1: Introduction Flashcards
1. The Corporation 2. Introduction to Financial Statement Analysis 3. Financial Decision Making and the Law of One Price 4. Appendix: The Price of Risk
agency problem
When decision makers, despite being hired as the agents of other stakeholders, put their own self-interest ahead of the interests of the stakeholders.
ask price
The price at which a market maker or specialist is willing to sell a security.
bid-ask spread
The amount by which the ask price exceeds the bid price.
bid price
The price at which a market maker or specialist is willing to buy a security.
board of directors (BoD)
A group elected by shareholders that has the
ultimate decision-making authority in the corporation.
“C” corporations
Corporations that have no restrictions on
who owns their shares or the number of shareholders, and therefore cannot qualify for subchapter S treatment and are subject to direct taxation.
chief executive officer (CEO)
The person charged with running the corporation by instituting the rules and policies set by the board of directors.
chief financial officer (CFO)
The most senior financial manager, who often reports directly to the CEO.
corporation
A legally defined, artificial being, separate from its owners.
dark pools
Trading venues in which the size and price of orders are not disclosed to participants. Prices are within the best bid and ask prices available in public markets, but traders face the risk their orders may not be filled if an excess of either buy or sell orders is received.
dividend payments
Payments made at the discretion of the corporation to its equity holders.
Dodd-Frank Act
A 2010 Congressional act that sought to bring about financial stability by bringing about sweeping changes to the financial regulatory system in response to the 2008 financial crisis.
equity
The collection of all the outstanding shares of a
corporation.
equity holder
An owner of a share of stock in a corporation (also shareholder or stockholder).
high frequency traders (HFTs)
Traders who place, update, cancel, and execute trades many times per second.
hostile takeover
A situation in which an individual or organization, sometimes referred to as a corporate raider, purchases a large fraction of a target corporation’s stock and in doing so gets enough votes to replace the target’s board of directors and its CEO.
limit order
Order to buy or sell a set amount of a security at a
fixed price.
limit order book
Collection of all current limit orders for a given security.
limited liability
When an investor’s liability is limited to her initial investment.
limited liability company (LLC)
A limited partnership without a general partner.
limited partnership
A partnership with two kinds of owners, general partners and limited partners.
liquid
Describes an investment that can easily be turned into cash because it can be sold immediately at a competitive market price.
liquidation
Closing down a business and selling off all its assets; often the result of the business declaring bankruptcy.
liquidity
Extent to which the market for an asset is liquid. Limit orders provide liquidity by making available an immediate opportunity to trade.
market makers
Individuals on the trading floor of a stock exchange who match buyers with sellers.
market orders
Orders to trade immediately at the best outstanding limit order available.
partnership
A sole proprietorship with more than one owner.
primary market
Market used when a corporation itself issues new shares of stock and sells them to investors.
private companies
The companies whose shares do not trade on a public market.
public companies
Those corporations whose stock is traded on a stock market or exchange, providing shareholders the ability to quickly and easily convert their investments into cash.
“S” corporations
Those corporations that elect subchapter S tax treatment and are allowed, by the U.S. Internal Revenue Tax code, an exemption from double taxation.
secondary market
Market shares continue to trade on after the initial transaction between the corporation and investors.
sole proprietorship
A business owned and run by one person.
specialists
Individuals on the trading floor of the NYSE who
match buyers with sellers; also called market makers.
stock
The ownership or equity of a corporation divided into shares.
stock market (or stock exchange)
Organized market on which the shares of many corporations are publicly traded.
transaction cost
In most markets, an expense such as a broker commission and the bid-ask spread investors must pay in order to trade securities.
10-Q
The quarterly reporting form that U.S. companies use to file their financial statements with the U.S. Securities and Exchange Commission (SEC).
accounts payable
The amounts owed to creditors for products or services purchased with credit.
accounts payable days
An expression of a firm’s accounts payable in terms of the number of days’ worth of cost of goods sold that the accounts payable represents.
accounts payable turnover
The ratio of annual cost of sales to accounts payable. A measure of how quickly the firm is paying its suppliers.
accounts receivable
Amounts owed to a firm by customers who have purchased goods or services on credit.
accounts receivable days
An expression of a firm’s accounts receivable in terms of the number of days’ worth of sales that the accounts receivable represents.
accounts receivable turnover
The ratio of annual sales to accounts receivable. A measure of how efficiently the firm is managing accounts receivable.
accumulated depreciation
The cumulative depreciation of an asset up to a given point in its life; equal to last period’s accumulated depreciation plus the current period’s depreciation expense.
amortization
A charge that captures the change in value of acquired assets. Like depreciation, amortization is not an actual cash expense.
annual report
The yearly summary of business sent by U.S. public companies to their shareholders that accompanies or includes the financial statement.
asset turnover
The ratio of sales to assets, a measure of how
efficiently the firm is utilizing its assets to generate sales.
assets
The cash, inventory, property, plant and equipment, and
other investments a company has made.
auditor
A neutral third party that corporations are required to hire that checks the annual financial statements to ensure they are prepared according to GAAP, and to verify that the information is reliable.
balance sheet
A list of a firm’s assets and liabilities that provides a snapshot of the firm’s financial position at a given point in time.
balance sheet identity
Total assets equals total liabilities plus stockholders’ equity.
book value
The acquisition cost of an asset less its accumulated
depreciation.
book value of equity
The difference between the book value of a firm’s assets and its liabilities; also called stockholders’ equity, it represents the net worth of a firm from an account- ing perspective.
capital expenditures
Purchases of new property, plant, and equipment.
capital lease
A lease viewed as an acquisition for accounting purposes. The asset acquired is listed on the lessee’s balance sheet, and the lessee incurs depreciation expenses for the asset. In addition, the present value of the future lease payment is listed as a liability, and the interest portion of the lease payments is deducted as an interest expense. Also known as a finance lease.
cash ratio
The ratio of cash to current liabilities. It is the most stringent liquidity ratio.
convertible bonds
Corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock.
current assets
Cash or assets that could be converted into cash within one year. This category includes marketable securities, accounts receivable, inventories, and pre-paid expenses such as rent and insurance.
current liabilities
Liabilities that will be satisfied within one year. They include accounts payable, notes payable, short-term debt, current maturities of long-term debt, salary or taxes owed, and deferred or unearned revenue.
current ratio
The ratio of current assets to current liabilities.
debt-equity ratio
The ratio of a firm’s total amount of short- and long-term debt (including current maturities) to the value of its equity, which may be calculated based on market or book values.
debt-to-capital ratio
The ratio of a firm’s total amount of short-and long-term debt (including current maturities) to the sum of the value of its debt and the value of its equity, which may
be calculated based on market or book values.
debt-to-enterprise value ratio
The fraction of a firm’s enterprise value that corresponds to net debt.
deferred taxes
An asset or liability that results from the difference between a firm’s tax expenses as reported for accounting purposes, and the actual amount paid to the taxing authority.
depreciation expense
Amount deducted, for accounting purposes, from an asset’s value to reflect wear and tear over a given
period.
diluted EPS
A firm’s disclosure of its potential for dilution from
options it has awarded which shows the earnings per share the company would have if the stock options were exercised.
dilution
An increase in the total number of shares that will divide a fixed amount of earnings; often occurs when stock
options are exercised or convertible bonds are converted.
DuPont Identity
Expression of the ROE in terms of the firm’s profitability, asset efficiency, and leverage.
earnings per share (EPS)
A firm’s net income divided by the total number of shares outstanding.
EBIT
A firm’s earnings before interest and taxes are deducted.
EBIT margin
The ratio of EBIT to sales.
EBITDA
A computation of a firm’s earnings before interest,
taxes, depreciation, and amortization are deducted.
enterprise value
The total market value of a firm’s equity and debt, less the value of its cash and marketable securities. It measures the value of the firm’s underlying business.
equity multiplier
Measure of leverage that indicates the value of assets held per dollar of shareholder equity.
financial statements
Firm-issued (usually quarterly and annually) accounting reports with past performance information.
Generally Accepted Accounting Principles (GAAP)
A common set of rules and a standard format for public companies to use when they prepare their financial reports.
goodwill
The difference between the price paid for a company and the book value assigned to its assets.
gross margin
The ratio of gross profit to revenues (sales).
gross profit
The third line of an income statement that represents the difference between a firm’s sales revenues and its costs.
growth stocks
Firms with high market-to-book ratios.
impairment charge
Captures the change in value of the acquired assets; is not an actual cash expense.
income statement
A list of a firm’s revenues and expenses over a period of time.
intangible assets
Non-physical assets, such as intellectual property, brand names, trademarks, and goodwill. Intangible assets appear on the balance sheet as the difference between the price paid for an acquisiton and the book value assigned to its tangible assets.
interest coverage ratio
An assessment by lenders of a firm’s leverage. Common ratios consider operating income, EBIT, or EBITDA as a multiple of the firm’s interest expenses.
inventories
A firm’s raw materials as well as its work-in-progress and finished goods.
inventory days
An expression of a firm’s inventory in terms of the number of days’ worth or cost of goods sold that the inventory represents.
inventory turnover
The ratio of the annual cost of sales to inventory. A measure of how efficiently a firm is managing its inventory.
leverage
The amount of debt held in a portfolio or issued by a
firm. See also buying stocks on margin.
liabilities
A firm’s obligations to its creditors.
long-term assets
Net property, plant, and equipment, as well as property not used in business operations, start-up costs in connection with a new business, investments in long-term securities, and property held for sale.
long-term debt
Any loan or debt obligation with a maturity of more than a year.
management discussion and analysis (MD&A)
A preface to the financial statements in which a company’s management discusses the recent year (or quarter), providing a background on the company and any significant events that may have occurred.
marketable securities
Short-term, low-risk investments that can be easily sold and converted to cash (such as money market investments, like government debt, that mature within a
year).
market capitalization
The total market value of equity; equals the market price per share times the number of shares.
market-to-book ratio (price-to-book [P/B] ratio)
The ratio of a firm’s market (equity) capitalization to the book value of its stockholders’ equity. Also referred to as the price-to-book or P/B ratio.
net debt
Total debt outstanding minus any cash balances.
net income or earnings
The last or “bottom line” of a firm’s income statement that is a measure of the firm’s income over a given period of time.
net profit margin
The ratio of net income to revenues, it shows the fraction of each dollar in revenues that is available to equity holders after the firm pays interest and taxes.
net working capital
The difference between a firm’s current assets and current liabilities that represents the capital available in the short-term to run the business.
off-balance sheet transactions
Transactions or arrangements that can have a material impact on a firm’s future performance yet do not appear on the balance sheet.
operating income
A firm’s gross profit less its operating expenses.
operating margin
The ratio of operating income to revenues, it reveals how much a company has earned from each dollar of sales before interest and taxes are deducted.
price-earnings ratio (P/E)
The ratio of the market value of equity to the firm’s earnings, or its share price to its earnings
quick ratio
The ratio of current assets other than inventory to current liabilities.
retained earnings
The difference between a firm’s net income and the amount it spends on dividends.
return on assets (ROA)
The ratio of net income plus interest expense to the total book value of the firm’s assets. This measure of ROA includes the benefit of the interest tax shield associated with leverage. As a benchmark, ROA is most com- parable to the firm’s unlevered cost of capital.
return on equity (ROE)
The ratio of a firm’s net income to the book value of its equity. As a benchmark, ROE is most com- parable to the firm’s required return on equity.
return on invested capital (ROIC)
The ratio of a firm’s after-tax profit excluding any interest expense (or income) to the sum of the book value of its equity and net debt. As a benchmark, ROIC is most comparable to the firm’s weighted average cost of capital.
short-term debt
Debt with a maturity of less than one year.
statement of cash flows
An accounting statement that shows how a firm has used the cash it earned during a set period.
statement of financial performance
Statement showing the firm’s revenues and expenses over a period of time.
statement of financial position
List of the firm’s assets and liabilities that provides a snapshot of the firm’s financial position at a given point in time.
statement of stockholders’ equity
An accounting statement that breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings.
stock options
A form of compensation a firm gives to its employees that gives them the right to buy a certain number of shares of stock by a specific date at a specific price.
stockholders’ equity
An accounting measure of a firm’s net worth that represents the difference between the firm’s assets and its liabilities.
turnover ratios
Measures of working capital computed by expressing annual revenues or costs as a multiple of the corresponding working capital account (accounts receivable, accounts payable, and inventory).
value stocks
Firms with low market-to-book ratios.
arbitrage
The practice of buying and selling equivalent goods or
portfolios to take advantage of a price difference.
arbitrage opportunity
Any situation in which it is possible to make a profit without taking any risk or making any investment.
bond
A security sold by governments and corporations to raise money from investors today in exchange for the promised
future payment.
competitive market
A market in which goods can be bought and sold at the same price.
discount factor
The value today of a dollar received in the future.
discount rate
The rate used to discount a stream of cash flows; the cost of capital of a stream of cash flows.
financial security
An investment opportunity that trades in a financial market.
future value (FV)
The value of a cash flow that is moved forward in time.
interest rate factor
One plus the interest rate, it is the rate of exchange between dollars today and dollars in the future.
Law of One Price
In competitive markets, securities or portfolios with the same cash flows must have the same price.
net present value (NPV)
The difference between the present value of a project’s or investment’s benefits and the present value of its costs.
no-arbitrage price
In a normal market, when the price of a security equals the present value of the cash flows paid by the security.
normal market
A competitive market in which there are no arbitrage opportunities.
NPV Decision Rule
When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. Also known as NPV Investment Rule.
portfolio
A collection of securities.
present value (PV)
The value of a cost or benefit computed in terms of cash today.
return
The difference between the selling price and purchasing
price of an asset plus any cash distributions expressed as a percentage of the buying price.
risk-free interest rate
The interest rate at which money can be borrowed or lent without risk over a given period.
Separation Principle
In a perfect market, the NPV of an investment decision can be evaluated separately from any financial transactions a firm is considering.
short sale
Selling a security you do not own.
time value of money
The difference in value between money today and money in the future; also, the observation that two cash flows at two different points in time have different values.
Valuation Principle
The value of an asset to the firm or its investors is determined by its competitive market price: The benefits and costs of a decision should be evaluated using these market prices, and when the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.
value additivity
A relationship determined by the Law of One Price, in which the price of an asset that consists of other assets must equal the sum of the prices of the other assets.
expected return
A computation for the return of a security based on the average payoff expected.
risk aversion
When investors prefer to have a safe future payment rather than an uncertain one of the same expected amount.
risk premium
Represents the additional return that investors expect to earn to compensate them for a security’s risk.
