Chapter 9: FINANCE

Using Funds To Maximize Value © 2009 South-Western, a division of Cengage Learning 1

LOOKING AHEAD

• • • • • •

How does maximizing financial value relate to social responsibility?

How do financial managers use key ratios?

How do financial managers use cash budgets?

Why is working capital management important?

How do financial managers evaluate capital budgeting proposals?

How do financial managers determine the firm’s capital structure?

2 © 2009 South-Western, a division of Cengage Learning

WHAT MOTIVATES FINANCIAL DECISIONS

• What types of assets do we need to achieve goals?

• How do we get the funds we need?

• Evaluate financial performance • Plan financial resources • Manage working capital • Evaluate investment opportunities • Determine appropriate strategy 3 © 2009 South-Western, a division of Cengage Learning

EVALUATING PERFORMANCE: WHERE DO WE STAND?

• Financial ratios provide insight into financial strengths and weaknesses • Use financial data from balance sheet and income statement % • Companies can compare their ratios with other businesses 4 © 2009 South-Western, a division of Cengage Learning

KEY FINANCIAL RATIOS

RATIO TYPE Current

Liquidity: ability to pay short-term liabilities.

Inventory Turnover Debt-to-equity

Asset Management: how firm is using assets to generate revenue.

Leverage: extent to which a firm relies on debt.

HOW IT IS COMPUTED

Current Assets Current Liabilities Cost of Good Sold Average Inventory Total Debt Total Owner’s Equity 5 © 2009 South-Western, a division of Cengage Learning

KEY FINANCIAL RATIOS

RATIO TYPE Debt-to assets

Leverage: measures the extent to which a relies on debt

Return on equity

Profitability: compares the amount of profit compared to resources invested

Return on assets

Profitability: compares the amount of profit compared to resources invested

Earnings per share

Profitability: compares the amount of profit compared to resources invested

HOW IT IS COMPUTED

Total Debt Total Assets Net Income – Preferred Div Avg Common Stock Equity Net Income Average Total Assets Net Income – Pref Dividends Avg # of Shares Out 6 © 2009 South-Western, a division of Cengage Learning

BASIC PLANNING TOOLS

Pro Forma Income Statement –

forecasts the sales, expenses and net income

Pro Forma Balance Sheet –

forecasts the types and amounts of assets a firm will need to carry out plans.

Cash Budget –

detailed projection of cash flows to determine when cash shortages and surpluses will occur.

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CASH BUDGET

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FINANCIAL PLANNING: PROVIDING A ROAD MAP FOR THE FUTURE

• What assets must be obtained?

• How much additional financing is needed?

• How much can the firm generate Internally? Externally?

• When will external financing be required?

9 © 2009 South-Western, a division of Cengage Learning

MANAGING WORKING CAPITAL: CURRENT EVENTS

• Net Working Capital: – Difference between current assets and liabilities • Working capital must be managed – Appropriate level of current assets – Current liabilities needed to finance activities 10 © 2009 South-Western, a division of Cengage Learning

SAMPLE BALANCE SHEET

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MANAGING CASH

• Need cash to pay bills • Cash does not earn returns 12 © 2009 South-Western, a division of Cengage Learning

CASH EQUIVALENTS

• Commercial Paper – Short-term unsecured promissory note (IOUs).

– Issued by major corporations with excellent credit rating – Sold at a discount; price plus interest is paid when the paper comes due • T-bills – Short-term IOUs issued by the U.S. government.

– T-Bills normal mature in 4, 13, or 26 weeks – Sold at a discount; face value is paid at maturity – Good market for T-Bills since they are backed by the government • Money Market Mutual Funds – Pooled funds to purchase a portfolio of short-term, liquid securities – Affordable way for small investors to get into the market 13 © 2009 South-Western, a division of Cengage Learning

MANAGING ACCOUNTS RECEIVABLE

Accounts Receivable -

Money which is owed to a company by a customer for products and services provided on credit.

• Set Credit Terms • Establish Credit Standards • Design Appropriate Collection Policy 14 © 2009 South-Western, a division of Cengage Learning

SHORT-TERM FINANCING

• Spontaneous Financing – Trade Credit • Short-Term Bank Loans – Line of Credit – Revolving Credit • Factoring • Commercial Paper 15 © 2009 South-Western, a division of Cengage Learning

BORROWING MONEY

“ “ “If you want to know the value of money, go and try to borrow some.” - Benjamin Franklin © 2009 South-Western, a division of Cengage Learning 16

CAPITAL BUDGETING: IN IT FOR THE LONG HAUL

• Replace machines and equipment • New machines and equipment • Build a new factory, warehouse or office • Introduce a new product line

Capital Budgeting –

a systematic evaluation of a firm’s major long-run capital investment opportunities.

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COMPARING CASH FLOWS THAT OCCUR AT DIFFERENT TIMES

Managers must evaluate costs and benefits of investment that occur over a period of many years.

Time Value of Money –

a dollar received today is worth more than a dollar received in the future.

Compounding –

earning interest in the current period on interest from previous periods.

18 © 2009 South-Western, a division of Cengage Learning

SOURCES OF LONG-TERM CAPITAL: LOANERS VS. OWNERS

Capital Structure –

the mix of equity and debt financing a firm uses for financing needs.

Debt Financing –

creditors.

Equity Financing –

owners.

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SAMPLE BALANCE SHEET

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SOURCES OF DEBT FINANCING

• Long-term loans • Issuing notes or bonds © 2009 South-Western, a division of Cengage Learning 21

SOURCES OF EQUITY FINANCING

• Direct contributions by owners – Owners directly contribute resources to unincorporated businesses – Corporations raise equity capital by issuing stock • Retained earnings 22 © 2009 South-Western, a division of Cengage Learning

Equity vs. Debt

• Equity doesn’t require payments • Debt has tax advantages • Equity gives up ownership control • Debt had interest © 2009 South-Western, a division of Cengage Learning 23