DSST Principles of Finance cheat sheet

Balance sheet identity: Assets = Liabilities + Stockholders' Equity; it is a snapshot at a point in time, while the income statement covers a period.

Current assets convert to cash within one year or the operating cycle; current liabilities come due within one year.

Retained earnings on the balance sheet equal cumulative net income minus cumulative dividends paid since inception, not cash.

Free cash flow = Operating cash flow − Capital expenditures − Change in net working capital.

The sustainable growth rate = ROE × (1 − dividend payout ratio); it is the growth achievable without new external equity.

DuPont decomposition: ROE = Net profit margin × Total asset turnover × Equity multiplier.

Cash flow identity: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders.

An increase in a current asset other than cash is a use of cash; an increase in a current liability is a source of cash.

Common-size statements express each item as a percentage of sales (income statement) or of total assets (balance sheet).

Future value of a lump sum: FV = PV × (1 + r)^n; present value: PV = FV / (1 + r)^n.

Annuity present value: PV = PMT × [1 − (1 + r)^−n] / r; annuity future value: FV = PMT × [(1 + r)^n − 1] / r.

Perpetuity value = PMT / r; growing perpetuity value = PMT / (r − g), valid only when r > g.

Effective annual rate: EAR = (1 + APR/m)^m − 1, where m is compounding periods per year; EAR exceeds APR when m > 1.

Ordinary annuity payments occur at period end; annuity due payments occur at period start and are worth (1 + r) times more.

For continuous compounding, FV = PV × e^(r×n) and EAR = e^APR − 1.

The Rule of 72 estimates doubling time as 72 divided by the percentage interest rate.

Discounting moves cash flows to the present; compounding moves them to the future; both use the same rate and period count.

Net working capital = Current assets − Current liabilities; the current ratio = Current assets / Current liabilities.

Quick (acid-test) ratio = (Current assets − Inventory) / Current liabilities.

Cash conversion cycle = Inventory period + Receivables period − Payables period; a shorter cycle frees cash.

Inventory period = 365 / inventory turnover; receivables period = 365 / receivables turnover.

Economic order quantity balances ordering costs against carrying costs; total carrying cost rises with order size.

Credit terms "2/10, net 30" mean a 2% discount if paid within 10 days, otherwise full payment due in 30 days.

The cost of foregoing a cash discount = (discount % / (1 − discount %)) × (365 / (credit period − discount period)).

A restrictive short-term financing policy uses more current liabilities and less net working capital, raising liquidity risk.

The operating cycle spans purchase of inventory through collection of receivables; it exceeds the cash conversion cycle by the payables period.

Bond price = present value of coupon payments plus present value of par value, discounted at the yield to maturity.

Bond prices move inversely to interest rates; the price equals par when the coupon rate equals the yield to maturity.

Longer maturity and lower coupon increase a bond's interest rate sensitivity (duration).

Preferred stock is valued as a perpetuity: P = D / r; it ranks above common stock but below debt in the claim hierarchy.

Constant-growth dividend model: P0 = D1 / (r − g), where D1 = D0 × (1 + g).

Cumulative preferred dividends in arrears must be paid before any common dividend is distributed.

Dividend growth g = retention ratio × ROE, where retention ratio = 1 − payout ratio.

Callable bonds carry higher yields than noncallable bonds; convertible bonds carry lower yields because the conversion option has value.

Common shareholders hold residual claims and voting rights; bondholders have a fixed contractual claim paid first.

Net present value = sum of discounted cash flows minus initial investment; accept a project when NPV > 0.

Internal rate of return is the discount rate that makes NPV zero; accept when IRR exceeds the required return.

NPV and IRR can conflict for mutually exclusive projects due to scale and timing; NPV is preferred because it measures added value.

Profitability index = PV of future cash flows / initial investment; use it to rank projects when capital is rationed.

Payback period ignores the time value of money and cash flows after the cutoff; discounted payback corrects the first flaw.

Use incremental cash flows only: exclude sunk costs, exclude financing costs (they enter via the discount rate), and include opportunity costs.

Depreciation is non-cash but reduces taxes; operating cash flow = (Sales − Costs) × (1 − T) + Depreciation × T.

Terminal cash flow includes salvage value plus tax effects on the sale of assets: tax = (Salvage − Book value) × T.

Modified IRR adjusts for reinvestment at the cost of capital and avoids multiple IRR solutions when signs of cash flow alternate.

WACC = (E/V) × Re + (D/V) × Rd × (1 − T), where V = E + D and T is the corporate tax rate.

After-tax cost of debt = pre-tax yield × (1 − T); interest is tax-deductible, so the tax shield lowers the effective cost.

Cost of equity via CAPM: Re = Rf + β × (Rm − Rf), where the market risk premium is (Rm − Rf).

Dividend growth model cost of equity: Re = D1 / P0 + g; it fails for firms paying no dividends.

The cost of preferred stock = preferred dividend / net price per share after flotation costs.

Use the market value of debt and equity for WACC weights, not book values.

Flotation costs raise the effective cost of new external equity and can be included by adjusting the project's initial cost.

WACC is the appropriate discount rate for projects of average risk; riskier projects require a higher, project-specific rate.

Expected return = Σ (probability × return) for each state of the economy.

Variance = Σ probability × (return − expected return)^2; standard deviation is its square root and measures total risk.

Diversification eliminates unsystematic (firm-specific) risk but not systematic (market) risk.

Beta measures systematic risk relative to the market; the market portfolio has beta 1.0, the risk-free asset beta 0.

Security market line: required return = Rf + β × market risk premium; assets above the line are underpriced.

Portfolio beta is the weighted average of component betas; portfolio standard deviation is not simply the weighted average of standard deviations.

Correlation below +1 reduces portfolio risk; the lower the correlation, the greater the diversification benefit.

Sharpe ratio = (Portfolio return − Risk-free rate) / Standard deviation; it measures reward per unit of total risk.

Coefficient of variation = Standard deviation / Expected return; it compares risk per unit of expected return across assets.