Finance 3000

Liquidity Ratios

Relationship between firm's liquid (current) assets and current liabilities • Commonly-used liquidity ratios • Current ratio • Quick (or acid-test) ratio • Cash ratio

Cash Flows from Operating Activities

Represents items directly associated with producing and selling the firm's products • Net income • Depreciation • Working capital accounts other than cash and short-term debt

Treasurer

Responsible for managing cash, credit, financing, capital budgeting, risk management

5 Financial Decision Application & Theory

Risk Financial asset real asset real markets time value of money (TVM)

Corporate Governance

Set of laws, policies, incentives, and monitors designed to handle issues arising from the separation of ownership and control

Cash Coverage =

(EBIT + Depreciation) / fixed charges

Average Collection Period (ACP) =

(accounts receivable x 365 days) / credit sales

Average collection period (ACP) =

(accounts receivable x 365 days) / credit sales

cash ratio =

(cash and marketable securities) / current liabilites

book value per share (BVPS) =

(common stock + paid-in surplus + retained earnings) / (number of shares of common stock outstanding)

Dividends per share (DPS) =

(common stock dividends paid) / (number of shares of common stock outstanding)

Quick Ratio =

(current assets - inventory) / current liabilites

days sales in inventory =

(inventory x 365 days) / sales or cost of goods sold

earnings per share (EPS) =

(net income available to common stock holders) / (total shares of common stock outstanding)

Accounts Payable Turnover Ratio

- Measures dollar of COGS per dollar of accounts payable.

Sales to Working Capital Ratio

- Measures dollar of sales produced per dollar of working capital • (Current assets minus current liabilities)

The Fixed Asset Turnover Ratio

- Measures dollars of sales produced per dollar of fixed assets

The Accounts Receivable Turnover Ratio

- Measures dollars of sales produced per dollar of accounts receivable

Total Asset Turnover Ratio

- Measures dollars of sales produced per dollar of total assets

Capital Intensity Ratio

- Measures dollars of total assets needed to produce a dollar of sales

The Average Collection Period (ACP) Ratio

- Measures number of days accounts receivable held until collected

Cash Coverage Ratio

- Measures operating cash available to meet interest and other fixed charges -Indicates if debt burden is too large

The Fixed-Charge Coverage Ratio

- Measures operating earnings available for interest and other fixed charges

Times Interest Earned Ratio

- Measures operating earnings dollars available to meet interest obligations

Debt Ratio

- Measures percentage of total assets financed with debt

Equity Multiplier Ratio

- Measures the dollars of assets on balance sheet for every dollar of equity financing

The Average Payment Period (APP) Ratio

- Measures the number of days accounts payable held before extending cash to pay for raw materials

Statement of Cash Flows

1) Financial statement that shows firm's cash flows over given period of time • includes only inflows and outflows of cash and marketable securities • excludes transactions with no direct effect on cash receipts and payments 2) Statement of Cash Flow bottom line • Reflects difference between cash sources and uses • Equals the change in cash on the firm's balance sheet

Interest taxable with two exceptions:

1) State and local government bonds are federally tax-exempt 2) One corporation owning stock in another corporation • 70% of dividends from other corporation are tax exempt. • Only taxed on remaining 30% at receiving corporation's tax rat

Type 1

1) no money no ideas • Do not lend or spend in business context • No direct role in financial markets • Indirect role: to provide labor and consume products

2 Economic participants & the 4 types

1) participants with "extra" investment money 2) participants with economically viable ideas TYPES: 1) no money no ideas 2) money, but no ideas 3) no money, but ideas 4) money and ideas

Type 2 & 3

2) money, but no ideas 3) no money, but ideas • use financial institutions and financial markets for mutually beneficial exchange • Type 2: makes temporary loans to Type 3 • Type 3: typically consists of companies engaging in R & D

Type 4

4) money and ideas • Use financial tools • evaluate own businesses • choose highest-potential ideas •Are self-funded, so no need for financial markets

approximate number of years to double an investment =

72 / interest rate

EXAMPLE: approximate number of years to double an investment = interest rate = 6%

72/6 = 12 years

Dividends paid to shareholders are/are not tax deductible

ARE NOT

marginal tax rate

Taxes paid for each dollar of firm's additional taxable income

Price-Earnings Ratio

Best known and most often quoted figure • Measures price investors will pay per dollar of earnings • High PE ratio usually indicates projected growth • Drives stock classification as growth or value

1 Inside monitors

Board of Directors

Cash Flows from Financing Activities

Cash flows from debt and equity financing transactions • Issuing short- or long-term debt • Issuing stock • Using cash to pay dividends • Using cash to pay off debt • Using cash to buy back stock

Hybrid Organizations

Combine attributes of several forms Advantages: •Offer single taxation and limited liability to all owners •S Corporations • Limited Liability Partnerships (LLPs) • Limited Liability Companies (LLCs)

Retained Earnings =

Cumulative earnings - reinvested - not paid as dividends + Beginning retained earnings + Net income during the period - Dividends paid = Ending retained earnings

Statement of Retained Earnings

Details changes in retained earnings during reporting period •Reconciles net income and dividends paid with changes in retained earnings from one period to the next beginning retained earnings + net income for period - cash dividends paid = Ending retained earnings

Times Interest Earned =

EBIT / interest

PV =

FV / (1 + i)^n

Financial institutions and markets

Facilitate flow of capital between investors and companies

International finance

Finance theory used in global business environment

Income Statement

Firm's total earned revenues and total incurred expenses - over period of time • Income statement top line = revenues • Expenses listed below revenues • Bottom line = difference between revenues and expenses

Corporate Income Taxes

Firms taxed on earnings U.S. tax code determines corporate tax obligations - overseen by Congress • Tax rate changes driven by changes in government, business or public environment • U.S. has progressive tax structure • the larger the income, the higher the taxes assessed

_____________ occurs when not all cash is returned to investors - Retained Earnings - Taxes

Friction

Common Stock and Paid-in-Surplus:

Fundamental ownership claim in public or private company

Finance in Your Personal Life

Help you make good personal financial decisions • Borrowing money for a new car • Refinancing home mortgage at lower rate • Making credit card or student loan payments • Saving for retirement

Subprime Mortgage Borrowers (The Financial Crisis)

Higher-risk borrowers charged higher interest rates due to higher risk of default

Chief Financial Officer

Highest level financial officer

Preferred Stock:

Hybrid security - characteristics of both long-term debt and common stock

4 Subareas of Finance

Investments financial management Financial institutions and markets International finance

Economically successful projects repay money (plus profit) to __________________

Investors

Public Corporations

Legally independent entity entirely separate from its owners Advantages: • Limited liability for owners • Can raise large amounts of capital • Easy to transfer ownership Disadvantages: • Double taxation (corporate level and personal level)

Securitization (The Financial Crisis)

Loan originators sell the loan repayment rights to other financial institutions or investors

current assets are the most/least liquid + 4 examples

MOST cash, marketable securities, accounts recievable, and inventory Inventory is least liquid of current assets

Corporate Goals

Maximize value of owners' equity • Increase current value per share (stock price) of existing shares Common methods • Maximize net income or profit • Minimize costs • Maximize market share

Asset Management Ratios

Measure efficiency of firm's asset use • Inventory •Accounts receivable •Fixed assets •Accounts payable management

Debt Management Ratios + Two major ratio types

Measure how much debt (financial leverage) versus equity a firm uses to finance assets •Two major ratio types • Measure debt amount • Measure firm's ability to service debt

cash ratio

Measures ability to pay short-term obligations with available cash and marketable securities

Days' Sales in Inventory Ratio

Measures average number of days inventory held

Dividend Payout Ratio

Measures fraction of earnings paid out to common stockholders as dividends

Return on Equity (ROE)

Measures return on common stockholders' investment •Affected by net income and amount of financial leverage • High ROE is usually a positive sign, unless driven by excessively high leverage

Outflow = Pos/Neg

NEGATIVE - cash going out

Sole Proprietorships

Not legally separate from the owner Advantages: • Easy to start • Light regulatory and paperwork burden • Single taxation at the personal tax rate Disadvantages: • Unlimited liability • Limited access to capital

Controller

Oversees accounting function

*Financial asset

Ownership in cash flow represented by securities like stocks, bonds, and other asset

Inflow = Pos/Neg

POSITIVE - cash received

FV =

PV ×(1 + i)^n

*real asset

Physical property like gold, machinery, equipment, real estate

*real markets

Places/processes that facilitate real asset trading

*time value of money (TVM)

Theory and application of valuing cash flows at various points in time

Ratios Used to Make Comparisons

Trend -Comparison to the same firm over time Competitors -Comparison to other firms in the same industry

*Risk

Uncertainty of future cash flows due to timing and size

fixed assets

Useful life exceeding one year • Physical (tangible) assets (e.g. net plant and equipment) • Less tangible, long-term assets (e.g. patents and trademarks)

investment in operating capital =

[Change gross fixed assets + change net operating working capital]

operating cash flow =

[EBIT (1-tax rate) + Depreciation]

Free Cash Flow (FCF) =

[EBIT (1-tax rate) + Depreciation] - [Change gross fixed assets + change net operating working capital] = operating cash flow - investment in operating capital

compounding

adding interest

Liabilities

are loans to the firm Current liabilities • Obligations due within a year • Accruals (accrued wages and accrued taxes) • Accounts payable • Notes payable Long-term debt • Long-term loans and bonds - maturities > one year

market value

assets listed at value if sold in todays market

book value

assets listed on balance sheet at purchase price

Ending Retained Earnings =

beginning retained earnings + net income for period - cash dividends paid

stockholders

claim on remaining cash flow

Dividend Payout =

common stock dividends / net income available to common stockholders

cross sectional analysis

comparing 2 firms from same industry

Accounts Payable Turnover =

cost of goods sold / accounts payable

Accounts Receivable Turnover =

credit sales / accounts receivable

Current Ratio =

current assets / current liabilites

Net working capital=

current assets-current liabilities measure of firm's ability to pay obligations healthy firms have positive net working capital

Fixed-Charge Coverage =

earnings available to meet fixed charges / fixed charges

EBIT meaning

earnings before interest and taxes

EBT meaning

earnings before taxes

Discounting

finding present value

debt holders

fixed claim on firms cash flows

Annual report =

four basic financial statements • balance sheet • income statement • statement of cash flows • statement of retained earnings

Liquidity

how fast can an asset be turned into cash

Rule of 72 means

how much time for an amount to double

Investments

involves methods and techniques for making decisions about what kinds of securities to own

Market value per share (MVPS) =

market price of the firm's common stock

Price-Earnings (PE) Ratio =

market price per share / earnings per share

Return on Equity (ROE) =

net income available to common stockholders / common stockholders equity

Profit Margin =

net income available to common stockholders / sales

Return on Assets (ROA) =

net income available to common stockholders / total assets

NOI meaning

net operating income

*Friction

occurs when not all cash is returned to investors - Retained Earnings - Taxes

simple interest

only interest on original deposit

Fixed Asset Turnover =

sales / fixed assets

Total Asset Turnover =

sales / total assets

Sales to Working Capital =

sales / working capital

Inventory Turnover =

sales or cost of goods sold / inventory

Interest payments are _________________________

tax deductible

average tax rate =

tax liability / taxable income

Capital Intensity =

total assets / sales

Equity Multiplier =

total assets / total equity or total assets / common stockholders equity

Debt Ratio =

total debt / total assets

Debt-to-Equity =

total debt / total equity

Accounting

tracks what happened to firm's money in the past

Finance professionals: USE

use financial statements to draw future inferences

Accountants: USE

use reports for a picture of past financial performance

what return does liquid assets offer?

zero return b/c its cash

Debt-to-Equity Ratio

—Measures dollars of debt financing for every dollar of equity financing

TVM Basic Concept:

• $1 today is worth more than $1 next year

financial management

• Decisions about acquiring and using cash Examples include: • Organizing and raising capital • Tax decisions • Projects to fund

Cash uses involve: (2)

• Decreasing liabilities (or equity) • Increasing non cash assets

equity

• Difference between firm's total assets and total liabilities Types of Equity Preferred Stock: • Hybrid security - characteristics of both long-term debt and common stock Common Stock and Paid-in-Surplus: • Fundamental ownership claim in public or private company Retained Earnings: • Cumulative earnings - reinvested - not paid as dividends

Inventory Turnover Ratio

• Dollar of sales produced per dollar of inventory •Often uses cost of goods sold instead of sales because inventory is listed on the balance sheet at cost

Board of Directors duties (Inside monitors)

• Hires the CEO • Evaluates management • Designs compensation plans

***Three approaches to minimizing this conflict of interest (agency Theory)

• Ignore if effect is minimal • Use accountants, debt holders to monitor managers •Provide incentives to managers • Equity stakes • Stock options • Employee Stock Option Plan (ESOP)

Cash sources involve: (2)

• Increasing liabilities (or equity) • Decreasing noncash assets

Five Groups of Financial Ratios

• Liquidity • Asset management • Debt management • Profitability • Market value

current assets

• Normally convert into cash within a year • Cash (and marketable securities) • Accounts receivable • Inventory

TVM Decision Based on:

• Size of cash flows • Time between cash flows • Rate of return

Net Change in Cash and Marketable Securities

• The bottom line of the statement of cash flows - total of cash flows from operating, investing, and financing activities • Reconciles to the net change in cash and marketable securities on the balance sheet over the period

Financial Management

• combines historical figures and current information • determines what should happen with firm's money now and in the future

*Financial management

• organization's approach to valuation

Finance applies specific value to

• things owned • services used • decisions made

Question: When interest rates are 9%, how long will it take $5,000 to double? use Calculator!!

•Assumptions: • Interest = 9% • PV = -5,000 • PMT = 0 • FV =10,000 •Solution: 8.04 years

4 Outside monitors?

•Auditors •Analysts •Banks •Credit rating agencies

Current Ratio

•Broadest liquidity measure •Measures current assets available to pay current liabilities

Quick Ratio

•Excludes inventory in numerator •Measures ability to pay short-term obligations without inventory sales

*Financial markets and financial intermediaries

•Facilitate flow of capital from investors to firms and back to investors •Earn very high profits because of specialized expertise and assets

Return on Assets (ROA)

•Measures overall return on firm's assets inclusive of leverage and taxes

Cash flow statement reports reflect: (3)

•Operating • Investing •Financing activities

Firm Goals

•Owner seeks to maximize shareholder wealth and company's value through • Maximizing present value of future cash flows • Maximizing owners' equity Decisions about: • attracting additional funds • projects in which to invest • returning profits to owners over time

General Partnerships

•Partners own the business together Advantages: • Relatively easy to start • Single taxation Disadvantages: • Partners jointly share unlimited liability • Personally liable for legal actions and debts of firm • Difficult to raise large amounts of capital

Profit Margin

•Percent of sales left after all firm expenses are paid

Time Value of Money (TVM)

•Powerful financial decision-making tool • Used by financial and nonfinancial business managers •Key to making sound personal financial decisions

***Agency Theory

•Problems arise when principal (shareholder) hires agent (manager) to operate firm but cannot monitor the agent's actions • Manager's interest may not be aligned with shareholder goals

Investment in Operating Capital (IOC)

•Purchase of physical capital or funds earmarked to replace equipment • Includes fixed assets, current assets, and spontaneous current liabilities (i.e. accounts payable and accruals)

Balance Sheet

•Reports firm's assets, liabilities and equity at a point in time Assets = Liabilities + Equity •Assets of firm, in order of liquidity - left side •Liabilities, in order of maturity - right side • Equity listed last - never matures

Cash Flows from Investing Activities

•Represents cash flows associated with buying or selling fixed or other longterm assets •Reflects the firm's investment in fixed assets