Accounting and Finance - KeynesYouDigIt/Knowledge GitHub Wiki

  • Business ethics: Standards of conduct for moral behavior
Definition Activity
Sales & Revenue
Gross Profit/Margin - COGS
Operating Profit - Overhead
Pre-tax Profit - Interest
Net Income - Taxes

3 Areas of Finance

  • Financial Management
  • Capital Markets
  • Investments

Corporate Structures

  • Proprietorships
  • Partnerships
  • Corporations - C & S
  • LLC
  • LLP

Intrinsic Value

  • Intrinsic value: Based on actual risk and return
  • Market value: What something is trading at

Always manage for intrinsic value, not market price.

Motivating Executives

  • Undervalued stocks are at risk from hostile takeovers
  • Angry boards fire managers
  • Tie compensation to intrinsic value
  • Bondholder interests can compete with stockholder interests
  • Ignoring stakeholder value can cause society to bite back and take it out on the company

Markets & Institutions

3 Ways Capital is Moved Around

Capital can be moved between business and savers 3 ways:

  • Directly: Savers give a business money, a business gives the saver securities
  • Primary Market Transaction: Savers and business trade money and securities directly through an investment bank that underwrites their transactions
  • Secondary Market Transaction: Businesses sell securities to an intermediary (like a bank), who sells CDs and notes to savers. Savers give cash the intermediary, who gives money to the business.

Types of Markets

  • Physical markets: Goods
  • Financial markets: Stocks and bonds
    • Derivatives are "derived" from financial markets, like options
      • Derivatives either hedge risk or speculate
      • Credit default swap: One institution insuring the investment of another in exchange for regular payments
    • Spot markets: Immediately
    • Futures markets: Agree to buy and sell at a set price in the future
    • Money market: Short-term, liquid debt
    • Capital market: Intermediate/long-term d ebt, stocks
    • Primary market: Corporations raising capital directly
    • Secondary market: Investors trade with each other (eg. stock exchanges)
    • Private market: Negotiated directly between parties
    • Public markets: Structured, standardized transactions on exchanges

Institutions

  • Investment bank: Helps companies raise capital and design securities
  • Commercial banks: "Finance department stores"
  • Financial services corporations: Large conglomerates
  • Credit unions: member to member
  • Pension funds: Retirement plans administered by commercial banks or institutions
  • Life insurance companies: Invest funds for a payout
  • Mutual funds: Diversify investments to reduce risk
  • Exchange Traded Funds (ETF): In a specific area, shares in a mutual funds are traded like stocks
  • Hedge fund: Unregulated, big minimums, hedge bets or speculative investments
  • Private equity firms: Buy entire companies

Stock Market

  • Establishes a firm's stock price
  • Physical (NYSE) vs. electronic (NASDAQ)

Brokerages have reps on the NYSE that take buy and sell orders and put them through a Specialist.

Dealer Market

  • Facilities
  • Few dealers who "make the market"
  • Lots of brokers who bring dealers and investers together
  • The network between dealers and brokers
  • Bid price: what a dealer will pay
  • Ask price: what a dealer will sell for
  • Bid-ask spread: Dealer's margin, will be wide if risky

Common Stock

  • "Closely Held": Privately owned, active management
  • "Publicly Owned": Lots of inactive investors
  • Bought on:
    • Secondary market
    • Primary market
    • IPO
  • Dutch auction: Investors bid, and highest price ("Clearing price") that would cause all shares to sell

Indexes

  • Dow Jones Industrial Average
  • S&P500
  • NASDAQ Composite
  • Market price: Current price
  • Intrinsic value: Real value w/ all possible information
  • Equillibrium price: Buy and sell orders balance out
  • Efficient market: Market price = intrinsic value, and equillibrium between buy and sell orders
    • High volatility indicates an inefficient market
    • Markets aren't efficient because people view potential gain and potential loss differently

Statements, Cash Flow, Taxes

Annual Report

  • Verbal section
  • Balance sheet - What we have, what we owe
  • Income statement - Sales & costs
  • Statement of cash flows - Beginning and ending cash, and what changed it
  • Statement of stockholder equity - Beginning and ending equity, what changed it

Balance Sheet

Snapshot at a point in time.

Assets

  • Current Assets (Cash, stocks, accounts receivable, inventory)
  • Fixed assets (Equipment, real estate)

Liabilities

  • Current liabilities (Wages, taxes, account payable)
  • Long-term debt
  • Stockholder equity
  • Stockholder equity: Paid-in capital + retained earnings. Also, total assets - total liabilities.
  • Working capital = current assets
  • Net working capital = current assets - current liabilities
  • "Free" liability is non-interest bearing

Income Statement (P&L)

Income over a period of time.

  • Net Sales
    • Operating Costs
    • Interest
    • Taxes
  • = Net income
    • / Shares = EPS (the "bottom line")
      • Dividends Paid = Retained Earnings on the balance sheet
  • Operating income/EBIT = Sales - Operating costs
    • Income derived from your core business
    • Use this to compare the operating performance of 2 companies
  • Depreciation: Loss of value of equipment over time
  • Amortization: Same but for intangibles (patents, copyrights, trademarks, goodwill)
  • EBITDA: How much cash are you generating?

Statement of Cash Flows

All items are expected to generate cash at some point.

Category Cash Flows
Operating + 819
Investing - 448
Financing - 206
------------------ ------------
Summary 165
+ Beginning cash 140
------------------ ------------
Ending cash 305

When you're out of cash, you're out of business.

Statement of Stockholder Equity

Retained earnings are a claim against assets, not a cash-equivalent. They aren't liquid.

Equity: Shareholder's capital + retained earnings

Activity Amount
Retained Earnings 425
Net Income +168
Dividends -93
Retained Earnings 500

Free cash flow: The amount of cash that could be withdrawn without hurting operations

[EBIT(1 - Tax Rate) + Depreciation & Ammortization] - Capital Expenditures + Δ Net Working Capital]

MVA vs. EVA

  • Market Value-Added: Excess of the market value of equity over its book value
  • Book Value: Common equity on balance sheet
  • Economic Valued-Added: Net operating profit after taxes (NOPAT) - Annual cost of capital
    • Or EBIT(1 - Tax Rate) - (Invested capital * % Cost of capital)
  • You can also apply these to invidual divisions or assets

Taxes

  • Marginal tax rate: Tax rate on the next dollar you make
  • Average tax rate: Total tax / total income
  • Capital gain/loss: From assets (stocks, bonds, real estate)
    • Short-term (1 year) capital gains are taxed higher than long-term gains
  • Dividends are taxed at 15%
  • Alternative minimum tax: Different tax system for wealthy people

Corporate Taxes

  • Interest income is taxed regularly
  • 70% of dividend income is excluded (the rest is triple-taxed)
  • Corporate taxes favor debt over equity financing
  • Losses can be carried back 2 years or forward 20 years to offset taxes
  • If you own 80% of another company's stock, you can consolidate your tax returns to offset taxes
  • Depreciation rates are set by congress

Analysis

You're trying to find something who's intrinsic value is much higher than its market value.

Ratios

Liquidity

How able are you to pay off debts that mature in < 1 year?

  • Current ratio: Current assets / Current liabilities
    • High numbers could mean excess inventory, aging accounts receivable, poor asset management
  • Quick ratio (acid test): (Current assets - inventory) / current liabilities
    • Like the current ratio, but takes out inventory since it's so hard to liquidate

Asset management

How efficiently are you using your assets?

  • Inventory turnover: Sales / Inventory
    • Lower means too much inventory
    • Inventory is a bad investment - no return!
  • Days sales outstanding (average collection period): Accounts receivable / Average daily sales
    • How much daily sales are tied up in receivables?
    • Longer increases risk of bad debts
  • Fixed assets turnover ratio: Sales / Net fixed assets
    • Do you have the right amount of fixed assets relative to your sales?
  • Total assets turnover ratio: Sales / total assets
    • Are current assets being used efficiently? (Inventory, accounts receivable, etc.)
    • How much sales you getting by investing in assets?

Debt management

How where your assets were financed, and what long-term debt do you have?

  • Total debt to total capital (debt ratio): Total debt / Total debt + equity
    • Higher means more risk to creditors
  • Times interest earned (TIE): EBIT / Interest charges
    • How many times over can you pay your annual interest?

Profitability

How profitably do you use your assets?

  • Return on equity: Net income / common equity
    • Stockholder's return on investment
    • The most important ratio
    • Easy to abuse
      • Doesn't consider risk
      • Doesn't consider amount of capital required
      • May encourage people to turn down profitable projects with a lower than average rate
      • Combine with risk and capital invested to get the shareholder value
  • Operating margin: EBIT / Sales
    • Low margin means high operating costs
  • Profit margin: Net income / Sales
    • Influenced by debt - Net income is after interest
  • Return on assets: Net income / Total assets
    • How well are your assets being used?
  • Return on invested capital: NOPAT / Total invested capital
    • Ignores assets
  • Basic earning power: EBIT / Assets
    • Levels the playing field for firms with different debt/tax situations

Market value

What do investors think about your future prosepcts?

  • Price/earnings ratio: Price per share / Earnings per share
    • High for strong growth, high risk
    • Low for slow growth, low risk
  • Market / book ratio: Common equity / Shares outstanding

DuPont Equation

ROE = Profit margin * Total Asset Turnover * Equity Multiplier

How much do you earn from sales * How quickly do your turnover inventory * How leveraged are you?

Assessing Performance

  • Compare to industry averages
  • Benchmark against competitors (better than average)
  • Trends over time
  • Be careful about comparing firms of different ages- depreciation and inflation are misleading
  • Seasonal factors dramatically affect ratios
  • "Window dressing": Deliberately manipulating ratios
  • Is there one key customer, product, or supplier driving the numbers?
  • Substantial overseas investment? Great opporunity, but risky.
  • How much competition? Competition drives margins down.
  • Do they have a strong R&D pipeline?
  • Are there legal and regulatory hurdles?

Time Value of Money

Time Lines

0       5%       1       5%       2
|----------------|----------------|
`PV` = $100                         `FV` = ?

Terms

PV = Present value, beginning amount FVₙ= Future value after ₙ periods CFₜ= Cash flow during a particular time period I = Interest rate (also r) N = Number of periods PMT= Payment amount

Compounding Interest: FVₙ = PV(1 + I)ᴺ Simple Interest: PV + PV(I * N)

Annuity: Equal payments over time, fixed # of periods. "Ordinary annuities" are due at the end of the period. Perpetuity: An annuity that isn't over a fixed # of periods Periodic Rate: Annual rate / periods Bond: Series of annuity payments + a lump sum Ammortized loan: Repaid in equal amounts

Finding the present value

  • Discounting is the opposite of compounding
  • What current amount would be worth that in the future?

PV = FVₙ / (1 + I)ᴺ

Annuities/perpetuities:

PV = PMT / I

  • "Payments" are even
  • "Cash flows" are uneven

PV of a bond = PV of the annuity + PV of the lump sum

Annual rates

  • Advertised annual rate: Nominal, APR, Quoted, Stated
  • Effective annual rate: Effective, EFF%, EAR
    • Produces the same future value with annual compounding
    • Higher than the APR if compounded more than once/year

Calculating fractional time periods:

AMT * (Periodic Rate)^Number of days

Interest Rates

Factors affecting the cost of money:

  • Production opportunities
  • Time preferences for consumption (chance to make more now vs. later)
  • Risk
  • Inflation

When there are fewer creditors in a market, borrowers pay a higher interest rate.

Real rate of inflation = Interest rate - Inflation rate

r* = Risk-free, inflation-free interest rate. Based on the rate on treasury bonds.

Quoted interest rate = r* + Inflation Premium + Risk of Default + Liquidity + Maturity risk (volatility in the future)

Yield = Real risk-free rate + interest premium + maturity premium

Yield curves:

  • Normal: Sloping up
  • Abnormal: Sloping down
  • Humped: Highest in the middle

Pure expectations theory

  • If the 2 year rate is x (eg. 1.05)
  • And the 1 year rate is y
  • You should be able to estimate next year's interest rate:o

y = 1 * 1.05 * 1 + x

Macroeconomic Factors

  • Fed policy
  • Budget deficit/surplus - Government either has to print money or demand more taxes
  • International factors - Trade deficits must be financed
  • Volume of business activity

Business Decisions

  • You might invest in longer-term debt to lock in an interest rate
  • Long and short-term debt mitigates risk

Bonds

Bonds are issued to raise debt capital. They require regular interest payments.

Issuers

  • Treasury bonds: Federal government, no default risk
  • Corporate bonds: Risk and rates range
  • Municipal bonds: Low default risk, exempt from taxes
  • Foreign bonds: Some default risk

Terms

  • Par value: The amount borrowed, generally $1000
  • Coupon rate: Yearly payment
    • They used to literally be mail-in coupons
    • Fixed or floating rates
    • If there's no coupon rate, then it sells for below par
  • Maturity date: When will it be repaid? Usually 10 years.
  • Call provisions: Allows borrower to pay back principal early
    • Usually has a penalty, usually 1 year of interest
    • Often has a deferral period where they can't
    • A "refunding operation" is similar to a home refinance
  • Sinking fund: Company buys or calls % of bonds per year
    • Buy if interest rates have risen
    • Call if they dropped
  • Convertible debt: Bonds exchangable for stock at a fixed price
  • Warrants: Give bondholder option to buy stock a set price
  • Put provisions: Allow holder to call debt early
  • Income bond: No payments if the company made no money
  • Indexed bond: Rate is anchored to the consumer price index

Bond Valuations

  • rd = Market interest rate (not coupon rate, although sometimes they are equal)
  • N = Years to maturity
  • INT = Dollars interest paid each year
  • M = Maturity value (par)

Bond Value:

Sum of t = 1 through N:

INT / (1 + rd)^t + M / (1 + rd)^N

If the going interest rate:

  • Rises, bond is cheaper than par, and is a discount bond
  • Falls, bond is more expensive than par, and is a premium bond

Bond Yields