Finance Chapter 2
cash flow
-the difference between the number of dollars that came in and the number of dollars that went out. -Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements
what is a flat-rate tax? what happens to marginal tax rate and average tax rate, with a flat-rate tax?
-there is only one tax rate, so the rate is the same for all income levels. - they are the same
What are the three financial statements
1.Balance Sheet 2.Income Statement 3. Cash Flow
How are assets clarified as?
As either current or fixed.
cash flow equation
Cash Flow = Net Income+ Depreciation
Cash flow to stockholders
Cash flow to stockholders = Dividends paid - Net new equally raised
What are the two dimensions of liquidity
Ease of Conversion versus Loss of value
Under Generally Accepted Accounting Principles (GAAP), audited financial statements in the U.S. mostly show assets at what cost?
Historical cost
Income Statement Equation
Income= Revenue- Expenses
How are liabilities listed?
Liabilities are listed at face value.
Liquid Firms ( business)
Liquid firms are less likely to experience financial distress
What is a question companies face?
Question companies face is the idea of cash management
in addition to investing in fixed assets, a firm will?
also invest in current assets
Taxes
can be one of the largest cash outflows a firm experiences
operating cash flow
cash generated from a firms normal business activities
as the firm changes its investments in current assets, its?
current liabilities will usually change as well
Net capital spending
is just money spent on fixed assets less money received from the sale of fixed assets.
Bond and bondholders refer to?
long-term debt and long-term creditors
Who is frequently interested in knowing the value of the firm?
managers and investors
capital spending
refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets)
cash flow to creditors and stockholders
represent the net payments to creditors and owners during the year.
equity holders are entitled to?
residual value, the portion left after creditors are paid
Shareholders' equity equation what is shareholders equity defined as?
shareholders' equity= assets-liabilities - defined as this residual portion
to determine the change in networking capital
take the difference between the beginning and ending net working capital figures.
A firms Equity
the difference between a firms assets and liabilities Equity is the ownership interest in the firm. T
the difference between market value and book value is important for understanding ?
the impact of reported gains or losses.
How is a balance sheet constructed ?
The left side lists the assets of the firm, and the right lists the liabilities and equity (or ownership) components of the firm.
according to the originators of the current tax rules how many corporate tax rates are there? do any more arise?
there are only four corporate tax rates. 15%,25% 34% and 35% 38% and 39% arise because of "surcharges" added on to the 34 and 35 percents rates
where are fixed values listed? It is a direct result of what?
they are listed at the bottom because they generally are not very liquid. -These are a direct result of management's investment decisions. (Please emphasize that "investment decisions" are not limited to investments in financial assets.)
Why is a balance sheet important to a potential creditor ?
would examine the liquidity and degree of financial leverage.
What is retained earnings a part of ? when does it happen?
*Retained earnings is part of Owners' Equity* -- Retained Earnings happens after the first year
what is the tax code? what does it determine?
-an often amended set of rules - it determines the size of the companies tax bill
How are assets listed?
Assets are listed in order of decreasing liquidity -Ease of conversion to cash -Without significant loss of value
Cash flow Identity
Cash flow from assets= cash flow to creditors(bondholders) + cash flow to stockholders. -how the cash flow from the firm is divided among the investors who financed the assets. Cash Flow From Assets = Operating Cash Flow - Net Capital Spending - Changes in NWC (= operating cash flow (operating income=earnings before interest and taxes + depreciation - taxes paid throughout the year) - Net capital spending (changes between the beginning and ending of invested in fixed long term assets) - changes in NWC (ending NWC- beginning NWC; find it by current assets - current liabilities))) -is the cash flow that the firm receives from its assets. This is an important equation to remember. We will come back to it and use it again when we do our capital budgeting analysis. We want to base our decisions on the timing and risk of the cash flows we expect to receive from a project
What is the current life of an liability? meaning? where are current liabilities listed? what are example of current liabilities ?
-less than one year - meaning the liability will be paid within the year. - current liabilities are listed before long-term liabilities Current liabilities= accounts payable (buying things on credit), notes payable (short term loans), etc.
When is Net Working Capital Positive? What type of firm is usually positive?
-positive when current assets exceed current liabilities -Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out -Usually positive in a healthy firm
Cash flow to creditors
Cash flow to creditors= interest expense( payment to debt holders) - Net new borrowing (When long term debt increases you are getting more money from investors. When you issue more debt you are getting more money.)
What is the most liquid and least liquid assets?
The current assets are more "liquid" (how fast/easy convert to cash). - listed first Inventory is the least liquid/the hardest to convert to cash of the current assets.
What does the market value of equity depend on?
The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the market's estimation of the current value of ALL of the assets of the firm.
why might the book value and market value for current assets be similar?
because current assets are bought and converted into cash over a relatively short spam of time.
expenses shown on the income statement are based on
the matching principle
cash flow from assets
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
The market value of an asset depends on?
things like riskiness and cash flow, neither of which have anything to do with accounting.
What are a firms Assets ? Show examples of assets
-What a firm owns - Ex: cash and accounts receivable
Cash flow to creditors is sometimes called
cash flow to bondholders
What do you do if you want The Net Working Capital to be positive?
-You want this number to be positive (high liquidity); Simply, they have more cash.
what is free cash flow? refers to?
-another name for cash flow from assets - refers to cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments
why do we need cash?
Because people finance us and we need it to pay those who do (shareholders/bondholders)
Rate of return
Rate of return= income generated + how much it changes in value (price)
change in net working capital
is measured as the net change in current assets relative to current liabilities for the period being examined and represents the amount spent on net working capital
What are liabilities classified as?
either current or long-term
In the long run, all business costs are ?
variable
can net capital spending be negative? when would this happen? what does the "net" refer to?
yes, would happen if the firm sold off more assets than it purchased. the net refers to purchases of fixed assets, net of any sales of fixed assets.
publicly traded companies
-Publicly traded companies must file regular reports with the Securities and Exchange Commission -These reports are usually filed electronically and can be searched at the SEC public site called EDGAR
What do the structures of the assets of a particular firm reflect?
The line of business the firm is in and also managerial decisions about how much cash and inventory to have and about credit policy, fixed asset acquisition and so on.
what is corporate taxation based on?
a modified flat-tax rate, that becomes a true flat tax rater for highest incomes.
why do we need to learn how to separate cash flows from noncash accounting entries
for the financial manager, the actual timing of cash inflows and outflows is critical in coming up with a reasonable estimate of market value, so we need to learn how to seperate them.
Net income
is often expressed on a per-share basis and called earnings per share. (EPS)
Illiquid asset
is one that cannot be quickly converted to cash without a substantial price reduction.
For the balance sheet, all the numbers are what? meaning?
- book value -the amount paid when you purchased assets.
The balance Sheet
- financial statement showing a firms accounting value on a particular date. -The balance sheet is a snapshot of the firm's assets and liabilities at a given point in time. -It is a convenient way of organizing and summarizing a firms assets, liabilities and ( the firms equity)
period costs
-are incurred during a particular time period and might be reported as selling, general, and administrative expense. -may be fixed and others may be variables
The balance sheet provides what value of the assets, liabilities, and equity?
-provides the book value -Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities, and equity of the firm.
Liquidity
-refers to the speed and ease with which an asset can be converted to cash. -Ability to convert to cash quickly without a significant loss in value - liquidity is valuable -Rate of return is key
Shareholders' equity ( common equity or Owners' equity) What is this intended to reflect on the balance sheet?
-the difference between the total value of its assets ( current and fixed) and the total value of its liabilities ( current and long-term) - reflect the fact that if firms were to sell all its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders.
Financial leverage. how does it work?
-the use of debt in a firms capital structure. -the more debt a firm has ( as a percentage of assets) , the greater the degree of financial leverage. - debt acts like a lever in the sense that using it can greatly magnify both gains and losses.
What are the three main things to keep in mind when examining a balance sheet?
1. Liquidity 2. Debt versus equity 3. Market value versus book value
Depreciation
Depreciation= Non-cash expense. Fixed assets are being depreciated
Why is a balance sheet important to a supplier?
might look at the size of accounts payable to see how promptly the firm pays its bills
Straight- line
the depreciation deduction is the same every year
How does the balance sheet balance?
the left side always equals the value of the right side. assets= liabilities + shareholders equity
what is the Matching principle ? what does it lead to?
- first determine revenues as described previously, and then match those revenues with the costs associated with producing them. - GAAP says to show revenue when it accrues and match the expenses required to generate the revenue -this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.
Shareholders benefit from? and bear the loss of? Which leads managers to?
-Shareholders are the ones that benefit from increases in the market value of a firm's assets. --They are also the ones that bear the losses of a decrease in market value. -Consequently, managers need to consider the impact of their decisions on the market value of assets, not on their book value
What is Income Statement ?
-financial statement summarizing a firms performance over a period of time. -The income statement is more like a video of the firm's operations for a specified period of time.
product costs
-include such things as raw materials, direct labor expense, and manufacturing overhead. -these are reported on the income statement ad costs of goods sold, but they include both fixed and variable costs.
Financial leverage increases what?
-increases the potential reward for stockholders - it also increases the potential for financial distress and business failure
What is a fixed asset? Is it liquid? What can it be?
-is one that has a relatively long life. -relatively liquid -Fixed assets can be either tangible (ex: truck of computer) - used in the business to generate cash. or intangible ( trademark or patten) - have no physical existence but can be valuable
A primary reason that accounting income differs from cash flow ? what is the most important?
-is that an income statement contains noncash -depreciation
What is the current life of an asset? meaning ?
-less than one year - meaning the asset will convert to cash within 12 months.
What are a firms Liabilities ? examples?
-what a firm owes -the first thing listed on the right side of the balance sheet. -Ex: accounts payable
When looking at an income statement, what three things must a financial manager keep in mind?
1. GAAP 2. cash versus noncash items 3. time and costs
written down to zero
the asset is assumed to have no value at the end of five years ( or the period years)
Liquid assets
Any asset can be converted to cash quickly is the price is cut enough But liquid assets typically earn a lower return Trade-off to find balance between liquid and illiquid assets --> the advantages of liquidity and forgone potential profits
Balance sheet identity (equation)
Assets = liabilities + shareholder equity
What are assets listed as on a balance sheet? and why are total assets not a good estimate of the worth of assets?
Assets are listed at historical costs less accumulated depreciation - this may bear little resemblance to what they could actually be sold for today. The balance sheet also does not include the value of many important assets, such as human capital. Consequently, the "Total Assets" line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth.
do average or marginal tax rates ever go down?
the average tax rate never goes down. marginal tax does go down.
what does the top half of the income statement address? what does the bottom deal with?
Consider discussing that the top half of the income statement addresses investment decisions, whereas the bottom half deals with financing
Generally Accepted Accounting Principles (GAAP)
the common set of standards and procedures by which audited financial statements are prepared.
The Liabilities side of the balance sheet reflects?
Managerial decisions about capital structure and the use of short-term debt.
Marginal vs. average tax rates exam question
Marginal tax rate - the percentage paid on the next dollar earned. specifically looking into long term investments Average tax rate - the tax bill / taxable income ( the percentage of your income that goes to pay taxes) Average tax rates vary widely across different companies and industries It is important to point out that we are concerned with the taxes that we will pay if a decision is made. Consequently, the marginal tax rate is what we should use in our analysis.
What value is important to financial managers?
Market Value.
What is Market Value
Market value is the price at which the assets, liabilities, or equity can actually be bought or sold.
Which is more important to the decision-making process?
Market values are generally more important for the decision making process because they are more reflective of the cash flows that would occur today.
Net Working Capital
Net Working Capital = Current Assets - Current Liabilities - the difference between current assets and liabilities
To the extent that a firm borrows money, it usually gives first claim to the firm's cash flow to who?
the creditors
What does shareholders equity consist of? What belongs to shareholders equity?
Remember that shareholders' equity consists of several components and that total equity includes all of these components, not just the "common stock" item. In particular, remind students that retained earnings belong to the shareholders.
what is the best estimate of the market value?
The best estimate of the market value of the firm's assets is market value of liabilities + market value of equity.
What is the last item on an income statement?
the last item is net income.
What is the right side of the balance sheet a direct result of?
The right-hand side of the balance sheet is a direct result of management's financing decisions.
What does the right side indicate in a balance sheet? what portion of the equity can most easily fluctuate?
This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets - total liabilities. - The portion of equity that can most easily fluctuate to create this balance is retained earnings.
Why is cash important?
Value of purchasing power/buy things cheap--When there is a crisis, price goes down. It becomes cheap. When you have enough cash compared to your competitors, you are able to buy that product cheap. Gives you an advantage over your competitor. Increases your return. Helps you reduce your risks; timing-have to have a global outlook
Long term debt
What you put there to issue bonds. More than a year.
what happens to liabilities when interest rate changes?
When interest rates change or the risk of the firm changes, the value of those liabilities change in the market as well. This is especially true for longer-term liabilities.
What is the first thing reported on an income statement?
You generally report revenues first and then deduct any expenses for the period parts include, financing expenses such as interest paid. taxes are reported separately.
What is classified as a long term liability?
a debt that is not due in the coming year. ex: A loan the firm will pay off in five years is one such long-term debt.
the companies presidents salary is an example of ?
a period cost that is probably fixed, at least in the short run.
Noncash items
expenses charged against revenues that do not directly affect cash flow, such as depreciation
What is the one thing we can rely on with taxes
is that they are always changing
The general rule (the recognition or realization 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 reliably be determined. - usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.
Why is a balance sheet important to a manager?
managers within the firm can track things like the amount of cash and the amount of inventory the firm keeps on hand.
What does income statement measure?
measures performance over some period of time, usually a quarter or a year.
the fact that the balance sheet assets are listed at cost means that their is no..?
necessary connection between total assets shown and the value of the firm.
Are liquid assets profitable to hold?
no, generally liquid assets are less profitable to hold
Highly liquid Asset
one that can be quickly sold without significant loss of value
who is a balance sheet useful to?
potentially useful to many different parties.
