Chapter 3: Understanding Financial Statements and Cash Flows Flashcards
Income Statement (Profit and Loss Statement)
A basic accounting statement that measures the results of a firm’s operations over a specified period, commonly 1 year. The bottom line of the income statement, net profits (net income), shows the profit or loss for the period that is available for a company’s owners (shareholders).
Cost of Goods Sold
The cost of producing or acquiring a product or service to be sold in the ordinary course of business.
Gross Profit
Sales or revenue minus the cost of goods sold.
Operating Expenses
Marketing and selling expenses, general and administrative expenses, and depreciation expense.
Operating Income (Earnings Before interest and taxes)
Sales less the cost of goods sold less operating expense.
Earnings Before Taxes (Taxable Income)
Operating income minus interest expense.
Net Income (Net Profit, or Earnings Available to Common Stockholders)
The earnings available to the firm’s common and preferred stockholders.
Earnings Per Share
Net income on a per share basis.
Dividends Per Share
The amount of dividends a firm pays for each share outstanding.
Common-Sized Income Statement
An income statement in which a firm’s expenses and profits are expressed as a percentage of its sales.
Profit Margins
Financial rations (sometimes simply referred to as margins) that reflect the level of the firm’s profits relative to its sales. Examples include the gross profit margin (gross profit divided by sales), operating profit margin (operating income divided by sales), and the net profit margin (net income divided by sales).
Gross Profit margin
Gross profit divided by net sales. It is a ration denoting the gross profit earned by the firm as a percentage of its net sales.
Operating Profit Margin
Operating income divided by sales. This ratio serves as an overall measure of the company’s operating effectiveness.
Net Profit Margin
Net income divided by sales. A ration that measures the net income of the firm as a percentage of sales.
Fixed Costs
Costs that remain constant, regardless of any change in a firm’s activity.
Semivariable Costs
Costs composed of a mixture of fixed and variable components.
What can a firm’s net profits be viewed as?
Gross profit= sales - cost of goods sold
Earnings Before Interest (Operating Profits) Equation
Gross profit - operating expenses
Net Profit (Net Income) Equation
Earnings before interest and taxes (operating profits) - interest expense - taxes
Which five activities determine a company’s net income?
- The revenue derived from selling the company’s product or service.
- The cost of producing or acquiring the goods or services to be sold.
- The operating expenses related to (1) marketing and distributing the product or service to the customer and (2) administering the business.
- The financing costs of doing business - namely, the interest paid to the firm’s creditors.
- The payment of taxes.
Profits Equation
Sales - expenses
Balance Sheet
A statement that shows a firm’s assets, liabilities, and shareholder equity at a given point in time. It is a snapshot of the firm’s financial position on a particular date.
Accounting Book Value
The value of an asset as shown on a firm’s balance sheet. It represents the depreciated historical cost of the asset rather than its current market value or replacement cost.
Liquidity
The ability to convert an asset into cash quickly without a significant loss of its value.
Current Assets (Gross Working Capital)
Current assets consist primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses.
Cash
Cash on hand, demand deposits, and short-term marketable securities that can quickly be converted into cash.
Accounts Receivable
Money owed by customers who purchased goods or services from the firm on credit.
Inventories
Raw materials, work in progress, and finished goods held by the firm for eventual sale.
Other Current Assets
Other short-term assets that will benefit future time periods, such as prepaid expenses.
Fixed Assets
Assets such as equipment, buildings, and land.
Depreciation Expense
A noncash expense to allocate the cost of depreciable assets, such as plant and equipment, over the live of the asset.
Accumulated Depreciation
the sum of all depreciation taken over the entire life of a depreciable asset.
Gross Fixed Assets
The original cost of a firm’s fixed assets.
Net Fixed Assets
Gross fixed assets minus the accumulated depreciation taken over the life to date of the assets.
Debt
Liabilities consisting of such sources as credit extended by suppliers or a loan from a bank.
Equity
Stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet.
Current Debt (Short-Term Liabilities)
Debt due to be paid within 12 months.
Accounts Payable (Trade Credit)
Credit provided by suppliers when a firm purchases inventory on credit.
Accrued Expenses
Expenses that have been incurred but not yet paid in cash.
Short-Term Notes (Debt)
Amounts borrowed from lenders, mostly financial institutions such as banks, where the loan is to be repaid within 12 months.
Long-Term Debt
Loans from banks or other sources that lend money for longer than 12 months.
Mortgage
A loan to finance real estate where the lender has the first claim on the property in the event the borrower is unable to repay the loan.
Preferred Stockholders
Stockholders who have claims on the firm’s income and assets after creditors, but before common stockholders.
Common Stockholders
Investors who own the firm’s common stock. Common stockholders are the residual owners of the firm.
Common Stock
Shares that represent ownership in a corporation.
Par Value
The arbitrary value a firm puts on each share of stock prior to its being offered for sale.
Paid-In Capital
The amount a company receives above par value from selling stock to investors.
Treasury Stock
The firm’s stock that has been issued and then repurchased by the firm.
Retained Earnings
Cumulative profits retained in a business up to the date of the balance sheet.
Common-Sized Balance Sheet
A balance sheet in which a firm’s assets and sources of debt and equity are expressed as a percentage of its total assets.
Debt Ratio
A firm’s total liabilities divided by its total assets. It is a ratio that measures the extent to which a firm has been financed with debt.
Net Working Capital
The difference between a firm’s current assets and its current liabilities. When the term working capital is used, it is frequently intended to mean net working capital.
Total Assets Equation
Total Liabilities (Debt) + Total Shareholders’ Equity
Ending Retained Earnings Equation
Beginning Retained Earnings + Net Income For the Year - Dividends Paid During the Year
Common Equity Equation
Common Shareholders’ Investment + Cumulative Profits - Cumulative Dividends Paid to Common Stockholders
Net Working Capital Equation
Current Assets - Current Liabilities
Cash Flows
A firm’s profits are not an adequate measure of its cash flows. To measure a company’s cash flows requires that we look both at the income statement and the changes in the balance sheet. Examining the statement of cash flows helps us understand where cash came from and how it was used.
Three Main Parts of a Statement of Cash Flows
- Cash Flows from Operations
- Cash Flows from Investing
- Cash Flows from Financing
Accrual Basis Accounting
A method of accounting whereby revenue is recorded when it is earned, whether or not the revenue has been received in cash. Likewise, expenses are recorded when they are incurred, even if the money has not actually been paid out.
Cash Basis Accounting
A method of accounting whereby revenue is recorded when cash is actually received. Likewise, expenses are recorded when physical cash is paid out.
Statement of Cash Flows
A statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities.
Free Cash Flows
The amount of cash available from operations after the firm pays for the investments it has made in operating working capital and fixed assets. This cash is available to distribute to the firm’s creditors and owners.
Financing Cash Flows
The amount of cash received from or distributed to the firm’s investors, usually in the form of interest, dividends, issuance of debt, or issuance or repurchase of stocks.
Cash Collections Equation
Sales - Change in Accounts Receivable
GAAP vs. IFRS
GAAP is rules-based and sets out rules that accountants must follow when preparing financial statements. IFRS is principles-based and sets out general principles. IFRS leaves more room for discretion than GAAP does, permitting managers to exercise their own judgment when deciding how to report in their financial statements, as long as they follow the spirit of the standards.
Generally Accepted Accounting Principles (GAAP)
Rules-based accounting principles, standards, and procedures that companies use to compile their financial statements, These principles are issued by the Financial Accounting Standards Board (FASB).
International Financial Reporting Standards (IFRS)
Principles-based set of international accounting standards starting how particular types of transactions and other events should be reported financial statements. IFRS are issued by the International Accounting Standards Board (IASB).
Taxable Income Summary
For the most part, taxable income for the corporation is equal to the firm’s operating income plus capital gains less any interest expense. Tax consequences, particularly tax rates, have a direct bearing on the decisions of the financial manager.
Taxable Income
Income from all sources, except for allowable exclusions, less any tax-deductible expenses.
Capital Gains
Gains from selling any asset that is not part of the ordinary operations.
Marginal Tax Rate
The tax rate that would be applied to the next dollar of income.
Average Tax Rate
The tax rate on average that a company pays on its total taxable income.
Limitations of Financial Statements
Accounting rules give managers discretion. Therefore what we see in financial statements may not exactly reflect the company’s financial situation. Sometimes, managers may even break the rules, which results in accounting malpractice/accounting fraud.
Free Cash Flows Summary
Free cash flows and financing cash flows are important measurements in making financial decisions. Only by understanding these cash flows can managers truly know how well a company is doing.
Free Cash Flow Equation
After-Tax Cash Flows from Operations - [Increase in net Operating Working Capital] OR + [Decrease in Net Operating Working Capital] and - [Increase in Long-Term Assets] OR + [Decrease in Long-Term Assets]
