I: The Art of Finance (and Why It Matters) Flashcards
Explain what is the common fallacy when thinking about financial intelligence and give one example.
We think that if a number shows up on the financial statements or the finance department’s reports to management, it must accurately represent reality.
Surely, a company sold what it sold, spent what it spent, earned what it earned. Even where fraud is concerned, unless a company really does ship empty boxes, how can its executives so easily make things look so different than they really are?
Enron’s spurious transactions.
Explain the term of the Art of accounting and finance.
The art of accounting and finance is the art of using limited data to come as close as possible to an accurate description of how well a company is performing.
What it means that assumptions and estimates introduce bias in the numbers on financial reports?
It means only that accountants and finance professionals have used certain assumptions and estimates rather than others when they put their reports together.
What is revenue (or sales)?
Revenue or sales refers to the value of what a company sold to its customers during a given period.
What are the options for when should revenue be recorded?
When should revenue be recorded (or “recognized,” as accountants like to say)? Here are some possibilities:
- When a contract is signed
- When the product or service is delivered (this one usually)
- When the invoice is sent out
- When the bill is paid
What is the income statement?
The income statement shows revenues, expenses, and profit for a period of time, such as a month, quarter, or year. It’s also called a profit and loss statement, P&L, statement of earnings, or statement of operations. Sometimes the word consolidated is thrown in front of those phrases, but it’s still just an income statement. The bottom line of the income statement is net profit, also known as net income or net earnings.
What are the operating expenses?
Operating expenses are the costs that are required to keep the business going day to day. They include salaries, benefits, and insurance costs, among a host of other items. Operating expenses are listed on the income statement and are subtracted from revenue to determine profit.
What is the difference between capital expenditure and operating expense?
All you need to know is that an operating expense reduces the bottom line immediately, and a capital expenditure spreads the hit out over several accounting periods. You can see the temptation here. Wait. You mean if we take all those office supply purchases and call them “capital expenditures,” we can increase our profit accordingly?
What are the capital expenditures?
A capital expenditure is the purchase of an item that’s considered a long-term investment, such as computer systems and equipment. Most companies follow the rule that any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. Operating expenses show up on the income statement, and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement
What accountants use accruals and allocations for?
Accountants use accruals and allocations to try to create an accurate picture of the business for the month
What is an accrual (obracun)?
An accrual is the portion of a given revenue or expense item that is recorded in a particular time span. Product development costs, for instance, are likely to be spread out over several accounting periods, and so a portion of the total cost will be accrued each month. The purpose of accruals is to match revenues to costs in a given time period as accurately as possible.
What are allocations (izdvajanje)?
Allocations are apportionments of costs to different departments or activities within a company. For instance, overhead costs such as the CEO’s salary are often allocated to the company’s operating units.
Explain the notion of depreciation on an example.
Say a company buys some expensive machinery or vehicles that it expects to use for several years. Accountants think about such an event like this: rather than subtract the entire cost from one month’s revenues—perhaps plunging the company or business unit into the red for that month—we should spread the cost out over the equipment’s useful life.
What is the depreciation (amortizacija)?
Depreciation is the method accountants use to allocate the cost of equipment and other assets to the total cost of products and services as shown on the income statement. It is based on the same idea as accruals: we want to match as closely as possible the costs of our products and services with what was sold. Most capital expenditures are depreciated (land is an example of one that isn’t). Accountants attempt to spread the cost of the expenditure over the useful life of the item
How is determined how much a company is worth?
Publicly traded companies, of course, are valued every day by the stock market. They are worth whatever their stock price is times the number of shares outstanding, a figure known as their market capitalization or just market cap.
Suppose, for example, your company proposes to acquire a closely held manufacturer of industrial valves. It’s a good fit with your business—it’s a “strategic” acquisition—but how much should you pay?
a) Well, you could look at the valve company’s earnings (another word for profits), then go to the public markets and see how the market values similar companies in relation to their earnings. (This is known as the price-to-earnings ratio method.
b) Or you could look at how much cash the valve company generates each year, and figure that you are, in effect, buying that stream of cash. Then you would use some interest rate to determine what that stream of future cash is worth today. (This is the discounted cash flow method.)
c) Alternatively, you could simply look at the company’s assets—its plant, equipment, inventory, and so on, along with intangibles such as its reputation and customer list—and make estimates about what those assets are worth (the asset valuation method).
