3.6. Comparison of interest treatment in SCF and FCF

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Do curso por Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

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Curso 3 de 5 em Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

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The Statement of Cash Flows. Analysis and Use of Financial Statements. Financial Accounting and Project Valuation

In Week 3 of the Course we discuss the idea and format of the Statement of Cash Flows and use examples to delve deeper in its role and importance. Special attention is paid to the use of financial accounting inputs – cash flows, net income, and investments – in valuation. Then we briefly discuss the analysis and use of financial statements as a powerful tool in the overall assessment of performance, financial stability, and future development of a company or investment project. Finally, wrapping up the first part of the Course, we draw conclusions about the role of financial accounting in financial valuation in the world of uncertainty.

3.1. The statement of cash flows (SCF) – idea and format10:51

3.2. SCF – Example 114:05

3.3. SCF – a more advanced Example 2 (1)12:25

3.4. SCF – a more advanced Example 2 (2)8:24

3.5. Valuation revisited – cash flows, net income, and FCF7:04

3.6. Comparison of interest treatment in SCF and FCF9:49

3.7. The big question – why use earnings?10:25

3.8. Analysis and use of financial statements – an overview12:39

3.9. Ratio analysis (1) – current position and performance6:05

3.10. Ratio analysis (2) – capital structure5:56

3.11. Ratio analysis (3) – operating performance11:11

3.12. Financial accounting and valuation – conclusions8:55

Conheça os instrutores

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, let me illustrate how this different treatment of

interest results in the different amounts

in a statement of cash flows and then in also free cash flow.

The difference is sort of quoted temporary and not that much significant,

but still it must be taken into account.

We'll use the following example.

So, we will say comparison,

quoted, of statement of cash flow and free cash flow.

And again that was all about interest.

By the way, that's one of the reason that

in most pieces in accounting, interest is ignored.

That is not because it's so difficult to put that into consideration,

but then you have to be really accurate than that.

Well, we will analyze the hypothetical firm with the following data.

Well first of all,

here will be its income statement,

but here I'll put some numbers about that,

and the tax rate that will be 40%.

That's the one that we normally use.

Then interest will be 30, that's pre-tax.

And then there will be new investment,

20 in equity and 10 in-depth.

And then, we will

for simplicity assume that net change in cash flow is zero.

Now, first let's produce the income statement of this company.

So, here we have cash revenue of 380,

cash expenses of 180.

So, that gives you EBITDA of 200,

that will subtract depreciation 50,

arrive at EBIT of 150.

Now, we subtract interest that is pre-tax here 30

and arrive at earnings before taxes which is 120.

And finally, we subtract taxes which is 40% of that which is 48,

and then we arrive at the final number,

that the net income is equal to 72.

So, that's the first important finding.

Now, equipped with these numbers,

let's go ahead and try to compare how these numbers would contribute

to our analysis of free cash flow and statement of cash flow.

First of all, we have to come up with the statement of cash flow given this.

Well here for this hypothetical firm, it's extremely straightforward.

Cash flow from operations,

here we have only net income of 72 plus depreciation of 50 and that is 122, positive.

Then, cash flow from investment.

This is, here we also assume that

replacement is equal to depreciation and that gives us minus 50.

And then new investment for both kinds of investments,

this is 30, and then this is 20 plus 10,

then the overall amount is negative 80.

And again, in cash flow from financing,

we know that there is new debt, which is 10.

And then, all other is equity investment.

And here, we will remember that,

because we do not know these dividends,

I will put a star here and for star we have to recall that

no change in cash assumed.

Therefore, we can say that the overall,

here we can say 122 less 80,

that gives you 42.

So, here we have to have negative 42.

So, the resulting thing is zero,

and that gives us the plug number for dividends.

So, dividends here will be 52.

So, that's sort of from here.

That's our statement of cash flow.

And the next table will be the comparison of the approach of the,

here statement of cash flow and I will put that in black.

And then, the other will be the approach of free cash flow,

I'll put that in blue. Now, let's see.

First of all, this is cash revenues,

here that will be 380.

I will first put this column;

cash expenses of 180,

then cash for interest,

and here I will put pre-tax, this is 30.

And here for the first time we see the difference,

the first number is clearly the same,

the second number is the same,

but the third number,

I'll put it in red, this is not applicable here.

Because later we just use the after tax interest payments,

but that will be further on.

Now, let's see the next thing that becomes different.

This is cash for taxes,

and here, it will be 48,

we take that from the income statement.

But here it will be 60,

because in the free cash flow we do not subtract interest and we go this way.

Now, as a result,

we see that cash flow from operations and then cash flow for investments,

they look like this.

In this approach, this is 122,

we've seen that before.

However, here it will be 140,

so it will be higher.

With investment, it's the same,

so it's 80 here,

and it's 80 there.

And if we draw a line,

here we will put this free cash flow. I'll put that in red.

Here it' we don't care and here that is 60.

But that's not it,

because now we have to

recall that interest also is taken through account of the free cash flow.

So this is interest after tax and here it's not applicable,

because we dealt with that up here.

However, here we have negative 18. What is that?

We had 30, 12 is the tax,

so 18 is after tax.

Now we have dividends and again dividends are the same on the both approaches.

So this is 52 and this is 52 here.

And then we have new debt,

which is also the same.

This is 10 and 10,

and that leads us to cash flow

from financing that here is 42,

as we had before.

But here as you can see it will be negative 60.

Well, clearly both here and here,

the result is zero because well,

here on the free cash flow,

the sum of that.

I'll put that sort of in brackets.

Here you will have 42.

I would put free cash flow in red,

but this is just the sum of these two to keep this in mind, I'll put like this.

So, see what happens?

The result is clearly the same,

but when, if you use the statement of cash flow,

like we are tempted to do then we could see that certain things could be

used not in the correct way

and because you know that people of valuation use this approach.

So, although some of these changes they are minor,

but they just pour light on the idea why we oftentimes deal

with the approach that does not

directly take the numbers from the statement of cash flows.

That's not yet it.

So, I'm wrapping up this episode of comparison and then in the next one,

I will go back to this very big question of how we have to

use the proper proxies for the company and project valuation.

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