Chapter 2 Financial Management

Financial Statements, Taxes, & Cash Flows

Balance sheet

summarizing what firm owns/assets, what they owe/liabilities, and the difference/stockholders equity

Accounting Equation

Assets = Liabilities + Stockholders equity

Assets = Liabilities + Common Stock + (Revenues - Expenses - Dividends)

Current Assets

life less than one year, will convert to cash within 12 months

What are examples of current assets?

inventory, cash, accounts receivable, prepaid expenses

Fixed Asset

relatively long life, tangible or intangible

What are examples of fixed assets (tangible or intangible)?

Net plant & equipment

Tangible: truck or computer

Intangible: Patent or trademark

Current liabilities

life less than one year, must be paid within the year

What are examples of current liabilites?

Accounts payable, Notes payable, Accrued Expenses

Long-term liabilities

debt not due in the coming year

stockholders equity

difference between total assets and total liabilities; reflects that if company sells assets & pays debts the rest will go to the shareholders

Net Working Capital (NWC)

difference between current assets and current liabilities; net change in current assets relative to current liabilities

What does a positive NWC show?

It shows a healthy firm over the next 12 months

How do you examine a balance sheet?

Look at liquidity (NWC), debt vs. equity(capital structure), and market value vs book value (MDM disagrees)

Liquidity

speed and ease an asset can be converted to cash. Balance sheet is ordered decreasingly from current to fixed

What assets are highly liquid?

Current assets because they can be converted quickly without significant loss of value

What assets are illiquid?

Fixed assets because they cannot be quickly converted without substantial price reduction

What is the tradeoff between liquidity and forgone potential profits?

There is a tradeoff since there is less risk of distress with highly liquid assets but liquid assets are less profitable.

Debt vs. equity

give creditors the first clai. to cashflow and shareholders the residual. The more debt there is the more leverage, so this increase the reward but also increases the risk

Book value

historical cost, or assets that are carried on what firm paid

Market value

Today’s value of the assets

What is the difference between the market value and book value of a current asset versus a fixed asset?

Current Assets will have relatively similar market and book values but fixed assets will not

What is the difference between the time period of the balance sheet and the income statement?

Balance is a specific date and income statement is a period of time

Income statement

Revenue - Expenses

How is the income statement formed?

Revenue: Net sales

Expenses: COGS, Depreciation, Interest, Taxes

= Net income

Net income is then subtracted by Dividends which is then added to retained earnings

How should you examine the income statement?

By looking at GAAP, Noncash items, & time and costs

GAAP (recognition and matching principles)

Recognition principle: shows revenue when it accrues or at the time of sale not at time of collection

Matching principle: first determines revenues & than matches those with costs associated in producing them

True or False: for the recognition and matching principles, cash outflows and inflows occurred at some other point than when costs and revenues were recognized

True

Revenues are recognized at time of sale not collection

Costs are recognized when the revenues are determines

Noncash items

depreciation/write-off: this could be deducted over a period but this is just for accounting purposes as full amount was given at time of purchase

Time & Costs

in the short-run some costs are fixed and others are variable, but in the long-run all are variable because the firm has enough time to change assets, debts, labor, and other expenses

Product Costs or COGS

raw materials, direct labor expense, manufacturing overhead (includes fixed and variable costs)

Period Costs

Particular time period & might be reported as selling, general, and administrative expenses (may be fixed or variable costs)

Average Tax Rate

Percentage of income that goes to taxes

Marginal tax rate

rate of the extra tax you pay if you earned 1 more dollar

Why is the marginal tax rate relevant for financial decisions?

Because any new income will be taxed at a marginal rate, so this could make you not want to earn any more income to avoid more taxes

How is net income expressed on a per income basis?

EPS = Earnings Per Share (Net Income / Total Shares Outstanding)

DPS = Dividends Per Share (Total Dividends / Total Shares Outstanding)

Cashflow

difference between the number of dollars that come in and went out

Is it unusual for a growing company to have a negative cashflow?

No, this means the firm raised more money by borrowing and issuing stock than it paid out to creditors and stockholders

Cashflow from Assets/ Free-Cash-Flow(FCF)

=Operating Cashflow - Net Capital Spending - Change in NWC

What 3 components does cashflow from assets involve?

Operating Cashflow, Capital Spending, Change in NWC

Operating cashflow

cashflow that results from firms day-to-day activities of producing and selling

= Revenue - Costs - Taxes (no depreciation or interest)

= EBIT + Depreciation - Taxes

Are expenses associated with financing included in the operating cashflow?

No, it basically just shows whether inflows can cover firms everyday outflows

Capital Spending

Net spending on fixed assets

= Ending Net Fixed Assets - Beginning Net Fixed Assets + Depreciation

Change in Net Working Capital (NWC) Formula

=Ending NWC - Beginning NWC

Cashflow to Creditors/Bondholders

= interest paid - net new borrowing

Cashflow to stockholders

= dividends paid - net new equity raised (Common stock + paid-in surplus)