cash flow analysis and statement

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CASH FLOW ANALYSIS AND STATEMENT Cash flow analysis is a method of analyzing the financing, investing, and operating activities of a company. The primary goal of cash flow analysis is to identify, in a timely manner, cash flow problems as well as cash flow opportunities. The primary document used in cash flow analysis is the cash flow statement. Since 1988, the Securities and Exchange Commission (SEC) has required every company that files reports to include a cash flow statement with its quarterly and annual reports. The cash flow statement is useful to managers, lenders, and investors because it translates the earnings reported on the income statement—which are subject to reporting regulations and accounting decisions—into a simple summary of how much cash the company has generated during the period in question. "Cash flow measures real money flowing into, or out of, a company's bank account," Harry Domash notes on his Web site, WinningInvesting.com. "Unlike reported earnings, there is little a company can do to overstate its bank balance." THE CASH FLOW STATEMENT A typical cash flow statement is divided into three parts: cash from operations (from daily business activities like collecting payments from customers or making payments to suppliers and employees); cash from investment activities (the purchase or sale of assets); and cash from financing activities (the issuing of stock or borrowing of funds). The final total shows the net increase or decrease in cash for the period. Cash flow statements facilitate decision making by providing a basis for judgments concerning the profitability, financial condition, and financial management of a company. While historical cash flow statements facilitate the systematic evaluation of past cash flows, projected (or pro forma) cash flow statements provide insights regarding future cash flows. Projected cash flow statements are typically developed using

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Page 1: Cash Flow Analysis and Statement

CASH FLOW ANALYSIS AND STATEMENTCash flow analysis is a method of analyzing the financing, investing, and operating activities of a company. The primary goal of cash flow analysis is to identify, in a timely manner, cash flow problems as well as cash flow opportunities. The primary document used in cash flow analysis is the cash flow statement. Since 1988, the Securities and Exchange Commission (SEC) has required every company that files reports to include a cash flow statement with its quarterly and annual reports. The cash flow statement is useful to managers, lenders, and investors because it translates the earnings reported on the income statement—which are subject to reporting regulations and accounting decisions—into a simple summary of how much cash the company has generated during the period in question. "Cash flow measures real money flowing into, or out of, a company's bank account," Harry Domash notes on his Web site, WinningInvesting.com. "Unlike reported earnings, there is little a company can do to overstate its bank balance."

THE CASH FLOW STATEMENT

A typical cash flow statement is divided into three parts: cash from operations (from daily business activities like collecting payments from customers or making payments to suppliers and employees); cash from investment activities (the purchase or sale of assets); and cash from financing activities (the issuing of stock or borrowing of funds). The final total shows the net increase or decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis for judgments concerning the profitability, financial condition, and financial management of a company. While historical cash flow statements facilitate the systematic evaluation of past cash flows, projected (or pro forma) cash flow statements provide insights regarding future cash flows. Projected cash flow statements are typically developed using historical cash flow data modified for anticipated changes in price, volume, interest rates, and so on.

To enhance evaluation, a properly-prepared cash flow statement distinguishes between recurring and nonrecurring cash flows. For example, collection of cash from customers is a recurring activity in the normal course of operations, whereas collections of cash proceeds from secured bank loans (or issuances of stock, or transfers of personal assets to the company) is typically not considered a recurring activity. Similarly, cash payments to vendors is a recurring activity, whereas repayments of secured bank loans (or the purchase of certain investments or capital assets) is typically not considered a recurring activity in the normal course of operations.

In contrast to nonrecurring cash inflows or outflows, most recurring cash inflows or outflows occur (often frequently) within each cash cycle (i.e., within the average time horizon of the cash cycle). The cash cycle (also known as the operating cycle or the earnings cycle) is the series of transactions or economic events in a given company whereby:

1. Cash is converted into goods and services.

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2. Goods and services are sold to customers.

3. Cash is collected from customers.

To a large degree, the volatility of the individual cash inflows and outflows within the cash cycle will dictate the working-capital requirements of a company. Working capital generally refers to the average level of unrestricted cash required by a company to ensure that all stakeholders are paid on a timely basis. In most cases, working capital can be monitored through the use of a cash budget.

THE CASH BUDGET

In contrast to cash flow statements, cash budgets provide much more timely information regarding cash inflows and outflows. For example, whereas cash flow statements are often prepared on a monthly, quarterly, or annual basis, cash budgets are often prepared on a daily, weekly, or monthly basis. Thus, cash budgets may be said to be prepared on a continuous rolling basis (e.g., are updated every month for the next twelve months). Additionally, cash budgets provide much more detailed information than cash flow statements. For example, cash budgets will typically distinguish between cash collections from credit customers and cash collections from cash customers.

A thorough understanding of company operations is necessary to reasonably assure that the nature and timing of cash inflows and outflows is properly reflected in the cash budget. Such an understanding becomes increasingly important as the precision of the cash budget increases. For example, a 360-day rolling budget requires a greater knowledge of a company than a two-month rolling budget.

While cash budgets are primarily concerned with operational issues, there may be strategic issues that need to be considered before preparing the cash budget. For example, predetermined cash amounts may be earmarked for the acquisition of certain investments or capital assets, or for the liquidation of certain indebtedness. Further, there may be policy issues that need to be considered prior to preparing a cash budget. For example, should excess cash, if any, be invested in certificates of deposit or in some form of short-term marketable securities (e.g., commercial paper or U.S. Treasury bills)?

Generally speaking, the cash budget is grounded in the overall projected cash requirements of a company for a given period. In turn, the overall projected cash requirements are grounded in the overall projected free cash flow. Free cash flow is defined as net cash flow from operations less the following three items:

1. Cash used by essential investing activities (e.g., replacements of critical capital assets). 2. Scheduled repayments of debt.

3. Normal dividend payments.

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If the calculated amount of free cash flow is positive, this amount represents the cash available to invest in new lines of business, retire additional debt, and/or increase dividends. If the calculated amount of free cash flow is negative, this amount represents the amount of cash that must be borrowed (and/or obtained through sales of nonessential assets, etc.) in order to support the strategic goals of the company. To a large degree, the free cash flow paradigm parallels the cash flow statement.

Using the overall projected cash flow requirements of a company (in conjunction with the free cash flow paradigm), detailed budgets are developed for the selected time interval within the overall time horizon of the budget (i.e., the annual budget could be developed on a daily, weekly, or monthly basis). Typically, the complexity of the company's operations will dictate the level of detail required for the cash budget. Similarly, the complexity of the corporate operations will drive the number of assumptions and estimation algorithms required to properly prepare a budget (e.g., credit customers are assumed to remit cash as follows: 50 percent in the month of sale; 30 percent in the month after sale; and so on). Several basic concepts germane to all cash budgets are:

1. Current period beginning cash balances plus current period cash inflows less current period cash outflows equals current period ending cash balances.

2. The current period ending cash balance equals the new (or next) period's beginning cash balance.

3. The current period ending cash balance signals either a cash flow opportunity (e.g., possible investment of idle cash) or a cash flow problem (e.g., the need to borrow cash or adjust one or more of the cash budget items giving rise to the borrow signal).

RATIO ANALYSIS

In addition to cash flow statements and cash budgets, ratio analysis can also be employed as an effective cash flow analysis technique. Ratios often provide insights regarding the relationship of two numbers (e.g., net cash provided from operations versus capital expenditures) that would not be readily apparent from the mere inspection of the individual numerator or denominator. Additionally, ratios facilitate comparisons with similar ratios of prior years of the same company (i.e., intracompany comparisons) as well as comparisons of other companies (i.e., intercompany or industry comparisons). While ratio analysis may be used in conjunction with the cash flow statement and/or the cash budget, ratio analysis is often used as a stand-alone, attention-directing, or monitoring technique.

FINANCIAL RATIOS

Financial ratios are one of the most common tools of managerial decision making. A ratio is a comparison of one number to another—mathematically, a simple division problem. Financial ratios involve the comparison of various figures from the financial statements in order to gain information about a company's performance. It is the interpretation, rather than the calculation,

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that makes financial ratios a useful tool for business managers. Ratios may serve as indicators, clues, or red flags regarding noteworthy relationships between variables used to measure the firm's performance in terms of profitability, asset utilization, liquidity, leverage, or market valuation.

USE AND USERS OF RATIO ANALYSIS

There are basically two uses of financial ratio analysis: to track individual firm performance over time, and to make comparative judgments regarding firm performance. Firm performance is evaluated using trend analysis—calculating individual ratios on a per-period basis, and tracking their values over time. This analysis can be used to spot trends that may be cause for concern, such as an increasing average collection period for outstanding receivables or a decline in the firm's liquidity status. In this role, ratios serve as red flags for troublesome issues, or as benchmarks for performance measurement.

Another common usage of ratios is to make relative performance comparisons. For example, comparing a firm's profitability to that of a major competitor or observing how the firm stacks up versus industry averages enables the user to form judgments concerning key areas such as profitability or management effectiveness. Users of financial ratios include parties both internal and external to the firm. External users include security analysts, current and potential investors, creditors, competitors, and other industry observers. Internally, managers use ratio analysis to monitor performance and pinpoint strengths and weaknesses from which specific goals, objectives, and policy initiatives may be formed.

PROFITABILITY RATIOS

Perhaps the type of ratios most often used and considered by those outside a firm are the profitability ratios. Profitability ratios provide measures of profit performance that serve to evaluate the periodic financial success of a firm. One of the most widely-used financial ratios is net profit margin, also known as return on sales.

Return on sales provides a measure of bottom-line profitability. For example, a net profit margin of 6 percent means that for every dollar in sales, the firm generated six cents in net income.

Two other margin measures are gross profit margin and operating margin.

Gross margin measures the direct production costs of the firm. A gross profit margin of 30 percent would indicate that for each dollar in sales, the firm spent seventy cents in direct costs to produce the good or service that the firm sold.

Operating margin goes one step further, incorporating nonproduction costs such as selling, general, and administrative expenses of the firm. Operating profit is also commonly referred to as earnings before interest and taxes, or EBIT. An operating margin of 15 percent would indicate that the firm spent an additional fifteen cents out of every dollar in sales on nonproduction

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expenses, such as sales commissions paid to the firm's sales force or administrative labor expenses.

Two very important measures of the firm's profitability are return on assets and return on equity.

Return on assets (ROA) measures how effectively the firm's assets are used to generate profits net of expenses. An ROA of 7 percent would mean that for each dollar in assets, the firm generated seven cents in profits. This is an extremely useful measure of comparison among firms's competitive performance, for it is the job of managers to utilize the assets of the firm to produce profits.

Return on equity (ROE) measures the net return per dollar invested in the firm by the owners, the common shareholders. An ROE of 11 percent means the firm is generating an 11-cent return per dollar of net worth.

One should note that in each of the profitability ratios mentioned above, the numerator in the ratio comes from the firm's income statement. Hence, these are measures of periodic performance, covering the specific period reported in the firm's income statement. Therefore, the proper interpretation for a profitability ratio such as an ROA of 11 percent would be that, over the specific period (such as fiscal year 2004), the firm returned eleven cents on each dollar of asset investment.

Table1 Profitability Ratios

Gross profit margin Return on assets

Operating margin Return on equity

Net profit margin

ASSET UTILIZATION RATIOS

Asset utilization ratios provide measures of management effectiveness. These ratios serve as a guide to critical factors concerning the use of the firm's assets, inventory, and accounts receivable collections in day-to-day operations. Asset utilization ratios are especially important for internal monitoring concerning performance over multiple periods, serving as warning signals or benchmarks from which meaningful conclusions may be reached on operational issues. An example is the total asset turnover (TAT) ratio.

This ratio offers managers a measure of how well the firm is utilizing its assets in order to generate sales revenue. An increasing TAT would be an indication that the firm is using its assets more productively. For example, if the TAT for 2003 was 2.2×, and for 2004 3×, the interpretation would follow that in 2004, the firm generated $3 in sales for each dollar of assets, an additional 80 cents in sales per dollar of asset investment over the previous year. Such change may be an indication of increased managerial effectiveness.

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A similar measure is the fixed asset turnover (FAT) ratio.

Fixed assets (such as plant and equipment) are often more closely associated with direct production than are current assets (such as cash and accounts receivable), so many analysts prefer this measure of effectiveness. A FAT of 1.6× would be interpreted as the firm generated $1.60 in sales for every $1 it had in fixed assets.

Two other asset utilization ratios concern the effectiveness of management of the firm's current assets. Inventory is an important economic variable for management to monitor since dollars invested in inventory have not yet resulted in any return to the firm. Inventory is an investment, and it is important for the firm to strive to maximize its inventory turnover. The inventory turnover ratio is used to measure this aspect of performance.

Cost of goods sold (COGS) derives from the income statement and indicates the expense dollars attributed to the actual production of goods sold during a specified period. Inventory is a current asset on the balance sheet. Because the balance sheet represents the firm's assets and liabilities at one point in time, an average figure is often used from two successive balance sheets. Managers attempt to increase this ratio, since a higher turnover ratio indicates that the firm is going through its inventory more often due to higher sales. A turnover ratio of 4.75×, or 475 percent, means the firm sold and replaced its inventory stock more than four and one-half times during the period measured on the income statement.

One of the most critical ratios that management must monitor is days sales outstanding (DSO), also known as average collection period.

This represents a prime example of the use of a ratio as an internal monitoring tool. Managers strive to minimize the firm's average collection period, since dollars received from customers become immediately available for reinvestment. Periodic measurement of the DSO will "red flag" a lengthening of the firm's time to collect outstanding accounts before customers get used to taking longer to pay. A DSO of thirty-six means that, on average, it takes thirty-six days to collect on the firm's outstanding accounts. This is an especially critical measure for firms in industries where extensive trade credit is offered, but any company that extends credit on sales should be aware of the DSO on a regular basis.

Table 2 Asset Utilization Ratios

Total asset turnover Days sales outstanding

Inventory turnover Fixed asset turnover

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LEVERAGE RATIOS

Leverage ratios, also known as capitalization ratios, provide measures of the firm's use of debt financing. These are extremely important for potential creditors, who are concerned with the firm's ability to generate the cash flow necessary to make interest payments on outstanding debt. Thus, these ratios are used extensively by analysts outside the firm to make decisions concerning the provision of new credit or the extension of existing credit arrangements. It is also important for management to monitor the firm's use of debt financing. The commitment to service outstanding debt is a fixed cost to a firm, resulting in decreased flexibility and higher break-even production rates. Therefore, the use of debt financing increases the risk associated with the firm. Managers and creditors must constantly monitor the trade-off between the additional risk that comes with borrowing money and the increased opportunities that the new capital provides. Leverage ratios provide a means of such monitoring.

Perhaps the most straightforward measure of a firm's use of debt financing is the total-debt ratio.

It is important to recall that there are only two ways to finance the acquisition of any asset: debt (using borrowed funds) and equity (using funds from internal operations or selling stock in the company). The total debt ratio captures this idea. A debt ratio of 35 percent means that, for every dollar of assets the firm has, 35 cents was financed with borrowed money. The natural corollary is that the other 65 cents came from equity financing. This is known as the firm's capital structure—35 percent debt and 65 percent equity. Greater debt means greater leverage, and more leverage means more risk. How much debt is too much is a highly subjective question, and one that managers constantly attempt to answer. The answer depends, to a large extent, on the nature of the business or industry. Large manufacturers, who require heavy investment in fixed plant and equipment, will require higher levels of debt financing than will service firms such as insurance or advertising agencies.

The total debt of a firm consists of both long- and short-term liabilities. Short-term (or current) liabilities are often a necessary part of daily operations and may fluctuate regularly depending on factors such as seasonal sales. Many creditors prefer to focus their attention on the firm's use of long-term debt. Thus, a common variation on the total debt ratio is the long-term debt ratio, which does not incorporate current liabilities in the numerator.

In a similar vein, many analysts prefer a direct comparison of the firm's capital structure. Such a measure is provided by the debt-to-equity ratio.

This is perhaps one of the most misunderstood financial ratios, as many confuse it with the total debt ratio. A debt-to-equity ratio of 45 percent would mean that for each dollar of equity financing, the firm has 45 cents in debt financing. This does not mean that the firm has 45 percent of its total financing as debt; debt and equity percentages, together, must sum to one (100

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percent of the firm's total financing). A little algebra will illustrate this point. Let x = the percent of equity financing (in decimal form), so 0.45 x is the percent of debt financing. Then x + 0.45 x = 1, and x = 0.69. So, a debt to equity ratio of 45 percent indicates that each dollar of the firm's assets are financed with 69 cents of equity and 31 cents with debt. The point here is to caution against confusing the interpretation of the debt-to-equity ratio with that of the total debt ratio.

Two other leverage ratios that are particularly important to the firm's creditors are the times-interest-earned and the fixed-charge coverage ratios. These measure the firm's ability to meet its on-going commitment to service debt previously borrowed. The times-interest-earned (TIE) ratio, also known as the EBIT coverage ratio, provides a measure of the firm's ability to meet its interest expenses with operating profits.

For example, a TIE of 3.6× indicates that the firm's operating profits from a recent period exceeded the total interest expenses it was required to pay by 360 percent. The higher this ratio, the more financially stable the firm and the greater the safety margin in the case of fluctuations in sales and operating expenses. This ratio is particularly important for lenders of short-term debt to the firm, since short-term debt is usually paid out of current operating revenue.

Similarly, the fixed charge coverage ratio, also known as the debt service coverage ratio, takes into account all regular periodic obligations of the firm.

The adjustment to the principal repayment reflects the fact that this portion of the debt repayment is not tax deductible. By including the payment of both principal and interest, the fixed charge coverage ratio provides a more conservative measure of the firm's ability to meet fixed obligations.

Table 3 Leverage Ratios Total debt ratio Times interest earned Long-term debt ratio Fixed charge coverage Debt-to-equity ratio

LIQUIDITY RATIOS

Managers and creditors must closely monitor the firm's ability to meet short-term obligations. The liquidity ratios are measures that indicate a firm's ability to repay short-term debt. Current liabilities represent obligations that are typically due in one year or less. The current and quick ratios are used to gauge a firm's liquidity.

A current ratio of 1.5× indicates that for every dollar in current liabilities, the firm has $1.50 in current assets. Such assets could, theoretically, be sold and the proceeds used to satisfy the

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liabilities if the firm ran short of cash. However, some current assets are more liquid than others. Obviously, the most liquid current asset is cash. Accounts receivable are usually collected within one to three months, but this varies by firm and industry. The least liquid of current assets is often inventory. Depending on the type of industry or product, some inventory has no ready market. Since the economic definition of liquidity is the ability to turn an asset into cash at or near fair market value, inventory that is not easily sold will not be helpful in meeting short-term obligations. The quick (or acid test) ratio incorporates this concern.

By excluding inventories, the quick ratio is a more strident liquidity measure than the current ratio. It is a more appropriate measure for industries that involve long product production cycles, such as in manufacturing.

Table 4 Liquidity Ratios Current ratio Quick ratio

MARKET VALUE RATIOS

Managers and investors are interested in market ratios, which are used in valuing the firm's stock. The price-earnings ratio and the market-to-book value ratio are often used in valuation analysis. The price/earnings ratio, universally known as the PE ratio, is one of the most heavily-quoted statistics concerning a firm's common stock. It is reported in the financial pages of newspapers, along with the current value of the firm's stock price.

A note of caution is warranted concerning the calculation of PE ratios. Analysts use two different components in the denominator: trailing earnings and forecast earnings. Trailing earnings refer to the firm's reported earnings, per share, over the last twelve months of operation. Forecast earnings are based on security analyst forecasts of what they expect the firm to earn in the coming twelve-month period. Neither definition is more correct than the other; one should simply pay attention to which measure is used when consulting published PE ratios. A PE ratio of sixteen can be interpreted as investors are willing to pay $16 for $1 worth of earnings. PE ratios are used extensively, on a comparative basis, to analyze investment alternatives. In investment lingo, the PE ratio is often referred to as the firm's "multiple." A high PE is often indicative of investors's belief that the firm has very promising growth prospects, while firms in more mature industries often trade at lower multiples.

A related measure used for valuation purposes is the market-to-book value ratio. The book value of a firm is defined as:

Technically, the book value represents the value of the firm if all the assets were sold off, and the proceeds used to retire all outstanding debt. The remainder would represent the equity that would be divided, proportionally, among the firm's shareholders. Many investors like to compare the current price of the firm's common stock with its book, or break-up, value.

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This is also known as the price/book ratio. If the ratio is greater than one, which is often the case, then the firm is trading at a premium to book value. Many investors regard a market-to-book ratio of less than one an indication of an undervalued firm. While the interpretation one draws from market ratios is highly subjective (do high PE or low PE firms make better investments?), these measures provide information that is valued both by managers and investors regarding the market price of a firm's stock.

Table 5 Market Value Ratios Price/earnings ratio Market-to-book ratio

CAUTIONS ON THE USE AND INTERPRETATION OF FINANCIAL RATIOS

Financial ratios represent tools for insight into the performance, efficiency, and profitability of a firm. Two noteworthy issues on this subject involve ratio calculation and interpretation. For example, if someone refers to a firm's "profit margin" of 18 percent, are they referring to gross profit margin, operating margin, or net profit margin? Similarly, is a quotation of a "debt ratio" a reference to the total debt ratio, the long-term debt ratio, or the debt-to-equity ratio? These types of confusions can make the use of ratio analysis a frustrating experience.

Interpreting financial ratios should also be undertaken with care. A net profit margin of 12 percent may be outstanding for one type of industry and mediocre to poor for another. This highlights the fact that individual ratios should not be interpreted in isolation. Trend analyses should include a series of identical calculations, such as following the current ratio on a quarterly basis for two consecutive years. Ratios used for performance evaluation should always be compared to some benchmark, either an industry average or perhaps the identical ratio for the industry leader.

Another factor in ratio interpretation is for users to identify whether individual components, such as net income or current assets, originate from the firm's income statement or balance sheet. The income statement reports performance over a specified period of time, while the balance sheet gives static measurement at a single point in time. These issues should be recognized when one attempts to interpret the results of ratio calculations.

Despite these issues, financial ratios remain useful tools for both internal and external evaluations of key aspects of a firm's performance. A working knowledge and ability to use and interpret ratios remains a fundamental aspect of effective financial management. The value of financial ratios to investors became even more apparent during the stock market decline of 2000, when the bottom dropped out of the soaring "dot.com" economy. Throughout the long run-up, some financial analysts warned that the stock prices of many technology companies—

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particularly Internet start-up businesses—were overvalued based on the traditional rules of ratio analysis. Yet investors largely ignored such warnings and continued to flock to these companies in hopes of making a quick return. In the end, however, it became clear that the old rules still applied, and that financial ratios remained an important means of measuring, comparing, and predicting firm performance.

What are the key risk management issues to be aware of and how do you mitigate them?

Project Risk ManagementWhen planning a project you hope for the best, but there is always a chance of something unexpected preventing this. Project risk management is about having the confidence of knowing what to do if the worse occurs, and what this will cost.

Project risk management consists of two key aspects: determining the risk, and designing counter measures.

Determining Risk

When determining risk there are three key aspects to consider:

1. The event causing the risk.2. The likelihood of the event happening.

3. The impact on the plan if the event occurs.

Risk Events

When planning, it is impossible to determine every risk causing event that may occur. Many things can occur on a project, and you could spend forever trying to anticipate them all. However, as will become clear, it is not important to consider them all, you need to consider a representative selection of events that could effect a project.

Risk Likelihood

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Even when we have a set of risk events, we do not generally have accurate statistics about their occurrence. It is unlikely therefore that we can determine their exact likelihood. This is a reason that a subjective scale of high, medium, or low is often used to determine likelihood. It focuses attention on those events you feel will be most likely to occur.

Risk Impact

The next step is to determine what impact a risk event may have on a project. This means determining what effect it will have on the scope, time, resource, or quality aspects of the project plan. These can vary from an annoyance through to a total catastrophe. Various scale scan be used but a similar three point scale of high, medium, or low is also often used.

Why Do It?

The process described so far appears very subjective, liable to error, and will definitely not be complete. So why do it? This is a valid question for many project plans, which just determine risk and go no further. However what we are really interested in is delivering a project plan in a way that satisfies the customer. This is the importance of the counter measures part. It states what you will do if a risk event occurs to mitigate the damage.

Designing Counter Measures

When designing counter measures it will be noticed that the same counter measure can be employed to cover several different types of risk. What is more those same counter measures will most likely prove useful against risks you have not anticipated. This is the power of risk planning; by planning how to deal with the worst that you can think of, you are also providing insurance for events you have not considered. Therefore you have raised the possibility that the project will be delivered successfully.

Generic Risk Counter Measures

Risk counter measures will reduce the likelihood, the impact, or both of a risk happening. There are various generic risk counter measures that can be used to reduce risk. As an example supposing you wanted to cross a busy road in order to buy some fish and chips. Your options could be:

4. Eliminate the risk: Buy fish and frozen chips from a supermarket and cook them at home.

5. Cease the activity: Decide not to have fish and chips.

6. Reduce the likelihood: Carefully check the road and only cross when there is no traffic.

7. Reduce the impact: Wear body armour so that if you are hit then it will have less effect.

8. Early warning: Check the road to see if there is any traffic before crossing.

9. Avoid: Decide to have a pizza instead from a shop on your side of the road.

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10. Share or transfer: Ring for a taxi to go and collect your fish and chips.

11. Accept risk: Just cross the road anyway.

Selecting Counter Measures

To select appropriate counter measures you check your list of risk events and consider for each of them what you could do to mitigate the effect of it happening. You start with the high likelihood and high impact events, and work down to the low likelihood and low impact events. For each consider the generic counter measures list and see if any can apply to the risk event you are considering. As an example for a test plan if there is a risk of the software being delivered to testing that does not even run, you may cease the testing activity. By documenting this in advance in the test plan all stakeholders are aware of the possibility of this extreme action. Another event may be the loss of one of the testing team. This could be covered by:

Reducing the likelihood, by ensuring the team are well paid, and have had a successful health check,

Reducing the impact, by having spare team members, or a call off arrangement with a contract agency,

Early warning, by having a strong system of staff appraisal, and other measures to see if staff are likely to become unavailable,

Accept the risk, by notifying the customer that if the event occurs then the scope, time scale, or quality standards will have to be adjusted and meeting convened to discuss.

A Balanced Risk Management Plan

A balance must be struck between no planning, and planning to the point of project paralysis. The key is to balance the cost of the planning process, along with likely costs of counter measures, against the benefits to be delivered by the project. This can only be done in conjunction with the various stakeholders. If it is done at the start of a project it might even lead to the conclusion that the project is not worth pursuing. If it is pursued then the risk plan enables a more accurate judgment to be made about the likely overall costs. A risk management plan makes you think about what it is you want to achieve, and what you are willing to pay for it. As a result you stand a far higher chance of achieving success.

What's "Risk Management"?

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Risk management is attempting to identify and then manage threats that could severely impact or bring down the organization. Generally, this involves reviewing operations of the organization, identifying potential threats to the organization and the likelihood of their occurrence, and then taking appropriate actions to address the most likely threats.

Traditionally, risk management was thought of as mostly a matter of getting the right insurance. Insurance coverage usually came in rather standard packages, so people tended to not take risk management seriously. However, this impression of risk management has changed dramatically. With the recent increase in rules and regulations, employee-related lawsuits and reliance on key resources, risk management is becoming a management practice that is every bit as important as financial or facilities management.

There are several basic activities which a nonprofit organization can conduct to dramatically reduce its chances of experiencing a catastrophic event that ruins or severely impairs the organization.

Conducting a Risk Management Assessment

Organizations should regularly undertake comprehensive, focused assessment of potential risks to the organization. This focused assessment should occur at least twice a year by a team of staff members representing all the major functions of the organization. The assessment should be carefully planned, documented and methodically carried out.

The most common risks are typically of the types listed below. Comprehensive checklists help a great deal to quickly review a wide range of organizational aspects. Other aspects require more careful review.

Checklists in the following sections cover almost 140 considerations to ensure a well-run and highly protected organization.

Best Protection: Good Management, Personnel Policies and Insurance

Good Management:

Efforts undertaken to manage an organization well also contribute to sound risk management. For example, a fully attentive board with a wide range of skills may be the most important guard against major threats to an organization.

Careful strategic planning and effective supervision helps ensure organizational resources are closely aligned to accomplishing the organization's mission, and that staff and volunteers are treated fairly and comply with rules and regulations.

Up-to-date, Reviewed Personnel Policies:

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Every organization must have up-to-date policies which guide the relationships between staff and management. There has been a noticeable increase in lawsuits regarding wrongful termination, harassment and discrimination, disagreements about promotions or salary actions, etc. Parties to lawsuits include the organization, management and/or board members. Therefore, personnel policies must be reviewed at least once a year by an outside advisor who is an expert about all of the employee-related laws and regulations.

Be sure that management is well versed about the policies. Typically, courts will interpret actions by organizational personnel as representative of the organization's preferred course of action and superseding related, documented policies.

Well-designed Insurance Coverage:

For a broad and basic overview of insurance. You might first review this information and then invite an insurance agent (or better yet, an insurance broker) to visit your organization to provide you an overview of the types of insurance typically sold to nonprofits. Note that many insurance professionals might not understand the nature of nonprofits. Therefore, you might first ask a few people from fellow nonprofits for references.

As dreadful as it may sound, you must schedule two hours sometime during the year to close your door and study your insurance policies. Note any questions and pose them to your insurance professional. Ask him or her to provide you a written, clear description regarding any ambiguities and to do so on company letterhead with his or her signature.

Note that Directors and Officers Insurance (D & O, and covered in the above "Insurance Against Liabilities" section) is increasingly considered because of the increasing number of lawsuits. In addition, D & O insurance helps attract highly experienced board members. Be sure your D & O insurance covers "insured vs. insured" which covers employee-related lawsuits and also covers ongoing costs to address a lawsuit (rather than paying only when the outcome of a lawsuit has been decided).

Legal Protection

To conduct a general audit of legal-related matters in your organization,.

Managing Risks in Financial Management

Sound financial and asset controls help minimize theft, fraud and waste.

Resource Management (people, computers, records and facilities)

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People:

This aspect of risk management is often overlooked. Each key role in an organization should have some type of resource to back up performance of that role. For example, another person in the organization should have general understanding of another person's role in case that other person for some reason is not able to perform the role. The use of up-to-date job descriptions, todo lists and receiving regular status reports both help to ensure understanding of how others carry out their roles. Have a staff member back up another member who is on vacation. During staff meetings, have a staff member give a presentation about their role and how they carry it out. Ensure that each critical role has at least one backup person who can step in to conduct the role. The backup assignment should be part of the person's job description to help the person take the assignment seriously.

Computers:

To avoid losing information stored on your computers when, e.g., a disk breaks (or "crashes"), ensure that computer files are regularly backed up to another media, e.g., backed up onto magnetic tapes, "zip" disk, CD-ROM, etc. Store the media offsite, that is, in a facility other than at your organization. If a disk crashes, you can repair the disk or get a new one and then restore the information from the backup media onto the new disk.Or, if backup media cannot be afforded (most are only a few hundred dollars), ensure files are stored on at least two different media devices, e.g., stored on an internal hard disk and then also on a diskette. Using a diskette as backup simply requires the computer user to occasionally save away his or her file to the diskette in addition to the hard disk. The same diskette can be used to backup files. Label the diskette with the time period during which files were backed up to it. Note that the major software applications themselves (Word, Excel, etc.) do not have to be backed up because the organization usually has the software application's master diskettes. The most important items to backup are usually database files, spreadsheet files and large documents written by users. Conducting regular backups is more a matter of managerial policy than technical limitations.

Records:

1. Record all records in a central location and well labeled.2. Keep critical documents (e.g., board minutes, leases and contracts, Articles of Incorporation, By Laws, letter from the IRS granting tax-exempt status, etc.) preferably in a fireproof box.3. Personnel files should be locked in desk drawers with access granted to the Executive Director and his or her assistant.4. Allocate two hours each year for staff to audit the agency's documentation for relevance, adequate labeling and reasonable organization.

General Facilities:

1. Always lock your doors. This seems obvious, but too many organizations fail to do so.2. Ensure your fire protection systems are fully functional by scheduling to test fire alarms twice a year or demanding that your facility's owner test alarms twice a year. Note that certain electrical equipment can be severely damaged from water sprinklers. Arrange adequate covering or arrangement to minimize water seepage if overhead sprinklers open up.

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3. Conduct inspections twice a year, including to:a) Inspect floors for ripped carpetsb) look for cables or wires laying on the floor (tape over them if you have to)c) Notice any electrical outlets with black soot hear outlets (this indicates electrical shortages)d) Ask all staff if their office accommodations are sufficient, e.g., their chairs are entirely comfortable (tilted correctly for their backs and at the right heights), is lighting sufficient for desk and computer work, etc.e) Notice any heavy items on or near the floor which staff must continually stoop to lift, e.g., boxes of paper for the copier or printers; open boxes before they're set on the floor or stack heavy items in a storage room on a shelff) Ensure all doors have fully functional door knobs (it's amazing how long people can tolerate something as small as a knob that continually jams so the door is difficult to open)g) Ensure there is a well-stocked first-aid kit available to all staffh) Post emergency numbers on the wall near the central phone i) During the winter, ensure adequate ice removal, e.g., spread sand over ice or use salt to melt icej) Schedule ten minutes in a staff meeting once a year for the entire staff to reflect on the quality of the facilities

Describe the tools and techniques for optimal financial analysisCorporate finance[1] is an area of finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value [2] while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, the short term decisions can be grouped under the heading "Working capital management". This subject deals with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).

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The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs.

(In the UK, the terms “corporate finance” and “corporate financier” tend to be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.)

Contents

[hide]12. 1 Capital investment decisions

1. 1.1 The investment decision

1. 1.1.1 Project valuation

2. 1.1.2 Valuing flexibility

3. 1.1.3 Quantifying uncertainty

2. 1.2 The financing decision

3. 1.3 The dividend decision

13. 2 Working capital management

1. 2.1 Decision criteria

2. 2.2 Management of working capital

14. 3 Financial risk management

15. 4 Relationship with other areas in finance

1. 4.1 Investment banking

2. 4.2 Personal and public finance

16. 5 Related professional qualifications

17. 6 References

18. 7 See also

[edit] Capital investment decisions

Capital investment decisions [3] are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate. (2) These projects

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must also be financed appropriately. (3) If no such opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.

[edit] The investment decision

Main article: Capital budgeting

Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting [4]. Making this capital allocation decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows.

[edit] Project valuation

Further information: Business valuation, stock valuation, and fundamental analysis

In general [5], each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: theory). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See Financial modeling.

The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate - often termed, the project "hurdle rate" [6] - is critical to making an appropriate decision. The hurdle rate is the minimum acceptable return on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the financing mix. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV include MVA / EVA (Stern Stewart & Co) and APV (Stewart Myers). See list of valuation topics.

[edit] Valuing flexibility

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Main articles: Real options analysis and decision tree

In many cases, for example R&D projects, a project may open (or close) paths of action to the company, but this reality will not typically be captured in a strict NPV approach.[7] Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the “flexibile and staged nature” of the investment is modelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project.

The two most common tools are Decision Tree Analysis (DTA) [8] [9] and Real options analysis (ROA) [10]; they may often be used interchangeably:

4. DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" - each scenario must be modelled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this “knowledge” of the events that could follow, and assuming rational decision making, management chooses the actions corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory: Choice under uncertainty.

4. ROA is usually used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option; (2) an appropriate valuation technique is then employed - usually a variant on the Binomial options model or a bespoke simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.)

[edit] Quantifying uncertainty

Further information: Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance

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Given the uncertainty inherent in project forecasting and valuation,[11] [9] analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface" (or even a "value-space"), where NPV is then a function of several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be internally consistent, whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV for the project is then the probability-weighted average of the various scenarios.

A further advancement is to construct stochastic or probabilistic financial models – as opposed to the traditional static and deterministic models as above. For this purpose, the most common method is to use Monte Carlo simulation to analyze the project’s NPV. This method was introduced to finance by David B. Hertz in 1964, although has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using an add-in, such as Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or "trials"; see Monte Carlo Simulation versus “What If” Scenarios. The output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value).

Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly - incorporating this correlation - so as to generate several thousand scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. (These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see Real options analysis: Model inputs.)

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[edit] The financing decision

Main article: Capital structure

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately [12] . As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation. Management must therefore identify the "optimal mix" of financing—the capital structure that results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)

The sources of financing will, generically, comprise some combination of debt and equity financing. Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of ownership, control and earnings. The cost of equity is also typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.

Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms of both timing and cash flows.

One of the main theories of how firms make their financing decisions is the Pecking Order Theory, which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Another major theory is the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when making their decisions. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One last theory about this decision is the Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.

[edit] The dividend decision

Main article: The Dividend Decision

Whether to issue dividends,[13] and what amount, is calculated mainly on the basis of the company's unappropriated profit and its earning prospects for the coming year. If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then management must return excess cash to investors. These free cash flows comprise cash remaining after all business expenses have been met.

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This is the general case, however there are exceptions. For example, investors in a "Growth stock", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see above and Real options.

Management must also decide on the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Today, it is generally accepted that dividend policy is value neutral (see Modigliani-Miller theorem).

[edit] Working capital management

Main article: Working capital

Decisions relating to working capital and short term financing are referred to as working capital management[14]. These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital.

The goal of Working capital management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA).

[edit] Decision criteria

Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term, decisions.

In addition to time horizon, working capital decisions differ from capital investment decisions in terms of discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite and return targets remain identical, although some constraints - such as those imposed by loan covenants - may be more relevant here).

Working capital management decisions are therefore not taken on the same basis as long term decisions, and working capital management applies different criteria in decision making: the

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main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the more important).

The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. (Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.)

4. In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. As above, firm value is enhanced when, and if, the return on capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

[edit] Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital [15]. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

Cash management . Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).

Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.

2. Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

[edit] Financial risk management

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Main article: Financial risk management

Risk management [16] is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management.

This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or preserving, firm value. All[citation needed] large corporations have risk management teams, and small firms practice informal, if not formal, risk management. There is a fundamental debate on the value of "Risk Management" and shareholder value that questions a shareholder's desire to optimize risk versus taking exposure to pure risk. The debate links value of risk management in a market to the cost of bankruptcy in that market.

Derivatives are the instruments most[citation needed] commonly used in financial risk management. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets or exchanges. These standard derivative instruments include options, futures contracts, forward contracts, and swaps. More customized and second generation derivatives known as exotics trade over the counter aka OTC.

See: Financial engineering; Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity risk; Market risk; Operational risk; Volatility risk; Settlement risk; Value at Risk;.

[edit] Relationship with other areas in finance

[edit] Investment banking

Use of the term “corporate finance” varies considerably across the world. In the United States it is used, as above, to describe activities, decisions and techniques that deal with many aspects of a company’s finances and capital. In the United Kingdom and Commonwealth countries, the terms “corporate finance” and “corporate financier” tend to be associated with investment banking - i.e. with transactions in which capital is raised for the corporation.[17] These may include

Raising seed, start-up, development or expansion capital Mergers, demergers, acquisitions or the sale of private companies

Mergers, demergers and takeovers of public companies, including public-to-private deals

Management buy-out, buy-in or similar of companies, divisions or subsidiaries - typically backed by private equity

Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise capital for development and/or to restructure ownership

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Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses

Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations

Secondary equity issues, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above.

Raising debt and restructuring debt, especially when linked to the types of transactions listed above

[edit] Personal and public finance

Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations have broad application to entities other than corporations, for example, to partnerships, sole proprietorships, not-for-profit organizations, governments, mutual funds, and personal wealth management. But in other cases their application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from personal finance and public finance.

Proxy statementA proxy statement is a statement required of a United States firm when soliciting shareholder votes. This statement is filed in advance of the annual meeting. The firm needs to file a proxy statement, otherwise known as a Form DEF 14A (Definitive Proxy Statement), with the U.S. Securities and Exchange Commission. This statement is useful in assessing how management is paid and potential conflict-of-interest issues with auditors. The statement includes:

1. Voting procedure and information.2. Background information about the company's nominated directors including relevant

history in the company or industry, positions on other corporate boards, and potential conflicts in interest.

3. Board compensation.

4. Executive compensation, including salary, bonus, non-equity compensation, stock awards, options, and deferred compensation. Also, information is included about perks such as personal use of company aircraft, travel, and tax gross-ups. Many companies will also include pre-determined payout packages for if an executive leaves the company.

5. Who is on the audit committee, as well as a breakdown of audit and non-audit fees paid to the auditor.

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MICROSOFT CORPORATION ONE MICROSOFT WAY

REDMOND, WASHINGTON 98052 

  PROXY STATEMENT FOR ANNUAL MEETING OF SHAREHOLDERS     TO BE HELD NOVEMBER 9, 2005  

 

This Proxy Statement, which was first mailed to shareholders on or about September 30, 2005, is furnished in connection with the solicitation of proxies by the Board of Directors of Microsoft Corporation (the “Company” or “Microsoft”), to be voted at the Annual Meeting of the shareholders of the Company, which will be held at 8:00 a.m. on November 9, 2005, at the Meydenbauer Center, 11100 NE 6th Street, Bellevue, Washington 98004, for the purposes set forth in the accompanying Notice of Annual Meeting of Shareholders. Shareholders who execute proxies retain the right to revoke them at any time before the shares are voted by proxy at the meeting. A shareholder may revoke a proxy by delivering a signed statement to the Secretary of the Company at or prior to the Annual Meeting or by executing and delivering another proxy dated as of a later date. The Company will pay the cost of solicitation of proxies.

 

 Shareholders of record at the close of business on September 9, 2005 will be entitled to vote at the meeting on the basis of one vote for each share held. On September 9, 2005, there were 10,659,471,791 shares of common stock outstanding, held of record by 149,637 shareholders.

 

1. ELECTION OF DIRECTORS AND MANAGEMENT INFORMATION  

 

Ten directors are to be elected at the Annual Meeting to hold office until the next annual meeting of shareholders, and until their successors are elected and qualified. The accompanying proxy will be voted in favor of the following persons to serve as directors unless the shareholder indicates to the contrary on the proxy. The election of the Company’s directors requires a plurality of the votes cast in person or by proxy at the meeting. However, pursuant to the Microsoft Corporation Corporate Governance Guidelines, if a majority of the votes cast are withheld for a director in an uncontested election, the director is to tender his or her resignation to the Board and the Board, taking into consideration the recommendation of the Governance and Nominating Committee, will determine whether to accept the resignation. Management expects that each of the nominees will be available for election, but if any of them is unable to serve at the time the election occurs, the proxy will be voted for the election of another nominee to be designated by the Board of Directors.

 

NOMINEES  

 

William H. Gates III, 49, a co-founder of the Company, has served as Chairman since the Company’s incorporation in 1981. Mr. Gates served as the Company’s Chief Executive Officer from 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. Mr. Gates is also a director of Berkshire Hathaway Inc.

 

 

Steven A. Ballmer, 49, has been a director of the Company since 2000. Mr. Ballmer has headed several Microsoft divisions during the past 20 years, including operations, operating systems development, and sales and support. In July 1998, he was promoted to president, a role that gave him day-to-day responsibility for running Microsoft. He was named Chief Executive Officer in January 2000, assuming full management responsibility for the Company. Mr. Ballmer is also a director of Accenture Ltd.

 

 James I. Cash Jr., Ph.D., 57, has been a director of the Company since 2001. Dr. Cash is formerly The James E. Robison Professor of Business Administration at Harvard Business

 

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School, where he also served as Senior Associate Dean and Chairman of HBS Publishing. Dr. Cash is also a member of the board of directors of The Chubb Corporation, General Electric Company, Phase Forward Incorporated, and Scientific-Atlanta, Inc.

 

Dina Dublon, 52, has been a director of the Company since March 2005. From December 1998 until her retirement in September 2004, Ms. Dublon served as Executive Vice President and Chief Financial Officer of JPMorgan Chase. Ms. Dublon joined Chemical Bank’s capital markets group as a trainee on the trading floor in 1981. Prior to joining Chemical Bank, Ms. Dublon worked for the Harvard Business School and Bank Hapoalim in Israel. Ms. Dublon is also a member of the board of directors of Accenture Ltd. and PepsiCo, Inc.

 

 

Raymond V. Gilmartin, 64, has been a director of the Company since 2001. From 1994 to May 2005, Mr. Gilmartin served as the Chairman of the Board, President, and Chief Executive Officer of Merck & Co., Inc. Mr. Gilmartin currently serves as Special Advisor to the Executive Committee of the Merck board of directors. Prior to joining Merck, Mr. Gilmartin was Chairman, President, and Chief Executive Officer of Becton Dickinson and Company. He joined that company in 1976 as Vice President, Corporate Planning, taking on positions of increasing responsibility over the next 18 years. Mr. Gilmartin also serves on the board of directors of General Mills, Inc.

 

 

Ann McLaughlin Korologos, 63, has been a director of the Company since 2000. Mrs. Korologos serves as Senior Advisor with Benedetto, Gartland & Co., Inc., a private investment banking company. Mrs. Korologos served as the United States Secretary of Labor from 1987 to 1989. She currently serves as a member of the board of directors of AMR Corporation (and its subsidiary, American Airlines), Fannie Mae, Harman International Industries, Inc., Host Marriott Corporation, and Kellogg Company.

 

 

David F. Marquardt, 56, has served as a director of the Company since 1981. Mr. Marquardt is a founding general partner of August Capital, a venture capital firm formed in 1995, and has been a general partner of various Technology Venture Investors entities, which are private venture capital limited partnerships, since August 1980. He is a director of Netopia, Inc., Seagate Technology, Inc., and various privately-held companies.

 

 

Charles H. Noski, 53, has served as a director of the Company since 2003. From December 2003 to March 2005, Mr. Noski served as Corporate Vice President and Chief Financial Officer of Northrop Grumman Corporation and served as a director from November 2003 to May 2005. Mr. Noski joined AT&T in 1999 as Senior Executive Vice President and Chief Financial Officer and was named Vice Chairman of AT&T’s Board of Directors in 2002. Mr. Noski retired from AT&T upon the completion of its restructuring in November 2002. Prior to joining AT&T, Mr. Noski was President, Chief Operating Officer, and a member of the board of directors of Hughes Electronics Corporation, a publicly-traded subsidiary of General Motors Corporation in the satellite and wireless communications business. He is a member of the American Institute of Certified Public Accountants and Financial Executives International, and a past member of the Financial Accounting Standards Advisory Council. Mr. Noski is also a director of Air Products and Chemicals, Inc. and Morgan Stanley.

 

 Dr. Helmut Panke, 59, has served as a director of the Company since 2003. Dr. Panke has been with BMW Bayerische Motoren Werke AG since 1982 in a variety of positions and, since May 2002, has served as Chairman of the Board of Management. From 1999 to 2002, he served as Member of the Board of Management for Finance. From 1996 to 1999, Dr. Panke was Member of the Board of Management for Human Resources and Information Technology. In his role as Chairman and CEO of BMW (US) Holding Corp. from 1993 to 1996, he was responsible for

 

Page 29: Cash Flow Analysis and Statement

the company’s North American activities. Dr. Panke is also a director of UBS AG.

 Jon A. Shirley, 67, served as President and Chief Operating Officer of Microsoft from 1983 to 1990. He has been a director of the Company since 1983. Prior to joining Microsoft, Mr. Shirley was with Tandy Corporation in a variety of positions.

 

INFORMATION ABOUT THE BOARD AND ITS COMMITTEES  

 

The system of governance practices followed by the Company is memorialized in the Microsoft Corporation Corporate Governance Guidelines and the charters of the five committees of the Board of Directors. The Governance Guidelines and charters are intended to assure that the Board will have the necessary authority and practices in place to review and evaluate the Company’s business operations and to make decisions that are independent of the Company’s management. The Governance Guidelines also are intended to align the interests of directors and management with those of Microsoft’s shareholders. The Governance Guidelines establish the practices the Board will follow with respect to board composition and selection, board meetings and involvement of senior management, chief executive officer performance evaluation, succession planning, board committees, and director compensation. The Board annually conducts a self-evaluation to assess compliance with the Governance Guidelines and identify opportunities to improve Board performance.

 

 

The Governance Guidelines and committee charters are reviewed periodically and updated as necessary to reflect changes in regulatory requirements and evolving oversight practices. The Governance Guidelines comply with corporate governance requirements contained in both the Nasdaq Stock Market (“Nasdaq”) and New York Stock Exchange listing standards and make other enhancements to the Company’s corporate governance policies, including creating the role of lead independent director. The chair of the Governance and Nominating Committee serves as the lead independent director. The lead independent director is responsible for coordinating the activities of the non-management directors, coordinating with the Chairman to set the agenda for Board meetings, chairing meetings of the non-management directors, and leading the Board’s review of the chief executive officer. The Board has five committees: an Audit Committee, a Compensation Committee, a Finance Committee, a Governance and Nominating Committee, and an Antitrust Compliance Committee. The Governance Guidelines, as well as the charter for each committee of the Board, may be viewed at www.microsoft.com/msft/corpinfo.mspx.

 

 

The Board of Directors holds regularly scheduled quarterly meetings. Typically, committee meetings occur the day prior to the board meeting. One quarter each year, the committee and board meetings occur on a single day so that the evening and following day can be devoted to presentations and discussions with senior management about long-term Company strategy as part of the Board’s annual retreat. In addition to the quarterly meetings, typically there are two other regularly scheduled meetings and several special meetings each year. At each quarterly board meeting, time is set aside for the non-management directors to meet without management present. The Board of Directors met nine times during fiscal year 2005. All directors attended 75% or more of the Board meetings and meetings of the committees on which they served during the last fiscal year. Directors are encouraged to attend the Annual Meeting of shareholders. Five directors attended the 2004 Annual Meeting.

 

 The table below provides current membership and meeting information for each of the Board committees for fiscal year 2005. Committee memberships changed during the fiscal year. Wm. G. Reed, Jr. retired from the Board as of the date of the Company’s Annual Meeting in November 2004. In December 2004, Ms. Korologos was appointed to the Audit Committee and

 

Page 30: Cash Flow Analysis and Statement

Mr. Cash was appointed to the Compensation Committee. In March 2005, Ms. Dublon was appointed to the Audit Committee.

Name

  Audi

Compensation

  Financ

Governance & Nominating

  Antitrust

Compliance 

Mr. Gates    

 

 

 

 

Mr. Ballmer    

 

 

 

 

Dr. Cash   X

  X

   

 

X*

 

Ms. Dublon   X

   

 

 

 

Mr. Gilmartin    

 

 

X*

  X

 

Mrs. Korologos   X

  X*

   

 

X

 

Mr. Marquardt    

 

X

  X

   

Mr. Noski   X*

   

X

   

 

Dr. Panke    

X

   

 

 

Mr. Shirley    

 

X*

   

 

Total meetings in fiscal year 2005

  10

  5  

5  

3  

3  

      * Committee Chairperson      

 

Below is a description of each committee of the Board of Directors. Each of the committees has authority to engage legal counsel or other experts or consultants as it deems appropriate to carry out its responsibilities. The Board of Directors has determined that each member of each committee meets the standards of independence under the Governance Guidelines and applicable Nasdaq listing standards, including that each member is free of any relationship that would interfere with his or her individual exercise of independent judgment.

 

 Audit Committee: The Audit Committee assists the Board of Directors in its oversight of the quality and integrity of the accounting, auditing, and reporting practices of the Company. The Audit Committee’s role includes overseeing the work of the Company’s internal accounting and financial reporting and internal auditing processes and discussing with management the Company’s processes to manage business and financial risk, and for compliance with significant applicable legal, ethical, and regulatory requirements. The Audit Committee is responsible for the appointment, compensation, retention, and oversight of the independent auditor engaged to prepare or issue audit reports on the financial statements and internal control over financial reporting of the Company. The Audit Committee relies on the expertise and

 

Page 31: Cash Flow Analysis and Statement

knowledge of management, the internal auditors, and the independent auditor in carrying out its oversight responsibilities. The Committee’s specific responsibilities are delineated in the Audit Committee Responsibilities Calendar accompanying the Audit Committee Charter. The Charter and Responsibilities Calendar as amended and restated effective July 1, 2005 are attached as Exhibit 1 to this Proxy Statement. The Board of Directors has determined that each Audit Committee member has sufficient knowledge in financial and auditing matters to serve on the Committee. In addition, the Board has determined that each of Dina Dublon and Charles H. Noski is an “audit committee financial expert” as defined by Securities and Exchange Commission (“SEC”) rules.

 

Compensation Committee: The primary responsibilities of the Compensation Committee are: (a) in conjunction with the lead independent director, review and approve the annual goals and objectives of the chairman and chief executive officer and evaluate performance against those goals and objectives, (b) approve the compensation of the chairman and chief executive officer; (c) oversee the performance evaluation of the Company’s other executive officers and approve their compensation; (d) oversee and advise the Board on the adoption of policies that govern the Company’s compensation programs; (e) oversee the Company’s administration of its equity-based compensation and other benefit plans; and (f) approve grants of equity compensation awards under the Company’s stock plan. The Compensation Committee’s role includes producing the report on executive compensation required by SEC rules. The specific responsibilities and functions of the Compensation Committee are delineated in the Compensation Committee Charter.

 

 

Finance Committee: The Finance Committee is responsible for overseeing and making recommendations to the Board about the financial affairs and policies of the Company including: (a) policies relating to the Company’s cash flow, cash management, and working capital, shareholder dividends and distributions, and share repurchases and investments; (b) financial strategies; (c) policies for managing financial risk; (d) tax planning and compliance; and (e) proposed mergers, acquisitions, divestitures, and strategic investments. The Finance Committee’s role includes designating officers and employees who can execute documents and act on behalf of the Company in the ordinary course of business under previously approved banking, borrowing, and other financing agreements. The specific responsibilities and functions of the Finance Committee are delineated in the Finance Committee Charter.

 

 Governance and Nominating Committee: The principal responsibilities of the Governance and Nominating Committee are to: (a) determine the slate of director nominees for election to the Company’s Board of Directors; (b) identify and recommend candidates to fill vacancies occurring between annual shareholder meetings; (c) review the composition of Board committees; (d) monitor compliance with, review, and recommend changes to the Company’s Corporate Governance Guidelines; and (e) review the Company’s policies and programs that relate to matters of corporate responsibility, including public issues of significance to the Company and its stakeholders. The Governance and Nominating Committee’s role includes periodically reviewing the compensation paid to non-employee directors, and making recommendations to the Board for any adjustments. In addition, the Chair of the Governance and Nominating Committee acts as the lead independent director and is responsible for leading the Board of Directors’ annual review of the chief executive officer’s performance. The Governance and Nominating Committee regularly reviews the charters of Board committees and, after consultation with the respective committee chairs, makes recommendations, if necessary, about changes to the charters. The specific responsibilities and functions of the

 

Page 32: Cash Flow Analysis and Statement

Governance and Nominating Committee are delineated in the Governance and Nominating Committee Charter.

 

The Governance and Nominating Committee annually reviews with the Board the applicable skills and characteristics required of Board nominees in the context of current Board composition and Company circumstances. In making its recommendations to the Board, the Governance and Nominating Committee considers, among other things, the qualifications of individual director candidates. The Governance and Nominating Committee works with the Board to determine the appropriate characteristics, skills, and experiences for the Board as a whole and its individual members with the objective of having a Board with diverse backgrounds and experience in business, government, education, and public service. In evaluating the suitability of individual Board members, the Board takes into account many factors, including general understanding of marketing, finance, and other disciplines relevant to the success of a large publicly-traded company in today’s business environment; understanding of the Company’s business and technology; educational and professional background; and personal accomplishment. The Board evaluates each individual in the context of the Board as a whole, with the objective of recommending a group that can best perpetuate the success of the Company’s business and represent shareholder interests through the exercise of sound judgment using its diversity of experience. In determining whether to recommend a director for re-election, the Governance and Nominating Committee also considers the director’s past attendance at meetings and participation in and contributions to the activities of the Board. If a majority of the votes for a director are cast as withheld in an uncontested election, the Governance Guidelines require that the director tender his or her resignation to the Board. The Board will determine whether to accept the resignation taking into consideration the recommendation of the Governance and Nominating Committee.

 

 

The Committee will consider shareholder recommendations for candidates for the Board. The name of any recommended candidate for director, together with a brief biographical sketch, a document indicating the candidate’s willingness to serve, if elected, and evidence of the nominating shareholder’s ownership of Company stock should be sent to the attention of the Deputy General Counsel, Finance and Operations, of the Company.

 

 Antitrust Compliance Committee: The Antitrust Compliance Committee oversees the performance of the Compliance Officer, who is charged under the Final Judgment entered by the District Court for the District of Columbia in State of New York et al. v. Microsoft Corp., No. 98-1232 (the “Final Judgment”) with developing and supervising Microsoft’s internal programs and processes to ensure compliance with antitrust laws and the Final Judgment. The Compliance Officer reports directly to the Antitrust Compliance Committee and the Chief Executive Officer, and may be removed by the Chief Executive Officer only with the concurrence of the Committee. The specific responsibilities in carrying out the Antitrust Compliance Committee’s oversight role are delineated in the Antitrust Compliance Committee Responsibilities Checklist attached to the Antitrust Compliance Committee Charter. The Compliance Officer is required to maintain a record of complaints received and actions taken by the Company with respect to them and to report credible evidence of violations of the Final Judgment to the Final Judgment plaintiffs. The Antitrust Compliance Committee receives regular reports from the Compliance Officer about existing and planned internal compliance programs and processes, complaints received and the Company’s response to them, and violations reported to the Final Judgment plaintiffs. In addition, the Antitrust Compliance Committee receives reports from the General Counsel and from other members of management

 

Page 33: Cash Flow Analysis and Statement

about compliance with the Final Judgment and about other issues that may arise concerning the Company’s compliance with antitrust and competition laws. The Antitrust Compliance Committee can authorize further inquiries into matters reported to it for the purpose of ensuring the adequacy of the Company’s processes and programs for fulfilling its obligations under the Final Judgment and antitrust laws. The Antitrust Compliance Committee provides guidance to the Compliance Officer and to management and reports regularly to the Board of Directors.

 

Director Compensation. Messrs. Gates and Ballmer receive no compensation for serving as directors, except that they, like all directors, are eligible to receive reimbursement of any expenses incurred in attending Board and committee meetings. During fiscal year 2005, each director, other than Messrs. Gates and Ballmer, received compensation for serving on the Board of Directors and committees of the Board as follows:

 

 

  an annual retainer of $50,000;  for each Board Committee chair, an annual retainer of $10,000;  for each Audit Committee member, an annual retainer of $10,000;  a per meeting fee of $1,000 for attendance at special meetings of Board Committees; and  a stock award grant for 4,000 shares, which vests over 5 years.

 

 

In addition, to assist directors in developing an in-depth understanding of the company’s business and products, and to facilitate the efficient operation of the Board through the use of various computing devices that feature Microsoft software, directors are provided with a Tablet PC for their use while they serve on the Board. Each year directors also may receive an additional personal computing device and a game device, each with associated peripherals, and Microsoft software and subscription services with an aggregate value up to $10,000.

 

  Shareholder Communications to the Board  

 Shareholders may contact an individual director, the lead independent director, the Board as a group, or a specified Board committee or group, including the non-employee directors as a group, by the following means:

 

 

  Mail: Microsoft Corporation  One Microsoft Way  Redmond, WA 98052-6399  Attn: Board of Directors

 

    Email: [email protected]  

 

Each communication should specify the applicable addressee or addressees to be contacted as well as the general topic of the communication. The Company will initially receive and process communications before forwarding them to the addressee. The Company generally will not forward to the directors a shareholder communication that it determines to be primarily commercial in nature, that relates to an improper or irrelevant topic, or that requests general information about the Company.

 

 

Concerns about accounting or auditing matters or possible violations of the Microsoft Standards of Business Conduct should be reported pursuant to the procedures outlined in the Standards of Business Conduct, which are available on the Company’s website at www.microsoft.com/mscorp/legal/buscond.

 

INFORMATION REGARDING BENEFICIAL OWNERSHIP OF PRINCIPAL SHAREHOLDERS, DIRECTORS, AND MANAGEMENT  

 

The following table sets forth, as of September 9, 2005, information regarding the beneficial ownership of the Company’s common shares by all directors, the Company’s Chief Executive Officer and the four other highest paid executive officers (the “Named Executive Officers”), and the directors and all executive officers as a group.

 

Page 34: Cash Flow Analysis and Statement

Names

  Amount and Nature of Beneficial Ownership of Common Shares as of 9/9/2005 (1)

  Percent of

Class 

William H. Gates III

  1,017,499,336(2)(3) 9.55%

Steven A. Ballmer

  409,977,990 3.85%

James I. Cash Jr.

  62,309(4) *

 

Dina Dublon

  0 *

 

Raymond V. Gilmartin

  54,887(5) *

 

Ann McLaughlin Korologos

  86,220(6) *

 

David F. Marquardt

  2,226,142 (7) *

 

Charles H. Noski

  6,024(8) *

 

Helmut Panke

  1,538 *

 

Jon A. Shirley

  3,235,610(9) *

 

James E. Allchin

  2,679,319(10) *

 

Kevin R. Johnson

  756,433 (11) *

 

Jeffrey S. Raikes

  13,960,001 (12) *

 

Executive Officers, Directors as a group (25 persons)

  1,475,200,520 (13) 13.79%

      * Less than 1%  

 (1) Beneficial ownership represents sole voting and investment power. To the Company’s knowledge, Mr. Gates was the only shareholder who beneficially owned more than 5% of the outstanding common shares as of September 9, 2005.

 

 (2) The business address for Mr. Gates is: Microsoft Corporation, One Microsoft Way, Redmond, Washington 98052.

 

 (3) Excludes 425,066 shares held by Mr. Gates’ wife, as to which he disclaims beneficial ownership.

 

 (4) Includes 47,221 options to purchase Company stock exercisable within sixty days of September 9, 2005 (“Vested Options”), and excludes 200 shares held in an account for the benefit of Dr. Cash’s nephew, as to which he disclaims beneficial ownership.

 

 (5) Includes 49,999 Vested Options, and excludes 1,200 shares held by Mr. Gilmartin’s wife, as  

Page 35: Cash Flow Analysis and Statement

to which he disclaims beneficial ownership.   (6) Includes 83,332 Vested Options.     (7) Includes 261,109 Vested Options.    (8) Includes 1,400 shares held in trusts for two of Mr. Noski’s minor children.  

 (9) Includes 1,128,940 shares held by the Shirley Family Limited Partnership, a limited partnership of which Mr. Shirley is the president of the sole general partner, and 83,332 Vested Options.

 

  (10) Includes 2,666,666 Vested Options.     (11) Includes 741,666 Vested Options.     (12) Includes 9,333,332 Vested Options.     (13) Includes 35,948,554 Vested Options.      

INFORMATION REGARDING EXECUTIVE OFFICER COMPENSATION  

 On September 20, 2005, the Company announced that James E. Allchin and Kevin R. Johnson, were appointed co-Presidents of the Microsoft Platform Products & Services Division, and Jeffrey S. Raikes was appointed President of the Microsoft Business Division.

 

 The following table discloses compensation received for the three fiscal years ended June 30, 2005 by the Named Executive Officers.

 

 SUMMARY COMPENSATION TABLE  

 

 

Annual Compensation

 

Name and Principal Position

  Year

  Salary

  Bonus (1)

 

Steven A. Ballmer     Chief Executive Officer; Director

  200520042003

 

$600,000

591,667550,000

 

$400,000

310,000313,447

 

William H. Gates III     Chairman;     Chief Software Architect; Director

 

200520042003

 

$600,000

591,667550,000

 

$400,000

310,000313,447

 

Kevin R. Johnson     Co-President, Microsoft Platform Products &      Services Division; Group Vice President

 

200520042003

 

$502,386

480,336379,125

 

$550,000

435,000300,000

 

Jeffrey S. Raikes     President, Microsoft Business Division;

  2005200

  $570,000

562,500

  $475,000

400,000

 

Page 36: Cash Flow Analysis and Statement

     Group Vice President 42003

522,917 350,000

James E. Allchin     Co-President, Microsoft Platform Products &     Services Division; Group Vice President

 

200520042003

 

$570,000

558,334504,168

 

$430,000

342,000350,000

 

   

 

Long-Term Compensation Awards

   

Name and Principal Position

  Year

  Restricted Stock Award(s) ($)

  Securities Underlying Options (#)

  All Other Compensation (2)

 

Steven A. BallmerChief Executive Officer; Director

  200520042003

 

------

 

---- --

 

$9,073

8,9378,931

 

William H. Gates IIIChairman; Chief Software Architect; Director

 

200520042003

 

------

 

------

 

2,469

2,787

2,931

 

Kevin R. JohnsonCo-President, Microsoft Platform Products & Services Division; Group Vice President

 

200520042003

 

----

$326,264 (5)

----

600,000

 

8,9831,046,007

(4)8,540

 

Jeffrey S. RaikesPresident, Microsoft Business Division;Group Vice President

 

200520042003

 

----

383,840 (6)

----

1,300,000

 

7,810

7,758

7,592

 

James E. AllchinCo-President, Microsoft Platform Products & Services Division; Group Vice President

 

20052004200

  ----

383,840 (6)

----

1,300,000

 

6,8461,468,381

(7)6,207

 

Page 37: Cash Flow Analysis and Statement

3

   

 (1) The amounts disclosed in the Bonus column were all awarded under the Company’s executive bonus program.

 

 

(2) Except as indicated in Notes 3 and 4, the amounts disclosed in the All Other Compensation column consist of Company contributions under the Company’s 401(k) plan and the value of cash and benefits and imputed income received under the Company’s broad-based flexible benefits program, as follows. Mr. Ballmer: 401(k) matching contributions of $6,300 for 2005, $6,150 for 2004, and $6,000 for 2003; flexible benefits of $2,773 for 2005, $2,787 for 2004, and $2,931 for 2003. Mr. Gates: flexible benefits of $2,469 for 2005, $2,787 for 2004, and $2,931 for 2003. Mr. Johnson: 401(k) matching contributions of $6,300 for 2005, $6,420 for 2004, and $6,021 for 2003; flexible benefits of $2,683 for 2005, $3,238 for 2004, and $2,519 for 2003. Mr. Raikes: 401(k) matching contributions of $6,300 for 2005, $6,150 for 2004, and $6,000 for 2003; flexible benefits of $1,510 for 2005, $1,608 for 2004, and $1,592 for 2003. Mr. Allchin: 401(k) matching contributions of $4,200 for 2005, $4,100 for 2004, and $4,000 for 2003; flexible benefits of $2,646 for 2005, $2,681 for 2004, and $2,207 for 2003.

 

 (3) These amounts do not include expenditures by the Company in connection with personal security arrangements made for executive officers when deemed advisable by the Company, which amounts were less than $50,000 for any executive officer.

 

 

(4) In addition to the amounts reported in Note 2, this amount includes $1,036,349 received by the executive in fiscal year 2004 in connection with the Company’s stock option transfer program. The executive transferred 2,404,000 stock options in the Company’s stock option transfer program that was completed in December 2003. The amount received by the executive in fiscal year 2004 is one-third of the total payment for the transferred options. The remaining amount will be paid to the executive in equal installments (plus interest) after November 12, 2005 and November 12, 2006 provided the executive remains continuously employed through those dates.

 

 

(5) Represents the grant of stock awards under which the executive has the right to receive, subject to vesting, 14,507 shares of common stock. The stock awards vest over five years at 20% per year beginning on the first anniversary of the grant. The value set forth above is based on the closing price on the date of grant, July 31, 2002, which was $22.49 (as adjusted for the 2-for-1 stock split on February 18, 2003 and $3.00 special dividend paid on December 2, 2004). The value as of June 30, 2005 of the remaining 6,045 unvested stock awards, together with the 696,296 shares (assuming target performance) issuable under the shared performance stock award described below under “Long-Term Incentive Compensation Plans — Awards in Last Fiscal Year,” was $16,724,469. The stock awards and shared performance stock awards are not entitled to dividends or dividend equivalents.

 

 (6) Represents the grant of stock awards under which the executive has the right to receive, subject to vesting, 17,067 shares of common stock. The stock awards vest over five years at 20% per year beginning on the first anniversary of the grant. The value set forth above is based on the closing price on the date of grant, July 31, 2002, which was $22.49 (as adjusted for the 2-for-1 stock split on February 18, 2003 and $3.00 special dividend paid on December 2, 2004). The value as of June 30, 2005 of the remaining 7,112 unvested stock awards, together with the 866,667 shares (assuming target performance) issuable under the shared performance stock award described below under “Long-Term Incentive Compensation Plans — Awards in Last Fiscal Year,” was $20,486,750. The stock awards and shared performance stock awards are not

 

Page 38: Cash Flow Analysis and Statement

entitled to dividends or dividend equivalents.

 

(7) In addition to the amounts reported in Note 2, this amount includes $1,461,600 received by the executive in fiscal year 2004 in connection with the Company’s stock option transfer program. The executive transferred 6,000,000 stock options in the Company’s stock option transfer program that was completed in December 2003. The amount received by the executive in fiscal year 2004 was one-third of the total payment for the transferred options. The remaining amount will be paid to the executive in equal installments (plus interest) after November 12, 2005 and November 12, 2006 provided the executive remains continuously employed through those dates.

 

  OPTION GRANTS IN LAST FISCAL YEAR    No stock options were granted to any of the Named Executive Officers during fiscal year 2005.  

 AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-

END OPTION VALUES  

 The following table provides information on option exercises in fiscal year 2005 by the Named Executive Officers and the value of their unexercised options at June 30, 2005.

 

 

Number of Securities Underlying Unexercised Options at Fiscal Year-End (#)

 

Name

  Shares Acquired on Exercise (#)

  Value Realized ($)

  Exercisable

  Unexercisable

 

Steven A. Ballmer

  --

  --

  --

  --

 

William H. Gates III

  --

  --

  --

  --

 

James E. Allchin

  --

  --

  541,666

  902,778

 

Kevin R. Johnson

  16,000

  $25,899

  250,000

  416,667

 

Jeffrey S. Raikes

  --

  --

  541,666

  902,778

 

   

 

Value of Unexercised In-the-Money Options at Fiscal Year-End ($)

 

Name

  Exercisable

  Unexercisable

 

Steven A. Ballmer

  --

  --

 

William H. Gates III

  --

  --

 

James E. Allchin

  $13,454,983

  $22,425,006

 

Kevin R. Johnson

  6,210,000

  10,350,008

 

Jeffrey S.   13,454,98   22,425,00  

Page 39: Cash Flow Analysis and Statement

Raikes 3 6

      LONG-TERM INCENTIVE PLANS — AWARDS IN LAST FISCAL YEAR  

 

 

Name

  Number of Shares, Units or other Rights (#)

  Performance or Other Period until Maturation or Payout

  Target (#)

  Maximum (#)

 

Steven A. Ballmer

  --

  --

  --

  --

 

William H. Gates III

  --

  --

  --

  --

 

James E. Allchin

  866,667

  1/1/04 - 6/30/06

  866,667

  1,300,000

 

Kevin R. Johnson

  696,296

  1/1/04 - 6/30/06

  696,296

  1,044,444

 

Jeffrey S. Raikes

  866,667

  1/1/04 - 6/30/06

  866,667

  1,300,000

 

       

 

On November 9, 2004, the Company’s shareholders approved amendments to the Company’s equity compensation plans that allowed the Board to adjust eligible equity awards, including awards under the shared performance stock award (“SPSA”) program, to maintain their pre-dividend value after the $3.00 special dividend that was paid in December 2004. Additional awards were granted for SPSA awards by the ratio of post- and pre-special dividend price as of the ex-dividend date. The numbers of shares listed in the table above reflect such adjustments to the SPSA awards for each of Messrs. Allchin, Johnson, and Raikes. Additionally, the numbers of shares listed in the table above for Mr. Johnson reflect an increase of 340,740 shares in the target amount and 511,110 shares in the maximum amount under his SPSA award in connection with an increase in Mr. Johnson’s compensation during fiscal year 2005.

 

 

The SPSA program is designed to focus our top leaders on shared business goals to guide our long term growth and address our biggest challenges by rewarding participants based on growth in customer satisfaction, unit volumes of our Windows products and usage of our development tools, and desktop application deployment over a multi-year performance period. Metrics were developed to measure performance in each of these areas. For the Named Executive Officers, the performance period is the two-and-one-half year period ending June 30, 2006.

 

 

At the beginning of the performance period, objective performance targets for each metric were established and each executive received a target SPSA award. At the end of the performance period, the performance for the metric is measured against the metric target resulting in a percentage score ranging from 0% if the minimum performance level isn’t achieved to 150% for maximum performance, in increments of 25%. The weighted average of these percentage scores will be multiplied by a participant’s target SPSA award to determine the actual SPSA award for the participant.

 

 The SPSA awards for the current Named Executive Officers will range from 0% to 150% of  

Page 40: Cash Flow Analysis and Statement

target. One-third of the total awards will be paid following the end of the performance period in Microsoft common stock. The remaining two-thirds will be paid in Microsoft common stock over the following two years in equal installments on or about August 31, 2007 and August 31, 2008, subject to continued employment. SPSA awards are subject to forfeiture if the executive’s employment terminates before the end of the performance period for any reason other than disability or death. Similarly, unpaid amounts are forfeited if the executive’s employment terminates prior to the payment date for any reason other than disability or death. The Compensation Committee will determine the final percentage in the exercise of its discretion. The Committee may amend the program to take into account significant changes in business or business strategy.

CHANGE IN CONTROL AND SEVERANCE ARRANGEMENTS  

 

The Company does not have change of control arrangements for its Named Executive Officers. Named Executive Officers may be eligible for severance under the Company’s severance plan, which provides up to 32 weeks base salary upon involuntary termination in certain circumstances.

 

REPORT OF THE MICROSOFT CORPORATION BOARD OF DIRECTORS COMPENSATION COMMITTEE  

  Role and Composition of the Committee  

 

The Compensation Committee discharges the Board’s responsibilities relating to compensation of the Company’s executive officers, including reviewing the competitiveness of executive compensation programs, evaluating the performance of the Company’s executive officers, and approving their annual compensation. The Committee working in conjunction with the Governance and Nominating Committee and the lead independent director also reviews and approves Chairman and CEO goals and objectives, evaluates Chairman and CEO performance, and sets Chairman and CEO compensation. The specific responsibilities and functions of the Compensation Committee are delineated in the Compensation Committee Charter.

 

 

The Compensation Committee has three members. Dr. James I. Cash Jr. joined the Committee in December 2004 following the retirement of Wm. G. Reed, Jr. from the Board of Directors. Each Committee member meets the independence requirements established by Nasdaq or, if higher, the New York Stock Exchange, as prescribed by the Company’s Corporate Governance Guidelines and the Committee’s Charter.

 

 The Committee is retaining an external compensation consultant to provide insights into market place trends in executive compensation, proposals for compensation programs, and other items as the Committee deems appropriate.

 

  Compensation Philosophy and Practice  

 

The Company operates in a highly competitive and rapidly changing industry. The key objectives of the Company’s executive compensation programs are to attract, motivate, and retain executives who drive Microsoft’s success and industry leadership. The Company achieves these objectives through a compensation philosophy that provides employees with a distinctive overall compensation package and the opportunity for outstanding performers to earn very competitive compensation over the long-term through a pay-for-performance approach. The programs are designed to:

 

   Provide executives with competitive cash and stock compensation with a significant portion of total compensation at risk, tied both to near-term individual performance and long-term Company performance as well as to the creation of shareholder value.

  Differentiate strongly within the organization so that Microsoft’s best performers receive a highly competitive compensation package.

 

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  Encourage executives to act as owners with an equity stake in the Company.   Components of Executive Compensation  

 

The components of the compensation program for executive officers are described below. Generally, compensation is substantially weighted towards equity compensation, and in particular towards performance based compensation. Salary and bonus generally constitutes 15% to 40%, and equity compensation constitutes 60% to 85% of total compensation. Bonus and shared performance stock awards generally constitute 65% to 90% of total compensation for executive officers. For executives and other senior leaders, the proportion of compensation provided by equity and the proportion of total compensation at risk increases with responsibility.

 

 

Cash. This element includes base salary and any bonus award earned for the fiscal year’s performance. The Company’s cash compensation policies provide a base salary that is consistent with industry pay levels and offer bonuses that reward superior performance. Executives have the opportunity to earn an annual bonus of up to 120% of base salary. Bonuses are determined based on a combination of qualitative and quantitative measures the details of which are established annually for each executive. The performance-based commitments used to determine bonuses will vary for each executive based on his/her responsibilities and may include financial or strategic measures, including but not limited to: revenue, contribution margin, innovation, product development and implementation, quality, customer satisfaction, or developer community satisfaction. Individual bonus awards reflect the individual’s performance compared to his/her performance-based commitments for the year and relative to performance of peers at the Company.

 

  Stock-based Incentives  

 

Stock Awards. Under Microsoft’s equity compensation program, employees receive grants of stock awards. A stock award is a right to receive Microsoft common shares over a vesting period. Upon vesting, employees receive Microsoft common shares that they own outright. We believe stock awards are a better way than stock options to provide significant equity compensation to employees that provides more predictable long-term rewards. The size of stock award grants is based on various factors relating to the responsibilities of the individual officers and their expected future contributions. We do not grant regular stock awards to our most senior executives (approximately 10 individuals), as we believe that their equity compensation should be tied to the performance of the Company through the shared performance stock awards described in the next paragraph.

 

 

Shared Performance Stock Awards. Executives may also receive grants under the Company’s shared performance stock award (SPSA) program, a long-term incentive program for executives and other senior leaders under which a significant portion of stock-based compensation depends on the growth in the number and satisfaction of our customers.

 

 

Target SPSA awards were made during fiscal year 2004 for the initial performance period ending June 30, 2006. At the end of the performance period, the actual number of shares of stock subject to an award will be determined by multiplying the target by a percentage ranging from 0% to 150% for the current Named Executive Officers, and ranging from 33% to 150% for other executive officers, based on the Company’s weighted performance against objective metrics for customer satisfaction, unit volumes of Windows products and usage of Microsoft’s developer tools, and desktop application deployment. Each stock award is equivalent in value to one share of Microsoft common stock. Shares of stock are issued in equal one-third increments following the end of the performance period and annually over the following two years.

 

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The size of an executive’s SPSA grant is based on the executive’s level and role assessed against long-term compensation data for competitive positions, and the executive’s expected future contributions to Microsoft. Additional details about the SPSA program and the grants made to the Named Executive Officers for the fiscal year 2004-2006 performance period are provided on page 6. In fiscal year 2005, SPSA grants were made only to newly-hired executives and in conjunction with employment related changes such as promotions.

 

  Executive Benefits  

 

In fiscal year 2005, Microsoft’s executives were eligible for the same level and offering of benefits made available to other employees, including the Company’s 401(k) Plan and welfare benefit programs. In addition to the standard benefits offered to all employees, Microsoft maintains a non-qualified deferred compensation plan that allows executives to defer bonus income and stock option income. Microsoft does not contribute to the non-qualified deferred compensation plan and participation is voluntary.

 

  How Executive Pay Levels are Determined  

 

Microsoft participates in several executive compensation benchmarking surveys that provide summarized data on levels of base salary, target annual incentives, and stock-based and other long-term incentives. These surveys also provide benchmark information on compensation practices such as the prevalence of types of compensation plans and the proportion of the types of pay components as part of the total compensation package. These surveys are supplemented by other publicly available information and input from compensation consultants on other factors such as recent market trends. The comparison group includes approximately 15 leading information technology companies and large market capitalization U.S. companies with whom Microsoft competes for executive talent. The median CEO salary and bonus for the comparison group were $1.065 million in base salary and $2.385 million in bonus. The Committee uses tally sheets that ascribe dollar amounts to the components of executive officer compensation, including salary, bonus, stock awards, shared performance stock awards, and executive benefits. Information about the Company’s severance arrangements is provided on page 7.

 

  How Microsoft’s Use of Stock-Based Awards is Determined  

 

As described above, during fiscal year 2005 the Company’s compensation and retention strategy included the use of stock awards and SPSA awards. The level of usage was determined based on factors such as compensation levels at comparison companies relative to Microsoft’s target total compensation levels and the desired mix of cash and equity pay. Each year, the Committee and management determine the appropriate usage, balancing these factors against the projected needs of the business as well as financial considerations, including the projected impact on shareholder dilution. The Company emphasizes differentiation in executive stock compensation and in the broad-based stock award program.

 

  Compensation for the Chairman and Chief Executive Officer    The Committee annually approves the compensation of Steven A. Ballmer, Chief Executive Officer, and William H. Gates III, Chairman and Chief Software Architect. The compensation of Messrs. Ballmer and Gates reflects their status as significant shareholders of the Company. Their salaries are significantly below competitive levels elsewhere in the information technology industry and large market capitalization U.S. companies, and they do not participate in the Company’s equity compensation program. They are eligible for an annual bonus of up to 120% of their salary based on a review of performance against objectives for the year. As the leaders of the Company they are focused on building long-term success, and as significant shareholders in the Company, their personal wealth is tied directly to sustained increases in the

 

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Company’s value.

 

Mr. Ballmer’s bonus was determined based on an evaluation of his performance against his annual objectives including achievement of revenue and profit plans, achievement of major product development objectives, progress in improving the number and satisfaction of Company customers, progress in business growth initiatives, and development of senior leadership. The Summary Compensation Table sets forth all compensation received by Mr. Ballmer during fiscal years 2003, 2004, and 2005. There is no Company-sponsored retirement program for Mr. Ballmer other than the Company’s 401(k) program, and he receives no benefits or perquisites from the Company other than the general Company benefits described above. Mr. Ballmer does not have a change of control arrangement. He may be eligible for severance under the Company’s general severance plan, which provides up to 32 weeks base salary upon involuntary termination in certain circumstances.

 

  Tax Deductibility under Section 162(m)  

 

Under Section 162(m) of the Internal Revenue Code, the Company may not be able to deduct certain forms of compensation in excess of $1,000,000 paid to any of the Named Executive Officers that are employed by the Company at year-end. The Committee believes that it is generally in the Company’s best interests to satisfy the requirements for deductibility under Section 162(m). Accordingly, the Committee has taken appropriate actions, to the extent it believes feasible, to preserve the deductibility of annual incentive and long-term performance awards. However, notwithstanding this general policy, the Committee also believes that there may be circumstances in which the Company’s interests are best served by maintaining flexibility in the way compensation is provided, whether or not compensation is fully deductible under Section 162(m).

 

  COMPENSATION COMMITTEE  

 Ann McLaughlin Korologos (Chair)James I. Cash, Jr.Helmut Panke

 

    PERFORMANCE GRAPH  

 

The chart below compares the five-year cumulative total return, assuming the reinvestment of dividends, on Microsoft common stock with that of the S&P 500 Index and the NASDAQ Computer Index. This graph assumes $100 was invested on June 30, 2000, in each of Microsoft common stock, the S&P 500 companies, and the companies in the Nasdaq Computer Index.

 

 Note: Microsoft management cautions that the stock price performance shown in the graph below should not be considered indicative of potential future stock price performance.

 

  COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN  

 AMONG MICROSOFT CORPORATION, THE S&P 500 INDEX AND THE NASDAQ

COMPUTER INDEX  

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      Cumulative Total Return         6/00     6/01     6/02     6/03     6/04     6/05         Microsoft Corporation     100     91     68     64     72     70     S&P 500 Index     100     85     70     70     83     89     Nasdaq Computer Index     100     41     26     30     35     44  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS  

 

Mr. Gates is the sole shareholder of Corbis Corporation, a company that provides digitized images and production services. The Company paid Corbis approximately $701,000 in fiscal year 2005 as licensing fees for digital images. Those licenses were entered into at arm’s length, and are similar to license agreements Microsoft enters into from time to time with other providers of digital images. The terms of the Corbis transactions are established by Corbis and the relevant business group at Microsoft seeking to use the digital images in Microsoft’s products, services, and marketing materials. The Company believes the terms are no less favorable to Microsoft than what are offered by Corbis to other large customers. Mr. Gates is not involved in negotiating agreements with Corbis or setting price or other terms, either on behalf of Microsoft or Corbis. Microsoft’s Audit Committee has reviewed and approved these arrangements.

 

 

A son of Mr. Shirley, a brother-in-law of Robert J. (Robbie) Bach, an executive officer of the Company, and a brother-in-law of Eric D. Rudder, an executive officer of the Company, were employed by the Company or one of its subsidiaries in fiscal year 2005, and each of them received fiscal year 2005 compensation that exceeded $60,000. Mr. Shirley’s son left the Company in March 2005.

 

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE  

 

Due to an administrative error, Bradford L. Smith was late in filing one Form 4 to report the exercise of a stock option and the same-day-sale of the underlying shares. Jean-Philippe Courtois was late in filing one Form 4 to report the indirect purchase of shares. Wm. G. Reed, Jr., who retired from the board in November 2004, was late in filing a Form 4 to report an open market purchase of stock after he retired from the Board but within six months of an open market sale.

 

REPORT OF THE MICROSOFT CORPORATION BOARD OF DIRECTORS AUDIT COMMITTEE    The Audit Committee operates under a written charter adopted by the Board of Directors that is available on the Company’s website at http://www.microsoft.com/msft/governance, and is

 

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attached as Exhibit 1. The charter, which was last amended effective July 1, 2005, includes a calendar that outlines the Audit Committee’s duties and responsibilities on a quarter-by-quarter basis. The Audit Committee reviews the charter, including the calendar, on an annual basis.

 

The Board annually reviews the Nasdaq listing standards definition of independence for audit committee members and has determined that each member of the Audit Committee meets that standard as well as the definition of independence for audit committee members contained in the listing standards for the New York Stock Exchange. In addition, the Board has determined that each of Dina Dublon and Charles H. Noski is an “audit committee financial expert” as defined by SEC rules.

 

 

The Board of Directors has the ultimate authority for effective corporate governance, including the role of oversight of the management of the Company. The Audit Committee’s purpose is to assist the Board of Directors in fulfilling its responsibilities by overseeing the accounting and financial reporting processes of Microsoft, the audits of Microsoft’s consolidated financial statements, the qualifications of the independent registered public accounting firm engaged as Microsoft’s independent auditor, and the performance of Microsoft’s internal auditors and independent auditors.

 

 

The Committee relies on the expertise and knowledge of management, the internal auditors and the independent auditor in carrying out its oversight responsibilities. Management is responsible for the preparation, presentation, and integrity of the Company’s consolidated financial statements, accounting and financial reporting principles, internal control over financial reporting, and procedures designed to ensure compliance with accounting standards, applicable laws, and regulations. Management is responsible for objectively reviewing and evaluating the adequacy, effectiveness, and quality of the Company’s system of internal control. Microsoft’s independent auditor, Deloitte & Touche LLP (“Deloitte & Touche”), is responsible for performing an independent audit of the consolidated financial statements and expressing an opinion on the conformity of those financial statements with accounting principles generally accepted in the United States. The independent auditor is also responsible for expressing opinions on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and on the effectiveness of the Company’s internal control over financial reporting.

 

 During the fiscal year ended June 30, 2005, the Audit Committee fulfilled its duties and responsibilities generally as outlined in the charter and the accompanying calendar. Specifically, the Committee, among other actions:

 

 

  Reviewed and discussed the Company’s quarterly earnings press releases, consolidated financial statements, and related periodic reports filed with the SEC, with management and the independent auditor;

 

Reviewed with management, the independent auditor, and the internal auditor management’s assessment of the effectiveness of the Company’s internal control over financial reporting and the independent auditor’s opinion about management’s assessment and the effectiveness of the Company’s internal control over financial reporting;

  Reviewed with the independent auditor, management, and the internal auditor the audit scope and plan; and

  Met in periodic executive sessions with each of the independent auditor, management, and the internal auditor.

 

 The Audit Committee has reviewed and discussed the Company’s audited consolidated financial statements and related footnotes for the fiscal year ended June 30, 2005, and the

 

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independent auditor’s report on those financial statements, with the Company’s management and independent auditor. Management represented to the Audit Committee that the Company’s financial statements were prepared in accordance with generally accepted accounting principles and Deloitte & Touche represented that its presentations included the matters required to be discussed with the Audit Committee by Statement on Auditing Standards No. 61, as amended, “Communication with Audit Committees” and SEC Regulation S-X, Rule 2-07. This review included a discussion with management and the independent auditor of the quality (not merely the acceptability) of the Company’s accounting principles, the reasonableness of significant estimates and judgments, and the disclosures in the Company’s financial statements, including the disclosures relating to critical accounting policies.

 

The Audit Committee recognizes the importance of maintaining the independence of the Company’s independent auditor, both in fact and appearance. Consistent with its charter, the Audit Committee has evaluated Deloitte & Touche’s qualifications, performance, and independence, including that of the lead audit partner. As part of its auditor engagement process, the Audit Committee considers whether to rotate the independent audit firm. The Audit Committee has established a policy pursuant to which all services, audit and non-audit, provided by the independent auditor must be pre-approved by the Audit Committee or its delegate. The Company’s pre-approval policy is more fully described in this proxy statement under the caption “Fees Billed by Deloitte & Touche.” The Audit Committee has concluded that provision of the non-audit services described in that section is compatible with maintaining the independence of Deloitte & Touche. In addition, Deloitte & Touche has provided the Audit Committee with the letter required by the Independence Standards Board Standard No. 1, “Independence Discussions with Audit Committees,” and the Audit Committee has engaged in dialogue with Deloitte & Touche regarding their independence.

 

 

Based on the reviews and discussions described above, the Audit Committee recommended to the Board of Directors that the audited consolidated financial statements be included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2005 for filing with the SEC, and selected Deloitte & Touche as the independent registered public accounting firm for fiscal year 2006. The Board is recommending that shareholders ratify that selection at the Annual Meeting.

 

  AUDIT COMMITTEE  

 

Charles H. Noski (Chair) James I. Cash Jr.Wm. G. Reed Jr.Ann McLaughlin Korologos

 

2. RATIFICATION OF INDEPENDENT AUDITOR  

 

The Audit Committee has selected Deloitte & Touche LLP (“Deloitte & Touche”) as the Company’s independent auditor for the current fiscal year, and the Board is asking shareholders to ratify that selection. Although current law, rules, and regulations, as well as the charter of the Audit Committee, require the Company’s independent auditor to be engaged, retained, and supervised by the Audit Committee, the Board considers the selection of the independent auditor to be an important matter of shareholder concern and is submitting the selection of Deloitte & Touche for ratification by shareholders as a matter of good corporate practice.

 

 The affirmative vote of holders of a majority of the shares of common stock represented at the meeting is required to approve the ratification of the selection of Deloitte & Touche as the Company’s independent auditor for the current fiscal year. THE BOARD OF DIRECTORS

 

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RECOMMENDS A VOTE FOR THE PROPOSAL.FEES BILLED TO DELOITTE & TOUCHE LLP  

  Fees  

 

The following table presents fees for professional audit services rendered by Deloitte & Touche for the audit of the Company’s annual financial statements for the years ended June 30, 2004 and 2005, and fees billed for other services rendered by Deloitte & Touche during those periods.

 

(in millions)

 

Year Ended June 30

  2004

  2005

 

Audit Fees

  $

15.9 

$ 15.5

 

Audit Related Fees (1)

  6.9 

5.0 

Tax Fees (2)

  1.2 

0.8 

All Other Fees (3)

  2.8 

1.1 

Total

  $

26.8 

$ 22.4

 

   

 

Audit Fees. These amounts represent fees of Deloitte & Touche for the audit of the Company’s annual consolidated financial statements, the review of financial statements included in the Company’s quarterly Form 10-Q reports, the Sarbanes-Oxley Act required audit of management’s assessment of the effectiveness of the Company’s internal control over financial reporting and the Deloitte & Touche independent audit of internal control over financial reporting, and the services that an independent auditor would customarily provide in connection with subsidiary audits, statutory requirements, regulatory filings, and similar engagements for the fiscal year, such as comfort letters, attest services, consents, and assistance with review of documents filed with the SEC. “Audit Fees” also include advice on accounting matters that arose in connection with or as a result of the audit or the review of periodic consolidated financial statements and statutory audits the non-U.S. jurisdictions require.

 

 Audit-Related Fees. Audit-Related Fees consist of assurance and related services that are reasonably related to the performance of the audit or review of Microsoft’s consolidated financial statements. This category includes fees related to the performance of audits and attest services not required by statute or regulations, audits of the Company’s employee benefit plans, due diligence related to mergers, acquisitions, and investments, additional revenue and license compliance procedures related to performance of the review or audit of Microsoft’s financial statements, and accounting consultations about the application of generally accepted accounting principles to proposed transactions. Revenue assurance and license compliance includes procedures under contracts that provide for review by an independent accountant, and advice about controls associated with the completeness and accuracy of the Company’s software licensing revenue. These services support the evaluation of the effectiveness of internal controls over revenue recognition, and enhance the independent auditor’s understanding of licensing

 

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programs and controls.

 

Tax Fees. These fees consist generally of the two categories of tax compliance and return preparation, and of tax planning and advice. For fiscal year 2004, fees for tax compliance and return preparation were $1,048,000 and fees for tax planning and advice were $165,000. For fiscal year 2005, fees incurred for tax compliance and return preparation were $774,000 and fees for tax planning and advice were $17,000. The compliance and return preparation services consisted of the preparation of original and amended tax returns, claims for refunds, and support during income tax audit or inquiries.

 

 All Other Fees. All Other Fees consist principally of services supporting the Company’s volume licensing compliance and revenue assurance initiatives, including data analysis and risk assessment.

 

 The Audit Committee has concluded the provision of the non-audit services listed above is compatible with maintaining the independence of Deloitte & Touche.

 

 Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor

 

 

The Audit Committee has established a policy regarding pre-approval of all audit and permissible non-audit services provided by the independent auditor. Each year, the Audit Committee approves the terms on which the independent auditor is engaged for the ensuing fiscal year. On at least a quarterly basis, the Committee reviews and, if appropriate, pre-approves services to be performed by the independent auditor, reviews a report summarizing fiscal year-to-date services provided by the independent auditor, and reviews an updated projection of the fiscal year’s estimated fees. The Audit Committee, as permitted by its pre-approval policy, from time to time delegates the approval of certain permitted services or classes of services to a member of the Committee. The Committee then reviews the delegate’s pre-approval decisions on a quarterly basis. Microsoft uses a centralized internal system to collate requests from Company personnel for services by the independent auditor to facilitate compliance with this pre-approval policy.

 

EQUITY COMPENSATION PLAN INFORMATION  

(In millions, except per share amounts)

 

June 30, 2005

  (a)

  (b)

  (c)

 

Plan category

  Number of securities to be issued upon exercise of outstanding options, warrants and rights(1)

 

Weighted-average exercise price of outstanding options, warrants and rights(2)

 

Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))(3)

 

Equity compensation plans approved by security holders

 

969.9

  $27.41

  975.6

 

Equity compensation

  0  

35.97

  0  

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plans not approved by security holders(4)

Total(5)

  969.9

  $27.41

  975.6

 

 (1) Includes 69 million shares issuable upon vesting of outstanding stock awards granted under the 2001 Stock Plan and 35.3 million shares issuable under outstanding shared performance stock awards granted under the 2001 Stock Plan (assuming target performance).

 

 (2) The weighted-average exercise price does not take into account the shares issuable upon vesting of outstanding stock awards or the shares issuable under outstanding shared performance stock awards, which have no exercise price.

 

 (3) Includes 159.1 million shares remaining available for issuance as of June 30, 2005 under the 2003 Employee Stock Purchase Plan.

 

 (4) The Microsoft Stock Option Plan for Consultants and Advisors authorized the grant of stock options to consultants and advisors to the Company. Options were last granted under this plan in fiscal year 2001. No additional options may be granted under this plan.

 

 (5) Does not include options to purchase an aggregate of .6 million shares, at a weighted average exercise price of $29.28, granted under a plan assumed in connection with an acquisition transaction. No additional options may be granted under this assumed plan.

 

PROPOSALS OF SHAREHOLDERS FOR 2006 ANNUAL MEETING  

 

Shareholders who, in accordance with Securities and Exchange Commission Rule 14a-8 wish to present proposals for inclusion in the proxy materials to be distributed in connection with next year’s Annual Meeting Proxy Statement must submit their proposals so that they are received at Microsoft’s principal executive offices no later than the close of business on June 1, 2006. As the rules of the SEC make clear, simply submitting a proposal does not guarantee that it will be included.

 

 

In accordance with our Bylaws, in order to be properly brought before the 2006 Annual Meeting, a shareholder’s notice of the matter the shareholder wishes to present, or the person or persons the shareholder wishes to nominate as a director, must be delivered to the Secretary of Microsoft at its principal executive offices not less than 120 nor more than 180 days before the first anniversary of the date of this proxy statement. As a result, any notice given by a shareholder pursuant to these provisions of our Bylaws (and not pursuant to the SEC’s Rule 14a-8) must be received no earlier than April 2, 2006 and no later than June 1, 2006, unless our Annual Meeting date is more than 30 days before or after November 9, 2006. If our 2006 Annual Meeting date is advanced or delayed by more than 30 days from this year’s meeting date, then proposals must be received no later than the close of business on the later of the 90th day before the 2006 Annual Meeting or the 15th day following the date on which the meeting date is publicly announced.

 

 

To be in proper form, a shareholder’s notice must include the specified information concerning the proposal or nominee as described in our Bylaws. A shareholder who wishes to submit a proposal or nomination is encouraged to seek independent counsel about our Bylaw and SEC requirements. Microsoft will not consider any proposal or nomination that does not meet the Bylaw requirements and the SEC’s requirements for submitting a proposal or nomination.

 

 Notices of intention to present proposals at the 2006 Annual Meeting should be addressed to Secretary, Microsoft Corporation, One Microsoft Way, Redmond, Washington 98052. The Company reserves the right to reject, rule out of order, or take other appropriate action with

 

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respect to any proposal that does not comply with these and other applicable requirements. SOLICITATION OF PROXIES  

 

The Proxy accompanying this Proxy Statement is solicited by the Board of Directors of the Company. Proxies may be solicited by officers, directors, and regular supervisory and executive employees of the Company, none of whom will receive any additional compensation for their services. Also, Georgeson Shareholder Communications may solicit proxies at an approximate cost of $12,500 plus reasonable expenses. Such solicitations may be made personally or by mail, facsimile, telephone, telegraph, messenger, or via the Internet. The Company will pay persons holding shares of common stock in their names or in the names of nominees, but not owning such shares beneficially, such as brokerage houses, banks, and other fiduciaries, for the expense of forwarding solicitation materials to their principals. All of the costs of solicitation of proxies will be paid by the Company.

 

VOTING PROCEDURES  

 Tabulation of Votes. Votes cast by proxy or in person at the meeting will be tabulated by Mellon Investor Services, LLC.

 

 

Effect of an Abstention and Broker Non-Votes. A shareholder who abstains from voting on any or all proposals will be included in the number of shareholders present at the meeting for the purpose of determining the presence of a quorum. Abstentions and broker non-votes will not be counted either in favor of or against the election of the nominees or other proposals.

 

AUDITORS  

 Representatives of Deloitte & Touche, LLC, independent auditor for the Company for fiscal 2005 and the current fiscal year, will be present at the Annual Meeting, will have an opportunity to make a statement, and will be available to respond to appropriate questions.

 

OTHER MATTERS  

 

The Board of Directors does not intend to bring any other business before the meeting, and so far as is known to the Board, no matters are to be brought before the meeting except as specified in the notice of the meeting. In addition to the scheduled items of business, the meeting may consider shareholder proposals (including proposals omitted from the Proxy Statement and form of Proxy pursuant to the proxy rules of the SEC) and matters relating to the conduct of the meeting. As to any other business that may properly come before the meeting, it is intended that proxies will be voted in respect thereof in accordance with the judgment of the persons voting such proxies.

 

  DATED: Redmond, Washington, September 30, 2005.   MICROSOFT CORPORATION AUDIT COMMITTEE CHARTER  

  ROLE    The Audit Committee of the Board of Directors assists the Board of Directors in fulfilling its responsibility for oversight of the quality and integrity of the accounting, auditing, and reporting practices of the Company, and such other duties as directed by the Board. The Committee’s purpose is to oversee the accounting and financial reporting processes of the Company, the audits of the Company’s financial statements, the qualifications of the public accounting firm engaged as the Company’s independent auditor to prepare or issue an audit report on the financial statements of the Company, and the performance of the Company’s internal audit function and independent auditor. The Committee’s role includes reviewing and assessing the qualitative aspects of financial reporting to shareholders, the Company’s processes to manage business and financial risk, and compliance with significant applicable legal, ethical, and regulatory requirements. The Committee is directly responsible for the

 

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appointment, compensation, retention and oversight of the independent auditor.   MEMBERSHIP  

 

The membership of the Committee consists of at least three directors, all of whom shall meet the independence requirements established by the Board and applicable laws, regulations and listing requirements. Each member shall in the judgment of the Board have the ability to read and understand fundamental financial statements. At least one member of the Committee shall in the judgment of the Board be an “audit committee financial expert” as defined by the rules and regulations of the Securities and Exchange Commission, and at least one member (who may also serve as the audit committee financial expert) shall in the judgment of the Board meet the financial sophistication standard as defined by the requirements of the Nasdaq Stock Market, Inc. The Board appoints the members of the Committee and the chairperson. The Board may remove any member from the Committee at any time with or without cause.

 

 

Generally, no member of the Committee may serve on more than three audit committees of publicly traded companies (including the Audit Committee of the Company) at the same time. For this purpose, service on the audit committees of a parent and its substantially owned subsidiaries counts as service on a single audit committee.

 

  OPERATIONS  

 

The Committee meets at least six times a year. Additional meetings may occur as the Committee or its chair deems advisable. The Committee will cause to be kept adequate minutes of all its proceedings, and will report on its actions and activities at the next quarterly meeting of the Board. Committee members will be furnished with copies of the minutes of each meeting and any action taken by unanimous consent. The Committee is governed by the same rules regarding meetings (including meetings by conference telephone or similar communications equipment), action without meetings, notice, waiver of notice, and quorum and voting requirements as are applicable to the Board. The Committee is authorized and empowered to adopt its own rules of procedure not inconsistent with (a) any provision of this Charter, (b) any provision of the Bylaws of the Company, or (c) the laws of the state of Washington.

 

  COMMUNICATIONS  

 

The independent auditor reports directly to the Committee. The Committee is expected to maintain free and open communication with the independent auditor, the internal auditors, and management. This communication will include periodic private executive sessions with each of these parties.

 

  EDUCATION  

 

The Company is responsible for providing new members with appropriate orientation briefings and educational opportunities, and the full Committee with educational resources related to accounting principles and procedures, current accounting topics pertinent to the Company and other material as may be requested by the Committee. The Company will assist the Committee in maintaining appropriate financial literacy.

 

  AUTHORITY    The Committee will have the resources and authority necessary to discharge its duties and responsibilities. The Committee has sole authority to retain and terminate outside counsel or other experts or consultants, as it deems appropriate, including sole authority to approve the firms’ fees and other retention terms. The Committee will be provided with appropriate funding by the Company, as the Committee determines, for the payment of compensation to the Company’s independent auditor, outside counsel and other advisors as it deems appropriate, and ordinary administrative expenses of the Committee that are necessary or appropriate in

 

Page 52: Cash Flow Analysis and Statement

carrying out its duties. In discharging its oversight role, the Committee is empowered to investigate any matter brought to its attention. Any communications between the Committee and legal counsel in the course of obtaining legal advice will be considered privileged communications of the Company, and the Committee will take all necessary steps to preserve the privileged nature of those communications.

 The Committee may form and delegate authority to subcommittees and may delegate authority to one or more designated members of the Committee.

 

  RESPONSIBILITIES  

 

The Committee’s specific responsibilities in carrying out its oversight role are delineated in the Audit Committee Responsibilities Calendar. The Responsibilities Calendar will be updated annually to reflect changes in regulatory requirements, authoritative guidance, and evolving oversight practices. As the compendium of Committee responsibilities, the most recently updated Responsibilities Calendar will be considered to be an addendum to this Charter.

 

 

The Committee relies on the expertise and knowledge of management, the internal auditors and the independent auditor in carrying out its oversight responsibilities. Management of the Company is responsible for determining the Company’s financial statements are complete, accurate and in accordance with generally accepted accounting principles and establishing satisfactory internal control over financial reporting. The independent auditor is responsible for auditing the Company’s financial statements and the effectiveness of the Company’s internal control over financial reporting. It is not the duty of the Committee to plan or conduct audits, to determine that the financial statements are complete and accurate and in accordance with generally accepted accounting principles, to conduct investigations, or to assure compliance with laws and regulations or the Company’s standards of business conduct, codes of ethics, internal policies, procedures and controls.

 

  Last Revised: July 1, 2005     MICROSOFT CORPORATION  

Audit Committee Responsibilities Calendar  

RESPONSIBILITY

  WHEN PERFORMEDAudit Committee Meetings

 

 

 

Q1

  Q2

  Q3

  Q4

  As Needed

 

1.

  The agenda for Committee meetings will be prepared in consultation between the Committee chair (with input from the Committee members), Finance management, the General Auditor and the independent auditor.

 

X

  X

  X

  X

  X

 

2.

  Review and update the Audit Committee Charter and Responsibilities Calendar annually.

   

 

 

X

   

3.

  Complete an annual evaluation of the Committee’s performance.

   

X

   

 

 

4.

  Provide a report in the annual proxy that includes the Committee’s review and discussion of matters with management and the independent auditor.

  X

   

 

 

 

5.

  Include a copy of the Committee charter as an appendix to the proxy statement at least once every three years.

   

 

 

 

X

 

Page 53: Cash Flow Analysis and Statement

6.

  Appoint or replace the independent auditor and approve the terms on which the independent auditor is engaged for the ensuing fiscal year.

   

 

 

X

   

7.

  At least annually, evaluate the independent auditor's qualifications, performance, and independence, including that of the lead partner. The evaluation will include obtaining a written report from the independent auditor describing: the firm’s internal quality control procedures; any material issues raised by the most recent internal quality control review, or peer review, of the firm or by any inquiry or investigation by governmental or professional authorities within the past five years, concerning an independent audit or audits carried out by the firm, and any steps taken to deal with those issues; and all relationships between the independent auditor and the Company.

 

 

 

 

X

  X

 

8.

  Resolve any disagreements between management and the independent auditor about financial reporting.

   

 

 

 

X

 

9.

  Establish and oversee a policy designating permissible services that the independent auditor may perform for the Company, providing for pre-approval of those services by the Committee subject to the de minimis exceptions permitted under applicable rules, and quarterly review of any services approved by the designated member under the policy and the firm’s non-audit services and related fees.

 

X

  X

  X

  X

  X

 

10.

  Review the responsibilities, functions and performance of the Company's internal audit department.

   

 

X

   

 

11.

  Review and approve the appointment or change in the General Auditor.

   

 

 

 

X

 

12.

  Ensure receipt from the independent auditor of a formal written statement delineating all relationships between the auditor and the company, consistent with Independence Standards Board Standard No. 1, and actively engage in a dialogue with the auditor about any disclosed relationships or services that may impact the objectivity and independence of the auditor, and take appropriate action to oversee the independence of the independent auditor.

 

X

   

 

 

 

13.

  Advise the Board about the Committee’s determination whether the Committee consists of three or more members all of whom are financially literate, including at least one member who has financial sophistication and is a financial expert.

 

X

   

 

 

 

14.

  Inquire of management, the General Auditor, and the independent auditor about significant risks or exposures, review the Company's policies for risk assessment and risk management, and assess the steps management has taken to control such risk to the Company.

 

 

 

 

X

  X

 

15   Review with the Finance management, the independent auditor   X    X    X 

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. and the General Auditor the audit scope and plan, and coordination of audit efforts to ensure completeness of coverage, reduction of redundant efforts, the effective use of audit resources, and the use of independent public accountants other than the appointed auditors of the Company.

16.

  Consider and review with Finance management, the independent auditor and the General Auditor:

   

 

 

 

 

 

a. The Company’s annual assessment of the effectiveness of its internal controls and the independent auditor’s attestation and report about the Company’s assessment.

  X

   

 

 

 

 

b. The adequacy of the Company’s internal controls including computerized information system controls and security.

  X

   

 

 

 

 

c. Any related significant findings and recommendations of the independent auditor and internal audit together with management's responses.

   

 

 

 

X

 

17

  Review with Finance management any significant changes to GAAP and/or MAP policies or standards.

  X

  X

  X

  X

   

18.

  Review with Finance management and the independent auditor at the completion of the annual audit:

   

 

 

 

 

 

a. The Company's annual financial statements and related footnotes.

  X

   

 

 

X

 

 

b. The independent auditor’s audit of the financial statements and its report thereon.

  X

   

 

 

X

 

 

c. Any significant changes required in the independent auditor’s audit plan.

  X

   

 

 

X

 

 

d. Any serious difficulties or disputes with management encountered during the course of the audit and management's response.

  X

   

 

 

X

 

 

e. Other matters related to the conduct of the audit which are to be communicated to the Committee under generally accepted auditing standards.

  X

   

 

 

X

 

19.

  Review with Finance management and the independent auditor at least annually the Company’s critical accounting policies.

  X

   

 

 

X

 

20.

  Review policies and procedures with respect to transactions between the Company and officers and directors, or affiliates of officers or directors, or transactions that are not a normal part of the Company’s business, and review and approve those related-party transactions that would be disclosed pursuant to SEC Regulation S-K, Item 404.

 

 

 

 

X

  X

 

21.

  Consider and review with Finance management and the General Auditor:

   

 

 

 

 

 

a. Significant findings by the independent auditor or the General Auditor during the year and management’s responses;

  X

  X

  X

  X

  X

 

Page 55: Cash Flow Analysis and Statement

 

b. Any difficulties encountered in the course of their audit work, including any restrictions on the scope of their work or access to required information;

  X

  X

  X

  X

  X

 

 

c. Any changes required in planned scope of their audit plan.

  X

  X

  X

  X

  X

 

22.

  Participate in a telephonic meeting among Finance management, the General Auditor and the independent auditor before each earnings release to discuss the earnings release, financial information and earnings guidance.

 

X

  X

  X

  X

   

23.

  Review and discuss with Finance management and the independent auditor the Company’s quarterly financial statements.

  X

  X

  X

  X

   

24.

  Review the periodic reports of the Company with Finance management, the General Auditor and the independent auditor prior to filing of the reports with the SEC, including the disclosures under "Management's Discussion and Analysis of Financial Condition and Results of Operations".

 

X

  X

  X

  X

   

25.

  In connection with each periodic report of the Company, review:

   

 

 

 

 

 

a. Management’s disclosure to the Committee and the independent auditor under Section 302 of the Sarbanes-Oxley Act, including identified changes in internal control over financial reporting.

 

X

  X

  X

  X

   

 

b. The contents of the Chief Executive Officer and the Chief Financial Officer certificates to be filed under Sections 302 and 906 of the Sarbanes-Oxley Act.

  X

  X

  X

  X

   

26.

  Monitor the appropriate standards adopted as a code of conduct for the Company.

   

X

   

 

X

 

27.

  Review with the Compliance Officer legal and regulatory matters that may have a material impact on the financial statements, related Company compliance policies, and programs and reports received from regulators.

 

X

  X

  X

  X

   

28.

  Develop, review and oversee procedures for (i) receipt, retention and treatment of complaints received by the Company regarding accounting, internal accounting controls and auditing matters, and (ii) the confidential, anonymous submission of employee concerns regarding accounting or auditing matters.

 

 

X

   

 

X

 

29.

  Meet with the independent auditor in executive session to discuss any matters the Committee or the independent auditor believes should be discussed privately with the Audit Committee.

  X

  X

  X

  X

   

30.

  Meet with the General Auditor in executive session to discuss any matters the Committee or the General Auditor believes should be discussed privately with the Audit Committee.

  X

  X

  X

  X

   

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31.

  Meet with Finance management in executive sessions to discuss any matters the Committee or Finance management believes should be discussed privately with the Audit Committee.

   

 

 

 

X

 

32.

  Set clear hiring policies for the Company's hiring of employees or former employees of the independent auditor who were engaged in the Company's account, and ensure the policies comply with any regulations applicable to the Company.

 

 

 

 

 

X

 

Analyzing Your Financial Ratios

Overview

Any successful business owner is constantly evaluating the performance of his or her company, comparing it with the company's historical figures, with its industry competitors, and even with successful businesses from other industries. To complete a thorough examination of your company's effectiveness, however, you need to look at more than just easily attainable numbers like sales, profits, and total assets. You must be able to read between the lines of your financial statements and make the seemingly inconsequential numbers accessible and comprehensible.

This massive data overload could seem staggering. Luckily, there are many well-tested ratios out there that make the task a bit less daunting. Comparative ratio analysis helps you identify and quantify your company's strengths and weaknesses, evaluate its financial position, and understand the risks you may be taking.

As with any other form of analysis, comparative ratio techniques aren't definitive and their results shouldn't be viewed as gospel. Many off-the-balance-sheet factors can play a role in the success or failure of a company. But, when used in concert with various other business evaluation processes, comparative ratios are invaluable.

This discussion contains descriptions and examples of the eight major types of ratios used in financial analysis: Income, Profitability, Liquidity, Working Capital, Bankruptcy, Long-Term Analysis, Coverage, and Leverage.

Outline:

Page 57: Cash Flow Analysis and Statement

19.   Purposes and Considerations of Ratios and Ratio Analysis20. Types of Ratios

21. Income Ratios

22. Profitability Ratios

23. Net Operating Profit Ratios

24. Liquidity Ratios

25. Working Capital Ratios

26. Bankruptcy Ratios

27. Long-Term Analysis

28. Coverage Ratios

29. Total Coverage Ratios

30. Leverage Ratios

31. Common-Size Statement

32. Resources

I. Purposes and Considerations of Ratios and Ratio Analysis

Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas.

Ratio analysis is primarily used to compare a company's financial figures over a period of time, a method sometimes called trend analysis. Through trend analysis, you can identify trends, good and bad, and adjust your business practices accordingly. You can also see how your ratios stack up against other businesses, both in and out of your industry.

There are several considerations you must be aware of when comparing ratios from one financial period to another or when comparing the financial ratios of two or more companies.

5. If you are making a comparative analysis of a company's financial statements over a certain period of time, make an appropriate allowance for any changes in accounting policies that occurred during the same time span.

6. When comparing your business with others in your industry, allow for any material differences in accounting policies between your company and industry norms.

7. When comparing ratios from various fiscal periods or companies, inquire about the types of accounting policies used. Different accounting methods can result in a wide variety of reported figures.

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8. Determine whether ratios were calculated before or after adjustments were made to the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments. In many cases, these adjustments can significantly affect the ratios.

9. Carefully examine any departures from industry norms.

Back to Outline

II. Types of Ratios

Income Profitability Liquidity Working Capital Bankruptcy Long-Term Analysis Coverage Leverage

Back to Outline

III. Income Ratios

Turnover of Total Operating Assets

Net Sales= Turnover of Total Operating Assets Ratio

Total Operating Assets*

Obviously, an increase in sales will necessitate more operating assets at some point (sales may rise without additional investment within a given range, however); conversely, an inadequate sales volume may call for reduced investment. Turnover of Total Operating Assets or sales to investment in total operating assets tracks over-investment in operating assets.

*Total operating assets = total assets - (long-term investments + intangible assets)

Note: This ratio does not measure profitability. Remember, over-investment may result in a lack of adequate profits.

Net Sales to Tangible Net Worth

Net Sales= Net Sales to Tangible Net Worth Ratio

Tangible Net Worth*

This ratio indicates whether your investment in the business is adequately proportionate to your sales volume. It may also uncover potential credit or management problems, usually called "overtrading" and "undertrading."

Overtrading, or excessive sales volume transacted on a thin margin of investment, presents a potential problem with creditors. Overtrading can come from considerable management skill, but outside creditors must furnish more funds to carry on daily operations.

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Undertrading is usually caused by management's poor use of investment money and their general lack of ingenuity, skill or aggressiveness.

*Tangible Net Worth = owner's equity - intangible assets

Gross Margin on Net Sales

Gross Margin*= Gross Margin on Net Sales Ratio

Net Sales

By analyzing changes in this figure over several years, you can identify whether it is necessary to examine company policies relating to credit extension, markups (or markdowns), purchasing, or general merchandising (where applicable).

*Gross Margin = net sales - cost of goods sold

Note: An increase in gross margin may result from higher sales, lower cost of goods sold, an increase in the proportionate volume of higher margin products, or any combination of these variables.

Operating Income to Net Sales Ratio

Operating Income= Operating Income to Net Sales Ratio

Net Sales

This ratio reveals the profitability of sales resulting from regular business as well as buying, selling, and manufacturing operations.

Note:Operating income derives from ordinary business operations and excludes other revenue (losses), extraordinary items, interest on long-term obligations, and income taxes.

Acceptance Index

Applications Accepted= Acceptance Index

Applications Submitted

Obviously, a high sales volume that comes from just two or three major accounts is much riskier than the same volume coming from a large number of customers. Losing one out of three major accounts is disastrous, while losing one out of 150 is routine. A growing firm should try to spread this risk of dependency through active sales, promotion, and credit departments. Although the quality of customers stems from your general management policy, the quantity of newly opened accounts is a direct reflection on your sales and credit efforts.

Note: This index of effectiveness does not apply to every type of business.

Back to Outline

IV. Profitability Ratios

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Closely linked with income ratios are profitability ratios, which shed light upon the overall effectiveness of management regarding the returns generated on sales and investment.

Gross Profit on Net Sales

Net Sales - Cost of Goods Sold= Gross Profit on Net Sales Ratio

Net Sales

Does your average markup on goods normally cover your expenses, and therefore result in a profit? This ratio will tell you. If your gross profit rate is continually lower than your average margin, something is wrong! Be on the lookout for downward trends in your gross profit rate. This is a sign of future problems for your bottom line.

Note: This percentage rate can — and will — vary greatly from business to business, even those within the same industry. Sales, location, size of operations, and intensity of competition are all factors that can affect the gross profit rate.

Back to Outline

V. Net Operating Profit Ratios

Net Profit on Net Sales

EAT*= Net Profit on Net Sales Ratio

Net Sales

This ratio provides a primary appraisal of net profits related to investment. Once your basic expenses are covered, profits will rise disproportionately greater than sales above the break-even point of operations.

*EAT= earnings after taxes

Note: Sales expenses may be substituted out of profits for other costs to generate even more sales and profits.

Net Profit to Tangible Net Worth

EAT= Net Profit to Tangible Net Worth Ratio

Tangible Net Worth

This ratio acts as a complementary appraisal of net profits related to investment. This ratio sizes up the ability of management to earn a return.  

Net Operating Profit Rate Of Return

EBIT= Net Operating Profit Rate of Return Ratio

Tangible Net Worth

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Your Net Operating Profit Rate of Return ratio is influenced by the methods of financing you utilize. Notice that this ratio employs earnings before interest and taxes, not earnings after taxes. Profits are taken after interest is paid to creditors. A fallacy of omission occurs when creditors support total assets.

Note: If financial charges are great, compute a net operating profit rate of return instead of return on assets ratio. This can provide an important means of comparison.

Management Rate Of Return

Operating Income= Management Rate of Return Ratio

Fixed Assets + Net Working Capital

This profitability ratio compares operating income to operating assets, which are defined as the sum of tangible fixed assets and net working capital.

This rate, which you may calculate for your entire company or for each of its divisions or operations, determines whether you have made efficient use of your assets. The percentage should be compared with a target rate of return that you have set for the business.

Earning Power

Net SalesX

EAT= Earning Power Ratio

Tangible Net Worth Net Sales

The Earning Power Ratio combines asset turnover with the net profit rate. That is, Net Sales to Tangible Net Worth (see "Income Ratios") multiplied by Net Profit on Net Sales (see ratio above). Earning power can be increased by heavier trading on assets, by decreasing costs, by lowering the break-even point, or by increasing sales faster than the accompanying rise in costs.

Note: Sales hold the key.

Back to Outline

VI. Liquidity Ratios

While liquidity ratios are most helpful for short-term creditors/suppliers and bankers, they are also important to financial managers who must meet obligations to suppliers of credit and various government agencies. A complete liquidity ratio analysis can help uncover weaknesses in the financial position of your business.

Current Ratio

Current Assets*= Current Ratio

Current Liabilities*

Popular since the turn of the century, this test of solvency balances your current assets against your current liabilities. The current ratio will disclose balance sheet changes that net working capital will not.

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*Current Assets = net of contingent liabilities on notes receivable

*Current Liabilities = all debt due within one year of statement data

Note: The current ratio reveals your business's ability to meet its current obligations. It should be supplemented with the other ratios listed below, however.

Quick Ratio

Cash + Marketable Securities + Accounts Receivable (net)= Quick Ratio

Current Liabilities

Also known as the "acid test," this ratio specifies whether your current assets that could be quickly converted into cash are sufficient to cover current liabilities. Until recently, a Current Ratio of 2:1 was considered standard. A firm that had additional sufficient quick assets available to creditors was believed to be in sound financial condition.

Note: The Quick Ratio assumes that all assets are of equal liquidity. Receivables are one step closer to liquidity than inventory. However, sales are not complete until the money is in hand.

Absolute Liquidity Ratio

Cash + Marketable Securities= Absolute Liquidity Ratio

Current Liabilities

A subsequent innovation in ratio analysis, the Absolute Liquidity Ratio eliminates any unknowns surrounding receivables.

Note: The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities.

Basic Defense Interval

(Cash + Receivables + Marketable Securities)= Basic Defense Interval

(Operating Expenses + Interest + Income Taxes) / 365

If for some reason all of your revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days your company can cover its cash expenses without the aid of additional financing.

Receivables Turnover

Total Credit Sales= Receivables Turnover Ratio

Average Receivables Owing

Another indicator of liquidity, Receivables Turnover Ratio can also indicate management's efficiency in employing those funds invested in receivables. Net credit sales, while preferable, may be replaced in the formula with net total sales for an industry-wide comparison.

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Note: Closely monitoring this ratio on a monthly or quarterly basis can quickly underscore any change in collections.

Average Collection Period

(Accounts + Notes Receivable)= Average Collection Period

(Annual Net Credit Sales) / 365

The Average Collection Period (ACP) is another litmus test for the quality of your receivables business, giving you the average length of the collection period. As a rule, outstanding receivables should not exceed credit terms by 10-15 days. If you allow various types of credit transactions, such as a retail outlet selling both on open credit and installment, then the ACP must be calculated separately for each category.

Note: Discounted notes which create contingent liabilities must be added back into receivables.

Inventory Turnover

Cost of Goods Sold= Inventory Turnover Ratio

Average Inventory

Rule of Thumb: Multiply your inventory turnover by your gross margin percentage. If the result is 100 percent or greater, your average inventory is not too high.

Back to Outline

VII. Working Capital Ratios

Many believe increased sales can solve any business problem. Often, they are correct. However, sales must be built upon sound policies concerning other current assets and should be supported by sufficient working capital.

There are two types of working capital: gross working capital, which is all current assets, and net working capital, which is current assets less current liabilities.

If you find that you have inadequate working capital, you can correct it by lowering sales or by increasing current assets through either internal savings (retained earnings) or external savings (sale of stock). Following are ratios you can use to evaluate your business's net working capital.

Working Capital Ratio

Use "Current Ratio" in the section on "Liquidity Ratios."

This ratio is particularly valuable in determining your business's ability to meet current liabilities.

Working Capital Turnover

Net Sales= Working Capital Turnover Ratio

Net Working Capital

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This ratio helps you ascertain whether your business is top-heavy in fixed or slow assets, and complements Net Sales to Tangible Net Worth (see "Income Ratios"). A high ratio could signal overtrading.

Note: A high ratio may also indicate that your business requires additional funds to support its financial structure, top-heavy with fixed investments.

Current Debt to Net Worth

Current Liabilities= Current Debt to Net Worth Ratio

Tangible Net Worth

Your business should not have debt that exceeds your invested capital. This ratio measures the proportion of funds that current creditors contribute to your operations.

Note: For small businesses a ratio of 60 percent or above usually spells trouble. Larger firms should start to worry at about 75 percent.

Funded Debt to Net Working Capital

Long-Term Debt= Funded Debt to Net Working Capital Ratio

Net Working Capital

Funded debt (long-term liabilities) = all obligations due more than one year from the balance sheet date

Note: Long-term liabilities should not exceed net working capital.

Back to Outline

VIII. Bankruptcy Ratios

Many business owners who have filed for bankruptcy say they wish they had seen some warning signs earlier on in their company's downward spiral. Ratios can help predict bankruptcy before it's too late for a business to take corrective action and for creditors to reduce potential losses. With careful planning, predicted futures can be avoided before they become reality. The first five bankruptcy ratios in this section can detect potential financial problems up to three years prior to bankruptcy. The sixth ratio, Cash Flow to Debt, is known as the best single predictor of failure.

Working Capital to Total Assets

Net Working Capital= Working Capital to Total Assets Ratio

Total Assets

This liquidity ratio, which records net liquid assets relative to total capitalization, is the most valuable indicator of a looming business disaster. Consistent operating losses will cause current assets to shrink relative to total assets.

Note: A negative ratio, resulting from negative net working capital, presages serious problems.

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Retained Earnings to Total Assets

Retained Earnings= Retained Earnings to Total Assets Ratio

Total Assets

New firms will likely have low figures for this ratio, which designates cumulative profitability. Indeed, businesses less than three years old fail most frequently.

Note: A negative ratio portends cloudy skies. However, results can be distorted by manipulated retained earnings (earned surplus) data.

EBIT to Total Assets

EBIT= EBIT to Total Assets Ratio

Total Assets

How productive are your business's assets? Asset values come from earning power. Therefore, whether or not liabilities exceed the true value of assets (insolvency) depends upon earnings generated.

Note: Maximizing rate of return on assets does not mean the same as maximizing return on equity. Different degrees of leverage affect these separate conclusions.

Sales to Total Assets

Total Sales= Sales to Total Assets Ratio

Total Assets

See "Turnover Ratio" under "Profitability Ratios."

This ratio, which uncovers management's ability to function in competitive situations while not excluding intangible assets, is inconclusive if studied by itself. But when viewed alongside Working Capital to Total Assets, Retained Earnings to Total Assets, and EBIT to Total Assets, it can confirm whether your business is in imminent danger.

Note: A result of 200 percent is more reassuring than one of 100 percnt.

Equity to Debt

Market Value of Common + Preferred Stock= Equity to Debt Ratio

Total Current + Long-Term Debt

This ratio shows you by how much your business's assets can decline in value before it becomes insolvent.

Note: Those businesses with ratios above 200 percent are safest.

Cash Flow to Debt

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Cash Flow*= Cash Flow to Debt Ratio

Total Debt

Also, refer to "Debt Cash Flow Coverage Ratio" in the section on "Coverage Ratios."

Since debt does not materialize as a liquidity problem until its due date, the closer to maturity, the greater liquidity should be. Other ratios useful in predicting insolvency include Total Debt to Total Assets (see "Leverage Ratios" below) and Current Ratio (see "Liquidity Ratios").

*Cash flow = Net Income + Depreciation

Note: Because there are various accounting techniques of determining depreciation, use this ratio for evaluating your own company and not to compare it to other companies.

Back to Outline

IX. Long-Term Analysis

Current Assets to Total Debt

Current Assets= Current Assets to Total Debt Ratio

Current + Long-Term Debt

This ratio determines the degree of protection linked to short- and long-term debt. More net working capital protects short-term creditors.

Note: A high ratio (significantly above 100 percent) shows that if liquidation losses on current assets are not excessive, long-range debtors can be paid in full out of working capital.

Stockholders' Equity Ratio

Stockholders' Equity= Stockholders' Equity Ratio

Total Assets

Relative financial strength and long-run liquidity are approximated with this calculation. A low ratio points to trouble, while a high ratio suggests you will have less difficulty meeting fixed interest charges and maturing debt obligations.

Total Debt to Net Worth

Current + Deferred Debt= Total Debt to Net Worth Ratio

Tangible Net Worth

Rarely should your business's total liabilities exceed its tangible net worth. If it does, creditors assume more risk than stockholders. A business handicapped with heavy interest charges will likely lose out to its better financed competitors.

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Back to Outline

X. Coverage Ratios

Times Interest Earned

EBIT= Times Interest Earned Ratio

I

EBIT = earnings before interest and taxes I = dollar amount of interest payable on debt

The Times Interest Earned Ratio shows how many times earnings will cover fixed-interest payments on long-term debt.

Back to Outline

XI. Total Coverage Ratios

EBIT+

s= Total Coverage Ratio

I 1-h

I = interest payments s = payment on principal figured on income after taxes (1 - h)

This ratio goes one step further than Times Interest Earned, because debt obliges the borrower to not only pay interest but make payments on the principal as well.

Back to Outline

XII. Leverage Ratios

This group of ratios calculates the proportionate contributions of owners and creditors to a business, sometimes a point of contention between the two parties. Creditors like owners to participate to secure their margin of safety, while management enjoys the greater opportunities for risk shifting and multiplying return on equity that debt offers.

Note: Although leverage can magnify earnings, it exaggerates losses.

Equity Ratio

Common Shareholders' Equity= Equity Ratio

Total Capital Employed

The ratio of common stockholders' equity (including earned surplus) to total capital of the business shows how much of the total capitalization actually comes from the owners.

Note: Residual owners of the business supply slightly more than one half of the total capitalization.

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Debt to Equity Ratio

Debt + Preferred Long-Term= Debt to Equity Ratio

Common Stockholders' Equity

A high ratio here means less protection for creditors. A low ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb possible losses of income and capital).

Total Debt to Tangible Net Worth

If your business is growing, track this ratio for insight into the distributive source of funds used to finance expansion.

Debt Ratio

Current + Long-Term Debt= Debt Ratio

Total Assets

What percentage of total funds are provided by creditors? Although creditors tend to prefer a lower ratio, management may prefer to lever operations, producing a higher ratio.

Times Interest Earned

Refer  to "Coverage Ratios"

Back to Outline

XIII. Common-Size Statement

When performing a ratio analysis of financial statements, it is often helpful to adjust the figures to common-size numbers. To do this, change each line item on a statement to a percentage of the total. For example, on a balance sheet, each figure is shown as a percentage of total assets, and on an income statement, each item is expressed as a percentage of sales.

This technique is quite useful when you are comparing your business to other businesses or to averages from an entire industry, because differences in size are neutralized by reducing all figures to common-size ratios. Industry statistics are frequently published in common-size form.

When comparing your company with industry figures, make sure that the financial data for each company reflect comparable price levels, and that it was developed using comparable accounting methods, classification procedures, and valuation bases.

Such comparisons should be limited to companies engaged in similar business activities. When the financial policies of two companies differ, these differences should be recognized in the evaluation of comparative reports. For example, one company leases its properties while the other purchases such items; one company finances its operations using long-term borrowing while the other relies primarily on funds supplied by stockholders and by earnings. Financial statements for two companies under these circumstances are not wholly comparable.

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Example Common-Size Income Statement  

  2008 2009 2010

Sales 100% 100% 100%

Cost of Sales 65% 68% 70%

Gross Profit 35% 32% 30%

Expenses 27% 27% 26%

Taxes 2% 1% 1%

Profit 6% 4% 3%

Back to Outline

Books

Peter Atrill and Eddie McLaney, "Accounting and Finance for Non-Specialists" (Prentice Hall, 1997)

Leopold Bernstein, John Wild, "Analysis of Financial Statements" (McGraw-Hill, 2000)

Daniel L. Jensen, "Advanced Accounting" (McGraw-Hill College Publishing, 1997)

Martin Mellman et. al., "Accounting for Effective Decision Making" (Irwin Professional Press, 1994)

Eric Press, "Analyzing Financial Statements" (Lebahar-Friedman, 1999)      

Back to Outline

Projected Financial analysis

Projected Financial StatementsProjected Financial Statements is summary of various component projections of revenues and expenses for the budget period. Projected Financial Statements indicates the expected net income for the period.

Projected Financial Statements are an important tool in determining the overall performance of a company. Projected financial statements have the balance sheet, income statement and cash flow statements to indicate the company performance.

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The Balance Sheet shows your assets, liabilities and equity at a particular point in time. It is basically a snapshot of your financial position. The basic accounting formula is assets equal liabilities plus owner’s equity. The asset section of the balance sheet should be presented in order of liquidity starting with the most liquid assets such as cash, accounts receivable and inventory. The liabilities section should be presented in order of maturity starting with liabilities that are payable over the next year such as a demand note payable and accounts payable.

The Income Statement captures profit performance, demonstrates immediate capability to service debt for banks or real potential for growth in returns for venture capital. This is often expressed in terms of sales volume, or compared to industry benchmarks.

The Statement of Cash Flows is the most critical forecast since it reflects viability rather than profitability. It can also be the most uncertain statement as projections extend into the future. Therefore, monthly cash flow is a key statement since it enables calculation of "coverage" at any given point.

Preparing projected financial statements can be very time consuming and it requires a careful analysis of the company's past and present financial health. Projected financial statements project or forecast a company's performance in the near future.

Preparing projected financial statements require careful analysis:

Prior to preparing projected financial statements, an analyst studies the financial history of the company. There may be some drawbacks, which the company may have encountered down the years. To eradicate such hurdles and for the betterment of the company's financial status, an analysis is conducted.

Factors considered for analysis of the financial health of the company: An analyst uses the following points to evaluate the position of the company:

1. Whether the company's operational activities are up to the mark2. If the company is well equipped financially

3. Condition of the market- if the market is in the process of growth, is at equilibrium or shriveling up.

4. The status of the company in relation to the other companies in the industry.

5. Strengths, weaknesses prevailing in the management of the company, type of product produced by the     company, economic cycle of the company, accompanying hazards in the production of goods,

6. Role of the management's performance in company growth

7. Risks associated with operational activities

8. Company's past performance records.

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By carefully studying the various trends in the company's past performances, the analyst tries to predict the company's performance in future. Even if the financial health of a company has remained fairly stable over the years and the projected financial statements forecast a still better growth trend in the financial statement, any unforeseen event may change the course, in the projected financial statement. The unforeseen events may occur in any part of the globe thereby impacting global economy in an adverse manner. An analyst keeps provision for such events and prepares details of a contingency fund, which can be made use of, if the above mentioned circumstances are encountered by any company.

Business Plan for a Startup BusinessThe business plan consists of a narrative and several financial worksheets. The narrative template is the body of the business plan. It contains more than 150 questions divided into several sections. Work through the sections in any order that you like, except for the Executive Summary, which should be done last. Skip any questions that do not apply to your type of business. When you are finished writing your first draft, you’ll have a collection of small essays on the various topics of the business plan. Then you’ll want to edit them into a smooth-flowing narrative.

The real value of creating a business plan is not in having the finished product in hand; rather, the value lies in the process of researching and thinking about your business in a systematic way. The act of planning helps you to think things through thoroughly, study and research if you are not sure of the facts, and look at your ideas critically. It takes time now, but avoids costly, perhaps disastrous, mistakes later.

This business plan is a generic model suitable for all types of businesses. However, you should modify it to suit your particular circumstances. Before you begin, review the section titled Refining the Plan, found at the end. It suggests emphasizing certain areas depending upon your type of business (manufacturing, retail, service, etc.). It also has tips for fine-tuning your plan to make an effective presentation to investors or bankers. If this is why you’re creating your plan, pay particular attention to your writing style. You will be judged by the quality and appearance of your work as well as by your ideas.

It typically takes several weeks to complete a good plan. Most of that time is spent in research and re-thinking your ideas and assumptions. But then, that’s the value of the process. So make time to do the job properly. Those who do never regret the effort. And finally, be sure to keep detailed notes on your sources of information and on the assumptions underlying your financial data.

If you need assistance with your business plan, contact the SCORE office in your area to set up a business counseling appointment with a SCORE volunteer or send your plan for review to a SCORE counselor at www.score.org. Call 1-800-634-0245 to get the contact information for the SCORE office closest to you.

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Business Plan

OWNERS

Your Business NameAddress Line 1Address Line 2City, ST ZIP CodeTelephone FaxE-Mail

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I. Table of Contents

I. Table of Contents.........................................................................................................

II. Executive Summary.....................................................................................................

III. General Company Description....................................................................................

IV. Products and Services..................................................................................................

V. Marketing Plan.............................................................................................................

VI. Operational Plan..........................................................................................................

VII. Management and Organization....................................................................................

VIII. Personal Financial Statement.......................................................................................

IX. Startup Expenses and Capitalization...........................................................................

X. Financial Plan..............................................................................................................

XI. Appendices..................................................................................................................

XII. Refining the Plan.........................................................................................................

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II. Executive Summary

Write this section last.

We suggest that you make it two pages or fewer.

Include everything that you would cover in a five-minute interview.

Explain the fundamentals of the proposed business: What will your product be? Who will your customers be? Who are the owners? What do you think the future holds for your business and your industry?

Make it enthusiastic, professional, complete, and concise.

If applying for a loan, state clearly how much you want, precisely how you are going to use it, and how the money will make your business more profitable, thereby ensuring repayment.

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III. General Company Description

What business will you be in? What will you do?

Mission Statement: Many companies have a brief mission statement, usually in 30 words or fewer, explaining their reason for being and their guiding principles. If you want to draft a mission statement, this is a good place to put it in the plan, followed by:

Company Goals and Objectives: Goals are destinations—where you want your business to be. Objectives are progress markers along the way to goal achievement. For example, a goal might be to have a healthy, successful company that is a leader in customer service and that has a loyal customer following. Objectives might be annual sales targets and some specific measures of customer satisfaction.

Business Philosophy: What is important to you in business?

To whom will you market your products? (State it briefly here—you will do a more thorough explanation in the Marketing Plan section).

Describe your industry. Is it a growth industry? What changes do you foresee in the industry, short term and long term? How will your company be poised to take advantage of them?

Describe your most important company strengths and core competencies. What factors will make the company succeed? What do you think your major competitive strengths will be? What background experience, skills, and strengths do you personally bring to this new venture?

Legal form of ownership: Sole proprietor, Partnership, Corporation, Limited liability corporation (LLC)? Why have you selected this form?

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IV. Products and Services

Describe in depth your products or services (technical specifications, drawings, photos, sales brochures, and other bulky items belong in Appendices).

What factors will give you competitive advantages or disadvantages? Examples include level of quality or unique or proprietary features.

What are the pricing, fee, or leasing structures of your products or services?

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V. Marketing Plan

Market research - Why?No matter how good your product and your service, the venture cannot succeed without effective marketing. And this begins with careful, systematic research. It is very dangerous to assume that you already know about your intended market. You need to do market research to make sure you’re on track. Use the business planning process as your opportunity to uncover data and to question your marketing efforts. Your time will be well spent.

Market research - How?There are two kinds of market research: primary and secondary.

Secondary research means using published information such as industry profiles, trade journals, newspapers, magazines, census data, and demographic profiles. This type of information is available in public libraries, industry associations, chambers of commerce, from vendors who sell to your industry, and from government agencies.

Start with your local library. Most librarians are pleased to guide you through their business data collection. You will be amazed at what is there. There are more online sources than you could possibly use. Your chamber of commerce has good information on the local area. Trade associations and trade publications often have excellent industry-specific data.

Primary research means gathering your own data. For example, you could do your own traffic count at a proposed location, use the yellow pages to identify competitors, and do surveys or focus-group interviews to learn about consumer preferences. Professional market research can be very costly, but there are many books that show small business owners how to do effective research themselves.

In your marketing plan, be as specific as possible; give statistics, numbers, and sources. The marketing plan will be the basis, later on, of the all-important sales projection.

EconomicsFacts about your industry:

What is the total size of your market?

What percent share of the market will you have? (This is important only if you think you will be a major factor in the market.)

Current demand in target market.

Trends in target market—growth trends, trends in consumer preferences, and trends in product development.

Growth potential and opportunity for a business of your size.

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What barriers to entry do you face in entering this market with your new company? Some typical barriers are:

o High capital costs

o High production costs

o High marketing costs

o Consumer acceptance and brand recognition

o Training and skills

o Unique technology and patents

o Unions

o Shipping costs

o Tariff barriers and quotas

And of course, how will you overcome the barriers?

How could the following affect your company?

o Change in technology

o Change in government regulations

o Change in the economy

o Change in your industry

ProductIn the Products and Services section, you described your products and services as you see them. Now describe them from your customers’ point of view.

Features and Benefits

List all of your major products or services.

For each product or service:

Describe the most important features. What is special about it?

Describe the benefits. That is, what will the product do for the customer?

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Note the difference between features and benefits, and think about them. For example, a house that gives shelter and lasts a long time is made with certain materials and to a certain design; those are its features. Its benefits include pride of ownership, financial security, providing for the family, and inclusion in a neighborhood. You build features into your product so that you can sell the benefits.

What after-sale services will you give? Some examples are delivery, warranty, service contracts, support, follow-up, and refund policy.

CustomersIdentify your targeted customers, their characteristics, and their geographic locations, otherwise known as their demographics.

The description will be completely different depending on whether you plan to sell to other businesses or directly to consumers. If you sell a consumer product, but sell it through a channel of distributors, wholesalers, and retailers, you must carefully analyze both the end consumer and the middleman businesses to which you sell.

You may have more than one customer group. Identify the most important groups. Then, for each customer group, construct what is called a demographic profile:

Age

Gender

Location

Income level

Social class and occupation

Education

Other (specific to your industry)

Other (specific to your industry)

For business customers, the demographic factors might be:

Industry (or portion of an industry)

Location

Size of firm

Quality, technology, and price preferences

Other (specific to your industry)

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Other (specific to your industry)

CompetitionWhat products and companies will compete with you?

List your major competitors:

(Names and addresses)

Will they compete with you across the board, or just for certain products, certain customers, or in certain locations?

Will you have important indirect competitors? (For example, video rental stores compete with theaters, although they are different types of businesses.)

How will your products or services compare with the competition?

Use the Competitive Analysis table below to compare your company with your two most important competitors. In the first column are key competitive factors. Since these vary from one industry to another, you may want to customize the list of factors.

In the column labeled Me, state how you honestly think you will stack up in customers' minds. Then check whether you think this factor will be a strength or a weakness for you. Sometimes it is hard to analyze our own weaknesses. Try to be very honest here. Better yet, get some disinterested strangers to assess you. This can be a real eye-opener. And remember that you cannot be all things to all people. In fact, trying to be causes many business failures because efforts become scattered and diluted. You want an honest assessment of your firm's strong and weak points.

Now analyze each major competitor. In a few words, state how you think they compare.

In the final column, estimate the importance of each competitive factor to the customer. 1 = critical; 5 = not very important.

Table 1: Competitive Analysis

Factor Me Strength Weakness Competitor A Competitor BImportance to Customer

Products

Price

Quality

Selection

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Factor Me Strength Weakness Competitor A Competitor BImportance to Customer

Service

Reliability

Stability

Expertise

Company Reputation

Location

Appearance

Sales Method

Credit Policies

Advertising

Image

Now, write a short paragraph stating your competitive advantages and disadvantages.

NicheNow that you have systematically analyzed your industry, your product, your customers, and the competition, you should have a clear picture of where your company fits into the world.

In one short paragraph, define your niche, your unique corner of the market.

StrategyNow outline a marketing strategy that is consistent with your niche.

Promotion

How will you get the word out to customers?

Advertising: What media, why, and how often? Why this mix and not some other?

Have you identified low-cost methods to get the most out of your promotional budget?

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Will you use methods other than paid advertising, such as trade shows, catalogs, dealer incentives, word of mouth (how will you stimulate it?), and network of friends or professionals?

What image do you want to project? How do you want customers to see you?

In addition to advertising, what plans do you have for graphic image support? This includes things like logo design, cards and letterhead, brochures, signage, and interior design (if customers come to your place of business).

Should you have a system to identify repeat customers and then systematically contact them?

Promotional Budget

How much will you spend on the items listed above?

Before startup? (These numbers will go into your startup budget.)

Ongoing? (These numbers will go into your operating plan budget.)

Pricing

Explain your method or methods of setting prices. For most small businesses, having the lowest price is not a good policy. It robs you of needed profit margin; customers may not care as much about price as you think; and large competitors can under price you anyway. Usually you will do better to have average prices and compete on quality and service.

Does your pricing strategy fit with what was revealed in your competitive analysis?

Compare your prices with those of the competition. Are they higher, lower, the same? Why?

How important is price as a competitive factor? Do your intended customers really make their purchase decisions mostly on price?

What will be your customer service and credit policies?

Proposed Location

Probably you do not have a precise location picked out yet. This is the time to think about what you want and need in a location. Many startups run successfully from home for a while.

You will describe your physical needs later, in the Operational Plan section. Here, analyze your location criteria as they will affect your customers.

Is your location important to your customers? If yes, how?

If customers come to your place of business:

Is it convenient? Parking? Interior spaces? Not out of the way?

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Is it consistent with your image?

Is it what customers want and expect?

Where is the competition located? Is it better for you to be near them (like car dealers or fast food restaurants) or distant (like convenience food stores)?

Distribution Channels

How do you sell your products or services?

Retail

Direct (mail order, Web, catalog)

Wholesale

Your own sales force

Agents

Independent representatives

Bid on contracts

Sales ForecastNow that you have described your products, services, customers, markets, and marketing plans in detail, it’s time to attach some numbers to your plan. Use a sales forecast spreadsheet to prepare a month-by-month projection. The forecast should be based on your historical sales, the marketing strategies that you have just described, your market research, and industry data, if available.

You may want to do two forecasts: 1) a "best guess", which is what you really expect, and 2) a "worst case" low estimate that you are confident you can reach no matter what happens.

Remember to keep notes on your research and your assumptions as you build this sales forecast and all subsequent spreadsheets in the plan. This is critical if you are going to present it to funding sources.

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VI. Operational Plan

Explain the daily operation of the business, its location, equipment, people, processes, and surrounding environment.

ProductionHow and where are your products or services produced?

Explain your methods of:

Production techniques and costs

Quality control

Customer service

Inventory control

Product development

LocationWhat qualities do you need in a location? Describe the type of location you’ll have.

Physical requirements:

Amount of space

Type of building

Zoning

Power and other utilities

Access:

Is it important that your location be convenient to transportation or to suppliers?

Do you need easy walk-in access?

What are your requirements for parking and proximity to freeway, airports, railroads, and shipping centers?

Include a drawing or layout of your proposed facility if it is important, as it might be for a manufacturer.

Construction? Most new companies should not sink capital into construction, but if you are planning to build, costs and specifications will be a big part of your plan.

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Cost: Estimate your occupation expenses, including rent, but also including maintenance, utilities, insurance, and initial remodeling costs to make the space suit your needs. These numbers will become part of your financial plan.

What will be your business hours?

Legal EnvironmentDescribe the following:

Licensing and bonding requirements

Permits

Health, workplace, or environmental regulations

Special regulations covering your industry or profession

Zoning or building code requirements

Insurance coverage

Trademarks, copyrights, or patents (pending, existing, or purchased)

Personnel Number of employees

Type of labor (skilled, unskilled, and professional)

Where and how will you find the right employees?

Quality of existing staff

Pay structure

Training methods and requirements

Who does which tasks?

Do you have schedules and written procedures prepared?

Have you drafted job descriptions for employees? If not, take time to write some. They really help internal communications with employees.

For certain functions, will you use contract workers in addition to employees?

Inventory What kind of inventory will you keep: raw materials, supplies, finished goods?

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Average value in stock (i.e., what is your inventory investment)?

Rate of turnover and how this compares to the industry averages?

Seasonal buildups?

Lead-time for ordering?

SuppliersIdentify key suppliers:

Names and addresses

Type and amount of inventory furnished

Credit and delivery policies

History and reliability

Should you have more than one supplier for critical items (as a backup)?

Do you expect shortages or short-term delivery problems?

Are supply costs steady or fluctuating? If fluctuating, how would you deal with changing costs?

Credit Policies Do you plan to sell on credit?

Do you really need to sell on credit? Is it customary in your industry and expected by your clientele?

If yes, what policies will you have about who gets credit and how much?

How will you check the creditworthiness of new applicants?

What terms will you offer your customers; that is, how much credit and when is payment due?

Will you offer prompt payment discounts? (Hint: Do this only if it is usual and customary in your industry.)

Do you know what it will cost you to extend credit? Have you built the costs into your prices?

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Managing Your Accounts Receivable

If you do extend credit, you should do an aging at least monthly to track how much of your money is tied up in credit given to customers and to alert you to slow payment problems. A receivables aging looks like the following table:

Total Current 30 Days 60 Days 90 Days Over 90 Days

Accounts Receivable Aging

You will need a policy for dealing with slow-paying customers:

When do you make a phone call?

When do you send a letter?

When do you get your attorney to threaten?

Managing Your Accounts Payable

You should also age your accounts payable, what you owe to your suppliers. This helps you plan whom to pay and when. Paying too early depletes your cash, but paying late can cost you valuable discounts and can damage your credit. (Hint: If you know you will be late making a payment, call the creditor before the due date.)

Do your proposed vendors offer prompt payment discounts?

A payables aging looks like the following table.

Total Current 30 Days 60 Days 90 Days Over 90 Days

Accounts Payable Aging

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VII. Management and Organization

Who will manage the business on a day-to-day basis? What experience does that person bring to the business? What special or distinctive competencies? Is there a plan for continuation of the business if this person is lost or incapacitated?

If you’ll have more than 10 employees, create an organizational chart showing the management hierarchy and who is responsible for key functions.

Include position descriptions for key employees. If you are seeking loans or investors, include resumes of owners and key employees.

Professional and Advisory SupportList the following:

Board of directors

Management advisory board

Attorney

Accountant

Insurance agent

Banker

Consultant or consultants

Mentors and key advisors

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VIII. Personal Financial Statement

Include personal financial statements for each owner and major stockholder, showing assets and liabilities held outside the business and personal net worth. Owners will often have to draw on personal assets to finance the business, and these statements will show what is available. Bankers and investors usually want this information as well.

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IX. Startup Expenses and Capitalization

You will have many startup expenses before you even begin operating your business. It’s important to estimate these expenses accurately and then to plan where you will get sufficient capital. This is a research project, and the more thorough your research efforts, the less chance that you will leave out important expenses or underestimate them.

Even with the best of research, however, opening a new business has a way of costing more than you anticipate. There are two ways to make allowances for surprise expenses. The first is to add a little “padding” to each item in the budget. The problem with that approach, however, is that it destroys the accuracy of your carefully wrought plan. The second approach is to add a separate line item, called contingencies, to account for the unforeseeable. This is the approach we recommend.

Talk to others who have started similar businesses to get a good idea of how much to allow for contingencies. If you cannot get good information, we recommend a rule of thumb that contingencies should equal at least 20 percent of the total of all other start-up expenses.

Explain your research and how you arrived at your forecasts of expenses. Give sources, amounts, and terms of proposed loans. Also explain in detail how much will be contributed by each investor and what percent ownership each will have.

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X. Financial Plan

The financial plan consists of a 12-month profit and loss projection, a four-year profit and loss projection (optional), a cash-flow projection, a projected balance sheet, and a break-even calculation. Together they constitute a reasonable estimate of your company's financial future. More important, the process of thinking through the financial plan will improve your insight into the inner financial workings of your company.

12-Month Profit and Loss ProjectionMany business owners think of the 12-month profit and loss projection as the centerpiece of their plan. This is where you put it all together in numbers and get an idea of what it will take to make a profit and be successful.

Your sales projections will come from a sales forecast in which you forecast sales, cost of goods sold, expenses, and profit month-by-month for one year.

Profit projections should be accompanied by a narrative explaining the major assumptions used to estimate company income and expenses.

Research Notes: Keep careful notes on your research and assumptions, so that you can explain them later if necessary, and also so that you can go back to your sources when it’s time to revise your plan.

Four-Year Profit Projection (Optional)The 12-month projection is the heart of your financial plan. The Four-Year Profit projection is for those who want to carry their forecasts beyond the first year.

Of course, keep notes of your key assumptions, especially about things that you expect will change dramatically after the first year.

Projected Cash FlowIf the profit projection is the heart of your business plan, cash flow is the blood. Businesses fail because they cannot pay their bills. Every part of your business plan is important, but none of it means a thing if you run out of cash.

The point of this worksheet is to plan how much you need before startup, for preliminary expenses, operating expenses, and reserves. You should keep updating it and using it afterward. It will enable you to foresee shortages in time to do something about them—perhaps cut expenses, or perhaps negotiate a loan. But foremost, you shouldn’t be taken by surprise.

There is no great trick to preparing it: The cash-flow projection is just a forward look at your checking account.

For each item, determine when you actually expect to receive cash (for sales) or when you will actually have to write a check (for expense items).

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You should track essential operating data, which is not necessarily part of cash flow but allows you to track items that have a heavy impact on cash flow, such as sales and inventory purchases.

You should also track cash outlays prior to opening in a pre-startup column. You should have already researched those for your startup expenses plan.

Your cash flow will show you whether your working capital is adequate. Clearly, if your projected cash balance ever goes negative, you will need more start-up capital. This plan will also predict just when and how much you will need to borrow.

Explain your major assumptions, especially those that make the cash flow differ from the Profit and Loss Projection. For example, if you make a sale in month one, when do you actually collect the cash? When you buy inventory or materials, do you pay in advance, upon delivery, or much later? How will this affect cash flow?

Are some expenses payable in advance? When?

Are there irregular expenses, such as quarterly tax payments, maintenance and repairs, or seasonal inventory buildup, that should be budgeted?

Loan payments, equipment purchases, and owner's draws usually do not show on profit and loss statements but definitely do take cash out. Be sure to include them.

And of course, depreciation does not appear in the cash flow at all because you never write a check for it.

Opening Day Balance SheetA balance sheet is one of the fundamental financial reports that any business needs for reporting and financial management. A balance sheet shows what items of value are held by the company (assets), and what its debts are (liabilities). When liabilities are subtracted from assets, the remainder is owners’ equity.

Use a startup expenses and capitalization spreadsheet as a guide to preparing a balance sheet as of opening day. Then detail how you calculated the account balances on your o pening day balance sheet.

Optional: Some people want to add a projected balance sheet showing the estimated financial position of the company at the end of the first year. This is especially useful when selling your proposal to investors.

Break-Even AnalysisA break-even analysis predicts the sales volume, at a given price, required to recover total costs. In other words, it’s the sales level that is the dividing line between operating at a loss and operating at a profit.

Expressed as a formula, break-even is:

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Break-Even Sales = Fixed Costs

1- Variable Costs

(Where fixed costs are expressed in dollars, but variable costs are expressed as a percent of total sales.)

Include all assumptions upon which your break-even calculation is based.

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XI. Appendices

Include details and studies used in your business plan; for example:

Brochures and advertising materials

Industry studies

Blueprints and plans

Maps and photos of location

Magazine or other articles

Detailed lists of equipment owned or to be purchased

Copies of leases and contracts

Letters of support from future customers

Any other materials needed to support the assumptions in this plan

Market research studies

List of assets available as collateral for a loan

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XII. Refining the Plan

The generic business plan presented above should be modified to suit your specific type of business and the audience for which the plan is written.

For Raising CapitalFor Bankers

Bankers want assurance of orderly repayment. If you intend using this plan to present to lenders, include:

o Amount of loan

o How the funds will be used

o What this will accomplish—how will it make the business stronger?

o Requested repayment terms (number of years to repay). You will probably not have much negotiating room on interest rate but may be able to negotiate a longer repayment term, which will help cash flow.

o Collateral offered, and a list of all existing liens against collateral

For Investors

Investors have a different perspective. They are looking for dramatic growth, and they expect to share in the rewards:

o Funds needed short-term

o Funds needed in two to five years

o How the company will use the funds, and what this will accomplish for growth.

o Estimated return on investment

o Exit strategy for investors (buyback, sale, or IPO)

o Percent of ownership that you will give up to investors

o Milestones or conditions that you will accept

o Financial reporting to be provided

o Involvement of investors on the board or in management

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For Type of BusinessManufacturing

Planned production levels

Anticipated levels of direct production costs and indirect (overhead) costs—how do these compare to industry averages (if available)?

Prices per product line

Gross profit margin, overall and for each product line

Production/capacity limits of planned physical plant

Production/capacity limits of equipment

Purchasing and inventory management procedures

New products under development or anticipated to come online after startup

Service Businesses

Service businesses sell intangible products. They are usually more flexible than other types of businesses, but they also have higher labor costs and generally very little in fixed assets.

What are the key competitive factors in this industry?

Your prices

Methods used to set prices

System of production management

Quality control procedures. Standard or accepted industry quality standards.

How will you measure labor productivity?

Percent of work subcontracted to other firms. Will you make a profit on subcontracting?

Credit, payment, and collections policies and procedures

Strategy for keeping client base

High Technology Companies

Economic outlook for the industry

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Will the company have information systems in place to manage rapidly changing prices, costs, and markets?

Will you be on the cutting edge with your products and services?

What is the status of research and development? And what is required to:

o Bring product/service to market?

o Keep the company competitive?

How does the company:

o Protect intellectual property?

o Avoid technological obsolescence?

o Supply necessary capital?

o Retain key personnel?

High-tech companies sometimes have to operate for a long time without profits and sometimes even without sales. If this fits your situation, a banker probably will not want to lend to you. Venture capitalists may invest, but your story must be very good. You must do longer-term financial forecasts to show when profit take-off is expected to occur. And your assumptions must be well documented and well argued.

Retail Business

Company image

Pricing:

o Explain markup policies.

o Prices should be profitable, competitive, and in accordance with company image.

Inventory:

o Selection and price should be consistent with company image.

o Inventory level: Find industry average numbers for annual inventory turnover rate (available in RMA book). Multiply your initial inventory investment by the average turnover rate. The result should be at least equal to your projected first year's cost of goods sold. If it is not, you may not have enough budgeted for startup inventory.

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Customer service policies: These should be competitive and in accord with company image.

Location: Does it give the exposure that you need? Is it convenient for customers? Is it consistent with company image?

Promotion: Methods used, cost. Does it project a consistent company image?

Credit: Do you extend credit to customers? If yes, do you really need to, and do you factor the cost into prices?

Five Year Projections [Date]

Income Statement 2003 2004 2005 2006 2007

Net sales          

Cost of goods sold          

Net operating income          

Operating expenses          

Net income            

Cash Flow Statement 2003 2004 2005 2006 2007

Beginning balance          

Cash inflow          

Cash outflow          

Ending cash balance          

Balance Sheet 2003 2004 2005 2006 2007

Cash          

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Accounts receivable          

Inventory          

Prepaid expenses          

Total current assets          

Fixed assets          

Total assets          

Accounts payable          

Short-term notes          

Accrued and other liabilities          

Total current liabilities          

Long-term debt          

Other long-term liabilities          

Total long-term liabilities          

Shareholders' equity          

Total liabilities and equity          

Exercise No.2

Financial analystA financial analyst, securities analyst, research analyst, equity analyst, or investment analyst is a person who performs financial analysis for external or internal clients as a core part of the job.

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Writing reports or notes expressing opinions is always a part of "sell-side" (brokerage) analyst job and is often not required for "buy-side" (investment firms) analysts. Traditionally, analysts use fundamental analysis principles but technical chart analysis and tactical evaluation of the market environment are also routine. Often at the end of the assessment of analyzed securities, an analyst would provide a rating recommending an investment action, e.g. to buy, sell, or hold the security.

The analysts obtain information by studying public records and filings by the company, as well as by participating in public conference calls where they can ask direct questions to the management. Additional information can be also received in small group or one-on-one meetings with senior members of management teams. However in many markets such information gathering became difficult and potentially illegal due to legislatory changes brought upon by corporate scandals in the early '00s. One example is Regulation FD (Fair Disclosure) in the United States. Many other developed countries also adopted similar rules.

Financial analysts are often employed by mutual and pension funds, hedge funds, securities firms, banks, insurance companies, and other businesses, helping these companies or their clients make investment decisions. Financial analysts employed in commercial lending perform "balance sheet analysis," examining the audited financial statements and corollary data in order to assess lending risks. In a stock brokerage house or in an investment bank, they read company financial statements and analyze commodity prices, sales, costs, expenses, and tax rates in order to determine a company's value and project future earnings. In any of these various institutions, the analyst often meets with company officials to gain a better insight into a company's prospects and to determine the company's managerial effectiveness. Usually, financial analysts study an entire industry, assessing current trends in business practices, products, and industry competition. They must keep abreast of new regulations or policies that may affect the industry, as well as monitor the economy to determine its effect on earnings.

Financial analysts use spreadsheet and statistical software packages to analyze financial data, spot trends, and develop forecasts. On the basis of their results, they write reports and make presentations, usually making recommendations to buy or sell a particular investment or security. Senior analysts may actually make the decision to buy or sell for the company or client if they are the ones responsible for managing the assets. Other analysts use the data to measure the financial risks associated with making a particular investment decision.

Financial analysts in investment banking departments of securities or banking firms often work in teams, analyzing the future prospects of companies that want to sell shares to the public for the first time. They also ensure that the forms and written materials necessary for compliance with Securities and Exchange Commission regulations are accurate and complete. They may make presentations to prospective investors about the merits of investing in the new company. Financial analysts also work in mergers and acquisitions departments, preparing analyses on the costs and benefits of a proposed merger or takeover. There are buy-side analysts and sell-side analysts.

Some financial analysts, called ratings analysts (who are often employees of ratings agencies), evaluate the ability of companies or governments that issue bonds to repay their debt. On the

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basis of their evaluation, a management team assigns a rating to a company's or government's bonds. Other financial analysts perform budget, cost, and credit analysis as part of their responsibilities.

Proof

PIONEER CEMENT LIMITED - Analysis of Financial Statements Financial Year 2004 - 2001 Q 2010

OVERVIEW  : Pioneer Cement Limited (PIOC) has started its project in November 1994 when its first unit commenced production. The second unit was commissioned in January 2006. PIOC is a medium sized company in the cement sector, which began its operations with an installed capacity of 2000 tons per day clinker.

The company underwent many expansion plans due to which its capacity was increased to 2350 tons per day in 2005 and in 2006 a new production line of 4300 tons per day clinker capacity started production. Pioneer Cement Limited was incorporated on 9th February 1986 as a public limited company. Presently, its shares are quoted on all the three stock exchanges of the country. It is part of the Noon Group, which holds the majority stake of 60% in the company, followed by a leading brokerage house, First National Equity Limited with 9% shareholding. The rest of the shares held by financial institutions, insurance companies and the general public.PIOC is involved in the manufacturing and marketing of cement. Its products include ordinary portland cement, suitable for concrete construction and sulphate resistant cement, ideal for construction in or near sea. The company s sulphate resistant cement has less than 2.0 C3A content whereas the maximum limit of C3A content, set by British and Pakistani standards, is 3.5.Thus, the company s sulphate resistant cement is highly preferred in important projects such as the Thal Greater Canal project. PIOC s products are sold under the brand name of Pioneer Cement and it was the winner of Brand of the Year Awards 2006 in cement sector in the national category.

The company s state-of-the-art European (FLS) plant is equipped with stringent quality control measures. PIOC is ISO 9001:2000 QMS and ISO: 14001:2004 certified. It meets local as well as international quality standards. PIOC produces and sells clinker and cement domestically and internationally.

The quantity sold was 11% more than last year, however following a decrease in net retention price by 27% sales declined to Rs 1432 million from Rs 2179 million in the corresponding period 2009. The net average retention price in 1Q10 was Rs 3212 per ton as compared to Rs 4405 per ton in 1Q09. Cement exports also declined by 75% mainly on account of declining international prices and rising international transport charges.

Clinker production declined by 29% to 283,439 tons while the cement production increased by 1% to 317,775 tons. Gross profit declined by 73% to Rs 115 million from Rs 454 million in 1Q09. Exchange loss of Rs 93 million (1Q09: Rs 144 million) pushed the PAT in the red.

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Distribution charges dropped down drastically to Rs 33 million from Rs 218 million due to a massive decline in exports that led to a major decline in the freight handling charges. LAT was recorded at Rs 67 million in 1Q10 as compared to Rs 16 million PAT in 1Q09. LPS was Rs 0.34

Going forward the debt to equity swap with NBP will be reflected in the balance sheet of Pioneer cement. The H1 10 results will reflect the above as improvement in the TIE and gearing ratios.

INDUSTRY OVERVIEW 

This year was really turbulent for the cement sector due to the overall deteriorating law and order situation and the economic recession in the country. The local demand for the cement and clinker plunged to almost 15% and was highly affected by the large budget deficit and the reduction in the development expenditure by the government in line with the new demands of IMF. The government reduced the expenditure on Public Sector Development Program (PSDP) in FY09, which caused a reduction in the demands of cement by government by 11.3m tons. However this situation was shadowed by a huge 47% increase in the demand abroad. Also the increased inflation and the prices of cement and clinker helped the companies to improve their profitability position. The country now is 5th in the world regarding the overall cement exporters, a feat which has never been achieved before. Moreover most of the companies, this year, tapped the attractive markets of Middle East and Central Africa to overcome the shortfall in local demand, a decision which led to highly appreciable results despite the overall crisis in financial sector of the economy.

PRODUCTION AND SALES 

At the year-end FY08 the local sales contributed 75% while the share of exports rose to 25% of total cement dispatches of the company. PIOC clearly benefited from the growth in demand for cement in India and the Middle East. As PIOC s plants are in close proximity of the Indian border, the shortage of cement in India made it a lucrative and accessible market for the company and exports are made through roads. The retention prices in India are better than other export market. As the cement prices in India are expected to rise further, PIOC can be expected to have increased value of sales and higher gross margins.

PIOC exported 293,431 tons of clinker, mostly to the Middle East due to depleted limestone reserves and idle installed grinding capacities. PIOC is also exporting to Europe and Africa. The production of cement decreased this year by 30% due to shortage of power and crisis-stricken political state of the country. The volume of local sales decreased by 30% in line with the industry trends and the exports decreased by 45% this year but due to the high prices both on local and international front, the company was able to make profit after taxes of about Rs 36m.

PROFITABILITY 

The cement sector is experiencing strong growth in cement dispatches but at the same time it is facing declining profitability. The cost of production for the sector went up due to rise in the prices of imported coal. Crude oil prices shot up during FY09 and had its impact on prices of coal and natural gas. Fuel costs were the largest portion of production costs of the PIOC. For

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POIC the prices of packaging material went up and formed 14% to total production costs. For POIC fuel and electricity costs form 60% of the cost of sales and higher electricity tariffs and fuel costs affected the earnings of the company. Company had an impact of Rs 149 million on earnings due to devaluation of rupee against the dollar and Japanese yen in the form of exchange losses. Financial cost also increased due to higher interest rates in the economy.

Profitability ratios indicate that PIOC like many other companies in the cement sector, has been plagued by lower earnings. PIOC s rising operating expenses and finance costs have led to negative net profit margin. Similarly return on assets and return on equity have also fallen. The company improved a lot in the FY09 as far as the profitability is concerned. The gross profit margin increased from 10% to 26.66% As compared to last year the gross profit earned in FY09 (Rs 1333 million) is 160% more than that of FY08 (Rs 820 million).

Escalation in cost of goods sold was controlled and COGS was reduced by 16% in FY09 due to a sharp reduction in the international coal prices. The sales also increased by 3% in this year. But even then the Pioneer Cement s gross profit margin was less than the industry average of 30.36%. Same is the case with the net profit margin, the company which incurred an overall loss last year last year was able to bring their profit margin from -3.71% to 0.72% in FY09. The company has greatly reduced its distribution costs by 23% than last year. However, Pioneer Cement is below the industry s average net profit margin of 5%, although the asset management and debt management this year was the best in the whole sector. Pioneer s ROA and ROE are less at 0.35% and 1.4% respectively as compared to the industry average, which is 6% and 8.4% respectively. PAT was Rs 36 million as compared to Rs 180 million in losses in FY08.

LIQUIDITY ANALYSIS

The liquidity position of the company has been deteriorating over the years due to substantial rise in the current liabilities. PIOC felt a liquidity crunch, like many other companies in the cement sector due to the price war and losses caused by that in FY08. The current liabilities of PIOC have also increased to Rs 2.987 billion during FY08, backed mainly by increased short-term borrowings by the company. To solve the liquidity problem PIOC initiated a process of restructuring its debt by issuing Sukuk of Rs 2.5 billion in FY08. This will help the company to liquidate its excessive current liabilities. It will also help the company to control its finance costs. Also in lieu of its payments to NBP, Pioneer due to its inability to pay its loans will issue shares to NBP. This restructuring would give a breather to the company whose current ratio was steadily moving downhill.

During FY08 the composition of current assets changed such that the most liquid assets: cash and bank balances constituted 18%, trade debts 5% and inventory 9% of total current assets. Stores, spares and tools are highly illiquid assets and they form a major portion of the company s current assets. The liquidity position of the company improved a bit in FY09 despite the overall crumbling economy. The improvement was very minimal though 0.26 was the liquidity ratio in FY08 while the company ended up at 0.29 in the FY09. This slight improvement was due to 30% increase in the current assets of the company. Against the assets, the liabilities increased by 17%. The industry average for the liquidity ratio was 0.92 for the FY09 with Attock Cement as the market leader as far as liquidity was concerned. This shows that the overall industry s position,

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though not ideal, is at least much better than the Pioneer Cement. In fact it is the only company in the cement sector, which has the liquidity ratio of below 0.5.

ASSET MANAGEMENT ANALYSIS

The asset management of the company seems to be quite effective during FY08 as the operating cycle of PIOC decreased to 9 days from 23 days in FY07. The operating cycle, however, has reduced due to faster sales turnover while days to collect trade debt remained the same in FY08. The days to sell the average inventory were 19 days in FY07 whereas in FY08 it took the company only 6 days to sell its inventory. The company s policy in FY09 to increase its inventory has affected the inventory turnover rate, which was reduced from 63 times to 25 times. This year, the cost of sales of the company, were also reduced by 16%, which also played its part in reduction of the inventory turn over.

As long as, this policy is increasing the profitability and sales of the company, the ratio inventory turnover of 25 is satisfactory, considering the fact that the cost of goods sold were also reduced considerably by 16% although the main part in achieving that astonishing feat was played by the revaluation of the total assets of the company in FY08 due to which the depreciation expense was reduced by 13%. The cross country analyses tells us that despite the reduction in the ITO the company was well above the industry average in FY09 which was only 9.2 times in fact the ITO of Pioneer Cement was the highest amongst the sector. So the average days to sell the inventory in FY09 were increased from 6 to 14. All this happened due to the huge volume of cement export to the rebuilding countries like Iraq, Afghanistan, India and the Middle East by all of the companies in Pakistan. The increasing export volume also increases the amount of inventory recorded in the company s books. This explains why the Inventory Turnover of the cement sector is 38.8 days on average and the Pioneer Cement is very well below the average indicating the good performance as far as supply chain is concerned.

The company seems to be leading the market as far as the asset management is concerned as its operating cycle of 17.33 days is very less than the industry average of almost 48 days. This incredible performance is really plausible. Another noticeable achievement of the company is that 3% growth in the overall sales of the company was achieved even though the trade debts were reduced by 7% in the FY09. This step was taken by the company owing to the liquidity and credit crunch in the global market place and with in the country as well. The company s total assets turn over was also stable at 0.48 and it was almost the same as previous financial year. Even though the sales increased by 3% and the total assets decreased by 1%. Yet the company s turn over is less than the industry average of 0.61 which is a healthy sign for the company. Same is the situation with the equity turnover ratio which hadn t changed from the previous figure of 1.07 and is well below the industry average of 1.3.

DEBT MANAGEMENT ANALYSIS

In FY08 the debt to equity ratio has declined owing largely to a fall in the debt. The company is trying to restructure its financing composition in favor of equity by issuing Sukuk financing and convertible loan into equity. This will reduce the current liabilities in the future. In the wake of rising interest rates in the economy, this strategy will prove to be beneficial for PIOC in the

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future. The company s debt to asset ratio has not changed much from the previous figure of 0.57 and is 0.58 this financial year. The total liabilities of the company were decreased by 3% while assets were decreased by 1%. However, a closer look at the liability structure of the company, tells that the current liabilities were increased by 17% due to huge rise of 104% in the accrued interest and 68% increase in the short-term financing of the company to hedge itself from the dangerous after-effects of the long-term debt financing.

While on the contrary, the long-term liabilities were decreased by 23% and all the long-term loans were either redeemed or significant portion of their principals was paid to the banks to reduce the increasing finance cost from the profit and loss account. Almost Rs 300m were disbursed from the company for that purpose, which affected the liquidity, but the whole industry was doing this and that trend was followed by other manufacturing concerns as well. The industry average in this ratio is 0.51, which is closer to that of the company. The company increased its equity by 1% in FY09. But due to the redemption policy of the long-term loans, the company s overall liabilities were also decreased by 3% yet the capital structure is dominated by the debt financing and trend will be continuing for a very long time in future.

A cross-country analysis tells that the capital structure of Pioneer Cement has too much debt in it. This year s industry average is 1.41 and it is much lesser than that of the Pioneer Cement. This is probably because the company is not owned by the single family which doesn t allow ownership to transfer into the foreign hands unlike other companies of the sector. The company s long-term debt to equity ratio reduction from 1.28 to 0.95 in FY09 confirms its policy of getting rid of long-term debts. In fact, the average ratio indicates that the whole industry has blindly followed this course of action to save them from the inflation.

The industry average of 0.35 suggests that Pioneer Cement has still got a lot of debt on its balance sheet but this is there because the share of equity in the capital structure is very less. The company s Times Interest Earned ratio is 2 and has increased from the last financial year when it was negative last year due to loss it incurred from the operations. Even though the interest rates have increased the finance cost by 104%. The other companies who got rid of the long-term debt fully have managed to save a lot of profit from being going to the interest account. The TIE industry average is 5.8 which is very much larger than that of Pioneer Cement but we have to keep in mind that the Pioneer Cement has got such a large amount of debt in its capital structure that it was not possible to get rid of it in one financial year.

SHARE PRICE ANALYSIS Share prices of the Pioneer Cement reduced from Rs 31 in June, 2008 to Rs 13.58 in June 2009. The Earnings per share were increased from negative to Rs 0.18, however they are pushed in the red in 1Q10.

The above mentioned facts and figures are a proof of hard work of financial analyst.

Q2

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The idea of the "cost of capital" is fundamental to what managerial finance and accounting professionals do, directly or indirectly, as part of their participation on cross-functional decision teams. They need to understand and apply techniques for estimating the cost of capital for long-term capital budgeting; merger and acquisition analysis; use of Economic Value Added (EVA[R]) as a firm-wide financial performance indicator; incentive systems for financial control, using residual income for evaluating financial performance; equity valuation analyses; and accounting for purchased goodwill. (1)

Here we offer readers an overview of theoretical and empirical issues involved in estimating a firm's weighted average cost of capital (WACC), and we review and apply several methods for estimating WACC for two widely held U.S. firms: General Electric (GE) and Microsoft. The most difficult to estimate component of a firm's WACC relates to the cost of equity capital ([K.sub.s]), a process complicated in practice by the need to make various assumptions and practical choices. Conventional methods for estimating WACC, therefore, can yield substantially different approximations depending on the assumptions used in estimating [K.sub.s], so good judgment and sensitivity analysis are required when attempting to estimate a firm's cost of capital for applications in accounting and finance.

THEORETICAL FRAMEWORK

Conceptually, a firm's cost of capital is an investor's opportunity cost of investing his or her capital in that firm. An estimate of the firm's WACC is an attempt to quantify the average return expected by all investors in the firm: creditors of short-term and long-term interest-bearing debt, preferred stockholders, and common stockholders. (2) The firm's cost of capital is a weighted average where the weights are determined by the value of the various sources of capital. (3)

In Equation 1 we show the conventional formula for estimating a firm's WACC.

EQUATION 1

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]

where,

[w.sub.i] = the weight of the i-th source of capital (i = 1, ..., N) based on that source's aggregate market value in relation to the firm's total value,

[[summation of].sub.i][w.sub.i] = 1, and

[K.sub.i] = the expected return on the i-th security.

The portion to the right of the equal sign in Equation 1 can be rewritten in a simplified equation when there are only two sources of capital: long-term interest-bearing debt and (common) equity, as shown in Equation 2.

EQUATION 2

WACC = [w.sub.d][K.sub.d](1 - T) = [w.sub.s][K.sub.s]

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where,

[K.sub.d] is the expected cost of long-term debt,

T is the firm's marginal income tax rate (combined federal and state),

[K.sub.s] is the expected cost of common stock, and

[w.sub.d] and [w.sub.s] are the weights of long-term debt and common stock in the firm's capital structure. (4) Note that this could be either its target or self-professed optimal capital structure. (5)

When determining the weights of debt and equity, we use their market values rather than book values because market values are more reflective of the true worth of the company.

There are two models that can be used to estimate [K.sub.s]: (1) a single-factor model called the Capital Asset Pricing Model (CAPM) and (2) a multiple-factor model called the Arbitrage Pricing Model (APM). (6) Next, we briefly outline these models below and a third model, the "bond yield plus risk premium model," that financial analysts frequently use.

ESTIMATING THE COST OF EQUITY WITH CAPM

To calculate Equation 2, we need a means of estimating the required returns ([K.sub.i]) for each component of the firm's capital structure. An asset-pricing model such as the CAPM can provide a convenient and theoretically consistent set of return estimates. The standard CAPM method says the required return on a risky asset such as common stock is related linearly to a nondiversifiable risk, otherwise known as "systematic" risk. Systematic risk is the riskiness of the "market portfolio" of all risky marketable assets. This relationship can be summarized concisely, as shown in Equation 3.

EQUATION 3

[K.sub.i] = [K.sub.rf] [[beta].sub.i] ([K.sub.m] - [K.sub.rf])

where,

[K.sub.rf] = the expected return on a riskless security;

[K.sub.m] = the expected return on the systematic risk factor, i.e., the market portfolio's return, which is represented by the return on a large equity portfolio such as the S&P 500; and

[[beta].sub.i] = beta = a measure of the i-th security's sensitivity to the systematic risk factor.

A firm's beta can be estimated from a regression using historical data for the returns on the stock ([K.sub.s]) and a market portfolio proxy ([K.sub.m]). Typically, monthly returns data are used when estimating this regression. This CAPM beta will be biased when estimating a forward-

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looking cost of equity capital. A forward-looking estimate for [K.sub.s] is important for our analysis because the CAPM (as well as the APM) assumes that investors base their investment decisions on expected returns on all marketable securities. In deriving their published estimates of corporate betas, brokerage and analytical firms such as Merrill Lynch, Bloomberg, and Value Line have used Marshall Blume's idea to reduce the bias in the estimated beta and, in theory, improve one's ability to develop forward-looking return estimates. (7) Value Line's adjustment technique is relatively simple, as shown in Equation 4.

EQUATION 4

[[??].sub.i] = 0.35 0.67 [[beta].sub.i]

where,

[[beta].sub.i] = beta estimated via Equation 3 using historical time-series data and

[[??].sub.i] = an adjusted beta to account for the mean-reversion bias in the estimated beta.

Estimating the other two key components of Equation 3, the risk-free rate ([K.sub.rf]) and the market risk premium ([K.sub.m] - [K.sub.rf]), also requires the analyst's judgment. (8)

Since the advent of the CAPM in the 1960s to explain the pricing of assets, there have been numerous theoretical and empirical developments in asset pricing. In particular, CAPM's single-factor relation described by Equation 3 can be generalized to accommodate multiple systematic risk factors using logic based on the concept of "financial arbitrage." This newer approach, called the Arbitrage Pricing Model (APM), explicitly incorporates risk factors beyond the market portfolio factor, but the APM does not spell out what those extra factors should be, so researchers have been forced to rely on extensive empirical testing of numerous macroeconomic and financial variables to find additional factors that might improve the explanatory power of the CAPM. (9) S. David Young and Stephen F. O'Bryne suggest using growth rates of real GDP and inflation, as well as interest rates, as additional factors in estimating [K.sub.s]. (10)

Other researchers have popularized the use of a three-factor model consisting of: (1) the "excess return," or risk premium, for the market portfolio ([K.sub.m] - [K.sub.rf] from Equation 3); (2) the return on a portfolio that represents the difference between the returns on a group of small capitalization stocks and the returns on a group of large capitalization stocks (referred to as a "Small Minus Big" portfolio, or an "SMB" factor, which is related to the size of the company); and (3) the return on a portfolio that represents the difference between the returns on a group of stocks with high market-to-book equity ratios and the returns on a group of stocks with low market-to-book equity ratios (referred to as a "High Minus Low" portfolio, or an "HML" factor, which is related to the relative valuation of the company). (11)

These two extensions of the CAPM are based on observed empirical relations and do not have a convincing theoretical justification for the additional factors. This has led many practitioners to stay with the more widely accepted and simpler CAPM approach. Yet there are advantages to

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using the APM, most notably the fact that it usually leads to greater explanatory power of real-world stock returns when compared to the CAPM.

THE "BOND YIELD PLUS RISK PREMIUM" METHOD

The other technique for estimating [K.sub.s] is the "Bond Yield Plus Risk Premium" (BY P). The BY P method is popular among some practitioners (most notably multibillionaire investor Warren Buffett) because of its simplicity and limited number of assumptions. The BY P method is essentially an ad hoc empirical relation with no solid theoretical justification. Yet there appears to be some empirical validity in the notion that the return on a company's stock can be estimated by taking the firm's bond yield-to-maturity (YTM) and adding a fixed risk premium to this yield. So, for example, a firm with a current bond YTM of 7% would lead to an estimated [K.sub.s] of 10% once a fixed 3% risk premium is added to the YTM. (12) Although there is no theoretical reason for adding a 3% premium, it appears that this relation is just as good or better for many stocks than using a formal model such as the CAPM.

Q3

Cost of capital

The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested its money someplace else with similar risk.

As per Accounting Dictionary

Cost of Capital

Rate of return that is necessary to maintain market value (or stock price) of a firm, also called a hurdle rate, cutoff rate, or minimum required rate of return. The firm's cost of capital is calculated as a weighted average of the costs of debt and equity funds. Equity

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funds include both capital stock (common stock and preferred stock) and retained earnings. These costs are expressed as annual percentage rates. For example, assume the following capital structure and the cost of each source of financing for the XYZ Company:

The cost of capital is used for Capital Budgeting purposes. Under the Net Present Value Method, the cost of capital is used as the Discount Rate to calculate the present value of future cash inflows. Under the Internal Rate of Return method, it is used to make an accept-or-reject decision by comparing the cost of capital with the internal rate of return on a given project. A project is accepted when the internal rate exceeds the cost of capital.

The cost of capital is the cost of a company's funds (both debt and equity), or, from an investor's point of view "the expected return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Summary

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital.

The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous (need to explain use of "exogenous" in this context).

The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity.

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Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows.

Cost of debt

The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, ceteris paribus,"all other things being equal", the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate.

Cost of equity

Cost of equity = Risk free rate of return + Premium expected for risk

Expected return

The expected return (or required rate of return for investors) can be calculated with the "dividend

capitalization model", which is That equation is also seen as: Expected Return = dividend yield + growth rate of dividends.

Capital asset pricing model

The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The expected return on equity according to the capital asset pricing model. The market risk is normally characterized by the β parameter. Thus, the investors would expect (or demand) to receive:

Where:

Es

The expected return for a securityRf

The expected risk-free return in that market (government bond yield)βs

The sensitivity to market risk for the securityRM

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The historical return of the stock market/ equity market(RM-Rf)

The risk premium of market assets over risk free assets.

In writing:

33. The expected return (%) = risk-free return (%) + sensitivity to market risk * (historical return (%) - risk-free return (%))

10. Put another way the expected rate of return (%) = the yield on the treasury note closest to the term of your project + the beta of your project or security * (the market risk premium)

5. the market risk premium historically has been between 3-5%

Comments

The models state that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk times the market risk premium.

The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.

The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005. [1] The dividends have increased the total "real" return on average equity to the double, about 3.2%.

The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure. This value cannot be known "ex ante" (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms.

Cost of retained earnings/cost of internal equity

Note that retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.

Weighted average cost of capital

Main article: Weighted average cost of capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost capital.

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The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet. To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt Cost of Preference Capital Cost of Equity Capital

Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital. [2]

Capital structure

Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the capital structure where the cost of capital is minimized so that the firm's value can be maximized.

The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin.

Modigliani-Miller theorem

If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.

Q4

Return on equityReturn on equity (ROE) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth.

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The formula

ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage. As with many financial ratios, ROE is best used to compare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate.

ROE is presumably irrelevant if the earnings are not reinvested.

1. The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.

2. The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).

3. New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"

4. Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share' basis, i.e., earnings per share/book value per share.

The DuPont formula

The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three important components. Essentially, ROE will equal the net margin multiplied by asset turnover multiplied by financial leverage. Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE.

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Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. [2] Increased debt will make a positive contribution to a firm's ROE only if the matching Return on assets (ROA) of that debt exceeds the interest rate on the debt

Beta and Security market line

The SML graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The relationship between β and required return is plotted on the security market line (SML) which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is E(Rm)− Rf. The security market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk

The Security Market Line

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versus expected return is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.

Now we are highlighting the lower part of the question which is:

One of the objectives of capital management is to find the right mix of capital. A comparison of Earnings Before Interest Taxes (EBIT) with Earnings per Share (EPS) under different financing plans can help determine which type of financing is most advantageous - debt financing or equity financing. Since debt has little effect on EBIT, we start our analysis with EBIT. We simply want to calculate what EPS will be under each financing plan. Both the debt and stock financing plans are plotted on a graph. Depending upon what we expect EBIT to be, the graph can tell us which financing plan will give us the highest EPS. The following graph plots EBIT and EPS under debt and stock financing:

At a level of $ 2 million EBIT, EPS is the same under either the stock or debt financing plan. If we expect EBIT to be below $ 2 million, then we would favor the stock plan since it yields a higher EPS. If we expect EBIT to be above $ 2 million, then debt would be preferred over stock after considering the increased risk.

Example 12 - EBIT / EPS Comparison

Atco Corporation wants to raise $ 4 million in capital for production facilities. Atco can issue stock (200,000 shares @ $ 20) or issue bonds at 10% interest. Atco's tax rate is 45%. Atco's projected EBIT is $ 6.5 million and it has long-term capital consisting of $ 2 million in bonds @ 8% and 100,000 shares of stock.

Calculate EPS (Earnings per Share) under different financing plans:

100% Stock 100% Bonds 50 / 50 Mix Expected EBIT $ 6,500,000 $ 6,500,000 $ 6,500,000Current Interest on Debt (160,000) (160,000) (160,000)New Interest on Debt - 0 - (400,000) (200,000)Earnings before Tax 6,340,000 5,940,000 6,140,000Less Taxes @ 45% (2,853,000) (2,673,000) (2,763,000)Earnings to Shareholders 3,487,000 3,267,000 3,377,000Shares Outstanding 300,000 100,000 200,000Earnings per Share (EPS) $ 11.62 $ 32.67 $ 16.89

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The returns or EPS under a 100% Bond Plan is much higher than other plans. If Atco expects an EBIT of $ 6.5 million, it can easily service higher levels of debt.

In the above example, it is quite clear that Atco can benefit from the use of more debt. However, suppose Atco expects EBIT to fall dramatically over the next few years. Atco should graph the two financing plans under different levels of EBIT. In order to prepare a graph, we need to determine three points:

1. The minimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Stock Plan.

2. The minimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Bond Plan.

3. The Indifference Point where EPS is the same under the 100% Stock Plan and the 100% Bond Plan. The following formula can be used to calculate the Indifference Point:

EPS = ((EBIT - I) (1 - TR) - PD) / number of shares outstanding

EPS: Earnings per Share EBIT: Earnings Before Interest Taxes TR: Tax RatePD: Preferred Dividends

Example 13 - Calculate Graph Points for EBIT / EPS Comparison

If we refer back to Example 12, we can determine that the minimum level of EBIT under the two financing plans is as follows:

100% Stock: Minimum EBIT to service fixed obligations is $ 160,000 ($ 2 million of existing debt x 8% interest rate)

100% Bond: Minimum EBIT to service fixed obligations is $ 560,000 ($160,000 + $ 400,000).

The starting point on the graph for the Stock Plan is an EBIT of $ 160,000 and the starting point on the graph for the Bond Plan is an EBIT of $ 560,000.

We need a third intersection point or indifference point where EPS is the same under the two financing plans (100% Stock and 100% Bonds). We can solve for the EBIT where EPS is the same:

100% Stock 100% Bonds

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(EBIT - $160,000) (1 - .45) = (EBIT - $560,000) (1 - .45) 300,000 shares 100,000 shares

.55 EBIT - $ 88,000 = .55 EBIT - $ 308,000 300,000 100,000

(.55 EBIT - $ 88,000) 100,000 = (.55 EBIT - $ 308,000) 300,000

55,000 EBIT - $ 8,800,000 = 165,000 EBIT - $ 92,400,000

110,000 EBIT = $ 83,600,000

EBIT = $ 760,000

At an EBIT of $ 760,000, we are indifferent to the two financing plans since EPS is the same. If EBIT were to fall below $ 760,000, we would favor the Stock Plan. If EBIT is expected to be above $ 760,000, we would favor the Bond Plan. The following calculation confirms the indifference point:

100% Stock 100% Bonds Indifference EBIT $ 760,000 $ 760,000Existing Interest (160,000) (160,000)Interest on New Debt - 0 - (400,000)Earnings before Tax 600,000 200,000Less Taxes @ 45% (270,000) ( 90,000)Earnings to Shareholders 330,000 110,000Shares Outstanding 300,000 100,000Earnings Per Share (EPS) $ 1.10 $ 1.10

Now that we have calculated all three points per Example 13, we can summarize our analysis on the following graph:

At an EBIT of $ 760,000, we have an EPS of $ 1.10.

Assessing Risk

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Once returns have been analyzed under different financing plans with EBIT / EPS comparisons, it is necessary to assess risk. Coverage ratios are commonly used to assess the risk associated with different financing plans. Coverage ratios show the additional risk associated with higher levels of debt financing. Examples of coverage ratios include:

Debt to Total Assets Ratio = Total Long-term Liabilities / Total Assets

Times Interest Earned Ratio = EBIT / Interest Expense

Times Burden Earned Ratio = EBIT / Interest Expense + (Principal Repayment / (1 - TR))

Example 14 - Calculate Coverage Ratio for Atco Corporation

If we refer back to Example 12, we can calculate Times Interest Earned under each financing plan and compare these ratios to industry averages.

100% Stock 100% Bonds $ 6,500,000 / $ 160,000 $ 6,500,000 / $ 560,000 40.6 11.6

There is a significant change in Times Interest Earned between the two financing plans. However, when we compare this ratio to an industry average for Atco Corporation, we find that the overall industry has a Times Interest Earned Ratio of 3.8. Therefore, there is more than adequate coverage for increased debt by Atco.

Targeted Debt Levels

One approach to establishing the right mix of capital is to follow a targeted debt level. Since some level of debt is desirable for maintaining higher returns, many managers will establish a target debt level for their capital structures (such as 40% of capital should be debt). Therefore, financing decisions should sometimes take into account a targeted set of coverage ratios. One of the principal concerns with using more debt is the ability to cover the additional fixed charges. As we just discussed in the previous segment, coverage ratios are used to monitor debt levels.

Another concern with the use of more debt is financial flexibility. As we increase debt, we risk the possibility of closing off this source of financing in the future. If we expect more and more financing in the future, then we need to make sure we have the flexibility to tap into debt financing over the long-term.

The Overall ProcessThe basic process for making financing decisions often boils down to three steps:

1. Measuring the returns under different financing plans. A comparison of EBIT / EPS under different financing plans can help. You also need to understand how much earnings will grow in the future. If

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you expect EBIT to decline in the future, then you will favor stock over debt. If you expect strong growth in earnings, then you have the ability to service higher debt loads and thus you will lean towards debt over equity.

2. Assessing the risk of each plan. The objective is to grow the business with some use of leverage and avoid excessive loads of equity. Coverage ratios (as previously discussed) are widely used to monitor risk. Under ideal circumstances, you want to grow the business according to a desired growth rate (G). A desired growth rate can be calculated as follows: G = P x R x A x T where P is Profit Margin, R is Retention Ratio, A is Asset Turnover, and T is Financial Leverage.

If the actual growth rate exceeds the desired growth rate, then you need to make sure you don't borrow too heavily since you need to maintain borrowing capacity. Higher debt loads for fast growing companies can hold back values. If there is low growth, financing with debt may be preferred since steady cash flows are available to service debt financing. Slow growing companies need to aggressively pursue investment opportunities for increased growth.

3. Recognizing the need for financial flexibility. Selecting a financing plan that allows for future flexibility can be critical to future success. You must be able to make competitive investments in the future to maintain or improve market share.

Q5

Given that acquisitions are challenging, it is great when you can get a break. The one which we all seek, but rarely uncover, is when the acquisition can actually fund itself. While unusual, there are situations where this can work very well.

Most high growth firms face growth constraints which can often be best overcome through an acquisition. But at the same time, they are usually cash poor as they use whatever spare cash they have to finance their growth. Thus, while an acquisition may look attractive, they are unable to finance the investment. Finding an acquisition which can fund itself is thus a real win.

Perhaps the easiest strategy is to asset strip. There are many situations where businesses have idle assets which can be stripped out and sold, passing funds back to the business. An acquirer

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who focuses on the core of the business might find a number of assets which can be sold off to generate cash. A similar exercise can be used to sell off non-core parts of the business with those functions being outsourced.

There are also situations where the business is being acquired for one specific asset or capability and the buyer has no need for the rest. Once the key asset or capability is secured, the rest of the business can be sold with the proceeds being used to pay off the vendors. Sometimes this can be done with little impact on the vendor business. For example, the acquirer might be interested in gaining ownership control over a specific IP but might then license this back to the business as part of subsequent sale.

Anther technique which can be used is to sell and lease back assets of the business. Thus where the vendor has considerable land, building and plant, these may be able to be converted to a lease agreement so that the acquirer can release the value of the assets and yet continue with long-term use of those same assets.

Some businesses have significant cashflow which can be used to finance debt, especially where the vendors have not used this resource themselves to finance debt. This can be attractive to a lending institution where the acquirer is able to provide additional guarantees on the debt.

Cash generation may also be used in situations where gross margins can be substantially improved following the acquisition. This may occur where the acquirer can reduce input costs or enable prices to be increased. The additional margins may be sufficient to service increased debt which can be used to finance the acquisition.

In order to set up these types of deals, the acquirer will have to find a lending institution which will underwrite the deal until such time as it can be refinanced. For this to happen, the acquirer will have to be very certain of the post acquisition changes which can be undertaken to refinance the acquisition. But it is certainly possible if you find the right target firm.

At some point in its life cycle, almost every company looks for financing from an external source either because the company is experiencing cash flow problems or because additional capital is required to fund an accelerated growth plan. Larger businesses can often borrow money from banks based on their historical performance or using fixed assets or inventory as collateral. Entrepreneurs and newer ventures, however, are often denied these options and have to look for other sources of funds.

There are a great many sources of capital open to entrepreneurs and small businesses, each with their own advantages and disadvantages. The ideal solution is to have a CFO or other finance expert who can advise the company on the best way to fund the company, since no single solution is correct for every business. In the absence of such an advisor, or even to aid in discussing the decision with them, this article aims to explain in broad terms some of the possible funding sources and how to go about assessing their appropriateness.At the risk of oversimplification, let’s divide the sources of funds into four categories: Debt, Equity, Grants, and Factors. Debt is any sort of borrowed funds that must be repaid at a later date. Equity involves the sale of stock (an ownership right) in the company in exchange for cash. Grants, which is being defined more broadly as a category here than it usually is, is cash received from any group in order

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to promote certain aspects of the business, but where the cash does not need to be repaid and no ownership interest in the company is given. Factors, which is likewise being broadly defined, are means of accelerating cash flows that the company is already entitled to.

Equity FinancingEvery company relies, to some extent, on equity financing. Anytime you give someone (even one of the founders) stock in the company in exchange for cash, services, or some asset, you are using equity to fund the company. The biggest advantage of equity financing is that there is no obligation to repay it. Even when a company issues preferred shares (a full discussion of types of equity is beyond the scope of this article) that "require" a dividend payment to the holders of those shares, the requirement is only that they are paid before other equity holders. If the company does not have the cash to pay the dividend, it cannot be forced into bankruptcy. This lowers the risk to the company, but increases the risk to investors.

Another great advantage to equity financing is that it makes the investor a part of the company. Equity investors in small businesses are frequently open to being asked for advice, introductions, or other aid that will help grow the business.There are, however, two major down-sides to equity investment. First is the need for higher returns. One of the underlying premises of finance is that the riskier the investment, the greater the reward (return on investment) the investor expects to receive. Since the risk to equity investors is greater than that to a creditor (a debt lender), equity investors will have greater expectations of your company’s performance

Second, equity investment results in "dilution." Dilution is the reduction in percent ownership of the company by existing shareholders when new shareholders are issued stock. Let’s set up an example that will be used throughout this article in order to illustrate this.Ed owns 100% of CoffeeChat, a small internet business that has been around for about a year. CoffeeChat is doing well, with profits of $10,000 in the first year. Ed believes that by spending an additional $20,000 on marketing and site development, he can grow the profits to $15,000 next year and $25,000 in the third year and every year thereafter. For simplification purposes, let’s say that the entire profits of the company can be distributed to the owners of the company at the end of the year.

Ed identifies a wealthy friend, Igor, willing to invest the $20,000 in CoffeeChat in exchange for 50% of the stock in the company. While this means the company will be able to grow to $25,000 three years from now, Ed will only be entitled to 50% of the profits because his interest has been "diluted" by Igor. The company will grow, but in year two Ed will receive only $7,500 and in every subsequent year $12,500. The business has grown such that Ed is making more money, but far less than he could if he could find a way to get the $20,000 with less or no dilution of his equity interest.

There are a number of sources of equity investment for entrepreneurs and small businesses. The most famous are Venture Capital Firms. Businesses must be aware, however, that venture capital money is often burdened with hefty performance requirements and is therefore not appropriate for a great many businesses. In addition, the vast majority of successful businesses in the United States never received venture capital financing. If, however, your company expects to see dramatic growth in a relatively short period of time (within about 5 years) and is positioned in a rapidly growing industry, capital from a venture capital fund can be an incredible advantage. Good venture capital firms will provide not only

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capital, but resources and advice that can dramatically boost the performance of your company if used properly.

Another well known source of equity funding is Angel Investors. Angels are high-net-worth individuals, usually former entrepreneurs themselves, who invest small amounts of money (relative to venture capital firms) in small, but growing businesses. The greatest downside of angel investment is often that finding angel investors can be a difficult and time consuming process. A number of angel groups (e.g. New York Angels) have helped to mitigate this problem, but finding an appropriate investor can still be a tricky proposition as many angels are not part of these organizations. Angels can provide some of the ancillary benefits a venture fund can (advice, expertise, etc.), depending on the experience and network of the investor. Often, angels can introduce companies they have invested in to venture capital funds if at a later point additional funding is needed.

Friends and family often prove to be the best source of equity funding. Talking with people you know and who believe in you about your company can be a great way to garner interest in what you are doing. These investors often have reasonable expectations around the return on their investment and usually allow the owners to continue managing the business without much interference.

Debt FinancingDebt is an important part of every business. Whether suppliers are giving your company 30 days from being invoiced to pay, or you are borrowing from a bank, or even if you are just paying for things on your credit card, it is very likely you already use debt in some way. There are two key advantages to debt. The first is that by using debt, the owners of the company can see a greater return on their investment in the long run because they have not been diluted. To illustrate, let’s return to the example of CoffeeChat.

Instead of turning to Igor for investment, Ed now goes to Bob and secures a small business loan for the $20,000. The loan has an interest rate of 5% per year and must be repaid in full by the end of year three. For simplification, let’s assume that no payments need be made before the end of the third year. That means Ed must pay Bob $22,050 at the end of year three. So Ed now receives $15,000 in year 2, only $2,950 in year 3, but the full $25,000 every year thereafter. Debt can, therefore, result in far better results for Ed in the long run.The second major advantage to Debt relates to its tax treatment. Interest payments made on debt are tax deductible. This means that the available cash you have at the end of the year to distribute to the owners or use by the company is higher than it would otherwise be.There is, however, a great disadvantage of debt. Unlike equity investment, you must repay your debt as directed in the terms of your agreement. If you do not, your creditors can force the company into bankruptcy, often resulting in the end of the business altogether.The ideal source of debt financing is from a bank, however, banks often require a long history of business cash flows or assets against which the bank can take a lien. Many startup businesses fail to meet either of these criteria. Microlenders who specialize in this sort of loan do exist, but be aware, they may have limits on the amount they will lend that are lower than your company needs.

The Small Business Administration is also a great source for debt financing. Though the administration itself does not lend money, it sponsors SBA guaranteed loans and can help small businesses find banks

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and microlenders that are appropriate for their needs. Be aware, SBA loans often have requirements on how the capital may be used as their goal is to promote certain economic interests the government has identified.

GrantsAre an important, and often overlooked, source of funding for small businesses. Grants, usually from the government or non-profits, are contributions of capital that do not take an equity interest in the company, but also do not need to be repaid. While this "free money" may seem great at first, there are two things to consider. First, the process of receiving one is often time consuming and filled with bureaucratic hurdles. Second, grants are given to promote the interests of the group giving the grant (e.g. lowering unemployment). As such, companies seeking the grant will have to meet strict requirements often tied to location, industry, job creation, and/or public interest furthered and show that the money will be used to that end.

One important source that has less stringent requirements on usage is business plan competitions. Many business schools and municipalities now sponsor these competitions in order to promote the creation of new businesses in their area. The process can be lengthy (university based competitions usually run the length of a school year), but the investment can be sizable and the entrepreneurs are often provided with assistance and guidance along the way by volunteer mentors.

FactorsAnother often overlooked source of funding is factors, however these are not always appropriate for startup ventures. Factors are groups that buy your accounts receivable (the as yet uncollected billings to your customers) for less than those billings would be worth if you waited for them to send you payment. The upside to factors is that if you have short-term cashflow problems, they can help you pay your immediate bills using money you have earned but not yet received. The downside is that you will receive less money than you would had you chosen to wait. This discount can be so great as to be the equivalent of paying a 36% annual interest rate on a loan. This incredible discount does not, however, lower your risk of getting paid. If your customer doesn’t pay the money owed, you are responsible for repaying the factor. Probably the greatest problem with factors for startup businesses is that it requires your company to have billed customers. If you are running a pre-revenue (or small revenue) startup and need additional capital to grow the business, this source may not prove particularly helpful.

Only you, as manager of your business, can decide what the best source of financing is for your business. Carefully weigh the advantages and disadvantages of each solution. Consider how much money you need and how soon you need it. The answer may prove to be a combination of different funding sources.

Q6

Cash flow activities

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The cash flow statement is partitioned into three segments, namely: cash flow resulting from operating activities, cash flow resulting from investing activities, and cash flow resulting from financing activities.

The money coming into the business is called cash inflow, and money going out from the business is called cash outflow.

Operating activities

Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.

Under IAS 7, operating cash flows include:[11]

Receipts from the sale of goods or services

Receipts for the sale of loans, debt or equity instruments in a trading portfolio

Interest received on loans

Dividends received on equity securities

Payments to suppliers for goods and services

Payments to employees or on behalf of employees

Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US GAAP)

Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include:

Depreciation (loss of tangible asset value over time)

Deferred tax

Amortization (loss of intangible asset value over time)

Any gains or losses associated with the sale of a non-current asset, because associated cash flows do not belong in the operating section.(unrealized gains/losses are also added back from the income statement)

Investing activities

Examples of Investing activities are

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Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)

Loans made to suppliers or received from customers

Payments related to mergers and acquisitions

Financing activities

Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement.

Under IAS 7,

Proceeds from issuing short-term or long-term debt Payments of dividends

Payments for repurchase of company shares

Repayment of debt principal, including capital leases

For non-profit organizations, receipts of donor-restricted cash that is limited to long-term purposes

Items under the financing activities section include:

Dividends paid

Sale or repurchase of the company's stock

Net borrowings

Payment of dividend tax

Disclosure of non-cash activities

Under IAS 7, noncash investing and financing activities are disclosed in footnotes to the financial statements. Under US General Accepted Accounting Principles (GAAP), noncash activities may be disclosed in a footnote or within the cash flow statement itself. Noncash financing activities may include

Leasing to purchase an asset Converting debt to equity

Exchanging noncash assets or liabilities for other noncash assets or liabilities

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Issuing shares in exchange for assets

With the help of the above mentioned activities we can prepare cash flow statement and we are describing about the cash flow statement and the way of preparation below:

A cash flow statement shows effects of change in the values of items of the statement of financial performance and statement of financial position, in cash or cash equivalent terms. It is prepared in Accordance with the guidelines of International Accounting Standard 7 (IAS 7). Cash flow statement evaluates the liquidity and solvency of a business. Figures used in a cash flow statement are based on the amount of cash flows, therefore are less likely to be manipulated. One limitation of the cash flow statement is that it is based on historical data. Cash flow statement can be prepared by the direct or indirect method. Although both methods will produce the same result but the information in indirect method is more detailed therefore it is preferred. Cash flow statement divides the cash flows into cash from operating activities, cash from investing activities and cash from financing activities.

Direct Method

The main difference between the direct and indirect method of preparing cash flow is, the approach used for computation of cash flow from the operating activities. In direct method, the operating activities include the cash received from customers, cash paid to suppliers, cash paid for expenses and cash paid for salaries and wages. The information provided in the direct method of preparing cash flow are not found elsewhere in the financial statements. Therefore it is difficult and costly to gather the information required for preparing cash flow statement by direct method. However it shows a true picture of cash flows from the operations of a company. Cash flow from investing activities and financing activities are computed in the same way under direct and indirect method and are shown below.

Indirect Method

In indirect method, first the profit before tax figure is taken from the statement of financial position and is adjusted for the interest and other non-cash items like depreciation, amortization of goodwill, profit or loss on disposal of fixed assets, government grants etc. Working capital changes are made to get the cash from operating activities figure. Increase in receivables and inventory is deducted while an increase in the payable is added to the profit figure. Similarly a decrease in receivables and inventory is added, while a decrease in payables is added to the profit figure. Actual amount of the interest and income tax paid is deducted from the figure of cash from operating activities to get net cash from operating activities.

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Cash from investing activities includes the cash received or paid for acquisition or disposal of machinery, property and other long term assets, cash paid for investments and dividends received from investments.

Cash from financing activities include cash paid and received from financing transactions like the receipts and payments for shares purchase and issue, debentures, loans, notes and other borrowings except bank overdraft. Dividends paid may be shown in both cash from operating activities and cash from financing activities.