Chapter 2 - Understanding Financial Statements and Cash Flow

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

The true value of any asset is its market value, which is simply the amount of cash we would get if we actually sold it. In contrast, the values shown on the balance sheet for the firm's assets are book values and generally are not what the assets are actually worth. Managers and investors will frequently be interested in knowing the market value of the firm.

What does operating cash flow refer to?

Operating cash flow is cash generated from a firm's normal business activities.

What does cash flow to stockholders refer to?

Dividends paid out by a firm less net new equity raised.

What does liquidity refer to?

Liquidity refers to the speed and ease with which an asset can be converted to cash. Liquidity really has two dimensions: ease of conversion versus loss of value.

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 (as a percentage of assets), the greater is its degree of financial leverage. Financial leverage increases the potential reward to shareholders, but it also increases the potential for financial distress and business value.

What does cash flow to creditors refer to?

A firm's interest payments to creditors less net new borrowing.

Explain the GAAP Matching Principle.

An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. The general rule (the recognition principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.

What are the considerations of time and costs in an income statement?

The future has two distinct parts: the short run and the long run. These are not precise time periods. the distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on. If our time horizon is relatively short, however, some costs are effectively fixed (they must be paid no matter what). Other costs, are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas.

What is the income statement?

The income statement measures performance over some period of time, usually a quarter or a year.

What does cash flow from assets refer to?

The total of cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and change in net working capital.

What is the consideration of earnings management in a income statement?

The way that firms are required by GAAP to report financial results is intended to be objective and precise. In reality, there is plenty of wiggle room, and, as a result, companies have significant discretion over their reported earnings. For example, corporations frequently like to show investors that they have steadily growing earnings. To do this, they might take steps to overstate or understate earnings at various times to smooth out dips and surges. With the increasing globalization of business, accounting standards need to be more alike across countries. In recent years, U.S. accounting standards have increasingly become more closely tied to International Financial Reporting Standards (IFRS).

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

By cash flow, we simply mean the difference between the number of dollars that came in and the number that went out. Cash flow identity reflects the fact that a firm generates cash through its various activities, and that cash is either is used to pay creditors or else is paid out to the owners of the firm (Cash flow from assets = Cash flow to creditors + Cash flow to stockholders).

What is the difference between an marginal and an average tax rate?

In making financial decisions, it is frequently important to distinguish between average and marginal tax rates. Your average tax rate is your tax bill divided by your taxable income, in other words, the percentage of your income that goes to pay taxes. Your marginal tax rate is the extra tax you would pay if you earned one more dollar.

What are noncash items?

Noncash items are expenses charged against revenues that do not directly affect cash flow, such as depreciation. This is the primary reason that accounting income differs from cash flow because an income statement contains noncash items.

What is the balance sheet?

The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm's equity) at a given point in time.

What is the net working capital?

The difference between a firm's current assets and its current liabilities is called net working capital. Net working capital is positive when current assets exceed current liabilities. Based on the definitions of current assets and current liabilities, this means that the cash that will become available over the next 12 months exceeds the cash that must be paid over that same period.