Key Terms for Prelim Exam

Topic 1 Chapter 3 - Financial Statements, Cash Flow, and Taxes (Eugene Brigham)

1) Annual report - a report issued annually by a corporation to its stockholders. It contains basic
financial statements as well as management’s analysis of the firm’s past operations and future
prospects.
2) Balance sheet - A statement of a firm’s financial position at a specific point in time.
a) Total Assets = current assets + noncurrent assets (net fixed assets)
i) Current assets = Cash, Marketable Securities, AR, Inventories, Prepaid Expense
ii) Cash and equivalents account - represents actual spendable money.
iii) Accounts receivable - represent credit sales that have not yet been collected.
iv) Inventories - show the cost of raw materials, work in process, and finished goods. Net
v) Fixed assets - represent the cost of the buildings and equipment used in operations minus
the depreciation that has been taken on these assets.
b) Total Liabilities = current liabilities + noncurrent liabilities
i) Current liabilities = accounts payable, accruals, and notes payable
ii) Total debt - includes both its short-term (notes payable) and long-term interest-bearing
liabilities.
(1) Total debt = Short-term debt + Long-term debt
c) Working capital - Current assets
i) Net working capital - Current assets minus current liabilities.
ii) Net operating working capital (NOWC) = Operating current assets minus operating current
liabilities
(1) Operating current assets = current assets – excess cash
(2) Operating current liabilities = current liabilities – notes payable
d) Stockholders’ equity - represents the amount that stockholders paid the company when shares
were purchased and the amount of earnings the company has retained since its origination.
i) Retained earnings - represent the cumulative total of all earnings kept by the company
during its life.
3) Income statement - Reports summarizing a firm’s revenues, expenses, and profits during a reporting
period, generally a quarter or a year.
a) Revenue – is the total amount of money generated by the sale of goods or services over a period
of time.
b) Net revenue = Revenue - returns - allowances
i) Returns refers to the monetary value of all returned items, and allowances equals the total
value of the discounts offered for the gross sales.
c) Gross income = net revenue – cost of goods sold
d) Operating income - Earnings from operations before interest and taxes (i.e., EBIT)
i) Operating income (or EBIT) = gross income - operating expenses
e) Net income = operating income – interest expense – tax expense
f) Earnings per share (EPS) = Net Income / Common Shares Outstanding
i) Diluted EPS - When a firm has options or convertibles outstanding or it recently has issued
new common stock.
g) Dividends per share (DPS) = Dividends Paid to Common Stockholders / Common Shares
Outstanding
h) Book Value per share (BVPS) = Total Common Equity / Common Shares Outstanding
 i) EBITDA - an acronym for earnings before interest, taxes, depreciation, and amortization.
i) Depreciation - the charge to reflect the cost of assets depleted in the production process.
Depreciation is not a cash outlay.
ii) Amortization - a noncash charge similar to depreciation except that it represents a decline in
value of intangible assets.
4) Statement of cash flows - a report that shows how items that affect the balance sheet and income
statement affect the firm’s cash flows.
a) Operating activities - deals with items that occur as part of normal ongoing operations.
i) Direct method: Net cash provided by operating activities = net income + Depreciation and
amortization – increase in AR – increase in inventories + increase in AP + increase in accrued
expenses
ii) Direct method: Net cash provided by operating activities = net income + Depreciation and
amortization + decrease in AR + decrease in inventories - decrease in AP - decrease in
accrued expenses
b) Investing activities - all activities involving long-term assets which includes the purchase and sale
of short-term investments other than trading securities, and lending and collecting on notes
receivables.
i) Net cash used in investing activities = acquisition or purchase of investments – sales of
investments
c) Financing activities – all activities involving total debt and payment of dividends to stockholders.
i) Net cash provided by financing activities = increase in short-debt debt + increase in long-
term liabilities - payment of dividends to stockholders
ii) Net cash provided by financing activities = - decrease in short-debt debt - decrease in long-
term liabilities - payment of dividends to stockholders
d) Cash and equivalents at the end of the year = Cash and equivalents at the beginning of the year
+ Operating activities + Investing activities + Financing activities
5) Statement of stockholders’ equity - a statement that shows by how much a firm’s equity changed
during the year and why this change occurred.
6) Free cash flow (FCF) - The amount of cash that could be withdrawn without harming a firm’s ability
to operate and to produce future cash flows.
a) FCF = [EBIT (1 - T) + Depreciation and Amortization] – [Capital expenditures + NOWC]
i) Net operating profit after taxes (NOPAT) = EBIT (1 - T)
ii) Capital expenditures - the cash used to purchase new fixed assets)
7) Net operating working capital (NOWC) = operating current assets – operating current liabilities
a) Operating current assets = current assets - excess cash)
b) Operating current liabilities = current liabilities - notes payable

Topic 2 Chapter 4 – Analysis of Financial Statements (Eugene Brigham)

1) Liquidity ratios - which give an idea of the firm’s ability to pay off debts that are maturing within a
year. Liquidity ratios show the relationship of a firm’s cash and other current assets to its current
liabilities. Liquidity ratios: current ratio, quick (acid test) ratio
a) Liquid asset - an asset that can be converted to cash quickly without having to reduce the asset’s
price very much.
b) Current ratio - is calculated by dividing current assets by current liabilities. It indicates the extent
to which current liabilities are covered by those assets expected to be converted to cash in the
near future.
i) Current assets - include cash, marketable securities, AR, inventories, prepaid expenses.
 ii) Current liabilities - consist of AP, accrued wages and taxes, and short-term NP to its bank, all
of which are due within 1 year.
c) Quick (Acid Test) Ratio - is calculated by deducting inventories from current assets and then
dividing the remainder by current liabilities.
2) Asset Management Ratios - measure how effectively a firm is managing its assets. Asset
management ratios - which give an idea of how efficiently the firm is using its assets. Asset
management ratios: inventory turnover ratio; days sales outstanding (DSO); fixed assets turnover
ratio; total assets turnover ratio
a) Turnover ratios - generally divide sales by some asset: Sales/Various assets. As the name implies,
these ratios show how many times the particular asset is “turned over” during the year.
b) Inventory Turnover Ratio - indicates how many times inventory is turned over during the year.
i) Inventory Turnover Ratio = cost of goods sold / inventories
c) Days Sales Outstanding (DSO) Ratio - indicates the average length of time the firm must wait
after making a sale before it receives cash.
i) Days Sales Outstanding (DSO) Ratio = AR / Average sales per day
(1) Average sales per day = annual sales / 365
d) Fixed Assets Turnover Ratio - measures how effectively the firm uses its plant and equipment.
i) Fixed Assets Turnover Ratio = sales / net fixed assets
e) Total Assets Turnover Ratio - measures how effectively the firm uses its total assets.
i) Total Assets Turnover Ratio = sales / total assets
3) Debt management ratios (Leverage ratios) - which give an idea of how the firm has financed its
assets as well as the firm’s ability to repay its long-term debt. Debt management ratios - measure
how effectively a firm manages its debt. Debt management ratios: total debt to total capital; times-
interest-earned (TIE) ratio
a) Total Debt to Total Capital - measures the percentage of the firm’s capital provided by
debtholders.
i) Total Debt to Total Capital = total debt / total capital
(1) Total capital = total debt + equity
b) Times-Interest Earned (TIE) Ratio - a measure of the firm’s ability to meet its annual interest
payments. It measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs.
i) Times-Interest Earned (TIE) Ratio = EBIT / interest charges
4) Profitability ratios - which give an idea of how profitably the firm is operating and utilizing its assets.
Profitability Ratios - show the combined effects of liquidity, asset management, and debt on
operating results. Profitability ratios: operating margin; profit margin; return on total assets (ROA);
return on common equity (ROE); return on invested capital (ROIC); basic earning power (BEP) ratio
a) Operating Margin - this ratio measures operating income, or EBIT, per dollar of sales.
i) Operating Margin = operating income / sales
b) Profit Margin (sometimes called the net profit margin) - this ratio measures net income per
dollar of sales.
i) Profit Margin = net income / sales
c) Return on Total Assets (ROA) - measures the rate of return on the firm’s assets.
i) Return on Total Assets (ROA) = net income / total assets
d) Return on Common Equity (ROE) - measures the rate of return on common stockholders’
investment. ROE reflects the effects of all of the other ratios, and it is the single best accounting
measure of performance.
i) Return on Common Equity (ROE) = net income / common equity
 e) Return on Invested Capital (ROIC) - measures the total return that the company has provided for
its investors.
i) Return on Invested Capital (ROIC) = after-tax operating income / total invested capital
(1) After-tax operating income = EBIT (1 – T)
(2) Total invested capital = debt + equity
f) Basic Earning Power (BEP) Ratio - indicates the ability of the firm’s assets to generate operating
income.
i) Basic Earning Power (BEP) Ratio = EBIT / total assets
5) Market value ratios - which give an idea of what investors think about the firm and its future
prospects. Market Value Ratios - Ratios that relate the firm’s stock price to its earnings and book
value per share. Market value ratios: price/earnings (P/E) ratio; market/book (M/B) ratio; enterprise
value/EBITDA ratio
a) Price/Earnings (P/E) Ratio - shows the dollar amount investors will pay for $1 of current
earnings. It shows how much investors are willing to pay per dollar of reported profits.
i) Price/Earnings (P/E) Ratio = price per share / earnings per share (EPS)
b) Market/Book (M/B) Ratio - is a metric that compares your business's book value to its market
value.
i) Market/Book (M/B) Ratio = market price per share / book value per share
c) Book value per share = common equity / shares outstanding
d) Enterprise Value/EBITDA (EV/EBITDA) Ratio - metric for investors aiming to gauge a company's
valuation. It is the ratio of a firm’s enterprise value relative to its EBITDA.
i) Enterprise Value/EBITDA (EV/EBITDA) Ratio = market value of equity + market value of total
debt + market value of other financial claims – cash and equivalents
6) DuPont equation - a formula that shows that the rate of return on equity can be found as the
product of profit margin, total assets turnover, and the equity multiplier. It shows the relationships
among asset management, debt management, and profitability ratios.
7) Benchmarking – Benchmarking - the process of comparing a particular company with a subset of top
competitors in its industry.
8) Trend analysis - An analysis of a firm’s financial ratios over time; used to estimate the likelihood of
improvement or deterioration in its financial condition.
9) “Window dressing” techniques - Techniques employed by firms to make their financial statements
look better than they really are.

Topic 3 Chapter 10 - Managing working capital

1. Working capital management - is the process of managing current assets and current liabilities to
ensure the short-term liquidity of your firm.
a. Net Working capital – represents a net investment in short-term assets.
b. Net Working capital = current assets - current liabilities
i. Current assets are inventories, trade receivables, cash (in hand and at bank).
ii. Current liabilities are trade payables, bank overdrafts.
2. Inventory management - the process of tracking the goods and materials used by a business to
produce or sell products.
a. Average inventories turnover period ratio - used to help monitor inventories levels by
providing a picture of the average period for which inventories are held.
b. Average inventories turnover period = (average inventories held / cost of sales) x 365
c. Lead time – the time between the placing of an order and the receipt of the goods) and the
likely level of demand.
 d. ABC system of inventories control - levels of control by dividing its inventories into three
broad categories: A, B and C. Each category will be based on the value of inventories held.
e. Economic order quantity (EOQ) - is concerned with determining the quantity of a particular
inventories item that should be ordered each time.
f. Enterprise resource planning (ERP) system - provide an automated and integrated approach
to managing a business.
g. Just-in-time (JIT) inventories management – have supplies delivered to the business just in
time for them to be used in the production process or in a sale.
h. XYZ inventories management - classifies inventories into three categories according to
variability of customer demand.
3. Receivable management refers to the planning and monitoring of debt owed to the firm from a
customer account.
a. Five Cs of credit – capital, capacity, collateral, condition, character
b. Cash discount - discount for prompt payment.
c. Debt factoring - is when a business sells its AR to a third party at a discount, enabling
companies to immediately unlock cash tied up in unpaid invoices without having to wait the
usual payment terms.
d. Invoice discounting - is a process in which a business sells an invoice to a financing company
to access cash tied in unpaid invoices.
e. Average settlement period for AR ratio (or Average collection period) - determine whether
it’s time to reconsider your payment terms, your credit policies or with whom you do
business.
i. Average settlement period for AR ratio (or Average collection period) = (average
AR / credit sales) x 365
ii. Average AR = (AR beg + AR ending) / 2
f. AR to sales ratio - liquidity ratio that measures how much of a company's sales occur on
credit.
i. AR to sales ratio = AR outstanding at the end of the period / sales revenue for the
period
g. Ageing schedule of trade receivables - a table that shows a company's AR, ordered by their
due dates.
4. Cash management - process of managing a company's cash flows to ensure that there is enough
liquidity to meet its financial obligations.
a. Operating cash cycle (OCC) - is the time lapse between paying for goods and receiving the
cash from the sale of those goods. The length of the OCC has a significant impact on the
amount of funds that the business needs to apply to working capital.
b. Bank overdrafts are simply bank current accounts that have a negative balance. They are a
type of bank loan and can be a useful tool in managing the business’s cash flow
requirements.
5. Payable management refers to the procedures, policies, and practices a company uses to manage
trade credit purchases.
a. Average settlement period for AP ratio - helps monitor the level of trade credit taken.
i. Average settlement period for AP ratio = (average AP / credit purchases) x 365

Topic 4 Ch01 – An Overview of financial management (Brigham)

1. Finance - is the study of how individuals, institutions, governments, and businesses acquire, spend,
and manage money and other financial assets.
 a. Financial management, also called corporate finance, focuses on decisions relating to how
much and what types of assets to acquire, how to raise the capital needed to purchase
assets, and how to run the firm so as to maximize its value.
b. Capital markets relate to the markets where interest rates, along with stock and bond
prices, are determined.
c. Investments relate to decisions concerning stocks and bonds and include a number of
activities: Security analysis, Portfolio theory, and Market analysis.
2. Sarbanes-Oxley Act - A law passed by Congress that requires the CEO and CFO to certify that their
firms’ financial statements are accurate.
3. Business Organization is an entity that is formed for the purpose of carrying on the commercial
enterprise of selling and buying.
a. Proprietorship - an unincorporated business owned by one individual.
b. Partnership - an unincorporated business owned by two or more persons.
c. Corporation - a legal entity created by a state, separate and distinct from its owners and
managers, having unlimited life, easy transferability of ownership, and limited liability
d. S corporation - A special designation that allows small businesses that meet qualifications to
be taxed as if they were a proprietorship or a partnership rather than a corporation.
e. Limited liability company (LLC) - A popular type of organization that is a hybrid between a
partnership and a corporation
f. Limited liability partnership (LLP) - similar to an LLC but used for professional firms in the
fields of accounting, law, and architecture. It provides personal asset protection from
business debts and liabilities but is taxed as a partnership.
4. Intrinsic value - An estimate of a stock’s “true” value based on accurate risk and return data. The
intrinsic value can be estimated, but not measured precisely.
5. Market price - the stock value based on perceived but possibly incorrect information as seen by the
marginal investor.
a. Marginal investor - an investor whose views determine the actual stock price.
6. Equilibrium - the situation in which the actual market price equals the intrinsic value, so investors
are indifferent between buying and selling a stock.
7. Corporate governance - Establishment of rules and practices by Board of Directors to ensure that
managers act in shareholders‘ interests while balancing the needs of other key constituencies such
as customers, employees, and affected citizens.
8. Environmental, Social, and Governance (ESG) measures - Three main factors for measuring social
responsibility in a firm.
9. Corporate raider - Individuals who target corporations for takeover because they are undervalued.
10. Hostile takeover - the acquisition of a company over the opposition of its management.
11. Stockholder wealth maximization - The primary financial goal for managers of publicly owned
companies implies that decisions should be made to maximize the long-run value of the firm’s
common stock.
12. Ethics - standards of conduct or moral behavior.
a. Business ethics - the rules, principles, and standards of deciding what is morally right or
wrong when working toward its employees, customers, community, and stockholders.

Topic 5 Ch13 - International aspects of financial management

1. Spot rate - the currencies can be exchanged immediately, at the rate ruling at the time of exchange.
2. Forward rate - the contract can be to exchange the currencies at some specified future date, at a
rate determined at the time of the agreement.
3. Law of one price - states that the price of an identical asset or commodity will have the same price
globally.
4. Forward exchange contract - delivery will take place at some specified future date, but the exchange
rate is set immediately.
5. Exchange rate risk - is the risk that the rate of exchange between two currencies will move adversely
for a particular business.
a. Transaction risk - the risk that the exchange rate will move in a direction that adversely
affects the business partway through a transaction only for a short-term period.
i. Money market hedge – is used to avoid transaction risk by combining the spot
foreign exchange market with borrowing or lending.
ii. Currency options - A foreign exchange option gives the owner the right, but not the
obligation, to exchange a specified amount of a particular currency for another one,
at a rate and at a time specified in the option contract.
iii. Currency futures - contracts are similar to forward contracts in that they bind the
parties to an exchange of a specified amount of currency, at an exchange rate and
future date set out in the contract. Futures differ from forwards, however, as the
contracts are standardized rather than tailored to the specific needs of the holder.
b. Economic risk - When a business’s fortunes can be affected by a more long-term hazards of
exchange rate movements.
i. Back-to-back loans - is an arrangement between two businesses located in different
countries. It involves each business making a loan to the other in its home currency
and receiving in return an equivalent loan in a foreign currency as security.
ii. Currency swaps - the agreement to swap debt of equivalent size based on an
expressed, or implied, exchange rate.
c. Translation risk - arises where a business generates income or holds assets, liabilities, or
equity in a foreign country resulting to the change in value in home country as a result of
changes in the exchange rate.
6. Double-taxation agreement - form of inter-governmental agreement that seeks to avoid the levying
of tax by more than one country on the same profits.

Topic 6 Ch02 - Financial planning (Peter Atril)

1) Projected (forecast) financial statements – part of the planning process that provide a
comprehensive picture of likely future performance and position in the evaluation of long-term
strategic options and the development of short-term plans.
2) Sales forecasts are predictions of how many products a business will sell in the future, based on data
such as previous sales.
a) Qualitative sales forecasting - produces a forecast based on subjective judgement.
b) Quantitative sales forecasting - undertake a numerical analysis of past sales in order to discern
future trends.
3) Projected cash flow statement monitors future changes in liquidity and helps managers to assess the
impact of expected future events on the cash balance.
a) Rolling cash flow projection (forecast) - is a report that uses historical data to predict the future
state of a business on a continuous basis. Rolling means the forecast is constantly adjusted.
4) Projected income statement provides an insight into likely future profits (or losses), which represent
the difference between the predicted level of revenue and expenses for a period.
a) Revenue is reported when control of the goods, or services has been transferred to the
customer.
 b) Expenses are matched to the revenues they help to generate and so are included within the
same income statement.
5) Projected statement of financial position (or balance sheet) reveals the end-of-period balances for
assets, liabilities and equity.
6) Per-cent-of-sales method - a simpler approach to forecasting, which assumes that most items
appearing in the income statement and statement of financial position vary with the level of sales.
Hence, these statements can be prepared by expressing most items as a percentage of the sales
revenue that has been forecast for the period.
a) Financing gap – where the additional assets required to sustain the increased sales may exceed
the combined increase in equity (in the form of retained earnings) and liabilities.
b) Plug - the way in which a business decides to fill the financing gap
7) Risk - the likelihood that what is estimated to occur will not actually occur.
a) Sensitivity analysis - involves taking a single variable (for example, volume of sales) and
examining the effect of changes in the chosen variable on the likely performance and position of
the business.
b) Scenario analysis - involve changing a number of variables simultaneously in order to portray a
possible state of the world.
8) Financial gearing (aka financial leverage) occurs when a business is financed, at least in part, by
borrowing (or by other funds with a fixed rate of return).
a) Indifference point - the point at which the three financing schemes provide the same level of
earnings per share
b) Degree of financial gearing - measures the sensitivity of earnings per share to changes in the
level of operating profit.
9) Operating gearing (aka operating leverage) - the relationship between fixed costs and variable costs
a) Fixed costs - remain constant when changes occur to the volume of activity.
b) Variable costs - vary according to the volume of activity.
c) Degree of operating gearing - measures the sensitivity of operating profit to changes in the level
of sales volume.
10) Degree of combined gearing – measures the effect of combining financial gearing and operating
gearing on returns to shareholders.