Review of Balance Sheet and Income Statement

Chapter 2: Class Notes Review of Balance Sheet Statement

1. Relationship Between Left-Hand Side and Right-Hand Side in Balance Sheet Statement

• Right-Hand Side Finance: Left-Hand Side

• Three ways to finance an asset:

  • Debtholder: Individuals or institutions that lend money to the company.

  • Shareholder: Owners of shares in the company who hold equity.

  • Retained Earnings: Profits reinvested into the business instead of distributed as dividends.

2. What Does the Balance Sheet Statement Tell Us?

• Provides a snapshot of the financial health of the business at a specific point in time.

• Equity Calculation:
  ext{Equity} = ext{Assets} - ext{Liabilities}

  • Shareholders take the residual value (the leftover) if the business liquidates its assets and pays off its debts.

• Liquidity

  • Two components:
    1) The speed and ease with which an asset can be converted into cash.
    2) Conversion must occur without significant loss of value.

  • Net Working Capital (NWC): a measurement of liquidity.
    ext{NWC} = ext{Current Assets} - ext{Current Liabilities}

  • Positive NWC indicates:

  • Ability to pay off current debts.

  • Capability to fund current operations.

  • Potential to invest in future activities and growth.

  • Negative NWC can imply:

  • Difficulty in financing daily operations.

  • Challenges in paying back creditors.

• Cash Management and Liquidity

  • High cash levels might initially seem good, but:

  • Excessive cash could indicate a lack of good investment opportunities, hindering future firm growth.

  • A large number of accounts receivable may lead to increased uncollectibles, thereby resulting in financial distress.

  • An excess of inventory may lead to difficulties in selling, indicating low sales projections.

3. Efficiency of Asset Usage

• Efficiency shows how effectively the company uses its assets to generate sales. Discussed financial ratios include:

  • Inventory turnover.

  • Accounts Receivable (AR) turnover.

  • Total asset turnover.

4. Leverage

• Indicates the level of financial risk a firm faces, particularly regarding how much debt the company carries.

• Financial Leverage: Refers to the use of borrowed funds, which can magnify both returns and losses for investors.

Book Value vs. Market Value

• Book Value:

  • Theoretical amount that would be paid to shareholders if the company were liquidated, calculated as:
    ext{Book Value} = ext{Total Assets} - ext{Total Liabilities}

  • This value does not reflect the current worth of the assets.

• Market Value (Market Capitalization):

  • Defined as:
    ext{Market Cap} = ext{Current Stock Price} imes ext{Number of Outstanding Shares}

  • Influenced by factors like riskiness and cash flows and is independent of accounting valuations.

  • More Useful for Financial Managers and Investors: Market value is more significant as it represents the cash price investors are willing to pay, reflecting expectations of future company performance.

Review of Income Statement

• Net Income Calculation:
  ext{Net Income} = ( ext{Total Revenue} + ext{Gains}) - ( ext{Total Expenses} + ext{Losses})

• EBIT (Earnings Before Interest and Taxes):

  • Also referred to as Operating Profit; it represents the company's performance from its core business activities while ignoring costs related to debt and tax expenses.

• Net Income provides insights into how well the management operates across all business aspects but may be subject to manipulation.

  • Important Note: Net income is NOT the same as cash flow due to:

  • Timing differences between sales recognition and cash receipt.

  • Inclusion of non-cash items such as depreciation.

Cash Flow

• Cash Flow from the Asset (CFFA):

  • Defined by the equation:
    ext{CFFA} = ext{Operating Cash Flow} - ext{Net Capital Spending} - ext{Changes in Net Working Capital}

  • The value of CFFA should ideally be positive and show an increasing trend over time.

  • A negative cash flow does not always indicate a critical issue and requires further analysis.

Operating Cash Flow (OCF)

• Calculated as: ext{OCF} = ext{EBIT} + ext{Depreciation} - ext{Taxes}

  • Reflects cash generated from a firm's businesses.

Capital Spending and Working Capital

• Capital Spending: Investments in fixed assets.

  • Net Capital Spending (NCS) defined as:
    ext{NCS} = ext{Ending Fixed Assets} - ext{Beginning Fixed Assets} + ext{Depreciation}

• Change in Net Working Capital indicates investments in current assets.

  • Represents as:
    ext{Changes in NWC} = ext{Ending NWC} - ext{Beginning NWC}

Cash Flow to Creditors (CFC)

• Calculated as: ext{CFC} = ext{Interest Paid} - ext{Net New Borrowing}

  • Interest Paid includes total interest expenses for creditors during the period.

  • Net New Borrowing is the difference between new issued debt and debt repaid.

Cash Flow to Stockholders (CFS)

• Calculated as: ext{CFS} = ext{Dividends Paid} - ext{Net New Equity Raised}

  • Dividends Paid captures total dividends disbursed to shareholders.

  • Net New Equity Raised reflects the difference between newly issued equity and stock repurchases.

Finance vs. Accounting