FIN Notes - Winston PDF

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Week 1: Overview Finance: a discipline concerned with determining value and marketing decisions based on that value assessment. The finance function allocates resources, including acquiring, investing, and managing of resources. Main areas of Finance: Investments, Financial markets and Intermediaries, Corporate Finance Investments: study of financial transactions from the perspective of investors outside the firm Financial markets and intermediaries: study of markets where financial securities (stocks and bonds) are bought and sold  study of financial institutions (commercial banks, investment banks, insurance companies) that facilitate the flow of money from savers to demanders of money Corporate finance:   

What long-term investments should the firm take on? (capital budgeting decision) Where will we get the long-term financing to pay for the investment? (capital structure decision)  fix income, equity shares, bonds How will we manage the everyday financial activities (important short-term management) of the firm? (working capital management decisions)

Public funds: money that the government has Private funds: money that the companies have Investment vehicle model 1. Investors provide financing to the firm in exchange for financial securities (claims on firm’s cash flows) 2. Firm invests these funds in assets 3. Income generated by the firm’s assets is distributed to the investors (i.e. holders of the firm’s financial securities) Financing decision (from where) Investment decision (for what)

The Balance Sheet Model (Accounting Model) Investment decisions are represented on the asset (left hand) side of the balance sheet Financial decisions are represented on the liabilities and equity (right hand) side of the balance sheet   

Analysing change of asset (what) Analysing change of liabilities and equity (where) Analysing change of working policy decisions, net working capital (how)

Capital budgeting (investment decision/what), capital structure (financing decision/where), net working capital (short-term cash flow/how)

Treasurer: oversees cash management, credit management, capital expenditures and financial planning  

Capital budgeting: allocation of resources (invest in other firms, instruments, stock) Risk management: risk of investments (liquidity, market, solvent, interest etc)

Controller: oversees taxes, cost accounting, financial accounting and data processing

Shareholders hold Board of Directors responsible for their interests (BOD elected) Debtholders hold management responsible for their interests (contractually bound) Debts  bonds Sources of External Financing 1. Debt    

Lenders: lending money to corporation, debt holders become the creditors and lenders Relationship determined by contract: debt contract is a legally binding agreement (specified principal, interest, maturity date and specific protective covenants) Security and seniority: Creditors/debt holders  shareholders/equity holders (residual claimants in case of bankruptcy) Senior bonds get their money back earlier than junior bonds (priority), senior bond owners less risk of not getting paid

2. Equity  Shareholders’ ownership rights – shareholders become the owners of the firm by buying shares (residual claimants of the firm)  Shareholders’ payoffs – shareholders receive monetary returns: i. Dividend per share: paid to investors from corporation’s after-tax dollars ii. Capital gain from sale of shares (ownership rights) at a price higher than during time of purchase Financial management primary goal: shareholder wealth maximisation = maximise stock price Goal of the firm is to maximize its value Maximise: value of the firm, wealth of its owners, price of stock, contribution to economy The 4 objectives best realised when firm uses finance’s systematic value maximising investment and financing decision criteria Maximizing stock price What determines stock prices – the underlying firm’s ability to generate cash flows Appraising companies: amount, timing, riskiness (affects asset value  stock prices)    

10 billion in 10 years, 5 billion in 2 years: timing 10 billion in 10 years (80% chance), 5 billion in 2 years (50% chance): riskiness Generates price of the stocks from the factors Determine the stock’s intrinsic value

Assuming market is efficient/equivalent/at equilibrium: market price = intrinsic value Intrinsic value: estimate of a stock’s true value based on accurate risk and return data Market price: based on perceived information as seen by the marginal investor (can be theoretically incorrect)

Agency relationship: principal hires an agent to represent their interest  stockholders hire managers via the BOD to run the company Agency problem: conflict of interest between principal and agent  managers not representing the best interest of the stockholders Potential conflict of interests: shareholders and managers, shareholders and creditors Agency costs: costs of conflict of interest between stockholders and management 

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Direct agency costs o Expenditures that benefit management (car and accommodation, big office, high pay) o Monitoring costs: auditors, audit committee, corporate governance Indirect agency costs o Lost opportunities which would increase firm value in the long run, if accepted

Shareholders vs managers: managers naturally inclined to act on their own best interests Except when:   

Compensation plans tied to share value Direct intervention by shareholders Threat of firing, threat of takeover

Handling the agency problem 1. 2. 3. 4.

Compensation plans that tie the fortunes of the managers to the fortunes of the firm Monitoring by lenders, stock market analysts and investors Threat that poorly performing managers will be fired Growing awareness of the importance of good corporate governance

Firms and its sources of funds Financial markets: markets where “financial instruments” are traded, act as intermediaries between savers and borrowers Money markets vs capital markets Money markets: where debt securities of less than one year are traded: treasury securities, commercial paper, bills, inter-bank loans  loosely connected dealer markets  banks are major players Capital markets: where equity and long-term debt claims are traded  usually auction markets like the Singapore Exchange Primary market vs secondary market Primary market: for government and corporations initially issued securities (e.g. IPO – primary market transaction)  

Public offering: where securities are offered to public at large; needs underwriting, more regulatory requirements, costly Private offering – where securities are offered to large financial institutions or wealthy individuals (less costly)

Secondary market: where existing financial claims are traded, getting market value of securities is easier   

Dealer market (e.g. OTC markets) Auction market (e.g. SGX, NYSE) Buying from another investor instead of issuer

Week 2: Financial Statement Analysis Annual report    

Balance sheet (change in numbers throughout the years  answer what when how in finance) Income statement Statement of retained earnings Statement of cash flows

Balance sheet characteristics: assets = liabilities + equity   

Resources must equal claims Order of listing – highest to lowest liquidity Valuing of items – generally at original cost (historical cost) – except marketable securities and inventories

Book value (historical costs less accumulated depreciation) are determined by GAAP Market values are determined by current trading values in the market Market value of shareholders’ equity = “market capitalization” = share price x number of outstanding shares Enterprise value of a firm assess the value of the underlying business assets (however financed) and separate from the value of any non-operating cash (i.e. excess cash) and marketable securities that the firm may have  cost of a company if someone were to acquire it Enterprise value = market value of equity + debt – excess cash   

Debt (market value if possible, if not use book value, difference not as large as equity) Excess cash (if possible, operating and non-operating cash difficult to separate) Market value of all the assets – excess cash (savings, surplus)

Market-to-book ratio = market value of equity ÷ book value of equity Debt-to-equity ratio = total value of debt ÷ book value of equity Basic stock concepts

Profits vs cash flows “Profits”    

Subtracts depreciation (non-cash expense)  could have an understatement of cash Ignore cash expenditures on new fixed assets (expense is capitalized) Record income and expenses at the time of sales, not when the cash exchanges actually occur Do not consider changes in working capital (money needed for everyday financing)

Importance of cash flow

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Cash is King: firms generate cash and spend it (increase cash, increase stock price) Sources of cash (inflow): decreases in assets (other than cash), increases in equity and liabilities Uses of cash (outflow): increases in assets (other than cash), decreases in equity and liabilities

Statement of cash flows: summarizes the sources and uses of cash over the period 1. Operating activities – includes net income and changes in most current accounts (AP, AR, Inv) 2. Investment activities – includes changes in fixed assets (PPE) 3. Financing activities – includes changes in notes payable, long-term debt and equity accounts as well as dividends Current assets + net fixed assets = current liabilities+ long-term debt + common stock + retained earnings Current assets – current liabilities = net working capital ΔCash = ΔRetained earnings + ΔCurrent liabilities – ΔCurrent assets other than cash – ΔNet fixed assets + Δ Long-term debt + Δ Common stock Dividend Payout Ratio = Dividends ÷ Net income Finance concept of cash flow   

Cash flow (from assets) is one of the most important pieces of information that a financial manager can derive from financial statements How cash is generated from utilizing assets, how it is paid to those that finance the purchase of the assets Cash generated from operations over the period of interest

Operating working capital: working capital stemming from operating policies (AR, inventory, AP) and removed from financing decisions (exclude non-operating working capital (notes payable) from calculations in Net Operating Working Capital) 

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Business operations generally require investment in net operating working capital o Operating cash on hand o Inventory o Accounts receivable o Increases in accounts payable from suppliers Fund are required for the above items to support sales though the related cash has not yet been collected from any sale Only consider operating working capital (notes payable not operating  liability)

2 types of liabilities 

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Interest bearing liabilities (from financing activities) o Short-term loans (less than 1 year maturity) o Notes payable (financing choices, not operating choices) Non-interest bearing liabilities (from operating activities) o Accounts payables (extended from suppliers)

Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) – Net Capital Spending (NCS) – Changes in NOWC (Net Operating Working Capital) Cash Flow From Assets (CFFA) + Interest Tax Shield = Cash Flow to Creditors + Cash Flow to Stockholders Interest tax shield: Protection from paying taxes due to interest expense

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Interest payments deducted from EBIT before calculation of taxes  interest payment functions to reduce amount of taxes paid  result in paying less tax than it otherwise would Dividend payment are not tax deductible  do not reduce amount of taxes paid

Determining CFFA: do not take in account interest tax shield (separate operations from financing – tax shield increases amount of cash flow available to creditors and shareholders) 

Cash benefit derived from financing activity, not operating activity

OCF = EBIT*(1-Tax Rate) + Depreciation  

OCF does not equal to cash from operating activity OCF use EBIT: don’t want to include interest tax shield

NCS = Ending Net Fixed Assets – Beg. Net Fixed Assets + Depreciation Changes in NOWC = Ending NOWC – Beginning NOWC 

Cash + accounts receivable + inventory – accounts payable

Interest Tax Shield = Cash generated from the reduction in the amount of taxes paid due to tax deductibility of interest = interest expense x tax rate Cash Flow to Creditors (B/S and I/S) = interest paid – net new borrowing (LT Debt and Notes Payable)  

Borrowing: All interest bearing liabilities Net new borrowing negative: assuming already paid down the borrowing

Cash Flow to Stockholders (B/S and I/S) = dividends paid – net new equity raised

Standardized financial statements: easier to compare financial information (as the company grows), useful for comparing companies of different sizes (esp. within the same industry)   

Common-size balance sheets – compute accounts as a percent of total assets Common-size income statements – compute line items as a percent of sales Common-base year statements – compute line items as a percent of base year

Combined – e.g. 0.5/1.21 = 0.41 Ratio analysis

1. 2. 3. 4.

 Time-trend analysis (over time): used to see how the firm’s performance is changing through time  Peer group analysis (with others): compare to similar companies or within industries What aspects of the firm are we attempting to analyse? What information goes into computing a particular ratio and how does that information relate to the aspect of the firm being analysed? What is the unit of measurement? (time, days percent) What are the benchmarks used for comparison? What makes a ratio “good” or “bad”?

Liquidity ratios

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Measure firm’s ability to pay bills in the short run (can we make required payments as they fall due?) Ability to convert assets to cash quickly without a significant loss in value Ability to meet its maturing short term obligations Excessive amount of liquidity – not investing cash – not enough investments which help shareholders – enterprise value becomes low Nature of tech industries: quick development  seeing start-ups of good value  buy them which involve ready cash, buying without wasting time raising capital

Current ratio = current assets ÷ current liabilities (higher the better) Quick ratio = (current assets – inventory) ÷ current liabilities (higher the better) Cash ratio = cash ÷ current liabilities NWC to total assets = NWC ÷ TA Interval measure = current assets ÷ average daily operating costs Long-term solvency (financial leverage) ratios  

Show how heavily the company is in debt (do we have the right mix of debt and equity?) Financial leverage: the extent that a firm relies on debt financing rather than equity (more debt, more likely to be unable to fulfil contractual obligations)

Total debt ratio = total debt ÷ total assets (lower the better) Debt/equity ratio = (total assets – total equity) ÷ total equity Equity multiplier = total assets ÷ total equity = 1 + debt/equity ratio Long-term debt ratio = long-term debt ÷ (long-term debt + total equity) Times interest earned ratio = EBIT ÷ interest (higher the better) Cash coverage ratio = (EBIT + depreciation) ÷ interest Asset management (turnover/efficiency) ratios    

Measure how productively the firm is using its assets (do we have the right amount of assets for the level of sales?) Inventory ratios – how quickly inventory is produced and sold Receivable ratios – success of the firm in managing its collection from credit customers Fixed asset and total asset turnover ratios – effectiveness in using its assets to generate sales

Inventory turnover = COGS ÷ inventory (higher the better) 

Use COGS instead of inventory as inventory is recorded at book value

Days’ sales in inventory = 365 ÷ inventory turnover (lower the better) Receivables turnover = sales ÷ receivables Days sales outstanding (account receivable days or average collection period) = average number of days after making a sale before receiving cash (lower the better) DSO = account receivable ÷ average daily sales = 365 ÷ receivables turnover 

Average daily sales = sales ÷ 365

Fixed asset turnover = sales ÷ net fixed assets (higher the better)

Total asset turnover = sales ÷ total assets (higher the better) Profitability ratios  

Measure the firm’s return on its investments (do sales prices exceed unit costs, and are sales high enough as reflected in profit margin (PM), return on equity (ROE), and return on assets (ROA)?) Combined effects of liquidity, asset management and debts on operating results

Profit margin = net income ÷ sales (higher the better) 

Negative profit margin: losing money

Basic earning power (BEC) = EBIT ÷ total assets (higher the better) 

BEP removes the effects of taxes and financial leverage

ROA = net income ÷ total assets (higher the better) 

Low ROA: ineffective assets (not using them to generate income)

ROE = net income (deduct preferred dividend if present) ÷ total common equity (higher the better)   

ROA is lowered by debt (interest expense lowers net income) Use of debt lowers equity, if equity is lowered more than net income, ROE would increase (interest rate of debt low – impact on numerator not much) More debt, reduce equity, equity drops, numerator and denominator both drop

Problems with ROE    

ROE and shareholder wealth are correlated, problems arise when ROE is the sole measure of performance ROE does not consider risk, focuses only on return (consider both risk and return is a better measure) ROE does not consider the amount of capital invested Might encourage managers to make investment decisions that do not benefit shareholders

Market value ratios    

Provides indications on the firm’s prospects and how the market values the firm (do investors like what they see as reflected in Price-Earning (P/E) and Market-to-Book (M/B) ratios?) Relates firm’s stock price to its earnings, cash flows and book value per share P/E: how much investors are willing to pay for $1 of earnings M/B: how much investors are willing to pay for $1 of book value equity

P/E = price ÷ earnings per share M/B = market price per share ÷ book value per share  

High number the better  high, investors view firm positively  PE ratio high But if too high  suggest there is a bubble in the market for this stock (over optimistic about prospect of the company, people crowding to buy)

Dupont System   

Merge income statement and balance sheet into 2 summary measures of profitability: ROA and ROE Dupont breaks down ROE Useful to make comparisons of ROE

ROE = NI ÷ TE

Multiply by TA÷TA (= 1) and then rearrange ROE = (NI ÷ TE) (TA ÷ TA) ROE = (NI ÷ TA) (TA ÷ TE) = ROA x EM Multiply by (Sales ÷ Sales) and then rearrange ROE = (NI ÷ TA) (TA ÷ TE) (Sales ÷ Sales) ROE = (NI ÷ Sales) (Sales ÷ TA) (TA ÷ TE) ROE = PM x TA TO x EM   

Profit margin: measures operating efficiency (how well it controls costs) Total asset turnover: measures asset use efficiency (how well it manages assets) Equity multiplier: measures financial leverage

Ratio analysis limitations       

Compare with industry averages difficult if firm operates many different divisions (diversified firm) Average performance not necessarily good Seasonal ...