Finance Final Exam 3

Chapters 2, 3, and 4 44 Questions

Net Working Capital:

Net Working Capital tells you how much short-term money a company has available to run its daily business.

👉 “Working capital = money available to keep the business running day-to-day”

Usually positive in a healthy firm.

Liquidity:

Liquidity = how fast an asset can be turned into cash without losing value.

Liquidity (Most → Least Liquid):

• Cash (most liquid)

• Accounts Receivable (money owed to company)

• Inventory (goods to sell)

• Fixed Assets (buildings, equipment)

• Intangible Assets (patents, goodwill)

👉 On the balance sheet, assets are listed from most to least liquid.

Financial Leverage:

Is when a company uses borrowed money (debt) to help finance its operations or investments.

👉 Financial leverage is how much a company relies on borrowed money to grow profits.

👉 “Using other people’s money to try to make more profit.”

Leverage:

High leverage = lots of debt → higher risk, higher possible return

Low leverage = little debt → lower risk, lower possible return

👉 “Leverage = using debt to boost returns (but also risk).”

Debt vs Equity:

👉 Debt = borrowed money 👉 Equity = ownership money

🏦 Debt

👉 Borrowed money (loans, bonds)

• Must be paid back

• Has interest

• Lender does NOT own the company

✔ Lower control risk for owners
❌ Must repay no matter what

🧑‍💼 Equity

👉 Owner’s money (selling shares)

• No repayment required

• Investors own part of company

• Dividends may be paid

✔ No mandatory payments
❌ Ownership is shared (dilution)

Average Tax Rate=

Taxes Payable / Taxable Income

Cash Flow:

👉 “Actual money moving in and out of the business”

📌 Types:

Cash in = customers paying, loans received

Cash out = expenses, investments, debt payments

Cash Flow Identity:

A firm’s cash flow is always balanced—meaning cash must come from somewhere and go somewhere.

👉 “Where cash comes from minus where cash goes”

Cash Flow= Sources of Cash−Uses of Cash

Cash Flow from Assets=

Cash Flow to creditors + Cash Flow to Stockholders

Sources of Cash:

👉 Things that bring money IN

• Sales revenue collected

• Borrowing money (debt)

• Selling assets

• Owner investment (equity)

✔ Cash increases

Uses of Cash:

👉 Things that take money OUT

• Buying inventory or equipment

• Paying expenses

• Paying debt

• Paying dividends

❌ Cash decreases

Statement of Cash Flows:

A financial report that shows: 👉 “Where cash came from and where it went”

It has 3 parts:

• Operating activities (daily business)

• Investing activities (equipment, assets)

• Financing activities (debt, equity)

Common Size Statements:

These make financial statements easier to compare by converting numbers into percentages.

Common Size Balance Sheets:

👉 Each item is shown as % of total assets.

Example:

• Cash = 10% of assets

• Inventory = 30%

• Debt = 50%

Common Size Income Statements:

👉 Each item is shown as % of sales

Example:

• Revenue = 100%

• Cost = 60%

• Profit = 40%

✔ Helps compare companies of different sizes

Examine Interactions:

👉 This means looking at how financial parts affect each other.

Example:

More sales → more inventory needed → more cash needed

More debt → more interest expense → lower profit

Explore Options:

👉 Testing different business decisions:

• What if sales grow 10%?

• What if costs increase?

• What if we borrow more?

Avoid Surprises:

👉 Make sure the company is prepared for:

• Cash shortages

• Too much debt

• Unexpected expenses

Ensure Feasibility and Internal Consistency:

Feasibility: 👉 “Can the plan actually work?”

Internal consistency: 👉 “Do all parts of the plan match?”

Example: You can’t assume high sales but no extra inventory.

Sales Forecast:

👉 Prediction of future sales

This is the starting point for financial planning.

Everything depends on it:

• income statement

• balance sheet

• cash flow

Pro Forma Statements:

👉 “Projected financial statements”

Includes:

• Pro forma income statement

• Pro forma balance sheet

✔ Based on expected future assumptions

Assets Requirements:

👉 How many assets the business needs to support sales.

Example: More sales → need more inventory, machines, cash

Financial Requirements:

👉 How the company will pay for those assets.

Options:

• Debt

• Equity

• Retained earnings

Plug Variable:

👉 The “missing number” in financial planning.

Used when something doesn’t balance.

Example:

• If assets ≠ liabilities + equity
  → plug variable adjusts (like cash or debt)

Economic Assumptions:

👉 Expectations about the economy used in forecasting:

• inflation

• interest rates

• market growth

• recession or expansion

✔ These affect sales and costs

Financial Planning Model (Slide):

There are 2 things that we can do with Net Income (i.e. Net Profit):

• Pay Dividends

• Put to Retained Earnings as Additions to Retained Earnings

• Dividends + Additions to Retained Earnings = Net Income

Payout Ratio = Dividend Paid / Net Income

Retention Ratio or Plow Back Ratio = Additions to Retained Earnings / Net Income

Payout Ratio + Retention Ratio = 100%

Income Statement:

Some costs move with sales → profit margin stays same

Some costs don’t → profit margin changes

Dividends are not expenses → they affect retained earnings

Balance Sheet:

Assets usually grow with sales

Accounts payable grows with sales

Debt and equity do NOT grow with sales (management choice)

Retained earnings changes based on profit and dividends

Profit Margin:

Profit margin = Net Income ÷ Sales

Shows how much profit the company makes from each dollar of sales.

👉 Higher margin = more efficient operations

Total Asset Turnover (Asset Use Efficiency):

Total Asset Turnover = Sales ÷ Total Assets

Shows how well a company uses its assets to generate sales.

📌 Example:

If a company has $200 in assets and generates $400 in sales:

• Turnover = 2.0

👉 It generates $2 in sales per $1 of assets

Financial Leverage (Debt Choice):

(Common Measure, What it tells, Key Idea)

Financial leverage = how much debt a company uses relative to equity

Common Measure: Debt-to-equity ratio or debt ratio

What it Tells You:

More Debt→ higher potential growth (but more risk)

Less debt→ safer but slower growth

Key Idea: Debt can amplify returns, but also increases financial risk.

Dividend Policy (Reinvestment Decision):

Dividend policy = how much profit is paid to shareholders vs reinvested

2 Parts:

Dividends paid to shareholders

Retained earnings reinvested in the business

Meaning: Decides how much money stays in the company to fund growth.

📌 What it tells you:

• High dividends → less money for growth

• High retention → more internal growth

Summary Big Picture:

📌 Summary (Big Picture)

• Income Statement = profit

• Balance Sheet = position

• Cash Flow = real money movement

• Liquidity = how fast assets become cash

• Ratios = financial health signals

• Financial planning = forecasting growth + funding needs

Income Statement (Formula also):

Shows profit over a period of time.

Formula:
Sales − Costs = Earnings Before Tax (EBT) − Taxes = Net Income

👉 Tells if company is profitable.

Balance Sheet (Formula also):

Shows what a company owns and owes at one point in time.

Formula: Assets = Liabilities + Equity

Assets = what you own

Liabilities = what you owe

Equity = owner’s value

Cash Flow Statement (Breaks Into):

Shows actual cash movement.

Breaks into:

Operating Activities (day-to-day business)

Investing Activities (buy/sell assets)

Financing Activities (debt + stock)

Cash vs Non-Cash Items:

Cash items: Money received or paid (sales, rent, salaries)

Non-cash items:

• Depreciation (paper expense, no actual cash leaves)

• Accounts receivable (sale happened but no cash yet)

👉 Key idea:
Net income ≠ cash flow

Taxes (Average Tax Rate and Marginal Tax Rate):

Average Tax Rate:

Average Tax Rate = Total Taxes ÷ Total Income

👉 “Overall tax burden”

Marginal Tax Rate:

Tax rate on the NEXT dollar earned

👉 Important for decision-making (like investing or hiring)

Cash Flow Terms (OCF, CFFA, FCF):

💵 Operating Cash Flow (OCF)

Cash generated from normal business operations

Simple idea: “Cash from selling goods/services”

🏢 Cash Flow from Assets (CFFA)

Total cash generated by all company assets

Formula: OCF − Net Capital Spending − Change in Net Working Capital

🧾 Free Cash Flow (FCF)

Cash left after maintaining business and investing in assets

Formula: FCF = OCF − Net Capital Spending − ΔNWC

Net Working Capital (NWC): Formula

NWC= Current Assets - Current Liabilities

Book Value vs Market Value:

Book Value: Accounting value (from balance sheet)

What the company is worth on paper.

Market Value: What investors are willing to pay

👉 Market value is usually more realistic.

Book Value: (Backward Looking)

Looks at old accounting records and historical costs.

Think: “What do the books say happened in the past?”

Market Value: (Moment)

Market Value→ Value at this Moment

Based on what investors would pay now.

Think: “What does the market think today?”

Net Income Methods:

Income statement method: Sales − Costs − Taxes

Dividend method: Net Income = Dividends + Additions to Retained Earnings

Margin method: Net Income = Sales × Profit Margin

Tax Rate Calculations:

Average Tax Rate = Taxes ÷ Income

Marginal Tax Rate = rate applied to next income bracket

Net Capital Spending (NCS):

NCS = Ending Net Fixed Assets − Beginning Net Fixed Assets + Depreciation

👉 Measures investment in long-term assets.

Operating Cash Flow (OCF):

Is simply the cash a business generates from its normal, day-to-day operations.

Think of it like this:

• It’s the money coming in from selling products or services

• Minus the cash going out to run the business (like paying employees, suppliers, rent, etc.)

Cash Flow to Creditors: (Money paid to lenders)

This is the cash a company pays to its lenders (like banks or bondholders).

👉 Money going out to repay debt.

If this number is high, the company is paying a lot to its lenders.

Cash Flow to Stockholders: (Money paid to owners)

This is the cash a company returns to its owners (shareholders).

👉 Money going out to investors.

It includes:

• Dividends paid

• Stock buybacks (company repurchases its own shares)

Cash Flow to Creditors and Cash Flow to Stockholders:

Cash flow to creditors = cash paid to lenders

Cash flow to stockholders = cash paid to owners

Creditors = lenders → get interest + loan repayments

Stockholders = owners → get dividends + buybacks

Cash Flow Statement: Sources vs Uses

💰 Source of Cash (cash IN)

• Increase in liabilities

• Increase in equity

• Decrease in assets

💸 Use of Cash (cash OUT)

• Decrease in liabilities

• Decrease in equity

• Increase in assets

Operating Activities:

Daily business:

Sales

Expenses

Taxes

Investing Activities:

Long-term assets:

Buying equipment (use of cash)

Selling equipment (source of cash)

Financing Activites:

Money from owners/lenders:

Loans (source)

Paying debt (use)

Dividends (use)

Common Size Balance Sheet and Income Statement:

Balance Sheet: Every item is shown as: % of Total Assets

Income Statement: Every item is shown as: % of Sales

Current Ratio:

Current Assets ÷ Current Liabilities

👉 Ability to pay short-term debts.

Quick Ratio:

(Current Assets − Inventory) ÷ Current Liabilities

👉 More strict liquidity test

Return on Assets (ROA):

Net Income ÷ Total Assets

👉 Efficiency of asset use

Return on Equity (ROE):

Net Income ÷ Equity

👉 Profit earned for owners.

Receivable Turnover:

Sales ÷ Accounts Receivable

👉 How fast company collects money.

Cash Coverage Ratio:

EBIT + Depreciation ÷ Interest Expense

👉 Ability to pay interest.

Financial Planning Process:

A company:

1. Forecasts sales

2. Estimates expenses

3. Predicts assets needed

4. Determines financing needed

Purpose of Financial Planning:

To answer:
👉 “How will the company grow and pay for it?”

Pro Forma Financial Statements:

“Pro forma” = projected/forecasted statements

Used to predict:

• Income

• Cash flow

• Balance sheet

Dividend Payout Ratio:

Dividends ÷ Net Income

👉 % of profits paid to shareholders.

Retention Ratio:

1 − Dividend Payout Ratio

Dividend Payout Ratio= (Dividends / Net Income)

👉 % reinvested in company.

Plowback Ratio:

Same as retention ratio:

(1 - Dividends / Net Income)
👉 Money reinvested into business.

Internal Growth Rate (IGR):

Growth using ONLY internal funds

👉 No external financing.

Sustainable Growth Rate (SGR):

Maximum growth using:

• retained earnings

• current financial structure

External Financing Need (EFN):

EFN = Assets needed − (Liabilities + Equity financing available)

👉 How much outside money company must raise.