Analyzing the Firm's Cash Flow
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Questions and Answers

What is a primary function of money markets for businesses?

  • To serve as a short-term investment for cash reserves (correct)
  • To provide high returns on investments
  • To eliminate the need for capital markets
  • To facilitate long-term investments

Which of the following best describes capital markets?

  • Markets dedicated to long-term debt and equity instruments (correct)
  • Markets that prohibit individual investors
  • Markets focused on the trade of commodities
  • Markets exclusively for short-term debt

How do individual investors typically participate in money markets?

  • By forming partnerships with large corporations
  • By purchasing foreign currency
  • By investing directly in corporate stocks
  • Through money market mutual funds or bank accounts (correct)

What distinguishes the primary market from the secondary market in capital markets?

<p>The primary market involves new issues, secondary involves resale (C)</p> Signup and view all the answers

Who are considered suppliers in capital markets?

<p>Banks, investors, and households with savings (D)</p> Signup and view all the answers

What is the role of money market mutual funds?

<p>To buy money market securities on behalf of investors (A)</p> Signup and view all the answers

Which of the following is NOT a typical supplier in capital markets?

<p>Businesses seeking new capital (D)</p> Signup and view all the answers

Why do money markets often yield lower returns than other investments?

<p>They are low-risk investments (A)</p> Signup and view all the answers

What is the primary ingredient in the financial valuation model?

<p>Cash flow (A)</p> Signup and view all the answers

What is the primary purpose of a cash budget?

<p>To estimate short-term cash requirements (A)</p> Signup and view all the answers

Which category of cash flows is directly related to the sale and production of a firm's products and services?

<p>Operating Cash Flows (C)</p> Signup and view all the answers

Which type of forecast is based on the relationship between the firm's sales and external economic indicators?

<p>External Forecast (B)</p> Signup and view all the answers

What characterizes equity-based financial instruments?

<p>They confer ownership of an asset (D)</p> Signup and view all the answers

What system is used to determine depreciation for tax purposes?

<p>Modified Accelerated Costs Recovery System (MACRS) (A)</p> Signup and view all the answers

Which of the following represents a cash inflow?

<p>Increase in any liability (B)</p> Signup and view all the answers

What should a business focus on if it experiences highly seasonal cash flows?

<p>Increasing the number of cash budget intervals (C)</p> Signup and view all the answers

Which item is classified under financing cash flows?

<p>Cash inflow from selling stock (B)</p> Signup and view all the answers

Which of the following financial instruments represents ownership and may provide dividends?

<p>Preferred Stock (C)</p> Signup and view all the answers

What type of financial instrument is a bond classified as?

<p>Debt-Based (A)</p> Signup and view all the answers

How does the statement of cash flows correlate to the balance sheets?

<p>It ties the beginning balance sheet to the end balance sheet. (C)</p> Signup and view all the answers

What type of cash flow includes cash inflow from the sale of stock?

<p>Financing Cash Flows (C)</p> Signup and view all the answers

What is NOT a characteristic of financial instruments?

<p>They are exclusively physical documents (B)</p> Signup and view all the answers

In cash budgeting, what does a sale forecast typically rely on?

<p>A mix of external and internal data (B)</p> Signup and view all the answers

Which of the following is a non-cash charge included in the cash flow statement?

<p>Depreciation (A)</p> Signup and view all the answers

What characterizes short-term debt-based financial instruments?

<p>They last for one year or less. (A)</p> Signup and view all the answers

Which of the following is considered a cash instrument?

<p>Stocks and bonds (A)</p> Signup and view all the answers

What is a unique characteristic of money market investments?

<p>They deal in debt of less than one year. (C)</p> Signup and view all the answers

What type of financial instrument includes loans made by an investor to the owner of an asset?

<p>Debt-based instruments (B)</p> Signup and view all the answers

Which of the following would NOT typically be classified as a derivative instrument?

<p>Bonds (C)</p> Signup and view all the answers

Which of the following is a feature of money market accounts?

<p>They have limits on withdrawals. (C)</p> Signup and view all the answers

What distinguishes bank deposits from debt-based instruments?

<p>Bank deposits represent a liability for the bank. (B)</p> Signup and view all the answers

Which of the following best describes the primary users of the money market?

<p>Governments and corporations for cash flow management (C)</p> Signup and view all the answers

What does Operating Cash Flow (OCF) measure?

<p>Cash flow generated from normal operations (B)</p> Signup and view all the answers

Which formula is used to calculate Free Cash Flow (FCF)?

<p>FCF = OCF - NFAI - NCAI (A)</p> Signup and view all the answers

What is included in the definition of Net Operating Profit After Tax (NOPAT)?

<p>EBIT multiplied by (1 – Tax Rate) (B)</p> Signup and view all the answers

Which of the following is a key aspect of the financial planning process?

<p>Preparation of pro-forma statements (C)</p> Signup and view all the answers

What are Net Fixed Assets Investments (NFAI) primarily associated with?

<p>Investments in physical assets and depreciation (C)</p> Signup and view all the answers

Which of the following is NOT a key input for short-term financial plans?

<p>Market share analysis (B)</p> Signup and view all the answers

What is Profit Planning primarily concerned with?

<p>Preparing pro-forma statements (C)</p> Signup and view all the answers

What does Cash Planning involve?

<p>Preparation of the firm’s cash budget (C)</p> Signup and view all the answers

Flashcards

Cash Budget

A statement that projects a company's expected cash inflows and outflows, used to estimate short-term cash needs.

Sales Forecast

A prediction of sales activity during a specified period, based on internal and/or external data.

External Forecast

A sales forecast based on the relationship between a company's sales and external economic indicators.

Internal Forecast

A sales forecast based on internal data, like sales figures from different departments.

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Financial Instruments

Tradeable assets representing a legal agreement with monetary value. They act as packages of capital.

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Equity-Based Financial Instruments

Financial instruments representing ownership of an asset, often in the form of stocks.

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Common Stock

Stocks that represent ownership of a company, with voting rights and potential for dividends.

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Preferred Shares

Stocks that have priority over common stock in receiving dividends and asset distribution.

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Net Increase/Decrease in Cash - Marketable Securities

The difference between the firm's cash and marketable securities at the end of the year and the beginning of the year.

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Operating Cash Flow (OCF)

The cash flow a company generates from its normal business operations, like producing and selling goods or services.

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Free Cash Flow (FCF)

The cash flow available to investors after covering all operating costs and investments in fixed assets and current assets.

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Net Fixed Assets Investment (NAFAI)

The change in a company's net fixed assets, considering depreciation.

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Net Current Assets Investment (NCAI)

The change in a company's net current assets, accounting for changes in assets and accruals.

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Financial Planning Process

The process of creating financial plans for the long term and short term, using a combination of cash planning and profit planning.

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Cash Planning

Planning that involves creating a detailed forecast of the company's cash inflows and outflows.

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Profit Planning

Planning that involves creating pro-forma financial statements to predict future financial performance.

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Cash Flow

The primary ingredient in financial valuation models. It represents the actual money coming into and out of a company.

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Depreciation

The portion of the cost of a fixed asset (like a machine or building) allocated to each year of its useful life. It's a non-cash expense that reflects the gradual wearing down of the asset.

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MACRS (Modified Accelerated Cost Recovery System)

A method used to calculate depreciation for tax purposes. It allows for a faster write-off of assets, resulting in lower taxes in the early years.

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Amortization

The write-off of intangible assets (like patents or trademarks) over their useful life. It recognizes the gradual decline in the value of the intangible asset.

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Depletion

The write-off of natural resources (like oil or gas) over their useful life. It reflects the gradual depletion of the resource.

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Statement of Cash Flows

A financial statement that summarizes the cash flow of a firm over a specific period. It classifies cash flows into operating, investing, and financing activities.

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Operating Cash Flows

Cash flows directly related to the normal day-to-day operations of a business, like sales, manufacturing, and expenses.

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Investment Cash Flows

Cash flows related to the buying or selling of long-term assets (like buildings or equipment) or investments in other companies.

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Cash Instruments

Financial instruments whose value is influenced by market forces and easily transferable. Examples include stocks, bonds, checks, deposits, and loans.

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Short-Term Debt-Based Financial Instruments

Financial instruments representing a loan from an investor to an asset owner, typically with a maturity of one year or less. Examples include Treasury bills (T-bills) and commercial paper.

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Long-Term Debt-Based Financial Instruments

Financial instruments representing a loan from an investor to an asset owner, typically with a maturity exceeding one year. Examples include bonds, mortgages, and corporate debt.

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Derivative Instruments

Financial instruments tied to the value of an underlying asset, such as stocks, bonds, or commodities. They can be used to speculate on price movements or hedge against risk.

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Money Market

A market dedicated to short-term debt investments, characterized by high safety and relatively low returns. Examples include overnight reserves and commercial paper.

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Money Market Funds

Investments in short-term debt securities, often managed by a mutual fund and with a target share price of $1. They offer higher interest rates than savings accounts but have higher account minimums and limits on withdrawals.

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Money Market Accounts

Bank accounts that offer higher interest rates than traditional savings accounts but also have higher account minimums and limits on withdrawals.

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Foreign Exchange Instruments

Financial instruments based on the value of foreign currencies. They are used for hedging against currency risk or speculating on exchange rate movements.

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What are money market instruments?

Money market instruments are short-term debt securities with maturities of less than a year. They provide low returns, often lower than inflation, but are considered very safe due to their short-term nature and high creditworthiness of issuers.

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What is the purpose of money markets?

Money markets are used by businesses and individuals to invest excess cash or borrow funds for short-term needs. They offer a safe and liquid way to manage cash flows.

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What is a money market mutual fund?

A money market mutual fund pools money from investors and buys money market securities on their behalf, offering diversification and professional management.

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How do large corporations use the money market?

Large corporations can directly borrow from the money market through dealers when they need short-term financing.

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How do small companies use the money market?

Small companies can access the money market through mutual funds, allowing them to invest their excess cash in a diversified portfolio of short-term debt securities.

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How can individuals invest in the money market?

Individuals can invest in the money market through their bank accounts or mutual funds. These options provide them with a safe and accessible way to manage short-term savings.

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What is the role of capital markets?

Capital markets deal with long-term debt and equity instruments, facilitating the allocation of funds between those who need capital (borrowers) and those who have capital (lenders).

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How are capital markets organized?

Capital markets are classified into primary and secondary markets. Primary markets are where new securities are issued, while secondary markets allow for the trading of existing securities.

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Study Notes

Analyzing the Firm's Cash Flow

  • Cash flow is the primary ingredient in financial valuation models.
  • From an accounting perspective, cash flow is summarized in a statement of cash flow.
  • From a financial perspective, firms focus on operating cash flow (used in managerial decision-making) and free cash flow (monitored by market participants).
  • Depreciation is the portion of fixed asset costs allocated against annual revenues over time.
  • Various depreciation methods exist, including Modified Accelerated Cost Recovery System (MACRS) for tax purposes.
  • Amortization is the write-off of intangible assets.
  • Depletion is the write-off of natural resources.
  • A statement of cash flows summarizes a firm's cash flow over a specific period.
  • Three categories of firm cash flows: Operating, Investment, and Financing cash flows.
    • Operating cash flows are directly linked to the firm selling and producing goods/services
    • Investment cash flows are associated with purchasing/selling fixed assets and equity investments.
    • Financing cash flows involve debt/equity financing transactions (e.g., incurring/repaying debt, selling/buying stock, paying dividends).

Inflows and Outflows of Cash

  • Inflows (Sources): Decrease in any asset, increase in any liability, net profit after tax, depreciation & other non-cash charges, sale of stock.
  • Outflows (Uses): Increase in any asset, decrease in any liability, net loss, dividends paid, repurchase/retirement of stock.

Interpreting Statement of Cash Flows

  • Statement of cash flows connects the beginning and end of a period's balance sheet, considering the period's performance.
  • Net increase/decrease in cash should be equivalent to the difference in cash and marketable securities from beginning to end of the year.
  • Operating cash flow (OCF) is cash generated from normal firm operations (production/sale of goods/services).
  • OCF can be calculated as:
    • NOPAT + Depreciation
    • [EBIT * (1 - T)] + Depreciation
    • Where NOPAT is Net Operating Profit After Tax, EBIT is Earnings Before Interest and Taxes, and T is the Tax Rate.
  • Free cash flow (FCF) is the cash available for investors after meeting operating needs and investments in net fixed assets (NFA) and net current assets (NCA).
  • FCF formula: OCF - NFAI - NCAI, where NFAI is Change in Net Fixed Assets + Depreciation and NCAI is Change in CA-Change in Assets and Accruals.

Financial Planning Process

  • Financial planning begins with long-term or strategic plans that guide short-term operational plans and budgets.
  • Key planning aspects:
    • Cash Planning: Preparing a cash budget
    • Profit Planning: Preparing pro-forma statements
  • Short-term (operating) plans specify short-term actions, supported by annual budgets and profit plans and consider various financial activities.
    • Key inputs: Sales forecast, other operating and financial data.
    • Key outputs: Operating budgets, cash budget, pro forma financial statements.
  • Cash budget estimates planned inflows/outflows of cash for short-term cash needs. Covers a 1-year period, divided into smaller intervals based on company activity. A sale forecast can be external, internal, or a mix of both based on relationships to external data, or estimations from sales channels respectively.

Financial Instruments

  • Financial instruments are assets that can be traded or viewed as packages of capital.
  • They often aid in the efficient flow of capital across investors globally.
  • Can be classified into debt-based (representing a loan) or equity-based (representing ownership).
  • Cash instruments: stocks, bonds, checks, deposits, and loans. Their value is market-driven.
  • Derivative instruments are agreements, not necessarily cash transactions

Money Market

  • Money market deals with short-term debt investments.
  • Characterized by high safety and low return rates.
  • Includes overnight reserves and commercial paper.
  • Used for short-term cash flow needs by investors and businesses.

Capital Markets

  • Capital markets deal with the sale and purchase of long-term debt and equity instruments.
  • Also called the stock and bond markets.
  • Involve the channeling of savings and investments between suppliers and those needing capital.
  • Consist of two parts: Primary and Secondary markets. Primary focuses on new issues, while Secondary is trading of previously issued securities.
  • Capital markets include various financial instruments like stocks and bonds.

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Analyzing the Firm's Cash Flow PDF

Description

This quiz covers essential concepts regarding cash flow and its significance in financial valuation models. You'll explore the different types of cash flows, including operating, investment, and financing cash flows, as well as related concepts like depreciation and amortization. Test your understanding of how cash flow impacts managerial decision-making and market evaluations.

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