corporate finance unit 2 study guides

Key Financial Statements

• Three primary financial statements provide a comprehensive view of a company's financial health (balance sheet, income statement, cash flow statement)
• Balance sheet presents a snapshot of a company's financial position at a specific point in time
  • Includes assets, liabilities, and shareholders' equity
• Income statement summarizes a company's financial performance over a period of time
  • Displays revenues, expenses, and net income or loss
• Cash flow statement tracks the inflows and outflows of cash during a specific period
  • Categorizes cash flows into operating, investing, and financing activities
• Notes to the financial statements offer additional context and explanations for reported figures
• Auditor's report provides an independent opinion on the accuracy and fairness of the financial statements
• Management discussion and analysis (MD&A) offers insights into the company's performance, risks, and future prospects

Importance of Financial Analysis

• Enables stakeholders to assess a company's financial health, performance, and potential for growth
• Helps investors make informed decisions about buying, holding, or selling shares in a company
• Allows creditors to evaluate a company's ability to repay debts and assess the risk of lending
• Assists management in identifying strengths, weaknesses, and areas for improvement in financial performance
• Facilitates comparisons between companies within the same industry or sector
• Provides a basis for valuation and determining the intrinsic value of a company's shares
• Supports strategic decision-making, such as mergers, acquisitions, and capital investments
• Helps detect financial irregularities, fraud, or mismanagement

Balance Sheet Breakdown

• Assets represent resources owned or controlled by a company that provide future economic benefits
  • Current assets are expected to be converted to cash or consumed within one year (cash, accounts receivable, inventory)
  • Non-current assets have a longer lifespan and are used to generate revenue over multiple periods (property, plant, equipment, intangible assets)
• Liabilities are obligations or debts owed by a company to external parties
  • Current liabilities are due within one year (accounts payable, short-term loans)
  • Non-current liabilities have a maturity longer than one year (long-term debt, deferred tax liabilities)
• Shareholders' equity represents the residual interest in a company's assets after deducting liabilities
  • Consists of contributed capital (funds invested by shareholders) and retained earnings (accumulated profits)
• The balance sheet equation: Assets = Liabilities + Shareholders' Equity
• Working capital is the difference between current assets and current liabilities, indicating a company's short-term financial health

Income Statement Essentials

• Revenue represents the total amount earned from the sale of goods or services during a specific period
• Cost of goods sold (COGS) is the direct cost associated with producing the goods or services sold
• Gross profit is calculated by subtracting COGS from revenue, showing the profit before operating expenses
• Operating expenses are costs incurred to run the business, such as salaries, rent, and marketing
• Operating income (EBIT) is the profit generated from a company's core business operations
  • Calculated by subtracting operating expenses from gross profit
• Non-operating income and expenses are not directly related to a company's core business (interest income, interest expense)
• Net income is the final profit after accounting for all revenues, expenses, and taxes
• Earnings per share (EPS) represents the portion of net income allocated to each outstanding share of common stock

Cash Flow Statement Basics

• Operating activities include cash inflows and outflows related to a company's core business operations
  • Cash received from customers, cash paid to suppliers and employees, and income tax payments
• Investing activities involve cash flows associated with the acquisition or disposal of long-term assets
  • Purchase or sale of property, plant, and equipment, investments in securities, or business acquisitions
• Financing activities encompass cash flows related to raising capital or returning funds to stakeholders
  • Issuing or repurchasing shares, borrowing or repaying loans, and paying dividends
• Free cash flow (FCF) is the cash generated by a company after accounting for capital expenditures
  • Calculated as operating cash flow minus capital expenditures
• The sum of cash flows from operating, investing, and financing activities, plus the beginning cash balance, equals the ending cash balance

Ratio Analysis Techniques

• Liquidity ratios assess a company's ability to meet short-term obligations
  • Current ratio: current assets / current liabilities
  • Quick ratio: (cash + marketable securities + accounts receivable) / current liabilities
• Profitability ratios measure a company's ability to generate profits relative to its revenue or assets
  • Gross profit margin: gross profit / revenue
  • Operating profit margin: operating income / revenue
  • Return on assets (ROA): net income / total assets
  • Return on equity (ROE): net income / shareholders' equity
• Solvency ratios evaluate a company's ability to meet long-term debt obligations
  • Debt-to-equity ratio: total liabilities / shareholders' equity
  • Interest coverage ratio: EBIT / interest expense
• Efficiency ratios gauge how effectively a company uses its assets and manages its operations
  • Inventory turnover: COGS / average inventory
  • Receivables turnover: revenue / average accounts receivable
  • Asset turnover: revenue / total assets

Cash Flow Analysis Methods

• Direct method reports cash receipts and payments from operating activities
  • Provides a more detailed view of cash flows but is less commonly used
• Indirect method starts with net income and adjusts for non-cash items and changes in working capital
  • More widely used and easier to prepare using information from the balance sheet and income statement
• Free cash flow to the firm (FCFF) represents the cash available to all investors, including bondholders and shareholders
  • Calculated as operating cash flow minus capital expenditures plus after-tax interest expense
• Free cash flow to equity (FCFE) represents the cash available to common shareholders after meeting all other obligations
  • Calculated as FCFF minus interest expense plus net borrowing
• Discounted cash flow (DCF) analysis estimates the intrinsic value of a company by projecting future cash flows and discounting them to the present value

Real-World Applications

• Investors use financial statement analysis to identify undervalued or overvalued stocks and make investment decisions
• Creditors assess a company's creditworthiness and ability to repay loans based on its financial health
• Management uses financial analysis to monitor performance, set targets, and make strategic decisions
  • Identifying areas for cost reduction, revenue growth, or operational improvements
• Analysts and researchers use financial data to compare companies within an industry and identify trends or best practices
• Regulators and auditors use financial statements to ensure compliance with accounting standards and detect irregularities
• Mergers and acquisitions teams analyze financial statements to determine the value and synergies of potential target companies
• Entrepreneurs and small business owners use financial analysis to secure funding, manage cash flow, and plan for growth