BEC: Financial management

Business Risk

the uncertainty associated with the ability to forecast EBIT (earning before interest and taxes). It is influenced by the company's operating cost structure, product characteristics, and marketing locations, as well as the firm's competitive position. Generally smaller firms that rely heavily on a small number of customers have greater business risk.

What basic elements affect revenues of Business Risk

These affect what according to business risk?

1. sensitivity to the business cycle

2. competition

3. stability of the local economy

4. stability of foreign economies

Operating Risk

created when the firm incurs an increasing level of fixed relative to variable costs in its operating structure. As a greater proportion of fixed costs are employed within the operating structure, the greater the risk that the breakeven point will not be met.

Interest rate risk

the risk of holding fixed interest-bearing instruments such as a bond when interest rates are changing. The price of long-term bonds is more sensitive to changes in interest rates than the price of short-term securities; thus, a rise in interest rates would cause the price of a fixed interest-bearing instrument to drop. Generally, the longer the maturity value, the greater the interest rate risk

Reinvestment Risk

arises when investments must be rolled over. If rates have declined, the interest earned will decline

Liquidity Risk

the risk that an asset cannot be sold for market value on short notice

Market Risk

the risk associated with a security that cannot be eliminated by diversification. this includes such items as recessions, inflation, and changing interest rates that affect all firms. This is also known as systematic risk

Company risk

risk that is specifically associated with a particular firm due to mix of products, new products, competition, patents, lawsuits, etc. Within a portfolio, company rest can be eliminated by proper diversification

Credit risk

The risk that receivables will not be collected in full on a timely basis. Increased risk includes costs related to bad debt that losses, higher receivables, balances, resulting in higher carrying costs, higher customer investigation fees, and collection cost.

Default risk

The risk that the borrower will be unable to make interest, and or principal payments as scheduled on the application. The higher the possibility of default, the greater the return required by the lender.

purchasing risk (purchasing power risk)

The risk that inflation will result in less purchasing power for a given sum of money. Assets that are expected to rise in value during a period of inflation have a lower risk. For example, real estate often appreciates during an inflationary period; however, cash loses value during that same period

Operating leverage

relates the percentage changes in EBIT to the percentage change in revenue. The greater the operating leverage, the greater the change in operating income, will be given a particular change in sales. Therefore, a company with a high degree of operating leverage would have a large change in operating income for a relatively small change in sales.

Financial leverage

refers to the extent to which debt and preferred stock (fixed income securities) are used in the capital structure. The larger the percentage of debt and preferred stock that is used for financing, the greater the risk that the company will not earn enough to cover the fixed interest and preferred dividend payments. The more leverage, the greater the risk, and the higher the cost of capital.

Pecking order theory

indicates that the order of financing of a company (or project) follows the path of least effort

The weighted average cost of capital

The weighted average of the cost of debt, and the various equity components of the firms capital structure. It is preferable to use weights based on the market value of the items or the firms target capital structure.

Capital Asset Pricing Model (CAPM)

The relevant risk on any security is it's contribution to the risk of a well diversified portfolio

Temporary current assets

Include assets that would fluctuate with the current business cycle as cells vary with the corresponding changes in the levels of accounts, receivable and inventory between the maximum and minimum levels over the annual business cycle

Permanent current assets

Would include assets that are more permanent in nature, and that they are carried even at the low points of the business cycle, such as the minimum accounts, receivable and inventory levels during the lowest part of the business cycle

Conservative approach

two financing short term debt uses permanent assets to finance all of the permanent operating assets requirements and also some of the seasonal needs. Spontaneous credit (accounts payable) is used to finance the remaining seasonal needs. Affirm using this approach, would hold liquid assets in marketable securities during the low points of the seasonal cycle.

Maturity, matching approach to financing

Matches assets to liability maturities. This approach minimizes, default risk, and is considered to be a moderate approach to financing.

Aggressive approach

To financing short term, debt would be to finance part of the permanent current assets with spontaneous credit, such as accounts payable. This approach can be earned to a high degree by also financing part of the fixed assets which short term borrowing.

Accounts payable, and accruals

Provide instant financing at no cost for a firm. Example, employees provide continual services and are paid only at set intervals. In a sense, employees provide the equivalent of small loans to the company.

Trade credit

An appealing source of financing, since it is free, however, the length of the credit is only for a very limited time

Unsecured bank loans

Are not backed by any collateral and come in a variety of forms

Line of credit

An agreement with the bank to have up to a specific amount of funds available as a short term loan during a particular period

Letter of credit

An international financing tool that guarantees payment to an international supplier upon the safe arrival of the Goods Buy issuing a loan to the purchaser. Can be irrevocable or revocable.

Commercial paper

an unsecured promissory note that is issued by large banks and big corporations to meet short term cash needs. It is a promise to repay the borrowed funds at a future given date with a maturity of no more than 270 days. Rates for these loans are normally lower than for banks. This financing option is considered to be quite safe due to the short term frame, and the strength of the borrowing companies; however, there is no flexibility in the repayment date, as might be received with a bank loan

Short term credit

Often secured by current assets, such as receivable and inventory and is often used by seasonal businesses were cash flow and working capital needs are not synchronized

Pledging of receivables

Intel's using the cash value of the receivable as collateral for a loan

Factoring

involves selling accounts receivable, two a factor as a form of short term financing the factor assumes the risk of collection and the purchasers notified of the factoring arrangement, and usually remits payments directly to the factor

Inventory financing

Intel the use of inventory, a security for a short term loan. Such a loan can attach to all inventory held or particular portion of inventory identified by serial numbers or place in a particular location.

Term loan

A legal agreement between a borrower and a lender where the borrower promises to make interest and principal payments at specific times to the lender for the use of the borrowed funds. It is a form of funded debt (long-term debt)

Bond

Generally, publicly offered form of long-term debt, where the borrower agrees to make payments of interest and principal on specific dates to the bondholder

Indenture

The legal document that contains the terms of the bond issued

Call provision

The right of the issuer to redeem the bond issue prior to the maturity, under certain circumstances

Sinking fund

Requires the issuer to retire, a portion of the bond issue, each year or deposit funds into a restricted account to be accumulated for the retirement of the bonds

Restrictive covenants

Conditions that must be met by the issue, or during the life of the bond issue, such as maintaining a debt ratio, no higher than a specified amount, restricting, dividend payments, maintaining current ratio, or other similar requirements

Bond ratings

determined using a rating system, such as SNP's, based upon the probability that the issuing corporation will go into default. AAA (very strong.) AA - high investment quality. A & BBB - investment grade. BB & B - substandard. CCC & D - speculative

Market value of bonds

Based upon the present value of discounted future, cash flows, comprise of an annuity plus a lump sum

Preferred stock

A hybrid in that it has some characteristics of death and some of the characteristics of equity. More risky than death; however, it is less risky than common stock.

Common stock

The most risk of the investments, stockholders are not guaranteed any type of returning either dividends or stock, appreciation, and these investors are the last to receive anything in liquidation

Retained earnings

GAAP profits that have not been paid out to shareholders

Working capital

Short term, assets, such as cash, receivables, and inventory

Networking capital

Current assets, less current liabilities

inventory conversion period

average time that inventory is held in dates before being sold ( average inventory/ average cost of good sold per day)

receivable collection period

average time that receivables are outstanding before they are turned into cash (average accounts receivable/ average sales per day)

payable deferral period

average time that short term obligations related to the purchase/production of inventory are outstanding (average payables/ average purchases per day)

Cash conversion cycle

The inventory conversion period and the receivable collection period less the payables deferral period. The amount of time that funds are tied up in non-cash current assets.

Compensating balances

Or amount required to be kept in an account by a bank and are often mandatory in order to obtain alone or to avoid paying fees for individual bank services

Cash budget

A cash management tool that details cash inflows, and outflows over specified period of time. It can be prepared on a yearly quarterly monthly weekly or even daily basis.

Target cash balance

The desired cash balance management believes to be necessary to safely conduct business. This amount may vary during the year due to the cyclical nature of many industries. When estimated cash inflows exceed estimated cash outflows forgiven. Including plan, capital expenditures, the excess can be used to repay short term credit, and or be invested.

Synchronizing cash flows

Matches the cash outflows with the timing of the receipt of cash inflows. This allows firm to keep transaction balances to a minimum.

Net float

The difference between the firms, checkbook, balance, and the balance of the account in the banks records

disbursement float

The amount of the checks written, but that have yet to be clear in the bank

Marketable securities

generally, low risk investments that can be quickly turned into cash example, US treasury bills, banks certificate of deposit, commercial paper

Netting

Atul, administrative and transaction cost resulting from currency conversion can be reduced

credit period

The length of time the customer is given to pay for the purchases

Discounts

The credit terms 3/10, net 30 allow customers to take a 3% discount if the payment is received within 10 days of invoice

Credit standards

The required financial strength of acceptable customers

Collection policy

How tough or lax, the firm is in terms of attempting to collect slow paying accounts

Quality of credit

The ability to collect receivables in full and in a timely manner

Collection procedures

Steps that a firm takes to collect past due account

just in time (JIT) production system

Purchases raw materials and component parts just as they are needed in the production process, that's reducing raw material inventory close to zero

Economic order quantity

The least amount of inventory that should be ordered given the various costs involved

safety stock

A level of inventory that is held in excess of the desired inventory level to cover unanticipated demand

Free trade credit

Credit received during the discount period

Liquidity

Measures a firms ability to satisfy short term obligations

Networking capital

Assumes that all current assets or liquid, and May readily be turned into cash that could be used to satisfy all current liabilities

current ratio

Relative comparison of current assets to current liabilities. Calculate the number of dollars of current assets that are available to cover each dollar of current liabilities.

Quick ratio

a stricter test for liquidity, then the current ratio because it includes only the most liquid of the current assets in calculation. It is a measure of the ability to discharge currently maturing obligations based on the most liquid assets, and does not include inventory

Cash ratio

A further refinement of the current ratio in that only cash, cash, equivalents, and marketable securities are compared to current liabilities, thus making it the most rigorous of the current, quick, and cash ratios. If all current liabilities had to be paid off today, how close can a company come to meeting those obligations?

Solvency/leverage

The organizations ability to meet long-term obligations(repayment of principal as well as interest) using cash or by converting non-cash assets into cash

Debt to total assets ratio

Indicates the extent that leverage has been used to finance the assets held to the degree to which creditor protection is provided in the case of insolvency

Debt to equity ratio

an alternative leverage ratio used to measure the relationship of debt to capital. The dollars of debt per dollar of equity are measured.

Times interest earned ratio

Measure a firms ability to cover interest charges, based on its earnings before interest and taxes. At minimum, a Company would need to pay current interest charges in a given period

Asset utilization, or activity ratio

Measure how well a company is utilizing its assets by turning the assets into sales or revenues

Total asset turnover ratio

indicates how many dollars of sales were created by each dollar of total assets

Accounts receivable, turnover ratio

measures the quality of the accounts, receivable collection process, and the ability of the company to turn their accounts receivable Balance into cash.

Number of days sales in trade accounts receivable

Measures the number of days on average that it takes to collect accounts receivable

Inventory turnover ratio

Measure the speed with which inventory can be converted into sales

Number of days sales in inventory

Measures the number of days it takes to sell existing inventory

profitability

Measures of success in terms of income defined in a variety of weeds over a period of time

Gross margin ratio

Compares the gross margin generated by the net sales revenue to the sales revenue

Net profit margin ratio

calculate the percentage of each dollar of sales that is recognized as net income

Return on assets ratio

Measures the productivity of assets in terms of producing income

Return on equity

Measures the return to common stockholders

Price earnings ratio

Indicates the relationship between the market value of common stock, per-share to its earnings per share

Dividend yield ratio

Shows the annual return per-share to common stockholders based on the current market price of the stock

Dividend payout, ratio to common shareholders

Measures the portion of net income available to common shareholders that is paid out in dividends

Economic value added

The economic profit as it relates to the cost of capital as opposed to GAAP profit

Compensating balance

A cash balance required to be held in an account by a bank in order to obtain alone, or to avoid paying directly for certain bank services

Zero balance accounts

Held at zero until the claim is made against the account

Lockbox

A system where checks were sent to the post office boxes, rather than corporate headquarters

depository transfer checks (DTC)

official bank checks that provide a means of moving funds from one account to another within the banking system

Cost approach

Based upon what it would cost to replace the subject item with an asset of like function and capacity

Market approach

Uses market comparison of identical, or comparable, assets or liabilities. A comparable is an item that has a reasonable and justifiable similarity to the subject item being valued.

Income approach

Uses the company's ability to create earnings or cash inflows, and the risk involved in the specific investment

Price

The actual observed exchange price that is used in the marketplace

Worth

Relates to the advantages of ownership based upon the perceived benefits at a particular point in time, and for a particular use

Value

Based upon the amount that would be received in exchange for an asset or settlement of a liability between willing parties in an arms length transaction we're both parties had acted with knowledge, with prudence, and without compulsion