business financecob.ualr.edu/lcholland/finc3310/impatica_files/finstate2r...2. calculating cash...

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Copyright 2004 by Larry C. Holland Slide 1

BUSINESS FINANCE

Financial Statement Analysis

2. Calculating Cash Flows from Financial Statements

Welcome back to the study of Financial Statement Analysis. This presentation is the second in the series and will focus on calculating cash flows from the financial statements.

2


Free Cash Flow to the Firm

Free Cash Flow to Equity

The primary goal in this section is to calculate the Free Cash Flow to the Firm and the Free Cash Flow to Equity. The calculation of these free cash flows will be an important part of calculating the cash flows in the Capital Budgeting topic, and later on for valuation of the firm.

3


Cash Flows:Changes in B/S

and Operating Cash Flow

Since a company goes bankrupt if it runs out of cash, it is important to manage the levels of cash available to the firm. The cash flows in a firm are generated by changes on the balance sheet as well as through operating cash flow from the income statement. We’ll first look at changes in the balance sheet and then develop a more complete method for measuring the cash flows in a firm.

4


Increase in Assets reduces Cash

Increase in Liabilities increases Cash

Increases on the left and right side of the balance sheet change the levels of cash and need to be managed properly to maintain sufficient cash availability. On the asset side, care should be taken on the acquisition of assets in order to preserve cash. Each time we acquire an asset, it reduces the amount of cash available. For example, you might choose to lease a warehouse rather than purchase it as an asset – just to preserve short-term cash. In contrast, an increase in liabilities is a source of cash. Each liability we assume (such as a loan) increases the amount of cash available.

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Sources and Uses of Cash

In this way, changes in the balance sheet over time explain changes in the cash account and can be identified as sources and uses of cash.

6


Balance Sheetas of December 31($ in thousands)

Assets 2003 2004

Current assets

Cash $ 45 $ 50

Accounts receivable 260 310

Inventory 320 365

• Total $ 625 $ 725Fixed assets

Net plant and equipment 985 1100Total assets $1610 $1825

For example, in this balance sheet, the accounts receivable increased from 260 in 2003 to 310 in 2004. This is an increase in an asset and represents a use of cash. Also, the inventory increased from 320 to 365. This is also a use of cash.

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Liabilities and equity 2003 2004

Current liabilitiesAccounts payable $ 210 $ 260Notes payable 110 110

• Total $ 320 $ 370Long-term debt 205 265Stockholders’ equity

Common stock and paid-in surplus 290 269

Retained earnings 795 921Total $1085 $1190

Total liabilities and equity $1610 $1825

On the right side of the balance sheet, the accounts payable increased from 210 in 2003 to 260 in 2004. This is an increase in a liability and represents a source of cash.

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The Capital Balance Sheet

Now that we’ve clarified the sources and uses of cash, lets organize the balance sheet a little differently so that it reflects the managerial decision making process. We call this slightly different view of the balance sheet the Capital Balance Sheet, or sometimes the Managerial Balance Sheet.

9


Debt

Equity

CA

FixedAssets

CL

The Accounting Balance Sheet

First, let’s look at the normal way that a balance sheet is presented in financial statements. This slide shows a conceptual view of a typical Accounting Balance Sheet, which could also be called the Asset Balance Sheet.

10


Debt

Equity

CA

FixedAssets

CL


On the left side of the accounting balance sheet are the current assets at the top

11


Debt

Equity

CA

FixedAssets

CL


and the fixed assets on the bottom.

12


Debt

Equity

CA

FixedAssets

CL


On the right side of the accounting balance sheet are the current liabilities at the top,

13


Debt

Equity

CA

FixedAssets

CL


The long-term debt in the middle,

14


Debt

Equity

CA

FixedAssets

CL


and the equity at the bottom.

15


Debt

Equity

CA

FixedAssets

CL


Decisions affecting the debt and equity of a business generally are not the responsibility of the operating manager. These are normally managed separately by the financial manager in a firm.

16


Debt

Equity

CA

FixedAssets

CL


However, the current liabilities are much more related to the operating part of the business. For example, the accounts payable reflect the relationship of the suppliers to the firm. Thus, it relates more to the operating decisions rather than the financing decisions.

17


Debt

Equity

CA

FixedAssets

CL


If you have noticed so far, the items on the left side of the balance sheet relate to the operating decisions of a firm. And most of the items on the right side of the balance sheet relate to the financing decisions of the firm, with the exception of the current liabilities.

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Debt

Equity

CA

FixedAssets

CL

If we moved the current liabilities to the left side of the balance sheet, then the items on the balance sheet would divide more cleanly from a managerial decision making basis.

19


Debt

EquityFixedAssets

CLCA

Notice on the left side that the current assets minus the current liabilities equals the net working capital.

20


Debt

Equity

NWC

FixedAssets


If we net the current liabilities against the current assets, the top of the left side of the balance sheet becomes the net working capital.

21


Debt

Equity

NWC

FixedAssets


This view of the balance sheet is called the Capital Balance Sheet. On the left are the two major categories for investing cash – net working capital and the fixed capital (or the fixed assets). On the right are the two sources of capital – debt and equity. This conceptual view of the balance sheet will be used several times in the remaining parts of this course.

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We can calculate the cash flows from the Income Statement

and the Balance Sheet.

Now that we have defined the capital balance sheet, we can calculate the cash flows from the Income Statement and the Balance Sheet.

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Debt

Equity

NWC

FixedAssets


Here is our representation of the capital balance sheet again.

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Debt

Equity

NWC

FixedAssets

Capital generates

cash

Conceptually, the net working and fixed capital on the left side of the balance sheet will generate net cash

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Debt

Equity

NWC

FixedAssets

Capital generates

cash

For thecapitalholders

for the capital holders on the right side of the capital balance sheet. We can show this in more detail by presenting a conceptual cash flow diagram before we actually complete a numerical example.

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Debt

Equity

NWC

FixedAssets

Free Cash Flow to the FirmFree Cash Flow to the Firm

Let’s look at the free cash flow to the firm on the left side of the balance sheet.

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Debt

Equity

NWC

FixedAssets

IncomeStatement


First, the net working capital and the fixed capital generate cash in the normal operations of the business, which is measured on the income statement.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

EBIT


On the income statement, the company generates cash in terms of the operating income of the firm, which we usually refer to as Earnings Before Interest and Taxes (or EBIT).

29


Debt

Equity

NWC

FixedAssets

IncomeStatement

EBIT


-Taxes

From EBIT, we also need to subtract taxes. Taxes in this case are a little different from that shown on a standard income statement. As part of the Free Cash Flow to the Firm, taxes should not take into account the deductibility of interest to reduce taxes. So taxes in this case are defined as the tax rate times EBIT. As a short cut, EBIT minus taxes could be calculated as EBIT times one minus the tax rate.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

EBIT

+Depr

-Taxes


And, finally, we need to add back depreciation to arrive at cash flow because depreciation is a non-cash deduction.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

EBIT

+Depr

-Taxes


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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes


The sum of EBIT minus Taxes plus Depreciation is equal to the Operating Cash Flow.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes


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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Net Capital


This isn’t the whole story, though. Some of the operating cash flow must be spent on net capital spending, which is accounted for in fixed assets. This includes the amount the fixed assets were depreciated (this holds capacity at the same level) and adds any new fixed assets (if there is any growth).

35


Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Net Capital


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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital


In addition, if there is any increase in Net Working Capital because of growth, that counts as a use of cash also. This completes the part of the flow diagram which describes the free cash flow to the firm. The free cash flow to the firm equals the operating cash flow minus any net capital spending minus any additions to net working capital. We can now look at how this cash flow is made available to the capital holders on the right side of the balance sheet.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

Free Cash Flow to DebtFree Cash Flow to DebtFree Cash Flow to the Firm =

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Some of the free cash flow to the firm would be made available to the creditors as free cash flow to debt.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Int.(1-t)

The cash flow connection with the creditors has two pieces. First of all, some of the cash is used to make the net interest payment, which is the interest net of tax (or the interest times one minus the tax rate).

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Int.(1-t)

NND


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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Int.(1-t)

NND


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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Int.(1-t)

NND

And second, any new debt issued would add to the cash flow. So the total cash flow to creditors would be the interest payment net of tax minus any net new debt.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

Free Cash Flow to the Firm =Free Cash Flow to EquityFree Cash Flow to Equity

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Div.

The rest of the cash flow from assets would be made available to the shareholders. This cash flow also has two pieces. The first part is the dividend payment, which uses some of the cash.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Div.

NNE


44


Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Div.

NNE


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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Div.

NNE


And second, any new equity issued would add to the cash flow. So the total cash flow to shareholders would be the dividend payment minus any net new equity.

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

Free Cash Flow to DebtFree Cash Flow to the Firm = +

Free Cash Flow to Equity

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

Div.Int.(1-t)

NND

NNE

If we include both the free cash flow to debt and the free cash flow to equity, we have the overall cash flow identity – the free cash flow to the firm equals the free cash flow to debt plus the free cash flow to equity.

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A Numerical Example

We are now ready to use a numerical example to demonstrate the calculation of the various cash flows from the financial statements.

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Equations for Cash Flows

1. The cash flow identityFree Cash flow to the Firm = Free Cash Flow to Debt

+ Free Cash Flow to Equity

2. Free Cash Flow to the FirmFree Cash Flow to the Firm = Operating cash flow

– Net capital spending– Additions to net working capital (NWC)

where:Operating cash flow = Earnings before interest and taxes (EBIT)

– Taxes + Depreciation Net capital spending = Ending net fixed assets

– Beginning net fixed assets+ Depreciation

Change in NWC = Ending NWC – Beginning NWC

3. Free Cash Flow to DebtFree Cash Flow to Debt = Interest paid – Net new borrowing

4. Free Cash Flow to EquityFree Cash Flow to Equity = Dividends paid – Net new equity

This slide shows all the equations we will use for the calculations.

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Assets 2003 2004

Current assets

Cash $ 45 $ 50


Inventory 320 365



And for the example problem, this is the left side of the balance sheet for 2003 and 2004.

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This is the right side of the balance sheet.

51


2004 Income Statement($ in thousands)

Net sales $710Cost of goods sold 380Depreciation 30Earnings before interest

and taxes $300Interest 20Taxable income 280Taxes 112Net income $168

Retained earnings $126Dividends 42

And this is the income statement for 2004.

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Free Cash Flow to the Firm = OCF

- Net Capital Spending- Additions to NWC

We know that the Free Cash Flow to the Firm is equal to the operating cash flow minus net capital spending minus additions to net working capital.

53


Operating Cash Flow = EBIT- Taxes+ Depreciation

The first part of free cash flow to the firm is the operating cash flow, which equals EBIT minus taxes plus Depreciation.

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Operating Cash Flow = EBIT (1-t)+ Depreciation

As a shortcut calculation, the EBIT minus taxes can be calculated as EBIT time one minus the tax rate. The Operating Cash Flow is then equal to EBIT times one minus the tax rate plus Depreciation.

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Net sales $710Cost of goods sold 380Depreciation 30

Earnings before interest Earnings before interest and taxesand taxes $300$300

Interest 20Taxable income 280Taxes 112Net income $168


On the income statement, the EBIT is equal to 300.

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Net sales $710Cost of goods sold 380Depreciation 30

Earnings before interest Earnings before interest and taxesand taxes $300$300

Interest 20Taxable income 280Taxes 112Net income $168


TaxesTaxesx .40 = 120x .40 = 120

Taxes are calculated directly from EBIT. The tax rate in this example is 40%, calculated from 112 divided by 280. Taxes calculated directly on EBIT would then be 300 times .40, or 120. Notice that this is somewhat higher than the taxes on the income statement after deducting interest.

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Net sales $710Cost of goods sold 380

DepreciationDepreciation 3030Earnings before interest Earnings before interest

and taxesand taxes $300$300Interest 20Taxable income 280Taxes 112Net income $168


TaxesTaxesx .40 = 120x .40 = 120

And finally, Depreciation is equal to 30.

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DepreciationDepreciation 3030Earnings before interest Earnings before interest

and taxesand taxes $300$300Interest 20Taxable income 280Taxes 112Net income $168


300300-- 120120

+30 +30 210210

The operating cash flow is then 300 minus 120 plus 30, or 210

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Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow


EBIT

+Depr

-Taxes

Add. NWC

Net Capital

300

+30

-120

210

This slide shows the operating cash flow of 210 and its three components on the cash flow diagram.

60


Free Cash Flow to the Firm:Operating cash flow:Operating cash flow:

EBITEBIT $ 300$ 300-- TaxesTaxes –– 120120+ Depreciation+ Depreciation + 30+ 30

$ 210$ 210

And this shows the calculation in table format. EBIT of 300 minus taxes of 120 plus depreciation of 30 equals 210.

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Free Cash Flow to the Firm:Operating cash flow:

EBIT $ 300– Taxes – 120+ Depreciation + 30

$ 210Net capital spending:Net capital spending:

The second piece of free cash flow to the firm is the net capital spending. Let’s go to the left side of the balance sheet to calculate this.

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Assets 2003 2004

Current assets

Cash $ 45 $ 50


Inventory 320 365


Net plant and equipmentNet plant and equipment 985985 1100Total assets $1610 $1825

In 2003, the fixed assets were 985. Suppose the net capital spending was equal to zero. What would the net fixed assets be at the end of the year?

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DepreciationDepreciation 3030Earnings before interest



We know from the income statement that the depreciation for the year is 30.

64



Assets 2003 2004

Current assets

Cash $ 45 $ 50


Inventory 320 365

• Total $ 625 $ 725Fixed assets 955955


If the net capital spending was zero for the year, the net fixed assets would be 955 by the end of 2004, or 985 less 30 depreciation.

65



Assets 2003 2004

Current assets

Cash $ 45 $ 50


Inventory 320 365

• Total $ 625 $ 725Fixed assets 955955


11001100--955955145145

Since the actual net fixed assets at the end of 2004 was 1100, this implies that the actual net capital spending was 1100 minus 955, or 145.

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$ 210Net capital spending:Net capital spending:

Ending net fixed assetsEnding net fixed assets $ 1,100$ 1,100–– Beginning net fixed assetsBeginning net fixed assets –– 985985+ Depreciation+ Depreciation + 30+ 30

$ 145$ 145

So the formula for calculating the net capital spending is the ending net fixed assets minus the beginning net fixed assets plus depreciation.

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$ 210Net capital spending:

Ending net fixed assets $ 1,100– Beginning net fixed assets – 985+ Depreciation + 30

$ 145Additions to net working capital:Additions to net working capital:

The last piece of free cash flow to the firm is the additions to net working capital. We can find this by first calculating the net working capital for 2003 and 2004.

68



Assets 2003 2004

Current assets

Cash $ 45 $ 50


Inventory 320 365

• Total $ 625$ 625 $ 725$ 725Fixed assets


Net working capital is defined as current assets minus current liabilities. The current assets for 2003 and 2004 are 625 and 725.

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• Total $ 320$ 320 $ 370$ 370Long-term debt 205 265Stockholders’ equity




The current liabilities are 320 for 2003 and 370 for 2004.

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Beginning EndingBeginning Ending

CACA 625 725625 725CL CL --320320 --370370NWC 305NWC 305 355355

Additions to NWC = 355 Additions to NWC = 355 -- 305 = 50305 = 50

Subtracting the current liabilities from the current assets shows that the net working capital was 305 at the beginning of the year and 355 at the end of the year. This means that the additions to net working capital must be 355 minus 305, or 50 for the year

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$ 145Additions to net working capital:

Ending net working capital $ 355– Beginning net working capital – 305

$ 50

This slide shows the additions to net working capital in table format. Again, the additions to net working capital is the ending net working capital minus the beginning net working capital.

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Operating Cash FlowOperating Cash Flow 210210

-- Net Capital SpendingNet Capital Spending --145145

-- Additions to Working CapitalAdditions to Working Capital --5050

Free Cash Flow to the FirmFree Cash Flow to the Firm 1515

The free cash flow to the firm is given by the operating cash flow of 210 minus the net capital spending of 145 minus the additions to net working capital of 50 , for a free cash flow to the firm of 15

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$ 145Additions to net working capital:

Ending net working capital $ 355– Beginning net working capital – 305

$ 50

Free Cash Flow to the Firm: $ 15

This slide shows all the detailed calculations in table format.

74


Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow


EBIT

+Depr

-Taxes

Add. NWC

Net Capital

300300

+30+30

--120120

210210

--145145

--5050

1515

This is the same data shown on the cash flow diagram.

We have shown how to calculate the free cash flow to the firm. Now we can show how this cash flow is connected to those who provide the capital.

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Total Free Cash Flow to Debt and Equity:

Free Cash Flow to Debt:Free Cash Flow to Debt:

The capital holders include the creditors holding debt and the stockholders holding equity. First, let’s find the free cash flow to debt.

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Free Cash Flow to Debt =Interest after tax- Net New Debt

The formula for the free cash flow to debt is the interest after tax minus any net new debt.

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and taxes $300

InterestInterest 2020Taxable income 280Taxes 112Net income $168


x (1x (1--.40) = 12.40) = 12

The interest net of tax is found in the income statement as the interest of 20 times one minus the tax rate of 40%, or 12.

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• Total $ 320 $ 370LongLong--term debtterm debt 205205 265265Stockholders’ equity




The net new debt is found on the balance sheet from the Long-term debt account. The Long-term debt increased from 205 in 2003 to 265 at the end of 2004. Since the Long-term debt increased, there was some net new debt issued.

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• Total $ 320 $ 370LongLong--term debtterm debt 205205 265265Stockholders’ equity




265265--205205

6060

The ending debt of 265 minus the beginning debt of 205 gives a net new debt of 60 in this example.

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Free Cash Flow to Debt:Free Cash Flow to Debt:Interest after taxInterest after tax $ 12$ 12–– Net new debtNet new debt –– 6060

$$ –– 4848

Thus, the free cash flow to debt is the interest net of tax of 12 minus the net new debt of 60, which yields a minus 48 free cash flow to debt.

81


Free Cash Flow to DebtCash Flow to DebtFree Cash Flow to the FirmFree Cash Flow to the Firm =

Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

300300

+30+30

--120120

210210

--145145

--5050

1515

Int.(1-t)

1212

--6060

--4848

And this slide shows the free cash flow to debt on the cash flow diagram.

82



Free Cash Flow to Debt:Interest after tax $ 12– Net new borrowing – 60

$ – 48

Free Cash Flow to Equity:Free Cash Flow to Equity:

Next, we can calculate the free cash flow to equity.

83


Free Cash Flow to Equity =Dividends Paid- Net New Equity

The free cash flow to equity equals the dividends paid minus any net new equity issued.

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Retained earnings $126

Dividends Dividends 4242

The dividends paid can be found on the income statement, in the division of net income into additions to retained earnings and dividends. The dividends are 42 in this example.

85





Common stock and Common stock and paidpaid--in surplusin surplus 290290 269269



And the net new equity is found on the balance sheet from the common stock account. In this example, the common stock decreased from 290 in 2003 to 269 in 2004.

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Common stock and Common stock and paidpaid--in surplusin surplus 290290 269269



269269--290290

--2121

Subtracting the beginning common stock from the ending common stock shows that new equity of -21 occurred, which indicates that this company repurchased stock.

87




$ – 48

Free Cash Flow to Equity:Free Cash Flow to Equity:Dividends paidDividends paid $ 42$ 42–– Net new equity raisedNet new equity raised 2121

$ 63$ 63

So the free cash flow to equity is the dividends paid of 42 minus a minus 21 net new equity, which equals dividends of 42 plus equity repurchased of 21, or free cash flow to equity of 63.

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$ – 48

Free Cash Flow to Equity:Dividends paid $ 42– Net new equity raised 21

$ 63

Free Cash Flow to the Firm $ 15

FCFF = FCFD + FCFF = FCFD + FCFEFCFE15 15 = = –– 48 + 6348 + 63

We can now show the overall balance. The free cash flow to the firm of 15 must equal the free cash flow to debt of minus 48 plus the free cash flow to equity of 63 . And this equation shows they are in balance.

89


Free Cash Flow to DebtFree Cash Flow to DebtFree Cash Flow to the Free Cash Flow to the FIrmFIrm == ++

Free Cash Flow to EquityFree Cash Flow to Equity

Debt

Equity

NWC

FixedAssets

IncomeStatement

Operating Cash Flow

EBIT

+Depr

-Taxes

Add. NWC

Net Capital

300300

+30+30

--120120

210210

--145145

--5050

1515

Int.(1-t)

1212

--6060

--4848

Div.

6363

4242

--2121

This slide shows the cash flow diagram with all the cash flows annotated. Looking at the overall diagram, you can see that there is an overall balance in the equations. The free cash flow to the firm must always equal the free cash flow to debt plus the free cash flow to equity.

Let’s summarize the material we have covered in this presentation.

90


SUMMARY

1. Found source and use of cash from changes in the balance sheet.

First of all, we found the source or use of cash from changes in the balance sheet from one year to the next. An increase in assets is a use of cash, and an increase in liabilities is a source of cash.

91


SUMMARY


2. Created the capital balance sheet.

Second, we adjusted the accounting balance sheet by moving the current liabilities to the left side of the balance sheet. This created the capital balance sheet, with net working capital on the left side of the balance sheet.

92


SUMMARY



3. Developed a cash flow diagram.

Next, we developed a cash flow diagram to conceptually show that the assets on the left side of the balance sheet generate cash for the benefit of the capital holders on the right side of the balance sheet.

93


SUMMARY



3. Developed a cash flow diagram.

4. Calculated the cash flows in a numeric example

And finally, we calculated the cash flows from the financial statements in a numeric example.

You will find in our continuing study of business finance that we place a heavy emphasis on cash flows because a company needs to have sufficient cash to keep the business going. We are ready now for a deeper look at financial statement analysis using financial ratios. But for now, this completes the section on calculating cash flows from financial statements.

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