Exam 1 Flashcards
3 types of questions financial manager should be concerned with
-Capital budgeting
-Capital structure
-Working capital management
Capital Budgeting
the process of planning and managing a firm’s long-term investments – evaluating the size, timing, and risk of future cash flows
-What long-term investments should you take on?
Capital Structure
the mixture of debt and equity maintained by a firm
-Where will you get the long-term financing to pay for your investment? Will you bring in other owners, or will you borrow the money?
-How much should the firm borrow (i.e., what mixture of debt and equity is best)?
-What are the least expensive sources of funds for the firm?
Working Capital Management
a firm’s short-term assets and liabilities
-How will you manage your everyday financial activities, such as collecting from customers and paying suppliers?
Owners
i.e. stockholders, usually not directly involved in making business decisions for large corporations, especially on a day-to-day basis
Managers
Employed by corporations to represent the owners’ interests and make decisions on their behalf
Financial Management Function
Usually associated with a top officer of the firm, such as a vice president of finance or the chief financial officer (CFO)
The Vice President of Finance
Coordinates the activities of the treasurer and the controller
The Controller’s Office
Handles cost and financial accounting, tax payments, and management information systems
The Treasurer’s Office
manages the firm’s cash and credit, financial planning, and capital expenditures
Chief Financial Officer
-Involved in the management and strategy of the organization from a financial perspective
-Part of the executive committee and sits on the board of directors
-The Treasurer and Controller report to the CFO
-Regarding financial matters, the buck stops here
-HR often reports to the CFO, and when that happens, they must speak the language (i.e., accounting and finance)
Treasurer
-Focuses on internal and external financial matters
-Building and maintaining banking relationships
-Managing cash flow and forecasting
-Making equity and capital structure decisions
-Responsible for investor relationships
-Handles stock-based equity decisions
-Ideally, a finance person with a personality
Controller or Comptroller
-Purely internal focus
-Provides reliable and accurate financial reporting
-Responsible for general accounting
-Handles reporting, financial analysis, and planning
-Ensures the day-to-day transactions are recorded accurately and correctly
-Without excellent and consistent data from the controller, the CFO and Treasurer can’t do their jobs.
Factors to consider in starting a business
-COST of creating the organization
-CONTINUITY or stability of the organization
-CONTROL of decision
-PERSONAL LIABILITY of the owners
-TAXATION of the organization’s earnings
-PROFIT distribution to the organization’s owners
Sole Proprietorship
A business owned by one person
Advantages: simplest type of business, least regulated, complete managerial control, owner keeps all profits, all income taxed as personal
Disadvantages: unlimited personal liability, limited lifespan, limited equity/capital, difficult to transfer ownership
Partnership
A business formed by 2 or more owners
Advantages: Simple and inexpensive to form, owners share profits, income taxed as personal
Disadvantages: unlimited liability in most cases, limited life of business, difficult to transfer ownership
Corporation
A business created as a distinct legal entity composed of one or more individuals or entities.
Advantages: public ownership, limited liability, ease of transferring ownership, unlimited life of the business, ease in raising cash/equity
Disadvantages: strict regulation, can be difficult/expensive to form, income subject to double taxation
Articles of Incorporation
A document that includes the corporation’s name, owners, intended life, business purpose, and the number of shares to be issued
Corporate Bylaws
Description of how the business will operate and how the corporation regulates its own existence
Limited Liability Corporation
Hybrid of partnership and corporation
Advantages: retains limited liability for owners
Disadvantages: operated and taxed like a partnership
Other corporate names for organizations
Joint stock companies, public limited companies, limited liability companies
Benefit Corporation
For profit
Legal attributes:
1. Accountability- must consider how an action will affect shareholders, employees, customers, the community, and the environment
2. Transparency- must provide an annual report detailing how the company pursued a public benefit during the year or any factors that inhibited the pursuit of this goal
3. Purpose- must provide a public benefit to society as a whole or the environment
Primary Goal of Financial Management
to maximize the current value per share of the existing stock
Other Goals of Financial Management
-survive
-avoid bankruptcy
-minimize cost
-maximize profit
-maintain steady growth
The Sarbanes-Oxley Act (SOX)
A U.S. law passed in 2002 to protect investors from corporate accounting fraud by improving financial reporting and auditing standards
Agency Relationship
The relationship between stockholders and management
-exists when someone (the principal) hires another (the agent) to represent their interests
The Agency Problem
the possibility of a conflict of interest between the stockholders and the management of a firm
Agency Costs
the costs of the conflict of interest between stockholders and management
Indirect Agency costs
lost opportunities
Direct Agency Costs
-Corporate expenditures benefit management but cost the stockholder (e.g., luxurious and unneeded corporate jets).
-Expense arises from the need to monitor management actions.
Two Incentives for Management to Increase Share Value
-Managerial compensation is usually tied to financial performance and often to share value.
-Managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.
Stockholders
Ultimately control the firm, as they elect the board of directors, who hire and fire managers
-May replace existing management via proxy fights and takeovers
Stakeholder
Someone other than a stockholder or creditor who potentially has a claim on the firm’s cash flows.
-May attempt to exert control over the firm, perhaps to the detriment of the owners.
Financial Market
Brings buyers and sellers together to buy and sell debt and equity securities.
-The most important differences between financial markets concern the types of securities traded, how trading is conducted, and who the buyers and sellers are.
Primary Markets
the corporation is the seller, and the transaction raises money for the corporation
-Involves public and private offerings/placements
Public Offerings
Selling securities to the general public
Private Placements
Negotiated sales involving a specific buyer
-Key feature: avoids regulatory requirements and expenses associated with a public offering
Secondary Market
Transfers ownership of corporate securities via one owner or creditor selling to another
-Securities are bought and sold to public after the original sale
Dealer market
A type of secondary market in stock and long-term debt, aka over-the-counter (OTC) markets, meaning the dealers are connected electronically instead of transacting in a central location
ex) Nasdaq
Auction market
Has a physical location, primary purpose is to match those who wish to sell with those who want to buy (with dealers playing a limited role)
ex) NYSE
Balance Sheet
a financial statement showing a firm’s accounting value on a particular date, shows assets, liabilities, and the difference between the two (equity)
Assets
Can be current or fixed
-current: life of less than one year ex. cash, inventory, accounts receivable
-fixed: relatively long life ex. truck or trademark
Liabilities
on right side of the balance sheet, can be current or long-term
-current: life of less than one year ex. accounts payable
-long-term: debts not due in the coming year ex. a loan that will be paid in 5 years
Shareholders Equity
the difference between the total value of the assets (current and fixed) and the total value of the liabilities (current and long-term).
Net Working Capital
the difference between a firm’s current assets and its current liabilities
-usually positive in healthy firm
-positive when cash that will become available over the next 12 months (i.e., current assets) exceeds cash that must be paid over the same period (i.e., current liabilities)
3 Things to Consider when Examining Balance Sheet
-liquidity
-debt vs equity
-market value vs book value
Liquidity
the speed and ease with which an asset can be converted to cash
-Consider ease of conversion vs the loss of value
Financial Leverage
the use of debt in a firm’s capital structure
-If a firm borrows money, it usually gives the first claim to the firm’s cash flow to creditors, with equity holders entitled to only the residual value.
Book Value
-The real worth of assets
-The historical transactions and cost of assets
-Fluctuations are periodic & infrequent
-Asset value reported on the balance sheet
Market Value
-Financial market asset worth
-Based on supply and demand
-Frequent fluctuations. Market dependent
-Max. price of assets as traded in the markets
The Income Statement
a financial statement summarizing a firm’s performance over a period of time, usually a quarter or a year.
Equation:
Revenues - Expenses = Income
3 thing financial manager should keep in mind when looking at income statement
-GAAP
-Cash vs noncash items
-time and costs
Taxes
Can be one of the largest cash outflows of a firm
-the size of a company’s tax bill is determined by the tax code, an often amended set of rules.
Tax Cuts and Jobs Act of 2017
Made federal corporate tax rates a flat 21%
-Tax rates on other business forms did not become flat
Average tax rate
total taxes paid divided by total taxable income
Marginal tax rate
the amount of tax payable on the next dollar earned
Cash flow
the difference between the number of dollars that came in and the number of dollars that went out
-No standard financial statement for this, statement of cash flows is a different issue
Cash Flow Identity
says the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm
cash flow from assets = cash flow to creditors + cash flow to stockholders
Operating Cash Flows
the cash generated from a firm’s normal business activities
revenues - cost, tells us whether a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows.
Capital Spending
the net spending on fixed assets (purchases of fixed assets less sales of fixed assets)
ie. CAPEX
-can be negative if firm sells more assets than it purchases
Change in Net Working Capital
measured as the net change in current assets relative to current liabilities for the period being examined and represents the amount spent on net working capital
Cash Flow from Assets
aka free cash flow, the total cash flow to creditors and cash flow to stockholders
Consists of operating cash flow, capital spending, and change in net working capital
Sources of Cash
activities that bring in cash
-Increase in accounts payable
-Increase in common stock
-Increase in retained earnings
Uses of cash
activities that involve spending cash
-Increases in accounts receivable
-Increase in inventory
-Decrease in long-term debt
-Decrease in notes payable
-Purchase of net fixed assets (PPE)
Statement of Cash Flows
a firm’s financial statement that summarizes its sources and uses of cash over a specified period
Groups into 3 categories:
-Operating activities.
-Investment activities.
-Financing activities.
Common-size statements
Financial statements presenting all items in percentage terms in order to compare statements from different sized companies
(can be common-size balance sheet, income statement, or statement of cash flows)
Common-base year statements
Present all items relative to a certain base year amount, i.e. trend analysis
-often used to investigate trends in the firm’s pattern of operations
Financial Ratios
relationships determined from a firm’s financial information and used for comparison purposes
Liquidity Ratios
Assess the company’s ability to pay out short-term debt
Leverage Ratios
Evaluate the company debt level in the capital structure
Efficiency Ratios
Investigate the company’s efficiency in utilizing its resources
Profitability Ratios
Assess the company’s ability to generate income from revenue
Valuation Ratios
Examines the company’s share price
The DuPont Identity
shows a company’s return on equity
ROE = Income/Equity
Internal Uses of Financial Statements
Performance evaluation and planning purposes
External Party Using Financial Statements
-Short-term and long-term creditors
-Potential investors
-Suppliers and large customers
-Credit rating agencies
-Competitors
-Potential targets for acquisition
Internal Uses of Ratio Analysis
-Future Planning
-Performance Evaluations
-Performance Comparison (e.g., Divisions, Managers & Employees)
-Salary Decisions
External Uses of Ratio Analysis
-Evaluation of Suppliers
-Evaluation of Competitors
-Evaluation of Outside Parties (e.g., creditors & Investors)
-Acquisitions & Mergers
Time Trend Analysis
uses a firm’s historical data as the standard for evaluation
Peer Group Analysis
compares firms to their peer group– firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways
Standard Industrial Classification (SIC) Codes
four-digit codes established by the U.S. government to classify a firm by its type of business operations, can be used to identify potential peers
North American Industry Classification System (NAICS)
a new industry classification system initiated in 1997, will eventually replace the older SIC codes
Problem with Financial Statement Analysis of Conglomerates
consolidated financial statements for these firms do not fit any neat industry category due to owning unrelated lines of business
Problems with Financial Statement Analysis
-No underlying theory exists to help us identify quantities to look at and establish benchmarks
-Financial statements outside the U.S. do not necessarily conform to all GAAP principles, making comparison difficult
-Even companies that are clearly in the same line of business may not be comparable
-Different firms use different accounting procedures
-Different firms end their fiscal years at different times.
-Unusual events may affect financial performance
Financial Planning
Establishes guidelines for change and growth in a firm
Concerned with the major (macro) elements of a firm’s financial and investment policies without examining the individual (micro) components of those policies in detail
4 Basic Elements of Financial Policy Needed for Financial Planning
- Capital Budgeting- What investments to take on (i.e., Assets)?
- Capital Structures- Where to get financing to pay for these investments (i.e., leverage)?
- Working Capital Management- How to manage these financial activities (i.e., liquidity & Working Capital)?
- Profit Sharing- What is the appropriate amount to pay shareholders?
An appropriate goal of financial planning
NOT growth on its own
-increasing the market value of the owner’s equity; if a firm is successful, growth will usually result.
Planning Horizon
the long-range time period on which the financial planning process focuses (usually the next two to five years)
Aggregation
a process by which small investment proposals of each of a firm’s operational units are added up and treated as one big project
Budget
A one year financial plan
Strategic Plan
A five year financial plan
What can financial planning accomplish?
-Examining interactions: must make explicit links between investment proposals for the different operating activities of the firm and available financing choices
-Exploring options: Allows firm to develop, analyze, and compare many different scenarios in a consistent way
-Avoiding surprises: Should identify what may happen to the firm if different events take place
-Ensuring feasibility and internal consistency: Verifies that the goals and plans made for specific areas of a firm’s operations are feasible and internally consistent
-Conclusion: Most important result of the planning process is that it forces managers to think about goals and establish priorities.
Sales Forecast
Required by nearly all financial plans and often given as the growth rate in sales
Pro Forma Statements
The forecast balance sheet, income statement, and statement of cash flows on a financial plan
Pro formas are projections, not guarantees.
Asset Requirements
Financial plan will describe projected capital spending, the projected balance sheet will contain changes in total fixed assets and net working capital
Financial Requirements
Financial plan will include a section about the necessary financing arrangements (e.g., dividend and debt policy)
The Plug
the designated source(s) of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance
Economic Assumptions
Financial plan will explicitly state the economic environment in which the firm expects to reside over plan’s life
Simple Model Financial Planning
A financial planning model in which every item increased at the same rate as sales
-SALES IS THE DRIVER
The Percentage of Sales Approach
a financial planning method in which accounts are varied depending on a firm’s predicted sales levels
-separate the income statement and balance sheet accounts into two groups, those that vary directly with sales and those that do not
External Financing Needed (EFN)
The amount of financing the business requires from outside sources to remain profitable
Sources of EFN
-short-term borrowing,
-long-term borrowing
-new equity
Internal Growth Rate
the maximum growth rate a firm can achieve without external financing of any kind
Sustainable Growth Rate
the maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-equity ratio
Determinants of Growth
-Profit margin
-Dividend policy
-Financial policy
-Total asset turnover
Caveats of Financial Planning
-do not always ask the right questions
-tend to rely on accounting relationships, not financial relationships
-leaves out the 3 basic elements of firm value (cash flow size, risk, timing)
-it is an iterative process
-implicitly contains different goals in different areas and satisfies many constraints
