Welcome to Class 15Welcome to Class 15

Research: Financial Domain & Research: Financial Domain & Case Studies – Part 1Case Studies – Part 1

Chapter 8Chapter 8

Financial Domain of Corporate PerformanceFinancial Domain of Corporate Performance

Assessment of corporate financial performance requires:

1. The integration of BOTHBOTH accounting and finance knowledge.

2. The ability to interpret Annual Report data.

It involves an investigation of changes in a firm’s:It involves an investigation of changes in a firm’s: Revenue Profitability Cash flow Liquidity Asset utilization Financial leverage Operating leverage Return on stockholder investment Stock value, and more

Natural Limitations of Performance AssessmentNatural Limitations of Performance Assessment

PerformancePerformance is a matter of is a matter of opinionopinion

TerminologyTerminology is often is often inconsistent inconsistent

Variations of OpinionVariations of Opinion

Variation of Opinion

Mathematical achievements by a firm can be interpreted from different perspectives.

Thus, a 5% increase in revenue may be considered “good” “good” performance by one analyst

BUT

Insufficient, disappointing, and “bad.” “bad.” by another analyst.

Each analyst may be comparing the firm’s achievements to a different set of performance benchmarks. Or, they may be assigning different values to individual performance components.

In other words, precise performance is a matter of “OPINION.”

Variations in TerminologyVariations in Terminology

A “terminologistterminologist” is one who studies, uses, or assigns words or phrases to "technicate" terms in order to convey a particular thought or idea.

Every profession has multiple terminologists.

The result is "terminologicalterminological incongruityincongruity" which has many negative effects.

It increases the probability of miscommunications and it is a nemesis to students and others trying to enter a new profession.

“Technicate” is an original word created to demonstrate what terminologists do in creating or redefining words to describe thoughts or ideas.

Technicate

Communication is enhanced Communication is enhanced when terminology used – when terminology used – is defined and clarified.is defined and clarified.

Thus, we define how the following term Thus, we define how the following term will be used for analysis purposes: will be used for analysis purposes:

““INVESTED CAPITAL”INVESTED CAPITAL”

Invested CapitalInvested Capital

For clarification purposes, in the context of this analysisFor clarification purposes, in the context of this analysisenvironment, environment, Invested CapitalInvested Capital will represent the will represent the

total of all funds contributed by both creditors total of all funds contributed by both creditors and and shareholders.shareholders.

Invested Capital

Invested Capital = Creditor Capital + Equity Capital

[IC] = [CC] + [EC][IC] = [CC] + [EC]

oror

Creditor Capital + Equity Capital = Invested Capital

[CC] + [EC] = [IC] [CC] + [EC] = [IC]

Accounting Equation

Assets = Liabilities + Equity

[A] = [L] + [E][A] = [L] + [E]

oror

Liabilities + Equity = Assets

[L] + [E] = [A] [L] + [E] = [A]

Think about it…

A closer look at A closer look at Assets, Liabilities, & EquityAssets, Liabilities, & Equity

Assets, Liabilities, & EquityThe broad categories of assets, liabilities, and equity are

divided into segments to enhance the understanding of crucial balance sheet relationships.

For example:For example:Assets are divided into those that are "current" and “noncurrent." Liabilities are separated in a similar fashion. Equity is divided into "paid in" and "earned." Invested capital, is divided into "borrowed" and "equity."

Businesses engaged in financial services or related activities as their primary source of revenue generally do not divide their assets and liabilities into current and noncurrent. These organizations include S & Ls, banks, investment houses, etc.

AssetsAssets: :

(1) Current Assets (1) Current Assets (assist with required payments)

(2) Noncurrent Assets (2) Noncurrent Assets (enable the firm to conduct its business) [facilities, equipment, property, long-term investments, intangibles, etc.]

 

LiabilitiesLiabilities (Borrowed Capital):

(1) Current Liabilities (1) Current Liabilities or near-term debt (due within 1 yr. or the operating cycle)

(2) Long-term debt (2) Long-term debt (all the other debt)

 

Shareholder Equity Shareholder Equity (Equity Capital):

(1) Earned Capital (1) Earned Capital (accumulated earnings that have been retained in the business)

(2) Paid-in Capital (2) Paid-in Capital (money paid by stockholders to purchase stock) 

Invested CapitalInvested Capital::

(1) Borrowed Capital (1) Borrowed Capital (credit extended by suppliers, banks, and note and bondholders, etc.)

(2) Equity Capital (2) Equity Capital (investments by stockholders)

Understanding the relationship between the Understanding the relationship between the different classes of accounts is fundamentally different classes of accounts is fundamentally

important to financial analyses.important to financial analyses.

These are highlighted in the Financial Position Model

Financial Position Model

N oncurrent AssetsI te m s such as b u ild ing s & e qu ip m e nt

th a t su pp ort b us ine ss o pe ra tio ns(A lso , lo n g-te rm in ve s tm e n ts , e tc .)

C urrent AssetsH e lp p a y b ills

Assets

Long-term D ebtP ro vid e s o pe ra tin g ca p ita l fo r the

p u rch a se o f No n cu rren t A sse ts a ndp ro v ide s som e a ss is ta nce w ith cu rre n t liq u id ity

C urrent L iabilitiesA re D eb ts g en e ra lly

d u e w ith in the ne x t ye ar

Stockholder Equity(1 ) P a id -in

(2 ) E a rn in gs

Claim s on Assets

  Important relationship between CA & CL

Important relationship

A thorough understanding of the

Financial Position ModelFinancial Position Model

is crucial to Financial Decision-Making

The Financial decision-making domain The Financial decision-making domain includes:includes:

1. Internal Financing Decisions

2. Asset/Debt Decisions

3. Debt/Equity Decisions

1. Internal Financing Decisions: Tactical and StrategicTactical and Strategic

Internal financing decisions fall into two main categories:

(1) Short-term focusShort-term focusTactical financing decisions

(2) Long-term focusLong-term focus Strategic financing decisions

(1) Tactical financing decisions center on maximizing internal funding by changing the way things are done.

For example, directing staff to consider ► SPEEDING the turnover of accounts receivable (ACP) ► Using JIT (just-in-time) inventory techniques

Objective: Improve performance by improving improving current system

Internal Financing Decisions: TACTICAL

Internal Financing Decisions: STRATEGIC(2) Strategic financing decisions center on completely changing

the way of specific functions within the firm are conducted for improved efficiency and enhanced cash flow

Significant changes in corporate operations, such as:► OUTSOURCING customer service, or ► SUBCONTRACTING major manufacturing (e.g. NIKE)

Objective: Improve performance by completely changingcompletely changing system

2. Asset and Debt Management Decisions

Asset and Debt decisions include consideration of how to maximize utilization of high-ticket assets such as property, facilities, equipment, intangibles, etc.

These decisions are also directed at maintaining an optimum balance between:

1. current assets and current liabilities2. current and noncurrent debt3. current and noncurrent assets

Capital budgeting: Decisions about whether to buy or sell property, plant, & equipment are part of this domain

3. Debt/Equity Decisions

Debt and Equity decisions are primarily concerned with:1. The use and extent of long-term financing2. The optimum level and configuration of equity3. The appropriate balance between total debt and

total equity.

Decision-making in this domain involves considering issues such as:

1. How much money is needed to sustain growth2. How should the company acquire those funds(For example, should the corporation issue bonds, issue common

stock, issue preferred stock, or borrow from other sources?)

Important Financial questions:

How much short-term cash is necessary and what is the best strategy to ensure that cash is available when necessary?

What is the best long-term strategy for investment in this company?

What is the optimum financial leverage?

What are the most appropriate sources of cash in-flow?

What is the optimum relationship between equity and debt financing?

Special note on Proxy Statements….

THEY ARE VERY IMPORTANT!!!THEY ARE VERY IMPORTANT!!!

They include:They include:1.1.Invitation to the annual meetingInvitation to the annual meeting2.2.Legal rights and administrative details available to the Legal rights and administrative details available to the shareholdersshareholders3.3.Biographies of all directors (most with pictures)Biographies of all directors (most with pictures)4.4.Board committees & board compensationBoard committees & board compensation5.5.Executive compensationExecutive compensation6.6.Shareholder proposalsShareholder proposals7.7.Information on salaries and bonusesInformation on salaries and bonuses8.8.Information on stock options and other significant Information on stock options and other significant declarations by the TMTdeclarations by the TMT

Proxy Statement & DEF 14AProxy statements Proxy statements are available from all publicly traded companies.

It contains information such as: Invitation to the annual meeting Legal rights and administrative details available to the shareholders Biographies of all directors (most with pictures) Board committees & board compensation Executive compensation Shareholder proposals

SEC Form DEF 14A SEC Form DEF 14A is a filing with the Securities and Exchange Commission (SEC) used in combination with an annual proxy. It includes: 1.Adequate information to allow shareholders to make informed decision when voting their shares. 2.Date, time and place of shareholder meetings, 3.Dissenter’s right of appraisal, modification or change of securities, voting procedures, and other relevant issues and data.

End, Research: Financial Domain & Case Studies – Part 1

Re-read Chapters 8Re-read Chapters 8