Finance 201-Midterm

Income Statement

reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement

Balance Sheet

a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period

Cash Flow Statement

A financial statement that provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given period

Accrual Accounting

method that records revenues and expenses when they are incurred, regardless of when cash is exchanged.

Historical Cost

a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company

Matching Principle

states that all expenses must be matched in the same accounting period as the revenues they helped to earn. In practice, matching is a combination of accrual accounting and the revenue recognition principle

Earnings Management

the use of accounting techniques to produce financial statements that present an overly positive view of a company’s business activities and financial position

Free Cash Flow (FCF)

represents the cash available for the company to repay creditors or pay dividends and interest to investors after paying taxes and for continuing operations.

Retained Earnings

the profits that a company has earned to date, less any dividends or other distributions paid to investors

Source of Cash

cash coming into the firm (assets)

Use of Cash

cash spent by the firm (liabilities)

2 standardization benefits

facilitates analysis, clarifies communication

Benefit of accrual accounting

better for understanding the true operations of an enterprise

Negative of accrual accounting

the standard financial statements are almost always misleading. It can lead to misstatement, misinterpretation, and misunderstanding

Cash accounting

recognizes transactions only when payment is exchanged

Assets on the balance sheet are listed in order of

decreasing liquidity

Liabilities on the balance sheet are listed in order of

payment due date

intangibles

brand/reputation, goodwill, patents, IP, customer lists, people/leadership etc.

on the balance sheet, assets involve _____ and liquidities involve ______

investment decisions, financing decisions

Can you find the current value of the firm on the balance sheet?

No! Balance sheet assets are listed at historical cost

Can you use your retained earnings to pay your bills?

No! You’ve already committed your retained earnings to finance your existing assets. To pay bills, you need cash!

Net Worth =

Assets-Liabilities

Net Operating Income is the same thing as

EBIT

There are two things you can do with Net Income:

payout or plowback

payout

pay it out in dividends

plowback

retain it within firm

New RE =

Old RE + NI - Dividends

9 Ways Earnings Lie

1. Inventory (LIFO VS FIFO)

2. Rising receivables

3. Extraordinary expenses or revenues

4. Asset sales (sale-leaseback)

5. Skimping on research

6. Reduced capital spending

7. Not really revenue (matching principle)

8. Pension shenanigans

9. Out-of-balance growth

Which financial statement is the most transparent

cash flow statement

Cash is

King

Three sources of cash flow

1. operating (AR, Inv, Depr., AP, Other current liabilities)

2. investing (PP&E)

3. Financing (Borrowing (NP & LT Debt), Stock (Equity), Dividends)

Change in Cash =

Operating CF + Investing CF + Financing CF

Cash Flow from Operations Equation

NI + Annual Depreciation ± assets ± liabilities

Cash flow from investing involves Net or Gross PP&E?

Gross PP&E

If Gross PP&E is not listed?

Net PP&E + Depreciation Expense

Free Cash Flow

cash flow available to all investors after required investment in fixed assets (CapEx) and required additions to working capital (WC)

Free Cash Flow to the Firm (FCFF) =

EBIT-Tax Pmt + Depr. - change in CapEX (gross PP&E) - change in WC (CA-CL)

Why can’t you easily compare two companies?

They are different in Size, Strategy, and Risk (SSR)

Benefits of ratio analysis

standardization (better comparison) and flexibility (adapt ratios or make your own)

Ratio analysis does not answer questions about the company it

tells you what questions to ask

What is the ultimate goal of the firm?

maximize shareholder wealth :)

3 types of financial ratio analysis

trend analysis, cross-section analysis, and goal achievement analysis

trend analysis

compare a firm’s financials with previous years

cross-section analysis

compare a firms financial ratios with those of its industry

goal achievement analysis

we analyze management’s success in achieving stated goals

4 categories of ratio analysis

liquidity, efficiency, leverage, profitability

Key Liquidity Ratios

1. current ratio

2. quick ratio

3. average collection period

4. A/R turnover

5. inventory turnover

Current Ratio

current assets/current liabilities

quick ratio (Acid-Test Ratio)

(current assets-inventory)/current liabilities

average collection period

AR/Daily Credit Sales (sales/365)

A/R Turnover

credit sales/AR

inventory turnover

COGS/Inventory

Key Efficiency Ratios

1. Total Asset Turnover

2. Fixed Asset Turnover

3. OIROI (also a profitability ratio)

total asset turnover

sales/total assets

fixed asset turnover

sales/fixed assets

OIROI

operating income (EBIT)/total assets

Key Leverage (financing) ratios

1. Debt Ratio

2. Times Interest Earned (TIE)

3. Cash Coverage Ratio

Debt Ratio

total debt/total assets

Times Interest Earned

EBIT/Interest Expense

Cash Coverage Ratio

(EBIT + Depreciation)/Interest Exp

Key Profitability Ratios

1. ROA

2. ROE

3. OIROI

4. Gross margin

5. Operating margin

6. Net margin

ROA

Net income/total assets

ROE

net income/total equity

Gross margin

gross profit/sales

operating margin

EBIT/sales

Net margin

net income/sales

DuPont Equation

ROE = Net Profit Margin (NI/sales) * Asset turnover (sales/TA) * leverage multiplier (A/E)

Percent of sales forecasting

a financial planning method in which accounts are varied depending on a firm’s predicted sales level

Sustainable Growth Rate

the maximum growth rate a firm can achieve without external equity financing while maintain a constant debt-equity ratio

Discretionary Financing Needed (DFN) is also known as

External Financing Needed (EFN)

Spontaneous Accounts (automatically vary with sales)

Most current assets, accounts payable, accruals, (sometimes Fixed Assets)

capacity

max amount that can be contained or produced by something

2 ways to increase capacity

produce faster or produce longer

Excess

capability not fully utilized

Shortage

cannot produce more

non-spontaneous accounts

notes payable, long-term liability accounts, common stock, interest and retained earnings (special case)

Interest is a special case non-spontaneous account

assume no change unless otherwise directed

Retained earnings is a special case non-spontaneous account

RE = Old RE + (Projected Sales x NM x 1-Payout Ratio)

Payout ratio

Dividend/NI

Plowback ratio

1-(Dividends/NI)

Find change in sales for percent of sales forecasting

(new sales-old sales)/old sales

Calculating DFN

DFN = Projected TA - Projected Total L&E

What is the sustainable growth rate

the only growth rate which allows the firm to maintain its current debt-equity ratio and avoid sales of new equity

Sustainable growth rate is not the optimal growth rate

true: its simple the maximum growth rate a company can achieve with its current financial structure

what must a company do to grow faster than the sustainable growth rate?

1. invest more in equity capital

2. increase financial leverage (use more debt)

3. increase target profit margin

Sustainable Growth Rate equation (g*)

g* = ROE x (1-payout ratio)

sustainable growth rate is a function of four things

1. profitability

2. asset usage efficiency

3. financing (leverage)

4. dividend policy

Expanded Sustainable Growth Rate

SGR = NM X Asset Turnover (Sales/Assets) X Leverage Multiplier (Assets/Equity) X (1-payout ratio)

payou ratio formula

dividends/net income

3 Key Uses of Budgets

1. determine future financing

2. signal need for corrective action

3. evaluate performance

The Cash Budget

Net Cash Flow (cash inflows-cash outflows)

+Beginning Cash

±Monthly borrowing

±Marketable Securities

=Ending Cash Balance

Why would you rather have a dollar today?

Risk, opportunity, inflation

Compounding

calculating the future value from the present value

Discounting

calculating the present value from the future value

Annuity

an equally-spaced sequence of equal cash flows paid for a specified length of time

2 examples of annuities

bonds and loans

Perpetuity

a fixed payment at a fixed interval every period forever.

PV of perpetuity

PV = (PMT/i)

Interest rate of a perpetuity

i = (PMT/PV)

When calculating a perpetuity the interest rate is written as a

decimal