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Tfin 2004 03 Cash flows |2August 23, 2004
Financial statements and cash flows
• Objectives for this session
Tfin 2004 03 Cash flows |3August 23, 2004
Levers of Performance
Return on Equity
Return on Invested Capital Leverage
Profit Margin Asset Turnover
Tfin 2004 03 Cash flows |4August 23, 2004
Summarized (managerial) balance sheet
Assets
Fixed assets (FA)
Working capital requirement (WCR)
Cash (Cash)
Liabilities
Stockholders' equity (SE)
Interest-bearing debt (D)
FA + WCR + Cash = SE + D
Working capital requirement : definition
+ Accounts receivable+ Inventories+ Prepaid expenses
- Account payable- Accrued payroll and other expenses
Interest-bearing debt: definition
+ Long-term debt+ Current maturities of long term debt+ Notes payable to banks
Tfin 2004 03 Cash flows |5August 23, 2004
Net Working Capital
• Net working capital can be understood in two ways:
• as an investment to be funded: Current Assets - Current Liabilities
• as a source of financing=Stockholders' equity + LT debt - Fixed Assets
Fixed Assets
Current Assets
Stockholder’s equity
Long term debt
Current liabilities
Net Working Capital
Current ratio: a measure of NWC
Current ratio = Current assets / Current liabilites
Net working capital = Current assets - Current liabilites
Current ratio > 1 NWC > 0
Tfin 2004 03 Cash flows |6August 23, 2004
Net Working Capital vs Working Capital Requirement
• Summarized balance sheet identity:
• FA + WCR + CASH = SE + LTD + STD
• can be written as:
• WCR + (CASH - STD) = (SE + LTD - FA)
• WCR + NLB = NWC
Working Capital
Requirement
Net Liquid Balance
Net Working Capital
Tfin 2004 03 Cash flows |7August 23, 2004
Return on invested capital
• Return on assets (net)= Net income / Total assets• Advantage: fits with DuPont system
• ROE = ROA x Equity multiplier
• Limitation: Net income = EBIT - Interest expense - Taxes
– Depends on capital structure:
• 1. Interest expense: function of interest-bearing debt
• 2. Interest expense : tax deductible
• Preferred measure: Return on Invested Capital (ROIC)
• NB: ROIC = ROA (gross) (1 - Tax rate)
• = ROE of a all equity financed firm
debt bearingInterest equity rs'Stockholde
TaxRate)-EBIT(1ROIC
Tfin 2004 03 Cash flows |8August 23, 2004
Financial leverage
• Financial leverage magnifies ROE only when ROA (gross) is greater than the interest rate on debt.
• Balance sheet: TA = SE + D
• Income statement: NI = EBIT - INT- TAX• Interest expense INT = r D (Interest expense = Interest rate x Interest-bearing debt)
• Taxes TAX = (EBIT - r D) Tc (Taxes = Taxable income x Tax rate)
• Remember : ROIC = ROAgross (1 - Tc)
• ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE)
SE
Dc
TrSE
TA
TAc
TEBIT
SE
NIROE
)1(
)1(
SE
DTrROICROICROE c ))1((
Tfin 2004 03 Cash flows |9August 23, 2004
Sources of Cash Inflow and Cash Outflow
Operating ActivitiesSales of goods and services
Investing ActivitiesSale of fixed assetsSales of LT financial assets
Financing ActivitiesIssuance of stocks and bondsLT and ST borrowing
Operating ActivitiesPurchase of suppliesSelling, general and administrative expensesTax expenses
Investing ActivitiesCapital expenditures and acquisitionsLT financial investments
Financing ActivitiesRepurchage of stocks and bondsRepayment of debtDividend payment
CASH
CF from operating activities
CF from investing activities
CF from financing activities
Tfin 2004 03 Cash flows |10August 23, 2004
Farber.com: a fable
• Starting a local version of Amazon.com
• Initial balance sheet t = 0
Cash 100 Book Equity 100
• Operations year 1: Sell 2 books @ €100 each Buy 2 books @ € 50 each
• Income statement year 1:
Revenue 200
Expenses 100
Net Income 100
• But….cash account = 0 What happened?
Tfin 2004 03 Cash flows |11August 23, 2004
Farber.com: what happened….
• Final balance sheet t = 1
Cash 0 Book Equity 200
Account Receivable 200
• Statement of cash flows: reconciles the two views– Direct method: + Cash collected from customers 0
- Cash payment to suppliers + 100
= Cash flow from operations - 100– Indirect method: Net Income +100
-Working Capital Requirement + 200
= Cash flow from operations -100
No payment from clients Initial Capital + Retained Earnings
Tfin 2004 03 Cash flows |12August 23, 2004
Farber.com: additional complications
• Initial balance sheet t = 0
Cash 100 Book Equity 100
• Operations year 1: Borrow and buy 2d hand computer @ €200 Sell 1 books @ €100 each Buy 2 books @ € 50 each
• Income statement year 1:
Revenue 100
Cost of goods sold 50
Depreciation 100
Interest 10
Net Income -60
• Final cash account -10
Straight-line depreciation
2 years
Tfin 2004 03 Cash flows |13August 23, 2004
Farber.com: details
• Final balance sheet t = 1• Cash -10 Book Equity 40• Account Receivable 100 Debt 200• Inventories 50• Fixed Assets 100• Total 240 Total 240
• Statement of cash flows: direct method
Cash collection from customers 0 (=REV - AR)
-Cash payment to suppliers 100 (=CGS+ INV)
-Cash paid for interest 10
Cash flow from operating activities -110
Cash flow from investing activities -200 (= FA+Dep)
Cash flow from financing activities +200
Change in cash -110
Tfin 2004 03 Cash flows |14August 23, 2004
Farber.com: statement of cash flows - indirect method
• Statement of cash flows
Net Income -60
+Depreciation +100
-Working Capital Requirement + 150
= Cash flow from operations -110
Cash flow from investing activities -200
Debt +200
Cash flow from financing activities +200
Change in cash -110
Tfin 2004 03 Cash flows |15August 23, 2004
Notations
• Income statement
• REV Revenue
• CGS Cost of goods sold
• SGA Selling, general and administrative expenses
• Dep Depreciation
• EBIT Earnings before interest and taxes
• Int Interest expenses
• TAX Taxes
• Tc Tax rate
• NI Net income
•
• Balance sheet
• FA Fixed assets, net
• AR Accounts receivable
• INV Inventories
• CASH Cash & cash equivalents
• SE Equity capital
• LTD Long term debt
• AP Accounts payable
• STD Short-term borrowing
• Statement of retained income
• DIV Dividendes
Tfin 2004 03 Cash flows |16August 23, 2004
Income statement and balance sheet
• Income statement
• EBIT = REV - CGS - SGA - Dep
• TAX = Tc (EBIT - Int)
• NI = EBIT - Int - TAX
• Balance sheet equation
• FA + AR + INV + CASH = SE + LTD + AP + STD
Working capital requirement: WCR AR + INV - AP
=(Current assets - CASH) - (Current liabilities - STD)
Summarised balance sheet:
FA + WCR + CASH = SE + D (D = LTD + STD)
Tfin 2004 03 Cash flows |17August 23, 2004
Cash flow statement : indirect method
FA + WCR + CASH = SE + D
FA = AQ - Dep AQ = Acquisitions - Disposals (investing & divesting)
SE = NI - DIV + KK = New issuance of capital
(NI + Dep - WCR) - (AQ) + (K + D -DIV) = CASH
Cash flow from
operating activities
Cash flow from
investing activities
Cash flow from
financing activities
+ + =
Tfin 2004 03 Cash flows |18August 23, 2004
Statement of cash flows: direct method
+ Cash collection from customers
- Cash payment to suppliers and employees
- Cash paid for interest
- Cash paid for taxes
= Cash flow from operating activities
+ Cash flow from investing activities
+ Cash flow from financing activity
= CASH
REV - AR
CGS + INV + SGA - AP
Int
TAX
(REV-CGS-SGA-Int-TAX)- WCR
-AQ
K + D - DIV
NI+Dep-WCR
(NI + Dep - WCR) + (-AQ) + (K + D - DIV) = CASH
Tfin 2004 03 Cash flows |19August 23, 2004
Free Cash Flow
• Free Cash Flow = Cash flow from operating activities
+ Cash flow from investing activities
• Calculating free cash flows of all equity firm:
Free Cash Flow = EBIT(1-TC) + Dep - WCR - AQ
• Statement of cash flows for all-equity firm:
Free Cash Flow = DIV - K + Cash
Tfin 2004 03 Cash flows |20August 23, 2004
Financial Forecasting
EBITDA-Depreciation=EBIT-Taxes+Net Income
Income Statement
Statement of
Cash Flows
CF from operating activities
UpdateBalance
Sheet
CF from investing activitiesCF from financing activities
Tfin 2004 03 Cash flows |21August 23, 2004
Financial Planning
• Based on ∆Revenues
• Assumptions on key ratios relating Revenues to:
• Gross margin: m = EBITDA /Revenues
• Working capital requirement: w = WCR / Revenues
• Net fixed assets: a = NFA / Revenues
• Financial policy:
• Payout ratio p = DIV/Net Income
• Depreciation d = Depreciation / Fixed Assets-1
• Environment:
• Tax rate TC
• Cost of debt i
Tfin 2004 03 Cash flows |22August 23, 2004
Data
• Revenues year 0: 2,000
• Growth rate year 1: 25%
• Balance sheet end year 0Net Fixed Assets 600
Working Capital Requirement 400
Cash 0
Total Assets 1,000
Book Equity 600
Debt (financial) 400
Total Liabilities + Stockholders’ equity
1,000
Gross margin: m = 30%WCR: w = 20%Net fixed assets: a = 30%Payout ratio p = 50%Depreciation d = 10%Tax rate TC = 40%Cost of debt i = 10%
Tfin 2004 03 Cash flows |23August 23, 2004
Step 1: Income statement
Year 0 Year 1
Sales 2,000 2,500 Rev-1 (1+g)
EBITDA 750 m × Rev
Depreciation 60 d × NFA-1
EBIT 690
Interests 40 i × D-1
Taxes 260
Net Income 390
Tfin 2004 03 Cash flows |24August 23, 2004
Step 2: Statement of Cash Flows
Year 0 Year 1
Net Income 390 From Income Stat.
Depreciation 60 From Income Stat.
∆WCR 100 w × Revenues
CF from operations 350
∆NFA 150 a × Revenues
Depreciation 60
CF from investing -210
Div 195 p × Net Income
Stock Issues/buy back 0 Assumption
∆Debt 55 Plug
CF from financing -140
∆Cash 0
Tfin 2004 03 Cash flows |25August 23, 2004
Step 3: Update balance sheet
Year 0 Year 1
Net Fixed Assets 600 750 NFA-1 + Inv – Dep
Working Capital 400 500 WCR-1 + WCR
Cash 0 0 Cash-1 + Cash
1,000 1,250
Book Equity 600 795 BEq-1+SI + NI – DIV
Debt 400 455 D-1 + D
1,000 1,250
Tfin 2004 03 Cash flows |26August 23, 2004
The Full Model
Year 0 Year 1 Year 2 Year 3 Year 4Income StatementSales 2,000 2,500 3,125 3,906 4,883EBITDA 750 938 1,172 1,465Depreciation 60 75 94 117EBIT 690 863 1,078 1,348Interest Expenses 40 46 52 61Taxes 260 327 410 515Net Income 390 490 616 772Statement of Cash FlowsEarnings 390 490 616 772Depreciation 60 75 94 117Var WCR 100 125 156 195Operating Cash Flow 350 440 553 694Var Net Fixed Assets 150 188 234 293Depreciation 60 75 94 117Cash Flow from Invest -210 -263 -328 -410Dividends 195 245 308 386Var Book Equity 0 0 0 0Var Debt 55 67 83 102CF from Financing -140 -178 -225 -284Var Cash 0 0 0 0Balance SheetFixed assets 600 750 938 1,172 1,465Working Capital 400 500 625 781 977Cash 0 0 0 0 0
1,000 1,250 1,563 1,953 2,441Book Equity 600 795 1,040 1,348 1,734Debt (Financial) 400 455 522 605 707
1,000 1,250 1,563 1,953 2,441
Financial planningSales growth rate 25%Gross margin 30%Depreciation rate 10%Cost of debt 10%Tax rate 40%Payout 50%WC/Sales 20%NFA/Sales 30%
Tfin 2004 03 Cash flows |27August 23, 2004
Sustainable growth
• What growth rate can a company achieve without requirement additional external equity?
Assets = (a+w) Revenues Assets = Book Equity + Debt
• = Book Equity + Book Equity
• = Net Income (1 – Payout)(1 + )
• = (Revenues) (Profit Margin)(1-Payout)(1+ )
• g = Revenues / Revenues
• = (Profit Margin)(1 – Payout)(1+ ) / (a+w)