Chapter 2: Financial Statements, Cash Flow, and Taxes Flashcards
Net cash flow
= net income - non-cash revenues + non-cash expenses
where net income = net income available for distribution to common shareholders
(may essentially be net income + depreciation and amortization)
Free cash flows
the stream of cash flows generated by operating activities that investors expect to receive now and in the future
amount of cash from operations available for distribution to the investors after making the necessary investments to support operations
Calculating free cash flow by how it is used
FCF = cash flow available for distribution to all the company’s investors after the company has made all investments necessary to sustain ongoing operations
calculating free cash flow by how it is generated
FCF = after-tax operating profit minus the amount of new expenditures necessary to sustain the business
5 steps to calculating free cash flow
1) calculate net operating profit after taxes
2) calculate net operating working capital
3) use net operating working capital to calculate total net operating capital
4) use total net operating capital from current and previous year to calculate net investment in operating capital for year
5) calculate FCF by subtracting net investment in operating capital from net operating profit after taxes
Net operating profit after taxes
= (earnings before interest and taxes) x (1-tax rate)
NOPAT
amount of profit a company would generate if it had no debt and held no financial assets
Net operating working capital
= operating current assets - operating current liabilities
NOWC
the working capital acquired with investor supported funds
(because each dollar of current liabilities is a dollar the company does not have to raise from investors)
(not same as net working capital which is assets - liabilities)
if NOWC = 0 all operations are funded with current liabilities
used to measure efficiency of fund use
Total net operating capital
= net operating working capital + operating long-term assets
aka net operating capital or operating capital
change in net operating capital from one year to another shows money invested in the company
= net amount of investor supplied operating capital
but net operating capital can be applied to individual divisions and investor supplied capital can only be applied to the entire company
Net investment in operating capital
net investment in operating capital made during the given year
= total net operating capital this year - total net operating capital last year
Calculation of free cash flow
= Net operating profit after taxes - net investment in operating capital
Operating current assets
Short term assets normally used in a company’s operating activities (essential to the ongoing operations)
does not include short term investments
Non operating assets
excluded from operating current assets, not not occur as a natural consequence of operating activities
short-term marketable securities
if an asset pays interest it is probably not an operating asset
operating current liabilities
short term liabilities that arise in the normal course of operations
(short term financing liabilities probably not operating liabilities. if it charges interest it is probably not an operating liability - so notes payable are financing, not operations)
investor-supplied capital
total amount of short-term debt, long-term debt, preferred stock, and total common equity shown on the balance sheet
= the amount of financing that the investors have provided a company
total investor supplied operating capital
= total investor-supplied capital - short-term investments
should be the same as total net operating capital from the year
but net operating capital can be applied to individual divisions and investor supplied capital can only be applied to the entire company
alternate calculation of free cash flow
= (EBIT*(1-T) + Depreciation) - (gross investment in fixed assets) - (investment in net operating working capital)
“good” uses of FCF
- pay interest to debtholders (after-tax interest expense)
- repay debtholders
- pay dividends to shareholders
- repurchase stock from shareholders
- buy short term investments or other nonoperating assets
“Negative” uses of free cash flow
- issuing new debt
- issuing new stock
- selling short term investments / nonoperating assets
After tax interest payment
Interest expense * (1 - tax rate)
net debt repayment (issuance)
= amount of debt at the beginning of the year - amount at the end of the year
positive = paid down some debt
negative = borrowed additional funds
Return on invested capital
how much NOPAT is generated by each dollar of operating capital
= NOPAT / operating capital
measure of how well the company is operating - excludes the impact of financial leverage
a real measure of profitability - shows returns from investments exceed cost of funds
compare to WACC to determine if ROIC is high enough to add value
Market value added
the difference between the market value of the firm’s stock and the cumulative amount of equity capital that was supplied by shareholders
= market value of stock - equity capital supplied by shareholders
= ((shares outstanding * stock price)+ market value of debt) - (book value of equity + bv of debt)
measures the effects of managerial actions since the inception of the company
alternate MVA calculation
= total market value - total investor supplied capital
= (market value of stock + market value of debt) - total investor supplied capital
investor supplied capital generally = equity + debt + preferred stock
Economic Value added
EVA
= NOPAT - (total net operating capital * WACC)
a measure of managerial effectiveness in a given year, the extent to which the firm has increased shareholder value
= Net operating profit after taxes - after tax dollar cost of capital used to support operations
estimate of businesses “true” profit for the year. the residual income that remains after the cost of ALL capital has been deducted (all capital = lending and equity, so after shareholders have received their return as well)
Cost of equity capital
because the shareholders give up the opportunity to invest and earn returns elsewhere the cost is an opportunity cost
Calculating EVA from ROIC
= (total net operating capital) * (ROIC - WACC)
as long as ROIC exceeds WACC growth increases value. If WACC exceeds ROIC growth may actually reduce value by costing too much
what does it mean if NOWC and fixed assets are both 0
essentially running a business without capital
rate of return will be higher because it is all/ almost all return
valuation of business increases because the capital is not being depended upon to run operations
how to drive NOWC to 0
- inventory efficiency / JIT inventory
- not selling on credit
capital efficiency
Deploying less capital to produce the same output
EBIT
Earnings before interest and taxes
Negative free cash flow
means no money left after operations and investment
not inherently bad as long as investments are worthwhile
Cost of capital
Rate at which company can get money. depends on percentage of capital from equity vs the percentage of capital from debt
- what the shareholders are looking for in return (depends on risk)
- cost of borrowing less tax savings
Cost of capital
Rate at which company can get money. depends on percentage of capital from equity vs the percentage of capital from debt
- what the shareholders are looking for in return (depends on risk) (return is built into WACC)
- cost of borrowing less tax savings
How to use weighted average cost of capital in business decisions
If investments offer a return equal to or higher than the cost of capital everyone is getting what they want or more
if return is lower than weighted average cost of capital it is not a good decision
0 NPV transaction
Transaction where the return is exactly equal to the weighted average cost of capital
still getting return for investors because return is built into WACC
Why is net income not a good measure of profit for financial measurement
Because does not consider cost of capital, only cost of borrowing
EVA based compensation schemes
require transparency from company
used to incentivize sustainable positive EVA
bonus mapped to EVA is deposited into an account which the employee can only draw some portion of. if EVA is negative the following year the company can take back some of previous bons
