finance test 1

Wholesale and Retail Markets

Primary Market -Wholesale market where firms' new securities are issued and sold for the first time Secondary Market -Retail market where previously issued securities are resold (traded

Amortization

Amortization expense is related to using intangible assets -Goodwill -Patents -Licenses Like depreciation, amortization is a non-cash expense

Agency Conflicts

An agency relationship exists between stockholders (principals) and the firm's hired management (agents) Ownership and Control -In large corporations, shared ownership among many shareholders may result in relatively little control over management -Shareholders own the corporation, but managers control the firm's assets and may use them for their own benefit

Current Assets

Assets likely to be converted to cash within a year (or one operating cycle) -Marketable securities -Accounts receivable -Inventory

Sarbanes-Oxley and Regulatory Reform

Better corporate governance reduces agency costs by requiring -More effective monitoring of managers' activities -Programs that promote appropriate behavior by managers -Penalties for executives who do not fulfill their fiduciary responsibilities

Federal Income Tax

Corporate Income Tax -The U.S. has a progressive tax with rates ranging from 15% to 39% -The higher the taxable income, the higher the tax liability Average vs. Marginal Tax Rate -Average Tax Rate is total taxes paid, divided by taxable income for the period -Marginal Tax Rate is the rate paid on the last dollar earned or the next dollar that will be earned

Agency Costs

Costs that arise from incurring and preventing conflicts of interest between a firm's owners and its managers These costs may reduce positive residual cash flow, stock price, and shareholder wealth Reduce agency costs by -Increased oversight -Align incentives Giving agents the right incentives to reduce agency costs -Managers tend to focus on wealth maximization when their compensation depends on stock price

Efficiency Ratios

Efficiency ratios indicate a firm's ability to use assets to produce sales. These are also called turnover ratios. In general, higher numbers are a favorable indicator. For Days Sales in Inventory, however, a lower number is favorable.

Financial Institutions and Their Services

Financial Institutions: -Provide lending and borrowing opportunities at the retail level for small customers and wholesale level for large customers -Efficiently collect funds in small amounts and lend them in larger amounts -Tailor loan amounts and contract terms to fit the needs of consumers, corporations, and small businesses

The Purpose of Financial Statements

Financial Statements provide stakeholders with a foundation for evaluating the financial health of a firm. Stakeholders include: Employees Management Stockholders Regulators Suppliers General Public Customers Creditors Evaluate a firm's internal environment -Efficiency, effectiveness, and risk level Evaluate a firm's interaction with the external environment -Corporate citizenship -Social responsibility -Assessment of the external environment -Response to the external environment Provide information about the performance of the firm -Stakeholders want to compare actual vs. potential performance

Coverage Ratios

For the following ratios, a higher number generally indicates less bankruptcy risk and (possibly) lower potential return

The Income Statement

Income Statement: Overview Measures the profitability of a firm for a reporting period Revenue is income from selling products and services - for cash or credit Expenses include costs of providing products and services, and asset utilization (depreciation and amortization)

Forms of Business Organization

Sole proprietorships Partnerships Corporations

Leverage Ratios

Leverage ratios indicate whether a firm is using the appropriate amount of debt financing. In general, higher ratios indicate greater potential return and greater bankruptcy risk.

Long-Term Liabilities

Long-term debt -Bank loans -Mortgages -Bonds with maturity longer than one year

Sole Proprietorship

Owned by a single person who is financially responsible for the actions and obligations of the business Advantages -Easiest to create and control -Easiest to dissolve -Right to all profits Disadvantages -Owner's personal assets at risk due to unlimited liability for firm obligations -Equity only from owner or business profit -Business income taxes as personal income -Difficult to transfer ownership

Common-Size Balance Sheet

The Common-Size Balance Sheet standardizes the amount in a balance sheet account by converting the dollar value of each item to its percentage of total assets -Dollar values on a regular balance sheet provide information on the number of dollars associated with a balance sheet account -Percentage values on a common-size balance sheet provide information on the relative size or importance of the dollars associated with a balance sheet account

Agency Relationship

-An agency relationship is created when the owner (a principal) of a business hires an employee (an agent) -The owner surrenders some control over the enterprise and its resources to the employee -Separating ownership from control creates the potential for agency conflicts

Equity

Common Stock -Ownership with control in a firm Preferred Stock -Ownership without control in a firm -Features make it an equity security that resembles debt Retained earnings -Profit kept and used to acquire assets. Treasury stock -Shares of its own stock a firm holds rather than sell them to the public. -Why? --The firm doesn't pay dividends on those shares --More control over voting --Can buy when firm believes stock is undervalued

Common-Size Financial Statements

Common-size financial statements show the dollar amount of each item as a percentage of a reference value -Common-size balance sheet may use total assets as the reference value; each item is expressed as a percentage of total assets -Common-size income statement may use net sales as the reference value; each item is expressed as a percentage of net sales

Direct Financing

Direct transfer of funds -Lender-saver contracts with a borrower-spender -Minimum transaction $1 million -Investment banks and money center banks help with origination, underwriting and distribution of new debt and equity -Underwriting is a service to assist firms in selling their debt or equity securities in a direct financing market

Tax Treatment of Dividends & Interest

Dividends and interest are not equal -The U.S. tax code allows interest payments on debt to reduce firms' taxable income -The tax code does not allow dividend payments to equity to reduce firms' taxable income -Therefore debt financing has a lower cost relative to equity financing

EBITDA, EBIT, EBT, and NI

Earnings-before-interest-taxes-depreciation-and-amortization (EBITDA) -Income from selling goods and services minus the cost of providing them Earnings-before-interest-and-taxes (EBIT) -EBITDA minus depreciation and amortization Earnings-before-taxes (EBT) -EBIT minus interest expense -Taxable income Net income (NI) -EBT minus taxes

The Financial System

Financial markets and institutions -Financial markets include markets for trading financial assets such as stocks and bonds -Financial institutions include banks, credit unions, insurance companies, and finance companies The financial system at work -The financial system is competitive -Money is borrowed in small amounts and loaned in large amounts -The system directs money to the best investment opportunities in the economy -Lenders earn profit from the spread between lending and borrowing rates How Funds Flow through the Financial System -The primary function of a financial system is to efficiently transfer funds from lender-savers to borrower-spenders Basic mechanisms by which funds are transferred in the financial system -Directly through financial markets -Indirectly through financial institutions

Financial Statements & Accounting Principles

Generally Accepted Accounting Principles (GAAP) -Accounting rules and standards that public companies must adhere to when they prepare financial statements and reports -Established by the Financial Accounting Standards Board (FASB) and authorized by the Securities and Exchange Commission (SEC) GAAP are guidelines, not rules -Firms have discretion about how their financial information is presented -Alternative terms on financial statements --Balance Sheet, Statement of Financial Condition --Income Statement, Statement of Operations, Profit and Loss Statement --Cost-of Goods-Sold, Cost-of-Sales, Cost-of-Revenue, Cost-of-Services-Sold International GAAP -Uniform accounting rules and procedures promoted by the International Accounting Standards Board -Firms in the European Union are moving toward a "European GAAP" -Economic and political pressure is building in the United States and Europe to develop a unified accounting system

Financial Ratios and Firm Performance

Ratios used vary across firms -Occupancy ratios (hotel) -Sales-per-square foot (retailing) -Loans-to-assets (banking) -Medical cost ratio (health insurance) Ratio values vary within industries Example: 2013 Gross Margin

Depreciation

The cost of a physical asset such as plant or machinery is written off over its lifetime. This is called depreciation, which is a non-cash expense. Firms use one of these depreciation methods: -Straight-Line Depreciation -Accelerated Depreciation Firms may choose one method for internal purposes and another for tax purposes or for statements released to the public

Limitations of Financial Statement Analysis

Weaknesses of financial statement analysis -Is not an exact science -Relies on accounting data and historical costs -Few guidelines or principles for determining whether a ratio is "high" or "low", or is a reason for confidence or for concern

Three Fundamental Decisions in Financial Management

-Capital Budgeting: decide which long-term assets to acquire to maximize net benefits for the firm -Financing: decide how to pay for short-term and long-term assets by finding the best combination of short-term debt, long-term debt, and equity -Working Capital: decide how to manage short-term resources and obligations by adjusting current assets and current liabilities to promote growth in cash flow Poor decisions about capital budgeting, financing, or working capital may lead to bankruptcy or business failure

Efficient Market Hypothesis

-Current prices of securities incorporate the knowledge and expectations of all participants -Security prices are correct; securities are not over-valued or under-valued -Participants are confident they pay or receive the intrinsic (fair) value of a security -Operational Efficiency: extent to which transaction costs are minimized -Informational Efficiency: extent to which security prices reflect all relevant information Strong-Form Efficiency -Security prices reflect all information, both public and private -Even inside information is reflected in prices Semistrong-Form Efficiency -Security prices always reflect all public information -Inside, or confidential information, is not reflected in prices Weak-Form Efficiency -Security prices only reflect historical information

The DuPont System

-Diagnostic tool for evaluating a firm's financial health -Uses related ratios that link the balance sheet and income statement -Based on two equations that connect a firm's ROA and ROE -Used by management and shareholders to understand factors that drive ROE

Inflation and Loan Contracts

-Lenders want the interest rates in loan contracts to include compensation for the inflation predicted to occur over the life of the contract -Compensation for expected inflation adjusts loan rates to offset the higher prices for goods and services expected to exist when a loan is repaid and a lender spends the money

Categories of Common Financial Ratios

-Liquidity ratios -Efficiency ratios -Leverage ratios -Profitability ratios -Market Value ratios

Marketability and Liquidity

-Marketability: ease with which a seller or buyer for an asset can be found -Liquidity: ease with which an asset can be converted into cash without loss of value -Financial markets increase marketability and liquidity of securities -Financial markets lower the costs of making transactions and make participants more willing and able to pay higher prices

The Determinants of Interest Rate Levels

-The Real Rate of Interest -Loan Contracts and Inflation -The Fisher Equation and Inflation -Cyclical and Long-Term Trends in Interest Rates

Brokers and Dealers

A broker brings a seller and a buyer together but does not buy or sell in the transaction -The broker does not take on risk A dealer participates in trades as a buyer or seller using her own inventory of securities -The dealer takes on risk

Corporation

A business owned by more than one person; none of them financially responsible for the actions and obligations of the business. The corporation is responsible for its obligations and actions. Advantages -Protects personal assets -No shareholder liability for business -Easiest to change ownership -Greatest access to sources of funds Disadvantages -Most difficult and expensive to establish -Dilutes individual control over the firm -Overall higher taxes on income for shareholders

Partnership

A business owned by more than one person; one or more of them financially responsible for the actions and obligations of the business Advantages -Limited protection of owner's personal assets -Owner's limited liability for firm obligations -More sources of equity -More sources of expertise Disadvantages -Shared control -Shared profit harder to dissolve

Selecting a Benchmark

A ratio or ratio analysis is relevant only when compared to an appropriate benchmark -Trend Analysis - comparison to the firm's historical performance -Peer Group Analysis - comparison to a select group of firms in the same industry -Industry Analysis - comparison to the aggregate of firms in the same industry

Five Important Accounting Principles

Assumption of Arm's Length Transaction -Parties involved in an economic transaction arrive at a decision independently and rationally Cost Principle -Asset values are recorded at the cost for which they were acquired (and must be adjusted if they fall in value) -Investors want current prices and prefer a market value balance sheet (finance) versus a book value balance sheet (accounting) Realization Principle -Revenue is recognized when a transaction is completed, although cash may be received earlier or later Matching Principle -Revenue is matched with the expense incurred to generate the expense Going Concern Assumption -Assumption that a company will continue to operation for the predictable future

Exchanges & Over-the-Counter Markets

Exchange: location where sellers and buyers meet to conduct transactions -New York Stock Exchange (NYSE) -Chicago Board Options Exchange (CBOE) Over-the-Counter Market: dealers conduct transactions over the phone or via computer -National Association of Securities Dealers Automated Quotations (NASDAQ)

Financial Ratios and Firm Performance

Financial ratios establish a common reference point across firms, even though the numerical value of the reference point will differ from firm-to-firm -Ratios make it easier to compare the performance of large firms to that of small firms -Ratios make it easier to compare the current and historical performance of a single firm as the firm changes over time (trend analysis)

The Balance Sheet

Firm Assets -The left side of a Balance Sheet shows assets a firms owns and uses to generate revenue -Assets are listed in order of liquidity Sources of Funds -The right side of the Balance Sheet show sources of the funds used to acquire assets -Liabilities are listed in the order in which they are due to be paid -Stockholder's Equity is listed last --Common stockholders are entitled to assets remaining after all other providers of funds are paid

Extraordinary Item

Income or expense associated with events that are infrequent and abnormal -Separated from the results of ordinary income -Shown separately on the income statement

Indirect Financing

Institutions, such as banks and insurance companies, are both borrowers and savers -An institution borrows money from a saver, lends money to a borrower, and must repay funds to the saver - whether or not it is repaid by the borrower

Cyclical & Long-Term Interest Rate Levels

Interest rates tend to rise and fall with changes in the rate of inflation Rates tend to rise when the growth rate of the economy increases and tend to fall when the growth rate of the economy slows Interest Rate, Business Cycle & Inflation -Interest rates tend to follow the business cycle -Interest rates tend to increase during an economic expansion -Interest rates tend to decrease during an economic contraction

Inventory Accounting

Inventory is the least liquid current asset Inventory is reported using one of two methods: -FIFO (first-in-first-out) assumes merchandise is sold in the order it was acquired by the firm -LIFO (last-in-first-out) assumes merchandise is sold in the reverse of the order it was acquired by a firm When the cost of inventory is increasing FIFO reporting shows the firm sold the less expensive inventory, which leads to: -Higher balance in inventory -Lower cost-of-goods-sold -Higher taxable income, income taxes, and net income When the cost of inventory is increasing LIFO reporting shows the firm sold the more expensive inventory, which leads to: -Lower balance in inventory -Higher cost-of-goods sold -Lower taxable income, income taxes, and net income A majority of corporations value inventory using LIFO because it yield the lowest taxable income and therefore lower taxes Firms may switch from one inventory accounting method to the other under extraordinary circumstances but not frequently

Current Liabilities

Liabilities scheduled to be paid within a year (or one operating cycle) -Accounts payable -Accrued wages -Debt with less than a year's maturity -Taxes

Hybrid Forms of Business Organization

Limited Liability Partnerships (LLPs) Limited Liability Companies (LLCs) Both combine limited liability with tax advantages of a partnership

Liquidity Ratios

Liquidity ratios indicate a firm's ability to pay short-term obligations with short-term assets without endangering the firm. In general, higher ratios are a favorable indicator

Market Value Ratios

Market value ratios indicate how the market is valuing the firm's equity. Higher ratios indicate greater shareholder wealth.

The Role of the Financial Manager

Maximize Shareholder Wealth -Maximizing the price of a firm's stock will maximize the value of a firm and the wealth of its shareholders/owners Stakeholders -Managers, employees, suppliers, creditors, and the government It's All About Cash Flows -Positive residual cash flow may be paid to firm owners as dividends or invested in the firm -The larger the positive residual cash flow, the greater the value of a firm -Negative residual cash flow, over the long run, leads to bankruptcy or closing a business

Money and Capital Markets

Money Market: market for low-risk securities with maturities of less than one year -Treasury Bills (T-Bills) -Commercial Paper Capital Market: market for securities with maturities longer than one year -Bonds -Common stock

Cash Flows

Net Cash Flows vs. Net Income -Accountants focus on net income and shareholders focus on net cash flows. These are not the same because of delays in inflows and outflows, and non-cash revenues and expenses Cash Flows to Investors -Cash flows available to investors from operating activities (CFOA)

Managing the Financial Function

Organizational Structure -Chief Financial Officer (CFO), responsible for the quality of the financial reports received by the Chief Executive Officer (CEO) -Positions Reporting to the CFO --Treasurer --Risk Manager --Internal Auditor -External Auditor -Audit Committee -Compliance and Ethics Director

Background for Financial Statement Analysis

Perspectives for Analysis -Stockholders focus on net cash flows, risk, rate of return, and the market value of the firm's stock -Managers focus on rate of return, efficient use of assets, controlling costs, increasing net cash flows, increasing the market value of the firm's stock, and job security -Creditors focus on the predictability of revenues and expenses, the ability to meet short-term obligations, the ability to make loan payments as schedule, and avoidance of changes in risk

Types of Financial Markets

Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets

Profitability Ratios

Profitability ratios indicate whether a firm is generating adequate profit from its assets. In general, higher ratios indicate better performance.

Market Efficiency

Public markets, such as the NYSE, are more efficient than private markets due to the information provided by a large number of participants and effective regulation

Long-Term Assets

Real Assets -Land -Buildings -Equipment Intangible Assets -Goodwill -Patents -Copyrights Real assets decline with use and are depreciated -Depreciation expense reduces taxable income and income taxes. -Assets are depreciated using either the straight line or accelerated depreciation method. -IRS depreciation is different from GAAP (what is reported to investors?) -Don't forget about section 179 of IRS code election to expense -Depreciation is a non-cash expense. (it lowers our taxable income without actually writing a check) Intangible assets lose value over time and are amortized (equivalent to being depreciated)

Market Value vs. Book Value

Recording Asset Value -Assets are traditionally reported at historical cost on a balance sheet -Balance sheet amount does not reflect current market value, only the acquisition cost Asset Valuation -Better information is provided to management and investors by marking-to-market, reporting balance sheet items at current market values -Difficult to determine market values of assets -The difference between the market values of assets and liabilities is a realistic estimate of the market value of shareholders' equity

Statement of Retained Earnings

Retained earnings -Shows cumulative effect of adjustments to shareholders' equity resulting from profit, losses, and paying dividends -Shows changes in the account for a period based on profit, loss, or dividend paid

Statement of Cash Flows

Summarizes cash outflows and cash inflows during a period Cash flows result from operating activities, investing activities, and financing activities Net cash flows equals cash inflows minus cash outflows

Annual Report

Summarizes the overall performance of a firm for the most recent fiscal year Provides information on -The company, its products, its activities, and its future -Summary of financial performance for the most recent year -Audited financial statements, five-year summary of financial data

Equilibrium Rate of Interest

The equilibrium rate of interest is a function of supply and demand -Savers supply more funds at higher rates -Borrowers demand less at higher rates -Equilibrium is the rate at which the quantity of funds supplied equals the quantity of funds demanded

Interest Rates

The interest rate is the fee for borrowing money expressed as a percentage of a loan The real rate of interest -The interest rate that would exist in the absence of inflation/deflation -Determined by the expected return on productive assets and time preference for consumption The nominal rate of interest -The interest rate adjust for inflation/deflation

The Importance of Ethics in Business

What are Ethics? -Ethics are society's standards for judging whether an action is right or wrong -Business Ethics are society's standards for acceptable behavior applied to business and financial markets Examples of Ethical Conflict in Business Agency Cost -Employee's unacceptable use of employer's computer Conflict of Interest -Mortgage contract which a home-buyer is unlikely to fulfill but earns a mortgage broker more money- Information Asymmetry -Seller knows about prior damage to the vehicle but the potential buyer does not Business Behavior -Regulation and market forces are not enough to maintain integrity in the marketplace -Business norms must be based on ethical beliefs, customs, and practices Ethical Behavior -It is sometimes difficult to judge whether behavior is ethical or not -Was the manager too careful? -Did the manager take too much risk? Consequences of Unethical Behavior -Inefficiency in the economy and costs to society -High legal and social costs -Problems such as the recent financial crisis in the U.S.

The Goal of the Firm

Why not maximize market share? -Giving away goods or services for free will maximize a firm's market share for a while, but the firm will not be able to pay its bills and stay in business Why not maximize profits? -Accounting profit differs from economic profit -Profit earned may not equal cash received Maximize the value of the firm's stock -Future cash flows are considered -The timing of future cash flows is considered -The risks associated with having to wait to for cash flows are considered Can management decisions affect stock prices? Its All About Cash flow! -Positive residual cash flow may be paid to firm owners as dividends or invested in the firm -The larger the positive residual cash flow, the greater the value of a firm -Negative residual cash flow - over the long run - leads to bankruptcy or closing a business