Chapter 2 Financial Statements Study Guide

Balance Sheet Purpose

Shows a company's financial position (assets, liabilities, equity) at a specific date.

Income Statement Purpose

Measures a company's profitability (revenues and expenses) over a period of time.

Cash Flow Statement Purpose

Tracks actual cash generated and distributed over a period of time.

Accounting Identity Formula

Assets = Liabilities + Equity. Assets owned equal total claims against them.

Current Assets Definition & Examples

Converted to cash/used within one year. Examples: cash, accounts receivable, inventory.

Fixed Assets Definition & Examples

Useful life exceeding one year. Examples: property, plant, equipment (PPE), trademarks.

Current Liabilities Definition & Examples

Debts due within one year. Examples: accounts payable, accrued interest, payroll.

Long-Term Liabilities Definition & Examples

Debts due after one year. Examples: long-term debt, loans, bonds payable.

Stockholders' Equity Definition & Examples

Owners' residual claim on assets. Examples: common stock, retained earnings.

Net Working Capital (NWC) Formula & Explanation

NWC = Current Assets - Current Liabilities. Measures short-term liquidity and cash safety buffer.

Positive vs. Negative NWC

Positive: short-term cash incoming exceeds outgoing. Negative: outgoing cash exceeds incoming.

Liquidity Definition & Trade-off

Speed of converting assets to cash without loss. Reduces distress risk but lowers returns.

Debt vs. Equity Financing

Indicates how assets are financed; debt creates financial leverage and fixed obligations.

Market Value vs. Book Value

Book value is GAAP historical cost; market value is actual current market sale price.

Debt-Equity (D/E) Ratio Formula & Explanation

D/E = Total Liabilities / Total Equity. Higher ratios mean higher financial leverage and risk.

Net Income Formula & Explanation

Net Income = Revenue - Expenses. Measures total accounting profit after all expenses.

Noncash Items on Income Statement

Expenses like depreciation that reduce accounting net income without consuming actual cash.

Earnings Per Share (EPS) Formula & Explanation

EPS = Net Income / Shares Outstanding. Shows profitability allocated to each individual share.

Cash Flow Identity Formula

CFFA = CF to Creditors + CF to Shareholders. Total cash generated equals cash distributed.

Cash Flow From Assets (CFFA) Formula & Explanation

CFFA = OCF - NCS - Change in NWC. Measures net cash produced by operations after investments.

Operating Cash Flow (OCF) Formula & Explanation

OCF = EBIT + Depreciation - Taxes. Reverses noncash depreciation to find operational cash generated.

Net Capital Spending (NCS) Formula & Explanation

NCS = Ending NFA - Beginning NFA + Depreciation. Tracks net cash spent on fixed assets.

Change in Net Working Capital Formula & Cash Effect

Change in NWC = Ending NWC - Beginning NWC. Increases represent cash spent/used.

Cash Flow to Creditors Formula & Explanation

CF to Creditors = Interest Paid - Net New Borrowing. Cash paid to lenders less net new loans.

Cash Flow to Shareholders Formula & Explanation

CF to Shareholders = Dividends - Net New Equity. Cash paid to owners less net equity raised.

Interpretation of Positive vs. Negative CFFA

Positive: firm paid cash to investors. Negative: firm raised cash from investors.

Depreciation in OCF vs. NCS

In OCF it adds back noncash expense; in NCS it adjusts for asset value decrease.

Sign Rules for Investor Cash Flows

Net new borrowing reduces CF to creditors; net new equity reduces CF to shareholders.

Acronym: CFFA

Cash Flow From Assets (also called free cash flow).

Acronym: OCF

Operating Cash Flow.

Acronym: NCS

Net Capital Spending.

Acronym: NWC

Net Working Capital.

Acronym: EPS

Earnings Per Share.

Practice: Calculate NWC (CA = $140,000, CL = $95,000)

NWC = $140,000 - $95,000 = $45,000 (Positive NWC).

Practice: Calculate D/E Ratio (Liabilities = $600k, Equity = $300k)

D/E Ratio = $600,000 / $300,000 = 2.0.

Practice: Calculate EPS (Net Income = $500k, Shares = 125k)

EPS = $500,000 / 125,000 = $4.00 per share.

Practice: Calculate OCF (EBIT = $90, Dep = $20, Taxes = $18)

OCF = $90 + $20 - $18 = $92.

Practice: Calculate NCS (Beg NFA = $210, End NFA = $250, Dep = $25)

NCS = $250 - $210 + $25 = $65.

Practice: Calculate Change in NWC (Beg NWC = $40, End NWC = $55)

Change in NWC = $55 - $40 = $15 (Use of cash).

Practice: Calculate CFFA (OCF = $92, NCS = $65, Change in NWC = $15)

CFFA = $92 - $65 - $15 = $12.

Practice: Calculate CF to Creditors (Interest = $14, Net New Borrowing = $9)

CF to Creditors = $14 - $9 = $5.

Practice: Calculate CF to Shareholders (Dividends = $20, Net New Equity = $7)

CF to Shareholders = $20 - $7 = $13.