Question

Accounting data is used to generate a firm’s financial statements, but a firm’s intrinsic value is based on its free cash flows, which are the cash flows available for distribution to the company’s investors after the company has made all of the investments necessary to sustain its ongoing operations.

Consider the following case:

J&H Corp. recently hired Jeffery. His immediate mandate was to analyze the company. He has to submit a report on the company’s operational efficiency and estimate its potential investment in working capital. He has the income statement from last year and the following information from the company’s financial reports as well as some industry averages.

•	Last year, J&H Corp. reported a book value of $600,000 in current assets, of which 10% is cash, 12% is short-term investments, and the rest is accounts receivable and inventory.
•	The company reported $510,000 of current liabilities including accounts payable and accruals. Interestingly, the company had no notes payable outstanding, and there were no changes in the company’s accounts payable during the year.
•	The company, however, invested heavily in plant and equipment to support its operations. It reported a book value of $960,000 for its operating long-term assets last year.

Income Statement For the Year Ended on December 31

	J&H Corp.	Industry Average
Net sales	$39,000,000	$48,750,000
Operating costs, except depreciation and amortization	31,200,000	39,000,000
Depreciation and amortization	1,560,000	1,950,000
Total operating costs	32,760,000	40,950,000
Operating income (or EBIT)	$6,240,000	$7,800,000
Less: Interest expense	624,000	1,170,000
Earnings before taxes (EBT)	$5,616,000	$6,630,000
Less: Taxes (40%)	2,246,400	2,652,000
Net income	$3,369,600	$3,978,000

Based on the information given to him, Jeffery submits a report on January 1 with some important calculations for management to use, both for analysis and to devise an action plan. Complete the following statements in his report. If your answer is negative, use the minus sign.

	Statement #1: J&H Corp.’s NOPAT is , which is   than the industry average of .
	Statement #2: The company is using in net operating working capital (NOWC).
	Statement #3: J&H Corp. is generating in net cash flow from its operations and an accounting profit of .
	Statement #4: The firm uses of total net operating capital to run the business. This value is computed as the      of J&H Corp.’s net operating working capital and its     .

Answer 1

Below is the solution, please comment if any further explaination needed

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Statement 1:

NOPAT = Operating Income x (1- Tax Rate)

J&H Corp

NOPAT = 6,240,000 x (1- 40%) = 6,240,000 x (1 – 0.4) = 6,240,000 x 0.6 = $3,744,000

Industry Average

NOPAT = 7,800,000 x (1- 40%) = 6,240,000 x (1 – 0.4) = 6,240,000 x 0.6 = $4,680,000

J&H Corp’s NOPAT is $3,744,000, which is $936,000 lower than industry average of $4,680,000

Statement 2:

Net Operating Working Capital

= Current Operating Assets − Current Operating Liabilities

Net Operating Working Capital

= (Cash + Accounts Receivable + Inventories)− (Accounts Payable + Accrued Expenses)

Short term investments are not included in Current Operating Assets

Given current assets = $600,000

Of them 12% in Short term investments i.e., $72,000

Therefore Current Operating Assets = 600,000 – 72,000 = $528,000

Current Operating Liabilities = $510,000

Net Operating Working Capital = $528,000 - $510,000 = $18,000

The company is using $18,000 in net operating working capital.

Statement 3:

Net cash flow from operations = Net income + Depreciation & Amortization + Changes in Working Capital

Changes in working capital = Working capital of the year = $600,000 - $510,000

= $90,000

Net cash flow from operations = $3,369,600 + $1,560,000 + $90,000 = $5,019,600

Here, Accounting profit is the total revenue minus the explicit costs

explicit costs includes operating expenses, depreciation, interest and taxes.

Therefore in this case Accounting Profit is equal to Net income = $3,369,600

J&H Corp is generating $5,019,600 in net cash flow from its operations and an accounting profit of $3,369,600

Statement 4:

Total net operating capital = Net Operating Working Capital + Non-current Operating Assets

As calculated in statement 2, Net Operating Working Capital = $18,000

Non-current Operating Assets = operating long term assets = $960,000

Total net operating capital = $18,000 + $960,000 = $978,000

The firm uses $978,000 of total net operating capital to run the business. The value is computed as the sum of J&H Corp’s net operating working capital and its Non-current Operating Assets (operating long term assets )