02 financial statements cash flow and taxes

The value of any business asset — whether it is a financial asset such as a stock or a bond, or a real physical asset such as land, buildings, and equipment — depends on the usable, after

F i n a n c i a l S t a t e m e n t s ,

C a s h F l o w, a n d T a x e s

SOURCE: © Bill O’Connell/Black Star

The trick is to find a product that will boom, yet whose manufacturer’s stock is undervalued If this sounds too easy, you are right Lynch argues that once you have discovered a good product, there is still much homework to be done This involves combing through the vast amount of financial information that is regularly provided by companies It also requires taking

a closer and more critical look at how the company conducts its business — Lynch refers to this as “kicking the tires.”

To illustrate his point, Lynch relates his experience with Dunkin’ Donuts As a consumer, Lynch was impressed with the quality of the product This impression led him to take a closer look at the company’s financial statements and operations He liked what he saw, and Dunkin’ Donuts became one of the best investments in his portfolio.

The next two chapters discuss what financial statements are and how they are analyzed Once you have identified a good product as a possible investment, the principles discussed in these chapters will help you

“kick the tires.” ■

uppose you are a small investor who knows a

little about finance and accounting Could you

compete successfully against large institutional

investors with armies of analysts, high-powered

computers, and state-of-the-art trading strategies?

The answer, according to one Wall Street legend, is a

resounding yes! Peter Lynch, who had an outstanding

track record as manager of the $10 billion Fidelity

Magellan fund and then went on to become the

best-selling author of One Up on Wall Street and Beating the

Street, has long argued that small investors can beat

the market by using common sense and information

available to all of us as we go about our day-to-day

lives.

For example, a college student may be more adept at

scouting out the new and interesting products that will

become tomorrow’s success stories than is an

investment banker who works 75 hours a week in a New

York office Parents of young children are likely to know

which baby foods will succeed, or which diapers are

best Couch potatoes may have the best feel for which

tortilla chips have the brightest future, or whether a

new remote control is worth its price.

A manager’s primary goal is to maximize the value of his or her firm’s stock Value

is based on the stream of cash flows the firm will generate in the future But howdoes an investor go about estimating future cash flows, and how does a managerdecide which actions are most likely to increase cash flows? The answers to bothquestions lie in a study of the financial statements that publicly traded firms mustprovide to investors Here “investors” include both institutions (banks, insurancecompanies, pension funds, and the like) and individuals Thus, this chapter beginswith a discussion of what the basic financial statements are, how they are used,and what kinds of financial information users need

The value of any business asset — whether it is a financial asset such as a stock

or a bond, or a real (physical) asset such as land, buildings, and equipment —

depends on the usable, after-tax cash flows the asset is expected to produce.Therefore, the chapter also explains the difference between accounting income

and cash flow Finally, since it is after-tax cash flow that is important, the

chap-ter provides an overview of the federal income tax system

Much of the material in this chapter reviews concepts covered in basic counting courses However, the information is important enough to go over again.Accounting is used to “keep score,” and if a firm’s managers do not know thescore, they won’t know if their actions are appropriate If you took midterm examsbut were not told how you were doing, you would have a difficult time improvingyour grades The same thing holds in business If a firm’s managers — whetherthey are in marketing, personnel, production, or finance — do not understand fi-nancial statements, they will not be able to judge the effects of their actions, andthe firm will not be successful Although only accountants need to know how to

ac-make financial statements, everyone involved with business needs to know how to interpret them. ■

A B R I E F H I S T O R Y O F A C C O U N T I N G

A N D F I N A N C I A L S T A T E M E N T S

Financial statements are pieces of paper with numbers written on them, but it

is important to also think about the real assets that underlie the numbers If youunderstand how and why accounting began, and how financial statements areused, you can better visualize what is going on, and why accounting informa-tion is so important

Thousands of years ago, individuals (or families) were self-contained in thesense that they gathered their own food, made their own clothes, and built theirown shelters Then specialization began — some people became good at mak-ing pots, others at making arrowheads, others at making clothing, and so on

As specialization began, so did trading, initially in the form of barter At first,each artisan worked alone, and trade was strictly local Eventually, though, mas-ter craftsmen set up small factories and employed workers, money (in the form

of clamshells) began to be used, and trade expanded beyond the local area Asthese developments occurred, a primitive form of banking began, with wealthymerchants lending profits from past dealings to enterprising factory ownerswho needed capital to expand or to young traders who needed money to buywagons, ships, and merchandise

When the first loans were made, lenders could physically inspect borrowers’assets and judge the likelihood of the loan’s being repaid Eventually, though,lending became more complex — borrowers were developing larger factories,traders were acquiring fleets of ships and wagons, and loans were being made

to develop distant mines and trading posts At that point, lenders could nolonger personally inspect the assets that backed their loans, and they neededsome way of summarizing borrowers’ assets Also, some investments were made

on a share-of-the-profits basis, and this meant that profits (or income) had to

be determined At the same time, factory owners and large merchants neededreports to see how effectively their own enterprises were being run, and gov-ernments needed information for use in assessing taxes For all these reasons, aneed arose for financial statements, for accountants to prepare those state-ments, and for auditors to verify the accuracy of the accountants’ work.The economic system has grown enormously since its beginning, and ac-counting has become more complex However, the original reasons for finan-cial statements still apply: Bankers and other investors need accounting infor-mation to make intelligent decisions, managers need it to operate theirbusinesses efficiently, and taxing authorities need it to assess taxes in a reason-able way

It should be intuitively clear that it is not easy to translate physical assets intonumbers, which is what accountants do when they construct financial state-ments The numbers shown on balance sheets generally represent the histori-cal costs of assets However, inventories may be spoiled, obsolete, or even miss-ing; fixed assets such as machinery and buildings may have higher or lowervalues than their historical costs; and accounts receivable may be uncollectable.Also, some liabilities such as obligations to pay retirees’ medical costs may noteven show up on the balance sheet Similarly, some costs reported on the in-come statement may be understated, as would be true if a plant with a usefullife of 10 years were being depreciated over 40 years When you examine a set

A B R I E F H I S T O R Y O F A C C O U N T I N G A N D F I N A N C I A L S T A T E M E N T S

Are you interested in

learning more about the

history of accounting? If

so, take a tour through the

“Virtual History of

Accounting” organized by the

Association of Chartered Accountants in

the United States and located at

http://www.acaus.org/history/

index.html.

of financial statements, you should keep in mind that a physical reality lies hind the numbers, and you should also realize that the translation from physi-cal assets to “correct” numbers is far from precise.

be-As mentioned previously, it is important for accountants to be able to erate financial statements, while others involved in the business need to knowhow to interpret them Particularly, financial managers must have a workingknowledge of financial statements and what they reveal to be effective Spread-sheets provide financial managers with a powerful and reliable tool to conductfinancial analysis, and several different types of spreadsheet models are pro-vided with the text These models demonstrate how financial principles taught

gen-in this book are applied gen-in practice Readers are encouraged to use these els to gain further insights into various concepts and procedures

chair-report presents four basic financial statements — the balance sheet, the income

statement, the statement of retained earnings, and the statement of cash flows Taken

together, these statements give an accounting picture of the firm’s operationsand financial position Detailed data are provided for the two or three most re-cent years, along with historical summaries of key operating statistics for thepast 5 or 10 years.1

The quantitative and verbal materials are equally important The financial

statements report what has actually happened to assets, earnings, and dividends

over the past few years, whereas the verbal statements attempt to explain whythings turned out the way they did

For illustrative purposes, we shall use data taken from Allied Food Products,

a processor and distributor of a wide variety of staple foods, to discuss the basicfinancial statements Formed in 1978 when several regional firms merged, Al-lied has grown steadily, and it has earned a reputation for being one of the bestfirms in its industry Allied’s earnings dropped a bit in 2001, to $113.5 millionversus $117.8 million in 2000 Management reported that the drop resultedfrom losses associated with a drought and from increased costs due to a three-month strike However, management then went on to paint a more optimisticpicture for the future, stating that full operations had been resumed, that sev-eral unprofitable businesses had been eliminated, and that 2002 profits were ex-pected to rise sharply Of course, an increase in profitability may not occur, and

Annual Report

A report issued annually by a

corporation to its stockholders It

contains basic financial

statements, as well as

management’s analysis of the past

year’s operations and opinions

about the firm’s future prospects.

1 Firms also provide quarterly reports, but these are much less comprehensive In addition, larger firms file even more detailed statements, giving breakdowns for each major division or subsidiary,

with the Securities and Exchange Commission (SEC) These reports, called 10-K reports, are made

available to stockholders upon request to a company’s corporate secretary Finally, many larger

firms also publish statistical supplements, which give financial statement data and key ratios going

back 10 to 20 years, and their reports are available on the World Wide Web.

For an excellent example

of a corporate annual

report, take a look at 3M’s

annual report found at

http://www.mmm.com/

about3M/index.jhtml Then, click on

investor relations and annual reports on

the left-hand side of your screen Here

you can find several recent annual

reports in Adobe Acrobat format.

analysts should compare management’s past statements with subsequent results

In any event, the information contained in an annual report is used by investors to

help form expectations about future earnings and dividends Therefore, the annual

report is obviously of great interest to investors

The left-hand side of Allied’s year-end 2001 and 2000 balance sheets, which

are given in Table 2-1, shows the firm’s assets, while the right-hand side showsthe liabilities and equity, or the claims against these assets The assets are listed

in order of their “liquidity,” or the length of time it typically takes to convertthem to cash The claims are listed in the order in which they must be paid: Ac-counts payable must generally be paid within 30 days, notes payable within 90

T A B L E 2 - 1 ASSETS 2001 2000 LIABILITIES AND EQUITY 2001 2000

NOTE: The bonds have a sinking fund requirement of $20 million a year Sinking funds are discussed in Chapter 8, but in brief, a sinking fund simply involves the repayment of long-term debt Thus, Allied was required to pay off $20 million of its mortgage bonds during 2001 The current portion of the long-term debt is included in notes payable here, although in a more detailed balance sheet it would be shown as a separate item under current liabilities.

Allied Food Products: December 31 Balance Sheets (Millions of Dollars)

Balance Sheet

A statement of the firm’s financial

position at a specific point in time.

days, and so on, down to the stockholders’ equity accounts, which representownership and need never be “paid off.”

Some additional points about the balance sheet are worth noting:

1 Cash versus other assets Although the assets are all stated in terms of

dollars, only cash represents actual money (Marketable securities can beconverted to cash within a day or two, so they are almost like cash and arereported with cash on the balance sheet.) Receivables are bills others oweAllied Inventories show the dollars the company has invested in raw ma-terials, work-in-process, and finished goods available for sale And netplant and equipment reflect the amount of money Allied paid for its fixedassets when it acquired those assets in the past, less accumulated depreci-ation Allied can write checks for a total of $10 million (versus current li-abilities of $310 million due within a year) The noncash assets shouldproduce cash over time, but they do not represent cash in hand, and theamount of cash they would bring if they were sold today could be higher

or lower than the values at which they are carried on the books

2 Liabilities versus stockholders’ equity The claims against assets are of

two types — liabilities (or money the company owes) and the ers’ ownership position.2 The common stockholders’ equity, or net worth, is a residual For example, at the end of 2001,

stockhold-Suppose assets decline in value; for example, suppose some of the counts receivable are written off as bad debts Liabilities and preferredstock remain constant, so the value of the common stockholders’ equitymust decline Therefore, the risk of asset value fluctuations is borne bythe common stockholders Note, however, that if asset values rise (per-haps because of inflation), these benefits will accrue exclusively to thecommon stockholders

ac-3 Preferred versus common stock Preferred stock is a hybrid, or a cross

between common stock and debt In the event of bankruptcy, preferredstock ranks below debt but above common stock Also, the preferred div-idend is fixed, so preferred stockholders do not benefit if the company’searnings grow Finally, many firms do not use any preferred stock, andthose that do generally do not use much of it Therefore, when the term

“equity” is used in finance, we generally mean “common equity” unlessthe word “total” is included

sec-tion is divided into two accounts — “common stock” and “retained

earn-2 One could divide liabilities into (1) debts owed to someone and (2) other items, such as deferred

taxes, reserves, and so on Because we do not make this distinction, the terms debt and liabilities are

used synonymously It should be noted that firms occasionally set up reserves for certain gencies, such as the potential costs involved in a lawsuit currently in the courts These reserves rep- resent an accounting transfer from retained earnings to the reserve account If the company wins the suit, retained earnings will be credited, and the reserve will be eliminated If it loses, a loss will

contin-be recorded, cash will contin-be reduced, and the reserve will contin-be eliminated.

Common Stockholders’ Equity

(Net Worth)

The capital supplied by common

stockholders — common stock,

paid-in capital, retained earnings,

and, occasionally, certain reserves.

Total equity is common equity plus

preferred stock.

Assets ⫺ Liabilities ⫺ Preferred stock ⫽stockholder’s equityCommon

$2,000,000,000⫺ $1,064,000,000 ⫺ $40,000,000 ⫽ $896,000,000

ings.” The retained earnings account is built up over time as the firm

“saves” a part of its earnings rather than paying all earnings out as dends The common stock account arises from the issuance of stock toraise capital, as discussed in Chapter 9

divi-The breakdown of the common equity accounts is important for somepurposes but not for others For example, a potential stockholder wouldwant to know whether the company actually earned the funds reported inits equity accounts or whether the funds came mainly from selling stock

A potential creditor, on the other hand, would be more interested in thetotal equity the owners have in the firm and would be less concerned withthe source of the equity In the remainder of this chapter, we generally

aggregate the two common equity accounts and call this sum common

eq-uity or net worth.

5 Inventory accounting Allied uses the FIFO (first-in, first-out) method

to determine the inventory value shown on its balance sheet ($615 lion) It could have used the LIFO (last-in, first-out) method During aperiod of rising prices, by taking out old, low-cost inventory and leaving

mil-in new, high-cost items, FIFO will produce a higher balance sheet mil-tory value but a lower cost of goods sold on the income statement (This

inven-is strictly accounting; companies actually use older items first.) Since lied uses FIFO, and since inflation has been occurring, (a) its balancesheet inventories are higher than they would have been had it used LIFO,(b) its cost of goods sold is lower than it would have been under LIFO,and (c) its reported profits are therefore higher In Allied’s case, if thecompany had elected to switch to LIFO in 2001, its balance sheet figurefor inventories would have been $585,000,000 rather than $615,000,000,and its earnings (which will be discussed in the next section) would havebeen reduced by $18,000,000 Thus, the inventory valuation method canhave a significant effect on financial statements This is important when

Al-an Al-analyst is comparing different compAl-anies

6 Depreciation methods Most companies prepare two sets of financial

statements — one for tax purposes and one for reporting to stockholders.Generally, they use the most accelerated method permitted under the law

to calculate depreciation for tax purposes, but they use straight line,which results in a lower depreciation charge, for stockholder reporting.However, Allied has elected to use rapid depreciation for both stock-holder reporting and tax purposes Had Allied elected to use straight linedepreciation for stockholder reporting, its 2001 depreciation expensewould have been $25,000,000 less, so the $1 billion shown for “net plant”

on its balance sheet would have been $25,000,000 higher Its net incomeand its retained earnings would also have been higher

7 The time dimension The balance sheet may be thought of as a

snap-shot of the firm’s financial position at a point in time — for example, on

December 31, 2000 Thus, on December 31, 2000, Allied had $80 lion of cash and marketable securities, but this account had been reduced

mil-to $10 million by the end of 2001 The balance sheet changes every day

as inventories are increased or decreased, as fixed assets are added or tired, as bank loans are increased or decreased, and so on Companieswhose businesses are seasonal have especially large changes in their bal-ance sheets Allied’s inventories are low just before the harvest season, but

re-T H E B A L A N C E S H E E re-T

Retained Earnings

That portion of the firm’s earnings

that has been saved rather than

paid out as dividends.

they are high just after the fall crops have been brought in and processed.Similarly, most retailers have large inventories just before Christmas butlow inventories and high accounts receivable just after Christmas There-fore, firms’ balance sheets change over the year, depending on when thestatement is constructed.

S E L F - T E S T Q U E S T I O N S

What is the balance sheet, and what information does it provide?

How is the order of the information shown on the balance sheet determined?Why might a company’s December 31 balance sheet differ from its June 30balance sheet?

T H E I N C O M E S T A T E M E N T

Table 2-2 gives the 2001 and 2000 income statements for Allied Food

Prod-ucts Net sales are shown at the top of each statement, after which various costsare subtracted to obtain the net income available to common shareholders,which is generally referred to as net income These costs include operatingcosts, interest costs, and taxes A report on earnings and dividends per share isgiven at the bottom of the income statement Earnings per share (EPS) is called

“the bottom line,” denoting that of all the items on the income statement, EPS

is the most important Allied earned $2.27 per share in 2001, down from $2.36

in 2000, but it still raised the dividend from $1.06 to $1.15.3Taking a closer look at the income statement, we see that depreciation andamortization are important components of total operating costs Depreciationand amortization are similar in that both represent allocations of the costs ofassets over their useful lives; however, there are some important distinctions

Recall from accounting that depreciation is an annual charge against income

that reflects the estimated dollar cost of the capital equipment used up in the

production process Depreciation applies to tangible assets, such as plant and equipment, whereas amortization applies to intangible assets such as patents,

copyrights, trademarks, and goodwill Some companies use amortization towrite off research and development costs, or the accounting goodwill that isrecorded when one firm purchases another for more than its book value Sincethey are similar, depreciation and amortization are often lumped together onthe income statement

Managers, security analysts, and bank loan officers often calculate EBITDA,

which is defined as earnings before interest, taxes, depreciation, and

amorti-3 Effective after December 15, 1997, companies must report “comprehensive income” as well as net income Comprehensive income is equal to net income plus several comprehensive income items One example of comprehensive income is the unrealized gain or loss that occurs when a marketable security, classified as available for sale, is marked-to-market For our purposes, in this introductory finance text, we will assume that there are no comprehensive income items, so we will present only basic income statements throughout the text.

Income Statement

A statement summarizing the

firm’s revenues and expenses over

an accounting period, generally a

quarter or a year.

Depreciation

The charge to reflect the cost of

assets used up in the production

process Depreciation is not a cash

A noncash charge similar to

depreciation except that it is used

to write off the costs of intangible

assets.

Intangible Assets

Assets such as patents, copyrights,

trademarks, and goodwill.

EBITDA

Earnings before interest, taxes,

depreciation, and amortization.

a There are 50,000,000 shares of common stock outstanding Note that EPS is based on earnings after preferred dividends — that is, on net income available to common stockholders Calculations of EPS, DPS, BVPS, and CFPS for 2001 are as follows:

b On a typical firm’s income statement, this line would be labeled “net income” rather than “net income before preferred dividends.” However, when

we use the term net income in this text, we mean net income available to common shareholders To simplify the terminology, we refer to net income available to common shareholders as simply net income Students should understand that when they review annual reports, firms use the term net income to mean income after taxes but before preferred and common dividends.

Cash flow per share ⫽ CFPS ⫽Net incomeCommon shares outstanding⫹ Depreciation ⫹ Amortization⫽$213,500,00050,000,000 ⫽ $4.27.

Book value per share ⫽ BVPS ⫽ Total common equity

Common shares outstanding ⫽$896,000,000

50,000,000 ⫽ $17.92.

Dividends per share ⫽ DPS ⫽Dividends paid to common stockholdersCommon shares outstanding ⫽$57,500,00050,000,000 ⫽ $1.15.

Earnings per share ⫽ EPS ⫽ Net income

Common shares outstanding ⫽$113,500,000

50,000,000 ⫽ $2.27.

Allied Food Products: Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per-Share Data)

and $78.3 million in taxes, we obtain net income before preferred dividends of

$117.5 million Finally, we subtract out $4 million in preferred dividends,which leaves Allied with $113.5 million in net income available to commonstockholders When analysts refer to a company’s net income, they generallymean net income available to common shareholders Likewise, throughout thisbook unless otherwise indicated, net income means net income available tocommon stockholders

While the balance sheet can be thought of as a snapshot in time, the

in-come statement reports on operations over a period of time, for example,

dur-ing the calendar year 2001 Durdur-ing 2001 Allied had sales of $3 billion, and itsnet income available to common stockholders was $113.5 million Incomestatements can cover any period of time, but they are usually preparedmonthly, quarterly, or annually Of course, sales, costs, and profits will belarger the longer the reporting period, and the sum of the last 12 monthly (or

4 quarterly) income statements should equal the values shown on the annualincome statement

For planning and control purposes, management generally forecastsmonthly (or perhaps quarterly) income statements, and it then compares actualresults to the budgeted statements If revenues are below and costs above theforecasted levels, then management should take corrective steps before theproblem becomes too serious

S E L F - T E S T Q U E S T I O N S

What is an income statement, and what information does it provide?

Why is earnings per share called “the bottom line”?

Differentiate between amortization and depreciation

What is EBITDA?

Regarding the time period reported, how does the income statement differfrom the balance sheet?

S T A T E M E N T O F R E T A I N E D E A R N I N G S

Changes in retained earnings between balance sheet dates are reported in the

statement of retained earnings Table 2-3 shows that Allied earned $113.5

million during 2001, paid out $57.5 million in common dividends, and plowed

$56 million back into the business Thus, the balance sheet item “Retainedearnings” increased from $710 million at the end of 2000 to $766 million at theend of 2001

Note that “Retained earnings” represents a claim against assets, not assets

per se Moreover, firms retain earnings primarily to expand the business, and

this means investing in plant and equipment, in inventories, and so on, not

pil-ing up cash in a bank account Changes in retained earnpil-ings occur because

Statement of Retained

Earnings

A statement reporting how much

of the firm’s earnings were

retained in the business rather

than paid out in dividends The

figure for retained earnings that

appears here is the sum of the

annual retained earnings for each

year of the firm’s history.

S T A T E M E N T O F R E T A I N E D E A R N I N G S

T A B L E 2 - 3

a Here, and throughout the book, parentheses are used to denote negative numbers.

Allied Food Products: Statement of Retained Earnings for Year Ending December 31, 2001 (Millions of Dollars)

F I N A N C I A L A N A LY S I S O N T H E I N T E R N E T

the Internet With just a couple of clicks, an investor can

easily find the key financial statements for most publicly traded

companies.

Say, for example, you are thinking about buying Disney

stock, and you are looking for financial information regarding

the company’s recent performance Here’s a partial (but by no

means a complete) list of places you can go to get started:

■ One source is Yahoo’s finance web site, finance.yahoo.

com.a Here you will find updated market information

along with links to a variety of interesting research sites.

Enter a stock’s ticker symbol, click on Get Quotes, and

you will see the stock’s current price, along with recent

news about the company Click on Profile (under More

Info) and you will find a report on the company’s key

fi-nancial ratios Links to the company’s income statement,

balance sheet, and statement of cash flows can also be

found The Yahoo site also has a list of insider

transac-tions, so you can tell if a company’s CEO and other key

insiders are buying or selling their company’s stock In

addition, there is a message board where investors share

opinions about the company, and there is a link to the

company’s filings with the Securities and Exchange

Com-mission (SEC) Note that, in most cases, a more complete

list of the SEC filings can be found at www.sec.gov or at

www.edgar-online.com.

■ Other sources for up-to-date market information are

cnnfn.com and cbs.marketwatch.com Each also has an

area where you can obtain stock quotes along with pany financials, links to Wall Street research, and links to SEC filings.

ticker symbol in the area labeled quotes and research The site will take you to an area where you can find a link to the company’s financial statements, along with analysts’ earnings estimates and SEC filings This site also has a section where you can estimate the stock’s intrinsic value (In Chapter 9 we will discuss various methods for calculating intrinsic value.)

■ If you are looking for charts of key accounting variables (for example, sales, inventory, depreciation and amortiza- tion, and reported earnings), along with the financial

statements, take a look at www.smartmoney.com.

Here you find links to analysts’ research reports along with the key financial statements.

my.zacks.com Each has free research available along with

more detailed information provided to subscribers Once you have accumulated all of this information, you may

be looking for sites that provide opinions regarding the tion of the overall market and views regarding individual stocks Two popular sites in this category are The Motley Fool’s web

direc-site, www.fool.com, and the web site for The Street.com, www.thestreet.com.

Keep in mind that this list is just a small subset of the formation available online You should also realize that a lot of these sites change their content over time, and new and inter- esting sites are always being added to the Internet.

in-a

To avoid redundancy, we have intentionally left off http:// in all web addresses

given here A quick way to change an address is to highlight the portion of the

address that is different and type in the appropriate letters of the new address.

Once you’re finished just press Enter.

A N A LY S T S A R E I N C R E A S I N G LY R E LY I N G O N C A S H F L OW TO VA L U E S TO C K S

common stockholders allow the firm to reinvest funds that otherwise could be

distributed as dividends Thus, retained earnings as reported on the balance sheet

do not represent cash and are not “available” for the payment of dividends or thing else.4

any-4The amount reported in the retained earnings account is not an indication of the amount of cash

the firm has Cash (as of the balance sheet date) is found in the cash account, an asset account A positive number in the retained earnings account indicates only that in the past the firm has earned some income, but its dividends have been less than its earnings Even though a company reports record earnings and shows an increase in the retained earnings account, it still may be short of cash The same situation holds for individuals You might own a new BMW (no loan), lots of clothes, and an expensive stereo, hence have a high net worth, but if you had only 23 cents in your pocket plus $5 in your checking account, you would still be short of cash.

Internet-related businesses, including Ziff-Davis Inc., which publishes

more than 80 magazines including PC Week and PC Magazine.

Ziff-Davis also provides training courses in computer

technol-ogy, and it distributes information through the Internet and

computer trade shows.

In an article on Softbank, Barron’s indicated that Ziff-Davis

has been “losing money,” and a quick look at the company’s

re-cent income statements confirms that it had losses in 1998 and

the first quarter of 1999 Despite the company’s negative

re-ported earnings, the company’s chief financial officer, Timothy

O’Brien, took exception with the notion that Ziff-Davis was

“losing money.” So, he sent Barron’s the following response:

To the Editor:

In his discussion of Softbank, Neil Martin (International

Trader, June 14) referred to Ziff-Davis as “losing money.” In

fact, Ziff-Davis continues to generate significant positive

cash flow.

We are a diversified media company Analysts measure

our strength and stability relative to our ability to generate

EBITDA (earnings before interest, taxes, depreciation, and

amortization) Analysts project that we will generate

EBITDAof approximately $220 million in 1999, and that

takes into account our substantial investment in ZDTV, the

company’s 24-hour cable network devoted to computing and

the Internet.

Ziff-Davis did report a net loss for 1998 and for the first

quarter of 1999 However, this loss was due to noncash

ex-penses, primarily the amortization of approximately $120 million in goodwill per year Even with continuing invest- ments in our key businesses, Ziff-Davis has the financial flexibility to continue to repay indebtedness with free cash flow.

Timothy C O’Brien, Chief Financial Officer, Ziff-Davis Cash-flow measures such as EBITDA have long been popular with bankers and other short-term lenders, who focus more on borrowers’ ability to generate cash to pay off loans than on ac- counting earnings In the past, these measures were less popu- lar with stock analysts, who focused on reported earnings and price earnings ratios However, today more and more Wall Street analysts are siding with Tim O’Brien, arguing that cash flow measures such as EBITDA often provide a better indication of true value than do earnings per share.

These analysts note that the DA part of EBITDA reduces ported profits but not cash, so EBITDA reflects the cash avail- able to a firm better than accounting profits It is logical that credit analysts interested in a company’s ability to repay its loans focus heavily on EBITDA, but what about equity analysts, who are seeking to find a firm’s value to its stockholders? First, most analysts agree that a firm’s value depends on its ability to generate cash flows over the long run If depreciation and amortization (DA) charges truly reflect a decline in the assets used to produce cash flows, then the DA will have to be rein- vested in the business if cash flows are to continue The DA may reflect “available cash” in the short run, but it is not truly

S T A T E M E N T O F R E T A I N E D E A R N I N G S

available to investors because it will have to be reinvested if

the business is to continue to operate.

So, analysts must consider the nature of the D and A

charges If depreciation is related to essential assets, as it

usu-ally is, then it is a cost that should be deducted to get an idea

of the firm’s long-run cash generating potential Amortization is

analyzed similarly, but here there is more ambiguity, because

amortization is related to two primary types of write-offs: (1)

amortization of research and development costs associated with

products such as airplanes, computers, software, and

pharma-ceutical drugs, and (2) amortization of merger-related goodwill,

which reflects the difference between the price a company pays

when it acquires another company and the book value of the

acquired company Both types of amortization can be huge, so

there can be huge differences between EBIT and EBITDA.

The key question then becomes, “Will the company be

re-quired to reinvest the cash flow reflected in the DA part of

EBITDA if it is to continue to generate cash flow on into the

fu-ture?” If the answer is yes, then the DA component is not “free

cash flow” that is available to investors, and it should be

de-ducted when determining the firm’s long-run earning power If

the answer is no, then DA does represent free cash flow and is

available to investors.

The situation where all this is most important is when

merg-ers occur and large amounts of goodwill are created Consider

two examples First, suppose Microsoft acquires a small software

company whose owner developed and patented a new type of

mouse Microsoft paid $3.1 million for the company, whose

book value was $100,000, so $3 million of goodwill was

cre-ated The mouse will help Microsoft for three years, after which

it will be obsolete Here it would be appropriate for Microsoft

to amortize the goodwill at the rate of $1 million per year; this

$1 million would need to be reinvested to maintain Microsoft’s cash flow, and this $1 million of its EBITDA would not represent long-run earning potential.

Now consider the case of Softbank’s acquisition of Davis Softbank paid far more for Ziff-Davis than Ziff-Davis’ ac- counting value as reflected on its balance sheet, and that dif- ference was recorded as goodwill Softbank paid the high price because Ziff-Davis was earning an abnormally high rate of re- turn on its book assets, and it was expected to earn high re- turns on into the future because it had created a niche in the publishing industry that would be hard for a new competitor to overcome Here, because the above-normal earning power is likely to be sustained over time, EBITDA is more reflective of long-run cash flow potential than is accounting profit Amortization will be high in an industry if patents are im- portant, as is the case in the pharmaceutical industry, or if mergers are producing a lot of goodwill, as has been the case with high-tech and financial services firms This was spelled out

Ziff-in a recent “Heard on the Street” column Ziff-in The Wall Street Journal, which noted that cash flow valuations are now in

vogue in the cable, high-tech, Internet, pharmaceutical, and nancial services sectors.

fi-SOURCES: Barron’s, July 19, 1999, 54; and “Analysts Increasingly Favor Using Cash Flow Over Reported Earnings in Stock Valuations,” Heard on The Street, The Wall

Street Journal, April 1, 1999, C2.

S E L F - T E S T Q U E S T I O N S

What is the statement of retained earnings, and what information does itprovide?

Why do changes in retained earnings occur?

Explain why the following statement is true: “Retained earnings as reported

on the balance sheet do not represent cash and are not ‘available’ for thepayment of dividends or anything else.”

N E T C A S H F L O W

When you studied income statements in accounting, the emphasis was

proba-bly on the firm’s net income In finance, however, we focus on net cash flow.

The value of an asset (or a whole firm) is determined by the cash flow it erates The firm’s net income is important, but cash flow is even more impor-tant because dividends must be paid in cash and because cash is necessary topurchase the assets required to continue operations

gen-As we discussed in Chapter 1, the firm’s goal should be to maximize its stockprice Since the value of any asset, including a share of stock, depends on thecash flow produced by the asset, managers should strive to maximize the cash

flow available to investors over the long run A business’s net cash flow generally

differs from its accounting profit because some of the revenues and expenses

listed on the income statement were not paid in cash during the year The lationship between net cash flow and net income can be expressed as follows:Net cash flow ⫽ Net income ⫺ Noncash revenues ⫹ Noncash charges (2-1)

re-The primary examples of noncash charges are depreciation and amortization.These items reduce net income but are not paid out in cash, so we add themback to net income when calculating net cash flow Another example of a non-cash charge is deferred taxes In some instances, companies are allowed to defertax payments to a later date even though the tax payment is reported as an ex-pense on the income statement Therefore, deferred tax payments would beadded to net income when calculating net cash flow.5At the same time, somerevenues may not be collected in cash during the year, and these items must besubtracted from net income when calculating net cash flow

Typically, depreciation and amortization are by far the largest noncash items,and in many cases the other noncash items roughly net out to zero For thisreason, many analysts assume that net cash flow equals net income plus depre-ciation and amortization:

Net cash flow ⫽ Net income ⫹ Depreciation and amortization (2-2)

To keep things simple, we will generally assume Equation 2-2 holds However,you should remember that Equation 2-2 will not accurately reflect net cashflow in those instances where there are significant noncash items beyond de-preciation and amortization

We can illustrate Equation 2-2 with 2001 data for Allied taken from Table 2-2:

Net cash flow ⫽ $113.5 ⫹ $100.0 ⫽ $213.5 million

To illustrate depreciation itself, suppose a machine with a life of five yearsand a zero expected salvage value was purchased in 2000 for $100,000 andplaced into service in 2001 This $100,000 cost is not expensed in the purchaseyear; rather, it is charged against production over the machine’s five-year de-preciable life If the depreciation expense were not taken, profits would beoverstated, and taxes would be too high So, the annual depreciation charge isdeducted from sales revenues, along with such other costs as labor and raw ma-

Net Cash Flow

The actual net cash, as opposed to

accounting net income, that a firm

generates during some specified

period.

Accounting Profit

A firm’s net income as reported on

its income statement.

5 Deferred taxes may arise, for example, if a company uses accelerated depreciation for tax purposes but straight-line depreciation for reporting its financial statements to investors.

I N VA L U I N G S TO C K S , I S I T E A R N I N G S O R C A S H F L OW T H AT M AT T E R S ?

49

terials, to determine income However, because the $100,000 was actually pended back in 2000, the depreciation charged against income in 2001 and

ex-subsequent years is not a cash outlay, as are labor or raw materials charges

De-preciation is a noncash charge, so it must be added back to net income to obtain the net cash flow If we assume that all other noncash items (including amortization)

sum to zero, then net cash flow is simply equal to net income plus depreciation

S T A T E M E N T O F C A S H F L O W S

When it comes to valuing a company’s stock, what’s more

important: cash flow or earnings? Analysts often disagree,

and the measure used often depends on the industry For

ex-ample, analysts have traditionally emphasized cash flow rather

than earnings when valuing cable stocks This distinction has

been important because, traditionally, cable companies have

had to make large capital expenditures These expenditures

generate large depreciation expenses, which depress reported

earnings However, since depreciation is a noncash expense,

cable companies often continue to show strong cash flows,

even when earnings are declining or even negative.

For example, in recent years leading cable companies such

as Tele-Communications Inc., Cox Communications, and Comcast

Corporation have all reported low or negative earnings

Never-theless, over the past five years cable stocks have outperformed

the overall market, generating an average annual return in

ex-cess of 30 percent One reason for this strong performance is

that each of these companies has generated a strong cash flow.

Besides their growth in cash flow, there are at least two

other reasons cable stocks have performed so well despite weak

earnings First, many believe that the cable companies will

be-come the dominant providers of Internet service, which if true will lead to much higher growth in the future Second, in recent years cable companies have become acquisition targets For ex- ample, AT&T recently acquired cable giant Tele-Communications Inc and Media One This takeover activity has helped bid up the prices of all cable stocks.

To be sure, many analysts take a more sanguine view of the cable industry’s future prospects Cable companies continue to face increased competition from digital satellite companies, and other technologies are emerging to compete with cable for providing high-speed Internet access Finally, despite their growth potential, it is clear that to compete in the years ahead the cable companies will have to continue making large capital expenditures As a result, much of the cash flow will not be available to pay dividends to shareholders — rather, it will be required for investments that are necessary to maintain existing revenues So, while cash flow will probably continue to be an important determinant of cable stock values, more and more analysts are insisting that these companies must also begin to generate positive earnings.

S E L F - T E S T Q U E S T I O N S

Differentiate between net cash flow and accounting profit

In accounting, the emphasis is on net income What is emphasized in nance, and why is that item emphasized?

fi-Assuming that depreciation is its only noncash cost, how can someone culate a business’s cash flow?

cal-S T A T E M E N T O F C A cal-S H F L O W cal-S

Net cash flow represents the amount of cash a business generates for its holders in a given year However, the fact that a company generates high cash

share-flow does not necessarily mean that the amount of cash reported on its balance

sheet will also be high The cash flow may be used in a variety of ways For ample, the firm may use its cash flow to pay dividends, to increase inventories,

ex-to finance accounts receivable, ex-to invest in fixed assets, ex-to reduce debt, or ex-to buyback common stock Indeed, the company’s cash position as reported on thebalance sheet is affected by a great many factors, including the following:

1 Cash flow Other things held constant, a positive net cash flow will lead

to more cash in the bank However, as we discuss below, other things aregenerally not held constant

2 Changes in working capital Net working capital, which is discussed in

detail in Chapter 15, is defined as current assets minus current liabilities.Increases in current assets other than cash, such as inventories and ac-counts receivable, decrease cash, whereas decreases in these accounts in-crease cash For example, if inventories are to increase, the firm must usesome of its cash to buy the additional inventory, whereas if inventoriesdecrease, this generally means the firm is selling off inventories and notreplacing them, hence generating cash On the other hand, increases incurrent liabilities such as accounts payable increase cash, whereas de-creases in these accounts decrease it For example, if payables increase,the firm has received additional credit from its suppliers, which savescash, but if payables decrease, this means the firm has used cash to pay offits suppliers

3 Fixed assets If a company invests in fixed assets, this will reduce its cash

position On the other hand, the sale of fixed assets will increase cash

4 Security transactions If a company issues stock or bonds during the

year, the funds raised will enhance its cash position On the other hand,

if it uses cash to buy back outstanding debt or equity, or pays dividends toits shareholders, this will reduce cash

Each of the above factors is reflected in the statement of cash flows, which

summarizes the changes in a company’s cash position The statement separatesactivities into three categories:

1 Operating activities, which includes net income, depreciation, and changes

in current assets and current liabilities other than cash and short-termdebt

2 Investing activities, which includes investments in or sales of fixed assets.

3 Financing activities, which includes cash raised during the year by issuing

short-term debt, long-term debt, or stock Also, since dividends paid orcash used to buy back outstanding stock or bonds reduces the company’scash, such transactions are included here

Accounting texts explain how to prepare the statement of cash flows, butthe statement is used to help answer questions such as these: Is the firm gen-erating enough cash to purchase the additional assets required for growth? Isthe firm generating any extra cash that can be used to repay debt or to invest

in new products? Will inadequate cash flows force the company to issue morestock? Such information is useful both for managers and investors, so thestatement of cash flows is an important part of the annual report Financial

Statement of Cash Flows

A statement reporting the impact

of a firm’s operating, investing,

and financing activities on cash

flows over an accounting period.

com-minus $2.5 million The operating cash flows are generated in the normal

course of business, and this amount is determined by adjusting the net incomefigure to account for depreciation and amortization plus other cash flows re-lated to operations Allied’s day-to-day operations in 2001 provided $257.5 mil-lion; however, the increase in receivables and inventories more than offset this

amount, resulting in a negative $2.5 million cash flow from operations.

The second section shows long-term fixed-assets investing activities Alliedpurchased fixed assets totaling $230 million; this was the only long-term in-vestment it made during 2001

S T A T E M E N T O F C A S H F L O W S

T A B L E 2 - 4

O PERATING A CTIVITIES

Additions (Sources of Cash)

Subtractions (Uses of Cash)

L ONG -T ERM I NVESTING A CTIVITIES

F INANCING A CTIVITIES

a Depreciation and amortization are noncash expenses that were deducted when calculating net income They must be added back to show the actual cash flow from operations.

b The net increase in fixed assets is $130 million; however, this net amount is after deducting the year’s depreciation expense Depreciation expense must be added back to find the actual expenditures on fixed assets From the company’s income statement, we see that the 2001 depreciation expense is $100 million; thus, expenditures on fixed assets were actually $230 million.

Allied Food Products: Statement of Cash Flows for 2001 (Millions of Dollars)

Allied’s financing activities, shown in the third section, include borrowingfrom banks (notes payable), selling new bonds, and paying dividends on itscommon and preferred stock Allied raised $224 million by borrowing, but itpaid $61.5 million in preferred and common dividends, so its net inflow offunds from financing activities was $162.5 million.

When all of the sources and uses of cash are totaled, we see that Allied’s cashoutflows exceeded its cash inflows by $70 million during 2001 It met thatshortfall by drawing down its cash and marketable securities holdings by $70million, as confirmed by Table 2-1, the firm’s balance sheet

Allied’s statement of cash flows should be worrisome to its managers and tooutside analysts The company had a $2.5 million cash shortfall from opera-tions, it spent $230 million on new fixed assets, and it paid out another $61.5million in dividends It covered these cash outlays by borrowing heavily and byselling off most of its marketable securities Obviously, this situation cannotcontinue year after year, so something will have to be done In Chapter 3, wewill consider some of the actions Allied’s financial staff might recommend toease the cash flow problem

S E L F - T E S T Q U E S T I O N S

What is the statement of cash flows, and what types of questions does itanswer?

Identify and briefly explain the three different categories of activities shown

in the statement of cash flows

M O D I F Y I N G A C C O U N T I N G D A T A

F O R M A N A G E R I A L D E C I S I O N S

Thus far in the chapter we have focused on financial statements as they are pared by accountants and presented in the annual report However, these state-ments are designed more for use by creditors and tax collectors than for man-agers and equity (stock) analysts Therefore, certain modifications are used forcorporate decision making and stock valuation purposes In the following sec-tions we discuss how financial analysts combine stock prices and accountingdata to evaluate and reward managerial performance

pre-OP E R AT I N G AS S E T S A N D OP E R AT I N G CA P I TA L

Different firms have different financial structures, different tax situations, anddifferent amounts of nonoperating assets These differences affect traditionalaccounting measures such as the rate of return on equity They can cause twofirms, or two divisions within a single firm, that actually have similar operations

to appear to be operated with different efficiency This is important, because ifmanagerial compensation systems are to function properly, operating managersmust be judged and compensated for those things that are under their control,

not on the basis of things outside their control Therefore, to judge managerial

performance, we need to compare managers’ ability to generate operating income (or EBIT) with the operating assets under their control.

The first step in modifying the traditional accounting framework is to divide

total assets into two categories, operatingassets, which consist of the cash and

marketable securities, accounts receivable, inventories, and fixed assets necessary

to operate the business, and nonoperatingassets, which would include cash

and marketable securities above the level required for normal operations, vestments in subsidiaries, land held for future use, and the like Moreover, oper-

in-ating assets are further divided into working capital and fixed assets such as plant

and equipment Obviously, if a manager can generate a given amount of profitsand cash flows with a relatively small investment in operating assets, that reducesthe amount of capital investors must put up and thus increases the rate of return

on that capital

The primary source of capital for business is investors — stockholders, holders, and lenders such as banks Investors must be paid for the use of theirmoney, with payment coming as interest in the case of debt and as dividendsplus capital gains in the case of stock So, if a company acquires more assetsthan it actually needs, and thus raises too much capital, then its capital costswill be unnecessarily high

bond-Must all of the capital used to acquire assets be obtained from investors?The answer is no, because some of the funds will come from suppliers and be

reported as accounts payable, while other funds will come as accrued wages and

ac-crued taxes, which amount to short-term loans from workers and tax authorities.

Generally, both accounts payable and accruals are “free” in the sense that noexplicit fee is charged for their use Therefore, if a firm needs $100 million ofcurrent assets, but it has $10 million of accounts payable and another $10 mil-

lion of accrued wages and taxes, then its investor-supplied capital would be only

$80 million

Those current assets used in operations are called operating working ital, and operating working capital less accounts payable and accruals is called net operating working capital Therefore, net operating working capital is

cap-the working capital acquired with investor-supplied funds.6Here is a workabledefinition in equation form:

(2-3)

Net operating working capital⫽ All current assets ⫺ liabilities that doAll current

not charge interest

M O D I F Y I N G A C C O U N T I N G D A T A F O R M A N A G E R I A L D E C I S I O N S

Operating Assets

The cash and marketable

securities, accounts receivable,

inventories, and fixed assets

necessary to operate the business.

Nonoperating Assets

Cash and marketable securities

above the level required for

normal operations, investments in

subsidiaries, land held for future

use, and other nonessential assets.

Operating Working Capital

Current assets used in operations.

Net Operating Working Capital

Operating working capital less

accounts payable and accruals It is

the working capital acquired with

investor-supplied funds.

6 Note that the term “capital” can be given two meanings First, when accountants use the term

“capital,” they typically mean the sum of long-term debt, preferred stock, and common equity, or perhaps those items plus interest-bearing short-term debt However, when economists use the term, they generally mean assets used in production, as in “labor plus capital.” If all funds were raised from long-term sources, and if all assets were operating assets, then money capital would equal operating assets, and the accountants’ capital would always equal the economists’ capital When you encounter the term “capital” in the business and financial literature, it can mean either asset capital or money capital For example, in Coca-Cola’s operating manuals, which explain to its employees how Coke wants the company to be operated, capital means “assets financed by investor- supplied capital.” However, in most accounting and finance textbooks, and in the traditional finance literature, “capital” means investor-supplied capital, not assets It might be easier if we picked one meaning and then used it consistently in this book However, that would be misleading, because both meanings are encountered in practice Therefore, we shall use the term “capital” in both ways However, you should be able to figure out which definition is implied from the context in which the term is used.

Now think about how these concepts can be used in practice First, allcompanies must carry some cash to “grease the wheels” of their operations.Companies continuously cash checks from customers and write checks to sup-pliers, employees, and so on Because inflows and outflows do not coincide per-fectly, a company must keep some cash and marketable securities in its bank ac-count In other words, some cash and marketable securities is required toconduct operations The same is true for most other current assets, such as in-ventory and accounts receivable, which are required for normal operations Ourmeasure of operating working capital assumes that cash and marketable securi-ties on the balance sheet represent the amount that is required under normaloperations However, in some instances companies have large holdings of cashand marketable securities that they are holding as a reserve for some contin-gency, or as a “parking place” for funds prior to an acquisition, a major captialinvestment program, or the like In such instances, the excess cash and mar-ketable securities should not be viewed as part of operating working capital.Looking at the other side of the balance sheet, some current liabilities — es-pecially accounts payable and accruals — arise in the normal course of opera-tions Moreover, each dollar of these current liabilities is a dollar that the com-pany does not have to raise from investors to acquire current assets Therefore,when finding the net operating working capital, we deduct these current liabil-ities from the operating current assets Other current liabilities that charge in-terest, such as notes payable to banks, are treated as investor-supplied capitaland thus are not deducted when calculating net operating working capital.

We can apply these definitions to Allied, using the balance sheet data givenback in Table 2-1 Here is the net operating working capital for 2001:

year-and, since it had $870 million of fixed assets, its total operating capital was

Therefore, Allied increased its operating capital from $1,520 to $1,800 million,

or by $280 million, during 2001 Furthermore, most of this increase went intoworking capital, which rose by $150 million This 23 percent increase in netoperating working capital, when sales only rose 5 percent (from $2,850 to

⫽ $1,520 million

Total operating capital⫽ $650 ⫹ $870

⫽ $650 million, Net operating working capital⫽ ($80 ⫹ $315 ⫹ $415) ⫺ ($30 ⫹ $130)

⫽ °marketableCash andsecurities

⫹receivableAccounts ⫹ Inventories¢ ⫺ °Accountspayable ⫹ Accruals¢

$3,000 million), should set off warning bells in your head: What caused Allied

to tie up so much additional cash in working capital? Are inventories not ing? Are receivables not being collected and thus building up? We will addressthese questions in detail later in the chapter

mov-NE T OP E R AT I N G PR O F I T A F T E R TA X E S ( N O PAT )

If two companies have different amounts of debt, hence different interestcharges, they could have identical operating performances but different net in-comes — the one with more debt would have a lower net income Net income

is certainly important, but as the example below shows, net income does not ways reflect the true performance of a company’s operations or the effectiveness

al-of its operating managers and employees A better measurement for comparing

managers’ performance is net operating profit after taxes, or NOPAT, which

is the amount of profit a company would generate if it had no debt and held nononoperating assets NOPAT is defined as follows:7

(2-5)

Using data from the income statement in Table 2-2, Allied’s 2001 NOPAT was

Thus, Allied generated an after-tax profit of $170.3 million from its operations.This was a little better than the 2000 NOPAT of $263(0.6) ⫽ $157.8 million.However, the income statements in Table 2-2 show that Allied’s earnings pershare declined from 2000 to 2001 This decrease in EPS was caused by an in-crease in interest expense, not by a decrease in operating profit See Table 2-2.Moreover, the balance sheets in Table 2-1 show that debt increased from 2000

to 2001 But why did Allied increase its debt? The reason was that Allied’s vestment in operating capital increased dramatically from 2000 to 2001, andthat increase was financed primarily with debt

in-FR E E CA S H FL O W

Earlier in the chapter we defined net cash flow as being equal to net incomeplus noncash adjustments, typically net income plus depreciation and amortiza-tion Note, though, that cash flows cannot be maintained over time unless de-preciating fixed assets are replaced and new products are developed, so man-agement is not completely free to use cash flows however it chooses Therefore,

we now define another term, free cash flow, which is the cash flow actually

available for distribution to all investors (stockholders and debtholders) after the

company has made all the investments in fixed assets, new products, and working ital necessary to sustain ongoing operations.

The profit a company would

generate if it had no debt and held

no nonoperating assets.

7 For firms with a more complicated tax situation, it is better to define NOPAT as follows: NOPAT

⫽ (Net income before preferred dividends) ⫹ (Net interest expense)(1 ⫺ Tax rate) Also, if firms are able to defer paying some of their taxes, perhaps by the use of accelerated depreciation, then NOPAT should be adjusted to reflect the taxes that the company actually paid on its operating in-

come For additional information see Tom Copeland, Tim Koller, and Jack Murrin, Valuation:

Mea-suring and Managing the Value of Companies, 3rd edition (New York: John Wiley & Sons, Inc., 2000);

and G Bennett Stewart III, The Quest for Value (New York: HarperCollins Publishers, Inc., 1991).

Free Cash Flow

The cash flow actually available

for distribution to all investors

(stockholders and debtholders)

after the company has made all

the investments in fixed assets,

new products, and working capital

necessary to sustain ongoing

operations.

When you studied income statements in accounting, the emphasis probablywas on the firm’s net income, which is its accounting profit However, we beganthis chapter by telling you that the value of a company’s operations is deter-mined by the stream of cash flows that the operations will generate now and inthe future As the statement of cash flows shows, accounting profit and cashflow can be quite different.

To be more specific, the value of a company’s operations depends on all thefuture expected free cash flows (FCF), defined as after-tax operating profitminus the amount of investment in working capital and fixed assets necessary tosustain the business Thus, free cash flow represents the cash that is actuallyavailable for distribution to investors Therefore, the way for managers to maketheir companies more valuable is to increase their free cash flow

CA L C U L AT I N G FR E E CA S H FL O W

As shown earlier in the chapter, Allied had a 2001 NOPAT of $170.3 million

Its operating cash flow is NOPAT plus any noncash adjustments as shown on

the statement of cash flows For Allied, where depreciation is the only noncashcharge, the 2001 operating cash flow is8

Operating cash flow ⫽ NOPAT ⫹ Depreciation (2-6)

⫽ $170.3 ⫹ $100

⫽ $270.3 million

Please note that this definition of operating cash flow is calculated on an tax basis As shown earlier in the chapter, Allied had $1,520 million of operatingassets, or operating capital, at the end of 2000, but $1,800 million at the end of

after-2001 Therefore, during 2001 it made a net investment in operating capital of

Net investment in operating capital ⫽ $1,800 ⫺ $1,520 ⫽ $280 million.Fixed assets rose from $870 to $1,000 million, or by $130 million However,Allied took $100 million of depreciation, so its gross investment in fixed assetswas $130 ⫹ $100 ⫽ $230 million for the year With this background, we find

the gross investment in operating capital as follows:

Gross investment ⫽ Net investment ⫹ Depreciation

Operating Cash Flow

Equal to NOPAT plus any

noncash adjustments, calculated

free cash flow See Copeland, Koller, and Murrin, Valuation: Measuring and Managing the Value of

Companies, for a more detailed discussion of how to incorporate amortization expenses into the

calculation of free cash flow.

If we subtract depreciation from both operating cash flow and gross investment

in operating capital in Equation 2-7, we obtain the following algebraicallyequivalent expression for free cash flow:

FCF ⫽ NOPAT ⫺ Net investment in operating capital (2-7a)

⫽ $170.3 ⫺ $280

⫽ ⫺$109.7 million

Even though Allied had a positive NOPAT, its very high investment in erating capital resulted in a negative free cash flow Since free cash flow is what

op-is available for dop-istribution to investors, not only was there nothing for

in-vestors, but investors actually had to provide more money to Allied to keep the

business going Investors provided most of the required new money as debt

Is a negative free cash flow always bad? The answer is, “Not necessarily It

depends on why the free cash flow was negative.” If FCF was negative because

NOPAT was negative, this is bad, because the company is probably ing operating problems Exceptions to this might be startup companies, orcompanies that are incurring significant current expenses to launch a newproduct line Also, many high-growth companies have positive NOPAT butnegative free cash flow due to investments in operating assets needed to sup-port growth There is nothing wrong with profitable growth, even if it causesnegative cash flows in the short term

experienc-M VA A N D E VA

S E L F - T E S T Q U E S T I O N S

What is net operating working capital?

What is total operating capital?

What is NOPAT? Why might it be a better performance measure than net come?

in-What is free cash flow? Why is free cash flow the most important nant of a firm’s value?

pic-9 The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders

of the consulting firm Stern Stewart & Company Stern Stewart copyrighted the terms “EVA” and

“MVA,” so other consulting firms have given other names to these values Still, EVA and MVA are the terms most commonly used in practice.

MA R K E T VA L U E AD D E D ( M VA )

The primary goal of most firms is to maximize shareholders’ wealth Thisgoal obviously benefits shareholders, but it also helps to ensure that scarceresources are allocated efficiently, which benefits the economy Shareholder

wealth is maximized by maximizing the difference between the market value of

the firm’s stock and the amount of equity capital that was supplied by

share-holders This difference is called the Market Value Added (MVA):

MVA ⫽ Market value of stock ⫺ Equity capital supplied by shareholders

⫽ (Shares outstanding)(Stock price) ⫺ Total common equity (2-8)

To illustrate, consider our illustrative company, Allied Food Products In

2001, its total market equity value was $1,150 million, while its balance sheetshowed that stockholders had put up only $896 million Thus, Allied’s MVAwas $1,150 ⫺ $896 ⫽ $254 million This $254 million represents the differencebetween the money that Allied’s stockholders have invested in the corporationsince its founding — including retained earnings — versus the cash they couldget if they sold the business The higher its MVA, the better the job manage-ment is doing for the firm’s shareholders

EC O N O M I C VA L U E AD D E D ( E VA )

Whereas MVA measures the effects of managerial actions since the very

incep-tion of a company, Economic Value Added (EVA) focuses on managerial

ef-fectiveness in a given year The basic formula for EVA is as follows:

EVA ⫽ Net operating profit after taxes, or NOPAT

⫺ After-tax dollar cost of capital used to support operations

⫽ EBIT(1 ⫺ Corporate tax rate)

⫺ (Total investor-supplied operating capital)(After-tax percentage

Total investor-supplied operating capital is the sum of the interest-bearing debt,preferred stock, and common equity used to acquire the company’s net operat-ing assets, that is, its net operating working capital plus net plant and equipment.EVA is an estimate of a business’s true economic profit for the year, and it dif-fers sharply from accounting profit.10EVA represents the residual income that re-

mains after the cost of all capital, including equity capital, has been deducted,

whereas accounting profit is determined without imposing a charge for equitycapital As we will discuss more completely in Chapter 10, equity capital has a cost,because funds provided by shareholders could have been invested elsewherewhere they would have earned a return Shareholders give up the opportunity toinvest funds elsewhere when they provide capital to the firm The return theycould earn elsewhere in investments of equal risk represents the cost of equity cap-

ital This cost is an opportunity cost rather than an accounting cost, but it is quite real

nevertheless

Note that when calculating EVA we do not add back depreciation Although

it is not a cash expense, depreciation is a cost, and it is therefore deducted when

Economic Value Added (EVA)

Value added to shareholders by

management during a given year.

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10 The most important reason EVA differs from accounting profit is that the cost of equity capital

is deducted when EVA is calculated Other factors that could lead to differences include ments that might be made to depreciation, to research and development costs, to inventory valua-

adjust-tions, and so on See Stewart, The Quest for Value.

Market Value Added (MVA)

The difference between the

market value of the firm’s stock

and the amount of equity capital

investors have supplied.

determining both net income and EVA Our calculation of EVA assumes thatthe true economic depreciation of the company’s fixed assets exactly equals thedepreciation used for accounting and tax purposes If this were not the case, ad-justments would have to be made to obtain a more accurate measure of EVA.EVA provides a good measure of the extent to which the firm has added toshareholder value Therefore, if managers focus on EVA, this will help to ensurethat they operate in a manner that is consistent with maximizing shareholderwealth Note too that EVA can be determined for divisions as well as for the com-pany as a whole, so it provides a useful basis for determining managerial compen-sation at all levels As a result of all this, EVA is being used by an increasing num-ber of firms as the primary basis for determining managerial compensation.Table 2-5 shows how Allied’s MVA and EVA are calculated The stock pricewas $23 per share at year-end 2001, down from $26 per share at the end of 2000;its percentage after-tax cost of capital was 10.3 percent in 2000 and 10.0 percent

in 2001, and its tax rate was 40 percent Other data in Table 2-5 were given in thebasic financial statements provided earlier in the chapter

Note first that the lower stock price and the higher book value of equity (due

to retaining earnings during 2001) combined to reduce the MVA The 2001MVA is still positive, but $460 ⫺ $254 ⫽ $206 million of stockholders’ valuewas lost during 2001

EVA for 2000 was just barely positive, and in 2001 it was negative ing income (NOPAT) rose, but EVA still declined, primarily because theamount of capital rose more sharply than NOPAT — by about 18 percent ver-sus 8 percent — and the cost of this increased capital pulled EVA down.Recall also that net income fell somewhat from 2000 to 2001, but not nearly

Operat-so dramatically as the decline in EVA Net income does not reflect the amount

M VA A N D E VA

T A B L E 2 - 5

MVA C ALCULATION

EVA C ALCULATION

a Investor-supplied operating capital equals the sum of notes payable, long-term debt, preferred stock, and common equity It could also be calculated as total liabilities and equity minus accounts payable and accruals.

MVA and EVA for Allied (Millions of Dollars)