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Chapter 2 Book Notes

by: David Kavalerchik

Chapter 2 Book Notes Fin 301

David Kavalerchik
GPA 3.2

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About this Document

These notes cover chapter 2 of "Financial Management: Core Concepts." It includes the in depth exploration financial statements; balance sheets, income statements, statement of retained earnings...
Intro to Finance
Ozgur Arslan Ayaydin
Class Notes
finance UIC uic fin FIN 302 Ozgur notes short cut
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This 9 page Class Notes was uploaded by David Kavalerchik on Friday January 29, 2016. The Class Notes belongs to Fin 301 at University of Illinois at Chicago taught by Ozgur Arslan Ayaydin in Spring 2016. Since its upload, it has received 37 views. For similar materials see Intro to Finance in Finance at University of Illinois at Chicago.


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Date Created: 01/29/16
Financial Statements We use four financial statements to measure and report the performance of a firm: 1.  The balance sheet  2.  The income statement  3.  The statement of retained earnings  4.  The statement of cash flows Balance Sheet: Represents the set of assets owned by the company and all claims against these assets. Think  of the  words own and owe. The balance sheet states what the company owns and what  it  owes at a fixed point in time. Notice that fixed point. The balance sheet is like  a snapshot of  all the assets and claims against these assets at that particular point  in time. Assets are things of economic value that the company owns. They can be physical (such as  buildings, equipment, and inventory), financial (such as accounts receivable), or intellectual  (such as patents and trademarks), and they  include cash itself.  Liabilities are the amounts of money that a company owes to others such as payroll, taxes, and money borrowed via loans. We typically call the liabilities the debt of the company.   Equity is the third section of the balance sheet and is what the owners receive after companies  have  satisfied their liabilities. In other words, it is what is left of the assets once the  company  has settled the liabilities. An identity is a relationship that is always satisfied for all the variables in an equation and is noted by the symbol ≡ . In other words, accounting identity: assets ≡ liabilities + owners equity Double­entry Bookkeeping: When the company records a debit amount and an equal credit  amount each time it records an economic transaction.  From the finance perspective, the balance sheet has five principal sections of  information: 1.  Cash account  2.  Working capital accounts  3.  Long­term capital assets accounts  4.  Long­term debt accounts  5.  Ownership accounts Cash Account:  It tells you how much money you currently have for paying bills or spending  on new items. Working Capital Accounts:  The current assets and current liabilities of the company. Current assets are accounts that will normally turn into cash over the course of  the  operating or business cycle of the firm.  Current liabilities are accounts that  will come due for payment over the operating or  business cycle. The measure of the relationship between current assets and current liabilities is net working  capital: net working capital = current assets − current liabilities Long­Term Capital Assets Accounts:  The long­term capital assets accounts of  the  balance sheet represent the capital investment of the company in things such as land, buildings, and machinery. Think “long term ­> buildings, land” and so on.  Long­Term Debt Accounts:  Debts that a company must pay more than one year from now are long­term liabilities. Ownership Accounts:  Also called ownership equity. Ownership Equity is what is left of the  assets once the company has settled the liabilities. Typically, it is made up of  common stock  and retained earnings.  The common stock account reflects the capital contributed to the firm by the stockholders Retained earnings are the earnings of the company that it reinvests in its core business. The Income Statement: Measures a company’s financial performance over a specific period of time. Distributed quarterly and annually for outside distribution and usually monthly for internal managers.    EBIT ­ earnings before interest and taxes revenue − operating expenses = earnings before interest and taxes" Net income is the accounting profit from the operations of the company during the period. Cash flow is the increase or decrease in cash for the period. To find cash flow we need to deal with 3 fundamental issues: ● accrual­ based accounting ● noncash expense items ● interest expense Accrual­based Accounting:  The company recognizes and records revenue at the time of  sale, whether or not it has received the revenue in cash. Similarly, the company records  expenses associated with the sale at the time of the sale, regardless of  whether the company  has paid out in cash the actual expenses. GAAP (Generally Accepted accounting Procedures) procedures allow the use of accrual­based  accounting to record revenue. Net income may not reflect the actual cash flow during the period because the company  assembles the income statement at a point in time when actual payment may be made at a later time.  Noncash Expense Items:  The income statement fails to contain noncash expense items like depreciation. Depreciation is a current expense of a cash outflow in a previous period. The  annual depreciation expense on the income statement is not an actual cash outflow during the  period. Interest Expense: We make a third adjustment to information from the income statement  because in finance we prefer to classify interest expense as part of the financing decisions of  the firm and not as part of its operating decisions. Now we can find the Operating Cash Flow (OCF). There are two ways to find it:  1. Start with the net income from the income statement and make  adjustments for depreciation and interest expense.       2.  Add the depreciation expense to EBIT and then subtract the taxes. Operating Cash Flow = earnings before interest and taxes + depreciation − taxes Statement of Retained Earnings Shows the distribution of net income for the past period. change in retained earnings = net income − distributed earnings ____________________________________________________________________________ Cash flow identity states that the cash flow from assets is equal to the cash flow to the cash  flow to the creditors and owners.  cash flow from assets ≡ cash flow to creditors + cash flow to owners (how to find the value of these 3 is outlined below) ■    cash flow from assets shows the success or failure of how the company uses the assets  (the operating and capital spending decisions) to generate cash inflow. ■    cash flow to creditors shows how the firm uses debt to finance the operations and its  repayment of the debt. ■    cash flow to owners completes the overview of financing and shows any additional  contributions by the owners and the return of capital to the owners. Cash Flow From Assets There are 3 components of the cash flow from assets: (1) operating cash flow OCF, (2) capital  spending, and (3) change in net working capital. OCF is the net income of the company, with depreciation and interest expenses added  back in to show the operating cash flow. (Noted earlier on pg 4) Capital spending is the change in the long­term assets plus the depreciation expense  from  the income statement. Capital spending = (ending long term assets − beginning long term assets) + depreciation The change in net working capital looks at both current assets and current liabilities from the  balance sheet and computes the change from the previous year to the next.  Cash Flow to Creditors cash flow to creditors = interest expense − net new borrowing from creditors Cash Flow to Owners cash flow to owners = dividends − net new borrowing from owners The Statement of Cash Flows Free Cash Flow Referred to as cash flow from assets in this book: the cash available to pay back creditors and owners once the company has made the investments in working capital and capital assets  necessary for growing and continuing the business.  It is the remaining cash “free” to distribute to creditors and owners." ____________________________________________________________________________ Financial Performance Reporting Fair Disclosure (regulation fair disclosure, or Reg FD) requires companies to release all   material information to all investors at the same time.


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