Below is the assignment, attached in the excel file is actually all the answers, I need these transferred into my own excel file, answering all the questions below.

Integrated mini-case: ?Working with Financial Ratios?, p. 113 ? including calculating the 25 ratios from p. 114 to compare to the industry, plus the DuPont analysis from p. 90

Case Summary

In a narrative format, discuss the importance of using financial ratios.

Case Analysis

Calculate the financial ratios discussed in the Attend portion of this unit. (You don't have to do any of the ratios we didn't discuss).

Application

Report to Garners' Platoon Mental Health Care's Board of Directors on the financial health of the company. What areas need improvement? In what areas are they doing well?

Compare the ratios you calculated to the industry averages and comment briefly on how well the company is doing.

integrated mini-case: Working with Financial Statements Cornett, Adair, & Nofsinger. (2009). Finance: Applications & theory (2nd ed.). New York, NY; McGraw-Hill Irwin. (problem on pp Listed are the 2015 financial statements for Garners' Platoon Mental Health Care, Inc. Spread the balance sheet and income st rates. Using the DuPont system of analysis and the industry ratios reported as follows, evaluate the performance of the firm. As we see from these ratios, Garners' Platoon Mental Health Care, Inc. is more profitable than the average firm in the industry that this superior performance comes from both profit margin (operating efficiency) and total asset turnover (efficiency in asse equity is supporting more dollars of assets relative to the industry. Thus, the firm is using relatively high levels of debt and low # Type 1 Liquidity 2 Liquidity 3 Liquidity 4 Asset mgmt 5 Asset mgmt 6 Asset mgmt 7 Asset mgmt 8 Asset mgmt 9 Asset mgmt 10 Asset mgmt 11 Asset mgmt 12 Asset mgmt 13 Asset mgmt 14 Debt mgmt 15 Debt mgmt 16 Debt mgmt 17 Debt mgmt 18 Debt mgmt 19 Debt mgmt 20 Profitability 21 Profitability 22 Profitability 23 Profitability 24 Profitability 25 Profitability 26 Profitability 27 Market value 28 Market value 29 DuPont 30 DuPont 31 Growth 32 Growth 33 Growth Ratio Current ratio Quick (Acid-test) ratio Cash ratio Inventory turnover ratio Days' sales in inventory ratio A/R turnover Avg. collection period A/P turnover Avg. payment period Fixed assets turnover Sales to working capital Total assets turnover ratio Capital intensity ratio Debt ratio Debt to equity ratio Equity multiplier Times interest earned ratio Fixed-charge coverage Cash Coverage Profit margin (gross) Profit margin (operating) Profit margin (net) Basic earnings power ROA (Return On Assets) ROE (Return on Equity) Dividend payout ratio Market to book ratio Price to earnings ratio ROA (DuPont) ROE (DuPont) Retention Ratio (RR) Internal growth rate Sustainable growth rate Calc Alt 1.60 0.74 0.20 2.83 1.28 129.00 286.02 4.49 2.02525 81.28 180.225 5.74 2.59 63.55 140.90 1.00 0.45173 4.03 0.54 0.24536 1.84 4.07569 56.20% 1.28 2.32 7.65 3.14 8.28 54.90% 48.37% 25.44% 26.65% 26.32% 13.84% 32.08% 31.18% 1.36 4.24 13.84% 32.08% 68.82% 10.53% 28.34% Ind 2.00 1.20 0.25 2.50 146.00 91.00 100.00 1.25 4.00 0.50 2.00 50.00% 1.00 2.00 7.25 8.00 49.16% 42.02% 18.75% 19.90% 9.38% 18.75% 35.00% 1.30 4.10 9.38% 18.75% d.). New York, NY; McGraw-Hill Irwin. (problem on pp. 113-114; formulas on pp. 92-93, 95) th Care, Inc. Spread the balance sheet and income statement. Calculate the financial ratios for the firm, including the internal and sustaina d as follows, evaluate the performance of the firm. more profitable than the average firm in the industry when it comes to overall efficiency expressed as ROA and ROE. The DuPont equation h efficiency) and total asset turnover (efficiency in asset use). Further, the ROE equation highlights that Garner's superior performance is ach he firm is using relatively high levels of debt and low levels of equity compared to the industry. Balance Sheet Assets Current assets: Cash & marketable securities A/R Inventory Total current Fixed assets: Plant & equip (gross) Less: Depreciation Plant & equip (net) Other long term assets: Total fixed Total assets Liabilities & Equity Liabilities Current liabilities Accrued wages & taxes A/P N/P Total current Long term debt Total liabilities Stockholders' equity: Preferred stock (30 mil shares) Common stock & paid in surplus (200 mil shares) Retained earnings Total equity Total liabilities & equity $ 421 $ 1,109 $ 1,760 $ 3,290 $ 5,812 $ 840 $ 4,972 $ 892 $ 5,864 $ 9,154 $ 316 $ 867 $ 872 $ 2,055 $ 3,090 $ 5,145 $ 60 $ 637 $ 3,312 $ 4,009 $ 9,154 n pp. 92-93, 95) he financial ratios for the firm, including the internal and sustainable growth rall efficiency expressed as ROA and ROE. The DuPont equation highlights OE equation highlights that Garner's superior performance is achieved while ared to the industry. Income Statement Net Sales Less: COGS Gross Profits Less: Other operating expenses EBITDA Less: Depreciation EBIT Less: Interest EBT Less: Taxes Net Income $ $ $ $ $ $ $ $ $ $ $ 4,980 2,246 2,734 125 2,609 200 2,409 315 2,094 767 1,327 Less: Preferred Stock Div. Net Income available to common stockholders Less: Common stock div. Addition to retained earnings $ 60 $ 1,267 $ 395 $ 872 Per (common) share data: EPS DPS BVPS MVPS $ $ $ $ 6.335 1.975 19.745 26.850 Balance Sheet (SPREAD) Assets Current assets: Cash & marketable securities A/R Inventory Total current Fixed assets: Plant & equip (gross) Less: Depreciation Plant & equip (net) Other long term assets: Total fixed Total assets Liabilities & Equity Liabilities Current liabilities Accrued wages & taxes A/P N/P Total current Long term debt Total liabilities Stockholders' equity: Preferred stock (30 mil shares) Common stock & paid in surplus (200 mil shares) Retained earnings Total equity Total liabilities & equity 4.60% 12.11% 19.23% 35.94% 63.49% 9.18% 54.32% 9.74% 64.06% 100.00% 3.45% 9.47% 9.53% 22.45% 33.76% 56.20% 0.66% 6.96% 36.18% 43.80% 100.00% Income Statement (SPREAD) Net Sales Less: COGS Gross Profits Less: Other operating expenses EBITDA Less: Depreciation EBIT Less: Interest EBT Less: Taxes Net Income 100.00% 45.10% 54.90% 2.51% 52.39% 4.02% 48.37% 6.33% 42.05% 15.40% 26.65% 1.20% 25.44% 7.93% 17.51% Less: Preferred Stock Div. Net Income available to common stockholders Less: Common stock div. Addition to retained earnings Per (common) share data: EPS DPS BVPS MVPS $ $ $ $ 6.335 1.975 19.745 26.850 Final PDF to printer PART TWO 2 Reviewing Financial Statements viewpoints Business Application S T O U T , The managers of DPH Tree Farm, Inc., believe the firm J could double its sales if it had additional factory space and acreage. If DPH purchased the factory space and acreage inI 2016, these new assets would cost $27 million to build andL would require an additional $1 million in cash, $5 million inL accounts receivable, $6 million in inventory, and $4 million I in accounts payable. In addition to accounts payable, DPH Tree Farm would finance the new assets with the sale of A a combination of long-term debt (40 percent of the total) N and common stock (60 percent of the total). Assuming all else stays constant, what will these changes do to DPH Tree 9 Farm's 2016 balance sheet assets, liabilities, and equity? (See 2015 balance sheet on p. 35) (See solution on p. 54) 5 Personal Application Chris Ryan is looking to invest in DPH Tree Farm, Inc. Chris has the most recent set of financial statements from DPH Tree Farm's annual report but is not sure how to read them or what they mean. What are the four financial statements that Chris should pay most attention to? What information will these key financial statements contain? (See solution on p. 54) Thinking of starting your own business? Learn more . . . 6 T S *See Appendix 2A: Various Formats for Financial Statements online at www.mhhe.com/can3e. 32 cor6168X_ch02_032-075.indd 32 25/09/13 4:48 PM Final PDF to printer Learning Goals LG2-1 Recall the major financial statements that firms must prepare and provide. LG2-2 Differentiate between book (or accounting) value and market value. LG2-3 Explain how taxes influence corporate managers' and investors' decisions. LG2-4 Differentiate between accounting income and cash flows. LG2-5 Demonstrate how to use a firm's financial statements to calculate its cash flows. LG2-6 Observe cautions that should be taken when examining financial statements. S T O U T , orporate managers must issue many reportsJto the public. Most stockholders, analysts, government entities, and other interested parties pay particular attention to annual reports. An annual report I provides four basic financial statements: the L balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. A financial statement provides an accounting-based L picture of a firm's financial position. Whereas accountants use reports to present a picture I of what happened in the past, finance professionals use financial statements to draw inferences about the future. The four statements function to provide key A information to managers, who make financial decisions, and to investors, who will accept or reject posN sible future investments in the firm. When you encountered these four financial statements in accounting classes, you learned how they function to place the right information in the right places. In this chapter, you will see how understanding these statements, which are the \"right places\" for crucial information, cre9 ates a solid base for your understanding of decision-making processes in managerial finance. Financial statements of publicly traded firms can5be found in a number of places. For example, all quarterly and annual financial statements can be found 6 at a firm's website (often under a section titled \"investor relations\"). Financial statements of publicly traded companies are reported to the Securities and Exchange T Commission (SEC), who makes them publicly available at their website (www.sec.gov); annual reports S statements are listed as 10-Qs. Finally, a number of are listed under the term 10-K, and quarterly financial websites exist (e.g., finance.yahoo.com) where one can view and download financial statements of publicly traded companies. Nonpublic firms are not required to submit financial statements to the SEC. Thus, it can be quite difficult to find detailed financial information about these firms. This is one reason why some large firms (Cargill, Toys \"R\" Us, Fidelity) hesitate to become publicly traded; they prefer to keep their financial statement information private. It should also be noted that this chapter presents a basic set of financial statements; enough so that, from a financial manager's viewpoint, we can identify the basic categories on each statement and relationships C 33 cor6168X_ch02_032-075.indd 33 25/09/13 4:48 PM Final PDF to printer financial statement Statement that provides an accounting-based picture of a firm's financial position. across statements. Individual firms' financial statements may look different from those presented in the chapter, depending on the level of detail and accounting methods used. Further, financial statements may be presented in various formats, e.g., in a pdf file or in an Excel spreadsheet. Appendix 2A to the chapter (located at the book's website, www.mhhe.com/can3e) presents the 2012 financial statements for Colgate-Palmolive Company as listed in its Annual Report, in its 10-K statement, and in an Excel spreadsheet. Note that while the numbers are the same in all formats, the presentation of the numbers can vary greatly. This chapter examines each statement to clarify its major features and uses. We highlight the differences between the accounting-based (book) value of a firm (reflected in these statements) and the true market value of a firm, which we will come to understand more fully. We also make a clear distinction between accounting-based income and actual cash flows, a topic further explored in Chapter 3, where we see how important cash flows are to the study of finance. We also open a discussion in this chapter about how firms choose to represent their earnings. We'll see S that managers have substantial discretion in preparing their firms' financial statements, depending on strategic plans for the T organization's future. This is worth looking into as we keep the discipline of O finance grounded in a real-world context. Finally, leading into Chapter 3, we discuss some cautions to bearU in mind when reviewing and analyzing financial statements. T , LG2-1 balance sheet The financial statement that reports a firm's assets, liabilities, and equity at a particular point in time. 2.1 Balance SheetJ The balance sheet reports a firm's assets, liabilities, and equity at a particular point in time. It is a picture ofI the assets the firm owns and who has claims on these assets as of a given date, L for example, December 31, 2015. A firm's assets must equal (balance) the liabilities and equity used to purchase the assets (hence L the term balance sheet): I (2-1) A Figure 2.1 illustrates a basic balance sheet and Table 2.1 presents a simple balance Nas of December 31, 2015 and 2014. The left side sheet for DPH Tree Farm, Inc., Assets 5 Liabilities 1 Equity liquidity The ease of conversion of an asset into cash at a fair value. current assets Assets that will normally convert to cash within one year. marketable securities Short-term, low-rate investment securities held by the firm for liquidity purposes. fixed assets Assets with a useful life exceeding one year. 34 of the balance sheet lists assets of the firm and the right side lists liabilities and equity. Both assets and liabilities 9 are listed in descending order of liquidity, that is, the time and effort needed to convert the accounts to cash. The most liquid 5 assetscalled current assetsappear first on the asset side of the balance sheet. The least liquid, called fixed assets, 6 appear last. Similarly, current liabilitiesthose obligations that the firm mustTpay within a yearappear first on the right side of the balance sheet. Stockholders' equity, which never matures, appears last on S the balance sheet. Assets Figure 2.1 shows that assets fall into two major categories: current assets and fixed assets. Current assets will normally convert to cash within one year. They include cash and marketable securities (short-term, low-rate investment securities held by the firm for liquidity purposes), accounts receivable, and inventory. Fixed assets have a useful life exceeding one year. This class of assets includes physical (tangible) assets, such as net plant and equipment, and other, less tangible, long-term assets, such as patents and trademarks. We find the value of net plant and equipment by taking the difference between gross plant and part two Financial Statements cor6168X_ch02_032-075.indd 34 25/09/13 4:48 PM Final PDF to printer figure 2.1 Total Assets Total Liabilities and Equity Current assets Cash and marketable securities Accounts receivable Inventory Fixed assets Gross plant and equipment Less: Depreciation Net plant and equipment Other long-term assets Current liabilities Accrued wages and taxes Accounts payable Notes payable Long-term debt table 2.1 The Basic Balance Sheet Stockholders' equity Preferred stock Common stock and paid-in surplus Retained earnings S T Balance Sheet for DPH Tree Farm, Inc. O DPH TREE FARM, INC. U Balance Sheet as of December 31, 2015 and 2014 (in millions T of dollars) 2015 2014 , Assets 2015 2014 $ 20 55 45 $ 120 195 315 $ 15 50 45 $ 110 190 300 $ $ Liabilities and Equity Current assets Cash and marketable securities Accounts receivable Inventory Total Fixed assets Gross plant and equipment Less: Depreciation Net plant and equipment Other long-term assets $ 24 70 111 $ 205 $ 25 65 100 $ 190 $ 368 53 $ 315 50 $ 300 40 $ 260 50 Total Total assets $ 365 $ 570 $ 310 $ 500 Current liabilities Accrued wages and taxes Accounts payable Notes payable Total Long-term debt Total debt Stockholders' equity Preferred stock (5 million shares) Common stock and paid-in surplus (20 million shares) Retained earnings Total Total liabilities and equity J I L L I A N 9 5 6 equipment (or the fixed assets' original value) and the depreciation accumulated T against the fixed assets since their purchase. Likewise, other long-term assets would be listed net of amortization. S 5 40 210 $ 255 $ 570 5 40 155 $ 200 $ 500 liabilities Funds provided by lenders to the firm. Liabilities and Stockholders' Equity Lenders provide funds, which become liabilities, to the firm. Liabilities fall into two categories as well: current or long-term. Current liabilities constitute the firm's obligations due within one year, including accrued wages and taxes, accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with maturities of more than one year. The difference between total assets and total liabilities of a firm is the stockholders' (or owners') equity. The firm's preferred and common stock owners provide the funds known as stockholders' equity. Preferred stock is a hybrid current liabilities Obligations of the firm that are due within one year. long-term debt Obligations of the firm that are due in more than one year. chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 35 35 25/09/13 4:48 PM Final PDF to printer stockholders' equity Funds provided by the firm's preferred and common stock owners. preferred stock A hybrid security that has characteristics of both longterm debt and common stock. common stock and paid-in surplus The fundamental ownership claim in a public or private company. retained earnings The cumulative earnings the firm has reinvested rather than pay out as dividends. security that has characteristics of both long-term debt and common stock. Preferred stock is similar to common stock in that it represents an ownership interest in the issuing firm but, like long-term debt, it pays a fixed periodic (dividend) payment. Preferred stock appears on the balance sheet as the cash proceeds when the firm sells preferred stock in a public offering. Common stock and paid-in surplus is the fundamental ownership claim in a public or private company. The proceeds from common stock and paid-in surplus appear as the other component of stockholders' equity. If the firm's managers decide to reinvest cumulative earnings (recorded on the firm's income statement) rather than pay the dividends to stockholders, the balance sheet will record these funds as retained earnings. Managing the Balance Sheet Managers must monitor a number of issues underlying items reported on their firms' balance sheets. We examine these issues in detail throughout the text. In this chapter, we briefly introduce them. These issues include: S T The level of net working capital. O The liquidity position of the firm. U The method for financing the firm's assetsequity or debt. T book value reported on the balance sheet and The difference between the the true market value of ,the firm. The accounting method for fixed asset depreciation. ACCOUNTING METHOD FOR FIXED ASSET DEPRECIATION Managers J they use to record depreciation against their can choose the accounting method fixed assets. Recall from accounting that depreciation is the charge against income I that reflects the estimated dollar cost of the firm's fixed assets. The straight-line L method and the MACRS (modified accelerated cost recovery system) are two Lchoose MACRS when computing the firm's taxes choices. Companies commonly and the straight-line method when reporting income to the firm's stockholders. I The MACRS method accelerates depreciation, which results in higher depreciaA tion expenses and lower taxable income, thus lower taxes, in the early years of N depreciation method used, over time both the a project's life. Regardless of the straight-line and MACRS methods result in the same amount of depreciation and therefore tax (cash) outflows. However, because the MACRS method defers 9 the payment of taxes to later periods, firms often favor it over the straight-line 5 method of depreciation. We discuss this choice further in Chapter 12. 6 net working capital The difference between a firm's current assets and current liabilities. NET WORKING CAPITAL We arrive at a net working capital figure by taking T the difference between a firm's current assets and current liabilities. S Net working capital 5 Current assets 2 Current liabilities (2-2) So, clearly, net working capital is positive when the firm has more current assets than current liabilities. Table 2.1 shows the 2015 and 2014 year-end balance sheets for DPH Tree Farm, Inc. At year-end 2015, the firm had $205 million of current assets and $120 million of current liabilities. So the firm's net working capital was $85 million. A firm needs cash and other liquid assets to pay its bills as expenses come due. As described in more detail in Chapter 14, liability holders monitor net working capital as a measure of a firm's ability to pay its obligations. Positive net working capital values are usually a sign of a healthy firm. LIQUIDITY As we noted previously, any firm needs cash and other liquid assets to pay its bills as debts come due. Liquidity actually refers to two dimensions: the 36 part two Financial Statements cor6168X_ch02_032-075.indd 36 25/09/13 4:48 PM Final PDF to printer ease with which the firm can convert an asset to cash, and the degree to which such a conversion takes place at a fair market value. You can convert any asset to cash quickly if you price the asset low enough. But clearly, you will wish to convert the asset without giving up a great portion of its value. So a highly liquid asset can be sold quickly at its fair market value. An illiquid asset, on the other hand, cannot be sold quickly unless you reduce the price far below fair value. Current assets, by definition, remain relatively liquid, including cash and assets that will convert to cash within the next year. Inventory is the least liquid of the current assets. Fixed assets, then, remain relatively illiquid. In the normal course of business, the firm would have no plans to liquefy or convert these tangible assets such as buildings and equipment into cash. Liquidity presents a double-edged sword on a balance sheet. The more liquid assets a firm holds, the less likely the firm will be to experience financial distress. However, liquid assets generate little or no profits for a firm. For example, cash is the most liquid of all assets, but it earns little, if any, for the firm. In contrast, fixed assets are illiquid, but provide the means to generate revenue. Thus, managS of liquidity on the balance ers must consider the trade-off between the advantages sheet and the disadvantages of having money sit idleTrather than generating profits. O DEBT VERSUS EQUITY FINANCING You learned in your high school physics U class that levers are very useful and powerful machinesgiven a long enough T lever, you can move almost anything. Financial leverage is likewise very powerful. Leverage in the financial sense refers to the extent to which a firm chooses , to finance its ventures or assets by issuing debt securities. The more debt a firm issues as a percentage of its total assets, the greater its financial leverage. We disJ magnify the firm's gains cuss in later chapters why financial leverage can greatly and losses for the firm's stockholders. I When a firm issues debt securitiesusually bondsto finance its activities L and assets, debt holders usually demand first claim to a fixed amount of the firm's cash flows. Their claims are fixed because theLfirm must only pay the interest owed to bondholders and any principal repayments that come due within I any given period. Stockholderswho buy equity securities or stocksclaim any A cash flows left after debt holders are paid. When a firm does well, financial leverN of the firm's profits promage increases shareholders' rewards, since the share ised to debt holders is set and predictable. However, financial leverage also increases risk. Leverage can create the potential 9 for the firm to experience financial distress and even bankruptcy. If the firm has a 5 debt holders can force the bad year and cannot make its scheduled debt payments, firm into bankruptcy. But managers generally prefer 6 to fund firm activities using debt, precisely because they can calculate the cost of doing business without giving T detail in Chapter 16, manaway too much of the firm's value. As described in more agers often walk a fine line as they decide upon the S firm's capital structurethe amount of debt versus equity financing held on the balance sheetbecause it can determine whether the firm stays in business or goes bankrupt. BOOK VALUE VERSUS MARKET VALUE Beginning finance students usually have already taken accounting, so they are familiar with the accounting point of view. For example, a firm's balance sheet shows its book (or historical cost) value based on generally accepted accounting principles (GAAP). Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what those assets might be worth today if the firm were to sell them. Inflation and market forces make many assets worth more now than they were worth when the firm bought them. So in many cases, book values differ widely from market values for the same assetsthe amount that the assets would fetch if the financial leverage The extent to which debt securities are used by a firm. capital structure The amount of debt versus equity financing held on the balance sheet. book (or historical cost) value Assets are listed on the balance sheet at the amount the firm paid for them. LG2-2 market value Assets are listed at the amount the firm would get if it sold them. chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 37 37 25/09/13 4:48 PM Final PDF to printer firm actually sold them. For the firm's current assetsthose that mature within a yearthe book value and market value of any particular asset will remain very close. For example, the balance sheet lists cash and marketable securities at their market value. Similarly, firms acquire accounts receivable and inventory and then convert these short-term assets into cash fairly quickly, so the book value of these assets is generally close to their market value. The \"book value versus market value\" issue really arises when we try to determine how much a firm's fixed assets are worth. In this case, book value is often very different from market value. For example, if a firm owns land for 100 years, this asset appears on the balance sheet at its historical cost (of 100 years ago). Most likely, the firm would reap a much higher price on the land upon its sale than the historical price would indicate. Again, accounting tools reflect the past: Balance sheet assets are listed at historical cost. Managers would thus see little relation between the total asset value listed on the balance sheet and the current market value of the firm's assets. Similarly, the stockholders' equity listed on the balance sheet generally differs from S In this case, the market value may be higher the true market value of the equity. or lower than the value listed T on the firm's accounting books. So financial managers and investors often find that balance sheet values are not always the most O relevant numbers. The following example illustrates the difference between the U of a firm's assets. book value and the market value EXAMPLE T , 2-1 LG2-2 Calculating Book versusJ Market Value For interactive versions of this example visit www.mhhe.com/can3e EZ Toy, Inc., lists fixed assets of $25 million on its balance sheet. The firm's fixed assets were I recently appraised at $32 million. EZ Toy, Inc.'s, balance sheet also lists current assets at L at $11 million. Current liabilities' book and market $10 million. Current assets were appraised values stand at $6 million and the firm's L long-term debt is $15 million. Calculate the book and market values of the firm's stockholders' equity. Construct the book value and market value I balance sheets for EZ Toy, Inc. A N SOLUTION: Recall the balance sheet identity in equation 2-1: Assets 5 Liabilities 1 Equity. Rearranging this equation: Equity 5 Assets 2 Liabilities. Thus, the balance sheets would appear as follows: Book Value Market Value Current assets Fixed assets $ 10m 25m $ 11m 32m Total $ 35m $ 43m Assets 9 5 Liabilities and Equity 6 Current liabilities T Long-term debt Stockholders' equity S Total Book Value $ 6m 15m 14m $ 35m Market Value $ 6m 15m 22m $ 43m Similar to Problems 2-17, 2-18, self-test problem 2 TIME OUT 38 2-1 What is a balance sheet? 2-2 Which are the most liquid assets and liabilities on a balance sheet? part two Financial Statements cor6168X_ch02_032-075.indd 38 25/09/13 4:48 PM Final PDF to printer 2.2 Income Statement You will recall that income statements show the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time, for example, the year 2015. Remember that while the balance sheet reports a firm's position at a point in time, the income statement reports performance over a period of time, for example, over the last year. Figure 2.2 illustrates a basic income statement and Table 2.2 shows a simple income statement for DPH Tree Farm, Inc., for the years ended December 31, 2015 and 2014. DPH's revenues (or net sales) appear at the top of the income statement. The income statement then shows various expenses (cost of goods sold, other operating expenses, depreciation, interest, and taxes) subtracted from revenues to arrive at profit or income measures. The top part of the income statement reports the firm's operating income. First, we subtract the cost of goods sold (the direct costs of producing the firm's product) from net sales to get gross profit (so, DPH Tree Farm enjoyed gross profits S we deduct other operating of $155 million in 2014 and $182 million in 2015). Next, expenses from gross profits to get earnings beforeTinterest, taxes, depreciation, and amortization (EBITDA); DPH Tree Farm's EBITDA was $140 million in 2014 Oinclude marketing and selland $165 million in 2015. Other operating expenses ing expenses as well as general and administrative U expenses. Finally, we subtract depreciation and amortization from EBITDA to getToperating profit or earnings before interest and taxes (EBIT) (so DPH Tree Farm's EBIT was $128 million in , 2014 and $165 million in 2015). The EBIT figure represents the profit earned from the sale of the product without any financing cost or tax considerations. The bottom part of the income statement summarizes the firm's financial and J tax structure. First, we subtract interest expense (the cost to service the firm's I So, as we follow our sample debt) from EBIT to get earnings before taxes (EBT). income statement, DPH Tree Farm had EBT of $110Lmillion in 2014 and $136 million in 2015. Of course, firms differ in their financial structures and tax situaL tions. These differences can cause two firms with identical operating income to I firm may finance its assets report differing levels of net income. For example, one with only debt, while another finances with only common equity. The company A with no debt would have no interest expense. Thus, even though EBIT for the two N firms is identical, the firm with all-equity financing and no debt would report higher net income. We subtract taxes from EBT to get the last item on the income Net sales Less: Cost of goods sold Gross profits Less: Other operating expenses Earnings before interest, taxes, depreciation, and amortization (EBITDA) Less: Depreciation and amortization Earnings before interest and taxes (EBIT) Less: Interest Earnings before taxes (EBT) Less: Taxes 9 5 6 T S Operating income income statement Financial statement that reports the total revenues and expenses over a specific period of time. gross profit Net sales minus cost of goods sold. EBITDA Earnings before interest, taxes, depreciation, and amortization. EBIT Earnings before interest and taxes. EBT Earnings before taxes. figure 2.2 The Basic Income Statement Financing and tax considerations Net income before preferred dividends Less: Preferred stock dividends Net income available to common stockholders chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 39 39 25/09/13 4:48 PM Final PDF to printer table 2.2 Income Statement for DPH Tree Farm, Inc. DPH TREE FARM, INC. Income Statement for Years Ending December 31, 2015 and 2014 (in Millions of Dollars) 2015 Net sales (all credit) Less: Cost of goods sold Gross profits Less: Other operating expenses Earnings before interest, taxes, depreciation, and amortization (EBITDA) Less: Depreciation and amortization Earnings before interest and taxes (EBIT) Less: Interest Earnings before taxes (EBT) Less: Taxes Net income $ $ 165 13 152 16 136 46 $ 90 10 80 25 55 $ $ $ $ $ $ $ Per (common) share data: Earnings per share (EPS) Dividends per share (DPS) Book value per share (BVPS) Market value (price) per share (MVPS) The bottom line on the income statement. $ $ S T O U T , net income 315 133 $ 182 17 $ Less: Preferred stock dividends Net income available to common stockholders Less: Common stock dividends Addition to retained earnings 2014 $ 4.00 $ 1.25 $ 12.50 $ 17.25 275 120 $ 155 15 $ $ $ 140 12 128 18 110 40 70 10 60 25 35 $ 3.00 $ 1.25 $ 9.75 $ 15.60 J I statement (the \"bottom line\"), L or net income. DPH Tree Farm, Inc., reported net income of $70 million in 2014 and L $90 million in 2015. Below the net income, or bottom line, on the income statement, firms often I report additional information summarizing income and firm value. For example, A in 2015, DPH Tree Farm, Inc., paid its preferred with its $90 million of net income stockholders cash dividends of N $10 million and its common stockholders cash dividends of $25 million, and added the remaining $55 million to retained earnings. Table 2.1 shows that retained earnings on the balance sheet increased from 9 in 2015. Other items reported below the bot$155 million in 2014 to $210 million tom line include: 5 6 Earnings per share (EPS) 5 Net income available to common stockholders TTotal shares of common stock outstanding S Dividends per share (DPS) 5 (2-3) Common stock dividends paid Number of shares of common stock outstanding (2-4) Book value per Common stock 1 Paid-in surplus 1 Retained earnings 5 (2-5) share (BVPS) Number of shares of common stock outstanding Market value per share (MVPS) 5 Market price of the firm's common stock (2-6) We discuss these items further in Chapter 3. 40 part two Financial Statements cor6168X_ch02_032-075.indd 40 25/09/13 4:48 PM Final PDF to printer Debt versus Equity Financing As mentioned earlier, when a firm issues debt to finance its assets, it gives the debt holders first claim to a fixed amount of its cash flows. Stockholders are entitled to any residual cash flows, or net income. Thus, when a firm alters its capital structure to include more or less debt (and, in turn, less or more equity), it impacts the residual cash flows available for the stockholders, i.e., the numerator of the EPS equation. Further, as the firm alters its capital structure, it will issue more shares of stock when it increases equity to reduce debt, or it will buy back shares of stock when it decreases equity to increase debt, i.e., the denominator of the EPS equation. Thus, a change in capital structure will cause a firm's stockholders' EPS to change. The question is: Will the reduction (increase) in financial distress and bankruptcy risk from the reduction (increase) in financial leverage appease the stockholders who have lost (gained) earnings per share? EXAMPLE LG2-1 S Impact of Capital Structure on a Firm'sT EPS Consider a firm with an EBIT of $750,000. The firm finances Oits assets with $1,600,000 debt (costing 5 percent) and 200,000 shares of stock selling at $6.00 per share. To reduce the firm's risk associated with this financial leverage, the firm isU considering reducing its debt by $600,000 by selling an additional 100,000 shares of stock. T The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $750,000. Calculate the dilution in, the firm's EPS from this change 2-2 For interactive versions of this example visit www.mhhe.com/can3e in capital structure. J The EPS before and after this change in capital structure is illustrated Ibelow: L Change Before Capital Structure Change After Capital Structure Change L EBIT $750,000 $750,000 80,000 50,000 ($1,600,000 3 0.05) Less: Interest ($1,000,000 3 0.05) I EBT 670,000 700,000 A Less: Taxes (40%) 268,000 280,000 Net income $402,000 $420,000 N SOLUTION: Divided by # of shares EPS 200,000 $2.01 300,000 $1.40 9 5 6 T S The change in capital structure would dilute the stockholders' EPS by $0.61. Similar to Problems 2-5, 2-6, 2-23, 2-24 Corporate Income Taxes LG2-3 Firms pay out a large portion of their earnings in taxes. For example, in 2012, Walmart had EBT of $24.40 billion. Of this amount, Walmart paid $6.74 billion (over 27 percent of EBT) in taxes. Firms may also defer taxes, e.g., in 2012, Walmart listed a provision for deferred taxes of $1.20 billion. Deferred taxes occur when a company postpones paying taxes on profits earned in a particular period. For example, some expenses, such as those associated with research and development or incurred in mergers, may be written off over a fixed number of years. In these cases, the firm's current year profits for tax purposes would be lower than the profits computed for accounting purposes. Thus, the company ends up postponing part of its tax liability on this year's profits to future years. chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 41 41 25/09/13 4:48 PM Final PDF to printer table 2.3 Corporate Tax Rates as of 2015 Pay this Amount on Base Income Taxable Income $0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 Over $18,333,333 average tax rate The percentage of each dollar of taxable income that the firm pays in taxes. The amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns. EXAMPLE 2-3 For interactive versions of this example visit www.mhhe.com/can3e 0 7,500 13,750 22,250 113,900 3,400,000 5,150,000 6,416,667 15% 25 34 39 34 35 38 35 Congress oversees the U.S. tax code, which determines corporate tax obligations. Corporate taxes can thus change with changes of administration or other changes in the business or public environment. As you might expect, the U.S. tax system is extremely complicated, so we do not attempt to cover it in detail S here. However, firms recognize taxes as a major expense item and many finanT cial decisions arise from tax considerations. In this section we provide a general overview of the U.S. corporateO tax system. The 2015 corporate tax schedule appears in Table 2.3. Note from this table U that the U.S. tax structure is progressive, meaning that the larger the income, T the higher the taxes assessed. However, corporate tax rates do not increase in , this progressive nature: They rise from a low of any kind of linear way based on 15 percent to a high of 39 percent, then drop to 34 percent, rise to 38 percent, and finally drop to 35 percent. J In addition to calculating their tax liability, firms also want to know their I tax rate. You can figure the average tax rate as average tax rate and marginal the percentage of each dollar of L taxable income that the firm pays in taxes. Average tax rate 5 marginal tax rate $ Plus this Percentage on Anything Over the Base TaxLliability I income Taxable (2-7) From your economics classes,Ayou can probably guess that the firm's marginal tax rate is the amount of additional taxes a firm must pay out for every addiN tional dollar of taxable income it earns. 9 LG2-3 5 6 Taxes Calculation of Corporate T million taxable income (EBT) in 2015. Use the tax Indian Point Kennels, Inc., earned $16.5 schedule in Table 2.3 to determine the firm's 2015 tax liability, its average tax rate, and its S marginal tax rate. SOLUTION: From Table 2.3, the $16.5 million of taxable income puts Indian Point Kennels in the 38 percent marginal tax bracket. Thus Tax liability 5 Tax on base amount 1 Tax rate (Amount over base) 5 $5,150,000 1 0.38($16,500,000 2 $15,000,000) 5 $5,720,000 Note that the base amount is the maximum dollar value listed in the previous tax bracket. In this example, we take the highest dollar value ($15,000,000) in the preceding tax bracket (35 percent). The additional percentage 42 part two Financial Statements cor6168X_ch02_032-075.indd 42 25/09/13 4:48 PM Final PDF to printer owed results from multiplying the income above and beyond the $15,000,000 (or $1,500,000) by the marginal tax rate (38 percent). The average tax rate for Indian Point Kennels, Inc., comes to: Average tax rate 5 Tax liability Taxable income 5 $5,720,000/$16,500,000 5 34.67% If Indian Point Kennels earned $1 more of taxable income, it would pay 38 cents (its tax rate of 38 percent) more in taxes. Thus, the firm's marginal tax rate is 38 percent. Similar to Problems 2-7, 2-8, 2-25, 2-26, self-test problem 3 INTEREST AND DIVIDENDS RECEIVED BY CORPORATIONS Any interest that corporations receive is taxable, although a notable exception arises: InterS est on state and local government bonds is exempt from federal taxes. The U.S. T tax code allows this exception to encourage corporations to be better commuO exception of sorts arises nity citizens by supporting local governments. Another when one corporation owns stock in another corporation. Seventy percent of any U dividends received from other corporations is tax exempt. Only the remaining T rate.1 30 percent is taxed at the receiving corporation's tax , LG2-3 J I Corporate Taxes with Interest and Dividend Income L million of taxable income, In the previous example, suppose that in addition to the $16.5 Indian Point Kennels, Inc., received $250,000 of interest onLstate-issued bonds and $500,000 of dividends on common stock it owns in DPH Tree Farm, Inc. How do these items I marginal tax rate? affect Indian Point Kennel's tax liability, average tax rate, and A SOLUTION: N EXAMPLE 2-4 For interactive versions of this example visit www.mhhe.com/can3e In this case, interest on the state-issued bonds is not taxable and should not be included in taxable income. Further, the first 70 percent of the dividends received from DPH Tree Farm is not taxable. Thus, only 30 percent of the dividends received are taxed, so: 9 Taxable income 5 $16,500,000 1 (0.3)$500,000 5 5 $16,650,000 6 T ) 5 $5,777,000 Tax liability 5 $5,150,000 1 0.38($16,650,000 2 $15,000,000 S The $500,000 of dividend income increased Indian Point Kennel's tax liability by $57,000. Indian Point Kennels, Now Indian Point Kennel's tax liability will be: Inc.'s resulting average tax rate is now: Average tax rate 5 $5,777,000/$16,650,000 5 34.70% Finally, if Indian Point Kennels earned $1 more of taxable income, it would still pay 38 cents (based upon its marginal tax rate of 38 percent) more in taxes. Similar to Problems 2-8, 2-25, 2-26 1 This tax code provision prevents or reduces any triple taxation that could occur: Income could be taxed at three levels: (1) on the income from the dividend-paying firm, (2) as income for the dividendreceiving firm, and (3) finally, on the personal income of stockholders who receive dividends. chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 43 43 25/09/13 4:48 PM Final PDF to printer INTEREST AND DIVIDENDS PAID BY CORPORATIONS Corporate interest payments appear on the income statement as an expense item, so we deduct interest payments from operating income when the firm calculates taxable income. But any dividends paid by corporations to their shareholders are not tax deductible. This is one factor that encourages managers to finance projects with debt financing rather than to sell more stock. Suppose one firm uses mainly debt financing and another firm, with identical operations, uses mainly equity financing. The equity-financed firm will have very little interest expense to deduct for tax purposes. Thus, it will have higher taxable income and pay more taxes than the debt-financed firm. The debt-financed firm will pay fewer taxes and be able to pay more of its operating income to asset funders, that is, its bondholders and stockholders. So even stockholders prefer that firms finance assets primarily with debt rather than with stock. However, as mentioned earlier, increasing the amount of debt financing of the firm's assets also increases risks. So these affects must be balanced when selecting the optimal capital structure for a firm. The debt-versus-equity financing issue is called capital structure, which we address more fully in Part Eight of theS book. EXAMPLE 2-5 For interactive versions of this example visit www.mhhe.com/can3e T O LG2-1 U Effect of Debt-versus-Equity Financing on Funders' Returns T Suppose that you are considering a stock investment in one of two firms (AllDebt, Inc., and , AllEquity, Inc.), both of which operate in the same industry and have identical operating incomes of $5 million. AllDebt, Inc., finances its $12 million in assets with $11 million in debt (on which it pays 10 percent interest) and $1 million J in equity. AllEquity, Inc., finances its $12 million in assets with no debt and $12 million in equity. Both firms pay 30 percent tax on their taxable income. I available to pay its debt and stockholders (the firms' Calculate the income that each firm has asset funders) and the resulting returns L to these asset funders for the two firms. SOLUTION: Operating income Less: Interest Taxable income Less: Taxes (30%) Net income Income available for asset funders (5 Operating income 2 Taxes) Return on asset-funders' investment L I A N AllDebt AllEquity $5.00m 1.10m $3.90m 1.17m $2.73m $5.00m 0.00m $5.00m 1.50m $3.50m 9 5 $3.83m $3.50m 6 $3.83m/$12.00m 5 31.92% $3.50m/$12.00m 5 29.17% T By financing most of its assets with debt and receiving the associated tax benefits from the interest paid on this Soperating income to the funders of its assets, i.e., its debt holders debt, AllDebt, Inc., is able to pay more of its and stockholders, than AllEquity, Inc. Similar to Problems 2-19, 2-20 TIME OUT 44 2-3 What is an income statement? 2-4 When a corporation owns stock in another corporation, what percentage of dividends received on the stock is taxed? part two Financial Statements cor6168X_ch02_032-075.indd 44 25/09/13 4:48 PM Final PDF to printer 2.3 Statement of Cash Flows LG2-4 Income statements and balance sheets are the most common financial documents available to the public. However, managers who make financial decisions need more than these two statementsreports of past performanceon which to base their decisions for today and into the future. A very important distinction between the accounting point of view and the finance point of view is that financial managers and investors are far more interested in actual cash flows than in the backward-looking profit listed on the income statement. The statement of cash flows is a financial statement that shows the firm's cash flows over a given period of time. This statement reports the amounts of cash the firm has generated and distributed during a particular time period. The bottom line on the statement of cash flowsthe difference between cash sources and usesequals the change in cash and marketable securities on the firm's balance sheet from the previous year's balance. That is, the statement of cash flows reconciles noncash balance sheet items and income statement items to show changes in the cash and marketable securitiesSaccount on the balance sheet over the particular analysis period. T To clarify why this statement is so crucial, it helps to understand that figures O cash inflows and outflows on an income statement may not represent the actual for a firm during a given period of time. There U are two main issues, GAAP accounting principles and non-cash income statement T entries. statement of cash flows Financial statement that shows the firm's cash flows over a period of time. , GAAP Accounting Principles Company accountants must prepare firm incomeJstatements following GAAP principles. GAAP procedures require that the firm recognize revenue at the time I of sale. But sometimes the company receives the cash before or after the time of L sale. Likewise, GAAP counsels the firm to show production and other expenses on the income statement as the sales of those goods L take place. So production and other expenses associated with a particular product's sale appear on the I income statement (for example, cost of goods sold and depreciation) only when that product sells. Of course, just as with revenueA recognition, actual cash outflows incurred with production may occur at a very N different point in time usually much earlier than GAAP principles allow the firm to formally recognize the expenses. 9 5 Noncash Income Statement Entries 6 Further, income statements contain several noncash entries, the largest of which T noncash expense incurred is depreciation. Depreciation attempts to capture the S to the point when those as fixed assets deteriorate from the time of purchase assets must be replaced. Let's illustrate the effect of depreciation: Suppose a firm purchases a machine for $100,000. The machine has an expected life of five years and at the end of those five years, the machine will have no expected salvage value. The firm incurs a $100,000 cash outflow at the time of purchase. But the entire $100,000 does not appear on the income statement in the year that the firm purchases the machinein accounting terms, the machine is not expensed in the year of purchase. Rather, if the firm's accounting department uses the straight-line depreciation method, it deducts only $100,000/5, or $20,000, each year as an expense. This $20,000 equipment expense is not a cash outflow for the firm. The person in charge of buying the machine knows that the cash flow occurred at the time of purchaseand it totaled $100,000 rather than $20,000. chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 45 45 25/09/13 4:48 PM Final PDF to printer In conclusion, finance professionals know that the firm needs cash, not accounting profits, to pay the firm's obligations as they come due, to fund the firm's operations and growth, and to compensate the firm's ultimate owners: its shareholders. LG2-5 Sources and Uses of Cash In general, some activities increase cash (cash sources) and some decrease cash (cash uses). Figure 2.3 classifies the firm's basic cash sources and uses. Cash sources include decreasing noncash assets or increasing liabilities (or equity). For example, a drop in accounts receivable means that the firm has collected cash from its credit salesa cash source. Likewise, if a firm sells new common stock, the firm has used primary markets to raise cash. In contrast, a firm uses cash when it increases noncash assets (buying inventory) or decreases a liability (paying off a bank loan). The statement of cash flows separates these cash flows into three categories or sections: S T 2. Cash flows from investing activities. O 3. Cash flows from financing activities. U 4. Net change in cash and marketable securities. T The basic setup of a statement of cash flows is shown in Figure 2.4 and a more , for DPH Tree Farm for the year ending Decemdetailed statement of cash flows 1. Cash flows from operating activities. cash flows from operations Cash flows that are the direct result of the production and sale of the firm's products. ber 31, 2015, appears as Table 2.4. Cash flows from operations (Section A in Figure 2.4 and Table 2.4) are those J result directly from producing and selling the cash inflows and outflows that I include: firm's products. These cash flows Net income (adding backLdepreciation,2 a noncash expense item that is included in net income). L Working capital accounts other than cash and operations-related shortI term debt. A Most finance professionals consider this top section of the statement of cash flows N quickly and compactly the firm's cash flows to be the most important. It shows generated by and used for the production process. For example, DPH Tree Farm, figure 2.3 Sources and Uses of Cash Sources of Cash Net income Depreciation Decrease a noncash current asset Decrease a fixed asset Increase a current liability Increase long-term debt Sell common or preferred stock 9 5 6 T S Uses of Cash Net losses Increase a noncash current asset Increase a fixed asset Decrease a current liability Decrease long-term debt Repurchase common or preferred stock Pay dividends 2 Any other noncash expense (e.g., amortization) would also be added back to net income and any noncash revenue would be subtracted. 46 part two Financial Statements cor6168X_ch02_032-075.indd 46 25/09/13 4:48 PM Final PDF to printer figure 2.4 Section A. Cash flows from operating activities Net income Additions (sources of cash): Depreciation Decrease in noncash current assets (e.g., decrease in accounts receivable) Increase in accrued wages and taxes Increase in accounts payable Subtractions (uses of cash): Increase in noncash current assets (e.g., increase in inventory) Decrease in accrued wages and taxes Decrease in accounts payable Section B. Cash flows from investing activities Additions: Decrease in fixed assets Decrease in other long-term assets Subtractions: Increase in fixed assets Increase in other long-term assets Section C. Cash flows from financing activities Additions: Increase in notes payable Increase in long-term debt Increase in common and preferred stock Subtraction: Decrease in notes payable Decrease in long-term debt Decrease in common and preferred stock Dividends paid The Statement of Cash Flows S T O U T , J I L L I A Inc., generated $97 million in cash flows from its 2015 production. That is, producing and selling the firm's product resulted in aNnet cash inflow for the firm. Section D. Net change in cash and marketable securities Managers and investors look for positive cash flows from operations as a sign of a successful firmpositive cash flows from the9firm's operations is precisely what gives the firm value. Unless the firm has a stable, healthy pattern in its cash 5 no matter what its level of flows from operations, it is not financially healthy cash flow from investing activities or cash flows from 6 financing activities. Cash flows from investing activities (Section B in Figure 2.4 and Table 2.4) T are cash flows associated with buying or selling of fixed or other long-term assets. This section of the statement of cash flowsS shows cash inflows and outflows from long-term investing activitiesmost significantly the firm's investment in fixed assets. For example, DPH Tree Farm, Inc., used $68 million in cash to purchase fixed and other long-term assets in 2015. DPH funded this $68 million cash outflow with the $97 million cash surplus DPH Tree Farm produced from its operations. Cash flows from financing activities (Section C in Figure 2.4 and Table 2.4) are cash flows that result from debt and equity financing transactions. These include raising cash by: Issuing short-term debt cash flows from investing activities Cash flows associated with the purchase or sale of fixed or other long-term assets. cash flows from financing activities Cash flows that result from debt and equity financing transactions. Issuing long-term debt Issuing stock chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 47 47 25/09/13 4:48 PM Final PDF to printer table 2.4 Statement of Cash Flows for DPH Tree Farm, Inc. DPH TREE FARM, INC. Statement of Cash Flows for Year Ending December 31, 2015 (in millions of dollars) 2015 Section A. Cash flows from operating activities Net income Additions (sources of cash): Depreciation Increase in accrued wages and taxes Increase in accounts payable Subtractions (uses of cash): Increase in accounts receivable Increase in inventory Net cash flow from operating activities Section B. Cash flows from investing activities Subtractions: Increase in fixed assets Increase in other long-term assets Net cash flow from investing activities S T Section C. Cash flows from financing activities O Additions: Increase in notes payable U Increase in long-term debt T stock Increase in common and preferred Subtractions: , Preferred stock dividends paid Common stock dividends paid Net cash flow from financing activities Section D. Net change in cash and marketable securities $ 90 13 5 5 25 211 $ 97 2$ 68 0 2$ 68 $ 0 5 0 210 225 2$ 30 2$ 1 J I L or using cash to: L Pay dividends I Pay off debt A Buy back stock N financing activities produced a net cash outIn 2015, DPH Tree Farm, Inc.'s, net change in cash and marketable securities The sum of the cash flows from operations, investing activities, and financing activities. 48 flow of $30 million. As we saw with cash flows from financing activities, this $30 million cash outflow was funded (at least partially) with the $97 million 9 cash surplus DPH Tree Farm produced from its operations. Managers, investors, and analysts normally expect 5 the cash flows from financing activities to include small amounts of net borrowing 6 along with dividend payments. If, however, a firm is going through a major period of expansion, net borrowing could reasonT ably be much higher. Net change in cash andSmarketable securities (Section D in Figure 2.4 and Table 2.4), the bottom line of the statement of cash flows, shows the sum of cash flows from operations, investing activities, and financing activities. This sum will reconcile to the net change in cash and marketable securities account on the balance sheet over the period of analysis. For example, the bottom line of the statement of cash flows for DPH Tree Farm is 2$1 million. This is also the change in the cash and marketable securities account on the balance sheet (in Table 2.1) between 2014 and 2015 ($24 million 2 $25 million 5 2$1 million). In this case, the firm's operating, investing, and financing activities combined to produce a net drain on the firm's cash during 2015cash outflows were greater than cash inflows, largely because of the $68 million investment in long-term and fixed assets. Of course, when the bottom line is positive, a firm's cash inflows exceed cash outflows for the period. part two Financial Statements cor6168X_ch02_032-075.indd 48 25/09/13 4:48 PM Final PDF to printer Even though a company may report a large amount of net income on its income statement during a year, the firm may actually receive a positive, negative, or zero amount of cash. For example, DPH Tree Farm, Inc., reported net income of $90 million on its income statement (in Table 2.2), yet reported a net change in cash and marketable securities of 2$1 million on its statement of cash flows (in Table 2.4). Accounting rules under GAAP create this sense of discord: Net income is the result of accounting rules, or GAAP, that do not necessarily reflect the firm's cash flows. While the income statement shows a firm's accountingbased income, the statement of cash flows more often reflects reality today and is thus more important to managers and investors as they seek to answer such important questions as: Does the firm generate sufficient cash to pay its obligations, thus avoiding financial distress? Does the firm generate sufficient cash to purchase assets needed for sustained growth? S its outstanding debt Does the firm generate sufficient cash to pay down obligations? T O U 2.4 Free Cash Flow T as net income plus noncash The statement of cash flows measures net cash flow adjustments. However, to maintain cash flows over, time, firms must continually replace working capital and fixed assets and develop new products. Thus, firm managers cannot use the available cash flows any way they please. Specifically, J expected free cash flows, the value of a firm's operations depends on the future defined as after-tax operating profit minus the amount of new investment in I working capital, fixed assets, and the development of new products. Thus, free L cash flow represents the cash that is actually available for distribution to the L investors in the firmthe firm's debt holders and stockholdersafter the investments that are necessary to sustain the firm's ongoing operations are made. I To calculate free cash flow (FCF), we use the mathematical equation that A appears below: free cash flows The cash that is actually available for distribution to the investors in the firm after the investments that are necessary to sustain the firm's ongoing operations are made. N FCF 5 3 EBIT (1 2 Tax rate) 1 Depreciation 4 2 3 DGross fixed assets 1 DNet operating working capital 4 9 5 3 NOPAT 1 Depreciation 4 2 Investment 5 in operating capital 5 Operating cash flow 2 Investment in6operating capital (2-8) Notice from this equation that free cash flow mergesTinformation from the income statement (performance) with information from S the balance sheet (resources used to produce performance). To calculate free cash flow, we start with operating cash flow. Firms generate operating cash flow (OCF) after they have paid necessary operating expenses and taxes. This net operating profit after taxes (NOPAT) is the net profit a firm earns after taxes, but before any financing costs. It is the profit available for debt holders and stockholders if the firm does not replace existing or invest in new working capital or fixed assets. Depreciation, a noncash charge, is added back to NOPAT to determine total OCF. We add other relevant noncash charges, such as amortization and depletion, back as well. Firms either buy physical assets or earmark funds for eventual equipment replacement to sustain firm operations; this is called investment in operating capital (IOC). In accounting terms, IOC includes the firm's gross investments (or changes) in fixed assets, current net operating profit after taxes (NOPAT) Net profit a firm earns after taxes but before any financing costs. chapter 2 Reviewing Financial Statements cor6168X_ch02_032-075.indd 49 49 25/09/13 4:48 PM Final PDF to printer assets, and spontaneous current liabilities (such as accounts payable and accrued wages). Thus, free cash flow measures how well managers utilize the resources of the company to increase firm performance and, thus, enhance shareholder wealth. EXAMPLE 2-6 LG2-5 Calculating Free Cash Flow For interactive versions of this example visit www.mhhe.com/can3e From Tables 2.1 and 2.2, in 2015, DPH Tree Farm, Inc., had EBIT of $152 million, a tax rate of 33.82 percent ($46m/$136m), and depreciation expense of $13 million. Therefore, DPH Tree Farm's operating cash flow was: OCF 5 EBIT (1 2 Tax rate) 1 Depreciation 5 $152m (1 2 0.3382) 1 $13m 5 $114m DPH Tree Farm's gross fixed assets increased by $68 million between 2014 and 2015. The S firm's current assets increased by $15 million and spontaneous current liabilities increased by T and taxes and $5 million in accounts payable). $10 million ($5 million in accrued wages Therefore, DPH's investment in operating capital for 2015 was: O IOC 5 DGross fixed assets 1 DNet operating working capital U 5 $68m 1 ($15m 2 $10m) 5 $73m T , Accordingly, what was DPH Tree Farm's free cash flow for 2015? SOLUTION: FCF 5 Operating cash flow 2 Investment in operating capital J$73m 5 $41m 5 $114m 2 I had cash flows of $41 million available to pay its stockholders In other words, in 2015, DPH Tree Farm, Inc., and debt holders. L Similar to Problems 2-11, 2-12, self-test L problem 4 I A N Like the bottom line shown on the statement of cash flows, the level of free cash flow can be positive, zero, or negative. A positive free cash flow value means that the firm may distribute funds 9 to its investors (debt holders and stockholders.) When the firm's free cash flows come in as zero or negative, however, the 5 firm's operations produce no cash flows available for investors. Of course, if free 6 cash flow is negative because operating cash flow is negative, investors are likely to take up the issue with the T firm's management. Negative free cash flows as a result of negative operating cash flows generally indicate that the firm is expeS riencing operating or managerial problems. A firm with positive operating cash flows, but negative free cash flows, however, is not necessarily a poorly managed firm. Firms that invest heavily in operating capital to support growth often have positive operating cash flows but negative free cash flows. But in this case, the negative free cash flow will likely result in growing future profits. TIME OUT 50 2-5 What is a statement of cash flows? 2-6 What are the main sections on the statement of cash flows? part two Financial