CHAPTER 2 - FINANCIAL STATEMENTS, CASH FLOW AND TAXES
Point 1. Most financial and managerial decisions are based on, or include, information from the firm's financial statements, which are based on the firm's accounting records. CHs 2 and 3 review: a) financial statements and b) financial statement (ratio) analysis.
Point 2. Value of any asset, investment, or security (firm, stock, bond, real estate, vehicle, equipment, machine, livestock, land, option, precious metal, collectible, etc.) depends on after-tax cash flows (CFAT). In finance, CFAT is the most important variable, not accounting income after-tax (NIAT). However, we use accounting income (NIAT) to determine CFAT.
Annual Report: a) Verbal Section (long) and b) Financial Statements (short)
a. Verbal Section: Comprehensive analysis of the company's overall situation, prospects for future, identification of any problems, threats, opportunities, etc.
b. Financial Section: 1) Balance Sheet, 2) Income Statement, 3) Statement of Retained Earnings and 4) Statement of CFs.
We use MicroDrive Inc. as a case study for material in CH 2 and CH 3.
1. BALANCE SHEET (2 or more years):
a. Assets listed in order of liquidity (Cash, marketable securities, AR, INV, FA).
Liabilities listed in order of maturity (AP-30 days, NP-90 days, accruals, bonds, stock-no 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: MicroDrive 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 4 years. SL = $2500/year. Accelerated Depreciation might allow $4000, $3000, $2000, $1000. Firms usually use the fastest depreciation allowable by IRS (SOYD, ACRS, MACRS), and use slowest (SL) for stockholder reporting. MicroDrive has used accelerated for both.
f. Balance sheet is a snapshot on ONE DAY, December 31, 2001 for MicroDrive. Note that the firm's financial position would be changing daily.
2. INCOME STATEMENT (2 or more years)
Firm's activity DURING or OVER a period of time (M, Q, A)
SLS - Operating Costs (Wages, Selling and Administrative, COGS, R&D) = EBITDA
EBITDA - DEP (Tangible Assets) - AMORT (Intangible Assets) = EBIT (OPERATING INCOME)
EBIT - INT = EBT (went down for MicroDrive)
EBT - TAX = NI before Preferred DIV (went down)
NI - Preferred DIV = NIAT (Net income available to common shareholders) (down)
NIAT = PROFITS = EARNINGS
NIAT - DIV = Retained Earnings (RE)
Price (P) = Market Price of Stock
EPS = NIAT / # Shares
DPS = DIV / #Shares
BVPS = E / # Shares
CFPS = (NIAT + DEP + AMORT) / # Shares
3. STATEMENT OF RETAINED EARNINGS (RE)
RE (2000) + NIAT (2001) - DIV (2001) = RE (2001)
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 (Cash)
(20) DEP (Non-Cash)
(30) TAX (37.5%) (Cash)
CASH ONLY: CASH IN (+CF), CASH OUT (-CF):
$100 (EBITDA) - $30 (TAX) = $70
+CF -CF CFAT
For MicroDrive: $113.5m + $100 = $213.5m
NIAT DEP CFAT
4. STATEMENT OF CFs
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).
b. Working Capital (WC) = Current Assets (CA) - Current Liabilities (CL).
General Rules: i) Increases (decreases) in non-cash CA, e.g., AR and INV, decrease (increase) CASH. Example: Car dealer, if INV of vehicles increases, it requires CASH to buy the inventory; if INV of vehicles decreases, the firm generates CASH by selling off INV and not replacing.
ii) Increases in CL such as AP increase CASH because the firm has additional credit from suppliers which saves cash, Decreases in AP decrease CASH, because the firm has used cash to pay off its suppliers.
c. FA. An increase in FA (Property, plant, equipment) requires CASH (-CF); A decrease (sale) of FA increases CASH.
d. Security Transactions and DIV pmts. Issuing stocks or bonds will increase CASH (+CF). Payments of DIVs reduce CASH (-CF). If firm buys back outstanding stock or bonds, this will decrease 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 2-4 on p. 42.
CF from Operating Activities: ($2.5m)
CF from Investing Activities: ($230.0m)
CF from Financing Activities $227.5m
CHANGE IN CASH ($5.0m)
CASH (2001) $15m - $5m (-CF) = $10m CASH (2001)
Concern: MicroDrive had -CF of $2.5m from operations, it spent $227.5m on new fixed assets (property, plant and equipment), paid $61.5m in DIV, it borrowed heavily ($224m), and it sold off all of its marketable securities ($65m).
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 (also 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 taxes, 4% flat state income 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 (munis) issued by state and local governments, and only for state residents. To compare taxable yields (YTM) on corporate or treasury bonds to tax-free municipals bonds, we use the formula:
Taxable YTM on Corporate Bond ( 1 - Tax Rate) = After-tax YTM on Corporate Bond vs. Muni YTM (already after-tax)
To convert muni YTM to "equivalent taxable YTM":
Equivalent Taxable YTM = YTM on muni
( 1 - Tax Rate)
Example: Suppose that YTM = 9.11% for taxable bonds and YTM = 5.50% for munis. For Investor A, T = 20%; for Investor B, T = 45%, Which bond gives a higher after-tax YTM?
Investor A: 9.11% (1 - .2) = 7.288% vs. 5.50% muni
Investor B: 9.11% (1 . 45) = 5.011% vs. 5.50% muni
What tax rate (T) would make an investor indifferent? 9.11 (1 - T) = 5.50% and T = 39.63%
If T > 39.63%, then invest in _______________
If T < 39.63%, then invest in _______________
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 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).