introduction to finance. what is finance? finance is the study of how people and businesses evaluate...
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Introduction to Finance
What is Finance?
Finance is the study of how people and businesses evaluate investments and raise capital to fund them.
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Corporate Finance addresses the following three questions:
1. What long-term investments should the firm choose?
2. How should the firm raise funds for the selected investments?
3. How should short-term assets be managed and financed?
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Forms of Business Organization The Sole Proprietorship
The Partnership
The Corporation
Sole Proprietorship
It is a business owned by a single individual who is entitled to all of the firm’s profits and is responsible for all of the firm’s debt.
The sole proprietors typically raise money by investing their own funds and by borrowing from a bank.
Sole Proprietorship (cont.) Advantages:
Easy to startNo need to consult others while making decisionsOrganization taxed at the personal tax rate
Disadvantages:Owner is personally liable for the business’s debtThe business ceases on the death of the proprietorHard to raise money
Partnership: General
A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit.
Partnership (cont.)
Advantages:Relatively easy to startOrganization taxed at the personal tax rateAccess to funds from multiple sources or partners
Disadvantages:Partners jointly share unlimited liabilityIt is not always easy to transfer ownership
Partnership: Limited
In limited partnerships, there are two classes of partners: general and limited.
The General Partner runs the business and faces unlimited liability for the firm’s debts
The Limited Partner does not run the business and is only liable up to the amount invested.
Corporation
Are the big organizations. Generally established when very large sums of money are required.Main defining characteristic is the separately of ownership (shareholders) from control (management)
The Board of directors are elected by the shareholder, and the board appoints the senior management of the firm.
Corporation (cont.)
AdvantagesLiability of owners is limited to invested fundsLife of corporation is not tied to the owner Easier to transfer ownershipEasier to raise Capital
Disadvantages Greater regulation Double taxation of dividends
Limited Liability Company (LLC)
Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) with the limited liability benefit of corporation (the owner’s liability is limited to what they invest).
Comparison
Five Basic Principles of Finance
1. Time Value of Money
2. Risk-Return Trade-off
3. Cash is King
4. Market Prices Reflect Expectations/News
5. People do what is best for them, unless you make them change their mind
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Time Value of Money
A dollar today is worth more than a dollar tomorrow We can invest the dollar today and earn interest.
Therefore, in the future we have the dollar invested plus interest
Risk-Return Trade-off
No one likes risk for its own sake. Therefore people will only take on more risk if they are compensated with higher returnsHigher the risk higher expected return
Note expected return may not be equal to the realized return.
Cash is King
Profit, Earnings, Net Income are accounting numbers designed to measure performance. These numbers can be manipulated
Cash flows are the actual dollars flowing in and out of the company and can’t be manipulated as easy
It is possible for a firm to report profits but have no cash.
Cash is King: Follow on
Financial decisions should only consider “incremental cash flow”
i.e. the difference between the cash flows the company will produce with the new investment and what it would make without the investment.
Market Prices Reflect News
Investors react quickly to news/information and decisions made by managers.
Good News ==> Higher stock prices
Bad News ==> Lower stock price.
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The Goal of Financial Managers What is the correct goal?
Maximize profit?Minimize costs?Maximize market share?Maximize shareholder wealth?
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The Financial ManagerThe Financial Managers increase shareholder wealth by:
1. Selecting value creating projects Capital Budgeting Decision
2. Making smart financing decisions Capital Structure Decision
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Financial Markets
FirmsInvestors
Secondary Market
money
securitiesSueBob
Stocks and Bonds
Money
Primary Market
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Quick Quiz1. What are the three basic questions Financial
Managers must answer?
2. What are the three major forms of business organization?
3. What is the goal of financial management?
4. What is the difference between a primary market and a secondary market?
Financial Statements and Cash Flow
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Financial Statements
Company managers, investors, and outside analysts use financial statements to conduct… Cash flow analysis Performance (ratio) analysis
The SEC requires U.S. companies to produce financial statements conforming to Generally Accepted Accounting Principles (GAAP), developed by the Financial Accounting Standards Board (FASB).
Basic Financial Statements
The accounting and financial regulatory authorities mandate the following four types of financial statements:
1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholder’s Equity
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The Balance Sheet
A snapshot of the firm’s accounting value at a specific point in time What does the company look like today
The Balance Sheet Identity is: Assets ≡ Liabilities + Stockholder’s Equity
Left Hand Side of the balance sheet must equal the Right Hand Side
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Balance Sheet
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
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U.S. Composite Corporation Balance Sheet
2007 2006Current assets: Cash and equivalents $140 $107 Accounts receivable 294 270 Inventories 269 280 Other 58 50 Total current assets $761 $707
Fixed assets: Property, plant, and equipment $1,423 $1,274 Less accumulated depreciation (550) (460) Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Total fixed assets $1,118 $1,035
Total assets $1,879 $1,742
The assets are listed in order by the length of time it would normally take a firm with ongoing operations to convert them into cash.
Cash is the most liquid with intangible assets being the least liquid.
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Balance Sheet Analysis When analyzing a balance sheet, the Finance
Manager should be aware of three concerns:1. Liquidity
2. Debt versus Equity
3. Value versus Cost
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Liquidity Refers to the ease and quickness with which assets
can be converted to cash—without a significant loss in value Generally the more liquid the asset the lower the rate of
return Current assets are more liquid than fixed assets The more liquid a firm’s assets, the less likely the
firm is to experience problems meeting short-term cash obligations (Ex. payroll) A profitable but illiquid firm will experience financial
distress
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Debt versus Equity Debt → Liability
Promise to payout cash, an IOU Equity is the residual
Assets – Liabilities ≡ Equity Debt represents a senior claim on firm assets
If the firm goes bankrupt debt holders get paid before equity holders
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Value versus Cost Accountants are historians, they care about
what something cost when purchaseUnder GAAP, financial statements carry assets at
cost Market value is the price at which assets,
liabilities, and equity could actually be bought or sold, TODAY
Cost and Market Value are two completely different conceptsWhat did we pay for it, versus what can we sell it
for
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The Income Statement Measures financial performance over a
specific period of timeHow has the company performed?
The accounting definition of income is:
Revenue – Expenses ≡ Income Generally the Income Statement is comprised
of several parts:
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U.S.C.C. Income Statement
The operations section of the income statement reports the firm’s revenues and expenses from principal operations.
Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes Current: $71 Deferred: $13Net income
$2,262 1,655
327 90
$190 29
$219 49
$170 84
$86
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Total operating revenues $2,262Cost of goods sold 1,655Selling, general, and administrative expenses 327Depreciation 90Operating income $190Other income 29
Earnings before interest and taxes $219Interest expense 49Pretax income $170Taxes 84 Current: $71 Deferred: $13Net income $86
The non-operating section of the income statement includes all financing costs, such as interest expense.
U.S.C.C. Income Statement
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Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes Current: $71 Deferred: $13Net income
Usually a separate section reports the amount of taxes levied on income.
$2,262 1,655
327 90
$19029
$219 49
$170 84
$86
U.S.C.C. Income Statement
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Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes Current: $71 Deferred: $13Net income
Net income is the “bottom line.”
$2,262 1,655
327 90
$19029
$219 49
$170 84
$86
U.S.C.C. Income Statement
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Income Statement Analysis There are three things to keep in mind when
analyzing an income statement:1. Generally Accepted Accounting Principles
(GAAP)
2. Non-Cash Items
3. Time and Costs
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GAAP• The matching principal of GAAP dictates that
revenues be matched with expenses. • Thus, income is reported when it is earned,
even though no cash flow may have occurred.
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Non-Cash Items• The income statements also makes allowances
for expense where no money changes hands• Depreciation is the most apparent example.
No firm ever writes a check for “depreciation.”
• Another non-cash item is deferred taxes, which does not represent a cash flow.
• Thus, net income is not cash.
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Time and Costs• In the short-run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials.
• In the long-run, all inputs of production (and hence costs) are variable.
• Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.
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Taxes “In this world nothing is certain but death and
taxes.” Ben Franklin
Taxes represent a major cost to the firm Taxes rules change, and are subject to political, not
economic forces What this means is that taxes do not need to make
economic sense Company is subject to two different tax rates
Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income
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Marginal versus Average Rates
Suppose your firm earns $4 million in taxable income. What is the firm’s tax liability?
.15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,356,100
What is the average tax rate?
What is the marginal tax rate?
If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?
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Net Working Capital
• Net Working Capital (NWC)≡
Current Assets – Current Liabilities
• NWC is usually positive for a growing firm • Why?
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U.S.C.C. Balance Sheet
2007 2006 2007 2006Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707
Long-term liabilities:Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation (550) (460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Common stock ($1 par value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock (26) (20) Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
Here we see NWC grow to $275 million in 2006 from $252 million in 2005.
This increase of $23 million is an investment of the firm.
$23 million
$275m = $761m- $486m
$252m = $707- $455
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Financial Cash Flow As finance people what we are really
interested in is the firm’s actual cash flow Since there is no magic in finance, it must be
the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)
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U.S.C.C. Financial Cash Flow
Cash Flow of the FirmOperating cash flow $238 (Earnings before interest and taxes plus depreciation minus taxes)Capital spending -173 (Acquisitions of fixed assets minus sales of fixed assets)Additions to net working capital -23 Total $42
Cash Flow of Investors in the FirmDebt $36 (Interest plus retirement of debt minus long-term debt financing)Equity 6 (Dividends plus repurchase of equity minus new equity financing) Total $42
Cash Flow from Assets Cash Flow to Investors
The Cash Flow Statement
The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash for the period spanned by the statement.
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The Statement of Cash Flows
The three components are:Cash flow from operating activitiesCash flow from investing activitiesCash flow from financing activities
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U.S.C.C. Cash Flow from Operations
To calculate cash flow from operations, start with net income, then add back non-cash items like depreciation and adjust for changes in current assets and liabilities (other than cash).
OperationsNet IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities
Accounts ReceivableInventoriesAccounts PayableAccrued ExpensesNotes PayableOther
Total Cash Flow from Operations
$869013
-24111618-3
$199
-8
Idea: Translate Net Income into cash
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U.S.C.C. Cash Flow from InvestingCash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i.e., net capital expenditures).
The cash from sales of our buildings/machinery minus the cost of buildings/machinery we bought
Acquisition of fixed assetsSales of fixed assets
Total Cash Flow from Investing Activities
-$19825
-$173
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U.S.C.C. Cash Flow from Financing
Cash flows to and from creditors and owners include changes in equity and debt.
Retirement of debt (includes notes)Proceeds from long-term debt salesDividendsRepurchase of stockProceeds from new stock issue
Total Cash Flow from Financing
-$73 86
-43
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$7
-6
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U.S.C.C. Statement of Cash Flows
The statement of cash flows is the addition of cash flows from operations, investing, and financing.
OperationsNet IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities
Accounts ReceivableInventoriesAccounts PayableAccrued ExpensesNotes PayableOther
Total Cash Flow from Operations
$869013
-24111618-3
$199-8
Acquisition of fixed assetsSales of fixed assets
Total Cash Flow from Investing Activities
-$19825
-$173
Investing Activities
Financing ActivitiesRetirement of debt (includes notes)Proceeds from long-term debt salesDividendsRepurchase of stockProceeds from new stock issue
Total Cash Flow from Financing
-$7386-43
43$7
-6
Change in Cash (on the balance sheet) $33
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Quick Quiz
1. What is the difference between book value and market value? Which should we use for decision making purposes?
2. What is the difference between accounting income and cash flow? Which do we need to use when making decisions?
3. What is the difference between average and marginal tax rates? Which should we use when making financial decisions?
4. How do we determine a firm’s cash flows? What are the equations, and where do we find the information?
Financial Statements Analysis and Long-Term Planning
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Financial Statements Analysis
Common-Size Balance Sheets Compute all accounts as a percent of total assets
Common-Size Income Statements Compute all line items as a percent of sales
Standardized statements make it easier to compare financial information, particularly as the company grows.
They are also useful for comparing companies of different sizes, particularly within the same industry.
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Ratio Analysis Ratios allow for a better comparison through time and/or
between companies Give a sense for how the firm is doing As we look at each ratio, ask yourself:
How is the ratio computed?What is the ratio trying to measure and why?What is the unit of measurement?What does the value indicate?How can we improve the company’s ratio?
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Categories of Financial Ratios
Short-term solvency, or liquidity ratios Long-term solvency, or financial leverage
ratios Asset management, or turnover ratios Profitability ratios Market value ratios
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Liquidity Ratios These measure the ability of the firm to meet its short
term obligations Why is this important?
Current Ratio = CA / CL 708 / 540 = 1.31 times
Quick Ratio (Acid Test) =(CA – Inventory) / CL (708 - 422) / 540 = 0.53 times
Cash Ratio = Cash / CL 98 / 540 = 0.18 times
Where do the “raw” numbers come from?
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Leverage Ratios These measure the ability of the firm to meet its long
term obligations Why is this important?
Total Debt Ratio = (TA – TE) / TA (3588 - 2591) / 3588 = 28%
Debt/Equity = TD / TE (3588 – 2591) / 2591 = 38.5%
Equity Multiplier = TA / TE = 1 + D/E 1 + .385 = 1.385
Where do the “raw” numbers come from?
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Coverage Ratios These measure the ability of the firm to pay
it’s debt holdersWhy do we care about paying the debt holders?
Times Interest Earned = EBIT / Interest691 / 141 = 4.9 times
Cash Coverage = (EBIT + Depreciation) / Interest(691 + 276) / 141 = 6.9 times
Where do the “raw” numbers come from?
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Inventory Ratios These tell else how efficiently the firm manages it’s
inventory Why do we care about this? Do we want these ratios to be high or low? Where do the “raw” numbers come from?
Inventory Turnover = Cost of Goods Sold / Inventory 1344 / 422 = 3.2 times
Days’ Sales in Inventory = 365 / Inventory Turnover 365 / 3.2 = 114 days
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Receivables Ratios These tell else how quickly the firm is paid
Why do we care about this?Do we want these ratios to be high or low?Where do the “raw” numbers come from?
Receivables Turnover = Sales / Accounts Receivable2311 / 188 = 12.3 times
Days’ Sales in Receivables = 365 / Receivables Turnover365 / 12.3 = 30 days
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Total Asset Turnover This tells us how efficiently the firm is turning
assets into salesWhy do we care about this?
Total Asset Turnover = Sales / Total Assets2311 / 3588 = 0.64 timesIt is not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets.
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Profitability Measures
These measure how efficiently the firm operates Why do we care about these? Where do the raw numbers come from?
Profit Margin = Net Income / Sales 363 / 2311 = 15.7%
Return on Assets (ROA) = Net Income / Total Assets 363 / 3588 = 10.1%
Return on Equity (ROE) = Net Income / Total Equity 363 / 2591 = 14.0%
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Market Value Measures These tell us how the market (people) feel
about the firmWhere do these raw numbers come from?
Market Price = $88 per share Shares outstanding = 33 million PE Ratio = Price per share / Earnings per share
88 / 11 = 8 times Market-to-book ratio = market value per
share / book value per share88 / (2591 / 33) = 1.12 times
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The Du Pont Identity Created by Du Pont in 1920 Breaking ROE (NI/TE)into three parts, so we can
understand where our return comes from ROE = PM * TAT * EM Calculation
ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE)
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What does it mean?
ROE = PM * TAT * EMProfit margin is a measure of the firm’s operating
efficiency – how well it controls costs.Total asset turnover is a measure of the firm’s
asset use efficiency – how well it manages its assets.
Equity multiplier is a measure of the firm’s financial leverage.
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Using Financial Statements
Ratios are not very helpful by themselves: they need to be compared to something
Time-Trend AnalysisUsed to see how the firm’s performance is changing
through time Peer Group Analysis
Compare to similar companies or within industriesSIC and NAICS codes
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Potential Problems to Remember when Analyzing Financial Statement There is no underlying theory, so there is no
definitive way to know which ratios are most relevant Benchmarking is difficult
Especially for diversified firms Firms use varying accounting procedures
Ex. LIFO versus FIFO Globalization means different accounting regulations
Firms have different fiscal years Extraordinary, or one-time, events
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Financing Growth When growth is slow, the firm may be able to rely
on internal financing Just using what they make
At higher growth rates, the firm will likely need to go to the capital market for additional financing
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The Internal Growth Rate The internal growth using the funds it generates The Internal Growth Rate can be calculated with
ROA and Plowback Plowback ratio: how much of net income is being
reinvested in the company b = Addition to Retained Earnings / Net Income
IGR = (ROA * b)/(1-ROA * b)
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IGR Calculation
If a firm has an ROA of 0.132, and a plowback ratio of 0.667, what is its IGR?
IGR = (ROA * b )/ (1 – ROA * b)
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The Sustainable Growth Rate The sustainable growth rate tells us how fast
the firm can grow by using internally generated funds and issuing debt, without changing the firm’s capital structureDo you expect this be higher or lower than the
internal growth rate? The Sustainable Growth Rate is calculated
with ROE and PlowbackJust like IGR but use ROE instead of ROA
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SGR Calculation
If the same firm has an ROE of 0.264, what is its SGR? Remember plowback is 0.667
(ROE * b )/ (1 – ROE * b)
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Quick Quiz1. How do you standardize balance sheets and
income statements?2. Why is standardization useful?3. What are the major categories of financial ratios?4. How do you compute the ratios within each
category?5. What are some of the problems associated with
financial statement analysis?
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Quick Quiz
6. What is the purpose of long-range planning?7. What are the major decision areas involved in
developing a plan?8. What is the percentage of sales approach?9. What is the internal growth rate?10. What is the sustainable growth rate?11. What are the major determinants of growth?