Introduction (Chapter 1-3) Flashcards
Value of any asset = ?
Value of any asset = Present value of its expected future cash flows
What are current and fixed assets?
Fixed assets: A new house, a new car, machinery etc. Is further divided into:
- Intangible assets: education, patents, franchises.
- Tangible assets: currencies, buildings, real estate etc.
Current assets: Cash, cash equivalents, inventory etc.
Fixed assets are hard to sell
Current assets are easier to sell
What is an investment?
Putting your money into a project that will give you a future payoff. If you believe the cost is less than the future payoff, it’s a good purchase.
What is corporate finance?
The study of the relationship between business decisions, cash flows, and the value of the stock in the business.
The top three concerns of corporate finance (found from the balance sheet):
- Capital budgeting. What long-term investments should the firm choose? (left side) We use the term capital budgeting to describe the process of making and managing expenditures on long-lived assets.
- Capital structure. How should the firm raise funds for the selected investments? (right side) The answer involves the firm’s capital structure, which represents the proportions of the firm’s financing from current liabilities, long-term debt, and equity.
- Working capital management. How should current assets be managed and financed? (upper)
The balance sheet and net working capital
The balance sheet is an accountant’s snapshot of the firm’s accounting value on a particular date, as though the firm stood momentarily still. The balance sheet states what the firm owns and how it is financed.
Assets = liabilities + shareholder equity
Net working capital = Current assets - Current liabilities
When analyzing a balance sheet, the Finance Manager should be aware of what three concerns?
Accounting liquidity:
* Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value
* Current assets are the most liquid.
* Some fixed assets are intangible.
* The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations.
* Liquid assets frequently have lower rates of return than fixed assets.
* People tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” We can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.
* A firm can be TOO liquid. Excess cash holdings lead to overall lower returns.
Debt versus equity:
Liabilities are obligations of the firm that require a payout of cash within a stipulated time period. Many liabilities involve contractual obligations to repay a stated amount at some point, along with interest over a period. Thus, liabilities are debts and are frequently associated with nominally fixed cash burdens. This puts the firm in default of a contract if not paid.
Stockholders’ equity is a claim against the firm’s assets that is residual and not fixed. In general terms, when the firm borrows, it gives the bondholders first claim on the firm’s cash flow.Bondholders can sue the firm if the firm defaults on its bond contracts. This may lead the firm to declare itself bankrupt.
- Creditors generally receive the first claim on the firm’s cash flow.
- Shareholders’ equity is the residual difference between assets and liabilities.
- Debt and equity have different costs; the relationship between them has impact on the firm’s profitability.
Value versus cost:
The accounting value of a firm’s assets is frequently referred to as the carrying value or the book value of the assets.
* Under Generally Accepted Accounting Principles (GAAP), financial statements of firms in the U.S. carry assets at historical cost.
* Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.
Is positive net working captial always positive?
Not neccessarily….
Reasons:
- Excessive Inventory
- Suboptimal Capital Allocation
- Collection Issues
- Industry Comparison
- Potential for Short
- Term Liabilities
- Liquidity vs. Solvency
What is the goal of financial management?
Maximize shareholder wealth
Shareholder vs stakeholder objectives
Shareholder: Key objective is to maximize shareholder value, short-term and longer term
Stakeholder: Key objective is to seek compromises which balance different interests
The cash allocation challenge
Warren buffet says:
- If the company can use the cash more intelligently than the owners to generate future revenues for the company it should not pay out dividends
- If the company cannot use the cash efficiently then they should be paid to shareholders
- Third option would be to repurchase own shares which can benefit all shareholders on aselective basis.
If the firm is to prosper, it must:
- Buy assets that generate more cash than they cost
- Sell financial instruments that raise more cash than they cost
I.e. generate more cash than you are using.
Methods to analyse progress of a company
- The Common-Size Balance Sheet computes all accounts as a percent of total assets.
- Common-Size Income Statements compute all line items as a percent of sales.
- Ratio analysis.
Computing profitability measures
- Return on Asset (ROA) = Net income / Total Assets
- Return on Equity (ROE) = Net income / Total Equity
- Profit margin = Net income / sales
- EBITDA Margin = EBITDA (sales – cost of goods sold) / Sales
- Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return on investment). As with many of the ratios, there are variations in how they can be computed. The most important thing is to make sure that you are computing them the same way as the benchmark you are using.
- ROE will always be higher than ROA as long as the firm has debt (and ROA is positive). The greater the leverage, the larger the difference will be. ROE is often used as a measure of how well management is attaining the goal of owner wealth maximization. The Du Pont identity is used to identify factors that affect the ROE.
Gross profit margin and the operating profit margin
- GPM = (Sales – COGS) / Sales
- OPM = EBIT / Sales
Financial ratios
- Ratios are not very helpful by themselves: they need to be compared to something
- Time-Trend Analysis: Used to see how the firm’s performance is changing through time
- Peer Group Analysis: Compare to similar companies or within industries.
Category 1, 4, 5 are most important
