Lesson 3 - Financial Statements and Long-Term Financial Planning

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.

• Income Statement
• Balance Sheet
• Statement of Changes to Stockholder’s Equity
• Statement of Cash Flow

• 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.

This shows the financial position of a business on a specific date. This shows the business’s assets, liabilities, and equity.

1. Cash
2. Accounts receivable - customers owe money to a business for goods and services sold on credit
3. Equipment
4. Buildings and land
5. Patents and copyrights

1. Accounts Payable - amounts owed to creditors for goods and services bought on credit.
2. Salaries owed to workers
3. Taxes payable
4. Interest payable

3. Equity (i.e. Net Assets) = Total assets - total liabilities

1. Equity > 0
2. Owner’s equity is very important for the creditors.
3. 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
  • Plant and equipment

5. Current Liabilities and Long-term Debt

• Current Liabilities
  • Accounts Payable (less than a year)
  • Notes Payable (less than a year)
• Long-term Debt
  • Bonds
  • Long-term debt is over a year

6. Stockholder’s Equity. A corporation has two capital accounts:

1. Contributed Capital
   • The amount of capital invested by stockholders
   • Total amount of shares outstanding
2. Retained Earnings
   • The remainder of equity goes into this account
   • Corporations use account to pay for dividends

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

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

1. 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)
2. Investing activities
   • Cash Inflow
     • Received cash from investments
     • Sold property or equipment
   • Cash Outflow
     • Purchased securities
     • Purchased land
3. Financing activities
   • Cash inflow
     • Company issues more stock
     • Company issues bonds
   • Cash outflow
     • Company pays dividends
     • Company retires its bonds or stocks

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

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

Sales forecast drives the model

For example

1. Sales are projected to rise by 10%
2. The debt/equity ratio stays at 0.50
3. 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.

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

1. Sales are projected to rise by 20%
2. The sales and costs remain the same percentage
3. Retained earnings 33% of net income and dividends 67% are of net income

Remember, this impacts the balance sheet. You projected more sales, therefore, the corporation should have more more assets, because retained earnings increased.

Corporation needs to borrow to expand operations. Given the original balance sheet below:

We project the balance sheet is below. To expand the business, we want to impose the constraints:

1. Keep Current Assets to Current Liabilities ratio = 2.0
   • Maximum short-term borrowing
2. Keep maximum debt at 40% of total assets

• 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.

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

→ Assets = A x g

• Previous period's assets (A)
• Projected growth in sales is g

→ RE = 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.

How fast can sales grow without requiring external financing?

Assume that:

1. Costs and assets grow at the same rate as sales
2. 40% of net income is paid out in dividends
3. 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%)