Accounting for Financial Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
The balance sheet shows the assets, along with the sources of funds used to acquire the assets, at a point in time, say 12/31/07. The income statement shows the sales and profits that were produced during an interval of time, say the year 2007. An individual would have assets, and a net worth, and a balance sheet would detail these holdings. The individual would also have income and expenses, and his or her income statement would detail these flows.
For a business, the most important number—the “bottom line”—is generally thought to be the net income. However, the firm’s net cash flow is also quite important, especially if one distrusts management and thinks the accounting statements might be misleading.
WorldCom understated costs. This had the effect of increasing its reported profits and its net worth. Also, since assets were not reduced by the correct amounts, reported assets were too high. This caused the reported debt ratio (debt/assets) to be too low, making the company look stronger than it actually was. Enron essentially transferred and got off its books debt that it was responsible for, along with assets that were actually worth less than had been paid for them. Enron “sold” the transferred assets to sham companies at inflated prices, thus allowing it to inflate its reported profits. Since both companies were able to report high profits and to look stronger than they actually were, their stock prices were much higher than they would have been had proper accounting been used.
When the deceptions were revealed, both Enron’s and WorldCom’s stock prices collapsed. Investors then became worried that other companies might have been doing the same thing (they were), so the prices of other stocks, including companies that were playing entirely by the rules, also fell.
c. The stock market collapse had serious economic consequences. First, companies had a hard time raising new equity capital, and that restricted growth. Second, individuals who saw their portfolios decline were worried and thus spent less, and that put a further drag on the economy. In general, a strong economy needs good capital markets, and that can occur only if investors can obtain good information about the companies whose securities they are buying.
In essence, the statement of cash flows strips out non-cash charges that are shown on the income statement and ends up showing the surplus or deficit of cash generated during the year. For example, depreciation and amortization charges reduce net income, but they are non-cash charges, so they are added back when constructing the statement of cash flows. Since cash is what’s available to companies to spend or pay out to investors, the cash flow statement is quite important, especially after Enron.
Net income is the reported after-tax accounting profits, and EPS is net income divided by the number of shares outstanding. (If options are outstanding, the number of shares used to find EPS may be adjusted to reflect EPS after options have been exercised.) EBITDA is operating income before interest, taxes, depreciation, and amortization. This number is especially important to banks and other creditors because it is an approximation to the cash flow being generated from operations that is available to make payments on debt. NOPAT is net operating profit after taxes. It is found as EBIT(1-T), and it shows how much after-tax operating profit the firm would generate if it had no debt. Free cash flow is the cash flow available to investors after the firm has paid its taxes and made all investments in fixed assets and working capital necessary to sustain operations going forward. FCF = (NOPAT + Depreciation) – Gross investment in operating assets = NOPAT – Net investment in operating assets. MVA is the market value of the stock minus the...
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