Mathis Foundations: Chapter 9 Finance

Average Collection Period

Accounts receivable divided by average daily credit sales

How does trade credit benefit companies?

Allows them to conserve existing cash

How do financial managers measure benefits and costs of long-term investment proposals?

Amount of cash flow they generate

Present Value

Amount of money that, if invested today at a given interest rate, would grow to become some future amount in a specified number of time periods

Trade Credit

Arises when suppliers ship materials, parts, or goods to a firm without requiring payment at the time of delivery

How does the level of trade credit adjust?

Automatically as business conditions change and company places larger or smaller orders with its suppliers

Asset Backed Commercial Paper

Secured form of commercial paper that is backed by collateral

Commercial Paper

Short term promissory notes that large corporations with strong credit rating can issue

U.S. Treasury Billy (T-bills)

Short term-IOU's issued by the government that owners can sell to other investors before they mature

Are incentives of top executives more tied to short-term or long-term performance?

Short-term performance

Do you want a larger or smaller EPS number?

Smaller EPS number

What is a 'factor' and how do they make a profit?

Someone who buys the accounts receivable of other firms and makes money by purchasing the receivables at a discount but collecting the full amount from customers

Promissory Note

Specifies the length of loan, rate of interest the firm must pay and other terms and conditions of the loan

Do start-up companies or mature firms have less financing options? Where does the lesser get financing from?

Start-up; Get it from the personal wealth of the owner

Inventories

Stock of finished goods, work in process, parts and materials that firms hold as part of doing business

Who has more debt: McDonald's with a debt-to-asset ratio of 59.6% or Subway with 1.19?

Subway because there debt-to-asset ratio is 1.19 where as McDonald's is only .596; (remember to convert both to a decimal or percentage to compare)

Risk-Return Tradeoff

Suggests that source and funds that offer the potential for high rates of return tend to be more risky than sources and uses of funds that offer lower returns

Net Present Value (NPV)

Sum of all present values of expected future cash flows from an investment minus the cost of that investment

What is one of the most important lessons in financial management?

There is a tradeoff between risk and return

What type of projects generate the most risk?

Those with the potential for highest return

Debt-to-Asset Ratio (Debt ratio)

Total liabilities divided by its total assets

How do financial managers adjust discount rates when computing present value for a high-risk project?

Use higher discount rate

Angel Investors

Wealthy individual who invest in Start-ups with the potential for generating rapid growth

Example of equity financing

When a company issues new stock or uses retained earnings to meet financial needs

Example of debt financing

When a company takes out bank loans, or issues and sells corporate bonds

When are retained earnings the highest?

When economy is booming and profits are high

When should a firm accept a proposal?

When there is a positive NPV

Is it possible for a company to have too much liquidity?

Yes

Why is too high of inventory bad?

You are selling out which frustrates customers and results in a decrease of sales

Budgeted Income Statement

A projection showing how a firm's budgeted sales and costs will affect expected net income

Certificate of Deposit (CD)

Interest-earning deposit that requires the funds to remain deposited for a fixed term and withdrawal of funds before terms expire results in financial penalty

Do you want a larger or smaller ROE percentage?

Larger ROE percentage

Dodd-Frank Act

Law enacted in the aftermath of the financial crisis of 2008-2009 that strengthened government oversight of financial markets and placed limitations on risky financial strategies such as heavy reliance on leverage

What does an uneven cash flows mean?

Lead to cash shortages and surpluses

Fiduciary Duty

Legal and ethical obligation of financial managers to make decisions consistent with the financial interests of their firm's owners

What is the most widely accepted goal of financial management?

Maximize its value of the firm to its owners

Asset Management Ratios

Measure how effectively an organization uses its assets to generate net income; measures turnover of inventory

Liquidity Ratio

Measure the ability of an organization to convert assets into the cash it needs to pay off liabilities; larger the ratio, the easier it is for a firm to pay off short-term debts

Leverage Ratio

Measure the extent to which a firm uses financial leverage

Inventory Turnover Ratio

Measures how many times a firm's inventory is sold and replaced each year; firm's cost of goods sold divided by average inventory levels

Profitability Ratios

Measures of how successful a firm is at achieving its goals

Return-on-Equity (ROE)

Measures the income earned per dollar invested by stockholders; Net income divided by owners equity

What does a higher debt ratio mean for a company?

More heavily leveraged a firm is

What is the most common way to evaluate capital budgeting proposals?

Net Present Value (NPV)

Capital Structure

Extent to which a firm relies on various forms of debt and equity to satisfy its financing needs

What is the type of analysis financial managers use to evaluate a firm's strengths and weaknesses?

Financial ratio analysis

Budgeted Balance Sheet

Forecasts the types and amounts of assets a firm will need to implement its future plans and how the firm will finance those assets

Corporate Bonds

Formal IOU's issued by the corporation that they sell to investors

Finance

Functional area of business that is responsible for finding the best sources of funds and the best ways to use them

Financial Capital

Fund a firm uses to acquire its assets and finance its operations ranging from short-term obligations to long-term investments

Debt Financing

Funds provided by creditors (lenders)

Equity Financing

Funds provided by the owners of the company

Is a higher or lower turnover ratio better? Why?

Higher because means a firm can continue daily operations with a small amount of inventory on hand and less cash used on keeping inventory on the shelves

Earnings per share (EPS)

How much net income a firm earned per share of common stock outstanding; (Net income - preferred dividends) divided by average number of shares of common stock outstanding

What is the first step a financial manager must take before they can choose the best financial strategy for the firm?

Identifying the firm's strengths and weaknesses

What does 2/10 net 30 mean

If the firm must pay within 30 days but if they pay within 10 days, they get a 2% discount

What are the disadvantages to equity financing?

1. Not tax deductible 2. Allowance of new stock issuance to gain money will dilute current stockholders share 3. Forgoes opportunity to use financial leverage

What are 3 disadvantages of debt financing?

1. Paying interest could eat up all earnings 2. Creditors will impose covenants on borrower 3. Restrictions from covenant can make it difficult to acquire more money

What 2 factors does a cash flow's value depend on

1. Amount of cash received 2. When it is received

What are the 2 pro forma financial statements?

1. Budgeted Income Statement 2. Budgeted Balance Sheet

What are 3 main forms of cash equivalents?

1. Commercial paper 2. U.S. Treasury Bills (T Bills) 3. Money Market Mutual Funds

What are 4 ways that companies acquire financial capital?

1. Direct contributions from owners 2. Reinvestment of earnings 3. Loans from banks 4. Newly issued stocks or bonds

What are the 4 main sources of long-term funds?

1. Direct investments from owners 2. Long-term debt 3. Term Loans 4. Corporate Bonds

What are the 3 advantages to a firm that sells its accounts receivables?

1. Gets money immediately 2. Save money by eliminating collection department 3. Factor will assume risk of bad debts on receivables it buys

What are two outcomes of having greater loyalty from employees due to a good work environment?

1. Higher Productivity 2. Lower employee turnover

What are 3 advantages to debt financing?

1. Interest payments on debt are tax-deductible 2. Firm can acquire additional funds without existing stockholders paying more or selling more stock 3. Can improve ROE to shareholders

What are 2 ratios used within Assets Management Ratio?

1. Inventory Turnover Ratio 2. Average Collection Period

What are the 4 basic categories that the most important ratios fall into?

1. Liquidity 2. Asset Management 3. Leverage 4. Profitability

What is 1 advantage and disadvantage of financial leverage?

1. Magnifies ROI when times are good 2. Reduces ROI when times are bad

What are the 3 advantages of equity financing?

1. More flexible and less risky 2. No required payments 3. No required covenants

What is a benefit and disadvantage of short credit periods?

1. Receive payments sooner 2. May result in lost sales

What are 2 ways companies can use their retained earnings?

1. Reinvesting back into company 2. Declaring dividends to pay out owners

What are the 4 main proposals that capital budgeting reviews?

1. Replacing old equipment 2. Buying additional equipment 3. Buying additional equipment to increase capacity 4. Modifying or installing new equipment in order to create safer work environment

What are the 2 main profitability ratios?

1. Return-on-Equity 2. Earnings per share

What is the typical maturity of a bond?

10 or more years

What is an average collection period that is considered to be very strong?

30 days

What percentage of small firms rely on trade credit as a source of short-term financial capital?

60%

Line of Credit

Bank agrees to provide the firm with funds up to some specified limit, as long as the firm maintains an acceptable credit rating

Revolving Credit Agreement

Bank makes a formal, legally binding commitment to provide the agreed upon funds; guaranteed line of credit

Why is trade credit sometimes called Spontaneous Financing?

Because it is granted when order is placed and no other paperwork or special arrangements are required

Why do stockholders prefer their companies to reinvest their earnings?

Increases company's profit which will increase market price of the stock

Why is commercial paper popular with companies?

Carry lower interest rates than interest rates charged on short-term loans by banks

Financial Ratio Analysis

Computing ratios that compare values of key accounts listed on financial statements

Cash Budget

Cover a one year period and show projected cash flows for each month

How do you compute a current liquidity ratio?

Current assets divided by current liabilities; want at least a value of 1

What ratio is a common measure of leverage?

Debt-to-Asset Ratio (Debt ratio)

Risk

Degree of uncertainty about the actual outcome of the decision

What is the major disadvantage of cash compared to other assets?

Earns little to no return

When is the only time that a corporation receives financial capital?

On newly-issued stock

What are examples of short-term obligations?

Paying bills from suppliers, meeting payroll, repaying loans from banks and paying government taxes

What does a positive NPV mean?

Present value of expected cash flows from project is greater than the cost of the project

Capital Budgeting

Procedure firm uses to plan for investments in assets or projects that it expects will yield benefits for more than a year

What is the purpose of a covenant?

Protect creditors by preventing the borrower from pursuing policies that might undermine its ability to repay loans

What are examples of long-term investments?

Purchase of plant and equipment and launch of new product line

Money Market Mutual Funds

Raise money by selling shares to large numbers of investors and are particularly attractive to smaller firms

Time value of Money

Reflects on the fact that a dollar received today is worth more than a dollar received in the future because the sooner you receive a sum of money, the sooner you can put that money to work to earn more

Term Loan

Regular schedule of fixed payments sufficient to ensure that the principal and interest are repaid by the end of the term's loan

Deleveraging

Replacing debt in their capital with more equity

Covenant

Requirement a lender imposes on the borrower as a condition of the loan

Cash Equivalents

Safe and highly liquid assets that any firms list with their cash holdings on their balance sheet