EZC1 - Principles of Finance/Master Study Set

Operating Expenses

All costs incurred through the company's operations that are not directly associated with the production process.

CFO Operations - Cash Flows

All flows related to producing and selling the firm's product - customer cash, raw materials, operating expenses, taxes. Methods of Calculation (2): 1. Indirect 2. Direct Start with net income, add back the non-cash expenses from the income statement and then adjust for changes in the operating accounts on the comparative balance sheet. For convenience, we repeat it in Table 2-3.

Retained Earnings (RE)

Money generated from the operations of the company that is plowed back (or retained) in the business. Represents funds that already have been reinvested in the existing assets of the firm. • Change in RE = Net Income - Dividends • New RE = Old RE + Change in RE • New RE = Old RE + Net Income - Dividends**

Balance Sheet (1)

Snapshot of the firm's assets and the financing of those assets at a given point in time ( "as of...") listing all assets, liabilities, and equity of the firm in the balance sheet equation.

EBIT (Earnings Before Interest & Taxes/Operating Profit/Operating Income)

Subtracting operating expenses from gross profit. EBIT = Sales - Operation Expense - COGS - Depreciation Expense [NOT INTEREST EXPENSE!] or Sales - COGS - Depreciation

Current Liabilities I

• A/P • Accruals (Obligations incurred in the current period but has not yet been paid) • Notes Payable (involve explicit interest-bearing lending arrangement with lending institution)

Current Assets I

• Cash • Marketable Securities (T-Bills, CD's) • A/R • Inventory (least liquid)

Equity

• Common Stock • Additional Paid-In Capital • Retained Earnings

Financing Ratios

• Debt Ratio • Times Interest Earned Ratio

Leverages to Pull

• Decrease costs, while holding sales constant (thus increasing NI) • Increase sales, while holding assets constant (thus increasing asset turnover) • Increase debt, while holding equity constant (we lever up) Third option most precarious!!

Statement of Cash Flows (3)

• Explains sources and uses of cash for a company - cash in and cash out for a company in a given year • Most transparent of three statements

Standard Forms - Advantages

• Facilitates Analysis • Clarifies Communication

Fixed Assets

• Gross Fixed Assets (less: Accumulated Depreciation = Net Fixed Assets) • Recorded on balance sheet at historical cost • Assets on balance sheet with a life span greater than one year

Accrual-Based Accounting

• It's revenue when the company "earns it" • Synchronizes the reporting process • Creates environment where a simplistic reading of the standard financial statements is almost always misleading

Depreciation Expense

• Non-cash expense affecting net income on the Income Statement • Created solely for taxation purposes • If not explicitly stated on the Income Statement, can be inferred from balance sheet; change in accumulated depreciation is equal to depreciation expense. **Formula--> Cost of Machine / Life of Machine

Profitability Ratios

• Return on Assets (ROA) • Return on Equity (ROE) • Gross Margin • Operating Margin • Net Margin

Ratio Analysis Advantages

• Standardize Financial Data • Flexibility • Leads to look-ins to right places to question • Evaluates whether the firm is achieving stated goal to maximize shareholder wealth • Evaluates management action to see if they are fully exploiting the firm's earning potential.

Gross Profit/Gross Income/Gross Loss

• Subtracting the cost of goods sold (or cost of services) from revenue • Sales Revenue - Cost of Goods Sold (COGS)

Efficiency Ratios

• Total Asset Turnover • Fixed Asset Turnover • OIROI (Profitability Ratio)

Comparison Methods In Ratio Analysis

• Trend Analysis • Cross Sectional Analysis • Progress Measurement

Quick Ratio/Acid Test Ratio

(Current Assets - Inventory) / Current Liabilities • More stringent test of liquidity as compared to Current Ratio • Since Inventory is the least liquid asset it is subtracted from current assets leaving - cash, marketable securities and A/R. ***Higher quick ratio better***

Cash Flows - Indirect Method

**For changes in Notes Payable, DO NOT adjust net income. Do we have the cash? yes(increase in cash asset)/no (decrease in cash asset)

Ratio Analysis

1) you cannot assess the firm's liquidity with only two ratios. 2) eBuy has a higher current ratio but a lower quick ratio when compared to the industry. 3) is not correct since the relationship between the current and quick ratio doesn't address the liquidity of accounts receivable. 4) is the most reasonable statement since a higher current ratio and lower quick ratio (as compared to the industry) indicates that eBuy has lots of inventory. The inventory build-up may be due to illiquid/non-salable inventory holdings. For eBuy, gross margin is 64.82% (= sales-COGS/sales = [2877-1012]/2877) and operating margin is 23.64% (= EBIT/Sales = 680/2877). If you take Gross Margin - Operating Margin, you get Operating Expense/Sales. For example, for Amazona 67.21-24.75 = 42.46%. This means that operating expenses at Amazona consume 42.46% of sales. For eBuy, this is only 41.18%. Hence, relative to sales, eBuy has lower operating expenses. eBuy's gross margin is lower than Amazona indicating that ebuy has higher cost of goods. Since, eBuy has lower gross and operating margin the data do not support the conclusion that eBuy is more profitable than Amazona.

Ratio Types (studied within text)

1. Liquidity 2. Asset Use Efficiency 3. Financing 4. Profitability

Comparative Balance Sheet

A balance sheet with two or more years of data.

Dividends in Arrears

A preferred stock characteristic where common stock dividends cannot be paid until the preferred dividends are paid.

Effective Yield

A rate that includes non-annual compounding = (1 + stated rate/m) - 1

Average Collection Period

AR / Daily Credit Sales ***If financial statements don't differentiate between cash/credit sales it is generally assumed it is a credit sale***

Liquidity

Ability of firm to meet its short-term (30-day debt) obligations • Current Ratio • Quick Ratio • Average Collection Period • A/R Turnover • Inventory Turnover

Addition to R/E (Retained Earnings)

Addition to R/E = New R/E - Old R/E

Contra-Asset Account

An allowance or reserve account against A/R created for questionable collectibles.

Long-Term Liabilities

As Stated

Leverage Multiplier

Assets / Equity *Measures how efficiently the firm is using its assets

Balance Sheet Equation

Assets = Liabilities + Owners' Equity

Agency Costs

Associated costs resulting from principle agency problem.

Cash Flow Groups

CFO - cash flows from operations CFI - cash flows from investing CFF - cash flows from financing Sum equals company's change in cash position from previous year

Inventory Turnover

COGS / Inventory ***Number of times inventory turns/sells per year***

CAPEX

Capital Expenditure (gross property, plant & equipment) changes from the two balance sheets

Cross Sectional Analysis

Compares firm's financial ratios with those of some peer group

A/R Turnover

Credit Sales / AR ***How long to collect on credit sales***

Operating Accounts on Balance Sheets

Current Assets & Current Liability Accounts (operating accounts facilitate company operations).

Current Ratio

Current Assets / Current Liabilities **Higher current ratios generally better (>1)**

Assets = Liabilities + Owners' Equity Formula

Current Assets Current Liabilities Cash A/P A/R N/P Inventory + + Fixed Assets Long-Term Debt PP&E less: AccDepr + = Owners' Equity Common Stock Retained Earnings = TOTAL ASSETS = TOTAL LIABILITIES + OWNERS' EQUITY

Depreciation

Depreciation form the Income Statement (or two balance sheets)

Income Statement (2)

Describes the revenues and expenses associated with a company's operations for a given period of time.

Free Cash Flow to Firm (FCFF)

EBIT - Cash Tax Payments + Depreciation - CAPEX - Increases in NWC

Free Cash Flow to the Firm (FCFF)

EBIT - Cash Tax Payments + Depreciation - CAPEX - Increases in NWC • Free cash flows used for valuations

Net Income

EBIT - Interest & Taxes ALSO NI = Dividends + Change in Retained Earnings

Times Interest Earned (TIE)

EBIT / Interest Expense *Compares company operating profit (EBIT) to interest expense.

Operating Margin

EBIT / Sales

EBIT = Interest Earned

EBIT = Interest Earned

NI (Net Income)

EBT - Tax Expense

EBT (Taxable Income/Earnings Before Taxes)

EBT = Sales - COGS - Depreciation Expense - Interest Expense

Tax Expense

EBT x Tax Rate

Equity = Owner's Equity

Equity = Owner's Equity

High Growth Firms

Fast growth carries data timing dilemma.

FIFO

First in First Out Inventory

Gross Margin

Gross Profit (or Sales - COGS) / Sales • Express as %

CFF Financing - Cash Flows

Includes any cash flows resulting from increased borrowing, debt repayment, stock issuance, stock repurchase or dividend payment. • Calculate CFF by comparing appropriate balance sheet accounts from one year to the next. • An increase in a financing account (ie. debt, notes payable, equity) signals a source of cash flowed into the company. • A decrease in financing account indicates that the company used cash to pay lenders or to buy back stock. Dividends = (Old RE + Net Income) - New RE * RE = Retained Earnings

Capital Gains

Increases in the value of stock

CFI Investing - Cash Flows

Involves any cash in or out of the company due to investment in or disposal of fixed assets. (assume for text investing is reflected in Gross PP&E account and that no assets are retired during the year.) **Net PP&E + Depreciation expense = Gross PP&E

Historical Cost Accounting

Items that appear on the financial statements are stated at their historical cost. • Disadvantages - future market value differs greatly from initial purchase price (i.e. land)

Current Assets II

Items that will generate cash within the next year.

LIFO (leads to higher COGS, lower earnings, lower ending inventory)

Last in First Out Inventory

Trend Analysis

Looks at firm's financial ratios over time

Return on Equity (ROE)

NI / Equity

Return on Assets (ROA)

NI / Total Assets *express as PERCENTAGE!!

NOPAT - After Tax Operating Profit

NOPAT = EBIT (1 - t)

Free Cash Flow to Equity Holders (FCFE)

Net Income + Depreciation - CAPEX - Increase in Net Working Capital (NWC) + Increase in Net Long-Term Debt

Indirect Method

Net Income + Non-Cash Expenses (from income statement) then adjust for changes in the operating accounts on the comparative balance sheet.

Net Margin (Net Profit Margin)

Net Income / Sales

Net Profit Margin

Net Income / Sales *Measures Firm's efficiency in controlling its costs

Fixed Assets II

Net PP&E

NWC

Net Working Capital (current assets - current liabilities) changes from the two balance sheets

Cash Flows - Direct Method

Not used in this text

Current Liabilities II

Obligations that will require cash within the next year.

Dividend

Old R/E [Retained Earnings]+ NI [Net Income] - New R/E[Retained Earnings]

OIROI (Profitability Ratio)

Operating Income (or EBIT) / Total Assets *Describes relationship between operating profit (EBIT) and the company's total asset base. *Tells how much pre-tax, pre-financing profit the company generates per dollar of assets

Book Value - Assets

Original Purchase Price - Accumulated Depreciation

PP&E

Property, Plant & Equipment

Total Asset Turnover II

ROE / (Net Margin x Leverage Multiplier)

Leverage Multiplier II

ROE / (Net Margin x Total Asset Turnover)

Leverage Multiplier Note

ROE = NI/S x S/A x (L/E + 1)

ROE Dupont Equation

ROE = Net Profit Margin x Total Asset Turnover x Leverage Multiplier

Return on Invested Capital (ROIC)

ROIC = NOPAT / (Costly Capital) • NOPAT = EBIT - Taxes • Costly Capital = All interest bearing debt + Total Equity *The advantage of ROIC is that it measures the return regardless of whether the company's financing comes from debt or equity.

Cost of Goods Sold/Cost of Services

Represents direct costs (direct materials and direct labor) associated with the production process.

Completed Contract Method

Revenue earned/booked when contract is completed.

Matching Principle

Revenues recognized and expenses incurred to generate those revenues must be reported together.

Gross Profit

Sales - COGS

Fixed Asset Turnover

Sales / Gross Fixed Assets *Holdings determined by the industry in which it operates

Total Asset Turnover

Sales / Total Assets *Current assets determined by management

Total Asset Turnover I

Sales / Total Assets *Measure for amount of bang for the buck the firm sells

Seasonal Firms

Those that have high sales during part of the year and low sales in another part of year

Progress Measurement

To measure progress and achieve goals.

Debt Ratio

Total Debt [Total Liabilities] / Total Assets • lower debt ratios better

Total Assets

Total of Current and Fixed Assets

Cash Tax Payments

Total tax payments from the Income Statement

Cash-Based System

Tracking cash in and cash out of business. Easy to understand but inaccurate.

Principle Agent Problem

When management chooses to enrich itself rather than shareholders, when the agent (worker or manager) doesn't act in the best interest of the principle (owner).

Optimal Debt Ratio

Will minimize the cost of financing and thus maximize company value.