Learn: Business Finance Exam 1 Study Guide

Finance

The process of making decisions that add value based on expected future cash flows.

Three cash flow elements

Timing, risk, and magnitude of cash flows.

Finance versus accounting

Accounting records past transactions; finance estimates and values future cash flows.

Time value of money

A dollar today is worth more than a dollar received later.

Intrinsic value

The present value of expected future cash flows from an asset.

Investment rule

Buy an asset when estimated intrinsic value exceeds market price.

Corporate finance career

Focuses on capital budgeting, financing, and working capital management.

Investments career

Analyzes firms and securities to make investment recommendations.

Financial planning career

Helps clients meet retirement, education, and estate goals.

Common finance skills

Decision making, quantitative analysis, risk-return assessment, and strong ethics.

Equity security

Stock representing ownership in a firm with voting rights and residual claim.

Residual claim

Equity holders' right to assets remaining after paying all obligations.

Debt security

Borrowing instrument promising interest payments and principal repayment.

Fixed income security

Another name for a debt security.

Derivative security

A security whose value is derived from an underlying asset.

Call option

Right to buy an underlying asset at a specified price before expiration.

Put option

Right to sell an underlying asset at a specified price before expiration.

Other derivatives

Forward contracts, futures contracts, and swaps.

Composite asset

Pooled investment offering diversification, professional management, and lower fees.

Index fund

A composite asset designed to track a specific market index.

Asset-backed security

Security backed by pooled cash-flow claims from underlying assets.

Mortgage-backed security

An asset-backed security supported specifically by mortgage payments.

Corporate finance

Manages long-lived assets, funding strategies, and short-term operating cash flows.

Capital budgeting

The process of accepting or rejecting long-term investment projects.

Capital structure

The mix of long-term debt and equity used for financing.

Net working capital

Current assets minus current liabilities.

Financial manager's goal

Increase firm value through smart investment and financing decisions.

Goal of financial management

Maximize shareholder value.

Value creation

Acquiring assets that generate more cash than their initial cost.

Current assets

Short-term assets expected to convert to cash within one year.

Fixed assets

Long-term assets, which can be tangible or intangible.

Tangible assets

Physical long-term assets such as machinery and equipment.

Intangible assets

Nonphysical long-term assets such as patents and trademarks.

Current liabilities

Short-term obligations due within one year.

Long-term debt

Borrowing obligations due after one year.

Shareholders' equity

Owners' residual interest calculated as total assets minus total liabilities.

Sole proprietorship

Unincorporated business owned by one person with unlimited personal liability.

Partnership

Business structure formed by two or more co-owners.

Corporation

Distinct legal entity owned by stockholders with limited liability.

Corporation advantages

Limited liability, easy ownership transfer, and perpetual life.

Corporation disadvantage

Double taxation on earnings and dividends.

Limited liability

Owners are only liable up to the amount of their investment.

LLC

Hybrid entity combining limited liability with pass-through partnership taxation.

Benefit corporation

For-profit company legally obligated to create a positive public impact.

Stakeholders

All groups affected by company decisions, including employees and community.

Agency relationship

Relationship between stockholders (principals) and corporate management (agents).

Agency problem

Conflict of interest between stockholders and firm management.

Agency costs

Costs arising from conflicts of interest between owners and management.

Management conflicts

Managers favoring personal perks or job security over firm value.

Aligning incentives

Linking management compensation to stock price or profit metrics.

Other controls

Proxy fights, board replacements, and takeover threats to align management.

Securities Act of 1933

Federal law regulating the primary issuance of new securities.

Securities Exchange Act of 1934

Established SEC and mandatory corporate reporting requirements.

Sarbanes-Oxley Act of 2002

Law enhancing corporate governance and financial reporting accuracy.

Balance sheet

Financial snapshot showing assets, liabilities, and equity at a given date.

Income statement

Financial report summarizing revenues and expenses over a specific period.

Statement of cash flows

Report of cash inflows and outflows across operating, investing, and financing activities.

Form 10-K

Annual financial statement report required by the SEC.

Form 10-Q

Quarterly financial report filed with the SEC.

Form 8-K

SEC filing required for major unscheduled corporate events.

Liquidity

Speed and ease of converting an asset to cash without significant value loss.

Financial leverage

Use of debt in capital structure to magnify potential returns and risks.

Book value

Asset or equity value recorded on financial statements based on historical cost.

Market value

Actual current price at which assets, liabilities, or equity can be traded.

P and L

Profit and loss statement; another term for income statement.

Sales or revenue

Top line figure of the income statement representing total gross earnings.

COGS

Cost of goods sold.

SG and A

Selling, general, and administrative operating expenses.

EBIT

Earnings before interest and taxes; measures operating profit.

EBT

Earnings before taxes; pretax income.

Net income

Total revenue minus total expenses; bottom line of the income statement.

Matching principle

GAAP rule requiring revenue and directly related expenses to be recognized simultaneously.

Noncash item

Expense that reduces net income without an immediate cash outflow.

Net income is not cash

Net income differs from cash flow due to accrual accounting and noncash items.

Short run vs long run

In the short run some costs are fixed; in the long run all costs vary.

Operating activities

Cash flows arising from core, day-to-day business operations.

Investing activities

Cash flows related to purchases or sales of long-term assets.

Financing activities

Cash flows from debt borrowing, equity issuance, dividends, and share repurchases.

Source of cash

Transaction generating cash, such as increasing liabilities or equity.

Use of cash

Transaction consuming cash, such as purchasing assets or paying off debt.

Free cash flow

Cash generated by the firm available to distribute to debt and equity investors.

Operating cash flow

Cash generated from business operations: EBIT plus depreciation minus taxes.

Capital spending

Net cash invested in fixed asset additions.

Change in NWC

Ending net working capital minus beginning net working capital.

Cash flow to creditors

Interest paid minus net new debt borrowing.

Cash flow to stockholders

Dividends paid minus net new equity raised.

Cash flow identity

Cash flow from assets equals cash flow to creditors plus cash flow to stockholders.

Corporate tax rate

Flat 21 percent U.S. federal corporate tax rate.

Average tax rate

Total tax expense divided by total taxable income.

Marginal tax rate

Tax rate applied to the next dollar of earned income.

Financial statement analysis

Evaluating financial reports to improve operational and investment decision-making.

Cross-sectional analysis

Comparing a company's metrics against industry peers at one time.

Time-series analysis

Comparing a single firm's financial ratios across multiple time periods.

Common-size balance sheet

Expresses balance sheet line items as a percentage of total assets.

Common-size income statement

Expresses income statement line items as a percentage of total sales.

Solvency

A company's capacity to meet its long-term financial obligations.

Liquidity ratios

Ratios measuring ability to settle short-term debts with current assets.

Financial leverage ratios

Ratios measuring long-term debt obligation burden and debt capacity.

Asset management ratios

Ratios evaluating efficiency of asset utilisation to generate sales.

Profitability ratios

Ratios assessing efficiency of turning sales and investments into profit.