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.

Financial Statements

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

Income Statement

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.

Balance Sheet Statement

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
  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
2. Liabilities - these are the debts or obligations of a business.
  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

Statement of Changes in Owner’s Equity

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

Statement of Cash Flows

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

Finance Formulas

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

 

An Example

Balance Sheet
December 31, 2001
Beginning Ending Beginning Ending
Current Assets Current Liabilities
     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
Retained Earnings 4,000 3,600
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
Interest 150
Taxable Income 1150
Taxes (20%) 230
Net Income 920
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

 

Sales Forecast

Sales forecast drives the model

For example

Income Statement Balance Sheet
Sales $200 Assets $100 Debt $50
Costs $180 Equity $50
Net Income $20 Total $100 Total $100
Assume
  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.

Pro-Forma Financial Statement
Income Statement Balance Sheet
Sales $220 Assets $110 Debt $55
Costs $198 Equity $55
Net Income $22 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

  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

 

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
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.

 

Maximum Allowable Borrowing

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

Balance Sheet
Original
Assets
     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
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:

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

 

Balance Sheet
Pro Forma
Assets Liabilities
     Cash $250      Account Payable $200 + ?
     Accounts Rec. 400      Notes Payable 200 + ?
     Inventory 500      Total Current Liabilities $400 + ?
     Total Current Assets 1,150 Long-term Debt 200 + ?
Net Fixed Assets 1,350 Common Stock 800 + ?
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.

 

General Formulas

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.

 

Maximum Sustainable Growth

How fast can sales grow without requiring external financing?

Income Statement Balance Sheet
Sales $200 Assets $100 Debt $50
Costs $180 Equity $50
Net Income $20 Total $100 Total $100
Dividends
Increase in Retained Earnings

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%)

 

FOLLOW ME