Finance Quiz 1

Net Working Capital (NWC)

Current assets - current liabilities

• Tells us whether a company has enough short-term resources to pay its short-term bills and keep running its business

• Important: Because a company can be profitable but still run out of cash

Capital Budgeting

Which long-lived assets should we invest in?

• Because businesses don’t have unlimited money

• Need to decide which investments will help them grow and create value

• Ex.) Selecting new equipment. We weigh the size, timing and risk of future cash flows

Capital Structure

How should we pay for them?

• How a company pays for its business using a combination of DEBT and EQUITY

• Should we borrow money, use investors’ money, or use a combination of both to finance our business?

• Ex.) The debt-equity mix, such as 45% debt and 55% equity

Working Capital

How do we run day-to-day cash?

• Money and short-term resources a company uses to keep its business running every day

• Do we have enough money and resources to keep our business operating and pay our bills?

• Ex.) How much cash to keep, inventory levels, credit terms, when to pay suppliers

Owners’ Liability

How much an owner is personally responsible for the debts and financial obligations of their business

• If my business loses money or can’t pay its debts, will I have to use my personal money to pay them?

• Some business owners can lose their personal money if their business fails, while others are generally protected

• How much financial risk someone takes when owning a business

Taxation

The process of the government collecting money (taxes) from individuals and businesses

• How much of the money we earn do we have to pay to the government?

• Taxes affect how much money a business actually keeps and can use

Life/Transfer

Refers to how long a business can exist (life) and whether ownership of the business can be passed or sold to someone else (transfer)

• What happens to my business if I die, retire, or want to sell it?

Raising Equity

Means a company gets money from investors in exchange for giving them part ownership of the business

• How can I get money to grow my business without taking out a loan?

Sole Proprietorship

Is a business owned and operated by ONE person

• What if I want to start my own business and be the only owner?

• Owners’ Liability: Unlimited

• Taxation: Personal Income

• Life/Transfer: Ends with the owner

• Raising Equity: Owner’s wealth

General Partnership

Is a business together and share the money, decisions, and responsibilities

• What if we want to start a business together and share the money, decisions, and responsibilities?

• Owners’ Liability: Unlimited: each partner is liable for all firms debts, even ones they didn’t know about

• Taxation: Personal Income

• Life/Transfer: Hard to transfer

• Raising Equity: Partners’ wealth

Limited Partnership

Is a business owned by two or more people where some partners manage the business and others mainly invest money

• What is one person wants to run the business, while another person just wants to invest money?

• Owners’ Liability: General partners unlimited. Limited partners lose at most what they invested

• Taxation: Personal Income

• Life/Transfer: Limited partners can sell their interest

• Raising Equity: Partners; wealth

Corporation

Is a business that legally separate from its owners (shareholders)

• How can we raise money from investors while protecting the owners’ personal assets?

• Owners’ Liability: Limited to the amount invested

• Taxation: Double taxation

• Life/Transfer: Unlimited life, easy to transfer

• Raising Equity: Easiest: can raise the largest sums

LLC (Limited Liability Company)

A type of business that protects its owners’ personal assets from business debts while allowing flexibility in management and taxation

• How can I own my own business without putting my personal money at risk if the business fails?

• Owners’ Liability: Limited

• Taxation: Usually like a partnership (no double tax)

• Life/Transfer: Varies

• Raising Equity: Limited

Role of the financial manager

Maximize the current market value per share of the existing stock (the market value of the owner

Depreciation

Is an expense but not a cash outflow. The cash left when the asset was bought, so add it back

Interest

Is paid to creditors. It’ a financing cash flow, not an operating one, but it does lower taxes

Stakeholders

Employees, customers, suppliers, government

• Also have claims on the firm’s cash flows

Agency Costs: Indirect

Lost opportunities. A good but risky project is passed up because managers fear for their jobs

Agency Costs: Direct

Spending that benefits managers (an unneeded corporate jet), and the cost of monitoring them (outside auditors)

Alignment Tools

Pay: stock and options, ideally ones that must be held for several years

Control: shareholders elect the board; proxy fights and takeovers can replace managers

Regulation: SEC disclosure, and Sarbanes-Oxley 2002: officers must personally certify the financial statements

Average Tax Rate

The percentage of your total income that you pay in taxes

Marginal Tax Rate

The percentage of tax you pay on your next additional dollar of taxable income

Liquidity

Is how quickly and easily an asset can be turned into cash without losing much of its value

• Can the firm pay its short-term bills?

Leverage

Using borrowed money (debt) to increase the potential return on an investment of grow a business

• How is the firm financed?

Turnover

Measures how quickly a company uses, sells, or replaces its assets to generate sales

• How hard do the assets work?

Profitability

Measures how well a company makes a profit from its sales, assets, or investments

• How much of each dollar is kept?

DuPont & Market

Is a way to measure how well a company uses its sales, assets, and debt to generate profits for its owners

Assets

What should we buy?

Liabilities + Equity

How do we pay for it?

Cash Flow Streams

The amounts of money that come in or go out over a period of time

Negative Cash Flow

Cash leaving your pockets

Positive Cash Flow

Cash entering your pocket

Annuity

Equal payments, equal intervals, a fixed number of periods

• Important because they help people plan, save, borrow, and manage money though regular payments over time

Perpetuity

A series of equal payments that continue FOREVER with no ending date

• Perpetuities help calculate the Present Value (PV) of payments that continue forever

Annuity Due

A series of equal payments made at the BEGINNING of each period (monthly, yearly, etc.)

• Annuities due help calculate the Present Value (PV) and Future Value (FV) of regular payments

Ordinary Annuity

A series of equal payments made at the END of each period (every month or every year)

• Ordinary Annuities help calculate the Present Value (PV) or Future Value (FV) of regular payments

• Fixed payment loan

Retirement

Helps people plan for regular income after they stop working

• Annuity

Loans

Helps calculate monthly car, mortgage, or student loan payments

• Annuity

Savings

Helps determine how much money you can accumulate by saving regularly

• Annuity

Investments

Helps calculate the Present Value (PV) of Future Value (FV) of regular cash payments

Lump Sum

Single payment of money made/received all at once

• Helps determine how much a single amount of money is worth today or in the future

Annual Percentage Rate (APR)

Stated annual interest rate, without accounting for how interest compounds

• Advertised interest rate

• APR = periodic rate x periods per year

• =NOMINAL(effect_rate, npery)

• Helps compare advertised interest rates on loans and investments

• Helps understand that stated cost of borrowing money

• Commonly used for credit cards, car loans, and investments

Effective Annual Rate (EAR)

Actual interest rate after accounting for compounding

• =EFFECT(nominal_rate, npery)

• More frequent compounding — higher EAR

• Shows how much interest you actually earn or pay over a year

• Helps compare investments or loans with different compounding periods

• Gives a more accurate picture of the effect of compound interest

Amount Borrowed

The amount borrowed is the Present Value (PV) of a loan

• PV is how much money you recieve today

Monthly Payments

PV helps determine how much money you can borrow

Interest (PV)

PV helps show how future payments relate to the amount borrowed today

Amoritzation

The process of paying off a loan over time through regular payments that cover both principal and interest

• Where each payment goes

Principle

The original amount of money borrowed

• Principle = payment - interest

Interest

The cost of borrowing money

Pure Discount Loan

Is a loan where you borrow money today and repay one larger lump sum at the end, with no payments in between

• Loan Valuation: Helps calculate the present value of a future payment

• Investing: Used to understand zero-coupon bonds

• Interest Rates: Helps determine the return earned by a lender or investor

Interest-Only Loan

A loan where you pay only the interest during the loan term and repay the orginal amount borrowed (principal) at the end

• Lower Initial Payments: You only pay interest during the loan term

• Cash Flow: Helps borrowers manage their money in the short term

• Loan Repayment: Shows how interest and principle are paid separately

• Financial Planning: Helps borrowers prepare for the large principle payment at the end

Amortized Loan

A loan that is gradually paid off through regular payments that include both principle and interest

• Loan Repayment: Helps you pay off debt gradually instead of all at once

• Budgeting: Makes it easier to plan for regular monthly payments

• Interest: Shows how much of each payment goes toward interest versus principle

• Financial Planning: Helps determine how long it takes to pay off a loan

How big a loan can I afford?

Present Value

What rate is this offer charging?

Rate

How long to pay it off?

NPER

Saving Phase

FV of an annuity

• FV in Excel

Spending Phase

Payment from a PV

• PMT in Excel

Nesting Egg

Money you save and grow over time for a future purpose

• Retirement

• FV in Excel

Excel - To find Payment

=PMT(rate, nper, pv, fv)

Excel - To find Present Value

=PV(rate, nper, pmt, fv)

Excel - To find Future Value

=FV(rate, nper, pmt, pv)

Excel - To find Rate (as an APR)

=RATE(nper, pmt, pv, fv)

Excel - To find Number of periods

=NPER(rate, pmt, pv, fv)

Excel - To find EAR from an APR

=EFFECT(nominal_rate, npery)

Excel - To find APR from an EAR

=NOMINAL(effect_rate, npery)

Excel - To find PV of uneven cash flows

=NPV(rate, value1, value2, …)

Return on Equity (ROE)

Measures how well a company uses its shareholders’ money to generate profit

• How profitable the company is for its owners (HOW MUCH)

• ROE = (Net Income/Total Shareholders’ Equity) x 100

• NI: Net Income + Equity: Owner’s money

• 
  

DuPont Identity (Expanded ROE Formula)

A formula that breaks down Return on Equity into three parts to explain how a company makes a profit using shareholders’ equity

Explains WHY a company’s ROE is high or low

• ROE = NPM x TAT x FLM

• NPM: Net Profit Margin — How much profit is made from sales

• TAT: Total Asset Turnover — How efficiently assets generate sales

• FLM: Financial Leverage Multiplier — How much the company relies on debt versus equity to finance assets

Total Asset Turnover (TAT)

Measures how efficiently a company makes in sales for every $1 of assets it owns

• TAT = Total Sales/Total Assets

• How effectively a company uses its assets to generate revenue, not necessarily profit

Financial Leverage Multiplier (FLM)

Measures how much a company uses debt and shareholders’ equity to finance its assets

• Helps show how much a company relies on borrowed money (debt) instead of its owners’ money (equity)

• FLM = Total Assets/Total Equity

Current Ratio

Measures a company’s ability to pay off its short-term debts using its short-term assets

• It tells you if a company has enough money and other short-term assets to pay its bills

• Current Ratio = Current Assets/Current Liabilities

Quick Ratio

Measures a company’s ability to pay off its short-term debts using its most liquid assets (excluding inventory)

• Tells you if a company can pay its short-term bills without having to sell its inventory

• Quick Ratio = (Current Ratio - Inventory)/Current Liability

Average Payment Period (PMT)

Measures how many days, on average, a company takes to pay its suppliers for purchases made on credit

• Tells you how long a company takes to pay its bills

• Average Payment Period = Accounts Payable/Average Purchase per Day

Inventory Turnover

Measures how many times a company sells and replaces its inventory during a specific period, usually one year

• Tells you how quickly a company sells its products

• Inventory Turnover = COGS/Inventory

Average Age of Inventory

Measures how many days, on average, a company holds inventory before selling it

• Tells you how long products sit in inventory before being sold

• Average Age of Inventory = 365/Inventory Turnover

Average Collection Period

Measures how many days, on average, a company takes to collect money from customers who purchased on credit

• Tells you how long it takes a company to get paid by its customers

• Average Collection Period = Accounts Receivable/Average Sales per Day

Gross Profit Margin

Measures how much money a company keeps from its sales after paying the direct costs of making or buying its products

• Tells you how much profit a company makes from selling products before paying other business expenses

• Gross Profit Margin = Sales - (Sales-COGS/Sales) x 100 — Gross Profit/Sales

Operating Profit Margin

Measures how much profit a company makes from its sales after paying operating expenses, but before interest and taxes

• Tells you how much money a company keeps from sales after paying the costs of running its business

• Operating Profit Margin = Operating Income/Sales

Times Interest Earned (TIE)

Measures how easily a company can pay the interest on its debt using its earnings

• Tells you how many times a company can cover its interest payments with its operating earnings

• TIE = EBIT/Interest Expense

• Above 1: Earnings exceed expenses

• Equal to 1: Earnings just cover interest expenses

• Below 1: Earnings are not enough to cover interest expenses

• High TIE — Easier to pay interest

• Low TIE — Harder to pay interest

EBIT

Earnings Before Interest and Taxes (operating earnings)

Interest Expense

The amount a company must pay in interest on its debt

Price-to-Earnings (P/E) Ratio

Measures how much investors are willing to pay for every $1 of a company’s earnings

• Tells you how expensive a company’s stock is compared to the profit it earns per share

• P/E = Price per share/Earnings per share

• High P/E — Investors pay more for each $1 of earnings, often because they expect growth

• Low P/E — Investors pay less for each $1 of earnings, possibly because growth expectations are lower