Chapter 2 (Finance)

ROE =

(net income / sales) x )sales / total assets) x ( total assets / book value of equity )

Can a firm with positive net income run out of cash?

-A firm can hav expositive net income but still run out of cash -for example, to expand its current production, a profitable company may spend more on investment activities than it generates form operating activities and financing activities. Net cash flow for that period would be negative, although its net income is positive. -it could also run out of cash if it sends a lot on financing activities, perhaps by paying off maturing long term debt, repurchasing shares, or paying dividends

We use the following guidelines to adjust four changes in working capital:

1. accounts receivable: when a sale is recorded as part of net income, but the cash has not yet been received from the customer, we must adjust the cash flows by deducting the increase in accounts receivable. This increase represents additional elating by the firm to its customers, and its educes the cash available to the firm 2. accounts payable: conversely, we add increases in accounts payable. Accounts payable represents borrowing by the firm from its suppliers. This borrowing increases the cash available to the firm 3. inventory: next, we deduct increases to inventory. increases to inventory are not recorded as an expense and do not contribute to net income. However, the cost of increasing inventory is a cash expense for the firm and must be deducted 4. other:finally, we deduct the increase in any other current assets net of liabilities excluding cash and debt

Current assets category includes:

1. cash and other marketable securities, which are short term, two risk investments that can be easily sold and converted to cash 2. accounts receivable, which are amounts owed to the firm by customers who ahve purchased goods to services on credit 3. inventories, which are composed of raw materials as well as work in progress and finished goods 4. other current assets, which is a catch all category that includes items such as prepaid expenses

Investors often uses accounting statements to evaluate a firm in one of two ways:

1. comer the firm with itself by analyzing how the firm has changed over time 2. compare the firm to other similar firms using a common set of financial rations

As a benchmark, creditors often look for an EBIT / interest coverage ratio in excess of

5x for high wealthy borrowers. When EBIT / interstate's falls below 1.5, lenders may begin to question a company's ability to repay its debts

The ROE provides a measure of the return that the firm has earned on its past investments.

A high ROE may indicate the firm is able to find investment opportunities that are very profitable.

While differences in net profit margins can be due to differences in efficiency, they can also result from

differences in leverage, which determines the amount of interest expense, as well as, differences in accounting assumptions

firms disclose the potential for dilution by reporting

diluted EPS, which represents earnings per share for the company calculated as though, for example, in the money stock options or other sock based compensation and been exercised or dilutive convertible debt had been converted

Growth is the number of shares is referred to as

dilution

Net income represents the total earnings of the firm's equity holders. It is often reported on a per share basis as the firm's

earnings per share, which we compute by dividing net income by the total number of shares outstanding

The income statement or statement of financial performance lists the

firm's revenues and expenses over a period of time

While leverage increases the risk to the firm's equity holders,

firms may also hold cash reserves in order to reduce risk. Thus, another useful measure to consider is the firm's net debt or debt in excess of its cash reserves

To mitigate the compliance burden on small firms, the Dodd-Frank Wall Street reform and consumer protection act passed in 2010 exempts

firms with less than 75 million in publicly held shares from the SOX section 404 requirements

gross margin =

gross profit / sales

The operating margin reveals

how much a company earns before interest and taxes from each dollar of sales

The assets on the left side show

how the firm uses it capital (its investments), and the right side summarizes the source of capital or how the firm raises the money it needs

Equity multiplier,

indicates the value of assets held per dollar of shareholder equity. The greater the firm's reliance on debt financing, the higher the equity multiplier will be

Financial statements are important tools through which investors, financial analysts, and other interested outside parties obtain

information about a corporation. They are also useful for managers within the firm as a source of information for corporate financial decisions

Lenders often asses a firm's ability to meet its interest obligations by comparing its earnings with its interest expenses using an

interest coverage ratio. One common ratio to consider is the firm's EBIT as a multiple of its interest expenses. A high ratio indicates that the firm is earning much more than is necessary to meet its required interest payments

The ROA calculation includes

interest expense in the numerator because the assets in the denominator ahve been funded by both debt and equity investors

inventory days =

inventory / average daily cost of sales

A warehouse fire destroyed 7 million worth of uninsured inventory

inventory would decrease by 7 million, as would the book value of equity

One of the great advantages of the corporate organizational form is that

it places no restrictions on who can won shares in the corporation

A higher current or quick ratio implies

less risk of the firm experiencing a cash shortfall in the near future

Assets =

liabilities + stockholders' equity

The assets on the left and the

liabilities on the right

Long term liabilities are

liabilities that extend beyond one year. We describe the main types as follows: 1. long term debt is any loan or debt obligation with a mautririty of more than a year. When a firm needs to raise funds to purchase an assert or make an investment, it may borrow those funds through a long term loan 2. capital leases are long term lease contracts that obligate the firm to make regular lease payments in exchange of ruse of an asset. they allow a firm to gain use of an asset by leasing it from the asset's owner. For example, a firm may lease a building to serve as its corporate headquarters 3. deferred taxes are taxes that are owed but have not yet been paid. firms generally keep two sets of finical statements: one for financial reporting and one for tax purposes. Occasionally, the rules for the two types of statements differ. deferred tax liabilities generally arise when the firm's financial income exceeds its income for tax purposes. because erred taxes will eventually be paid, the appear as a liability on the balance sheet

global used 4 million in cash and 7 million in new long term debt to purchase a 11 million building

long term assets would increase by 11 million, cash would decrease by 4 million and long term liabilities would increase by 7 million. there would be no change to the book value of equity

A final measure of leverage is a firm's equity multiplier, measured in

look value terms as total assets / book value of equity. This measure captures the amplification of the firm's accounting returns that results from leverage. The market value equity multiplier, which is generally measured as enterprise value / market value of equity, indicates the amplifications of shareholders' financial risk the results from leverage

Price earning ration (P/E) =

market capitalization / net income = share price / earning per share

enterprise value =

market value of equity + debt - cash

market to book ratio =

market value of equity / book value of equity

The income statement provides a

measure of the firm's profit over a given time period. However, it does not indicate the amount of cash the firm has generated. There are two reasons that net income does not correspond to cash earned. First there are non-cash entires on the income statement, such as depreciation and amortization. Second, certain uses of cash, such as the purchase of a building or expenditures on inventory, are not reported on the income statemnt

Asset turnover

measures how efficiently the firm is utilizing its assets to generate sales

Net profit margin,

measures its overall profitability.

debt to enterprise value ratio =

net debt / market value of equity + net debt = net debt / enterprise value

retained earnings =

net income - dividends

return on equity =

net income / book value of equity

Net profit margin =

net income / sales

The last or bottom line of the income statement shows the firm's

net income, which is a measure of its profitability during the period. The income statement is sometimes called a profit and loss, or P&L statement and the net income is also referred to as the firm's earnings

EPS=

net income/ shares outstanding

The first category of long term asserts is

net property, plant, and equipment. These include assets such as real estate or machinery that produce tangible benefits for more than one year.

The differences between current assets and current liabilities Is the firm's

net working capital, the capital available in the short term to run the business

To evaluate the speed at which a company turns sales into cash, firm soften computer the

number of accounts receivable days-that is the number of days' worth of sales accounts receivable represents

The liabilities show the firm's

obligations to creditors. Also shown with liabilities on the right side of the Balance sheet is the stockholder's equity

These statement of cash flows is divided into three sections:

operating activities, investment activities and financing activities.

operating margin =

operating income / sales

ROIC is the most useful in assessing the

performance of the underlying business

The management discussion and analysis is a

preface to the financial statements in which the company's management discusses the recent year, providing a background on the company and any significant events that may have occurred

Every public company is required to

produce four financial statements: the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders' equity. These statements provide investors and creditors with an overview of the firm's financial performance

stockholders use the statements to assess the firm's

profitability and ability to make future dividend payments

Key financial ratios measure the firm's

profitability, liquidity, working capita, interest coverage, leverage, valuations and operating returns

A more stringent test of the firm's liquidity is the

quick ratio, which compares only cash and near cash assets, such as short term invents and accounts receivable to current liabilities

The P/E ratio is the

ratio of the value of equity to the firm's earnings, either on a Toal basis or on a per share basis

The gross margin of a firm is the

ration fo gross profit to revenues

The difference between the price paid for the company and the book value assigned to its tangible assets is

recorded separately as goodwill and intangible assets

The change in stockholders' equity can be computed as

retained earnings

Change in stockholders' equity =

retained earnings + net sales of stock = net income - dividends + sales of stock = repurchases of stock

The difference between a firm's net income and the amount it spends on dividends is referred to as the firm's

retained earnings for that year

Investors are concerned with the

risk inherent in return provided by their investments

market value of equity=

shares outstanding x market price per share

The higher turnover corresponds to

shorter days and thus a more efficient use of working capital

Stock ownership is most investors'

sole tie to the company

The statement of stockholders' equity breaks down the

stockholders' equity computed on the balance sheet into the amount that came from issuing shares versus retained earnings

all of these liquidity ratios are limited in

that they only cosigner the firm's current assets

DuPoint Identity expresses

the ROE in terms of the firm's profitability, asset efficiency and leverage

The return on invested capital measures

the after tax profit generated by the business itself, excluding any interest expenses and compares it to the capital raised from equity and debt holders that has already been deployed

If the firm assesses that the value of these intangible assets defined over time, it will reduce

the amount listed on the balance sheet by an amortization or impairment charge that captures the change in value of the acquired assets. Like depreciation, amortization is not an actual cash expense.

The most important element of a firm's financial statements are

the balance sheet, income statement and the statement of cash flows

Stockholders' equity

the difference between the firm's assets and liabilities, is an accounting measure of the firm's net worth

a firm's market capitalization measures the market value of the firm's equity, or the value that remains after the firm has paid its debt.

the enterprise value of a firm assess the value of the underlying business assets, unencumbered by debt and separate from any cash and marketable securities

Leverage

the extent to which it relies on debt as a source of financing

The income statement shows

the flow of revenues and expenses generated by those assets and liabilities between two dates

the net profit margins shows

the fraction of each dollar in revenues that is available to equity holders after the firm pay interest and taxes

the firm's statement of cash flows utilizes

the information from the income statement and balance sheet to determine how much cash the firm has generated, and how that cash has been allocated, during a set period

the market value of equity is often referred to as the company's market capitalization.

the market value of a stock does not depend on the historical cost of the firm's assets; instead, it depends on what investors expect those assets to produce in the future

The total market value of a firm's equity equals

the number of shares outstanding times the firm's market price per share

profitability ratio is the operating margin

the ratio of operating income to revenues

The market to book ratio for most successful firms substantially exceeds 1, indicating that

the value of the firm's assets when put to use exceeds their historical cost. Variations in this ratio reflect differences in fundamental firm characteristics as well as the value added by management

One way firms evaluate their performance and communicate information to investors is through

their financial statements

Firms must also send an annual report with

their financial statements to their shareholders each year

Operating expenses

these are expenses from ordinary course of running the business that are not directly related to producing the goods or services being sold. They include administrative expenses and overhead, salaries, marketing costs, and research and development expenses. The third type of operating expense, depreciation and amortization, is not an actual cash expense but represents an estimate od the costs that arise form wear and tear or obsolescence of the firm's assets. The firm's gross profit net of operating expense is called operating income

The final line of the statement of cash flows combines that cash flows from

these three activities to calculate the overall change in the firm's cash valance over the period of the statement

A key competitor announces a radical new pricing policy that will drastically undercut global's prices

this event would not affect the balance sheet

An assets's accumulated depreciation is the

total amount deducted over its life. The firm reduces the value of fixed assets over time according to a depreciation schedule that depends on the asset's life span. Depreciation is not an actual cash expense that the firm pays; it is a way of recognizing that buildings and equipment wear out and thus become less valuable the older they get

net debt =

total debt - cash and short term investments

debt equity ratio =

total debt / total equity

debt to capital ratio =

total debt / total equity + total debt

The sum of the current liabilities and long term liabilities is

total liabilities. The difference between the firm's assets and liabilities is the stockholders' equity, it is also called the book value of equity.

Managers use financial statement to look at

trends in their own business and to compare their own results with that of competitors

analysts often classify firms with low market to book ratios as

value stocks and those with high market to book ratios as growth stocks

By comparing operating or EBIt margins across firms within an industry,

we can assess the relative efficiency of the firm's operations

creditors often compare a firms current assets and current liabilities to assess

whether the firm has sufficient working capital to meet its short term needs

management is also required to disclose any off balance sheet transactions,

which are transactions or arrangements that can have a material impact on the firm's future performance yet do not appear on the balance sheet

Enron's record as the largest bankruptcy of all time lasted only until July 21, 2002, when World Com

which at its peak had a market capitalization of 120 billion, filed for bankruptcy

The book value of an asset

which is the value shown in the firm's financial statements, is equal to its acquisition cost less accumulated depreciation. Net property, plant and equipment shows the book value of these assets

The first two lines of the income statement list the revenues from sales of products and the costs incurred to make and sell the products

Cost of sales shows costs directly related to producing the goods or services being sold, such as manufacturing costs. Other costs such as administrative expenses, research and development and interest expenses are not included in the cost of sales. The third line is gross profit, which is the difference between sales revenues and the costs

Return on Invested Capital =

EBIT (1- tax rate) / book value of equity + net debt

EBITDA =

EBIT + Depreciation and Amortization

EBIT margin =

EBIT / sales

Because equipment tends to wear out and become obsolete over time,

Global will reduce the value recorded for this equipment each year by deducting a depreciation expense.

Return on Assets =

Net income + interest expense / book value of assets

Financial analysts gather information, analyze it, and make recommendations.

They read financial statements to determine a firm's value and project future earnings, so that they can provide guidance to businesses and individuals to help them with their investment decisions

Global's engineers discover a new manufacturing process that will cut the cost of its flagship product by over 50%

This event would not affect the balance sheet

Current assets are either

cash or assets that could be converted into cash within one year.

The statement of cash flows shows the

cash used from operating, investing and financing activities

The assets list the

cash, inventory, property, plant and equipment and other investments the company has made

Corporations are required to hire a neutral third party, known as an auditor to

check the annual financial statements to ensure that the annual financial statements are reliable and prepared according to GAAP

debt equity ratio is a

common ratio used to assess a firm's leverage

Fenerally Accepted Accounting Principles provide

common set of rules and a standard format for public companies to use when they prepare their reports. This standardization also makes it easier to compare the financial results of different firms

Firms issue financial statements regularly to

communicate financial information to the investment community

Analysts often evaluate the firm's return on investment by

comparing its income to its investment using ratios such as the firm's return on equity

Depreciation is deducted when

computing net income, but it is not an actual cash outflow

current ratio =

current assets/ Current liabilities

Liabilities that will be satisfied within one year are known as

current liabilities. They include the following: 1. accounts payable, the amounts owed to suppliers for products or services purchased with credit. 2. short term debt or notes payable and current maturities of long term debt, which are all repayments of debt that will occur within the next year 3. items such as. salary or taxes that are owed but have not yet been paid, and deferred or unearned revenue, which is revenue that has been received for products that have not yet been delivered

Calculate the fraction of the firm financed by debt in terms of

debt to capital ratio

Purchases of new property, plant and equipment are referred to as

capital expenditures

Risker firms have lower P/E ratios

Because the P/E ratios considers the value of the firm's equity, it is sensitive to the firm's choice of leverage. The P/E ratio is therefore of limited usefulness when comparing firms with markedly different leverage

Global used 16 million of its available cash to repay 16 million of its long term debt

Long term liabilities would decrease by 16 million, and cash would decrease by the same amount. The book value of equity would be unchanged

ROA has the benefit that it is less sensitive to leverage than

ROE. However, it is sensitive to working capital

The balance sheet or statement of financial portion lists the firm's

assets and liabilities, providing a snapshot of the firm's financial position at a given point in time.

In an attempt to improve the reliability of financial reporting and corporate governance, Congress passed the

Sarbanes-Oxley Act (SOX) in 2002. While SOX continues many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and shareholders. SOX attempted to achieve this goal in three ways: 1) by overhauling incentives and the independence in the auditing process, 2) by stiffening penalties for providing false information, and 3) by forcing companies to validate their internal financial control processes

The four required financial statements are the

balance sheet, the income statement, the statement of cash flows, and the statement of stockholders' equity

Convertible bonds

a form of debt that can be converted to shares

Firms with low net working capital may face

a shortage of funds unless they generates sufficient cash from their ongoing activities

Executives with stock options that give the holder the right to

buy a certain number of shares by a specific date at a specific price

firms often gauge their cash position by

calculating the cash ratio, which is themes stringent liquidity ratio: cash ratio = cash / current liabilities

a firm's gross margin reflects its

ability to sell a product for more than the cost of producing it

Financial statements are

accounting reports with past performance information that a firm issues periodically

Enron was the most well known of the

accounting scandals of the early 2000s

Accounts payable days =

accounts payable/average daily cost of sales

accounts receivable days =

accounts receivable / average daily sales

A large customer owing 2 million for products it already received declared bankruptcy, leaving no possibility that global would ever receive paymet

accounts receivable would decreased by 2 million, as would the book value of equity

Ideally, the balance sheet would provide us with an

accurate assessment of the true value of the firm's equity. Unfortunately, this is unlikely to be the case. First, many off the assets listed on the balance sheet are valued based on their historical cost rather than their true value today. A second, and probably more important, problem is the many of the firm's valuable assets are not captured on the balance sheet

Operating activity starts with net income from the income statement. It then adjusts this number by

adding back all non-cash entries related to the firm's operating activities. The next section, investment activity, lists the cash used for investment. The third section, financing activity shows the flow of cash between the firm and its investors

turnover ratios are an

alternative way to measure working captial

inventory turnover =

annual cost of sales / inventory

accounts receivable turnover =

annual sales / accounts receivable and accounts payable turnover = annual cot of sales / accounts payable

The P/E ratio is a simple measure that is used to

asses whether a stock is over or under valued based on the idea that the value of a stock should be proportional to the level of earnings it can generate for its shareholders. P/E ratios can vary widely across industries and tend to eb highest for industries with high expected growth rates

Bondholders use the firm's financial statements to

assess the ability of the company to make its debt payments