FINANC 3000 1st Edition Lecture 2 Outline of Last Lecture I. What is Finance?II. Goals of Financial ManagementIII. Organizational Form of the BusinessIV. The Agency ProblemOutline of Current Lecture I. Balance SheetII. Income StatementIII. Statement of Cash FlowsIV. Statement of Retained EarningsCurrent LectureBalance Sheet- Reports firm’s assets, liabilities and equity at a point in timeo Assets= Liabilities + EquityAssets- Current Assetso Normally convert into cash within a yearo Cash (and marketable securities)o Accounts receivableo Inventory- Fixed Assetso Useful life exceeding one year Physical (tangible) assets (e.g. net plant and equipment) Less tangible, long-term assets (e.g. patents, trademarks, and goodwill)Liabilities- Liabilities are loans to the firmo Current liabilities- obligations due within a yearThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. Accruals (accrued wages and accrued taxes) Accounts payable Notes payable- portion of long term debt due in current yearo Long term debt- long term loans and bonds- maturities > one yearEquity - Differences between a firm’s total assets and total liabilities- Types of equityo Preferred stock- hybrid security- characteristics of both long term debt and common stocko Common stock and Paid-in- Surplus- fundamental ownership claim in public or private companyo Retained Earnings- cumulative earnings- reinvested- not paid as dividendsNet Working Capital- Net Working Capital= current assets – current liabilities- Net working capital is measure of firm’s ability to pay obligations- Healthy firms have positive net working capitalLiquidity- Ability to convert assets into cash at Fair Market Value (FMV)- Current assets = most liquido Cash, marketable securities, accounts receivable, and inventoryo Inventory is least liquid of current assets- Fixed assets = less liquid- Liquidity is a double-edged swordo Risk-return trade-offo More liquidity- firm can more easily pay obligations- less riskyo Liquid assets offer low returnso Fixed assets illiquid- help generate revenue and profitsDebt vs. Equity Financing- Financial leverage = debt securitieso Magnifies gains and losseso Debt holders = fixed claim on firm’s cash flows (interest paid on securities)o Stockholders = claim on remaining cash flow- Choice of firm’s capital structure (% of debt vs. % of equity) represents management’s risk and return preferenceBook Value vs. Market Value- Book Value (historical cost)o Assets listed on balance sheet at purchase price- Market Valueo Assets listed at value if sold in today’s marketIncome Statement- Firm’s total earned revenues and total incurred expenses- over a period of timeo Income statement top line = revenueso Expenses listed below revenueso Bottom line = difference between revenues and expenses- Firm’s operating income reported in top part- Summary of financial and tax structure in bottom partCorporate Income Taxes- Firms taxed on earnings- U.S. tax code determines corporate tax obligations – overseen by Congresso Tax rate changes driven by changes in government, business or public environment- Average Tax Rateo Percentage of each dollar of taxable income that the firm pays in taxes Average tax rate = tax liability/ taxable income- Marginal Tax Rateo Taxes paid for each dollar of firm’s additional taxable incomeStatement of Cash Flows- Financial statement that shows firm’s cash flows over given period of timeo Reflects that actual cash that has been given or receivedo Excludes transactions with no direct effect on cash receipts and paymentso Bottom line shows the change in cash on the firm’s balance sheet- Two main sources of differenceo GAAP Accounting Principleso Noncash income statement entriesCash flows from Operating Activities- Cash flows that result from directly producing and selling the firms products:o Net incomeo Depreciationo Working capital accounts other than cash and short-term debt (such as AR and AP)Cash flows from Investing Activities- Represents cash flows associated with buying or selling fixed or other long-term assets- Reflects the firm’s investment in or disposal of fixed assetsCash flows from Financing Activities- Cash flows from debt and equity financing transactionso Issuing short- or long- term debto Issuing stocko Using cash to pay dividendso Using cash to pay off debto Using cash to buy back stockFree Cash Flow- The cash available for distribution to the investors after the investments for firm’s necessary, ongoing operations- After-tax operating profit minus the amount of new investment in working capital, fixed assets, and the development of new productStatement of Retained Earnings- Detail changes in retained earnings during reporting period- Reconciles net income and dividends paid with changes in retained earnings from one period to the next Cautions in Interpreting Financial Statements- GAAP standards required for financial statements- Firms can use “earnings management” with GAAP accounting ruleso “Smooth” earningso Use different depreciation methods- Sarbanes-Oxley Act passed in 2002o Prevents deceptive accounting and management