Chapter 2

Question 1

Balance sheet

Answer 1

Snapshot of a firm’s resources, systemizing and summarizing what the company owns at given time (assets), what it owes (liabilities), and the difference between the two (equity of the company)

Question 2

Net working capital

Answer 2

Net working capital = the difference between a firm’s current assets and its current liabilities.
Positive net working capital means the cash that will become available over the next 12 months exceeds the cash that must be paid over the same period.

Question 3

Structure of balance sheet

Answer 3

The structure of the assets for a particular firm reflects the line of business the firm is in, managerial decisions about how much cash and inventory to have, about credit policy, fixed asset acquisitions.
The liabilities of the balance sheet primarily reflects managerial decisions about capital structure and the use of short-term debt.

Question 4

Liquidity

Answer 4

Liquidity refers to the speed and ease with which an asset can be converted to cash at fair value.
Assets are normally listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid assets are listed first.

The more liquid business is less likely to experience financial distress.

Question 5

Debt vs Equity

Answer 5

To the extent that a firm borrows money, it usually gives first claim to the firm’s cash flow to creditors. Equity holders are entitled to only the residual value, the portion left after creditors are paid. The value of this residual portion is the shareholders’ equity in the firm:

Equity=Assets-Liabilities(Debts)

Question 6

Financial leverage

Answer 6

The use of debt in a firm’s capital structure.
The more debt a firm has (as a % of assets), the grater is its degree of financial leverage. Financial leverage increases the potential reward to shareholders, but it also increases the potential for financial distress and business failure.

Question 7

Income Statement

Answer 7

Income statement measures performance over some period of time.
Revenues - Expenses = Income

Question 8

Matching principle

Answer 8

Expenses shown on the income statement are based on the matching principle. First determine revenues on the basis of realization principle and then match those revenues with the costs associated with the producing them.

Question 9

Taxes

Answer 9

Can be one of the largest cash outflows a firm experiences. Tax bill is determined by the tax code or “set of rules”.

Question 10

Average and marginal tax rates

Answer 10

Average tax rate is tax bill divided by taxable income (% of income that goes to pay taxes)
Marginal tax rate is the rate of the extra tax one would pay if they earned one more dollar.

Question 11

Balance sheet

Answer 11

The value of firm’s assets is equal to the value of its liabilities plus the value of its equity.

Question 12

Cash flow from assets

Answer 12

*Operating cash flow - day-to-day activities of producing and selling. Expenses associated with firm’s financing of its assets are not included because they are not operating expenses.
*Capital spending - net spending on fixed assets (purchases of fixed assets less sales of fixed assets)
*Change in net working capital - net change in current assets relative to current liabilities, representing the amount spent on net working capital

Question 13

Operating cash flow

Answer 13

OCF = revenues - costs;
not including depreciation, interest.
including taxes
OCF = earnings before interest and taxes + depreciation - taxes

Question 13

Capital spending

Answer 13

Capital spending/capital expenditures => CAPEX
Net capital spending: money spent on fixed assets less money received from the sale of fixed assets.
Net capital spending: ending net fixed assets - beginning net fixed assets + depreciation

Question 14

Total cash flow

Answer 14

Operating cash flow
- amounts invested in fixed assets and net working capital

Question 15

Cash flow to creditors and stockholders

Answer 15

The cash flows to creditors are stockholders represent the net payments to creditors and owners during the year.

Question 16

Cash flow to creditors

Answer 16

Also referred to as cash flow to bond holders:
Interest paid less net new borrowing

Question 17

Cash flow to stockholders

Answer 17

Dividends paid less net new equity raised.
To get new equity raised we need to look at the common stock and paid-in surplus account, which tells us how much stock the company has sold.

Question 18

Cash flow from assets

Answer 18

Cash flow from assets = Cash flow to creditors (bondholders) + Cash flow to stockholders (owners)

Cash flow from assets = Operating cash flow - net capital spending - Change in net working capital (NWC)

Question 19

Sources of cash

Answer 19

Activities that bring in cash are called sources of cash.
Decrease in an asset account or an increase in a liability (or equity) account.

Question 20

Uses of cash

Answer 20

Activities that involve spending cash are called uses (or applications) of cash.
An increase in left-side (asset) account or a decrease in a right-side (liability or equity) account is a use of cash.

An increase in an asset account means the firm, on net basis, bought some assets and is the use of cash. If liability account goes down, firm has made a net payment which is a use of cash.