FIN203 Notes for SUSS PDF

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Study Unit 1 (Overview of Finance, Financial Statements) Corporate Finance ​ - Deals with how the firm raises funds and utilises them. The firm raises funds from its owners. Funds can come through borrowing from banks and investors as well as credits given by its suppliers. **a) What long term inves...

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Study Unit 1 (Overview of Finance, Financial Statements) 1. Corporate Finance - Deals with how the firm raises funds and utilises them. The firm raises funds from its owners. Funds can come through borrowing from banks and investors as well as credits given by its suppliers. a) What long term investments the firm should make? 2) Investments (capital budgeting) = how a company manages their investments. a) How the firm raises funds and utilizes them?

Corporate Finance Decisions 3) Financing (their capital structure) Equity Financing = what does a company has to pay? dividends to shareholders. (but is discretionary and not compulsory.) If you are an equity owner, you own a part of the business of the company. -

You have some say of the company, have voting rights in decisions.

Debt Financing = Company borrows money from creditors to finance itself. Company has to pay interest for borrowing money. If do not pay, can be sued for bankruptcy. -

Creditors = a person that holds a debt from a company. Not an owner of a company, no voting rights.

-

Bonds = the company borrows money from an entity issuing a bond.

If you are a business and you want to raise funds/money for the company, which financing decision is a better decision? Equity financing. This is because you won’t know when you will have issue paying back debts. However, most businesses use debt financing. -> why?

4) Working Capital Management = How a company handle operations ( manpower, equipment, current assets, current liabilities)

-

E.g. Inventories → how much inventory to hold. Too much, turnover cost, storage cost, obsolescence (Inventory = money. Money is stuck there) Too little inventory: forgo potential sales.

-

Cash - whether to have cash on hand or to invest in short-term (marketable securities: sellable investments) or long term Hold too much - underutilised cash. Hold too little - unable to pay up short term liabilities.

5) Dividends decision = how much to give back to shareholders. -

Many companies don’t pay dividends.

-

How much to pay decision is based on a) How profitable the company is b) What else in the company that it needs money for.

-

Shareholders expect returns that are higher than the principal amount of the share.

● Decision that is most important: Investments. What capital to invest. ● Financing decision is second (how to finance shareholders)

6) Investments - Focus on the financial assets of the firm like stocks and bonds. a) Risk and return of financial assets as well as their pricing b) Features of financial assets or securities c) Management of securities in a portfolio

7) Financial Institutions - bring together people, companies or the government who need funds with people, firms or the government that have excess funds to invest. E.g. banks, insurance companies and mutual fund companies. a) How interest rates are determined b) Markets within which financial assets are traded

i)

Primary Market (Stocks and Bonds, Money) - Where companies raise funds and where securities are issued for the first time

ii)

Secondary Market (Investors)

8) International Finance - Looks at the finance from an international perspective. As firms trade with firms in other countries, the movements of the foreign exchange rate (i.e. the rate of exchange between the home currency and foreign currency, add another dimension to the management of the firm’s finances. Even if the firm buys and sells the same amount of goods and services at the same fixed price, the foreign exchange rate movements could affect the performance of the firm due to the foreign exchange gains or losses. a) How financial transactions are conducted when foreign currencies and laws and regulations are involved. b) How changes in foreign exchange rates affect financial transactions and investments

9) Comparisons of 3 Business Forms: Features

Life Span

Sole Proprietorship

Partnership

Corporation

(1 owner)

(more than 1 owner)

(company)

Limited to life of

Life ends if one

Unlimited Life

owner

partner dies or sells

1. (separation of

his stake

ownership and management. Can count on the expertise of professionals)

2. (has greater performance: a 120

year loan can be used on a company but not on a sole proprietorship) Liability

Unlimited

Unlimited unless

(debts by creditors

partner is a limited

are fully on owners.

partner

Limited

If can’t pay, creditors can take personal assets.) Liquidity

Financial Resources

Ownership difficult

Ownership difficult

Ownership easier to

to transfer

to transfer

transfer

Difficult to raise

Relatively difficult to

Relatively easier to

capital

raise capital

raise capital

● Sole proprietorship is easy to start but limited by issues relating to liability, transfer of ownership and fund raising. ● Corporation overcomes problems of sole proprietorship but is harder to start and is most regulated. ● The partnership structure sits in between the other two business forms in terms of the pros and cons.

10) Goal of Finance a) Maximise shareholder’s wealth - guides managerial actions i)

Takes into account the time value of money and risk and considers all cash flows that would accrue to the shareholder over time

ii)

Addresses the deficiencies of other goals, e.g.

● Profit Maximization does not take into account the time value of money and risk ● Minimising costs may come at the expense of the future well-being of the firm if R&D expenses or headcount are reduced. ● Maximising market share may come only through incurring large advertising and promotion expenses but firm may not be able to recover those expenses through more profits.

Financial goal of a company: Maximise the intrinsic value of the firm's shares. (Maximising shareholder value) -

Why not maximising profits? If a company invests in R&D, immediately will have lower profits to fund the R&D. Long term then will see profits. Maximising shareholder value is continuous, as shareholders will continue to hold shares.

11) Conflict of Interest - The Agency Problem a) Shareholders (the principals) are the owners of the company b) Professional managers (the agents) are hired to run the company c) Agency problem i) ii)

The agent may not always act in the best interests of the principal E.g. Managers may want to increase the growth and size of the company. However, such actions may not translate into increased shareholder’s wealth ● Managers may overpay when they buy over another company

d) Overcoming the agency problem i)

Compensate the managers partly through share options ● If the company does well and the share price rises, then the managers’ share options increase in value, i.e. alignment of interest. ● Share options - giving shares but have to pay for it.

12) Financial Statements Formulas

TERM

Company’s Financial

Assets = Liabilities +

Balance Sheet

Position at the end of the

Owners’ Equity

period How well did the company

Revenues - Expenses = Net

perform (or operate) during

Profit (Net Loss)

Income Statement

the period? Changes to company’s

Beg. retained earnings + Net

Statement of changes in

retained earnings during

Profit (or - net loss) = Ending

equity

the period

retained earnings

How much cash did the

Operating cash flow +/-

company generate and

Investing cash flows +/-

spend during the period?

Financing cash flows =

Cash flow statement

Increase / Decrease in cash

13) The Balance Sheet - An accountant’s snapshot of the firm’s accounting value as of a particular date (like a photo)

a) Assets shown on the left b) Liabilities and shareholders’ equity are shown on the right

Assets = Liabilities + Shareholders’ Equity

Assets refers to the economic resources that produce a future benefit. Liabilities refers to obligations payable to outsiders or outside claims to the assets of the firm. Shareholders’ equity refers to “insider” claims to the assets of the firm. (Note: Liability holders have priority of claims over shareholders)

Total Value of Assets

Total Firm Value to

(What the company owns)

Investors (What the company owes)

● Current Assets

=

● Fixed Assets 1) Tangible 2) Intangible

● Current Liabilities ● Long-Term Debt ● Shareholders’ Equity

14) On the Balance Sheet: a) The assets are listed in order by the length of time it normally would take a firm with ongoing operations to convert them into cash b) Current assets are assets that would be converted into cash within a year. c) Liabilities are listed in the order of the length of time the payment come due. d) Current liabilities are due within a year. e) The proportion of debt to equity indicates the amount of leverage or indebtedness of the firm.

f) The higher the leverage the greater the probability of the firm not being able to pay its debt.

15) The Income Statement (like a video) a) The income (or profit and loss) statement measures performance over a specific period of time b) Revenue - Expenses = Income c) The operating section of the income statement reports the firm’s revenue and expenses from principal operations. d) The non-operating section of the income statement includes all financing costs, such as interest expense. E.g Revenue

80

Might be revenue unearned

Expenses

(20)

Might be expenses unspent

Net income

60

16) Book value vs Market Value a) Book value of financial statement item i)

Value as shown in the financial statements

b) Book value i)

Derived using accounting process which incorporates certain assumptions and conventions known as accounting standards.

c) Book value may not reflect market value i)

Market value is the price that is likely to be transacted in the marketplace today for that item. (e.g. a property was bought 30 years ago for $500,000. The book value is the historical cost. The market value is much higher due to increase in property prices over the years.)

*What it can fetch in the marketplace.*

Difference in cash flows and Profits - in finance , cash flows are more important. *CFFA = OCF - (NCS - change in NWC) ^ Reinvestments in long term fixed assets (planes, buildings, machines) CFFA is what is the cash flow is being generated from running core business that is left after you reinvest in the business. Cash flow that is left must be free to be distributed into CFS and CFC. Therefore,

CFFA = CFS + CFC

Legend: CFFA = Cash Flow from Assets

CFS = cash flow from shareholders

OCF = Operating Cash Flow

CFC = Cash Flow from Creditors

NCS = Net Capital Spending (buying fixed assets) NWC = Net Working Capital = Current Assets - Current Liabilities

17) Financial Ratio Analysis a) Used to determine the past performance and current financial condition of the firm b) Ratios provide a sound basis for projecting future cash flows c) Users of financial ratios include: i)

Management

ii)

Investors

iii)

Creditors

iv)

Competitors

18) Usage of Ratios a) Cross-Sectional Analysis

i) ii)

Inter-firm Comparison Industry Comparison

b) Time-Series Analysis i)

Analyse the behaviour of ratios over time to discover trends ● Horizontal Analysis - Compare the % change in an accounting item over time ● Vertical Analysis - Express each item in the I/S as a % of sales. Express each item in the B/S as a % of total assets. Statements obtained are called “common-size statements”.

19) Components of Ratio Analysis: a) Liquidity or short term solvency b) Debt management or leverage or long term solvency c) Asset Management or activity d) Profitability e) Valuation

20) Liquidity Ratios - Measure firm’s ability to meet its short term obligations. (Inability to pay creditors can result in bankruptcy.) Creditors will be concerned for this ratio. a) Current Ratio = Current Assets / Current Liabilities *Higher the better

i) ii)

Current Liabilities need to be repaid within 1 year Funds to pay the liabilities are cash or assets that can be converted into cash within 1 year.

b) Quick (acid-test) Ratio = (Current Assets - Inventories) / Current Liabilities *Higher the better

i)

Ratio excludes inventories from current assets ● Inventories (least liquid) are not so easily sold or converted into cash ● Quick Sale requires big discount to the original price

● Ratio gives a better gauge of the availability of funds to pay the creditors. c) Immediate or Cash Ratio = (Cash + Marketable Securities) / Current Liabilities *Marketable securities refer to investments. Short term in nature and very liquid

i)

Ratio gives greatest assurance regarding the ability to repay

21) Debt Management Ratios (Leverage/Gearing) - Measure the extent of the firm’s debt burden *This group of ratios are concerned with the long-term debt of a company. A company that does not borrow much money would no need to worry about repaying its debtors and the issue of staying solvent. *Lower the ratio the better. Higher the ratio, higher risk.

a) Total Debt Ratio = Total Debt / Total Assets or Total Liabilities / Total Assets b) Debt-Equity Ratio = Long Term Debt / Equity c) Equity Multiplier = Total Assets / Equity i)

The above three ratios measure the overall indebtedness of the firm, namely how much of the assets were funded through borrowing.

d) Time interest earned = EBIT / Interest Expense i) ii)

Principal of a loan is paid at the end of the loan period Ratio measures the ability of a firm to meet yearly interest payments from earnings (profit) before interest and taxes (EBIT)

e) Cash Coverage = (EBIT + Depreciation) / Interest Expense i)

Depreciation is an accounting expense but does not result in cash outflow.

22) Asset Management (Activity) Ratios - Show the efficiency with which assets are used to generate sales. If the firm can use less assets for its operations, then less funds are needed for capital. a) Asset Turnover = Sales / Inventories

i)

Slow inventory turnover is a symptom that products are not selling well.

b) Average Collection Period (Days Sales Outstanding) = Receivables / Average Sales per day or 365 / Accounts receivables turnover or 365 / (Sales / Accounts Receivables) or Accounts Receivables / Average Sales per day *Lower the ratio the better

i) ii)

Compare the average collection period with the credit period If the customer is way behind in their payments, there is a greater likelihood that the debt may turn bad.

c) Fixed Asset Turnover = Sales / Net Fixed Assets i)

High fixed asset turnover can be achieved by using the assets more intensively (Running the machines for longer periods)

ii)

Beware of high fixed asset turnover resulting from companies leasing, instead of buying, their assets (buildings, machines, etc.)

d) Total Asset Turnover = Sales / Total Assets i)

Measures the overall effectiveness in using the assets

23) Profitability Ratios - Measure the success of the firm in earning a net return on sales or investments. a) Profit Margin = Net Income / Sales i)

Ratio is also called the Net Profit Margin

ii)

Shows the “Bottom Line” in percentage terms

iii)

Indicates the return from the company for shareholders.

b) Gross Profit Margin = Gross Profit / Sales i)

Indicates the pricing power (the ability of the company to set the price) of the company

ii)

High GPM shows that company can sell its product with a high “mark-up” over cost.

c) Operating Profit (EBIT) Margin = (Gross profit - Expenses) / Sales = EBIT / Sales

i)

Ratio measures a company's ability to control expenses

d) Return on Assets (ROA) - Net Income / Total Assets *Higher the ratio the better

i) ii)

Ratio is also known as Return on Investment (ROI) Used by businesses to compare attractiveness of various investments

e) Return on Equity (ROE) = Net Income / Common Equity *Common equity - does not does preferred shares into consideration

i)

Measures return to shareholders

24) Valuation Ratios - Utilize market data in addition to data from the financial statements to assess investment merit a) Price-Earning Ratio (P/E) = Price per share / Earnings per share i)

High ratio may signify high growth prospects

ii)

Not applicable if firm is making losses

iii)

Useful for initial public offering (IPO) pricing

b) Price-Sales Ratio (P/S) = Price per share / Sales per share i)

Used to value firm if P/E ratio not applicable. E.g. firm is making losses, or valuing professional service firms.

c) Market-to-book Ratio = Market Price per share / Book Value per share i)

High market-to-book ratio may indicate growth prospects or large amount of intangible assets (e.g. patents)

25) The DuPont System/Analysis - A method of decomposing the Return on Assets (ROA) and Return on investments (ROE) ratios into simpler ratios resulting in greater insights to the performance of a firm. Measure Return on Assets and Return on Equity.

a) Return on Assets (ROA) =

Net Income / Sales

x

Sales / Total Assets

=

Profit Margin

x

Total Asset

Turnover

We note that ROA can be explained by the profit margin and total asset turnover. Comparing a supermarket with a fashion boutique. The supermarket is very busy with a high volume of sales. Its turnover is high but the supermarket makes low margins on its sales. By contrast, fashion boutiques are seldom crowded. Their turnover is low but they command high margins on their products.

b) Return on Equity (ROE) =

Net Income / Total

x

Total Asset / Equity

Asset =

ROA

x

Equity Multiplier

=

Profit Margin x

x

Equity Multiplier

Total Asset Turnover *Equity Multiplier = Total Assets / Equity

As total assets (A) = total debt (L) plus total equity (E), a low amount of equity implies a high amount of debt. So the ratio of total assets to total equity is a measure of leverage. T...