FIN 330 Exam 1

Gross Profit Margin

Gross Profits/Sales how well the firms management controls its expenses to generate profits

Profitability Ratios

Has the firm earned adequate returns on its investments? - cost management and performance - cost control and efficiency - gross profit margin - operating profit margin - net profit margin - operating return on assets - return on equity

Asset Management Efficiency Ratios

How effective is management in running the company? Measures the firm's effectiveness in utilizing its assets to generate sales - total asset turnover - fixed asset turnover - receivables turnover - inventory turnover

Capital Structure Ratios

How has the firm financed the purchase if its assets? - debt ratio: capacity measure, how much debt is currently on the balance sheet - times interest earned ratio: coverage or service ratio, how well a firm can cover debt costs

Investing Activities

Includes cash transactions involving the purchase and sale of long-term assets and current investments cash flow that arise out of the purchase and sale of long-term assets such as plant and equipment

What statement reports the financial activity (performance) of a firm over time?

Income Statement

Which statement is also called the P&L statement?

Income Statement

Name the three basic financial statements

Income Statement Balance Sheet Cash Flow Statement

How are the common-size income statement and balance sheet constructed?

Income Statement divide each entry in the income statement by sales Balance Sheet divide each entry in the balance sheet by total assets

What are some common reasons for analyzing a firms financial statements?

Internal Management can assess - what is good/what is poor or bad Control Plan External Creditors - likelihood of repayment Investors - performance given investment - ROE is very important to investors

What is the agency issue in business and how can the problem be addressed?

Management are agents for a company's owners. With little or no 'skin in the game,' agents may act in their own interest rather than the owners' interest. The cost of decisions are borne by the owners while benefits (if there are any) are enjoyed by the agents. This is an agency cost. Examples include taking on riskier projects because if they pan out, management looks good. If they don't, stock prices go down. Management may buy expensive art for their office or not worry about how much flights cost for business travel or what hotels they stay in because the company pays. It's actually the owners who are paying. The market for management is one constraint on management's behavior because resumes should look good and show accomplishments when looking for another job. Another way is to tie management's compensation to stock performance through the use of deferred pay such as the use of options. These are agency costs because the agent should actually try to maximize value without having to have separate incentives to do so.

Why should management understand financial statements? What are the three primary ways management uses the information in financial statements?

Management needs to understand the information found in financial statements because that information is used for a. Assess performance b. Planning c. Monitor and control

Price-Earnings Ratio (PE)

Market Price per Share/Earnings per Share how much investors have been willing to pay for $1 of reported earnings

What is the goal of the financial manager? Where do we monitor results?

Maximize shareholder value/wealth. Common share prices

Return on Equity (ROE)

Net Income/Common Equity measures the accounting return on the common stockholders investment

Net Profit Margin

Net Income/Sales how much income is generated from each dollar of sales after adjusting for all expenses

Times Interest Earned Ratio

Net Operating Income (EBIT)/ Interest Expense coverage or service ratio, how well a firm can cover debt costs

Operating Profit Margin (OPM)

Net Operating Income (EBIT)/Sales how much profit is generated from each dollar of sales after accounting for both COGS and operating expenses

Operating Return on Assets (OROA)

Net Operating Income (EBIT)/Total Assets summary measure of operating profitability

Net Working Capital

Networking capital (NWC) = Current Assets-Current Liabilities firms ability to repay loans

Is it possible to evaluate change in sales from this statement?

No this is a statement of ratios so sales are always 100%. You must look to raw numbers to see whether sales went up and by how much.

If the Operating Profit Margin has gone down from one year to the next on a common-size income statement while the Gross Profit Margin has gone up what explains the difference?

Operating expenses go up COGS goes down

Why use ratios instead of raw numbers to analyze statements?

Ratios factor out size so that it is possible to make comparisons across time or against competitors

What does a single ratio by itself tell an analyst?

Ratios should not be examined in isolation. They must be compared to something in order to get any meaning from a ratio.

What accounts are impacted when a sale is made for credit?

Sales increase and Accounts receivable increase

Fixed Asset Turnover

Sales/Net Plant and Equipment firms efficiency in utilizing its fixed assets (PPE)

Total Asset Turnover

Sales/Total Assets amount of sales generated per dollar invested in the firms assets

Increase in accounts payable

Source of cash Financing

Increase in notes payable

Source of cash Financing

Average tax rates

The average tax rate is a rate that can be applied to taxable income to calculate tax expense

What is the goal of a firm?

The goal when making financial decisions is to maximize the value of the firm. This is the same as maximize shareholders' equity/wealth. Performance is measured through change in common stock price.

Marginal tax rates

The marginal tax rate is the rate applied to the next dollar of earnings

How are the ratios in the statement interpreted?

The statement expresses every item on the statement as a percent of sales. Where was revenue spent and what was left over from revenues after expenses. Three ratios come from the common size income statement - Gross Profit Margin (GPM), Operating Profit Margin (OPM) and Net Profit Margin (NPM) Looking at different statements over time allows users to see whether a firm is improving profit margins and if so how (what expenses have gone down) and if not then why not (what expenses have gone up).

Debt Ratio

Total Liabilities (debt)/Total Assets\ capacity measure, how much debt is currently on the balance sheet

Across time for one firm - what's this called?

Trend analysis - looking at how one firm has changed over time

Inventory Turnover

COGS/Inventories - how many times the company turns over its inventory during the year

Which statement is of particular importance to management because it is possible to determine the sources and uses of cash over a period of time?

Cash Flow Statement

Financing activities

Cash flow activities that include (a) obtaining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends. changes in the firms use of debt and equity such as issue of new shares, the repurchase of outstanding shares, and the payment of dividends

Operating Activities

Cash flow activities that include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income. represents companies core business, including sales and expenses

How are profits and cash flow different?

Cash flow is the amount of cash that can actually be taken out of the business Company's profits can differ dramatically from its cash flows, possibly for a company to report profits without generating any cash

Is an increase in accounts receivable a source of cash or a use of cash?

Use of cash used cash to buy asset

Is a decrease in accounts payable a source of cash or a use of cash?

Use of cash used cash to pay off loan

Increase in inventory

Use of cash Operating

Compare to benchmark - what's this called?

Cross sectional analysis - see how a firm compares to benchmarks or other firms in the same industry (its competitors)

Across time and benchmark

Cross sectional times series analysis

Current Ratio

Current Assets/Current Liabilities compares a firms current (liquid) assets to its current (short-term) liabilities number of times CAs can cover CL as they come due

What account on the Income Statement is a noncash charge that reduces taxable income?

Depreciation expense

What noncash charges are included on the Income Statement?

Depreciation expense

Negative Net Working Capital

When current liabilities exceed current assets bad position to repay debts on time and not very liquid

What is the source of value for any asset?

Expected future cash flows

Working Capital

Working capital are the current accounts on the Balance Sheet - Current Assets and Current Liabilities - these accounts are expected to be converted to cash within the year (assets) or paid within the year (liabilities)

How are ratios interpreted?

You can always interpret ratios as per unit of the denominator since the denominator is the input that is being adjusted for size. There are conventions for ratios though, for example, times interest earned is the number of times earnings generated from operations can cover interest expense.

What three questions are answered in the study of finance?

a. Capital Budgeting b. Capital Structure c. Working Capital Management

Quick Ratio (Acid-test Ratio)

(Current Assets - Inventory) / Current Liabilities excludes the inventory from current assets as inventory may not be very liquid more stringent; what if the least liquid assets are not consider when evaluating liquidity

Limitations to financial ratio analysis

1) It is sometimes difficult to identify industry categories or comparable peers. 2) The published peer group or industry averages are only approximations. 3) Industry averages may not provide a desirable target ratio. 4) Accounting practices differ widely among firms. 5) A high or low ratio does not automatically lead to a specific conclusion. 6) Seasons may bias the numbers in the financial statements. 7) Offer simply clues 8) The results of the analysis are no better than the quality of the statements

Who uses financial statements?

1. Investors: to check if it is beneficial to invest in the company 2. Lenders: to check if the company can give them back the money they lend to it 3. Suppliers: to check if the company can pay them for supplying it with goods/services 4. Employees: to check the current financial situation of the company to request raise in salary or to ensure that they will keep their job and the company is not going to shut down 5. Customers: to check that the company is going to continue its operations so that it can cover their needs 6. Government: to impose taxes 7. managers assess the financial condition of the firm monitor and control operations financial forecasting and planning

What are the five principles of finance?

1. Money has a time value 2. There is a risk-reward trade-off 3. Cash flows are the source of value 4. Market prices reflect information 5. Individuals respond to incentives

What are the three basic types of issues that arise in business that are addressed by the study of business finance?

1. What long-term investments should the firm undertake? 2. How should the firm raise money to fund these investments? 3. How can the firm best manage its cash flows as they arise in its day-to-day operations?

Partnership

A business in which two or more persons combine their assets and skills Partnerships are also relatively easy to form and profits are taxed at individual rates. Partners share in the profits. Sources of funding is expanded but is still more limited than the corporate form. Ownership is not easily transferred, and partners have unlimited liability no matter which partner incurred the liability. Limited partnerships take care of some of the liability issues.

Sole Proprietorship

A business is owned by one person and they raise money by investing their own funds and borrowing from a bank Sole proprietorship which is easy to form, the owner enjoys all profits and pays taxes as an individual. This form has limited access to funding, ownership is not easily transferred, and the owner has unlimited liability.

Corporation

A business owned by stockholders who share in its profits but are not personally responsible for its debts The corporate form is the hardest and most expensive to form, but ownership is easily transferred (particularly for publicly traded corporations). There is more access to capital, and owner's liability is limited to the amount invested. (They do not risk their personal assets beyond the value of their shares.) Dividends are double taxed - first as earnings at the corporation and then as income to the stockholder at the individual rate. Sole proprietors make up the largest number of businesses in the U.S., but corporations are the largest in size.

Source of Cash

A decrease of an asset (including cash) or an increase in a liability. brings cash into the firm decrease in an asset increase in a liability increase in owners equity

Income Statement

A financial statement showing the revenue and expenses for a fiscal period. Revenue-Expenses=Profits Revenue earned Expenses incurred Profit earned - Cost of Goods Sold = Gross Profit - Operating Expenses = Net Operating Income (EBIT) - Interest Expense = Earnings Before Taxes (EBT) - Income Taxes = Net Income

Balance Sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date. Total Assets=Total Liabilities+Total Shareholders Equity - Assets (everything of value the company owns) - Liabilities (the company debts) - Stockholders equity (the money invested by the company owners) (SE=total assets-total liabilities) - current assets - cash - accounts receivable - inventory - other - gross plant and equipment - accumulated depreciation - net plant and equipment - liabilities - stockholders equity and common - current liabilities - accounts payable - accrued expenses - short-term notes - long-term debt

time series analysis

A forecasting method that uses historical sales data to discover patterns in the firm's sales over time and generally involves trend, cycle, seasonal, and random factor analyses

Cash Flow Statement

A summary that shows total income and spending for a given time period change in cash balance=ending cash balance-beginning cash balance

Capital Structure

combinations of debt and equity on the balance sheet

Who are the true owners of a corporation?

common stockholders The investors have the right to elect the board of directors and share in the profits of the firm

Why is ethics relevant to the financial management of a firm?

consequences to being unethical end careers ties to long-term success and trust

What accounts are impacted when the sale is collected?

Accounts receivable decrease and cash increases

What account on the Balance Sheet reduces the value of assets?

Accumulated depreciation

Use of Cash

An increase of an asset (including cash) or the decrease of a liability. causes cash to leave the firm increase in an asset decrease in a liability decrease in owners equity

Accounts Receivable Turnover

Annual Credit Sales/Accounts Receivable - how many times receivables are rolled over during the year

What are the basic categories of assets and liabilities on a balance sheet

Assets: - cash - accounts receivable - inventory - other current assets Liabilities: - accounts payable - accrued expenses - short-term notes - long-term debt - stockholders equity

Individual account liquidity ratios Average collection period Days sales in inventory Accounts Receivable Turnover Inventory Turnover

Average Collection Period: - how long to collect credit sales (AR/average daily credit sales) - Average daily credit sales = Annual credit sales/365 Days sales in inventory: - Days sales in Inventory - how long to turn inventory into a sale = 365/Inventory Turnover Inventory Turnover: COGS/Inventories - how many times the company turns over its inventory during the year

What statement reports the financial position of a firm at a point in time?

Balance sheet

Content and purpose of the cash flow statement

daily operations of a firm How much did the firm generate from its operations? How much did the firm invest in plant and equipment? Did the firm raise additional funds, and if so, how much and from what sources?

Why are financial ratios helpful in analyzing financial statements?

gives meaning Financial ratios analysis is an invaluable tool in analyzing financial statements, evaluating business performance, and identifying company issues. With the financial ratios' analysis, the business evaluation will become much more manageable and easier to compare to competitors and industry average.

When an asset balance increases, this indicates that the firm has more of that asset, so why is this a use of cash?

its not increasing cash, you are using cash to gain the asset

What categories are explored using ratio analysis?

liquidity ratios capital structure ratios asset management efficiency ratios profitability ratios market value ratios

Market Value Ratios

market perceptions of performance how are the firms shares valued in the stock market? - Price-Earning Ratio

Zero Net Working Capital

pressure on management to manage receivables more efficiently perfect, very hard to do

Why do large and growing firms tend to choose the corporate form of an organization?

raise capital not personally tied to the business

What account on the Balance Sheet represents the total contribution (from day one of operations) from stockholders from earnings that weren't paid out in dividends?

retained earnings

Fill in the blanks. The higher the ___ the higher the ___.

risk, reward

What changes to accounts on the balance sheet are cash inflows/outflows?

spending/income

Liquidity ratios and what it attempts to measure

the ability to meet short-term obligations as they come due comparing the firm's current assets to the firms current liabilities - current ratio - acid test ratio

cross-sectional analysis

the comparison of different firms' financial ratios at the same point in time; involves comparing the firm's ratios to those of other firms in its industry or to industry averages

Liquidity

the ease with which an asset can be converted into cash

What is finance?

the study of how people and business evaluate investments and raise capital to fund them

Increase in accounts receivable

use of cash Operating

Increase in fixed assets

use of cash investing

Positive Net Working Capital

when current assets exceed current liabilities good position to pay its debts on time and is consequently very liquid