Financial Accounting

Some Caveats

The main problem is that the models are really accounting statement generators rather than determinants of value. As we will see, value is determined by cash flows, timing and risk; and these financial planning models do not address any of these issues.

Non-Cash Items

The matching principle also creates the recognition of non-cash items. For example, when we purchase a machine, the cash flow occurs immediately, but we recognize the expense of the machine over time as it is used in the production process (i.e., depreciation). The largest non-cash deduction for most firms is depreciation; however, other non-cash items include amortization and deferred taxes. Non-cash expenses reduce taxes and net income, but do not actually represent a cash outflow. Non-cash deductions are part of the reason that net income is not equivalent to cash flow.

Compounding Periods

To this point, we have assumed annual interest rates; however, many projects / investments have different periods. For example, bonds typically pay interest semi-annually, and house loans are on a monthly payment schedule. To apply the formulas, we must adjust for compounding periods:FV = C0 × (1 + r/m)m×T

Computing Total Asset Turnover

Total Asset Turnover (TAT) = sales / total assets

Computing Leverage Ratios

Total debt ratio = (total assets - total equity) / total assetsV ariations:debt/equity ratio = (total assets - total equity) / total equityUsing the balance sheet identity, the debt/equity ratio can also be calculated as: debt ratio / (1 - debt ratio) Equity multiplier = total assets / total equity = 1 + debt/equity ratio The equity multiplier captures the leverage effect in the DuPont identity.

Value versus Cost

Under current accounting standards, financial statements are reported on an historical cost (i.e., book value) basis. However, book values are generally not all that useful for making decisions about the future because of the historical nature of the numbers. Also, some of the most important assets and liabilities do not show up on the balance sheet. For example, the people that work for a firm can be very valuable assets, but they are not included on the balance sheet. This is especially true in service industries.

Time and Costs

We need to plan for both short-run cash flows and long-run cash flows. In the short run, some costs are fixed regardless of output, and other costs are variable. For example, fixed assets are generally fixed in the short run, while inputs such as labor and raw materials are variable. In the long run, all costs are variable. It is important to identify these costs when doing a capital budgeting analysis. Additionally, accountants typically classify costs as product costs and period costs, rather than fixed and variable.

Managerial Goals: direct agency costs

compensation and perquisites for management

U.S.C.C. Balance Sheet

Since a firm needs current assets (e.g., inventory) to generate sales, as the firm grows, so generally does its net working capital.

The Partnership

- A business with multiple owners, but not incorporatedGeneral partnership - all partners share in gains or losses; all have unlimited liability for all partnership debts.Limited partnership - one or more general partners run the business and have unlimited liability. A limited partner's liability is limited to his or her contribution to the partnership, and they cannot help in running the business.Advantages include more equity capital than is available to a sole proprietorship, relatively easy to start (although written agreements are essential), and income taxed once at personal tax rate.Disadvantages include unlimited liability for general partners, dissolution of partnership when one partner dies or wishes to sell, low liquidity

The Corporation

- A distinct legal entity composed of one or more owners

Categories of Financial Ratios

-Short-term solvency, or liquidity, ratios: The ability to pay bills in the short-run -Long-term solvency, or financial leverage, ratios: The ability to meet long-term obligations -Asset management, or turnover, ratios: Efficiency of asset use-Profitability ratios: Efficiency of operations and how this translates to the "bottom line" -Market value ratios: How the market values the firm relative to the book values

Potential Problems

-no underlying financial theory-finding comparable firms-what to do with conglomerates, multidivisional firms -differences in accounting practices-differences in capital structure -seasonal variations, one-time events

The Sole Proprietorship

A business owned by one personAdvantages include ease of start-up, lower regulation, single owner keeps all the profits, and taxed once as personal income.Disadvantages include limited life, limited equity capital, unlimited liability and low liquidity.

Growing Annuity: Example

A growing stream of cash flows with a fixed maturity C 1+gT PV= 1 1− r−g 1+r

Computing Liquidity Ratios

Current Ratio = current assets / current liabilitiesQuick Ratio = (current assets - inventory) / current liabilities Cash Ratio = cash / current liabilities

The Agency Problem

Agency RelationshipsThe relationship between stockholders and management is called the agency relationship. This occurs when one party (principal) hires another (agent) to act on their behalf. The possibility of conflicts of interest between the parties is termed the agency problem.

External Financing and Growth

All else equal, more growth means more external financing will be needed.Assuming no spontaneous sources of funds, EFN equals the increase in total assets less the addition to retained earnings.Low growth firms will run a surplus that causes a decline in the debt-to-equity ratio. As the growth rate increases, the surplus becomes a deficit, and the firm will need external financing.

The Corporate Firm

Although many forms of business organizations exist, the corporate form is the standard by which we address most large scale problems. This approach, however, does not imply that the methods we develop are inappropriate for other business types.

Amortized Loan with Fixed Payment - Example

Amortized Loans: Borrower repays part or all of the principal over the life of the loan. Two methods are (1) fixed amount of principal to be repaid each period, which results in uneven payments, and (2) fixed payments, which results in uneven principal reduction. Traditional auto and mortgage loans are examples of the second type of amortized loans.Consider a $200,000, 30-year loan with monthly payments of $1330.60 (7% APR with monthly compounding). You would pay a total of $279,016 in interest over the life of the loan. Suppose instead you cut the payment in half and pay $665.30 every two weeks (note that this entails paying an extra $1330.60 per year because there are 26 two week periods). You will cut your loan term to just under 24 years and save almost $70,000 in interest over the life of the loan.Calculations on TI-BAII plusFirst: PV = 200,000; N=360; I=7; P/Y=C/Y=12; CPT PMT = 1330.60 (interest = 1330.60*360 - 200,000)Second: PV = 200,000; PMT = -665.30; I = 7; P/Y = 26; C/Y = 12; CPT N = 614 payments / 26 = 23.65 years (interest = 665.30*614 - 200,000)

Percent of Sales and EFN

An alternative method for calculating EFN is to use a formula approach, where we subtract expected increases in (spontaneous) liabilities and equity from the expected increase in assets. Assets Sales − Spon Liab Sales ΔSales −(PM Projected Sales)(1−d) EFN = Sales

What Is a Firm Worth?

An investment is worth the present value of its future cash flows. Since a company is a series of investments, it is worth the total present value of all cash flows generated by the firm.

The Income Statement

As mentioned earlier, the income statement measures flows over a period of time. Specifically, it measures revenues collected relative to the costs associated with those revenues (matching principle). The difference between these two is the firm's income. Thus, the income statement takes the following form: Revenue - Expenses = Income

Income Statement Analysis

As with the balance sheet, there are things to remember when trying to interpret the income statement: GAAP, non-cash items, and timing. Remember that GAAP require that we recognize revenue when it is earned, not when the cash is received, and we match costs to revenues (i.e., the matching principle). Thus, income is reported when it is earned, not when cash is actually generated from the transaction. Consequently, net income is NOT cash flow.

U.S. Composite Corporation Balance Sheet

Assets: The Left-Hand SideAssets are divided into several categories. Make sure that students recall the difference between current and fixed assets, as well as tangible and intangible assets. Assets are listed in order of how long it typically takes for the specific asset to be converted to cash, with those taking the shortest time being listed first. 4 Liabilities and Equity: The Right-Hand SideThis portion of the balance sheet represents the sources of funds used to finance the purchase of assets. Since sources and uses must equal, the balance sheet is an equality:Assets = Liabilities + Stockholder's Equity

Computing Inventory Ratios

Inventory turnover = cost of goods sold / inventory Days' sales in inventory = 365 days / inventory turnover

A Comparison

Corporations account for the largest volume of business (in dollar terms) in the U.S. Advantages include limited liability, unlimited life, separation of ownership and management (ability to own shares in several companies without having to work for all of them), liquidity, and ease of raising capital. Disadvantages include separation of ownership and management (agency costs) and double taxation. Recent tax laws reduce the level of double taxation, but it has not been eliminated.

Net Working Capital

The difference between a firm's current assets and its current liabilities.

What long-term investments should the firm choose?

Capital budgeting - Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure.

Where will we get the long-term financing to pay for the investments?

Capital structure - Capital structure in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

Financial Cash Flow

Cash is the lifeblood of a business and is, therefore, the most important item that can be extracted from financial statements.We generate cash flow from assets, then use this cash flow to reward creditors and stockholders. In conjunction with the balance sheet identity, we know that the cash flow from assets must, therefore, equal the cash flows to creditors and stockholders: CF(A) CF(B) + CF(S)Stated explicitly, the cash flow identity isCash Flow from Assets = Cash Flow to Creditors + Cash Flow to Stockholders

Financial Statements Analysis

Common-Size Balance SheetsExpress each account as a percent of total assets. Common-Size Income StatementExpress each item as a percent of sales.

Determinants of Growth

Determinants of growth - From the DuPont identity, ROE can be viewed as the product of profit margin, total asset turnover, and the equity multiplier. Anything that increases ROE will increase the sustainable growth rate as well. Therefore, the sustainable growth rate depends on the following four factors: Operating efficiency - profit marginAsset use efficiency - total asset turnoverFinancial leverage - equity multiplierDividend policy - retention ratioThe sustainable growth rate that we commonly see in other texts or applications is ROE*b - why is it different? The formula that is used throughout the text is based on an ROE that is computed using ending balance sheet numbers for equity. The "simpler" formula is appropriate only when the ROE is computed using beginning equity balance sheet numbers.

Computing Market Value Measures

Earnings Per Share (EPS) = net income / shares outstandingPrice-earnings ratio = price per share / earnings per shareMarket-to-book ratio = market value per share / book value per shareMarket capitalization = Price per share x Shares OutstandingEnterprise Value (EV) = Market capitalization + Market value of interest bearing debt - Cash 10 EV multiple = EV / EBITDA

Finding the Number of Periods

FV = PV(1 + r) - rearrange and solve for T. Remember your logs!T = ln(FV / PV) / ln(1 + r) TT 14 Or, use the financial calculator, just remember the sign convention. If you compute a negative N (or receive an error), you have likely forgotten the sign convention!Example: How many periods before $100 today grows to $150 at 7%? T = ln(150 / 100) / ln(1.07) = 6 periods Rule of 72 - the time to double your money, (FV / PV) = 2.00 is approximately (72 / r%) periods. The rate needed to double your money is approximately (72/t)%.Example: To double your money at 10% takes approximately (72/10) = 7.2 periods.

The Financial Manager

Financial Managers should make decisions that increase firm value, which effectively involves three primary categories of financial decisions. Capital budgeting - process of planning and managing a firm's investments in fixed assets. The key concerns are the size, timing, and risk of future cash flows. Capital structure - mix of debt (borrowing) and equity (ownership interest) used by a firm. What are the least expensive sources of funds? Is there an optimal mix of debt and equity? When and where should the firm raise funds? Working capital management - managing short-term assets and liabilities. How much inventory should the firm carry? What credit policy is best? Where will we get our short-term loans? These broad categories, however, can be summarized with two concrete responsibilities: ➢ Selecting value creating projects ➢ Making smart financing decisions

Financial Models

Financial planning is based on the three areas of corporate finance that were discussed in chapter one: capital budgeting decisions, capital structure decisions, and working capital management.

U.S.C.C. Cash Flow from Financing

Financing Activities Change in notes payable Change in long-term debt Change in common stock - Dividends

The Capital Structure Decision

Financing policy determines the liabilities and equity side of the balance sheet. means arranging capital from various sources, in order, to meet the need of long-term funds for the busines

U.S.C.C. Cash Flow from Investing

Investment Activities+ Ending net fixed assets- Beginning net fixed assets + Depreciation

The Goal of Financial Management

From a stockholder (owner) perspective, the goal of buying the stock is to gain financially. Thus, the goal of financial management in a corporation is to maximize the current value per share of the existing stock. A More General GoalThe more general goal is to maximize the market value of owners' equity.

Present Value

Given r, what amount today (Present Value or PV) will produce a given future amount? Remember that FV = $C0 (1 + r). Rearrange and solve for $C0, which is the present value. Therefore,PV = FV / (1 + r) = C1 / (1 + r)Example: $110 in 1 period with an interest rate of 10% has a PV = $110 / (1.1) = $100 Discounting - the process of finding the present value.

Regulation

Historically, most regulation has focused on the disclosure of relevant information, thereby putting all investors on an equal playing field. The Securities Act of 1933 and the Securities Exchange Act of 1934These Acts provide the basic regulatory framework for the public trading of securities in the United States. The 1933 Act focuses on the issuance of securities, while the 1934 Act established the SEC and addressed other regulatory issues, such as insider trading and corporate reporting. Sarbanes-OxleyFollowing the scandals at Enron, WorldCom, and Tyco, among others, "Sarbox" was enacted in 2002. This Act significantly increased the auditing and reporting requirements that public firms face, and it also explicitly placed the responsibility for any fraud on the corporate directors. As with any law, however, there is a cost. In response to the added burden, many (particularly small) firms have delisted and others have foregone going public. For others, the cost of compliance has significantly increased, thereby reducing profits.

Future Value

If you invest $C today at an interest rate of r, you will have $C + 12 $C(r) = $C(1 + r) in one period. The general form is: FV = C0×(1 + r) where r is the interest rate per period (or opportunity cost) C0 (also called PV) is the value at period 0 FV (also called Ct+T) is the value at period t+TCompounding solves for the value at the end of the investment duration (FV), and discounting solves for the value at the beginning of the investment duration (PV).Example: $10,000 at 5% interest gives $10,000(1.05) = $10,500

Debt versus Equity

Interest and principal payments on debt have to be paid before cash may be paid to stockholders. The company's gains and losses are magnified as the company increases the amount of debt in the capital structure. This is why we call the use of debt financial leverage.The balance sheet identity can be rewritten to illustrate that owners' equity is just what is left after all debts are paid. Owners' Equity = Assets - LiabilitiesTherefore, equity holders are referred to as residual claimants.

Interest-Only Loans

Interest-Only Loans: Borrower pays interest only each period and the entire principal at maturity. Corporate bonds are a common example of interest-only loans.

Liquidity

Liquidity is a measure of how easily an asset can be converted to cash. Since assets are listed in ascending order of how long it takes to be converted to cash, they are, by definition, listed in descending order of liquidity (i.e., most liquid listed first). Liability order, however, reflects time to maturity.It is important to point out to students that liquidity has two components: (1) how long it takes to convert to cash and (2) the value that must be relinquished to convert to cash quickly. Any asset can be converted to cash quickly if you are willing to lower the price enough. It is also important to point out that owning more liquid assets makes it easier to meet short-term obligations; however, they also provide lower returns. Consequently, too much liquidity can be just as detrimental to shareholder wealth maximization as too little liquidity.

The Capital Budgeting Decision

Long-term investment decisions determine the level of fixed assets. Capital Budgeting is a decision-making process where a company plans and determines any long term capital expenditures whose returns in terms of cash flows are expected to be received beyond a year. Investment decisions may include any of the below: Expansion Acquisition Replacement New Product R&D Major Advertisement Campaign Welfare investment

Managing Managers

Managerial compensation can be used to encourage managers to act in the best interest of stockholders. One commonly cited tool is stock options. The idea is that if management has an ownership interest in the firm, they will be more likely to try to maximize owner wealth. Stockholders technically have control of the firm, and dissatisfied shareholders can oust management via proxy fights, takeovers, etc. However, this is easier said than done. Staggered elections for board members often make it difficult to remove the board that appoints management. Poison pills and other anti-takeover mechanisms make hostile takeovers difficult to accomplish.

U.S.C.C. Cash Flow from Operations

Operating Activities + Net Income+ Depreciation Deferred Taxes + Decrease in current asset accounts (except cash)+ Increase in current liability accounts (except notes payable) - Increase in current asset accounts (except cash)- Decrease in current liability accounts (except notes payable) It may be good to note that cash flow from operations effectively accounts for interest expense since it is subtracted prior to net income; however, this flow is more generally related to financing activities.

Annuity Example

Ordinary Annuity - multiple, identical cash flows occurring at the end of each period for a fixed number of periods. The present value of an annuity of $C per period for T periods at r percent interest: PV = C[1 - 1/(1 + r)T] / r Example: If you are willing to make 36 monthly payments of $100 at 1.5% per month, what size loan can you obtain? PV = 100[1 - 1/(1.015)36] / .015 = 100(27.6607) = 2766.07 Or, use the calculator: PMT = -100; N = 36; I/Y = 1.5; CPT PV = $2,766.07 (Remember that P/Y = 1 when using period rates.) Finding the future value of an ordinary annuity: T FV = C[(1 + r) - 1] / rExample: If you make 20 payments of $1000 at the end of each period at 10% per period, how much will be in your account after the last payment?FV = $1,000[(1.1)20 - 1] / .1 = 1,000(57.275) = $57,275Or, use the calculator: PMT = -1,000; N = 20; I/Y = 10; CPT FV = $57,275 (Remember to clear the registers before working each problem.)In general, we assume that cash flows occur at the end of each time period. This assumption is implicit in the ordinary annuity formulas presented. An annuity due has cash flows that occur at the beginning of the period.

Present Value and Discounting

PV of future amount in t periods at r is:PV = FV [1 / (1 + r)T], where [1 / (1 + r)T] is the discount factor, or the present value interest factor, PVIF(r,T)Example: If you have $259.37 in 10 periods and the interest rate was 10%, how much did you deposit initially?PV = $259.37 [1/(1.1)10] = $259.37(.3855) = $100Discounted Cash Flow (DCF) - the process of valuation by finding the present valuePresent versus Future ValuePresent Value factors are reciprocals of Future Value factors:PVIF(r,T) = 1 / (1 + r)T and FVIF(r,T) = (1 + r)TExample: FVIF(10%,4) = 1.14 = 1.464PVIF(10%,4) = 1 / 1.14 = .683

Perpetuity: Example

Perpetuity - series of level cash flows forever PV = C / r Good examples of perpetuities include preferred stock and British consols.

Short-Term Asset Management

Short-term asset management choices (e.g., conservative versus aggressive) affect the level of net working capital.

The Goal of Financial Management

Possible Goals Profit Maximization - this is an imprecise goal. Do we want to maximize long-run or short-run profits? Do we want to maximize accounting profits or some measure of cash flow? Because of the different possible interpretations, this should not be the main goal of the firm. Other possible goals that students might suggest include minimizing costs or maximizing market share. Both have potential problems. We can minimize costs by not purchasing new equipment today, but that may damage the long-run viability of the firm. Many dot.com companies got into trouble in the late 1990's because their goal was to maximize market share. They raised substantial amounts of capital in IPO's and then used the money on advertising to increase the number of "hits" on their site. However, many firms failed to translate those "hits" into enough revenue to meet expenses, and they quickly ran out of capital. The stockholders of these firms were not happy. Stock prices fell dramatically, and it became difficult for these firms to raise funds. In fact, many of these companies have gone out of business.

Pure Discount Loans

Pure Discount Loans: Borrower pays a single lump sum (principal and interest) at maturity. Treasury bills are a common example of pure discount loans.

U.S.C.C. Statement of Cash Flows

Putting it all together: Net cash flow from operating activities Net cash flow from investing activities Net cash flow from financing activities 8 = Net increase (decrease) in cash over the period

Ratio Analysis

Questions to answer when interpreting financial ratios: -How is the ratio computed?-What aspects of the firm are we attempting to analyze?-What is the unit of measurement (times, days, percent)?-What does the value indicate? (What are the benchmarks used for comparison? What makes a ratio "good" or "bad"?)-What actions could the company take to improve the ratio? (How will this affect other ratios?)

Computing Receivables Ratios

Receivables turnover = sales / accounts receivableDays' sales in receivables = 365 days / receivables turnover(Also called "average collection period" or "days' sales outstanding.")

The Multiperiod CaseFuture Value and Compounding

Reinvesting interest, we earn interest on interest, i.e., compounding FV = $C0 (1 + r)(1 + r) = $C0 (1 + r)2 Example: $100 at 10% for 2 periods gives $100(1.1)(1.1) = $100(1.1)2 = $121In general, for T periods, FV = $C0 (1 + r) , where (1 + r) is the future value interest factor, FVIF(r,T) Example: $100 at 10% for 10 periods gives $100(1.1)10 = $259.37 The interest rate is really just the "growth" rate of money, and the future value formula can be used more generally to find the future amount of anything that is expected to grow at a constant rate over a set number of periods.

GAAP

Remember that GAAP require that we recognize revenue when it is earned, not when the cash is received, and we match costs to revenues (i.e., the matching principle). Thus, income is reported when it is earned, not when cash is actually generated from the transaction. Consequently, net income is NOT cash flow.

Financial Planning Ingredients

Sales Forecast - most other considerations depend upon the sales forecast, so it is said to "drive" the modelPro Forma Statements - the output summarizing different projectionsAsset Requirements - investment needed to support sales growth Financial Requirements - debt and dividend policiesThe "Plug" - designated source(s) of external financingEconomic Assumptions - state of the economy, anticipated changes in interest rates, inflation, etc.

Percent of Sales Approach

Sales generate retained earnings (unless all income is paid out in dividends). Retained earnings, plus external funds raised, support an increase in assets. More assets lead to more sales, and the cycle starts again.This simplified approach assumes that certain items are fixed and other vary proportionally with sales. Once forecasted, you must select a plug account that will be used to make the balance sheet balance. This number generally reflects External Financing Needed (EFN).

Net Present Value

Some tips for computing NPV:Only add (subtract) cash flows from the same time period Use the Time LineSpecify a cash flow for each time period (even when it is $0) Use an appropriate discount rate The general form for calculating NPV: The initial cash flow is typically an investment and is subtracted to compute the NPV. Note that the formula from the text assumes that the discount rate (r) is the same each period. Even though this is often the case, you may wish to point out this assumption to students and go over an example that uses two discount rates at different time periods.An Example: You have an opportunity to invest in a business that will pay $200,000 in one year, $400,000 in two years, $600,000 in three years and $800,000 in four years. You can earn 12% per year compounded annually on a mutual fund that has similar risk. If it costs $1.2 million to start this business, should you invest? 0 1 2 3 4 years ||||| ||||| CF -$1.2 mil $200,000 $400,000 $600,000 $800,000 Discount rate = 12% NPV=−C + C1 + C2 ++ CT (1+r)T 0 (1+r)1 (1+r)2 13 0 = $232,932

Stakeholders

Stakeholders are other groups, besides stockholders, that have a vested interest in the firm and potentially have claims on the firm's cash flows. Stakeholders can include creditors, employees, customers, and the government.

Financial Statements Analysis

Standardizing Financial StatementsStandardized statements allow users to compare companies of different sizes (particularly within the same industry) or to better compare an individual company as it grows through time.

What Rate is Enough?

Start with the basic time value of money equation and rearrange to solve for r: FV = PV(1 + r)TOr, you can use a financial calculator to solve for r (I/Y on the calculator). It is important to remember the sign convention on most calculators and enter either the PV or the FV as negative. Example: What interest rate makes a PV of $100 become a FV of $150 in 6 periods? r = (150 / 100)1/6 - 1 = 7%or PV = -100; FV = 150; N = 6; CPT I/Y = 7%

Continuous Compounding

Starting with the general formula:FV = C0× (1 + r/m)m×TWhat would happen if m approached infinity? This is known as continuous compounding. If we take the limit of the equation, it reduces to:FV = C0 × erTwhere e is a constant, transcendental number equal to approximately 2.718.The EAR of a continuously compounded investment is: EAR=er -1

Effective Annual Rates of Interest

Stated or quoted interest rate (also called annual percentage rate, or APR) - rate before considering any compounding effects, such as 10% compounded quarterlyEffective annual rate of interest - rate on an annual basis that reflects compounding effects, e.g., 10% compounded quarterly has an effective rate of 10.38%. 15 Compounding over Many Years EAR = [1 + (quoted rate)/m]m - 1, where m is the number of periods per yearExample: 18% compounded monthly is [1 + (.18/12)]12 - 1 = 19.56%

Taxes

Tax rates affect the firm's cash flow and, therefore, the firm's value. Since we want to maximize firm value, we need to include taxes in our decisions.Marginal tax rate - rate paid on next dollar of incomeAverage tax rate = tax bill / taxable income Since decisions create incremental income, we want to use the marginal rate in our decisions.

Balance Sheet Model of the Firm

The Balance Sheet presents a picture of the firm at a point in time, and it provides a model by which to address the three basic questions that corporate finance managers must answer.

Hypothetical Organization Chart

The Chief Financial Officer (CFO) or Vice-President of Finance coordinates the activities of the treasurer and the controller. The controller handles cost and financial accounting, taxes, and information systems (i.e., data processing). The treasurer handles cash and credit management, financial planning, and capital expenditures.

The DuPont Identity

The DuPont Identity provides analysts with a way to break down ROE and investigate what areas of the firm need improvement. ROE = (NI / total equity)multiply by one (assets / assets) and rearrangeROE = (NI / assets) (assets / total equity) = ROA*EM multiply by one (sales / sales) and rearrangeROE = (NI / sales) (sales / assets) (assets / total equity) ROE = PM*TAT*EM

The Internal Growth Rate

The Internal Growth Rate (IGR) is the growth rate the firm can maintain with internal financing only. IGR = (ROA*b) / [1 - ROA*b]

The Sustainable Growth Rate

The Sustainable Growth Rate (SGR) is the maximum growth rate a firm can achieve without external equity financing, while maintaining a constant debt-to-equity ratio.SGR = (ROE*b) / [1 - ROE*b]

The Balance Sheet

The balance sheet provides a snapshot of the firm's financial position at a specific point in time. Thus, it is commonly referred to as a "stock" statement, whereas the income statement would be considered a "flow" statement since it covers a period of time.The balance sheet identity is: Assets ≡ Liabilities + Stockholder's Equity

Cash Flow Management

The common assumption is that cash flow is a better metric to evaluate, as opposed to earnings, which can be more easily manipulated by subjective decisions allowed by GAAP (generally accepted accounting principles).While this may be true, firms can still "manage" cash flows, particularly by, for example, classifying items as operating rather than investing cash flows. This will not change the total cash flow, but it may make the firm's operations seem stronger than they actually are. Nonetheless, since total cash flow is unchanged by this "management," it is thus a better measure than earnings.Financial Statements Analysis

Balance Sheet Analysis

There are three primary concerns that need to be addressed when analyzing a balance sheet: liquidity, debt versus equity, and market value versus historical cost.

Valuing "Lumpy" Cash Flows

There are two ways to calculate the present value of multiple cash flows: discount the last amount back one period and add them as you go, or discount each amount to time zero and then add them.There are two ways to calculate the future value of multiple cash flows: compound the accumulated balance forward one period at a time, or calculate the future value of each cash flow and add them at the ending period. r = (FV / PV) 1/T - 1 Compounding Periods The Algebraic FormulaAlternative forms of the TVM relationship Solving for future value: Solving for present value: Solving for the discount rate: Solving for the time period: Ct+T = Ct × (1 + r)TCt = Ct+T ÷ (1 + r)Tr = (Ct+T ÷ Ct) 1/T - 1T = ln(Ct ÷ Ct+T )÷ ln(1 + r)

The Statement of Cash Flows

There is an official accounting statement called the Statement of Cash Flows, which explains the change in the cash account on the firm's balance sheets between two periods. The statement typically has three components: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. It is helpful to think of cash inflows and outflows: Sources and Uses of cash 7 Activities that bring in cash are sources. Firms raise cash by selling assets, borrowing money, or selling securities.Activities that involve cash outflows are uses. Firms use cash to buy assets, pay off debt, repurchase stock, or pay dividends. There are some mechanical Rules for determining Sources and Uses: Sources: Uses: Decrease in asset accountIncrease in liabilities or equity account Increase in asset accountDecrease in liabilities or equity account

Computing Profitability Measures

These measures are based on book values, so they are not comparable with returns that you see on publicly traded assets. Profit margin = net income / salesEBITDA Margin = EBITDA / SalesReturn on Assets (ROA) = net income / total assetsReturn on Equity (ROE) = net income / total equityFor ROA, we could use EBIT rather than Net Income to get a measure that is neutral with respect to capital structure.

U.S.C.C. Financial Cash Flow

These slides provide a walkthrough of the calculation of the components of cash flow.CF of the Firm = operating cash flow - net capital spending - changes in net working capital Operating cash flow (OCF) = EBIT + depreciation - taxesNet capital spending (NCS) = purchases of fixed assets - sales of fixed assets orNCS = ending net fixed assets - beginning net fixed assets + depreciation Changes in NWC = ending NWC - beginning NWCCash Flow to Creditors and StockholdersCash flow to creditors = interest paid + retirement of debt - proceeds from new debt orCash flow to creditors = interest paid - net new borrowing = interest paid - (ending long-term debt - beginning long-term debt) Cash flow to stockholders = dividends paid + stock repurchases - proceeds from new stock issues or Cash flow to stockholders = dividends paid - net new equity raised = dividends paid - (ending common stock, APIC & Treasury stock - beginning common stock, APIC & Treasury stock)It is important to point out that changes in retained earnings are not included in "net new equity raised."

Using the DuPont Identity

These three ratios indicate that a firm's return on equity depends on its operating efficiency (profit margin), asset use efficiency (total asset turnover) and financial leverage (equity multiplier).

U.S.C.C. Income Statement

This series of slides walks through the various sections of the income statement, pointing out that the general operation of the business is reflected in the top portion, with non-operating impacts (including taxes) being reflected in the lower portion.The "bottom line" is net income, which provides a measure of the overall earnings of the firm.

Computing Coverage Ratios

Times interest earned ratio = EBIT / interestCash coverage ratio = (EBIT + depreciation + amortization) / interest = EBITDA / interestYou can also calculate a type of inverse value as follows: Interest Bearing Debt / EBITDA = (196 + 457) / 967 = .68 Values less than one are indicative of a stable position.

The Importance of Cash Flow

To create value, the firm must generate more cash than it uses. Stated differently, the firm must generate sufficient cash flow, after taxes, to compensate investors for providing the firm with financing. Additionally, the value of the cash flows generated by the firm must be analyzed in light of both the timing of the cash flows, as well as the risk of the cash flows.

How will we manage the daily financial activities of the firm?

Working capital- Working capital is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital.

EAR on a Financial Calculator

You can also do this on most calculators. For the TI-BA-II+, press 2nd I Conv (above the number 2), enter 18 for the NOM rate (do not forget to press enter), press the up arrow to go to C/Y and enter 12, press the up arrow to go to EFF and press CPT = 19.56%. Most other financial calculators can do this as well. Assume you expect to get a refund of $978. What is the APR with weekly compounding? What is the EAR? How large does the refund have to be for the APR to be 15%? Using a financial calculator to find the APR: PV = 978 - 50 = 928; FV = -978; N = 3 weeks; CPT I/Y = 1.765% per week; APR = 1.765 (52 weeks per year) = 91.76%!!! 52Compute the EAR = (1.01765) - 1 = 148.38%!!!! You would be better off taking a cash advance on your credit card and paying it off when the refund check comes, even if you have the most expensive card available.Refund (net of $50) needed for a 15% APR:PV + 50 = PV(1 + (.15/52))3 PV = $5,761.14

Managerial Goals: indirect agency costs

cost of monitoring and sub-optimal decisions