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Financial Statements and Free Cash Flow. Cash is King!. Investors care about cash flow. It is worth going to a lot of trouble to disentangle cash flow from published financial statements. Annual report has 4 parts 1. Balance Sheet Income Statement Statement of Cash Flows

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Financial Statements and Free Cash Flow

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Financial statements and free cash flow l.jpg

Financial Statements and Free Cash Flow

DES Chapter 3


Cash is king l.jpg

Cash is King!

  • Investors care about cash flow.

  • It is worth going to a lot of trouble to disentangle cash flow from published financial statements.

DES Chapter 3


Annual report has 4 parts 1 l.jpg

Annual report has 4 parts1

  • Balance Sheet

  • Income Statement

  • Statement of Cash Flows

  • Statement of Shareholders’ Equity

    1And of course, the footnotes

DES Chapter 3


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GAAP

  • Statements prepared according to GAAP are reasonably consistent from firm-to-firm.

  • But the standard measures (earnings per share, net change in cash, net income, and return on equity) are not sufficient for valuation purposes.

DES Chapter 3


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Accruals

  • Part of the problem with GAAP is accruals

    • Accrual basis

    • Matching principle

      When does cash come in and go out, versus when are these cash flows recognized?

DES Chapter 3


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The Balance Sheet

  • Assets

    • Accounts receivable (AR)—money owed to ACME by customers who purchased on credit terms

    • Inventory

    • Long-term assets, like property, plant and equipment (PPE).

    • Accumulated depreciation—is subtracted from gross PPE to get net PPE.

DES Chapter 3


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2007

2008

2009

Cash

37.30

41.40

45.12

Inventory

522.14

579.58

631.74

Accounts receivable

932.40

1,034.96

1,128.11

Total current assets

1,491.84

1,655.94

1,804.98

Gross PPE

2,619.28

3,031.40

3,443.32

Accumulated depreciation

754.48

961.47

1,187.09

Net PPE

1,864.80

2,069.93

2,256.23

Total assets

3,356.64

3,725.87

4,061.20

Acme's Balance Sheet: Assets

DES Chapter 3


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The balance sheet…

  • Liabilities and owners’ equity

    • Accrued expenses

    • Short-term debt

    • Long-term debt

    • Common stock

    • Retained earnings

DES Chapter 3


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Accounts payable

372.96

413.99

451.24

Accrued expenses

186.48

206.99

225.62

Short

-

term debt

183.19

285.90

381.71

Total current liabilities

742.63

906.88

1,058.57

Long

-

term debt

1,000.00

1,000.00

1,000.00

Total liabilities

1,742

.63

1,906.88

2,058.57

Common stock

500.00

600.00

600.00

Retained earnings

1,114.01

1,218.99

1,402.63

Total common equity

1,614.01

1,818.99

2,002.62

Total liabilities and equity

3,356.64

3,725.87

4,061.20

Acme's Balance Sheet: Liabilities

200720082009

DES Chapter 3


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The Income Statement

  • Sales

  • Expenses

    • Cost of goods sold (COGS)

    • Sales, general, and administrative (SGA)

    • Depreciation

  • Net income and additions to R.E.

DES Chapter 3


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2007

2008

2009

Sales

3,729.60

4,139.86

4,512.44

Costs of Goods Sold

2,312.35

2,566.71

2,797.71

Sales, General and Administrative

745.92

827.97

902.49

Depreciation

186.4

8

206.99

225.62

Operating Profit

484.85

538.18

586.62

Interest expense

88.05

96.49

105.73

Earnings Before Taxes

396.80

441.70

480.89

Taxes

158.72

176.68

192.36

Net Income

238.08

265.02

288.53

Acme's Income Statement

DES Chapter 3


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Income statement items…

  • Sales

    • Only reflects products or services defined (according to GAAP) as sold, net of items returned.

  • Expenses

    • Cost of Goods Sold (COGS)

      • These are direct costs of producing products or services that were sold during the period

    • Sales, general and administrative expenses (SGA)

      • Hard to attribute these expenses to a specific item. E.g. marketing, insurance, salaries of executives.

DES Chapter 3


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Income statement items…

  • Expenses continued…

    • Depreciation

      • Not a cash expense. Is the recognition of money that was spent years ago on capital assets.

    • Operating profit = Sales – COGS – SGA – Depreciation.

  • Interest expense

    • Interest paid on debt.

  • Earnings before taxes

    • Operating profit minus interest expense

  • Taxes

  • Net income

    • Earnings before taxes minus taxes

DES Chapter 3


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Statement of shareholder's equity

  • Net Income

  • Dividends

  • Stock issues

  • Stock repurchases

DES Chapter 3


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2008

2009

Balance as of December 31 of previous year

1,614.01

1,818.99

N

et Income

265.02

288.53

Dividends on Common Stock

(160.04)

(104.88)

Issuance of Common Stock

100.00

0.00

Common Stock Repurchases

0.00

0.00

Balance as of December 31

1,818.99

2,002.62

Acme's statement of shareholders' equity

DES Chapter 3


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Statement of Cash Flows

  • Because of accrual accounting, not everything on the income statement represents a cash flow—the statement of cash flows corrects for this.

  • 3 parts:

    • Cash flow from operating activities

    • Cash flow from investing activities

    • Cash flow from financing activities

  • Net cash flow

DES Chapter 3


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Cash flow from operating activities

  • Sources of cash flow:

    • Net income

    • Depreciation, because it was deducted from net income, but it really wasn’t a cash expense, so it is added back in.

    • If liabilities go up, it is like borrowing more, so it is a source of cash—so increases in accounts payable and increases in accruals are sources of cash.

DES Chapter 3


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Cash flow from operating activities

  • Uses of cash flow

    • If assets go up, that represents an expenditure (in order to pay for the asset), and so cash goes down. So if inventory increases, it required a use of cash flow to pay for it, so increases in inventory and accounts receivable are subtracted.

DES Chapter 3


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Accounts receivable

  • Accounts receivable deserve a bit more discussion:

    • An account receivable represents money for goods sold that the company has not yet received. So the company is basically lending the customer the money for the goods. It takes cash to make a loan, so if the company’s accounts receivable increase, it is a use of cash.

DES Chapter 3


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Cash flow from operating activities

  • Net cash from operating activities is the sum of these items. In 2009, ACME generated cash of $424.72 million from its operating activities, despite the fact that it had net income of only $288.53 million. The difference comes mainly from depreciation. Asset and liability changes account for the rest.

DES Chapter 3


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2008

2009

Operating Activities

Net Income

265.02

288.53

Depreciation & Amortization

206.99

225.62

Change in Inventory

(57.44)

(52.16)

Change in Account

s Receivable

(102.56)

(93.15)

Change in Accounts Payable

41.03

37.25

Change in Accruals

20.51

18.63

Net cash from operating activities

373.55

424.72

Acme's statement of cash flows

DES Chapter 3


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Investing activities

  • Companies use their cash to purchase fixed assets. These purchases show up here. In 2009 Acme used $411.92 million to purchase fixed assets. This was a use of cash so it shows up as a negative number.

DES Chapter 3


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Financing activities

  • The money (other than that provided by operations) has to come from somewhere—this section tells where.

    • If short-term or long-term debt or common stock increases, then cash goes up.

    • If the company retires debt or repurchases common stock, then cash goes down.

    • Cash goes down when dividends are paid.

DES Chapter 3


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2008

2009

DES Chapter 3


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Adding them up…

  • The sum of cash flow from operations, investing activities, and financing activities represents the total change in cash. If this sum is positive, then the total amount of cash the company has goes up. For ACME, cash went up by $3.72 million in 2009.

DES Chapter 3


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Net cash flow

20082009

Net cash from operating activities373.55424.72Net cash from investing activities-412.12-411.92Net cash from financing activities42.76-9.08Net cash flow (net change in cash)4.103.72

Starting cash37.2041.40Ending cash41.4045.12

DES Chapter 3


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Acme’s free cash flow

  • Free cash flow is cash potentially available for distribution to stockholders and creditors:

    • Dividends and stock repurchases

    • Interest and principal payments

DES Chapter 3


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Free cash flow calculation

  • FCF calculated as

    • NOPAT – investment in operating capital

      For 2009:

      NOPAT2009 = Operating profit – taxes on o.p.

      =$586.62(1 – 0.40) = $351.97

DES Chapter 3


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FCF calculation

  • Net operating working capital:

    • NOWC2009 = (cash + inventory + AR) – (AP + Accrued expenses) = $1,128.11

  • Total operating capital in 2009:

    • = NOWC + net long-term operating capital (which is PPE for ACME)

    • = $1,128.11 + $2,256.23 = $3,384.34

    • TOC in 2008 is $3,104.89

DES Chapter 3


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FCF calculation

  • FCF = NOPAT – net investment in operating capital

    • = $351.97 – ($3,384.34 - $3,104.89)

    • = $72.52 million

DES Chapter 3


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Operating profit

484.85

538.19

586.6

2

Tax on operating profit

193.94

215.28

234.65

NOPAT

290.91

322.91

351.97

Operating current assets

1,491.84

1,655.94

1,804.97

Operating current liabilities

559.44

620.98

676.86

NOWC

932.40

1,034.96

1,128.11

Total operating capital

2,797.20

3,104.89

3,384.34

Investment in total net operating capital

307.69

279.45

FCF

15.22

72.52

Acme's Free Cash Flow

2007

2008

2009

DES Chapter 3


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Uses of FCF

  • How was this $72.52 million used?

    • Paid $106 million to debtholders in interest—but after-tax amount was only $64 million because it is deductible.

    • Paid $105 million in dividends.

    • For a total of $169 million, which is quite a bit more than its FCF of $73 million. It borrowed the rest, for a total new borrowing of $169 - $73 = $96 million.

DES Chapter 3


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Financing approach to calculating FCF

  • FCF = After-tax interest expense – Net CF from financing activities

    = $63.44 – (-9.08) = $72.52

DES Chapter 3


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Acme’s operating performance

  • ROIC = NOPATt/Capitalt-1

  • ROIC2008 = NOPAT2008/Capital2007

    = $322.91/$2,797.2

    = 11.5%

  • ROIC2009 = NOPAT2009/Capital2008

    = $351.97/$3,104.89

    = 11.3%

DES Chapter 3


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Is this good or bad?

  • If ROIC is greater than the cost of capital (WACC) then ACME is adding value. Since WACC is 10%, ROIC shows that ACME is earning more than its investors require.

DES Chapter 3


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