Introduction to Finance Chapter 2
Introduction to Finance Chapter 2 Fin 301
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This 5 page Class Notes was uploaded by Rodriguez Notetaker on Sunday January 10, 2016. The Class Notes belongs to Fin 301 at Drexel University taught by Dr. Tricia Robak in Fall 2016. Since its upload, it has received 24 views. For similar materials see Principles of Finance in Finance at Drexel University.
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Date Created: 01/10/16
Introduction to Finance 301: Chapter 2: Financial Statements, Taxes, and Cash 2.1 The Balance Sheet Balance Sheet: is a snapshot of the firm. It’s a summary what a firm owns (its assets) what a firm owes, and the difference between the two at a given point in time. Balance sheet identity o Assets = liabilities + stockholders’ equity Assets: o Classified as current or fixed Fixed assets are the ones that have a long life can be tangible (truck for example) or intangible (trademark). Current assets Are the ones that have a life less than one year (converted to cash within 12 months) o Liabilities and owners’ equity: Liabilities Classified as current or long-term o Current: have a life of less than one year and are listed before long-term liabilities o Long-term: is a debt that is not due in the coming year and also any loans which should be paid off by 5 years Shareholders’/Stockholders’ equity Is intended to reflect the fact that, if the firm were to sell all its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders. The balance sheet balances because the value of the left side always equals the value of the right side. Net working capital o The difference between a firm’s current assets and its current liabilities NWC = CA-CL o It is positive if CA exceed CL Meaning the cash that will become available over the next 12 months exceeds the cash that must be paid over the same period. Balance sheet preview The structure of the assets reflects the line of business the firm is in and also managerial decisions about how much cash and inventory to have and about credit policy the liabilities side of the balance sheet primarily reflects managerial decisions about capital structure and the use of short-term debt. Liquidity o It refers to the speed and ease with which an asset can be converted to cash o Two dimensions Ease of conversion Loss of value o Assets are normally listed on the balance sheet in order of decreasing liquidity meaning that most liquid assets are listed first o Current very liquidity o Fixed are relatively illiquid. o The more liquid a business is the less likely it is to experience financial distress Meaning that liquid assets are generally less profitable to hold Debt versus Equity o Financial leverage: the use of debt in a firm’s capital structure o The more debt the firm has (as a percentage of assets) the greater is its degree of financial leverage o Financial leverage increases the potential reward to shareholders meaning it also increases the potential for financial distress and business failure Market value versus book value o GAAP (Generally Accepted Accounting Principles) Show assets at historical cost Meaning carried on the books o Current assets Market value and book value are similar These type of assets are bought and converted into cash over a relatively short span of time o Fixed assets The actual market value of an asset (what the asset could be sold for) is equal to its book value Ex. A railroad you pay at a certain price a century ago is not the same price as today’s market but nevertheless the balance sheet would show the historical cost o The difference Market value is actually the value of the asset that depends on things like cash flows and riskiness Book value can be changed from time to time because changes can take place to lead to reductions on certain assets 2.2 The Income Statement Income statement: o Measures performance over some period of time, usually a quarter or a year o Revenues – Expenses = Income First part of the IS is the revenue and then the expenses from the firm’s principal operations The subsequent parts are more like financial expenses like interest paid Then taxes Then last item is the net income or earning per share GAAP and the income statement o The general rule is the realization principle Is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known This means that revenue is recognized at the time of sale which is not the same as the time of collection o Expenses are based on the matching principle That is to first determine revenues as described previously and then match those revenues with the costs associated with producing them It is realized at the time of sale With both things said above the IS may not be at all representative of the actual cash inflows and outflows that occurred during a particular period 2.4 Cash Flow Cash flow o The difference between the number of dollars that came in and the number that went out Cash Flow Identity: o Cash flow from assets = Cash flow to creditors + Cash flow to stockholders Cash Flow from Assets o Cash Flows from assets: Three components: operating cash flow, capital spending and change in NWC (Net Working Capital) o Operating Cash Flow Refers to the cash flow that results from the firm’s day-to- day activities of producing and selling o Capital Spending Refers to the net spending on fixed assets (purchases of fixed asssets less sales of fixed assets) o Changes in Net Working Capital Refers to Current assets – Current Liabilities for the period being examined Operating Cash Flow o Earning before interest and taxes + Depreciation – Taxes o It tells us whether a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows Capital Spending o Is money spent on fixed assets less money received from the sale of fixed assets o Ending net fixed assets – Beginning net fixed assets + depreciation = net capital spending o Capital Spending can be NEGATIVE It can happen when the firm sold off more assets than it purchased Net means to purchases of fixed assets net of any sales of fixed assets Change in Net Working Capital o Ending Net Working Capital – Beginning Net Working Capital = Change in NWC NWC = Current assets – Current Liabilities Conclusion: o Cash Flow from assets: OCF – Net capital Spending – NWC Cash flow to creditors and stockholders o Represent the net payments to creditors and owners during the year o Cash flow to creditors: is Interest Paid - Net New Borrowing o Cash flow to stockholders: is Dividends paid – Net New Equity Raised Cash Flow to Creditors o Interest paid – Net New Borrowing = Cash flow to creditors Net New Borrowing= Ending Long Term Debt – Beginning Long Term Debt Cash Flow to Stockholders o Dividends paid – Net New Equity Raised = Cash flow to stockholders Net New Equity Raised = Ending Common stock and paid- in surplus account – Beginning Common stock and paid-in surplus account Cash Flow identity needs to be balanced on both sides
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