Accounting and Finance

P.V. Viswanath

For use with

Fundamentals of Corporate Finance

Brealey, Myers and Marcus, 4th ed.

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Key Concepts and Skills

Know the difference between book value and market value

Know the difference between accounting income and cash flow

Know the difference between average and marginal tax rates

Know how to determine a firm’s cash flow from its financial statements

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Chapter Outline

The Balance SheetThe Income StatementTaxesCash Flow

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The Balance Sheet

The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time

Assets are listed in order of liquidity Ease of conversion to cash Without significant loss of value

Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity

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The Balance Sheet

Current AssetsCash & SecuritiesReceivablesInventories

+

Fixed AssetsTangible AssetsIntangible Assets

Current LiabilitiesPayablesShort-term Debt

+

Long-term Liabilities

+

Shareholders’ Equity

=

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Pepsico Inc. Balance Sheet (in mil. $)

28-Dec-02 29-Dec-01 28-Dec-02 29-Dec-016,052 4,998Cash And

Cash 1,638 683 Accounts Payable 5,490 3,484Short Term Investments 207 966 Short/Current Long Term Debt 562 354Net Receivables 2,531 2,142 Other Current Liabilities -   1,160Inventory 1,342 1,310 6,052 4,998

Other Current Assets 695 752 2,187 2,6516,413 5,853 5,937 5,398

2,611 2,871 14,176 13,0217,390 6,876 30 433,631 3,374 9,268 8,6051,588 1,467 9,298 8,6741,841 1,254

23,474 21,695 Tot Liabs & Shareholders' Equity 23,474 21,695

Total Current AssetsLong Term InvestmentsProperty Plant and Equipment

Assets

Current Assets

Total Assets

GoodwillIntangible AssetsOther Assets

Total Stockholder Equity

Liabilities

Common Stock & Other Paid-up CapitalRetained Earnings

Total Liabilities

Long Term DebtOther long-term liabilities

Current Liabilities

Total Current Liabilities

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Market vs. Book Value

The balance sheet provides the book value of the assets, liabilities and equity.

Market value is the price at which the assets, liabilities or equity can actually be bought or sold.

Market value and book value are often very different. Why?

Which is more important to the decision-making process?

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Market Value vs. Book Value

Example

According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion.

Q: What is the market value of your assets?

A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion.

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Market Value vs. Book Value

Example

Book Value Balance Sheet

Assets = $10 bil Debt = $4 bil

Equity = $6 bil

Market Value Balance SheetAssets = $11.5 bil Debt = $4 bil

Equity = $7.5 bil

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Income Statement

The income statement is more like a video of the firm’s operations for a specified period of time.

You generally report revenues first and then deduct any expenses for the period

Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue

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Income Statement Pepsico Inc. (in mil. $)

I ncome Statement Dec 02 Dec 01

Revenue 25,112.00 26,935.00

Cost of Goods Sold 10,523.00 9,837.00

Gross Profit 14,589.00 17,098.00

SG&A Expense 8,523.00 11,608.00

Depreciation & Amortization 1,112.00 1,082.00

Operating Income 4,954.00 4,408.00

Nonoperating Income 316 227

Nonoperating Expenses 178 219

I ncome Before Taxes 4,868.00 4,029.00

I ncome Taxes 1,555.00 1,367.00

Net Income After Taxes 3,313.00 2,662.00

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Taxes

Marginal vs. average tax rates Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income

Income before taxes was $4868 and $4029 and taxes were $1555 and $1367 for 2002 and 2001 resp. (in mil. $)

The average tax rates were 31.94% and 33.93%.

However, the tax paid on an additional dollar of income in either year would have been 35%, considering that in 2002, any income over $18 mil. was taxed at a rate of 35%.

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Statement of Cashflows

A firm’s cashflows can be quite different from its net income. For example: The income statement does not recognize capital

expenditures as expenses in the year that the capital goods are paid for. Those expenses are spread over time as a deduction for depreciation.

The income statement recognizes revenues and expenses when sales are made, even though the money may not have been collected (revenues) or paid out (expenses).

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The Statement of Cashflows

The statement of cashflows shows the firm’s cash inflows and outflows from Operations Investments and Financing

The form of this statement is determined by accounting standards.

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Statement of Cash Flows:Operating Activities

Operating activities are earnings-related activities.  Generally these relate to Income Statement activities, and items included in working capital.  Included are:

Sales and expenses necessary to obtain sales Related operating activities, such as extending credit to

customers investing in inventories obtaining credit from suppliers payment of taxes insurance payments Other activities that don't easily fit into the other two

categories, such as settlements in lawsuits.

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Statement of Cash Flows:Investing and Financing Activities

Investing activities relate to  the acquisition and disposal of noncash assets: assets which are expected to generate income for the company over a period of time.  These include lending funds and collecting on these loans.

Financing activities relate to the contribution, withdrawing and servicing of funds to support business activities.

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Pepsico Inc. (in mil. $)Statement of Cash Flows 2002

3,313

1,112-390-260704-53201

4,627

-1,437757153

-527

-1,041-1,734-404

-3,17934

$955

Net IncomeOperating Activities, Cash Flows Provided By or Used In

Changes In InventoriesChanges In Other Operating ActivitiesTotal Cash Flow From Operating Activities

DepreciationAdjustments To Net IncomeChanges In Accounts ReceivablesChanges In Liabilities

Other Cashflows from Investing ActivitiesTotal Cash Flows From Investing Activities

Investing Activities, Cash Flows Provided By or Used InCapital ExpendituresInvestments

Change In Cash and Cash Equivalents

Total Cash Flows From Financing ActivitiesEffect Of Exchange Rate Changes

Financing Activities, Cash Flows Provided By or Used InDividends PaidSale Purchase of StockNet Borrowings

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An alternate way of defining cashflows

Sometimes we are interested in defining cashflows for other purposes, such as project evaluation. Or we may interested in how cash is generated from the use of assets and how it is paid to those that finance the purchase of the assets

For this purpose, we separate cashflows into flows from assets and flows to shareholders and creditors.

We are interested in whether cashflows refer to investments, in the sense that they expand the asset base and are ultimately reflected in the balance sheet; or to operating returns from the use of assets, which are reflected in the income statement.

This differs from the GAAP oriented categorization of cashflows in the Statement of Cashflows.

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Cashflows from Assets

Since increases in working capital are increases in investments, they are not relevant for the determination of cashflows pertaining to recurring returns from the use of assets. A definition of Operating Cashflow for project evaluation purposes becomes: Operating Cashflow = EBIT + Depreciation – Taxes.

The other items that appear in the Cashflows from Operations category in the Statement of Cashflows, e.g. change in accounts receivable are, really, short-term investments. We define these separately as Change in Working Capital.

Finally, we have Net Capital Spending or long-term investments. Together, we have

Cashflows from Assets = Operating Cashflow – Change in Working Capital – Net Capital Spending.

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An alternative definition of cashflows

Interest

Dividends

Operating Cashflow

Assets Liabilities

Current Assets – Current Liabilities

Fixed Assets Equity Paid-in capital

Debt

Retained Earnings

CF to Stockholders

CF to Debtholders

Net Capital Spending

Change in WC

Income Statement

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Cash Flow From Assets

Definition:Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

Identity:Since cashflows from assets have to equal cashflows from liabilities, we have:Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

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An alternative definition of cashflows

Operating Cashflows– recurring cashflows generated by the use of assets

Δ (Net Working Capital) and Net Capital Spending are investment outlays to build up the assets that generate cashflows.

Cashflows to Stockholders and Cashflow to Bondholders are how the investments are funded.

The division of cashflows into operating cashflows and new investments in assets is important in forecasting future cashflows. Investments in assets are the drivers and operating cashflows are the result of this investment.

New investment and forecasted growth in operating cashflows need to be consistent with each other.

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An alternate way of defining cashflows: Summary

I. The Cashflow identity:Cashflow from assets = Cashflow to creditors + cashflow to stockholders

II. Cashflow from assets = Operating Cashflow - Net Capital Spending - Change in Net Working Capital (NWC)whereOperating Cashflow = EBIT + Depreciation – Taxes

Net Capital Spending = Δ (Net Fixed Assets) + Depreciation (approximately)III. Cashflow to creditors = Interest paid – Net new borrowingIV. Cashflow to stockholders = Dividends paid – Net new equity raised

Because data in the firm’s public financial statements are aggregated, it is often difficult to recover the quantities above without access to more detailed firm accounts.

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Example: US Corporation Balance Sheet Information

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US Corporation Income Statement Information

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Cashflow to Assets: Computation

Operating Cash Flow (I/S) = EBIT + depreciation – taxes = $547

Net Capital Spending ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130

Changes in Net Working Capital (B/S) = ending NWC – beginning NWC = $330

Cash Flow From Assets (CFFA) = 547 – 130 – 330 = $87

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Cashflow to Stockholders/Creditors

CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24

CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63

CFFA = 24 + 63 = $87

As we saw before, this is the same amount that we computed for Cashflow from Assets

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Quick Quiz

What is the difference between book value and market value? Which should we use for decision making purposes?

What is the difference between accounting income and cash flow? Which do we need to use when making decisions?

What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

How do we determine a firm’s cash flows? What are the equations and where do we find the information?