Finance Quiz: Time Value of Money and Financial Statements

Finance

Time Value of Money

• Present value (PV): the current value of future cash flows
• Future value (FV): the value of present cash flows at a future date
• Net present value (NPV): the difference between PV and FV
• Formula: NPV = Σ (CFt / (1 + r)^t)

Financial Statements

• Balance Sheet: snapshot of company's financial position at a specific point in time
  • Assets = Liabilities + Equity
• Income Statement (Profit & Loss Statement): revenues and expenses over a specific period
  • Revenues - Expenses = Net Income
• Cash Flow Statement: inflows and outflows of cash over a specific period
  • Operating, Investing, and Financing activities

Financial Ratios

• Liquidity Ratios:
  • Current Ratio: Current Assets / Current Liabilities
  • Quick Ratio: (Current Assets - Inventory) / Current Liabilities
• Profitability Ratios:
  • Gross Margin: (Revenue - COGS) / Revenue
  • Operating Margin: (Operating Income / Revenue)
  • Return on Equity (ROE): Net Income / Shareholders' Equity
• Efficiency Ratios:
  • Asset Turnover: Revenue / Total Assets
  • Inventory Turnover: COGS / Average Inventory

Capital Budgeting

• Capital Budgeting Decision Rules:
  • Net Present Value (NPV) Rule: accept if NPV > 0
  • Internal Rate of Return (IRR) Rule: accept if IRR > Cost of Capital
  • Payback Period Rule: accept if Payback Period < Maximum Acceptable Period
• Cost of Capital: the minimum rate of return required by investors

Risk Management

• Types of Risk:
  • Market Risk: changes in market conditions
  • Credit Risk: borrower default
  • Liquidity Risk: inability to convert assets to cash
  • Operational Risk: internal failures or external events
• Risk Management Strategies:
  • Diversification
  • Hedging
  • Insurance
  • Asset Liability Management

Finance

Time Value of Money

• Present value (PV) represents the current value of future cash flows, considering the time value of money.
• Future value (FV) is the value of present cash flows at a future date, which is calculated by considering the interest rate and time.
• Net present value (NPV) is the difference between the present value and future value, which helps in evaluating investment opportunities.
• The formula for NPV is NPV = Σ (CFt / (1 + r)^t), where CFt is the cash flow at time t, r is the interest rate, and t is the time period.

Financial Statements

• A balance sheet provides a snapshot of a company's financial position at a specific point in time, with the accounting equation being Assets = Liabilities + Equity.
• An income statement (profit & loss statement) shows revenues and expenses over a specific period, with the goal of calculating net income through the formula Revenues - Expenses = Net Income.
• A cash flow statement displays the inflows and outflows of cash over a specific period, categorizing them into operating, investing, and financing activities.

Financial Ratios

Liquidity Ratios

• The current ratio measures a company's ability to pay its short-term debts, calculated by dividing current assets by current liabilities.
• The quick ratio, also known as the acid-test ratio, assesses a company's ability to pay its short-term debts with its most liquid assets, calculated by dividing (current assets - inventory) by current liabilities.

Profitability Ratios

• The gross margin ratio shows the profitability of a company's products, calculated by dividing (revenue - COGS) by revenue.
• The operating margin ratio indicates a company's pricing strategy and operating efficiency, calculated by dividing operating income by revenue.
• The return on equity (ROE) ratio measures a company's profitability from shareholders' perspective, calculated by dividing net income by shareholders' equity.

Efficiency Ratios

• The asset turnover ratio assesses a company's ability to generate revenue from its assets, calculated by dividing revenue by total assets.
• The inventory turnover ratio measures the number of times inventory is sold and replaced during a period, calculated by dividing COGS by average inventory.

Capital Budgeting

• The net present value (NPV) rule is a decision-making criterion in capital budgeting, where a project is accepted if its NPV is greater than zero.
• The internal rate of return (IRR) rule is another decision-making criterion, where a project is accepted if its IRR is greater than the cost of capital.
• The payback period rule is based on the time it takes for a project to recover its initial investment, and a project is accepted if its payback period is less than the maximum acceptable period.

Risk Management

Types of Risk

• Market risk arises from changes in market conditions, such as interest rates, exchange rates, and commodity prices.
• Credit risk occurs when a borrower defaults on their debt obligations.
• Liquidity risk is the inability to convert assets into cash quickly enough to meet short-term obligations.
• Operational risk encompasses internal failures or external events that can impact a company's operations.

Risk Management Strategies

• Diversification involves spreading investments across different asset classes to minimize risk.
• Hedging is a strategy to reduce risk by taking positions that offset potential losses.
• Insurance is a risk management strategy that transfers risk to a third party.
• Asset liability management is a strategy to manage risk by matching assets with liabilities.