Accounting For Financial Management

Chapter 6
Accounting for Financial

Management
Need to Know Concepts
Balance sheet
Income statement
Statement of cash flows
Free cash flow (FCF)
LIFO vs. FIFO
NOPAT, ROIC, MVA, EVA
Basic Financial Statements
Balance sheet
Income statement
Financial performance over a period of

time
Statement of stockholders equity
Financial position at a point in time
Amounts and sources of changes in

equity
Statement of cash flows
Reports on cash flows
Balance Sheet: Assets

Cash
S-T invest.
AR
Inventories
Total CA
Gross FA
Less: Depr.
Net FA
Total assets
2014
$
9,000
48,600
351,200
715,200
1,124,000
491,000
(146,200)
344,800
$1,468,800
2015
$
7,282
20,000
632,160
1,287,360
1,946,802
1,202,950
(263,160)
939,790
$2,886,592
4
Assets
Assets are listed in order of

liquidity
Current assets: expected to
convert into cash within a year
Book values vs. market values
Book values (a.k.a. carrying values):

shown on the balance sheet
Market values: current value
determined in the marketplace
5
FIFO vs. LIFO
FIFO (first-in, first-out): the first

item purchased is assumed to be
the first item sold.
LIFO (last-in, first-out): the last

item purchased is assumed to be
the first item sold.
6
Inflationary Environment &

Stable Inventory
Quantities
FIFO
Lower COGS
Higher profit
Higher inventory
balances
LIFO
Higher COGS
Lower profit
Lower inventory
balances
Balance Sheet: Liabilities

& Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E
2014
$ 145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
$1,468,800
2015
$ 324,000
720,000
284,960
1,328,960
1,000,000
460,000
97,632
557,632
$2,886,592
8
Liabilities and Equity
Current liabilities: expected to pay

off within a year
Common equity (a.k.a. equity or
net worth)
Sum of common stock and retained

earnings
Equity = assets - liabilities
Income Statement
2014
2015
Sales
$3,432,000
$5,834,400
COGS
2,864,000
4,980,000
340,000
720,000
18,900
116,960
3,222,900
5,816,960
209,100
17,440
62,500
176,000
Other expenses
Deprec.
Tot. op. costs
EBIT
Int. expense
Pre-tax
earnings
Taxes (40%)
Net income
146,600
(158,560)
58,640
(63,424)
87,960
($ 95,136)
10
Depreciation vs.
Amortization
Depreciation is a non-cash charge

against tangible asset (e.g.,
buildings, machines)
Amortization is a non-cash charge
against intangible asset (e.g.,
goodwill, patent)
11
EBITDA
Earnings before interest, taxes,

depreciation, and amortization
Useful for comparing companies with
different capital structure, a proxy
(xEBITDA) for Merger & Acquisition
(M&A) targets
EBITDA2015 = EBIT + Depreciation
EBITDA2015 = 17,440 + 116,960 = $134,400
EBITDA2015 = Sales COGS Other Expenses
EBITDA2015 = 5,834,400 4,980,000
12
Statement of
Stockholders Equity
Show the changes in stockholders

equity account between balance
sheet dates
Income
Cash dividends
Issuance/repurchase of stock
13
Statement of Cash Flows
Cash flow from operating activities

(CFO)
Cash flow from investing activities (CFI)
Activities focus on cash income including

noncash and working capital adjustments
Acquisition or disposal of fixed assets or
short-term financial investment
Cash flow from financing activities (CFF)
Activities affect capital structure

14
Statement of Cash Flows:

2015
Operating Activities
Net Income
Adjustments:
Depreciation
Change in AR
Change in inventories
Change in AP
Change in accruals
Net cash provided (used) by
($
95,136)
116,960
(280,960)
(572,160)
178,400
148,960
($503,936
15

2015
Investing Activities
Cash used to acquire FA
Change in S-T invest.
Net cash prov. (used) by inv.
act.
($711,950
)
28,600
($683,350
)
16

2015
Financing Activities
Change in notes payable
Change in long-term debt
Payment of cash dividends
Net cash provided (used) by fin.
act.
$
520,000
676,568
(11,000)
$1,185,56
8
17
Summary of Statement of
CF
CFO (used)
CFI (used)
CFF
Net change in cash
Cash at beginning of year
Cash at end of year
($
503,936)
(683,350)
1,185,568
(1,718)
9,000
$
7,282
18
What can you conclude

from the statement of
cash flows?
Net CFO = -$503,936, because of

negative net income and increases in
working capital.
The firm spent $711,950 on fixed
assets.
The firm borrowed heavily and sold
some short-term investments to meet
its cash requirements.
Even after borrowing, the cash account
fell by $1,718.
19
What is free cash flow

(FCF)?
Why is it important?
FCF is the amount of cash

available from operations for
distribution to all investors
(including stockholders and
debtholders) after making the
necessary investments to support
operations.
A companys value depends on the
amount of FCF it can generate.
20
Calculating Free Cash Flow in 5 Easy Steps

Step 1
Step 2
Earning before interest and taxes

X (1 Tax rate)
Net operating profit after taxes
Operating current assets

Operating current liabilities
Net operating working capital
Step 3
Net operating working capital

+ Operating long-term assets
Total net operating capital
Step 5
Step 4
Net operating profit after taxes

Net investment in operating capital
Free cash flow
Total net operating capital this year

Total net operating capital last year
Net investment in operating capital
21
Net Operating Profit after

Taxes (NOPAT)
NOPAT measures the after-tax profit
of a company as if it had no debt,
excluding the effects of financial
decision
NOPAT = EBIT(1 - Tax rate)
NOPAT2015 = $17,440(1 - 0.40)
= $10,464
NOPAT2014 = $125,460
22
What are operating

current assets?
Operating current assets (CA) are

the CA needed to support
operations.
Operating CA include: cash,

inventory, accounts receivable
Operating CA exclude: short-term
investments, because these are not a
part of operations
23
What are operating

current liabilities?
Operating current liabilities (CL)

are the CL resulting as a normal
part of operations.
Operating CL include: accounts

payable and accruals.
Operating CL exclude: notes payable,
because this is a source of financing,
not a part of operations.
24
Net Operating Working

Capital (NOWC)
NOWC = Operating
CA
NOWC2015
Operating
CL
= (7,282 + 632,160 + 1,287,360)
- (324,000 + 284,960)
= $1,317,842
NOWC2014 = $793,800
25
Total net operating capital

(a.k.a. Operating capital)
Total net operating capital= NOWC

+ Operating long-term assets
Total net operating capital2015
= 1,317,842 + 939,790
= $2,257,632
Total net operating capital2014
= 793,800 + 344,800
= $1,138,600
26
Free Cash Flow (FCF) for

2015
FCF = NOPAT - Net investment in
operating capital
= 10,464 - (2,257,632 - 1,138,600)
= 10,464 - 1,119,032
= -$1,108,568
Is a negative FCF always bad? Not
necessarily
27
What are the five uses of

FCF?
1. Pay interest to debtholders
2. Repay debtholders (i.e., pay off
some of the debt)
3. Pay dividends to shareholders
4. Repurchase stock
5. Buy short-term investments or
other non-operating assets
28
Uses of FCF
After-tax interest payment =
$105,600
Reduction (increase) in debt = 1,196,568
Payment of dividends =
11,000
Repurchase (Issue) stock =
0
Purch. (Sale) of ST
28,600
investments =
Total uses of FCF =
$1,108,568
29
Return on Invested Capital

(ROIC)
ROIC measures how much NOPAT

is generated by each dollar of
operating capital
ROIC = NOPAT / total net operating

capital
ROIC2015 = 10,464 / 2,257,632 =
0.50%
ROIC2014 = 11.00%
30
The firms cost of capital is

10%. Did the growth add
value?
No. The 2015 ROIC of 0.50% is less

than the WACC of 10%. Investors did
not get the return they require.
Note: High growth usually causes
negative FCF (due to investment in
capital), but thats ok if ROIC > WACC.
For example, in 2008 Qualcomm had
high growth, negative FCF, but a high
ROIC.
31
Market Value Added (MVA)
MVA = (Market value of stock +

Market value of debt) Total
investor-supplied capital
Market value of debt is estimated by

using the book value of debt
Total investor-supplied capital
includes equity, debt, and preferred
stock
32
MVA (Assume market value

of debt = book value of
debt.)
Current price = $6/share
Number of shares = 100,000 shares
Book value of debt = $300,000
Total investor-supplied capital = $700,000
Market Value of Equity:
(100,000)($6.00) = $600,000
MVA = (600,000 + 300,000) 700,000

= $200,000
33
Economic Value Added

(EVA)
EVA is an estimate of value created

by management, focus on
managements effectiveness
EVA = NOPAT - (WACC)(Capital)
WACC is weighted average cost of

capital
Capital = total net operating capital
34
Economic Value Added

(WACC = 10% for both
years)
EVA = NOPAT- (WACC)(Capital)
EVA2015 = 10,464 - (0.10)(2,257,632)
= 10,464 - 225,763
= -$215,299
EVA2014 = 125,460 - (0.10)(1,138,600)
= 125,460 - 113,860
= $11,600
35
MVA vs. EVA
MVA reflects the

performance
since inception
MVA applies to
the entire
corporation
EVA shows the

value added
during a given
year
EVA can be
applied to
individual
divisions or units
within a
corporation
36
Corporate Income Taxes
Marginal tax rate
Rate paid on the last dollar of income
Average tax rate
The average rate paid on all income
37
2007-2014 Corporate Tax

Rates
Taxable Income
Tax on Base
Rate on amount
above base
15%
7,500
25%
75,000 - 100,000
13,750
34%
100,000 - 335,000
22,250
39%
113,900
34%
10M - 15M
3,400,000
35%
15M - 18.3M
5,150,000
38%
18.3M and up
6,416,667
35%
0 -50,000
50,000 - 75,000
335,000 - 10M
38
Corporate Income Taxes

Example
A firm had $60,000 pre-tax

income. Calculate the tax liability,
marginal tax rate, and average tax
rate?
Tax liability
50,000 (.15) + 10,000 (.25) = $10,000
Marginal tax rate = 25%

Average tax rate
10,000 / 60,000 = 16.67%

39
Dividends Paid by a
Corporation
Corporations own stock in other

corporations can exclude 70% of
the dividend amounts from tax.
40
Dividends Paid by a
Corporation
A corporation received $60,000 of

dividend from another corporation.
Assuming tax rate at 35%,
calculate the effective tax rate and
tax liability
Effective tax rate
(0.30) (0.35) = .105 = 10.5%
Tax liability
(.105) (60,000) = $6,300

41
Municipal vs. Corporate

Bond
Municipal bond yield = Corporate

bond yield (1 Tax rate)
An investor has an option to purchase

a 10% corporate bond. If an investor
is in the 25% tax bracket, calculate
the equivalent municipal bond yield
that the investor would be indifferent
to invest between these two bonds.
.10 (1 0.25) = .075 = 7.5%
42
Capital Gain and Capital

Loss
Capital gain the profit of an asset

sold more than cost
Capital loss the loss of an asset
sold less than cost
43
Chapter 6 Quiz
44
Question 1
Operating current assets is least

likely to include:
A. Short-term investments
B. Inventories
C. Accounts receivable
D. Cash
45
Question 1 (Answer) A
Operating current assets include

cash, inventory, and accounts
receivable. They do not include
short-term investments.
46
Question 2
In an inflationary environment and

stable inventory quantities and
using FIFO, which of the following
will most likely be lower compared
to using LIFO?
A. COGS
B. Profit
C. Inventory balance
47
Question 2 (Answer) A
Under FIFO, COGS will be lower

because the oldest inventory, at
lower costs, will be sold first.
48
Question 3
If a firm has revenue = $80,000,

COGS = $40,000, inventories =
$6,000, depreciation = $5,000, tax
rate = 30%, its NOPAT is closest to:
A. $20,300
B. $24,500
C. $28,000
49
Question 3 (Answer) B
EBIT = 80,000 40,000 5,000

EBIT = $35,000
NOPAT = EBIT (1 tax rate)
NOPAT = 35,000 (1 0.30)
NOPAT = $24,500
50
Question 4
Which of the following is NOT one

of the five uses of FCF?
A. Repurchase stock from

shareholders
B. Repay debtholders
C. Upgrade machines
D. Pay dividends to shareholders
51
Question 4 (Answer) C
Five uses of FCF include: pay

interest to debtholders, repay
debtholders (i.e., pay off some of
the debt), pay dividends to
shareholders, repurchase stock,
and buy short-term investments or
other non-operating assets.
Upgrade machines is not one of
the five uses of FCF.
52
Question 5
According to Sarbanes-Oxley and

Financial Fraud reading, which of the
following statements is most accurate?
A. When two firms have the same operating

circumstance, managers most likely report
identical financial statements.
B. WorldCom committed fraud by
overstating net income.
C. WorldCom recorded capital expenditures
as ordinary operating costs.
53
Question 5 (Answer) B
WorldCom committed fraud by

recording operating costs as
capital expenditures resulted in
overstating net income.
54

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Chapter 6

Accounting for Financial

Need to Know Concepts

Basic Financial Statements

Financial performance over a period of

Statement of stockholders equity

Financial position at a point in time

Amounts and sources of changes in

Statement of cash flows

Reports on cash flows

Balance Sheet: Assets

Assets are listed in order of

Book values (a.k.a. carrying values):

FIFO vs. LIFO

FIFO (first-in, first-out): the first

LIFO (last-in, first-out): the last

Inflationary Environment &

Balance Sheet: Liabilities

Liabilities and Equity

Current liabilities: expected to pay

Sum of common stock and retained

Depreciation is a non-cash charge

Earnings before interest, taxes,

EBITDA2015 = EBIT + Depreciation

EBITDA2015 = 17,440 + 116,960 = $134,400

EBITDA2015 = Sales COGS Other Expenses

EBITDA2015 = 5,834,400 4,980,000

Show the changes in stockholders

Statement of Cash Flows

Cash flow from operating activities

Cash flow from investing activities (CFI)

Activities focus on cash income including

Cash flow from financing activities (CFF)

Activities affect capital structure

Statement of Cash Flows:

Statement of Cash Flows:

Statement of Cash Flows:

What can you conclude

Net CFO = -$503,936, because of

What is free cash flow

FCF is the amount of cash

Calculating Free Cash Flow in 5 Easy Steps

Earning before interest and taxes

Operating current assets

Net operating working capital

Net operating profit after taxes

Free cash flow

Total net operating capital this year

Net Operating Profit after

NOPAT2015 = $17,440(1 - 0.40)

What are operating

Operating current assets (CA) are

Operating CA include: cash,

What are operating

Operating current liabilities (CL)

Operating CL include: accounts

Net Operating Working

= (7,282 + 632,160 + 1,287,360)