Cumulative Final

What is the balance sheet?

A financial statement showing a firm's accounting value on a particular date. It organizes and summarizes what a firm owns (assets), owes (liabilities), and the difference between the two (equity).

How are assets classified on a balance sheet?

Assets are classified as either current or fixed.

• Fixed assets have a relatively long life (e.g., tangible like a truck or intangible like a patent)

• Current assets have a life of less than one year (e.g., inventory, cash, accounts receivable).

How are liabilities classified on a balance sheet?

Liabilities are classified as either current or long-term.

• Current liabilities have a life of less than one year (e.g., accounts payable).

• Long-term liabilities are debts not due in the coming year (e.g., a five-year loan).

What is shareholders' equity?

Is the difference between the total value of assets (current and fixed) and the total value of liabilities (current and long-term)

What is the balance sheet equation?

Assets= Liabilities+ Shareholders’ equity

What is net working capital?

The difference between a firm’s current assets and its current liabilities. It is usually positive in a healthy firm, indicating that cash available over the next 12 months exceeds cash that must be paid over the same period

What three important things should be kept in mind when examining a balance sheet?

1. Liquidity

2. Debt vs Equity

3. Market value vs Book Value

Define liquidity in the context of a balance sheet?

Liquidity refers to the speed and ease with which an asset can be converted to cash. A highly liquid asset can be quickly sold without significant loss of value, while an illiquid asset cannot. Assets are typically listed on the balance sheet in order of decreasing liquidity.

What is financial leverage?

The use of debt in a firm’s capital structure. If a firm borrows money, creditors usually have the first claim to the firm’s cash flow, with equity holders receiving only the residual value.

What is the difference between book value and market value on a balance sheet?

• Book values are the values shown on the balance sheet for a firm’s assets, generally representing their historical cost under GAAP

• Market values are what assets are actually worth, depending on factors like riskiness and cash flows. For financial managers, market value is more important than accounting values

What is an income statement?

A financial statement that summarizes a firm’s performance over a period of time, typically a quarter or a year

What is the income statement equation?

Revenues-Expenses= Income

What are the key components of an income statement, from top to bottom?

Revenues and expenses from principal operations, followed by financing expenses (like interest paid), then taxes, and finally net income (the “bottom line”)

What three things should a financial manager keep in mind when looking at an income statement?

1. GAAP (income figures may not represent actual cash flows),

2. Cash versus noncash items (e.g., depreciation)

3. Time and costs (product vs. period costs).

What is a noncash item on an income statement?

Expenses charged against revenues that do not directly affect cash flow, such as depreciation

What is the federal corporate tax rate in the U.S. after the Tax Cuts and Jobs Act of 2017?

A flat 21%

Define average tax rate and marginal tax rate.

• Average tax rate is calculated as total taxes paid divided by total taxable income.

• Marginal tax rate is the amount of tax payable on the next dollar earned.

What is cash flow?

The number of dollars that came into and went out of a firm

State the cash flow identity

Cash flow from assets = Cash flow to creditors + Cash flow to stockholders

What are the three components of cash flow from assets?

Operating cash flow, capital spending, and change in net working capital.

How is operating cash flow calculated?

Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation - Taxes. It indicates whether a firm's business operations generate enough cash to cover its operational cash outflows

What is net capital spending (CAPEX)?

Money spent on fixed assets minus money received from the sale of fixed assets. It can be negative if a firm sells more assets than it buys.

How is cash flow to creditors calculated?

Cash flow to creditors = Interest paid - Net new borrowing

How is cash flow to stockholders calculated?

Cash flow to stockholders = Dividends paid - Net new equity raised.

Sources of Cash

Activities that bring in cash (e.g. decrease in asset, increase in liability/equity)

Uses of Cash

Activities involving spending cash (e.g., increase in asset, decrease in liability/equity).

Statement of Cash Flows

Summarizes firm's cash sources and uses over time (operating, investment, financing).

Categories of Cash Flow Activities

Operating, Investment, Financing.

Why standardize financial statements?

For comparison across different-sized companies or over time.

Common-Size Statements

Financial statements where all items are presented as percentages.

• Common-Size Balance Sheets: Percentage of total assets

• Common-Size Income Statements: Percentage of total sales

• Common-Size Statement of Cash Flows: Percentage of total source (or uses)

Common-Base Year Statements (Trend Analysis)

Financial Statements showing items relative to a base year amount

Financial Ratios

Relationships from financial information used for comparison

Categories of Financial Ratios

Short-term solvency, long-term solvency, asset management, profitability, market value

Current Ratio

Measures short-term liquidity. Higher is generally better for creditors (normally at least 1).

Quick (or Acid-Test) Ratio

Like current ratio, but excludes inventory (least liquid current asset).

Cash Ratio

Useful for very short-term creditors.

Total Debt Ratio

Considers all debts. Variations: Debt-equity ratio, Equity multiplier.

Times Interest Earned (TIE) Ratio

Measures how well interest obligations are covered (interest coverage ratio).

Cash Coverage Ratio

Measures cash from operations for financial obligations (uses EBITD).

Inventory Turnover

How many times inventory was sold/turned over.

Days' Sales in Inventory

Average days inventory sits before selling.

Receivables Turnover

How many times credit accounts are collected and re-loaned.

Days' Sales in Receivables

Average days to collect credit sales.

Total Asset Turnover

Sales generated per dollar of assets

Profit Margin

Profit generated per dollar of sales. High is desirable

Return on Assets (ROA)

Profit per dollar of assets.

Return on Equity (ROE)

Stockholder return; profit per dollar of equity.

Price-Earnings (PE) Ratio

Investor willingness to pay per dollar of earnings. Higher PEs suggest future growth.

Market-to-Book Ratio

Compares market value of investments to historical costs. Less than 1 may indicate failed value creation.

DuPont Identity Components

ROE broken into:

1. Operating efficiency (profit margin)

2. Asset use efficiency (total asset turnover)

3. Financial leverage (equity multiplier)

DuPont Identity Formula

ROE = Profit margin × Total asset turnover × Equity multiplier

Problems with Financial Statement Analysis

• No clear theory for benchmarks

• Conglomerates hard to categorize

• Global competitors

• Non-U.S. statements may not conform to GAAP

• Accounting differences/fiscal year ends affect comparability

• Unusual events distort performance

Relevant Cash Flow

A change in the firm's future cash flow due to a project decision.

Incremental Cash Flows

Difference in future cash flows with and without a project

Stand-Alone Principle

Project evaluation based solely on its incremental cash flows

Sunk Cost

An already incurred cost not relevant to investment decisions

Opportunity Cost

The most valuable alternative given up by undertaking an investment

Erosion

New project cash flows reduce existing project cash flows

Synergy Gains

New project boosts sales of existing projects

Net Capital Spending

Costs of purchasing long-term assets minus proceeds from selling them.

Change in Net Working Capital

Investment required for cash, inventory, and receivables for a project

Financing Costs (in Project Analysis)

Not included; focus is on cash flow from project assets.

Aftertax Cash Flow

Cash flow after considering taxes, which are a cash outflow

Components of Cash Flow from Assets (for a Project)

Operating cash flow, capital spending, and changes in net working capital

Operating Cash Flow (OCF) Formula

EBIT + Depreciation - Taxes.

Bottom-Up Approach (for OCF)

Starts with net income and adds back noncash deductions like depreciation (if no interest expense)

Top-Down Approach (for OCF)

Starts with sales, subtracts costs and taxes, omitting noncash items

Tax Shield Approach (for OCF

OCF is non-depreciation cash flow plus depreciation tax shield

MACRS (Modified Accelerated Cost Recovery System)

U.S. tax law depreciation method allowing accelerated write-off of property

MACRS Depreciation Calculation

Asset cost multiplied by a fixed percentage each year based on tax life

Factors Not Explicitly Considered in MACRS Depreciation

Expected salvage value and expected economic life.

Typical MACRS Property Classes

Three-year (research equipment), Five-year (autos, computers), Seven-year (most industrial equipment).

Bonus Depreciation (Tax Cuts and Jobs Act 2017)

Increased to 100% for 2018-2022, then drops 20% annually until zero after 2026

Book Value vs. Market Value of an Asset

Book value can significantly differ from market value.

Special Cases of DCF Analysis

1. Cost-cutting proposals/improving efficiency

2. Competitive bids

3. Evaluating equipment options with different economic lives

Equivalent Annual Cost (EAC)

The PV of a project's costs calculated on an annual basis

Cost of Capital

The minimum required rate of return on new investment.

Firm's Cost of Capital (Factors)

Primarily depends on the use of funds, not the source. Reflects the risk of the project.

Required Return

The same as the appropriate discount rate.

Cost of Equity

Return required by equity investors given the risk of the cash flows.

Dividend Growth Model (DGM)

A method to calculate the cost of equity using dividends, current stock price, and growth rate.

CAPM (Capital Asset Pricing Model)

A method to calculate the cost of equity using the risk-free rate, market risk premium, and beta.

Advantages of DGM

Simple to understand and use.

Disadvantages of DGM

Only applicable to dividend-paying firms, assumes constant dividend growth, highly sensitive to growth rate estimate, does not explicitly consider risk.

Advantages of CAPM

Explicitly adjusts for risk, applicable to all firms if beta is available

Disadvantages of CAPM

Requires estimating market risk premium and beta, uses historical data to predict the future.

Cost of Debt

The return required by bondholders. Best estimated by the YTM (Yield to Maturity) on outstanding debt.

Cost of Preferred Stock

Return required by preferred stockholders, calculated as dividend yield (Dividend / Price).

Weighted Average Cost of Capital (WACC)

The weighted average of the costs of a firm's components of capital. Used as the discount rate for projects with similar risk as the firm.

Market Value of Equity (E)

Shares outstanding × Stock price.

Market Value of Debt (D)

Market price per bond × Number of bonds outstanding.

Total Firm Value (V)

E + D.

Capital Structure Weights

wE = E/V and wD = D/V.

Flotation Costs

Issuance costs for new securities. Increase the cost of raising capital.

Current Assets

are assets expected to become cash within one year

What is included in current assets?

Cash, Marketable Securities, Accounts Receivable and Inventories

Current Liabilities

Obligations due within one year

What is included in current liabilities

Accounts Payable, Expenses Payable and Notes Payable

Sources of Cash

activities that increase a firm’s cash

What are some examples of sources of cash?

• Increasing long-term debt (borrowing)

• Increasing equity (selling stock)

• Increasing current liabilities (e.g. accounts payable, like getting a 90-day loan)

• Decreasing current assets other than cash ( e.g, selling inventory for cash)

• Decreasing fixed assets( e.g. selling property)