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Chapter 2. Model for Financial Statements, Cash Flows, and Taxes

THE ANNUAL REPORT The annual report contains a verbal section plus four key statements: the balance sheet, income statement, statement of retained earnings, and statement of cash flows. These statements contain a wealth of information that is used by bankers, stock and bond analysts, and managers. Hence, they are quite important. Spreadsheets are used both to create and to analyze these statements, as we demonstrate in this model. Regarding statement creation, firms' accounting information is maintained in computer files, which are adjusted as sales occur, materials are purchased, and so forth. The firm's accountants periodically--monthly, quarterly, and annually--extract information from the general files and compile the four statements. These statements-- in both printed and spreadsheet format --are made available to security analysts, and if the firm wants to borrow money, the same information is provided to potential lenders. The firm's financial staff also uses the data to analyze the firm's condition--its strengths and weaknesses--and this information is used in the quest to improve operations and increase the firm's value. In this model, we start with the same balance sheet and income statement that was used in the chapter, but in an Excel format, and then we show how Excel (and other spreadsheet packages) can be used to analyze the data. The analysis will be extended in Chapter 3, which go on to examine various ratios and other metrics used to appraise firms and to compare them with other companies. Notice that a spreadsheet model dealing with taxes is shown on the tab labeled "TAXES" found in the lower left section of the screen. Click on this tab to see the taxes model. Then, to return to the financial statement model, click on the tab for that model. The "Taxes" model is meant to accompany the Web Appendix 2A. In addition, note that in cells which summarize data in other cells, such as sums or differences, the spreadsheet uses formulas rather than fixed numbers. For example, the cell for Total Assets in 2002 (F65) contains the SUM formula rather than just $2,000. (The cell itself shows $2,000, but if you put the pointer on F65, then the formula line will show that the cell actually contains a formula.) That way, if the data for any input (cash, for instance) changes, the spreadsheet will automatically recalculate and provide the correct net value for Total Assets. As you will see as you go through our models, this automatic recalculation feature is one of the most useful and powerful aspects of Excel and other spreadsheets. Finally, note that we show just below this introduction, before the financial statements, some information that is used to develop aspects of the financial statements, including the tax rate, number of shares outstanding, and price per share. Generally, in financial models, data that are used to construct statements are shown in an Input Data Section toward the top of the model.

INPUT DATA SECTION: Historical Data Used in the Analysis 2002 $23.00 50 40% 11.0% 2001 $26.00 50 40% 10.3%

Year-end common stock price Year-end shares outstanding (in millions) Tax rate After-tax cost of capital

A 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105

The balance sheet can be thought of as a snapshot in time of a firm's financial position. You can observe the firm's level of assets and the manner in which they have used debt and equity to fund those assets. BALANCE SHEETS - Allied Food Products - December 31 (in millions of dollars) 2002 Assets Cash and marketable securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total debt Preferred stock (400,000 shares) Common stock (50,000,000 shares) Retained earnings Total common equity Total liabilities and equity $10 $375 $615 $1,000 $1,000 $2,000 2001 $80 $315 $415 $810 $870 $1,680

$60 $110 $140 $310 $754 $1,064 $40 $130 $766 $896 $2,000

$30 $60 $130 $220 $580 $800 $40 $130 $710 $840 $1,680

The income statement summarizes a firm's revenues and expenses over an accounting period, usually a year. The "bottom line" of an income statement is the firm's net income. Collectively, the income statement gives an indication of a firm's operating ability. INCOME STATEMENTS - Allied Food Products - Years Ending December 31 (in millions of dollars) 2002 Net sales Operating costs except depreciation Earnings before interest, taxes, deprn, and amortization (EBITDA)* Depreciation Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net Income before preferred dividends Preferred dividends Net Income available to common stockholders Common dividends Addition to retained earnings *Allied has no amortization charges. $3,000.0 $2,616.2 $383.8 $100.0 $283.8 $88.0 $195.8 $78.3 $117.5 $4.0 $113.5 $57.5 $56.0 2001 $2,850.0 $2,497.0 $353.0 $90.0 $263.0 $60.0 $203.0 $81.2 $121.8 $4.0 $117.8 $53.0 $64.8

A 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 PER-SHARE DATA

We can now use the above information to calculate three specific per-share data measures: earnings per share (EPS), dividends per share (DPS), and book value per share (BVPS). Simply divide the totals by the appropriate number of shares outstanding. Note that BVPS is calculated by dividing total common equity (common stock plus retained earning) by shares outstanding. 2002 $2.27 $1.15 $17.92 2001 $2.36 $1.06 $16.80

Earnings per share (EPS) Dividends per share (DPS) Book value per share (BVPS)

The per share data give managers and investors a quick look at the some items that affect the price of the stock.

STATEMENT OF RETAINED EARNINGS - Allied Food Products (2002) The statement of retained earnings takes the previous year's balance of retained earnings, adds the current year's net income, and then subtracts dividends paid to common stockholders. The end result is the new balance of retained earnings. Allied's statement is shown below, in millions: 2002 Balance of Retained Earnings, Dec. 31, 2001 $710.0 Add: Net Income, 2002 $113.5 Less: Dividends to common stockholders ($57.5) Balance of Retained Earnings, Dec. 31, 2002 $766.0

STATEMENT OF CASH FLOWS - Allied Food Products (2002) Information from the balance sheet and income statement can be used to construct the Statement of Cash Flows, which is shown below for Allied, in millions of dollars. 2002 Operating Activities Net Income before preferred dividends Additions (Sources of Cash) Depreciation and amortization Increase in accounts payable Increase in accruals Subtractions (Uses of Cash) Increase in accounts receivable Increase in inventories Net cash provided by operating activities Long-term investing activities Cash used to acquire fixed assets Financing Activities Increase in notes payable Increase in bonds Payment of common and preferred dividends Net cash provided by financing activities Net decrease in cash and marketable securities Cash and securities at beginning of the year Cash and securities at end of the year $117.5 $100.0 $30.0 $10.0 ($60.0) ($200.0) ($2.5)

($230.0)

$50.0 $174.0 ($61.5) $162.5 ($70.0) $80.0 $10.0

A 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192

SUMMARY DATA - Relating to Operating Performance and Cash Flows Now that the statements have been developed, we can use the data contained in them to calculate some items that are of interest to managers, investors, and lenders. All of these items are used more extensively in subsequent chapters, where we look in more depth at how historical financial statements are analyzed and how future financial results are predicted. 2002 2001 Net operating working capital (NOWC) $800.0 $650.0 Total operating capital $1,800.0 $1,520.0 Net Operating Profit After Taxes (NOPAT) $170.3 $157.8 Net Cash Flow (NCF) $213.5 $207.8 Cash Flow Per Share (CFPS) $4.27 $4.16 Operating Cash Flow (OCF) $270.3 $247.8 Free Cash Flow (FCF) ($109.7) N/A Economic Value Added, EVA (in millions of dollars) ($27.7) $1.2 Market Value Added, MVA (in millions of dollars) $254.0 $460.0 CONCLUSIONS This spreadsheet model should have either refreshed your memory of or introduced you to spreadsheet models. A second sheet in this file, found under the tab TAXES, introduces another spreadsheet application. You can access the TAXES model by clicking on the tab in the lower section of the screen. It is worth noting that the models developed for Chapter 2 are all relatively simple, and the tasks they perform, could be done just as easily, or more easily, with a calculator. However, in Chapter 3 and subsequently, you will see that spreadsheet models are extremely valuable, hence why they are terribly important to business today.

THE FEDERAL INCOME TAX SYSTEM

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This worksheet explores the calculation of corporate income taxes under the federal tax system. By using special Excel functions, we can input a corporate tax schedule into a spreadsheet and then have a cell automatically display a company's tax liability. Either of two procedures can be used, the IF function or the VLOOKUP function. Both functions are explained below, using the data shown in the following tax table. LOOKUP There are actually two lookup functions, VLOOKUP for looking up items in vertical columns, and HLOOKUP for looking up things in horizontal rows. Since our tax table is arranged in columns, we use VLOOKUP. In words, Excel first looks down Column 1 (or A) and finds the largest value that does not exceed the firm's taxable income. Next, it looks for the corresponding value in Column 3 (or C), which is the base amount of the tax. Then, it again looks down Column (1) and finds the corresponding marginal tax rate as shown in Column 4. Then it multiplies the tax rate times the difference between the firm's taxable income and the bottom tax bracket to get the incremental tax. Then it adds the base tax to the incremental tax to get the firm's total tax liability. Begin by highlighting the range A40:D47, which contains the tax table. Then click on the inverted triangle at the left of the 4th row (the formula bar) and type the word "taxtable" to name the range. Then put the pointer on E50, and then click the function wizard, fx, select "Lookup & Reference," and then select VLOOKUP. You will then get a menu box like the one shown below. When you fill in the menu box, and click OK, you will get this equation on the formula bar and $3,400,000 in cell E50. =VLOOKUP(B32,taxtable,3) Next, put the pointer on D51, get the VLOOKUP menu box, and look up the marginal tax rate. The correct value is 35.0%, and here is the formula: =VLOOKUP(B32,taxtable,4) Next, put the pointer on D52 and look up the marginal tax bracket and then subtract it from the firm's income to find the incremental income. Here is the formula: =B32-VLOOKUP(B32,taxtable,1) Finish by adding the tax on the marginal income to the tax on the bracket base. Taxable Income: $12,000,000 Corporate Tax Rates, as of January 2002 If a corporation's taxable income is between: (1) $0 $50,000 $75,000 $100,000 $335,000 $10,000,000 $15,000,000 $18,333,333 (2) $50,000 $75,000 $100,000 $335,000 $10,000,000 $15,000,000 $18,333,333 and up It pays this Plus this percentage amount on the on the excess base of the bracket over the base (3) (4) $0 15.0% $7,500 25.0% $13,750 34.0% $22,250 39.0% $113,900 34.0% $3,400,000 35.0% $5,150,000 38.0% $6,416,667 35.0%

1st VLOOKUP to find the base amount of tax: 2nd VLOOKUP to find the marginal tax rate: 3rd VLOOKUP to find the marginal income to be taxed:

$ $ 35.0% 2,000,000 $

3,400,000 700,000

Total tax liability:

$4,100,000