Financial Management Week 2

CHAPTER 2 OUTLINE
CHAPTER 2
• Financial Statements and Reports
• The Balance Sheet
• The Income Statement
• Statement of Changes in Equity
FINANCIAL STATEMENTS, CASH • Net Cash Flow
• Statement of Cash Flows
FLOW, AND TAXES • Free Cash Flow available for Distribution to
Investors
• MVA and EVA
• Taxes
2-2
Financial Statements and Reports International Financial Reporting

Standards (IFRS)
• A company’s annual report describes the
• Canada adopted IFRS in 2011 for publicly traded
operating results from the past year and new companies.
plans for the coming year with four financial
• Canadian private enterprises were given the
statements:
option to use either IFRS or the Accounting
– Balance sheet Standards for Private Enterprises (ASPE).
– Income statement • We will be referring to IFRS to deal with specific
– Statement of changes in equity accounting issues in this text.
– Statement of cash flows
2-3 2-4
The Balance Sheet The Balance Sheet: Assets

• Also referred to as the statement of financial
position 2013 2012
Cash and equivalents 10 15
• Provides a snapshot of the firm’s financial Short-term investments 0 65
position at a particular point in time Accounts receivable 375 315
• Shows assets on the left side or at the top and Inventories 615 415
Total current assets $1,000 $810
liabilities/equity (i.e. claims against assets) on
Net plant and equipment 1,000 870
the right side or at the bottom Total assets $2,000 $1,680
• Records with book values when assets are
purchased or liabilities are issued
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Implications on Assets Implications on Assets (cont’d)
• All assets are stated in dollars. • Accounts receivable (A/R) is the amount of sales
• Only cash represents the actual money that the customers have not yet paid for.
can be spent. • Inventory shows the dollars the firm has invested
in raw materials, work-in-process, and finished
• Some marketable securities mature very soon
goods available for sale (FIFO vs. WA).
and are called “cash equivalents” and are
included with cash. • Long-term assets can be reported either as
gross/book value and accumulated depreciation
• Other marketable securities have a longer or as net amount (the book value less
time until maturity and are called “short-term accumulated depreciation).
investments.”
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The Balance Sheet: Liabilities Implications on Liabilities and Equity

2016 2015
Accounts payable 60 30 • Accounts payable (A/P) is an obligation the
Notes payable 110 60
firm has to pay its suppliers for its purchases.
Accruals 140 130
Total current liabilities $310 $220 • Notes payable represents loans the firm must
Long-term bonds 754 580 repay within a year.
Total liabilities $1,064 $800 • Accruals are the amount of taxes and wages
Preferred stock (400,000 shares) 40 40
the firm has yet to pay in a year.
Common stock (50,000,000 shares) 130 130
• Long-term bonds reflect a claim held by
Retained earnings 766 710
Total common equity $896 $840
investors other than shareholders.
Total liabilities and equity $2,000 $1,680
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Implications on Liabilities and Equity (cont’d) The Balance Sheet

2013 2012 2013 2012
• Preferred stock is a hybrid between common stock Cash and equivalents 10 15 Accounts payable 60 30
and debt. Short-term

investments
0 65 Notes payable 110 60
• Common stock account records the proceeds the Accounts receivable 375 315 Accruals 140 130
Total current
firm received from selling shares of stock in the Inventories 615 415
liabilities
$310 $220
past. Total current assets

Net plant and
$1,000 $810 Long-term bonds 754 580
1,000 870 Total liabilities $1,064 $800
• Retained earnings are the cumulative amount of equipment
Preferred stock
earnings not paid out as dividends. (400,000 shares)
40 40
• The sum of common stock and retained earnings is Common stock

130 130
(50,000,000 shares)
called “common equity,” or simply “equity,”
Retained earnings 766 710
representing the assets net of the liabilities, or net Total common
$896 $840
worth. equity
Total liabilities and
Total assets $2,000 $1,680 $2,000 $1,680
2-11
equity 2-12
The Income Statement The Income Statement (cont’d)
• Show a firm’s performance over a period of time, • Neither depreciation nor amortization is paid in cash.
such as a month, a quarter, or a year • EBITDA can be a better measure of financial strength than
• EBITDA (earnings before interest, taxes, net income.
depreciation, and amortization) results from • EBITDA is not as important as FCF.
subtracting operating costs from net sales. • Net income (NI, also called profit or earnings) is revenue
• Depreciation and amortization are annual less expenses, taxes, and preferred dividends (before
paying common dividends).
charges reflecting the estimated costs of the
long-term assets used up each year. • EPS (earnings per share) is net income divided by the
number of shares outstanding, also called “the bottom
line.”
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The Income Statement (cont’d) Stock Price and Other Data

2016 2015
Net sales 3,000.0 2,850.0 2016 2015
Op. costs excluding depre. & amort. 2,616.2 2,497.0 Common stock price $23.00 $26.00
EBITDA $383.8 $353.0 # of shares 50,000,000 50,000,000
Depre. & amort. 100.0 90.0 Earnings per share (EPS) $2.27 $2.36
EBIT (operating income) $283.8 $263.0 Dividends per share (DPS) $1.15 $1.06
Int. expense 88.0 60.0 Book value per share (BVPS) $17.92 $16.80
Earnings before taxes (EBT) $195.8 $203.0 Cash flow per share (CFPS) $4.27 $4.16
Taxes (40%) 78.3 81.2
Net income before preferred dividends $117.5 $121.8
Preferred dividends 4.0 4.0
Net Income (NI) $113.5 $117.8
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What Happened to Sales and Net Comprehensive Income in IFRS

Income? • Consists of net income plus other
comprehensive income (OCI)
• Sales increased by over $150 million.
• OCI examples: Unrealized gains or losses in
• Total operating costs shot up. asset value as a result of asset re-
• Interest expenses also went up. evaluation and gains or losses on foreign
• Net income was down. exchange instruments
• The firm paid less tax as a result. • In this text, net income not including OCI is
the essential figure we will be dealing with.
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Statement of Changes in Equity Net Cash Flow (NCF)
• Net cash flow ≠ accounting profit, as some
revenues and expenses are not received or paid
Preferred Common Retained Total
Shares Stock Earnings Equity in cash.
Balance, 12/31/2015 $40.0 $130.0 $710.0 $880.0 NCF = NI – Noncash revenues + Noncash charges
Add: Net income, 2013 117.5 117.5
Less: Dividends paid, 2013 (61.5) (61.5)
• Examples of noncash revenues/charges:
– Depreciation and amortization (largest)
Issuance of stock 0.0 0.0
– Deferred tax payments
Balance, 12/31/2016 $40.0 $130.0 $766.0 $936.0 – Revenue not collected in cash
NCF = NI + Depreciation and amortization
2-19 2-20
Statement of Cash Flows Constructing Statement of Cash

• Summarizes the changes in a firm’s cash
Flows
position • Start with net income from the income statement.
• Adjust net income to reflect noncash revenues
• Separates the firm’s activities into three (subtracting) and expenses (adding).
categories • Calculate the changes for every account on the nearest
– Operating activities two years’ balance sheets.
• An increase in a noncash asset account decreases cash,
– Investing activities while a decrease in such an account increases cash.
– Financing activities • An increase (decrease) in any liability or equity account
increases (decreases) cash.
• Dividend payment and share buyback reduce cash.
2-21 2-22
Statement of Cash Flows: 2016 Statement of Cash Flows: 2016 (cont’d)

Operating Activities
Net Income $117.5
Investing Activities
Adjustments: Cash used to acquire FA (230.0)
Depreciation 100.0 Change in S-T investment 65.0
Change in A/R (60.0) Net cash provided by inv. act. ($165.0)
Change in inventories (200.0)
Change in A/P 30.0
Change in accruals 10.0
Net cash provided by op. act. ($2.5)
2-23 2-24
Statement of Cash Flows: 2013 (cont’d) Summary of Statement of Cash Flows 2013
Financing Activities Net cash provided by op. act. (2.5)

Change in notes payable 50.0 Net cash provided by inv. act. (165.5)
Change in long-term debt 174.0
Net cash provided by fin. act. 162.5
Payment of cash dividends (61.5)
Net cash provided by fin. act. $162.5 Net change in cash ($5.0)
Cash at beginning of year 15.0
Cash at end of year $10.0
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What Can You Conclude from the Free Cash Flow: The Cash Flow
Statement of Cash Flows? Available for Distribution to Investors
• The firm is not generating cash flow in its • Unlike accountants, who are concerned with
operating activities. recording transactions and focus on the firm’s net
• Net CF from operations = –$2.5 million because income, financial managers and analysts
of reduced net income and big increases in emphasize the stream of cash flows that the firm
working capital. will generate now and in the future.
• The firm spent $230 million on fixed assets. • More specifically, they focus on free cash flows
• The firm borrowed heavily and sold bonds to (FCF), the cash flow available for distribution to
meet its cash requirements. all investors after making all investments
• Even after borrowing, the cash account fell by $5 necessary to sustain ongoing operations.
million.
2-27 Copyright © 2017 by Nelson Education Ltd. 2-28
Net Operating Profit After Taxes

(NOPAT)
NOPAT = EBIT(1 – Tax rate)
= Operating income × (1 – Tax rate)
• NOPAT2016 = $283.8 × (1 – 0.4)

= $170.3 million
• NOPAT2015 = $157.8 million
Copyright © 2017 by Nelson Education Ltd. 2-29 Copyright © 2017 by Nelson Education Ltd. 2-30
Net Operating Working Capital Operating Current Assets
(NOWC)
• Operating current assets are the current
NOWC = Operating current assets – Operating assets needed to support operations.
current liabilities
– Op CA include cash, inventory, receivables.
NOWC2016 = ($10 + $375 + $615) – ($60 + $140) – Op CA exclude short-term investments
because these are not a part of operations.
= $800 million
Use (Cash + A/R + inventories) – (A/P + accruals) to

compute NOWC2015.
Operating Current Liabilities Total Net Operating Capital

(Also Called Operating Capital)
• Operating current liabilities are the current
liabilities resulting as a normal part of Total net operating capital = NOWC
operations. + Operating long-term assets
– Op CL include accounts payable and

• Operating long-term assets include land, buildings,
accruals.
factories, equipment, etc.
– Op CL exclude notes payable because this is
• (TN)OC2016 = $800 + $1,000 = $1,800 million
a source of financing, not a part of
operations. • (TN)OC2015 = $585 + $870 = $1,455 million
Alternative to Calculating Total Net Net Investment in Operating Capital

Operating Capital
Total net operating capital = Total investor-supplied capital
• Change in total net operating capital between
– Short-term investments two years:
Total investor-supplied capital = Notes payable – During 2016, MicroDrive made:
+ Long-term bonds • Net investment in operating capital =
+ Preferred stock
+ Common equity (TN) OC 2016 – (TN) OC 2015 =
$1,800 – $1,455 = $345 million
• For MicroDrive, at year-end 2015: total net
operating capital = ($60 + $580 + $40 + $840) –
$65 = $1,520 – $65 = $1,455 million
Free Cash Flow (FCF) vs. Five Uses of FCF
Net Cash Flow (NCF)
• NCF is not the amount of cash flow that management is 1. Pay interest on debt.
completely free to use.
• FCF is the amount of cash available from operations for 2. Pay back principal on debt.
distribution to all investors (including stockholders and 3. Pay cash dividends.
debtholders) after making the necessary investments to
support operations. 4. Buy back stock.
FCF = NOPAT – Net investment in operating capital 5. Buy nonoperating assets (e.g., marketable
• MicroDrive’s FCF in 2016 = securities, investments in other
$170.3 – $345 = –$174.7 million companies, etc.)
• A company’s value depends upon the amount of FCF it
can generate.
Alternative to Calculating FCF Evaluating FCF, NOPAT, and

FCF = Operating cash flow (OCF) Operating Capital
– Gross investment in operating capital • Is a negative free cash flow always bad?
OCF = NOPAT + depreciation • Not necessarily; it depends on why the free cash
Gross investment in operating capital = flow is negative.
Net investment in op. capital + Depreciation • If FCF is negative because NOPAT is negative, it is
a bad sign.
• FCF = ($170.3 + $100) – ($345 + $100)
• There is nothing wrong with a high-growth
• = $270.3 – $445.0
profitable (positive NOPAT) firm having a negative
• = –$174.7 million (same as before) FCF because of making large investments in
• FCF = NOPAT – Net investment in op. capital operating assets to support growth.
Return on Invested Capital (ROIC) The Firm’s Cost of Capital Is 11%.

Did the Growth Add Value?
• A performance measure indicating how much
NOPAT is generated by each dollar of operating • No. The ROIC of 9.46% is less than the WACC
capital. It is one way to determine whether
growth is profitable. of 11%. Investors did not get the return they
require.
ROIC = NOPAT / Operating capital
• Note: High growth usually causes negative FCF
• ROIC2016 = $170.3 / $1,800 = 9.46% (due to investment in capital), but that is fine
if ROIC > WACC.
• Is this enough to cover the firm’s cost of capital?
• Firm had high growth, negative FCF, but a high
ROIC.
Market Value Added (MVA) and Market Value Added (MVA)
Economic Value Added (EVA) • MVA is a measure of the difference between
• The two performance measures were developed the total market value of a firm and its total
book value
to incorporate stock prices into traditional MVA = Market value of stock
accounting data and modified data – Equity capital supplied by shareholders
= (Shares outstanding)(Stock price)
• MVA measures the effects of managerial actions – Total common equity
since the inception of a firm.
• EVA focuses on managerial effectiveness in a
given year.
2013 Imperial Oil MVA

MVA (cont’d) (Assume Market Value of Debt = Book Value of
• If the market value and book value of debt are Debt)
close, that is, • Market value of equity in 2013:
Market value of debt = Debt capital supplied by debtholders – $39.9 billion
• Book value of equity 2013:
• Then MVA is: – $19.5 billion
MVA = Total market value (stock + debt) • MVA2013 = $39.9 – $19.5 = $20.4 billion
– Total investors supplied capital
Economic Value Added (EVA) EVA (WACC = 11% for 2016)

• EVA is an estimate of a business’s true EVA = NOPAT – (WACC)(Capital)
economic profit for the year
EVA2016 = $170.3 – (0.11)($1,800)
• It differs from accounting profit.
= $170.3 – $198.0
• EVA represents the residual income remaining
after the cost of all capital (both debt and = –$27.7 million
equity) has been deducted. Alternatively,
• Accounting profit does not take a charge for EVA = (Operating capital)(ROIC – WACC)
equity capital. EVA2016 = $1,800 × (0.0946 – 0.11)
• EVA measures the extent to which the firm = $1,800 × (–0.0154)
has increased shareholder value. = –$27.7 million
EVA (cont’d) Taxes
• EVA in 2016 was negative primarily because • The value of a firm depends on the stream of
the amount of capital rose more sharply than after-tax cash flows.
NOPAT and the cost of this additional capital • Interest income and dividends are taxed in
pulled EVA down. investors’ hands.
• EVA is typically used to evaluate managerial • Taxes affect both corporations’ and investors’
performance as part of an incentive decision making.
compensation program. • For example, firms prefer to use more debt
than equity while investors are in favour of
equity investment.
Key Features of the Tax Code

• Corporate Taxes
– Rates vary with firm size, location, and type of
income being earned.
– Both the federal and provincial governments
tax companies.
• Individual Taxes
– Rate are progressive.
– Income tax must be paid at the federal and
provincial level.
Features of Corporate Taxes Key Features of Personal Taxes

• A corporation can: • Individuals face progressive tax rates, from
– deduct its interest expenses but not its dividend
payments
15% to 29%.
– carry back losses for 3 years and carry forward losses • The rate on capital gains is one-half the rate of
for 20 years* ordinary income.
– Exclude 100% of dividend income if received from • Dividends consist of a gross-up of the actual
another Canadian corporation
dividend, calculating tax on the grossed-up
*The loss treatment is to avoid penalizing corporations
whose incomes fluctuate substantially from year dividend and then taking a tax credit on the
to year. grossed-up amount.
Summary
• A description of the balance sheet, income

statement, statement of changes in equity,
statement of cash flows
• A presentation of some background
information on cash flows
• A discussion of free cash flow
• An overview of Canadian federal and
provincial income tax system
Copyright © 2017 by Nelson Education Ltd. 2-55

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CHAPTER 2 OUTLINE

Financial Statements and Reports International Financial Reporting

The Balance Sheet The Balance Sheet: Assets

The Balance Sheet: Liabilities Implications on Liabilities and Equity

Implications on Liabilities and Equity (cont’d) The Balance Sheet

and debt. Short-term

past. Total current assets

• The sum of common stock and retained earnings is Common stock

The Income Statement (cont’d) Stock Price and Other Data

What Happened to Sales and Net Comprehensive Income in IFRS

NCF = NI + Depreciation and amortization

Statement of Cash Flows Constructing Statement of Cash

Statement of Cash Flows: 2016 Statement of Cash Flows: 2016 (cont’d)

Financing Activities Net cash provided by op. act. (2.5)

Net Operating Profit After Taxes

• NOPAT2016 = $283.8 × (1 – 0.4)

• NOPAT2015 = $157.8 million

Use (Cash + A/R + inventories) – (A/P + accruals) to

Operating Current Liabilities Total Net Operating Capital

– Op CL include accounts payable and

Alternative to Calculating Total Net Net Investment in Operating Capital

Alternative to Calculating FCF Evaluating FCF, NOPAT, and

Return on Invested Capital (ROIC) The Firm’s Cost of Capital Is 11%.

2013 Imperial Oil MVA

Economic Value Added (EVA) EVA (WACC = 11% for 2016)

Key Features of the Tax Code

Features of Corporate Taxes Key Features of Personal Taxes

• A description of the balance sheet, income

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