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Chapter 9: FINANCE

Using Funds To Maximize Value

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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?

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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

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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

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KEY FINANCIAL RATIOS

RATIORATIO TYPETYPE HOW IT IS HOW IT IS COMPUTEDCOMPUTED

Current Liquidity: ability to pay short-term liabilities.

Current Assets

Current Liabilities

Inventory

Turnover

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

Cost of Good Sold

Average Inventory

Debt-to-equity Leverage: extent to which a firm relies on debt.

Total Debt

Total Owner’s Equity

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KEY FINANCIAL RATIOS

RATIORATIO TYPETYPE HOW IT IS HOW IT IS COMPUTEDCOMPUTED

Debt-to-assets

Leverage: measures the extent to which a relies on debt

Total Debt

Total Assets

Return on equity

Profitability: compares the amount of profit compared to resources invested

Net Income – Preferred Div

Avg Common Stock Equity

Return on assets

Profitability: compares the amount of profit compared to resources invested

Net Income

Average Total Assets

Earnings per share

Profitability: compares the amount of profit compared to resources invested

Net Income – Pref Dividends

Avg # of Shares Out

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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?

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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

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SAMPLE BALANCE SHEET

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MANAGING CASH

• Need cash to pay bills• Cash does not earn returns

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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

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MANAGING ACCOUNTS RECEIVABLE

• Set Credit Terms

• Establish Credit Standards

• Design Appropriate Collection Policy

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

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SHORT-TERM FINANCING

• Spontaneous Financing– Trade Credit

• Short-Term Bank Loans– Line of Credit– Revolving Credit

• Factoring• Commercial Paper

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BORROWING MONEY

““

“If you want to know the value of money, go and try to borrow

some.”- Benjamin Franklin

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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.

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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

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SOURCES OF EQUITY FINANCING

• Direct contributions by owners– Owners directly contribute resources to

unincorporated businesses– Corporations raise equity capital by issuing

stock

• Retained earnings

Equity vs. Debt

• Equity doesn’t require payments

• Debt has tax advantages

• Equity gives up ownership control

• Debt had interest

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