Business Finance
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Financial systems consist of individuals, businesses, and the government. There are three main factors that impact economic conditions:
Interest Rates: The higher the interest rate, the less cash you will have to spend on other things. Businesses won't borrow and invest because it's often more profitable to just leave their money in the bank. In 1981, America raised inflation to 19%, which did curb inflation but led to severe economic pain. It's been 70 years since we've gotten inflation down from 5%.
Consumer Prices: The consumer price index is based on a list of necessities you need to survive and its current price over base price times 100. This index is a crucial measure as it reflects the cost of living and helps to gauge inflation, influencing both consumer behavior and monetary policy.
Money Supply: Too much money results in lower interest rates but higher consumer prices. Too much money also pushes up prices and can lead to inflationary pressures, as more money in circulation increases demand for goods and services without a corresponding increase in supply.
Foreign Exchange Rate: The value of another country’s currency in relation to your own.
Security: An investment instrument issued by corporations to represent ownership or debt.
Bond: A bond represents money borrowed by an entity.
Types of Financial Markets:
Capital Markets: Where long-term debt or equity-backed securities are bought and sold.
Money Markets: Where short-term borrowing and lending occur, usually with maturities of one year or less.
Derivative Markets: Where financial instruments deriving their value from underlying assets are traded, such as options and futures.
Foreign Exchange Markets: Where currencies are traded against each other.
Commodity Markets: Where raw materials and primary products are traded, including metals, energy, and agricultural goods.
Factors that Affect the Value of Securities: Supply and demand, future cash flows, risk, liquidity, and interest rates.
The Financial Planning Process:
Determine current situation.
Set financial goals.
Evaluate alternatives.
Make a decision based on the evaluation of alternatives and the associated opportunity costs.
Review your progress.
Opportunity Cost: What you give up by making a choice.
Types of Financial Institutions:
Deposit Institutions: Commercial banks, savings and loan associations, mutual savings banks, credit unions.
Non-Deposit Institutions: Life insurance companies, investment companies, mortgage companies, check-cashing companies, pawnshops.
Basic Accounting Equation:
Assets = Liabilities + Equity
Commercial Banks: Offer checkings accounts, Provide Savings Accounts, make loans and offer other services to businesses.
Thrift institution: a type of financial institution that primarily focuses on accepting savings deposits and making mortgage loans, which include savings and loan associations and mutual savings banks.
Credit union: A user owned not for profit bank where individuals share money and take money from each other at lower interest rates compared to traditional banks.
Life insurance Companies: These institutions provide financial protection to individuals and families by paying out a specified sum upon the insured person's death, as well as offering savings and investment options for policyholders.
Investment Companies: Firms that provide capabilities for individuals to diversify their stock.
Consumer finance companies: provide loans to buy cars and fridges and for financial emergencies.
Mortgage Companies: Provide loans to purchase real estate, helping individuals and families secure financing for homes while often requiring collateral in the form of the property itself.
Pawnshops: You lend in jewelry and they give you money. Current expenses: Stuff you use up in a year or less like rent and electricity.
Capital Expenditures: Expenses incurred to acquire or upgrade physical assets such as property, industrial buildings, or equipment, which are expected to provide benefits over a longer period, typically exceeding one year.
GOVERNMENT FINANCES:
Federal Government: Oversee interstate commerce.
State Government: Regulate business activities within their own boundary.
Local Government: Manage police and firefighters just local stuff.
Income tax: is charged by the federal government on individuals' annual income.
Sales tax: imposed by state and local governments on the sale of goods and services.
Property Tax: A tax levied on real estate properties, primarily used to fund local government services such as education, infrastructure, and public safety. Federal government borrowing:
US savings Bond: A debt security issued by the U.S. Department of the Treasury, intended to help finance government spending while providing a safe investment option for individual investors.
Treasury Bills: Short-term debt obligations of the U.S. government that are sold at a discount and mature in a year or less, making them a low-risk investment choice.
Treasury Notes:
Treasury Bonds: Municipal Bonds: Debt securities issued by states, municipalities, or counties to finance projects such as schools, highways, and infrastructure, offering tax-exempt interest income.
TYPES OF ECONOMIC SYSTEMS:
Capitalist Economy: An economic system characterized by private ownership of resources and the market determining production and pricing.
Traditional economy: An economic system in which customs, traditions, and beliefs shape the goods and services produced, often relying on subsistence agriculture and barter trade.
Command economy: An economic system where the government makes all decisions regarding the production and distribution of goods and services, often leading to centralized control and planned economies.
Mixed economy: A combination of capitalist and command economies, where both private and public sectors play significant roles in economic decision-making, allowing for a balance between market freedom and government intervention.
The USA free enterprise economy: A system that emphasizes individual entrepreneurship, competition, and minimal government intervention, promoting the idea that private individuals can own and operate businesses to generate profit.
Legal Forms of Business Ownership:
Sole Proprietorship: A business owned and operated by a single individual, who is personally responsible for all debts and liabilities incurred by the business.
Partnership: A business structure in which two or more individuals manage and operate a business, sharing profits, losses, and responsibilities, while also having personal liability for the debts of the partnership.
Corporation: A legal entity that is separate and distinct from its owners, providing limited liability protection to its shareholders, who are not personally responsible for the corporation's debts or liabilities.
Limited Liability Company (LLC): A hybrid business structure that combines the benefits of a corporation's limited liability with the tax advantages of a partnership, allowing owners (members) to protect their personal assets while enjoying pass-through taxation.
Financial Markets:
Commodity Markets: markets where resources like oil or electricity are exchanged. Major ones include The New York Mercantile Exchange and London Metal Exchange. The two types are spot markets where things are sold on the spot and future markets where deals for future dates of delivery are negotiated.
Stock Markets: platforms where shares of publicly traded companies are bought and sold, providing a way for companies to raise capital and for investors to gain ownership in companies. Major stock exchanges include the New York Stock Exchange (NYSE) and the NASDAQ.
Bond Markets: where debt securities are issued and traded, allowing companies and governments to borrow money from investors. These markets are crucial for financing long-term projects and managing interest rate risks. Major bond markets include the U.S. Treasury market and corporate bond markets.
Capital markets: where companies and governments can raise funds by issuing equity or debt instruments, facilitating investment and growth in the economy.
Money Markets: where short-term borrowing and lending occurs, typically involving maturities of one year or less, allowing participants to manage liquidity and meet immediate financial needs.
Derivatives Market: a financial market for derivatives, which are contracts whose value is derived from the performance of underlying assets, allowing for risk management and speculation.
Foreign Exchange Markets: where currencies are traded, enabling businesses and individuals to convert one currency into another, which is essential for international trade and investment.
Primary Offering: the initial sale of a company's securities to the public, which allows the company to raise capital for expansion and other operational needs.
Secondary Offering: the sale of additional shares by a company after the initial public offering (IPO), typically used to raise more capital for growth or to pay down debt.
Creditor: an individual or institution that extends credit to another party, expecting repayment of the principal amount along with interest over time.
Debtor: an individual or entity that owes money to a creditor, typically as a result of borrowing funds or receiving credit.
Principal: the original sum of money borrowed or lent, which does not include interest or any other charges.
Interest: the cost of borrowing money, typically expressed as a percentage of the principal amount, which is paid to the creditor over the term of the loan.
Basic Accounting Equation: The fundamental formula in accounting that establishes the relationship between assets, liabilities, and equity. It is expressed as:
Assets = Liabilities + Equity
This equation shows that everything a company owns (assets) is financed by borrowing money (liabilities) or its own funds (equity).
Assets: Resources owned by a company that have economic value and can provide future benefits. Examples include cash, inventory, property, and equipment.
Liabilities: Obligations or debts that a company owes to external parties, which are expected to be settled over time through the transfer of economic benefits. Examples include loans, accounts payable, and mortgages.
Owner's Equity: The residual interest in the assets of a company after deducting liabilities. It represents the owner's claim on the assets of the business and includes contributed capital and retained earnings.
Budget Direprancies: Differences between the planned budget and actual financial performance, which can indicate areas of overspending or underspending. Common causes include unexpected expenses, changes in revenue, or inaccurate forecasting.
Cash Budget: A detailed plan that outlines expected cash inflows and outflows over a specific period, helping businesses manage liquidity and ensure they have sufficient cash to meet obligations.
Capital Budget: A financial plan for long-term investments, focusing on the allocation of resources for projects that will generate future cash flows, such as purchasing new ]
Operating Budget: A comprehensive plan that outlines expected income and expenses for the day-to-day operations of a business, typically covering a fiscal year. It serves as a tool for managing short-term financial performance and ensuring that the organization remains within its financial means.
Cash budgets: A detailed plan that outlines expected cash inflows and outflows over a specific period, helping businesses manage liquidity and ensure they have sufficient cash to meet their obligations.
Capital Budgeting: The process of planning and managing a company's long-term investments, capital budgeting involves evaluating potential major projects or investments to determine their value and profitability over time.
Steps in Budget Preparation:
Identify financial goals and objectives: Establish clear targets for income and expenses that align with the organization's strategic plan.
Gather historical data: Analyze past financial performance to inform future budget estimates and identify trends.
Estimate revenues: Project expected income from various sources, including sales, investments, and other revenue streams.
Determine expenses: Identify all costs related to operations, including fixed and variable expenses, and categorize them accordingly.
Review and adjust: Collaborate with department heads to review budget drafts, make necessary adjustments, and ensure alignment with overall business strategy.
Finalize the budget: Prepare the final budget document for approval by management or the board, ensuring all stakeholders are on board.
Monitor and evaluate: Continuously track performance against the budget throughout the fiscal year, making adjustments as needed to respond to changing circumstances.
Simple Interest and Compound Interest
Simple Interest: Interest calculated only on the principal amount (the original amount of money). The formula is:I = P * r * t
where I = interest, P = principal, r = annual interest rate (in decimal), and t = time in years.
Compound Interest: Interest on both the principal and previously accrued interest. To calculate compound interest, use the formula:
A = P (1 + r/n)^(nt)
where A = the future value of the investment/loan, P = principal, r = annual interest rate (decimal), n = number of times interest is compounded per year, and t = number of years.
Future Cash Flows
Calculating Future Cash Flows: The future cash flow value is important for assessing investments. It can be calculated using either the simple or compound interest method, depending on the specifics of the investment. The formula to calculate the future value of a cash flow is:
Future Value = Cash Flow * (1 + r)^n
where Cash Flow is the present value of money, r is the interest rate, and n is the number of periods until the payment is received.
DOUBLE-ENTRY ACCOUNTING: When a change in the financial position occurs, it must be recorded in at least two accounts to maintain the accounting equation. This ensures that the total debits equal total credits, providing a complete picture of the financial transactions. For examples both assets and liabilities must be altered
The steps in the accounting cycle:
1.transactions are recorded in journals
2.Entries are posted in aprropriate accounts
3.a trial balance of the accounts are prepared
4.adjusting entries are recorded
5.financial statements are prepared
6.Closing antries are completed
Accounting Assumptions,Principles and,Practices
Single economic entity: A business is treated as a separate entity from its owners or other businesses, allowing for clear financial reporting and accountability.
Going Concern: The assumption that a business will continue to operate indefinitely, unless there is evidence to the contrary, which is essential for valuing assets and liabilities appropriately.
Monetary Unit: The assumption that all financial transactions are recorded in a consistent currency, which simplifies the comparison of financial statements over time and across different entities.
Periodic Reporting: The practice of preparing financial statements at regular intervals, such as quarterly or annually, to provide stakeholders with timely and relevant information about the business's financial performance and position.
Historic costs: The original monetary value of an asset at the time of purchase, which is used for accounting purposes and provides a basis for measuring depreciation and valuing the asset over time.
Revenue Rocognition: The principle that dictates when revenue should be recognized in the financial statements, typically when it is earned and realizable, ensuring that income is reported in the period in which it is generated.
Expense and Revenue Matching: The accounting principle that requires expenses to be matched with the revenues they help generate in the same accounting period, ensuring that financial statements reflect the true profitability of a business.
Full Disclosure: The accounting principle that mandates all relevant financial information must be disclosed in the financial statements, providing transparency and allowing stakeholders to make informed decisions based on a complete understanding of the company's financial position.
Standard Practice and consistency: The principle that emphasizes the importance of using the same accounting methods and practices over time, allowing for comparability of financial statements across different periods and ensuring that stakeholders can rely on the consistency of reported financial information.
Professional Competence: The obligation of accountants to maintain a high level of knowledge, skill, and professional judgment in their work, ensuring that they provide accurate and reliable financial reporting while adhering to ethical standards and continuing education requirements.
Due Care: The principle that requires accountants to exercise diligence and care in the preparation and presentation of financial statements, ensuring that all aspects of the financial reporting process are conducted with thoroughness and attention to detail.
Independence and Integrity: The ethical principle that mandates accountants to remain unbiased and free from conflicts of interest in their professional duties, ensuring that they uphold honesty and transparency in all financial reporting activities.
Types of financial information:
Data, Records, Reports
Information Integrity: The assurance that financial information is accurate, reliable, and presented in a manner that reflects the true economic situation of an organization, thereby fostering trust among stakeholders.
Major financial decisions
1.what investments need to be made
how the investments should be financed
How the businesses investments should be efficiently managed
Asset planning: This involves evaluating the current assets of the business and determining the optimal allocation of resources to maximize returns while minimizing risks. Specifically mergers and acquisitions
Asset financing: This refers to securing capital for investments by utilizing the company's assets as collateral, allowing businesses to maintain liquidity while pursuing growth opportunities.
-Debt financing: borrowing money to grow your business
-equity financing:selling some of your business to finance itself
Asset management:making sure existing assets are giving us as high of a return as possible
Balance sheet: a financial statement that summarizes a company's assets, liabilities, and shareholders' equity at a specific point in time, providing insight into its financial position. Working capital is a better measure of financial position than this
Retained earnings: the cumulative amount of net income that a company retains, rather than distributing it as dividends to shareholders, which can be reinvested in the business or used to pay off debt.
cash flow: a company with inc positive cash flow is profitable
Solvency: the ability of a company to meet its long-term financial obligations, indicating whether it has enough assets to cover its liabilities over the long term.
Financial Ratios:
liquidity Ratios
Current ratio: a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year, calculated by dividing current assets by current liabilities.
Quick ratio: a more stringent liquidity ratio that measures a company's ability to meet its short-term obligations with its most liquid assets, calculated by subtracting inventory from current assets and then dividing by current liabilities.
Asset Management Ratios:
Inventory Turnover: a ratio that measures how many times a company's inventory is sold and replaced over a period, calculated by dividing the cost of goods sold by the average inventory.
Total assets turnover ratio: a measure of how efficiently a company uses its assets to generate sales, calculated by dividing net sales by average total assets.
Accounts Recievable ratio: a ratio that assesses how effectively a company collects receivables from its customers, calculated by dividing net credit sales by average accounts receivable.
Debt Management ratio
Debt Ratio: a financial ratio that indicates the proportion of a company's assets that are financed by debt, calculated by dividing total liabilities by total assets.
Times interested ratio: a ratio that measures a company's ability to meet its debt obligations, calculated by dividing earnings before interest and taxes (EBIT) by interest expenses.
Profitability Ratio:
Profit Margin on Sales Ratio: a profitability ratio that assesses how much profit a company makes for every dollar of sales, calculated by dividing net income by total sales revenue.
Profit Margin on total assets Ratio: a profitability ratio that indicates how efficiently a company is using its assets to generate profit, calculated by dividing net income by total assets.
Return on Equity Ratio: a profitability ratio that measures the ability of a firm to generate profits from its shareholders' equity, calculated by dividing net income by average shareholders' equity.
Market Performance Ratios
Earnings per share ratio: a financial metric that indicates the portion of a company's profit allocated to each outstanding share of common stock, calculated by dividing net income by the number of outstanding shares.
Price Earnings Ratio: a valuation ratio calculated by dividing the current share price by the earnings per share (EPS), used to assess whether a stock is overvalued or undervalued relative to its earnings.
Market to Book Ratio: a financial metric that compares a company's market value to its book value, calculated by dividing the market price per share by the book value per share, indicating how much investors are willing to pay for each dollar of net assets.
Debit to equity Ratio: a financial leverage ratio that compares a company's total debt to its total equity, calculated by dividing total liabilities by shareholders' equity, providing insight into the proportion of debt used to finance the company's assets.
Return on Equity (ROE): a financial metric that measures a company's profitability relative to shareholders' equity, calculated by dividing net income/average shareholders' equity, indicating how effectively management is using a company’s assets to create profits.
Cash Budgeting:an estimate for future cash reciepts and payments for a specific period of time
Cash Reciepts:the expected inflows of cash from various sources, including sales revenue, accounts receivable collections, and other income, which are essential for effective cash management and planning.
-Accounts recievable: the money owed to a business by its customers for goods or services delivered but not yet paid for, serving as a crucial component of cash flow management.
Cash Payments: the anticipated outflows of cash necessary for operating expenses, such as salaries, rent, utilities, and inventory purchases, which must be carefully monitored to ensure liquidity and financial stability.
Cash Excess or shortage: the difference between cash receipts and cash payments, indicating whether a business has surplus cash available or if it is facing a deficit, which can significantly impact its ability to meet obligations and invest in growth opportunities.
Cash Flow Forecasting: the process of estimating future cash inflows and outflows over a specific period, enabling businesses to anticipate cash needs and make informed financial decisions.
Cash excess or Shortage:too much or not enough cash
Cash control method:deposit all cash recieved and make all payments by check
Working Capital: Current Assets-Minus Current Laibilities
Curret assets: Items that will become cash within a year
Current laibilities: Amounts due to be paid within a year
Accounts Payable: amounts owed to suppliers aor others for items borrowed on credit
Current ratio: a financial metric used to evaluate a company's ability to pay its short-term obligations, calculated by dividing current assets by current liabilities. Has to be greater than one to be deemed appropriate; a ratio below one indicates that a company may struggle to meet its short-term debts.
Inventory Management
Direct Materials: the raw materials that are directly traceable to the production of finished goods, essential for manufacturing processes and impacting overall production costs.
Work-in-Progress (WIP): refers to the costs associated with products that are in the process of being manufactured but are not yet completed, including labor, materials, and overhead costs
Finished Goods: the completed products that are ready for sale to customers, representing a crucial component of a company's inventory and directly influencing revenue generation..
Inventory Turnover: Sales by Inventory
Turnover ratio: is a measure of how efficiently a company manages its inventory, indicating how many times inventory is sold and replaced over a specific period. A higher ratio suggests effective inventory management, while a lower ratio may indicate overstocking or sales issues.
Break even analysis:
Step 1:determine gross profit
selling price-variable cost/gross Profits per unit
Step 2
Fixed costs/gross profit per unit
Compensation:
inderict compensation:Insurance,Pension funds and educational expenses
Peice rate: A method of compensation where employees are paid a fixed rate for each unit produced or sold, incentivizing higher productivity.
Commision: A form of compensation where employees earn a percentage of the sales they generate, motivating them to increase their sales performance.
Social Security and Medicare: Government programs that provide financial assistance and healthcare to eligible individuals, typically funded through payroll taxes, ensuring a safety net for retirees and the disabled.
Employer tax: A tax imposed on employers based on the wages paid to their employees, which helps fund various government programs such as Social Security, unemployment insurance, and Medicare.
Unemployment Insurance: A program that provides temporary financial assistance to workers who have lost their jobs through no fault of their own, funded by employer taxes, ensuring support during periods of unemployment.
Credit terms: The conditions under which credit is extended, including the length of time a borrower has to repay the loan and the interest rate applied, which can significantly impact cash flow and overall business operations. 2/10 n/30
Aging of accounts recievable: Categorizing accounts recievable based on how long they will be due
Capital projects: buying something new that will increase capital
Replacement project: Replaces old equipment or building
Cost-saving Project: Like investing in something new to save costs long term'
New Product : Developing a new product line that can enhance revenue streams and diversify market offerings. Also Intellectual property or the rights to ideas characters or trademarks think Disney
Government required project: Projects req by the goverments regulations and policies
Social benefit project:Initiatives aimed maybe towards employee satisfaction or overall enviorment well being
Project Selection Factors:
Independent projects: Projects that do not affect each other
Mutually exclusive Projects: If you select one you might not be able to select others
Complimentary Projects: When two or more projects are dependent on each other
Capital Budgeting:Deciding how to allocate resources for long-term investments in a way that maximizes the fir m's value.
The process:
1.Set goals or establish money available
2.determine potential projects
3.forcast cash flows determine how we can gain money and how we will loose money. Depriciation is not accounted for in this
4.Identify risks and cost of capital.
5.Select and Implement project
COST OF CAPITAL:
Cost of debt:The rate of return required by creditors
Cost of equity:The percentage company owners expect to earn based on how much they invested in the company
Optimal capital structure: The mix of debt and equity financing that minimizes the overall cost of capital while maximizing the company's market value.
WACC weighed average cost of capittal: Percent of debt times Cost of debt +Percent of equity times cost of equity+ WACC.The WACC formula helps in determining the average rate that a company is expected to pay to finance its assets, providing a benchmark for evaluating investment opportunities.
Capital Decision Tools:
Payback method:How long will it take for cash flows of a project to recover the initial investment? This method is useful for assessing the liquidity and risk of an investment, as it indicates the time required for the project to generate enough cash to cover its costs.
Net Present value: Used to calculate how muc h money it will make in the future to how much money it will make today
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