AFM101 Study Guide - Midterm Guide: Cash Flow, Accrual, Matching Principle

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Capital Gains: Big Cash Hoards
- When companies have lots of cash, they don’t know where to allocate it?
o Some companies pile it away
- Distorted picture of company’s performance because most of what they earn is from
investments of cash, rather than operating
What do companies use this cash for?
1) Paying dividends
2) Reinvesting by repurchasing shares, acquiring new companies
3) Storing the cash in banks
4) Paying off debts
- Managers make poor decisions because cash is readily available
- Investors can’t evaluate the performance of a company if lots of earning is from investments of
cash (rather than operating)
Cash Flow Reigns Once Again
- Earnings Quality: Company wants to know that a dollar earned is actually a dollar earned
o Cash Flow helps evaluate the quality of earnings
Cash flows are harder to manipulate, it is a clean way to assess company’s health
Free Cash Flow: Cash from Operating Activities Money going towards Investments
- When there is a negative cash flow, it is due to heavy expenditures
- Companies need positive cash flow
Companies risk future growth if they store away cash and do not invest in it
- Investors buy stocks that are going up and sell those that are falling
- Rising Accruals (in receivables and unpaid bills) signals BAD CASH FLOW
Informative or Misleading?
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- Proforma Earnings: reporting earnings in a NON GAAP way
Informative because:
- They reflect company’s earnings for the year very well
- Predict company’s future earnings very well
- Matches current stock price
- Companies may use proforma earning because:
o Revenue for proforma reporting is higher than GAAP reporting of earnings
o They want to meet/exceed forecasted earnings
o Proforma would report an INCOME rather than a LOSS from GAAP reporting
Therefore, investors would focus on a gain rather than a loss
Adjustments made to GAAP
1) Costs related to business
2) Non-Cash Expenses
3) Non- Recurring Items
Hide and Seek
- Companies use dirty legal accounting tricks
o Investors need to beware of these 10:
1) Big Bath:
- make the company look like it’s losing as much as possible, make the company look really bad
and in the next year, the company will look much profitable and better
2) Everything but the Bad Stuff Accounting (Proforma Accounting)
- Highlight all the good things, nothing bad
3) Moving Debt Off Balance Sheet
- Moving debt off the balance sheet
o Makes liabilities look less
- Would be hard for investors to see how much debt they actually have
4) Pension Plan Makeover
- Pension plan must be funded at a certain level
o Company makes shortfalls
5) Turning Expenses into Assets
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