Chapter 07 - Viewing the Business through the Financial Statements

CHAPTER SEVEN
Viewing the Business Through the Financial Statements
Concept Questions
C7.1 Free cash flow is a dividend from the operating activities to the financing activities;
that is, it is the net cash payoff from operations that is disposed of in the financing
activities. The operations generate value then distribute some of the value in the
free cash flow dividend, leaving the remainder of the value generated reinvested in
net operating assets.
Think of a firm without any debt; in this case, C I = d, that is, the free cash flow
is the dividend to shareholders.

C7.2

Refer to the cash conservation equation: the firm must buy debt, by buying down

to its own financial obligations or by buying others debt as a financial asset.

C7.3

The firm borrows: C - I = d + F. So, if C - I = 0, then the firm borrows to pay the

dividend such that d + F = 0.

C7.4

An operating asset is used to produce goods or services to sell to customers in

operations. A financing asset is used for storing excess cash to be reinvested in

operations, pay off debt, or pay dividends.

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Chapter 07 - Viewing the Business through the Financial Statements

C7.5

An operating liability is an obligation incurred in producing goods and services

for customers. A financial liability is an obligation incurred in raising cash to finance

operations.

C7.6

True. From the reformulated balance sheets and income statement,

C-I = OI -NOA. So, with operating income identified in a reformulated income

statement and successive net operating assets identified in a reformulated balance sheet,
free cash flow drops out. See Box 7.3.

C7.7

Operations drive free cash flow. Specifically, value is added in operations

through operating earnings, and free cash flow is the residual after some of this value is
reinvested in net operating assets.

C7.8

Free cash flow (driven by operations) drives dividends. But dividends are the

residual of free cash flow after servicing the interest and principal claims of debt or
investing in net financial assets.

C7.9

Net operating assets are increased by earnings from operations and reduced by

free cash flow. Expanding, net operating assets are increased by operating revenues and
cash investment and reduced by operating expenses and cash from operations.

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Chapter 07 - Viewing the Business through the Financial Statements

C7.10 Net financial obligations are increased by the obligation to pay interest, and by
dividends, and are reduced by free cash flow.

C7.11 True. Free cash flow is a dividend from the net operating assets to the net
financial obligations. So, as CSE = NOA - NFO, free cash flow does not affect CSE.

Exercises
Drill Exercises
E7.1. Applying the Cash Conservation Equation (Easy)
a. Apply the cash conservation:
CI=d+F
$143 = $49 + ?
? = $94 million
b. Net dividend (d) = $162 + 53 = $215
Debt financing flows (F) = -$86
Now apply the cash conservation equation:
CI=d+F
= $215 + (-86)
= $129 million
E7.2. Applying the Treasurers Rule
a. The treasurers rule:
C I i d = Cash applied to debt trading
$2,348 23 (14 + 54) = $2,365 million

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Chapter 07 - Viewing the Business through the Financial Statements

After paying interest and receiving $40 million (14 54) from the negative net
dividend, there was $2,365 of cash left over from the free cash flow. The treasurer
used it to buy debt, either by buying back the firms own debt or investing in debt
assets.
b. From the treasurers rule,
C I i = d + cash from trading in debt
-$1,857 32 = d + cash from trading in debt
= ($1,050 + stock repurchases share issues) + cash from trading
in debt
(The dividend is $1.25 per share 840 million shares = $1,050 million)
The cash shortfall after paying the dividend is $1,857 + 32 + 1,050 = $2,939
million. The treasurer meets this shortfall by selling debt either issuing the
firms own debt or selling debt assets (financial assets) that the firm holds or
by issuing shares.
E7.3. Balance Sheet and Income Statement Relations
a. Net financial assets = Financial obligations financial assets
= $432 - $1,891
= -$1,459 million
That is, the firm has net financial obligation (negative NFA)
Net operating assets = Common equity + Net financial obligations
= $597 + 1,459
= $2,056 million
b. Operating income (after tax) = Comprehensive income + NFE (after tax)
= $108 + 47
= $155 million
E7.4. Using Accounting Relations
The reformulated balance sheet:
Net Operating Assets
2009

Net Financial Obligations and Equity

2008

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2009

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Chapter 07 - Viewing the Business through the Financial Statements

Operating assets
Operating liabilities

205.3
40.6

189.9 Financial liabilities

34.2 Financial assets
NFO
CSE
155.7

NOA

164.7

(a) Dividends

= Net income CSE

120.4
45.7
74.7
90.0
164.7

(Clean-surplus equation)

= 1.9
(These are net dividends)
(b) C I

= OI NOA
= 21.7 9.0
= 12.7

(c) RNOAt

= OIt / (NOAt + NOAt-1)

= 21.7/160.2
= 13.55%

(d) NBC

= Net interest/ (NFOt + NFOt-1)

= 7.1/76.55
= 9.27%

E7.5. Using Accounting Relations

(a)
Income Statement:
Start with the income statement where the answers are more obvious:
A = $9,162
B = 8,312
C=

94

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120.4
42.0
78.4
77.3
155.7

Chapter 07 - Viewing the Business through the Financial Statements

(Comprehensive income = operating revenues operating expenses net financial

expenses)
Balance sheet:
D = 4,457
E = 34,262
F = 34,262
G = 7,194
H = 18,544
Before going to the cash flow statement, reformulate the balance sheet into net
operating assets (NOA) and net financial obligations (NFO):
Jun-09 Dec
Operating assets
Operating liabilities

28,631
7,194

Jun-09 Dec

30,024
8,747

Financial obligations
Financial assets
Net financial obligations
Common equity

Net operating assets

Cash Flow Statement:

21,437

21,277

7,424
4,457
2,967

6,971
4,238
2,733

18,470
21,437

18,544
21,277

Free cash flow:

J = 690

[C - I = OI - NOA]

Cash investment:

I = (106)
(a liquidation)

[I = C - (C - I)]

Total financing flows:

M = 690

[C - I = d + F]

Net dividends:

K = 865

[Net dividends = Earnings - CSE]

Payments on net debt:

L = (175)
[F = d + F - d]
(more net debt issued)

(b)

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Chapter 07 - Viewing the Business through the Financial Statements

Operating accruals can be calculated in two ways:

1.

2.

(c)

(d)

NFO

Operating accruals

Operating accruals

Operating income Cash from operations

850 584

266

NOA Investment

160 (-106)

266

NFE (C - I) + d

59 690 + 865

234

The net dividend of $865 was generated as follows:

Operating income
less NOA
Free cash flow
less net financial expenses
plus increase in net debt

850
160
690
59
631
234
865

E7.6. Inferences Using Accounting Relations

(a)
This firm has no financial assets or financial obligations so CSE = NOA and total
earnings = OI. Also the dividend equals free cash flow (C - I = d).

Price
CSE (apply P/B ratio to price)
Free cash flow
Dividend (d = C - I)

2009

2008

224
140

238
119
8.4
8.4

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Chapter 07 - Viewing the Business through the Financial Statements

Price + dividend
Return (246.4 224)
Rate of return

246.4
22.4
10%

(b)
There are three ways of getting the earnings:
1.

2.

3.

Stock return - premium

22.4 (119 - 84)

(12.6)

C - I + NOA

8.4 + (119 140)

(12.6)

(Earnings

OI as there are no financial items)

Earnings

CSE + dividend

-21 + 8.4

(12.6)

Earnings

OI

(a loss)

Applications
E7.7. Applying the Treasurers Rule: Microsoft Corporation
a.
The treasurer would run through the following calculation to find the cash surplus or
deficit:
Cash flow from operations
Cash investment

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23.4 billion
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Chapter 07 - Viewing the Business through the Financial Statements

Free cash flow

Interest receipts
$702 million
Taxes
253
Cash available to shareholders
Net payout to shareholders:
Stock repurchase
Dividends
Share issued

20.2
0.449
20.649
40.0 billion
4.7
(2.5)
42.200

Cash surplus

(21.551)

As the surplus is actually a cash shortfall, the treasurer must sell debt. He or she does so
by selling part of the $23.7 billion in financial assets on hand.
b.
In the treasurers plan, $4.2 billion would be added to cash investments:
Cash flow from operations
Cash investment (3.2 + 4.2)
Free cash flow
Interest receipts
$702 million
Taxes
253
Cash available to shareholders
Net payout to shareholders:
Stock repurchase
Dividends
Share issued
Cash surplus

23.4 billion
7.4
16.0
0.449
16.449

40.0 billion
4.7
(2.5)
42.200
(25.751)

Now the treasurer must liquidate more of the $23.7 billion in financial assets on hand.
c.
With almost all of its financial assets of $23.7 billion distributed, under these scenarios,
Microsoft might need cash for further stock repurchases, dividends, or investments in
operations.
E7.8. Accounting Relations for Kimberly-Clark Corporation
a. Reformulate the balance sheet:

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Chapter 07 - Viewing the Business through the Financial Statements

Operating assets
Operating liabilities
Net operating assets (NOA)
Financial obligations
Financial assets

$6,496.4
382.7

Common equity

2007

2008

$18,057.0
6,011.8
12,045.2

$16,796.2
5,927.2
10,869.0

6,113.7

$4,395.4
270.8 4,124.6

(ii)

$ 5,931.5

$ 6,744.4

(iii)

b. Free cash flow = Operating income Change in net operating assets

= $2,740.1 (12,045.2 10,869.0)
= $1,563.9
c. NOA (end) = NOA (beginning) + Operating income Free cash flow
$12,045.2

(i)

= $10,869.0 + 2,740.1 1,563.9

d. CSE (end) = CSE (beginning) + Comprehensive income Net payout

Comprehensive income = Operating income Net financial expense
$2,593.0 = $2,740.1 147.1
$5,931.5 = 6,744.4 + 2593.0 Net payout
Thus, net payout = $3,405.9

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