1-1. 1-2 Key Concepts and Skills Have a good understanding of: The basic types of financial...

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SESSİON 1

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Key Concepts and Skills

Have a good understanding of:• The basic types of financial management

decisions and the role of the financial manager

• The goal of financial management• The financial implications of the different

forms of business organization• The conflicts of interest that can arise

between owners and managers

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Basic Areas Of Finance

1. Corporate finance = Business Finance

2. Investments

3. Financial institutions

4. International finance

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Investments

• Work with financial assets such as stocks and bonds

• Value of financial assets, risk versus return, and asset allocation

http://www.careers-in-business.com/

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Financial Institutions

• Companies that specialize in financial matters

–Banks – commercial and investment, credit unions, savings and loans

– Insurance companies–Brokerage firms

http://www.careers-in-business.com/

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International Finance• An area of specialization within each of

the areas discussed so far• May allow you to work in other countries

or at least travel on a regular basis• Need to be familiar with exchange rates

and political risk• Need to understand the customs of

other countries; speaking a foreign language fluently is also helpful

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Finance and …

• Marketing– Budgets, marketing research, marketing financial

products• Accounting

– Dual accounting and finance function, preparation of financial statements

• Management– Strategic thinking, job performance, profitability

• Personal finance– Budgeting, retirement planning, college planning,

day-to-day cash flow issues

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Business Finance

• Some important questions that are answered using finance– What long-term investments should the firm

take on?– Where will we get the long-term financing to

pay for the investments?– How will we manage the everyday financial

activities of the firm?

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Financial Management Decisions

• Capital budgeting– What long-term investments or projects

should the business take on?• Capital structure

– How should we pay for our assets?– Should we use debt or equity?

• Working capital management– How do we manage the day-to-day

finances of the firm?

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Forms of Business Organization

Three major forms in the United States• Sole proprietorship• Partnership

–General–Limited

• Corporation–S-Corp–Limited liability company

http://www.sba.gov/smallbusinessplanner/start/chooseastructure/START_FORMS_OWNERSHIP.html

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Sole Proprietorship

• Advantages–Easiest to start–Least regulated–Single owner

keeps all of the profits

–Taxed once as personal income

• Disadvantages–Limited to life of

owner–Equity capital

limited to owner’s personal wealth

–Unlimited liability–Difficult to sell

ownership interest

Business owned by one person


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Partnership

• Advantages–Two or more

owners–More capital

available–Relatively easy to

start–Income taxed once

as personal income

• Disadvantages–Unlimited liability

• General partnership• Limited partnership

–Partnership dissolves when one partner dies or wishes to sell

–Difficult to transfer ownership

Business owned by two or more persons


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Corporation

• Advantages–Limited liability–Unlimited life–Separation of

ownership and management

–Transfer of ownership is easy

–Easier to raise capital

• Disadvantages–Separation of

ownership and management (agency problem)

–Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate, while dividends paid are not tax deductible)

A legal “person” distinct from owners and a resident of a state


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International Corporate Forms• Joint stock companies• Public limited companies• Limited liability companies

• All share:– Public ownership– Limited liability

http://www.corporateinformation.com/

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Goal Of Financial Management

• What should be the goal of a corporation?– Maximize profit?– Minimize costs?– Maximize market share?– Maximize the current value per share

of the company’s existing stock– Maximize the market value of the

existing owners’ equity

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Goal Of Financial Management

• Does this mean we should do anything and everything to maximize owner wealth?– Outsourcing?– Off-shoring?– Enron?– Corporate support of charities?

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The Agency Problem

• Agency relationship– Principal hires an agent to represent its

interests– Stockholders (principals) hire managers

(agents) to run the company• Agency problem

– Conflict of interest between principal and agent

• Management goals and agency costs

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Do Managers Act in the Shareholders’ Interests?

• Managerial compensation– Incentives can be used to align

management and stockholder interests– Incentives need to be carefully structured

to insure that they achieve their goal• Corporate control

– Threat of a takeover may result in better management

• Other stakeholders

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Cash Flows Between the Firm and the Financial Markets

Figure 1.2

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Financial Markets

• Cash flows to the firm• Primary vs. secondary markets

–Dealer vs. auction markets–Listed vs. over-the-counter securities

• NYSE• NASDAQ

http://www.nyse.com/

http://www.nasdaq.com/

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Know: – The difference between book value and

market value– The difference between accounting income

and cash flow– The difference between average and

marginal tax rates– How to determine a firm’s cash flow from

its financial statements

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The Balance Sheet• A snapshot of the firm’s assets and liabilities

at a given point in time (“as of …”)• Assets

− Left-hand side (or upper portion)− In order of decreasing liquidity

• Liabilities and Owners’ Equity– Right-hand side (or lower portion)– In ascending order of when due to be paid

• Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity

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The Balance Sheet• Net working capital

– Current Assets minus Current Liabilities– Usually positive for a healthy firm

• Liquidity− Speed and ease of conversion to cash

without significant loss of value− Valuable in avoiding financial distress

• Debt versus Equity− Shareholders’ equity = Assets - Liabilities

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Market vs. Book Value

• Book value = the balance sheet value of the assets, liabilities, and equity.

• Market value = true value; the price at which the assets, liabilities, or equity can actually be bought or sold.– Market value and book value are often

very different. Why?– Which is more important to the decision-

making process?

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Income Statement• The income statement measures performance

over a specified period of time (period, quarter, year).

• Report revenues first and then deduct any expenses for the period

• End result = Net Income = “Bottom Line”– Dividends paid to shareholders– Addition to retained earnings

• Income Statement Equation:• Net Income = Revenue - Expenses

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Financial Statements• GAAP Matching Principle:

– Recognize revenue when it is fully earned

– Match expenses required to generate revenue to the period of recognition

• Noncash Items– Expenses charged against revenue that

do not affect cash flow– Depreciation = most important

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Financial Statements

• Time and Costs– Fixed or variable costs– Not obvious on income statement

• Earnings Management–Smoothing earnings–GAAP leaves “wiggle room”

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Taxes

• Marginal vs. Average tax rates–Marginal – % tax paid on the next dollar

earned–Average – total tax bill / taxable income– If considering a project that will increase

taxable income by $1 million, which tax rate should you use in your analysis?

http://www.irs.ustreas.gov/

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The Concept of Cash Flow• Cash flow = one of the most important

pieces of information that can be derived from financial statements

• The accounting Statement of Cash Flows does not provide the same

information that we are interested in here

• Our focus: how cash is generated from utilizing assets and how it is paid to those who finance the asset purchase.

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!! Cash Flow !!

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Know: – How to standardize financial statements for

comparison purposes– How to compute and interpret important

financial ratios– The determinants of a firm’s profitability and

growth

Understand the problems and pitfalls in financial statement analysis

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Standardized Financial Statements

• Common-Size Balance Sheets– All accounts = percent of total assets (%TA)

• Common-Size Income Statements– All line items = percent of sales or revenue

(%SLS)• Standardized statements are useful for:

– Comparing financial information year-to-year– Comparing companies of different sizes,

particularly within the same industry

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Prufrock CorporationBalance Sheets - Table 3.1

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Prufrock CorporationCommon-Size Balance Sheets Table 3.2

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Ratio Analysis

• Allow for better comparison through time or between companies

• Used both internally and externally• For each ratio, ask yourself:

–What the ratio is trying to measure –Why that information is important

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Categories of Financial Ratios

• Liquidity ratios or Short-term solvency • Financial leverage ratios or Long-term

solvency ratios• Asset management or Turnover ratios• Profitability ratios• Market value ratios

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Table 3.5

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Liquidity Ratios

• Current Ratio = CA / CL– 708 / 540 = 1.31 times

• Quick Ratio = (CA – Inventory) / CL– “Acid Test”– (708-422) / 540 = 0.53 times

• Cash Ratio = Cash / CL– 98/ 540 = .18 times

ASSETS Liabilities & Owners EquityCurrent Assets Current Liabilities

Cash 98$ Accounts Payable 344$ Accounts Receivable 188$ Notes Payable 196$ Inventory 422$ Total 540$

Total 708$ Long term debt 457$ Owners' Equity

Common Stock and paid in surplus 550$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$

PRUFROCKBalance Sheet -2010

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Financial Leverage Ratios

• Total Debt Ratio = (TA – TE) / TA– (3588-2,591) / 3588 = 0.28 times

• Debt/Equity = TD / TE– (0.28/0.72) = 0.39 times

• Equity Multiplier = TA/TE = 1 + D/E– ($1 /0.72) = 1.39

ASSETS Liabilities & Owners EquityCurrent Assets Current Liabilities

Cash 98$ Accounts Payable 344$ Accounts Receivable 188$ Notes Payable 196$ Inventory 422$ Total 540$

Total 708$ Long term debt 457$ Owners' Equity

Common Stock and paid in surplus 550$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$


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Financial Leverage Ratios

• Times Interest Earned = EBIT / Interest– 691/141 = 4.9 times

• Cash Coverage = (EBIT + Deprec) / Interest– (691 + 276) / 141 = 6.9 times

Sales 2,311$ COGS 1,344$ Depreciation 276$ EBIT 691$ Interest 141$ Taxable Income 550$ Taxes 187$ Net Income 363$

Dividends 121$ Addition to RE 242$

PRUFROCKIncome Statement - 2010

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Asset Management: Inventory Ratios

• Inventory Turnover = COGS / Inventory– 1344/422 = 3.2 times

• Days’ Sales in Inventory = 365 / Inventory Turnover– 365 / 3.2= 114 days

ASSETS Liabilities & Owners Equity Sales 2,311$ Current Assets Current Liabilities COGS 1,344$

Cash 98$ Accounts Payable 344$ Depreciation 276$ Accounts Receivable 188$ Notes Payable 196$ EBIT 691$ Inventory 422$ Total 540$ Interest 141$

Total 708$ Long term debt 457$ Taxable Income 550$ Owners' Equity Taxes 187$

Common Stock and paid in surplus 550$ Net Income 363$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$ Dividends 121$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$ Addition to RE 242$



3-42

Asset Management: Receivables Ratios

• Receivables Turnover = Sales / AR– 2311/188 = 12.3 times

• Days’ Sales in Receivables = 365 / Receivables Turnover– 365 / 12.3 = 30 days









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Asset Management: Asset Turnover Ratios

• Total Asset Turnover = Sales / Total Assets– 2311/3588 = 0.64 times

• Capital Intensity Ratio = 1/TAT– 1/0.64 = 1.56









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Profitability Measures

• Profit Margin = NI / Sales– 363/2311 = 15.7%

• Return on Assets (ROA) = NI / TA– 363/3588 = 10.12%

• Return on Equity (ROE) = NI / TE– 363 / 2591 = 14.01%









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Market Value Measures• Market Price = $88 per share = PPS• Shares outstanding = 33 million

• Earnings per Share = EPS = 363/33 = $11• PE Ratio = PPS / EPS

– $88 / $11 = 8 times

• Price/Sales Ratio = PPS/Sales per share– $88/($2,311/33) = 1.26

• Market-to-book ratio = PPS / Book value per share– Book value per share = Total Equity/shares outstanding

= $2,591/33 = $78.52– Market-to-Book = $88/78.52 = 1.12 times

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Prufrock Ratios

Current Ratio 1.31 Total Debt Ratio 0.28Quick Ratio 0.53 Debt to Equity 0.39Cash Ratio 0.18 Equity Multiplier 1.39

Times Interest Earned 4.9Inventory Turnover 3.20 Cash Coverage 6.9Days' Sales in Inventory 114Receivables Turnover 12.30 Profit Margin 15.70%Days' Sales in Receivables 30 ROA 10.12%Total Asset Turnover 0.64 ROE 14.00%Capital Intensity Ratio 1.56

Market Price 88.00$ Shares Outstanding 33 mEPS 11.00$ Price/Sales Ratio 1.26PE Ratio 8.0 Book value per share $78.52Market to Book 1.12

Market Value Measures

PRUFROCK RECAPFinancial Leverage Ratios


Asset Management Ratios

Liquidity Ratios

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Table 3.6

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The DuPont Identity• ROE = NI / TE = Basic Formula• ROE = PM * TAT * EM = Dupont Identity

– PM = Net Income / Sales– TAT = Sales / Total Assets– EM = Total Assets / Total Equity

TE

NI

TE

TA

TA

Sales

Sales

NIROE

Profit Margin Asset Use Leverage = ROE

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Using the Du Pont Identity

• ROE = PM * TAT * EM– Profit margin

• Measures firm’s operating efficiency• How well does it control costs

– Total asset turnover • Measures the firm’s asset use efficiency • How well does it manage its assets

– Equity multiplier • Measures the firm’s financial leverage• EM = TA/TE = 1+D/E ratio

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Prufrock’s DuPont Identity

• ROE = PM * TAT * EM– PM = 15.7%– TAT = .64– EM = 1.39

• ROE = .157 x .64 x 1.39 = .139667 = 14%

Current Ratio 1.31 Total Debt Ratio 0.28Quick Ratio 0.53 Debt to Equity 0.39Cash Ratio 0.18 Equity Multiplier 1.39

Times Interest Earned 4.9Inventory Turnover 3.20 Cash Coverage 6.9Days' Sales in Inventory 114Receivables Turnover 12.30 Profit Margin 15.70%Days' Sales in Receivables 30 ROA 10.12%Total Asset Turnover 0.64 ROE 14.00%Capital Intensity Ratio

Market Price 88.00$ Shares Outstanding 33 mEPS 11.00$ Price/Sales Ratio 1.26PE Ratio 8.0 Book value per share $78.52Market to Book 1.12

Market Value Measures

PRUFROCK RECAPFinancial Leverage Ratios


Asset Management Ratios

Liquidity Ratios

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Internal and Sustainable GrowthPayout and Retention Ratios

• Dividend payout ratio (“b”) = DPS/EPS = Cash dividends / Net income

• Retention ratio (“1 – b”) = (EPS-DPS)/EPS = (Addition to Retained Earnings) / Net income

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• Dividend payout ratio (“b”) =– Cash dividends / Net income (DIV / NI)– 121/363 = 33.3%









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• Retention ratio (“1 – b”) = (NI - DIV)/ NI– Addition to Retained Earnings / Net income – $242/363 = 66.7%









3-54

The Internal Growth Rate• How much the firm can grow assets

using retained earnings as the only source of financing.

7.23%

.667.10121

.667.1012

bROA - 1

bROA Rate Growth Internal

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The Sustainable Growth Rate• How much the firm can grow by using

internally generated funds and issuing debt to maintain a constant debt ratio.

10.29%0.667 0.14 - 1

0.667 .14bROE-1

bROE Rate Growth eSustainabl

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Determinants of Growth

• Profit margin – operating efficiency• Total asset turnover – asset use

efficiency• Financial leverage – choice of optimal

debt ratio• Dividend policy – choice of how much

to pay to shareholders versus reinvesting in the firm

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Table 3.7

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Why Evaluate Financial Statements?

• Internal uses– Performance evaluation – compensation and

comparison between divisions– Planning for the future – guide in estimating future

cash flows

• External uses– Creditors– Suppliers– Customers– Stockholders

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Benchmarking• Ratios need to be compared to something• Time-Trend Analysis

– How the firm’s performance is changing through time

– Internal and external uses• Peer Group Analysis

– Compare to similar companies or within industries

– SIC and NAICS codes

http://www.naics.com/

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Problems with Financial Analysis

• Conglomerates – No readily available comparables

• Global competitors• Different accounting procedures• Different fiscal year ends• Differences in capital structure• Seasonal variations and one-time events

1-1. 1-2 Key Concepts and Skills Have a good understanding of: The basic types of financial...

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