mid-term outline - lmfg v4

8/7/2019 Mid-Term Outline - LMFG v4

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PPT Notes

Managing for Shareholder Value

In the 1990s, the creation of shareholder value emerged as a critical performance challenge and became one of theprimary goals of modern management. -HelfertIn the U.S., top management is expected to maximize shareholder value.If countries whose economic systems are not

based on maximizing shareholder value give investors lower returns on capital, they will slowly be starved for capital, ascapital markets continue to globalize. - Copeland, Koller, and Murrin

Who Provides the Financial Capital?

Debtholders:

Financial claim equal to amount borrowed by company plus rate of return (interest).

Financial claim typically backed by assets.

Priority over stockholders in bankruptcy.

Includes banks, public bondholders, other long-term debt financing sources.NOTES:-Ex: GM, through restructuring, original shareholders didnt get anything-By preference determines risk

Stockholders:

Owners of the company, as represented by stock and voting interest.

Common stock has no guaranteed financial return or claim to distribution of profits.

Participates in upside value creation through future dividends or stock price appreciation.NOTES:-No right to anything; company may choose to pay dividends or stock price increases-Can be private or public (ex: private Cargill, Facebook, Walmart); both debt and stock can be private or public-Private limited number of stockholders, limited availability of financial information

Shareholder Value = Market Equity Value Also referred to as equity market capitalization.

Total value of a companys equity =Market Cap = price per share x # of shares outstanding

Major Stock Indices

DJIA:

Most widely watched indicator of stock market movements in U.S.

Includes 30 of the largest, most established companies representing a cross-section of industries.

Stock Price weighted*

*current divisor as of 8/31/10 = .13232NOTES:

Biggest limitations its stock price weighted Ex: increase of 10%

o BofA; $13 pps; $1.3/.13232 = 9.8 points up (impact on DOW)

o 3M; $81 pps; $8.1/.13232 = 61 points up

BofA has 3x market cap of 3M this index can be misleading

Prof: possibly a reason Google has never been on the DOW because no splits (apx $450 / share); changes inDOW make-up are slow and careful to change because of impact

Undue influence to higher stock-price cos


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When Dow established (in 1880s), literally added up companies by value, and divided by all stocks in aggregate

Companies come and go: GM replaced by Cisco; Citigroup replaced by Travelers; AIG replaced by Kraft

Total shares outstanding totally arbitrary (per share value is irrelevant, only when you compare it to otherbenchmarks)

S&P 500:

500 largest companies chosen by market capitalization, liquidity and industry grouping.

Market-capitalization weighted*Total equity market capitalization as of 8/31/10 = $9,511.3 billion

NOTES:Probably shows more true to general movement of marketplace (DOW can move up or down when majority of others arenot)Market-cap weighted according to total market equity cap size

How is Shareholder Value Created?

Build future profits and CASH FLOWS!

Manage the level of risk that the company undertakes.

NOTES:How to use resources to build FUTURE profits and cash flowEverything in the markets is based on expectations; use past results only to evaluate future impact

Managing for Shareholder Value

Setting business strategy with the deliberate recognition of the goal to create shareholder value.o Choosing product/market areas where company has competitive advantage.

o Investing/divesting based on sound financial discipline.

Managing the company such that the gap between potential and actual value-creation performance is narrowed.o Selling underutilized assets.

o Divesting underperforming business units.

NOTE: if gap between potential and actual grows, risk for hostile takeover

Understanding the companys value drivers and core competencies (ex: Coca Cola)o Strong brands

o Customer loyalty

o Strategic relationships

o Market selection

Tying the managements compensation to value or value measures.o Stock options

o Restricted stock

o Long-term orientation

Communicating effectively to the investing public.o Disseminating comprehensive, accurate, and timely information.

o Understanding shareholder disclosure rules.--Regulation FD Fair Disclosure (same information release to all)

Understanding the customer:o Market surveys/data analysis

o Customer satisfaction index

o Customer retention rates

o Competitiveness metrics

Business Decision-Making


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o All business decisions reflect economic trade-offs.

o Recognition of limited resources

o Analysis of costs vs. benefits

o Impact on long-term financial performance / sustainability / cash flow generation

The value-creating company can be defined as an organization in which management has achieved integration of theinterests and actions of its key stakeholders, that is, shareholders, managers, employees, customers, suppliers, creditors,and the community. HelfertNOTES:Choosing based on competitor advantage

-As companies begin to invest, are they using good financial discipline?What to do: sell or divest

-If gap grows, become a hostile takeover target-Ex: Potash grocery hostile takeover underway look at in news

Past few years: huge payouts and excessive risk too short a window to ensure long-term orientation-Ex: lock-up arrangements and claw-back clauses in contracts / compensation (up to 3 years)

The Business System

Three primary areas of business decision-making:o Investment: attainment of assets/resources.

o Operations: utilization of assets/resources.

o Financing: funding of assets/resources.

Investment Segment

About carefully determining where you should allocate your resources, not just throwing money at ito Avoid too much or too little investment

Ex: airline industry

New investment planes, systems, etc. --- capital intensive industryOperations Segment

Depreciation Effect

New Investment

Investment Base

Dis-investment


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Revenue = price x volume

o Ex: airline industry

o From tickets directed approach

o Complex pricing structure; how much sold already vs. time of stay vs. time to departure

o Costs fuel, maintenance, employeesFinancing Segment

Ex: profitability of airlines no business model that truly works yet, from a pure accounting standpointo Most airlines have negative retained earnings

NOTES:Investments on balance sheet (add impact of investments on the cash flow)Ops on income statementFinancing similar to investments; how its financed on balance sheet, additions to it from cash flow statement

The Business System All areas are interrelated.

Overall corporate strategy must be consistently applied throughout the business system.

Business Model

Definition:

The process by which a company generates revenues and profits by meeting a specified customer need.

In other words. SHOW ME THE MONEY!

Volume

Costs

(Fixed and variable)

Price

Dividends InterestOperating

Profit

After taxes

Retained earnings

Long-term debtShareholders Equity

Funding Potential


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o How to create sustainable revenue and profit generation

Business Model Requirements

Positive customer value proposition

Positive cash flow potential through profit margins and/or resource velocity.

Competitive differentiation due to use of key resources and process strengths.NOTES:Customers see and nail an existing need, or create a new need (ex: Twitter)Resource velocity correct balance of resource utilization and turnover for max revenueWhat that allows company to make it successful and do it repeatedly competitive advantages???

Generic Business Models

Direct: Source of revenue comes directly from sale of goods or services to customers.

Indirect: Source of revenue comes from 3rd party (e.g. advertisers) with the attempt to reach users.

o Indirect ex: many of first internet services began this way (e.g., Google initial payments through web

advertisers)

Hybrid model: Some fee income generated by users, some through 3rd party (ex: Facebook, but no longer the

business model)

***Balance Sheet

Addresses key questions:o What does the company own (assets)?

o What does the company owe against those assets (liabilities)?

o Is the company financially solvent?

Reflects consolidated financial data.

Shows financial condition of company on a specific date.

All data shown in $s. Be mindful of $ denominations (e.g. $ in millions).NOTES:

-Assets tangible and intangible items that the company owns-FINANCIAL GOAL #1 maximize shareholder value (long term, sustainable)-FINANCIAL GOAL #2 maximize performance with the least commitment of resources-Balance sheet represents much of the company resources-Assets: performing assets, not losing value-Assets: a necessary part of doing business, and use of assets will bring company revenues and income (need factories,inventories, etc); BUT not like personal balance sheet every dollar invested in company needs to generate a properreturn; more tied up in assets more needed to satisfy capital investors-Dont necessarily want too much of them

Balance Sheet Equation

The Balance Sheet must balance!

For every business transaction, at least two accounting entries are made. After every transaction, the accountingequation remains balanced.

Assets

Current Assetso Reasonably expected to be converted into cash within one year.

--Examples: cash, accounts receivable, inventory, prepaid expenses.

Fixed Assets


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o Longer-life assets used in the operation of the business

--Examples: land, plant, and equipment.

o An amount is deducted each year from the value of the fixed assets to reflect age and usage

(depreciation).

Other Assetso Financial Investments (stocks & bonds)

o Minority interests in other companies

o Intangible assets

Intangible Asset characteristics

No physical substance.

Basis of valuation is cost. Only included on balance sheet if costs aresignificant.

Must be reasonable evidence of future benefits with certainty of duration.

Intangible Asset examples:

Goodwill: Represents the excess of price paid in an arms length transaction over the famarket value of the assets acquired.

Other Intangibles: Patents and copyrights, trademarks, and brand names (if purchased).

Intangible Asset exclusions:

If a growing company and does it organically, not lots of intangible value on balancesheet

Versus a similar size company that used acquisition to growwill look different

Exs:

Advertising campaigns

Development of brand names

Research and development

Liabilities

Current Liabilitieso Due for payment within one year

o Examples: notes payable, accounts payable, accrued liabilities (ex: wages), unearned revenues (ex: pre-pays for goods or services), current portion of long term debt anything youre deferring payment on

Long term liabilitieso Debt obligations due after one year

Examples: bank debt, deferred taxes

Off-balance sheet liabilitieso Examples include operating leases and loan guarantees.

o Listed in footnotes of financial statements

o Represents financial risk not shown directly on balance sheet.

Working Capital

Represents the excess of current assets not funded by current liabilities.

General definition:WC = Current Assets Current Liabilities

Refined definition: current assets excludes cash and marketable securities; current liabilities excludesinterest-bearing debt

NOTES:

Used in 2 different ways: if cash considered a part of WC, then it seems like a lot of WC and you need WC to behigh-Other option, remove cash from assets and remove interest-bearing debt from liabilities


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o Then remainder is: assets (book equity) = inventory and AR; liability = AP and Accrued Liabilities;

this means refined WC can be LOW, close to zero

Helps dissect the balance sheet love to have cheap credit sources to fund working needs, keep WC as low aspossible

If increase, then need to finance with interest-bearing debt, which is undesiredo Ex: big 4 accounting firms run with really low WC why? Because they balance A/R against A/L on a

monthly basis, dont need much else to runo Because partnership, have to pay income tax on cash so want to move quickly through to partners and not

sit in companyo Must manage AR well!!! Convert as quickly as possible

Taking cash out of equation allows us to see how efficiently this is working

Owners Equity

(Additional) Paid in Capital (APIC): represents the aggregate dollars invested by the stockholders.

Retained Earnings: represents the accumulation of earnings that have not been paid in dividends.

Treasury Stock: subtracted from owners equity to represent the value of the shares repurchased by the company(difference between issued and outstanding stock)

NOTES:What affects stockholders equity?

-Represents the residual of Assets Liabilities-Increases:

-Retained earnings or-APIC (issuance of stock)

-Decreases:-Dividends-Stock repurchases

If stock price falls, NO impact in stockholders equity (market value unrelated)

Balance Sheet

What is generally not reflected on the Balance Sheet?o Skilled workforce

o Strong brand names (unless purchased)

o Customer loyalty

o Certain other intangible assets (e.g., R&D)

o The market value of the stock.

NOTES:Balance Sheet: what makes it strong?

-Quality of assets (newer assets)-Low and manageable levels of interest-bearing debt-Solid equity base from retained earnings

-All costs are either capitalized or expensed cost

-Capitalized first to balance sheet, then as used or sold to IS-Ex: PPE (to depreciation on IS), inventory (to COGS on IS)

-Expensed straight to IS-Ex: R&D, T&E, marketing, personnel

-Pseudo-reflected on balance sheet profitability through retained earnings

Income Statement

Addresses key questions:


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o Are the companys revenues growing?

o How are the various costs impacting the earning power of the company?

o Has the company been profitable over a specified period of time?

Income Statement Equation:Revenues - Total Costs = Net profits

Revenues: reflecting the dollar proceeds arising from the sale of goods or rendering of services.

Costs: relating to production, material purchases, research and development, marketing, administrative overhead,interest expense on debt financing, taxes, etc.

Profits:o General term used to recognize that some costs have been subtracted from revenues.

o Measured at many different points on the income statement, to reflect the deduction of increasing level of

costs.

o Term used interchangeably with earnings or income.

Gross Profit= Revenues - Cost of Goods Sold

Operating Profit = Gross profit - additional operating costs

o Also called earnings before interest and taxes (EBIT)

Represents the earning power of the corporation. Profit from Continuing Operations=

Operating Profit - Other Expenses (Income)

o Also called pretax profit

Net Profits =Pretax profit - taxes

o What do Net Profits represent?

The amount of profits or losses generated for the owners.

An increase in owners equity on the Balance Sheet (after subtraction of dividends paid).o What do Net Profits notrepresent?

The amount of cash, if any, received by the owners.

The amount of cash generated by the company!NOTES:IS reflects general operating expenses (EXPENSE items not capital items)If manufacturer / retailer first deduct COGS (not on service firms)Net profits / earnings / income / bottom line not available to shareholders, no CLAIM to it

-Board will decide to reinvest (for stock appreciation) and / or issue dividendsEarnings do NOT equal cash flow

-Need Cash Flow statement:-CapEx (only on IS as Depreciation / Amortization)-AR-Non-cash compensation-Inventory build-up

-Dividends-Principal repayments / borrowings

Extraordinary Expenses (ex: merger one-time costs)

Nonrecurring in nature

Related to disposition of business or product line.

Shown on income statement after Net Income from Continuing Operations

What is Depreciation?


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A non-cash operating expense.

A spreading of the capital investment costs over the useful life of the assets.

A reflection of the limited life of the fixed assets.

How is Depreciation Calculated?

Cost: The total investment outlay for the asset.

Estimated Useful Life: The projected life, generally expressed in years.

Residual Value: The assets scrap value at end of useful life.Straight-Line Method of Depreciation

Simplest and most widely used method.

Annual depreciation charge =

Cost Scrap value

Useful life (in years)

Annual depreciation charge is tax-deductible expense on income statement.

Total accumulation of annual depreciation charges reduces fixed assets on balance sheet.

What is Amortization?

Relates to the capitalization ofintangible assets. A non-cash charge similar to depreciation of physical assets.

Goodwill is no longer amortizable. Write-off is required if value is impaired.

Cash Flow Statement

Balance sheet and income statement alone are deficient.

Cash flow statement reconciles income statement and balance sheet

Addresses key questions:o What is the source of the companys cash flow?

operating activities?

sale of assets?

borrowings from a bank?

Company cannot have sustainable cash flow without earnings!

How is the companys cash flow being used?o fund losses?

o purchase assets?

o repay debt?

Statement focuses on changes during the period.

Statement is summarized into 3 categories:o Cash flow from operating activities

net income or net loss for the period

add-back of non-cash items: depreciation

decrease or increase in current assets

decrease or increase in current liabilitieso Cash flow from investing activities

capital expenditures

proceeds from sale of assetso Cash flow from financing activities

borrowing or repayment of debt

dividends paid


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purchases of common stock into TreasuryNOTES:-Earnings best proxy of cash flow to start (Net Profit)-Depreciation & Amortization-Deferred income taxes-Then Changes in WC: more or less credit required?

-AR: more credit to customers (use of cash)-Inventories: going up (use of cash)

-AR and Inventories both going up: probably ok, company appears to be growing-Only concern if they end with cash less than desirable to maintain ops-All of normal operating inflows and outflows and expenses are already reflected because STARTED with bottom line ofIS

-This just helps us reconcile the two statements: profits generated, then how much grew or decreased-SCF drives shareholder value: Cash is king!

Earnings vs. Cash Flow

Earnings include non-cash charges such as depreciation and amortization.

Earnings do not reflect the changes in current assets and current liabilities (working capital) during the year.

Earnings do not reflect the expenditures on fixed assets (capital expenditures).

Earnings do not reflect the borrowings or repayment of debt, except in the form of interest expense.

Earnings do not reflect the payment of cash to shareholders (dividends).

Cash Flow: Source or Use?

Items which increase cash flow:

o Profitable operations

o Reductions in all assets

o Increased borrowings

o Sale of stock

Items which decrease cash flow:

o Losses from operationso Investment in assets

o Repayment of debt

o Payment of dividends

It is the change in assets or liabilities that determines if it is a source or use of cash.

It is the nature of the earnings (positive or negative) that determines whether it is a source or use of cash.

Impact of Growth on Cash Flow

Investment: additional inventory, new plant capacity

Operations: bigger sales force, marketing and promotional costs, new distribution channels.

Financing: greater interest expense from higher levels of debt.

Growth requires cash, butthe stock market demands growth! So is growth good or bad?

o It depends

How much is it going to cost to grow this business?

Price reductions

Increased working capital needs

Increased investment in fixed assets


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Factors to review to invest in major capital outlay?

E.g., when is it ok for middle section to go negative?o Cash flow from operating activities is HIGH (driven by profits)

o Cash and marketable securities on BS is it high? Can we afford to draw it down?

o Debt financing capability (already highly leveraged, or some capability to borrow)

o How much dividends required that year

o Equity offering (on balance with risk of signal to market / stock dilution)

Exs of current news:

o BB&B has excess cash what to do with it?

o McDonalds increased dividends this quarter by 11%

Why?

Have cash on hand / strong profits

Dont usually pay dividends if theres good growth potential and need money for growth/ CapEx

***


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Corporate Financial Goals

To increase the long-term value to its owners: SHAREHOLDERS!

To obtain the mostperformance over time with the leastcommitment of resources.

Support revenue growth while keeping control of operational costs, i.e. maximize profit margins.

Minimize level of investment requiredo working capital and fixed capital

o investor capital

NOTES:

Ratios! Good to use beyond financial statements to key in on performance

WC = CA CL (current assets current liabilities) excess of our funding needs over what we can fund witheasy (aka non-interest bearing) credit

o Represents excess, so we want to keep it low to avoid long-term, interest-bearing debt

Performance Measurement

Performance may be assessed with differing viewpoints: 3 categories of stakeholderso Management

o Lenders

o Owners Not mutually exclusive, just different emphasis.

Management viewpoint

o Profitability of the operations

o Effectiveness of the resources being used

o Growth!

Owners viewpoint:

o Stock price appreciation

o Dividends

Lenders viewpoint:o Liquidity for timely debt repayment

o Cash Flowo Expected pay-out in the event of liquidation

o Risk averse! No sharing in upside.

Revenue Growth Analysis

Compounded Growth Rateso 3 yrs, 5 yrs, 10 yrs

Comparison with competitors/industry

Gained or lost market share?NOTES:

CGR = compounded annually, this is the growtho CGR doesnt indicate anything about volatility, only where it starts and ends

Ending Revenue = Beginning Revenue * (1 + CGR) ^ p

Where p = # periods

If CGR is growing faster than industry, then gaining market share (and reverse)o Note: companies choose CGR based on what looks best / gives highest growth rate; note how many

years theyre usingmore the better!

Profit Margin Analysis

Profit Margin = Profit


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Revenues

Focuses on the relationship of costs to sales and the resulting profits to sales.

Helps to identify where costs are getting out of line or are trending adversely.

Analysis uses income statement only.

Gross margin is influenced by:o Revenue component: price and volume

o COGS component: per unit cost of raw materials and labor

o Changing product mix

Operating profit* margin is influenced byo all of the above factors, plus

o selling and administrative costs, R&D expenses, marketing expenditures, other operating expenses

*Also called Earnings before interest and taxes (EBIT)

Pretax margin is influenced by:o all of the above factors, plus

o the extent of financial leverage and the interest expenses associated with it.

Net margin (after-tax margin) is influenced by:o All of the above factors, plus

o Tax burdenNOTES:

How well are we controlling our costs how much gaining profits relative to costso All from IS only

Profit = numerator, revenues = denominator

Resource Management

Common measures of effective resource management:o Inventory turnover

o Accounts receivable days outstanding

o Accounts payable days outstanding

o Working capital percentageo Fixed asset turnover

Inventory turnover represents the efficiency in which inventory is used to support sales.Inventory turnover = Cost of Goods Sold (times)

Inventory

NOTE: On averageinventory held for 12 months / inventory turnover rate = Turn Months

Efficiency of Accounts Receivable is measured in days outstanding:Days Outstanding AR = Accounts Receivable

Sales per day (Sales / 365 days)

NOTE: how fast we are collecting

Efficiency of Accounts Payable is measured in days outstanding:Days Outstanding AP = Accounts Payable

Cost of Goods Sold per day (COGS / 365 days)

NOTE: Growth is a-ok more free credit! Unless so extreme they cant meet their bills

Efficiency of working capital management is measured as a % of revenues: WC Efficiency = Working Capital*

Revenues


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*Defined as current assets (excluding cash and marketable securities) minus current liabilities (excluding interest-bearing debt.

Fixed-asset turnover measures the level of capital intensity for a company.Fixed-asset turnover = Revenues

Net PPE

NOTE: Ideal to keep HIGH; capital-intensive industries, by definition, have lower fixed-asset rates BUT stillwant to best industry standard

Return Measures

Useful for assessing both profit performance and asset utilization.

Most relevant to shareholder value creation.NOTES:return has 2 very different connotations

-Accounting definition = some profit on some level of investment-Past results, what is level of profit relative to level of investment

-Return on Equity (vs. ROI finance returns)-All return measures are %s

Return on Assets

Relates annual profits to the total assets used in the business to generate the profit. ROA = Net Income

Average Total Assets

NOTE: Not used very often; how much profit generated relative to the assets from that time

Return on Equity

Return on Common Equity: Relates net profits to the book value of the shareholders investment.ROE = Net Income

Average Shareholders Equity

NOTE: Ex: news this week i-banks ROE on decline up to of value in coming decade

ROE Influencing Factors:ROE = f (profitability, asset utilization, financial leverage)

NOTE: Options to impact ROE:-Reduce operating expenses-Increase pricing if volume is not adversely impacted-Dispose of underutilized assets-Cost synergies from M&A-Increase financial leverage (how use? To retire equity? To invest effectively in new assets?)

ROE Limitations:o

single period focus; (time problem)o ignores riskiness of earnings stream caused by financial leverage; (risk problem)

o doesnt relate specifically to cash flow;

o doesnt relate returns to market value of equity. (value problem)

NOTES:Higher ROEs coming from higher leveraged companies in general-But doesnt fully recognize the risk associated with this; might change risk profile of the companyROE attempts to turn profits generally (from stockholders equity) to accounting measure


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-Measures profits to a historical value of equity (because cash invested at TIME of investment in SE) vs. marketvalue-Stockholders equity: cash invested by shareholders AND retained earnings

Financial Leverage

Measures the extent to which debt has been used in the capital structure.

Increases the proportion of fixed costs (interest and principal payments).

Increases the risk of the firm but may greatly enhance the returns to the owners.

Financial Leverage can be measured by the ratio of debt to total capital:Financial Leverage / Debt to Capital Ratio= Long term debt (incl. current portion LTD)

Total Capital

NOTE:-Capital structure = invested capital (how much invested from debt)-Concept of leverage boosts returns to equity holders (if well managed)-LTD = long term debt and interest-bearing current liabilities; numerator includes ALL interest-bearing debt LTD ANDcurrent maturity of long term debt and notes payable

Total Capital = LTD + Stockholders Equity

Liquidity

Liquidity measures the degree to which a company can repay its current obligations with assets that can be readilyconverted in to cash.

NOTE: Ex: Liquidity dealt death knell to Lehman-Does cash and other current assets cover current liabilities?-Want to know how liquid really is current assets? Can sell inventories? Collect AR?-Compare year-on-year-Current assets / current liabilities > 1 then can cover short-term

Liquidity Ratio = Current assets

Current liabilities

(A current ratio in excess of 1 indicates some protection for the short term lenders.)

Interest Coverage

Interest Coverage measures the extent to which the annual profits of the firm covers the annual interest costs.Interest coverage = EBIT (aka Operating Profit = EBIT)

Interest Expense

NOTE: How much profits do we have to cover our interest expense

Shareholder Value Measures Market-Related Measures Total Shareholder Return (TSR) does relate to the economic return on the shareholders actual investment.

TSR = (End. stock price Beg. Stock price) + dividends paid per share

beginning stock price

NOTE: Creating shareholder value in the period? Via stock price appreciation and true cash via dividends

Price/Earnings Ratio is a commonly used stock valuation technique.P/E: Stock Price

Earnings per share

NOTE:-Buy multiple of earnings because of what you EXPECT to EARN in the FUTURE

-Can be impacted by distress or huge growth-Appropriate to compare to companies P/E in the same industry?

-One may have higher growth, or more likely one operates more efficiently


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-Ex: why huge P/E ratios during .com boom?-Lots of P! (and low E)

Dividend payout:

Annual dividend per share

Earnings per share

Dividendyield:Annual dividend per share

Stock price per share

NOTE:-If paying out large portions of earnings in dividendssaying best use of cash is to return it to shareholders (nocurrent strategy to grow) (or repurchase) particular type of company-Ex: utility companies-Dividends granted on quarterly basis, but look at it on a full year basis

Capital Structure Decision-making

Begin with understanding corporate strategy and projected need for cash infusions;o Growth or return strategy?

Focus of financing decision should be to support corporate strategy.o Exception: recapitalization (Scotts Miracle Gro ex from book)

Company Life Cycle

Focus on this to demonstrate impact for growth

Start-up Phase

o Development of products/services

o Establishing business model

o Focus is on gaining sufficient momentum to become self-sustaining

o Negative cash flow from operating activities requires need for equity financing.

NOTES:o Ex: product line, divisions, etc. mostly likely more specific than for the entire company

o Find advantages to make business model self-sustaining

o Equity financing rely on initial equity investors, often in form of VC or angel funds (because often cant

obtain debt financing yet)

Nature of assets factor into financing decision

Lots of physical assets lend to ability for debt financing, because you have something tosecure the debt against

If mostly intangible, then equity financing

Rapid Growth Phase

o Expanding market share and/or growing market;

o Profitable;

o High working capital and fixed asset needs requiring external financing.

NOTES:o If survive and still have financing to proceed, then into rapid growth phase

Ideally cash flow becomes positive in this phase

Establishing presence in market

But still have high working capital needs (and fixed capital needs too)

Doesnt all have to be equity financing at this point, but still often the case


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Maturation Phase

o Stagnant or declining growth in market refers to growth trajectory (not market share decline thats in

the Declining Phase)o High cash generation (idea of BCG cash cow);

o Low investment needs.

NOTES:o Maybe even turn to using cash to contract equity through stock repurchases

Declining Phase

o Actual decline in revenues;

o Marginally profitable;

o Liquidation of assets;

o Generation of cash exceeds reinvestment needs.

NOTES:

o Eventual decline how to get out of business and move on to something else

o Ex: Kodak, too much of business dependent on traditional film; hit bottom line hard

o Trigger declining phase: technology becomes obsolete and / or competitors enter market

Growth Strategy Justifying Factors:

o Life cycle in start-up or rapid growth phase; OR

o Opportunities arise in current or new markets to support growth andcompany performance merits

growth.

Truly experiencing growth in revenue, assets, etc. mostly TOP LINE growth

Typical financial characteristics:

o High CGRs in revenues and assets;

o Substantial capital expenditures;

Determined as cash flow from investing activities as % of cash flow from operating activitieso Significant use of external financing;

o Low or non-existent dividend payout cash better used for expansion insteadNOTES:

o Of amount generating out of operating activities, how much are we investing (as % of cash generated)?

External financing not necessarily debt financing concern if you use your debt capacity at thistime, then harder to go back for more debt financing

Most of earnings retained (low or no dividends)o Does anyone ever stop growing?

Ex: Starbucks instead focused on bottom line growth - want strong retained earnings / profi

leads into idea of a returns strategy instead

Returns Strategy

A successfulreturns strategy may result in a high growth rate in earnings.

Both a growth and returns strategy can create shareholder value.o Ex: Ex: McDonalds; doesnt have to be top line growth to have the market respond favorably

Bottom-line growth as focus with a returns strategyo Refers to decrease in costs/expenses

Justifying Factors:o Life cycle in maturation or declining phase; OR


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o Inferior profitability and/or asset utilization do not justify growth were in growth phase and werent

managing assets well needed to get performance measures back in line, otherwise just burning throughcash; so switch strategy to retrench and clean up

o Ex: Amazon.com in 2005 - 2006

NOTES:o If cant really grow BUT still generating a lot of cash milking it for what it is

o Same stores sales growth: Revenue growth with existing stores (within a given year) vs. new store

openingso All revenue growth is not created equal much better from existing stores

Revenue growth from new store openings requires much more investment up front andtakes a while to reach same level of profitability as existing stores

o Ex: Starbucks:

Growing rapidly but cannibalizing own products / stores

Negative same store growth in 2008 / 2009 despite overall revenue growth

o Misleading regarding true health of company; not sustainable

Starbucks had chosen growth strategy, which led to these negative results change toreturns strategy

o Ex: McDonalds in 2004 margins and returns tanked the Plan to Win strategy to reorg andfix the financial issue

How to buy more products within existing stores and make more gross profit margin onitems within stores

o Open market will penalize growth if not justified and will reward returns strategy if better for the

companyo Hard to stay in return strategy for a long time; typically used to transition to another growth strategy

Typical financial characteristics:o Low CGR in revenues or assets.

o Low level of capital expenditures.

o (Better for companies in maturation/declining phase)

o Announced share repurchase programs.

o Relatively high dividend payout.

NOTES:o If retailer, same stores growth declines

Lower absolute dollars into fixed assets as well as lower % of cash from cash-generatingactivities

o Probably not obtaining new financing

Recapitalization Strategy

Financial strategy notbusiness strategy becomes the primary focus;

Using high levels of financial leverage to replace equity.

High risk, high returns.

NOTES: One exception to financing strategy matching corporate strategy here the company USES finance strategy to

drive corporate strategy

More likely to occur in maturation phase dont need a lot of cash going into it so can leverage up the company

Common - Equity recap or LBO

Sustainable Growth

It is a sad truth that rapid growth has driven almost as many companies into bankruptcy as slow growth has.


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R. HigginsEx: Krispy Kreme, Boston Market, and Mrs. Fields all grew too quickly ran out of cash, couldnt meet debt service,couldnt sustain growthThe concept of sustainable growth is simply defined as the growth in the business that can be sustained by stable policiesover a period of time, and it is reflected by growth in shareholder equity.

E. Helfert

Sustainable Growth

Assumptions for model:o Company wants to maintain target capital structure and target dividend payout

o No new equity is issued.

Sustainable Growth Rate: g*

g* = Change in Equity

Equity b.o.p.

= Retention rate x Earnings = Retention rate x ROE

Equity b.o.p.

NOTE: Only way equity goes up is through retained earnings; if want to maintain same leverage ratio, then need to beborrowing more

Therefore, g* = f (profitability, asset utilization, financial leverage, and dividend policy)

NOTE:

Anything that influences ROE influences sustainable growth only addition is dividend policy because of theretention component

Model assumes not changing debt to total capital structure only adding it as much as equity increases

If company wants to increase g*, then they can:o Not pay dividends

o

Increase profits

Sustainable Growth purpose is to avoid bankruptcy to ensure actual growth = sustainable growth point

Ifactual growth > g* (actual growth = investing activities), either:o Profitability must increase;

o Asset utilization must improve;

o Dividend payout must decrease;

o Financial leverage must increase; or

o New equity must be issued (final option because dilutive: can go to equity capital markets)

NOTES:o Do the first three above before resorting to last two

o Ex: if actual growth > sustainable growth, perhaps opening too many stores to maintain growth

o Many companies dont want to issue too much equity has a dilutive and downward market effecto If growing at a level greater than that of the companys current sustainable growth rate, then will run out of

cash need another option (from list above) to get to needed g*

Sustainable Growth

Ifactual growth < g*, either:o Dividend payout could increase;

o Debt could be retired; or


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o Stock could be repurchased

NOTE: says actual growth is less than that level needed for sustainability

o Focuses your strategy from growth to bottom-line / returns strategy

Ex: P&G returns strategy, actual growth < g* for themFinancing to U.S. Non-financial Companies, 1998 2007*

InternalRetained Profits 14.4%Depreciation 46.8%

Subtotal 61.2%

ExternalIncreased debt 57.1%New equity (18.3%)

Subtotal 38.8%*Federal Reserve System

NOTES:

Internal drivers for sustainability: Profits + depreciation add-back

Negative equity is from companies repurchasing shares and avoid dilution External here 57% was debt financed, but 18% was repurchased extreme hesitation of management to issue

new equity

Designing Financial Securities

Not significantly constrained by law or regulation

Must appeal to investors

Must meet company needs short-term vs. long-term needsNOTES:

Equity common stock as the primary formo Also preferred stock (gives some voting rights)

Debt standard bank borrowings (for average size small / medium company this is primary source of debt)

Larger companies, bank borrowings used for working capital / line of credit financing; instead issue corporatebonds

o Difference is that corporate bonds can be publicly traded and are in increments of $1000; have coupon

rates instead of interest rates

SEC doesnt constrain types of securities; instead SEC cares about communication of all relevant info to investors

Financing Considerations

1. Cost of Incremental Funds what it costs the company to get new money

Credit worthiness of company aka company performance

Degree of companys financial leverage

o More leveraged = more risky; therefore it costs more to get more $ Source of financing: debt, preferred stock, common stock, or hybrid securities.

o Debt is cheaper than equity

2. Risk Exposure how much risk the company is willing to take on in terms of contractual obligations (debtperspective)

Operating risk and financial risk;

Measured by variability of earnings;

Heightened by fixed financial charges;


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Varies during company life cycle.3. Flexibility if fast growing and may need financing later, may need to offer equity

Keeping future funding options open;

Requires forward planning. NOTE: a highly leveraged company loses investor interest because its riskier

4. Timing increasing importance lately

Impacted by changing conditions in the financial markets;

Affects cost spreads between different funding alternatives.NOTE: need rising market for equity to be appealing; studies show need 3-4 weeks of confidence in market

Ex: August 2010; junk bonds increased in popularity riskier companies, but higher return rate popularbecause couldnt get these rates of returns elsewhere

5. Control:

Restrictive covenants in debt agreements (restricts what you can do with the money)

Ownership dilution (only relevant if issuing voting stock vote gets diluted by additional shares)6. Market Signaling:

Issuance of equitymay imply conservatism is required;o Stock prices drop when you issue equity; could indicate concern about the future

Issuance of debt may imply management is optimistic about future idea that growth is coming because thecompany needs debt

Debt Advantages

Initially least costly to company due to preferred status and tax deductibility of interest;

Allows for maturity matching with assetso Idea that timing is designed to allow asset monies to coincide with maturity of debt

Some companies will mis-match because theyre anticipating lower interest rates in future (notcommon)

Non-dilutive to shareholders;

Potential for boosting of EPS and ROE.

Debt Disadvantages

Reduces future financing flexibility;

Exposes company to greater risk of earnings and cash flow variability;

Introduces default risk and related distress costs.o Financial distress is when company incurs when it uses too much debt; as debt increases, costs of

financial distress costs increase, and can eventually outweigh tax advantageso Distress costs:

Bankruptcy costs expected costs of bankruptcy (probability that bankruptcy will recur x cost ifit does)

Does not necessarily imply liquidation

Costs vary with level of physical assets bankruptcy is cheaper if capital intensive

Indirect costs arise as probability of bankruptcy grows Conflict of interest parties involved begin to worry more about themselves than the firm

Overinvestment problem owners take more risk because they can at the creditors risk

Underinvestment problem managers forego opportunities because too much of benefitsaccrue to creditors instead

Common Stock Advantages

Least risky to company;


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o No obligations to issue dividends or repurchase stock

Maintains flexibility for future financing

Common Stock Disadvantages

Highest cost

Greatest potential loss of control

Ownership and EPS dilutiono ROIC = EBIT * (1-tax rate) / invested capital

***Introduction to Valuation

What is the value of my stock? It depends (on the circumstances)

Valuation Basis

Valuation standard to be used determined by the following factorso Size/relative influence of block of stock being valued

o Purpose of valuation

o Forced or voluntary transactiono Relative marketability of block of stock (i.e., readily tradable)

NOTE: Ex: In general, privately held companies not readily tradable; Facebook is ex of shifting private firm b/cof secondary market, but still not as marketable as public firms

Valuation Basis 2 Approaches / Purposes for Valuation

Going Concern: The ability to continue with business operations without the foreseeable threat of liquidation.o Valued from what are expectations of firm going forward in this business

Mostly focused on this topic; financial statements are based on this assumption of valuation

Liquidation: Likely to result in lowest value to stockholders; based on value of underlying assets, net ofliabilities.

o Not forward looking, but instead what is underlying value of assets; usually only get cents on dollar for

liquidation (typically less than book value) generally distressed or moved to sell

If assume liquidating, then usually in Non-Marketable Minority Interest Value

Going Concern Values

Control Value: Also known as Acquisition value or highest and best use valueo Usually around 80%+ of stock; when company makes bid for other firm

Ex: BHP trying to buy 100% of Potash stock

Marketable Minority Interest Value: public unaffected trading priceo What shares trade at in 100-share basis; assumption that trading price is unaffected by speculation or by

bids for control

Ex: Potashs current stock price is closer to implied Control Value b/c its affected (priced with a

control premium) expectation is now that company will be taken over; company is inplay; bid was made and company is actually trading above offer price because arbitragersbelieve bid will be driven up by other offer or demand from initial offerer

Non-marketable Minority Interest Value: discount from public price to reflect lack of trading market (no liquidity)

Control Value

Tender offer price for 80%+ of total outstanding stock of public company;

Value to majority owner of private company;


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Incorporates a premium over unaffected stock price, reflecting:o Synergies!

Ex: overhead cost reductions, economies of scale efficiencies

Are always expected; but studies have indicated unless in same business, then likely wont getsynergies

o Anticipated expense savings;

o Benefits of heightened financial leverage.

Interest expense is tax-deductible creates benefit with more financial leverage

Inverse of control premium is minority discounto Control premium = movement from marketable minority interest to control value

o Minority discount = movement from control value to marketable minority interest

Marketable Minority Interest Value

Value associated with:o 100-share trades as quoted;

o Illiquid stock holding put rights, e.g. stock held in ESOPs (ESOP = employee stock ownership plans)

o Active company stock repurchase programs (like companies creating the market)

NOTES:o Put = option to sell

o Repurchase programs can exist even for private companies

o discount for lack of marketability often in 25-35% range

Defined as the movement from marketable minority interest value to non-marketable minorityinterest value

Non-Marketable Minority Interest Value

Value associated with:o Restricted stock issued to management;

o Private company stock holding no marketability rights and no near-term plans to go public

Value of minority interest in privately-held company; no active trading and no auto repurchase bycompany

Lack of Marketability Discount

Recognition that Liquidity is a valued attribute;

Reflective of hypothetical cost of doing an IPO;

Reflective of discounts evidenced by restricted stock transactions.NOTES:

If hold stock, want ability to sell it thats why discounts are accepted

2 justifications for discount:

o Legal costs of an IPO; seasoning discount if going public, then small initial discount

o Restricted stock

If you own 100% of own company, then generally thought good liquidity value; BUT perhaps Control Value ofprivate vs. public companies may differ

How are Values Established?

Fair Market Value orientation:


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o The price paid by a willing buyer to a willing seller, neither under compulsion to buy or sell, having

complete information and appropriate time necessary to transact.

Sense of fairness: Who stands to benefit?

Appropriate methodology is dependent on the valuation basis applied.

Valuation methodology is forwardlooking:o Discounting of projected future cash flows (DCF);

o Applying some multiple of current or near term projected earnings.

Earnings vs. Cash Flow

Accounting earnings is useful forvaluation, only when earnings is a good proxy for the expected long-term cash flow ofthe company.

P/E Valuation

Approach used for marketable minority interest determination;

Analysis reviews P/Es and relative performance of public companies deemed comparable.

The higher the expected growth in earnings, the higher the P/E to be applied.

DCF Valuation Approach used for minority interest orcontrolling interest value determination, depending on assumptions used;

DCF Valuation

Projected cash flows reflect key elements of Cash Flow Statement:o Projected net income + depreciation

o Additions to working capital

o Capital expenditures necessary to support revenue growth

o Changes in debt financing.

Cash flows projected over 5 or more years;

Estimate made of Continuing value to reflect value beyond projection period.

Cash flows discounted to present at investors required rate of return.

Change-of-Control Multiples

Similar to P/E approach whereby acquisitions of companies in similar industries are analyzed.

Price multiples based on EBITDA, not net earnings. Why?***

***NOTES 11.11.10

Factors positively impacting PV:

Lower discount rate Magnitude of cash flows higher

Timing of cash flows closer they are, higher PV

ARISA fiduciary based


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Jamies Class Notes from Sept. 9th, 2010

History of the profession:

o Item and time as long as we have currency, we need accounting. Ill buy X and you now and pay you for it in 2

weeks for an exchange of a different currencyneed to figure out how to manage exchanges of items (currency,

products, money, etc.) and time. Need a way to keep track of exchanges in units of some currency. As soon as you

have trade and a trading partner to be accountable for, you need someone to count the stuff accountants =

recording trade (w/ other countries, companies, etc.)

o As trading became more complex (used to fill a ship, if it sank, etc. then you had a complete loss. Voyage goes out,

sell everything, come back with other products, and those goods are sold, pay off others and then divvy up the rest

amongst investors) and an enterprise begins to have a life beyond the original voyage, then began double entry book

keeping. Now recognizing a system that we still use today (Baccioli?, from Italy 1492).

o Industrial revolution, England and Scotland, get to the Victorian era and the emergence of the private pools of private

capital that supplied the capital for the huge industrial projects (canals, mines, toll roads, and rail roads) that sparked

the industrial revolution (these 4 demanded a lot of capital) and needed investors. Now need a way to keep track of all

of this on an ongoing basis because shareholders will want to be deemed out, have dividends, have to have a good

ledger, have to know who the shareholders are. The corporations of the day adopted in the later part of the first half,

sets of financial statements that would be comprehendible today. Continuity of principles going back to 19th century

England and even to Baccioli. To inform management, shareholders, and debt holders, what the position is, what the

entitlements are to participate in the benefits/ownership of those companies.

o Had auditors in the shareholder group. Have common interests and would go to the company and come back and tell

people whats going on. At that time, they thought that there was a unity, a shareholder who had an interest in the

company that you wanted scrutinizing the companys finances. The whole debate about auditor and conflict of

interests is big. In the middle of the 19th century, the job of scrutinizing the accounts became so complicated that it

would beyond the capabilities of the investors so sought out help. His research is that an Auditor was signed by

Deloitte in 1850

o With the flows of capital from London, firms expanding geographically and firms came to the US from England w/

the flow of capital so the firms we know today have their origins in London.

o Next, passed the American Securities Laws in 1933 and 1934 when have a fin..? There was lobbying for gov. audit,

because there was no legislation

o From 1930s through today. After the 2nd WW and until the mid 1980s, the delivery of assurance, audit services, was

pretty much divided amongst the large 8 accounting firms the big 8 that audited the large companies until the mid

1980s when: the tier of firms below the largest 8 began to disappear through merger and consolidation, etc. to the

point when there were really about 2 left today. And the big 8 really came down to what wee know to the 4 surviving

firms that dominate the delivery of assurance to large global companies. This has left a seriously divided structure.

The big 4 firms completely dominated the audit. Outside of the US its even tighter. Hundreds of thousands of CPAs,

but the big 4 just does most all of the large public companies. (PWC, Deloitte, KPMG and E&Y)

o Professional Standards - Accountant and auditor describe the profession


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o GAAP generally accepted accounting principles (vs. GAAS generally accepted auditing standards)

Rules by which transactions are recorded on financial statements and presented, issued by companies

(issuers) and used by usurers.

Ex. financial info needs to be provided in one currency.

Ex. Balance sheets need to balance, etc.

Need t o understand the politics in the way that it is structured.

In US they are pronounces by the FASB private body that issues the accounting principles for the

US, done at the securities exchange commission. SEC has the authority to issue accounting standards.

But for 76 years it has deferred to industry, specifically to the FASB. So there is constant dialogue

between the SEC and the FASB.

IASB international principles issued by them (international accounting standards board) quasi

private- they only become authority in a particular country when they are adopted by that country.Primary standards outside of the US.

Heads of both FASB and IASB are on their way out. Some important and subtle differences betwee

the standards so the notion of replacing the heads of the 2 at the same time could have large political

ramifications. Debate if it should be someone internal who is entrenched in the principles, etc. or

someone from outside who might do a better job keeping up the political discussions, especially

between IASB and FASB (for US only)

o GAAS gen. ace. Audit standards

Scrutiny of financial statements.

Test and scrutinize the transactions to make sure that everything was recorded properly, make sure

everyone was honest, and then report the results.

Because they are effectively the tool kit, it historically grew up on an in the field basis what was

good got shared among the firms and it was what was good practice. It later got published Public

Company Accounting Oversight Board.and Legislation:

Authority to issue auditing standards in the US (PCAOB) how to do audits, what techniques

must or should be followed, etc. came into effect in 2002. This agency pronounces the rules.

Internationally, auditing standards issued by IASB. Agency supported by the inter. Federation of

accountants.

GAAS is issued by the gov. in some countries.

o With the passage of the .law and the PCAOBwith all of the scandal, 2 years ago? SOx? The law raised

the level of obligations of corporations to sign off and report on financial statements including a requirement

to report on the system and its internal controls in the company. Since 2002 have the requirement that


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companies report on their internal controls and a requirement that the outside auditor scrutinize the company

on its own and create its own report to determine if the companys report was really reasonable. The

advocates of the legislation say look how better things are. Others say that given the last 3 years, how could

you say that were better and in any event are we asking the right question being are we better off now than

we had done 8 years ago, maybe should ask are we better off now than other changes we could have made 8

years ago.

o SOx, global in its scope because requires reporting for any company that does business in the US. So the large

companies traded, etc. are all obliged to file these reports. Part of the legislation that extends the PSOB s

oversight over the large accounting firms seems to extend to the firms operating outside the US, which is a

debate about cross-border authority. An issue not yet settled.

o Accounting firms what is interesting given their size ~$30 billion, is that they are all private enterprises w/

partners and do not have outside investors and do not publish much about financial information themselves.

Local rules and still the case from history is that owned internally by own partners. Argument: they should be

allowed to have outside investors come in to support the large accounting firms. The question you have to ask

is: why would you want that? the large accounting firms are doing very well by their partners today. If therewere a case to be made for outside ownership, outside equity would have been lobbying for it long ago if

there were room for it or if it was needed. No one can make the business argument of why that would be

good. If there were a case for it, it would have been done by now.

o State of the profession today:

Liability exposure of the accounting firms: the exposure in the US comes primarily form:

1. negligence liability (poorly performed job primarily exposed to those with whom the

firm has a privity of contract, eyeball relationship with, 3rd party known to be relying on the

firm) and

2. Statutory liability liability under the 1933 and 34 securities acts for false statements made

in connection with the purchaser of sales? That liability that underbids the securities class

actions on behalf of investors that is the nightmare against the accounting firms across the

last 40 years, any corporate fraud, etc. that affects the securities prices, the basics of the

exposure of the accounting firms are huge. And as the size of the companies and the size of

corporate frauds has skyrocketed, the size of the exposures has outrun the financial

capabilities to respond to the problems in a worse case scenario.

o Enron

o Anderson 1 billion dollar claim and that is the magnitude that an accounting firm

could withstand, but when Lehman bankruptcy was 300 + dollars, earn and young

couldnt respond to such litigation. Nightmare cases that the profession cant sustain

under.

o The accounting firm business model is not sustainable


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o Bc the financial statements are such a critical foundation block, a familiarity with this

bus. Model is imp. But the threatened nature of the model is no small thing.

o Price earnings ratio: numerator (PPS) and denominator is EPS

Criticized analytical tool today

o Financial statements are criticized for not really representing the values as

determined by analysts, etc.

o Reasons for the differences:

o Is it serving a purpose, is the profession legitimate. And what value are the auditors

contributing? Why do we spend so much money to get the auditors report.

o Are auditors today really bringing any value to prevent fraud? Where were the

auditors when todays large scandals erupt?

o What is the business model and does it serve a necessary purpose?

With all of the dialogue and the issuance of accounting principles, there is no legal safeguard for

compliance with the standards. Dont get a pass for showing that you did it just as the principles say.

So the discussion of lets get it intellectually correct, and publish the standards that make the most

sense, a necessary task to be taken to be sure, but not one that gets you anywhere in the court house!

The liability claim that says, I dont care what the standards say, this company acting with or without

the standards, made a mistake for xyz reasons, and I have a claim against them. So the disconnect is

critical.

If one of the big 4 goes out then.truly awful results. On the other hand, there is no dialogue thatgoes on today, for solutions of whats going on with the shrinkage of the auditor choices and the

structural weaknesses and the vastly exaggerated numbers for litigation. If take out one of the 4 firms,

then would take the whole structure down, it cant shrink.

o Where do you go to get financial information; 2 places:

o www.sec.gov

Search the Next-Generation EDGAR System

Company Name:

10-Q = quarterly report

8-K = filings about developments about the company that are imp. Enough that under the law they

need to be filed under the SEC (updating of material information for the market).

10-K = annual report filed directly after the end of the fiscal year by public companies in the US.
http://www.sec.gov/http://www.sec.gov/http://www.sec.gov/


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S-8 = internal stock options

Audit ex: Starbucks: commodity product (deemed imp. For compliance with security laws).

3 essential messages:

o 1. Who Deloitte is

o 2. We have audited the financial statements and we did them in accordance with the

standards of the SAOB our goal is to obtain reasonable assurance, etc.

o 3. In our opinion paragraph - presented fairly in all material respects (down to a

number that is small enough that the users are all reflected in the financial statements

so not to the cents or even hundreds of millionsbut to a material effect since the

company values are measured in the billions. The management at the company might

care about the smaller numbers, but the investment world doesnt).

o Final part is telling you whose principles are being applied (under US generallyaccepted accounted principles.

o The other option is to go to the companys own website (for investors, info for the public, etc., can find the

info there).

Lias Additional Class Notes:

Sept. 16th, 2010

Intro: Balance Sheet & IS Collectively past events, decisions and performance

Indicators of solvency, profitability and the generation of cash

Product of and responsibility of management prepared and managed by leadership (with auditor help)

Basic Accounting Conventions

Timing transactions recorded and matched to time period in which they occuro Revenue recognition when realized, not when collected

Basis recorded at values at time of transaction (matters of historical cost)

Everything always balances!

Balance Sheet Equation

ASSETS LIABILITIES = EQUITYo (or Assets = Liabilities + Equity)

Income Statement Equation

REVENUE COSTS = EARNINGS

Entries

2 entries for double-entry bookkeeping: Debit and Credit


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o Balance Sheet

Debit on left, reflects an increase of asset

Credit on right, reflects reduction in asset or increase in liability / equityo Income Statement (opposite!)

Debit on left, reflects a decrease

Credit on right, reflects an increase in inflow

Ex: WorldWide Sports Financial Statements

Balance Sheet Income Statement

Assets Liabilities Revenue

Cash Long-term Loans CostsFixed Assets AP COGSInventory Total Liabilities WagesAR Other Total Assets Equity Depreciation

Investment Interest

Retained Earnings Total CostsTotal Equity Net Earnings

Issue no decrease in Inventoryo Missing Inventory credit / COGS debit

Depreciation issue with under or over reporting if deprecation recorded as a one-time entry (functionallytreated as an expense)

o Levels out recording over items useful life

o Depreciation usually best to front-load depreciation entries into earlier years

o Options:

Straight-line

Etc. (fill in)

o Ex: item for 60, salvage value of 15, used for 3 years value of 15 / year depreciation

Dollar Denomination

Always same magnitudeo Except earnings per share

Notes: from REC, Inc.

Current Assets expected to be converted to cash within the year

Land no appreciation or depreciation

PPE look to see if company is capital-intensiveo Accumulated Depreciation (tangible assets) / Amortization (intangible) accumulated over all years

Intangible assets if allowed to be recorded (strict rules), then considered in Other Assets

o Ex: patent, copyright, etc. something accountants deem has ascertainable value

o Goodwill biggest category; requires transaction between arms-length buyer and company

Ex: if transaction is acquisition, then can record assets up to market value (on historical cashvalue accounts)

Defined as excess of what was paid in transaction over fair market value of underlying assets

Used to be amortized over a pre-set period of time; accounting rules now do not requireamortization, so long as the acquisition does NOT decrease in value


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o Could be issue: ideally want large accounts to go to depreciable assets for tax reasons

Assets indicators:

o AR: extending credit; likely B2B in some portion

o Inventory: large inventories - at least means a manufacturer, wholesaler or retailer (not services)

o Buildings and Equipment: probably a manufacturer

o Company seems to be growing organically (vs. acquisition)

Liabilities indicators:o AP: supplier credit for raw materials, paid on credit (typically for 45 days)

Good form of financing time delay with no interest (aka free credit) unless youre late

Idea of good working capital if you can turn the materials and generate revenue before payingo Notes payable / current maturities repayment required in this year (under current liabilities)

o Accrued liabilities: debts owed on free credit; e.g., wages payable; taxes payable

Stockholders Equityo Par Value and Additional Paid-in-capital: what investors have already put in your business

Only represents the value of the time the shareholders purchased shares from the company

Par Value always set to arbitrary value, often $1o Retained earnings: if net profit and no dividends, then RE

September 30th, 2010

Walmart acquiring South Africa-based Massmart

Slower / stagnating growth in US

First mover advantage into Africa (missed the boat on Brazil, never caught up)

Still low-volume, high-margin retailer

Risks:o Political risk somewhat mitigated b/c acquiring existing company, but still issue w/African nations

o 13.6 x pre-tax earnings hefty price for a retailer in a developing world, particularly for tight margins

o How going to finance?

Southwest acquiring Airtran

$1.4B cash and stock transactiono Means every Airtran shareholder will get a portion cash and a portion SW shares

o Dont know how theyll finance cash

Risks:o Processes / training programs / etc to allow for easy replication SW is notorious for a successful

business model

Pilots interchangeable, replacement parts, mechanics, etc.o Mitigating: Airtran involves more airline models (more risky), but owned by Boeing (better leverage)

MIDTERM: 2.5 3 hours available Friday through Monday

Short answer and computational, maybe a few multiple choice

SCF

Expect cash flow to be POSITIVE from operating activities major contributor is profitso Profits + Changes in Working Capital

o If negative, could be ok if one-time cash outlay, if business is growing

Expect cash flow to be NEGATIVE from investing


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o Very unlikely to be positive, unless something like liquidating PPE or converting investments / assets into

cash

Expect cash flow from financing to be:o Positive if:

o Negative if:

De-leveraging, buying back stock, paying dividendso If growth company, expect POSITIVE

Ex: Inventory how its reflected on each statement?

BS = will contain changes between years in total balance might be stable or increasing if expandingo In Current Assets, at cost value

IS = will appear as COGS

CF = will play through as operating activitieso Increase if liquidating with less refill / high sales

o Decrease if build inventory

Ex: Equity how reflected on each statement? BS = in Shareholders Equity reflects book value

IS = no impact

CF = issue stock source of cash; if repurchased stock use of cash

P/E Ratio = multiple

Price (per share currently on the market)

Earnings per share

Or as P = m x E

October 7th, 2010

REC Performance Measures

CGR compound growth rate; shows rate that would be required to change year-over-yearo Flat amount doesnt show volatility or shifts between years

o Requires 1 extra period for # of years

Resource Management / Asset Utilization Measures

Desired Method take average of balance sheet accounts

Inventory Turnover high as possibleo COGS / Inventory

AR Days low as possible; uses of casho AR / Sales per day

AP Days high as possible; interest-free debt financing

o But high could mean having trouble paying bills beginning of financial distresso AP / COGS per day

Net Working Capital as % of Revenueso Calculated for purpose of measuring efficiency

WC current assets (reduce inventories and AR) and current liabilities (reduce AP)

Net WC = CA CL

Desired to be as low as possible; excess has to be funded more expensively


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Ex: Starbucks negative; means firm has efficient use of inventory management, lots ofcheap financing through strong supplier relationships enviable position

o NWC / Revenues

***

Book Notes:

Higgins Chapter 1

Finance Principles1. A companys finances and operations are integrally connected.Depreciation: Over a period of time, a companys fixed assets are consumed, or worn out, in the creation of products.

The accountant recognizes this by continually reducing the accounting value of fixed assets and increasing thevalue of the merchandise flowing into inventory.

The company must invest part of its newly received cash in new fixed asset.Profits do not equal cash flow.

The fact that a company is profitable is no assurance that its cash flow will be sufficient to maintain solvency.Too much/long in AR or a rapid period of sales where the money is not coming to the company quick enough to replenish

cash for the expenses (need for more assets (materials)).The most important sources of information for evaluating the financial health of a company is its financial statements

(usually includes a balance sheet, income statement, and a cash flow statement)Balance Sheet: Financial snapshot in timeAssets - Liabilities = Shareholders equityShareholders equity= stockholders equity=net worth= equityIncome Statement: These are accruals This document shows how the companys operations have affected the value of

the investment/company. With the income statement you can observe the changes in owners equity into revenuesand expenses, where revenues are increases in owners equity generated by sales, and expenses are reductions inowners equity incurred to earn the revenue.

Revenue (Net Sales)- Expenses (Cost of good sold/Cost of sales-operating expense-nonoperating expenses- taxes)= Netincome/Profits

Cash Flow Statement: This document focuses on solvency, having enough cash in the bank to pay bills as the come due.The cash flow statement provides a detailed look at changes in the companys cash balance over time.

Cash flow is the movement of money into or out of a cash account over a period of time. There are 4 common types ofcash flow

Net cash flow= Net income + Noncash itemsA problem with Net cash flow as a measure of cash generation is that it implicitly assumes a businesss current assets

and liabilities are either unrelated to operations or do not change over time.Cash flow from operating activities=net cash flow + Changes in current assets and liabilitiesFree Cash Flow= Total cash available for distribution to owners and creditors after funding all worthwhile investment

activitiesFree cash flow is essentially cash flow from operating activities less capital expenditures

Discounted cash flow=A sum of money today having the same value as a future stream of cash receipts and distributions

Current Assets and LiabilitiesAssets and liabilities should be listed on the balance sheet in order of decreasing liquidity.


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Assets: Most liquid like marketable securities and AR appears at top.Liabilities: short term loans and Ap are at the top.Current liabilities and assets are the ones that are expected to turn into cash within a year, all others are called long term.Inventory is a current asset!Measuring Earnings

Accrual Accounting

First you identify the earnings for the period and then you find the corresponding costs to revenue.According to the accrual principle of accounting, revenue is recognized as soon as the effort required to generate the sale

is substantially complete and there is a reasonable certainty that payment will be received.For credit sales the accrual principle means that revenue is recognized at the time of sale, not when the customer pays.Depreciation

Release/spread the cost of the capital expense into the F/S over a period of life expectancy.When thinking about how much to depreciate one must consider the assets useful life, its salvations value, and the

method of allocation to be employed.These should be determined using economic and engineering information, experience and other objective data.Two methods of depreciatingStraight line methodAn uniform amount is depreciated each year

Accelerated depreciationMore of the capital expense is depreciated first, and then less is depreciated as the years go onTaxesMany companies keep 2 sets of books, one to report to shareholders and the companies tax books. The companies tax

books will minimize current taxes by employing the most rapid method of depreciation over the shortest usefullife the tax authorities allow.

The dual reporting means that actual cash payments to tax authorities are usually different (can be more or less) than whatappears on the shareholders version of the income statement.

Tax deferral technique effectively creates an interest free loan from the government.R&D including marketing is recorded as operating cost and fully expensed the first year (does not get depreciated)

This is because it is difficult to estimate the payoffs of the expense year to year.

A company generates cash in 2 ways: by reducing an asset or increasing a liability. A company also uses cash in 2 ways:

to increase an asset or to reduce a liability account.When an employee exercises a stock option, she owes tax on the difference between the value of the stock on the exercise

date and what is known as the option strike price, specified when the option was granted. The tax consequence forthe company are just the reverse. It is entitled to claim a tax-deductible expense for precisely the same amount eventhough it never makes a cash outlay at anytime over the life of the option.

Market Value vs. Book value

Book value= Shareholder equityBalance sheet unaccounted for Assets: patents and trademarks, loyal customers, ...trained workers.Balance sheet unaccounted for Liabilities: Pending lawsuits, inferior management....Goodwill: This is the one way that intangible assets, such as brand names and patents find their way onto company

balance sheets. Thisis defined when one company buys another company at a price above its book value.A realized income is once the asset is sold and turned into cash, like when you sell a stock.

The value problemAccounting statements suffer from several limitations when used to assess economic performance or business value.Many accounting values are transactions based and hence backward looking, while market values are forward looking.Accounting often creates a false dichotomy between realized and unrealized incomeAccountants refuse to assign a cost to equity capital, thereby suggesting that positive accounting profit means financial

health

Chapter 2

Notes:


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One or even several ratios might be misleading, but when combined with other knowledge of a companys managementand economic circumstances, ratio analysis can tell a revealing story.

Many of the ratios can be distorted for seasonal sales. Seasonal sales can distort AR.Capital Intensive=Companies that require large investments in long lived assets to produce their goods and thus especially

sensitive to the state of the economy.Most of their costs are fixed

Auto manufacturers and airlinesThe term Grossing up tends to mean the amount before taxesMarket values are forward looking while book values look at historical figures.Market values are based on investors expectation about future cash flows.Market values ratios are especially helpful when assessing the financial leverage of rapidly growing, start up businesses.

Even when such companies have terrible coverage ratios, lenders may still extend them credit is they believefuture cash flow will be sufficient to service the debt.

Common size financial statements: The purpose of scaling financial statements is to concentrate on underlying trends byabstracting from changes in the dollar figures caused by growth and decline. It is also useful when comparingcompanies of different sizes.

A common size balance sheet presents each asset and liability as a % of total assetsA common size income statement, all items are scaled in proportion to net sales.

Responses to US accounting breakdown.The passage of the Sarbanes-Oxley Act 2002 requires the chief executive officers and chief financial officers to personally

attest to the appropriateness, fairness, and accuracy of their companys financial reports.There has been some express growing enthusiasm for the European, broad-brush approach, and to promote the possibility

of increased international cooperationHow do you decide if a company is healthy or sick?

Compare the ratios to rules of thumb, compare them to industry averages, or the most useful, look for changes in the ratiosover time.

Return on Equity (ROE)=(Net income/Shareholders equity)=(profit margin)x(asset turnover)x(financial leverage)

Net Income = Profits = Earnings

This is done as a % (profit as a % from money provided by owners)**Not necessarily good if ROE is increased by financial leverage. No one should automatically assume a higher ROE is

always better than a lower one.ROE suffers from three critical deficiencies as a measure of financial performance, the timing, risk, and value problems.Timing Problem= It is not forward looking, instead it is backwards looking for a single year. So if you have a lot of costs

such as a new product cost or start up cost, this will skew the ratio.The Risk Problem= The ROE says nothing about what risks a company has taken to generate it.Look to ROICThe Value Problem= ROE measures the return on stockholders investment; however, the investment figure used is the

book value of the shareholders equity, not the market value.The market value of equity is more significant to shareholder because it measures the current, realizable worth of the

shares, while book value is only history. So even when ROE measures managements financial performance, itmay not be synonymous with a high return on investment to shareholders. Thus, it is not enough for investorsto find companies capable of generating high ROEs; these companies must be unknown to others, becauseonce they are known, the possibility of high returns to investors will melt away in higher stock prices.

This is a measure of efficiency with which a company employs owners capital.It is a measure of earnings per dollar invested equity capital or the % return to owners on their investmentThis reflects the companys pricing strategy and ability to control operating costs.More ROE, the better, but increase in competition will decrease ROE.The more asset turn over the betterProfit Margin= (Net income/sales)

Presented as a %This summarizes a companys income statement performance by showing profit per dollar of sales. In other words the

fraction of each dollar of sales that show up as profit on the income statement.


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Companies with high profit margins tend to have lower asset turnovers (as price increases, you dont need to sell asmuch). More value the company adds to the product, usually the higher the profit margin.

Affected by changes in gross margin, tax rate, and % income statement pg. 63Asset Turnover= (Sales/Assets)

Presented as (# of times)This summarizes the companys management of the asset side of its balance sheet by showing the resources required to

support sales.Companies with high asset turn over tend to have lower profit marginsIf the turn over is 1.3, it means that $1.30 in sales was generated for each $1 of investment.Low asset turnover signifies an asset intensive businessesEffected by Days sales in cash, Collection period, inventory turnover, fix asset turnover, % balance sheet. pg 63Inventory Turnover= (Cost of goods sold)/(ending inventory)

Presented as (# of times)(365/(Inventory turnover))=(# days it takes for a single turnover)

Financial leverage=debt capacity= (Assets / Shareholders equity)

Presented as (# of times)This summarizes management of the liabilities side of the balance sheet by showing the amount of shareholders equity

used to finance the assets.

Companies with low ROAs generally employ more debt financing and vice versa.Financial leverage can be very useful when dealing with safe, stable, liquid assets such as banks.A company increase its financial leverage when it raises the proportion of debt relative to equity used to finance the

business.**Financial leverage is not something management necessarily wants to maximize, even when doing so increases ROE.

Instead, the challenge of financial leverage is to strike a prudent balance between the benefits and costs of debtfinancing.

In general, businesses with highly predictable and stable operating cash flows, such as Florida Power and Light, can safelyundertake more financial leverage than firms facing a high degree of market uncertainty, such as Netflix.

Note: The financial burden a company faces by using debt financing ultimately depends not on the size of its liabilitiesrelative to assets or the equity, but its ability to meet the annual cash payments the debt requires.

Effected by Payable period, Debt to assets, times interest earned, times burden covered, current ratio, acid test. pg 63

Return of Assets(ROA)= Profit Margins x Asset turnover=Net income/AssetsPresented as a % (It is profit as a % of money provided by owners and creditors)This determines $/asset. In other words if the calculation comes out to 5%, then that

mid-term outline - lmfg v4

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