Unit 2 Concepts Flashcards
What does liquidity measure? Explain the trade-off a firm faces between high liquidity and low liquidity levels.
Liquidity measures how quickly and easily an asset can be converted to cash without significant loss
in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in
meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated
with it—namely that higher returns can generally be found by investing the cash into productive
assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial management
staff to find a reasonable compromise between these opposing needs.
Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period?
The recognition and matching principles in financial accounting call for revenues, and the costs
associated with producing those revenues, to be “booked” when the revenue process is essentially
complete, not necessarily when the cash is collected or bills are paid. Note that this way is not
necessarily correct; it’s the way accountants have chosen to do it.
In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?
Historical costs can be objectively and precisely measured whereas market values can be difficult to
estimate, and different analysts would come up with different numbers. Thus, there is a trade-off
between relevance (market values) and objectivity (book values).
In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow. Explain what each is and why it is excluded in operating cash flow.
Depreciation is a noncash deduction that reflects adjustments made in asset book values in accordance
with the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a
financing cost, not an operating cost.
Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can this happen with market values? Why or why not?
Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that
if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How
many shares do you want to buy? More generally, because of corporate and individual bankruptcy
laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed
assets in market value.
Suppose a company’s cash flow from assets is negative for a particular period. Is this necessarily a good sign or a bad sign?
For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly
leading to negative cash flow from assets. In general, what matters is whether the money is spent
wisely, not whether cash flow from assets is positive or negative.
Suppose a company’s operating cash flow has been negative for several years running. Is this necessarily a good sign or a bad sign?
It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-
up, so it depends.
Could a company’s change in NWC be negative in a given year? (Hint: Yes.) Explain how this might come about. What about net capital spending?
For example, if a company were to become more efficient in inventory management, the amount of
inventory needed would decline. The same might be true if it becomes better at collecting its
receivables. In general, anything that leads to a decline in ending NWC relative to beginning would
have this effect. Negative net capital spending would mean that more long-lived assets were liquidated
than purchased.
Could a company’s cash flow to stockholders be negative in a given year? (Hint: Yes.) Explain how this might come about. What about cash flow to creditors?
If a company raises more money from selling stock than it pays in dividends in a particular period, its
cash flow to stockholders will be negative. If a company borrows more than it pays in interest, its cash
flow to creditors will be negative.
Referring back to the Procter & Gamble example used at the beginning of the chapter, note that we suggested that Procter & Gamble’s stockholders probably didn’t suffer as a result of the reported loss. What do you think was the basis for our conclusion?
The adjustments discussed were purely accounting changes; they had no cash flow or market value
consequences unless the new accounting information caused stockholders to revalue the derivatives.
A firm’s enterprise value is equal to the market value of its debt and equity, less the firm’s holdings of cash and cash equivalents. This figure is particularly relevant to potential purchasers of the firm. Why?
Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have
to take on the company’s debt but would pocket its cash. Enterprise value differs significantly from
simple market capitalization in several ways, and it may be a more accurate representation of a firm’s
value. In a takeover, the value of a firm’s debt would need to be paid by the buyer. Thus, enterprise
value provides a much more accurate takeover valuation because it includes debt in its value
calculation.
Companies often try to keep accounting earnings growing at a relatively steady pace, thereby avoiding large swings in earnings from period to period. They also try to meet earnings targets. To do so, they use a variety of tactics. The simplest way is to control the timing of accounting revenues and costs, which all firms can do to at least some extent. For example, if earnings are looking too low this quarter, then some accounting costs can be deferred until next quarter. This practice is called earnings management. It is common, and it raises a lot of questions. Why do firms do it? Why are firms even allowed to do it under GAAP? Is it ethical? What are the implications for cash flow and shareholder wealth?
In general, it appears that investors prefer companies that have a steady earnings stream. If true, this
encourages companies to manage earnings. Under GAAP, there are numerous choices for the way a
company reports its financial statements. Although not the reason for the choices under GAAP, one
outcome is the ability of a company to manage earnings, which is not an ethical decision. Even though
earnings and cash flow are often related, earnings management should have little effect on cash flow
(except for tax implications). If the market is “fooled” and prefers steady earnings, shareholder wealth
can be increased, at least temporarily. However, given the questionable ethics of this practice, the
company (and shareholders) will lose value if the practice is discovered.
