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Questions and Answers
What does the term 'GAAP' stand for in accounting?
What does the term 'GAAP' stand for in accounting?
The S1 report is submitted to the SEC only when a company goes public.
The S1 report is submitted to the SEC only when a company goes public.
True
What is the primary purpose of using the accrual accounting method?
What is the primary purpose of using the accrual accounting method?
To reflect income and expenses accurately when goods and services are provided.
Revenue recognition requires that revenue needs to be ______ and ______.
Revenue recognition requires that revenue needs to be ______ and ______.
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Match the following financial terms with their definitions:
Match the following financial terms with their definitions:
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Which of the following is NOT recorded as an expense until goods and services are used to generate revenue?
Which of the following is NOT recorded as an expense until goods and services are used to generate revenue?
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Operating Profit includes only revenues from sales activities.
Operating Profit includes only revenues from sales activities.
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What is the top line of an income statement?
What is the top line of an income statement?
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What are assets primarily defined as?
What are assets primarily defined as?
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Liabilities represent claims on a company's assets by owners.
Liabilities represent claims on a company's assets by owners.
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What are retained earnings?
What are retained earnings?
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Preferred stock tends to be more expensive than _____ but cheaper than _____ due to higher coupon rates.
Preferred stock tends to be more expensive than _____ but cheaper than _____ due to higher coupon rates.
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Match the following balance sheet terms with their definitions:
Match the following balance sheet terms with their definitions:
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Which equation correctly represents retained earnings?
Which equation correctly represents retained earnings?
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The par value of common stock is generally a high value, such as $10.
The par value of common stock is generally a high value, such as $10.
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What does APIC stand for in the context of stock?
What does APIC stand for in the context of stock?
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What does EBITDA stand for?
What does EBITDA stand for?
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Channel stuffing is a legitimate accounting practice to increase a company's revenue.
Channel stuffing is a legitimate accounting practice to increase a company's revenue.
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What factor makes earnings or net income a better metric for assessing future cash flow?
What factor makes earnings or net income a better metric for assessing future cash flow?
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Under US GAAP, to find the Interest Expense, you multiply the discount rate by the __________.
Under US GAAP, to find the Interest Expense, you multiply the discount rate by the __________.
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Match the following lease terms with their corresponding definitions:
Match the following lease terms with their corresponding definitions:
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Which of the following is a reason companies may utilize deferred tax assets?
Which of the following is a reason companies may utilize deferred tax assets?
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What is one potential benefit of using accelerated depreciation?
What is one potential benefit of using accelerated depreciation?
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Under Operating Leases, companies must calculate Interest Expense, Depreciation, and Lease Principal Repayment.
Under Operating Leases, companies must calculate Interest Expense, Depreciation, and Lease Principal Repayment.
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What does a deferred tax liability (DTL) represent?
What does a deferred tax liability (DTL) represent?
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Days Sales Outstanding (DSO) measures how quickly a company collects its receivables.
Days Sales Outstanding (DSO) measures how quickly a company collects its receivables.
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What is the formula for calculating Return on Equity (ROE)?
What is the formula for calculating Return on Equity (ROE)?
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The Cash Conversion Cycle (CCC) is calculated as DIO + DSO - _______.
The Cash Conversion Cycle (CCC) is calculated as DIO + DSO - _______.
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Match the ratios with their meanings:
Match the ratios with their meanings:
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Which of the following ratios measures how easily a company can pay for its interest expense?
Which of the following ratios measures how easily a company can pay for its interest expense?
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A lower Days Inventory Outstanding (DIO) number indicates better inventory management.
A lower Days Inventory Outstanding (DIO) number indicates better inventory management.
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What is the implication of a company experiencing a Net Operating Loss (NOL)?
What is the implication of a company experiencing a Net Operating Loss (NOL)?
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What is the formula for present value of a constant growth perpetuity?
What is the formula for present value of a constant growth perpetuity?
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Free cash flow is calculated by adding net income, depreciation, and amortization together and then subtracting capital expenditures and working capital.
Free cash flow is calculated by adding net income, depreciation, and amortization together and then subtracting capital expenditures and working capital.
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Define unlevered free cash flow.
Define unlevered free cash flow.
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The constant growth perpetuity formula is represented as C/(r - ______).
The constant growth perpetuity formula is represented as C/(r - ______).
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Match the following cash flow types with their definitions:
Match the following cash flow types with their definitions:
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What happens to present value when there is an increase in risk?
What happens to present value when there is an increase in risk?
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What does a negative free cash flow indicate about a company?
What does a negative free cash flow indicate about a company?
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If a company has greater depreciation than capital expenditures, it indicates it has many growth opportunities.
If a company has greater depreciation than capital expenditures, it indicates it has many growth opportunities.
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What does a higher WACC indicate regarding investment risk?
What does a higher WACC indicate regarding investment risk?
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The average growth rate should exceed the growth rate of the country's GDP.
The average growth rate should exceed the growth rate of the country's GDP.
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What is the formula for calculating free cash flow adjusted for growth?
What is the formula for calculating free cash flow adjusted for growth?
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The _____ is the discount rate used to calculate NPV and represents the cost of capital for a business.
The _____ is the discount rate used to calculate NPV and represents the cost of capital for a business.
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What is the maximum typical average growth rate in relation to the country's GDP?
What is the maximum typical average growth rate in relation to the country's GDP?
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Junk bonds typically have low interest rates and are considered safe investments.
Junk bonds typically have low interest rates and are considered safe investments.
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What is the expected rate of return for debt holders known as?
What is the expected rate of return for debt holders known as?
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Study Notes
Introduction to Financial Markets and Business Valuation
- Businesses serve customers and investors, aiming to maximize investor value.
- Value is derived from future cash flows.
- Businesses use cash flow to pay off debt, pay equity holders (dividends/stock repurchases), and reinvest in the business.
- Business value is the present value of future cash flows.
- Businesses aim to return cash to investors or reinvest for future profit.
Financial Markets
- Capital markets are used for long-term financing.
- Money markets involve short-term lending and borrowing, with lower risk.
- Examples of capital market instruments include debt (loans) and equity (raising capital by offering ownership).
Financing Methods
- Debt financing involves borrowing money, repaying principal plus interest. Higher-risk borrowers pay higher interest; loans can be secured with collateral
- Equity financing involves selling ownership stakes in a business, equity holders make decisions. Public companies are responsible for maximizing shareholder value.
- Equity is more expensive than debt due to higher risk and higher potential return; Debt is a tax deductible expense whereas Equity isn't.
Dilutive Securities
- Dilutive securities can create more shares if the company's share price reaches certain levels, such as stock options, and convertible bonds.
Public vs. Private Companies
- Public companies: easier to raise capital, can pay employees with stock, greater liquidity, subject to SEC regulations, and must publicly disclose information.
- Private companies: less regulatory burden, maintain secrecy, don't need to report new innovations or products, and don't have debt and equity on public markets.
Market Capitalization and Equity Value
- Market capitalization is calculated as shares outstanding multiplied by share price.
- Share price alone does not determine a company's value.
Dividend and Share Buyback
- Dividend yield is the percentage of a company's share price it pays out as dividends.
- Share buybacks involve repurchasing shares from the open market. This is typically done when there are no good investment opportunities with a return on invested capital (ROIC) above the weighted average cost of capital (WACC)
Efficient Market Hypothesis
- Weak: past prices don't predict future
- Semi-strong: all public information is accounted for
- Strong: all public and private information is accounted for
Market Exposure
- High market exposure means significant investment in a specific sector or security class.
Types of Assets
- Real assets: tangible or intangible assets generating cash flow (factories, patents).
- Financial assets: claims on cash flows from real assets (stocks, bonds).
Risk and Reward
- Higher risk generally correlates with higher potential reward.
- Alpha: returns above expectations.
- Risk-free rate: based on 10-year US Treasury (~3.8%)
Capital Structure
- Different stakeholders have varying claims on company assets.
- Priority rule in bankruptcy: stakeholders with the least risk are paid out first (debt before equity).
- Higher-risk stakeholders demand higher returns
Short Selling
- Borrow stock expected to decrease in value; sell it immediately.
- Buy back at a lower price, return stock to original holder.
- Pay dividends and interest to brokerage.
Time Value of Money (TVM)
- Future value (compound interest calculations) are used.
Discount Rate
- Discount rates get the present and future cash flows in present value terms,
- Higher discount rate = lower present value.
Net Present Value (NPV)
- The current value of future cash flows, essentially the difference between cash inflows and cash outflows
- If NPV is positive: invest. If negative: don't invest
- The present value of the bond's cash flows is equal to the face value of the bond.
- Assets = everything owned, including cash from equity and debt
- Assets − Liabilities = Equity (Book Value of Equity)
Leverage
- Leverage is simply debt. Companies with high leverage have more debt.
- Higher leverage can result in higher return on equity (ROE).
Return on Invested Capital (ROIC)
- ROIC = reinvestment ability of a company, calculated by dividing profits/invested capital.
- ROIC > WACC = Positive NPV
- ROIC < WACC = Negative NPV
Bonds
- Current yield measures annual coupon payment relative to current market price.
- Yield to Maturity (YTM) is the annual interest rate earned if hold the bond until it matures
- Bonds can be purchased at a premium, discount, or par value.
Accounting
- Accrual accounting recognizes revenue when earned, regardless of when cash is received
- Revenues increase shareholders' equity, and expenses decrease shareholders' equity
Income Statement
- Reports revenues and expenses over a period of time.
- Revenue recognition is earned when service/goods are provided.
- Recognizing expenses when used to provide revenues
Balance Sheet
- Shows a company's financial position at a specific point in time
- Assets = resources owned to generate future benefits.
- Liabilities= claims against assets by creditors.
- Stockholders' equity = owners' stake in the business
Retained Earnings
- Prior retained earnings + net income − dividends
- Money reinvested, not dividends
Cost of Capital
- A measure of a company's cost to lenders, investors etc
- Cost of debt: includes interest payments
- Cost of Equity: Risk free rate, plus beta * risk premium
Discounted Cash Flow (DCF)
- Projects future cash flows to perpetuity and discounts them to present value.
- Levered Free Cash Flow: Net income + D&A - cap ex - working capital = FCF
- Unlevered Free Cash Flow: EBIT (1-tax rate) + D&A - Capex - Change in NWC
Valuation
- The Value of any asset is the Present Value of its Future Cash Flows
- Value investing is purchasing undervalued assets, expecting dividends/returns
- Enterprise Value: Market value of a company's core operations
- Equity Value or Market Cap: Market value of the company
LBO (Leveraged Buy-out)
- Use of debt to finance a buyout of a company
- Raise capital from outside investors
- Buy undervalued companies to realize high returns.
Valuation Methodologies
-
Public Comps- based on real market data. Advantages: less dependent on future assumptions; quick to calculate, disadvantages: comparable companies needed, may not be accurate, etc.
-
Precedent Transactions- based on real company deals. Advantages: may capture more specific deal details; effective for thinly traded stocks or volatile companies. Disadvantages: data limitation, comparable deals rare.
-
Discounted Cash Flow (DCF)- projects future cash flows to perpetuity. Advantages: less dependent on market conditions; better financial risk reflect. Disadvantages: rely on far-future assumptions
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Description
Test your knowledge on essential accounting principles and terms in this quiz. Topics include GAAP, accrual accounting, financial statements, and balance sheets. Perfect for students and professionals looking to refresh their understanding of accounting concepts.
