Business Finance - Exam 2

2, 7, 3

What is a balance sheet?

It’s a “snapshot” at a specific time

Assets (left) Liabilities/Owner’s Equity (right)

Equation for Total Assets

Total liabilities + owner's’ equity

Net Working Capital Equation

Current Assets - Current Liabilities

NWC= (Cash + Accounts Receivable + Inventory) - (Accounts payable + Notes payable)

Equation for current assets

Cash + accounts receivable + inventory

Equation for current liabilities

accounts payable + notes payable

What is liquidity?

Ease of conversion without significant loss of value
• Order of liquidity // Current assets →fixed assets →intangible assets
• E.g.: Cash, Accounts receivable, Inventory, Equipment, Real estate, Trademark

Debt v. Equity

• Equity: owners’ right to business’ money  (“Equity” on the Balance Sheet)

• Debt: creditors’ right to business’ money (“Liability” on the Balance Sheet)

• Creditors’ rights is always superior to owners’ rights to business’ money

• Therefore: Equity = Assets - Liabilities

What is an income statement?

Performance over a period of time
• Income = Revenue – Expenses
• Expenses include: Interest payments, Depreciation, Taxes

What is Depreciation (a non-cash item)

• An assigned amount of an asset’s use during the time period

• Does not affect cash flow

• E.g.: Value of an automobile (Think of market v. book implications)

What is the average tax rate?

Taxes Paid / Total Taxable Income  (Reflects total tax expense)

What is marginal tax rate?

Determined by schedule of taxes (percentage paid on next dollar of taxable income)

What are the 2 uses of net income?

1. Payout to owners
- Paid to shareholders as dividends
-Only way for shareholders to get money out of business and still retain ownership
2. Kept in the business
- Booked as Retained Earnings
- Provides funds internally for growth
- Retained earnings are plowed back into the firm

What is cash flow?

• Money coming in – Money going out
(Not necessarily the same as accounting Cash Flow Statement or Profit & Loss Statement)

Cash Flow from Assets (Money in) = Cash Flow to Creditors + Cash Flow to Owners (Money out)

What is Operating Cash Flow (OCF) Cash and Equivalents?

It’s cash and Equivalents

Earnings before taxes & interest + Depreciation-Taxes

Cash generated by normal business activities
• Remember: EBIT = Revenue – COGS minus depreciation
• Depreciation is a non-cash expense
• Therefore, Depreciation expense must be added back into EBIT to find cash flow

What is Capital Spending (Fixed Assets)?

Ending fixed assets-Beginning fixed assets+Depreciation

What is Change in Working Capital (NWC)?

It is current assets and current liabilities

Change in NWC

(Ending current assets – Ending current liabilities) minus
(Beginning current assets – Beginning current liabilities)

Equation for Ending NWC - Beginning NWC

[(Ending Cash + Ending Accounts Receivable + Ending Inventory)
Minus
(Ending Accounts Payable + Ending Notes Payable)]
Minus
[(Beginning Cash + Beginning Accounts Receivable + Beginning Inventory)
Minus
(Beginning Accounts Payable + Beginning Notes Payable)]

How to find cash flow from assets?

Operating Cash Flow - Capital Spending - Change in Work Capital

What is the meaning of Free Cash Flow?

• A.K.A.: FCF

• Money that is “free” to be given to owners/shareholders

• Cash Flow from Assets is an important component of FCF

• FCF is used to determine the price of a stock

How to find Cash Flow to creditors

Interest paid – Net new borrowing
(Net new borrowing = new debt – retired debt)

How to find Cash Flows to Stockholders

• Cash Flows to Stockholders
Dividends paid – Net new equity
(Net new equity = new issues of stock – repurchased stock)

How to find Stocks

1. Assets = Debts (liabilities) + Equity

2. Equity = Stock = Ownership interest in a firm

3. Owning “stock” = owning a proportional “share” of a firm

What is common stock?

Rights of a Shareholder : Determined by State Law & Corporate Charter
1. Proportional vote for Board of Directors
2. Proportional share of any dividends paid
3. Proportional share of assets remaining after liquidation
4. Proportional vote on “matters of great importance”
(e.g. mergers, voluntary liquidation, etc.)
[Proportion = # shares held / # total shares]

What is cumulative voting?

• (Number of shares held) x (number of directors)
  Shareholder can cast total number of votes in any fashion
  (e.g. casting all votes for 1 director)

What is straight voting?

Shareholder casts proportional vote for each director
(A majority shareholder effectively controls selection of Board)

What is proxy voting?

A granting of voting authority to another

What is pre-emptive right?

It’s the right of current shareholders to purchase additional shares offered by the firm before offering to public (Gives opportunity to keep proportional interest)

What is classes of stock?

• Firms can create “classes” of stock (often designated “Class A” or Class “B”)
• Different classes will have different voting rights
• Typically used to maintain control of firm
• Limited in publicly traded stocks

How do shareholders get their money?

1. Capital Gains

2. Dividends

What is Capital Gains?

It’s appreciation of market value of shares
• Shareholder must give up ownership interest

What is dividends?

It’s payment made by firm to shareholders proportionally
• Paid out of Cash (Net Income)
• (Occasionally will be paid in stock shares)

What does payment at the discretion of Board mean?

It’s when shareholders cannot vote themselves a dividend

What does it mean by payment can not be “forced” or required?

It means no default or bankruptcy if no dividend

How to find payment out of after tax profits of firm

Net Income = Retained Earnings - Dividends

What is preferred stock?

CHARACTERISTICS

1. A fixed dividend rate

2. Priority over common stock for dividends

3. No voting rights
   STATE VALUE
   1. Liquidated value (price paid at firm liquidation)
   2. Fixed dividend in dollars/share (i.e. “$5 preferred”)
   • Cumulative/Non-cumulative dividends
   IF dividends are paid, cumulative preferred receives all past
   dividends not paid before any common dividend is paid

Bonds

• Debt / Liability
• Creditor
• Low risk to principal
• Specified regular payments
• Payments tax-deductable to firm
• Entitles holder to only payments & principal
• PV is discounted certain cash flows

Stocks

• Equity
• Owner
• High risk to principal
• No certain payments
• Dividends are an after-tax payment
• Shareholder has an interest in all profits of the firm
• PV is discounted expected cash flows

How is stock valuation similar to bonds?

Stock prices are the present value of all expected future cash flows

• expected future flows are the dividends and capital gain (market appreciation of share price)

• “Unlike bonds” stocks do not have a definite term as stocks can be held forever

Stock Valuation Calculations

Recall: (1+r)^t , as t increases, PV decreases

• as t → ∞, PV → 0

• Three possible scenarios: zero growth, constant growth, and non-constant growth

What is zero growth?

Dividends are the same every year (will never change)

• same principle as a perpetuity (stable annual payment in perpetuity)

P0 = D/R ( Where R = “required rate of return”)

What is Constant Growth?

Assumes dividend will increase at same rate (g) year after year

Dt = D0 (1 + g )t

• P0 = D0 (1+g)/( R - g )or P0 = D1/(R - g) AKA: “The Dividend Growth Model”

What is the dividend growth model?

CAVEAT ! The growth rate, g, must be less then the required return, R, or the model
cannot be used
• Therefore, for any point in time: Pt = Dt (1 + g ) / (R – g) Pt = Dt+1 / (R – g)

What is non-constant Growth?

Sometimes g, the growth rate of the dividend is greater than R, the required return. If g can be assumed to become constant at some point in the future, Non-constant Growth model can be used
• Can also be used if near term dividends = 0, if it can be assumed that there will be constant growth dividends at some point in the future

What is R?

The required return; the interest rate that an investor wants or needs in order to be
motivated to make the purchase
• For now, R will always be given and it has two parts
1. Dividend Yield: Dividend/Price
2. Market price appreciation (Capital Gains Yield): g, the rate at which the value of the investment grows

Required Return = Dividend Yield + Capital Gains Yield

What is the correlation between price and return? (when price goes up what happens to return?)

Price (p) increases then Return (R) decreases

What are internal financial rations?

It’s targets and measures (planning/compensation), *tied to how we get payed

What are external financial ratios?

Strengths and weaknesses (evaluation/comparison)

What is standard of Comparison?

AKA Benchmarks

1. Trend analysis

2. Peer analysis

What is Trend analysis?

Time series: comparing different time periods for the same firm

What is peer analysis?

Cross-sectional: comparing against different firms or industry in the same time periods

What is management by exception?

It’s identifying performance that differs significantly from a benchmark

(a number by itself has no particular meaning)

What are problems with comparisons?

1. Methods of Measurement: Accounting rules

2. Similarity of Business: SIC Codes, NAICS codes

3. Geographical Factors: Laws, markets, expenses, etc.

What are the methods of measuring for comparison?

1. Common size statement analysis : Allows for “full” comparison
2. Ratio analysis : Allows for comparison of specific elements of performance

What are the common size statement analysis?

1. Procedure:
   - Select a basis (e.g. revenue, assets, liabilities)
   - Divide all financial statement components
   - Compare the calculated percentages

2. Internal/trend analysis use: Compare %’s period-to-period

3. Peer analysis: “Scale” firms to each other

What is Ration analysis: Market Performance?

1. Earnings per Share = Net Income/ Shares outstanding
2. Price-Earnings Ratio = Share price / (Earnings / Shares outstanding)
3. Market-to-Book Ratio = Market value of firm/ Net Book value of firm
= Share price / (Equity/Total shares)

What is ration analysis: payout and retention?

• Source: income statement (net income)
1. Dividend Payout Ratio = Cash dividends/Net Income
2. Retention Ratio (aka plowback ratio or “b”) = Change in Retained Earnings/Net Income = (Ending R.E.-Beginning R.E.)/Net Income
***Dividend Payout Ratio + Retention Ratio = 1

What is internal growth rate?

• Maximum possible growth rate from internal financing only (i.e. retained earnings)
• Tells us how much a firm can grow without new debt or new equity (i.e. growth from profitability) = (ROA*Retention Ratio)/[1- (ROA*Retention Ratio)]

What is sustainable growth rate?

• Maximum possible growth rate for a constant debt ratio
• Firm may take on new debt (to maintain debt ratio) but not new equity

= (ROE*Retention Ratio)/[1- (ROE*Retention Ratio)]

What are alternative calculations

• If “total equity” is from beginning of a period: SGR = ROE x retention ratio
• End of period more commonly used
• Alternative is a quick method often employed to make preliminary judgments
• Result will be very close

What is ratio analysis of profitability?

1. Profit Margin = Net Income / Sales
2. Return on Assets (ROA) = Net Income / Total Assets
3. Return on Equity (ROE) = Net Income / Total Equity

What is ratio analysis of solvency?

• Source: balance sheet
• Measures: Financial Leverage, ability to pay debt (loans)
1. Total Debt Ratio = (Assets-Equity)/Assets or Liabilities/Assets
1a. Debt-to-Equity Ratio (aka: Debt/Equity Ratio) = Total Debt/Total Equity
1b. Equity Multiplier = Assets/Equity or 1 + Debt/Equity Ratio (Dollars of Assets per $1 of Equity)

Source: income statement
2. Times Interest Earned = EBIT/Interest (Ability to pay interest)
3. Cash Coverage Ratio = (EBIT + Depreciation)/Interest or EBITDA/Interest
(Adding back Depr. to see cash flows)

What is ratio analysis of liquidity

Source: balance sheet
• Measures: Ability to pay bills in near term
1. Current Ratio = Current Assets/Current Liabilities
2. Quick Ratio (a.k.a. Acid Ratio) = (Current Assets-Inventory)/Current Liabilities
3. Cash Ratio = Cash/Current Liabilities

What is ratio analysis: asset management (asset utilization)?

Source: balance sheet & income statement
1. Inventory turnover = COGS/Inventory
1a. Days Sales in Inventory = 365/Inv. Turnover
2. Receivables turnover = Sales/Acc’ts Rec.
2a. Days Sales in Receivables=365/Rec. Turnover
3. Total Asset Turnover = Sales/Total Assets n.b. : Sales = Revenue

What is DuPont Analysis?

• “DuPont Identity”
Return on Equity (ROE) = Profit margin*Total asset turnover*Equity multiplier
• Meaning: Return on Equity (ROE) has 3 parts
1. Operational Efficiency (Profit margin)
2. Asset Utilization Efficiency (Total Asset Turnover)
3. Financial Leverage (Equity Multiplier)

What are the steps of developing the DuPont Identity?

Step 1: ROE=Net Income/Total Equity
• Step 2: (Net Income/Total Equity)*(Assets/Assets) = (Net Income/Assets)*(Assets/Total Equity)
• Step 3: [(Sales/Sales)*(Net Income/Assets)]*(Assets/Total Equity)
= (Net Income/Sales)*(Sales/Assets)*(Assets/Total Equity)

Why use the DuPont Identity?

• Provides a structure for using financial statement
analysis
1. In what segments (operations, assets or
leverage) is the firm significantly different?
(management by exception)
2. Drill down in identified areas to uncover source

What are the DuPont Analysis Shortcomings?

Does not consider the cost of debt
• DuPont Analysis says: Higher debt = higher Equity Multiplier = higher Return on Equity
• But higher debt = higher interest payments = lower net income = lower profit margin
• Increasing debt may appear to improve performance ex ante but may reduce performance ex post (It’s all about the timing)