Lesson 3 - Financial Statements and Long-Term Financial Planning
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This lecture reviews the four financial statements of a corporation, which are are the income, balance sheet, changes to owner's equity, and cash flow statements. Several financial equations are introduced, and
are applied to the financial statements. The cash flow statement is examined more closely, because cash flows help finance an expansion of operations.� For example, when a corporation expects sales to increase, how are the financial
statements impacted, and how does a corporation finance this expansion.
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Financial Statements
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- Income Statement
- Balance Sheet
- Statement of Changes to Stockholder’s Equity
- Statement of Cash Flow
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Income Statement
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The most important financial statement. Did the business earn a profit or a loss (profit is also called net income).
- Revenues: Are inflows of assets received in exchange for goods and services, which the business produces
- Expenses: Are outflows of assets as a result of the major operations of a business.
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Balance Sheet Statement
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This shows the financial position of a business on a specific date. This shows the business’s assets, liabilities, and equity.
1. Assets - economic resources owned by a business
- Cash
- Accounts receivable - customers owe money to a business for goods and services sold on credit
- Equipment
- Buildings and land
- Patents and copyrights
2. Liabilities - these are the debts or obligations of a business.
- Accounts Payable - amounts owed to creditors for goods and services bought on credit.
- Salaries owed to workers
- Taxes payable
- Interest payable
3. Equity (i.e. Net Assets) = Total assets - total liabilities
- Equity > 0
- Owner’s equity is very important for the creditors.
- If a business does not pay its debts, the creditors can legally force the business to sell its assets to pay off the debt.
4. Current and Fixed Assets
- Current Assets
- Cash
- Accounts Receivable
- Inventory
- Fixed Assets
5. Current Liabilities and Long-term Debt
- Current Liabilities
- Accounts Payable (less than a year)
- Notes Payable (less than a year)
- Long-term Debt
- Long-term debt is over a year
6. Stockholder’s Equity. A corporation has two capital accounts:
- Contributed Capital
- The amount of capital invested by stockholders
- Total amount of shares outstanding
- Retained Earnings
- The remainder of equity goes into this account
- Corporations use account to pay for dividends
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Statement of Changes in Owner’s Equity
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This financial statement shows changes in owner’s equity, reflecting investments
and withdrawals
Corporation
- Investment is when corporation issues new stock
- Withdrawal is when corporation pays dividends
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Statement of Cash Flows
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Shows the cash inflows and outflows of a business. This statement is important, because a business needs adequate cash to operate such as paying workers, taxes, rent, and interest payments
- Operating Activities
- Cash inflows
- Customers pay for sales in cash
- Customers pay accounts receivables
- Merchandise inventory decreases
- Accounts payable increases
- Cash outflows
- Pay salaries
- Pay expenses (in cash)
- Investing activities
- Cash Inflow
- Received cash from investments
- Sold property or equipment
- Cash Outflow
- Purchased securities
- Purchased land
- Financing activities
- Cash inflow
- Company issues more stock
- Company issues bonds
- Cash outflow
- Company pays dividends
- Company retires its bonds or stocks
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Finance Formulas
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Net Working Capital = Current Assets – Current Liabilities
- Limits financing options
- Daily operations of the business
Change in Net Working Capital (NWC) = Ending NWC – Beginning NWC
Cash Flow from Assets = Cash Flow to Creditors (Bondholders) + Cash Flow to Stockholders (Owners)
- Stockholders and bondholders benefit from a corporation’s assets
Operating Cash Flow = Earnings before Interest and Taxes (EBIT) + Depreciation – Taxes
- Why look at the Earnings before Interest and Taxes (EBIT)?
- Depreciation is an internal transaction
- Interest is outside the control of the corporation
- Taxes are outside the control of the corporation
Net capital spending = End Net Fixed Assets – Beginning Net Fixed Assets + Depreciation
- Net fixes assets means the depreciation was deducted
Cash Flow from Assets = Operating Cash Flow – Net Capital Spending – Change in Net Working Capital
Cash Flow to Creditors = Net interest paid - Net New Borrowing
Cash Flow to Stockholders = Dividends Paid - Net New Stock Sold
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An Example
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Balance Sheet December 31, 2001 |
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Beginning |
Ending |
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Beginning |
Ending |
Current Assets |
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Current Liabilities |
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Cash |
$500 |
$600 |
Accounts Payable |
$3,500 |
$4,000 |
Accounts Receivable |
1,000 |
1,100 |
Notes Payable |
4,000 |
4,000 |
Inventory |
10,000 |
9,900 |
Current Liabilities |
$7,500 |
$8,000 |
Current Assets |
$11,500 |
$11,600 |
Long-term Debt (Bond Holders) |
10,000 |
10,000 |
Net Fixed Assets |
30,000 |
31,000 |
Common Stock |
20,000 |
21,000 |
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Retained Earnings |
4,000 |
3,600 |
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Total |
$41,500 |
$42,600 |
Total |
$41,500 |
$42,600 |
Income Statement |
Sales |
$3,000 |
Costs |
1,500 |
Depreciation |
200 |
Earnings Before Interest and Taxes (EBIT) |
$1,300 |
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Interest |
150 |
Taxable Income |
1150 |
Taxes (20%) |
230 |
Net Income |
920 |
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Dividends paid |
$100 |
Calculate Financial Statistics
Operating Cash Flow = EBIT + Depreciation - Taxes = $1,300 + 200 - 230 = 1,270
Change in Net Working Capital = (11,600 - 8,000) - (11,500 - 7,500) = -400
Net Capital Spending = 31,000 + 200 - 30,000 = 1,200
Cash Flow from Assets = Operating Cash Flow - Change in Net Working Capital - Net Capital Spending = 1,270 - (-400) + 1,200 = 2,870
Cash Flow to Creditors = 150 - 0 = 150
Cash Flow to Stockholders = 100 - 1,000 = -900
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Sales Forecast
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Sales forecast drives the model
For example
Income Statement |
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Balance Sheet |
Sales |
$200 |
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Assets |
$100 |
Debt |
$50 |
Costs |
$180 |
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Equity |
$50 |
Net Income |
$20 |
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Total |
$100 |
Total |
$100 |
Assume
- Sales are projected to rise by 10%
- The debt/equity ratio stays at 0.50
- Costs and assets grow at the same rate as sales
We can create a Pro Forma Statements, which are financial statements based on different projections.
Pro-Forma Financial Statement |
Income Statement |
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Balance Sheet |
Sales |
$220 |
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Assets |
$110 |
Debt |
$55 |
Costs |
$198 |
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Equity |
$55 |
Net Income |
$22 |
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Total |
$110 |
Total |
$110 |
What is the plug?
Projected net income is $22.00, but equity increased by $5.00. What happened to the difference, $22 - $5? The company paid $17 in dividends.
Another example
Assume
- Sales are projected to rise by 20%
- The sales and costs remain the same percentage
- Retained earnings 33% of net income and dividends 67% are of net income
Income Statement Original |
Income Statement Projection |
Sales |
$3,000 |
Sales (+20%) |
$3,600 |
Costs |
$2,550 |
Costs (85%) |
$3,060 |
Net Sales |
$450 |
Net Sales |
$540 |
Taxes (20%) |
$90 |
Taxes (20%) |
$108 |
Net Income |
$360 |
Net Income |
$432 |
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Dividends |
$301.50 |
Dividends |
$289.44 |
Addition to retained earnings |
$148.50 |
Addition to retained earnings |
$142.56 |
Remember, this impacts the balance sheet. You projected more sales, therefore, the corporation should have more more assets, because
retained earnings increased.
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Maximum Allowable Borrowing
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Corporation needs to borrow to expand operations. Given the original balance sheet below:
Balance Sheet Original |
Assets |
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Cash |
$200 |
Account Payable |
$200 |
Accounts Rec. |
200 |
Notes Payable |
200 |
Inventory |
300 |
Total Current Liabilities |
$400 |
Total Current Assets |
$700 |
Long-term Debt |
200 |
Net Fixed Assets |
800 |
Common Stock |
800 |
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Retained Earnings |
100 |
Total |
$1,500 |
Total |
$1,500 |
We project the balance sheet is below. To expand the business, we want to impose the constraints:
- Keep Current Assets to Current Liabilities ratio = 2.0
- Maximum short-term borrowing
- Keep maximum debt at 40% of total assets
Balance Sheet Pro Forma |
Assets |
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Liabilities |
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Cash |
$250 |
Account Payable |
$200 + ? |
Accounts Rec. |
400 |
Notes Payable |
200 + ?
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Inventory |
500 |
Total Current Liabilities |
$400 + ? |
Total Current Assets |
1,150 |
Long-term Debt |
200 + ? |
Net Fixed Assets |
1,350 |
Common Stock |
800 + ? |
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Retained Earnings |
100 + ? |
Total |
$2,500 |
Total |
$2,500 |
- A possible financing strategy:
- Borrow short-term first
- If needed, borrow long-term next
- Sell equity as a last resort
- Total Assets increased by $1,000, we need to finance this?
- Look at retained earnings first.
- Current Assets / Current Liabilities = 2.0
- Two is a common number
- Implies that current liabilities cannot exceed $575. We already have $400, which allows us to borrow up to $175.
- Maximum borrowing is 2,500*0.4 = 1,000. If we borrow the maximum for current liabilities, then we can only borrow $425 long-term debt. Long-term debt is already $200, so new long-term borrowing is $225.
- Maximum new borrowing is $175 + $225 = $400.
We are still short by $1,000 - $175 - $225 = $600, so we probably need to issue new stock.
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General Formulas
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Internal financing - the corporation uses retained earnings to expand
operations. The increase in retained earnings is determined by:
- Retained Earnings (RE) in $
- Previous period's sales (S) in $
- Projected growth in sales (g)
- Profit margin (PM)
- Ratio of net income to sales
- Complicated tax structures can change this ratio
- Earnings retention (b)
- b is a fraction
- Called "plowback" ratio
- 1 - b is the fraction that goes to the stockholders as dividends
How much do we need to finance? We know sales increased by g. Therefore, assets like cash and accounts receivable should also have grown by g. If we are operating at full capacity, then
DAssets = A x g
- Previous period's assets (A)
- Projected growth in sales is g
DRE = S(1 + g) x PM x b
If the required increase in assets exceeds the internal funding available (i.e., the increase in retained earnings), then the difference is the financed externally as current liabilities, long-term debt, or issuing new equity.
Note: Interactive spreadsheets can be created to handle more complicated cases.
What about capacity?
We assumed 100% operating capacity. What if the operating capacity is below 100%?
Net fixed assets may not increase, thus not requiring financing.
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Maximum Sustainable Growth
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How fast can sales grow without requiring external financing?
Income Statement |
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Balance Sheet |
Sales |
$200 |
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Assets |
$100 |
Debt |
$50 |
Costs |
$180 |
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Equity |
$50 |
Net Income |
$20 |
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Total |
$100 |
Total |
$100 |
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Dividends |
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Increase in Retained Earnings |
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Assume that:
- Costs and assets grow
at the same rate as sales
- 40% of net income is
paid out in dividends
- No external financing is available (debt or equity)
What is the maximum growth rate achievable?
The maximum growth rate is given by
max. growth rate = ROA x b / (1 – (ROA x b))
- Return on assets ROA
- Divide net income by total assets
- Retained earnings, b
ROA = $20/$100 = 0.20
b = 1 - 0.4 = 0.6
max. growth rate = 0.20 (0.6) / (1 - (0.20 x 0.6)) = 0.136 (or 13.6%)
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