Quiz 1 - Chapters 3 and 4

Dupont equation tells us the firms ROE is determined by 3 factors

(1) net profit margin, which measures the firm's operating efficiency and how it manages its interest expense and taxes; (2) total asset turnover, which measures the efficiency with which the firm's assets are utilized; and (3) the equity multiplier, which measures the firm's use of financial leverage.

guidelines for financial statement analysis

1. perspective: stockholder, manager, or creditor? 2. always use audited financial statements 3. use statements that cover 3-5 years to conduct analysis using a trend analysis 4. use benchmarks to compare with competitors

3 ways to establish a benchmark

1. trend analysis 2. industry analysis 3. peer group analysis

benchmark

A standard against which performance is measured

The Matching Principle

Accountants try to match revenue on the income statement with the expenses incurred to generate the revenue.

International GAAP

Accounting is often called the language of business. Just as there are different dialects within languages, there are different international "dialects" in accounting. US - GAAP International - IFRS

Amoritization Expense

Amortization is the process of writing off expenses for intangible assets—such as patents, licenses, copyrights, and trademarks—over their useful life.

Working capital

An increase in current assets (such as accounts receivable and inventory) is a use of cash.

long term liabilities and equity

An increase in long-term debt (bonds and private placement debt) or equity (common and preferred stock) is a source of cash. The retirement of debt or the purchase of treasury stock requires the firm to pay out cash, reducing its cash balances.

Fixed Assets

An increase in long-term fixed assets is a use of cash. If a company purchases fixed assets during the year, it decreases cash because it must use cash to pay for the purchase. If the firm sells a fixed asset during the year, the firm's cash position will increase.

Dividends

Any cash dividend payment decreases a firm's cash balance.

how are assets ordered on the balance sheet?

Assets are listed in order of their liquidity, with the most liquid assets, cash and marketable securities, at the top. The liquidity of an asset is defined by how quickly it can be converted into cash without loss of value. Thus, an asset's liquidity has two dimensions: (1) the speed and ease with which the asset can be sold and (2) whether the asset can be sold without loss of value.

cash flow to investors (CFI) equation

CFI=CFOA−CFNWC−CFLTA

cash flow invested in long-term assets (CFLTA) equation

CFLTA= Long-term assets current period− Long-term assets previous period

cash flow invested in net working capital (CFNWC) equation

CFNWC=NWCcurrent period− NWCprevious period

Cash flow to investors from operating activity (CFOA)

CFOA= EBIT− Current taxes+ Noncash expenses

non cash expenses

CFOA= EBIT− Current taxes+ Noncash expenses other noncash expenses: depletion charges, deferred taxes, expenses that were paid in cash in a previous period, revenues previously received as cash but not yet earned

financing activities

Cash flows from financing occur when cash is obtained from or repaid to creditors or owners (stockholders). Typical financing activities involve cash received from the issuance of common or preferred stock, as well as cash from bank loans, notes payable, and long-term debt. Cash payments of dividends to stockholders and cash purchases of treasury stock reduce a company's cash position.

long term investing activities

Cash flows from long-term investing activities relate to the buying and selling of long-term assets.

operating activities

Cash flows from operating activities in the statement of cash flows are the net cash flows that are related to a firm's principal business activities. The most important items are the firm's net income, depreciation and amortization expense, and working capital accounts

statement of returned earnings

Corporations often prepare a statement of retained earnings, which identifies the changes in the retained earnings account from one accounting period to the next. During any accounting period, two events can affect the retained earnings account balance: 1. When the firm reports net income or loss. 2. When the board of directors declares and pays a cash dividend.

Current Assets

Current assets are assets that can reasonably be expected to be converted into cash within one year.

current liabilities

Current liabilities are obligations payable within one year.

scaling

Dividing numbers by a common base to form a ratio is called scaling.

DuPont System

DuPont system of analysis is a diagnostic tool that uses financial ratios to evaluate a company's financial health. The process has three steps. First, management assesses the company's financial health using the DuPont ratios. Second, if any problems are identified, management corrects them. Finally, management monitors the firm's financial performance over time, looking for differences from ratios established as benchmarks by management.

FIFO (first in, first out)

FIFO method, when the firm makes a sale, it assumes the sale is from the oldest, lowest-cost inventory—first in, first out. Thus, during rising prices, firms using FIFO will have the lowest cost of goods sold, the highest net income, and the highest inventory value.

Limitations of Financial Statement Analysis

First, it depends on accounting data based on historical costs. Second, there is little theory to guide us in making judgments based on financial statement and ratio analysis.

Goodwill

Goodwill is a long term intangible asset that arises only when a firm purchases another firm. Conceptually, goodwill is a measure of how much the price paid for the acquired firm exceeds the sum of the values of acquired firm's individual assets. There are a variety of reasons why the purchase price of an asset might exceed its value to the seller. Goodwill may arise from improvements in efficiency, the reputation or brands associated with products or trademarks, or even a valuable client base for a particular service.

The Assumption of Arm's-Length Transactions

It assumes that the parties to a transaction are economically rational and are free to act independently of each other. In other words, all transactions are assumed to be "arm's-length transactions." The price you pay for something or the price for which you sell something is what gets recorded on the financial statements.

North American Industry Classification System (NAICS)

It was intended to refine and replace the older SIC codes, but it has been slow to catch on.

leverage ratios/long term solvency ratios

Leverage ratios measure the extent to which a firm uses debt rather than equity financing and indicate the firm's ability to meet its long-term financial obligations, such as interest payments on debt and lease payments. The ratios are also called long-term solvency ratios.

how are liabilities ordered on the balance sheet?

Liabilities on the balance sheet are listed based on their maturity, with the liabilities having the shortest maturities listed at the top. Maturity refers to the length of time remaining before the obligation must be paid.

liquid assets

Liquid assets have active secondary markets and can be sold quickly for cash without a loss of value.

Long term assets

Long-term (productive) assets are the assets that the firm uses to generate most of its income. Long-term assets may be tangible or intangible. Tangible assets are balance sheet items such as land, mineral resources, buildings, equipment, machinery, and vehicles that are used over an extended period of time.

long term liabilities

Long-term liabilities include debt instruments due and payable beyond one year as well as other long-term obligations of the firm. They include bonds, bank term loans, mortgages, and other types of liabilities, such as pension obligations and deferred compensation.

net income equation

Net Income = Revenues - Expenses

earnings per share

Net income is often reported on a per-share basis and is then called earnings per share (EPS), where EPS equals net income divided by the number of common shares outstanding. A firm's earnings per share tell a stockholder how much the firm has earned (or lost) for each share of stock outstanding.

Net plant and equipment equation

Net plant and equipment=Total plant and equipment− Accumulated depreciation

net sales

Net sales are defined as total sales less all sales discounts and sales returns and allowances.

Net working capital (NWC) equation

Net working capital (NWC)=Total current assets− Total current liabilities

net working capital

Net working capital is a measure of a firm's ability to meet its short-term obligations as they come due. One way that firms maintain their liquidity is by holding more current assets than current liabilities.

net working capital equation

Net working capital=Total current assets−Total current liabilities

peer group analysis

Once a peer group has been identified, management can obtain the associated financial information and compute average ratio values against which the firm can compare its performance.

extraordinary items

Other items reported separately in the income statement are extra-ordinary items, which are reserved for nonoperating gains or losses. Extraordinary items are unusual and infrequent occurrences, such as gains or losses from floods, fires, earthquakes, or accidents.

preferred stock

Preferred stock is a cross between common stock and long-term debt. Preferred stock pays dividends at a specified fixed rate, which means that the firm cannot increase or decrease the dividend rate, regardless of whether the firm's earnings increase or decrease.

profitability ratio

Profitability ratios measure management's ability to efficiently use the firm's assets to generate sales and manage the firm's operations. These measurements are of interest to stockholders, creditors, and managers because they focus on the firm's earnings.

stockholders perspective

Stockholders are primarily concerned with the value of their stock and with how much cash they can expect to receive from dividends and capital appreciation over time.

EBIT

Subtracting depreciation and amortization from EBITDA yields the next intermediate figure, EBIT, or earnings before interest and taxes.

EBITDA

The first intermediate income figure is EBITDA, or earnings before interest, taxes, depreciation, and amortization. The importance of EBITDA is that it shows what is earned purely from operations and reflects how efficiently the firm can manufacture and sell its products without taking into account the cost of the productive asset base

insolvency

The inability to pay debts when they are due is known as insolvency. Thus, liquidity ratios are also known as short-term solvency ratios. The two most important liquidity ratios are the current ratio and the quick ratio.

Creditors perspective

The primary concern of creditors is whether and when they will receive the interest payments they are entitled to and when they will be repaid the money they loaned to the firm.

common size balance sheet

To create a common-size balance sheet, we divide each of the asset accounts by total assets. We also divide each of the liability and equity accounts by total assets since Total assets = Total liabilities + Total equity.

total stockholders equity equation

Total Stockholder's equity=Total assets−Total liabilities

total assets equation

Total assets=Total liabilities+Total stockholder's equity

EBT

When interest expense is subtracted from EBIT, the result is EBT, or earnings before taxes.

LIFO (last in, first out)

a company using the LIFO method assumes the sale is from the newest, highest-cost inventory—last in, first out. During a period of inflation, firms using LIFO will have the highest cost of goods sold, the lowest net income, and the lowest inventory value.

Standard Industrial Classification (SIC) System

a numerical system developed by the U.S. government to classify businesses according to the type of activity they perform

GAAP

a set of widely agreed-upon rules and procedures that define how companies are to maintain financial records and prepare financial reports.

additional paid-in capital

additional paid-in capital is the amount of capital received from the sale of common stock in excess of par value.

audit

an audit means that an independent accountant has attested that the financial statements present fairly, in all material respects, the firm's financial condition at a point in time.

average tax rate

average tax rate is simply the total taxes paid divided by taxable income

the common stock account

common stock account identifies the funding from equity investors that was used to start and maintain the business and is priced at a par value

common size financial statement

common-size financial statement is one in which each number is expressed as a percentage of some base number, such as total assets or net revenues (net sales). Common-size financial statements make it easier to evaluate changes in a firm's performance and financial condition over time. They also allow you to make more meaningful comparisons between the financial statements of two firms that are different in size.

Common Size Income Statement

common-size income statement is to express each account as a percentage of net sales; a good measure of firm's efficiency and profitability

depreciation expense

companies are allowed to prepare two sets of financial statements: one for tax purposes and one for financial reporting to the SEC and investors. the total amount of depreciation expensed to the income statement over the life of an asset is the same. Total depreciation cannot exceed the price paid for the asset. Accelerating depreciation only alters the timing of when the depreciation is expensed.

debt to equity ratio

debt-to-equity ratio tells us the amount of debt for each dollar of equity.

default (insolvency) risk

default (insolvency) risk—the risk that it will not be able to pay its debt as it comes due.

depreciation

depreciation allocates the cost of a limited-life asset to the periods in which the firm is assumed to benefit from the asset. land is not depreciated

cash reconciliation

final part of the statement of cash flows is a reconciliation of the firm's beginning and ending cash positions.

financial leverage

financial leverage refers to the use of debt in a firm's capital structure.

financial ratio

financial ratio is simply one number from a financial statement that has been divided by another financial number.

Annual reports are divided into 3 sections

financial tables - financial info and operations for the year corporate public relations - product lines, services, and contributions to the community financial statements - balance sheet, income statement, RE, and cash flows

annual report

he most important report that firms issue to their stockholders and make available to the general public.

industry analysis

identify a group of firms that have the same product line, compete in the same market, and are about the same size. The average ratio values for these firms will be our benchmarks.

income statement

income statement summarizes the revenues, expenses, and the profitability (or losses) of the firm over some period of time, usually a month, a quarter, or a year.

trend analysis

involves looking at historical financial statements to see how various ratios are increasing, decreasing, or staying constant over time. (financial statements should cover 3-5 years for this reason)

liquidity position

liquidity position, we want to know whether the firm can pay its bills when cash flow from operations is insufficient to pay short-term obligations, such as payroll, invoices from vendors, and maturing bank loans.

Balance sheet: left hand side (Assets)

listed at book value assets are owned by the firm and are used to generate income.

marginal tax rate

marginal tax rate is the tax rate that is paid on the last dollar of income earned.

market value

market value—the amount they are worth today.

efficiency rations/asset turnover ratios

measure how efficiently a firm uses its assets

market to market

process of recording assets at their current market value is often called marking to market. provides decision makers with financial statements that more closely reflect a company's true financial condition

balance sheet

reports the firm's financial position at a particular point in time

retained earnings

retained earnings account represents earnings that have been retained and reinvested in the business over time rather than being paid out as cash dividends. The change in retained earnings from one period to the next can be computed as the difference between net income and dividends paid.

the realization principle

revenue is recognized only when the sale is virtually completed and the exchange value for the goods or services can be reliably determined.

Common stock ownership rights

right to vote, preemptive right, right to receive cash dividends, if the firm is liquidated, the right to all remaining corporate assets after all creditors and preferred stockholders have been paid.

Manager's perspective

same performance measures as stockholders: profitability, how much cash is available for stockholders, capital appreciation, return on investment, and the like. Managers, however, are also responsible for running the business on a daily basis and must make decisions that will maximize the value of the stockholders' shares in the long run.

organization of the statement of cash flows

statement of cash flows is organized around three business activities—operating activities, long-term investing activities, and financing activities—and the reconciliation of the cash account.

statement of cash flows

statement of cash flows shows the company's cash inflows (receipts) and cash outflows (payments and investments) for a period of time. it is important to understand that changes in the balance sheet accounts reflect cash flows.

3 perspectives from which we can view financial statement analysis

stockholders, managers, and creditors

Net income

taxes are subtracted from EBT to arrive at net income.

Balance sheet: right side (liabilities and stockholders equity)

tells us how the firm has financed its assets. liabilities are obligations of the firm that represent claims against its assets. These claims arise from debts and other obligations to pay creditors, employees, or the government. stockholders equity represents the residual claim of the owners on the remaining assets of the firm after all liabilities have been paid.

The Going Concern Assumption

the assumption that a business will remain in operation for the foreseeable future. The going concern assumption allows the accountant to record assets at cost rather than their value in a liquidation sale, which is usually much less.

cash flow to investors

the cash flow that a firm generates for its investors in a given period, excluding cash inflows from the sale of securities to investors

book value

the net value of an asset or liability recorded on the financial statements—normally reflects historical cost

financial statement analysis

the use of financial statements to analyze a company's performance and assess its strengths and weaknesses.

total debt ratio

total debt ratio tells us the amount of debt for each dollar of total assets.

treasury stock

treasury stock account represents stock that the firm has repurchased from investors.