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3Santikian_FBE 421_sp11_revised

3Santikian_FBE 421_sp11_revised - FBE 421 Financial A...

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FBE 421: Financial Analysis & Valuation Lecture 3 Financial Statement Analysis
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Lecture Outline Understanding Financial Statements and Cash Flow Income Statement Balance Sheet Cash Flow Statement Computation of Firm Free Cash Flow (FCF) Reconciling the Cash Flow Statement with Firm FCF Free Cash Flow and Non-operating Income Primary objective learn how to translate accounting earnings from financial statements to cash flows used in valuation.
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Introduction Valuing an ongoing business requires: a forecast of the investment’s free cash flow an estimate of the appropriate risk-adjusted discount rate Project valuation differs from valuation of an ongoing business because: Firms typically have a history of past performance that is recorded in their financial statements, whereas proposed projects do not. By using information from the financial statements about how the firm has made money in the past, we can forecast future free cash flows and future financial performance.
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Understanding Financial Statements and Cash Flow Financial statements are prepared in accordance with a set of reporting guidelines called, Generally Accepted Accounting Principles (GAAP). Source of guidelines: Securities and Exchange Commission (SEC), the Public Company Accounting Oversight Board (PCAOB), and the accounting profession in general. Note : These rules and guidelines will not, in general, result in financial statements that provide information in the form that is most conducive for valuing a firm. But , a firm’s financial statements can be recast in such a way as to reveal the firm’s cash flows. We need to understand the relation between accounting earnings and cash flows .
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Income Statement: Cash vs. Accrual Accounting The accrual-based income statement is constructed using two fundamental principles: (1) the revenue recognition principle , to determine which revenues to include in the statement (2) the matching principle , to determine what expenses to include. The firm’s profits, or net income, for the period represent the difference in revenues recognized as earned during the period, minus the matching expenses the firm incurred in generating those revenues: Important : Note that there is no requirement that cash ever change
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Income Statement: Cash vs. Accrual Accounting Very, Very Important: Net income is not the same as cash flow! The income statement is prepared using the principles of accrual accounting, not cash accounting . The entries in the income statement do not necessarily correspond to transfers of cash during the period for which the statement was prepared.
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Example: Better Buys, Inc. To illustrate, consider the following example involving the purchase and sale of a big-screen television set: On December 15 , Better Buys Inc. orders and receives a new big- screen television set. The set cost Better Buys $2,500, but the manufacturer gave Better Buys credit terms of “net 90,” such that the firm has 90 days to pay for the set with no penalty or interest charged.
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