Principles of Finance

Lesson 1: What is finance?

L.O. - Define finance and subspecialties in finance.

Finance is the study of managing and allocating funds at the personal or business level.

Accounting is the system of recording, reporting, and summarizing past financial information and transactions.

Finance uses accounting information to manage and allocate capital.

Economics is the social science that analyzes the production, distribution, and consumption of goods and services.

Capital is a financial asset that can be used by a firm or individual (i.e. machinery or cash held by a firm).

• The difference between finance and accounting is that finance focuses on the future and accounting focuses on the past – what has already happened.

• There are three primary areas (subspecialities) in finance and sometimes there’s overlap between them.

  1. Business/ Corporate Finance which deals with sources of funding (how do firms manage their finances to get the best results?)

  2. Investments which deal with managing other people’s money (how do I get the best return for my client?)

  3. Institutions which deal with banks, pension funds, insurance funds, etc.

Lesson 2: Goals and Applications of Finance

L.O. – Distinguish between the goals and applications of personal and organizational finance.

The main goal of personal finance is to maximize the happiness you, as an individual, gain from your decisions as a consumer (to maximize individual utility). Achieving this goal requires that something be given up and deciding if the benefit will outweigh the cost (opportunity cost).

The main goal of organizational finance is to maximize shareholder wealth (public) or maximize owner wealth (private)

The main principal that underlies the questions asked in both personal and organizational finance is whether the benefits of an action outweigh the costs.

Lesson 3: The Role of Finance in Business Environments

L.O. – Identify the role of finance in business environments.

Finance has three main roles:

1. Making Investment Decisions which deal with what types of assets will be bought to help grow the firm and add value.

2. Making Financing Decisions which deal with what financing capital will be used for new assets/ projects for the firm.

3. Managing Working Capital which deals with the day-to-day operations of the firm (i.e. inventory, pay suppliers, etc.).

*Used to maximize shareholder wealth*

Making investing decisions is the most important role of financial managers, who assess benefits vs. costs.

There are many career opportunities in Finance:

• Corporate Finance

• Investment Banking

• Private Equity

• Commercial Banking

• Financial Planning

• Insurance

• Real Estate

Lesson 4: Finance and Personal Decision-Making

L.O. – Identify the role finance plays in personal decision-making.

Personal financial decision-making is aligned with the definition of finance (i.e. you are the financial manager of your household).

Budgeting, assessing financial goals, financing goals, and investing in achieving goals are all roles that finance plays in personal decision-making. Benefits > Costs.

Lesson 5: Financial Securities & Financial Markets

L.O. – Identify the types of financial markets.

There are two types of financial markets: the Money Market and the Capital Market, the Capital Market is further broken down into the primary and secondary markets. The Money Market is used by government and corporate entities to borrow/ lend money short-term. The Capital Market is used for long-term assets that are held > a year. These markets exist to manage liquidity and risks for the government, corporations, and individuals.

The Primary Market is where securities (stocks/ bonds) are first sold. Firms entering the primary market will typically hire a syndicate group made up of large investment banks and sometimes underwriters that help with initial issuances. These groups are usually temporary. The underwriters will buy all the securities from the issuer and then re-sell them for a higher cost to investors. Firms going public for the first time will perform an initial public offering (IPO).

Bonds are issued in two ways with a syndicate, the first is via competitive sale and the second is via a negotiated sale. In both, the syndicates will place bids on different bonds and the underwriter with the highest bond and lowest interest rate will be accepted. The difference is that with negotiated sales, it involves a more thorough interview process, and firms will carefully select the management team placing these bonds.

The Secondary Market, known as the stock market, is where securities are traded after the IPO. The prices in the stock market are determined by supply and demand and there are two types: the Auction Market and the Dealer Market. An Auction Market has a physical location, and prices are determined by the highest price an investor is willing to pay. An example is the New York Stock Exchange (NYSE). A Dealer Market doesn’t have a physical location and securities are bought and sold through a network of dealers who trade for themselves, it does also involve bidding (i.e. NASDAQ). Most stocks listed on NASDAQ have multiple dealers for each stock, the idea behind this is to provide liquidity.

Lesson 6: Financial Institutions

L.O. – Define the types of financial institution.

Depository Institutions accept monetary deposits and provide loans. Includes: Savings Banks, Commercial Banks, Savings and Loan Associations, and Credit Unions.

1. Savings & Loans Association: type of depository institution (AKA Thrift Institution) that places a significant focus on providing loans for residential mortgages and real estate.

Non-Depository Institutions are not allowed to accept monetary deposits but may perform functions such as lending money or acting as an intermediary between saver and lenders. Includes: Brokerage Firms, Investment Firms, Mutual and Hedge Funds.

1. Securities Firm: facilitates the investment and purchase of securities in financial markets.

2. Investment Firm: invests the capital of investors in financial securities (i.e. Mutual Funds & Investment Trusts).

3. Contractual Savings Institution: raise capital for long-term contractual agreements (i.e. insurance company or a private pension fund).

Other investment financial institutions include pension funds (use the contributions to a company’s retirement accounts to buy securities to provide retirement funds to those contributors) & private equity funds (investment companies funded by wealthy individuals that invest in private companies or purchase entire companies with the purpose of achieving a financial return through the eventual sale of the company).

Lesson 7: The Roles of Financial Institutions

L.O. – Identify primary activities of financial institutions.

1. Central banks are the financial institutions that oversee and manage all other banks. They ensure that a nation’s economy remains healthy by controlling the amount of money circulating in the economy.

2. Banks and credit unions offer products and services to individual consumers and businesses. They receive deposits and extend loans to individuals and businesses.

3. Insurance companies offer products to help individuals transfer risk of loss. They charge premiums to invest in bonds and stocks to pay claims.

4. Mutual funds offer investments and buy financial securities and instruments on behalf of investors.

5. Pension funds are retirement funds contributed through companies to invest and provide retirement.

6. Investment banks offer various services such as underwriting, facilitating mergers, and trading financial securities on behalf of large institutions and companies.

7. Private equities receive money from institutional investors and wealthy individuals to buy high-potential companies or troubled companies to improve and earn returns by selling them or going public.

Lesson 8: Major Economic Indicators

L.O. – Explain the influence of financial markets and institutions on major economic indicators.

Economic indicators are used to assess, measure, and evaluate the overall state of the macroeconomy. There are 3 types of economic indicators: leading, lagging, and coincident.

Leading: usually change before the economy changes as a whole. They have the potential to forecast where an economy is headed, therefore, governments and policymakers may use them to implement or alter policies and programs so as to avoid economic downturn and negative events.

1. Yield Curve: a graph that plots the interest rates of bonds with different maturity dates, oftentimes U.S. Treasury bonds. A normal yield curve = longer maturity bonds have higher interest rates than shorter ones. An inverted yield curve = when longer-term bonds have a lower interest rate than shorter-term bonds. Flat yield curve = when both short-term and long-term bonds have the same interest rate.

2. Stock Market Return: A rising market may mean an improving economy, while a declining market may signal a worsening economy.

Lagging: change after the economy changes. They do not generally predict the future economy; however, they indicate changes and patterns in the economy over time. They can help identify trends in the long run.

1. Unemployment Rate: the percentage of those in the labor force who are jobless. When the economy is in recession there are not as many jobs available, and the employment rate is expected to rise. When the economy recovers and does well, more jobs are created – the unemployment rate is expected to fall.

2. Consumer Price Index: measures changes in the inflation rate. It examines the average prices of a basket of consumer goods and services and the changes associated with the cost of living. When CPI decreases = deflation; when CPI increases = inflation.

Coincident: collected, used, and analyzed as economic shifts happen. They provide information about the current state of the economy. They are often used jointly with leading and lagging indicators so that analysts can look at the big picture of past changes leading to future trends.

1. Gross Domestic Product: the monetary value of all the finished goods and services produced within a country’s borders in a specific time period. When GDP increases = the economy is strong, when GDP decreases = economy is in recession.

2. Personal Income: provides some insight into overall consumer spending in an economy and can be related to changes in overall consumption. When the economy is doing well, personal income generally increases which leads to an increase in spending. When the economy is not doing well, personal income decreases which leads to consumer spending being tightened.

**Both financial markets and financial institutions influence and are influenced by these key indicators.

Lesson 9: Ethical, Legal, and Moral

L.O. – Define the terms ethical, legal, and moral.

Ethics refers to the accepted standards of conduct that guide a person’s behaviors. A person guided by ethics considers and strives to achieve the best outcome for all stakeholders. Ethics may be formed by social norms, cultural background, or religious beliefs and influences.

Morals reflect one’s beliefs about right and wrong, good and bad, or just and unjust.

Legal standards equate to if you are acting legally, you are following the laws and rules set by an authority. However, if you act unlawfully, there are established penalties and punishments for those behaviors.

Lesson 10: Ethical Dilemmas in Finance

L.O. – Identify ethical dilemmas in finance.

An ethical dilemma is an issue in the process of deciding between multiple options where no option is completely acceptable from an ethical standpoint.

Profit vs. Shareholder Wealth (Enron): Profitable businesses provide goods and services efficiently. They also hire workers and enable them to purchase goods and services from other businesses in the economy. This improves the profitability of all businesses and creates more employment opportunities. The cycle goes on. However, unethical attempts to maximize shareholder value can backfire and cost the shareholders billions of dollars. This happened with Enron.

Low Costs vs. Ethical Manufacturing (TOMS):One of the key financial decisions that a firm has to make is what variables to use in a potential project that can add value to the firm. These variables may include revenue and cost factors. Ethical decision-making can be integrated into the core of business decisions, even before a project is fully developed. Some firms are trying to ensure that they do not exploit labor workers or pay them insufficient wages by using cheaper labor (i.e. TOMS).

Customer Demand vs. Good Due Diligence (The Financial Crisis): Sometimes, ethical decision-making can have a significant impact on you, even if you are not directly involved in the decisions being made.

Lesson 11: Ethical Conflicts

L.O. – Identify differing demands that lead to ethical conflicts.

Conflicting Interests in a Corporation: Financial managers, shareholders, and bondholders each have different roles and interests in a corporation. For example, financial managers are interested in safe but successful projects, shareholders prefer riskier projects for higher returns, and bondholders prefer safer projects for assured returns.

Agency Problems: Management might not act in the best interest of the shareholders, leading to agency costs. For instance, management might invest in projects that do not maximize shareholders’ value.

Conflicts between Managers and Shareholders: Managers might take actions that do not align with maximizing shareholder wealth, such as self-dealing or spending money on wasteful projects.

Conflicts between Shareholders and Bondholders: Shareholders and bondholders have different relationships to the firm, different rights, and different financial incentives, which can lead to conflicts.

Individual Responsibility and Client Demand: A client may demand unethical actions, leading to a conflict between professional responsibility and client loyalty.

Conflicts between Work and Personal Affairs: Ethical situations can arise due to conflicts between professional and personal interests.

Lesson 12: Interest Rate

L.O. – Identify the fundamentals of interest rates.

Definition: Interest rate is the percentage of the principal charged by a lender to a borrower for the use of assets (when used in TVM calculations called Discount Rate).

Expression: It is typically expressed annually as the annual percentage rate (APR), which is the annual interest rate that is charged for borrowing money or that is earned through investment.

Application: Interest rates apply to various financial activities, including loans for cars, homes, and business capital.

Types: There are two main types of interest: simple interest and compound interest.

• Simple Interest: This is calculated on the principal amount only. The formula for annual simple interest is:

  Annual Interest = Principal × Interest Rate

  To find the total interest over multiple years, multiply the annual interest by the number of years (t):

  Total Interest = Annual Interest × t

• Compound Interest: This type of interest is calculated on the principal amount plus any accumulated interest. It’s described as 'interest on interest'. The formula for compound interest over a number of periods is:

  Total Interest = Principal × (1+Interest Rate) Number of Periods − Principal

  These formulas help determine the interest charges on a loan or the growth of an investment over time. Compound interest, in particular, can significantly increase the amount of money earned or owed due to its exponential nature.

Lesson 13: Required Return

L.O. – Identify the fundamentals of required return.

The fundamentals of required return:

Required Rate of Return: This is the compensation an investor or lender will accept for the level of risk associated with investments or loans. It’s also known as the hurdle rate in corporate finance.

Components of Required Rate of Return

Opportunity Cost: The potential gain lost when one alternative is chosen over another. For investors, it represents the earnings forgone from other possible investments.

Risk: The possibility that the actual return will differ from the expected return. It’s the uncertainty of not receiving the expected outcome.

Inflation: The rate at which the average price level of goods and services rises, decreasing the purchasing power of money. It must be considered in the required rate to maintain value over time.

These components collectively determine the interest rate or required rate of return for an investment.

Lesson 14: Inflation

L.O. – Identify the fundamentals of inflation.

The fundamentals of inflation are:

Definition: Inflation is the rise in prices over time and is expressed as a percentage. It indicates a decline in purchasing power of goods/ services with the same amount of money.

Causes: The main sources of inflation include an increased demand for goods and services (demand creates scarcity to counter that prices go up), rising costs (increase due to regulations, accidents, high demand, increase in production costs, etc.), and adaptive expectations (when prices go up, employees expect & demand higher wages to maintain their standard of living).

Effects: Inflation results in a decrease in the purchasing power of money, meaning that you can buy less with the same amount of money over time.

Technology Impact: Technological advancements can reduce the effects of inflation by decreasing the cost of goods, increasing productivity, and substituting labor with automation. However, other factors like the cost of raw materials and adaptive expectations of employees for higher wages contribute to overall inflation.

Lesson 15: Nominal Rate and Real Rate

L.O. – Describe how interest rates, required return, and inflation can inform decision-making.

Interest rates, required return, and inflation can inform decision-making by:

Interest Rates: They influence the cost of borrowing and the return on savings, affecting decisions on loans, investments, and capital allocation.

Required Return: This is the minimum return needed to justify an investment, guiding choices on which projects or assets to pursue.

Inflation: It erodes purchasing power, so understanding inflation trends helps in making long-term financial plans and contract adjustments.

These factors are crucial for financial analysis and strategic planning in finance.

Side Bar:

Interest rates include three components: opportunity cost, risk, and inflation. The interest rate, or required rate of return, is determined by:

Rate=Risk - Free Rate + Risk Premium

Risk Premium is the compensation for the amount of risk taken on by investors.

Nominal Rate is the rate at which invested money grows for a certain period of time and is the interest rate most often used in your daily life.

The component of an interest rate that is an indicator of inflation and opportunity cost is the risk-free rate. It describes the rate of return on an investment with no risk, so it just measures inflation and opportunity cost.

Lesson 16: Why Time Value of Money?

L.O. – Define time value of money (TVM).

Time Value of Money (TVM) is the idea that money available today is worth more than the same amount of money in the future (caused by inflation).

Time impacts the value of cash flows, so the value of a project depends on how these differences in cash flow timing is assessed.

Three variables are important to understand when it comes to TVM:

1. The amount of cash flows

2. The timing of cash flows

3. The rate that the value of cash flows changes due to time.

Present Value is the value that measures the worth of cash flow in terms of the dollar amount in the relative past (present = past purchasing power).

Future Value is the value that measures the worth of relative cash flows in terms of the dollar amount in the relative future.

Compounding means find a future value given a present value.

Discounting means find a present value given a future value.

Annuity is a stream of cash flows of an equal amount paid every consecutive period. There are three different types of annuities:

1. Ordinary a series of equal payments made at the end of consecutive periods over a fixed length of time (i.e. an auto loan, you purchase a car and pay a monthly, equal payment for the term of the loan starting a month from today).

2. Annuity Due a series of equal payments made at the beginning of consecutive periods (i.e. rent payment, a monthly, equal payment for the term of the contract starting when you sign the contract).

3. Perpetuity a constant stream of identical cash flows that go on forever (an ordinary annuity that has no end).

Time Value of Money Variables in Excel

Time Value of Money Functions in Excel

*If you are doing an annuity problem, enter nper as the number of equal payments made. For example, if you make a $200 payment each month for five years, nper is 60 because you will make 60 payments of $200 over the next five years.

*If interest rate (RATE) is not yearly, divide by 12 to get the monthly interest for monthly payments.

Lesson 17: Time Value of Money and Decision-Making

L.O. – Explain how time value of money (TVM) calculations are used in making financial decisions.

TVM plays an important role in decision-making because it allows us to estimate the value of an investment today and compare it to the cost in the future if we were to pursue the investment.

Decision-Making Framework: TVM serves as a critical tool for comparing the benefits and costs of financial decisions over time, ensuring that the value of money received or paid in the future is accurately assessed against present values.

Business Decisions: Financial managers use TVM to evaluate investment and financing decisions, analyzing cash flows and discount rates to determine the viability and profitability of projects.

Personal Finance: Individuals apply TVM when making personal financial choices, such as selecting mortgage terms or planning for retirement, to understand the impact of interest rates and time on the value of money.

Comparative Analysis: By incorporating TVM, one can compare cash flows at different times, making it possible to evaluate the true worth of investments and loans over their entire term.

Understanding and applying TVM calculations enable both businesses and individuals to make sound financial choices that consider the changing value of money over time.

Lesson 18: Time Value of Money in Excel—Part 1 & 2

L.O. – Calculate NPV, PV, FV, and IRR using a spreadsheet application.

Solving Single Sum Cash Flow Calculations - Future Value (FV) & Present Value (PV):

Example: Suppose you invested $1,000 in the stock of XYZ Corp. After 30 years, you hear a TV commentator say. “The average annual appreciation of XYZ stock over the last 30 years was 14.5%.” What is the value of your $1,000 investment after the 30 years?

1. Identify what we’re solving for… after = future value.

2. Identify the information given and input into each column in XL Sheet…

   • Rate = 14.5%

   • NPER = 30 years

   • PMT = we are only focusing on a single cash flow, so ignore this box or put 0.

   • PV = $1,000 (Initial investment payment, input as a negative because you are making a payment).

   • Type = only doing a single cash flow, so don’t need to consider this but inputting 0 indicates an ordinary annuity, pmt(s) made at the end of a period. Inputting 1 indicates an annuity due, pmt(s) made at the beginning of a period.

3. Input “=fv” XL will provide equation which is “=fv(rate, nper, pmt, [pv], [type].

4. Select the correct information based on the order of XL equation (i.e. =fv(C2,C3,C4,C5)

5. XL will give answer of $58,098.46 based off the information put in the columns.

Example 2: You purchased some land 5 years ago. The current value of the land is $50,000. If the value of the land increases at a rate of 3% per year, how much did you pay for the land 5 years ago?

1. Identify what we’re solving for… the present value at the point that we would have purchased the land for 5 years ago.

2. Identify the information given and input into each column in XL Sheet…

   • Rate = 3%

   • NPER = 5 years

   • PMT = we are only focusing on a single cash flow, so ignore this box or put 0.

   • FV = $50,000

   • Type = only doing a single cash flow, so don’t need to consider this but inputting 0 indicates an ordinary annuity, pmt(s) made at the end of a period. Inputting 1 indicates an annuity due, pmt(s) made at the beginning of a period.

3. Input “=pv” XL will provide equation which is “=pv(rate, nper, pmt, [pv], [type].

4. Select the correct information based on the order of XL equation (i.e. =fv(C2,C3,C4,C5)

5. XL will give answer of ($43,130.44) - an outflow (negative) amount because this is what we paid for the land 5 years ago.

Lesson 19: Return

L.O. – Identify measures of return.

When you hear the term basis point it means one one-hundredth of one percent (0.01). So, if a stock price has had a positive return of 58 basis points, it really means 0.58% (kind of deceptive in my opinion).

What is return? It is the gain (positive) or loss (negative) on an investment over a period of time. It is expressed as an annualized percentage (the ratio of money made vs. invested). This annualization process takes several forms. One of them is the calculation of the holding period return (the return over any period) and annualize based on simple interest. The HPR is calculated:

(Ending Price – Beginning Price)

Beginning Price

For stock and bond securities, this return is reflected in any increase in the stock price above the original stock price at the time of purchase and includes any additional cash flows (such as dividends) received during the period. Return is more often compared using annual numbers vs. monthly. An annualized return will tell you the rate of return for less than a year but is computed as if for a full year.

Another measure of return is the Expected Return, which allows for an estimate of what is expected to happen based on the likelihood of different potential scenarios happening. In finance, you use both historical data and expectational data. Expectational data is used to calculate a “best guess” estimate of future prices/ returns. When using expectational data, the return is based on the probability of different scenarios happening and the returns expected in each.

Both HPR and expected return are presented in nominal terms and include three factors: inflation, risk, and opportunity cost. Real Return is found by subtracting the inflation rate. Real returns are helpful in that they compare returns over different periods as inflation rates fluctuate:

(Return – inflation rate)

Lesson 20: Risk

L.O. – Describe types of risk.

What is risk? It is defined as the possibility that the realized or actual return will differ from the expected one. In finance, this could mean that one project is riskier than another or that stocks are riskier than bonds, etc. Risk is the uncertainty in the distribution of possible outcomes.

One way to measure risk is to use the stock/ bond’s standard deviation of returns. Standard deviation is a measure of dispersion of possible outcomes about the average. The greater the standard deviation, the greater the uncertainty/ risk.

Lesson 21:

Lesson 22:

Lesson 23: Why Ratio Analysis?

L.O. – Describe the main ways that ratios are used in finance.

Ratios are used to analyze and compare companies and their performances because they standardized financial data, they are not determined by rules making them flexible, they lead you to focus on the right places to enable you to understand the current performance of the companies, and they help you evaluate whether a firm is achieving its goal to maximize shareholder wealth.

Ratios only take on their full analytical power when they are placed in a comparative context. The process is called Benchmarking, where a firm’s financial performance is compared to that of similar firms. There are three main methods to compare the performance of different firms: trend analysis, cross-sectional analysis, and progress measurement.

A trend analysis compares a firm’s financial ratios over time by comparing the current year’s performance to previous year’s performances (usually looking 5 years back). This lets the firm see how management is performing and whether it’s improving over time. Looking at past trends tells the analyst what’s happening to the firm’s liquidity, efficiency, financing, and profitability and helps the firm forecast the future (usually 3 years).

A Cross-sectional analysis compares a firm’s financial ratios to those of a peer group. This method consists of first determining the benchmark standards from the financial information of the peer group and then comparing the current firm to those benchmarks. This is the most common use of ratios when doing an equity valuation. Cross-sectional analysis requires data not only about the target firm but also about its peers, competitors, industry, or the market at large.

Progress measurement is using ratios to measure progress and achieve goals, it is critical for firms to stay competitive in today's global markets.

Lesson 24: Types of Ratios

L.O. – Describe the five major ratio categories.

The five major ratio categories are: liquidity, activity, leverage, profitability, and market. Liquidity ratios measure a firm’s ability to meet short-term obligations without raising external capital (debt or equity). It measures not only how much cash a firm has but also how easily a firm can convert short-term assets into cash.

Activity ratios (efficiency ratios) measure how well a firm uses its assets to generate sales/ cash (the firm’s operational efficiency and profitability). It analyzes inventories, fixed assets, and A/R. It expresses the financial health and the utilization of the financial statement components.

Leverage ratios (financing ratios/ solvency ratios) consider how the firm is financed. They describe in what proportions the firm uses equity and debt to finance assets. Can the firm stay financially healthy in the long term, pay interest on its loans, and pay off its long-term debt?

Profitability ratios can be based on either sales or asset investments and are commonly used to directly judge how profitable the firm is and how well management is doing in maximizing owner wealth. A company’s profitability relative to the past or to competitors indicates how well the company is doing. An example of profitability ratio is the gross margin, which is calculated as gross profit over sales (the higher the gross margin ratio is, the lower the cost was to produce and sell that good or service).

Market ratios are used to evaluate the current share price of a public firm’s stock. They are used by both current and potential investors to determine whether a firm’s stock is under or overvalued. Helps the investors decide if they should buy or sell the stock.

• Underpriced = expectation of price to rise (buy).

• Overpriced = expectation of price to decline (sell).

Lesson 25: Financial Ratios

L.O. – Identify what specific financial ratios indicate about an organization’s health.

Liquidity ratios measure a firm’s ability to meet short-term obligations (i.e.: current and quick ratios). Current ratio is a direct comparison between current liabilities, obligations that will require cash within a year, and current assets, items that will generate cash within a year. The formula is:

A higher ratio typically means that there’s a better likelihood that the firm will be able to meet short-term obligations. It does NOT equate to overall liquidity; this is due to the chance that a firm may have difficulties liquidating inventories and A/R. A drop below one in a firm’s current ratio indicates that a firm doesn’t have the assets to cover the liabilities. The only difference between Current and Quick ratios is that the quick ratio subtracts the inventory from the current assets. A quick ratio is also called an acid-test ratio and the formula is:

On the Balance Sheet, inventory is the least liquid so quick ratio uses a stricter test of what is considered a liquid asset, an asset that can be converted to cash quickly. A higher quick ratio is also indicative that a firm has a greater ability to meet short-term obligations.

Activity Ratios measure a firm’s ability to generate sales or cash from its assets. Including A/R turnover, avg. collection period, inventory turnover, total asset turnover, fixed asset turnover, and operating income return on investment.

A/R Turnover is an activity ratio used to measure how well/ how often a firm can collect on their A/R (debt). The formula used to calculate the A/R Turnover is:

When a firm’s A/R Turnover decreases it may indicate that the firm is taking longer to collect its A/R, and so the A/R is turning over less frequently each year. The Average Collection Period (ACP) converts the A/R Turnover into a day count instead of a yearly one. The formula used to calculate the ACP is:

The ratio may indicate the tightness of the company’s credit standard for its customers. Tighter standard = shorter ACP. Looser credit standard may attract customers (especially those tight on cash) but may also increase the firm’s bad credit.

Inventory Turnover is the number of times a firm can sell its inventory in a year. Higher inventory turnover ≠ better management of inventory. To calculate inventory turnover:

Total Asset Turnover (TAT) measures how well a company is using its assets to generate sales. It is calculated:

More efficient asset utilizers generate more sales per dollar of assets (all else equal). It is helpful to compare a firm to itself over time and to that of firms within the same industry (i.e. Walmart and Target). Comparing the TAT to firms outside of the industry would cause the meaning of the ratio to be lost due to different business/ organization models across the different industries (apples to apples vs. apples to oranges).

Fixed Asset Turnover (FAT) measures how many dollars in sales a firm generates per dollar of fixed assets (non-current assets or total assets – current assets). The volume of the current assets reflects management’s risk preference (Low risk = higher current assets and vice versa). FAT removes the management-influenced current assets and compares sales solely to the long-term assets used by a firm. To calculate FAT:

Operating Income Return on Investment (OIROI) describes the relationship between operating profit (earnings before interest and tax or EBIT) and the company’s asset base. It tells us how much pre-tax, pre-financing profits the company generates per dollar of assets. The OIROI can also be classified as a profitability ratio. The formula to calculate OIROI is:

Leverage Ratios consider how a firm is financed and how results from operations affect its ability to fulfill its debt agreements and provide a return to its equity shareholders. They include: the debt ratio, which measures the proportion of a firm’s assets financed with debt (raises money by selling bonds/ loans to investors/ creditors – borrowed money) and is calculated by dividing the Total Liabilities by the Total Assets. Debt-to-equity ratio, like debt ratio, this ratio is used to evaluate a firm’s financial leverage (how many dollars of debt per every dollar of equity. It indicates the company’s ability to cover all its outstanding debts using the company’s equity. It is calculated by dividing the Total Liabilities by the Total Owner’s Equity. As well as times interest earned (TIE), shows us how easily a company can pay its interest costs with its operating income. It is calculated by dividingEBIT by the interest expense.

Profitability Ratios are used to judge how well management is maximizing owner wealth and include return on assets, return on equity, gross margin, operating margin, and net profit margin.

The Return on Assets (ROA) measure how much profit a company earns from its assets. It is calculated by dividing net income by total assets. ROA is useful for comparing companies across different industries, as it reflects the return (profit) on all the capital invested. Investors prefer companies with higher ROA, as they generate more profit with less money. The Return on equity (ROE) demonstrates how much profit a company earns from its equity. It is calculated by dividing net income by total equity. ROE is like ROA, but it also reflects the impact of debt financing. A firm that uses debt effectively will have a higher ROE than ROA.

Profitability Ratios also include three margins, the first is Gross margin, which is how much revenue is left after deducting the cost of goods sold (COGS) from sales. It is calculated by dividing gross profit (sales minus COGS) by sales. A higher gross margin means a higher profit margin and a lower production cost. Gross margin can be affected by factors such as production efficiency, price competition, and industry characteristics. Next is Operating margin, which is the percent of sales remaining after covering COGS and operating expenses. It is also pre-tax, so it is often used to compare firms with different capital structures. It is calculated by dividing EBIT by Sales. Finally, is the Net (profit) margin, calculated as net income (all expenses minus revenue) divided sales. It is also known as the “Profit margin” and is one of the easiest ratios to understand. Positive number = created value.

Market Ratios are used to value an entire company or the current price of a single share of its stock. One ratio is Market-to-book (M/B Ratio) compares the market value of equity (market cap) with the book value of equity (total equity). It is calculated by dividing market cap by total equity. This ratio indicates how the market perceives a company’s growth potential and value. A market-to-book ratio of >1 means a growth stock (the market values the firm for more than the balance sheet reports the firm is worth – indicates future growth), while a market-to-book ratio of <1 means a value stock (which may indicate a good investment, or it could indicate a company that is about to go out of business).

Another market ratio is Price-to-earnings (P/E Ratio) measures how much investors are paying for each dollar of earnings. It is calculated by dividing the market price per share by the earnings per share. P/E is perhaps the most popular way to value stocks and compare them with similar companies in the same industry. A higher P/E means a higher valuation and a higher expectation of future growth. Investors can use the industry average P/E to estimate the market value of a company based on its earnings. For example, if the industry average P/E is 20 and a company has earnings of $4 per share, its market value per share would be 20 × 4 = $80.

Lesson 26: DuPont Framework

L.O. – Define the components of the DuPont framework.

• Profitability: This is measured by the net profit margin, which is the ratio of net income to sales. It indicates how much profit a firm generates from each dollar of revenue.

• Activity: This is measured by the total asset turnover, which is the ratio of sales to total assets. It indicates how efficiently a firm uses its assets to generate sales.

• Financing: This is measured by the leverage multiplier, which is the ratio of total assets to owners’ equity. It indicates how much debt a firm uses to finance its assets.

Increasing the debt financing, increases the leverage multiplier, which will increase the return on equity (ROE) of a firm.

ROE (Return on Equity):

Net Income/Sales (x)Sales/Total Assets (x) Total Assets/Owner’s Equity

=Net Profit (x) Total Asset Turnover (x) Leverage Multiplier

=Profitability (x) Activity (x) Financing

Lesson 27: Learning from DuPont

L.O. – Identify a company’s ability to impact its return on equity (ROE) using the DuPont framework.

A firm’s ability to impact its ROE using the DuPont Framework is dependent on three factors:

• Net Profit Margin: measures a firm’s profitability and their ability to turn sales into profit for shareholders. For example, a positive net profit margin that is higher than the industry’s norm, indicates that a firm has a strong performance in its operations and the ability to convert sales to profit. How profitable is the firm?

• Total Asset Turnover: measures a firm’s efficiency in using its assets/ resources to generate sales. For example, when a firm’s total asset turnover (TAT) is higher than the industry’s ratio, it demonstrates that the firm is more efficient in using its assets (resources) to generate sales. How well does the firm use its assets to turn profit?

• Leverage Multiplier: measures the firm’s policy on how much debt it uses to finance its assets. For example, a leverage multiplier lower than the industry average indicates that the firm uses less debt than other companies to finance its assets (lower risk firm to invest in). How risky is the firm to invest in? Do they have a high debt ratio?

Sidebar:

A higher ROE means the company is generating more income for each dollar of equity invested by shareholders.

If a firm has no debt or lower leverage multiplier (100% of its assets are financed by equity instead of debt) it has a higher Return on Assets (ROA).

One way for firm to increase its ROE for sure is to both decrease their equity financing, which will then increase the leverage multiplier and to increase their net margin profit.

Lesson 28: Introduction to Budgeting

L.O. – Describe the budgeting process.

The budgeting process involves the following steps:

Know yourself: Set your personal or organizational goals and visions based on your values and preferences2.

Understand the key areas of savings, income, and expenses: Analyze your current financial situation and identify the sources and uses of your cash flow3.

Develop savings, income, and expense strategies: Create a plan to achieve your goals by allocating your resources wisely and reducing unnecessary spending or debt.

Keep records: Track your actual income and expenses against your budget and monitor your progress and performance.

Use a method that meets your needs and objectives: Choose a budgeting technique that suits your personality, lifestyle, and goals4. For example, you can use a spreadsheet, an app, or a paper planner to create and manage your budget.

Eliminate consumer debt and minimize long-term debt: Avoid borrowing money to buy things that you do not need or cannot afford5. Pay off your existing debts as soon as possible and save more for your future.

Lesson 29: Steps to Create a Cash Budget

L.O. – Identify the steps in creating a budget.

Determine Cash Receipts: The amount of money that comes in from sales, income, or other sources.

Estimate Cash Disbursements: The amount of money that goes out for expenses, such as rent, utilities, inventory, or debt payments.

Create a Budget: The plan that shows the expected cash inflows and outflows for each period, and the resulting cash position.

Lesson 30: Items Included in Budget Construction

L.O. – Recognize the items included in budget construction.

Cash Receipts: These are the sources of cash inflow, such as sales, collections, salary, or wages.

Cash Disbursements: These are the expenses or outflows of cash, such as materials, labor, rent, utilities, taxes, or entertainment.

Net Cash Flow: This is the difference between cash receipts and cash disbursements, which indicates the surplus or deficit of cash for a given period.

Borrowing or Repayment: This is the amount of money that is borrowed or repaid to meet the minimum cash requirement or to use the excess cash.

Side Bar:

Three things that should be included in a cash budget for a business are:

1. Cash Receipts

2. Cash Disbursements

3. Borrowing

Lesson 31: Tracking, Monitoring, and Revising a Budget

L.O. – Explain the importance of tracking, monitoring, and revision, with respect to the budgeting process.

Tracking Cash Flows: Allows you to recognize where and how your money is spent so you can monitor your cash flows and revise your budget as needed.

Monitoring Cash Flows: Allows you to evaluate whether your actual cash flows are in line with your goals and to understand when correction or revision is needed.

Revising the Budget: Allows you to 1. identify troubled areas where expenditures or earnings are not aligning with expectations, such as overspending or lower sales, 2. adapt to changes in income and spending patterns, which could be due to new competitors or seasonal variations in sales, 3. implement gradual changes to ensure smoother transitions and helps others familiarize with the new budget, and 4. make necessary adjustments to meet your financial objectives effectively.

Lesson 32: Introduction to Financial Forecasting

L.O. - Describe the financial forecasting process.

The financial forecasting process involves the following:

Purpose: It’s used to understand the implications of today’s decisions on future performance, particularly in terms of investment and financing decisions.

Key Forecasts: It includes profit forecasting (projecting future earnings) and balance sheet forecasting (understanding changes in finances).

DFN Estimation: A crucial insight from the process is estimating the Discretionary Financing Needed (DFN), which reflects future financing needs based on growth expectations.

Assumptions and Accuracy: The process relies on assumptions about future sales, asset-sales relationships, and profitability, making accuracy dependent on the quality of these assumptions.

Sidebar:

Financial forecasting supplements historical data with proposed investments or changes to allow for more accurate foresight which helps facilitate future success and growth of a firm.

Financial forecasting helps managers understand what key assumptions to make for the future which helps in financial decision-making.

Lesson 33: Goals of Financial Planning

L.O. - Describe the link between asset requirements and sales growth.

Asset requirements and sales growth are linked through spontaneous accounts, which naturally vary with sales. As a company’s sales grow, certain accounts like accounts receivable, inventory, and accounts payable automatically increase as well. This is because more sales typically require more inventory to meet demand, which in turn requires purchasing more materials, impacting accounts payable. The growth in these spontaneous accounts is crucial for companies to assess the additional funding needed to support sales growth.

Lesson 34: The Percent of Sales Method: Determining Financing Needs from a Sales Forecast

L.O. - Describe how additional financing requirements are determined from a sales forecast.

The process of determining additional financing requirements from a sales forecast involves the following key steps:

Sales Projection: It starts with a projection of sales revenue, which is typically provided by the marketing or sales department based on market analysis and trends.

Spontaneous Accounts: Next, changes in spontaneous balance sheet accounts are forecasted based on the predicted change in sales. These include accounts like receivables and payables that naturally change with sales volume.

Discretionary Accounts: Management decisions affect discretionary accounts such as notes payable and equity, which do not automatically change with sales.

Fixed Asset Accounts: There are two accounts that do not fit into either spontaneous or discretionary accounts, these must be considered separately. Changes in fixed assets depends on the firm’s current production capacity utilization. For example, if sales increase but the production capacity has been reached, fixed assets may grow so that production capacity can meet sales.

Retained Earnings (RE): There are three reasons why RE may require attention:

1. Depreciation expense: If the firm decides to invest in new fixed assets, depreciation expense will change on the income statement. This will affect net income as fixed assets are not a spontaneous account.

2. Interest expense: If the firm must take on more debt or decides to pay off some of the debt in the forecast, then the interest expense must be adjusted on the forecasted income statement. This will affect net income and RE as interest-bearing liabilities are a discretionary account.

3. Dividends: The retained earnings account is also affected by the firm’s dividend policy.

Net Margin & Dividend Policy (Payout Ratio) are constant when forecasting changes in the RE account (for the purposes of this course).

Only two things can happen to Net Income: it can either be paid out as dividends and/or it can be retained within the firm’s RE.

To project RE: Projected RE = Old RE + (Projected Sales x Net Margin x Plowback Ratio).

where Plowback Ratio = 1 - Payout Ratio

and Payout Ratio = Dividends/ Net Income

Determine Total Financing Need: All assets need to be financed so the firm’s total financing needs to equal its total assets. The same holds true for the firm’s total projected assets must equal future total financing.

DFN Calculation: The last step is to calculate the Discretionary Financing Needed (DFN), which is the additional funding required to support the projected sales, calculated as projected total assets minus projected liabilities and equity.

This method uses historical data to estimate financial statements for future periods “as if” sales grew as predicted.

Sidebar:

The Discretionary Financing Needed (DNF) is determined after the Pro-Forma financial statements are forecasted using the Percent of Sales Method. The DNF is additional financing needed to fund the predicted growth of sales.

As a financial manager, you would leave the notes payable account the same in the projected financial statements when conducting financial forecasting using the percent of sales method.

When estimating changes in the balance sheet based on the predicted changes in sales you are forecasting spontaneous accounts as they change in proportion to sales growth.

Lesson 35: The Sustainable Growth Rate: Four Ways to Decrease DFN

L.O. - Identify the relationship between a firm’s sustainable growth rate and its additional funds needed.

Sustainable Growth Rate (SGR): This is the growth rate at which a firm can grow without issuing new equity. It’s calculated as SGR = ROE × (1 - b), where ROE is the return on equity and b is the dividend payout ratio (dividends/net income). The SGR can be influenced by adjusting any of the basic components of these ratios, including profitability (net margin), asset use efficiency (total asset turnover), capital structure (leverage), and dividend policy.

Additional Funds Needed (DFN): This is the additional financing a firm needs to support its sales growth. If a firm grows at a rate higher than its SGR, it will have a positive DFN, meaning it needs additional financing. If a firm grows at a rate equal to its SGR, it will have a zero DFN, meaning it doesn’t need additional financing.

Therefore, controlling the variables that change the SGR will decrease the DFN. For example, a firm can decrease its DFN by slowing sales growth, examining capacity constraints (fixed assets), lowering dividend payout, or increasing net margin.

Lesson 36: Using Forecasting to Determine Fixed Asset Requirements

L.O. - Describe the use of forecasting to prepare appropriate future asset levels, given projected sales growth.

Forecasting is used to prepare future asset levels in relation to projected sales growth:

Lumpy Assets: Fixed assets, such as factories and equipment, cannot be purchased in parts but as a whole. This is referred to as “lumpy assets,” which are paid for in lump sums.

Sales Capacity: To determine if investment in fixed assets is necessary, firms calculate their sales capacity, which is the maximum sales they can achieve given their current production capacity.

This approach helps firms plan for future asset levels and understand when significant investments are necessary to support sales growth.

Lesson 37: Net Present Value (NPV)

L.O. - Explain the strengths and weaknesses of the net present value (NPV).

The Net Present Value is the present value of future cash flows that may come from a project minus the initial cost of the project. If the NPV is greater than 0, it means that the present value of future cash flows is greater than the cost, and the project should be accepted.

Strengths of NPV:

Considers Time Value of Money: NPV considers the idea that today’s dollar is worth more than a dollar in the future.

Calculates Value Added to the Firm: NPV tells you how much value is added to the firm with the investment project.

Considers Risk and Required Return: NPV takes risk into account by considering the required rate of return, or cost of capital, as a discount rate.

Weaknesses of NPV:

Requires Calculation of Appropriate Cost of Capital: Estimating the cost of capital for a project is challenging. Various capital structures, timing of flows, and investment potentials alter the project's risk level and affect the required rate of return for investors.

Not Useful to Compare Projects of Varying Sizes: The NPV method is not always useful for comparing two projects of different sizes. For example, a $1.5 million project may have a higher NPV than a $1,500 project so, more profit would be added to the firm. However, in terms of return percentage per amount invested, the $1,500 project may have a much higher rate of return.

Lesson 38: Internal Rate of Return

L.O. - Explain the strengths and weaknesses of internal rate of return (IRR).

The Internal Rate of Return (IRR) is the rate of return that a firm earns on its capital projects. The IRR is easier to interpret and communicate vs. the NPV. The IRR is the rate of return that makes the NPV of the project equal to zero.

If the return or the IRR exceeds the cost of capital, you should accept the project; if the IRR is short of the cost of capital, you should reject the project.

(IRR > Discount Rate = Accept; IRR < Discount Rate = Reject).

Advantages:

Easy to Interpret: IRR is straightforward to understand as it represents the percentage return on an investment.

Time Value of Money: IRR takes into account the time value of money, ensuring future cash flows are appropriately discounted.

No Required Rate of Return: Unlike NPV, IRR doesn’t require a pre-calculated required rate of return, allowing for quicker decision-making.

Disadvantages:

Not Value Indicative: IRR doesn’t indicate the actual value created by a project, leading to suboptimal decisions if used as the sole criterion.

Mutually Exclusive Projects: IRR cannot directly compare mutually exclusive projects, which means it’s not suitable for choosing between different project options.

Reinvestment Assumption: Assumes cash flows can be reinvested at the IRR rate, which is often unrealistic.

Project Duration: IRR is not suitable for comparing projects with different durations due to varying reinvestment opportunities.

Conventional Cash Flows: IRR requires conventional cash flows (initial outlay followed by positive inflows) and may not work with unconventional cash flows.

***Because of the many disadvantages to using the IRR, you should defer to the results of the NPV for choosing the best project to create value for the firm.***

Lesson 39: Profitability Index

L.O. - Explain the strengths and weaknesses of the profitability index (PI).

The Profitability Index (PI) is the present value of future cash flows divided by the initial outlay or the project cost. It is the ratio of payoff to investment for a proposed project. If the PI is greater than one, then the present value of future cash flows is greater than the project cost and we should accept the project.

Advantages of the Profitability Index (PI):

1. Considers the Time Value of Money (TVM)

2. Takes into account the risk of future cash flows through the cost of capital

3. Includes all future cash flows

4. Indicates whether an investment will create value for the company

The first four advantages are the same as the NPV.

***5. Useful for Ranking Multiple Projects when the Budget is Limited: helps the firm choose which projects will have the highest return when the capital that can be invested available is limited.

Disadvantages of the Profitability Index (PI):

1. Requires calculation of the cost of capital: Similar to the NPV, estimating the cost of capital for a project is challenging. Various capital structures, timing of flows, and investment potentials alter the project's risk level and affect the required rate of return for investors.

2. Not useful for mutually exclusive projects: Similar to the IRR, PI cannot directly compare mutually exclusive projects, which means it’s not suitable for choosing between different project options.

Lesson 40: Financial Securities and Capital Investment