CHAPTER 3 - Financial Statements, CF and Taxes (approx. 50 minutes)
Annual Report: 1) Verbal Section (long) and 2) Financial Statements (short)
Verbal Section: Comprehensive analysis of the company's overall situation, prospects for future, identification of any problems, threats, opportunities, etc.
Financial Section: 1) Balance Sheet, 2) Income Statement, 3) Statement of Retained Earnings and 4) Statement of CFs.
1. BALANCE SHEET (see Figure 3-1 on p. 68 and Table 3-1 on p. 70):
a. Assets listed in order of liquidity.
Liabilities listed in order of maturity.
b. Total Assets (TA) = Debt (D) + Equity (E)
E = TA - D
Notice that if Debt remains constant, any change in asset value (TA) is offset by a change in E. For example, if AR written off as bad debts, TA falls and E falls by the same amount. If TA rises due to inflation, E rises by the same amount.
c. Preferred Stock (PS) vs. Common Stock (CS). PS is a "hybrid" of D (fixed payments) and E (dividends paid out of after-tax income). Liquidation, PS has higher priority than CS, but lower than D.
d. E (Net Worth) = CS + Retained Earnings (RE)
e. Inventory Accounting: Allied uses FIFO (first-in, first-out), consistent with actual practice. LIFO could also be used, difference is important when comparing companies.
f. Depreciation methods, Straight line (SL) vs. Accelerated. Example: $10,000 asset, life of 5 years. SL = $2000/year. Accelerated Depreciation might allow $3500, $3000, $2000, $1000, $500. Firms usually use the fastest depreciation allowable by IRS, and use SL for stockholder reporting. Allied has used accelerated for both.
f. Balance sheet is a snapshot on ONE DAY, December 31, 2005 for Allied. Note that the firm's financial position would be changing daily.
2. INCOME STATEMENT (see Table 3-2, p. 73)
Firm's activity DURING or OVER a period of time (M, Q, A)
SLS - Operating Costs = EBITDA
EBITDA - DEP (Tangible Assets) - AMORT (Intangible Assets) = EBIT (OPERATING INCOME)
EBIT - INT = EBT
EBT - TAX = NI before Preferred DIV
NI - Preferred DIV = NIAT (Net income available to common shareholders)
NIAT = PROFITS = EARNINGS
NIAT - DIV = Retained Earnings (RE)
----------------------------------------------
Per-Share Data (see p. 73)
Price (P) = Market Price of Stock
EPS = NIAT / # Shares
BVPS = E / # Shares
CFPS = (NIAT + DEP + AMORT) / # Shares
3. STATEMENT OF RETAINED EARNINGS (RE), see Table 3-4, p. 79
RE (2004) + NIAT (2005) - DIV (2005) = RE (2004)
Allied: $750m + $117.5m - $57.5m = $810m
CFAT (Emphasized in Finance) vs. NIAT (Emphasized in Accounting)
Asset Values and Firm Values are determined by CFAT, not NIAT.
CFAT = NIAT + DEP + AMORT
DEP and AMORT are added back to NIAT, because they are NON-CASH expenses, to calculate CFAT.
Example: $100 EBITDA
(20) DEP
$80 EBT
(30) TAX (37.5%)
$50 NIAT
+$20 DEP
$70 CFAT
CASH ONLY: CASH IN (+CF), CASH OUT (-CF):
$100 (EBITDA) - $30 (TAX) = $70
+CF -CF CFAT
For Allied (p. 75): $117.5m + $100 = $217.5m
NIAT DEP CFAT
4. STATEMENT OF CFs (or Sources and Uses of CASH)
CFAT (Net CF) = amount of cash a business generates for its shareholders in a year. CF may be used to pay DIV, increase INV, finance AR, invest in FA, reduce D, buy back CS. Statement of CFs is determined by:
a. +CF (-CF) usually leads to an increase (decrease) in CASH (balance sheet item).
NOTE: +CF (CASH IN) = SOURCE OF CASH, and -CF (CASH OUT) = USE OF CASH.
b. Changes in Working Capital (WC) = ΔCurrent Assets (CA) - ΔCurrent Liabilities (CL).
General Rules: i) Increases in non-cash CA (AR and INV) decrease CASH; and decreases in non-cash CA (AR and INV) increase CASH. Example: Car dealer - If INV of vehicles increases, it requires CASH to buy the inventory and would be a USE (decrease) of CASH; if INV of vehicles decreases, the firm generates CASH by selling off INV and not replacing, which would be a SOURCE (increase) of cash.
ii) Increases in CL such as AP increase CASH because the firm has additional credit from suppliers which saves cash (SOURCE OF CASH), Decreases in AP decrease CASH, because the firm has used cash to pay off its suppliers (USE OF CASH).
c. FA - An increase (investment) in FA (Property, plant) requires CASH (-CF or USE OF CASH), and a decrease (sale) of FA increases CASH (+CF or SOURCE OF CASH).
d. Security Transactions and DIV pmts. Issuing stocks or bonds will increase CASH (+CF, SOURCE OF CASH). Payments of DIVs reduce CASH (-CF or USE OF CASH). If firm buys back outstanding stock or bonds, this will decrease CASH (-CF or USE OF CASH).
Three Sections of the Statement of CFs:
1. Operating Activities: NIAT, DEP, Changes in CA (AR and INV) and CL (AP) other than cash and short-term debt.
2. Investing Activities: Increases or decreases in FA.
3. Financing Activities: Issuing D (bonds, loans) or E (stock), DIV payments, any buyback of stocks or bonds.
See Table 3-3 on p. 77.
CF from Operating Activities: ($2.5m)
CF from Investing Activities: ($230.0m)
CF from Financing Activities +$162.5m
CHANGE IN CASH ($70.0m)
CASH (2004) $80m - $70m (-CF) = $10m CASH (2005)
Concern: Allied had -CF of $2.5m from operations, it spent $230m on new fixed assets (property, plant and equipment), paid $61.5m in DIV, it borrowed heavily ($224m for bonds and notes payable), and it sold off most of its marketable securities.
FEDERAL INCOME TAX SYSTEM
Taxable income over Not over Tax rate
$ 0 $ 50,000 15%
50,000 75,000 25%
75,000 100,000 34%
100,000 335,000 39%
335,000 10,000,000 34%
10,000,000 15,000,000 35%
15,000,000 18,333,333 38%
18,333,333 .......... 35%Federal Income Taxes are progressive.
State Tax: Michigan imposes a single business tax (sometimes described as a business activities tax or value added tax) of 1.9% on the sum of federal taxable income of the business, compensation paid to employees, dividends, interest, royalties paid and other items.
Personal (Individual) Income Taxes (2003) go from 10% to 35% for federal, 4% flat tax for Michigan.
Interest Paid is a tax-deductible expense for corporations. Interest paid by individuals (car loans, student loans, credit cards, etc.) can NOT be deducted, except for interest payments for mortgages on your primary residence, and one additional home. Interest only is deductible, not principal payments.
Interest Earned is taxable income, except for interest on tax-free municipal bonds issued by state and local governments, and only for state residents.
Dividends Paid by corporations are not tax-deductible to the firm, and must be paid out of after-tax income (NIAT). If a firm pays 40% combined federal-state taxes, has $10m in EBT, it could pay out $10m of interest but only $6m in DIV ($10m - $4m Tax = $6m). Note that this tax treatment creates a bias in FAVOR of debt, and a bias AGAINST equity, because debt is tax-deductible. Why might this be a problem?
Dividends Received. Tax changes in 2003 have partially addressed the issue of double taxation, with a maximum tax rate now on DIV income of 15%.
Capital Gains are profits from the sale of investment assets/securities (stocks, bonds, real estate) held for more than one year. Example: Buy Microsoft for $10,000 and sell for $15,000 several years later, you have a cap gain of $5,000. Staring in 2003, cap gains are taxed at a maximum of 15%, like DIV. Before 2003, the max on cap gains was 20%, and DIV income was taxed as ordinary income, up to 38.6% max. This difference in tax treatment of DIV and Cap Gain income also created a bias in FAVOR of cap gains and AGAINST paying DIV. For example, if a firm has $1m in profits (NIAT) and pays DIV, the shareholders pay up to 38.6% on DIV income. If the firm keeps the $1m as RE and invests in the business, the value of the firm should increase by $1m or more, and the stock price will rise. Investors can sell some or all of their stock to get cash, and get taxed at a lower tax rate (20% before 2003).
Depreciation. Straight line vs. Accelerated. A capital asset (property, plant, equipment, computers, vehicles) is usually depreciated over its useful life, according to straight line depreciation. Example: $100,000 machine that will last for 10 years, DEP = $10,000 per year. As part of fiscal tax policy that is intended to encourage capital spending/investment, Congress often allows "accelerated" methods of depreciation. For example, the $100,000, 10-year machine might qualify for accelerated 5 year DEP, so the firm can deduct $20,000 per year, reduce taxable income, reduce taxes paid, and increase CFAT. Or accelerated depreciation can be "front-end loaded," with more depreciation allowed in early years, e.g., 40%, 30%, 15%, 10%, 5% (vs. 20% in each year).