Exam 1 Flashcards
The system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities
Finance
What are the three interconnected areas in finance?
Financial Management (corporate finance)
Capital Markets (financial institutions)
Investments (asset pricing, portfolio theory
Forms of Business Organization
Proprietorship
Partnership
Corporation
Advantages of a Corporation
Unlimited life, easy transfer of ownership, limited liability, and ease of raising capital
Disadvantages of a Corporation
double taxation and cost of setup and report filing
The primary financial goal of management is _______________, which translates to ___________.
shareholder wealth maximization
maximizing stock price
Value of any asset is ___________ of cash flow stream to owners.
present value
Most significant decisions are evaluated in terms of their ____________________.
financial consequences
_________ change over time as conditions change and as investors obtain new information about a company’s prospects.
Stock prices
____________ recognize that being socially responsible and maximizing stakeholder welfare is consistent with maximizing long-term shareholder value.
Managers
factors that affect managerial behavior
Managerial compensation packages
Direct intervention by shareholders
The threat of firing
The threat of takeover
__________ are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds.
Stockholders
_________ receive fixed payments and are more interested in limiting risk, particularly concerned about the use of additional debt, and attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions.
bondholders
____________ have a progressive structure (the higher the income, the higher the marginal tax rate).
Personal taxes
First, subject to flat tax rate of 21%. Also, can be subject to state tax (about 5% in Ms).
Corporations
provides a snapshot of a firm’s financial position at one point in time based on book values.
Assets = Liabilities + Owner’s Equity
Balance sheet
summarizes a firm’s revenues and expenses over a
given period – thus, shows profitability. Also known as profit and loss statement
Income statement
reports the impact of a firm’s activities on cash flows
over a given period.
Statement of cash flows
shows how much of the firm’s earnings were retained, rather than paid out as dividends.
Statement of stockholders’ equity
______ accounts are listed in order of liquidity (convertibility to cash)
Asset
Items expected to be converted to cash within one year
Current assets
Cash, Marketable securities, Accounts receivable, Notes receivables, Prepaid expenses, and Inventory
Current assets
(cash equivalents) - temporary investments of excess cash
Marketable securities
(from sales on credit) - money owed to you by customers. includes allowance for bad debts to determine collection value
Accounts receivable
from issued loans
Notes receivables
represent future expense items already paid for
Prepaid expenses
Long-term commitment of funds (at least one year). Includes stocks, bonds, investments in other corporations (McDonalds owning Chipotle, Coke owning Keurig)
Investments
Carried at original cost minus accumulated depreciation
Property, Plant, and Equipment (Fixed Assets)
___________ are financed through liabilities or stockholders’ equity.
Total assets
- Represent financial obligations of the firm and typically
listed starting with current liabilities to longer-term obligations
Liabilities
assumed due within one-year. consist of accounts payable, notes payable, and accrued expense,
current liabilities
represents amount owed on open account to suppliers
Accounts payable
short-term signed obligations to creditors
Notes payable
is generated when a service has been provided to the
company and a company has not yet been billed and made a payment (e.g. salaries to employees, interest expense)
Accrued expense
assumed due in more than one year
long-term debt
Represents total contribution and ownership
interest of preferred and common stockholders. Consist of Preferred stock, Common stock, and Retained Earnings
Stockholders’ Equity
represent the firm’s cumulative earnings since
inception minus dividends and other adjustments
Retained Earnings
> Point-in-time snapshot
Values based on historical or original cost basis - book value
Market value may be worth two to three times original cost, so it may require many times original cost to replace
Balance Sheet Limitations
> is sometimes referred to “operating profit” or “operating income,” and
is sometimes called “pre-tax income”
EBIT
(or earnings before interest, taxes, depreciation, and
amortization) also referred to sometimes as “gross profit”
EBITIDA
▪ Income gained or lost during given period is
function of verifiable transactions (but some
transactions can be in the pipeline)
▪ Flexibility (AKA discretion) in reporting
transactions can result in differing
measurements of income gained from similar
events at end of time period
»>i.e. depreciation
Income Statement Limitations
companies have 2 options on what to do with net income
- pay dividends (to shareholders)
- keep it (add it to retained earnings)
Emphasizes critical nature of cash flow to firm operations
Statement of Cash Flows
Allows matching of revenues and expenses in period
in which they occur to appropriately measure profits
Advantage of accrual method
Adequate attention not directed to firm’s actual cash
flow position
Disadvantage of accrual method
__________ analysis helps in combating
discrepancies faced through accrual method of
accounting
Cash-flow
net income, depreciation, changes in CAs and CLs
Cash flows from operating activities
changes in long-term assets
Cash flows from investing activities
changes in long-term debt and stock dividends
Cash flows from financing activities
results of statement of cash flows added together to compute net change in _______
cash flow (total)
Current Assets - Current Liabilities
Net Working Capital
Operating Current Assets - Operating Current Liabilities
(Current Assets - Excess Cash) - (Current Liabilities - Notes Payable)
Net Operating Working Capital
“the amount of cash that could be withdrawn without harming a firm’s ability to operate and produce future cash flows.”
Free Cash Flow (FCF)
[EBIT (1-T) + Depreciation and amortization] - [Capital expenditures + change in NOWC]
Free Cash Flow (FCF)
change in Net Fixed Assets + Depreciation
>this is calculated in the investing section of the statement of cash flows
Capital Expenditures
Why are ratios useful?
-standardize numbers and facilitate comparisons
-good starting point for strategic
initiatives
-highlight weaknesses and
-comparisons should be made through time
and with competitors (industry analysis, Benchmark (peer) analysis, and trend analysis)
-Finding truly comparable companies is difficult because no two organizations are exactly alike.
-Finding a comparable industry can be difficult for
conglomerate firms with various segments (i.e. Disney)
-Seasonal factors can distort
Issues/Limitations of Ratio Analysis
5 major categories of Ratios
Liquidity, Asset management, Debt management, Profitability, and Market value
what question does liquidity answer?
Can we make required short-term payments?
What question does Asset management answer?
Are we utilizing our assets efficiently to generate sales revenue?
What question does Debt management answer?
What is the mix of debt and equity?
What question does Profitability answer?
Do sales prices exceed unit costs, and how profitable is the firm?
What question does Market value answer?
How does the market value out assets/earnings?
______ should be greater than one… A firm should have more current assets than liabilities.
Current assets ÷ Current liabilities
Current ratio
_______ removes inventory from the numerator. Inventory not as liquid and some may be not be sellable (damaged, obsolete, expired, etc.)
(Current assets - Inventories) ÷ Current liabilities
Quick ratio
How many times a year does a firm sell out all its inventory? Bigger is better!
Cost of goods sold ÷ Inventories
Inventory Turnover (IT)
How long does it take to get paid by customers? Smaller is better! this number should be compared to sales contracts and internal payment policies.
=Receivables ÷ Average sales per day
=Receivables ÷ (Annual sales ÷ 365)
Days Sales Outstanding (DSO)
How well is the firm using its assets to generate sales? Bigger is better!
=Sales ÷ Net fixed assets
Fixed Assets Turnover (FATO)
How well is the firm using its assets to generate sales? Bigger is better?
=Sales ÷ Total assets
Total Assets Turnover (TATO)
▪ How much debt is the firm using to fund invested capital?
= Total debt ÷ Total invested capital
= (notes payable + LT debt) ÷ notes payable + LT debt + equity)
Total Debt-to-Capital Ratio
Is the firm earning enough to pay the interest on their debt? Bigger is better!
=EBIT ÷ Interest expense
Times-Interest-Earned (TIA)
Are assets being funded with debt or equity?
The higher (lower) the value, the more debt (equity) is used.
=Total assets ÷ Total equity
=(total liabilities + total equity) ÷ total equity
Equity Multiplier (EM)
Is the firm making money? How profitable is the firm? Bigger is better! Consists of Operating Margin (OM),
Profit Margin (PM), Basic Earning Power (BEP), Return on Assets (ROA), Return on Equity (ROE), and Return on Invested Capital (ROIC)
Profitability
Price-Earnings (P/E), Market-to-Book (M/B), and Market Value Added (MVA)
For all, bigger is better! All will be large if expected growth is high and risk is low.
Market Value
How much are investors willing to pay for $1 of earnings?
=Price/Earnings per share
=Price/(net income/ # of shares)
Price-Earnings (P/E)
How much are investors willing to pay for $1 book value equity?
=Market price/Book value per share
=Market price/(total equity/ # of shares)
Market-to-Book (M/B)
What is the difference between a firm’s market and book value of equity?
=(Market price X Shares Out) - Book value of equity
=Market value of equity - Book value of equity
Market Value Added (MVA)
breaks down the components of ROE as operating profitability (PM), asset utilization (TATO), and debt utilization (equity multiplier).
ROE=Profit Margin X Total assets turnover X Equity multiplier
ROE=(Net Income/Sales) X (Sales/Total assets) X (Total assets/Equity)
The DuPont Equation
Qualitative Factors Should Also Be Considered
▪ Are the firm’s revenues tied to one key customer, product, or supplier?
▪ What percentage of the firm’s business is generated overseas?
▪ Firm’s competitive environment
▪ Major expected changes in the future
▪ Legal and regulatory environment
Forecast an income statement and balance sheet using a ____________________.
percentage of sales method
Use the ______________ equation and discuss the relation between asset growth and the need for funds.
Additional Funds Need (AFN)
Excess capacity and other factors affect _______ if constant percentage of sales assumption is dropped
needed funds
A Financial Plan typically starts with a ___________.
sales forecast
Good sales forecasts typically start with historical information and account for changes in:
- Economic conditions
- Interest rates/inflation/pricing
- Marketing pressure
- Products offered, and much more!
We must figure out the __________ to facilitate the change in sales as well as the liabilities that will spontaneously change.
* Funding options include using internal funds, additional debt or issuing equity.
* Easiest method: percent of sales method
asset requirements
How much additional funding (sometimes called external funds needed) will we need to support this growth?
If % of sales ratios are expected to remain constant:
(A0/S0)change in S – (L0/S0)S – M(S1)(RR)
The AFN (or EFN) Equation
Higher dividend payout ratio?
Increase AFN: Less retained earnings
Higher profit margin?
Decrease AFN: Higher profits, more retained earnings
Higher capital intensity ratio?
Increase AFN: Need more assets for a given level of sales.
Pay suppliers in 60 days, rather than 30 days?
Decrease AFN: Creditors supply more capital (i.e. L0*/S0 increases).
When _____________ is dropped, the AFN formula no longer works, and the only way to determine AFN is by working through the financial statements.
Constant % of sales
On example was determining required NFA when expecting changes in capacity usage:
- Determine full capacity sales
- Determine original NFA as a proportion of full capacity sales
- Determine new level for needed NFA
= actual sales/ % of capacity used
Full capacity sales
Target fixed assets/sales = original fixed assets/full capacity sales
determine original NFA as a proportion of full capacity sales
=(target fixed assets/sales) X projected sales
Required level of fixed assets
dropping the constant percent of sales assumption:
- Decreasing expected DSO
- Purchasing a new facility (given new NFA)
- Increasing expected inventory turnover
