Financial Instruments Overview
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Questions and Answers

A Cash Budget is designed to cover a period of more than one year.

False (B)

The Cash Forecast is used to estimate the firm's long-term financial requirements.

False (B)

Internal Forecasts rely solely on external economic indicators.

False (B)

Financial instruments can only be real documents and cannot be virtual.

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

Equity-Based Financial Instruments represent ownership of an asset.

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

Financial instruments are categorized based on their asset class, which includes Debt-Based and Equity-Based.

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

Common Stock and Preferred Shares are types of Debt-Based Financial Instruments.

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

ETFs and mutual funds are exclusively debt-based instruments.

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

Derivatives include financial instruments such as futures and options.

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

Short-term debt-based financial instruments last for more than one year.

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

Treasury bills and commercial paper are examples of long-term debt securities.

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

Money market investments are characterized by safety and high returns.

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

Cash instruments are influenced by market conditions.

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

Checks are categorized as derivative instruments.

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

Investors can participate in the money market by purchasing money market mutual funds.

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

Certificates of deposit (CDs) are considered equity-based instruments.

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

Operating cash flows are directly related to the acquisition of fixed assets.

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

Depreciation is the allocation of the cost of intangible assets over time.

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

The three categories of a firm's cash flows are operating, investing, and financing cash flows.

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

Financing cash flows include cash inflows from the sale of stock and cash outflows to pay dividends.

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

A decrease in any liability results in an inflow of cash.

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

The Statement of Cash Flows reflects the performance of the firm by connecting the beginning and ending balance sheets.

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

Amortization and depletion both relate to the write-off of tangible assets.

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

Free cash flow is primarily used for long-term managerial decision-making.

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

The Firm's Operating Cash Flow (OCF) is calculated by subtracting depreciation from Net Operating Profit After Tax (NOPAT).

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

Free Cash Flow (FCF) is the cash flow remaining after meeting operating needs and paying for investments in fixed and current assets.

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

Net Operating Profit After Tax (NOPAT) is equal to Earnings Before Interest and Taxes (EBIT) multiplied by the tax rate.

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

The financial planning process begins with short-term financial plans that guide long-term strategies.

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

Cash planning involves the preparation of the firm's cash budget.

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

Net Fixed Assets in Investments (NFAI) can be calculated as the change in net fixed assets plus depreciation.

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

Free Cash Flow (FCF) is calculated by subtracting Total Assets from Operating Cash Flow (OCF).

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

Money market investments typically have lower returns than inflation.

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

One of the key inputs for short-term financial plans is the sales forecast.

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

Capital markets are solely focused on short-term debt instruments.

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

Money market mutual funds only cater to large corporations.

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

The capital markets include both the stock market and bond markets.

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

Individuals cannot invest directly in capital markets.

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

Suppliers in capital markets include only banks and financial institutions.

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

The primary market refers to the trade of previously issued financial securities.

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

Small companies often invest excess cash through money market accounts.

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

Flashcards

Cash flow

The primary ingredient in financial valuation models. It represents the actual cash generated or used by a firm.

Statement of Cash Flows

This summarizes a company's cash inflows and outflows over a specific period.

Operating Cash Flow

Cash generated from the everyday operations of a company, including sales, production, and expenses.

Free Cash Flow

Cash flow available to investors after all expenses, including investments and debt payments.

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Depreciation

The allocation of the cost of a fixed asset over its useful life, reflecting the gradual decrease in its value.

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Amortization

The write-off of intangible assets, such as patents or copyrights, over time.

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Depletion

The allocation of the cost of natural resources, such as oil or minerals, over time.

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Investment Cash Flow

Cash flows from buying and selling assets, including property, equipment, and investments in other companies.

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Net Increase/Decrease in Cash - Marketable Securities

The difference between the cash and marketable securities on the balance sheet at the beginning and end of the year. It reflects how much cash has been generated or used by investing activities.

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Operating Cash Flow (OCF)

The cash flow a company generates from its normal operations, including production and sales of goods and services.

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Net Operating Profit After Tax (NOPAT)

A measure of a company's profitability after deducting operating expenses, taxes, and depreciation.

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Free Cash Flow (FCF)

The cash flow available to investors after a company has met its operating needs and paid for investments in fixed assets and current assets.

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Net Fixed Assets Investment (NAFAI)

The change in net fixed assets over a period plus depreciation. Represents the total investment in fixed assets.

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Net Current Assets Investment (NCAI)

The change in current assets minus the change in current liabilities. Represents the total investment in current assets.

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Financial Planning Process

The process of creating long-term and short-term financial plans to guide the company's financial activities.

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Cash Planning

A key aspect of financial planning that involves preparing the company's budget for cash inflows and outflows.

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Sales Forecast

A prediction of the sales activity during a specific period, based on internal or external data.

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External Forecast

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

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Internal Forecast

A sales forecast based on a consensus of individual forecasts within the company's sales channels.

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Cash Budget

A statement showing the firm's planned cash inflows and outflows, used to estimate short-term cash needs.

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Financial Instrument

Assets that can be traded, representing a package of capital that can be exchanged.

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Equity-Based Financial Instruments

Financial instruments representing ownership of an asset, such as stocks.

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Common Stock

Stocks that represent ownership in a company and entitle holders to voting rights.

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Preferred Shares

Stocks that offer a fixed dividend payment and usually do not carry voting rights.

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Debt-Based Financial Instruments

Financial instruments representing loans made by investors to asset owners. These are essentially IOUs, where investors lend money for a specific period and receive interest payments.

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Short-Term Debt-Based Financial Instruments

Short-term debt-based financial instruments that mature in one year or less. They are considered highly liquid and safe investments.

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Cash Instruments

A category of financial instruments that encompasses stocks, bonds, and other securities whose values are directly affected by market forces.

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Money Market

A financial market where short-term debt investments are traded. It is characterized by high safety and relatively low returns.

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Money Market Mutual Fund

A type of mutual fund that invests in short-term debt instruments, providing investors with a safe and liquid investment option.

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Money Market Account

A type of bank account that offers higher interest rates than traditional savings accounts. However, they often have minimum balance requirements and limits on withdrawals.

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Derivative Instruments

A financial instrument whose value is derived from the value of an underlying asset. Examples include futures, options, and swaps.

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Preferred Share Equity

A type of equity instrument representing ownership in a company. Unlike common stock, they carry a fixed dividend payment.

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Capital Market

A market where long-term debt and equity instruments are bought and sold, typically with maturities of more than a year.

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Primary Market

The market where new securities, like stocks and bonds, are issued for the first time to raise capital. It's where companies go public.

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Secondary Market

The market where existing securities, like stocks and bonds, are traded among investors. Think of it as a used market.

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Suppliers in Capital Markets

Participants in capital markets who provide funds, typically banks and investors, including households, pension funds, and insurance companies.

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Users in Capital Markets

Participants in capital markets who need funds for their operations or investments, typically businesses, governments, and individuals.

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Money Market vs. Capital Market

A key difference between the money market and the capital market is the length of time for which funds are borrowed or invested.

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Study Notes

Cash Flow Analysis

  • Cash flow is the primary element in financial valuation models.
  • An accounting perspective summarizes cash flow in a statement of cash flow.
  • A financial perspective focuses on operating cash flow (used in managerial decisions) and free cash flow (monitored by market participants).
  • Depreciation is the portion of fixed asset costs allocated over time against annual revenues. Methods like Modified Accelerated Cost Recovery System (MACRS) are used for tax purposes.
  • Amortization is the write-off of intangible assets.
  • Depletion is the write-off of natural resources.

Statement of Cash Flows

  • Summarizes a firm's cash flow over a specific period.
  • Three categories of firm cash flows:
    • Operating cash flows: relate to sales and production.
    • Investment cash flows: relate to buying/selling fixed assets and investments in other firms.
    • Financing cash flows: relate to debt/equity financing, stock sales/repurchases, and dividends.

Inflow and Outflow of Cash

  • Inflows (sources): decreases in assets, increases in liabilities, net profits after taxes, and non-cash charges, stock sales.
  • Outflows (uses): increases in assets, decreases in liabilities, net losses, dividends, and stock repurchases.

Interpreting Statement of Cash Flows

  • Connects balance sheets at the beginning and end of a period, considering firm performance.
  • Net increase/decrease in cash - difference in cash and marketable securities from the start to the end of the year.
  • Operating cash flow (OCF) is the cash generated from normal operations (production and sale).
    • OCF = NOPAT + Depreciation; NOPAT = EBIT x (1-T) where EBIT= earnings before interest and taxes, T=tax rate.
  • Free Cash Flow (FCF) – cash available to investors after costs and investments.
    • Formula: FCF = OCF - Change in Net Fixed Assets - Change in Net Current Assets

Financial Planning Process

  • Long-term (strategic) plans guide short-term (operational) plans and budgets.

  • Two key aspects:

    • Cash planning (cash budget preparation).
    • Profit planning (pro-forma statements preparation).

  • Short-term financial plans specify short-term actions and their anticipated impact.

  • Key inputs: sales forecast, operating data, etc.

  • Key outputs: operating budgets, cash budget, pro-forma financial statements.

  • Cash budget estimates planned cash inflows and outflows to predict short-term cash needs.

  • Cash budget is designed for a one-year period, divided into shorter time intervals to reflect seasonality or uncertainty.

  • Sales forecast predicts sales, based on internal (firm's sales data) or external (economic indicators) factors.

Financial Instruments

  • Financial instruments are tradable assets.
  • Two primary categories:
    • Equity instruments represent ownership. Common and preferred stocks, ETFs, and mutual funds.
    • Debt instruments represent loans. Short-term debt (e.g., Treasury bills, commercial paper), bank deposits, and CDs.
  • Cash instruments (e.g., securities) are easily transferable, value influenced by markets
  • Derivative instruments (future, options, and swaps) are contracts whose value is derived from another asset.

Money Market

  • Short-term debt investment market (e.g., overnight reserves, commercial paper).
  • Money market mutual funds, Treasury Bills, and bank accounts are instruments often for short-term cash needs (e.g., by large corporations, small firms or individuals.)
  • Lower returns relative to other investments, high safety.

Capital Markets

  • Markets for long-term debt and equity instruments.
  • Two market classifications: primary and secondary markets.
  • Suppliers (e.g. banks, institutions) provide capital; users (e.g., businesses) seek capital.

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Analyzing the Firm's Cash Flow PDF

Description

This quiz covers the key concepts related to financial instruments, including categories such as equity-based and debt-based instruments. Test your understanding of cash budgets, forecasting, and the role of derivatives in finance. Assess your knowledge on the characteristics and examples of different financial instruments.

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