Share Holders Equity & Net Working Capital

A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt of $200. What does the balance sheet look like? What is shareholders’ equity? What is net working capital?

In this case, total assets are $100 + 500 = $600 and total liabilities are $70 + 200 = $270, so shareholders’ equity is the difference: $600 − 270 = $330. The balance sheet would look like this:

Net working capital is the difference between current assets and current liabilities, or $100 − 70 = $30.

Income Statement (Net Income & Other Order of Income Statement)

BALANCE SHEET With order of Liquidity

Balance Sheet ($ in Millions) Assets 1998 1997 Liabilities and

Owners' Equity

1998 1997

Current Assets Current Liabilities

Cash 690 600 Accounts Payable 530 460 Accounts Receivable

340 300 Notes Payable 240 240

Inventory 120 100 Total Current Liabilities

770 700

Total Current Assets

1150 1000 Long-Term Liabilities

Long-Term Debt 571 710 Fixed Assets Total Long-Term

Liabilities 571 710

Property, Plant, and Equipment

1210 1200 Owners' Equity

Less Accumulated Depreciation

357 280 Common Stock ($1 Par)

122 120

Net Fixed Assests

853 920 Capital Surplus 218 210

Retained Earnings 322 180 Total Owners'

Equity 662 510

Total Assets 2003 1920 Total Liab. and Owners' Equity

2003 1920

Income Statement ($ in Millions)

1998Sales 1710 Cost of Goods Sold 1100 Administrative Expenses 100 Depreciation 77 Earnings Before Interest and Taxes 423

Interest Expense 50 Taxable Income 373 Taxes 30 Net Income 343 Dividends 201 Addition to Retained Earnings 142

Book & Market Value

Klingon Widgets, Inc., purchased new cloaking machinery three years ago for $7 million. The machinery can be sold to the Romulans today for $3.2 million. Klingon's current balance sheet shows net fixed assets of $4,000,000, current liabilities of $2,200,000, and net working capital of $900,000. If all the current assets were liquidated today, the company would receive $2.8 million cash. What is the book value of Klingon's assets today? What is the market value? Solution: To find the book value of current assets, we use: NWC = CA - CL. Rearranging to solve for current assets, we get: CA = NWC + CL = $900K + 2.2M = $3.1M The market value of current assets and fixed assets is given, so: Book value CA = $3.1M Market value CA = $2.8M Book value NFA = $4.0M Market value NFA = $3.2M Book value assets = $3.1M + 4.0M = $7.1M Market value assets = $2.8M + 3.2M = $6.0M

Market Value versus Book Value

The Klingon Corporation has net fixed assets with a book value of $700 and an appraised market value of about $1,000. Net working capital is $400 on the books, but approximately $600 would be realized if all the current accounts were liquidated. Klingon has $500 in long-term debt, both book value and market value. What is the book value of the equity? What is the market value?

We can construct two simplified balance sheets, one in accounting (book value) terms and one in economic (market value) terms:

In this example, shareholders’ equity is actually worth almost twice as much as what is shown on the books. The distinction between book and market values is important precisely because book values can be so different from true economic value.

Cash Flow Chart

 

Operating Cash Flow / Cash Flow to Creditors / Cash Flow to Stockholders/ Net Working Capital (NWC) Jetson Spacecraft Corp. shows the following information on its 2009 income statement: sales $ 196,000; costs $104,000; other expenses $6,800; depreciation expense $9,100; interest expense $14,800; taxes $21,455; dividends $10,400. In addition, you’re told that the firm issued $5,700 in new equity during 2009 and redeemed $7,300 in outstanding long-term debt. a. What is the 2009 operating cash flow? OCF = EBIT + Depreciation – Taxes = $76,100 + 9,100 – 21,455 = $63,745 b. What is the 2009 cash flow to creditors? CFC = Interest – Net new LTD = $14,800 – (–7,300) = $22,100 c. What is the 2009 cash flow to stockholders? CFS = Dividends – Net new equity = $10,400 – 5,700 = $4,700 d. If net fixed assets increased by $27,000 during the year, what was the addition to NWC?

We know that CFA = CFC + CFS, so:

CFA = $22,100 + 4,700 = $26,800

CFA is also equal to OCF – Net capital spending – Change in NWC. We already know OCF. Net capital spending is equal to:

Net capital spending = Increase in NFA + Depreciation = $27,000 + 9,100 = $36,100

Now we can use:

CFA = OCF – Net capital spending – Change in NWC

$26,800 = $63,745 – 36,100 – Change in NWC

Solving for the change in NWC gives $845, meaning the company increased its NWC by $845.

Balance Sheet ($ in Millions) Assets 1998 1997 Liabilities and

Owners' Equity

1998 1997

Current Assets Current Liabilities

Cash 690 600 Accounts Payable 530 460 Accounts Receivable

340 300 Notes Payable 240 240

Inventory 120 100 Total Current Liabilities

770 700

Total Current Assets

1150 1000 Long-Term Liabilities

Long-Term Debt 571 710 Fixed Assets Total Long-Term

Liabilities 571 710

Property, Plant, and Equipment

1210 1200 Owners' Equity

Less Accumulated Depreciation

357 280 Common Stock ($1 Par)

122 120

Net Fixed Assests

853 920 Capital Surplus 218 210

Retained Earnings 322 180 Total Owners'

Equity 662 510

Total Assets 2003 1920 Total Liab. and Owners' Equity

2003 1920

Income Statement ($ in Millions)

1998Sales 1710 Cost of Goods Sold 1100 Administrative Expenses 100 Depreciation 77 Earnings Before Interest and Taxes 423

Interest Expense 50 Taxable Income 373 Taxes 30 Net Income 343 Dividends 201 Addition to Retained Earnings 142

Cash Flow to Creditors

The Cash Flow to Creditors is defined as debt service less new long term borrowing. (Debt service represents interest expense and repayments of principal.) An equivalent definition which makes use of values which can readily be obtained form the Balance Sheet and Income Statement is interest expense less net new borrowing. This can be calculated as follows:

Cash Flow to Creditors = Interest Expense - Ending Long-term Debt + Beginning Long-term Debt

Interest Expense is the fundamental cash flow from the firm to its Creditors. Moreover, if a firm's Long-term Debt increases from one year to the next (i.e., more new debt was issued than was repaid) then the Creditors supplied the firm with additional cash.

Cash Flow to Creditors Example

Using information from the above Balance Sheet and Income Statement. Solution:

Cash Flow to Creditors = $50 - $571 + $710 = $189

Or

Cash Flow to Creditors Looking at the income statement in Table 2.2, we see that U.S. paid $70 in interest to creditors. From the balance sheets in Table 2.1, we see that long-term debt rose by $454 − 408 = $46. So U.S. Corporation paid out $70 in interest, but it borrowed an additional $46. Thus, net cash flow to creditors is:

Cash flow to creditors is sometimes called cash flow to bondholders; we will use these terms interchangeably.

Cash Flow to Common Stockholders

The principal cash flow from the firm to its Common Stockholders is dividends. Firms also issue new stock periodically. This represents a cash flow from the Common Stockholders to the firm. (Some firm also repurchase their own stock, i.e., a cash flow from the firm to its stockholders. When this occurs the repurchased shares are recorded on the Balance Sheet as Treasury Stock. (The Balance Sheet used for the examples on this page indicates that the firm has no Treasury Stock.) The Cash Flow to Common Stockholders can be calculated as common dividends paid less net new common equity raised.

Cash Flow to Common Stockholders = Dividends Paid - (Ending Common Stock - Beginning Common Stock)- (Ending Capital Surplus - Beginning Capital Surplus)+ (Ending Treasury Stock - Beginning Treasure Stock)

Cash Flow to Common Stockholders Example

Using information from the above Balance Sheet and Income Statement.

Solution:

Cash Flow to Common Stockholders = $201 - ($122 - $120) - ($218 - $210) - ($0 - $0) = $191

OR

Cash Flow to Stockholders From the income statement, we see that dividends paid to stockholders amounted to $103. To get net new equity raised, we need to look at the common stock and paid-in surplus account. This account tells us how much stock the company has sold. During the year, this account rose by $40, so $40 in net new equity was raised. Given this, we have the following:

The cash flow to stockholders for 2012 was thus $63.

The last thing we need to do is to verify that the cash flow identity holds to be sure we didn't make any mistakes. From the previous section, we know that cash flow from assets is $87. Cash flow to creditors and stockholders is $24 + 63 = $87, so everything checks out. Table 2.6 contains a summary of the various cash flow calculations for future reference.

Cash Flow to Investors (Debtholders and Equityholders)

Once the above items have been determined, the Cash Flow to the Investors in the Firm can be calculated as follows:

Cash Flow to Investors = Cash Flow to Debtholders + Cash Flow to Common Stockholders + Cash Flow to Preferred Stockholders

Cash Flow to Investors Example

Using information from the previous examples.

Solution:

Cash Flow to Investors = $189 + $191 + $0 = $380

Notice that the Cash Flow to Investors equals the Cash Flow from Assets determined on the previous page. This was not by accident. Thus, just as there is a Balance Sheet Identity (Total Assets = Total Liabilities and Owners' Equity) there is also a Cash Flow Identity (Cash Flow from Assets = Cash Flow to Investors).

Operating Cash Flow

Operating Cash Flow measures the cash flows generated by the firm's main operations. (In effect, the ability of the firm to sell its products for more than the cost of production.) Operating Cash Flow can be determined as follows:

Operating Cash Flow = EBIT + Depreciation - Taxes

The calculation begins with EBIT (Earnings before Interest and Taxes) because Interest Expense is not a cash flow that operations are dependent upon. Interest Expense reflects how the firm chooses to finance its assets, not its ability to operate them successfully. Depreciation Expense (from the Income Statement) is added back because it is a non-cash expense which was subtracted out in the determination of EBIT. Finally, the taxes which the firm actually paid in cash during the period are subtracted.

Operating Cash Flow Example

Using information from the above Balance Sheet and Income Statement.

Solution:

Operating Cash Flow = $423 + $77 - $30 = $470

Capital Spending

Capital Spending reflects the firm's net investment in fixed assets during the period. It can be calculated as follows:

Capital Spending = Ending Net Fixed Assets - Beginning Net Fixed Assets + Depreciation

In this calculation, Depreciation Expense (from the Income Statement) must be added back because the balance for Ending Net Fixed Assets on the Balance Sheet is reduced by the Depreciation Expense which was incurred during the period.

Capital Spending Example

Using information from the above Balance Sheet and Income Statement.

Solution:

Capital Spending = $853 - $920 + $77 = $10

Additions to Net Working Capital

Additions to Net Working Capital measure the firm's investment in Net Working Capital during the period. Net Working Capital (NWC) is defined as Current Assets minus Current Liabilities.

Additions to NWC = Ending NWC - Beginning NWC

Additions to Net Working Capital Example

Using information from the above Balance Sheet and Income Statement.

Solution:

Ending NWC = Ending CA - Ending CL = $1150 - $770 = $380

Beginning NWC = Beginning CA - Beginning CL = $1000 - $700 = $300

Additions to NWC = $380 - $300 = $80

Cash Flow from Assets

Once the above items have been determined, the Cash Flow from the Firm's Assets can be calculated as follows:

Cash Flow from Assets = Operating Cash Flow - Capital Spending - Additions to NWC

A healthy firm would be expected to generate positive cash flow. However, if the firm is young and/or is investing heavily to promote growth, then a negative Cash Flow from the Firm's Assets may be excused.

Cash Flow from Assets Example

Using information from the previous examples.

Solution:

Cash Flow from Assets = $470 - $10 - $80 = $380

Financial Cash Flow Equations

Operating Cash Flow = EBIT + Depreciation - Taxes Capital Spending = Ending Net Fixed Assets

- Beginning Net Fixed Assets+ Depreciation

Additions to NWC = Ending NWC - Beginning NWC Net Working Capital = Current Assets - Current Liabilities

Cash Flow from Assets = Operating Cash Flow- Capital Spending - Additions to NWC

Cash Flow to Creditors = Interest Expense - Ending Long-term Debt + Beginning Long-term Debt

Cash Flow to Common Stockholders = Dividends Paid - (Ending Common Stock - Beginning Common Stock) - (Ending Capital Surplus - Beginning Capital Surplus) + (Ending Treasury Stock - Beginning Treasure Stock)

Cash Flow to Preferred Stockholders

= Preferred Dividends Paid - (Ending Preferred Stock - Beginning Preferred Stock)

Cash Flow to Investors = Cash Flow to Debtholders + Cash Flow to Common Stockholders+ Cash Flow to Preferred Stockholders

Earnings Per Share & Dividends per Share

Earnings per Share = Net Income / Shares

Dividends per Share = Dividends / Shares

Relationship of Cash Flow to Stockholders and other investments

The lakeside Inn had operating cash flow of $48,450. Depreciation ws $6,700 and interest paid was $2,480. A net total of $2,620 was paid on long-term debt. The firm spent $24,000 on fixed assets and decreased net working capital by $1,330. What is the amount of the cash flow to stockholders?

Remember the relationship equation OCF - NCS - NWC = CFFA = CFTC + CFTS OCF and NWC were given. NCS = $24,000 Therefor, CFFA = $48,450 - $24,000 - (- $1330) = $25,700 Then calculate CFTC CFTC = Interest Paid - Net New Borrowing CFTC = $2,480 - ( - $2,620) = $5,100 Then plug everything back into the original equation CFFA = CFTC + CFTS CFFA - CFTC = CFTS $25, 780 - $5,100 = $20,680 = CFTS