Unit 3 finance

accounting equation

assets = liabilities +owner’s equity

accrual basis

accounting system in which revenue is recorded or recognized

when earned yet not necessarily received, and in which expenses are recorded

when legally incurred and not necessarily when paid

Assets

tangible or intangible resources owned or controlled by a company, individual, or other entity with the intent that they will provide economic value

cash basis

method of accounting in which transactions are not recorded in the financial statements until there is an exchange of cash

current assets

asset typically used up, sold, or converted to cash in one year or less

current liabilities

debt or obligation due within one year or, in rare cases, a

company’s standard operating cycle, whichever is greater

Depreciation

process of allocating the costs of a tangible asset over the

asset’s economic life

direct method

approach used to determine net cash flows from operating activities, whereby accrual basis revenue and expenses are converted to cash basis collections and payments

Dividends

portion of the net worth (equity) that is returned to owners of a corporation as a reward for their investment

Expenses

costs associated with providing goods or services

free cash flow

operating cash, reduced by expected capital expenditures

Gains

increases in organizational value from activities that are “incidental or

peripheral” to the primary purpose of the business

income statement

financial statement that measures the organization’s financial performance for a given period of time

indirect method

approach used to determine net cash flows from operating

activities, starting with net income and adjusting for items that impact new income

but do not require outlay of cash

Liabilities

probable future sacrifice of economic benefits arising from present

obligations of a particular entity to transfer assets or provide services to other

entities in the future as a result of past transactions or events

Loss

decrease in organizational value from activities that are “incidental or

peripheral” to the primary purpose of the business

net income

-revenues and gains that are greater than expenses and losses

noncash expenses

expenses that reduce net income but are not associated

with a cash flow; most common example is depreciation expense

noncurrent assets

assets used in the normal course of business for more

than one year that are not intended to be resold

noncurrent liabilities

liabilities that are expected to be settled in more than

one year

owner’s equity

residual interest in the assets of an entity that remains after

deducting its liabilities

retained earnings

cumulative, undistributed net income or net loss for the

business since its inception

Revenue

inflows or other enhancements of assets of an entity or settlements

of liabilities from delivering or producing goods, rendering services, or other

activities that constitute the entity’s ongoing major or central operations

statement of cash flows

financial statement listing the cash inflows and

cash outflows for the business for a period of time

questions

1. What is the difference between gross profit and net income?

GP = Revenue - Cost of Goods Sold

NI = Total Revenue - Total Expenses (including COGS, operating expenses, taxes, and interest)

Gross Profit: This is the profit a company makes after subtracting the direct costs associated with making and selling its products (known as the Cost of Goods Sold or COGS). It only looks at production efficiency and direct variable costs.

Net Income: Often called the "bottom line," this is the total profit remaining after all business expenses have been deducted from total revenue. This includes operating expenses, taxes, interest, depreciation, and overhead costs.

2. If a classified balance sheet has total assets of $900,000 and total owner’s equity

of $350,000, what must the company’s total liabilities be?

Based on the basic accounting equation (Assets}= Liabilities} + {Owner's Equity), you can find total liabilities by subtracting owner's equity from total assets:\900,000 \text{ (Assets)} - \$350,000 \text{ (Owner's Equity)} = \$550,000$

3. What key element of the income statement flows through to the balance sheet?

The key element of the income statement that flows through to the balance sheet is net income (or net loss).

4. What key columns are commonly found on the statement of owner’s equity?

-Common Stock (or Capital Stock): Tracks the par or stated value of issued shares.

-Additional Paid-in Capital (APIC): Shows the amount paid by investors above the par value of the stock.

-Retained Earnings: Records the cumulative net income of the company minus any dividends distributed to owners.

-Treasury Stock: (If applicable) Represents shares the company has bought back, which are subtracted from total equity.

-Accumulated Other Comprehensive Income (AOCI): Captures gains and losses that bypass the income statement (such as foreign currency translation adjustments or certain unrealized pension costs).

5. Ted’s firm reported net income for the current period of $65,750. Is it safe to

assume that because Ted’s firm reported such a large net income, it has plenty of

cash to fund its operations? Why or why not?

No, it is not safe to assume that Ted's firm has plenty of cash just because it reported a large net income.

The primary reasons for this include:

Accrual Accounting: Net income is calculated using accrual accounting, which records revenues when they are earned and expenses when they are incurred, regardless of when cash actually changes hands. A company can show massive profitability on the income statement while waiting to collect cash from customers (accounts receivable).

Non-Cash Expenses: The income statement includes expenses like depreciation and amortization that reduce net income but do not actually involve an outflow of cash.

Cash Outflows Outside the Income Statement: Cash is heavily impacted by activities that don't hit the income statement, such as paying off long-term debt principal, purchasing equipment (capital expenditures), buying inventory, or distributing owner dividends.

A company can easily be highly profitable on paper (net income) while facing a cash crunch.

6. What useful insights does free cash flow (FCF) provide in financial analysis?

Free Cash Flow (FCF) provides crucial insights into a company's financial health and performance that standard net income can miss. Key insights include:

True Discretionary Cash: FCF measures the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets (like property, plant, and equipment). This represents the actual cash available for strategic initiatives, paying down debt, issuing dividends, or making acquisitions.

Indicator of Financial Flexibility: A consistently positive and growing FCF shows that a business is self-sustaining and not heavily reliant on external financing (debt or equity) to fund its day-to-day operations or growth.

Quality of Earnings Verification: Because FCF focuses strictly on cash movements rather than accounting accruals, it acts as a reality check on net income. If a company reports high net income but low or negative FCF, it can signal potential red flags, such as trouble collecting accounts receivable or inventory buildup.

Capital Efficiency: It highlights how efficiently management is deploying capital toward long-term investments (CapEx) relative to the cash being generated from core operations.

7. Describe how common-size statements are useful.

Common-size statements standardize financial statements by expressing each line item as a percentage of a common base figure (such as total revenue for an income statement or total assets for a balance sheet). They are useful because they allow for:

Trend Analysis Over Time: They make it easy to spot structural changes in a single company across multiple years, revealing whether specific costs or assets are growing faster or slower than overall revenue or asset growth.

Peer and Competitor Comparison: They allow analysts to effectively compare companies of vastly different sizes (e.g., comparing a small regional retailer to a multi-national giant) by leveling the playing field into percentage terms.

Proportional Insight: They quickly highlight inefficiencies or red flags, such as a sudden jump in the percentage of cost of goods sold or operating expenses relative to total sales.

8. What is the difference between a calendar year and a fiscal year?

Calendar Year: A 12-month period that begins on January 1 and ends on December 31 (matching the standard Gregorian calendar).

Fiscal Year: Any consecutive 12-month period chosen by a company or government for financial reporting and accounting purposes. It does not have to start in January; for example, a company's fiscal year might run from October 1 through September 30. Businesses often choose a fiscal year that ends during their seasonal slow period (called a "natural business year") to make inventory counts and auditing easier.