Ch3

Income Statements

A report summarizing a firm's revenues, expenses, and profits during a reporting period, generally a quarter or a year.

Explain in words the difference between net working capital and net operating working capital.

-Current liabilities include accts payable, accruals, and notes payable to the bank -Distinction between "free" liabilities (accruals and accts payable) and interest bearing notes payable (which incur interest expense the is included as a financing cost on the firm's income statement) -NOWC differs from NWC bc interest-bearing notes payable are subtracted from current liabilities

What are the two claims against assets

-liabilities (or money the company owes to others) -stockholders' equity

What are the long-term capital gains? Are they taxed like other income? Explain.

Capital gain that you hold on for more than a year that made profit. The tax rate on long-term capital gains is only 15%. Thus, if in 2013, you were in the 35% tax bracket, the short term capital gains you earned would be taxed just like ordinary income; but your long-term capital gains would only be taxed at 15%. The tax rate on long-term capital gains usually remains considerably lower than the tax rate on ordinary income.

Why do changes in retained earnings occur?

Changes occur in retained earnings because it depends on if the money is reinvested back into the business.

Current assets

Consists of assets that should be converted to cash within one year -cash and cash equivalents -accounts receivable -inventory

What are the two major categories assets are divided into? Explain.

Current assets Fixed (long-term) assets

Why is earnings per share (EPS) called "the bottom line"?

Denotes that of all items on the income statement, EPS is the one that is most important to stockholders

Can investors be confident that if the financial statements of different companies are accurate and are prepared in accordance with GAAP, that the data by one company will be comparable to the data provided by another?

Investors need to be cautious when they review financial statements. While following GAAP, managers still have a lot of discretion in deciding how and when to report certain transactions. -These differences make it difficult for investors to compare companies and gauge their true performance

What info does a balance sheet provide?

Left side- assets the company owns Right side- firm's liabilities and stockholders' equity, which are claims against the firm's assets

Differentiate btw S and C corporations

S Corporation is a small corporation that, under subchapter S of the Internal Revenue Code, elects to be taxed as a proprietorship or a partnership yet retains limited liability and other benefits of the corporate form of organization.

Explain this statement: Our tax rates are progressive

That is, the higher one's income, the larger the percentage paid in taxes.

Current liabilities

consist of claims that must be psi off within one year -accounts payable -accruals (total of accrued waged and accrued taxes -notes payable to banks and other short-term lenders that are due within one year

What is EBIT, or operating income?

Derived from the firm's regular core business (ex: producing and selling foods) -Earnings from operations before deducting interest and taxes, which are considered to be non-operating costs Operating Income (or EBIT)= Sales revenues- operating costs

Why is the annual report of great interest to investors?

The info contained in the annual report can be used to help forecast future earning and dividends

Net Operating Profit After Taxes (NOPAT)

The profit a company would generate if it had no debt and held only operating assets EBIT (1-T)

Retained Earnings

They represent the cumulative total of all earnings kept by the company during its life

How does EVA differ from accounting net income?

While accounting income takes into account the cost of debt (the company's interest expense), it does not deduct for the cost of equity capital. By contrast, EVA takes into account the total dollar cost of all capital which includes both the cost of debt and equity capital.

How is the order in which items are shown on the balance sheet determined?

-Assets are listed by the length of time before they will be converted to cash (inventories and accounts receivable) or used by the firm (fixed assets) -Claims are listed in the order in which they must be paid: accounts payable must generally be paid within a few days, accruals must also be paid promptly, notes payable to banks must be paid within one year, and so forth, down to SE accounts, which rep ownership and need never be "paid off"

Why might different companies account for similar transactions in different ways?

-May stem from legitimate differences of opinion about the correct way to record transactions -Other cases, managers may choose to report numbers in a manner that helps them present either higher or more stable earnings over time -These differences make it difficult for investors to compare companies and gauge their true performances

Identify and briefly explain the four sections in the statement of cash flows

1. Operating Activities -net income -depreciation and amortization -inc in inventories -inc in accts receivable -inc in accts payable -inc in accrued wages and taxes -net cash provided by (used in) operating activities 2. Long-term investing activities -additions to property, plant, and equipment -net cash used in investing activities 3. Financing Activities -inc in notes payable -inc in bonds -payment of dividends to stockholders -net cash provided by financing activities 4. Summard -net decr in cash (net sum of 1, II, and III) -cash and equivalents at the beginning of the year -cash and equivalents at the end of the year

Progressive

A tax system where the tax rate is higher on higher incomes. The personal income tax in the US, which ranges from 0% on the lowest incomes to 39% on the highest incomes, is progressive.

What is EBITDA?

Earnings before interest, taxes, depreciation, and amortization

Explain why this statement is true: The retained earnings account reported on the balance sheet does not represent cash and is not "available" for dividend payments or anything else.

Even though a company reports record earnings and shows an increase in retained earnings, it still may be short of cash if it is using its available cash to purchase current and fixed asserts to support growth. (Ex: you own a BMW and many clothes, but if you had only $.23 in your pocket plus $5 in your checking account, you will still be short of cash)

Economic Value Added (EVA)

Excess of NOPAT over capital costs EVA= NOPAT - annual dollar cost of capital = EBIT(1-T) - (total invested capital X after-tax percentage cost of capital)

How does our tax system influence the use of debt financing by corporations?

If a firm uses debt, it must pay interest, whereas if it uses stock, it is expected to pay dividends. Interest paid can be deducted from operating income to obtain taxable income, but dividends paid cannot be deducted. The fact that interest is a deductible expense has a profound effect on the way businesses are financed- the corporate tax system favors debt financing over equity financing.

Long-term debt

Includes bonds that mature in more than a year

Stockholders' equity

It represents the amount that stockholders paid the company when shares were purchased and the amount of earnings the company has retained since the organization: Stockholders' equity= paid-in capital+ Retained Earnings Can be thought of as a residual: SE= Total Assets- Total Liabilities

If during the year a company has high cash flows from its operations, does that mean that cash on its balance sheet will be higher at the end of the year than it was at the beginning of the year? Explain.

Not really because they could have a loss of cash from investing activities that help to increase the profits of the firm.

What is the logic behind allowing tax loss carry-backs/carry- forwards?

Ordinary corporate operating losses can be carried backward for 2 years and carried forward for 20 years to offset taxable income in a given year. The purpose of permitting the loss treatment is to avoid penalizing corporations whose incomes fluctuate substantially from year to year.

What is free cash flow (FCF)?

The amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows. FCF= (EBIT(1-T) + Depreciation & amortization) - (capital expenditures + trianlgeshape Net operating working capital) capital expenditures (the cash used to purchase new fixed assets) can be found under the investment activities on the Statement of Cash Flows

Market Value Added (MVA)

The excess of the market value of equity over its book value MVA is the difference btw the market value of a firm's equity and the book value as shown on the balance sheet, with market value found by multiplying the stock price by the number of shares outstanding

Capital Gain or Loss

The profit (loss) from the sale of a capital asset for more (less) than its purchase price -capital gain- buy a capital asset and later sell it for more than you paid, you earn a profit -capital loss- when you suffer a loss

Explain in words the difference between total debt and total liabilities

Total debt includes both short-term and long-term interest bearing liabilities TD= Short term debt + long term debt Total liabilities equal total debt plus the company's "free" (non-interest bearing) liabilities TL= TD + (Accounts payable + accruals)

What's the difference btw marginal and average tax rates?

marginal is the tax rate applicable to the last unit of a person's income average is taxes paid divided by taxable income

Which is more like a snapshot of the firm's operations- the balance sheet or the income statement? Explain your answer.

the income statement, because it shows what the firms operating income is and what their expenses are compared to what they are bringing in.

What two types of information does an annual report provide?

1. a verbal section, often presented as a letter from the chairperson, which describes the firm's operating results during the past year and discusses new development that will affect the future operations. It attempts to explain why things turned out the way they did and what might happen in the future. 2. The report provides four basic financial statements. So the quantitative material is what has actually happened to its assets, earnings, and dividends over the past few years.

What 4 financial statements are typically included in the annual report?

1. balance sheet- shows what assets the company owns and who has claims on those assets of a given date 2. income statement- shows the firm's sales and costs (thus profits) during some past period 3. statement of cash flows- shows how much cash the firm began the year with, how much it has ended up with, and what it did to incr/decr its cash 4. statement of stockholder's equity- shows the amount of equity stockholders had at the start of the year, the items that incr or decr equity, and the equity at the end of the year

Amortization

A noncash charge similar to depreciation except that is represents a decline in value of intangible assets (patents, copyrights, trademarks, and goodwill)

Why is FCF an important determinate of a firm's value?

A positive level of FCF indicates that the firm is generating more than enough cash to finance current investments in fixed assets and working capital. A negative free cash flow means that the company does not have sufficient internal funds to finance investments in fixed assets and working capital, and that it will have to raise new money in the capital markets in order to pay these investments.

Annual report

A report issued annually by a corporation to its stockholders. It contains basic financial statements as well as management's analysis of the firm's past operations and future prospects.

What is a statement of cash flows, and what are some questions it answers?

A report that shows who items that affect the balance sheet and income statement affect the firm's cash flows -How much cash the firm is generating

What is the balance sheet?

A statement of a firm's financial position at a specific point in time.

What information does the statement of stockholders' equity provide?

A statement that shows by how much a firm's equity changed during the year and why this change occurred.

What's the AMT, and what's it's purpose?

Alternative Minimum Tax- people must calculate their tax under the "regular" system and then under the AMT system, where many deductions are added back into income and then taxed at a special AMT rate.

Long-term (fixed) assets

Assets expected to be used for more than one year; they include plant and equipment in addition to intellectual property such as patents & copyrights. -plant and equipment is generally reported net of accumulated depreciation -Allied's long-term assets consist entirely of net plant and equipment and often refer to them as "net fixed assets"

Net Working Capital

Current assets minus current liabilities NWC= CA-CL

Net Operating Working Capital (NOWC)

Current assets minus non-interest-bearnig current liabilities NOWC= Currents assets- (current liabilities - notes payable)

Working Capital

Current assets, which are often called working capital because these assets "turn over"; that is they are used and then replaced throughout the year.

Depreciation

The charge to reflect the cost of assets depleted in the production process. Depreciation is not a cash outlay. (tangible assets)