EZC1 - Principles of Finance/Master Study Set
Operating Expenses
All costs incurred through the company's operations that are not directly associated with the production process.
CFO Operations - Cash Flows
All flows related to producing and selling the firm's product - customer cash, raw materials, operating expenses, taxes. Methods of Calculation (2): 1. Indirect 2. Direct Start with net income, add back the non-cash expenses from the income statement and then adjust for changes in the operating accounts on the comparative balance sheet. For convenience, we repeat it in Table 2-3.
Retained Earnings (RE)
Money generated from the operations of the company that is plowed back (or retained) in the business. Represents funds that already have been reinvested in the existing assets of the firm. • Change in RE = Net Income - Dividends • New RE = Old RE + Change in RE • New RE = Old RE + Net Income - Dividends**
Balance Sheet (1)
Snapshot of the firm's assets and the financing of those assets at a given point in time ( "as of...") listing all assets, liabilities, and equity of the firm in the balance sheet equation.
EBIT (Earnings Before Interest & Taxes/Operating Profit/Operating Income)
Subtracting operating expenses from gross profit. EBIT = Sales - Operation Expense - COGS - Depreciation Expense [NOT INTEREST EXPENSE!] or Sales - COGS - Depreciation
Current Liabilities I
• A/P • Accruals (Obligations incurred in the current period but has not yet been paid) • Notes Payable (involve explicit interest-bearing lending arrangement with lending institution)
Current Assets I
• Cash • Marketable Securities (T-Bills, CD's) • A/R • Inventory (least liquid)
Equity
• Common Stock • Additional Paid-In Capital • Retained Earnings
Financing Ratios
• Debt Ratio • Times Interest Earned Ratio
Leverages to Pull
• Decrease costs, while holding sales constant (thus increasing NI) • Increase sales, while holding assets constant (thus increasing asset turnover) • Increase debt, while holding equity constant (we lever up) Third option most precarious!!
Statement of Cash Flows (3)
• Explains sources and uses of cash for a company - cash in and cash out for a company in a given year • Most transparent of three statements
Standard Forms - Advantages
• Facilitates Analysis • Clarifies Communication
Fixed Assets
• Gross Fixed Assets (less: Accumulated Depreciation = Net Fixed Assets) • Recorded on balance sheet at historical cost • Assets on balance sheet with a life span greater than one year
Accrual-Based Accounting
• It's revenue when the company "earns it" • Synchronizes the reporting process • Creates environment where a simplistic reading of the standard financial statements is almost always misleading
Depreciation Expense
• Non-cash expense affecting net income on the Income Statement • Created solely for taxation purposes • If not explicitly stated on the Income Statement, can be inferred from balance sheet; change in accumulated depreciation is equal to depreciation expense. **Formula--> Cost of Machine / Life of Machine
Profitability Ratios
• Return on Assets (ROA) • Return on Equity (ROE) • Gross Margin • Operating Margin • Net Margin
Ratio Analysis Advantages
• Standardize Financial Data • Flexibility • Leads to look-ins to right places to question • Evaluates whether the firm is achieving stated goal to maximize shareholder wealth • Evaluates management action to see if they are fully exploiting the firm's earning potential.
Gross Profit/Gross Income/Gross Loss
• Subtracting the cost of goods sold (or cost of services) from revenue • Sales Revenue - Cost of Goods Sold (COGS)
Efficiency Ratios
• Total Asset Turnover • Fixed Asset Turnover • OIROI (Profitability Ratio)
Comparison Methods In Ratio Analysis
• Trend Analysis • Cross Sectional Analysis • Progress Measurement
Quick Ratio/Acid Test Ratio
(Current Assets - Inventory) / Current Liabilities • More stringent test of liquidity as compared to Current Ratio • Since Inventory is the least liquid asset it is subtracted from current assets leaving - cash, marketable securities and A/R. ***Higher quick ratio better***
Cash Flows - Indirect Method
**For changes in Notes Payable, DO NOT adjust net income. Do we have the cash? yes(increase in cash asset)/no (decrease in cash asset)
Ratio Analysis
1) you cannot assess the firm's liquidity with only two ratios. 2) eBuy has a higher current ratio but a lower quick ratio when compared to the industry. 3) is not correct since the relationship between the current and quick ratio doesn't address the liquidity of accounts receivable. 4) is the most reasonable statement since a higher current ratio and lower quick ratio (as compared to the industry) indicates that eBuy has lots of inventory. The inventory build-up may be due to illiquid/non-salable inventory holdings. For eBuy, gross margin is 64.82% (= sales-COGS/sales = [2877-1012]/2877) and operating margin is 23.64% (= EBIT/Sales = 680/2877). If you take Gross Margin - Operating Margin, you get Operating Expense/Sales. For example, for Amazona 67.21-24.75 = 42.46%. This means that operating expenses at Amazona consume 42.46% of sales. For eBuy, this is only 41.18%. Hence, relative to sales, eBuy has lower operating expenses. eBuy's gross margin is lower than Amazona indicating that ebuy has higher cost of goods. Since, eBuy has lower gross and operating margin the data do not support the conclusion that eBuy is more profitable than Amazona.
Ratio Types (studied within text)
1. Liquidity 2. Asset Use Efficiency 3. Financing 4. Profitability
Comparative Balance Sheet
A balance sheet with two or more years of data.
Dividends in Arrears
A preferred stock characteristic where common stock dividends cannot be paid until the preferred dividends are paid.
Effective Yield
A rate that includes non-annual compounding = (1 + stated rate/m) - 1
Average Collection Period
AR / Daily Credit Sales ***If financial statements don't differentiate between cash/credit sales it is generally assumed it is a credit sale***
Liquidity
Ability of firm to meet its short-term (30-day debt) obligations • Current Ratio • Quick Ratio • Average Collection Period • A/R Turnover • Inventory Turnover
Addition to R/E (Retained Earnings)
Addition to R/E = New R/E - Old R/E
Contra-Asset Account
An allowance or reserve account against A/R created for questionable collectibles.
Long-Term Liabilities
As Stated
Leverage Multiplier
Assets / Equity *Measures how efficiently the firm is using its assets
Balance Sheet Equation
Assets = Liabilities + Owners' Equity
Agency Costs
Associated costs resulting from principle agency problem.
Cash Flow Groups
CFO - cash flows from operations CFI - cash flows from investing CFF - cash flows from financing Sum equals company's change in cash position from previous year
Inventory Turnover
COGS / Inventory ***Number of times inventory turns/sells per year***
CAPEX
Capital Expenditure (gross property, plant & equipment) changes from the two balance sheets
Cross Sectional Analysis
Compares firm's financial ratios with those of some peer group
A/R Turnover
Credit Sales / AR ***How long to collect on credit sales***
Operating Accounts on Balance Sheets
Current Assets & Current Liability Accounts (operating accounts facilitate company operations).
Current Ratio
Current Assets / Current Liabilities **Higher current ratios generally better (>1)**
Assets = Liabilities + Owners' Equity Formula
Current Assets Current Liabilities Cash A/P A/R N/P Inventory + + Fixed Assets Long-Term Debt PP&E less: AccDepr + = Owners' Equity Common Stock Retained Earnings = TOTAL ASSETS = TOTAL LIABILITIES + OWNERS' EQUITY
Depreciation
Depreciation form the Income Statement (or two balance sheets)
Income Statement (2)
Describes the revenues and expenses associated with a company's operations for a given period of time.
Free Cash Flow to Firm (FCFF)
EBIT - Cash Tax Payments + Depreciation - CAPEX - Increases in NWC
Free Cash Flow to the Firm (FCFF)
EBIT - Cash Tax Payments + Depreciation - CAPEX - Increases in NWC • Free cash flows used for valuations
Net Income
EBIT - Interest & Taxes ALSO NI = Dividends + Change in Retained Earnings
Times Interest Earned (TIE)
EBIT / Interest Expense *Compares company operating profit (EBIT) to interest expense.
Operating Margin
EBIT / Sales
EBIT = Interest Earned
EBIT = Interest Earned
NI (Net Income)
EBT - Tax Expense
EBT (Taxable Income/Earnings Before Taxes)
EBT = Sales - COGS - Depreciation Expense - Interest Expense
Tax Expense
EBT x Tax Rate
Equity = Owner's Equity
Equity = Owner's Equity
High Growth Firms
Fast growth carries data timing dilemma.
FIFO
First in First Out Inventory
Gross Margin
Gross Profit (or Sales - COGS) / Sales • Express as %
CFF Financing - Cash Flows
Includes any cash flows resulting from increased borrowing, debt repayment, stock issuance, stock repurchase or dividend payment. • Calculate CFF by comparing appropriate balance sheet accounts from one year to the next. • An increase in a financing account (ie. debt, notes payable, equity) signals a source of cash flowed into the company. • A decrease in financing account indicates that the company used cash to pay lenders or to buy back stock. Dividends = (Old RE + Net Income) - New RE * RE = Retained Earnings
Capital Gains
Increases in the value of stock
CFI Investing - Cash Flows
Involves any cash in or out of the company due to investment in or disposal of fixed assets. (assume for text investing is reflected in Gross PP&E account and that no assets are retired during the year.) **Net PP&E + Depreciation expense = Gross PP&E
Historical Cost Accounting
Items that appear on the financial statements are stated at their historical cost. • Disadvantages - future market value differs greatly from initial purchase price (i.e. land)
Current Assets II
Items that will generate cash within the next year.
LIFO (leads to higher COGS, lower earnings, lower ending inventory)
Last in First Out Inventory
Trend Analysis
Looks at firm's financial ratios over time
Return on Equity (ROE)
NI / Equity
Return on Assets (ROA)
NI / Total Assets *express as PERCENTAGE!!
NOPAT - After Tax Operating Profit
NOPAT = EBIT (1 - t)
Free Cash Flow to Equity Holders (FCFE)
Net Income + Depreciation - CAPEX - Increase in Net Working Capital (NWC) + Increase in Net Long-Term Debt
Indirect Method
Net Income + Non-Cash Expenses (from income statement) then adjust for changes in the operating accounts on the comparative balance sheet.
Net Margin (Net Profit Margin)
Net Income / Sales
Net Profit Margin
Net Income / Sales *Measures Firm's efficiency in controlling its costs
Fixed Assets II
Net PP&E
NWC
Net Working Capital (current assets - current liabilities) changes from the two balance sheets
Cash Flows - Direct Method
Not used in this text
Current Liabilities II
Obligations that will require cash within the next year.
Dividend
Old R/E [Retained Earnings]+ NI [Net Income] - New R/E[Retained Earnings]
OIROI (Profitability Ratio)
Operating Income (or EBIT) / Total Assets *Describes relationship between operating profit (EBIT) and the company's total asset base. *Tells how much pre-tax, pre-financing profit the company generates per dollar of assets
Book Value - Assets
Original Purchase Price - Accumulated Depreciation
PP&E
Property, Plant & Equipment
Total Asset Turnover II
ROE / (Net Margin x Leverage Multiplier)
Leverage Multiplier II
ROE / (Net Margin x Total Asset Turnover)
Leverage Multiplier Note
ROE = NI/S x S/A x (L/E + 1)
ROE Dupont Equation
ROE = Net Profit Margin x Total Asset Turnover x Leverage Multiplier
Return on Invested Capital (ROIC)
ROIC = NOPAT / (Costly Capital) • NOPAT = EBIT - Taxes • Costly Capital = All interest bearing debt + Total Equity *The advantage of ROIC is that it measures the return regardless of whether the company's financing comes from debt or equity.
Cost of Goods Sold/Cost of Services
Represents direct costs (direct materials and direct labor) associated with the production process.
Completed Contract Method
Revenue earned/booked when contract is completed.
Matching Principle
Revenues recognized and expenses incurred to generate those revenues must be reported together.
Gross Profit
Sales - COGS
Fixed Asset Turnover
Sales / Gross Fixed Assets *Holdings determined by the industry in which it operates
Total Asset Turnover
Sales / Total Assets *Current assets determined by management
Total Asset Turnover I
Sales / Total Assets *Measure for amount of bang for the buck the firm sells
Seasonal Firms
Those that have high sales during part of the year and low sales in another part of year
Progress Measurement
To measure progress and achieve goals.
Debt Ratio
Total Debt [Total Liabilities] / Total Assets • lower debt ratios better
Total Assets
Total of Current and Fixed Assets
Cash Tax Payments
Total tax payments from the Income Statement
Cash-Based System
Tracking cash in and cash out of business. Easy to understand but inaccurate.
Principle Agent Problem
When management chooses to enrich itself rather than shareholders, when the agent (worker or manager) doesn't act in the best interest of the principle (owner).
Optimal Debt Ratio
Will minimize the cost of financing and thus maximize company value.