Finals Flashcards
Four Financial Objectives
- Efficiency - productivity of assets (ROA/ROE)
- Liquidity - ability to meet short-term commitments (CA-CL=Wrking CAP)
- Prosperity - Ability to grow (Rev, wrk Cap, NonCA, yrs profit)
- Stability - financial structure of firm (assets - equity/debt)
- (triple bottom line)
External Factors that affect a firm’s finances
Changes in the external environment
- Economic
- Political
- Global and open world economies
- Faster technological changes
- Shorter product life cycle
- Pressure for innovation and quality
Types of business decisions (3)
- Operating - Internal financing (mangers)
Typically short-term - profit for year, depreciation/amortization, wrk Cap - Financing - External Financing (investors)
Typically long-term - mortgages, bonds, commons shares, preferred shares - Investing
Non-CA
How the statements are linked
- Balance Sheet @ beginning of period - Snapshot of Financial Position
- During the period
Statement of Income
Statement of Changes in Equity
Statement of Cash Flows - Balance Sheet @ end of period Snapshot of Financial Position
Types of Financial Analysis
- Statement of cash flows
- Horizontal Analysis
- Vertical Analysis
- Ratio Analysis
- Break-even Analysis
- Operational Analysis
Statement of cash flows
Focused on cash accounting.
Financial statement that provides aggregate data regarding all cash inflows and outflows of a company
Horizontal Analysis
Technique for Financial Statement Analysis. Compares historical data, such as ratios or line items, over a number of accounting periods. Can be in dollars or percentages.
Vertical Analysis
Technique for Financial Statement Analysis. Line item is listed as a percentage of a base figure within the statement. Used for all financial statements:
- Income statement – percentage of gross sales or revenue
- Balance Sheet – percentage of total assets or liabilities
- Cash flow statement – each cash inflow or outflow as a percentage of the total cash inflows.
Ratio Analysis
Measures liquidity, profitability, debt, operating performance and investment valuation.
Break-even Analysis
Determines the point at which revenue received equals the costs associated with receiving the revenue.
Operational Analysis
Studies with the aim of identifying opportunities for improving operations of a company.
Decision Making Types
- Financial decisions
- Working capital decisions
- Capital budgeting decisions
- Growth decisions
- Capital Structure decisions
- Lease or buy decisions
- Pricing decisions
- Operating budgeting decisions
Financial decisions
- four stages of a developmental life cycle, each with their own funding needs.
- long term
Working capital decisions
Management of working capital requires evaluating factors affecting cash flows — including the evaluation of appropriate interest rates.
Capital budgeting decisions
Planning process to determine which long term investments are worth pursuing.
Growth decisions
When to scale and how to finance movement through the company’s development life cycle.
Capital Structure decisions
The mix of debt and equity that maximizes a firm’s return on capital, thereby maximizing its value.
Lease or buy decisions
Lease or buy decision involves applying capital budgeting principles to determine if leasing as asset is a better option than buying it.
Pricing decisions
Decisions that are impacted by your cost, revenue requirements and consumer’s willingness to pay for your good or service.
Operating budgeting decisions
Decisions related to a firm’s operations and operational costs.
Accrual vs. Cash accounting
Based on Cash Flow Statement
Accrual – Accrual basis is a method of recording accounting transactions for revenue when earned and expenses when incurred.
Cash – Cash basis refers to a major accounting method that recognizes revenues and expenses at the time cash is received or paid out.
Cash Inflow and Outflow
Asset - Cash inflow (down) Cash outflow (up)
Equity - Cash inflow (up) Cash outflow (down)
Liability - Cash inflow (up) Cash outflow (down)
Preparing Cash Flow Statement
Information needed:
- Balance sheets for the end of last year and end of the current year are needed to calculate the amount of change in each balance sheet account. These changes in balance sheet accounts are needed to prepare certain parts of the statement of cash flows.
- Income statement information for the current year is needed as the starting point for converting net income from an accrual basis to a cash basis, which is shown in the operating activities section of the statement of cash flows.
- Other information is needed to complete the statement of cash flows, such as cash dividends paid and the original cost of long-term investments sold.
Activity
Cash Flow Statement
Together and in teams
Why analyze financial statements?
Ensure liquidity Maintain solvency Improve productivity of assets Maximize return Secure long-term prosperit
Limitations of Financial Ratios
- To make ratios meaningful…
Need to “benchmark”
Look at trends
Compare financial performance with other businesses or industry averages - Only give signals— do not answer questions relating to why, what, or how
- Ensure that numbers used are similar – different accounting methods and ratio calculations
- Business size may make a difference
- Nature of the operations may also be different (new plant versus worn-out plant)
Operating leverage
- High operating leverage
A large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs.
Larger fluctuation of profit with changes in revenue - more risky - Low operating leverage
A large proportion of the company’s sales are variable costs, so it only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales.
Smaller fluctuation of profit with changes in revenue
Factors that affect profit
Volume of production
Prices
Costs (fixed & variable)
Changes in product mix
Cost concepts
Controllable / non-controllable
Direct / indirect
Committed fixed / discretionary fixed
Contribution margin
Contribution Margin = Revenue – Variable Expenses (Variable Direct Materials, Variable Labour & Variable Overhead)
Could also be per product = Sale price – Variable Direct Material (per unit of product) – Variable Labour (per unit of product) – Variable overhead (per unit of product)
Financial Leverage
- The more debt financing a company uses, the higher its financial leverage
- A high degree of financial leverage results higher risk to shareholders
- The less financing a company uses, the lower its financial leverage
- A low degree of financial leverage results in lower risk to shareholders
Power of Leverage - Debt-Coverage Ratios
- Solvency Ratios: Net income + depreciation / Short term Liabilities + Long term Liabilities
- Interest Coverage Ratio: Operating Income (EBIT) + Interest Expense / Interest Expense
- Debt/Total Assets: percentage of company’s assets financed by debt. Higher the ratio, greater degree of leverage.
- Debt/Equity: degree of financial leverage being used. The higher the ratio, it implies a higher amount of debt and higher interest expense. A capital structure of equal parts debt and equity would result in a debt/equity ratio of 1. Above 1, a company has more debt; below 1, the company has more equity.
Budgeting and Financial Projections Steps
First: Sales projections with Sensitivity Analysis!
Then: Production/Merchandising projections;
Sales and Administrative expenses projections;
Capital expenses projections
Then: Cash Flow projections
Identify short-term financing needs
Then: Pro-forma Income Statement
Finally: Pro-forma Balance Sheet
Financing needs – What do businesses need financing for?
Buy property, plant, and equipment Additional investments in research and development Promote the launch of a new product Acquire a new business Additional working capital
Internal and external financing
1. Internal financing Cash flow from the operations Profit for the year Add back: depreciation Deduct: dividends paid = Total funds generated by the business Working capital Inventories Trade receivables
- External financing
Shareholders (equity)
Lenders (long- and short-term)
Leasing
Different types of risk related to financing options (Business, Financial & Instrument)
Risk/return of financing options
- Business risk
Built-into the firm’s operations
Uncertainty in the marketplace
- Financial risk
Related to the firm’s capital structure
Debt versus equity
- Instrument risk
Quality of security
Secured versus unsecured loansStrategies for approaching lenders
- Lender’s Criteria
- The matching principle
- Matching strategy (matching maturities)
- Short-term funds finance – temporary working capital
- Creditworthiness
Lender’s Criteria for extending credit
Some are more restrictive or focus on different priorities than others. Relationship and reputation matters either as much or more than technical requirements.
The matching principle
The matching principle requires that revenues and any related expenses be recognized together in the same period. Thus, if there is a cause-and-effect relationship between revenue and the expenses, record them at the same time. If there is no such relationship, then charge the cost to expense at once. This is one of the most essential concepts in accrual basis accounting, since it mandates that the entire effect of a transaction be recorded within the same reporting period.
Matching strategy (matching maturities)
is the acquisition of investments whose payouts will coincide with an individual or firm’s liabilities. Under a matching strategy, each investment is chosen based on the investor’s risk profile and cash flow requirements. The payout might consist of dividends, coupon payments or principal repayment.
Short term requirements
are met with short-term debts and long-term requirements with long-term debts. The underlying principal is that each asset should be compensated with a debt instrument having almost the same maturity.
- Long-term funds finance – fixed assets and permanent working capital
- Short-term funds finance – temporary working capital
Creditworthiness
How safe you are as a borrower in the perspective of the lender. How likely you are to make your payments on time and pay a loan in full.
Cs - of credit (Factors that investors look at to assess the creditworthiness of a business)
Character Collateral Capacity Capital Circumstances Coverage
Barriers to Creditworthiness
Poor earnings record
Questionable management ability
Collateral of insufficient quality or quantity
Slow and past due in trade or loan payments
Poor accounting system
New firm with no established earnings record
Poor moral risk (character)
Types of equity financing and their differences (sources of equity funding)
Equity Financing
- Raising capital through the sale of shares of an enterprise
- The sale of an ownership interest to raise funds for business purposes
- Common shares
Voting rights
Dividends if available
- Preferred shares
Preferential access to dividends
May have voting rights
Government financing
Conventional Intermediate and Long-term Financing
- Term loan
Financing amount depends on what can be offered as security and is determined by lender
Banks, trust companies, insurance companies, and pension funds
- Conditional sales contract
Agreement made between a buyer and a seller for the purchase of an asset (e.g., truck) by installments
- Bonds
Long-term loans that could be secured or unsecured (20 to 30 years)
- Mortgages
Long-term loan to finance real property, land, and buildings
Sources and forms of short-term financing
Supplier financing - Trade credit - Consignment sales Chartered banks and trust companies - Line of credit - Interim (bridge) financing Asset-based financing - Accounts receivable factoring - Inventory financing
Lease vs. buy decisions and factors
- Capital cost allowance - Tax effects of capital cost allowance represent an advantage to ownership
- Obsolescence - Makes leasing more attractive
- Operating and maintenance charges - Represent an expense to ownership and make leasing more attractive
- Salvage or residual value- Advantage to ownership
- Tax effects - Lease payments are fully tax deductible and make leasing more attractive
Tools for solving TMV problems (formulas, interest tables, financial calculators/spreadsheets)
Future Value of a Single Sum
Present value of a future lump sum
Future value of an annuity
Present value of an annuity
Rule of 72
The Rule of 72 is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.
Loan amortization
STEP 1: Calculate the payment per period
STEP 2: Determine the interest in Period t
STEP 3: Compute principal payment in Period t
STEP 4: Determine ending balance in Period t
STEP 5: Start again at Step 2 and repeat
5 Methods - Evaluating Capital Expenditure Projects
- Accounting methods
- Use financial statement information
- Do not consider time value of $ - Payback method
- Simple technique that considers time risk only - NPV
- IRR or Discounted Cash Flow (DCF)
- Profitability Index (PI)
