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# wk7_8 - EC150: Financial Economics SLIDE SET #3: ACCOUNTING...

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EC150: Financial Economics EC150: Financial Economics SLIDE SET #3: ACCOUNTING STATEMENTS AND CASH FLOWS (BASED ON RWJ CHAPTER 2)

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Cash flow versus accounting numbers Cash flow versus accounting numbers For finance and financial decisions, the most important item extracted from accounting statements is actual cash flow. Important: Finance is based on cash flows, not accounting figures. It is true, nonetheless, that much of the information you need to derive cash flow is available from accounting statements.
The two most important The two most important accounting statements accounting statements The Balance Sheet , which provides information regarding the firm’s financial position at a point in time. The Balance Sheet Identity is: Total Assets = Total Liabilities + Owners Equity The Income Statement , which provides information as to the firm’s performance over an interval of time.

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Some Key Financial Ratios Some Key Financial Ratios Financial statements contain a wealth of useful information. To briefly illustrate, define the following: I = Income, S = Sales, A = Average Assets, E = Average Owners Equity, p = profit margin = I/S, T = asset turnover = S/A, L = leverage ratio = A/E, ROA = return on assets = I/A, ROE = return on equity = I/E. Note that ROA = (I/S)(S/A) = pT, and ROE = pTL
Some Key Financial Ratios (Cont.) Some Key Financial Ratios (Cont.) ROE and ROA are key measures of financial performance, and are driven by the profit margin, asset turnover, and leverage ratios. Let’s analyze these numbers for U.S. Composite Corporation To do this, let’s look at the balance sheets for two consecutive years (table 2.1) and associated income statement (table 2.2).

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Some Key Financial Ratios (Cont.) Some Key Financial Ratios (Cont.) For U.S. Composite Corporation (table 2.1, 2.2) I=86 (net income, table 2.2) S=2262 (net income, table 2.2) A = (1879+1724)/2 = 1801.5 (average assets, table 2.1) E = (805+725)/2 = 765 (average owner’s equity, table 2.1) P = 86/2262 = 3.802% (net profit margin, table 2.2)
Some Key Financial Ratios (Cont.) For U.S. Composite Corporation (table 2.1, 2.2) T = 2262/1801.5 = 1.2556, (total asset turnover, both tables) L = 1801.5/765 = 2.3549 (leverage ratio, table 2.1) ROA = 86/1801.5 = 3.802%x1.2556 = 4.77%, ROE = 86/765 = 3.802%x1.2556x2.3549 = 11.24%.

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## This note was uploaded on 03/26/2008 for the course EC 150 taught by Professor Kutsoati during the Spring '08 term at Tufts.

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wk7_8 - EC150: Financial Economics SLIDE SET #3: ACCOUNTING...

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