Rutgers Parul Jain - Financial Management Midterm 1

Capital Budgeting

What long-term investments or projects should the business take on?

Capital Structure

- How should we pay for our assets and investments?

- Should we use debt or equity?

Working Capital Management

How do we manage day-to-day finances, short-term assets (inventory) and liabilities (accounts payable) of the firm?

Sole Proprietorship

business owned and operated by one person

- least regulated

- owner keeps all profits

- owner has unlimited liability for business debts

Partnership

A business in which two or more persons combine their assets and skills

- similar advantages to sole proprietorship

- unlimited liability for all partners

- can be general or limited

General Partnership

partnership in which partners share equally in both responsibility and liability

Limited Partnership

one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business

Corporation

A business owned by stockholders who share in its profits but are not personally responsible for its debts

- stockholders and managers are separate

- profits are double taxed

- superior in raising money

- superior in transferring ownership

Goal of Financial Management

*Maximize the current value of the company's stock/value of owners equity

- Maximize profit

- Minimize costs

- Maximize market share

- Based on stockholders desires

The Sarbanes-Oxley Act of 2002

Regulates management greed and abuse; requires public companies to annually assess and report on the design and effectiveness of internal control over financial reporting.

Agency Relationship

Relationship between stockholders and management

- exists when the (principal) hires an (agent) to represent his or her interests

Agency Problem

Conflict of interest between principal and agent

Managerial Compensation

Incentives can be used to align management and stockholder interests

The incentives need to be structured carefully to make sure that they achieve their goal

Corporate Control

The threat of a takeover may result in better management

Stakeholders

Any person or entity other than a stockholder or creditor who potentially has a claim on the cash slows of a firm

Primary Market

The original sale of securities by governments and corporations

Secondary Market

Where securities are bought and sold after the original sale, between other investors

Auction Markets (Secondary Market)

- has a physical location

- match those who wish to sell with those who wish to buy

Dealer Market (Secondary Market)

- a market where dealers buy and sell for their own accounts

Securities and Exchange Commission (SEC)

- Public offerings of debt and equity must be registered with SEC

over-the-counter (OTC) market

Dealer markets in stocks and long-term debt

2 distinct groups that report to the chief financial officer

The treasurer's office and the controller's office

Balance Sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date.

current assets

items that can or will be converted into cash within one year

- Listed in decreasing liquidity

fixed assets

assets that will be held or used for a period longer than one year

tangible (fixed assets)

property, plant, and equipment

intangible (fixed assets)

patents and trademarks

Current Liabilities

liabilities due within a year, come before long-term liabilities

- Accounts Payable

long-term liabilities

obligations that a company expects to pay after one year

- debt due after one year

bond and bondholder

long-term debt and long-term creditors

Net Working Capital

current assets - current liabilities

Liquidity

the ease with which an asset can be converted into cash

financial leverage

the use of debt in a firm's capital structure

-increases the potential reward, but also increases potential for distress and failure

Book Value

Values shown on the Balance Sheet, generally not what the assets are actually worth

GAAP (Generally Accepted Accounting Principles)

audited financial statements in US mostly show assets at historical costs (Book Value)

Market Value

the amount for which something can be sold on a given market.

Income Statement

Summarizes a firms revenue and expenses over a period of time.

Revenues - Expenses = Income

Dividends

earnings distributed to stockholders, counts as an expense

Earnings Per Share (EPS)

net income/shares outstanding

recognition or realization principle

revenue can only be recognized once the underlying goods or services associated with the revenue have been delivered

Matching Principle

recognize expenses in the same period as the revenues they help to generate

Accounting income vs cash flow

Accounting Income statement contains noncash items like depreciation

noncash items

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

Accountants classify costs as:

Product Costs and Period Costs

Product Costs

direct materials, direct labor, manufacturing overhead

- (Cost of Goods Sold)

- fixed and variable

Period Costs

all the costs that are not product costs.

- selling, general and administrative

-variable and fixed

- Ex. Salaries

average tax rate

total tax bill divided by total taxable income

- all marginal tax brackets added together

marginal tax rate

tax rate that applies to the next dollar of taxable income

- Income in the tax bracket (75,000 - 50,000) multiplied by tax rate of that bracket (.25)

flat-rate tax (US System)

income tax rate stays the same, regardless of taxable income

- marginal is always same as average

tax inversion

US based company merges with oversees company to avoid paying US taxes

Tax Cuts and Jobs Act of 2017

Sets US taxes as a flat-rate 21%

Cash Flow Statement

difference between the flow of money in and out of the business.

Cash flow from assets = Cash flow to creditors + Cash flow to stockholders

Cash flow from assets

operating cash flow - net capital spending - change in net working capital

Operating Cash Flow (OCF)

cash generated from a firm's normal business operating activities

EBIT + Depreciation - Taxes

- EBIT: Earnings before Taxes

- We add back depreciation because its a noncash expense

capital spending

money spent on fixed assets minus money received from sale of fixed assets

Ending Net Fixed Assets - Beginning net fixed Assets + Depreciation = Net Capital Spending

Change in Net Working Capital

Net change in current assets relative to current liabilities for the period being examined.

Ending NWC - Beginning NWC = Change in NWC

Accounting Operating cash flow

Different from normal OCF because: interest is deducted when net income is computed

- Interest is considered an operating expense rather than financial expense

cash flow from assets

The cash flow of a firm that is available for distribution to the firm's creditors and stockholders

Operating Cash Flow - Net capital spending - change in NWC

Free Cash Flow (FCF)

a.k.a cash flow from assets

- cash that the firm is free to distribute to creditors and stockholders

Cash flow to creditors (bondholders)

a firm's interest payments to creditors less net new borrowing

Cash flow to stockholders (owners)

dividends paid - net new equity raised

Sources of Cash

a firm's activities that generate cash

uses of cash

a firm's activities in which cash is spent

Statement of Cash Flows

a firm's financial statement that summarizes its sources and uses of cash over a specified period

common-size statement

A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

common-base year statement

a standardized financial statement presenting all items relative to a certain base year

Assets 2018/Assets 2017

Combined Common-Size and Base Year Assets = ((Common size 2018 - 2017) + Common Base)/2

Financial Ratios

ways of comparing and investigating the relationships between different pieces of financial information

-eliminates size problem

Short-Term Solvency Ratio

financial ratio for measuring a company's liquidity and its ability to pay bills over short run (Current Assets, Liabilities)

Current Ratio

current assets divided by current liabilities

- measure of short term liquidity

Quick Ratio

Since inventory is least liquid we omit it in acid test ration

(Current Assets - Inventory) / Current Liabilities

Cash Ratio

Interest for short term creditors

Cash / Current Liabilities

Net working capital to total assets

Net Working Capital / Total Assets

interval measure

How long can business keep running with dry cash inflow.

Current Assets/Average Daily Operating Costs

Total Debt Ratio

how much debt per dollar of assets

(Total Assets - Total Equity) / Total Assets

Debt to Equity Ratio

Total Debt/Total Equity

Equity Multiplier

Total Assets/Total Equity

Long-term debt ratio

long term debt / (long term debt + total equity)

Times Interest Earned

Measure of long term solvency, how well the company has its interest obligations covered

EBIT/ interest

Cash Coverage Ratio

How well can the company pay its obligations using all its cash including depreciation

(EBIT + Depreciation) / Interest

Inventory Turnover

The higher the ratio the more efficiently we are managing inventory

COGS/Average Inventory

Days' Sales in Inventory

Measures the average number of days that inventory is held by a company.

365 days / Inventory turnover.

Receivables Turnover

How fast we collect outstanding credit accounts

Sales / Accounts Receivable

Days' Sales in Receivables

The ratio tells how many days it takes to collect the average level of accounts receivable.

365 days / Accounts receivable turnover ratio.

NWC Turnover

ratio of sales to NWC. The ratio measures how much "work" a firm gets out of its working capital.

Sales/NWC

Fixed Asset Turnover

For every dollar in fixed assets how much we generate in sales.

Sales/Net Fixed Assets

Total Asset Turnover

For every dollar in assets how much we generate in sales.

Sales/Total Assets

Profit Margin Ratio

How much profit per dollar in sales

Net Income/Sales

Return on Assets (ROA)

Measures how profitably a company uses its assets.

Net income/total assets.

Return on Equity

For every dollar in equity how much we generated in profit.

How the stockholders fared during the year.

Net Income/Total Equity

EPS

Earnings per share

net income/shares outstanding

PE Ratio

How many more times the shares sell for more than earnings per

price per share/earnings per share

Market to Book Ratio

market value per share/book value per share

Enterprise Value (EV)

An estimate of the market value of the company's operating assets

Total market value of the stock + Book value of all liabilities - Cash

EBITDA ration

Enterprise Value / EBITDA

ROE

ROA x Equity Multiplier = ROA x (1 + Debt Equity ratio)

Profit Margin x Total Asset turnover x Equity multiplier

DuPont Identity

Breaking ROE into 3 parts: Profit margin, Total Asset turnover, Financial leverage or Equity multiplier

Why evaluate financial statements?

Internal Uses:

-Performance Evaluation

-Planning for the future

External Uses:

-creditors

-suppliers

-customers

-Stockholders

Benchmarking ratios

- Time Trend Analysis

- Peer Group Analysis

Financial Planning

formulates the way in which financial goals are to be achieved

- planning horizon

- level of aggregation

Elements of Financial Planning

Investment in new assets - determined by capital budgeting decisions

Degree of financial leverage - determined by capital structure decisions

Cash paid to shareholders - determined by dividend policy decisions

Liquidity requirements - determined by net working capital decisions