Chapter 2 Review
Market value per share
= market price of the firm's common stock
Statement of retained earnings
A financial statement that reconciles net income earned during a given period and any cash dividends paid with eh change in retained earnings over the period.
Differentiate between book (or accounting) value and market value.
A firm's balance sheet shows its book (or historical cost) value based on generally accepted accounting principles (GAAP). Under GAAP, assets are listed on the balance sheet at the amount the firm paid for them, regardless of what they might be worth today. Market value is the amount the firm would get if it actually sold an asset. The book value and market value of a firm's current assets are generally very close in value. However, the book value of a firm's fixed assets is often very different from the market value.
preferred stock
A hybrid security that has characteristics of both long-term debt and common stock
Why do financial managers and investors find cash flows to be more important than accounting profit
A very important distinction between the accounting point of view and the finance point of view is that financial managers and investors are far more interested in actual cash flows than in the backward-looking profit listed on the income statement. The statement of cash flows is a financial statement that shows the firm's cash flows over a given period of time. This statement reports the amounts of cash the firm has generated and distributed during a particular time period. The bottom line on the statement of cash flows—the difference between cash sources and uses—equals the change in cash and marketable securities on the firm's balance sheet over a period of tim
How does the choice of accounting method used to record fixed asset depreciation affect management of the balance sheet?
ACCOUNTING METHOD FOR FIXED ASSET DEPRECIATION Managers can choose the accounting method they use to record depreciation against their fixed assets. Recall from accounting that depreciation is the charge against income that reflects the estimated dollar cost of the firm's fixed assets. The straight-line method and the MACRS (modified accelerated cost recovery system) are two choices. Companies commonly choose MACRS when computing the firm's taxes and the straight-line method when reporting income to the firm's stockholders. The MACRS method accelerates depreciation, which results in higher depreciation expenses and lower taxable income, thus lower taxes, in the early years of a project's life. Regardless of the depreciation method used, over time both the straight-line and MACRS methods result in the same amount of depreciation and therefore tax (cash) outflows. However, because the MACRS method defers the payment of taxes to later periods, firms often favor it over the straight-line method of depreciation.
What is an income statement?
An income statement shows the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time—generally one year. Remember that while the balance sheet reports a firm's position at a point in time, the income statement reports performance over a period of time, for example, over the last year.
current assets
Assets that will normally convert to cash within one year
What does the Sarbanes-Oxley Act require of firm managers?
At the extreme, earnings management has resulted in some widely reported accounting scandalsPage 50involving Enron, Merck, WorldCom, and other major U.S. corporations that tried to artificially influence their earnings by manipulating accounting rules. Congress responded to the spate of corporate scandals that emerged after 2001 with the Sarbanes-Oxley Act, passed in June 2002. Sarbanes-Oxley requires public companies to ensure that their corporate boards' audit committees have considerable experience applying generally accepted accounting principles (GAAP) for financial statements. The act also requires that a firm's senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm's financial condition during the period covered. If a firm's board of directors or senior managers fail to comply with Sarbanes-Oxley (SOX), the firm may be delisted from stock exchanges. American Spectrum Realty failed to file quarterly and annual reports in 2013 and 2014 in a timely manner. As a result, as discussed in the nearby Finance at Work box, the firm's common stock became subject to delisting. Congress's goal in passing SOX was to prevent deceptive accounting and management practices and to bring stability to jittery stock markets battered in 2002 by accounting and managerial scandals that cost employees their life savings and harmed many innocent shareholders as well. See also the discussion of the role of ethics in finance in
Average tax rate
Average tax rate = tax liability / taxable income
Cash flows from investing activites
Cash flows associated with the purchase or sale of fixed or other long-term assets
What is the difference between cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities?
Cash flows from investing activities (Section B in Figure 2.4 and Table 2.4) are cash flows associated with the buying or selling of fixed or other long-term assets. This section of the statement of cash flows shows cash inflows and outflows from changes inPage 46 long-term investing activities—most significantly the firm's investment in fixed assets. For example, DPH Tree Farm, Inc., used $68 million in cash to purchase fixed and other long-term assets in 2018. DPH funded this $68 million cash outflow with the $97 million cash surplus DPH Tree Farm produced from its operations. Cash flows from financing activities (Section C in Figure 2.4 and Table 2.4) are cash flows that result from changes in debt and equity financing. These include raising cash by Issuing short-term debt Issuing long-term debt Issuing stock or using cash to Pay dividends Pay off debt Buy back stock Net change in cash and marketable securities (Section D in Figure 2.4 and Table 2.4), the bottom line of the statement of cash flows, shows the sum of cash flows from operations, investing activities, and financing activities. This sum will reconcile to the net change in cash and marketable securities account on the balance sheet over the period of analysis. For example, the bottom line of the statement of cash flows for DPH Tree Farm is −$1 million. This is also the change in the cash and marketable securities account on the balance sheet (in Table 2.1) between 2017 and 2018 ($24 million - $25 million = −$1 million). In this case, the firm's operating, investing, and financing activities combined to produce a net drain on the firm's cash during 2018—cash outflows were greater than cash inflows, largely because of the $68 million investment in long-term and fixed assets. Of course, when the bottom line is positive, a firm's cash inflows exceed cash outflows for the period.
Book Value per share
Common Stock + paid-in surplus + retained earnings/number of shares of common stock outstanding
The income statement is prepared using GAAP. How does this affect the reported revenue and expense measures listed on the balance sheet?
Company accountants must prepare firm income statements following GAAP principles. GAAP procedures require that the firm recognize revenue at the time of sale. But sometimes the company receives the cash before or after the time of sale. Likewise, GAAP counsels the firm to show production and other expenses on the income statement as the sales of those goods take place. So production and other expenses associated with a particular product's sale appear on the income statement (for example, cost of goods sold and depreciation) only when that product sells. Of course, just as with revenue recognition, actual cash outflows incurred with production may occur at a very different point in time— usually much earlier than GAAP principles allow the firm to formally recognize the expenses.
EBITDA
Earnings before interest, taxes, depreciation, and amortization
On which of the four major financial statements (balance sheet, income statement, statement of cash flows, or statement of retained earnings) would you find the following items? (LG2-1)
Earnings before taxes. b.Net plant and equipment = Total Assets (right). c.Increase in fixed assets.= Total Assets (right). d.Gross profits. e.Balance of retained earnings, December 31, 20xx.=Total Liabilities and Equity f.Common stock and paid-in surplus.=Total Liabilities and Equity g.Net cash flow from investing activities. h.Accrued wages and taxes.=Total Liabilities and Equity i.Increase in inventory.= Total Assets (right).
FCF equation
FCF = EBIT × (1-tax rate) + Noncash charges - Capital expenditures - Increase in working capital •FCF = Cash flows •EBIT × (1-tax rate) → Accounts for tax rate •Noncash charges → Accounts for noncash items like depreciation •Capital expenditures → PP&E and similar expenditures •Increase in working capital → Change in current assets - Current liabilities
How does the payment of interest on debt affect the amount of taxes the firm must pay?
Finally, we subtract depreciation and amortization from EBITDA toPage 37 get operating income or earnings before interest and taxes (EBIT)1 (so DPH Tree Farm's EBIT was $128 million in 2017 and $152 million in 2018). The EBIT figure represents the profit earned from the sale of the product without any financing cost or tax considerations. Page 38The bottom part of the income statement summarizes the firm's financial and tax structure. First, we subtract interest expense (the cost to service the firm's debt) from EBIT to get earnings before taxes (EBT). So, as we follow our sample income statement, DPH Tree Farm had EBT of $110 million in 2017 and $136 million in 2018. Of course, firms differ in their financial structures and tax situations. These differences can cause two firms with identical operating income to report differing levels of net income. For example, one firm may finance its assets with only debt, while another finances with only common equity. The company with no debt would have no interest expense. Thus, even though EBIT for the two firms is identical, the firm with all-equity financing and no debt would report higher net income. We subtract taxes from EBT to get the last item on the income statement (the "bottom line"), or net income. DPH Tree Farm, Inc., reported net income of $70 million in 2017 and $90 million in 2018
Income statement
Financial Statement that reports the total revenues and expenses over a specific period of time
Statement of Cash Flows
Financial Statement that shows the firm's cash flows over a period of time
Observe cautions that should be taken when examining financial statements.
Firms must prepare their financial statements according to GAAP, which provides a common set of standards intended to produce financial statements that are objective and precise. However, GAAP also allows managers significant discretion over the firm's reported earnings. Managers and financial analysts have recognized for years that firms use considerable latitude in accounting rules to manage their reported earnings in a wide variety of contexts
Explain how taxes influence corporate managers' and investors' decisions
Firms pay out a large portion of their earnings as taxes. The U.S. Congress sets (and often changes) the U.S. tax code, which in turn determines corporate tax obligations. The U.S. tax system is extremely complicated and we do not attempt to cover it in detail here. However, taxes are a major expense item for a firm and they are a crucial part of many financial decisions
Why can the book value and market value of a firm differ?
For example, a firm's balance sheet shows its book (or historical cost) value based on generally accepted accounting principles (GAAP). Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what those assets might be worth today if the firm were to sell them. Inflation and market forces make many assets worth more now than they were worth when the firm bought them. So in many cases, book values differ widely from market values for the same assets—the amount that the assets would fetch if the firm actually sold them. For the firm's current assets—those that mature within a year—the book value and market value of any particular asset will remain very close. For example, the balance sheet lists cash and marketable securities at their market value. Similarly, firms acquire accounts receivable and inventory and then convert these short-term assets into cash fairly quickly, so the book value of these assets is generally close to their market value.
Liabilities
Funds provided by lenders to the firm
If, during a given period, a firm pays out more in dividends than it has net income, what happens to the firm's retained earnings?
If a firm pays out more in dividends than it has net income, retained earnings will decrease.
What is the difference between an average tax rate and a marginal tax rate?
In addition to calculating their tax liability, firms also want to know their average tax rate and marginal tax rate. You can figure the average tax rate as the percentage of each dollar of taxable income that the firm pays in taxes. Average tax rate =Tax liabilityTaxable income (2-7) From your economics classes, you can probably guess that the firm's marginal tax rate is the amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns
List and describe the four major financial statements
LG 2-1 Balance Sheet reports a firm's assets, liabilities, equity at a particular point in time. It is a picture of the assets the firm owns and who has claims on the assets as of a given date. A firm's assets must equal (balance) the liabilities and equity used to purchase the assets (hence the term balance sheet) the income statement: statement of cash flows, or statement of retained earnings n any annual report, you will find the four basic financial statements—the balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. These four statements provide an accounting-based picture of a firm's financial position. These statements often provide a key source of information for firm managers to make financial decisions and for investors to decide whether to invest in the firm.
What is the difference between current liabilities and long-term debt? (
Lenders provide funds, which become liabilities, to the firm. Liabilities fall into two categories as well: current or long-term. Current liabilities constitute the firm's obligations due within one year, including accrued wages and taxes, accounts payable, and notesPage 33 payable. Long-term debt includes long-term loans and bonds with maturities of more than one year.
Assets equation
Liabilities + Equity =Assets
What are the costs and benefits of holding liquid securities on a firm's balance sheet?
Liquidity actually refers to two dimensions: the ease with which the firm can convert an asset to cash, and the degree to which such a conversion takes place at a fair market value. You can convert any asset to cash quickly if you price the asset low enough. But clearly, you will wish to convert the asset without giving up a great portion of its value. So a highly liquid asset can be sold quickly at its fair market value.
What is earnings management?
Managers have significant discretion over their reported earnings. Managers and financial analysts have recognized for years that firms use considerable latitude in using accounting rules to manage their reported earnings in a wide variety of contexts. Indeed, within the GAAP framework, firms can "smooth" earnings. That is, firms often take steps to over- or understate earnings at various times. Managers may choose to smooth earnings to show investors that firm assets are growing steadily. Similarly, one firm may be using straight-line depreciation for its fixed assets, while another is using a modified accelerated cost recovery method (MACRS), which causes depreciation to accrue quickly. If the firm uses MACRS accounting methods, it writes fixed asset values down quickly; assets will thus have lower book values than if the firm used straight-line depreciation methods. This process of controlling a firm's earnings is called earnings management.
Earnings per share equation (EPS)
Net income available to common stockholders/total shares of common stock outstanding
Current Liabilites
Obligations of the firms that are due within one year
2-1 Balance Sheet You are evaluating the balance sheet for Goodman Bees Corporation. From the balance sheet you find the following balances: cash and marketable securities = $400,000, accounts receivable = $1,200,000, inventory = $2,100,000, accrued wages and taxes = $500,000, accounts payable = $800,000, and notes payable = $600,000. Calculate Goodman Bees' net working capital. (LG2-1)
Recall the balance sheet identity in equation 2-1: Assets = Liabilities + Equity. Rearranging this equation: Equity = Assets - Liabilities. Thus, the balance sheets would appear as follows:
Market Value versus Book Value Little Carrie's SpinBall Corp. lists fixed assets of $16 million on its balance sheet. The firm's fixed assets have recently been appraised at $20 million. Little Carrie's SpinBall Corp.'s balance sheet also lists current assets at $6.25 million. Current assets were appraised at $7.50 million. Current liabilities' book and market values stand at $3.75 million and the firm's book and market values of long-term debt are $8.75 million. Calculate the book and market values of the firm's stockholders' equity. Construct the book value and market value balance sheets for Little Carrie's SpinBall Corp.
Recall the balance sheet identity in equation 2-1: Assets = Liabilities + Equity. Rearranging this equation: Equity = Assets - Liabilities. Thus, the balance sheets would appear as follows:
Sarbanes-Oxley Act of 2002
Requires that a firm's senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm's financial condition during the period covered
marketable securities
Short-Term, low-rate investment securities held by the firm for liquidity purposes
From a firm manager's or investor's point of view, which is more important—the book value of a firm or the market value of the firm?
The "book value versus market value" issue really arises when we try to determine how much a firm's fixed assets are worth. In this case, book value is often very different from market value. For example, if a firm owns land for 100 years, this asset appears on the balance sheet at its historical cost (of 100 years ago). Most likely, the firm would reap a much higher price on the land upon its sale than the historical price would indicate.
What do we mean by a progressive tax structure?
The 2018 corporate tax schedule appears in Table 2.3. Note from this table that the U.S. tax structure is progressive, meaning that the larger the income, the higher the taxes assessed and the higher the taxes paid per dollar of income. However, corporate tax rates do not increase in any kind of linear way based on this progressive nature: They rise from a low of 15 percent to a high of 39 percent, then drop to 34 percent, rise to 38 percent, and finally drop to 35 percent.
Average Tax Rate
The Percentage of each Dollar of Taxable Income that the firm pays in taxes
Marginal tax rate
The amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns
book (or historical cost) value
The amount the firm paid for the assets
Market Value
The amount the firm would get if it sold the assets
What is a balance sheet?
The balance sheet reports a firm's assets, liabilities, and equity at a particular point in time. A firm's assets must equal (balance) the liabilities and equity used to purchase the assets (hence the term balance sheet ).
Free cash flows
The cash that is actually available for distribution to the investors in the firms after the investments that are pessary to sustain the firm's ongoing operation are made
Net Working capital
The difference between a firm's current assets and current liabilities
liquidity
The ease with which an asset can be converted into cash
financial leverage
The extent to which debt securities are used by a firm
Balance Sheet
The financial statement that reports a firm's assets, liabilities, and equity at a particular point in time
common stock and paid-in surplus
The fundamental ownership claim in a public or private company
Differentiate between accounting income and cash flows.
The income statement is prepared using GAAP. Following GAAP, revenue is recognized at the time of sale, which is not necessarily when cash is received. Likewise, under GAAP, expenses appear on the income statement as they match sales. That is, production and other expenses associated with the sales reported on the income statement (for example, cost of goods sold and depreciation) are recognized at the time the product is sold. Again, the actual cash outflow associated with these expenses may occur at a very different point in time. In addition, the income statement contains several noncash items. The largest is depreciation. As a result, figures shown on an income statement may not represent the actual cash inflows and outflows for a firm during a particular period. For the financial manager and investors, however, these cash flows are precisely the most important information available among the financial documents—more important than the accounting profit listed on the income statement. Cash, not accounting profit, is needed to pay the firm's obligations as they come due, to fund operations and growth, and to compensate firm owners.
Which are the most liquid assets and liabilities on a balance sheet?
The most liquid assets—called current assets—appear first on the asset side of the balance sheet. The most liquid liabilities—called current liabilities—appear first on the liabilities and equity side of the balance sheet.
Retained Earnings
The portion of company profits that are kept by the company rather than distributed to the stockholders as cash dividends
What is a statement of cash flows?
The statement of cash flows is a financial statement that shows the firm's cash flows over a given period of time. This statement reports the amounts of cash that the firm generates and distributes during a particular time period. The bottom line on the statement of cash flows—the difference between cash sources and uses—equals the change in cash and marketable securities on the firm's balance sheet from the previous year's balance. That is, the statement of cash flows reconciles income statement items and noncash balance sheet items to show changes in the cash and marketable securities account on the balance sheet over the particular analysis period.
Demonstrate how to use a firm's financial statements to calculate its cash flows
The statement of cash flows is the financial statement that shows the firm's cash flows over a given period of time. The statement of cash flows reports how much cash the firm generates and distributes during the time period analyzed. The bottom line of the statement of cash flows—the difference between cash sources and cash uses—equals the change in cash and marketable securities on the firm's balance sheet. That is, the statement of cash flows reconciles income statement items and noncash balance sheet items to get to the change in the cash and marketable securities account on the balance sheet over the period of analysis.
What are the main sections on the statement of cash flows?
The statement of cash flows separates cash flows into four categories or sections: cash flows from operating activities; cash flows from investing activities; cash flows from financing activities; and net change in cash and marketable securities.
What is a statement of retained earnings?
The statement of retained earnings provides additional details about changes in retained earnings during a reporting period. This financial statement reconciles net income earned during a given period and any cash dividends paid within that period on one side with the change in retained earnings between the beginning and ending of the period on the other
What is earnings management?
This process of controlling a firm's earnings is called earnings management.
What are free cash flows for a firm? What does it mean when a firm's free cash flow is negative?
When evaluating the statement of cash flows, the overall change in the cash account should be evaluated with care. For example, a negative cash flow could be the result when a growing firm invests in new fixed assets, inventory, and so on. Cash expenditures used to expand firm capacity would drain cash during the expansion period. However, if utilized efficiently, would result in increases in cash flows through time. Thus, the cash flow statement assists financial professionals to identify where cash is generated and where cash is dispersed over a time period. These cash inflows and outflows should then be evaluated based on how they added to the value of the firm to its stockholders. The statement of cash flows measures net cash flow as net income plus noncash adjustments. However, to maintain cash flows over time, firms must continually replace working capital and fixed assets and develop new products. Thus, firm managers cannot use the available cash flows any way they please. Specifically, the value of a firm's operations depends on the future expected free cash flows, defined as after-tax operating profit minus the amount of new investment in working capital, fixed assets, and the development of new products. Thus, free cash flow represents the cash that is actually available for distribution to the investors in the firm—the firm's debt holders and stockholders—after the investments that are necessary to sustain the firm's ongoing operations are made.
When a corporation owns stock in another corporation, what percentage of dividends received on the stock is taxed?
When one corporation owns stock in another corporation, 70 percent of any dividends received from other corporations is tax exempt. Only the remaining 30 percent is taxed at the receiving corporation's tax rate.
Which of the following activities result in an increase (decrease) in a firm's cash? (LG2-5) a.Decrease fixed assets. b.Decrease accounts payable. c.Pay dividends. d.Sell common stock. e.Decrease accounts receivable. f.Increase notes payable.
a.Decrease fixed assets. =Decrease a current liability b.Decrease accounts payable. c.Pay dividends.= d.Sell common stock.= Pay dividends E.Decrease accounts receivable. f.Increase notes payable =
On which of the four major financial statements (balance sheet, income statement, statement of cash flows, or statement of retained earnings) would you find the following items?
a.Earnings before taxes. b.Net plant and equipment. c.Increase in fixed assets. d.Gross profits. e.Balance of retained earnings, December 31, 20xx.: balance sheet f.Common stock and paid-in surplus. g.Net cash flow from investing activities. h.Accrued wages and taxes. i.Increase in inventory.
fixed assets
assets with a useful life exceeding one year
cash flows from operations
cash flows that are the direct result of the production and sale of the firm's products
Cash flows from financing activities
cash flows that result from debt and equity financing transactions
Dividends per share
common stock dividends paid/number of shares of common stock outstanding
EBIT
earnings before interest and taxes
EBT
earnings before taxes
Stockholders' equity
funds provided by the firm's preferred and common stock owners
Net Operating Profit After Taxes (NOPAT)
net profit a firm earns after taxes but before any financing costs
Gross Profit
net sales - cost of goods sold
long-term debt
obligations of the firm that are due in more than one year
Financial Statement
statement that provides an accounting-based picture of a firm's financial position
capital structure
the amount of debt versus equity held on the balance sheet
Net Income
the bottom line on the income statement
Earnings Management
the process of controlling a firm's earnings
Net Change in cash and marketable securities
the sum of the cash flows from operations, investing activities, and financing activities