Finc 332 Chap 2
asset mgmt, or turnover, measures / ratios
- help describe how efficiently a firm uses its assets to generate sales 1. inventory turnover 2. days' sales in inventory 3. receivables turnover 4. days' sales in receivables 5. total asset turnover
profitability measures
-measure how efficiently the firm uses its assets and how efficiently the firm manages its operations -focus on net income 1. profit margin 2. return on assets 3. return on equity
ST solvency, or liquidity, ratios
-measure how quickly we can meet ST goals -provide info about firm's liquidity 1. current ratio 2. quick / asset-test ratio 3. cash ratio
2.8: Could a company's change in NWC be negative in a given year? Explain how this might come about. What about net capital spending?
NWC = current assets - current liabilities cash flow for the firm = OCF - net capital spending - change in NWC 1. yes, it can be negative if beg NWC is bigger than end NWC --> if this is the case, cash flow for firm would incr. -can be negative when liabilities > assets -for example, if a co. were to become more efficient in inventory mgmt, the amt of inventory needed would decline 2. net capital spending can be negative (ex: if sell equipment so end bal is less than beg bal) -neg. net capital spending would mean more long lived assets were liquidated than purchased
Cash Flow of the Firm (equation 1)
-Cash flow of the firm = cash flows from assets [CF(A)] Equation 1 --> CF(A) = Operating cash flow (OCF) - capital spending - [change in net working capital (NWC)] Operating cash flow (OCF) = Earnings before interest and taxes (EBIT) + depreciation - current taxes --> Captures cash flow generated from a company's general business activities --> Problematic if OCF is negative for long periods of time
Balance Sheet Review (cont.)
-Equity (also known as stockholders' equity, shareholders' equity, owners' equity) --> Preferred stock (if applicable) --> Common stock --> Retained earnings -Characteristics of debt versus equity 1. income from debt is tax deductible 2. shareholder income not tax deductible
Income Statement Review
-Reflects a period of time -Income statement categories: --> EBITDA - earnings before interest, taxes, depreciation, and amortization --> EBIT - earnings before interest and taxes --> EBT - earnings before taxes; also known as taxable income or pretax income --> Taxes - based upon marginal rate --> Net income - also called profit or earnings
Balance Sheet Review
-Reflects point in time -Items are recorded at book value - why does book value and market value differ -Basic accounting equation: Assets = Liabilities + Equity -Liquidity of assets determines if they are current or long-term -Required time to pay determines if liabilities are current or long-term (if expected to covert to cash withtin a year, then current)
LT solvency measures / ratios
-address firm's LT ability to meet its obligations or financial leverage 1. total debt ratio 2. debt-equity ratio 3. equity multiplier (1+ DE ratio) 4. times interest earned ratio 5. cash coverage ratio
2.1: What does liquidity measure? Explain the trade off a firm faces between high liquidity and low liquidity levels.
-liquidity measures how easily an asset is converted to cash w/o loss of value -desirable for firms to have high liquidity bc they can more safely meet ST creditor demands BUT firms reap higher returns by investing in illiquid assets -the more liquid a business is, the less likely it is to experience financial distress but liquid assets are less profitable to hold
market value measures
-look at market price per share of stock -how much investors are willing to pay per dollar of current earnings 1. price earnings ratio 2. price sales ratio 3. market to book ratio 4. enterprise value 5. EBITDA value
Cash Flow of the Firm (cont.) equation 2
Equation 2 --> CF(A) = CF(B) + CF(S) --> CF(A) = Cash flow to creditors + cash flow to stockholders --> Cash flow to creditors = interest paid - net new borrowing --> Cash flow to stockholders = dividends paid - net new equity raised --> Cash flow from assets can be negative for a growing firm
2.4: In comparing accounting net income and operating cash flow, what two items do you find in NI that are not in operating cash flow? Explain what each is and why it is excluded in operating cash flow.
OCF = EBIT + Depreciation - taxes 1. depreciation: noncash deduction 2. interest expense: financing (not operating) cost
Accounting Statement of Cash Flows
Operating activities: core business activities, such as manufacturing, distributing, marketing and selling a product or service. These activities should provide the majority of a company's cash flow Investing activities: purchases/ sales of assets, loans made to suppliers or received from customers, dividends received, etc Financing activities: deals with LT debt, accounts for external activities that allow a firm to raise capital and repay investors, such as issuing cash dividends, adding or changing loans or issuing more stock
Sources and Uses of Cash
Source of cash -Increase of a liability (or equity) -Decrease of an asset (other than cash itself) Use of cash -Increase of an asset (other than cash itself) -Decrease of a liability (or equity)
2.9: could a company's cash flow to stockholders be negative in a given year? explain how this might come about. what about cash flow to creditors?
if a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative -can be negative when equity > dividends if co. borrows more than it pays in interest, its cash flow to creditors will be negative -can be negative when change in LT debt > interest paid
Cash Flow of the Firm (cont.)
Capital spending = Ending net fixed assets - beginning net fixed assets + depreciation --> Captures changes in "long-term" capital Net working capital (NWC) = current assets - current liabilities --> Captures changes in "short-term" capital -->Change in net working capital = Ending net working capital-beginning net working capital --> Increases in NWC are often a result of a company's growth