Fina 320 Exam 1

Finance (definition)

The study of decision-making under scarcity and uncertainty, not just the study of money.

Three questions every financial decision answers

1) How much money is needed? 2) Where will it come from? 3) Do the benefits justify the costs and risks?

Finance vs. Accounting

Accounting records what already happened (historical). Finance uses that data to decide what should happen next.

Three areas of finance

Business Finance (Corporate Finance), Investments, Financial Markets & Institutions

Business Finance (Corporate Finance)

How organizations raise, manage, and invest financial resources

Investments (as an area of finance)

How individuals and organizations grow wealth over time

Financial Markets and Institutions

The systems that move money throughout the economy, connecting savers and borrowers

Direct finance

Lenders provide funds directly to borrowers through financial markets (no intermediary)

Indirect finance

Lenders provide funds to financial intermediaries (banks, etc.), which then lend to borrowers

The Financial Management Cycle (4 steps)

1) Raise money 2) Invest money 3) Generate results 4) Reinvest or distribute

Cash vs. Profit

A company can be highly profitable on paper but still run out of cash to pay bills; finance focuses more on cash flow than accounting profit

Role of the CFO

Oversees financial planning, budgeting, risk management, financing/investment decisions, and reporting

Primary goal of financial management

Maximize the long-term value of the firm for its shareholders (not just short-term profit)

Governance chain

Shareholders elect Board of Directors, who hire/oversee Executive Management, who make Financial Decisions, whose goal is to increase long-term shareholder value

Risk (in finance)

Uncertainty of outcomes, NOT the same as loss — a risky investment can produce very high or very low returns

Risk-Return Tradeoff

Investors require higher expected returns to accept greater risk, because rational investors prefer certainty

Risk tolerance

An individual investor's willingness to accept risk, which varies based on age, dependents, time horizon, and income needs

Five broad finance career paths

Corporate Finance, Banking, Investments, FinTech, Consulting

Why financial markets exist

To connect individuals/organizations with excess funds (savers) to those who need capital (borrowers) efficiently

Savers

Individuals, businesses, or institutions with excess funds available for investment

Borrowers

Individuals, businesses, or governments seeking funds to finance spending or investment

Capital allocation process

The movement of funds from savers to borrowers, directing money toward its most productive uses

Three channels of capital allocation

Direct transfers, investment banking transactions, financial intermediaries

Direct transfers (capital allocation)

A borrower obtains money directly from an investor, without a financial institution involved

Investment banking transactions

Investment banks help companies issue securities (pricing, marketing, regulatory compliance), often buying then reselling to investors

Financial intermediary (definition)

An institution that collects funds from savers and then invests or lends those funds to borrowers

Examples of financial intermediaries

Commercial banks, credit unions, mutual funds, pension funds, insurance companies

Benefits of financial intermediaries

Reduced transaction costs, professional expertise, diversification, liquidity, risk management

Credit union vs. commercial bank

Credit union = member-owned cooperative; commercial bank = shareholder-owned, for-profit

Stock (definition)

Represents ownership in a corporation

Why companies issue stock

To raise capital for growth (factories, products, technology, acquisitions) while sharing risk/reward with investors

Initial Public Offering (IPO)

When a private company sells stock to the public for the first time; company creates and sells new shares and receives the capital

NYSE

Largest stock exchange by market value; historically an auction-market trading floor

NASDAQ

World's first electronic stock market; home to many tech companies

Primary market

New securities are issued; the issuing company receives the money (e.g., an IPO)

Secondary market

Existing securities are traded between investors; the company does NOT receive money (e.g., buying Apple stock on the NYSE)

Why secondary markets matter

They provide liquidity, making investors more willing to buy securities in the primary market in the first place

Efficient market

A market where security prices quickly and fully reflect available information

Efficient Market Hypothesis (EMH)

The idea that security prices reflect available information, so investors should not expect to consistently beat the market using public information alone

Weak form (EMH)

Prices reflect all historical prices and returns

Semi-strong form (EMH)

Prices reflect all public information

Strong form (EMH)

Prices reflect all information, both public and private

Financial statements (why they matter)

They are the primary way organizations communicate financial information to stakeholders, reducing uncertainty for economic decisions

The Three Primary Financial Statements

Balance Sheet, Income Statement, Statement of Cash Flows

Balance Sheet (key question)

What does the company own and owe? (a snapshot at a point in time)

Income Statement (key question)

Did the company earn a profit? (over a period of time)

Statement of Cash Flows (key question)

Where did cash come from and where did it go? (over a period of time)

The Accounting Equation

Assets = Liabilities + Owners' Equity

Current assets

Assets expected to be converted to cash, sold, or used within one year (cash, A/R, inventory)

Long-term (fixed) assets

Assets that provide benefit beyond one year (buildings, machinery, equipment, land)

Depreciation

The annual decline in value of a fixed asset

Current liabilities

Obligations due within one year (accounts payable, short-term loans, accrued expenses)

Long-term liabilities

Obligations due beyond one year (long-term loans, corporate bonds, mortgage debt)

Owners' Equity formula

Equity = Assets − Liabilities

Income Statement structure (top to bottom)

Revenue → −COGS → Gross Profit → −Operating Expenses → Operating Income (EBIT) → −Interest → Pretax Income (EBT) → −Taxes → Net Income

EBIT

Earnings Before Interest and Taxes; lets analysts compare companies regardless of debt levels and tax situations

Origin of the phrase "the bottom line"

Net income sits as the last line of the income statement (also called the P&L)

Three sections of the Statement of Cash Flows

Operating Activities (CFO), Investing Activities (CFI), Financing Activities (CFF)

Operating Activities (cash flow)

Cash flows from normal business operations (collections from customers, payments to employees/suppliers)

Investing Activities (cash flow)

Cash flows from buying/selling long-term assets (equipment, buildings, acquisitions)

Financing Activities (cash flow)

Cash flows from transactions with investors/creditors (borrowing, issuing stock, repaying debt, dividends)

Net Cash Flow formula

CFO + CFI + CFF

Indirect method (operating cash flow)

Operating Cash Flow = Net Income + Non-Cash Expenses ± Changes in Working Capital

Connection: Net Income to Balance Sheet

Net income (less dividends) increases Retained Earnings, a component of owners' equity

Connection: Cash Flow Statement to Balance Sheet

The statement of cash flows explains the change between beginning and ending cash balances on the balance sheet

Connection: Depreciation across statements

Expense on income statement; added back as non-cash item in Operating Cash Flow; reduces net fixed assets on balance sheet

Why profit and cash flow differ

The income statement uses accrual accounting — revenue/expenses recognized when earned/incurred, not necessarily when cash changes hands

Depreciation (as a cash flow concept)

A non-cash expense — reduces net income but is added back on the cash flow statement because no cash left the business in that period

Marginal tax rate

The tax rate applied to the next dollar of taxable income; most relevant for financial decision-making

Average (effective) tax rate

Total tax paid divided by total income

Interest Tax Shield formula

Interest Expense × Tax Rate (tax savings created because interest is tax-deductible)

Limitations of financial statements (list)

Reflect the past, rely on estimates, use historical cost (not market value), miss intangible assets, involve accounting discretion, don't directly measure risk

Historical cost vs. market value

Many assets are recorded at original purchase cost, not current market value, so book value can diverge from market value

Financial statement analysis (definition)

The process of evaluating a company's financial condition and performance using ratios and financial statement information

Common-size income statement

Each income statement line item expressed as a percentage of sales

Common-size balance sheet

Each balance sheet line item expressed as a percentage of total assets

Five categories of financial ratios

Liquidity, Efficiency (Asset Management), Debt Management (Leverage/Solvency), Profitability, Market Value

Current Ratio formula

Current Assets ÷ Current Liabilities

Quick Ratio (Acid-Test Ratio) formula

(Current Assets − Inventory) ÷ Current Liabilities

Cash Ratio formula

Cash ÷ Current Liabilities

Inventory Turnover formula

Cost of Goods Sold ÷ Inventory

Days Inventory Outstanding (DIO) formula

365 ÷ Inventory Turnover

Accounts Receivable Turnover formula

Sales ÷ Accounts Receivable

Days Sales Outstanding (DSO) formula

365 ÷ AR Turnover, or Accounts Receivable ÷ (Sales ÷ 365)

Accounts Payable Turnover formula

COGS ÷ Accounts Payable

Days Payable Outstanding (DPO) formula

365 ÷ AP Turnover, or Accounts Payable ÷ (COGS ÷ 365)

Cash Conversion Cycle (CCC) formula

DIO + DSO − DPO

Total Asset Turnover (TATO) formula

Sales ÷ Total Assets

Debt Ratio formula

Total Debt ÷ Total Assets

Debt-to-Equity Ratio formula

Total Debt ÷ Total Equity

Equity Multiplier formula

Total Assets ÷ Total Equity

Times Interest Earned (TIE) formula

EBIT ÷ Interest Expense

Cash Coverage Ratio formula

(EBIT + Depreciation) ÷ Interest Expense

Gross Profit Margin formula

(Sales − COGS) ÷ Sales

Operating Profit Margin formula

EBIT ÷ Sales

Net Profit Margin formula

Net Income ÷ Sales

Return on Assets (ROA) formula

Net Income ÷ Total Assets

Return on Equity (ROE) formula

Net Income ÷ Total Equity

DuPont Equation

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier

DuPont: Profit Margin component

Net Income ÷ Sales (measures profitability)