Assets & Capital Budget – Financial Management Test

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Assets & Capital Budget – Financial Management Test

These financial management chapters discuss Assets & Capital Budget – Test 1 is based on these chapters

Financial Statements

objective is to provide economic decision makers with useful information about a firm’s financial performance and change in financial positions

Source of information for managers, shareholders, creditors, and other stakeholders

Balance sheet

reports the firm’s financial condition at a point in time. Snapshot

3 major elements of a balance sheet

Assets are probable future economic benefits controlled by an entity; used to generate revenue

Liabilities are probable future economic costs

owner’s Equity is the residual interest in the net assets of an entity that remains after deducting its liabilities.

Liquidity (financial ratio)

Short-term Solvency Ratios

Meet short-term obligations

Liquidity ratios

Current ratio, quick ratio, avg payment period

Avg payment period (formula)

= Accounts Payable /(Cost of Goods Sold⁄365)

Asset Management (financial ratio)

Turnover Ratios

How efficiently mgmt. is utilizing assets

Capital structure

The specific mixture of long-term debt and equity the firm uses to finance its operations.

Good understanding of the effects of equity and debt financing are important for financial managers.

A firm’s ________ __________ is really just a reflection of it’s borrowing policy

capital structure

Working capital

firm’s level of current assets.

Too little = liquidity problems
Too much= inefficiency

Effective working capital policies are crucial to LT growth and survival.

Three main forms of business

sole proprietorship, partnership, corporation


single owner with unlimited liability for debts and legal obligations.

Advantages to a sole proprietorship

easy to establish, simple decisions, little regulation

Disadvantages to a sole proprietorship

unlimited liability, limited capital pool, ownership is difficult to transfer


A form of business ownership in which the business is owned by two or more persons

General partnership

all partners share in the gain or losses of the business and all partners have unlimited liability for all partnership debts and other legal obligations

Limited partnership

One or more general partners run business and have unlimited liability. Limited partners liability limited to contributions, and cannot help run the business

Advantages to a partnership

Easy to establish, larger capital pools than sole proprietorship

Disadvantages to a partnership

Difficult to reach decisions, gen. partners have unlimited liability, limited partners have less control

__________ is generally more readily available for a partnership, but there are still significant limitations on the ability to raise large amounts of ________

Capital, capital


owned by stockholders, liability is legally limited to the amount of money invested.

Can borrow money and own property, sue or be sued, enter into contracts

Advantages to a corporation

limited liability, large amounts of capital, corporation’s life is not limited to that of the owners

Disadvantages to a corporation

difficult to establish, double taxation, agency costs

Agency Conflicts question

Do managers always act and make decisions that reflect stockholder’s best interest?

Agency relationship

Relationship between principal and agent

Agency problem

the possibility of conflict of interest between the principal and the agent


Owners (stockholders, equity holders, equity owners)


Managers (people elected by owners to run company)

Sources of agency conflict

Shirking by the agent (avoiding responsibilities)

Diversion of resources by agent for private use

Differential time horizon of the agent and principal

Differential risk preferences of the agent and the principal

Agency costs

arise when management makes investment decisions that may result in a loss of value for shareholders

Monitoring of management, restrictions on mgmt. actions, loan covenants

Agency conflict factors

Managerial compensation

Oversight and accountability

Control of the firm

Managerial compensation

Compensation (stock options, bonus, promotion, etc.) can be used to align interests

Capital budgeting

The process of identifying and evaluating capital projects where the cash flow to the firm will be received over a period longer than a year.

The financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire

________ ________ may be the most important responsibility that a financial manager has

Capital budgeting

Evaluating the _____, ______, and ______ of future cash flows is the essence of capital budgeting

size, time, risk

Oversight and accountability

Additional independent auditors

Control of the firm

Ultimately rests with shareholders

Dissatisfied shareholders can fire management

Goal of the firm?

Maximize shareholder wealth

Financial managers make decisions that ________ the value of the owner’s equity?


Sarbanes-Oxley Act of 2002

set new and enhanced standards for all U.S public company boards, management and public accounting firms

Key titles in SOX Act?

Corporate responsibility

Corporate and Criminal Fraud Accountability

Auditor independence

Enhanced financial disclosures


someone (in this case, other than a stockholder or creditor) who potentially has a claim on the cash flows of the firm..

Ex. Employees, customers, suppliers, government

Financial market

brings together buyers and sellers of debt and equity securities

Primary market is…

original sale of securities by governments and corporations.

Initial Public Offering (IPO)
Treasury Security Auction

Secondary market is…

market where existing securities are offered for resale

Financial securities (instruments)- claim to a cash flow

Primary market- $ goes to the company

Secondary market- Claims are traded

Primary markets

Corporation is the seller

Corporate stock or bond issues are almost always sold with the assistance of an investment bank.

In primary markets, new equity issues involve either

First time issues by firms whose shares are not currently traded (Initial Public Offerings)

New shares issued by firms whose shares are already trading in the marketplace (Seasoned Offering)

Private placement is a negotiated sale involving a specific buyer; generally, the buyer is a hedge fund

Secondary markets

provide the means for transferring corporate ownership.

The better the secondary the market, the easier it is for firms to raise external capital in the primary market.

NYSE is a…

auction market.

Have a physical location and attempt to match buyers with sellers


dealer market or over the counter.

In a dealer market, most of the buying and selling is done by the dealer.

System of computers


provide probable future economic benefits controlled by an entity as a result of previous transactions.

Assets are used to generate sales (or revenue)

Current assets

cash and other assets that will likely be converted into cash or used up within one year or operating cycle.

Presented in order of their liquidity

Cash and cash equivalents (marketable securities), accounts receivable, inventories

Fixed assets

do not meet the definition of current assets because they will not be converted into cash or used up within one year or operating cycle

Long-term assets

Tangible assets

long term assets with physical substance

Ex: plant, equip, natural resources, land

Equity is created by

financing activities (primary mkt transaction) and operating activities

Accounting equation

Also known as the Accounting Identity, Balance Sheet Equation, Balance Sheet Identity

Assets = Liabilities + Owners’ Equity

Net working capital

difference between a firm’s current assets and current liabilities.

Not enough working capital may indicate liquidity problems;
Too much working capital may be an indication of inefficient use of assets.


refers to the ability to quickly convert investments into cash closest to fair market value

Multidimensional: Ease of conversion and loss of value

Use of debt in a firm’s capital structure is called…

financial leverage.

Increases potential reward, but increases risk of financial distress and business failure

Market value

true value of an asset, or the amount of cash that would be received if we sold the asset today

Book value

values on the balance sheet. How much it cost to obtain (historical cost)

Income statement

reports the revenues and expense of the firm over a period of time (it measures flows)

IS equation:
Revenues – Expenses = Net Income

Revenues are…

amounts reported from the sale of goods and services

Expenses are

amounts incurred to generate revenue and include costs of goods sold, operating expenses, interest and taxes.

Accrual method of accounting

revenue is recognized when earned and expense are recognized when incurred

firms can manipulate net income by recognizing revenue earlier or later by delaying or accelerating the recognition of expenses.

Tax Rates

prior to 2018, marginal system of varying rates; 2018 is a flat-rate tax

Sole proprietorships and partnerships are taxed at individual rates; LLCs have different tax status

Average tax rate

tax bill (taxes due) divided by taxable income

Marginal tax

extra tax the tax payer would pay if they earned one more dollar

Cash flow

difference between number of dollars that came in and went out

Operating cash flows

cash flows that result from the firms day-to-day activities of producing and selling

Net capital spending (net investment in fixed assets)

purchases of fixed assets minus the sale of fixed assets

Change in net working capital

amount spent on net working capital

OCF tells us…

whether a firm’s cash inflows from its business are sufficient to cover its everyday cash outflows

Change in net working capital (formula)

= ending NWC – beg. NWC

Financial statements are

framework for calculating financial ratios

Internal uses by managment

External uses: Investors, suppliers, lenders

To make financial comparison possible..

Standardize the financial statements

A common way to do this is to use common-size statements

Common-size financial statements

work with percentages instead of dollars

Common-size balance sheet

divide all of the accounts by expressing each as a percentage of total assets

Common Size Income Statement

divide all of the items by revenues. All items are expressed as a percentage of sales.

Financial ratios

provide a way to compare and investigate relationship between different pieces of financial information

used for internal comparisons and comparisons across firms

Limitations of financial ratios

not useful in isolation

Comparable ratios can be hard to find for companies in multiple industries

must be analyzed relative to one another

determining a range of acceptable values is difficult

Ratio analysis

Absolute numbers vs ratios

3 types of ratio analysis

trend or time series


industry average

5 financial ratios


Asset management

Financial leverage


Market value

Asset Management ratios

Total Asset Turnover, Inventory turnover, Avg payment period (Acc rec period)

Financial leverage (financial ratio)

Long-term Solvency Ratios

How efficiently mgmt. is using debt

Financial leverage ratios

Total debt ratio, equity multiplier, interest coverage/ times interest earned

Profitability (financial ratio)

Controlling costs, operation

Profitability ratios

Profit margin, return on assets, return on equity

ROA & ROE (formulas)

= Net Inc/ Total Assets (or Total SE)

Market value (financial ratio)

How the market values the firm

Market value ratios

Price/Earnings, EPS

DuPont Analysis


(NI/Sales) x (Sales/TA) x (TA/TSE)
(PM) x (TAT) x (EM)

Intangible assets

long term assets that lack physical substance.

Ex: goodwill, copyright, etc


obligations owed by an entity from previous transactions that are expected to result in an outflow of economic benefits in the future

Current liabilities

obligations that will be satisfied within on year.

Non current liabilities

provide information about the firm’s long-term financing activities.

Current liabilities include..

accounts payable

taxes payable

current portion of long-term debt

Stockholder’s equity is…

residual interest in assets that remains after subtracting liabilities