Financial Concepts Explained: A Comprehensive Guide
Discount Factor and Interest Rate
If the one-year discount factor is equal to 0.94340, the interest rate must be equal to 6%.
Equation: 1 / 0.94340 – 1 = 0.05995 ≈ 6%
Balance Sheet Analysis
The following example shows a balance sheet for a certain company (all quantities are in million dollars).
Net Working Capital
Net Working Capital = Total Current Assets – Total Current Liabilities
Net Working Capital in 2006
2006 Net Working Capital = 2006 Total Current Assets – 2006 Total Current Liabilities
Market-to-Book Ratio
If in 2006 Luther has 10.2 million shares outstanding, and these shares are trading at $16 per share, then Luther’s market-to-book ratio can be calculated as follows:
Market Capitalization = Total Current Shares * Share Price = 163.2
Market-to-Book Ratio = Market Capitalization / Stockholders’ Equity
Gross Profit Calculation
Gross Profit = Total Sales – Cost of Sales
Cash Flow Statement: Acquisitions
The cost of acquiring a company for its patents will be recorded as an outflow under Investment Activities on the statement of cash flows.
Income Statement Analysis
Return on Equity (ROE)
Return on Equity (ROE) = Net Income / Stockholders’ Equity
Operating Margin
Operating Margin = Operating Income / Cost of Sales
Arbitrage Opportunities
Arbitrage opportunities are short-lived because once investors take advantage of the opportunity, prices will respond so that the buying and selling price become equal.
Market Prices in Cost-Benefit Analysis
Market prices are useful in cost-benefit analysis because they can be used to convert different services and commodities into equivalent cash values, which can then be compared.
Present Value and Interest Rates
An increase in the interest rate will cause the present value of a future cash flow to fall.
Comparing Investments with Different Discount Rates
If two investments have the same future cash flows, the investment with the lower discount rate will have a higher present value.
Solar Water Heater Investment
To determine if a solar water heater investment is sound, calculate the annual savings required:
Required Annual Savings = Investment Cost * Interest Rate
Example: $2,100 * 0.10 = $210
Present Value of a Donation
To calculate the present value of a donation with increasing payments, use the following formula:
Present Value = Initial Payment / (Interest Rate – Growth Rate) * (1 – (1 + Growth Rate / 1 + Interest Rate)^Number of Years)
Income Statement and Net Income
Net income is distributed either to dividends or retained earnings.
Law of One Price
The Law of One Price states that if equivalent goods or securities are traded simultaneously in different competitive markets, they will trade for the same price in each market. This statement is true.
Savings Account Growth
To calculate the time it takes for an investment to grow to a certain amount, use the following formula:
Time (Years) = log(Future Value / Present Value) / log(1 + Interest Rate)
Present Value of a Cash Flow Stream
To calculate the present value of a cash flow stream, discount each cash flow back to its present value and sum the results.
Financial Statements
Public companies are required to produce several financial statements, but the statement of activities is not one of them.
Compounding
Earning interest on prior interest earnings is called compounding.