Understanding Balance Sheets and Income Statements in Finance

CH:3 Term: Balance Sheet: The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time. Assets are usually listed in descending order of liquidity, or the ability to convert to cash. While the assets depict what is owned, liabilities and equity represent what is owed or who provided the funding for the assets. Balance Sheet Identity: {Assets = Liabilities + Stockholders’ Equity}

Net Working Capital: The difference between current assets and current liabilities. It is positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out. Usually, it is positive in a healthy firm.

Market Value vs. Book Value: The balance sheet provides the book value of the assets, liabilities, and equity. Market value is the price at which the assets, liabilities, or equity can actually be bought or sold. Market value and book value are often very different. Why? Market values are generally more important for the decision-making process because they are more reflective of the cash flows that would occur today.

Income Statement: Sales - Cost - Depreciation = EBIT - Interests = EBT - Taxes = NI: Dividends + R.E: The income statement is more like a video that shows the revenues, expenses, and net income of a firm over a period of time. The accounting definition of income is: Revenue – Expenses ≡ Income. Income is reported when it is earned, even though no cash flow may have occurred. The matching principle – Generally Accepted Accounting Principle (GAAP) says to show revenue when it accrues and match the expenses required to generate the revenue. Revenues and expenses are not always cash items - sell goods for credit rather than cash, depreciation, deferred taxes. Net income is NOT the same as cash flow. Non-cash items refer to expenses charged against revenues that do not directly affect cash flow.

Which one of the following statements concerning liquidity is correct? Balance sheet accounts are listed in order of decreasing liquidity.

Depreciation: is a non-cash expense that reduces the pretax income.

*Art's Boutique has sales of $640,000 and costs of $480,000. Interest expense is $40,000 and depreciation is $60,000. The tax rate is 34 percent. What is the net income? $39,600*

Assume sales are $900, cost of goods sold is $450, depreciation expense is $80, interest paid is $40, selling and general expenses are $220, dividends paid is $10, and the tax rate is 34 percent. What is the addition to retained earnings? 900 - 450 - 80 - 40 - 220 = 110 - 66 = 72.6 - 10 = 62.60 *

Assume sales are $1,780; cost of goods sold is $545, general expenses are $100, depreciation expense is $185, interest paid is $35, and the tax rate is 35 percent. What is the net income amount? 594.75

Know how to calculate.

CH:4 An increase in which one of the following accounts increases a firm's current ratio without affecting its quick ratio? Inventory. Which cash coverage ratio would a lender prefer its borrower to have? The highest one. A total asset turnover measure of 1.03 means that a firm has $1.03 in sales for every $1 in total assets.

XYZ Corp. has an operating profit margin of 7%, a debt burden of 0.8, and a total asset to total equity ratio of 1.5. What asset turnover ratio is necessary to achieve an ROE of 18%? ROE formula: try every number. 2.14

Which of the following is correct? “Market value added” measures the difference between the market value of the firm’s equity and its book value. Residual income is also called “economic value added.” EVA measures the net profit of a firm or division after deducting the cost of the capital employed ~all the above~.

What is the residual income for a firm with $1 million in total capital, $300,000 in after-tax operating income, and a 20% cost of capital? 1,000,000 x 0.20 = 200,000; 300,000 - 200,000 = 100,000.

A sign that a firm is efficient is a: high inventory turnover.

Which of the following will increase a firm’s times interest earned ratio? A decrease in cost of goods sold.

A cash coverage ratio of less than one indicates: the firm does not have enough cash to make its interest payments.

The current ratio is a good proxy for a firm’s liquidity. What effect on the growth rate of earnings can be accomplished by decreasing the dividend-payout ratio from 70% to 40% if the firm has an ROE of 20%? 0.3 x 0.2 = 6%; 0.6 x 0.2 = 12%. The growth rate can increase from 6% to 12%.

Quick ratio = Cash + AR / CL (Notes Payable + Accounts Payable).