Chapter Nine Key Terms Business 101

Financial capital

The funds a firm uses to acquire its assets and finance its operations

Finance

The functional area of business that is concerned with finding the best sources and uses of financial capital

Goal of financial management

To maximize the value of the firm to its owners

A socially responsible firm has an obligation to?

Respect the needs of all stakeholders

Being socially responsible requires?

A long-term commitment to the needs of different stakeholders

Fiduciary duty of financial managers?

Managers should make decisions that are most consistent with the interests of ownership when conflicts arise

Risk

The degree of uncertainty regarding the outcome of a decision

Risk-return trade-off

The observation that financial opportunities that offer high rates of return are generally riskier than opportunities that offer lower rates of return

Financial ratio analysis

Computing ratios that compare values of key accounts listed on a firm’s financial statements

Liquid asset

An asset that can quickly be converted into cash with little risk of loss

Liquidity ratios

Financial ratios that measure the ability of a firm to obtain the cash it needs to pay its short-term debt obligations as they come due

Key liquidity ratio is?

The current ratio, which compares current assets to
liabilities

Asset management ratios

Financial ratios that measure how effectively a firm is using its assets to generate revenues or cash

Asset management ratios are also called?

activity ratios

Key asset management ratios

• Inventory turnover calculates how quickly a firm sells its inventory to generate revenue

• Average collection period shows how long it takes for a firm to collect from customers

Financial leverage

The use of debt in a firm’s capital structure

Leverage ratios

Ratios that measure the extent to which a firm relies on debt financing in its capital structure

Key leverage ratio is?

Interest coverage, which compares a firm’s annual earnings to its annual interest expenses

Profitability ratios

Ratios that measure the rate of return a firm is earning on various measures of investment

Profitability ratios provide?

measure of how successful the firm is at earning a profit

The larger the percentage of net profit margin?

The more profit a firm earns on each dollar of revenue

Key profitability ratio is?

Net profit margin

Net profit margin

Indicates the percentage a firm earns on each dollar of revenue, after paying all operating expenses, interest, and taxes

Budgeted income statement

A projection showing how a firm’s budgeted sales and costs will affect expected net income

Budgeted income statement is also called

A pro forma income statement

Budgeted balance sheet

A projected financial statement that forecasts the types and amounts of assets a firm will need to implement its future plans and how the firm will finance those assets

A budgeted balance sheet is also called?

A pro forma balance sheet

Cash budget

A detailed forecast of future cash flows that helps financial managers identify when their firm is likely to experience temporary shortages or surpluses of cash

Projecting cash flows helps financial managers determine?

• When the firm is likely to need additional funds to meet short-term cash shortages

• When surpluses of cash will be available to pay off loans or to invest in other assets

Trade credit

Spontaneous financing granted by sellers when they deliver goods and services to customers without requiring immediate payment

Spontaneous financing

Financing that arises during the natural course of business without the need for special arrangements

Factor

A company that provides short-term financing to firms by purchasing their accounts receivables at a discount

Line of credit

A financial arrangement between a firm and a bank in which the bank pre-approves credit up to a specified  limit, provided that the firm maintains an acceptable credit rating

Revolving credit agreement

A guaranteed line of credit in which a bank makes a binding commitment to provide a business with funds up to a specified credit limit at any time during the term of the agreement

Commercial paper

Short-term (and usually unsecured) promissory notes issued by large corporations

Direct Investments From Owners

Investments can be obtained by selling new stock and by reinvesting earnings

Retained earnings

The part of a firm’s net income it reinvests

Long-Term Debt

• Borrowing from banks and other lenders

• Issuing bonds

Covenant

A restriction lenders impose on borrowers as a condition of providing long-term debt financing

Term Loans

A lump sum of money borrowed and repaid in fixed installments over a set period

Corporate Bonds

Corporations’ own formal IOUs, which they sell to investors

Equity financing

Funds provided by the owners of a company

• A company issues and sells new stock or uses retained earnings

Debt financing

Funds provided by lenders (creditors)

• A company takes out a bank loan or issues and sells corporate bonds

Capital structure

The mix of equity and debt financing a firm uses to meet its permanent financing needs

Pros of Debt Financing

• Interest payments are a tax-deductible expense

• Firms can acquire additional funds without requiring existing stockholders to invest more of their own money or the sale of stock to new investors

Cons of Debt Financing

• Requirement to make fixed payments

• Creditors often impose covenants on the borrower

Pros of Equity Financing

• More flexible and less risky than debt financing

• Imposes no required payments

Cons of Equity Financing

• Does not yield the same tax benefits as debt financing

• Existing owners might not want a firm to issue more stock, as it may dilute their share of ownership

• A company that relies mainly on equity financing forgoes the opportunity to use financial leverage

Financial Leverage

Using Debt to Magnify Gains (and Losses)

What does Financial Leverage Do?

• Magnifies the return on the stockholders’ investment when times are good

• Reduces the financial return to stockholders when times are bad

Many companies use leverage to?

magnify their return on equity (ROE)

• The required interest and principal payments on debts became a heavy burden

• Debt financing has become significantly more expensive for highly leveraged firms under the 2018 tax laws

Sound financial management requires?

keeping a level head and balancing risk and return

Dodd-Frank Act

A law enacted in the aftermath of the financial crisis of 2008–2009 that strengthened government oversight of financial markets and placed limitations on risky financial strategies such as heavy reliance on leverage

A firm’s cash refers to?

Holdings of currency plus demand deposits

Cash equivalents

Safe and highly liquid assets that many firms list with their cash holdings on their balance sheet

U.S. Treasury bills

Short-term marketable IOUs issued by the U.S. federal government

Money market mutual funds

A mutual fund that pools funds from many investors and uses these funds to purchase very safe, highly liquid securities

Managing Accounts Receivable

Balancing advantages of offering credit with the costs involves setting credit terms, establishing credit standards, and deciding on an appropriate collection policy

Managing Inventories

Firms must hold inventories to operate businesses

• Manufacturing firms look to keep inventories as low as possible in an attempt to reduce costs and improve efficiency

Capital budgeting

The process a firm uses to evaluate long-term investment proposals

Evaluating Capital Budgeting Proposals

Financial managers measure the benefits and costs of long-term investment proposals in terms of the cash flows they generate

Time value of money

The principle that a dollar received today is worth more than a dollar received in the future

Cash flow’s value depends on?

The amount of cash received, and when it is received

Present value

The amount of money that, if invested today at a given rate of interest called the discount rate, would grow to become some future amount in a specified number of time periods

The Risk-Return Trade-Off Revisited

In general, projects with the potential for high returns also carry a high degree of uncertainty and risk

Net present value (NPV)

The sum of the present values of expected future cash flows from an investment, minus the cost of that investment