 164,925-209,425 32 209,425-523,600 35 523,600+ 37 Deep in the Heart of Taxes Algernon, a small proprietorship owned by an unmarried individual, has a taxable income of $80,000. What is its tax bill? Its average tax rate? Its marginal tax rate? From Table 2.3, we see that the tax rate applied to the first $9,950 is 10 percent; the rate ‘applied over that up to $40,525 is 12 percent; the rate applied after that up to our total of $80,000 is 22 percent. So Algernon must pay .10 x $9,950 + .12 x ($40,525 - 9,950) + 22 x ($80,000 — 40,525) = $13,348.50. The average tax rate is thus $13,348,50/$80,000 = .1669, oF 16.69%. The marginal rate is 22 percent because Algeron's taxes would rise by 22 cents if it earned another dollar in taxable income. Normally, the marginal tax rate will be relevant for financial decision making. The reason is that any new cash flows will be taxed at that marginal rate. Because financial decisions usually involve new cash flows or changes in existing ones, this rate will tell us the marginal effect of a decision on our tax bill With a flat-rate tax, such as the U.S. federal corporate tax (as of 2018), there is only one tax rate, so the rate is the same for all income levels. With such a tax system, the marginal tax rate is always the same as the average tax rate. Before moving on, we should note that the tax rates we have discussed in this section relate to federal taxes only. Overall tax rates can be higher if state, local, and any other taxes are considered. Net Working Capital Net working capital is current assets minus current liabilities. Net working capital is posi- tive when current assets are greater than current liabilities. This means the cash that will become available over the next 12 months will be greater than the cash that must be paid out. The net working capital of the U.S. Composite Corporation is $252 million in 2021 and $271 million in 2022 Current assets __-—= Current liabilities. © __—=—_Net working capital (millions) (millions) 2 2021 $707 - $455 2022 761 - 490 = In addition to investing in fixed assets (i.e., capital spending), a firm can invest in net working capital. This is called the change in net working capital. The change in net28 a PARTI Overview 2.5 sv ise coverage online ‘et working capital in 2022 ang the n ponte inge in net working capital worki it 2 difference ng capital in 2022 isthe difference Revert Ta cha 2021—that is, $271 million — 252 million = is usually positive in a growing firm.” Cash Flow of the Firm Perhaps the most important item that ean be extra e statement actual cash flow of the firm, An official counting statement called thi of cash flows helps to explain the change in accounting cash and emia Aeoey = us, Composite is $41 million in 2022. (See Section 2.6.) Notice in Table 2.1 cash and equivalents increase from $157 milion in 2021 to $198 million i 2022. However, we will look at cash flow from a different perspective: the perspective of finance. In finance, the value of the firm is its ability to generate financial cash flow. (We will talk more about financial cash flow in a later chapter.) ‘ "The first point we should mention is that cash flow is not the same net working capital. For example, increasing inventory requires using cash. Because both inventories sev cash are cument assets, this docs not affect net working capital. In this case, an increase in inventory parchased with cash is associated with a decrease in the cash balance. ‘AS we established that the value of value of the liabilities and the value of the equity, assets (ice, its operating activities), CF(A), must equal t tors, CF(B), and equity investors, CF(S): CF(A) = CF(B) + CF(S) The first step in determining cash flows of the firm is to figure out the cash flow ‘from operations. As can be seen in Table 2.4, operating cash flow is the cash flow gener ‘ated by business activities, including sales of goods and services. Operating cash flow reflects tax payments, but not financing, capital spending, or changes in net working capital: ied from financial statements is the a firm’s assets is always equal to the combined the cash flows received from the firm's the cash flows to the firm’s credi- (in millions) Earnings before interest and taxes $159 Depreciation Current taxes Operating cash flow Another important component of cash flow involves fixed changes in . When US. Composite sold its power systems subsidiary in 2022, it generated $05 milion in ables sometimes include shortterm,iteestbearing debt usually referred to as notes payable. HOVE eb: and noninerest beat it ring, shortterm debt (sich ing, sorter db usa inched theese erating” networking capital The intrestbeaing Sh f cing activites, and the interest is considered 8CHAPTER 2 Financial Statements and Cash Flow =m 29. Table 2.4 Financial Cash Flow of the US. Composite Corporation Cash flow of the firm Operating cash flow $234 (Eamings before interest and taxes plus depreciation minus taxes) Capital spending 173 (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash flow to investors in the firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity 8 (Dividends plus repurchase of equity minus new equity financing) Total 54a cash flow. The net change in fixed assets equals the acquisition of fixed assets minus the Sales of fixed assets. The result is the cash flow used for capital spending: Acquisition of fixed assets. $198 Sales of fixed assets =25 Capital spending | (6149 + 24 = increase n propery plant, and == equipment + Increase in intangible assets) We also can calculate capital spending as: Capital spending = Ending net fixed assets — Beginning net fixed assets + Depreciation 1,118 — 1,035 + 90 173, Cash flows also are used for making investments in net working capital. In U.S. Composite Corporation in 2022, additions to net working capital are: Additions to net working capital $19 | Note that this $19 million is the change in net working capital we previously calculated, Total cash flows generated by the firm's assets are then equal to: ‘Operating cash flow $234 Capital spending ~173 | Additions to net working capital = 19) Total cash flow of the firm ra ' The total outgoing cash flow of the firm can be separated into cash flow paid to creditors and cash flow paid to stockholders. The cash flow paid to creditors representsLLL eee Xy 30 mm PARTI Overview ing of interest expense, Cred. icit recor in Table 2.4 and an explie® TT Debt service is interest pay. a regroupii grouping of the dat Mo as debe service. tors are paid an amount generally referred ments plus repayments of principal (ie. retirement °F EP)" 5 Composites tongte (A impertantsouesofeah ow she eae of new deDL US: TOV ite debt increased by $13 million (the difference between S86 MIAN YO Te $73 million in retirement of old debt).° An increase in lonessO™ 10 of new borrowing and repayment of maturing obligations plus in 49 Interest $ e Retirement of debt ee Debt service iz Proceeds from long-term debt sales 86 Total Cash flow paid to creditors also can be calculated as: interest paid — Net new borrowing = Interest paid — (Ending longterm debt — Beginning long-term debt) 49 — (471 - 458) Cash flow paid to creditors Cash flow of the firm also is paid to the stockholders. It is the net effect of paying dividends plus repurchasing outstanding shares of stock and issuing new shares of stock: Dividends Repurchase of stock Cash to stockholders Proceeds from new stock issue Total In general, cash flow to stockholders can be determined as: Cash flow to stockholders = Dividends paid — Net new equity raised = Dividends paid — (Stock sold — Stock repurchased) To determine stock sold, first notice that the common st | went up by a combined $23 + 20 = $43, which implies t worth of stock. Second, treasury stock went up by $6, in fock and capital surplus accounts that the company sold $43 million \dicating that the company bought Tae ear eli tat te Rew Goad the retirees bar usually found in the “notes” tothe ‘case, This increase can also be sen from the increase in longterm deat oye eT in longterm debt on the bal sheet, footnoted in Table 2.1 ins lance sheet from $458 milion to $42.6 Excel Nise, dmg oe CHAPTER 2. Financial Statements and Cash Flow 31 back $6 million worth of stock. Net new equity is $43 - 6 = $43 million, so the cash flow to stockholders was: 37. Dividends paid were Cash flow to stockholders = $43 - (43 - 6) = $6 which is what we previously calculated. Some important observations can be drawn from our discussion of cash flow: 1, Several types of cash flow are relevant to understanding the financial situation of the firm. Operating cash flow, defined as earnings before interest plus depreciation ‘minus taxes, measures the cash generated from operations not counting capital spending or working capital requirements. It is usually positive; a firm is in trouble if operating cash flow is negative for a long time because the firm is not generating enough cash to pay operating costs. Total cash flow of the firm includes adjust- ments for capital spending and additions to net working capital. It will frequently >be negative. When a firm is growing at a rapid rate, spending on inventory and fixed assets can be higher than operating cash flow. 2. Net income is not cash flow. The net income of the U.S. Composite Corporation in 2022 was $86 million, whereas cash flow was $42 million. The two numbers are not usually the same. In determining the economic and financial condition of a firm, cash flow is more revealing. A firm’s total cash flow sometimes goes by a different name, free cash flow. Of course, there is no such thing as “free” cash (we wish!). Instead, the name refers to cash that the firm is free to distribute to creditors and stockholders because it is not needed for working. capital or fixed asset investments. For now, we will stick with “total cash flow of the firm” as our label for this important concept because, in practice, there is some variation in exactly how free cash flow is computed. Nonetheless, whenever you hear the phrase “free cash flow,” you should understand that what is being discussed is cash flow from assets that can be distributed to investors. The Accounting Statement of Cash Flows As previously mentioned, there is an official accounting statement called the statement of cash flows. This statement helps explain the change in accounting cash, which for U.S. Composite is $41 million in 2022. It is very useful in understanding financial cash flow. The first step in determining the change in cash is to figure out cash flow from operating activities. This is the cash flow that results from the firm's normal activities in producing and selling goods and services. The second step is to make an adjustment for cash flow from investing activities. The final step is to make an adjustment for cash flow from financing activities. Financing activities are the net payments to creditors and owners (excluding interest expense) made during the year. The three components of the statement of cash flows are explained next. CASH FLOW FROM OPERATING ACTIVITIES To calculate cash flow from operating activities we start with net income. Net income can be found on the income statement and is equal to $86 million. We now need to add back noncash expenses and adjust for changes in current assets and liabilities (other than cash and notes payable). The result is cash flow from operating activiti32 PARTI Overview Net income Depreciation Deferred taxes Change in assets and liabilities Accounts receivable Inventories Accounts payable ash flow from operating activities CASH FLOW FROM INVESTING ACTIVITIES Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (ie., net capital expenditures). The result for U.S. Com- posite is shown here: ‘Acquisition of fixed assets Sales of fixed assets Cash flow from investing activities CASH FLOW FROM FINANCING ACTIVITIES Cash flows to and from creditors and owners include changes in equity and debt: Retirement of long-term debt Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Cash flow from financing activities ‘The statement of cash flows is the addition of cash flows from operations, cash flows from investing activities, and cash flows from financing activities, and is produced in Table 2.5.Table 2.5 Statement of Consolidated Cash Flows of the U.S. Composite Corporation Depreciation Deferred taxes Changes in assets and liabilities Accounts receivable Inventories Accounts payable Total cash flow from operations Investing acti Acquisition of fixed assets Sales of fixed assets Total cash flow from investing activities Financing activities Retirement of long-term debt Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total cash flow from fins Change in cash (on the bi When we add all the cash flows together, we get the change in cash on the balance sheet of $41 million. The accounting statement of cash flows shown here is similar to the total cash flow of the firm used in finance that was discussed in the previous section (see Table 2.4). The biggest difference lies in the treatment of interest payments to debtholders, also known as interest expense. The statement of cash flows starts with net income, from which interest has already been deducted as an expense. Conceptually, interest paid to debtholders should actually go under financing activities, but that is not how the accounting is handled. 2.7 Cash Flow Management One of the reasons cash flow analysis is popular is the difficulty in manipulating, or spinning, cash flows. GAAP allows for significant subjective decisions to be made regarding many key areas, The use of cash flow as a metric to evaluate a company comes from the idea that there is less subjectivity involved, and, therefore, itis harder to spin the numbers. But several well known cases have shown that companies can still find ways to manipulate operating cash flow. For example, security systems company Tyco used several ploys to alter cash flows. The company purchased more than $800 million of customer security alarm accounts from deal- ers. The cash flows from these transactions were reported in the financing activity section of the accounting statement of cash flows. When Tyco received payments from customers, the cash inflows were reported as operating cash flows. Another method used by Tyco was34 mm PART! Overview o have acquired companies prepay operating expenses. In other words (Re Company aedied to have quired companies preps) ease In one case, the Payments totaled bell enor es) was consolidated with TyC®, the prepay. more than $50 million. When the scquired company . ments redueed Tyeo's cash outflows, increasing the operating cash owe ts reduced Tyco's cash outf ee ge aveused of engaging in a number of " sreccuua case er a rades essentially involved the sale of natural senables “Ton ip rade ith the repurchase of tne resources from the same party at Fe eeerar ey ynegy would sell an asset for $100, and immediatly repur he same price. In essence, Dynegy would sell an asse chase I rom the bayer for $100, The problem arose with the teatment of the cash Hows from the sale. Dynegy treated the cash from the sale of the asset as an operating cash flow but classified the repurchase as an investing cash outflov. The ttl cash flows of the contracts traded by Dynegy in these round-trip trades totaled $300 mil s a ej Adelphia Communications was another company that apparently manip\ i ck flows. In Adelphia's case, the company capitalized the labor required to instal cable. In other words, the company classified this labor expense as a fixed asset. While this practice is fairly common in the telecommunications industry, ‘Adelphia capitalized a higher per- centage of labor than is common. The effect of this classification was that the labor was treated as an investment cash flow, which increased the operating cash flow. In each of these examples, the companies were trying to boost operating cash flows by shifting cash flows to a different heading. ‘The important thing to notice is that these movements don't affect the total cash flow of the firm, which is why we recommend focusing on this number, not just operating cash flow. Summary and Conclusions Besides introducing you to corporate accounting, the purpose of this chapter has been to teach ‘you how to determine cash flow from the accounting statements of a typical company. 1. Cash flow is generated by the firm and paid to creditors and shareholders. It can be clas- sified as: a. Cash flow from operations. b. Cash flow from changes in fixed assets, . Cash flow from changes in working capital. 2. Calculations of cash flow are not difficult, but they require care and particular attention to detail in properly accounting for noncash expenses such as depreciation and deferred taxes. It is especially important that you do not confuse cash flow with changes in net working capital and net income. Concept Questions 1, Liquidity True or false: All assets are liquid at some price. Expl 2, Accounting and Cash Flows Why might the revenue and cost figures shown on a stan dard income statement not represent the actual cash inflo during a period? ws and outflows that occurred 3. Accounting Statement of Cash Flows Looking at the accountis i ounting statement of cash flows, what does the bottomline : fer ‘number mean? How useful is this number for analyzingCHAPTER 2. Financial Statements and Cash Flow a 35 4. Cash Flows How do financial cash flows and the accounting statement of cash flows differ? Which is more useful for analyzing a company? 5. Book Values versus Market Values Under standard accounting rules. it is possible for @ company’s liabilities to exceed its assets. When this occurs, the owners’ equity is nega- tive. Can this happen with market values? Why or why not? Cash Flow from Assets Why is it not necessarily bad for the cash flow from assets to be negative for a particular period? 7. Operating Cash Flow Why is it not necessarily bad for the operating cash flow to be negative for a particular period? Net Working Capital and Capital Spending Could a company’s change in net working capital be negative in a given year? (Hint: Yes.) Explain how this might come about. ‘What about net capital spending? 9. Cash Flow to Stockholders and Creditors Could a company's cash flow to stockholders be negative in a given year? (Hint: Yes.) Explain how this might come about. What about cash flow to creditors? 10. Firm Values In July 2020, Kraft Heinz announced that it was writing off $2.9 billion due to the loss in value of several of its well-known brands, including Oscar Meyer and Maxwell House. We would argue that Kraft Heinz's stockholders probably didn’t suffer 48 a result of the reported loss. What do you think is the basis for our conclusion? Questions and Problems a connect 1. Building a Balance Sheet Bing, Inc., has current assets of $5,400, net fixed assets of $28,100, current liabilities of $4,100, and long-term debt of $10,600. What is the value of the shareholders’ equity account for this firm? How much is net working capital? 2. Building an Income Statement Gia, Inc, has sales of $497,000, costs of $276,000, depre- ciation expense of $43,000, interest expense of $24,000, and a tax rate of 21 percent. What is the net income for the firm? Suppose the company paid out $30,000 in cash dividends. What is the addition to retained earnings? 3. Market Values and Book Values Klingon Widgets, Inc., purchased new cloaking machin- ery three years ago for $6 million. The machinery can be sold to the Romulans today for $5.4 million. Klingon’s current balance sheet shows net fixed assets of $3.5 million, cur- rent liabilities of $945,000, and net working capital of $275,000. If the current assets and current liabilities were liquidated today, the company would receive a total of $1.25 million cash. What is the book value of Klingon’s total assets today? What is the sum of the market value of NWC and the market value of fixed assets? SX + Cilewlating Taxes Timmy Tappan is single and had $189,000 in taxable income. Using the rates from Table 2.3 in the chapter, calculate his income taxes. What is the average tax rate? What is the marginal tax rate? 5. Caleulating OCF Graff, Inc., has sales of $49,800, costs of $23,700, depreciation expense of $2,300, and interest expense of $1,800. If the tax rate is 22 percent, what is the operating cash flow, or OCF? 6. Calculating Net Capital Spending Wallace Driving School's 2020 balance sheet showed net fixed assets of $2.3 million, and the 2021 balance sheet showed net fixed assets of $3.1 million. The company's 2021 income statement showed a depreciation expense of $327,000. What was net capital spending for 2021? [riINance Basic (Questions 1-10) 7. Building a Balance Sheet The following table presents the long-term liabilities and stockholders’ equity of Information Control Corp. from one year ago:360 om INTERMEDIATE (Questions 11-22) PART I uu. Overview —__— {$ 48,000,000 Lengieim 3,100,000 referred stock 4 00 Common stock ($1 par value) A aoe caine tained earning: 51,000,000 pital surpid During the past year, the company issued 4.6 million shares of new stock at a total price of Sol rullibe, cad boned $34 milion in new longterm debt. The OMFS Blermed $75 mills et teoonse and ald $1.9 saillon sn dooms) CORTES the current balance sheet reflecting the changes that ‘occurred at the company during the year. Cash Flow to Creditors The 2020 balance sheet of Osaka’s Tennis Shop, Inc., showed longterm debt of $2.25 million, and the 2021 balance sheet showed longterm debt of $2.66 million. The 2021 income statement showed an interest expense of $305,000, What was the firm's cash flow to creditors during 2021? : Cash Flow to Stockholders The 2020 balance sheet of Osaka’s Tennis Shop, Inc, showed $780,000 in the common stock account and $4.78 million in the additional paid-in surplus account, The 2021 balance sheet showed $965,000 and $5.04 million in the same two accounts, respectively. Ifthe company paid out $654,000 in cash dividends during 2021, what was the cash flow to stockholders for the year? Calculating Cash Flows Given the information for Osaka's Tennis Shop, Inc., in Prob- ems 9 and 10, suppose you also know that the firm's net capital spending for 2021 was $1.5 million and that the firm reduced its net working capital investment by $55,000, What was the firm's 2021 operating cash flow, or OCF? Cash Flows Ritter Corporation's accountants prepared the following financial state- ments for yearend 2021: a. Explain the change in cash during 2021. b. Determine the change in net working capital in 2021. ¢. Determine the cash flow generated by the firm's assets during 2021 RITTER CORPORATION Teresa Prod) Revenue $781 Expenses 539 | Depreciation 94 | Net income idends CT Meco rel Ute),) Coens Peay! Assets Cash 6 Other current assets . ” 7 ee Net fixed assets 400 420 Total assets $642 $702 Liabilities and Equity Accounts payable Cong cet is tee ‘Stockholders’ equity 354 387 Total liabilities and equity $642 $70212. B. 14, 15. 16. 1. 18. 19. CHAPTER 2 Financial Statements and Cash Flow am (37 Financial Cash Flows The Stancil Corporation provided the following current information; Proceeds from long-term borrowing $13,800 Proceeds from the sale of common stock 5,000 Purchases of fixed assets 27,500 Purchases of inventories 2,600 Payment of dividends 13,800 Determine the total cash flows spent on fixed assets and NWC. What are the cash flows to investors of the firm? Building an Income Statement During the year, the Senbet Discount Tire Company had gross sales of $895,000, The firm's cost of goods sold and selling expenses were $461,000 and $215,000, respectively. The company also had notes payable of $685,000. These notes carried an interest rate of 4 percent. Depreciation was $108,000. The tax rate was 21 percent. a. What was the company's net income? b, What was the company’s operating cash flow? Calculating Total Cash Flows Nightwish Corp. shows the following information on its 2021 income statement: Sales = $336,000; Costs = $194,700; Other expenses = $9,800; Depreciation expense = $20,600; Interest expense = $14,200; Taxes = $21,275; Divi dends = $21,450. In addition, you're told that the firm issued $7,100 in new equity during 2021 and redeemed $5,400 in outstanding long-term debt. What is the 2021 operating cash flow? b, What is the 2021 cash flow to creditors? c. What is the 2021 cash flow to stockholders? 4. If net fixed assets increased by $53,200 during the year, what was the addition to net working capital (NWC)? Using Income Stafements Given the following information for Troiano Pizza Co., calculate the depreciation expense: Sales = $76,800; Costs = $36,900; Addition to retained earnings = $6,800; Dividends paid = $2,370; Interest expense = $5,300; Tax rate = 22 percent. Residual Claims Polska, Inc., is obligated to pay its creditors $10,300 very soon. a. What is the market value of the shareholders’ equity if assets have a market value of $11,600? b. What if assets equal $9,400? Net Income and OCF During 2021, Raines Umbrella Corp. had sales of $865,000. Cost of goods sold, administrative and selling expenses, and depreciation expenses were $535,000, $125,000, and $170,000, respectively. In addition, the company had an inter- est expense of $90,000 and a tax rate of 25 percent. (Ignore any tax loss carryforward provisions and assume interest expense is fully deductible.) a. What is the company's net income for 2021? b, What is its operating cash flow? ¢. Explain your results in parts (a) and (b). ‘Accounting Values versus Cash Flows In Problem 17, suppose Raines Umbrella Corp. paid out $128,000 in cash dividends. Is this possible? If spending on net fixed assets and net working capital was zero, and if no new stock was issued during the year, what do you know about the firm's long-term debt account? Caleulating Cash Flows Martinez Industries had the following operating results for 2021: Sales = $38,072; Cost of goods sold = $27,168; Depreciation expense = $6,759; Interest expense = $3,050; Dividends paid = $2,170. At the beginning of the year, netPARTI Overview 20. (lard acu wore'$22,700, currant asses were $B025cund current ables were $4.51 At the end of the year, net fixed assets were $28,053, curate were $9,904, and current liabilities were $5,261. The tax rate for 2021 was 22 Ps a. What is net income for 2021? 'b. What is the operating eash flow for 2021%, . What is the cash flow from assets for 20: 7 If no new debt was isued during the year, what isthe cash Fo | fo aediand Mat is the cash flow to stockholders? Explain and interpret the posi ens of your answers in parts (a) through (4). Calculating Cash Flows Consider the following Parrothead Enterprises: 2 Is this possible? Explain. abbreviated financial statements for En Soe aie! eA NSr ee seid ED ——___Assets Liabilities and Owners’ Equity Sales seas | = ozo zante Corts 849 2020-2021 7070 woz | CO aa Current assets $1327 $1,438 Current liabilities. $ 530 $ 595| Interest pai 427 | Net fixed assets 5,470 6587 Long-term debt 2,891 3.075 i What is owners’ equity for 2020 and 2021? b. What is the change in net working capital for 2021? c. In 2021, Parrothead Enterprises purchased $2,740 in new fixed assets. How much in fixed assets did Parrothead Enterprises sell? What is the cash flow from assets for the year? The tax rate is 21 percent. 4. During 2021, Parrothead Enterprises raised $554 in new long-term debt. How much longterm debt must Parrothead Enterprises have paid off during the year? What is the cash flow to creditors? Use the following information for Ingersoll, Inc., for Problems 21 and 22. Assume the tax rate is 21 percent. 21. 2. Sales $7,616 $8174 | Depreciation 1094 1,094 Cost of goods sold 2,621 2,975 Other expenses 621 519 Interest 510887 Cash 3.994 5,058 Accounts receivable 4,387 5,955 Short-term notes payable 7m 7 Long-term debt 13,083 15,601 Net fixed assets 33,490 35444 ‘Accounts payable 4195 4068 Inventory 9400 9.660 | Dividends 929 1,022, Financial Statements Draw up an income statement and . for 2020 and 2021. and balance sheet for this company Calculating Cash Flow For 2021, calculate the cash creditors, and cash flow to stockholders. Mlow from assets, cash flow toCHAPTER 2. Financial Statements and Cash Flow am 39 aes 23. Cash Flows You are researching Time Manufacturing and have found the following ‘accounting statement of cash flows for the most recent year. You also know that the company paid $81 million in current taxes and had an interest expense of $38 million. Use the accounting statement of cash flows to construct the financial statement of cash flows. Rate) Statement of Cash Flows (in millions) Operations Net income Depreciation Deferred taxes Changes in assets and liabilities Accounts receivable 12) Inventories 15 Accounts payable 4 Accrued expenses ~6 Other 2 Total cash flow from operations ‘$282 Investing activities Acquisition of fixed assets Sale of fixed assets Total cash flow from investing activities Financing activities Retirement of long-term debt Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total cash flow from financing activities Change in cash (on balance sheet) 24, Net Fixed Assets and Depreciation On the balance sheet, the net fixed assets (NFA) account is equal to the gross fixed assets (FA) account (Which records the acquisition cost of fixed assets) minus the accumulated depreciation (AD) account (which records the total depreciation taken by the firm against its fixed assets). Using the fact that NFA = FA ~ AD, show that the expression given in the chapter for net capital spending, NFAcgg~NFAveg + D (where D is the depreciation expense during the year), is equiva, lent t0 FAgg—FAbey- Excel Master It! Problem 7 Excel Using Excel to find the marginal tax rate can be accomplished using the VLOOKUP function. aX Master However, calculating the total tax bill is a litle more difficult. Below we have shown a copy coverone oxsine of the IRS tax table for an individual for 2021 (the income thresholds are indexed to inflation and change through time)40 PART! Overview ea is [irs a eg Cy URL as (0 § 9950 10% of the amount over $0 9.950 : 401525 $995.00 plus 12% of the amount over $9950 = 40525 86375 $4,664.00 plus 22% of the amount ovel Beet, 86.375 164,925 $14,751.00 plus 24% of the amount over fy 464.925 209,425 $33,603.00 plus 32% of the amount over & A 209,425 523,600 $47,843.00 plus 35% of the amount over Bees) 523,600 $157,804.50 plus 37% of the amount over $523: s than $9,950 is 10 percent. 1 is $995 plus the marginal $9,950 times the marginal In reading this table, the marginal tax rate for taxable income les If the taxable income is between $9,950 and $40,525, the tax bil taxes. The marginal taxes are calculated as the taxable income minus tax rate of 12 percent Below, we have the tax table for a married couple filing jointly: Ceeeaccnets ree acres boa) s ° $ 19,900 19,900 81,050 12 81,050 172,750 22 172,750 329,850 24 329,850 418,850 32 418,850 628,300 35 628,300 37 a. Create a tax table in Excel for a married couple similar to the individual tax table shown above. Your spreadsheet should then calculate the marginal tax rate, the aver- age tax rate, and the tax bill for any level of taxable income input by a user. b. For a taxable income of $265,000, what is the marginal tax rate? c. For a taxable income of $265,000, what is the total tax bill? 4. For a taxable income of $265,000, what is the average tax rate? CASH FLOWS AT WARF COMPUTERS, INC. Wart Computers, Inc, was founded 15 years ago by Nick Warf, a computer programmer. The small initial investment to start the company was made by Nick and his friends. Over the years, this same group has supplied the limited additional investment needed by the company in the form of both equity and short- and long-term debt. Recently the company has developed a virtual keyboard (VK). The VK uses sophisticated artificial intelligence algorithms that allow the user to speak naturally and have the computer input the text, correct spelling and grammatical errors, and format the document according to preset user guidelines. The VK even suggests alternative phrasing and sen- tence structure, and it provides detailed stylistic diagnostics. Based on a proprietary, very advanced software/hardware hybrid technology, the system is a full generation beyond what is currently on the market. To introduce the VK, the company will require significant outside investment, Nick has made the decision to seek this outside financing in the form of new equit investments and bank Joans. Naturally, new investors and the banks will require a detailed financial analysis. Your employer, Angus Jones & Partners, LLC. has asked you to examine the financial statements provided by Nick. Here are the balance sheets for the two most recen years and the most recent income statement; pi cee eam: CHAPTER 2. Financial Statements and Cash Flow = 41 Reo tous. BALANCE SHEETS (in thousands) 2021 2022 Current assets Cash and equivalents $ S16 $ 596 2021 Current liabilities Accounts payable $645 2022 $ 685 Accounts receivable 883 945 Accrued expenses 529 329 Inventories 875 (846 Total current Other 3124 liabilties $ $104 Total current assets $2377 $2508 ong-term liabilities Fixed assets Deferred taxes $ 210 $ 282 Property, plant, and Longsterm debt 1517 _1557 equipment $4197 $5476 Total long-term Less accumulated liabilties $1727 $1839 depreciation 1481 77? gy ; naa fockholders’ equi Net property, plant, and Prefered sock $-25.« $25 equipment $2756 $2699 Common aise Ngee ai nonobese 5 Capital surplus 10271044 oe $36 _1047 accumulated retained Total fixed assets $3,962 $4746 earnings ame 3,414 Less treasury stock __ 166 __253 Total equity $3168 $4,401 Total liabilities and shareholders’ equity $5060. $2254 Total assets Waconia Meera (in thousands) Sales Cost of goods sold Selling, general, and admir Depreciation Operating income Other income eBIT Interest expense Pretax income Taxes Current: $615 Deferred: $72 Net income Dividends: $757 Retained earnings: $1,298 istrative expense Nick also has provided the following information: During the year the company raised $301,000 in new long-term debt and retired $261,000 in long-term debt. The company also sold $22,000 in new stock and repurchased $87,000 in stock. The company purchased $1,955,000 in fixed assets and sold $565,000 in fixed assets. ‘Angus has asked you to prepare the financial statement of cash flows and the accounting statement of cash flows. He also has asked you to answer the following questions: 1. How would you describe Warf Computers's cash flows? 2. Which cash flow statement more accurately describes the cash flows at the company? 3. In light of your previous answers, comment on Nick's expansion plans.