TOPIC TWO

ACCOUNTING STATEMENTS
and CASH FLOW and
FINANCIAL PLANNING and
GROWTH

The importance of financial

statements
To assess firms current performance
To monitor and control firms
operations
To plan and forecast firms future
performance
These are important not only to firms
managers and existing shareholders,
but also to potential shareholders.

FINANCIAL STATEMENTS
BALANCE SHEET a snapshot of the
firms assets, liabilities and equities
Asset = Liabilities + Shareholders
equity (Owners equity)
Therefore, Owners Equity = Assets Liabilities

Debt vs equity (capital structure):

creditors have first claim on firms cash
flow or asset over shareholders

Balance Sheet
Assets
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses

Fixed Assets
Machinery & Equipment
Buildings and Land

Other Assets
Investments &
patents

Liabilities (Debt) & Equity

Current Liabilities

Accounts Payable
Accrued Expenses
Short-term notes

Long-Term Liabilities
Long-term notes
Mortgages

Equity

Preferred Stock
Common Stock (Par
value)
Paid in Capital
Retained Earnings

FINANCIAL STATEMENTS
Financial leverage: the use of debt in a
firms capital structure. The more debt
a firm has the greater its degree of
financial leverage.
Market value vs Book value: values
shown in balance sheet for firms assets
are book values (historical costs). For
financial managers, the market value of
the stock (shareholders equity) is more
important than the accounting value.

FINANCIAL STATEMENTS
INCOME STATEMENT a measure of the
firms performance over some period of
time.
Sales (Revenue or Turnover)
- Cost of goods sold
- Depreciation
= Earnings before interest and taxes (EBIT)
- Interest paid
= Taxable income (Profit before tax)
- Taxes
= Net profit (Net income or net earnings)

SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses

Income
Statement

OPERATING INCOME (EBIT)

Interest Expense
EARNINGS BEFORE TAXES (EBT)
Income Taxes
EARNINGS AFTER TAXES (EAT)
Preferred Stock Dividends
NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS

FINANCIAL STATEMENTS
STATEMENT OF RETAINED EARNINGS
reports how net income & dividends affect
a companys financial position during the
period
Example: In 2005 retained earnings for M Corp. is
$1,629.
Beginning balance, retained earnings, 2004
$1,320
+ Net Income
$412
- Dividends
$103
Ending balance, retained earnings, 2005
$1,629

FINANCIAL STATEMENTS
STATEMENT OF CASH FLOWS

Financial CASH FLOW

Assets = Liabilities + Shareholders
equity
CF from assets = CF to creditors +
CF to shareholders
This is the cash flow identity
It reflects the fact a firm generates
cash through various activities and
the cash is used to pay creditors or
paid out to the shareholders

Financial CASH FLOW

CASH FLOW FROM ASSETS involves
three components:
1. Operating cash flow cash flow
that results from firms day-to-day
activities of producing & selling
2. Capital spending net spending on
fixed assets
3. Change in net working capital
net change in current assets relative
to current liabilities

Financial CASH FLOW

Operating cash flow (OCF): Revenue
Costs
- Dont include depreciation because
its a non-cash item
- Dont include interest because its a
financing expense
- Include taxes because its paid in
cash
OCF = EBIT + Depreciation - Taxes

Financial CASH FLOW

M. Corp (2005)
Operating Cash Flow
Earnings before interest & taxes (EBIT)
$694
+ Depreciation
65
- Taxes
212
Operating cash flow
547
This is different from accounting definition of
operating cash flow: Net income +
depreciation = $412 + $65 = $477

Financial CASH FLOW

Capital spending: Cash spent on fixed
asset cash received from sale of fixed
assets
At end of 2005, net fixed assets = $1,709.
At end of 2004, it was $1,644. So, $1,709
- $1,604 = $65. However, during the year,
the company wrote off (depreciated) $65
of fixed assets (refer to income
statement). So, So, during the year 2005
the company has spent $1,709 - $1,644 +
$65 = $130 on fixed assets.

Financial CASH FLOW

Ending net fixed assets
$1,709
- Beginning net fixed assets
1,644
+ Depreciation
65
Net capital spending
547
Another name of capital spending is capital
expenditure (CAPEX)

Financial CASH FLOW

Change in net working capital (NWC):
Refer to balance sheet. In 2005 current
assets = $1,403, in 2004 current assets =
$1,112. So during the year, the company
invested $291 in current assets.
Meanwhile, current liabilities were $428 in
2004 & $389 in 2005.
So, NWC in 2005 = $1,403 - $389 = $1,014;
NWC in 2004 = $1,112 - $428 = $684
Ending NWC
- Beginning NWC
Change in NWC

$1,014
684
$ 330

Financial CASH FLOW

CASH FLOW FROM ASSETS = Operating
cash flow net capital spending change
in NWC
Operating cash flow
$547
- Net capital spending
130
- Change in NWC
330
Cash flow from assets
$ 87
Based on cash flow identity earlier, CF from
assets = CF to creditors + CF to
shareholders.
CF from assets sometimes are denoted as

Financial CASH FLOW

CASH FLOW TO CREDITORS = Interest paid
net new borrowing
Refer to income statement. The company
paid $70 in interest to creditors. In balance
sheet, we see that long-term debt increase
by $46 ($454 - $408). So the company
paid out $70 in interest, but borrowed
additional $46.
Interest paid
$70
- Net new borrowing
46
Cash flow to creditors
$24
Cash flow to creditors is also called cash flow
to bondholders.

Financial CASH FLOW

CASH FLOW TO STOCKHOLDERS =
dividends paid - net new equity raised.
Refer to income statement. Dividend paid
to shareholders = $103. Common stock &
paid-in surplus account increased by $40,
so this shows that net new equity raised is
$40.
Dividends paid
$103
- Net new equity raised
Cash flow to shareholders

40
$63

Financial CASH FLOW

CASH FLOW FROM ASSETS = CASH FLOW
TO CREDITORS + CASH FLOW TO
SHAREHOLDERS
Cash flow from assets
=$87
Cash flow to creditors
= $24
Cash flow to shareholders = $63
$87 = $24 + $63

Financial CASH FLOW

CASH FLOW FROM ASSETS = CASH FLOW TO
CREDITORS + CASH FLOW TO
SHAREHOLDERS
CF from assets = Operating CF net capital
spending change in NWC
Operating CF = EBIT depreciation taxes
Net capital spending = Ending net fixed assets
beginning net fixed assets + depreciation
Change in NWC = Ending NWC Beginning
NWC

CF to creditors = Interest paid net new

borrowing

SOURCES & USES OF CASH

Sources of cash
- Decrease in asset
- Increase in liabilities &
shareholders equity
Uses of cash
- Increase in asset
- Decrease in liabilities &
shareholders equity

SOURCES & USES OF CASH

Increase

Decrease

Asset

Use of fund

Source of fund

Liabilities

Source of fund

Use of fund

M Corporation
Balance Sheet
2004

2005

Assets
Current Assets
Cash
Accounts receivable
Inventory

104
455
553

160
688
555

233u
2u

Total

1,112

1,403

Fixed assets
Net plant & equipment

1,644

1,709

Total assets

2,756

3,112

232
196

266
123

34s
-73u

428
408

389
454

46s

65u

Liabilities & Owners Equity

Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Owners equity

Elements of Financial Planning

Model
Investment in new assets
determined by capital budgeting
decisions
Degree of financial leverage
determined by capital structure
decisions
Cash paid to shareholders
determined by dividend policy
decisions
Liquidity requirements

4-34

Financial Planning Process

Planning Horizon - divide decisions into shortrun decisions (usually next 12 months) and
long-run decisions (usually 2 5 years)
Aggregation - combine capital budgeting
decisions into one big project
Assumptions and Scenarios
Make realistic assumptions about important variables
Run several scenarios where you vary the
assumptions by reasonable amounts
Determine at least a worst case, normal case and
best case scenario
4-35

Role of Financial Planning

Examine interactions help management
see the interactions between decisions
Explore options give management a
systematic framework for exploring its
opportunities
Avoid surprises help management
identify possible outcomes and plan
accordingly
Ensure feasibility and internal consistency
help management determine if goals can
be accomplished and if the various stated
4-36
(and unstated) goals of the firm are

Financial Planning Model

Ingredients
Sales Forecast many cash flows depend directly
on the level of sales (often estimated sales growth
rate)
Pro Forma Statements setting up the plan as
projected financial statements allows for
consistency and ease of interpretation
Asset Requirements the additional assets that
will be required to meet sales projections
Financial Requirements the amount of financing
needed to pay for the required assets
Plug Variable determined by management
decisions about what type of financing will be
used (makes the balance sheet balance)
Economic Assumptions explicit assumptions
4-37
about the coming economic environment

Pro Forma Statements

Pro Forma Statements "a financial statement
prepared on the basis of some assumed events
and transactions that have not yet occurred."
Ralph Estes, Dictionary of Accounting (MIT,
Cambridge, 1981, p. 105).
Example: (Fixed asset)

4-38

Actual furniture &

equipment

$350,000

Projected furniture &

equipment purchases

$45,000

Projected depreciation

($35,000)

Projected furniture &

equipment

$360,000

Example: Historical Financial

Statements
Gourmet Coffee Inc.
Balance Sheet
December 31, 2004
Assets 1000 Debt
400

Revenues

2000

Costs

1600

1000 Net Income

400

Equity 600
Total

4-39

1000 Total

Gourmet Coffee Inc.

Income Statement
For Year Ended
December 31, 2004

Example: Pro Forma Income

Statement
Initial Assumptions
Revenues will grow
at 15% (2000*1.15)
All items are tied
directly to sales and
the current
relationships are
optimal
Consequently, all
other items will also
grow at 15%

Gourmet Coffee Inc.

Pro Forma Income
Statement
For Year Ended 2005
Revenues

2,300

Costs

1,840

Net Income

460
4-40

Example: Pro Forma Balance

Sheet
Case I (Plug variable =
dividend)
Equity increases by 15%
Equity becomes 690, so
increases by 90
Net income is 460, so
we know that addition
to retained earnings is
90 (the increase in
equity), while the
balance is paid as
dividend
So dividend = 460 90
= 370

Gourmet Coffee Inc.

Pro Forma Balance Sheet
Case 1
Assets

1,150 Debt
Equity

Total

1,150 Total

4-41

460
690
1,150

Example: Pro Forma Balance

Sheet
Case II (Plug variable
= debt)
Assumption: No
dividends are paid, so
all net income becomes
addition to retained
earnings
So, equity becomes 600
+ 460 = 1,060
To make it balance with
total asset, Debt =
1,150 1,060 = 90
This shows that debt
decreases by 400 90
= 310
So repay debt by 310

Gourmet Coffee Inc.

Pro Forma Balance Sheet
Case 1
Assets
1,150 Debt
90
Equity
Total

1,150 Total

4-42

1,060
1,150

Percent of Sales Approach

Some items vary directly with sales, while others
do not
Income Statement
Costs may vary directly with sales - if this is the case,
then the profit margin is constant
Depreciation and interest expense may not vary directly
with sales if this is the case, then the profit margin is
not constant
Dividends are a management decision and generally do
not vary directly with sales this affects additions to
retained earnings

Balance Sheet

4-43

Initially assume all assets, including fixed, vary directly

with sales
Accounts payable will also normally vary directly with
sales
Notes payable, long-term debt and equity generally do

Example: Income Statement

Tashas Toy Emporium

Tashas Toy Emporium

Income Statement, 2004

Pro Forma Income Statement,

2005
Sales
5,500

% of
Sales
Sales

5,000

Costs

3,300

Costs

3,000

2,200

EBT

2,000

60% EBT
Taxes
40%
Net Income
16%

Taxes
(40%)

800

Net Income

1,200

Dividends

600

Add. To RE

600

4-44

24%

880
1,320

Dividends

660

Add. To RE

660

Assume Sales grow at 10%

Dividend Payout Rate = 50%

Example: Balance Sheet

(Operating at full capacity)

Tashas Toy Emporium Balance Sheet

Current

% of
Sales

Pro
Forma

Current % of
Pro
Sales Forma

ASSETS

Liabilities & Owners Equity

Current Assets

Current Liabilities

Cash

$500

10%

A/R

2,000

40

Inventory

3,000
5,500

Total

$550

$900 18%

$990

2,200 N/P

2,500

n/a

2,500

60

3,300

3,400

n/a

3,490

110

6,050 LT Debt

2,000

n/a

2,000

CS & APIC

2,000

n/a

2,000

RE

2,100

n/a

2,760

4,100

n/a

4,760

Fixed Assets

A/P
Total
Owners Equity

Net PP&E

4,000

80

4,400

Total Assets

9,500

190

10,450

Total
Total L & OE
4-45

9,500

10,250

Example: External Financing

Needed
The firm needs to come up with an
additional $200 in debt or equity to
make the balance sheet balance
TA TL&OE = 10,450 10,250 = 200

Choose plug variable

4-46

Borrow more short-term (Notes Payable)

Borrow more long-term (LT Debt)
Sell more common stock (CS & APIC)
Decrease dividend payout, which
increases the Additions To Retained
Earnings

Example: Operating at Less than

Full Capacity
Suppose that the company is currently operating
at 80% capacity.
Full Capacity sales = 5000 / .8 = 6,250
Estimated sales = $5,500, so would still only be
operating at 88%
Therefore, no additional fixed assets would be required.
Pro forma Total Assets = 6,050 + 4,000 = 10,050
Total Liabilities and Owners Equity = 10,250
10,050 10,250 = -200

Choose plug variable

4-47

Repay some short-term debt (decrease Notes Payable)

Repay some long-term debt (decrease LT Debt)
Buy back stock (decrease CS & APIC)
Pay more in dividends (reduce Additions To Retained
Earnings)

Example: Balance Sheet

(Operating at less than full
capacity)Tashas Toy Emporium Balance Sheet
Current

% of
Sales

Pro
Forma

Current % of
Pro
Sales Forma

ASSETS

Liabilities & Owners Equity

Current Assets

Current Liabilities

Cash

$500

10%

A/R

2,000

40

Inventory

3,000
5,500

Total

$550

$900 18%

$990

2,200 N/P

2,500

n/a

2,500

60

3,300

3,400

n/a

3,490

110

6,050 LT Debt

2,000

n/a

2,000

CS & APIC

2,000

n/a

2,000

RE

2,100

n/a

2,760

4,100

n/a

4,760

Fixed Assets

A/P
Total
Owners Equity

Net PP&E

4,000

80

4,000

Total Assets

9,500

190

10,050

Total
Total L & OE
4-48

9,500

10,250

Growth and External Financing

At low growth levels, internal
financing (retained earnings) may
exceed the required investment in
assets
As the growth rate increases, the
internal financing will not be enough
and the firm will have to go to the
capital markets for money
Examining the relationship between
growth and external financing
4-49

The Internal Growth Rate

The internal growth rate tells us how
much the firm can grow assets using
retained earnings as the only source
of financing.
Using the information from Tashas
Toy Emporium
ROA = 1200 / 9500 = .1263
ROA b
Internal
Growth
Rate

b = retention ratio
1 - ROA b
.1263 .5
b = .5

4-50

1 .1263 .5
6.74%

.0674

The Sustainable Growth Rate

The sustainable growth rate tells us
how much the firm can grow by using
internally generated funds and issuing
debt to maintain a constant debt
ratio. (no new equity issued)
Using Tashas Toy Emporium
ROE = 1200 / 4100 = .2927
ROE b
b = .5
Sustainable Growth Rate
4-51

1 - ROE b
.2927 .5

.1714
1 .2927 .5
17.14%

The Sustainable Growth Rate

In some textbooks, sustainable
growth rate is expressed as
g = b x ROE

4-52

Determinants of Growth
Profit margin operating efficiency
Total asset turnover asset use
efficiency
Financial leverage choice of optimal
debt ratio
Dividend policy choice of how much
to pay to shareholders versus
reinvesting in the firm
4-53