Fundamentals of Corporate Finance Canadian Canadian 8th Edition Ross
CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS
LIQUIDITY
Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated with it—namely that higher returns can generally be found by investing the cash into productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing needs.
MATCHING COST AGAINST REVENUE
The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it.
HISTORICAL AND MARKET VALUE
Historical costs can be objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between relevance (market values) and objectivity (book values).
DEPRECIATION CONCEPT (a noncash deduction)
Depreciation is a noncash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a financing cost, not an operating cost.
MARKET VALUE NEVER LESS THAN “0” CONCEPT
Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value.
PURPOSE AND SOURCE CONCEPT
For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start up, so it depends (wisely aspect).
MORE EFFICIENT CONCEPT
If a company were to become more efficient in inventory management, the amount of inventory needed would decline.
If a company were to become more efficient in receivables management), collecting its receivables should be better.
LESS EFFICIENT FOR COMPANY CONCEPT
In general, anything that leads to a decline in ending NWC (A/R changes < A/P changes) relative to beginning would not be nice.
Negative net capital spending would mean more long-lived assets were liquidated than purchased (not a good condition).
LESS “NICE” FOR THIRD PARTY CONCEPT
If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative (depends on RATE).
If a company borrows more than it pays in interest, its cash flow to creditors will be negative (depends on RATE).
VALUE OF COMPANY
Enterprise value differs significantly from simple market capitalization in several ways, and it may be a more accurate representation of a firm's value.
Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have to take on the company's debt.
In a takeover, the value of a firm's debt would need to be paid by the buyer when taking over a company. This enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation (note: a must actually IMO!)
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