BMAL-590 Business Finance

Common stock

(sometimes listed as Common Stock at Par Value) equals the number of outstanding common shares multiplied by the par value per share. Par value (often $1) is an artifact of earlier pre-computer accounting methods used to track the number of outstanding shares. It has no relation to the actual value of the shares.

Balance Sheet Assets

-organized in order of liquidity: 1. Current Assets -includes all cash and items expected to be converted into cash in next 12 months A. Cash and Equivalents - money market B. Accounts Receivable - amounts due from customers C. Inventory - cost of raw materials D. Prepaid Expenses - rents, taxes, prepaid advertising 2. Fixed Assets A. Property Plant and Equipment -factories 3. Other Assets A. Intangible Assets -brand names, trademarks, formulas, etc

Successful long-term planning means asking and answering probing questions like these:

1. In what emerging markets might we have a sustainable competitive advantage? 2. How can we leverage our competitive strengths across existing markets in which we currently do not compete? 3. How can we respond to any threats to our current business? 4. In which geographic regions should we produce? Where should we sell? 5. Can we deploy resources more efficiently by exiting certain markets and using those resources elsewhere?

Financial Planning

A long-term financial plan begins with strategy. Typically, the senior management team analyzes the markets in which the firm competes and tries to identify ways to protect and increase the firm's competitive advantage in those markets. Financial managers strive to develop and implement effective financial plans that support, but do not drive, the company's strategic goals and objectives while managing risk and uncertainty. In order for the company to function effectively, it must have adequate funding sources in place based on effective analysis and comprehensive financial forecasts.

current liabilities on the balance sheet include three types of accounts:

Accounts Payable Notes Payable Accrued Expenses

spontaneous liabilitiesor spontaneous financing

Accounts payable and accruals are often called this because they tend to change directly with changes in sales.

Assessing Financial Performance: Activity Ratios

All other factors being equal, analysts favor a high turnover ratio because it indicates that a firm generates more sales (and, ideally, more cash flow for investors) from a given investment in assets.

Cash disbursements

Cash payments made by a business include all outlays of cash by the firm in the period. The most common cash disbursements are cash purchases, fixed asset outlays, payments of accounts payable, wages, interest payments, taxes, and rent and lease payments. Cash disbursements may also include items such as dividends and share repurchases. It is important to remember that depreciation and other noncash expenses are not included in the cash budget. They are not outlays of cash and merely represent a scheduled write-off of an earlier cash outflow. However, depreciation does have a cash flow effect through its impact on tax payments.

Financing Strategies

Conservative Strategy Aggressive Strategy Matching Strategy

Which of the following is an inflow of cash to a corporation?

Decreasing inventory

When a firm has no "other income," its operating profit and _____ are equal.

EBIT

Matching Strategy

Finance permanent assets with long-term funding sources and temporary asset requirement with short-term financing. ​

pro forma

Financial managers and analysts can also prepare a statement of cash flows developed from projected, or pro forma, financial statements. They use this approach to determine if the firm will need additional external financing or will generate excess cash that could be reinvested or distributed to stockholders.

Finance plays several roles in long-term planning

First, financial managers draw on a broad set of skills to assess the likelihood that a given strategic objective can be achieved. Second, the finance function assesses the feasibility of a strategic action plan given a firm's existing and prospective sources of funding. Financial analysts generally treat expected dividend payments as a factor that limits a firm's ability to make new investments. Third, finance clearly plays an important control function as firms implement their strategic plans. Financial analysts prepare and update cash budgets to make sure that firms do not unknowingly slip into a liquidity crisis. Fourth, a major contribution of finance to the strategic planning process involves risk management. The finance function manages risk exposures so that the firm can take risks for which it has a comparative advantage and can hedge risks for which it has no advantage.

net operating profits after taxes (NOPAT),

Free cash flow for a given period is calculated in two steps. First, we must examine the firm's net operating profits after taxes (NOPAT), which is the firm's earnings before interest and after taxes: 𝑁𝑂𝑃𝐴𝑇=𝐸𝐵𝐼𝑇×(1−𝑇) where EBIT is earnings before interest and taxes and T is the corporate tax rate.

Inflows and outflows

Inflows: 1. Decrease in any asset 2. Increase in any liability 3. Net income (profit after taxes) 4. Depreciation and non-cash charges 5. Sale of common or preferred stock Outflows: 1. Increase in any asset 2. Decrease in any liability 3. Net loss 4. Dividends paid 5. Repurchase or retirement of stock A decrease in an asset (such as inventory) is an inflow of cash because cash that has been tied up in the asset is released and can be used for some other purpose, such as repaying a loan. In contrast, an increase in inventory (or any other asset) is an outflow of cash because additional inventory ties up more of the firm's cash. Logic suggests that if net income is a cash inflow, then a net loss (negative net profit after taxes) is a cash outflow. The firm must balance its losses with an inflow of cash from, say, selling off some of its fixed assets or increasing external borrowing. Can a firm have a net loss (negative NOPAT) and still have positive operating cash flow? Yes. This can occur when depreciation and other noncash charges during the period are greater than the net loss. The statement of cash flows treats net income (or net losses) and depreciation and other noncash charges as separate entries.

sales target growth rates

Most firms establish growth as one of their long-term objectives, and most firms, when planning for growth, focus on meeting sales target growth rates. It is not unusual to observe a distinct upward trend in any company's historical sales volume. However, in a single year many firms experience sharp quarter-to-quarter sales changes due to seasonal factors. Construction-related businesses generate much higher volume in the summer than they do in the winter. In contrast, toy companies experience peak volume in the winter.

"book value"

Net PP&E on the balance sheet is the total "book value" of the assets, which is the original cost of the assets less accumulated depreciation to date. Depreciation is taken according to standardized formulas and does not reflect the reduction in actual value of the assets which can vary for many reasons.

fixed asset turnover ratio

Net Sales / Average Net Fixed Assets As with other ratios, the "normal" level of fixed asset turnover varies widely from one industry to another.

Two types of debt ratio:

One type focuses on balance sheet measures of outstanding debt relative to other sources of financing. The other type, known as coverage ratios, focuses more on income statement measures of the firm's ability to generate sufficient cash flow to make scheduled interest and principal payments.

A firm's total cash flows can be conveniently divided into:

Operating flows Investment flows Financing flows Taking on new debt (short-term or long-term) results in a cash inflow; repaying existing debt requires a cash outflow. Similarly, the sale of stock generates a cash inflow; whereas the repurchase of stock or payment of cash dividends results in a cash outflow. In combination, the operating, investment, and financing cash flows during a given period affect the firm's cash and marketable securities balances.

_____ ratios would provide the best information regarding total return to common stockholders.

Profitability

Securities and Exchange Commission (SEC)

The agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies. regulates publicly traded U.S. companies as well as the nation's stock and bond markets. It mandates that companies generate financial statements following international accounting standards (IAS) The SEC requires four key financial statements: (1) the balance sheet (2) the income statement (3) the statement of retained earnings (4) the statement of cash flows

(WACC)

The cost of funds is found by multiplying the firm's weighted average cost of capital (WACC) by the total funds invested (total assets minus current liabilities). EVA's degree of positive correlation with actual share valuations remains unclear.

book value of equity

The difference between the book value of a firm's assets and its liabilities; also called shareholders' equity and stockholders' equity, it represents the net worth of a firm from an accounting perspective.

cash dividend per share (DPS)

The final entry in the income statement is the cash dividend per share (DPS) paid to common stockholders.

Public Company Accounting Oversight Board (PCAOB)

The group charged with determining auditing standards and reviewing the performance of auditing firms. It effectively gives the SEC authority to oversee the accounting profession's activities Established by the Sarbanes-Oxley Act of 2002

stockholders' equity

The last entry on the balance sheet, stockholders' equity is the owners' residual share of the business, including their original investment plus any money the firm has earned and retained since its inception. Stockholders' equity includes preferred stock, common stock, paid-in-capital in excess of par, and retained earnings. However, the net worth of the firm includes only the common stock, paid-in-capital in excess of par, and retained earning.

Liquidity

The length of time it takes to convert accounts into cash during the normal course of business. The most liquid asset (cash) appears first, and the least liquid (fixed assets) comes last. Current assets are those that are easy to sell and turn into cash, while fixed assets are physical assets like buildings and equipment.

Financial Accounting Standards Board (FASB)

The primary accounting standard-setting body in the United States. examines controversial accounting topics and issues standards that, in terms of their impact on accounting practices, almost have the force of law.

Financial Statements: Balance Sheet Stockholders' Equity

The stockholders' equity section provides information about the claims against the firm held by investors who own preferred and common shares. It is reflected in four types of accounts: Preferred Stock Common Stock Paid-in-capital in excess of par Retained earnings

Notes to Financial Statements

These notes provide detailed information on the accounting policies, calculations, and transactions that underlie entries in the financial statements. Notes typically provide additional information about a firm's revenue recognition practices, income taxes, fixed assets, leases, and employee compensation plans. Professional security analysts find this information particularly useful, and they routinely scour the notes when evaluating the firm's performance and value.

DuPont system

This approach uses both income statement and balance sheet information to break the ROA and ROE ratios into component pieces. It highlights the influence of both the net profit margin and the total asset turnover on a firm's profitability The advantage of the DuPont system is that it breaks a company's return on common equity into three components tied to the financial statements: 1. Net profit margin 2. Assets to equity 3. Total asset turnover

Aggressive Strategy

Use less expensive but riskier short-term debt to finance both seasonal peaks and part of long-term growth in sales and assets.​

Conservative Strategy

Use more expensive long-term financing to finance both permanent assets and temporary assets.

percentage-of-sales method

When firms construct pro forma statements by assuming that all items grow in proportion to sales and by extending that percentage to all income statement and balance sheet accounts, they are using the percentage-of-sales method. This is a good starting point since such balance sheet items as receivables, inventory, and payables do typically increase with sales, although not always in a linear fashion.

cash budget

a detailed plan showing how cash resources will be acquired and used over a specific time period Firms use the cash budget to ensure they will have enough cash available to meet short-term financial obligations. Any surplus cash resources can be invested quickly and efficiently. The cash budget also includes cash receipts, all the firm's cash inflows in a given period. The most common components of cash receipts are cash sales, collections of accounts receivable, and other cash receipts. The firm estimates collections of accounts receivable using the past payment patterns of its customers.

Generally Accepted Accounting Principles (GAAP)

a set of accounting standards that is used in the preparation of financial statements developed by the Financial Accounting Standards Board (FASB)

financial ratio analysis

a technique for measuring the performance of a firm according to its balance sheet, income statement, and market valuation They can be used to determine the company's strengths and weaknesses, its historical performance, and its present financial condition. Managers use ratios to improve the company's performance. Creditors use ratios to see whether the firm will be able to repay its debts, while stockholders want to predict what future dividends and earnings will be. One complication of ratio analysis is that a normal ratio in one industry may be highly unusual in another.

Cash and cash equivalents

assets such as checking account balances at commercial banks that can be used directly as means of payment.

average age of inventory

average number of days' sales in inventory (365/ inventory turnover)

Bottom-up sales forecasts

begin by assessing demand in the coming year on a customer-by-customer basis. Managers add up these figures across sales territories, product lines, and divisions to arrive at the overall sales forecast for the company. This approach generally does not rely on mathematical and statistical models.

Net property, plant, and equipment

calculated as Gross PP&E less accumulated depreciation - the cumulative expense recorded for the depreciation of fixed assets since their purchase; this reflects a decline in the asset's economic value over time. The one fixed asset that is not depreciated is land because it seldom declines in value.

external financing required (EFR)

calculated it follows: (Gross change in total assets for the year - net cash generated from operations) / Total assets at the end of the year.

Return on Common Equity (ROE)

captures the return earned on the common stockholders' (owners') investment in the firm For a firm that uses only common stock to finance its operations, the ROE and ROA figures will be identical. With debt or preferred stock on the balance sheet, these ratios will usually differ. When the firm earns a profit, even after making interest payments to creditors and paying dividends to preferred stockholders, the firm's ROE will exceed its ROA. Conversely, if the firm's earnings fall short of the amount it must pay to lenders and preferred stockholders, then the ROE will be less than ROA.

Investment flows

cash flows associated with purchase and sale of both fixed assets and equity investments in other firms

When evaluating financial ratios, analysts typically first examine a firm's ratio _____

compared to the firm's previous years' ratios

Accrued Expenses

costs that have been incurred by the firm that have not yet been paid. Examples of accruals include taxes owed to the government and wages due employees.

Liabilities

debts that the firm owes to others

Which of the following is NOT a cash disbursement?

depreciation expenses

Noncash charges

depreciation is a noncash charge depreciation, amortization, and depletion allowances - are expenses that appear on the income statement but do not involve an actual outlay of cash. Almost all firms list depreciation on their income statements, but when amortization or depletion occur in a firm's financial statements you would treat them in a similar manner.

Long-term liabilities

due after more than a year and include deferred taxes and long-term debt.

EBIT

earnings before interest and taxes Other income, earned on transactions directly related to producing and/or selling the firm's products, is added to operating income to yield earnings before interest and taxes (EBIT) When a firm has no "other income," its operating profit and EBIT are equal. Next, the firm subtracts interest expense - representing the cost of debt financing - from EBIT to find its pretax income.

Sustainable Growth

economic growth and development that meet present needs without harming the needs of future generations Firms frequently set planning goals in terms of target growth rates, typically annual growth in sales or assets. A firm's growth can be measured by increases in its market value, its asset base, the number of people it employs, or any number of other metrics. Most firms define and measure growth targets in terms of sales as well.

treasury stock

entry records the value of common shares that the firm currently holds in reserve. Usually, treasury stock appears on the balance sheet because the firm has reacquired previously issued stock through a share repurchase program.

Paid-in-capital in excess of par

equals the number of shares outstanding multiplied by the original selling price of the shares, net of the par value. The combined value of common stock and paid-in-capital equals the proceeds the firm received when it originally sold shares to investors (including initial public offerings and rights offerings).

Assets

include everything that can be used to benefit the business or give the company the right to receive benefits

Inventories

include raw materials, work in process (partially finished goods), and finished goods held by the firm.

Total Asset Turnover Ratio

indicates the efficiency with which a firm uses all its assets to generate sales. Like the fixed asset turnover ratio, total asset turnover indicates how many dollars of sales a firm generates per dollar of total asset investment.

Intangible assets

items such as patents, trademarks, copyrights, or mineral rights entitling the company to extract oil and gas on specific properties.

deferred tax entry

long-term liability that reflects the difference between the taxes that firms actually pay and the tax liabilities they report on their public financial statements.

sustainable growth model

looks at how much growth a firm can generate by maintaining the same financial relationships as the year before starts with a balance sheet identity, adds a few assumptions, and ultimately derives an expression that determines how rapidly a firm can grow while maintaining a balance between its outflows (increases in assets) and inflows (increases in liabilities and equity) of funds. Specifically, the sustainable growth model assumes the following: (1) The firm's only form of equity is common stock (E), and it will not issue new shares of common stock next year. (2) The firm's total asset turnover ratio, the ratio of sales divided by total assets (S/A), remains constant. (3) The firm pays out a constant fraction, d, of its earnings as dividends. (4) The firm maintains a constant assets-to-equity ratio (A/E). (5) The firm's net profit margin, m, is constant.

Most pro forma statements begin with a sales forecast. One approach to deriving a sales forecast is the top-down approach. Top-down sales forecasts rely heavily on ______

macroeconomic and industry forecasts

A firm's income statement:

made up of many elements that each have an effect on it. On a typical income statement, a firm's expenses are deducted from its revenues to come up with the firm's net profits or losses for that given period.

Liquidity ratios

measure a firm's ability to satisfy its short-term obligations as they come due. Because a common precursor to financial distress or bankruptcy is low or declining liquidity, liquidity ratios are good leading indicators of cash flow problems. The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.

Activity ratios

measure the speed with which the firm converts various accounts into sales or cash. Analysts use activity ratios as guides to assess how efficiently the firm manages its assets and its accounts payable.

Return on total assets (ROA), often called return on investment (ROI)

measures management's overall effectiveness in using the firm's assets to generate returns to common stockholders. To improve ROA, a firm needs to improve its cost control, for example, by reducing labor costs, purchases, and overhead; or the company needs to increase its revenues through higher pricing or changing its product mix or volumes. The firm might also be able to improve its capacity utilization, making more use of the same equipment. A firm could also improve its working capital management, collecting accounts receivable faster or paying its accounts payable more slowly.

debt ratio

measures the proportion of total assets financed by the firm's creditors. The higher this ratio, the greater is the firm's reliance on borrowed money to finance its activities

For both managers and external financial analysts, ______ is the single most important accounting number found on the income statement.

net income (net profit after tax)

Spontaneous current liability changes

occur automatically with changes in sales. They must, therefore, be deducted from current assets in order to find the net change in short-term investment for the determination of free cash flow.

laws permit firms to construct two sets of financial statements:

one for tax purposes and one for reporting to the public For example, when a firm purchases a long-lived asset, it can choose to depreciate the asset rapidly for the purpose of obtaining large, immediate tax write-offs. When the firm constructs financial statements for release to the public, however, it may choose a different depreciation method - perhaps one that results in higher reported earnings in the early years of the asset's life.

Current Ratio

one of the most commonly cited financial ratios, measures the firm's ability to meet its short-term obligations. It is defined as current assets divided by current liabilities. The more predictable a firm's cash flows, the lower the acceptable current ratio.

Notes Payable

outstanding short-term loans, typically from commercial banks.

A speedup in _____ will _____ a firm's financing needs; whereas, a slowdown in ______ will ______ a firm's financing needs.

payments; increase; collections; increase

A firm's balance sheet

presents a "snapshot" view of the company's financial position at a specific moment in time. By definition, a firm's assets must equal the combined value of its liabilities and stockholders' equity. The basic balance sheet equation is Assets = Liabilities + Stockholders' Equity. Thus, creditors and equity investors finance all of a firm's assets. The balance sheet consist of three sections that list a firm's assets and liabilities as well as the claims of the stockholders. ssets and liabilities appear in descending order of liquidity,

Inventory turnover

provides a measure of how quickly a firm sells its goods.

Statement of Cash Flows

provides a summary of what cash has gone into and out of a firm because of its operations, investments, and financing activities during a year. It isolates the firm's operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the year. Although financial managers are interested in the information in the firm's accrual-based financial statements, their primary focus is on cash flows.

Top-down sales forecasts

rely heavily on macroeconomic and industry forecasts. Senior managers establish a firm-wide objective for increased sales; individual divisions or business units receive targets that, in aggregate, collectively achieve the firm's overall growth target; division heads pass down sales targets to product line managers and other smaller-scale units. The sales targets will vary across units within the division, but they must add up to achieve the divisional goal.

Statement of Retained Earnings

reports how the company's retained earnings balance changed from the beginning to the end of the period this statement is primarily used to see how the firm has made its investment/consumption decision.

Marketable securities

represent liquid short-term investments, which financial analysts view as a form of "near cash." They include Treasury notes, commercial paper, and others.

Accounts receivable

represent the amount customers owe the firm from sales made on credit.

earnings per share (EPS)

represents the amount earned during the period on each outstanding share of common stock Dividing earnings available for common stockholders by the number of shares of common stock outstanding results in earnings per share

Long-term planning

requires more than paying close attention to a firm's existing markets. Even more important is the ability to identify and prioritize new market opportunities and risks

Financial flows

result from debt and equity financing transactions.

Preferred Stock

shows the total proceeds from the sale of preferred stock. This form of ownership has preference over common stock when the firm distributes income and assets.

The quick or acid-test ratio

similar to the current ratio except that it excludes inventory, which is usually the least-liquid current asset. The generally low liquidity of inventory results from two factors: 1. Many types of inventory cannot be easily sold because they are partially completed items, special-purpose items, etc; 2. Inventory is typically sold on credit, so it becomes an account receivable before being converted into cash. The quick ratio provides a better measure of overall liquidity only when a firm's inventory cannot be easily converted into cash. If inventory is liquid, then the current ratio is the preferred measure.

Free Cash Flow (FCF)

the amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows Managers and analysts track a variety of cash flow measures. Among these, one of the most important is FCF

Accounts Payable

the amounts owed for credit purchases by the firm

The cost of capital

the annual percentage cost of an average dollar of long-term funds employed in the firm from all sources and given the firms proportional mix of those sources, which is called its capital structure. Firms that use this metric as a measure of growth attempt to maintain ROI above some minimum hurdle rate based on the firm's cost of capital. he general assumption is that if ROI is greater than the cost of capital (plus perhaps a fudge factor), then the firm is earning more on its funds than the associated costs, and shareholder value will be created. One problem with this approach is that it compares accounting-based ROI to an economic-based measure of the return demanded by suppliers of capital.

average payment period

the average amount of time needed to pay accounts payable Firms use the average payment period to evaluate their payment performance. This metric measures the average length of time it takes a firm to pay its suppliers. The average payment period equals the firm's average daily purchases divided into the accounts payable balance

operating cash flow (OCF)

the cash flow a firm generates from normal operations—from the production and sale of its goods and services. Adding depreciation back into NOPAT yields OCF 𝑂𝐶𝐹=𝑁𝑂𝑃𝐴𝑇+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛= [𝐸𝐵𝐼𝑇×(1−𝑇)]+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛OCF=NOPAT+Depreciation=[EBIT×(1−T)]+Depreciation

Retained earnings

the cumulative total of the earnings that the firm has reinvested in its assets and operations since its inception. Retained earnings are not a reservoir of unspent cash. When the retained earnings "vault" is empty, it is because the firm has already reinvested the earnings in new assets and/or has paid common stock dividends.

Economic value added (EVA®)

the difference between net operating profits after taxes (NOPAT) and the cost of funds. When applied correctly, EVA prompts managers to make the same investment decisions that the net present value (NPV) method directs them to do.

The key input required to build a cash budget is

the firm's sales forecast

Gross profit

the first income measure. It is the amount by which sales revenue exceeds the cost of goods sold (the direct cost of producing or purchasing the goods sold). Next, a firm deducts from gross profits various operating expenses, including selling expense, general and administrative expense, and depreciation expense. The resulting operating profit represents the profits earned from the sale of products, although this amount does not include financial and tax costs.

Gross property, plant, and equipment (PP&E)

the original cost of all real property, structures, and long-lived equipment owned by the firm.

Net income

the proverbial "bottom line" and the single most important accounting number for both corporate managers and external financial analysts. The final step is to subtract taxes from pretax income to arrive at net income, or net profits after taxes

Current Liabilities

those that must be paid within one year and include accounts payable, notes payable, and accrued expenses

International Financial Reporting Standards (IFRS)

used in many countries as the regulatory basis for the preparation of financial statements. They are designed to provide a common global language for financial reporting, particularly in the European Union, so published financial information is comparable across international boundaries.

operating flows

which are the cash inflows and outflows directly related to the production and sale of products or services