chapter 2 Flashcards
financial statements
accounting reports with past performance information that a firm issues periodically. they’re useful tools for investors, financial analysts, and other interested outside parties to obtain information about a corporation and for managers for corporate financial decisions.
10-Q
required quarterly financial statement for US public companies.
10-K
US public companies are required to file an annual report to their shareholders.
Generally Accepted Accounting Principles (GAAP)
provide a common set of rules and a standard format for public companies to use when they prepare their reports. it makes it easier to compare financial results.
auditor
a neutral third party hired to check the annual financial statements to ensure that they are reliable and prepared according to GAAP.
four required financial statements
- The balance sheet
- The income statement
- The statement of cash flows
- The statement of stockholders’ equity
they provide investors and creditors with an overview of the firm’s financial performance.
balance sheet/statement of financial position
lists the firm’s assets and liabilities and provides a firm’s financial position at a given point in time.
current assets
either cash or assets that could be converted into cash within one year. includes:
1. cash and other marketable securities
2. accounts receivable
3. inventories
4. other current assets, a catch-all category incl. prepaid expenses
marketable securities
short-term low-risk investments that can be easily sold and converted into cash, eg. money market investments.
accounts receivable
amounts owed to the firm by customers who have purchased goods or services on credit
inventories
composed of raw materials, WIP, and finished goods.
net property, plant, and equipment
for example, real estate or machinery that produce tangible benefits for more than one year. it shows the book value of assets
long-term assets
- net property, plant, and equipment
- other long-term assets
depreciation expense
the value recorded of equipment will be reduced annually by deducting depreciation expense because it wears out or becomes obsolete.
accumulated depreciation
the total amount deducted over the life of the equipment.
book value of an asset
the value shown in financial statements. it is the acquisition cost less accumulated depreciation.
amortisation/impairment change
a decrease in the value of intangible assets. it captues the change in value.
current liabilties
liabilities that will be satisfied within one year. include:
1. accounts payable
2. short-term debt or notes payable, and current maturities of long-term debt
3. items owed but not yet paid, and deferred or unearned revenue
accounts payable
amounts owed to suppliers for products or services purchased with credit.
short-term debt or notes payable, and current maturities of long-term debt
all repayments of debt that will occur within the next year.
deferred or unearned revenue
revenue that has been received for products not yet delivered.
net working capital
the difference between current assets and current liabilities and the capital available in the short term to run the business.
long-term liabilities
liabilities that extend beyond on year. main types:
1. long-term debt
2. capital leases
3. deferred taxes
long-term debt
any loan or debt obligation with a maturity of more than one year.
capital leases
long-term lease contact that obligate the firm to make regular lease payments in exchange for use on asset, eg. a building.
deferred taxes
taxes owed but not yet paid. arise when the firm’s financial income exceeds its income for tax purposes.
total liabilities
the sum of current liabilities and long-term liabilities.
stockholders’ equity/book value of equity
the difference between the firm’s assets and liabilties. it is an accounting measure of the firm’s net worth.
market capitalisation/market value of equity/’market cap’
the value that remains after the firm has paid its debt. it depends on what investors expect those assets to produce rather than historical cost. it includes future prospects of the firm.
market-to-book ratio/price-to-book [P/B] ratio
variations reflect differences in fundamental firm characteristics and value added by management. successful firms exceed 1.
value stocks
firms with low market-to-book ratios
growth stocks
firms with high market-to-book ratios.
enterprise value of a firm/total enterprise value (TEV)
assesses the value of the underlying business assets, unencumbered by debt and separated from any cash and marketable securities. it is the market value of operating assets.
income statement/statement of financial performance/profit and loss (P&L) statement
lists the revenues and expenses over a period of time. it shows the flow of revenues and expenses generated by those assets and liabilties in a period.
net income/earnings
measures a firm’s profitability during a period. the total earnings of the firm’s equity holders. it is the ‘bottom’ line of the income statement.
gross profit
the difference between sales revenues and costs.
operating income
the firm’s gross profit net of operating expenses
other income
income/expenses arising from activities that are not central part of the business, eg. income from investments.
stock options
give the holder the right to buy a certain number of shares by a specific date at a specific price. the company issues new stock and number of outstanding shares grows.
convertible bonds
a form of debt that can be converted to shares. also increases the number of outstanding shares and therefore leads to dilution.
diluted EPS
discloses the potential for dilution and represents earnings per share for the company as though in-the-money stock options or other stock-based compensation had been exercises or dilutive convertible debt had been converted.
statement of cash flow
utilises the information from the income statement and balance sheet to determine how much cash was generated and how it was allocated during a period.
operating expenses
expenses from the ordinary course of running the business that are not directly related to producing the goods or services being sold.
operating activities
starts with net income from income statement and adjusts by adding back non-cash entries, (eg. depreciation expense) related to operating activities.
investment activities
lists the cash used for investment.
financing activities
shows the cash flow between firm and its investors.
capital expenditures
purchases of new property, plant, and equipment. They do not immediately appear on the income statement, but as depreciation expenses.
retained earnings
the difference between a firm’s net income and the amount it spends on dividends.
statement of stockholders’ equity
breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing shares (par value plus paid-in capital) versus retained earnings. The book value of stockholders’ equity is not a useful assessment of value for financial purposes, so the statement of stockholders’ equity is used infrequently.
management discussion and analysis (MD&A)
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. They may also discuss the coming year, goals, projects, and future plans. They should also discuss risks that the firm faces or issues that may affect liquidity and resources. It should also disclose off-balance sheet transactions.
off-balance sheet transactions
transactions or arrangements that can have a material impact on the firm’s future performance yet do not appear on the balance sheet.
notes to the financial statements
provide further details on the information in the statements. It is important to fully interpret the statements.
gross margin
reflects the firm’s ability to sell a product for more than the cost of producing it.
operating margin
reveals how much a company earns before interest and taxes from each dollar of sales.
net profit margin
shows the fraction of each dollar in revenues that is available to equity holders after the firm pays interest and taxes. However, differences can also result from differences in leverage, which determines the amount of interest expense and differences in accounting assumptions.
quick ratio
more stringent test of the firm’s liquidity and compares only cash and “near cash” assets, eg. short-term investments and accounts receivable to current liabilities.
A higher current or quick ratio implies less risk of the firm experiencing cash shortfall in the near future. Inventory is excluded because it may not be that liquid.
cash ratio
most stringent liquidity ratio and is used to gauge a firm’s cash position.
accounts receivable days
the number of days’ worth of sales accounts receivable represents. It is used to evaluate the speed at which a company turns sales into cash.
turnover ratios
computed by expressing annual revenues or costs as a multiple of the corresponding working capital account, eg. Inventory turnover.
working capital ratios
combined information in the income statement and balance sheet can be used to gauge how efficiently the firm is utilising net working capital.
interest coverage ratio
Lenders often assess a firm’s ability to meet its interest obligations by comparing its earnings with its interest expenses by using an interest coverage ratio.
leverage
the extent to which the firm relies on debt as a source of financing. Leverage increases the risk to the firm’s equity holders, but they may also hold cash reserves to reduce risk.
debt-equity ratio
used to assess leverage. book values or market values are used, but book debt-equity is not really useful since it can be negative.
debt-to-capital ratio
can also be calculated using book values or market values.
equity multiplier
captures the amplification of the firm’s accounting returns that result from leverage.
market value multiplier
indicates the amplification of shareholders’ financial risk that results from leverage.
valuation ratios
used to gauge the market value of the firm.
price-earnings ratio (P/E)
used to assess 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. either on a total basis or on a per-share basis. If it is 25, investors are willing to pay 25 times the firm’s earnings to purchase a share.
operating returns
evaluate a firm’s return on investment by comparing its income to its investment.
return on equity (ROE)
provides a measure of the return the firm has earned on past investments. High ROE may indicate that the firm can find investment opportunities that are very profitable.
return on assets (ROA)
less sensitive to leverage than ROE, but it is sensitive to working capital.
return on invested capital (ROIC)
measures the after-tax profit generated by the business itself, excluding any interest expenses or income, and compares it to the capital raised from equity and debt holders that has already been deployed (ie. not held as cash). This is the most useful measure.
the DuPont Identity
expresses the ROE in terms of the firm’s profitability, asset efficiency, and leverage.
net profit margin
measures overall profitability.
asset turnover
measures how efficiently the firm is utilising its assets to generate sales.
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.
Sarbanes-Oxley Act (SOX)
overall intent is to improve the accuracy of information given to boards and shareholders. it was established after accounting scandals.
Dodd-Frank Act
exempts firms with less than $75 million in publicly held shares from the SOX Section 404 requirements. Also, an individual who provides information about a possible violation gets 10 to 30% of the penalty or recovery.
efficiency ratios
‘How efficient are the firm’s operations?’
profitability ratios
‘How profitable is the firm?’
leverage ratios
‘Can the firm repay its debt?’
value ratio
‘How much value has the firm created?’
carry trade strategy
borrowing in low interest rate currency and investing in high interest rate currency. this is not an arbitrage strategy because of exchange rate risk.
short squeeze
a rapid increase in price of a stock owing primarily to an excess of short positions in a stock. it occurs when short sellers of stock move to cover their positions (buy back the stock they borrowed), purchasing large volumes of stock relative to the market volume.
free cash flows
includes operating and investment cash flows, but not financing cash flows. this is the separation principle.
financing cash flows
interest paid on loans or cash flows due to loans and equity.
