Financial Management Exam 1 (Ch. 1-7) Rutgers Hoffman

Corporate Finance

The study of ways to answer:

- What long term investments should you take on?

Where will you get the long-term financing to pay for your investment?

- How will you manage your everyday financial activities?

Owners (Stockholders)

usually not directly involved in making business decisions, especially on day-to-day basis

Managers

represent the owners interests and make decisions on their behalf

Vice President of Finance

coordinates activities of the treasurer and the controller

Controller's Office handles

- cost

- financial accounting

- tax payments

- management information systems

Treasurers office is responsible for

- cash

- credit

- financial planning

- capital expenditures

Financial Manager must be concerned with

- Capital Budgeting: process of planning and managing firms long-term investments

- Capital Structure: mixture of debt and equity maintained by firm

- Working Capital Management: firms short term assets and liabilities

types of legal forms of business

- sole proprietorship

- partnership

- corporation

- (LLC)

Sole Proprietorship

- one owner

ADV

- simplest type of business to start

- least regulated

- owner keep all profit

DISADV

- owner has unlimited liability

- all income is taxed as personal income

- life is limited to owner lifespan

- amount of equity is limited to proprietor personal wealth

- difficult to transfer ownership

Partnership

- business owned by 2+ individuals

ADV & DISADV

- Similar to proprietorship

Corporation

- distinct legal entity composed of 1 or more individuals

- legal 'person', seperate from owners with their own rights and privileges

- stockholders & managers are seperate

ADV

- ownership can be transferred

- unlimited life

- limited liability for stockholders

DISADV

- double taxation

Limited Liability Corp (LLC)

- combines personal liability protection of a corp w/ tax flexibility of partnership

- offer flexibility in how they can be managed & structured (Single or multi owner)

- Choose how they want to be taxed (as a sole propr, partnership, S-Corp, or C-corp)

Other names for Corporations

- joint stock company

- public limited companies

- limited liability companies

Benefit Corporation

- for profit

- accountability: consider how actions affect shareholders, employees, customers, community & environment

- transparency: must provide annual report detailing how the company pursued a public benefit during the year

- purpose: must provide a public benefit (either to society or environment)

Goal of Financial Management

- Make money / add value for owners

- Profitability goals

- controlling risk goals

- maximizing current value of stock

A more general goal

Maximize the market value of the existing owners equity

Agency Relationship

relationship between stockholders and management

Agency Problem

possibility of conflict of interest between stockholders and management of a firm

Indirect Agency Costs

lost opportunities

Direct Agency Costs

- corporate expenditures that benefit management but costs the stockholder

- expense that arises from the need to monitor management actions

Management incentive to increase share value

- compensation is usually tied to financial performance

- managers who are successful in pursuing stockholder goals will be in greater demand in the labor market, commanding higher salaries

Control of the Firm

- stockholders ultimately control the firm, as they elect board of directors, who hires and fires managers

- management may be replaced via proxy fights and takeovers

Stakeholders

someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm

Financial Market

a way if bringing buyers and sellers together to buy and sell debt and equity securities

Primary Market

- corporation is the seller

- transaction raises money for the corporation

- involves selling securities to general public

- private placements are negotiated sales involving a specific buyer

Secondary Market

- one owner or creditor selling to another

- a means for transferring ownership of corporate securities

Dealer Market

- type of secondary market

- over the counter markets (OTC)

- dealers are connected electronically

- Large OTC market is NASDAQ

Auction Market

- type of secondary market

- has a physical location

- purpose to match sellers with buyers

- largest is the New York Stock Exchange (NYSE)

Balance Sheet

- financial statement showing a firms accounting value on a particular date

- organizes and summarizes assets, liabilities, and equity

- left and right side always equal

- Assets = liabilities + equity

Assets

- Current (less than 1 year) or Fixed (long term)

- may be tangible or intangible

Liabilities

- current (less than 1 year) or fixed (long term)

- first thing listed on the right side

Shareholder Equity

- difference between total value of assets and total value of liabilities

Net Working Capital

- difference between a firms current assets and current liabilities

- positive when current assets exceeds current liabilities

- positive in a healthy firm

Liquidity

- speed and ease with which an asset can be converted to cash without significant loss of value

- assets are listed in order of decreasing liquidity

If a firm borrows money, first claim to cash flow goes to

creditors, equity holders only entitled to residual value

Financial Leverage

use of debt in a firms capital structure

Book Value

- assets value on balance sheet

- historical cost (what the firm paid for assets)

- not what assets are currently worth

Market Value

- current value

- depends on riskiness and cash flows

Income Statement

- summarizes a firms performance over a period of time

- first thing reported is revenue and expenses, last is net income

- taxes are reported separately

Income = Revenues - Expenses

A Financial Manager should keep 3 things in mind when looking at an income statement

- GAAP

- Cash vs Noncash Items

- Time and Costs

Noncash Items

- expenses charged against revenues that do not directly affect cash flow, such as depreciation

- crucial to seperate

Product Costs

includes things such as raw materials, direct labor expense, and manufacturing overhead

Period Costs

incurred during a particular time period and might be reported as selling, general, and administrative expenses

Taxes

- one of the largest cash outflows a firm experiences

- determined by tax code

- became a flat 21% rate after 2017

- always changing

Average Tax Rate

= total taxes paid / total taxable income

Marginal Tax Rate

amount of tax payable on the next dollar earned

Cash Flow

- difference between number of dollars that came in and the number of dollars that went out

- no standard financial statement presents this info in the way we wish

Statement of Cash Flows

- standard financial accounting statement

- concerned w/ different issue

Cash Flow Identity

cash flow from the firms assets is equal to the cash flow paid to suppliers of capital to the firm

- reflects the fact that a firm generates cash through various activities, and then used to pay creditors or to owners

Cash Flow from Assets

= Cash flow to creditors + Cash flow to stockholders

= Operating cash flow - Net capital spending - Change in net working capital (NWC)

Operating Cash Flow

- cash generated from a firms normal business activities

- tells us whether a firms cash inflows are sufficient to cover every day cash outflows

- does not include depreciation or interest in calculation (does include taxes)

- negative number is bad

Capital Spending

net spending on fixed assets

(Purchase of fixed assets - sale of fixed assets)

Change in Net Working Capital

- measured as the net change in current assets relative to current liabilities for the period being examined

- represents the amount spend on net working capital

Free Cash Flow

- another term for 'Cash Flow from Assets'

- refers to firms cash as 'free' to distribute to creditors and stockholders because its not needed for working capital or fixed asset investments

Cash Flow to Creditors (bondholders) Formuka

= interest paid - net new borrowing

Cash Flow to Stockholders

= dividends paid - net new equity raised

Operating Cash Flow Formula

Earnings Before Interest & Taxes (EBIT) + Depreciation - Taxes

Net Capital Spending Formula

= Ending net fixed assets - beginning net fixed assets + depreciation

Change in NWC Formula

= Ending NWC - Beginning NWC

Sources of Cash

activities that bring in cash

- decrease in left side (asset) or increase in right side (liability/equity)

Uses of Cash

Activities that involve spending cash

- increase in left side (asset) or decrease in right side (liability/equity)

Statement of Cash Flows

- a firms financial statement that summarizes its sources and uses of cash over a specified period

- reporting cash flow per share is prohibited

all changes are grouped into 3 categories:

- operating activities

- investment activities

- financing activities

Standardizing Financial Statements

nearly impossible to directly compare statements for two companies because of difference in size

Common Size Statements

- present all items in percentage terms

- common size balance sheets express items as percentage of total assets

- common size income statements express items as percentage of total sales

- common size statement of cash flows expresses items as percentage of total sources (or uses)

Common Base Year Statements

presents all items relative to a certain base year amount

Financial Ratios

relationships determined from a firms financial information and used for comparison purposes

Financial Ratios Categories

- Short term solvency, or liquidity

- long term solvency, or financial leverage

- Asset management, or turnover

- Profitability

- Market Value

Short Term Solvency, or Liquidity, Ratios

- Current Ratio

- Quick Ratio

- Cash Ratio

- Net Working Capital to Total Assets

- Interval Measure

Current Ratio

- measurement of short term liquidity

- to a creditor, the higher the better

- to a firm, high ratio indicates inefficient use of cash/assets

- expect number of at least 1

Current Ratio Formula

= Current Assets / Current Liabilities

Quick Ratio (acid-test)

- computed like current ratio, except inventory is omitted because its least liquid current asset

- large inventories are sign of short term trouble

Quick Ratio Formula

= (Current Assets - Inventory) / Current Liabilities

Cash Ratio

of interest to a very short term creditor

Cash Ratio Formula

= Cash / Current Liabilities

Net Working Capital to Total Assets

low values may indicate relatively low levels of liquidity

Net Working Capital to Total Assets Formula

= Net Working Capital / Total Assets

Interval Measure

Indicates how long the business can continue

Interval Measure Formula

= Current Assets / Average Daily Operating Costs

Long Term Solvency Ratios

- Total Debt Ratio

- Debt Equity Ratio

- Equity Multiplier

- Long Term Debt Ratio

- Times Interest Earned Ratio

- Cash Coverage Ratio

Total Debt Ratio

- considers all debts of all maturities to all creditors

- Debt Equity ratio & Equity multiplier are variations

Total Debt Ratio Formula

= (Total Assets - Total Equity) / Total Assets

Debt Equity Ratio Formula

= Total Debt / Total Equity

Equity Multiplier Formula

= Total Assets / Total Equity

Long Term Debt Ratio Formula

= Long Term Debt / (Long Term Debt + Total Equity)

Times Interest Earned (TIE) Ratio

measures how well a company has its interest obligations covered

- often called interest coverage ratio

Times Interest Earned (TIE) Ratio Formula

= EBIT / Interest

Cash Coverage Ratio

- basic measure of a firms ability to generate cash from operations

- frequently used as a measure of cash flow available

Cash Coverage Ratio Formula

= (EBIT + Depreciation) / Interest

Asset Management, or Turnover, Ratios

- Inventory Turnover

- Days Sales in Inventory

- Receivables Turnover

- Days Sales in Receivables

- NWC Turnover

- Fixed Asset Turnover

- Total Asset Turnover

Inventory Turnover

how many times the firm sold off or turned over the entire inventory

Inventory Turnover Formula

= COGS / Inventory

Days Sales in Inventory

tells us how many days inventory sits (on average) before it is sold

Days Sales in Inventory Formula

= 365 Days / Inventory Turnover

Receivables Turnover

shows how many times a firm collects outstanding credit accounts and reloans the money

Receivables Turnover Formula

= Sales / Accounts Receivable

Days Sales in Receivables

average number of days it takes for a firm to collect on its credit sales

Days Sales in Receivables Formula

= 365 Days / Receivables Turnover

NWC Turnover

how much 'work' we get out of our working capital

NWC Turnover Formula

= Sales / NWC