Investment is based on plans for committing existing or new
funds to three main areas:
- Working Capital
- Physical Assets
- Major Spending Programs, such as R&D, Product Development,
Acquisitions, etc.
If an investment is not working out, then it is necessary to
disinvest. Yardsticks, such as Net Present Value are used
in making investment decisions.
Once the investments are made, it is necessary to operate the
resulting projects efficiently. Decisions such as the appropriate
level of operating leverage, on the production side; and the choice
of price/marketing strategy on the sales side are involved in
the operating process.
The profits from the operations of the firm feed into the third
process, the financing process. Here dividend payout decisions
have to be made, as well as the appropriate sourcing of funds
from a variety of sources, both equity-based and debt-based.
In order to take the proper decisions, it is necessary for the
manager to have access to the right information. Information
related to the investment and the funding process can be found
in the balance sheet, while information related to the operating
process can be found primarily in the Income Statement.
The Statement of Retained Earnings provides more details regarding
the disposition of the equity account. The Statement of
Cash Flows provides more detail regarding the sources and uses
of cash, which can help in a proper analysis of the operations
of the firm.
We will now discuss these four financial statements in a little
more detail.
The Balance Sheet
The balance sheet is a snapshot of the firm; it is a means of organizing
and summarizing what a firm owns (its assets) and what it owes (its
liabilities). Here is an example of a balance sheet.
Example
| Assets |
|
|
Liabilities |
|
|
| |
1993 |
1994 |
|
1993 |
1994 |
| Current Assets |
|
|
Current Liabilities |
|
|
| Receivables |
1200 |
1250 |
Payables |
1229 |
1149 |
| Inventories |
1400 |
1683 |
|
|
|
| Cash |
1987 |
2087 |
|
|
|
| Total Current Assets |
4587 |
5020 |
Total Current Liabilities |
1229 |
1149 |
| |
|
|
Working Capital =Current Assets- Current Liabilities |
3358 |
3871 |
| Fixed Assets |
|
|
Long-term debt |
3475 |
4300 |
| Tangible Fixed Assets |
5106 |
5315 |
|
|
|
| Intangible Fixed Assets |
3000 |
3000 |
|
|
|
| Total assets |
12693 |
13335 |
Total liabilities |
4704 |
5449 |
| |
|
|
Shareholders' equity = |
|
|
| |
|
|
Owner's Equity |
|
|
| |
|
|
Common Stock and Paid-in Surplus |
2000 |
1476 |
| |
|
|
Retained Earnings |
5989 |
6410 |
| |
|
|
Total liabilities and shareholders' equity |
12693 |
13335 |
Damodaran presents a convenient way of categorizing the items
in a balance sheet:
| Assets |
Liabilities |
| Long Lived Real Assets |
Fixed Assets |
Current Liabilities |
Short-term Liabilities of the firm |
| Short-lived Assets |
Current Assets |
Debt |
Debt Obligations of the firm |
| Investments in securities and assets of other
firms |
Financial Investments |
Other Liabilities |
Other long-term Obligations |
| Assets which are not physical, like patents
& trademarks |
Intangible Assets |
Equity |
Equity Investment in Firm |
Important Concepts Pertaining to the Balance Sheet:
Net Working Capital: The difference between current assets
and current liabilities. This represents the amount of capital
that the firm is using for the short-run needs of the business.
Shareholders’ Equity: The difference between what
the business owns and what it owes, i.e. the shareholder’s
wealth in the firm.
Liquidity: This refers to the speed and ease with which
an asset can be converted to cash. Assets are normally listed
on the balance sheet in order of liquidity.
Market Value versus Book Value: The Book Value of an asset
is based on accounting concepts, which are often linked up with
historical cost. This need not be the same as market value. In
addition, assets such as managerial talent and liabilities such
as potential product liability suits are often not represented
on the balance sheet. Finance is usually interested in market
value, rather than in book value.
The rule that assets are valued at book rather than market, in
financial statements is generally true. However, financial
investments are not always subject to this rule, since, often,
dependable market values can be obtained from liquid markets.
The rules that apply in this case are, in summary form, as follows:
| Majority |
Minority |
| Active Investment |
Active Investment |
Passive Investment |
| > 50% ownership of asset |
20% to 50% ownership of asset |
Between 0% and 20%
ownership of asset |
| |
|
Investments held to maturity |
Investments available for sale |
Trading Investments |
The accounting treatment:
The balance sheets of the two firms are consolidated,
with the assets and the liabilities of the two firms being
merged and shown together. The ownership stake of the
minority shareholders is shown in the balance sheet as a liability. |
The accounting treatment:
The investment is carried at historical acquisition cost;
a proportional amount of the income of the firm is added to
the book value of the investment, while dividends paid are
deducted from the book value. The proportional income
is reported in the income statement, but the receipt of dividends
is not recognized in the income statement. However,
the concomitant increase in cash is recorded. |
The accounting treatment:
Shown at historical value, with interest/dividends shown
in the income statement |
The accounting treatment:
Valued at market, but unrealized gains and losses are
shown as part of equity in the balance sheet and not in the
income statement. |
The accounting treatment:
Valued at market and unrealized gains/losses are shown
in the income statement. |
My interpretation:
Essentially treated as a subsidiary, except that minority
holdings in the owned firm are shown on the liabilities side;
the same is done in the Income Statement as well. |
My interpretation:
Equity approach:
Recorded at book value just like any other asset; except that
income and dividends are treated as adjustments to the book
value (dividends in this case are comparable to depreciation
in the usual fixed asset case, except that there will be cash
implications in our situation).
The regular income of the firm would show up on the liabilities
side, as an addition to retained earnings, while in our case,
it is treated as a reduction on the assets side. |
My interpretation:
Recorded at book value, just like any other asset; however,
this approach differs from the equity approach in terms of
how income is treated. |
My interpretation:
Since these assets are traded in a liquid market, there
is a reliable price available for them, and there is an intention
to use this market (since the assets are considered available
for sale); in this case, this price trumps acquisition cost
as an accounting measure of value. Unrealized
gains-and-losses are shown on the liabilities side, and not
on the assets side as in the equity approach. |
My interpretation:
For the same reasons as in the case of investments available
for sale, these are valued at market. Their treatment
can be compared to the treatment of inventory, but even unsold
"inventory" is considered "sold," because
they are so liquid and saleable. |
Intangible assets, such as patents, if they are generated internally
through research and development don't even show up as assets in
the balance sheet since they are simply expensed. If they
are acquired from other parties, then they are shown at historical
value. Goodwill is an example of such an intangible asset.
It is created when a firm acquires another firm where the purchase
price is greater than the book value of tangible assets or intangible
assets such as patents and trade names; the excess price is called
goodwill. Hence it is simply a reflection of the difference
between the book value of assets and the market value of the acquired
firm that owned the assets.
Income Statement
An Income Statement provides information about a firm's operating
activities over a specified time period. The main categories
are shown in the table below:
| Gross Revenues from sale of products and
services |
Revenues |
| Expenses associated with generating revenues |
- Operating Expenses |
| Operating Income for the period |
= Operating Income |
| Expenses associated with borrowing and
other financing |
- Financial Expenses |
| Taxes due on taxable income |
- Taxes |
| Earnings to Common and Preferred Equity
for current period |
= Net Income before Extraordinary Items |
| Profits and Losses not associated with
operations |
-(+) Extraordinary Losses (Profits) |
| Profits or losses associated with changes
in accounting rules |
- Income Changes caused by changes in
accounting methods |
| Dividends paid to preferred stockholders |
- Preferred Dividends |
| |
= Net Income to Common Stockholders |
Example: Rasputin Corporation
| Income Statement (in Millions of
Dollars) |
1993 |
1994 |
| Sales |
1745 |
1990 |
| Cost of Goods Sold |
690 |
770 |
| Depreciation |
184 |
184 |
| EBIT |
871 |
1036 |
| Interest |
122 |
148 |
| Taxable Income |
749 |
888 |
| Taxes (34%) |
255 |
302 |
| Net Income |
494 |
586 |
| Dividends |
150 |
165 |
| Addition to Retained Earnings |
344 |
421 |
Shares Outstanding = 125 million
Earnings per share for 1993= Net Income/# shares = 494/125 =
$3.95
Dividend per share for 1993= Total Dividends/# shares = 150/125
= $1.20
An Income Statement is a record of the revenues and expenses
of a firm over a particular period of time using GAAP, rather
than the actual cash flows.
Let us consider a balance sheet. We know that GAAP rules are
used to make up the balance sheet; and these are tilted towards
recording the past. However, the financial analyst is interested
in what the balance sheet can tell him about the future. When
a financial analyst looks at a balance sheet for purposes of valuation
or for purposes of analyzing the firm's capital structure, he might
like to see a balance sheet that looks somewhat like this:
| Assets |
Liabilities |
Existing Investments
Generate
Cashflows today
Includes long lived (fixed) and
short-lived (working capital) assets |
Assets-in-place |
Debt |
Fixed Claim on cashflows
Little or no role in management
Fixed
Maturity
Tax Deductible |
| Expected value that will be created by future
investments |
Growth Assets |
Equity |
Residual Claim on cashflows
Significant role in management
Perpetual
Lives |
The Assets side of
the picture
Given the discussion of valuation principles above, we see that
it is not easy to generate values for assets-in-place and growth
assets from the traditional balance sheet information. For
example, intangible assets are given short shrift in the traditional
accounting methodology. One way to do this would be to take
the research and development expenses from the Income Statement
and to capitalize them.
In order to do this, we would first need to get an estimate of
the amount of time that it takes for research and development
to be converted into commercial products. This is called
the amortizable life of the product. This would be long
for a pharmaceutical company, but shorter for a software company.
Suppose, for example, that the amortizable life is six years.
We then collect the annual R&D expenses for the company.
Assuming that the amortization is uniform over time, R&D expenses
from six years ago and more, would have been fully amortized.
R&D expenses from five years ago would only have one-sixth
of their value unamortized; R&D from four years ago, would
be two-sixths unamortized, and so on. These unamortized
values are then added together to obtain an estimate of the value
of R&D as an asset, following accounting principles similar
to that used with Property, Plant and equipment.
This approach would, first of all, give us a better idea of the
market value of the firm; secondly, by looking at the ratio of
such "growth" assets to the total value of all assets,
we can get a better estimate of the growth rate. In addition,
the greater the proportion of such "growth" assets,
the lower the proportion, we would expect, of debt in the capital
structure of the firm, as will be explained in the notes
on Capital Structure.
Capitalization of R&D:
For example, SmithKline Beecham (SBH) report on their website
Research and Development expenses for the last five years:
| Year |
R & D expense (in £) |
Unamortized proportion |
Unamortized Value |
| 1999 |
1018 |
1 |
1018 |
| 1998 |
910 |
0.8 |
728 |
| 1997 |
843 |
0.6 |
505.8 |
| 1996 |
764 |
0.4 |
305.6 |
| 1995 |
653 |
0.2 |
130.6 |
Suppose we assume that the amortizable life is five years.
Then, if we are computing the value of R&D asset in 1999,
none of the £1018 incurred this year will have been amortized;
all of it will be added into the value of R&D asset.
For 1998, 20% of that (or one-fifth) will be amortized, and the
remaining 80% (0.8 times £910) will be included in the value of
R&D asset. Proceeding thus, we have a value of £2688
for the R&D asset as of 1999.
Of course, if we capitalize R&D expenses to create a new
asset, we will have to adjust Operating Income as well.
We will add back R&D expenses, but then subtract the amortization
of the R&D asset. Hence:
Adjusted Operating Income = Operating Income + R&D expenses
- Amortization of the R&D asset
Adjusted Net Income = Net Income + R&D expenses - Amortization
of the R&D asset
Another example:
Apple Inc (AAPL)
From
the information submitted to the SEC by Apple Inc. on 9/29/2007
(Source: http://phx.corporate-ir.net/phoenix.zhtml?c=107357&p=irol-SECText&TEXT=aHR0cDovL2NjYm4uMTBrd2l6YXJkLmNvbS94bWwvZmlsaW5nLnhtbD9yZXBvPXRlbmsmaXBhZ2U9NTI4NjAzNSZhdHRhY2g9T04%3d)
Company Background
Apple Inc. and its wholly-owned subsidiaries (collectively "Apple"
or the "Company") design, manufacture, and market personal
computers, portable digital music players, and mobile communication
devices and sells a variety of related software, services, peripherals,
and networking solutions. The Company sells its products worldwide
through its online stores, its retail stores, its direct sales
force, and third-party wholesalers, resellers, and value-added
resellers. In addition, the Company sells a variety of third-party
Macintosh ("Mac"), iPod and iPhone compatible products,
including application software, printers, storage devices, speakers,
headphones, and various other accessories and peripherals through
its online and retail stores. The Company sells to education,
consumer, creative professional, business, and government customers.
The Company's fiscal year is the 52 or 53-week period that ends
on the last Saturday of September. Unless otherwise stated, all
information presented in this Form 10-K is based on the Company's
fiscal calendar.
The
following financial statements information has been obtained from
Disclosure (the financial data from 2003 to 2007 are obtained
from Mergent Online):
Balance Sheet
(in millions of dollars)
|
As Reported Annual
Balance Sheet |
9/29/07
|
9/30/06
|
9/24/05
|
9/25/04
|
9/27/03
|
| Cash & cash equivalents |
9,352
|
6,392
|
3,491
|
2,969
|
3,396
|
| Short-term investments |
6,034
|
3,718
|
4,770
|
2,495
|
1,170
|
| Accounts receivable, gross |
1,684
|
1,304
|
941
|
821
|
815
|
| Allowances |
47
|
52
|
46
|
47
|
49
|
| Accounts receivable, net |
1,637
|
1,252
|
895
|
774
|
766
|
| Purchased parts |
NA
|
NA
|
NA
|
1
|
2
|
| Work in process |
NA
|
NA
|
NA
|
NA
|
4
|
| Finished goods |
NA
|
NA
|
NA
|
100
|
50
|
| Inventories |
346
|
270
|
165
|
101
|
56
|
| Deferred tax assets |
782
|
607
|
331
|
231
|
190
|
| Vendor non-trade receivables |
2,392
|
1,593
|
417
|
276
|
NA
|
| NAND flash memory prepayments |
417
|
208
|
NA
|
NA
|
NA
|
| Other current assets |
996
|
469
|
231
|
209
|
NA
|
| Other current assets |
3,805
|
2,270
|
648
|
485
|
NA
|
| Other current assets, net |
NA
|
NA
|
NA
|
NA
|
309
|
| Total current assets |
21,956
|
14,509
|
10,300
|
7,055
|
5,887
|
| Land & buildings |
762
|
626
|
361
|
351
|
350
|
| Machinery, equipment, & internal-use software |
954
|
595
|
494
|
422
|
393
|
| Office furniture & equipment |
106
|
94
|
81
|
79
|
74
|
| Leasehold improvements |
1,019
|
760
|
545
|
446
|
357
|
| Property, plant & equipment, gross |
2,841
|
2,075
|
1,481
|
1,298
|
1,174
|
| Accumulated depreciation & amortization |
1,009
|
794
|
664
|
591
|
505
|
| Property, plant & equipment, net |
1,832
|
1,281
|
817
|
707
|
669
|
| Goodwill |
38
|
38
|
69
|
80
|
85
|
| Acquired intangible assets, net |
299
|
139
|
27
|
17
|
24
|
| Long-term NAND flash memory prepayments |
625
|
1,042
|
NA
|
NA
|
NA
|
| Non-current deferred tax assets |
88
|
NA
|
183
|
86
|
NA
|
| Capitalized software development costs, net |
83
|
21
|
38
|
25
|
NA
|
| Other assets |
426
|
175
|
117
|
80
|
NA
|
| Total other assets |
1,222
|
1,238
|
338
|
191
|
NA
|
| Total assets |
25,347
|
17,205
|
11,551
|
8,050
|
6,815
|
| |
|
|
|
|
|
| Accounts payable |
4,970
|
3,390
|
1,779
|
1,451
|
1,154
|
| Deferred revenue - current |
1,410
|
746
|
501
|
544
|
NA
|
| Deferred margin on component sales |
545
|
324
|
NA
|
NA
|
NA
|
| Other accrued tax liabilities |
488
|
388
|
NA
|
NA
|
NA
|
| Accrued marketing & distribution |
288
|
298
|
221
|
147
|
NA
|
| Accrued compensation & employee benefits |
254
|
221
|
167
|
134
|
NA
|
| Accrued warranty & related costs |
230
|
284
|
188
|
105
|
NA
|
| Other current liabilities |
1,114
|
820
|
628
|
299
|
NA
|
| Accrued expenses |
4,329
|
3,081
|
1,705
|
1,229
|
899
|
| Current debt |
NA
|
NA
|
NA
|
NA
|
304
|
| Total current liabilities |
9,299
|
6,471
|
3,484
|
2,680
|
2,357
|
| Deferred tax liabilities |
NA
|
NA
|
NA
|
294
|
235
|
| Deferred revenue - non-current |
830
|
355
|
281
|
NA
|
NA
|
| Deferred tax liabilities |
619
|
381
|
308
|
NA
|
NA
|
| Other non-current liabilities |
67
|
14
|
12
|
NA
|
NA
|
| Non-current liabilities |
1,516
|
750
|
601
|
NA
|
NA
|
| Total liabilities |
10,815
|
7,221
|
4,085
|
2,974
|
2,592
|
| |
|
|
|
|
|
| Common stock |
5,368
|
4,355
|
3,521
|
2,514
|
1,926
|
| Deferred stock compensation |
NA
|
NA
|
60
|
93
|
62
|
| Retained earnings (accumulated deficit) |
9,101
|
5,607
|
4,005
|
2,670
|
2,394
|
| Accumulated other comprehensive income (loss) |
63
|
22
|
-
|
-15
|
-35
|
| Total shareholders' equity |
14,532
|
9,984
|
7,466
|
5,076
|
4,223
|
| Total liabilities & shareholder's equity |
25,347
|
17,205
|
11,551
|
8,050
|
6,815
|
Income Statement
(in millions of dollars)
|
As
Reported Annual
Income Statement |
9/29/07
|
9/30/06
|
9/24/05
|
9/25/04
|
9/27/03
|
| Net
sales |
24,006
|
19,315
|
13,931
|
8,279
|
6,207
|
| Cost
of sales |
15,852
|
13,717
|
9,888
|
6,020
|
4,499
|
| Gross
margin |
8,154
|
5,598
|
4,043
|
2,259
|
1,708
|
| Research
& development expense |
782
|
712
|
534
|
489
|
471
|
| Selling,
general & administrative expense |
2,963
|
2,433
|
1,859
|
1,421
|
1,212
|
| Special
charges: restructuring costs |
-
|
-
|
-
|
23
|
26
|
| Total
operating expenses |
3,745
|
3,145
|
2,393
|
1,933
|
1,709
|
| Operating
income (loss) |
4,409
|
2,453
|
1,650
|
326
|
-1
|
| Gain
(losses) on non-current investments, net |
-
|
-
|
-
|
4
|
10
|
| Interest
income |
647
|
394
|
183
|
64
|
-
|
| Interest
expense |
-
|
-
|
-
|
3
|
-
|
| Gains
on sales of short term investments |
-
|
-
|
-
|
1
|
-
|
| Other
income (expense), net |
-48
|
-29
|
-18
|
-9
|
-
|
| Interest
& other income, net |
-
|
-
|
165
|
53
|
-
|
| Other
income & expenses |
599
|
365
|
-
|
-
|
-
|
| Interest
& other income, net |
-
|
-
|
-
|
-
|
83
|
| Total
interest & other income, net |
-
|
-
|
165
|
57
|
93
|
| Income
(loss) before provision for income taxes |
5,008
|
2,818
|
1,815
|
383
|
92
|
| Current
federal income taxes expense (benefit) |
1,219
|
619
|
303
|
34
|
18
|
| Deferred
federal income taxes expense (benefit) |
85
|
56
|
146
|
56
|
-7
|
| Total
federal income taxes expense (benefit) |
1,304
|
675
|
449
|
-
|
-
|
| Current
state income taxes expense (benefit) |
112
|
56
|
66
|
5
|
4
|
| Deferred
state income taxes expense (benefit) |
9
|
14
|
-91
|
-18
|
-11
|
| Total
state income taxes expense (benefit) |
121
|
70
|
-25
|
-
|
-
|
| Current
foreign income expense (benefit) |
103
|
101
|
59
|
46
|
21
|
| Deferred
foreign income taxes expense (benefit) |
-16
|
-17
|
-3
|
-16
|
-1
|
| Total
foreign income taxes expense (benefit) |
87
|
84
|
56
|
-
|
-
|
| Provision
for (benefit from) income taxes |
1,512
|
829
|
480
|
107
|
24
|
| Income
(loss) before accounting change |
-
|
-
|
1,335
|
276
|
68
|
| Cumulative
effect of accounting change, net |
-
|
-
|
-
|
-
|
1
|
| Net
income (loss) |
3,496
|
1,989
|
1,335
|
276
|
69
|
| Year
end shares outstanding |
872.329
|
855.263
|
835.019
|
782.887
|
733.453
|
Software Development Costs
Research
and development costs are expensed as incurred. Development costs
of computer software to be sold, leased, or otherwise marketed
are subject to capitalization beginning when a product's technological
feasibility has been established and ending when a product is
available for general release to customers pursuant to SFAS No. 86,
Computer Software to be Sold, Leased, or Otherwise Marketed. In
most instances, the Company's products are released soon after
technological feasibility has been established. Therefore, costs
incurred subsequent to achievement of technological feasibility
are usually not significant, and generally most software development
costs have been expensed.
In
2007, the Company determined that both Mac OS X Version 10.5 Leopard
("Mac OS X Leopard") and iPhone achieved technological
feasibility. During 2007, the Company capitalized $75 million
of costs associated with the development of Leopard and iPhone.
In accordance with SFAS No. 86, the capitalized costs related
to Mac OS X Leopard and iPhone are amortized to cost
of sales commencing when each respective product begins shipping
and are recognized on a straight-line basis over a 3 year
estimated useful life of the underlying technology.
Total
amortization related to capitalized software development costs
was $13 million, $18 million, and $16 million in
2007, 2006, and 2005, respectively.
Questions:
Given the following information on the
firm’s balance sheet, and income statement
1.
If you were a financial analyst,
how would you like to treat the R&D expense?
2.
If you capitalize the expense,
how large will it be? Since both Mac OS X Version 10.5 Leopard
and iPhone have 3 years amortizable life, we can assume the other
R&D expense can be amortized for 3 years. Estimate the value
of the R&D asset as of September 29, 2007.
3.
Operating income for 2007 has
been disclosed as $4,409 million, compute the adjusted operating
income if the company were capitalizing R&D.
Solutions:
1.
Yes, it is significant to include R&D as an asset because
the company’s future cash flows depend on research and development
outlays.
2.
Because the nature of the Apple’s products (for example
the iPhone will become obsolete in about 3 years), the amortizable
life of R&D is about 3 years.
| |
Life of R&D = 3 years
|
|
| Fiscal Year |
R&D Outlay |
Unamortized Portion
at end of 2007 |
Value |
Amortization for 2007 |
| 2004 |
$489 |
0.0000 |
$0.00 |
$163.00 |
| 2005 |
$534 |
0.3333 |
$178.00 |
$178.00 |
| 2006 |
$712 |
0.6667 |
$474.67 |
$237.33 |
| 2007 |
$782 |
1.0000 |
$782.00 |
$0.00 |
| |
Capitalized value of R&D for 2007
= |
$1,434.67 |
|
| |
|
Total R&D Amortization Expense for 2007 =
|
$578.33 |
Note: The amortization for the period of 2004 to 2006, we
divide each R&D outlay by 3. The amortization for 2007 is
zero. From the above, the value of R&D asset, as of
the end of 2007 would be $1,434.67 million.
3.
Adjusted Operating Income = Operating Income + R&D
Expense (R&D outlay for this year) - Amortization of R&D
Asset = 4,409 + 782 – 578.33 = $4,612.67 million
The Liabilities side
Similarly, on the liabilities side, a financial analyst would
want to know the firm's debt-equity ratio, or equivalently, the
debt ratio. Let's look at the simplest measure of the debt
ratio.
The Debt Ratio:
How would you compute the debt ratio? Well, we know the
debt ratio is defined as Total Debt/Total Assets: just find total
debt and divide by total assets! However, we are faced
with several questions: do we take long-term debt or only short-term
debt? And what do we do with other liabilities, such as
Provisions for Risks and Charges and Deferred Taxes? The
custom is to only use Long-term debt in the computation of the
debt ratio number. The reason is that short-term debt or
other liabilities acquired in the normal running of the business
are considered operational. The debt ratio is used more
as a financing ratio -- as a measure of risk from a long-term
perspective. If we use the example of GE (see below for
the reported financial statements), the
debt ratio would be 46603/304012 or 15.33% for 1997.
However, we often use the identity Debt + Equity = Total assets
to generate the Debt/Equity ratio. If we simply defined
Equity as 34,438 (Total Common Equity), we would get a Debt/Equity
ratio of 1.353. However, if we used the identity, we would
get a debt-equity ratio of 0.1811 or 18.11%, which gives quite
a different picture. If we are excluding current liabilities
because they pertain to the operational side of the business,
clearly it would be the 1.353 that would give us a better idea
of the extent of the firm's leverage.
Yet another approach would be to rewrite the balance sheet by
excluding all current assets and current liabilities and simply
including net current liabilities (net of current assets) as an
element on the liabilities side. (On the other hand, one
might argue that it's more appropriate to include working capital
on the assets side). Items such as Provisions for Risks,
etc. could be folded into equity if they could be considered operational
charges, effectively being financed by retained earnings.
In this case, we would have net current liabilities of 29,367
(Current Liabilities - Current Assets), with total assets the
being $212,711. Obviously, this would give us different
numbers altogether.
A debt ratio, by itself, does not tell us much, however, until
we compare it to the debt ratios of other firms. Hence,
the main point, is to make sure that the ratios are constructed
similarly for all firms. This again is the reason why many
analysts look at the debt/equity ratio rather than the debt ratio.
For another example of debt-equity ratio computation, using AT&T,
click here. This example
highlights the different numbers that are computed by different
sources.
In addition to the issues mentioned above, there are some liabilities
that are not clearly laid out in the firm's balance sheet.
For example, lease obligations and employee benefits are also
liabilities, but these have to be estimated separately.
Operating Leases:
Example 1:
Here is an example using projected operating lease payments.
Operating leases do not, under current GAAP rules, have to be
reported as liabilities. Nevertheless, they are similar
to liabilities, such as bonds, in that they constitute fixed cash
outflows in the future.
Suppose a firm had equity with a book value of $800 million,
and a market value of $1 billion. It has no debt at all.
However, it does have operating leases. The estimated operating
lease payments is $90 million for the next two years, 85 m. three
years hence, 80m. each for the fourth and fifth year, and 75m.
for the following five years. The firm's cost of debt is
around 7%. How would a financial analyst capitalize these
lease payments?
Since the projected operating lease payments have, more or less,
the same risk characteristics as the firm's debt, it is reasonable
to use the cost of debt to discount the lease payments.
Doing this, we have the table below:
| Year |
Operating Lease expense |
Present Value at7% |
| 1 |
90 |
84.11215 |
| 2 |
90 |
78.60949 |
| 3 |
85 |
69.38532 |
| 4 |
80 |
61.03162 |
| 5 |
80 |
57.03889 |
| 6-10 |
75 |
219.2358 |
|
Sum of present values |
569.4313 |
This gives us a debt value for the operating leases of $569.4313
million. The firm's debt-to-equity ratio now jumps from
0.0 to 0.57!
Of course, if the operating lease payments are capitalized, we
need to adjust the assets side of the balance sheet as well.
In fact, an asset of equal size will be created. In addition,
operating income will be affected as well, since depreciation
on this asset will have to be recognized; furthermore, the operating
lease expenses that had originally been recognized will have to
be added back to Operating Income, since these lease payments
are no more expensed. On the other hand, there will be an
imputed interest expense on the operating lease liability that
will affect financing cash flows, but not operating income.
Damodaran suggests assuming, for convenience, that the interest
expense on the debt created by converting operating leases be
equal to the operating lease expense less the depreciation of
the asset created by the operating leases. Using this assumption,
we get:
Adjusted Operating Income = Operating Income - Depreciation on
operating lease asset + operating lease expenses
= Operating Income + Imputed Interest expense on operating leases.
Net Income will not be affected because the imputed interest
expense will have to be subtracted from Operating Income, just
as any other interest expense would be.
Example 2: Here is another
example in Excel.
Example 3: Here is a real-life example:
Look at the firm, Hologic, Inc. (HOLX). Suppose we were interested
in capitalizing their operating lease expenses for the balance
sheet for the year ending Sept. 30, 2006. Their 10Ks have the
following information:
Notes to Consolidated Financial Statements (In thousands, except
per share data)
Future minimum lease payments under all of the Company’s
operating leases are approximately as follows:
| Fiscal
Years Ending |
Amount |
| September 29,
2007 |
6,855 |
| September 27,
2008 |
6,419 |
| September 26,
2009 |
6,032 |
| September 25,
2010 |
5,670 |
| September 24,
2011 |
5,398 |
| Thereafter |
37,095 |
Operating lease payment information for the year ending September
30, 2006were not available on the 2006 10K submission. However,
in the previous year's 10K submission, it was stated that minimum
lease payments for the year ending Sept. 30, 2006 amounted to
$4844. Hence we use this amount as the operating lease payment
for 2006.
The 2006 10Ks also contain the following information (F-37):
The Company conducts its operations in leased facilities under
operating lease agreements that expire through fiscal 2022. The
Company leases certain equipment under operating lease agreements
that expire through fiscal 2015.
On the basis of this information, the $37,095 were equally distributed
over the years 2012 through 2022. If one wanted to be more conservative,
one could have spread out the payments only until 2015. However,
we do not have enough information to figure out exactly what the
payments are until 2015, and what the subsequent payments are.
Making the assumption of equal payments until 2022, we can compute
the capitalized value of the operating lease by discounting the
numbers back to 2006. For this, we need a discount rate, which
should be the rate that HOLX would pay if it were issuing new
debt with such a maturity in Sept. 2006. We don't have this information;
however, (variable) interest rates on existing debt (maturing
at various times from 2007 to 2011) were from 5% to 6.5% (p. 55
of 2006 10K). Of course, what we want is the fixed rate corresponding
to such debt. However, if the term structure is relatively flat,
then we could use these variable rates, which, at least, would
include some default premium (even though a fixed rate might have
a larger default premium). In any case, using this discount rate,
we get a capitalized value of $44,362.38.
To compute the implied financing cost for 2006, we add 4844 (assumed
to be the lease payment in 2006; see above) to $44,362.38, discount
the result back one year and multiply by the int rate, to get
0.065(4844 + 44,362.38))/(1.065) = $3003.21. The corrected operating
income, therefore is 50,339 + 3003.21 or $53,342.21
Statement of Retained Earnings:
This statement provides information on how much of the firm’s
earnings were retained in the business, and how much were paid
out in dividends, as well as the cumulative amount retained during
the life of the business.
Statement of Retained Earnings, Rasputin Corporation for the
Year Ending December 31, 1994.
| Balance of retained earnings,
December 31, 1993 |
$5989 |
| Add Net Income, 1994 |
$586 |
| Less: Dividends to Common Stockholders |
$165 |
| Balance of Retained Earnings,
December 31, 1994 |
$6410 |
Accounting flows versus cash flows
GAAP uses the realization principle, which recognizes revenue
when the earnings process is virtually complete, and the value
of an exchange of goods or services can be reliably determined.
In practice, revenue is usually recognized at the time of a sale,
whether or not cash is generated, as e.g. in the case of a credit
sale.
Noncash Items
Income statements contain other noncash items, such as depreciation.
Depreciation is the recognition of the decrease in value of a
productive asset over time, although based on a predetermined
rule, rather than the actual value decrease. Clearly, there is
no cash flow associated with depreciation; the actual cash flow
would have occurred whenever the asset was paid for.
Time and Costs
It is common to treat costs as being variable or fixed depending
on one’s time horizon. For a given time horizon, all costs
that are fixed within that time horizon are called fixed, and
those that vary are called variable. For example, if the time
horizon is relatively short, wages, payments to suppliers, etc.
are variable, while machinery and plant are fixed. Given a sufficiently
long horizon, all costs are variable. This concept is important
to the financial manager in that it determines which costs are
irrelevant for decision making because they are fixed, and hence
unalterably sunk.
Average Versus Marginal Tax Rates:
The difference between these two concepts is similar to the concept
of fixed versus variable costs. Just as variable costs are relevant
for decision making, even though fixed costs, too, must be borne;
similarly, the marginal tax rate is the relevant quantity for
decision making, although all taxes must be paid.
The marginal tax rate is the tax paid on the marginal dollar
of income. In other words, if income increases by one dollar,
the total tax paid would increase by as many cents as the marginal
tax rate.
Statement of Cash Flows
Since it is cash flow that ultimately repays loans, replaces equipment,
expands facilities and pays dividends, it is necessary to look beyond
the income statement at the Statement of Cash Flows (SCF).
Analyzing a company's cash inflows and outflows and their operating,
financing or investing sources helps us assess a company's liquidity
(nearness to cash of assets and liabilities), solvency (the ability
to pay liabilities when they mature) and financial flexibility (the
ability to react and adjust to opportunities and adversities).
Net Cash Flows can differ from Net Income because of non-cash-flow
items, such as depreciation. The SCF reports cash receipts
and payments by operating, financing, and investing activities.
- Operating activities are earnings-related activities.
Generally these relate to Income Statement activities, and items
included in working capital. Included are:
- Sales and expenses necessary to obtain sales
- Related operating activities, such as extending credit
to customers
- investing in inventories
- obtaining credit from suppliers
- payment of taxes
- insurance payments
- Other activities that don't easily fit into the other two
categories, such as settlements in lawsuits.
- Investing activities relate to the acquisition and
disposal of noncash assets: assets which are expected to generate
income for the company over a period of time. These include
lending funds and collecting on these loans.
- Financing activities relate to the contribution, withdrawing
and servicing of funds to support business activities.
Computation of Cash Flows:
Before looking at a more realistic set of financial statements,
it is worthwhile looking at the general methodology used in computing
cash flows. There are two ways of doing this: one, to start
with the accounting numbers and then modifying them in order to
arrive at the cash flow; two, to compute the cash flow numbers
directly. We first look at the indirect method:
| Net Cash flows provided by Operating Activities
= |
Net Income |
| |
+ Depreciation |
| |
- Increase in Receivables |
| |
- Increase in Inventories |
| |
+ Increase in Accounts Payable |
Two kinds of adjustments are shown above. One, noncash
deductions from Net Income like depreciation are added back.
Two, the effect of changes in working capital accounts that are
due to non-cash transactions are undone. For example, if
goods are sold on credit, two things occur: one, sales increase
and thereby net income; two, accounts receivable increase by the
same. However, no cash has come into the firm. Hence,
we adjust for this by subtracting the increase in accounts receivable
from Net Income. The other adjustments are similar.
Financing flows occur because of increases or decreases in the
firm's common or preferred stock or in its long-term debt.
Furthermore, he main entry under Investing Activities is Capital
Expenditures. Hence, in simple cases, we could write:
| Net Cash flows provided by Financing Activities
= |
Net Proceeds from Long-term Borrowing |
| |
+ Net Proceeds from Sale of Common Stock |
| |
- Cash Dividends paid to Stockholders |
| |
|
| Net Cash flows used by Investing Activities
= |
Capital Expenditures |
Finally,
| Cash at end of year = |
Cash at beginning of year + Net Cash flows provided
by Operating Activities + Net Cash flows provided by Financing
Activities- Net Cash flows used by Investing Activities |
Using this model, we can compute for 1994:
Net Cash Flows provided by Operating Activities =
| Net Income |
586 |
| + Depreciation |
+184 |
| - Increase in Receivables |
-(1250-1200) |
| - Increase in Inventories |
-(1683-1400) |
| + Increase in Accounts Payable |
+(1149-1229) |
| |
=357 |
Net Cash flows provided by Financing Activities =
| Net Proceeds from Long-term Borrowing |
4300-3475 |
| + Net Proceeds from Sale of Common Stock |
+(1476-2000) |
| - Cash Dividends paid to Stockholders |
-165 |
| |
=136 |
Net Cash Flows Used by Investing Activities = Capital Expenditures
= Ending Fixed Assets - Beginning Fixed Assets + Depreciation
= 8315-8106+184 = 393.
We can now reconcile Beginning Cash with Ending Cash:
| Ending Cash = |
Beginning Cash |
|
$1987 |
| |
+ Net Cash flows provided by Operating
Activities |
+ 357 |
|
| |
+ Net Cash flows provided by Financing
Activities |
+ 136 |
|
| |
- Net Cash flows used by Investing
Activities |
- 393 |
+$100 |
| |
|
|
=$2087 |
Free Cashflow and the Statement of Cashflows:
Cash Flow computations are useful in Asset Valuation, in Capital
Structure Analysis, and in Dividend Policy Analysis. A key
concept for these purposes is Free Cash Flow to Equity, as well
as Free Cash Flows to the firm. These are often conveniently
defined using accounting quantities as:
| Free Cash Flows to Equity (FCFE)
= |
Net Income - (Capital Expenditures - Depreciation)
- (Change in Noncash Working Capital) + (New Debt Issued -
Debt Repayments) - Preferred Dividends |
| Cash Flows to the Firm (FCFF) = |
EBIT (1-tax rate) - (Capital Expenditure - Depreciation)
- (Change in Noncash Working Capital) |
| Cash Flows to the Firm (FCFF) = |
FCFE + Interest Expense (1- tax rate) - (New
Debt Issues - Principal Repayments) + Preferred Dividends. |
Cashflow from Operating Activities as defined in the Statement
of Cashflows is essentially Net Income + Depreciation - (Change
in Noncash Working Capital). Hence, we have
Free Cash Flow to the Firm (FCFF) = Cash Flows from Operating
Activities from the Statement of Cashflows - (Capital expenditures
required to maintain productive capacity) and
Free Cash Flow to Equity (FCFE) = Cash Flows from Operating Activities
from the Statement of Cashflows - (Capital expenditures required
to maintain productive capacity) - (dividends on preferred stock)
- (New Debt Issued - Debt Repayments).
However, we must keep in mind that the Statement of Cashflows
is a historical document and computes historical quantities, while
FCFF/FCFE are used to forecast. For this purpose, it is much better
to use a more disaggregated model of cashflows so that appropriate
assumptions can be made regarding the different components of
free cashflow. Thus, we might have different models to forecast
future values of change in working capital as opposed to net income
and depreciation.
An alternate approach to the computation of Net Cash Flows
provided by Operating Activities:
The formula provided above for Net Cash Flows provided by Operating
Activities, however, do not take into account other sources of
cash flows. For example, there may be an entry for changes in
prepaid expenses, which would have to be deducted from Net Income.
Prepaid expenses refer to expenses pertaining to income generation
in future periods, which nevertheless have been paid in advance.
Since they do not relate to income this period, they don't show
up in the current Income statement; however, since they represent
operating cash outflows, they must be taken into account in the
Statement of Cash Flows.
In principle, it would be necessary to first adjust each item
in the Income Statement to take into account any non-cash entries,
and then to take into account cashflows that have occurred in
the current period, but have not been recorded in the Income Statement
because they do not pertain to this period's income.
However, many of the non-cash entries in the Income Statement
would probably show up as changes in Current Assets or Current
Liabilities. Furthermore, any cashflows occuring in the current
period, but not pertaining to this period's income would also
show up as changes in Current Assets or Current Liabilities, provided
that these assets/liabilities have a maturity of one year or less.
Hence, an alternate approach to computing the Net Cash Flow provided
by Operating Activities would be to begin with Net Income, subtract
from that the changes in non-cash Working Capital, and then make
adjustments for items that are Current Assets or Current Liabilities,
but do not pertain to Operations (i.e. add back changes in such
items if they are assets, and subtract changes in such items if
they are liabilities). The following formula gives some examples
of such adjustments. However, it must be noted that these examples
are not exhaustive.
| Net Cash Flow provided by Operating Activities
= |
Net Income |
| |
- Change in Noncash Working Capital |
| |
- Change in Dividends Payable |
| |
+ Depreciation |
Computation of Capital Expenditures
It must be noted that Depreciation in the Income Statement could
vary from the change in Accumulated Depreciation recorded in the
Balance Sheet under Property, Plant and Equipment. This is because
there could be other sources of Depreciation, such as in Cost
of Goods sold. Only the depreciation recorded under Property,
Plant and Equipment is relevant for the computation of capital
expenditures. Furthermore, the computation as shown above assumes
that any sales of Property, Plant and Equipment is done at book
value. If there is a loss or gain, that can complicate the computation
of capital expenditures.
Example using GE's Financial Statements
Let's now take an actual firm's financial statements and note
the problems involved in computing various financial ratios, as
well as in reconstructing the Cash Flow Statement, using the information
provided. Here's information on GE's Financial Statements
for 1996 and 1997.
| (In
millions of $) |
Assets |
|
|
Liabilities |
|
|
1997 |
1996 |
Difference |
|
1997 |
1996 |
Difference |
| Cash and
marketable securities |
76,482 |
64,080 |
12,402 |
Current Liabilities |
120,668 |
100,507 |
20,161 |
| Noncash
Current Assets |
14,819 |
13,177 |
1,642 |
Long
Term Debt |
46,603 |
49,246 |
-2,643 |
| Other
Investments |
10,320 |
9,148 |
1,172 |
Prov Risks/Charges |
5,484 |
5,177 |
307 |
| Invst
in Assoc Companies |
5,983 |
6,442 |
-459 |
Deferred
Taxes |
8,651 |
8,273 |
378 |
| Long
Term Receivables |
121,454 |
115,132 |
6,322 |
Other Liabilities |
84,486 |
75,067 |
9,419 |
| Prop
Plant Eq-Gross |
55,657 |
50,784 |
4,873 |
Total
Liabilities |
265,892 |
238,270 |
27,622 |
| Less
Accum. Depreciation |
23,341 |
21,989 |
1,352 |
Minority Interest |
3,682 |
3,007 |
675 |
| Net
PP&E |
32,316 |
28,795 |
3,521 |
Common Shareholder's Equity |
6,368 |
3,763 |
2,605 |
|
|
|
|
Less Treasury Stock |
15,268 |
11,308 |
3,960 |
| Other
Assets |
42,638 |
35,628 |
7,010 |
plus Retained Earnings |
43,338 |
38,670 |
4,668 |
|
|
|
|
Total Common Equity |
34,438 |
31,125 |
3,313 |
| Total Assets |
304,012 |
272,402 |
31,610 |
Total Liabs and Equity |
304,012 |
272,402 |
31,610 |
Here is the Income Statement for 1996 and 1997 (in millions):
|
1996 |
1997 |
| Net
Sales or Revenue |
90,777 |
79,082 |
| Cost
of Goods Sold |
34,724 |
28,637 |
| Gross Income |
51,971 |
46,660 |
| Depreciation
and Amortization |
4,082 |
3,785 |
| Selling,
Gen and Admn expenses |
9,367 |
8,160 |
| Total
Operating Expenses |
48,173 |
40,582 |
| Operating
Income |
42,604 |
38,500 |
| Non
Operating Interest Income |
1 |
18 |
| Extra
Charges - Pretax |
3,401 |
0 |
| Other
Income/Expenses - Net |
-20,939 |
-19,539 |
| Interest
Expense |
8,384 |
7,904 |
| Pretax
Income |
9,881 |
11,075 |
| Income
Taxes |
2,976 |
3,526 |
| Minority
Interest |
240 |
269 |
| After
tax Other Income/Expenditures |
1,538 |
0 |
| Net
Income |
8,203 |
7,280 |
Construction of the Statement of Cash
Flows:
|
|
|
|
Outflows |
|
1997 |
1996 |
Increase from 1996 to 1997 |
Operating Activity |
Investing Activity |
Financing Activity |
| Assets
(in millions) |
|
|
|
|
|
|
| Cash
and Equivs |
76,482 |
64,080 |
12,402 |
|
|
|
| Net Receivables |
8,924 |
8,704 |
220 |
220 |
|
|
| Raw
Materials |
3,070 |
3,028 |
42 |
|
|
|
| Finished
Goods |
2,895 |
2,404 |
491 |
|
|
|
| Progress
Payments & Other |
-70 |
-959 |
889 |
|
|
|
| Inventories |
5,895 |
4,473 |
1,422 |
1422 |
|
|
| Tot
Current Assets |
91,301 |
77,257 |
14,044 |
|
|
|
| Other
Investments |
10,320 |
9,148 |
1,172 |
|
1,172 |
|
| Invst
in Assoc Cos |
5,983 |
6,442 |
-459 |
|
-459 |
|
| Long
Term Receivables |
121,454 |
115,132 |
6,322 |
6,322 |
|
|
| PP&E
- Gross |
55,657 |
50,784 |
4,873 |
|
7,6031 |
|
| Accum
Depr. |
23,341 |
21,989 |
1,352 |
-4,0821 |
|
|
| Net PP&E |
32,316 |
28,795 |
3,521 |
|
|
|
| Deferred
Charges |
9,095 |
7,832 |
1,263 |
|
1,263 |
|
| Other
Tangible Assets |
14,422 |
11,789 |
2,633 |
|
2,633 |
|
| Intang
Other Assets |
19,121 |
16,007 |
3,114 |
|
3,114 |
|
| Other
Assets |
42,638 |
35,628 |
7,010 |
|
|
|
| Total Assets |
304,012 |
272,402 |
31,610 |
|
|
|
|
|
|
|
|
|
|
| Liabilities |
|
|
|
|
|
|
| Accounts Payable |
10,407 |
10,205 |
202 |
-202 |
|
|
| ST
Debt and Curr Portion of LT debt |
98,075 |
80,200 |
17,875 |
-17,875 |
|
|
| Accrued
Payroll |
1,321 |
1,315 |
6 |
-6 |
|
|
| Dividends
Payable |
979 |
855 |
124 |
|
|
-124 |
| Income
Taxes Payable |
2,866 |
2,487 |
379 |
-379 |
|
|
| Other
Current Liabs |
7,020 |
5,445 |
1,575 |
-1,575 |
|
|
| Tot
Curr Liabs |
120,668 |
100,507 |
20,161 |
|
|
|
| Long
Term Debt |
46,603 |
49,246 |
-2,643 |
|
|
2,643 |
| Provisions
for Risks/Charges |
5,484 |
5,177 |
307 |
-307 |
|
|
| Deferred
Taxes |
8,651 |
8,273 |
378 |
-378 |
|
|
| Other
Liabs |
84,486 |
75,067 |
9,419 |
|
|
-9,419 |
| Tot
Liabs |
265,892 |
238,270 |
27,622 |
|
|
|
| Unrealized
Sec Gains/Losses |
2,138 |
671 |
1,467 |
|
|
-1,467 |
| Minority
Interest |
3,682 |
3,007 |
675 |
|
|
-675 |
| Common
Stock/Ordinary Capital |
594 |
594 |
0 |
|
|
|
| Capital
Surplus |
2,838 |
2,442 |
396 |
|
|
-396 |
| Retained
Earnings |
43,338 |
38,670 |
4,668 |
-8,2032 |
|
3,5352 |
| Unrealized
ForEx Gains/Losses |
798 |
56 |
742 |
|
|
-742 |
| Treasury
Stock |
15,268 |
11,308 |
3,960 |
|
|
3,960 |
| Common
Shareholders Equity |
34,438 |
31,125 |
3,313 |
|
|
|
| Tot
Liabs and Equity |
304,012 |
272,402 |
31,610 |
|
|
|
|
|
Computed
Cash and Cash Equivalent Outflows |
-25,043 |
15,326 |
-2,685 |
|
|
Computed
Cash (only) Outflows |
-14,311 |
15,326 |
-2,685 |
|
|
Reported Cash (only)
Outflows |
-14,240 |
18,275 |
-5,705 |
Footnotes:
- Increase in Gross
PP&E is only $4,873. However, Increase in Accumulated
Depreciation is only $1,352, whereas Depreciation Expense is
$4,082. The reason for the lower value of Accumulated
Depreciation is presumed to be Asset Sales of $2,730 (4,082-1,352).
Hence Capital Expenditures are presumed to be $7,603 (Increase
in Gross PP&E + Asset Sales).
- Increase in Retained
Earnings of $4,668 can be computed as Net Income ($8,203) less
Dividends Declared ($3,535).
- Note that in order to consistently
record all entries in the last three columns as outflows, the
cashflow entries for liabilities will be the negative of the
fourth column (Increase from 1997 to 1996). Thus, Increase
in Net Receivables is recorded in the Operating Cashflow column
as 220, because an increase in receivables implies that goods
of the corresponding have been sold to customers, without a
corresponding payment inflow; the entry in the fourth column
is also 220, since that is the amount by which Net Receivables
for 1997 is higher compared to Receivables for 1996. On
the other hand, Increase in Accounts Payables is recorded in
the Operating Cashflow column as -202, even though the 1997
figure is greater than the 1996 figure by 202. This is
because an increase in Accounts Payables means that goods have
been purchased to the tune of 202, without a corresponding payment;
i.e. there has been an inflow of 202, rather than an outflow.
In order to consistently record flows as outflows, we must record
the number as -202. (However, note Depreciation and Dividends.)
Using the information generated above, we can write out the Statement
of Cash Flows:
| Cash Flows from Operating Activities |
|
|
| Net Income |
8,203 |
|
| Add (deduct) adjustments to
cash basis: |
|
|
| Increase in accounts receivables |
-220 |
|
| Increase in Inventory |
-1,422 |
|
| Increase in Long-term receivables |
-6,322 |
|
| Depreciation |
4,082 |
|
| Increase in Accounts Payable |
202 |
|
| Increase in ST debts and currentportion
of LT debt |
17,875 |
|
| Increase in Accrued Payroll |
6 |
|
| Increase in Income Taxes Payable |
379 |
|
| Increase in Other Current Liabs |
1,575 |
|
| Increase in Provisions for Risks/Charges |
307 |
|
| Increase in Deferred Taxes |
378 |
|
| Net Cash Flows from Operating Activities |
|
14,311 |
| Cash Flows from Investing Activities |
|
|
| Increase in Other Investments |
-1,172 |
|
| Decrease in Investments in Associated
Cos |
459 |
|
| Capital Expenditures |
-7,603 |
|
| Increase in Deferred
Charges |
-1,263 |
|
| Increase in Other Tangible Assets |
-2,633 |
|
| Increase in Other Intangible
Assets |
-3,114 |
|
| Net Cash Flows from Investing Activities |
|
-15,326 |
| Cash Flows from Financing Activities |
|
|
| Dividends
Declared |
-3,535 |
|
| Increase
in Dividends Payable (adjustment to dividends declared) |
124 |
|
| Decrease in Long-Term Debt (Debt
Repayments) |
-2,643 |
|
| Decr in Treasury Stock (Stock
repurchase) |
-3,960 |
|
| Increase in Minority
Interest |
675 |
|
| Incr in Unrealized Securities
Gains/Losses |
1,467 |
|
| Incr. Unrecognized ForEx Gains/Losses |
742 |
|
| Increase in Other Liabs |
9,419 |
|
| Net Cash Flows from Financing Activities |
|
2,685 |
| Net Increase in Cash and Equivalents |
|
12,402 |
| |
|
|
| Beginning Cash and Equivalents |
|
64,080 |
| Add Increase from SCF |
|
12,402 |
| Ending Cash and Equivalents |
|
76,482 |
Explanatory Notes:
- Minority Interest represents
the proportionate stake of minority shareholders in a company's
majority-owned subsidiary that is consolidated. Since
the parent includes all net assets of a consolidated subsidiary
in its financial statements, it reports the minority's interest
as a credit.
- Actual Dividends paid equal
$3,535 - $124 = $3,411.
- Deferred Charges are costs
incurred but deferred because they are expected to benefit future
periods or are prepaids benefitting future periods. Examples
are prepaid pension costs and certain intangibles.
Treatment of Cash and Cash Equivalents:
Our computed numbers do not match precisely with the Reported
Statement of Cash Flows; part of the problem is that our balance
sheet combines figures for Cash and Cash Equivalents. The
reported numbers are:
| |
1996 |
1997 |
Change |
| Cash (from reported SCF) |
4,191 |
5,861 |
1,670 |
| Cash and Equivalents (from Balance Sheet) |
64,080 |
76482 |
12,402 |
| Equivalents |
59,889 |
70621 |
10,732 |
If we include this increase in Cash Equivalents as an operating
cash flow, we need to modify our figure for Cash and Cash Equivalent
Outflows by $10,732 in order to get the corresponding figure for
cash outflows alone. Our Operating Cash Outflows becomes
-25,043 + 10,732 = -14,311.
There is still a discrepancy between the reported numbers and
the numbers that we have computed. If some of the posited
asset sales were made at a price higher than the book value, there
would be a gain from the sale of assets that would be included
in Net Income. This amount would need to be subtracted from
Net Income, giving us a lower value for Operating Cash Flows.
It would then be added to Cash Flows from Investing, since it
is more properly an investing flow, than an operating flow.
Furthermore, there were several acquisitions made by GE during
1997. If GE used the purchase method to account for the
acquisition, then the flows that we have in our computations assigned
to Operating Flows should be reassigned to Cash Flows from Investing.
This would also cause some discrepancies between our computations
and the reported SCF numbers.
Here is the complete Statement of Cash Flows reported by GE:
| CASH
FLOW PROVIDED BY OPERATING ACTIVITY (in millions of dollars) |
| Net Income
(Loss) |
8,203 |
| Depreciation/Amortization |
4,082 |
| Net Incr
(Decr) Assets/Liabs |
1,733 |
| Other Adjustments,
Net |
222 |
| Net Cash
Prov (Used) by Oper |
14,240 |
|
|
| CASH
FLOW PROVIDED BY INVESTING ACTIVITY(in millions of dollars) |
| (Incr) Decr
in Prop, Plant |
-6,137 |
| (Acq) Disp
of Subs, Business |
-5,245 |
| (Incr) Decr
in Securities Inv |
-1,898 |
| Other Cash
Inflow (Outflow) |
-4,995 |
| Net Cash
Prov (Used) by Inv |
-18,275 |
|
|
| CASH
FLOW PROVIDED BY FINANCING ACTIVITY(in millions of dollars) |
| Issue (Purchase)
of Equity |
-2,815 |
| Issue (Repayment)
of Debt |
21,249 |
| Incr (Decr)
In Borrowing |
-10,103 |
| Dividends,
Other Distribution |
-3,411 |
| Other Cash
Inflow (Outflow) |
785 |
| Net Cash
Prov (Used) by Finan |
5,705 |
| Net Change
in Cash or Equiv |
1,670 |
| Cash or
Equiv at Year Start |
4,191 |
| Cash or
Equiv at Year End |
5,861 |
The Impact of Capital Structure on Total Returns to Suppliers
of Capital
Example: The Menendez Corporation expects to have sales of $12m.
in 1998. Costs other than depreciation are expected to be 75%
of sales, and depreciation is expected to be $1.5m. All sales
revenue will be collected in cash, and costs other than depreciation
must be paid for during the year. Menendez’s federal-plus-state
tax rate is 40%.
Income Statement (in millions of dollars):
| Sales |
$12 |
| Costs of Goods Sold |
9 |
| Depreciation |
1.5 |
| Net Profit |
1.5 |
| Taxes |
.6 |
| After Tax Income |
0.9 |
Total returns to investors = $0.9m.
Total cash flow = 0.9 (After-tax income) + 1.5 (Depreciation)
= 2.4m.
Suppose Menendez were financed with debt as well as equity, and
interest payments in 1998 totalled $0.5 m. Then the Income Statement
would read as follows:
Income Statement (in millions of dollars):
| Sales |
$12 |
| Costs of Goods Sold |
9 |
| Depreciation |
1.5 |
| Interest paid |
0.5 |
| Net Profit |
1.0 |
| Taxes |
.4 |
| After Tax Income |
0.6 |
Total Returns to Investors = 0.6 to stockholders + 0.5 to bondholders
= 1.1m.
Note that the second capital structure decreased taxes paid by
0.2m and thus increased total returns to investors (stockholders
as well as bondholders) by 0.2m. from 0.9m to 1.1m. |
