FINC 3610 Sirmans Test 1: Key Economic Terms & Definitions

Pros of Sole Proprietorship

easy startup

taxed as personal income

Cons of Sole Proprietorship

- Unlimited Liability

- Life limited to that of owner

- Equity limited to owner's wealth

- Difficulty in transferring ownership

Pros of General Partnership

easy start-up

partnership agreement

taxed as personal income

Cons of General Partnership

unlimited liability

equity limited to owners life

difficult transfer

Difference between general and limited liability partnership

in LLP, the limited partner is only liable for the amount they invested; limited partner doesn't run the business

Pros of a Corporation

Limited liability

Easy transfer of ownership

Unlimited life

Equity is not limited

Cons of a Corporation

difficult startup

article of incorporation

double taxation of earnings

Chief Financial Officer (CFO)

Corporate officer who is responsible for all of the accounting and finance issues of the company

Treasurer

oversees cash management, credit management, capital expenditures, and financial planning

Controller

oversees taxes, cost accounting, financial accounting and data processing

Accountant's Role

Accountants spend time on the collection and presentation of financial data

Financial Manager's Role

Financial managers analyze financial data and make decisions based on their assessment of the associated risk and return

3 Major Questions of Corporate Finance

What long-term investments should you make?

How should you finance those investments?

How do you manage the daily operations of the firm such as collecting from customers and paying suppliers?

Capital Budgeting

the process of allocating the firm's capital to new projects and investments

involves estimating the size, risk, and timing of the firm's cash flows

How is Capital Budgeting done?

Estimate future cash flows

Estimate the cost of those cash flows

Discount the cash flows

Capital Structure

mixture of debt and equity it uses to finance its investments and operations

Short-term cash management

Working capital refers to Short Term assets and liabilities

Financial Markets Process (A-F)

Firm issues securities

Firm invests in assets

Cash flow from firm's assets

Government (taxes) are paid

Cash flows are reinvested

Dividend and debt payments are made

Manager's objective

Maximize shareholder value

3 decisions of maximizing shareholder value

Investment Decision, Financing Decision, Dividend Decision

Investment Decision

invest in assets that earn a return greater than the minimum acceptable hurdle rate

Financing Decision

Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations

Dividend Decision

If there are not enough investments that create value, return the cash to the owners

Does shareholder value always override other considerations?

No, need to avoid illegal behavior as well as keep customers and employees happy for retention

When does an agency problem arise?

when the interests and the motives of the managers do not coincide with those of the owners

Direct agency costs

expenditures not necessary for the firm

Making unnecessary acquisitions to make company bigger

Indirect agency costs

costs from not pursuing good projects because managers are risk adverse

Corporate governance

rules and regulations that govern a firm and its managers that serve to protect minority shareholders

Corporate governance examples

Board of directors hire new managers

Managerial compensation can be tied to financial performance or stock price

Natural source of corporate governance

Activist investors who buy out and take over company to make changes

purpose of balance sheet

Reports assets, liabilities, and equity at a specific date.

Provides information about resources, obligations to creditors, and equity in net resources.

Helps in predicting amounts, timing, and uncertainty of future cash flows.

organization of balance sheet

listed in order of liquidity

Net Working Capital

current assets - current liabilities

Balance sheet provides

book value of the assets, liabilities, and equity

Where might we find the market value of the firm's equity?

Stock Price

Purpose of Income Statement

summarize the profit-generating activities that occurred during a particular reporting period

Purpose of the Statement of Cash Flows

indicates the actual cash in and out during a period of time

3 major categories of cash flows

operating cash flows (related to sales and cash flow production)

Investing cash flows (large expenditures)

Financing cash flows (capital raising, paying down debt)

Why does liquidity matter on an asset level?

That asset is easier to trade in

Why does liquidity matter on a firm level?

the firm can use the assets if in financial distress

Must strike a balance because the most liquid assets are usually not the most profitable

What makes the income statement different than the statement of cash flows?

The statement of cash flows shows actual cash inflows and outflows during the period while the income statement shows recognized items based on GAAP

Cash inflows

- a decrease in assets other than cash (ie sell PPE, collect accounts receivable)

- increase in liabilities (ie take out a bank loan)

- net profits after taxes

- depreciation and other noncash charges

- sale of stock

Cash outflows

-increase in any asset

-decrease in any liability

-net loss after taxes

-dividends paid

-repurchase or retirement of stock

Cash flow from assets formula

Operating Cash Flow - Net Capital Spending - Change in Net Working Capital

Operating Cash Flow formula

EBIT + Depreciation - Taxes

Net capital spending formula

ending net fixed assets - beginning net fixed assets + depreciation

Change in net working capital formula

Ending Net Working Capital - Beginning Net Working Capital

_______ is not an actual cash flow, but it is marked as an expense on the income statement

depreciation

Financial statements are ____ looking

backward

average tax rate

a firm's tax bill divided by its taxable income

marginal tax rate

tax rate that applies to the next dollar of taxable income

progressive tax system

a tax whose average tax rate increases as the taxpayer's income increases and decreases as the taxpayer's income decreases

How does a company generate cash?

selling a product, service, asset, or security

How does a company spend cash?

purchasing labor, materials, or assets by paying cash to suppliers or owners

What is the balance sheet standardized by?

total assets

What is the income statement standardized by?

total sales

Why do we standardize financial statements?

to make it easier to compare financials across firms

cross sectional analysis

compare one firm to another firm or group of firms at a single point in time

time series analysis

compare changes in financials of a single firm

How do we select peer firms?

characteristics like size, age, and leverage

common to look at industry norm using SIC or other industry codes

Why do shareholders care about financials analysis?

evaluate buy/sell decisions in the market

Why do creditors care about financials analysis?

examine the long-term viability and short term bankruptcy risk of the firm

Why do managers care about financials analysis?

looking to make decisions that maximize shareholder value

Why do customers and suppliers care about financials analysis?

consider the stability of their relationship

current ratio

current assets divided by current liabilities

total debt ratio

(Total Assets - Total Equity) / Total Assets

times interest earned ratio

EBIT/Interest

Total Asset Turnover

Sales/Total Assets

profit margin

net income/net sales

Return on Assets (ROA)

Net Income/Total Assets

Return on Equity (ROE)

Net Income/Total Equity

price to earnings ratio

stock price/earnings per share

what is financial leverage?

the use of debt in a firm's capital structure

Financial leverage is the difference between

ROE and ROA

what type of firms are naturally able to maintain higher leverage ratios?

a more established company with stable cash flows

Why might a large company like Walmart have a much thinner profit margin compared to Facebook yet the two have a similar return on equity (ROE)?

Walmart has more leverage but the additional debt expense reduce's the firm's profit margin so that the 2 are equal

DuPont Identity

ROE = profit margin x total asset turnover x equity multiplier

DuPont Identity with ROA

ROE = ROA X (1 + debt-equity ratio)

ROE may be affected by 3 things

operational efficiency (profit margin)

asset use efficiency (asset turnover)

financial leverage (equity multiplier)

potential problems with financial statement analysis

firm diversification

earnings management and "window dressing"

Firm Diversification

large conglomerates don't fit a specific industry

multinational companies are diversified across countries

earnings management and "window dressing"

managers have some discretion on accounting methods which can affect financials