Finance

• Personal Finance
• Corporate Finance
• Public Finance
Sourcing / Using Funds
• Global Finance

MAXIMIZATION OF VALUE

Time Value of Money, Free Market

(Globalization), Risk/Return Trade-off
Concept of Money Monetary Policy

Resources Consumer

MONEY SUPPLY

Fiscal Policy
Concept of Money
 Raw mats → Finished goods

Manufacturer
/ Trader

Surplus / Deficit
Resources

Financial
Intermediaries
 FINANCIAL
INTERMEDIARIES
• Reserve Requirement
• Open market Operation
• FX Trading
• Discounting / BSP
Rediscounting Facilities
• Banking regulations

Monetary Policy
Domestic

sourcing
Risk/Return
use Trade-offs

Avoid
Mitigate
Global
Absorb

Corporate
Finance
END OF PRESENTATION

THANK YOU!!!!
Financial Markets and
Institutions

The Capital Allocation Process

Financial Markets
Financial Institutions
Stock Markets and Returns
Stock Market Efficiency
How is capital transferred between savers and
borrowers?

• Direct transfers
• Investment banks
• Financial intermediaries
 The Capital Allocation Process

• In a well-functioning economy, capital flows

efficiently from those who supply capital to those
who demand it.
• Suppliers of capital: individuals and institutions
with “excess funds.” These groups are saving
money and looking for a rate of return on their
investment.
• Demanders or users of capital: individuals and
institutions who need to raise funds to finance
their investment opportunities. These groups are
willing to pay a rate of return on the capital they
borrow.
 What is a market?

• A market is a venue where goods and services

are exchanged.
• A financial market is a place where individuals
and organizations wanting to borrow funds are
brought together with those having a surplus of
funds.
 Types of Financial Markets

• Physical assets vs. Financial assets

• Spot vs. Futures
• Money vs. Capital
• Primary vs. Secondary
• Public vs. Private
 The Importance of Financial Markets

• Well-functioning financial markets facilitate the

flow of capital from investors to the users of
capital.
 Markets provide savers with returns on their money
saved/invested, which provide them money in the
future.
 Markets provide users of capital with the necessary
funds to finance their investment projects.
• Well-functioning markets promote economic
growth.
• Economies with well-developed markets perform
better than economies with poorly-functioning
markets.
What are derivatives? How can they be used to
reduce or increase risk?

• A derivative security’s value is “derived” from the

price of another security (e.g., options and
futures).
• Can be used to “hedge” or reduce risk. For
example, an importer, whose profit falls when the
dollar loses value, could purchase currency
futures that do well when the dollar weakens.
• Also, speculators can use derivatives to bet on the
direction of future stock prices, interest rates,
exchange rates, and commodity prices. In many
cases, these transactions produce high returns if
you guess right, but large losses if you guess
wrong. Here, derivatives can increase risk.
 Types of Financial Institutions

• Investment banks
• Commercial banks
• Financial services corporations
• Credit unions
• Pension funds
• Life insurance companies
• Mutual funds
• Exchange traded funds
• Hedge funds
• Private equity companies
 Physical Location Stock Exchanges vs.
Electronic Dealer-Based Markets

• Auction market vs. Dealer market (Exchanges vs. OTC)

• NYSE vs. Nasdaq
• Differences are narrowing
 Stock Market Transactions

• Apple Computer decides to issue additional stock

with the assistance of its investment banker. An
investor purchases some of the newly issued
shares. Is this a primary market transaction or a
secondary market transaction?
 Since new shares of stock are being issued, this is a
primary market transaction.
• What if instead an investor buys existing shares of
Apple stock in the open market. Is this a primary or
secondary market transaction?
 Since no new shares are created, this is a secondary
market transaction.
 What is an IPO?

• An initial public offering (IPO) occurs when a

company issues stock in the public market for
the first time.
• “Going public” enables a company’s owners to
raise capital from a wide variety of outside
investors. Once issued, the stock trades in the
secondary market.
• Public companies are subject to additional
regulations and reporting requirements.
S&P 500 Index, Total Returns: Dividend Yield +
Capital Gain or Loss, 1968-2013

Source: Data taken from various issues of The Wall Street Journal
“Investment Scoreboard” section.
 Where can you find a stock quote, and what
does one look like?

• Stock quotes can be found in a variety of print sources

(The Wall Street Journal or the local newspaper) and
online sources (Yahoo!Finance, CNNMoney, or MSN
MoneyCentral).
Stock Quote for Twitter, Inc., June 3, 2014

Source: Twitter, Inc. (TWTR), finance.yahoo.com.

 What is meant by stock market efficiency?

• Securities are normally in equilibrium and are

“fairly priced.”
• Investors cannot “beat the market” except
through good luck or better information.
• Efficiency continuum
Highly Highly
Inefficient Efficient

Small companies not followed by Large companies followed by

many analysts. Not much contact many analysts. Good
with investors. communications with investors.
 Implications of Market Efficiency

• You hear in the news that a medical research

company received FDA approval for one of its
products. If the market is highly efficient, can
you expect to take advantage of this
information by purchasing the stock?
 No. If the market is efficient, this information will
already have been incorporated into the
company’s stock price. So, it’s probably too late
for her to “capitalize” on the information.
 Implications of Market Efficiency

• A small investor has been reading about a “hot”

IPO that is scheduled to go public later this week.
She wants to buy as many shares as she can get
her hands on, and is planning on buying a lot of
shares the first day once the stock begins trading.
Would you advise her to do this?
 Probably not. The long-run track record of hot IPOs
is not that great, unless you are able to get in on the
ground floor and receive an allocation of shares
before the stock begins trading. It is usually hard for
small investors to receive shares of hot IPOs before
the stock begins trading.
 Possible Reasons Markets May Not Be
Efficient

• It is costly and/or risky for traders to take

advantage of mispriced assets.
• Cognitive biases cause investors to make
systematic mistakes that lead to inefficiencies.
This is an area of research know as “behavioral
finance.” Behavioral finance borrows insights
from psychology to better understand how
irrational behavior can be sustained over time.
Some examples include:
 Evaluating risks differently in up and down markets.
 Overconfidence leads to self-attribution bias and
hindsight bias.
Financial Statements, Cash
Flow, and Taxes

Key Financial Statements

• Balance Sheet
• Income Statement
• Statement of Stockholders’ Equity
• Statement of Cash Flows
Free Cash Flow
Federal Tax System
 The Annual Report

• Balance sheet – provides a snapshot of a firm’s

financial position at one point in time.
• Income statement – summarizes a firm’s
revenues and expenses over a given period of
time.
• Statement of cash flows – reports the impact of
a firm’s activities on cash flows over a given
period of time.
• Statement of stockholders’ equity – shows how
much of the firm’s earnings were retained,
rather than paid out as dividends.
 Overview of D’Leon Inc.

• Snack food company that underwent major

expansion in 2014.
• So far, expansion results have been
unsatisfactory.
 Company’s cash position is weak.
 Suppliers are being paid late.
 Bank has threatened to cut off credit.
• Board of Directors has ordered that changes
must be made!
 Balance Sheet: Assets

2015 2014
Cash 7,282 57,600
A/R 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less: Dep. 263,160 146,200
Net FA 939,790 344,800
Total Assets 2,866,592 1,468,800
 Balance Sheet: Liabilities and Equity

2015 2014
Accts payable 524,160 145,600
Accruals 489,600 136,000
Notes payable 636,808 200,000
Total CL 1,650,568 481,600
Long-term debt 723,432 323,432
Common stock 460,000 460,000
Retained earnings 32,592 203,768
Total Equity 492,592 663,768
Total L & E 2,866,592 1,468,800
 Income Statement

2015 2014
Sales $6,034,000 $3,432,000
COGS 5,528,000 2,864,000
Other expenses 519,988 358,672
Total oper. costs excl.
deprec. & amort. $6,047,988 $3,222,672
Depreciation and amortization 116,960 18,900
EBIT ($ 130,948) $ 190,428
Interest expense 136,012 43,828
EBT ($ 266,960) $ 146,600
Taxes (106,784) 58,640
Net income ($ 160,176) $ 87,960
 Other Data

2015 2014
No. of shares 100,000 100,000
EPS -$1.602 $0.88
DPS $0.11 $0.22
Stock price $2.25 $8.50
Lease pmts $40,000 $40,000
 Statement of Stockholders’
Equity (2015)

Total
Common Stock Retained Stockholders’
Shares Amount Earnings Equity
Balances, 12/31/14100,000 $460,000 $203,768 $663,768
2015 Net income (160,176)
Cash dividends (11,000)
Addition (subtraction)
to retained earnings (171,176)
Balances, 12/31/15 100,000 $460,000 $ 32,592 $492,592
 Statement of Cash Flows (2015)

Operating Activities
Net income ($160,176)
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accruals 353,600
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provide d by operating activities ($164,176)
 Statement of Cash Flows (2015)

Long-Term Investing Activities

Additions to property, plant,& equipment ($711,950)
Net cash used in investing activities ($711,950)
Financing Activities
Increase in notes payable $436,808
Increase in long-term debt 400,000
Payment of cash dividends (11,000)
Net cash provided by financing activities $825,808
Summary
Net decrease in cash ($ 50,318)
Cash at beginning of year 57,600
Cash at end of year $ 7,282
Conclusions about D’Leon’s Financial Condition
from Its Statement of CFs

• Net cash from operations = -$164,176, mainly

because of negative NI.
• The firm borrowed $836,808 to meet its cash
requirements.
• Even after borrowing, the cash account fell by
$50,318.
 Did the expansion create additional
after-tax operating income?

AT operating income = EBIT(1 – Tax rate)

AT operating income15 = -$130,948(1 – 0.4)

= -$130,948(0.6)
= -$78,569

AT operating income14 = $114,257

What effect did the expansion have on net
operating working capital?

NOWC  Current   Current  Notes 

assets  liabilities payable 

NOWC 15  ($7,282  $632,160  $1,287,360 )

 ($1,650,568  $636,808 )
 $913,042

NOWC 14  $842,400
Assessment of the Expansion’s Effect on
Operations

2015 2014
Sales $6,034,000 $3,432,000
AT oper. inc. -78,569 114,257
NOWC 913,042 842,400
Net income -160,176 87,960
 What was the free cash flow (FCF) for 2015?

 Depr. and   Capital 

FCF  EBIT(1  T)     NOWC
 amortization expenditures 

FCF15 = [-$130,948(1 – 0.4) + $116,960] –

[($1,202,950 – $491,000) + $70,642]
= -$744,201

Is negative free cash flow always a bad sign?

Performance Measures for Evaluating Managers

• Accounting statements insufficient for

evaluating managers’ performance because
they do not reflect market values.
• Performance Measures
MVA = Difference between market value and
book value of a firm’s common equity.
(P0 x Number of shares) – Book value.
EVA = Estimate of a business’ true economic
profit for a given year.

EBIT(1  T)  Total invested  Cost of 

 capital capital 
 What was D’Leon’s MVA in 2015 and 2014?

MVA15 = ($2.25 x 100,000) – $492,592

= -$267,592

MVA14 = ($8.50 x 100,000) – $663,768

= $186,232

Shareholder wealth has been destroyed!

What is the relationship between EVA and MVA?

• If EVA is positive, then AT operating income >

cost of capital needed to produce that income.
• Positive EVA on annual basis helps to ensure
MVA is positive.
• MVA is applicable to entire firm, while EVA can
be calculated on a divisional basis as well.
 Does D’Leon pay its suppliers on time?

• Probably not.
• A/P increased 260%, over the past year, while
sales increased by only 76%.
• If this continues, suppliers may cut off D’Leon’s
trade credit.
 Does it appear that D’Leon’s sales price
exceeds its cost per unit sold?

• NO, the negative after-tax operating income

and decline in cash position shows that D’Leon
is spending more on its operations than it is
taking in.
 What if D’Leon’s sales manager decided to offer 60-day
credit terms to customers, rather than 30-day credit terms?

• If competitors match terms, and sales remain

constant...
 A/R would .
 Cash would .
• If competitors don’t match, and sales double...
 Short-run: Inventory and fixed assets  to meet
increased sales. A/R , Cash . Company
may have to seek additional financing.
 Long-run: Collections increase and the
company’s cash position would improve.
 How did D’Leon finance its expansion?

• D’Leon financed its expansion with external

capital.
• D’Leon issued long-term debt which reduced its
financial strength and flexibility.
Would D’Leon have required external capital if they
had broken even in 2015 (Net income = 0)?

• YES, the company would still have to finance

its increase in assets. Looking to the
Statement of Cash Flows, we see that the firm
made an investment of $711,950 in net fixed
assets. Therefore, they would have needed to
raise additional funds.
 What happens if D’Leon depreciates fixed assets
over 7 years (as opposed to the current 10 years)?

• No effect on physical assets.

• Fixed assets on the balance sheet would
decline.
• Net income would decline.
• Tax payments would decline.
• Cash position would improve.
 Federal Income Tax System

• Individual Taxes
• Corporate Taxes
 Corporate and Personal Taxes

• Both have a progressive structure (the higher

the income, the higher the marginal tax rate).
• Corporations
 Rates begin at 15% and rise to 35% for
corporations with income over $10 million,
although corporations with income between $15
million and $18.33 million pay a marginal tax rate
of 38%.
 Also subject to state tax (around 5%).
 Corporate and Personal Taxes

• Individuals
 Rates begin at 10% and rise to 39.6% for single
individuals with incomes over $406,750 and
married couples filing jointly with incomes over
$457,600.
 May be subject to state tax.
Tax Treatment of Various Uses and Sources of Funds

• Interest paid: tax deductible for corporations

(paid out of pre-tax income), but usually not for
individuals (interest on home loans being the
exception).
• Interest earned: usually fully taxable (an
exception being interest from a “muni”).
• Dividends paid: paid out of after-tax income.
Tax Treatment of Various Uses and Sources of Funds

• Dividends received: most investors pay 15%

taxes.
 Investors in the 10% or 15% tax bracket pay 0%
on qualified dividends.
 Taxpayers in the 39.6% tax bracket pay 20%
taxes on dividends.
 Dividends are paid out of net income which has
already been taxed at the corporate level, this is
a form of “double taxation”.
 A portion of dividends received by corporations
is tax excludable, in order to avoid “triple
taxation.”
 More Tax Issues

• Tax Loss Carry-Back and Carry-Forward – since corporate

incomes can fluctuate widely, the Tax Code allows firms to
carry losses back to offset profits in previous years or
forward to offset profits in the future.
• Capital gains – defined as the profits from the sale of
assets not normally transacted in the normal course of
business, capital gains for individuals are generally taxed
as ordinary income if held for a year or less, and at the
capital gains rate if held for more than a year. Corporations
face somewhat different rules.
• Most taxpayers pay 15% taxes on long-term capital gains.
• Taxpayers in the 39.6% tax bracket pay 20% taxes on
long-term capital gains.
Financial Statement Analysis

1
Financial Statement Analysis:
Lecture Outline
 Review of Financial Statements
 Ratios
– Types of Ratios
– Examples
 The DuPont Method
 Ratios and Growth
 Summary
– Strengths
– Weaknesses
– Ratios and Forecasting
Stock Price
Expected Market
Cashflows Conditions

NPV
Timing of
MVA Stock Price
Cashflows
EVA

Risk of
Cashflows
Financial Analysis
 Assessment of the firm’s past, present
and future financial conditions
 Done to find firm’s financial strengths
and weaknesses
 Primary Tools:
– Financial Statements
– Comparison of financial ratios to past,
industry, sector and all firms
Financial Statements
 Balance Sheet
 Income Statement

 Cashflow Statement

 Statement of Retained Earnings

Sources of Data
 Annual reports
 Published collections of data
 Investment sites on the web
The Main Idea
 Value for the firm comes from cashflows
 Cashflows can be calculated as:

 (Revt - Costt - Dept)x(1-) + Dept

—OR—
 (Revt - Costt)x(1-) + xDept
—OR—
 Revtx(1-) - Costtx(1-) + xDept
Review: Major Balance Sheet Items
Assets Liabilities and Equity
 Current assets:  Current liabilities:

– Cash & securities – Payables

– Receivables – Short-term debt
– Inventories  Long-term
 Fixed assets: liabilities
– Tangible assets  Shareholders'
– Intangible assets equity
Review: Major Income Statement Items
 Gross Profit = Sales - Costs of Goods Sold
 EBITDA
= Gross Profit - Cash Operating Expenses
 EBIT = EBDIT - Depreciation - Amortization
 EBT = EBIT - Interest
 NI or EAT = EBT- Taxes
 Net Income is a primary determinant of the
firm’s cashflows and, thus, the value of the
firm’s shares
Objectives of Ratio Analysis
 Standardize financial information for
comparisons
 Evaluate current operations
 Compare performance with past
performance
 Compare performance against other
firms or industry standards
 Study the efficiency of operations
 Study the risk of operations
Rationale Behind Ratio Analysis
 A firm has resources
 It converts resources into profits through
– production of goods and services
– sales of goods and services
 Ratios
– Measure relationships between resources and
financial flows
– Show ways in which firm’s situation deviates from
 Its own past
 Other firms
 The industry
 All firms-
Types of Ratio Comparisons
There are two types of ratio
comparisons that can be made:
Cross-Sectional Analysis
Time-Series Analysis
– Combined Analysis uses both types of
analysis to assess a firm's trends versus its
competitors or the industry
 Types of Ratios
 Financial Ratios:
– Liquidity Ratios
 Assess ability to cover current obligations
– Leverage Ratios
 Assess ability to cover long term debt obligations
 Operational Ratios:
– Activity (Turnover) Ratios
 Assess amount of activity relative to amount of
resources used
– Profitability Ratios
 Assess profits relative to amount of resources used
 Valuation Ratios:
 Assess market price relative to assets or earnings
Liquidity Ratio:
 Current Ratio:
Current Assets 7,681.00
Current Ratio :   1.48
Current Liabilities 5,192.00

 Quick (Acid Test) Ratio:

Current Assets - Inventories 7,681.00  391.00
Acid Test Ratio :   1.40
Current Liabilities 1,107,000
 Ratio Comparison: Current Ratio
2.5

2
Current Ratio

1.5

0.5

0
Measures of Debt
There are Two General Types of Debt
Measures
– Degree of Indebtedness
– Ability to Service Debts
Leverage Ratio:
 Debt Ratio:
Total Liabilities 6,163.00
Debt Ratio :   53.73%
Total Assets 11,471.00
 Ratio Comparison: Debt Ratio
0.8
0.7
0.6
Debt Ratio

0.5
0.4
0.3
0.2
0.1
0
Profitability Ratio:
 Return on Assets (ROA):
Net Income 1,666.00
ROA :   14.52%
Total Assets 11,471.00

 Return on Equity (ROE):

Net Income 1,666.00

ROE :   31.39%
Total Common Equity 5,308.00
Profitability Ratio:

 Net Profit Margin:

EBIT 2,451.00
Net Profit Margin :   6.59%
Sales 25,265.00

 Retention Ratio
EPS - Div 0.66  0
Retention Ratio (  ) :   100%
EPS 0.66
 Ratio Comparison: ROE
80%
70%
60%
50%
ROE

40%
30%
20%
10%
0%
 Ratio Comparison: ROA
25%

20%

15%
ROA

10%

5%

0%
 Ratio Comparison: Profit Margin
9%
8%
7%
Profit Margin

6%
5%
4%
3%
2%
1%
0%
Basic Profitability Measures
Gross Profits
Gross Profit Margin (GPM) GPM=
Sales
Operating Profits (EBIT)
Operating Profit Margin (OPM) OPM =
Sales
Net Profit After Taxes
Net Profit Margin (NPM) NPM=
Sales
Net Profit After Taxes
Return on Total Assets (ROA) ROA=
Total Assets
Net Profit After Taxes
Return On Equity (ROE) ROE=
Stockholders’ Equity
Earnings Available for
Common Stockholder’s
Earnings Per Share (EPS) EPS =
Number of Shares of Common
Stock Outstanding
Market Price Per Share of
Price/Earnings (P/E) Ratio P/E =
Common Stock
Earnings Per Share
Activity (Turnover) Ratio:
 Total Asset Turnover Ratio:
Sales 25,265.00
Total Asset Turnover :   2.20
Total Assets 11,471.00

 Inventory Turnover Ratio:

Sales 25,265.00
InventoryTurnover:   64.62
Inventory 391.00
Ratio Comparison: Asset Turnover
350%

300%
Asset Turnover

250%

200%

150%

100%

50%

0%
11 Five Important Activity Measures
Cost of Goods Sold
Inventory Turnover (IT) IT =
Inventory

Average Collection Period (ACP) Accounts Receivable

ACP =
Annual Sales/360

Average Payment Period (APP) Accounts Payable

APP=
Annual Purchases/360
Fixed Asset Turnover (FAT) Sales
FAT =
Net Fixed Assets
Total Asset Turnover (TAT) Sales
TAT =
Total Assets
The DuPont System
 Method to breakdown ROE into:
– ROA and Equity Multiplier
 ROA is further broken down as:
– Profit Margin and Asset Turnover
 Helps to identify sources of strength and
weakness in current performance
 Helps to focus attention on value drivers
The DuPont System

ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

The DuPont System
ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

ROE  ROA  Equity Multiplier

Net Income Total Assets
 
Total Assets Common Equity
The DuPont System
ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

ROA  Profit Margin  Total Asset Turnover

Net Income Sales
 
Sales Total Assets
 The DuPont System
ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

ROE  Profit Margin  Total Asset Turnover  Equity Multiplier

Net Income Sales Total Assets
  
Sales Total Assets Common Equity
The DuPont System:
Net Income Sales Total Assets
ROE   
Sales Total Assets Common Equity
 Profit Margin  Total Asset Turnover  Equity Multiplier
 ROA  Equity Multiplier

1,666.00 25,265.00 11,471.00

ROE   
25,265.00 11,471.00 5,308.00
 0.0659  2.2025  2.1611
 0.1452  2.1611
 31.39%
A Note on Sustainable Growth
and Stock Returns
 In the long run
– Sustainable growth and long run capital gains
(g) = ROE x 
 Recall the relationship between stock
returns (r), capital gains (g) and forward
dividend yields (D1/P0):
– r = g + D1/P0 = g + Do(1+g)/P0
 Note: r & g must be quarterly if D is
quarterly and annual if D is annual
Summary of Financial Ratios
 Ratios help to:
– Evaluate performance
– Structure analysis
– Show the connection between activities and
performance
 Benchmark with
– Past for the company
– Industry
 Ratios adjust for size differences
Limitations of Ratio Analysis
 A firm’s industry category is often difficult
to identify
 Published industry averages are only
guidelines
 Accounting practices differ across firms
 Sometimes difficult to interpret deviations
in ratios
 Industry ratios may not be desirable targets
 Seasonality affects ratios
More Issues Regarding Ratios
 “Average” performance is not
necessarily good, perhaps the firm
should aim higher.
 Seasonal factors can distort ratios.
 “Window dressing” techniques can
make statements and ratios look better
than they actually are.
 Inflation has distorted many firms’
balance sheets, so analyses must be
interpreted with judgment.
Consider Qualitative Factors When Evaluating a
Company’s Future Financial Performance

• Are the firm’s revenues tied to one key

customer, product, or supplier?
• What percentage of the firm’s business is
generated overseas?
• Firm’s competitive environment
• Future prospects
• Legal and regulatory environment
Ratios and Forecasting
 Common stock valuation based on
– Expected cashflows to stockholders
– ROE and  are major determinants of cashflows to
stockholders
 Ratios influence expectations by:
– Showing where firm is now
– Providing context for current performance
 Current information influences expectations by:
– Showing developments that will alter future
performance
FINANCIAL
PLANNING AND
FORECASTING
• Identify the importance of strategic planning 
and the central role that financial forecasting 
plays in the overall planning process.
• Compute for the Additional Funds Needed 
(AFN) and identify its relevance in financial 
management decisions.
• IMPORTANCE AND PROCESS OF STRATEGIC PLANNING
• UNDERSTAND PRINCIPLES OF FINANCIAL FORECASTING
o Benefits of financial forecasting
o Financial modelling
o Methods in financial forecasting
• PREPARING FORECASTED FINANCIAL STATEMENTS
o Assumptions
o Additional funds needed
o Sustainable growth rate
STRATEGIC PLANNING
• Formalizes the goals and objectives of the company
• It answers the questions:
• Why the company exists
• What will the company be in the future
• What are the goals and objectives of the company
• What will be the focus to attain such goals and
objectives
• What are the roles of each member of the company
• What will be the quantitative results if such goals and
objectives are achieved
 Assess
organization

Monitor Develop
and vision and
evaluate mission

Assess
Implement
environment

Write it all Agree on

down! priorities

Strategic Planning
 What do
we want
Where to
do we achieve?
want to The
go?
Vision
What do
we want
to be?
What
community
do we
dream of?

Strategic Planning
 How do we
overcome our
weaknesses to
How do we
take
use our
advantage of
strengths to
opportunities?
take
advantage of
opportunities?
SWOT
How do we
overcome
the
weaknesses
that make us
How do we vulnerable to
use our threats?
strengths to
make us less
vulnerable to
threats?
Strategic Planning
Benefits of Financial Forecasting
 Provides a disciplined means of evaluating the cash needs of the
company
 Allows visualization of financial results of plans
 Prepare to take advantage of opportunities
 Better prepare for contingencies
 Helps to plan for future growth
 Can be used in measuring future performance
Principles of Financial Forecasting
 Build and support a schedule of assumptions
 Begin with a forecast of revenue
 Decide whether to forecast in real or nominal terms
 Choose an appropriate time span and forecasting interval
 Integrate the financial statements
 Assess the reasonableness of the model
Methods of Financial Forecasting:
UsingPro Forma, or Projected, Financial
Statements (more exact, time
consuming)

Percent-of-Sales Method (less precise,

easier to calculate)
Steps in a Pro Forma Income Statement
 Establish a sales projection
 Forecast economic conditions
 Survey sales personnel
 Determine production needs, COGs, and gross profit
 Determine units to be produced
 Determine the cost of producing the units
 Compute cost of goods sold
 Compute gross profit
 Compute other expenses
 General and administrative
 Interest expense
 Finally construct the pro forma income statement
Percent-of-Sales Method
A short-cut, less exact, easier method of
determining financing needs (The “quick and
dirty” approach)
 Assumesthat B/S accounts will maintain a
constant percentage relationship to sales
**Assets / Current Sales = % of Sales
Percent-of-Sales Method
 Step 1: Estimate year-by-year Sales Revenue and
Expenses
 Step 2: Estimate Levels of Investment Needs (in
Assets) required to Meet Estimated Sales (using
Financial Ratios)
 Step 3: Estimate the Financing Needs (Liabilities)
Techniques of sales forecasting
Subjective Methods:
 Jury of Executive opinion
 Sales Force estimates

Objective methods:
 Trend Analysis by Extrapolation (Long term trend, Cyclical
variations, Seasonal variations, and erratic movement)
 Regression Analysis (Relationship between dependent
variable Sales, and independent variables like Income,
etc).
Percent-of-Sales Method
AFN* = A/S (change S) – L/S (change S) – PS2(1-D)
*other references use: Required New Funds (RFN) or Discretionary Financing Needs (DFN) or External Funds
Requirement (EFR)

Where:
A/S = % relationship of assets to sales
change S = Change in Sales (forecast – prior sales)
P = Profit margin
S2 = Forecasted Sales
D = Dividend Payout Ratio. (1-D) is retention rate.
The effects of other factors on the
AFN forecast.
 Excess capacity:
 Existence lowers AFN.
 Base stocks of assets:
 Leads to less-than-proportional asset increases.
 Economies of scale:
 Also leads to less-than-proportional asset increases.
 Lumpy assets:
 Leads to large periodic AFN requirements, recurring
excess capacity.
Growth and External Financing
 At low growth levels, internal financing (retained earnings)
may exceed the required investment in assets.
 As the growth rate increases, the internal financing will not be
enough and the firm will have to go to the capital markets for
money
 Examining the relationship between growth and external
financing required is a useful tool in long-range planning
 Discuss two growth rates that are useful for financial planning.
 Internal growth rate
 Sustainable growth rate
Growth Rate
 Theinternal growth rate tells us how much the firm can grow
assets using retained earnings as the only source of financing.
That is, with no external financing
 Internal growth = ROA x b
 The
sustainable growth rate tells us how much the firm can
grow by using internally generated funds and issuing debt to
maintain a constant debt ratio.
 Sustainable growth = ROE x b

Where b = retention ratio

Determinants of Growth
 Profit margin – operating efficiency
 Total asset turnover – asset use efficiency
 Financial leverage – choice of optimal debt ratio
 Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
Sustainable Rate of Growth
 The
maximum sales growth rate a firm
can have while maintaining its
capital structure (financing mix).
Sustainable Rate of Growth

g* = ROE (1 - b)
where
b = dividend payout ratio (dividends / net income)
ROE = return on equity (net income / common equity)

ROE = net income

sales x sales
assets x assets
common equity
Budgets
 Budgets indicate the amount and
timing of future financing needs.
 Budgets provide a basis for taking
corrective action if budgeted and
actual figures do not match.
 Budgets provide the basis for
performance evaluation.
WORKING CAPITAL
MANAGEMENT
Learning Objectives
• Identify the importance of Working Capital Management to 
the firm’s profitability and stock prices.
• Identify the different Current Assets, Investment and 
Financing Policies available for a firm.
• Compute Cash Conversion Cycle and identify its relevance 
to financial management decisions.
• Evaluate the Current Assets (Cash, Accounts and 
Receivable) of Firms.
• Evaluate the Current Liabilities of Firms.
BASIC DEFINITIONS

• Gross working capital:  Total current assets
• Net working capital (NWC):  Current assets ‐ Current liabilities
• Net operating working capital (NOWC):
Operating CA – Operating CL =  (Cash + Inv. + A/R) –
(Accruals + A/P)
WORKING CAPITAL MANAGEMENT
• Day‐to‐day control
• Cash
• Inventories
• Accounts receivable
• Accruals
• Accounts payable
• Working capital policy
• The level of each current asset
• How current assets are financed
CASH CONVERSION CYCLE
The time between payments made for materials and 
labor and payments received from sales:

Cash  Inventory Receivables Payables

Conversion = Conversion +  Collec on   − Deferral
Cycle Period  Period Period
INVENTORY CONVERSION PERIOD
Average time required to convert materials 
into finished goods and to sell those goods:
Inventory
Inventory Conversion Period 
Sales per day
RECEIVABLES COLLECTION PERIOD
• Average length of time required to convert the firm’s 
receivables into cash:
Receivables
Receivables Collection Period 
Sales / 365

Receivables Collection Period = Days Sales Outstanding (DSO)
PAYABLES DEFERRAL PERIOD
• Average length of time between the purchase of 
materials and labor and the payment of cash for them:
Payables
Payable Deferral Period 
Purchases per Day
Payables

Cost of goods sold / 365
CASH CONVERSION OBJECTIVE
Shorten the cash conversion cycle as much as possible 
without hurting operations:
• Reduce Inventory Conversion period
• Process & sell goods quicker
• Reduce Receivables Collection period
• Speed up collections
• Lengthen Payables Deferral Period
• Slow firm’s payments
CASH MANAGEMENT: CASH = 
“NON‐EARNING ASSET”
• Transactions: 
• Must have some cash to pay current bills.
• Precautionary balances = “Safety stock”
• Compensating balances: 
• For loans and/or services provided.
• Speculation: 
• Take advantage of bargains
• Take discounts
CASH BUDGET: THE PRIMARY CASH 
MANAGEMENT TOOL
• Projected cash inflows, outflows, and ending cash 
balances forecast loan needs and funds available for 
temporary investment
• Daily, weekly, or monthly, depending upon budget’s 
purpose
• Monthly for annual planning
• Daily for actual cash management
DATA REQUIRED FOR CASH BUDGET
• Sales forecast
• Information on collections delay
• Forecast of purchases and payment terms
• Forecast of cash expenses: wages, taxes, utilities, and so on
• Initial cash on hand
• Target cash balance
CASH MANAGEMENT TECHNIQUES
• Synchronize inflows and outflows
• Billing cycle = Payment cycle
• Use Float
• Remote disbursement accounts (+)    Net 
• Collections float (‐) Float
• Lockbox Plan
• Payment by wire transfer or automatic debit
• Reduce the need for a cash “safety stock”:
• Increase forecast accuracy
• Hold marketable securities instead of a cash 
• Negotiate a line of credit 
INVENTORY MANAGEMENT GOALS
• Ensure that the inventory needed to sustain 
operations is available
• Minimize the costs of ordering and carrying 
inventory 

• Trade‐off to balance goals
INVENTORY MANAGEMENT: 
CATEGORIES OF INVENTORY COSTS
• Carrying Costs 
• Storage and handling 
• Insurance
• Property taxes
• Depreciation
• Obsolescence
INVENTORY MANAGEMENT: CATEGORIES 
OF INVENTORY COSTS
• Ordering Costs
• Cost of placing orders
• Shipping
• Handling costs
INVENTORY MANAGEMENT: CATEGORIES 
OF INVENTORY COSTS
• Costs of Running Short
• Loss of sales
• Loss of customer goodwill
• Disruption of production schedules
RECEIVABLES MANAGEMENT
A/R = Credit sales/day X Collection Period
Collection period ‐ Average time from credit sale to collection of cash

• Credit policy
• Receivables monitoring
ELEMENTS OF CREDIT POLICY
• Credit Period = How long to pay?
• Shorter period reduces DSO 
• Reduces average A/R
• May discourage sales
• Cash Discounts  
• Lowers price
• Attracts new customers 
• Reduces DSO
ELEMENTS OF CREDIT POLICY
• Credit Standards  
• Tighter standards reduce bad debt losses,
• May reduce sales
• Fewer bad debts reduces DSO
• Collection Policy
• Tougher policy will reduce DSO
• May damage customer relationships
RECEIVABLES MONITORING
Credit sale events:
1. Inventories reduced by COGS
2. A/R increased by sales price
3. Price – COGS = Profit 
Profit  Retained Earnings
DSO = Days Sales Outstanding
DSO = Average Collection Period
DAYS SALES OUTSTANDING
ADS  Average Daily Sales

Annual Sales (Units Sold)  (Sales Price)

ADS  
365 365

Receivables  (ADS)  (DSO)

Receivables Receivables
DSO  
Sales per Day Sales/365
TRADE CREDIT
• Credit furnished by a firm’s suppliers
• Accounts Payable
• Often largest source of short‐term credit, especially 
for small firms
• Spontaneously increases
• Easy to get, but cost can be high
• Example: 2/10, net 30
• 2% discount if paid within 10 days
• Due in 30 days
WORKING CAPITAL FINANCING POLICIES
• Moderate = Match the maturity of the assets with 
the maturity of the financing
• “Maturity matching”
• “Self‐liquidating”
• Aggressive = Use short‐term financing to finance 
permanent assets
• Conservative = Use permanent capital for 
permanent assets and temporary assets
SHORT‐TERM INVESTMENTS
• Marketable securities
• Lower yields than operating assets
• Held for same reasons as cash
• Benefits:
• Reduces risk and transactions costs
• Won’t need to issue securities or borrow as 
frequently
• Ready cash for opportunities = “speculative 
balances”
• Disadvantages
• Low after‐tax return
SHORT‐TERM FINANCING
• Advantages
• Funds available relatively quickly
• Lower cost
• Yield curve usually upward sloping
• Lower flotation costs
• Can repay early without penalty
• Less restrictive loan covenants
SHORT‐TERM FINANCING
• Disadvantages
• Higher risk
• Interest expense fluctuates  
• Required repayment comes quicker
• Firm may have trouble rolling over loans
SHORT‐TERM BANK LOANS
• Compensating Balances
• Raises the effective loan rate
• Illegal in many states
• Informal Line of Credit
• Maximum amount bank will extend
• Revolving Credit Agreement
• Formal line of credit
• Periodic commitment fee
• Bank legally obligated to honor agreement
COMMERCIAL PAPER (CP)

• Short term, unsecured promissory notes issued by large, 
strong companies
• Maturity = 1‐9 months; average 5 months
• Interest rates fluctuate daily just above the T‐bill rate
• Less personal than bank relationships
SECURITY IN SHORT‐TERM FINANCING
• Commercial paper is never secured
• Better to borrow on an unsecured basis
• Lower bookkeeping costs
• Collateral options:
• Marketable securities
• Land or buildings
• Equipment
• Inventory
• Receivables
 LIQUIDITY RATIO C. Debt to Equity Ratio

A. Current Ratio Debt to Total Liability

Total Current Assets Equity

Ratio
Current Ratio Total Shareholder’s Equity
Total Current Liabilities

D. Times Interest Earned Ratio

B. Quick Ratio
Times Earnings bef ore Interest and
Current Assets - Inventories Tax (EBIT)
Quick Ratio Interest
Earned
Total Current Liabilities Ratio Interest Expense

C. Cash Ratio
E. Cash Coverage Ratio
Cash + Marketable Securities
Cash Ratio EBIT + Depreciation
Cash
Total Current Liabilities Coverage
Ratio Interest Expense

D. Working Capital to Total Asset Ratio

ACTIVITY RATIO
Working
Capital to Current Assets - Current Liabilities
Total
A. Asset Turnover Ratio
Asset
Ratio Total Assets Sales Revenue
Asset
Turnover
Ratio
Average Assets

LEVERAGE RATIOS B. Accounts Receivable Turnover Ratio

A. Debt Ratio
Accounts
Total Liability Receivable Credit Sales
Debt Ratio Turnover
Total Asset Ratio Average Accounts Receivable

B. Equity Ratio C. Days’ Sales Receivable

Equity Total Shareholder’s Equity Days’ Sales Average Receivables*

Ratio Receivable
Total Asset Average Daily Sales**

* Beginning AR + Ending AR / 2
** Sales Revenue / 360

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D. Inventory Turnover Ratio ● ARP - Average Receivable Period or
Average Collection Period
Inventory Cost of Sales Average Receivables
Turnover ARP
Ratio Average Inventory Average Daily Sales

E. Days’ Sales Inventory ● APP - Average Payable Period

Average Accounts Payable
Days’ Sales Average Inventory* APP
Inventory
Average Daily Sales** Average Daily Purchases

* Beginning Inv. + Ending Inv. / 2

** Cost of Sales / 360
PROFITABILITY RATIO
F. Accounts Payable Turnover Ratio
AS TO MARGINS
Accounts 1. Gross Profit Margin (GPM)
Payable Purchases* Gross Prof it
Turnover GPM
Ratio Accounts Payable Net Sales

* Cost of Goods Sold + Ending Inventory -

Beginning Inventory 2. Operating Profit Margin (OPM)
Operating Prof it
G. Days’ Payable Outstanding
OPM

Days’ Sales Average Accounts Payable* Net Sales

Outstanding
Average Daily Purchases**
3. Net Profit Margin (NPM)
* Beginning AP + Ending AP / 2 Net Income Af ter Tax
** Purchases / 360 NPM

H. Normal Operating Cycle Net Sales

Cash
AIP + ARP - APP AS TO RETURNS
Conversion
1. Return on Sales (ROS)
Cycle
Net Income
ROS
● AIP - Average Inventory Period Net Sales
Average Inventory
AIP
2. Return on Assets (ROA)
Average Daily Cost of Sales
Net Income
ROA
Average Assets

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3. Return on Equity (ROE)

ROE Net Income

Average Equity

AS TO SHAREHOLDER’S INTEREST
1. Earnings Per Share (EPS)
Net Income - Pref erred Dividends
EPS
Number of Outstanding Common
Stocks

2. Price-Earnings Ratio (PER)

PER Market Price per share

Earnings per share

3. Dividend Yield (DY)

Dividend Per Share
DY
Market Price per Share

4. Pay-Out Ratio (POR)

Dividends per Share
POR
Earnings per Share

5. Plow Back Ratio (PBR)

Earnings per Share - Dividends per
PBR Share

Earnings per Share

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