new venture development

New Venture Development

Exam II Materials

Analysis of Financial Statements

Vertical analysis on the income statement uses total or net revenues for the denominator

Answers the question: How much of our total revenues were consumed by each expense?

Vertical analysis on the balance sheet uses total assets for the denominator

Answers the question: How much of our total assets are represented by each asset category?

Horizontal analysis on the income statement and balance sheet use the previous period’s entry as the denominator and the difference between the current and previous periods for the numerator.

(CashQ2 – CashQ1) X 100 CashQ1

Chapter 4Analysis of Financial Statements

Learning Objectives• Understand the purpose of financial

statement analysis.• Perform a vertical analysis of a company’s

financial statements by:– Comparing those accounts on the income

statement as a percentage of net sales and comparing those accounts on the balance sheet as a percentage of total assets for a period of two or more accounting cycles.

– Determining those areas within the company that require additional monitoring and control.

Learning Objectives (continued)– Perform a horizontal analysis of a company’s

financial statements by:• Comparing the percentage change of components on

a company’s income statement and balance sheet for a period of two or more years.

• Determining those areas within the company that require additional monitoring and control.

– Perform ratio analysis of a company and compare those ratios to other companies within the same industry using industry averages.

Learning Objectives (continued)

– Analyze the relationships that exist between the several categories of ratios in determining the health of a business.

– Distinguish between liquidity, activity, leverage, profitability, and market ratios.

– Know how to obtain financial statements and financial information from various sources.

Three Methods of Analyzing Financial Statements

• Vertical analysis• Horizontal analysis• Ratio analysis

Vertical Analysis

• Vertical analysis is the process of using a single variable on a financial statement as a constant and determining how all of the other variables relate as a percentage of the single variable.

Vertical Analysis of an Income Statement

• The vertical analysis of the income statement is used to determine, specifically, how much of a company’s net sales consumed by each individual entry on the income statement.

• Constant is net sales. The formula is:

100$ in Sales Net

$ in Item Statement Income Sales Net of Percentage

Horizontal Analysis

• Horizontal analysis is a determination of the percentage increase or decrease in an account from a base time period to successive time periods.

• The basic formula is:

Percentage Change New time period amount - Old time period amount

Old time period amount100

Gross sales 300,580$ 315,487$ 101.73 4.96Less returns 5,124 9,253 1.73 80.58Net sales 295,456 306,234 100.00 3.65Cost of goods sold 101,250 120,002 34.27 18.52Gross profit 194,206 186,232 65.73 (4.11)Operating expenses Administration 74,983 76,450 25.38 1.96 Advertising 35,214 37,250 11.92 5.78 Overhead 27,120 28,300 9.18 4.35Operating income 56,889 44,232 19.25 (22.25)Interest 7,000 6,250 2.37 (10.71)Earnings before taxes 49,889 37,982 16.89 (23.87)Taxes 7,483 5,697 2.53 (23.87)Net profit 42,406$ 32,285$ 14.35 (23.87)

Horizontal Analysis 2005-

2006 (%)Account Year 2005 Year 2006

Vertical Analysis 2005 (%)

Table 4-1 Sample Income Statement Data

Markadel Retail StoreIncome Statement Data

From January 1 through December 31, 2005 and 2006

Vertical Analysis of a Balance Sheet• Vertical analysis of the balance sheet is

always carried out by using total assets as a constant, or 100 percent, and dividing every figure on the balance sheet by total assets.

• The formula is:

100$in Assets Total

$in ItemSheet Balance Assets Total of Percentage

Table 4-2 Sample Balance Sheet Data

Current assets Cash 10,210$ 8,175$ 4.77 (19.93) Notes receivable 5,280 8,102 2.47 53.45 Accounts receivable 15,320 18,025 7.16 17.66 Inventory 35,020 50,515 16.37 44.25 Total current assets 65,830 84,817 30.77 28.84Fixed assets Land 25,000 25,000 11.69 0.00 Buildings 135,000 135,000 63.10 0.00 Accumulated depreciation (47,000) (50,000) 21.97 6.38 Equipment 58,250 58,250 27.23 0.00 Accumulated depreciation (23,150) (28,150) 10.82 21.60 Total fixed assets 148,100 140,100 69.23 (5.40)Total assets 213,930$ 224,917$ 100.00 5.14

Current liabilities Accounts payable 34,250 40,003 16.01 16.80 Notes payable 25,000 33,035 11.69 32.14 Total current liabilities 59,250 73,038 27.70 23.27Long-term debt Mortgage payable 65,000 63,000 30.38 (3.08) Bank loan payable 10,000 15,000 4.67 50.00 Total long-term debt 75,000 78,000 35.06 4.00Total liabilities 134,250 151,038 62.75 12.51Owner’s equity 79,680 73,879 37.25 (7.28)Total liabilities and owner’s equity 213,930$ 224,917$ 100.00 5.14

Markadel Retail StoreBalance Sheet Data

As of December 31, 2005 and 2006

Category

Horizontal Analysis

2005-2006 (%)

Vertical Analysis 2005 (%)Year 2005 Year 2006

Ratio Analysis

• Ratio analysis is used to determine the health of a business, especially as that business compares to other firms in the same industry or similar industries.

• A ratio is nothing more than a relationship between two variables, expressed as a fraction.

Types of Business Ratios• Liquidity ratios determine how much of a

firm’s current assets are available to meet short-term creditors’ claims.

• Activity ratios indicate how efficiently a business is using its assets.

• Leverage (debt) ratios indicate what percentage of the business assets is financed with creditors’ dollars.

Types of Business Ratios (continued)• Profitability ratios are used by potential

investors and creditors to determine how much of an investment will be returned from either earnings on revenues or appreciation of assets.

• Market ratios are used to compare firms within the same industry. They are primarily used by investors to determine if they should invest capital in the company in exchange for ownership.

Liquidity Ratios

• Current Ratio: The current ratio is calculated by dividing total current assets by total current liabilities.

• The current ratio is given by the following:

sliabilitie Current

Assets Current Ratio Current

Liquidity Ratios (continued)• Quick, or Acid Test, Ratio: This ratio does

not count the sale of the company’s inventory or prepaids. It measures the ability of the firm to meet its short-term obligations without liquidating its inventory.

• The acid test ratio is given by the following:

sliabilitieCurrent

prepaids-inventory - assetsCurrent RatioQuick

Activity Ratios• Inventory turnover ratio (or, simply,

inventory turnover) indicates how efficiently a firm is moving its inventory. It basically states how many times per year the firm moves it average inventory.

• Inventory turnover is given as follows:

Costat Inventory Average

COGS turnover Inventory

2

inventory Ending inventory Beginning inventory Average

Activity Ratios (continued)• Accounts receivable turnover ratio allows

us to determine how fast our company is turning its credit sales into cash.

• Accounts receivable turnover is given by the following:

receivable Accounts

sales Credit turnover receivable Accounts

Activity Ratios (continued)

• Average collection period is the average number of days that it takes the firm to collect its accounts receivable.

• Average collection period is given by the following:

turnover receivable Accounts

yearper Days period collection Average


• Fixed asset turnover ratio indicates how efficiently fixed assets are being used to generate revenue for a firm.

• Fixed asset turnover is given by the following:

assets Fixed

sales Net turnover asset Fixed


• Total asset turnover ratio indicates how efficiently our firm uses its total assets to generate revenue for the firm.

• Total asset turnover is given by the following:

assets Total

sales Net turnover asset Total

Leverage Ratios

• Debt-to-equity ratio indicates what percentage of the owner’s equity is debt.

• Debt-to-equity is given by the following:

orequity sOwner'

sliabilitie Total ratio equity-to-Debt

sliabilitie Total - assets Total

sliabilitie Total ratioequity -to-Debt

Leverage Ratios (continued)

• Debt-to-total-assets ratio indicates what percentage of a business’s assets is owned by creditors.

• Debt-to-total-assets is given by the following:

assets Total

sliabilitie Total ratioasset -total-to-Debt

Leverage Ratios (continued)• Times-interest-earned ratio shows the

relationship between operating income and the amount of interest in dollars the company has to pay to its creditors on an annual basis.

• Times-interest-earned is given by the following:

Interest

income Operating ratio earned-interest-Times

Profitability Ratios

• Gross profit margin ratio is used to determine how much gross profit is generated by each dollar in net sales.

• Gross profit margin is given by the following:

sales Net

profit Gross ratio margin profit Gross

Profitability Ratios (continued)

• Operating profit margin ratio is used to determine how much each dollar of sales generates in operating income.

• Operating profit margin is given by the following:

sales Net

income Operating ratio margin profit Operating

Profitability Ratios (continued)• Net profit margin ratio tells us how much

a firm earned on each dollar in sales after paying all obligations including interest and taxes.

• Net profit margin is given by the following:

sales Net

profit Net ratio margin profit Net

Profitability Ratios (continued)• Operating return on assets ratio is also

referred to as operating return on investment and allows us to determine how much we are actually earning on each dollar in assets prior to paying interest and taxes.

• Operating return on assets is given by the following:

assets Total

income Operating assetson return Operating

Profitability Ratios (continued)• Net return on assets (ROA) ratio is also

referred to as net return on investment and tells us how much a firm earns on each dollar in assets after paying both interest and taxes.

• Net return on assets is given by the following:

assets Total

profitNet ratio assetson return Net

Profitability Ratios (continued)• Return on equity (ROE) ratio tells the

stockholder, or individual owner, what each dollar of his or her investment is generating in net income.

• Return on equity (ROE) is given by the following:

or

equity sOwner'

Profit Net ratio equity on Return

sliabilitie Total - assets Total

ProfitNet ratioequity on Return

Profitability Ratios (continued)

• Return on equity (ROE) can also use the relationship between the return on assets and the amount of debt to assets. It can be expressed with the following formula:

AssetsDebt

-1

ROA ratioequity on Return

Market Ratios• Earnings per share ratio is nothing more

than the net profit or net income of the firm, less preferred dividends (if the company has preferred stock), divided by the number of shares of common stock outstanding (issued).

• Earnings per share is given by the following:

shares common of Number

dividends Preferred - income Net ratio share per Earnings

Market Ratios (continued)• Price earnings ratio is a magnification of

earnings per share in terms of market price of stock.

• Price earnings ratio is given by the following:

share per Earnings

stock of price Market ratio earnings Price

Market Ratios (continued)

• Operating cash flow per-share ratio compares the operating cash flow on the statement of cash flows to the number of shares of common stock outstanding.

goutstandinstock of sharesCommon

flowcash Operating shareper flowcash Operating

Vertical Vertical

Category 2005 Analysis 2005 2006 Analysis 2006

Current assets 7,000,000$ 46.67% 9,000,000$ 60.00%Total fixed assets 8,000,000 53.33% 6,000,000 40.00%Total assets 15,000,000 100.00% 15,000,000 100.00%

Current liabilities 3,000,000$ 20.00% 1,000,000$ 6.67%Long-term debt 4,000,000 26.67% 4,000,000 26.67%

Owner’s equity 8,000,000 53.33% 10,000,000 66.67%

Total liabilities & owner’s equity 15,000,000$ 100.00% 15,000,000$ 100.00%

Table 4-3 Balance Sheet, Sample Company

Current assets 7,000,000$ 9,000,000$ 28.57%Total fixed assets 8,000,000 6,000,000 -25.00%Total assets 15,000,000 15,000,000 0.00%

Current liabilities 3,000,000$ 1,000,000$ -66.67%Long-term debt 4,000,000 4,000,000 0.00%

Owner’s equity 8,000,000 10,000,000 25.00%

Total liabilities & owner’s equity 15,000,000$ 15,000,000$ 0.00%

Table 4-4 Sample Balance Sheet

20062005Horizontal

Analysis

CONSOLIDATED BALANCE SHEETS

In thousands, except share data Oct 2, 2005 Oct 3, 2004

173,809$ 145,053$ 95,379 483,157 37,848 24,799

190,762 140,226 546,299 422,663

94,429 71,347 70,808 63,650

Total current assets 1,209,334 1,350,895 60,475 135,179

201,461 167,740 1,842,019 1,551,416

72,893 85,561 35,409 26,800 92,474 68,950

3,514,065$ 3,386,541$

220,975$ 199,346$ 232,354 208,927

44,496 29,231 78,293 62,959

277,000 —

198,082 123,684

175,048 121,377 748 735

Total current liabilities 1,226,996 746,259 — 21,770

2,870 3,618 193,565 144,683

90,968 956,685 39,393 39,393

1,939,359 1,444,892 20,914 29,241

Total shareholders’ equity 2,090,634 2,470,211

3,514,065$ 3,386,541$

Fiscal Year Ended

Current assets:

InventoriesPrepaid expenses and other current assetsDeferred income taxes, net

Cash and cash equivalentsShort-term investments — available-for-sale securitiesShort-term investments — trading securitiesAccounts receivable, net of allowances of $3,079 and

Long-term investments — available-for-sale securitiesEquity and other investmentsProperty, plant and equipment, netOther assets

Current liabilities:

Other intangible assetsGoodwill

TOTAL ASSETS

Accounts payableAccrued compensation and related costsAccrued occupancy costsAccrued taxesShort-term borrowingsOther accrued expenses

Deferred revenue

Current portion of long-term debt

Retained earnings

Deferred income taxes, netLong-term debtOther long-term liabilities

Table 4-5 Starbucks Corporation Consolidated Balance Sheet*

LIABILITIES AND SHAREHOLDERS’ EQUITY

ASSETS

Accumulated other comprehensive income

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

Shareholders’ equity:Common stock ($0.001 par value) and additional paid-in capital — authorized, 1,200,000,000 shares; issued and outstanding, 767,442,110 and 794,811,688 shares, respectively, (includes 3,394,200 common stock units in Other additional paid-in capital

Table 4-6 Starbucks Corporation Consolidated Statement of EarningsCONSOLIDATED STATEMENTS OF EARNINGS In thousands, except earnings per share

2-Oct-05 Oct 3, 2004 Sept 28, 2003

5,391,927$ 4,457,378$ 3,449,624$

Licensing 673,015 565,798 409,551 Foodservice and other 304,358 271,071 216,347

977,373 836,869 625,898

6,369,300 5,294,247 4,075,522 2,605,212 2,191,440 1,681,434 2,165,911 1,790,168 1,379,574

197,024 171,648 141,346 340,169 289,182 244,671 357,114 304,293 244,550

5,665,430 4,746,731 3,691,575 76,745 59,071 36,903

780,615 606,587 420,850 15,829 14,140 11,622

796,444 620,727 432,472 301,977 231,754 167,117

Net earnings 494,467$ 388,973$ 265,355$ 0.63$ 0.49$ 0.34$ 0.61$ 0.47$ 0.33$

Basic 789,570 794,347 781,505 Diluted 815,417 822,930 803,296

Fiscal Year Ended

Total specialty

Net revenues:Company-operated retailSpecialty:

Other operating expensesDepreciation and amortization General and administrative expenses

Total net revenuesCost of sales including occupancy Store operating expenses

Subtotal operating expenses

Earnings before income taxesIncome taxes

Operating incomeInterest and other income, net

Income from equity investees

Source: Securities and Exchange Commission, Washington DC, Edgar Online, Form 10-K, Filing Date: 12/16/2005.

Net earnings per common share — Net earnings per common share — Weighted average shares outstanding:

CONSOLIDATED STATEMENT OF CASH FLOWS In thousands

Oct 2, 2005 Oct 3, 2004 Sept 28, 2003

494,467$ 388,973$ 265,355$

367,207 314,047 266,258 20,157 13,568 7,784

(31,253) (3,770) (6,767) (49,633) (31,801) (21,320) 30,919 38,328 28,966

109,978 63,405 36,590 10,097 11,603 5,996

Accounts receivable (49,311) (24,977) (8,384) Inventories (121,618) (77,662) (64,768) Accounts payable 9,717 27,948 24,990 Accrued compensation and related costs 22,711 54,929 42,132 Deferred revenue 53,276 47,590 30,732 Other operating assets and liabilities 56,894 36,356 8,554

923,608 858,537 616,118

(643,488) (887,969) (481,050) 469,554 170,789 218,787 626,113 452,467 141,009 (21,583) (7,515) (69,928)

(7,915) (64,747) (47,259) (643,989) (412,537) (377,983)

(221,308) (749,512) (616,424)

163,555 137,590 107,183 277,000 — —

(735) (722) (710) (1,113,647) (203,413) (75,710)

(673,827 (66,545) 30,763 283 3,111 3,278

28,756 45,591 33,735

145,053 99,462 65,727

173,809$ 145,053$ 99,462$

1,060$ 370$ 265$ 227,812$ 172,759$ 140,107$ Income taxes

Source: Securities and Exchange Commission, Washington DC, Edgar Online, Form 10-K, Filing Date: 12/16/2005.www.sec.gov

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATIONCash paid during the year for:

Interest

End of period

Net increase in cash and cash equivalentsCASH AND CASH EQUIVALENTSBeginning of period

Effect of exchange rate changes on cash and cash equivalentsNet cash provided/(used) by financing activities

Borrowings under revolving credit facilityPrincipal payments on long-term debtRepurchase of common stock

Net cash used by investing activitiesFINANCING ACTIVITIES

Proceeds from issuance of common stock

Net additions to property, plant and equipment

Maturity of available-for-sale securitiesSale of available-for-sale securitiesAcquis itions, net of cash acquiredNet additions to equity investments, other investments and other assets

Adjustments to reconcile net earnings to net cash provided by operating activities:Depreciation and amortizationProvis ion for impairments and asset disposalsDeferred income taxes, net

Table 4-7 Starbucks Corporation Consolidated Statement of Cash Flows*

Fiscal Year Ended

OPERATING ACTIVITIESNet earnings

Cash provided/(used) by changes in operating assets and liabilities:

Purchase of available-for-sale securities

Equity in income of investeesDistributions of income from equity investeesTax benefit from exercise of nonqualified stock optionsNet accretion of discount and amortization of premium on marketable securities

Net cash provided by operating activitiesINVESTING ACTIVITIES

Chapter 5Profit, Profitability, and

Break-Even Analysis

Learning Objectives• Understand the difference between

efficiency and effectiveness.• Distinguish between profit and profitability.• Compare accounting and entrepreneurial

profit.• Understand the relationship of profit margin

and asset turnover on the earning power of a company.


• Given the variable costs, revenue, and fixed costs of a business, determine the break-even point and contribution margin.

• Construct and analyze a break-even chart when given variable costs, revenue, and fixed costs of a business.


• Understand the use of leverage and its relationship to profitability and loss.

• Distinguish between Chapters 11, 13, and 7 bankruptcy.

• Compare and contrast the degree of operating, financial, and combined leverage and their effect on the profitability of a corporation.

Efficiency and Effectiveness

• Efficiency is obtaining the highest possible return with the minimum use of resources.

• Effectiveness, on the other hand, is accomplishing a specific task or reaching a goal.

Profit Versus Profitability• Profit is an absolute number that is earned

on an investment. – Accounting profit, for a business, is typically

shown at the bottom of an income statement as net income.

– Entrepreneurial profit is the amount that is earned above and beyond what the entrepreneur would have earned if he or she had chosen to invest time and money in some other enterprise.

Profit Versus Profitability (continued)

• Profitability can be measured in a business by using a ratio that is obtained by dividing net profit by total assets. Profitability, therefore, is our Return on Assets.

Earning Power

• The earning power of a company can be defined as the product of two factors: – The company’s ability to generate income on

the amount of revenue it receives, which is also known as net profit margin; and

– Its ability to maximize sales revenue from proper asset employment, also known as total asset turnover.

Earning Power Formulas

• Earning power is equal to net profit margin multiplied by total asset turnover which is equal to return on investment (total assets).

assets Total

sales Net x

sales Net

(income) profit Net

turnover asset Total x margin profit Net power Earning

assets Total

(income) profit Net power Earning

Break-Even Analysis• Break-even analysis is a process of

determining how many units of production must be sold, or how much revenue must be obtained, before we begin to earn a profit.

• For break-even quantity:

VC- P

FC BEQ

Cost Category Payment Basis Cost ($)

Rent Monthly 2000.00Salaries Monthly 5000.00Employee benefits Annually 7000.00Insurance Quarterly 1500.00Property taxes Annually 3000.00Wood Per truck 1.25Paint and finishing Per truck 0.25Labor Per truck 2.50Packing and shipping Per truck 2.00

Table 5-1 Cost Data for Carl’s Toy Trucks

Break-Even Analysis (continued)

• Break-even dollars:

Where VC is variable cost expressed as a percentage of sales (revenue).– For retail firm: VC percentage =(Cost of

Goods Sold)/(Net Sales)– For manufacturing firm: VC percentage =

(Variable cost of a unit)/(Selling price)

P

VCFC

BE

1

$

Break-Even Analysis (continued)

• Contribution margin is the amount of profit that will be made by a company on each unit that is sold above and beyond the break-even quantity.

• Contribution margin is also the amount the company will lose for each unit of production by which it falls short of the break-even point.

Profit and Break-Even• Desired profit with break-even analysis in

quantity to produce.

– VC is variable cost per unit• Desired profit with break-even analysis in

dollars.

– VC is a percentage of sales dollar (e.g., cost of goods sold as a percent).

VC - P

profit Desired FC quantity Total

dollar) sales theof percentage a (as VC-1

profit Desired $

FCBE

Break-Even Charts

Figure 5-1 Break-Even Chart for Carl's Toy Trucks

0

100

200

300

400

500

600

700

0 10 20 30 40 50 60 70

Units Sold in Thousand (000)

Do

llars

in T

ho

usa

nd

s (0

00)

Total Revenue

Total Cost = FC + VC

Break-Even Point

Fixed Costs (FC)

LossArea

Profit Area

Leverage

• Leverage uses those items that have a fixed cost to magnify the return to a company. Fixed costs can be related to company operations or related to the cost of financing.– Interest expenses paid on the amount of debt

incurred is the fixed cost of financing.– A firm is heavily financially leveraged if the

fixed costs of financing are high.

Leverage (continued)

• Degree of operating leverage (DOL) is the percentage change in operating income divided by the percentage change in sales.

salesin change Percentage

income operatingin change Percentage DOL


• Degree of financial leverage (DFL) is the percentage change in earnings per share divided by the percentage change in operating income.

income operatingin change Percentage

shareper earningsin change Percentage DFL


• Degree of combined leverage (DCL) is the percentage change in earnings per share divided by the percentage change in sales.

sales change Percentage

shareper earningsin change Percentage DCL

income operatingin change Percentage

shareper earningsin change Percentage

salesin change Percentage

income operatingin change Percentage DCL x

Chapter 7

Working Capital Management

Learning Objectives

• Understand the general concept of working capital management.

• Describe the asset categories that are included in working capital management.

• Determine the methods of managing disbursement and collection of cash to increase business profitability.

• Understand how a business balances extending credit and its ability to manage increased accounts receivable.

Learning Objectives (continued)• Explain how accounts receivable are analyzed.• Understand the role that proper inventory

management plays in the profitability of a business enterprise.

• Understand how a business’s current liabilities are managed.

• Understand the relationship of accrued liabilities management and obligations to federal and local government agencies.

• Understand the relationship of trade and cash discounts to the minimization of accounts payable.

Working Capital• Working capital consists of the current

assets and the current liabilities of a business.

• Current assets are gross working capital.– Cash, marketable securities, accounts

receivable, and inventory

• Net working capital is the difference between a business’s total current assets and its total current liabilities.

Working Capital Management

• Working capital management is our ability to effectively and efficiently control current assets and current liabilities in a manner that will provide our firm with maximum return on its assets and will minimize payments for its liabilities.

Current Asset Management

• Cash management• Marketable securities management• Accounts receivable management• Inventory management

Cash Management

• The goal of cash management is to obtain the highest return possible on cash. Cash consists of:– Petty cash– Cash on hand– Cash in bank, checking– Cash in bank, savings

Cash Management (continued)• Float

– The disbursement float is the time that elapses between payment by check and the check’s actually clearing the bank, at which point funds are removed from our checking account.

– Collections float is the amount of time that elapses between your depositing a debtor’s check in your account and the check’s clearing, at which point the funds are actually placed in your account.

Cash Management (continued)

• Float (continued)– Managing collection float:

• A lockbox is a post office box that is opened by an agent of the bank, and checks received there are immediately deposited in our account.

• Electronic funds transfer is accomplished when funds are immediately transferred from one bank account to another via computer.

Marketable Securities Management

• Marketable securities normally are those investment vehicles that include U.S. treasury bills, government and corporate bonds, and stocks.

• Excess cash should be placed in the above vehicles because they increase in value more than cash itself.

Accounts Receivable Management

• The goal of accounts receivable management is to increase sales by offering credit to customers. – Options to offering credit include:

• The business issuing its own credit card or line of credit.

• Factoring—selling accounts receivable to another firm at a discount off of the original sales price.

Accounts Receivable Management (continued)

• The 3 C’s of credit:– A customer’s character is favorable if that

customer has paid his or her bills on time in the past and has favorable credit references from other creditors.

– Capacity to pay refers to whether the customer has enough cash flow or disposable income to pay back a loan or pay off a bill.

– Collateral is the ability to satisfy a debt or pay a creditor by selling assets for cash.


• Credit terms are the requirements that our business establishes for payment of a loan (the use of credit by a customer). – To speed up collections, cash discounts are

often offered to a business customer. An example would be 2/10 net 30. If the customer pays the bill within 10 days of the invoice a 2 percent discount is given. Otherwise the entire net is due 20 days later or at the 30th day.


• Analyzing accounts receivable:– Accounts receivable turnover:

– Example:

– Collection days is 365 days in a year divided by accounts receivable turnover:

receivable Accounts

Sales Credit turnover recievable Accounts

6$50,000

$300,000 turnover recievable Accounts

daysdays 61833.60 6

365 days Collection

• Use of collection days:– If collection days exceed our credit terms, then

we have to speed up collections.• Example: If we give terms of 30 days and we collect

in 61 days as previously shown, then we have to speed up collections in order to better manage accounts receivable. We may also have to re-evaluate our credit policies.

– If collection days are less then our terms, then we have increased our liquidity. May also consider loosening credit policy.


• Aging of accounts receivable is accomplished by determining the amounts of accounts receivable, the various lengths of time for which these accounts have been due, and the percentage of accounts that falls within each time frame.


Table 7-1 Aging of Accounts Receivable

Customer Outstanding

Balance Days

Outstanding1 5,000$ 302 7,000 453 15,000 304 12,000 705 8,000 906 15,000 607 6,000 1208 10,000 1009 13,000 45

10 9,000 90

Total 100,000$

Customer 0–30 31–60 61–90 90+

1 5,000$ 2 7,000$ 3 15,000 4 12,000$ 5 8,0006 15,0007 6,000$ 8 10,0009 13,00010 9,000

Totals 20,000$ 35,000$ 29,000$ 16,000$

PercentageOutstanding 20% 35.00% 29.00% 16.00%

Aging Schedule

Days Outstanding

Inventory Management• The overall goal of inventory management

is to minimize total inventory costs while maximizing customer satisfaction.

• Two primary decisions must be made:– Establish the reorder quantity (the number of

items to order) – Establish the reorder point (that level of

inventory at which a new order will be placed).

• Economic Order Quantity Formula:– Attempts to balance ordering costs against

storage costs and provide us with the most economic quantity to order to minimize overall inventory costs.

– Where

Inventory Management (continued)

IP

DSEOQ

2


– Determining EOQ with quantity discounts requires the following procedures:• Compute EOQ for each discounted price.• If the computed EOQ falls within the discounted

quantity area, then order the EOQ.• If the EOQ does not fall within the discounted

quantity area, then compute total inventory costs.• Order the minimum quantity that provides the

lowest overall total inventory costs.

Warehouse storage cost (I) = 0.40Ordering cost (S) = 10.00$ Annual demand (D) = 16,000

PriceDiscount Quantity

EOQQuantity to Order

Total Cost

20.00$ 0–500 200.00 200 321,600.00$ 19.00$ 501–1,000 205.20 501 306,223.16$ 18.90$ Over 1,000 205.74 1,001 306,343.62$

Table 7-2 EOQ with Quantity Discounts

Total costs for each quantity

20.205)19)($40.0(

)10)($000,16)(2(2

IP

DSEOQ

16.223,306$501

)10)($000,16(

2

)19.$)($0)(501()19)($000,16(

2

TC

Q

DSQIPDPTC


• Reorder Point Calculations – The reorder point (ROP) has three factors that

are used in determining the quantity of an item that exists when we actually place an order:• Lead-time (L) is the time that lapses from order

placement to order receipt.• Daily demand (d) is the quantity of a product that is

used per day. • Safety Stock (ss) the quantity of stock you keep for

variations in demand.

ssLdROP

Current Liabilities Management• Current liabilities management consists

of minimizing our obligations and payments for short-term debt, accrued liabilities, and accounts payable. It consists of:– Short-term debt management– Accrued liabilities management (servicing

long-term debt)– Accounts payable management

Current Liabilities Management (continued)

• Short-term debt management– Short-term debt consists of business

obligations that will be paid within the current accounting period. They consist of the following:• Current payments on long-term debt• Bank lines of credit• Notes payable • Accounts payable • Short-term loan for one year or less

Current Liabilities Management (continued)

• Lines of credit:– A line of credit is similar to a credit card.

• With it, we obtain a credit limit, but we are not obligated to make payments unless we actually borrow the money.

• A line of credit is normally obtained from our primary bank.

• A line of credit is used when our cash outflow exceeds our cash inflow.

Accrued Liabilities Management (continued)

• Accrued liabilities are those obligations of the firm that are accumulated during the normal course of business and are primarily payroll taxes and benefits, property taxes, and sales taxes.

Accounts Payable Management

• Accounts payable are the debts of a business which are owed to vendors. Vendors offer several types of discounts. They are: – Trade discounts– Cash discounts– Quantity discounts

Accounts Payable Management (continued)

• Trade discounts are amounts deducted from list prices of items when specific services are performed by the trade customer. – Trade discounts may be expressed as a single

amount, such as 30 percent, or in a series, such as 30/20/10.


• Trade discount examples– 2/10 net 30 - buyer must pay within 30 days of the invoice date, but will

receive a 2% discount if they pay within 10 days of the invoice date.– 3/7 EOM - buyer will receive a cash discount of 3% if the bill is paid

within 7 days after the end of the month indicated on the invoice date.– 3/7 EOM net 30 - buyer must pay within 30 days of the invoice date, but

will receive a 3% discount if they pay within 7 days after the end of the month indicated on the invoice date

– 2/15 net 40 ROG - buyer must pay within 40 days of receipt of goods, but will receive a 2% discount if paid in 15 days of the invoice date.

– Trade discounts may be expressed as a single amount, such as 30 percent, or in a series, such as 30/20/10.


• Calculation of trade discounts:– Calculation of trade discounts can be

accomplished by moving backward from the list price.

$210($300x0.3)-$300

Price Discounted discount trade - price List

$168$42-$210($210x0.2) -$210

$151.20$16.80-$168($168x0.1) -$168


• Calculation of trade discounts (continued)– The net cost rate factor is the actual

percentage of the list price paid after taking all successive trade discounts—50.4 percent in this case.

– One minus the net cost rate factor is the single equivalent discount.


• Calculation of trade discounts (continued)– A second simpler way of determining the net

cost rate factor and the invoice price is to multiply the complements of the trade discounts as shown below:

0.504(0.9)(0.7)(0.8) factor rate cost Net

0.90.1-1 complement Third

0.80.2-1 complement Second

0.7.03-1 complement First


• Calculation of trade discounts (continued)– The invoice price (the price that you actually

pay the vendor) can be simply calculated by the following formula:

20.151$)504.0)(300($ price Invoice

factor ratecost net x priceList price Invoice


• Cash discounts are offered to credit customers to entice them to pay promptly. – The seller views a cash discount as a sales discount. – The customer views it as a purchase discount. – The terms of a cash discount play an important role in

determining how the invoice will be paid.

• “Preferred payment” method discount– Some retailers (particularly small retailers with low

margins) offer discounts to customers paying with cash, to avoid paying fees on credit card transactions.


• Cash discounts will normally appear on an invoice in terms such as 2/10 n30. – This means that the customer may deduct 2 percent off

of the invoice price if he or she pays within 10 days. – If the customer does not pay within 10 days, he has the

use of 98% of the money owed for the next 20 days.– If the customer pays within 30 days, the net, or total

amount, of the invoice is due.– If he or she pays after 30 days, the credit agreement

with the seller normally stipulates that a monthly interest charge be added to the unpaid balance.


• Calculations used in cash discounts:– A $10,000 invoice with terms of 2/10 n30– Option 1: Pay off the $10,000 with a payment

of $9,800 within 10 days of the invoice date. • This is computed by multiplying the invoice price

by 1 minus the discount (1 - 0.02 = 0.98, and $10,000 x 0.98 = $9,800).

• Or by taking the invoice price times the discount and subtracting it from the invoice price ($10,000 x 0.02 = $200, and $10,000 - $200 = $9,800).


• Calculations used in cash discounts (continued):– A $10,000 invoice with terms of 2/10 n30– Option 2: Pay the invoice price of $10,000 on

the 30th day after the invoice date. If this option is chosen, he will pay the equivalent of 36.7 percent annual interest because of his delaying payment. The logic is shown on the following page.


• Calculations used in cash discounts (continued):– $200 is the cost paid on $9,800 for 20 days, or

an interest rate of 2.04 percent ([$200 $9,800] x 100).

– This will result in an effective annual interest rate of 36.7 percent (2.04 x [360 20days]).

– The effective annual interest rate is obtained by multiplying the time period interest rate by the number of time periods in an accounting year (360 20).


• Quantity discounts are offered by vendors to increase their own cash flow when they offer discounts to customers who purchase items in large quantities.

Item Number Quantity Unit Cost10010 1–99 15.00$

100–499 14.50 500–999 14.00

Table 7-5 Quantity Discounts

Capital budgeting

Chapter 10

Adelman & Marks

Key terms

• Capital budgeting– The method used to justify the acquisition of

capital goods

• Capital goods– Assets that have a useful life greater than 1 year

Why capital budgeting?

• A company should make the decision to enter into a specific project, acquire another company, or purchase a specific long-term asset if the present value of the benefits exceeds the the present value of the costs.

• Remember that assets are tools your business uses to help generate revenues

• Example: Capital budgeting helps a business to make the most profitable decisions regarding purchase of delivery vehicles.

Factors Affecting Capital Budgeting

• Changes in regulations (CFC banned in air conditioning)

• Research and Development investments (half of all new products fail)

• Changes in business strategy (when economy changes or opportunities/threats arise

Five Steps in Capital Budgeting

1. Write a proposal that identifies projected costs and benefits

2. Evaluate the data with respect to expected benefits and costs

3. Make a decision that provides greatest value while minimizing costs

4. Follow up on decision through post-audit to compare costs to benefits

5. Take corrective action if post-audit indicates benefits are not meeting expectations

Costs in capital budgeting

• Start-up costs – total $ spent to start a project (equipment, training costs, maintenance, service agreements, hiring new people, storage space, etc)

• Working capital costs – cash, investments, A/R, and inventory to show bank you can make monthly payments ($ is legally committed to lender, so it’s an opportunity cost)

• Tax factor costs – additional taxes that have to be paid

Benefits in capital budgeting

• Investments in capital equipment should increase cash flows

• Capital equipment investments can be written off and provide reduced tax liability

• MACRS! (see MACRS worksheet)

Techniques

• Payback• Net present value (NPV)• Profitability index (PI)• Internal rate of return (IRR)• Accounting rate of return (ARR)• Lowest total cost (LTC)

Payback

• # of years it takes to get back the money it invested in project or asset

• Payback = C / ATB– C = cost of project– ATB = annual after-tax benefit of project

• Example – invest in $25,000 project that creates $3,000 in ATB

• Payback occurs in $25,000/$3,000 = 8.33 yrs

Net present value

• Uses time value of $ by discounting future costs and benefits to present

• Combines:– PV of stream of payments for even cash flows and– PV of future lump sum of unequal yearly cash flows

• Important considerations – (1) interest rate of lender and (2) interest rate you could make by investing in some other project or asset

Weighted Average Cost of Capital

• Multiplies cost of debt by its proportion of total funds raised and multiplies cost of equity (opportunity cost to owner) by its proportion of total funds raised

• Key terms:– Real rate of return (return received after factoring out

inflation)– Inflation premium (expected average inflation for term

of investment)– Risk premium (rate added to interest rate to account for

risk of investment) (see Techniques)

Getting to NPV

• NPV = PVB - PVC• NPV is net present value of investment• PVB is present value of the benefit• PVC is present value of the cost of the

investment• If NPV is negative, do not make the

investment (see example)

Profitability Index

• PI = PVB / PVC• From example: $170,394/$100,000 = 1.70• This project returns $1.70 for every $1

invested

Accounting rate of return

• ARR = (average annual income)/(average cost of investment over its life)

• Does not incorporate time value of $• Example: spend $10,000 on software that

will help you earn $3,000/yr for 4 yrs• ARR = $3,000/$10,000 = 30%

Lowest total cost

• Include all costs associated with two or more competing investments

• Calculate PVs of these costs• Add the present value of any residual

benefits (salvage value) that investment can provide

• Select investment with lowest total cost

Recommendations

• Use NPV for new projects or assets• For existing operations (replacing

equipment and service contracts) use LTC

new venture development

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