Midterm 1 Part 1 Flashcards
What are the three basic financial statements?
- Balance Sheet
- PnL or Income statement
- Statement of Cash flows
What is the purpose of analyzing a company’s financial statements?
To understand the economic character / health of the company and use the information to make good valuation decisions
True or False: In finance, we learn how to create financial statements
False
What is the purpose of learning financial statements in finance if we’re not going to be creating them?
To understand how to make decisions based on the information available to us.
Finance people learn how to READ and interpret financial statements rather than put them together
What is cash accounting?
Putting together financial statements based solely on cash in and out of the firm.
What is accrual accounting?
Accrual accounting looks at revenues we’ve incurred during THAT YEAR and then tries to determine how we financed that revenue.
The left side matches the right side of the Balance sheet
What is the matching principle?
The left and right side balance. Revenues and the expenses used to generate those revenues MUST BE REPORTED TOGETHER IN THE SAME YEAR.
Which type of accounting makes the matching principle true?
Accrual accounting
True or False: Accrual accounting represents cash in and out of the firm
False
GAAP
Generally Accepted Accounting Principles
What are two main accounting-ese principles that you must understand to be able to read financial statements?
- Accrual accounting
- Historical cost
What is one setback of accrual based financial statements?
You can’t just look at them simply, because the dates of revenues and financing reported may not necessarily be accurate.
They’re a little complex to analyze, lots of room for interpretation.
What is the most common accounting system in America?
Accrual
Why do people use the accrual system (vs. the cash system) if it’s difficult to interpret?
Because it makes COMPARING companies easier. The cash system does the opposite: it makes the statements easier to comprehend but it’s almost impossible to compare different companies.
What is the historical cost principle?
It means that items that appear on a financial statement are listed at their historical cost, meaning the cost that they were originally purchased for (even if it was 20 years in the past).
The historical cost principle does not account for TVM
What is one of the problems of the historical cost principle?
It means that an asset’s book value will not accurately match the current market value
What are two reasons why standardized forms are important?
- It facilitates analysis
- Clarifies communication
True or False: You look like an idiot if you don’t use the standard form when putting financial statements together.
True
What is the balance sheet showing?
A snapshot or summary of the firm’s assets and financing structure.
True or False: The balance sheet shows the company’s assets and liabilities from a specific point in time.
True.
The BS will always have a date listed “as of”
What does the BS equation mean?
It means that any asset of the company has to be financed through debt or equity.
What are the two types of assets on the balance sheet?
Current and fixed
What is a current asset?
Either cash or an asset that can be turned into cash within one year.
How are current assets listed on the BS? In what order?
In order of liquidity
Types of current assets
Cash, inventory, accounts receivable, marketable securities
What are marketable securities?
They are generally short-term, high-quality assets like Treasury bills and CDs
What is another name for a marketable security?
Cash equivalents
What does liquidity measure?
How quickly an asset can be turned into cash without taking a large discount in value
What are accounts receivable?
It is essentially money that we have loaned to somebody else that we want them to pay back
How is AR generated?
By selling / buying on credit
Is the AR on a BS accurate? Why or why not?
It is not always accurate. We have to ASSUME that they will pay us back, but if they don’t, then that money doesn’t actually exist.
What are questionable receivables?
Potentially bad debt.
It’s like you loan money to somebody and you aren’t sure if they’ll be able to pay you back.
What is a contra-asset account?
It is a reserve account that management keeps to balance the AR amount on the BS for accounts that we don’t think we’ll receive a full repayment from (questionables)
What is usually the least liquid type of CA?
Inventories
What potential risks are inventories subject to?
Spoilage, shrinkage (waste/theft), salability (will they still be marketable at full price)
LIFO
Last in first out
The last inventory items purchased are the first sold to customers
FIFO
First in first out
The first inventory items purchased by the company are the first sold to customers
What do LIFO and FIFO apply to?
They are accounting assumptions that determine the value of your inventory.
They determine how and when the cost of goods will be recognized on the BS
Who decides whether to use FIFO or LIFO?
Management
Why would it be better to choose FIFO over LIFO, or vice versa?
The decision is made solely to influence the value of the inventory you can list on your BS
Why are fixed assets generally less accurate than current assets?
Because fixed assets are long term assets, which are all recorded at historical cost. This cost does not account for TVM, so the book value is different than the market value.
True or False: An asset depreciates exactly the same as the depreciation schedule outlines
FALSE
An asset’s value is determined by the market, not a schedule. If you can find somebody willing to buy your asset, it doesn’t matter how much it’s depreciated
What is the only real difference between current and fixed assets?
Current assets have a life span less than one year, fixed assets have a life greater than one year
What are current liabilities?
Liabilities that are going to require cash within the next year
In what order are CL listed on the BS?
In order of maturity, shortest maturity listed first
Examples of CL
Accounts payable, notes payable, accruals
What are AP?
It’s money that you owe somebody else because you bought on credit
What is a Note payable?
They are explicitly an interest bearing lending agreement. Basically it’s AP, but the institution requires you to pay interest, like a bank
What’s the difference between NP and AP?
Just interest, they’re both loans
What are accruals?
It’s money that you owe but haven’t paid out yet (based on the date on the financial statement)
Like employee wages or utilities
Are current liabilities accurate?
Typically yes, they’re easy to track
What is an example of a long-term debt?
A bond could be
True or False: A long term debt has a life over one year
True
True or False: The value of long term debt on a BS is accurate
False
Types of equity
Common stock, preferred stock, Retained earnings, Additional paid-in capital
True or False: The book value of equity is the same as market value
False
What are retained earnings?
It’s money the company has earned that has NOT been paid out to stockholders.
True or False: If the company has $10 mil in RE, it can use that money to fund a new project
FALSE
Because RE is balanced out on the balance sheet. The BS has a net sum of 0. That money was already used to finance something else.
RE represents money that has been reinvested to the existing assets of the firm.
True or False: The money included in the RE includes all the money the company has ever made that it has not paid out in dividends (from inception)
TRUE
Simplified
Why do ratio analysis?
Because it allows us to compare similar features of very different companies - rather than compare financial statements that would be difficult to interpret given the differences.
True or False: Ratio analysis helps us determine which company is the better performer
True
True or False: Ratio analysis can help us choose a company to invest in
True
True or False: Ratios take companies of different sizes and scale them according to their own operations, allowing them to be compared.
True
Standardization
Scaling companies according to their own size and parameters
True or False: Ratio analysis is also helpful when comparing present company performance to past company performance
True
Why do banks use ratio analysis when determining the mortgage amount?
Because they want to see how the ratio of debt you would be taking on if they gave you the loan. If one person would be taking on 38% debt, and another person taking on 26% debt, the person with 26% would be better able to make the payments and would get the loan.
What are the advantages of ratio analysis?
- Standardization
- Flexibility
- Helps you look for information in the right places
- Determine if the firm is meeting the goal of maximizing shareholder wealth
True or False: Ratios and ratio analysis have to follow a predetermined set of rules so that everybody can interpret them the same way.
False
How are ratios flexible?
They don’t follow rules so they can be adjusted to meet any needs
True or False: If the ratio you are using does not give you the information you need to know, then invent a new one.
True
True or False: Ratios tell you what is happening in the company
False
Ratios indicate that something is changing in the company, but they don’t indicate how. They SHOW YOU where to look though.
True or False: As an analyst, your job is to notice trends in ratio analysis and dig deeper for insight
True
What is the mantra of ratio analysis?
Ratios don’t answer questions, they just show you what questions to ask
True or False: In a publicly traded company, the CEO and executives act as agents for the shareholders
TRUE
They are chosen and elected by shareholders
How is company management evaluated?
On the basis that they are meeting the needs of the investors
What is the principle-agent problem?
When the owner/manager doesn’t act in the best interests of the shareholders, they maximize money to their OWN pocket
What are agency costs?
The costs that result from the principle-agent problem
When using ratio analysis to determine if management is being successful in its goals, what is the main question you should be asking?
Not if the company is making money, but if it’s making as much money as it COULD be making
What are the four main categories of ratios in ratio analysis?
- Liquidity
- Asset use efficiency
- Financing
- Profitability
Who cares the most about liquidity ratios?
The lenders, banks etc.
Why do banks care so much about liquidity ratios?
Because they want to make sure the company has enough cash to make their payments every month.
What does a liquidity ratio mean?
It shows how much cash the firm has available at any given time (liquid assets)
True or False: The liquidity of a firm refers to its ability to meet short-term obligations
True
True or False: Any short-term creditor, including raw materials suppliers, are the most interested in liquidity ratios
True
What is the most common liquidity ratio?
Current ratio
What does a higher current ratio mean?
It means that the firm will be better able to meet its short-term obligations
What does it mean if the currency ratio is approaching 1 or falls below 1?
It means the firm is probably unlikely to be able to pay short term obligations. Serious cash and liquidity problems
What is another word for quick ratio?
Acid test ratio
True or False: Inventory is the least liquid type of current assets
True
Why does the quick ratio also compare current assets and current liabilities, but in a slightly different way?
It takes inventory out of the equation because it is the least liquid. It is simply defining “liquidity” in a different way.
This is why it’s called the “quick” ratio, because it’s only comparing assets that can be liquidated QUICKLY
True or False: A high quick ratio is better than a high current ratio
True, because the assets are VERY liquid
What is the average collection period ratio?
It is the average number of days it takes a company to collect its receivables.
What are daily credit sales?
They are annual credit sales divided by 365
What are credit sales?
Sales made where payment is made at a later date.
They’re just sales but the payment timing is different.
True or False: If the financial statements don’t differentiate between cash and credit sales, you should just assume all sales are credit.
True
True or False: If the financial statements don’t differentiate between cash and credit sales, you would divide sales by 365 to find daily credit sales
TRUE
What does an average collection period of 32 mean?
If the company sells goods TODAY, on average it will take about 32 days to collect the payment for those goods.
What does the AR Turnover ratio mean?
It describes the number of times a firm collects its AR per year
True or False: AR Turnover and the average collection period ratios are redundant and will rarely be used together
TRUE
Why are the AR turnover and average collection period ratios redundant?
Because they both show when the firm is collecting cash for goods sold.
