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Chapter 2

FIN 300 Chapter Notes - Chapter 2: Operating Cash Flow, Fixed Asset, Cash Flow

Course Code
FIN 300
Yuanshun Li

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Chapter 2
2.1 The balance sheet
-It is a convenient means of organizing and summarizing what a firm owns( its
assets), what a firm owes ( its liabilities), and the difference between the two
( the firm’s equity) at a given time
Assets: the left hand side
-A fixed asset is one that has a relatively long life
-Tangible or intangible
-Accountants refer to these assets as capital assets
-Current assets have a life of less than one year
Liabilities and owners equity: the right hand side
-Current liabilities have a life of less than one year
-Bond and bondholders refer to long term debt and long term creditors
-The difference between the total value of the assets (current and fixed) and
the total value of the liabilities (current and long term) is the shareholders
equity AKA common equity or owners equity
Net working capital
-Difference between a firms current assets and its current liabilities is called
net working capital
-Liabilities side of the balance sheet primarily reflects managerial decisions
about capital structure and the use of short term debt
-Three particularly important things to keep in mind when examining a balance
sheet are liquidity , debt versus equity, and market value versus book value
-Refers to the speed and ease with which an asset can be converted to cash
-Has two dimensions: ease of conversion versus loss of value
-Liquid assets are generally less profitable to hold
Debt versus equity
-Shareholders equity = assets – liabilities
-The use of debt is a firms capital structure is called financial leverage
Market value versus book value
-Historical cost – assets are carried on the books at what the firm paid for them
-Book values are objective as they are a matter of record and not subject to
opinion. Due to inflation, book values generally understate the market values
of assets and so are conservative
-Asset market values are significantly below book values, accountants write
down assets.
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-The fact that balance sheet assets are listed at cost means that there is no
necessary connection between the total assets shown and the value of the
2.2 The income statement
-Net income is often expressed on a per-share basis and called earnings per
share (EPS)
-The difference between net income and cash dividends is the addition to
retained earnings for the year
GAAP and the income statement
-The realization principle is to recognize revenue when the earnings process is
virtually complete and the value of an exchange of goods or services is known
or can be reliably determined
-Revenue is recognized at the time of sale, which need not be the same as the
time of collection
-Costs shown on the income statement are based on the Matching principle –
determine revenues and then match those revenues with the costs associated
with producing them
Time and costs
-In the long run, all business costs are variable
-Product costs are reported on the income statements as costs of goods sold,
but they include both fixed and variable costs
-Period costs are incurred during a particular time and are reported and selling,
general, and administrative expenses.
2.3 Cash Flow
Cash flow from assets
-Operating cash flow refers to the cash flow that results from the firms day to
day activities
-Capital spending refers to the net spending on fixed assets
-Additions to net working capital is the amount spent on net working capital
Operating cash flow
-Defined as net income plus depreciation
-This definition of cash flow thus considers interest paid to be an operating
expense. Our definition treats it properly as a financing expense. If there were
no interest expense, the two definitions would be the same
Capital spending
-Net capital spending is just money spent on fixed assets less money received
from the sale of fixed assets
Change in net working capital
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