INTERVIEW

What is exactly this interview?

In your material you will learn a great deal about financial management

I have found that if the students find a financial manager who practices this material it adds great value to the student

 

 

Please find a person who you can interview 

Use the material in the chapters and craft at least five questions and arrange time with the person.

Please write and submit at least a five page paper.

 

You can interview someone out side of the organization or inside your organization

 

A sample question you would want to ask:

 

1) In our class we learned about financial ratios. How do you use these in your business and if you currently do not then have you used them before and how do they help you manage the business better?

 

The goal of this paper is to allow you to show some of the techniques in the class and interview a current financial manager

 

Please make this a paper and not a series of questions 

 

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Goals and Functions of Financial Management
1

Chapter Outline
Introduction to Finance
Risk-Return Tradeoff
Forms of Organizations
Corporate Governance
Goals of Financial Management
Social Responsibility and Finance
Role of Financial Markets

Financial Management
Financial Management or business finance is concerned with managing an entity’s money.
For example, a company must decide:
where to invest its money.
whether or not to replace an old asset.
when to issue new stocks and bonds.
whether or not to pay dividends.

Relationship between Finance, Economics and Accounting
Economics provides structure for decision making in many important areas.
Provides a broad picture of economic environment.
Accounting provides financial data in various forms.
Income statements, balance sheets, and statement of cashflows.
Finance links economic theory with the numbers of accounting.

Evolution in the Field of Finance
At the turn of the century: Emerged as a field separate from economics.
By 1930s: Financial practices revolved around such topics as:
Preservation of capital.
Maintenance of liquidity.
Reorganization of financially troubled corporation.
Bankruptcy.

Evolution in the Field of Finance (cont’d)
By mid-1950s: Finance becomes more analytical.
Financial Capital (accounting capital/ money) was used to purchase Real Capital (economic capital/ long-term plant and equipment).
Cash and inventory management
Capital structure theory
Dividend policy

Recent Issues in Finance
Recent focus has been on:
Risk-return relationships.
Maximization of returns for a given level of risk.
Portfolio management.
Capital structure theory.
New financial products with a focus on hedging are being widely used.

Recent Issues in Finance (cont’d)
The following are significant to financial managers during decision making:
Effects of inflation and disinflation on financial forecasting.
Required rates of return for capital budgeting decisions.
Cost of capital.

Advances in Internet and Finance
Internet and its acceptance has enabled acceleration of e-commerce solutions for “old economy” companies.
E-commerce solutions for existing companies
B2C
B2B
Spurt in new business models and companies
Amazon.com
eBay

Advances in Internet and Finance (cont’d)
For a financial manager e-commerce impacts financial management because it affects the pattern and field through which cash flows through the firm.
B2C Model: Products are bought with credit cards, credit card checks are performed, and selling firms get the cash flow faster.
B2B: Orders can be placed, inventory managed, and bids to supply products can be accepted –all online.

Functions of the Financial Manager

Risk-Return Trade-Off
Influences operational side (capital versus labor/ Product A versus Product B)
Influences financial mix (stocks versus bonds versus retained earnings)
Stocks are more profitable but riskier.
Savings accounts are less profitable and less risky (or safer)
Financial manager must choose appropriate combinations

Sole Proprietorship
Represents single-person ownership
Advantages:
Simplicity of decision-making.
Low organizational and operational costs.
Drawback
Unlimited liability to the owner.
Profits and losses are taxed as though they belong to the individual owner.

Partnership
Similar to sole proprietorship except there are two or more owners.
Articles of partnership: Specifies ownership interest, the methods for distributing profits, and the means of withdrawing from the partnership.
Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution.

Corporation
Corporation
Articles of incorporation: Specify the rights and limitations of the entity.
Its owned by shareholders who enjoy the privilege of limited liability.
Has a continual life.
Key feature is the easy divisibility of ownership interest by issuing shares of stock.

Corporation (cont’d)
Disadvantage:
The potential of double taxation of earnings.
Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.

Corporate Governance
Agency theory
Examines the relationship between the owners and managers of the firm.
Institutional investors
Have more to say about the way publicly owned companies are managed.
Public Company Accounting Oversight Board (PCAOB)

Sarbanes-Oxley Act of 2002
Set up a five member Public Company Accounting Oversight Board (PCAOB) with responsibility for:
Auditing standards within companies
Controlling the quality of audits
Setting rules and standards for the independence of the auditors.
Major focus is to make sure that publicly-traded corporations accurately present their assets, liabilities, and equity and income on their financial statements.

Goals of Financial Management
Valuation Approach
Maximizing shareholder wealth (shareholder wealth maximization)
Management and stockholder wealth
Retention of position of power in long run is by becoming sensitized to shareholder concerns.
Sufficient stock option incentives to motivate achievement of market value maximization.
Powerful institutional investors are increasing management more responsive to shareholders.

Social Responsibility
Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society.
Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms.

Ethical Behavior
Ethical behavior creates invaluable reputation.
Insider trading
Protected against by the Securities and Exchange Commission (SEC).

The Role of Financial Markets
Financial markets are indicators of maximization of shareholder value and the ethical or the unethical behavior that may influence the value of the company.
Participants in the financial market range over the public, private and government institutions.
Public financial markets
Corporate financial markets

Structure and Functions of the Financial Markets
Money markets
Securities in this market include commercial paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.
Capital markets
Long-term markets
Securities include common stock, preferred stock and corporate and government bonds.

Stocks versus Bonds
Stock = ownership or equity
Stockholders own the company

Bond = debt or IOU
Bondholders are owed $ by company

Allocation of Capital
Primary market
When a corporation uses the financial markets to raise new funds, the sale of securities is made by way of a new issue.
Secondary market
When the securities are sold to the public (institutions and individuals).
Financial managers are given a feedback about their firms’ performance.

Return Maximization and Risk Minimization
Investors can choose risk level that meets their objective and maximizes return for that given level of risk.
Companies that are rewarded with high-priced securities can raise new funds in the money and capital markets at a lower cost compared to competitors.
Firms pay a penalty for failing to perform competitively.

Restructuring
Restructuring can result in:
Changes in the capital structure (liabilities and equity on the balance sheet).
Selling of low-profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities.
Removal or large reductions in the of current management team.
It has resulted in acquisitions and mergers.

Internationalization of Financial Markets
Allocation of capital and the search for low cost sources of financing on the rise in global market.
The impact of international affairs and technology has resulted in the need for future financial managers to understand
International capital flows.
Computerized electronic funds transfer systems.
Foreign currency hedging strategies.

Technological Impact on Capital Market
Consolidation among major stock markets and mergers of brokerage firms with domestic and international partners.
Electronic markets have gained popularity as against traditional organized exchanges and NASDAQ.
Resulted in the merger of NYSE with Archipelago and NASDAQ bought out Insinet from Reuters.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Sources of Short-Term Financing
8

Chapter Outline
Trade credit from suppliers.
Bank loans.
Commercial paper.
Borrowing in foreign markets.
Using collaterals like accounts receivable and inventory for larger loans.

Financing Arrangements
Lines of credit are sometimes referred to as a revolving credit facility where interest cost:
Is based on LIBOR (the London Interbank Offering Rate)
Is based on the company’s senior unsecured credit rating – a percentage margin.
Primary aim of the borrowing firms:
Minimize cost.

Trade Credit
40 percent of short-term financing is in the form of accounts payable or trade credit.
Accounts payable
Spontaneous source of funds.
Growing as the business expands.
Contracting when business declines.

Payment Period
Trade credit is usually extended for 30-60 days.
Extending the payment period to an unacceptable period results in:
Alienate suppliers.
Diminished ratings with credit bureaus.
Major variable in determining the payment period:
The possible existence of a cash discount.

Cash Discount Policy
Allows reduction in price if payment is made within a specified time period.
Example: A 2/10, net 30 cash discount means:
Reduction of 2% if funds are remitted 10 days after billing.
Failure to do so means full payment of amount by the 30th day.

Net-Credit Position
Determined by examining the difference between accounts receivable and accounts payable.
It is positive if accounts receivable is greater than accounts payable and vice versa.
Larger firms tend to be net providers of trade credit (relatively high receivables).
Smaller firms in the relatively user position (relatively high payables).

Bank Credit
Provide self-liquidating loans
Use of funds ensures a built-in or automatic repayment scheme.
Changes in the banking sector today:
Centered around the concept of ‘full service banking’.
Expanded internationally to accommodate world trade and international corporations.
Deregulation has created greater competition among other financial institutions.

Prime Rate and LIBOR
Prime rate
Rate a bank charges to its most creditworthy customers.
Increases as a customer’s credit risk increases.
LIBOR (London Interbank Offered Rate)
Rate offered to companies:
Having an international presence.
Ability to use the London Eurodollar market for loans.

Prime Rate versus LIBOR on U.S. Dollar Deposits

Compensating Balances
A fee charged by the bank for services rendered or an average minimum account balance.
When interest rates are lower, the compensating balance rises.
Required account balance computed on the basis of:
Percentage of customer loans outstanding.
Percentage of bank commitments towards future loans to a given account.

Compensating Balances – Example
If one needs $100,000 in funds, he/ she must borrow $125,000 to ensure the intended amount will be available. This would be calculated as:
Amount to be borrowed = Amount needed
(1 – c)
= $100,000
(1 – 0.2)
= $125,000
Where ‘c’ is the compensating balance expressed as a decimal.

To check on this calculation, the following can be done:
$125,000 Loan
– 25,000 20% compensating balance requirement
$100,000 Available funds

Maturity Provisions
Term loan
Credit is extended for one to seven years.
Loan is usually repaid in monthly or quarterly installments.
Only superior credit applicants, qualify.
Interest rate fluctuates with market conditions.
Interest rate may be tied to the prime rate or LIBOR.

Cost of Commercial Bank Financing
Effective interest on a loan is based on the:
Loan amount.
Dollar interest paid.
Length of the loan.
Method of repayment.
Discounted loan – interest is deducted in advance – effective rate increases.

Effective rate = Interest X Days in the year (360)
Principal Days loan is outstanding

Interest Costs with Compensating Balances
Assuming that 6% is the stated annual rate and that 20% compensating balance is required;

Effective rate with = Interest
compensating balances (1 – c)
= 6% = 7.5%
(1 – 0.2)
When dollar amounts are used and the stated rate is not known, the following can be used for computation:
Days in a
Effective rate with = Interest X year (360)
compensating balances Principal – Compensating Days loan is
balance in dollars outstanding

Rate on Installment Loans
Installment loans require a series of equal payments over the period of the loan.
Federal legislation prohibits a misrepresentation of interest rates, however this may be misused.

Annual Percentage Rate
Truth in Lending Act of 1968 requires the actual APR to be given to the borrower.
Annual percentage rule:
Protects unwary consumer from paying more than the stated rate.
Requires the use of the actuarial method of compounded interest during computation.
Lender must calculate interest for the period on the outstanding loan balance at the beginning of the period.
It is based on the assumptions of amortization.

The Credit Crunch Phenomenon
The Federal Reserve tightens the growth in the money supply to combat inflation – the affect:
Decrease in funds to be lent and an increase in interest rates.
Increase in demand for funds to carry inflation-laden inventory and receivables.
Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns.

The Credit Crunch Phenomenon (cont’d)
Credit conditions can change dramatically and suddenly due to:
Unexpected defaults.
Economic recessions.
Other economic setbacks.

Financing Through Commercial Paper
Short-term, unsecured promissory notes issued to the public.
Finance paper/ direct paper
Sold by financial firms, directly to the lender.
Dealer paper
Sold by industrial companies, use of intermediate dealer network for its distribution.
Book-entry transactions
Computerized handling of commercial paper, where no actual certificate is created.

Total Commercial Paper Outstanding

Advantages of Commercial Paper
Fuelled by the rapid growth of money-market mutual funds, and their need for short-term securities for investments.
No associated compensating balance requirements.
Associated prestige for the firm to float their paper in an elite market.

Comparison of Commercial Paper Rate to Prime Rate (annual rate)

Limitations on the Issuance of Commercial Paper
Many lenders have become risk-averse post a multitude of bankruptcies.
Firms with downgraded credit rating do not have access to this market.
The funds generation associated with this is less predictable.
Lacks the degree of commitment and loyalty associated with bank loans.

Foreign Borrowing
Eurodollar loan
Denominated in dollars and made by foreign bank holding dollar deposits.
Short-term to intermediate terms in maturity.
LIBOR is the base interest paid on loans for companies of the highest quality.
One approach – borrow from international banks in foreign currency.
Borrowing firm may suffer currency risk.

Use of Collateral in Short-Term Financing
Secured credit arrangement when:
Credit rating of the borrower is too low.
Need for funds is very high.
Primary concern – whether the borrower can generate enough cash flow to liquidate the loan when due.
Uniform Commercial Code: standardizes and simplifies the procedures for establishing security against a loan.

Accounts Receivable Financing
Includes:
Pledging accounts receivables.
Factoring or an outright sale of receivables.
Advantage:
Permits borrowing to be tied directly to the level of asset expansion at any point of time.
Disadvantage:
Relatively expensive method of acquiring funds.

Pledging Accounts Receivables
Lending firm decides on the receivables that it will use as a collateral.
Loan percentage depends on the firms:
The financial strength.
The creditworthiness.
Interest rate is well above the prime rate.
Computed against the balance outstanding.

Factoring Receivables
Receivables are sold outright to the finance company.
Factoring firms do not have recourse against the seller of the receivables.
Finance companies may do all or part of the credit analysis.
To determine and ensure the quality of the accounts.
Factoring firm is:
Absorbing risk – for which a fee is collected
Actually advancing funds to the seller – paid a lending rate.

Factoring Receivables – Example
If $100,000 a month is processed at a 1% commission, and a 12% annual borrowing rate, the total effective cost is computed on an annual basis.
1%……Commission
1%……Interest for one month (12% annual/12)
2%……Total fee monthly
2%……Monthly X 12 = 24% annual rate.
The rate may not be considered high due to factors of risk transfer, as well as early receipt of funds.
It also allows the firm to pass on mush of the credit-checking cost to the factor.

Asset Backed Public Offering
There is an increasing trend in public offerings of security backed by receivables as collateral.
Interest paid to the owners is tax free.
Advantages to the firm:
Immediate cash flow.
High credit rating of AA or better.
Provides – corporate liquidity, short-term financing.
Disadvantage to the buyer:
Risk associated – receivables actually being paid.

Inventory Financing
Factors influencing use of inventory:
Marketability of the pledged goods.
Associated price stability.
Perish-ability of the product.
Degree of physical control that the lender can exercise over the product.

Stages of Production
Stages of production
Raw materials and finished goods usually provide the best collateral.
Goods in process may qualify only a small percentage of the loan.

Nature of Lender Control
Provides greater assurance to the lender but higher administrative costs.
Types of Arrangements:
Blanket inventory liens: Lender has a general claim against inventory.
Trust receipts (floor planning) an instrument – the proceeds from sales go to the lender.
Warehousing a receipt issue – goods can be moved only with the lender’s approval.
Public warehousing.
Field warehousing.

Appraisal of Inventory Control Devices
Well-maintained control measures involves:
Substantial administrative expenses.
Raise overall cost of borrowing.
Extension of funds is well synchronized with needs.

Hedging to Reduce Borrowing Risk
Engaging in a transaction that partially or fully reduces a prior risk exposure.
The financial futures market:
Allows the trading of a financial instrument at a future point in time.
No physical delivery of goods.

Hedging to Reduce Borrowing Risk (cont’d)
In selling a Treasury bond futures contract, the subsequent pattern of interest rates determine if it is profitable or not.

Sales price, June 2006 Treasury
bond contract* (sale occurs in January 2006.)……………$100,000
Purchase price, June 2006 Treasury
bond contract (purchase occurs in June 2006)…………….$95,000
Profit on futures contract………….…………………………….$5,000
* Only a small percentage of the actual dollars involved must be invested to initiate the contract. This is known as the margin.

Hedging to Reduce Borrowing Risk (cont’d)
If interest rates increase:
The extra cost of borrowing money to finance the business can be offset by the profit of the futures contract.
If interest rates decrease:
A loss is garnered on the futures contract as the bond prices rise.
This is offset by the lower borrowing costs of the financing firm.
The purchase price of the futures contract is established at the time of the initial purchase transaction.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Time Value of Money
9

Chapter Outline
Time value associated with money.
Future and present value of a dollar.
Tables for future and present values and their need in computations.
Determination of yield.

Relationship to the Capital Outlay Decision
Capital allocation or budgeting is required for:
Purchase of new plant or equipment
The introduction of a new product line.
Determine whether the future benefits are sufficiently large to justify the current outlay.
Mathematical tools help in making capital allocation decisions.

Future Value – Single Amount
Measuring the value of an amount that is allowed to grow at a given interest over a period of time is necessary.
Assuming that the worth of $1,000 needs to be calculated after 4 years at a 10% interest per year, we have:
1st year……$1,000 X 1.10 = $1,000 2nd year……$1,000 X 1.10 = $1,210 3rd year……$1,210 X 1.10 = $1,331 4th year……$1,331 X 1.10 = $1,464

Future Value – Single Amount (cont’d)
A generalized formula is:
Where
FV = Future value
PV = Present value
i = Interest rate
n = Number of periods;
In the previous case, PV = $1,000, i = 10%, n = 4, hence;

Future Value of $1

Future Value – Single Amount (cont’d)
In determining future value, the following can be used:

Where, = The interest factor.

If $10,000 were invested for 10 years at 8%, the future value, would be:

Present Value – Single Amount
A sum payable in the future is worth less today than the stated amount.
The formula for the present value is derived from the original formula for future value:

The present value can be determined by solving for a mathematical solution to the formula above, thus restating the formula as:
Assuming;

Present Value of $1

Relationship of Present and Future Value

Future Value – Annuity
A series of consecutive payments or receipts of equal amount.
The future value of each payment can be totaled to find the future value of an annuity.
Assuming, A = $1,000, n = 4 and i = 10%.

Future Value of an Annuity of $1

Compounding Process for Annuity

Present Value – Annuity
Calculated by discounting each individual payment back to the present and then all of the these payments are added up.
Assuming that A = $1,000, n = 4, i = 10%, we have:

Presentation of Time Value Relationship
Requires various comparison which include:
The relationship between present value and future value.
The relationship between the present value of a single amount and the present value of an annuity.
Future value related to future value of annuity.

Annuity Equaling a Future Value
Assuming that at a 10% interest rate, after 4 years, an $4,641 needs to accumulated:

For n = 4, and i = 10%, is 4.641. This A equals $1,000.

Annuity Equaling a Present Value
Determining what size annuity can be equated to a given amount:

Assuming n = 4, i = 6%;

Relationship of Present Value to Annuity

Annuity Equaling a Present Value (cont’d)
Determining the necessary repayments on a loan:

Assuming n 20, i = 8%,

Total payments ($4,074 for 20 years)……………..$81,480
Repayment of principal…………………………….– 40,000
Payments applied to interest……………………….$41,480

Payoff Table for Loan (amortization- table)

Review

Yield – Present Value of a Single Amount
To calculate the yield on an investment producing $1,464 after 4 years having a present value of $1,000;

We see that for n = 4 and = 0.683, the interest rate or yield is 10%.

Yield – Present Value of a Single Amount (cont’d)
Interpolation may also be used to find a more precise answer.

Difference between the value at the lowest interest rate and the designated value.

The exact value can be determined thus:

Yield – Present Value of an Annuity
To calculate the yield on an investment of $10,000, producing $1,490 per annum for 10 years;

Hence;

Special Considerations in Time Value Analysis
Certain contractual agreements may require semiannual, quarterly, or monthly compounding periods.
In such cases, to determine n, multiply the number of years by the number of compounding periods during the year.
The factor of i is determined by dividing the quoted annual interest rate by the number of compounding periods.

Cases
Case 1: Determine the future value of a $1,000 investment after 5 years at 8% annual interest compounded semiannually.
Where, n = 5 X 2 = 10; i = 8% / 2 = 4%

Case 2: Determine the present value of 20 quarterly payments of $2,000 each to be received over the next 5 years, where i = 8% per annum.
Where, n = 20; i = 20%

Patterns of Payment
Time value of money evolves around a number of different payment or receipt patterns.
Assume, a contract involving payments of different amounts each year for a three year period.
To determine the present value, each payment is discounted to the present and then totaled;
(Assume 8% discount rate)

Deferred Annuity
Assume, a contract involving payments of different amounts each year for a three year period.
An annuity of $1,000 is paid at the end of each year from the fourth through the eighth year.
To determine the present values of the cash flows at 8% discount rate;

To determine the annuity;

Deferred Annuity (cont’d)

To discount the $3,993 back to the present, which falls at the beginning of the fourth period, in effect, the equivalent of the end of the third period, it is discounted back three periods, at 8% interest rate.

Deferred Annuity (cont’d)

Alternate Method to Compute Deferred Annuity
Determine the present value factor of an annuity for the total time period, where n = 8, i = 8%, = 5.747
Determine the present value factor of an annuity for the total time period (8) minus the deferred annuity period (5). Here, 8 – 5 = 3; n = 3; i = 8%. Thus the value is 2.577.
Subtracting the value in step 2 from the value of step 1, and multiplying by A;

Alternate Method to Compute Deferred Annuity (cont’d)
$3,170 is the same answer for the present value of the annuity as that reached by the first method.
The present value of the five-year annuity is added up to the present value of the inflows over the first three years to arrive at:

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Current Asset Management
7

Chapter Outline
What is current asset management?
Cash management and its importance.
Management of marketable securities.
Accounts receivable and inventory management.
Liquidity vis-à-vis returns.

What is Current Asset Management?
Involves the management of cash, marketable securities, accounts receivable, and inventory.
Ensures a competitive advantage and often creates an increase in shareholder value.
Primarily concerned with liquidity and safety, and then on maximizing profits.

Cash Management
Financial managers actively attempt to keep cash (non-earning asset) to a minimum.
It is critical to have sufficient cash to assuage emergencies.
Steps to improve overall profitability of a firm:
Minimize cash balances.
Have accurate knowledge of when cash moves in and out of the firm.

Reasons for Holding Cash Balances
Transactions balances
Payments towards planned expenses.
Compensative balances for banks
Compensate a bank for services provided rather than paying directly for them.
Precautionary needs
Emergency purposes.

Cash Flow Cycle
Ensure that cash inflows and outflows are synchronized for transaction purposes.
Cash budgets is a tool used to track cash flows and ensuing balances.
Cash flow relies on:
Payment pattern of customers.
Speed at which suppliers and creditors process checks.
Efficiency of the banking system.

Cash Flow Cycle (cont’d)
Cash-generating process is continuous although the cash flow may be unpredictable and uneven.
Cash inflows are driven by sales and influenced by:
Type of customers.
Customers’ geographical location.
Product being sold.
Industry.

Expanded Cash Flow Cycle

E-commerce and Sales
Benefits: faster cash flow.
Credit card companies advance cash to the retailer within 7-10 days against retailer’s with a 30 day payment terms.
Financial managers must pay close attention to the percentage of sales generated:
By cash.
By outside credit cards.
By the company’s own credit terms.

Outcome of Extra Cash
Account receivable is collected or the credit card company advances payment.
Used for various payments such as interest to lenders, dividends to stockholders, taxes to the government etc.
Used to invest in marketable securities.
Therefore when there is a need for cash a firm can:
Sell the marketable securities.
Borrow funds from short-term lenders.

Collections and Disbursements
Primary concern to the financial manager is the management of:
Cash inflows – still affected by collection mechanisms.
Payment outflow.

Float
Difference between firm’s recorded amount and amount credited to the firm by a bank.
Arises due to time delays in mailing, processing and clearing checks through the banking system.
Can be managed to some extent by combining disbursements and collection strategies.
Main challenge: the physical presentation of the check to the issuing bank.

Float (cont’d)
Check Clearing for the 21st Century Act (Check 21)
Allows banks and others to electronically process a check.
Factors that help in reducing float:
Ease of credit and debit cards payments and on-line banking for customers.
Wire transfers for corporations.
Rise of Internet commerce.

Use of Float – Day one

Use of Float – Day two

Improving Collections
Setting up multiple collection centers at different locations.
Adopt lockbox system for expeditious check clearance at lower costs.

Extending Disbursements
General trend:
Speed up processing of incoming checks.
Slow down payment procedures.
Extended disbursement float – allows companies to hold onto their cash balances for as long as possible.

Cost-Benefit Analysis
Allows companies to analyze the benefits, received by investing on an efficiently maintained cash management program.

Cash Management Network

Electronic Funds Transfer
Funds are moved between computer terminals without the use of a ‘check’.
Automated clearinghouses (ACH)
Transfers information between financial institutions and between accounts using computer tape.
Central clearing facilities include:
National Automated Clearinghouse Association (NACHA)
Federal Reserve system
Electronic Payment Network
VISA

International Electronic Funds Transfer
Carried out through Society for Worldwide Interbank Financial Telecommunications (SWIFT).
Uses a proprietary secure messaging system.
Each message is encrypted.
Every money transaction is authenticated by a code, using smart card technology.
Assumes financial liability for the accuracy, completeness, and confidentiality of transaction.

International Cash Management
Factors differentiating international cash management from domestic based systems:
Differing payment methods and/or higher popularity of electronic funds transfer.
Subject to international boundaries, time zone differences, currency fluctuations, and interest rate changes.
Differing banking systems, and check clearing processes.
Differing account balance management, and information reporting systems.
Cultural, tax, and accounting differences.

International Cash Management (cont’d)
Financial managers try to keep as much cash as possible in a country with a strong currency and vice versa.
Sweep account:
Allows companies to maintain zero balances.
Excess cash is swept into an interest-earning account.

An Examination of Yield and Maturity Characteristics
Marketable securities

Types of Short-Term Investments

Management of Accounts Receivable
Accounts receivable as an investment.
Should be based on the level of return earned equals or exceeds the potential gain from other investments.
Credit policy administration
Credit standards
Terms of trade
Collection policy

Credit Standards
Determine the nature of credit risk based on:
Prior records of payments and financial stability
Current net worth and other related factors
5 Cs of credit:
Character
Capital
Capacity
Conditions
Collateral

Dun and Bradstreet Report – An Example

Terms of Trade
Stated term of credit extension:
Has a strong impact on the eventual size of accounts receivable balance.
Creates a need for firms to consider the use of cash discounts.

Collection Policy
A number if quantitative measures applied to asses credit policy.
Average collection period

Ratio of bad debts to credit sales
Aging of accounts receivable

An Actual Credit Decision
Accounts receivable = Sales = $10,000 = $1,667
Turnover 6

Brings together various elements of accounts receivable management.

Inventory Management
Inventory has three basic categories:
Raw materials used in the product
Work in progress, which reflects partially finished products
Finished goods, which are ready for sale.
Amount of inventory is affected by sales, production, and economic conditions.
Inventory is the least of liquid assets – should provide the highest yield.

Level versus Seasonal Production
Level production
Maximum efficiency in manpower and machinery usage.
May result in high inventory buildup.
Seasonal production
Eliminates inventory buildup problems.
May result in unused capacity during slack periods.
May result in overtime labor charges and overused equipment repair charges.

Inventory Policy in Inflation and Deflation
Inventory position can be protected in an environment of price instability by:
Taking moderate inventory positions (by not committing at a single price).
Hedging with a futures contract to sell at a stipulated price some months from now.
Rapid price movements in inventory may also have a major impact on the reported income of the firm.

The Inventory Decision Model
Carrying costs
Interest on funds tied up in inventory.
Cost of warehouse space, insurance premiums and material handling expenses.
Implicit cost associated with the risk of obsolescence and perish-ability.
Ordering costs
Cost of ordering.
Cost of processing inventory into stock.

Determining the Optimum Inventory Level

Economic Ordering Quantity
EOQ = 2SO ;
C
Where,
S = Total sales in units
O = Ordering cost for each order
C = Carrying cost per unit in dollars;
Assuming:
EOQ = 2SO = 2 X 2,000 X $8U = $32,000 = 160,000
C $0.20 $0.20
= 400 units

Inventory Usage Pattern

Safety Stocks and Stock Outs
Stock out occurs when a firm is:
Out of a specific inventory item.
Unable to sell or deliver the product.
Safety stock reduces such risks.
Increases cost of inventory due to a rise in carrying costs.
This cost should be offset by:
Eliminating lost profits due to stock outs
Increased profits from unexpected orders.

Safety Stocks and Stock Outs (cont’d)
Assuming that;

Average inventory = EOQ + Safety stock
2
Average inventory = 400 + 50
2
The inventory carrying costs will now increase by $50.
Carrying costs = Average inventory in units X Carrying cost per unit
= 250 X $0.20 = $50.

Just-in-Time Inventory Management
Basic requirements for JIT:
Quality production that continually satisfies customer requirements.
Close ties between suppliers, manufactures, and customers.
Minimization of the level of inventory.
Cost Savings from lower inventory:
On average, JIT has reduced inventory to sales ratio by 10% over the last decade.

Advantages of JIT
Reduction in space due to reduced warehouse space requirement.
Reduced construction and overhead expenses for utilities and manpower.
Better technology with the development of electronic data interchange systems (EDI).
EDI reduces re-keying errors and duplication of forms.
Reduction in costs from quality control.
Elimination of waste.

Areas of Concern for JIT
Integration costs.
Parts shortages could lead to lost sales, and slow, growth.
Un-forecasted increase in sales:
Inability to keep up with demand.
Un-forecasted decrease in sales:
Inventory can pile up.
A revaluation may be needed in high-growth industries fostering dynamic technologies.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Working Capital and the Financing Decision
6

Chapter Outline
Working capital management.
Current asset management.
Asset financing.
Long-term versus short-term financing.
Risk and profitability vis-à-vis asset financing.

Working Capital Management
The financing and management of the current assets of a firm.
Crucial to achieving long-term objectives of the firm or its failure.
Requires immediate action.

The Nature of Asset Growth
Effective current assets management requires matching of the forecasted sales and production schedules.
Differences in actual sales and forecasted sales can result in:
Unexpected buildups.
Reduction in inventory, affecting receivables and cash flow.
Firm’s current assets could be:
Self-liquidating.
‘Permanent’ current assets.

The Nature of Asset Growth (cont’d)

Controlling Assets – Matching Sales and Production
Fixed assets grow slowly with:
Increase in productive capacity.
Replacement of old equipment.
Current assets fluctuate in the short run, depending on:
Level of production versus the level of sales.
When production is higher than sales the inventory rises.
When sales are higher than production, inventory declines and receivables increase.

Controlling Assets – Matching Sales and Production (cont’d)
Cash budgeting process
Level production method
Smooth production schedules
Use of manpower and equipment efficiently to lower cost
Match sales and production as closely as possible in the short run.
Allows current assets to increase or decrease with the level of sales.
Eliminates the large seasonal bulges or sharp reductions in current assets.

Quarterly Sales and Earnings Per Share for McGraw Hill

Quarterly Sales and Earnings Per Share, Target and Limited Brands

Point-of-Sales Terminals
Retail-oriented firms use new, computerized inventory control systems linked online.
Digital inputs or optical scanners
Helps adjust orders or production schedules.
Radio Frequency Identification (RFID)

Temporary Assets under Level Production – An Example
Yawakuzi Motorcycle Company
Sales fluctuations: High sales demand during early spring and summer; sales drop during October through March.
Decision: Apply level production method – 12-month sales forecast is issued.
Result: Level production and seasonal sales combine to produce fluctuating inventory.

Yawakuzi Sales Forecast (in units)

Yawakuzi’s Production Schedule and Inventory

Sales Forecasts, Cash Receipts, and Payments, and Cash Budget

Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (cont’d)
Table 6-3 is created to examine the buildup in accounts receivable and cash.
Sales forecast: Based on assumptions taken earlier (table 6-1).
Cash receipts: 50% cash collected during the month of sale and 50% pertains to the prior month.
Cash budget: a comparison of cash receipt and payment schedules to determine cash flow.

Total Current Assets, First Year ($millions)

Yawakuzi’s Nature of Asset Growth

Cash Budget and Assets for II Year With No Growth in Sales ($millions)
Graphic presentation of the current asset cycle.

Patterns of Financing
Selection of external sources to fund financial assets is an important decision.
The appropriate financing pattern:
Matching of asset buildup and length of financing pattern.

Matching Long-Term and Short-Term Needs

Alternative Plans
It is important to consider other alternatives.
The challenge of constructing a financial plan is to prioritize the current assets into temporary and permanent.
The exact timing of asset liquidation, even in the light of ascertaining dollar amounts is onerous.
It is also difficult to judge the amount of short-term and long-term financing available.

Long-Term Financing
Firms can be assured of having adequate capital at all times:
Use long-term capital to cover part of the short-term needs.
Long-term capital can be used to finance:
Fixed assets.
Permanent current assets.
Part of the temporary current assets.

Using Long-Term Financing for Part of Short-Term Needs

Short- Term Financing
Small businesses do not have total access to long-term financing.
They rely on short-term bank and trade credit.
Advantage: interest rates are lower.
Short-term finances are used finance:
Temporary current assets.
Part of the permanent working capital needs.

Using Short-Term Financing for Part of Long-Term Needs

The Financing Decision
Corporations usually have multiple financial alternatives to reduce their costs of funds.
Achieved through the use of a combination of financing methods.
Aim to strike a balance between short-term versus long-term considerations against:
The composition of the firm’s assets
The willingness to accept risk.
Influenced by the term structure of interest rates.

Term Structure of Interest Rates
A yield curve – that shows the relative level of short-term and long-term interest rates.
U.S. government securities are popular as they are free of default risks.
Corporate debt securities entail a higher interest rate due to more financial risks.
Yield curves for both securities change daily to reflect:
Current competitive conditions.
Expected inflation.
Changes in economic conditions.

Basic Theories – Yield Curve
Liquidity premium theory
Long-term rates should be higher than short-term rates.
Market segmentation theory
Treasury securities are divided into market segments by the various financial institutions investing in the market.
Expectations hypothesis
Yields on long-term securities is a function of short-term rates.

Long- and Short-Term Annual Interest Rates
Relative volatility and the historical level of short-term and long-term rates.

Alternative Financing Plans
A Decision Process: Comparing alternative financing plans for working capital.

Impact of Financing Plans on Earnings

Varying Condition and its Impact
Tight money periods
Capital is scarce making short-term financing difficult to find or may ensue very high rates.
Inadequate financing may mean loss of sales or financial embarrassment.
Expected value
Represents the sum of the expected outcomes under both conditions.

Expected Returns under Different Economic Conditions

Expected Returns for High Risk Firms

Percentage of Working Capital to Sales for the S&P’s Industrials
Shift in asset structure

Toward an Optimal Policy
A firm should:
Attempt to relate asset liquidity to financing patterns, and vice versa.
Decide how it wishes to combine asset liquidity and financing needs.
Risk-oriented firm – short-term borrowings and low degree of liquidity.
Conservative firm – long-term financing and high degree of liquidity.

Asset Liquidity and Financing Assets

Toward an Optimal Policy
Company needs must be met by structuring:
Working capital position
The associated risk-return trade-off
The ultimate concern:
Maximize the overall valuation of the firm.
Use astute analysis of risk-return options.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Analysis
3

Chapter Outline
Ratio analysis and its importance.
Use of ratio for measurements.
The Du Pont system of analysis.
Trend analysis.
Evaluation of reported income to identify distortion.

Ratio Analysis
Financial ratios
Used to weigh and evaluate the operating performance of a firm.
Used to compare performance record as against other firms in the industry.
Analyzing ratios and numerical calculations.
Such data is provided by various organizations.

Ratios and their Classification
A. Profitability ratios
1. Profit margin.
2. Return on assets (investment).
3. Return on equity.
B. Asset utilization ratios
4. Receivable turnover.
5. Average collection period.
6. Inventory turnover.
7. Fixed asset turnover.
8. Total asset turnover.

Ratios and their Classification (cont’d)
C. Liquidity ratios
9. Current ratio.
10. Quick ratio.
D. Debt utilization ratios
11. Debt to total assets.
12. Times interest earned.
13. Fixed charge coverage.

Types of Ratios
Profitability ratios
Measurement of the firm’s ability to earn an adequate return on:
Sales
Assets
Invested capital
Asset utilization ratios
Measures the speed at which the firm is turning over accounts receivable.

Types of Ratios (cont’d)
Liquidity ratios
Emphasizes the firm’s ability to pay off short-term obligations as and when due.
Debt utilization ratios
Estimates the overall debt position of the firm.
Evaluates in the light of asset base and earning power.

Financial Statement for Ratio Analysis

Profitability Ratios

Administrator (A) – Replace equations with appropriate graphics.

Du Pont System of Analysis
A satisfactory return on assets might be derived through:
A high profit margin
A rapid turnover of assets (generating more sales per dollar of its assets)
Or both
Return of assets (investment) =
(Profit margin) X (Asset turnover)

Du Pont System of Analysis (cont’d)
A satisfactory return on equity might be derived through:
A high return on total assets;
A generous utilization of debt;
Or a combination of both.

Return on equity = Return on assets (investments)
[1 – (Debt/ Assets)]

Du Pont Analysis

Examples for Analysis using the Du Pont System

Asset Utilization Ratios
These ratios relate the balance sheet to the income statement.

Administrator (A) – Replace equations with appropriate graphics

Asset Utilization Ratios (cont’d)

Administrator (A) – Replace equations with appropriate graphics

Liquidity Ratios

Administrator (A) – Replace equations with appropriate graphics

Debt Utilization Ratios
Measures the prudence of the debt management policies of the firm.

Administrator (A) – Replace equations with appropriate graphics

Debt Utilization Ratios (cont’d)
Fixed charge coverage measures the firm’s ability to meet the fixed obligations.
Interest payments alone are not considered.

Income before interest and taxes………………..$550,000
Lease payments…………………………………… $50,000
Income before fixed charges and taxes…………$600,000

Summary of Ratio Analysis

Trend Analysis

Trend Analysis in the Computer Industry

Impact of Inflation on Financial Analysis
Inflation
Revenue is stated in current dollars.
Plant, equipment, or inventory may have been purchased at lower price levels.
Profits may be more a function of increasing prices than due to good performance.

Comparison of Replacement and Historical Cost Accounting

Comparison of Replacement and Historical Cost Accounting (cont’d)
Replacement costs – reduces income but increases assets.
An increase lowers the debt-to-assets ratio.
A decrease indicates a decrease in the financial leverage of the firm.
A declining income results in a decreased ability to cover interest costs.

Impact of Disinflation on Financial Analysis
Disinflation
Financial assets such as stocks and bonds have the potentials to do well – encouraging investors.
Tangible assets do not have the potential.
Deflation
Actual reduction of prices affecting everybody due to bankruptcies and declining profits.

Other Elements of Distortion in Reported Income
Effect of changing prices.
Reporting of revenues.
Treatment of nonrecurring items.
Tax write-off policies.

Explanation of Discrepancies

Explanation of Discrepancies (cont’d)
Sales
Use of defer recognition until each payment is received or full recognition at the earliest possible date.
Cost of goods sold
Use of different accounting principles – LIFO versus FIFO.

Explanation of Discrepancies (cont’d)
Extraordinary gains/ losses
Inclusion of events when computing current income or leaving them out.
Net income
Use of different methods of financial reporting.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Operating and Financial Leverage
5

Chapter Outline
What is leverage?
Operating leverage.
Financial leverage.
Potential profits or increased risk?

What is Leverage?
Use of special forces and effects to magnify or produce more than the normal results from a given course of action.
Can produce beneficial results in favorable conditions.
Can produce highly negative results in unfavorable conditions.

Leverage in Business
Determining type of fixed operational costs.
Plant and equipment
Eliminates labor in production of inventory.
Expensive labor
Lessens opportunity for profit but reduces risk exposure.
Determining type of fixed financial costs.
Debt financing
Substantial profits but failure to meet contractual obligations can result in bankruptcy.
Selling equity
Reduces potential profits but minimize risk exposure.

Operating Leverage
The extent to which fixed assets and associated fixed costs are utilized in a business.
Operational costs include:
Fixed
Variable
Semivariable

Break-Even Chart: Leveraged Firm

Break-Even Analysis
The break-even point is at 50,000 units, where the total costs and total revenue lines intersect.
Units = 50,000 .
Total Variable Fixed Costs Total Costs Total Revenue Operating Income
Costs (TVC) (FC) (TC) (TR) (loss)
(50,000 X $0.80) (50,000 X $2)
$40,000 $60,000 $100,000 $100,000 0

Administrator (A) – replace equations with appropriate graphics

Break-Even Analysis (cont’d)
The break-even point can also be calculated by:

Fixed costs = Fixed costs = FC
Contribution margin Price – Variable cost per unit P – VC
i.e. $60,000 = $60,000 = 50,000 units
$2.00 – $0.80 $1.20

Administrator (A) – replace equations with appropriate graphics

Volume-Cost-Profit Analysis: Leveraged Firm

A Conservative Approach
Some firms choose not to operate at high degrees of operating leverage.
More expensive variable costs may be substituted for automated plant and equipment.
This approach may cut into potential profitability of the firm as shown in Figure 5-2.

Break-Even Chart: Conservative Firm

Volume-Cost-Profit Analysis: Conservative Firm

The Risk Factor
Factors influencing decision on maintaining a conservative or a leveraged stance include:
Economic condition.
Competitive position within industry.
Future position – stability versus market leadership.
Matching an acceptable return with a desired level of risk.

Cash Break-Even Analysis
Helps in analyzing the short-term outlook of a firm.
Non-cash items are excluded:
Depreciation
Sales (accounts receivable rather than cash)
Purchase of materials
Accounts payable

Degree of Operating Leverage (DOL)
Percentage change in operating income
Occurs as a result of a percentage change in units sold.
Computed only over a profitable range of operations.
Directly proportional to the firm’s break-even point.

DOL = Percent change in operating income
Percent change in unit volume

Operating Income or Loss

Computation of DOL
Leveraged firm:

DOL = Percent change in operating income = $24,000 X 100
Percent change in unit volume $36,000
20,000 X 100
80,000
= 67% = 2.7
25%
Conservative firm:

DOL = Percent change in operating income = $8,000 X 100
Percent change in nit volume $20,000
20,000 X 100
80,000
= 40% = 1.6
25%

Administrator (A) – Replace equations with appropriate graphics

Algebraic Formula for DOL
DOL = Q (P – VC)
Q (P – VC) – FC
Where,
Q = Quantity at which DOL is computed.
P = Price per unit.
VC = Variable costs per unit.
FC = Fixed costs.
For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80, and FC = $60,000:

DOL = 80,000 ($2.00 – $0.80) ;
80,000 ($2.00 – $0.80) – $60,000
= 80,000 ($1.20) = $96,000 ;
80,000 ($1.20) – $60,000 $96,000 – $60,000
i.e. DOL = 2.7

Limitations of Analysis
Weakening of price in an attempt to capture an increasing market.
Cost overruns when moving beyond an optimum-size operation.
Relationships are not fixed.

Nonlinear Break-Even Analysis

Financial Leverage
Reflects the amount of debt used in the capital structure of the firm.
Determines how the operation is to be financed.
Determines the performance between two firms having equal operating capabilities.

BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage

Impact on Earnings
Examine two financial plans for a firm, where $200,000 is required to carry the assets.

Total Assets = $200,000
Plan A (leveraged) Plan B (conservative)
Debt (8% interest) $150,000 ($12,000 interest) $50,000 ($4,000 interest)
Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25)
Total financing $200,000 $200,000

Administrator (A) – Replace table with appropriate graphics

Impact of Financing Plan on Earnings per Share

Financing Plans and Earnings per Share

Degree of Financial Leverage
DFL = Percent change in EPS
Percent change in EBIT
For the purpose of computation, it can be restated as:
DFL = EBIT .
EBIT – I
Plan A (Leveraged):
DFL = EBIT = $36,000 = $36,000 = 1.5
EBIT – I $36,000 – $12,000 $24,000
Plan B (Conservative):
DFL = EBIT = $36,000 = $36,000 = 1.1
EBIT – I $36,000 – $4,000 $32,000

Limitations to the Use of Financial Leverage
Beyond a point, debt financing is detrimental to the firm.
Lenders will perceive a greater financial risk.
Common stockholders may drive down the price.
Recommended for firms that are:
In an industry that is generally stable.
In a positive stage of growth.
Operating in favorable economic conditions.

Combining Operating and Financial Leverage
Combined leverage: when both leverages allow a firm to maximize returns.
Operating leverage:
Affects the asset structure of the firm.
Determines the return from operations.
Financial leverage:
Affects the debt-equity mix.
Determines how the benefits received will be allocated.

Combined Leverage Influence on the Income Statement

Combining Operating and Financial Leverage

Operating and Financial
Leverage

Degree of Combined Leverage
Uses the entire income statement.
Shows the impact of a change in sales or volume on bottom-line earnings per share.

DCL = Percentage change in EPS ;
Percentage change in sales (or volume)
Using data from Table 5-7:

Percent change in EPS = $1.50 X 100
Percent change in sales $1.50 = 100% = 4
$40,000 X 100 $25%
$160,000

Degree of Combined Leverage (cont’d)
DCL = Q (P – VC) ,
Q (P – VC) – FC – I
From Table 5-7,
Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000.

DCL = 80,000 ($2.00 – $0.80) =
80,000 ($2.00 – $0.80) – $60,000 – $12,000
= 80,000 ($1.20) =
80,000 ($1.20) – $72,000
DCL = $96,000 = $96,000 = 4
$96,000 – $72,000 $24,000

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Forecasting
4

Chapter Outline
Financial forecasting in a firm’s strategic growth.
Three financial statements.
Percent-of-sales method.
Various methods to determine the amount of new funds required in advance.
Factors that affect cash flow.

Financial Forecasting
Ability to plan ahead and make necessary changes before actual events occur.
Outcome of a firm through external events might be a function of both:
Risk-taking desires.
Ability to hedge against risk with planning.
No growth or a decline – not the primary cause of shortage of funds.
A comprehensive financing plan must be developed for a significant growth.

Constructing Pro Forma Statements
A systems approach to develop pro forma statements consists of:
Constructing it based on:
Sales projections
Production plans
Translating it into a cash budget.
Assimilating all materials into a pro forma balance sheet.

Development of Pro Forma Statements

Pro Forma Income Statement
Provides a projection on the anticipation of profits over a subsequent period.
Establish a sales projection.
Determine a production schedule and the associated use of new material, direct labor, and overhead to arrive at a gross profit.
Compute other expenses.
Determine profit by completing the actual pro forma statement.

Establish a Sales Projection
Lets assume Goldman Corporation has two primary products: wheels and casters.

Stock of Beginning Inventory
Number of units produced will depend on beginning inventory.

Determine a Production Schedule and the Gross Profit
To determine the production requirements:
Units
+ Projected sales
+ Desired ending inventory
– Beginning inventory
= Production requirements

Production Requirements for Six Months

Unit Costs
Cost to produce each unit:

Total Production Costs

Cost of Goods Sold
Costs associated with units sold during the time period.
Assumptions for the illustration:
FIFO accounting is used
Therefore allocation of cost of current sales to beginning inventory
Then to goods manufactured during this period

Allocation of Manufacturing Costs and Determination of Gross Profit

Value of Ending Inventory

Other Expense Items
Other expense items must be subtracted from gross profits to arrive at net profit.
Earning before taxes
General and administrative expenses, interest expenses are subtracted from gross profit.
Earning after-taxes
Taxes are deducted from the above sum balance.
Contribution to retained earnings
Dividends are deducted from the above sum balance.

Actual Pro Forma Income Statement

Cash Budget
Pro forma income statement must be translated into cash flows.
The long-term is divided into short-term pro forma income statement.
More precise time frames are set to help in anticipating the patterns of cash outflows and inflows.

Monthly Sales Pattern

Cash Receipts
In the case of Goldman Corporation:
The pro forma income statement is taken for the first half year:
Sales are divided into monthly projections.
A careful analysis of past sales and collection records shows:
20% of sales is collected in the month.
80% in the following month.

Monthly Cash Receipts

Cash Payments
Monthly costs associated with:
Inventory manufactured during the period (material, labor and overhead).
Disbursements for general and administrative expenses.
Interest payments, taxes and dividends.
Cash payments for new plant and equipment.

Component Costs of Manufactured Goods

Cash Payments (cont’d)
Assumptions for the next two tables:
The costs are incurred on an equal monthly basis over a six-month period.
The sales volume however varies each month.
Employment of level monthly production to ensure maximum efficiency.
Payment for material, once a month after purchases have been made.

Average Monthly Manufacturing Costs

Summary of Monthly Cash Payments

Actual Budget
Difference between monthly receipts and payments is the net cash flow for the month.
Allows the firm to anticipate the need for funding at the end of each month.

Monthly Cash Budget

Cash Budget with Borrowing and Repayment Provisions

Pro Forma Balance Sheet
Represents the cumulative changes over time.
Important to examine the prior period’s balance sheet.
Some accounts will remain unchanged, while others will take new values.
Information is derived from the pro forma income statement and cash budget.

Development of a Pro Forma Balance Sheet

Pro Forma Balance Sheet (cont’d)

Explanation of Pro Forma Balance Sheet

Analysis of Pro Forma Statement
The growth ($25,640) was financed by accounts payable, notes payable, and profit.
As reflected by the increase in retained earnings.

Total assets (June 30, 2005)………$76,140
Total assets (Dec 31, 2004)……….$50,500
Increase……………………………..$25,640

Percent-of-Sales Method
Based on the assumption that:
Accounts on the balance sheet will maintain a given percentage relationship to sales.
Notes payable, common stock, and retained earnings do not maintain a direct relationship with sales volume.
Therefore percentages are not computed.

Balance Sheet of Howard Corporation

Percent-of-Sales Method (cont’d)
Funds required is ascertained.
Financing is planned based on:
Notes payable.
Sale of common stock.
Use of long-term debts.

Percent-of-Sales Method (cont’d)
Company operating at full capacity – needs to buy new plant and equipment to produce more goods to sell:
Required new funds:
(RNF) = A (ΔS) – L (ΔS) – P (1 – D)
S S
Where: A/S = Percentage relationship of variable assets to sales; ΔS = Change in sales; L/S = Percentage relationship of variable liabilities to sales; P = Profit margin; = New sales level; D = Dividend payout ratio.

RNF = 60% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $60,000 – $25000 – $18,000 (.50)
= $35,000 – $9000
= $26,000 required source of new funds.

Percent-of-Sales Method (cont’d)
Company not operating at full capacity – needs to add more current assets to increase sales :

RNF = 35% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $35,000 – $25,000 – $18,000 (.50)
= $35,000 – $25,000 – $9,000
= $1,000 required source of new funds.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Accounting
2

Outline
Income Statement
Price-earnings Ratio
Balance Sheet
Statement of Cash Flows
Tax-free Investments (Deprecation)

Basic Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows

Income Statement
Device to measure the profitability of a firm over a period of time.
It covers a defined period of time.
It is presented in a stair-step or progressive fashion
To examine the profit or loss after each type of expense item is deducted.

Income Statement (cont’d)
Sales – Cost of Goods Sold (COGS)
= Gross Profit (GP)

GP – Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)

EBIT – Interest = Earnings Before Taxes (EBT)

EBT – Taxes = Earnings After Taxes (EAT) or Net Income (NI)

Income Statement (cont’d)

Return to Capital
Three primary sources of capital:
Bondholders
Preferred stockholders
Common stockholders
Earnings per share
Interpreted in terms of number of outstanding shares.
May be paid out in dividends or retained by company for subsequent reinvestment.
Statement of retained earnings
Indicates the disposition of earnings.

Statement of Retained Earnings

Price-Earnings (P/E) Ratio
Refers to the multiplier applied to earnings per share to determine current value of the common stock.
P/E Ratio = Market Price of Stock / Earnings per share (EPS).
Some factors that influence P/E:
Earnings and the sales growth of the firm.
Risk (volatility in performance).
Debt-equity structure of the firm.
Dividend payment scheme.
Quality of management.

Price-Earnings (P/E) Ratio (cont’d)
Allows comparison of the relative market value of many companies based on $1 of earnings per share.
Indicates expectations about the future of the company.
Price-earnings ratios can be confusing.

Price-earnings Ratios for Selected U.S. Companies

Limitations of the Income Statement
Income that is gained or lost during a given period is a function of verifiable transactions.
Stockholders, hence may perceive only a much smaller gain or loss from actual day-to-day operations.
Flexibility in the reporting of transactions might result in differing measurements of income gained from similar events at the end of a time period.

Balance Sheet
Indicates what the firm owns and how these assets are financed in the form of liabilities and ownership interest.
Delineates the firm’s holdings and obligations.
A cumulative chronicle of all transactions that have affected the corporation since its inception.
Items are stated on an original cost basis rather than at current market value.

Balance Sheet Items
Liquidity: Asset accounts are listed in order of liquidity.
Current assets: items that can be converted to cash within 12 months or within the normal operating cycle of the firm.
Marketable securities: temporary investment of excess cash.
Accounts receivable: allowance for bad debts, to determine their anticipated collection value.

Balance Sheet Items (cont’d)
Inventory: includes raw materials, goods in progress or finished goods.
Prepaid expenses: represents future expense items, that are already paid for.
Example: insurance premiums or rent
Investments: long-term commitment of funds (at least one year).
Includes stocks, bonds or investments in other companies.

Balance Sheet Items (cont’d)
Plant and equipment: carried at original cost minus accumulated depreciation.
Accumulated depreciation: sum of all past and present depreciation charges on currently owned assets.
Depreciation expense is the current year’s charge.

Balance Sheet Items (cont’d)
Total assets: Financed through liabilities or stockholders’ equity.
Short-term obligations
Accounts payable: amounts owed on open accounts to suppliers.
Notes payable: short-term signed obligations to bankers and other creditors.
Accrued expense: payment yet to be made towards – service already provided or an obligation incurred.

Stockholder’s Equity
Represents total contribution and ownership interest of preferred and common stockholder’s.
Preferred stock.
Common stock.
Capital paid in excess of par.
Retained earnings.

Statement of Financial Position (Balance Sheet)

Concept of Net Worth

Net value/ book value = Stockholder’s equity – preferred stock component

Market value is of primary concern to the:
Financial manager
Security analyst
Stockholders

Limitations of the Balance Sheet
Most of the values are based on historical or original cost price.
Troublesome when it comes to plant and equipment inventory.
FASB ruling on disclosure of inflation adjustments no longer in force.
It is purely a voluntary act on the part of the company.

Limitations of the Balance Sheet (cont’d)
Differences between per share values may be due to:
Asset valuation
Industry outlook
Growth prospects
Quality of management
Risk-return expectations.

Comparison of Market Value to Book Value per Share

Statement of Cash Flows
Emphasizes the critical nature of cash flow to the operations of the firm.
It represents cash or cash equivalents items easily convertible to cash within 90 days.
Cash flow analysis helps in combating the discrepancies faced through the accrual method of accounting.

Statement of Cash Flows (cont’d)
Advantage of accrual method:
Allows the matching of revenues and expenses in the period in which they occur to appropriately measure profits.
Disadvantage of accrual method :
Adequate attention is not directed to the actual cash flow position of the firm.

Concepts Behind the Statement of cash Flows

Determining Cash Flows from Operating Activities
Translation of income from operations from an accrual to a cash basis.
Direct method
Every item on the income statement is adjusted from accrual to cash accounting.
Indirect method
Net income represents the starting point.
Required adjustments are made to convert net income to cash flows from operations.

Indirect Method

Comparative Balance Sheets

Cash Flows from Operating Activities

Determining Cash Flows from Investing Activities
Investing activities:
Long-term investment activities in mainly plant and equipment.
Increasing investment is a use of funds.
Decreasing investments is a a source of funds.

Determining Cash Flows from Financing Activities
Financial activities apply to the sale or retirement of:
Bonds
Common stock
Preferred stock
Other corporate securities
Payment of cash dividends.
Sale of firm’s securities is a source of funds.
Payment of dividend and the repurchase of securities is a use of funds.

Overall Statement Combining the Three Sections

Analysis of the Overall Statement
How are increases in long-term assets being financed?
Preferably, adequate long-term financing and profits should exist.
Short-term funds may be used to carry long-term needs – could be a potential high-risk situation.
Example: trade credit and bank loans

Depreciation and Fund Flows
Depreciation attempts to allocate the initial cost of an asset over its useful life.
Charging of depreciation does not directly influence the movement of funds.

Comparison of Accounting and Cash Flows

Free Cash Flow
Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends.
Capital expenditures: Maintains the productive capacity of firm.
Dividends: Maintains the necessary payout on common stock and to cover any preferred stock obligations.
Free cash flow is used for special financing activities.
Example: leveraged buyouts

Income Tax Considerations
Corporate tax rates
Progressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 15-20%.
Cost of tax-deductible expense

Depreciation as a Tax Shield
Not a new source of fund.
Provides tax shield benefits measurable as depreciation times the tax rate.

Corporation A Corporation B
Earnings before depreciation and taxes…….. $400,000 $400,000
Depreciation……………………………………… 100,000 0
_________ _________
Earnings before taxed………………………….. 300,000 400,000
Taxes (40%)………………………………………. 120,000 160,000
_________ _________
Earnings after taxes……………………………… 180,000 240,000
+Depreciation charged without cash outlay…. 100,000 0
_________ _________
Cash flow…………………………………………… $280,000 $240,000
Difference…………………………………………… $40,000

What is exactly this interview?

In your material you will learn a great deal about financial management

I have found that if the students find a financial manager who practices this material it adds great value to the student

 

 

Please find a person who you can interview 

Use the material in the chapters and craft at least five questions and arrange time with the person.

Please write and submit at least a five page paper.

 

You can interview someone out side of the organization or inside your organization

 

A sample question you would want to ask:

 

1) In our class we learned about financial ratios. How do you use these in your business and if you currently do not then have you used them before and how do they help you manage the business better?

 

The goal of this paper is to allow you to show some of the techniques in the class and interview a current financial manager

 

Please make this a paper and not a series of questions 

 

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Goals and Functions of Financial Management
1

Chapter Outline
Introduction to Finance
Risk-Return Tradeoff
Forms of Organizations
Corporate Governance
Goals of Financial Management
Social Responsibility and Finance
Role of Financial Markets

Financial Management
Financial Management or business finance is concerned with managing an entity’s money.
For example, a company must decide:
where to invest its money.
whether or not to replace an old asset.
when to issue new stocks and bonds.
whether or not to pay dividends.

Relationship between Finance, Economics and Accounting
Economics provides structure for decision making in many important areas.
Provides a broad picture of economic environment.
Accounting provides financial data in various forms.
Income statements, balance sheets, and statement of cashflows.
Finance links economic theory with the numbers of accounting.

Evolution in the Field of Finance
At the turn of the century: Emerged as a field separate from economics.
By 1930s: Financial practices revolved around such topics as:
Preservation of capital.
Maintenance of liquidity.
Reorganization of financially troubled corporation.
Bankruptcy.

Evolution in the Field of Finance (cont’d)
By mid-1950s: Finance becomes more analytical.
Financial Capital (accounting capital/ money) was used to purchase Real Capital (economic capital/ long-term plant and equipment).
Cash and inventory management
Capital structure theory
Dividend policy

Recent Issues in Finance
Recent focus has been on:
Risk-return relationships.
Maximization of returns for a given level of risk.
Portfolio management.
Capital structure theory.
New financial products with a focus on hedging are being widely used.

Recent Issues in Finance (cont’d)
The following are significant to financial managers during decision making:
Effects of inflation and disinflation on financial forecasting.
Required rates of return for capital budgeting decisions.
Cost of capital.

Advances in Internet and Finance
Internet and its acceptance has enabled acceleration of e-commerce solutions for “old economy” companies.
E-commerce solutions for existing companies
B2C
B2B
Spurt in new business models and companies
Amazon.com
eBay

Advances in Internet and Finance (cont’d)
For a financial manager e-commerce impacts financial management because it affects the pattern and field through which cash flows through the firm.
B2C Model: Products are bought with credit cards, credit card checks are performed, and selling firms get the cash flow faster.
B2B: Orders can be placed, inventory managed, and bids to supply products can be accepted –all online.

Functions of the Financial Manager

Risk-Return Trade-Off
Influences operational side (capital versus labor/ Product A versus Product B)
Influences financial mix (stocks versus bonds versus retained earnings)
Stocks are more profitable but riskier.
Savings accounts are less profitable and less risky (or safer)
Financial manager must choose appropriate combinations

Sole Proprietorship
Represents single-person ownership
Advantages:
Simplicity of decision-making.
Low organizational and operational costs.
Drawback
Unlimited liability to the owner.
Profits and losses are taxed as though they belong to the individual owner.

Partnership
Similar to sole proprietorship except there are two or more owners.
Articles of partnership: Specifies ownership interest, the methods for distributing profits, and the means of withdrawing from the partnership.
Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution.

Corporation
Corporation
Articles of incorporation: Specify the rights and limitations of the entity.
Its owned by shareholders who enjoy the privilege of limited liability.
Has a continual life.
Key feature is the easy divisibility of ownership interest by issuing shares of stock.

Corporation (cont’d)
Disadvantage:
The potential of double taxation of earnings.
Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.

Corporate Governance
Agency theory
Examines the relationship between the owners and managers of the firm.
Institutional investors
Have more to say about the way publicly owned companies are managed.
Public Company Accounting Oversight Board (PCAOB)

Sarbanes-Oxley Act of 2002
Set up a five member Public Company Accounting Oversight Board (PCAOB) with responsibility for:
Auditing standards within companies
Controlling the quality of audits
Setting rules and standards for the independence of the auditors.
Major focus is to make sure that publicly-traded corporations accurately present their assets, liabilities, and equity and income on their financial statements.

Goals of Financial Management
Valuation Approach
Maximizing shareholder wealth (shareholder wealth maximization)
Management and stockholder wealth
Retention of position of power in long run is by becoming sensitized to shareholder concerns.
Sufficient stock option incentives to motivate achievement of market value maximization.
Powerful institutional investors are increasing management more responsive to shareholders.

Social Responsibility
Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society.
Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms.

Ethical Behavior
Ethical behavior creates invaluable reputation.
Insider trading
Protected against by the Securities and Exchange Commission (SEC).

The Role of Financial Markets
Financial markets are indicators of maximization of shareholder value and the ethical or the unethical behavior that may influence the value of the company.
Participants in the financial market range over the public, private and government institutions.
Public financial markets
Corporate financial markets

Structure and Functions of the Financial Markets
Money markets
Securities in this market include commercial paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.
Capital markets
Long-term markets
Securities include common stock, preferred stock and corporate and government bonds.

Stocks versus Bonds
Stock = ownership or equity
Stockholders own the company

Bond = debt or IOU
Bondholders are owed $ by company

Allocation of Capital
Primary market
When a corporation uses the financial markets to raise new funds, the sale of securities is made by way of a new issue.
Secondary market
When the securities are sold to the public (institutions and individuals).
Financial managers are given a feedback about their firms’ performance.

Return Maximization and Risk Minimization
Investors can choose risk level that meets their objective and maximizes return for that given level of risk.
Companies that are rewarded with high-priced securities can raise new funds in the money and capital markets at a lower cost compared to competitors.
Firms pay a penalty for failing to perform competitively.

Restructuring
Restructuring can result in:
Changes in the capital structure (liabilities and equity on the balance sheet).
Selling of low-profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities.
Removal or large reductions in the of current management team.
It has resulted in acquisitions and mergers.

Internationalization of Financial Markets
Allocation of capital and the search for low cost sources of financing on the rise in global market.
The impact of international affairs and technology has resulted in the need for future financial managers to understand
International capital flows.
Computerized electronic funds transfer systems.
Foreign currency hedging strategies.

Technological Impact on Capital Market
Consolidation among major stock markets and mergers of brokerage firms with domestic and international partners.
Electronic markets have gained popularity as against traditional organized exchanges and NASDAQ.
Resulted in the merger of NYSE with Archipelago and NASDAQ bought out Insinet from Reuters.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Sources of Short-Term Financing
8

Chapter Outline
Trade credit from suppliers.
Bank loans.
Commercial paper.
Borrowing in foreign markets.
Using collaterals like accounts receivable and inventory for larger loans.

Financing Arrangements
Lines of credit are sometimes referred to as a revolving credit facility where interest cost:
Is based on LIBOR (the London Interbank Offering Rate)
Is based on the company’s senior unsecured credit rating – a percentage margin.
Primary aim of the borrowing firms:
Minimize cost.

Trade Credit
40 percent of short-term financing is in the form of accounts payable or trade credit.
Accounts payable
Spontaneous source of funds.
Growing as the business expands.
Contracting when business declines.

Payment Period
Trade credit is usually extended for 30-60 days.
Extending the payment period to an unacceptable period results in:
Alienate suppliers.
Diminished ratings with credit bureaus.
Major variable in determining the payment period:
The possible existence of a cash discount.

Cash Discount Policy
Allows reduction in price if payment is made within a specified time period.
Example: A 2/10, net 30 cash discount means:
Reduction of 2% if funds are remitted 10 days after billing.
Failure to do so means full payment of amount by the 30th day.

Net-Credit Position
Determined by examining the difference between accounts receivable and accounts payable.
It is positive if accounts receivable is greater than accounts payable and vice versa.
Larger firms tend to be net providers of trade credit (relatively high receivables).
Smaller firms in the relatively user position (relatively high payables).

Bank Credit
Provide self-liquidating loans
Use of funds ensures a built-in or automatic repayment scheme.
Changes in the banking sector today:
Centered around the concept of ‘full service banking’.
Expanded internationally to accommodate world trade and international corporations.
Deregulation has created greater competition among other financial institutions.

Prime Rate and LIBOR
Prime rate
Rate a bank charges to its most creditworthy customers.
Increases as a customer’s credit risk increases.
LIBOR (London Interbank Offered Rate)
Rate offered to companies:
Having an international presence.
Ability to use the London Eurodollar market for loans.

Prime Rate versus LIBOR on U.S. Dollar Deposits

Compensating Balances
A fee charged by the bank for services rendered or an average minimum account balance.
When interest rates are lower, the compensating balance rises.
Required account balance computed on the basis of:
Percentage of customer loans outstanding.
Percentage of bank commitments towards future loans to a given account.

Compensating Balances – Example
If one needs $100,000 in funds, he/ she must borrow $125,000 to ensure the intended amount will be available. This would be calculated as:
Amount to be borrowed = Amount needed
(1 – c)
= $100,000
(1 – 0.2)
= $125,000
Where ‘c’ is the compensating balance expressed as a decimal.

To check on this calculation, the following can be done:
$125,000 Loan
– 25,000 20% compensating balance requirement
$100,000 Available funds

Maturity Provisions
Term loan
Credit is extended for one to seven years.
Loan is usually repaid in monthly or quarterly installments.
Only superior credit applicants, qualify.
Interest rate fluctuates with market conditions.
Interest rate may be tied to the prime rate or LIBOR.

Cost of Commercial Bank Financing
Effective interest on a loan is based on the:
Loan amount.
Dollar interest paid.
Length of the loan.
Method of repayment.
Discounted loan – interest is deducted in advance – effective rate increases.

Effective rate = Interest X Days in the year (360)
Principal Days loan is outstanding

Interest Costs with Compensating Balances
Assuming that 6% is the stated annual rate and that 20% compensating balance is required;

Effective rate with = Interest
compensating balances (1 – c)
= 6% = 7.5%
(1 – 0.2)
When dollar amounts are used and the stated rate is not known, the following can be used for computation:
Days in a
Effective rate with = Interest X year (360)
compensating balances Principal – Compensating Days loan is
balance in dollars outstanding

Rate on Installment Loans
Installment loans require a series of equal payments over the period of the loan.
Federal legislation prohibits a misrepresentation of interest rates, however this may be misused.

Annual Percentage Rate
Truth in Lending Act of 1968 requires the actual APR to be given to the borrower.
Annual percentage rule:
Protects unwary consumer from paying more than the stated rate.
Requires the use of the actuarial method of compounded interest during computation.
Lender must calculate interest for the period on the outstanding loan balance at the beginning of the period.
It is based on the assumptions of amortization.

The Credit Crunch Phenomenon
The Federal Reserve tightens the growth in the money supply to combat inflation – the affect:
Decrease in funds to be lent and an increase in interest rates.
Increase in demand for funds to carry inflation-laden inventory and receivables.
Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns.

The Credit Crunch Phenomenon (cont’d)
Credit conditions can change dramatically and suddenly due to:
Unexpected defaults.
Economic recessions.
Other economic setbacks.

Financing Through Commercial Paper
Short-term, unsecured promissory notes issued to the public.
Finance paper/ direct paper
Sold by financial firms, directly to the lender.
Dealer paper
Sold by industrial companies, use of intermediate dealer network for its distribution.
Book-entry transactions
Computerized handling of commercial paper, where no actual certificate is created.

Total Commercial Paper Outstanding

Advantages of Commercial Paper
Fuelled by the rapid growth of money-market mutual funds, and their need for short-term securities for investments.
No associated compensating balance requirements.
Associated prestige for the firm to float their paper in an elite market.

Comparison of Commercial Paper Rate to Prime Rate (annual rate)

Limitations on the Issuance of Commercial Paper
Many lenders have become risk-averse post a multitude of bankruptcies.
Firms with downgraded credit rating do not have access to this market.
The funds generation associated with this is less predictable.
Lacks the degree of commitment and loyalty associated with bank loans.

Foreign Borrowing
Eurodollar loan
Denominated in dollars and made by foreign bank holding dollar deposits.
Short-term to intermediate terms in maturity.
LIBOR is the base interest paid on loans for companies of the highest quality.
One approach – borrow from international banks in foreign currency.
Borrowing firm may suffer currency risk.

Use of Collateral in Short-Term Financing
Secured credit arrangement when:
Credit rating of the borrower is too low.
Need for funds is very high.
Primary concern – whether the borrower can generate enough cash flow to liquidate the loan when due.
Uniform Commercial Code: standardizes and simplifies the procedures for establishing security against a loan.

Accounts Receivable Financing
Includes:
Pledging accounts receivables.
Factoring or an outright sale of receivables.
Advantage:
Permits borrowing to be tied directly to the level of asset expansion at any point of time.
Disadvantage:
Relatively expensive method of acquiring funds.

Pledging Accounts Receivables
Lending firm decides on the receivables that it will use as a collateral.
Loan percentage depends on the firms:
The financial strength.
The creditworthiness.
Interest rate is well above the prime rate.
Computed against the balance outstanding.

Factoring Receivables
Receivables are sold outright to the finance company.
Factoring firms do not have recourse against the seller of the receivables.
Finance companies may do all or part of the credit analysis.
To determine and ensure the quality of the accounts.
Factoring firm is:
Absorbing risk – for which a fee is collected
Actually advancing funds to the seller – paid a lending rate.

Factoring Receivables – Example
If $100,000 a month is processed at a 1% commission, and a 12% annual borrowing rate, the total effective cost is computed on an annual basis.
1%……Commission
1%……Interest for one month (12% annual/12)
2%……Total fee monthly
2%……Monthly X 12 = 24% annual rate.
The rate may not be considered high due to factors of risk transfer, as well as early receipt of funds.
It also allows the firm to pass on mush of the credit-checking cost to the factor.

Asset Backed Public Offering
There is an increasing trend in public offerings of security backed by receivables as collateral.
Interest paid to the owners is tax free.
Advantages to the firm:
Immediate cash flow.
High credit rating of AA or better.
Provides – corporate liquidity, short-term financing.
Disadvantage to the buyer:
Risk associated – receivables actually being paid.

Inventory Financing
Factors influencing use of inventory:
Marketability of the pledged goods.
Associated price stability.
Perish-ability of the product.
Degree of physical control that the lender can exercise over the product.

Stages of Production
Stages of production
Raw materials and finished goods usually provide the best collateral.
Goods in process may qualify only a small percentage of the loan.

Nature of Lender Control
Provides greater assurance to the lender but higher administrative costs.
Types of Arrangements:
Blanket inventory liens: Lender has a general claim against inventory.
Trust receipts (floor planning) an instrument – the proceeds from sales go to the lender.
Warehousing a receipt issue – goods can be moved only with the lender’s approval.
Public warehousing.
Field warehousing.

Appraisal of Inventory Control Devices
Well-maintained control measures involves:
Substantial administrative expenses.
Raise overall cost of borrowing.
Extension of funds is well synchronized with needs.

Hedging to Reduce Borrowing Risk
Engaging in a transaction that partially or fully reduces a prior risk exposure.
The financial futures market:
Allows the trading of a financial instrument at a future point in time.
No physical delivery of goods.

Hedging to Reduce Borrowing Risk (cont’d)
In selling a Treasury bond futures contract, the subsequent pattern of interest rates determine if it is profitable or not.

Sales price, June 2006 Treasury
bond contract* (sale occurs in January 2006.)……………$100,000
Purchase price, June 2006 Treasury
bond contract (purchase occurs in June 2006)…………….$95,000
Profit on futures contract………….…………………………….$5,000
* Only a small percentage of the actual dollars involved must be invested to initiate the contract. This is known as the margin.

Hedging to Reduce Borrowing Risk (cont’d)
If interest rates increase:
The extra cost of borrowing money to finance the business can be offset by the profit of the futures contract.
If interest rates decrease:
A loss is garnered on the futures contract as the bond prices rise.
This is offset by the lower borrowing costs of the financing firm.
The purchase price of the futures contract is established at the time of the initial purchase transaction.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Time Value of Money
9

Chapter Outline
Time value associated with money.
Future and present value of a dollar.
Tables for future and present values and their need in computations.
Determination of yield.

Relationship to the Capital Outlay Decision
Capital allocation or budgeting is required for:
Purchase of new plant or equipment
The introduction of a new product line.
Determine whether the future benefits are sufficiently large to justify the current outlay.
Mathematical tools help in making capital allocation decisions.

Future Value – Single Amount
Measuring the value of an amount that is allowed to grow at a given interest over a period of time is necessary.
Assuming that the worth of $1,000 needs to be calculated after 4 years at a 10% interest per year, we have:
1st year……$1,000 X 1.10 = $1,000 2nd year……$1,000 X 1.10 = $1,210 3rd year……$1,210 X 1.10 = $1,331 4th year……$1,331 X 1.10 = $1,464

Future Value – Single Amount (cont’d)
A generalized formula is:
Where
FV = Future value
PV = Present value
i = Interest rate
n = Number of periods;
In the previous case, PV = $1,000, i = 10%, n = 4, hence;

Future Value of $1

Future Value – Single Amount (cont’d)
In determining future value, the following can be used:

Where, = The interest factor.

If $10,000 were invested for 10 years at 8%, the future value, would be:

Present Value – Single Amount
A sum payable in the future is worth less today than the stated amount.
The formula for the present value is derived from the original formula for future value:

The present value can be determined by solving for a mathematical solution to the formula above, thus restating the formula as:
Assuming;

Present Value of $1

Relationship of Present and Future Value

Future Value – Annuity
A series of consecutive payments or receipts of equal amount.
The future value of each payment can be totaled to find the future value of an annuity.
Assuming, A = $1,000, n = 4 and i = 10%.

Future Value of an Annuity of $1

Compounding Process for Annuity

Present Value – Annuity
Calculated by discounting each individual payment back to the present and then all of the these payments are added up.
Assuming that A = $1,000, n = 4, i = 10%, we have:

Presentation of Time Value Relationship
Requires various comparison which include:
The relationship between present value and future value.
The relationship between the present value of a single amount and the present value of an annuity.
Future value related to future value of annuity.

Annuity Equaling a Future Value
Assuming that at a 10% interest rate, after 4 years, an $4,641 needs to accumulated:

For n = 4, and i = 10%, is 4.641. This A equals $1,000.

Annuity Equaling a Present Value
Determining what size annuity can be equated to a given amount:

Assuming n = 4, i = 6%;

Relationship of Present Value to Annuity

Annuity Equaling a Present Value (cont’d)
Determining the necessary repayments on a loan:

Assuming n 20, i = 8%,

Total payments ($4,074 for 20 years)……………..$81,480
Repayment of principal…………………………….– 40,000
Payments applied to interest……………………….$41,480

Payoff Table for Loan (amortization- table)

Review

Yield – Present Value of a Single Amount
To calculate the yield on an investment producing $1,464 after 4 years having a present value of $1,000;

We see that for n = 4 and = 0.683, the interest rate or yield is 10%.

Yield – Present Value of a Single Amount (cont’d)
Interpolation may also be used to find a more precise answer.

Difference between the value at the lowest interest rate and the designated value.

The exact value can be determined thus:

Yield – Present Value of an Annuity
To calculate the yield on an investment of $10,000, producing $1,490 per annum for 10 years;

Hence;

Special Considerations in Time Value Analysis
Certain contractual agreements may require semiannual, quarterly, or monthly compounding periods.
In such cases, to determine n, multiply the number of years by the number of compounding periods during the year.
The factor of i is determined by dividing the quoted annual interest rate by the number of compounding periods.

Cases
Case 1: Determine the future value of a $1,000 investment after 5 years at 8% annual interest compounded semiannually.
Where, n = 5 X 2 = 10; i = 8% / 2 = 4%

Case 2: Determine the present value of 20 quarterly payments of $2,000 each to be received over the next 5 years, where i = 8% per annum.
Where, n = 20; i = 20%

Patterns of Payment
Time value of money evolves around a number of different payment or receipt patterns.
Assume, a contract involving payments of different amounts each year for a three year period.
To determine the present value, each payment is discounted to the present and then totaled;
(Assume 8% discount rate)

Deferred Annuity
Assume, a contract involving payments of different amounts each year for a three year period.
An annuity of $1,000 is paid at the end of each year from the fourth through the eighth year.
To determine the present values of the cash flows at 8% discount rate;

To determine the annuity;

Deferred Annuity (cont’d)

To discount the $3,993 back to the present, which falls at the beginning of the fourth period, in effect, the equivalent of the end of the third period, it is discounted back three periods, at 8% interest rate.

Deferred Annuity (cont’d)

Alternate Method to Compute Deferred Annuity
Determine the present value factor of an annuity for the total time period, where n = 8, i = 8%, = 5.747
Determine the present value factor of an annuity for the total time period (8) minus the deferred annuity period (5). Here, 8 – 5 = 3; n = 3; i = 8%. Thus the value is 2.577.
Subtracting the value in step 2 from the value of step 1, and multiplying by A;

Alternate Method to Compute Deferred Annuity (cont’d)
$3,170 is the same answer for the present value of the annuity as that reached by the first method.
The present value of the five-year annuity is added up to the present value of the inflows over the first three years to arrive at:

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Current Asset Management
7

Chapter Outline
What is current asset management?
Cash management and its importance.
Management of marketable securities.
Accounts receivable and inventory management.
Liquidity vis-à-vis returns.

What is Current Asset Management?
Involves the management of cash, marketable securities, accounts receivable, and inventory.
Ensures a competitive advantage and often creates an increase in shareholder value.
Primarily concerned with liquidity and safety, and then on maximizing profits.

Cash Management
Financial managers actively attempt to keep cash (non-earning asset) to a minimum.
It is critical to have sufficient cash to assuage emergencies.
Steps to improve overall profitability of a firm:
Minimize cash balances.
Have accurate knowledge of when cash moves in and out of the firm.

Reasons for Holding Cash Balances
Transactions balances
Payments towards planned expenses.
Compensative balances for banks
Compensate a bank for services provided rather than paying directly for them.
Precautionary needs
Emergency purposes.

Cash Flow Cycle
Ensure that cash inflows and outflows are synchronized for transaction purposes.
Cash budgets is a tool used to track cash flows and ensuing balances.
Cash flow relies on:
Payment pattern of customers.
Speed at which suppliers and creditors process checks.
Efficiency of the banking system.

Cash Flow Cycle (cont’d)
Cash-generating process is continuous although the cash flow may be unpredictable and uneven.
Cash inflows are driven by sales and influenced by:
Type of customers.
Customers’ geographical location.
Product being sold.
Industry.

Expanded Cash Flow Cycle

E-commerce and Sales
Benefits: faster cash flow.
Credit card companies advance cash to the retailer within 7-10 days against retailer’s with a 30 day payment terms.
Financial managers must pay close attention to the percentage of sales generated:
By cash.
By outside credit cards.
By the company’s own credit terms.

Outcome of Extra Cash
Account receivable is collected or the credit card company advances payment.
Used for various payments such as interest to lenders, dividends to stockholders, taxes to the government etc.
Used to invest in marketable securities.
Therefore when there is a need for cash a firm can:
Sell the marketable securities.
Borrow funds from short-term lenders.

Collections and Disbursements
Primary concern to the financial manager is the management of:
Cash inflows – still affected by collection mechanisms.
Payment outflow.

Float
Difference between firm’s recorded amount and amount credited to the firm by a bank.
Arises due to time delays in mailing, processing and clearing checks through the banking system.
Can be managed to some extent by combining disbursements and collection strategies.
Main challenge: the physical presentation of the check to the issuing bank.

Float (cont’d)
Check Clearing for the 21st Century Act (Check 21)
Allows banks and others to electronically process a check.
Factors that help in reducing float:
Ease of credit and debit cards payments and on-line banking for customers.
Wire transfers for corporations.
Rise of Internet commerce.

Use of Float – Day one

Use of Float – Day two

Improving Collections
Setting up multiple collection centers at different locations.
Adopt lockbox system for expeditious check clearance at lower costs.

Extending Disbursements
General trend:
Speed up processing of incoming checks.
Slow down payment procedures.
Extended disbursement float – allows companies to hold onto their cash balances for as long as possible.

Cost-Benefit Analysis
Allows companies to analyze the benefits, received by investing on an efficiently maintained cash management program.

Cash Management Network

Electronic Funds Transfer
Funds are moved between computer terminals without the use of a ‘check’.
Automated clearinghouses (ACH)
Transfers information between financial institutions and between accounts using computer tape.
Central clearing facilities include:
National Automated Clearinghouse Association (NACHA)
Federal Reserve system
Electronic Payment Network
VISA

International Electronic Funds Transfer
Carried out through Society for Worldwide Interbank Financial Telecommunications (SWIFT).
Uses a proprietary secure messaging system.
Each message is encrypted.
Every money transaction is authenticated by a code, using smart card technology.
Assumes financial liability for the accuracy, completeness, and confidentiality of transaction.

International Cash Management
Factors differentiating international cash management from domestic based systems:
Differing payment methods and/or higher popularity of electronic funds transfer.
Subject to international boundaries, time zone differences, currency fluctuations, and interest rate changes.
Differing banking systems, and check clearing processes.
Differing account balance management, and information reporting systems.
Cultural, tax, and accounting differences.

International Cash Management (cont’d)
Financial managers try to keep as much cash as possible in a country with a strong currency and vice versa.
Sweep account:
Allows companies to maintain zero balances.
Excess cash is swept into an interest-earning account.

An Examination of Yield and Maturity Characteristics
Marketable securities

Types of Short-Term Investments

Management of Accounts Receivable
Accounts receivable as an investment.
Should be based on the level of return earned equals or exceeds the potential gain from other investments.
Credit policy administration
Credit standards
Terms of trade
Collection policy

Credit Standards
Determine the nature of credit risk based on:
Prior records of payments and financial stability
Current net worth and other related factors
5 Cs of credit:
Character
Capital
Capacity
Conditions
Collateral

Dun and Bradstreet Report – An Example

Terms of Trade
Stated term of credit extension:
Has a strong impact on the eventual size of accounts receivable balance.
Creates a need for firms to consider the use of cash discounts.

Collection Policy
A number if quantitative measures applied to asses credit policy.
Average collection period

Ratio of bad debts to credit sales
Aging of accounts receivable

An Actual Credit Decision
Accounts receivable = Sales = $10,000 = $1,667
Turnover 6

Brings together various elements of accounts receivable management.

Inventory Management
Inventory has three basic categories:
Raw materials used in the product
Work in progress, which reflects partially finished products
Finished goods, which are ready for sale.
Amount of inventory is affected by sales, production, and economic conditions.
Inventory is the least of liquid assets – should provide the highest yield.

Level versus Seasonal Production
Level production
Maximum efficiency in manpower and machinery usage.
May result in high inventory buildup.
Seasonal production
Eliminates inventory buildup problems.
May result in unused capacity during slack periods.
May result in overtime labor charges and overused equipment repair charges.

Inventory Policy in Inflation and Deflation
Inventory position can be protected in an environment of price instability by:
Taking moderate inventory positions (by not committing at a single price).
Hedging with a futures contract to sell at a stipulated price some months from now.
Rapid price movements in inventory may also have a major impact on the reported income of the firm.

The Inventory Decision Model
Carrying costs
Interest on funds tied up in inventory.
Cost of warehouse space, insurance premiums and material handling expenses.
Implicit cost associated with the risk of obsolescence and perish-ability.
Ordering costs
Cost of ordering.
Cost of processing inventory into stock.

Determining the Optimum Inventory Level

Economic Ordering Quantity
EOQ = 2SO ;
C
Where,
S = Total sales in units
O = Ordering cost for each order
C = Carrying cost per unit in dollars;
Assuming:
EOQ = 2SO = 2 X 2,000 X $8U = $32,000 = 160,000
C $0.20 $0.20
= 400 units

Inventory Usage Pattern

Safety Stocks and Stock Outs
Stock out occurs when a firm is:
Out of a specific inventory item.
Unable to sell or deliver the product.
Safety stock reduces such risks.
Increases cost of inventory due to a rise in carrying costs.
This cost should be offset by:
Eliminating lost profits due to stock outs
Increased profits from unexpected orders.

Safety Stocks and Stock Outs (cont’d)
Assuming that;

Average inventory = EOQ + Safety stock
2
Average inventory = 400 + 50
2
The inventory carrying costs will now increase by $50.
Carrying costs = Average inventory in units X Carrying cost per unit
= 250 X $0.20 = $50.

Just-in-Time Inventory Management
Basic requirements for JIT:
Quality production that continually satisfies customer requirements.
Close ties between suppliers, manufactures, and customers.
Minimization of the level of inventory.
Cost Savings from lower inventory:
On average, JIT has reduced inventory to sales ratio by 10% over the last decade.

Advantages of JIT
Reduction in space due to reduced warehouse space requirement.
Reduced construction and overhead expenses for utilities and manpower.
Better technology with the development of electronic data interchange systems (EDI).
EDI reduces re-keying errors and duplication of forms.
Reduction in costs from quality control.
Elimination of waste.

Areas of Concern for JIT
Integration costs.
Parts shortages could lead to lost sales, and slow, growth.
Un-forecasted increase in sales:
Inability to keep up with demand.
Un-forecasted decrease in sales:
Inventory can pile up.
A revaluation may be needed in high-growth industries fostering dynamic technologies.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Working Capital and the Financing Decision
6

Chapter Outline
Working capital management.
Current asset management.
Asset financing.
Long-term versus short-term financing.
Risk and profitability vis-à-vis asset financing.

Working Capital Management
The financing and management of the current assets of a firm.
Crucial to achieving long-term objectives of the firm or its failure.
Requires immediate action.

The Nature of Asset Growth
Effective current assets management requires matching of the forecasted sales and production schedules.
Differences in actual sales and forecasted sales can result in:
Unexpected buildups.
Reduction in inventory, affecting receivables and cash flow.
Firm’s current assets could be:
Self-liquidating.
‘Permanent’ current assets.

The Nature of Asset Growth (cont’d)

Controlling Assets – Matching Sales and Production
Fixed assets grow slowly with:
Increase in productive capacity.
Replacement of old equipment.
Current assets fluctuate in the short run, depending on:
Level of production versus the level of sales.
When production is higher than sales the inventory rises.
When sales are higher than production, inventory declines and receivables increase.

Controlling Assets – Matching Sales and Production (cont’d)
Cash budgeting process
Level production method
Smooth production schedules
Use of manpower and equipment efficiently to lower cost
Match sales and production as closely as possible in the short run.
Allows current assets to increase or decrease with the level of sales.
Eliminates the large seasonal bulges or sharp reductions in current assets.

Quarterly Sales and Earnings Per Share for McGraw Hill

Quarterly Sales and Earnings Per Share, Target and Limited Brands

Point-of-Sales Terminals
Retail-oriented firms use new, computerized inventory control systems linked online.
Digital inputs or optical scanners
Helps adjust orders or production schedules.
Radio Frequency Identification (RFID)

Temporary Assets under Level Production – An Example
Yawakuzi Motorcycle Company
Sales fluctuations: High sales demand during early spring and summer; sales drop during October through March.
Decision: Apply level production method – 12-month sales forecast is issued.
Result: Level production and seasonal sales combine to produce fluctuating inventory.

Yawakuzi Sales Forecast (in units)

Yawakuzi’s Production Schedule and Inventory

Sales Forecasts, Cash Receipts, and Payments, and Cash Budget

Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (cont’d)
Table 6-3 is created to examine the buildup in accounts receivable and cash.
Sales forecast: Based on assumptions taken earlier (table 6-1).
Cash receipts: 50% cash collected during the month of sale and 50% pertains to the prior month.
Cash budget: a comparison of cash receipt and payment schedules to determine cash flow.

Total Current Assets, First Year ($millions)

Yawakuzi’s Nature of Asset Growth

Cash Budget and Assets for II Year With No Growth in Sales ($millions)
Graphic presentation of the current asset cycle.

Patterns of Financing
Selection of external sources to fund financial assets is an important decision.
The appropriate financing pattern:
Matching of asset buildup and length of financing pattern.

Matching Long-Term and Short-Term Needs

Alternative Plans
It is important to consider other alternatives.
The challenge of constructing a financial plan is to prioritize the current assets into temporary and permanent.
The exact timing of asset liquidation, even in the light of ascertaining dollar amounts is onerous.
It is also difficult to judge the amount of short-term and long-term financing available.

Long-Term Financing
Firms can be assured of having adequate capital at all times:
Use long-term capital to cover part of the short-term needs.
Long-term capital can be used to finance:
Fixed assets.
Permanent current assets.
Part of the temporary current assets.

Using Long-Term Financing for Part of Short-Term Needs

Short- Term Financing
Small businesses do not have total access to long-term financing.
They rely on short-term bank and trade credit.
Advantage: interest rates are lower.
Short-term finances are used finance:
Temporary current assets.
Part of the permanent working capital needs.

Using Short-Term Financing for Part of Long-Term Needs

The Financing Decision
Corporations usually have multiple financial alternatives to reduce their costs of funds.
Achieved through the use of a combination of financing methods.
Aim to strike a balance between short-term versus long-term considerations against:
The composition of the firm’s assets
The willingness to accept risk.
Influenced by the term structure of interest rates.

Term Structure of Interest Rates
A yield curve – that shows the relative level of short-term and long-term interest rates.
U.S. government securities are popular as they are free of default risks.
Corporate debt securities entail a higher interest rate due to more financial risks.
Yield curves for both securities change daily to reflect:
Current competitive conditions.
Expected inflation.
Changes in economic conditions.

Basic Theories – Yield Curve
Liquidity premium theory
Long-term rates should be higher than short-term rates.
Market segmentation theory
Treasury securities are divided into market segments by the various financial institutions investing in the market.
Expectations hypothesis
Yields on long-term securities is a function of short-term rates.

Long- and Short-Term Annual Interest Rates
Relative volatility and the historical level of short-term and long-term rates.

Alternative Financing Plans
A Decision Process: Comparing alternative financing plans for working capital.

Impact of Financing Plans on Earnings

Varying Condition and its Impact
Tight money periods
Capital is scarce making short-term financing difficult to find or may ensue very high rates.
Inadequate financing may mean loss of sales or financial embarrassment.
Expected value
Represents the sum of the expected outcomes under both conditions.

Expected Returns under Different Economic Conditions

Expected Returns for High Risk Firms

Percentage of Working Capital to Sales for the S&P’s Industrials
Shift in asset structure

Toward an Optimal Policy
A firm should:
Attempt to relate asset liquidity to financing patterns, and vice versa.
Decide how it wishes to combine asset liquidity and financing needs.
Risk-oriented firm – short-term borrowings and low degree of liquidity.
Conservative firm – long-term financing and high degree of liquidity.

Asset Liquidity and Financing Assets

Toward an Optimal Policy
Company needs must be met by structuring:
Working capital position
The associated risk-return trade-off
The ultimate concern:
Maximize the overall valuation of the firm.
Use astute analysis of risk-return options.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Analysis
3

Chapter Outline
Ratio analysis and its importance.
Use of ratio for measurements.
The Du Pont system of analysis.
Trend analysis.
Evaluation of reported income to identify distortion.

Ratio Analysis
Financial ratios
Used to weigh and evaluate the operating performance of a firm.
Used to compare performance record as against other firms in the industry.
Analyzing ratios and numerical calculations.
Such data is provided by various organizations.

Ratios and their Classification
A. Profitability ratios
1. Profit margin.
2. Return on assets (investment).
3. Return on equity.
B. Asset utilization ratios
4. Receivable turnover.
5. Average collection period.
6. Inventory turnover.
7. Fixed asset turnover.
8. Total asset turnover.

Ratios and their Classification (cont’d)
C. Liquidity ratios
9. Current ratio.
10. Quick ratio.
D. Debt utilization ratios
11. Debt to total assets.
12. Times interest earned.
13. Fixed charge coverage.

Types of Ratios
Profitability ratios
Measurement of the firm’s ability to earn an adequate return on:
Sales
Assets
Invested capital
Asset utilization ratios
Measures the speed at which the firm is turning over accounts receivable.

Types of Ratios (cont’d)
Liquidity ratios
Emphasizes the firm’s ability to pay off short-term obligations as and when due.
Debt utilization ratios
Estimates the overall debt position of the firm.
Evaluates in the light of asset base and earning power.

Financial Statement for Ratio Analysis

Profitability Ratios

Administrator (A) – Replace equations with appropriate graphics.

Du Pont System of Analysis
A satisfactory return on assets might be derived through:
A high profit margin
A rapid turnover of assets (generating more sales per dollar of its assets)
Or both
Return of assets (investment) =
(Profit margin) X (Asset turnover)

Du Pont System of Analysis (cont’d)
A satisfactory return on equity might be derived through:
A high return on total assets;
A generous utilization of debt;
Or a combination of both.

Return on equity = Return on assets (investments)
[1 – (Debt/ Assets)]

Du Pont Analysis

Examples for Analysis using the Du Pont System

Asset Utilization Ratios
These ratios relate the balance sheet to the income statement.

Administrator (A) – Replace equations with appropriate graphics

Asset Utilization Ratios (cont’d)

Administrator (A) – Replace equations with appropriate graphics

Liquidity Ratios

Administrator (A) – Replace equations with appropriate graphics

Debt Utilization Ratios
Measures the prudence of the debt management policies of the firm.

Administrator (A) – Replace equations with appropriate graphics

Debt Utilization Ratios (cont’d)
Fixed charge coverage measures the firm’s ability to meet the fixed obligations.
Interest payments alone are not considered.

Income before interest and taxes………………..$550,000
Lease payments…………………………………… $50,000
Income before fixed charges and taxes…………$600,000

Summary of Ratio Analysis

Trend Analysis

Trend Analysis in the Computer Industry

Impact of Inflation on Financial Analysis
Inflation
Revenue is stated in current dollars.
Plant, equipment, or inventory may have been purchased at lower price levels.
Profits may be more a function of increasing prices than due to good performance.

Comparison of Replacement and Historical Cost Accounting

Comparison of Replacement and Historical Cost Accounting (cont’d)
Replacement costs – reduces income but increases assets.
An increase lowers the debt-to-assets ratio.
A decrease indicates a decrease in the financial leverage of the firm.
A declining income results in a decreased ability to cover interest costs.

Impact of Disinflation on Financial Analysis
Disinflation
Financial assets such as stocks and bonds have the potentials to do well – encouraging investors.
Tangible assets do not have the potential.
Deflation
Actual reduction of prices affecting everybody due to bankruptcies and declining profits.

Other Elements of Distortion in Reported Income
Effect of changing prices.
Reporting of revenues.
Treatment of nonrecurring items.
Tax write-off policies.

Explanation of Discrepancies

Explanation of Discrepancies (cont’d)
Sales
Use of defer recognition until each payment is received or full recognition at the earliest possible date.
Cost of goods sold
Use of different accounting principles – LIFO versus FIFO.

Explanation of Discrepancies (cont’d)
Extraordinary gains/ losses
Inclusion of events when computing current income or leaving them out.
Net income
Use of different methods of financial reporting.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Operating and Financial Leverage
5

Chapter Outline
What is leverage?
Operating leverage.
Financial leverage.
Potential profits or increased risk?

What is Leverage?
Use of special forces and effects to magnify or produce more than the normal results from a given course of action.
Can produce beneficial results in favorable conditions.
Can produce highly negative results in unfavorable conditions.

Leverage in Business
Determining type of fixed operational costs.
Plant and equipment
Eliminates labor in production of inventory.
Expensive labor
Lessens opportunity for profit but reduces risk exposure.
Determining type of fixed financial costs.
Debt financing
Substantial profits but failure to meet contractual obligations can result in bankruptcy.
Selling equity
Reduces potential profits but minimize risk exposure.

Operating Leverage
The extent to which fixed assets and associated fixed costs are utilized in a business.
Operational costs include:
Fixed
Variable
Semivariable

Break-Even Chart: Leveraged Firm

Break-Even Analysis
The break-even point is at 50,000 units, where the total costs and total revenue lines intersect.
Units = 50,000 .
Total Variable Fixed Costs Total Costs Total Revenue Operating Income
Costs (TVC) (FC) (TC) (TR) (loss)
(50,000 X $0.80) (50,000 X $2)
$40,000 $60,000 $100,000 $100,000 0

Administrator (A) – replace equations with appropriate graphics

Break-Even Analysis (cont’d)
The break-even point can also be calculated by:

Fixed costs = Fixed costs = FC
Contribution margin Price – Variable cost per unit P – VC
i.e. $60,000 = $60,000 = 50,000 units
$2.00 – $0.80 $1.20

Administrator (A) – replace equations with appropriate graphics

Volume-Cost-Profit Analysis: Leveraged Firm

A Conservative Approach
Some firms choose not to operate at high degrees of operating leverage.
More expensive variable costs may be substituted for automated plant and equipment.
This approach may cut into potential profitability of the firm as shown in Figure 5-2.

Break-Even Chart: Conservative Firm

Volume-Cost-Profit Analysis: Conservative Firm

The Risk Factor
Factors influencing decision on maintaining a conservative or a leveraged stance include:
Economic condition.
Competitive position within industry.
Future position – stability versus market leadership.
Matching an acceptable return with a desired level of risk.

Cash Break-Even Analysis
Helps in analyzing the short-term outlook of a firm.
Non-cash items are excluded:
Depreciation
Sales (accounts receivable rather than cash)
Purchase of materials
Accounts payable

Degree of Operating Leverage (DOL)
Percentage change in operating income
Occurs as a result of a percentage change in units sold.
Computed only over a profitable range of operations.
Directly proportional to the firm’s break-even point.

DOL = Percent change in operating income
Percent change in unit volume

Operating Income or Loss

Computation of DOL
Leveraged firm:

DOL = Percent change in operating income = $24,000 X 100
Percent change in unit volume $36,000
20,000 X 100
80,000
= 67% = 2.7
25%
Conservative firm:

DOL = Percent change in operating income = $8,000 X 100
Percent change in nit volume $20,000
20,000 X 100
80,000
= 40% = 1.6
25%

Administrator (A) – Replace equations with appropriate graphics

Algebraic Formula for DOL
DOL = Q (P – VC)
Q (P – VC) – FC
Where,
Q = Quantity at which DOL is computed.
P = Price per unit.
VC = Variable costs per unit.
FC = Fixed costs.
For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80, and FC = $60,000:

DOL = 80,000 ($2.00 – $0.80) ;
80,000 ($2.00 – $0.80) – $60,000
= 80,000 ($1.20) = $96,000 ;
80,000 ($1.20) – $60,000 $96,000 – $60,000
i.e. DOL = 2.7

Limitations of Analysis
Weakening of price in an attempt to capture an increasing market.
Cost overruns when moving beyond an optimum-size operation.
Relationships are not fixed.

Nonlinear Break-Even Analysis

Financial Leverage
Reflects the amount of debt used in the capital structure of the firm.
Determines how the operation is to be financed.
Determines the performance between two firms having equal operating capabilities.

BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage

Impact on Earnings
Examine two financial plans for a firm, where $200,000 is required to carry the assets.

Total Assets = $200,000
Plan A (leveraged) Plan B (conservative)
Debt (8% interest) $150,000 ($12,000 interest) $50,000 ($4,000 interest)
Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25)
Total financing $200,000 $200,000

Administrator (A) – Replace table with appropriate graphics

Impact of Financing Plan on Earnings per Share

Financing Plans and Earnings per Share

Degree of Financial Leverage
DFL = Percent change in EPS
Percent change in EBIT
For the purpose of computation, it can be restated as:
DFL = EBIT .
EBIT – I
Plan A (Leveraged):
DFL = EBIT = $36,000 = $36,000 = 1.5
EBIT – I $36,000 – $12,000 $24,000
Plan B (Conservative):
DFL = EBIT = $36,000 = $36,000 = 1.1
EBIT – I $36,000 – $4,000 $32,000

Limitations to the Use of Financial Leverage
Beyond a point, debt financing is detrimental to the firm.
Lenders will perceive a greater financial risk.
Common stockholders may drive down the price.
Recommended for firms that are:
In an industry that is generally stable.
In a positive stage of growth.
Operating in favorable economic conditions.

Combining Operating and Financial Leverage
Combined leverage: when both leverages allow a firm to maximize returns.
Operating leverage:
Affects the asset structure of the firm.
Determines the return from operations.
Financial leverage:
Affects the debt-equity mix.
Determines how the benefits received will be allocated.

Combined Leverage Influence on the Income Statement

Combining Operating and Financial Leverage

Operating and Financial
Leverage

Degree of Combined Leverage
Uses the entire income statement.
Shows the impact of a change in sales or volume on bottom-line earnings per share.

DCL = Percentage change in EPS ;
Percentage change in sales (or volume)
Using data from Table 5-7:

Percent change in EPS = $1.50 X 100
Percent change in sales $1.50 = 100% = 4
$40,000 X 100 $25%
$160,000

Degree of Combined Leverage (cont’d)
DCL = Q (P – VC) ,
Q (P – VC) – FC – I
From Table 5-7,
Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000.

DCL = 80,000 ($2.00 – $0.80) =
80,000 ($2.00 – $0.80) – $60,000 – $12,000
= 80,000 ($1.20) =
80,000 ($1.20) – $72,000
DCL = $96,000 = $96,000 = 4
$96,000 – $72,000 $24,000

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Forecasting
4

Chapter Outline
Financial forecasting in a firm’s strategic growth.
Three financial statements.
Percent-of-sales method.
Various methods to determine the amount of new funds required in advance.
Factors that affect cash flow.

Financial Forecasting
Ability to plan ahead and make necessary changes before actual events occur.
Outcome of a firm through external events might be a function of both:
Risk-taking desires.
Ability to hedge against risk with planning.
No growth or a decline – not the primary cause of shortage of funds.
A comprehensive financing plan must be developed for a significant growth.

Constructing Pro Forma Statements
A systems approach to develop pro forma statements consists of:
Constructing it based on:
Sales projections
Production plans
Translating it into a cash budget.
Assimilating all materials into a pro forma balance sheet.

Development of Pro Forma Statements

Pro Forma Income Statement
Provides a projection on the anticipation of profits over a subsequent period.
Establish a sales projection.
Determine a production schedule and the associated use of new material, direct labor, and overhead to arrive at a gross profit.
Compute other expenses.
Determine profit by completing the actual pro forma statement.

Establish a Sales Projection
Lets assume Goldman Corporation has two primary products: wheels and casters.

Stock of Beginning Inventory
Number of units produced will depend on beginning inventory.

Determine a Production Schedule and the Gross Profit
To determine the production requirements:
Units
+ Projected sales
+ Desired ending inventory
– Beginning inventory
= Production requirements

Production Requirements for Six Months

Unit Costs
Cost to produce each unit:

Total Production Costs

Cost of Goods Sold
Costs associated with units sold during the time period.
Assumptions for the illustration:
FIFO accounting is used
Therefore allocation of cost of current sales to beginning inventory
Then to goods manufactured during this period

Allocation of Manufacturing Costs and Determination of Gross Profit

Value of Ending Inventory

Other Expense Items
Other expense items must be subtracted from gross profits to arrive at net profit.
Earning before taxes
General and administrative expenses, interest expenses are subtracted from gross profit.
Earning after-taxes
Taxes are deducted from the above sum balance.
Contribution to retained earnings
Dividends are deducted from the above sum balance.

Actual Pro Forma Income Statement

Cash Budget
Pro forma income statement must be translated into cash flows.
The long-term is divided into short-term pro forma income statement.
More precise time frames are set to help in anticipating the patterns of cash outflows and inflows.

Monthly Sales Pattern

Cash Receipts
In the case of Goldman Corporation:
The pro forma income statement is taken for the first half year:
Sales are divided into monthly projections.
A careful analysis of past sales and collection records shows:
20% of sales is collected in the month.
80% in the following month.

Monthly Cash Receipts

Cash Payments
Monthly costs associated with:
Inventory manufactured during the period (material, labor and overhead).
Disbursements for general and administrative expenses.
Interest payments, taxes and dividends.
Cash payments for new plant and equipment.

Component Costs of Manufactured Goods

Cash Payments (cont’d)
Assumptions for the next two tables:
The costs are incurred on an equal monthly basis over a six-month period.
The sales volume however varies each month.
Employment of level monthly production to ensure maximum efficiency.
Payment for material, once a month after purchases have been made.

Average Monthly Manufacturing Costs

Summary of Monthly Cash Payments

Actual Budget
Difference between monthly receipts and payments is the net cash flow for the month.
Allows the firm to anticipate the need for funding at the end of each month.

Monthly Cash Budget

Cash Budget with Borrowing and Repayment Provisions

Pro Forma Balance Sheet
Represents the cumulative changes over time.
Important to examine the prior period’s balance sheet.
Some accounts will remain unchanged, while others will take new values.
Information is derived from the pro forma income statement and cash budget.

Development of a Pro Forma Balance Sheet

Pro Forma Balance Sheet (cont’d)

Explanation of Pro Forma Balance Sheet

Analysis of Pro Forma Statement
The growth ($25,640) was financed by accounts payable, notes payable, and profit.
As reflected by the increase in retained earnings.

Total assets (June 30, 2005)………$76,140
Total assets (Dec 31, 2004)……….$50,500
Increase……………………………..$25,640

Percent-of-Sales Method
Based on the assumption that:
Accounts on the balance sheet will maintain a given percentage relationship to sales.
Notes payable, common stock, and retained earnings do not maintain a direct relationship with sales volume.
Therefore percentages are not computed.

Balance Sheet of Howard Corporation

Percent-of-Sales Method (cont’d)
Funds required is ascertained.
Financing is planned based on:
Notes payable.
Sale of common stock.
Use of long-term debts.

Percent-of-Sales Method (cont’d)
Company operating at full capacity – needs to buy new plant and equipment to produce more goods to sell:
Required new funds:
(RNF) = A (ΔS) – L (ΔS) – P (1 – D)
S S
Where: A/S = Percentage relationship of variable assets to sales; ΔS = Change in sales; L/S = Percentage relationship of variable liabilities to sales; P = Profit margin; = New sales level; D = Dividend payout ratio.

RNF = 60% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $60,000 – $25000 – $18,000 (.50)
= $35,000 – $9000
= $26,000 required source of new funds.

Percent-of-Sales Method (cont’d)
Company not operating at full capacity – needs to add more current assets to increase sales :

RNF = 35% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $35,000 – $25,000 – $18,000 (.50)
= $35,000 – $25,000 – $9,000
= $1,000 required source of new funds.

Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Accounting
2

Outline
Income Statement
Price-earnings Ratio
Balance Sheet
Statement of Cash Flows
Tax-free Investments (Deprecation)

Basic Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows

Income Statement
Device to measure the profitability of a firm over a period of time.
It covers a defined period of time.
It is presented in a stair-step or progressive fashion
To examine the profit or loss after each type of expense item is deducted.

Income Statement (cont’d)
Sales – Cost of Goods Sold (COGS)
= Gross Profit (GP)

GP – Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)

EBIT – Interest = Earnings Before Taxes (EBT)

EBT – Taxes = Earnings After Taxes (EAT) or Net Income (NI)

Income Statement (cont’d)

Return to Capital
Three primary sources of capital:
Bondholders
Preferred stockholders
Common stockholders
Earnings per share
Interpreted in terms of number of outstanding shares.
May be paid out in dividends or retained by company for subsequent reinvestment.
Statement of retained earnings
Indicates the disposition of earnings.

Statement of Retained Earnings

Price-Earnings (P/E) Ratio
Refers to the multiplier applied to earnings per share to determine current value of the common stock.
P/E Ratio = Market Price of Stock / Earnings per share (EPS).
Some factors that influence P/E:
Earnings and the sales growth of the firm.
Risk (volatility in performance).
Debt-equity structure of the firm.
Dividend payment scheme.
Quality of management.

Price-Earnings (P/E) Ratio (cont’d)
Allows comparison of the relative market value of many companies based on $1 of earnings per share.
Indicates expectations about the future of the company.
Price-earnings ratios can be confusing.

Price-earnings Ratios for Selected U.S. Companies

Limitations of the Income Statement
Income that is gained or lost during a given period is a function of verifiable transactions.
Stockholders, hence may perceive only a much smaller gain or loss from actual day-to-day operations.
Flexibility in the reporting of transactions might result in differing measurements of income gained from similar events at the end of a time period.

Balance Sheet
Indicates what the firm owns and how these assets are financed in the form of liabilities and ownership interest.
Delineates the firm’s holdings and obligations.
A cumulative chronicle of all transactions that have affected the corporation since its inception.
Items are stated on an original cost basis rather than at current market value.

Balance Sheet Items
Liquidity: Asset accounts are listed in order of liquidity.
Current assets: items that can be converted to cash within 12 months or within the normal operating cycle of the firm.
Marketable securities: temporary investment of excess cash.
Accounts receivable: allowance for bad debts, to determine their anticipated collection value.

Balance Sheet Items (cont’d)
Inventory: includes raw materials, goods in progress or finished goods.
Prepaid expenses: represents future expense items, that are already paid for.
Example: insurance premiums or rent
Investments: long-term commitment of funds (at least one year).
Includes stocks, bonds or investments in other companies.

Balance Sheet Items (cont’d)
Plant and equipment: carried at original cost minus accumulated depreciation.
Accumulated depreciation: sum of all past and present depreciation charges on currently owned assets.
Depreciation expense is the current year’s charge.

Balance Sheet Items (cont’d)
Total assets: Financed through liabilities or stockholders’ equity.
Short-term obligations
Accounts payable: amounts owed on open accounts to suppliers.
Notes payable: short-term signed obligations to bankers and other creditors.
Accrued expense: payment yet to be made towards – service already provided or an obligation incurred.

Stockholder’s Equity
Represents total contribution and ownership interest of preferred and common stockholder’s.
Preferred stock.
Common stock.
Capital paid in excess of par.
Retained earnings.

Statement of Financial Position (Balance Sheet)

Concept of Net Worth

Net value/ book value = Stockholder’s equity – preferred stock component

Market value is of primary concern to the:
Financial manager
Security analyst
Stockholders

Limitations of the Balance Sheet
Most of the values are based on historical or original cost price.
Troublesome when it comes to plant and equipment inventory.
FASB ruling on disclosure of inflation adjustments no longer in force.
It is purely a voluntary act on the part of the company.

Limitations of the Balance Sheet (cont’d)
Differences between per share values may be due to:
Asset valuation
Industry outlook
Growth prospects
Quality of management
Risk-return expectations.

Comparison of Market Value to Book Value per Share

Statement of Cash Flows
Emphasizes the critical nature of cash flow to the operations of the firm.
It represents cash or cash equivalents items easily convertible to cash within 90 days.
Cash flow analysis helps in combating the discrepancies faced through the accrual method of accounting.

Statement of Cash Flows (cont’d)
Advantage of accrual method:
Allows the matching of revenues and expenses in the period in which they occur to appropriately measure profits.
Disadvantage of accrual method :
Adequate attention is not directed to the actual cash flow position of the firm.

Concepts Behind the Statement of cash Flows

Determining Cash Flows from Operating Activities
Translation of income from operations from an accrual to a cash basis.
Direct method
Every item on the income statement is adjusted from accrual to cash accounting.
Indirect method
Net income represents the starting point.
Required adjustments are made to convert net income to cash flows from operations.

Indirect Method

Comparative Balance Sheets

Cash Flows from Operating Activities

Determining Cash Flows from Investing Activities
Investing activities:
Long-term investment activities in mainly plant and equipment.
Increasing investment is a use of funds.
Decreasing investments is a a source of funds.

Determining Cash Flows from Financing Activities
Financial activities apply to the sale or retirement of:
Bonds
Common stock
Preferred stock
Other corporate securities
Payment of cash dividends.
Sale of firm’s securities is a source of funds.
Payment of dividend and the repurchase of securities is a use of funds.

Overall Statement Combining the Three Sections

Analysis of the Overall Statement
How are increases in long-term assets being financed?
Preferably, adequate long-term financing and profits should exist.
Short-term funds may be used to carry long-term needs – could be a potential high-risk situation.
Example: trade credit and bank loans

Depreciation and Fund Flows
Depreciation attempts to allocate the initial cost of an asset over its useful life.
Charging of depreciation does not directly influence the movement of funds.

Comparison of Accounting and Cash Flows

Free Cash Flow
Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends.
Capital expenditures: Maintains the productive capacity of firm.
Dividends: Maintains the necessary payout on common stock and to cover any preferred stock obligations.
Free cash flow is used for special financing activities.
Example: leveraged buyouts

Income Tax Considerations
Corporate tax rates
Progressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 15-20%.
Cost of tax-deductible expense

Depreciation as a Tax Shield
Not a new source of fund.
Provides tax shield benefits measurable as depreciation times the tax rate.

Corporation A Corporation B
Earnings before depreciation and taxes…….. $400,000 $400,000
Depreciation……………………………………… 100,000 0
_________ _________
Earnings before taxed………………………….. 300,000 400,000
Taxes (40%)………………………………………. 120,000 160,000
_________ _________
Earnings after taxes……………………………… 180,000 240,000
+Depreciation charged without cash outlay…. 100,000 0
_________ _________
Cash flow…………………………………………… $280,000 $240,000
Difference…………………………………………… $40,000