p1-introducton to finman (1)

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Financial Management:An Introduction

Columban College

1st Semester AY 2011-12

The following slides are benchmarked from Prof. Joel Yu of University of the Philippines –

Diliman.

Outline

• Finance: Overview• Financial Statements• Financial Ratio Analysis• Financial Planning

Main Reference: Gitman, Lawrence, Principles of Managerial Finance, 12th edition

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Finance: An Overview What is Finance? Major Areas in Finance Finance & Economics Finance & Accounting Goal of the firm

What is Finance?• Finance is the art and science of managing

money.• At the macro level, finance studies financial

institutions and markets and how they operate within the financial system.

• At the micro level, finance covers financial planning, asset management, and fund raising for businesses and financial institutions.

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What is Finance?

Source: Gitman, Lawrence, Principles of Managerial Finance, 12th edition

What is Finance?


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Major Areas & Opportunities in Finance

• Financial Services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and government.

• Career opportunities include banking, personal financial planning, investments, real estate, and insurance.

Major Areas & Opportunities in Finance

• Managerial finance is concerned with the duties of the financial manager in the business firm.

• The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit.

• They are also more involved in developing corporate strategy and improving the firm’s competitive position.

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The Managerial Finance Function: Relationship to Economics

• The field of finance is actually an outgrowth of economics.

• In fact, finance is sometimes referred to as financial economics.

• Financial managers must understand the economic framework within which they operate in order to react or anticipate to changes in conditions.

The Managerial Finance Function: Relationship to Economics (cont.)

• The primary economic principle used by financial managers is marginal cost-benefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs.

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The Managerial Finance Function: Relationship to Accounting

• The firm’s finance (treasurer) and accounting (controller) functions are closely-related and overlapping.

• In smaller firms, the financial manager generally performs both functions.

The Managerial Finance Function: Relationship to Accounting (cont.)

• One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows.

• The significance of this difference can be illustrated using the following simple example.

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• The Nassau Corporation experienced the following activity last year:

• Now contrast the differences in performance under the accounting method versus the cash method.

Sales $100,000 (1 yacht sold, 100% still uncollected)

Costs $ 80,000 (all paid in full under supplier terms)

INCOME STATEMENT SUMMARY

ACCRUAL CASH

Sales $100,000 $ 0

Less: Costs (80,000) (80,000)

Net Profit/(Loss) $ 20,000 $(80,000)


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• Finance and accounting also differ with respect to decision-making.

• While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making purposes.

• The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.

Investment Year 1 Year 2 Year 3 Total (years 1-3)Rotor 1.40$ 1.00$ 0.40$ 2.80$ Valve 0.60$ 1.00$ 1.40$ 3.00$

Earnings per share (EPS)

Which Investment is Preferred?Goal of the Firm: Maximize Profit???

• Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.

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level & timing of cash flows

risk of cash flows

Goal of the Firm: Maximize Shareholder Wealth!!!

• Why?• Because maximizing shareholder wealth properly

considers cash flows, the timing of these cash flows, and the risk of these cash flows.

• This can be illustrated using the following simple stock valuation equation:

Return RequiredDividends FuturePrice Share

Goal of the Firm: Maximize Shareholder Wealth!!! (cont.)

• The process of shareholder wealth maximization can be described using the following flow chart:

Figure 1.3 Share Price Maximization

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Goal of the Firm: What About Other Stakeholders?• Stakeholders include all groups of individuals who have

a direct economic link to the firm including employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm.

• The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of its stakeholders.

• Such a view is considered to be "socially responsible."

The Agency Issue: The Agency Problem

• Whenever a manager owns less than 100% of the firm’s equity, a potential agency problem exists.

• In theory, managers would agree with shareholder wealth maximization.

• However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle.

• This would cause managers to act in ways that do not always benefit the firm shareholders.

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The Agency Issue: Resolving the Problem

• Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check.

• Agency Costs are the costs borne by stockholders to maintain a corporate governance structure that minimizes agency problems and contributes to the maximization of shareholder wealth.

The Agency Issue: Resolving the Problem (cont.)

• Examples would include bonding or monitoring management behavior, and structuring management compensation to make shareholders interests their own.

• A stock option is an incentive allowing managers to purchase stock at the market price set at the time of the grant.

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The Agency Issue: Resolving the Problem (cont.)

• Performance plans tie management compensation to measures such as EPS growth; performance shares and/or cash bonuses are used as compensation under these plans.

• Recent studies have failed to find a strong relationship between CEO compensation and share price.

Financial Statements Income Statement Balance Sheet Statement of R/E Cash Flow Statement

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Financial Statements

• The income statement provides a financial summary of a company’s operating results during a specified period.

• Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

Income Statement


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• The balance sheet presents a summary of a firm’s financial position at a given point in time.

• Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

Balance Sheet


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• The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

Statement of Retained Earnings

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• The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended.

• This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

Cash Flow Statement

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Financial Ratio Analysis Types of ratio comparisons An example Dupont system of analysis Cautions for doing financial ratio

analysis

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Financial Ratio Analysis

Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.

It is of interest to shareholders, creditors, and the firm’s own management.

Trend or time-series analysis

Used to evaluate a firm’s performance over time

Types of Ratio Comparisons


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Trend or time-series analysis Cross-sectional analysis

Used to compare different firms at the same point in time




Industry comparative analysis

One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance



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Industry comparative analysis

Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis




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Financial Ratio Analysis: An Example

Using the Bartlett Company Financial Statements

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Liquidity Ratios• Current Ratio

Current ratio = total current assetstotal current liabilities

Current ratio = $1,233,000 = 1.97$620,000

Quick Ratio

Quick ratio = Total Current Assets - Inventorytotal current liabilities

Quick ratio = $1,233,000 - $289,000 = 1.51$620,000

Liquidity Ratios

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Inventory Turnover

Inventory Turnover = Cost of Goods SoldInventory

Inventory Turnover = $2,088,000 = 7.2$289,000

Activity Ratios

Average Collection Period

ACP = Accounts ReceivableNet Sales/365

ACP = $503,000 = 59.7 days$3,074,000/365

Activity Ratios

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APP = Accounts PayableAnnual Purchases/365

Average Payment Period

APP = $382,000 = 95.4 days(.70 x $2,088,000)/365

Activity Ratios

Total Asset Turnover

Total Asset Turnover = Net SalesTotal Assets

Total Asset Turnover = $3,074,000 = .85$3,579,000

Activity Ratios

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Debt Ratio = Total Liabilities/Total Assets

Debt Ratio

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

Financial Leverage Ratios

Times Interest Earned Ratio

Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5


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Fixed-Payment coverage Ratio (FPCR)

FPCR = EBIT + Lease Payments Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR = $418,000 + $35,000 = 1.9$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}


Common-Size Income Statements

Profitability Ratios

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GPM = Gross Profit/Net Sales

Gross Profit Margin

GPM = $986,000/$3,074,000 = 32.1%


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Operating Profit Margin

OPM = EBIT/Net Sales

OPM = $418,000/$3,074,000 = 13.6%


Net Profit Margin

NPM = Net Profits After Taxes/Net Sales

NPM = $221,000/$3,074,000 = 7.2%


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Return on Total Assets (ROA)

ROA = Net Profits After Taxes/Total Assets

ROA = $221,000/$3,597,000 = 6.1%


ROE = Net Profits After Taxes/Stockholders Equity

Return on Equity (ROE)

ROE = $221,000/$1,754,000 = 12.6%


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EPS = Earnings Available to Common StockholdersNumber of Shares Outstanding

Earnings Per Share (EPS)

EPS = $221,000/76,262 = $2.90


P/E = Market Price Per Share of Common StockEarnings Per Share

Price Earnings (P/E) Ratio

P/E = $32.25/$2.90 = 11.1

Market Ratios

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Market Ratios

• Market-to-Book RatioBV/Share = Common Stock Equity

Number of Shares of Common Stock BV/Share = $1,754,000/72,262 = $23.00

M/B Ratio = Market Price/Share of Common StockBook Value/Share of Common Stock

M/B Ratio = $32.25/$23.00 = 1.40

Summarizing All Ratios

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Summarizing All Ratios

DuPont System of Analysis

• The DuPont system is used to dissect the firm’s financial statements and to assess its financial condition.

• It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE

• The advantage of the DuPont system is that it allows you to break ROE into a profit on sales component, an efficiency-of-asset-use component, and a use-of-leverage component.

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DuPont System of Analysis

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Ratios must be considered together; a single ratio by itself means relatively little.

Financial statements that are being compared should be dated at the same point in time.

Use audited financial statements when possible.

The financial data being compared should have been developed in the same way.

Be wary of inflation distortions.

Cautions for Doing Ratio Analysis

Financial Planning The financial planning process Profit planning Cash Planning

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Financial planning involves guiding, coordinating, and controlling the firm’s actions to achieve its objectives.

Two key aspects of financial planning are cash planning and profit planning.

Cash planning involves the preparation of the firm’s cash budget.

Profit planning involves the preparation of both cash budgets and pro forma financial statements.

The Financial Planning Process

Pro forma financial statements are projected, or forecast, financial statements - income statements and balance sheets.

The inputs required to develop pro forma statements using the most common approaches include: financial statements from the preceding year the sales forecast for the coming year key assumptions about a number of factors


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Cash Planning

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Cash Planning: Cash Budgets• The cash budget or cash forecast is a statement of the firm’s

planned inflows and outflows of cash.• It is used to estimate short-term cash requirements with particular

attention to anticipated cash surpluses and shortfalls.

• Surpluses must be invested and deficits must be funded.• The cash budget is a useful tool for determining the timing of cash

inflows and outflows during a given period.• Typically, monthly budgets are developed covering

a 1-year time period.

Cash Planning: Cash Budgets• The cash budget begins with a sales forecast, which is

simply a prediction of the sales activity during a given period.

• A prerequisite to the sales forecast is a forecast for the economy, the industry, the company and other external and internal factors that might influence company sales.

• The sales forecast is then used as a basis for estimating the monthly cash inflows that will result from projected sales—and outflows related to production, overhead and other expenses.

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Cash Planning: Cash Budgets• General Format of a Cash Budget

Cash Planning: Cash Budgets An Example: Coulson Industries• Coulson Industries, a defense contractor, is developing a cash

budget for October, November, and December. Halley’s sales in August and September were $100,000 and $200,000 respectively. Sales of $400,000, $300,000 and $200,000 have been forecast for October, November, and December. Historically, 20% of the firm’s sales have been for cash, 50% have been collected after 1 month, and the remaining 30% after 2 months. In December, Coulson will receive a $30,000 dividend from stock in a subsidiary.

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Cash Planning: Cash Budgets An Example: Coulson Industries• Based on this information, we are able to develop the

following schedule of cash receipts for Coulson Industries.

Cash Planning: Cash Budgets An Example: Coulson Industries• Coulson Company has also gathered the relevant information

for the development of a cash disbursement schedule. Purchases will represent 70% of sales—10% will be paid immediately in cash, 70% is paid the month following the purchase, and the remaining 20% is paid two months following the purchase. The firm will also expend cash on rent, wages and salaries, taxes, capital assets, interest, dividends, and a portion of the principal on its loans. The resulting disbursement schedule thus follows.

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Cash Planning: Cash Budgets An Example: Coulson Industries

Cash Planning: Cash Budgets An Example: Coulson Industries• The Cash Budget for Coulson Industries can be derived

by combining the receipts budget with the disbursements budget. At the end of September, Coulson’s cash balance was $50,000, notes payable was $0, and marketable securities balance was $0. Coulson also wishes to maintain a minimum cash balance of $25,000. As a result, it will have excess cash in October, and a deficit of cash in November and December. The resulting cash budget follows.

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Cash Planning: Cash Budgets An Example: Coulson Industries

Evaluating the Cash Budget• Cash budgets indicate the extent to which cash shortages or

surpluses are expected in the months covered by the forecast.

• The excess cash of $22,000 in October should be invested in marketable securities. The deficits in November and December need to be financed.

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Coping with Uncertainty in the Cash Budget• One way to cope with cash budgeting uncertainty is to prepare

several cash budgets based on several forecasted scenarios (e.g., pessimistic, most likely, optimistic).

• From this range of cash flows, the financial manager can determine the amount of financing necessary to cover the most adverse situation.

• This method will also provide a sense of the riskiness of alternatives.

• An example of this sort of “sensitivity analysis” for Coulson Industries is shown on the following slide.

Coping with Uncertainty in the Cash Budget

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Profit Planning

Profit Planning: Pro Forma Statements• Pro forma financial statements are projected, or

forecast, financial statements – income statements and balance sheets.

• The inputs required to develop pro forma statements using the most common approaches include:▫ Financial statements from the preceding year▫ The sales forecast for the coming year▫ Key assumptions about a number of factors

• The development of pro forma financial statements will be demonstrated using the financial statements for Vectra Manufacturing.

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Profit Planning: Pro Forma Financial Statements

Profit Planning: Pro Forma Financial Statements

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Profit Planning: Pro Forma Financial Statements• Step 1: Start with a Sales Forecast▫ The first and key input for developing pro forma financial

statements is the sales forecast for Vectra Manufacturing.

Profit Planning: Pro Forma Financial Statements• Step 1: Start with a Sales Forecast (cont.)

▫ The previous sales forecast is based on an increase in price from $20 to $25 per unit for Model X and from $40 to $50 per unit for Model Y.

▫ These increases are required to cover anticipated increases in various costs, including labor, materials, & overhead.

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Profit Planning: Pro Forma Financial Statements• Step 2: Preparing the Pro Forma

Income Statement▫ A simple method for developing a pro forma income

statement is the “percent-of-sales” method.

▫ This method starts with the sales forecast and then expresses the cost of goods sold, operating expenses, and other accounts as a percentage of projected sales.

▫ Using the Vectra example, the easiest way to do this is to recast the historical income statement as a percentage of sales.


Income Statement (cont.)▫ Using these percentages and the sales forecast we developed, the

entire income statement can be projected.

▫ The results are shown on the following slide.

▫ It is important to note that this method implicitly assumes that all costs are variable and that all increase or decrease in proportion to sales.

▫ This will understate profits when sales are increasing and overstate them when sales are decreasing.

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Profit Planning: Pro Forma Financial Statements• Step 2: Preparing the Pro Forma Income Statement

(cont.)


Income Statement (cont.)▫ Clearly, some of the firm’s expenses will increase with the level of

sales while others will not.

▫ As a result, the strict application of the percent-of-sales method is a bit naïve.

▫ The best way to generate a more realistic pro forma income statement is to segment the firm’s expenses into fixed and variable components.

▫ This may be demonstrated as follows.

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Profit Planning: Pro Forma Financial Statements• Step 2: Preparing the Pro Forma Income Statement

(cont.)

Profit Planning: Pro Forma Financial Statements• Step 3: Preparing the Pro Forma Balance Sheet▫ Probably the best approach to use in developing

the pro forma balance sheet is the judgmental approach.

▫ Under this simple method, the values of some balance sheet accounts are estimated and the company’s external financing requirement is used as the balancing account.

▫ To apply this method to Vectra Manufacturing, a number of simplifying assumptions must be made.

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Profit Planning: Pro Forma Financial Statements• Step 3: Preparing the Pro Forma Balance Sheet (cont.)

1. A minimum cash balance of $6,000 is desired.

2. Marketable securities will remain at their current level of $4,000.

3. Accounts receivable will be $16,875 which represents approximately 45 days of sales on average [($16,875/$135,000)*365].

4. Ending inventory will remain at about $16,000. 25% ($4,000) represents raw materials and 75% ($12,000) is finished goods.

5. A new machine costing $20,000 will be purchased. Total depreciation will be $8,000. Adding $20,000 to existing net fixed assets of $51,000 and subtracting the $8,000 depreciation yields a net fixed assets figure of $63,000.

Profit Planning: Pro Forma Financial Statements• Step 3: Preparing the Pro Forma Balance Sheet (cont.)

6. Purchases will be $40,500 which represents 30% of annual sales (30% x $135,000). Vectra takes about 73 days to pay on its accounts payable. As a result, accounts payable will equal $8,100 [(73/365) x $40,500].

7. Taxes payable will be $455 which represents about one-fourth of the 2007 tax liability.

8. Notes payable will remain unchanged at $8,300.

9. There will be no change in other current liabilities, long-term debt, and common stock.

10. Retained earnings will change in accordance with the pro forma income statement.

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Profit Planning: Pro Forma Financial Statements• Step 3: Preparing the Pro Forma Balance

Sheet (cont.)

Evaluation of Pro Forma Statements: Weaknesses of Simplified Approaches• The major weaknesses of the approaches to pro forma

statement development outlined above lie in two assumptions:▫ That the firm’s past financial performance will be replicated in

the future▫ That certain accounts can be forced to take on desired values

• For these reasons, it is imperative to first develop a forecast of the overall economy and make adjustments to accommodate other facts or events.

p1-introducton to finman (1)

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