Chapter 2 conceptual questions

2.4c Why is interest paid not a component of operating cash flow?

To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don't want to include depreciation because its not a cash outflow, and WE DON'T WANT TO INCLUDE INTEREST BECAUSE IT'S A FINANCIAL EXPENSE.

2.2b What are the three things to keep in mind when looking at an income statement?

When looking at an income statement, the financial manager needs to keep three things in mind: GAAP, cash versus noncash items, and time and costs.

2.2c Why is accounting income not the same as cash flow? Give two reasons.

An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. For example, if we manufacture a product and then sell it on credit, the revenue is realized at the time of sale. The production and other costs associated with the sale of the product will likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some different time. A primary reason that accounting income differs from cash flow is that an income statement contains noncash items.

2.1a What is the balance sheet identity?

Assets = Liabilities + Shareholders' equity

2.4a What is the cash flow identity? Explain what it says.

Cash flow from Assets = Cash flow to Creditors + Cash flow to Stockholders It says that the cash flow from the firm's assets is equal to the cash flow paid to suppliers of capital to the firm. What it reflects is the fact that a firm generates cash through its various activities, and that cash is either used to pay creditors or paid out to the owners of the firm.

2.1b What is liquidity? Why is it important?

Liquidity refers to the speed and ease with which an asset can be converted to cash. The more liquid a business is, the less likely it is to experience financial distress (that is, difficulty in paying debts or buying needed assets).

2.4b What are the components of operating cash flow?

Operating cash flow refers to the cash flow that results from the firm's day-to-day activities of producing and selling. Operating cash flow = Earning before interest and taxes + Depreciation - Taxes

2.2a What is the income statement equation?

Revenues - Expenses = Income

2.1d Explain the difference between accounting value and market value. Which is more important to the financial manager? Why?

The difference between market value and book value is important for understanding the impact of reported gains and losses. However, a change in accounting rules all by itself has no effect on what the assets is question are really worth. Instead, the market value of an asset depends on things like risk and cash flows, neither of which have anything to do with accounting. For financial managers, the accounting value of the stock is not an especially concern; it is the market value that matters. Hence whether we speak of the value of an asset or the value of the firm, we will normally mean its market value.

2.1c What do we mean by financial leverage?

The use of debt in a firm's capital structure is called financial leverage. The more debt a firm has the greater is its degree of financial leverage.