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Balance Sheet Identity

Balance Sheet = Snapshot of firm, shows accounting value on a particular date


Assets = What firm owns. Current or fixed (tangible/intangible)


Liabilities = What firm owes.


Current or long-term SE/Common Equity/Owner's Equity = Worth. If firm were to sell assets and pay off debt with the money, what's leftover is owned by shareholders


3 main concerns: Liquidity, Debt/Equity, Market/Book


Liquidity Trade-Off

Liquidity = speed and ease with which an asset can be converted to cash without a significant loss of value.

-↑ liquidity = ↓financial distress (paying debt/buying needed assets)

-Liquid assets are less profitable to hold, and hurt long-term solvency

∴ Tradeoff between advantages of liquidity and foregone potential profits


Debt vs. Equity

Financial Leverage = Use of debt in capital structure.

↑ debt (% of assets) = ↑leverage.

Debt = Lever because it magnifies gains and losses of wealth to the company.


Market vs. Book Value

Book = historical cost

Market = actual worth currently

-Current items might have similar market and book values


Income Statement

Income Statement = summary of performance over a period of time

Income = Revenues - Expenses

3 main concerns: GAAP & The Income Statement, Non-Cash Items, Time & Cost


GAAP & the Income Statement

Revenue Recognition Principle = recognize revenue when the earning process is virtually compete and value of exchange is known

Matching Principle = match costs with the revenues they are associated with

Non-Cash Items = expenses charged against revenues that do not directly affect cash flow

-Actual timing of cash inflows and outflows Used for a reasonable estimate of market value


Time and Cost

In the LR all business cost are variable, in SR some costs are fixed.

Product Costs = COGS, raw materials, direct labor, manufacturing overhead.

Period Costs = selling, general and administrative expenses, incurred during a time period



Tax Reform Act 1986/Omnibus Budget Reconciliation Act 1993 = corporate tax rates are not strictly increasing (15-39%). It added the 38 and 39 tax brackets.

Average Tax Rate = Total taxes paid divided by total taxable income

Marginal Tax Rate = Amount of tax payable on next dollar

-With a flat rate, marginal is always the same as tax.

-Our corporate tax rate is a modified flat-rate tax, which becomes a true flat rate for high income (at 35%)


Cash Flow Identity

Cash Flow From Assets = Cash Flow To Creditors + Cash Flow to Stockholders


Cash Flow From Assets

  1. Operating Cash Flow = from daily activitiies of producing and selling. Revenues minus costs (only cash outflows)
  2. Net Capital Spending = money spent on fixed assets less money received form sale of fixed assets
  3. Change in Net Working Capital = net change in current assets relative to current liabilities for the period


Cash Flow to Creditors & Cash Flow to Stockholders

Cash Flow to Creditors = firm's interest payments to creditors less net new borrowing

Cash Flow to Stockholders = Dividends paid out by firm less net new equity

-Together they represent net payments to creditors and owners during the year