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Managing Financial Performance March 18, 2004 "Money talks...but all mine ever says is goodbye.“ --Anon Agenda Chapter 13: Evaluating and Managing Financial Performance Accounting Statements Working-Capital Management Assessing Financial Performance Capital Budgeting

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Managing financial performance l.jpg

Managing Financial Performance

March 18, 2004


Money talks but all mine ever says is goodbye anon l.jpg

"Money talks...but all mine ever says is goodbye.“--Anon


Agenda l.jpg

Agenda

  • Chapter 13: Evaluating and Managing Financial Performance

    • Accounting Statements

    • Working-Capital Management

    • Assessing Financial Performance

    • Capital Budgeting


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Accounting Statements

  • Reports of a firm’s financial performance and resources, including an income statement, a balance sheet and a cash flow statement

    • Help determine a startup’s financial requirements

    • Assesses the financial implications of a business plan

    • Provide an accurate picture of operating results.

    • Permit a quick comparison of current data with prior years’ operations.

    • Facilitate prompt filing of reports and tax returns to regulatory and tax-collecting agencies.

    • Reveal employee fraud, waste, and record-keeping errors.


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Internal Accounting Controls

  • A system of checks and balances that safeguards assets and enhances the accuracy and reliability of financial statements.

  • Types of internal controls

    • Identifying transactions requiring owner authorization

    • Ensuring checks issued have supporting documentation

    • Limiting access to accounting records and computers

    • Sending bank statements directly to the owner

    • Safeguarding blank checks

    • Requiring employees to take vacations


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The Income Statement

  • A report showing the profit or loss from a firm’s operations over a given period of time.

  • “How profitable is the business?”

  • Sales – Expenses = Profits

    • Revenue from product or service sales

    • Costs of producing product or service (COGS)

    • Operating expenses (marketing, selling, general and administrative expenses, and depreciation)

    • Financing costs (interest paid)

    • Tax payments


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The Income Statement

Operating Activities

Financing Activities

Taxes

Operating Income

Sales Revenue

Earnings Before Taxes

Interest expense on debt (financing costs)

Income taxes

Cost of producing or acquiring product or service

(cost of goods sold)

=

Gross profit

=

=

Marketing and selling expenses, general and administrative expenses and depreciation(operating expenses)

Earnings Before Taxes

Net Income Available

,

to Owners

=

Operating Income


Income statement l.jpg

Income Statement

Sales revenue$830,000

Cost of goods sold_550,000

Gross profit$290,000

Operating expenses:

Marketing expenses$90,000

General and administrative expenses 72,000

Depreciation _28,000

Total operating expenses$190,000

Operating income$100,000Interest expense__20,000

Earnings before taxes$ 80,000

Income tax (25%) 20,000

Net income $ 60,000

Dividends paid$_15,000

Change in retained earnings$ 45,000


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The Balance Sheet

  • A report showing a firm’s assets, liabilities, and owners’ equity at a specific point in time

    Outstanding debt + Owner’s equity = Total assets


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The Balance Sheet: An Overview

Debt (Liabilities) and

Equity (Net Worth)

Assets

Current Assets

Debt Capital

Current Debt

Cash

Accounts payable

Accounts receivable

Accrued expenses

Inventories

Short-term notes

Long-term Debt

+

Long-term notes

Mortgages

Fixed Assets

Machinery andequipment

+

Buildings and land

Owner's Equity

Owner's net worth

+

or

Partnership equity

or

Other Assets

Common stock equity

Long-terminvestments, patents

=

=

Total Assets

Total Debt and Equity


Fit between the income statement and balance sheet l.jpg

Fit between the Income Statement and Balance Sheet

Income statement reports the profits from

January 1, 2002 through December 31, 2002

January 1

December 31

2001 Balance Sheet Reports a firm's financial position at beginning of 2002 (end of 2001)

2002 Balance Sheet Reports a firm's financial position at end of 2002


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The Cash-Flow Statement

  • A financial report that shows changes in a firm’s cash position over a given period of time

  • Accrual-Basis Accounting

    • A method of accounting that matches revenues when they are earned against the expenses associated with those revenues.

  • Cash-Basis Accounting

    • A method of accounting that reports transactions only when cash is received or a payment is made.


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Flow of Cash through a Business

Owner's

Borrowed

Sale of

Borrowed

Investment

Funds

Fixed Assets

Funds

Collection of

Collection of

Cash

Accounts

Accounts

Sales

Receivable

Receivable

Payment of

Purchase of

Expenses

Fixed Assets

Payment of

Payment for

Dividends

Inventory


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Managing Working Capital

  • Working Capital Management

    • The management of current assets and current liabilities

  • Net Working Capital

    • The sum of a firm’s current assets (cash, account receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals).

  • Working Capital Cycle

    • The daily flow of resources through a firm’s working-capital accounts


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The Working-Capital Cycle

  • Purchase or produce inventory for sale, which increases accounts payable.

  • a. Sell inventory for cash.b. Sell inventory for credit (accounts receivable).

  • Pay the accounts payable (decreases cash and accounts payable).

  • Collect the accounts receivable (decreases accounts payable and increases cash).

  • Begin cycle again


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The Working Capital Cycle

1

Purchase

Increases

Increases inventory

or produce

accounts payable

inventory

2

Sell the

Decreases inventory

inventory

Increases

2a

2b

accounts

for cash

on credit

receivable

3b

3a

Pay

Decreases

Pay

operating

accounts

accounts

expenses

payable

payable

and taxes

4

Decreases

Collect

accounts

accounts

receivable

receivable

decreases

increases

increases

decreases

5

Cash

Begin cycle

again


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Working-Capital Time Line

Order

Inventory

Cash Collection

Placed

Received

of Receivables

Sale

Days in Inventory

Days in Accounts Receivable

a

b

c

d

e

Days in Accounts Payable

Cash Conversion Period

Cash Payment

for Inventory

Cash conversion period—the time required to convert paid-for inventories and accounts receivable into cash.

Source: Adapted from Terry W. Maness and John T. Zeitlow, Short-Term Financial Management (New York: Dryden Press/Harcourt Brace, 1998), p. 4.


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Three-Month Cash Budget

May June JulyAugustSeptemberMonthly Sales$100,000$120,000 $130,000 $130,000$120,000

Cash receipts

Cash sales for month (40%) $ 52,000 $ 52,000 $ 48,000

1 month after sale (30%)36,000 39,000 39,000

2 months after sale (30%)30,000 36,00039,000

Step 1Total collections$118,000$127,000$126,000

Purchases (80% of sales)$104,000 $104,000 $ 96,000$ 80,000

Cash disbursementsStep 2a Payments on purchases$104,000$104,000$ 96,000Rent3,0003,0003,000

Wages and salaries18,00018,00016,000

Step 2bTax prepayment1,000Utilities (2% of sales)2,600 2,600 2,400

Interest on long-term note800

Step 2cShort-term interest (1% of short-term debt)106113

Total cash disbursements$128,600$127,706$118,313

Step 3Net change in cash$ 10,600$ 706$ 7,687

Step 4Beginning cash balance5,0005,0005,000

Step 5Cash balance before borrowing$ 5,600$ 4,294$ 12,687

Step 6Short-term borrowing (payments)10,6007067,687Ending cash balance$ 5,000$ 5,000$ 5,000

Step 7Cumulative short-term debt outstanding$ 10,600$ 11,306$ 3,619


Managing inventory l.jpg

Managing Inventory

  • Inventory is a “necessary evil.”

    • Product supply and consumer demand don’t always match up

  • Reducing Inventory to Free Cash

    • Monitoring current inventory

      • Determine age and suitability for sale.

    • Controlling stockpiles

      • Match on-hand inventory with demand.

      • Avoid personalizing the business-customer relationship.

      • Avoid forward purchasing of inventory; the carrying cost for excess inventory may exceed any savings.


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Assessing Financial Performance

  • Does the firm have the capacity to meet its short-term (one year or less) financial commitments?

    • Is the liquidity of the firm’s assets sufficient?

  • Is the firm producing adequate operating profits on its assets?

  • How is the firm financing its assets?

  • Are the owners (stockholders) receiving an acceptable return on their equity?


  • Measuring liquidity approach i l.jpg

    Measuring Liquidity: Approach I

    Current

    assets

    -

    Inventories

    =

    Acid-test

    ratio

    Current

    liabilities

    • Current Ratio

      • A measure of a company’s relative liquidity determined by comparing cash and near-cash current assets against the debt (current liabilities) coming due and payable within one year.

    • Acid-test ratio (quick ratio)

      • A measure of a company’s liquidity that excludes inventories

    Current

    assets

    =

    Current

    ratio

    liabilities

    Current


    Measuring liquidity approach ii l.jpg

    Measuring Liquidity: Approach II

    • Average Collection Period

      • The average time it takes a firm to collect its accounts receivable.

    • Account Receivable Turnover Ratio

      • The number of time accounts receivable “roll over” during a year.

    • Inventory Turnover Ratio

      • The number of times inventories “roll over” during the year.


    Measuring return on investment l.jpg

    Measuring Return on Investment

    Operating incomereturn on investment

    Operating

    income

    =

    Total

    Assets

    • OIROI: A measure of operating profits relative to total assets – a rate of return that is independent of how the company is financed

    • Operating Profit Margin: The ratio of operating profits to sales, showing how well a firm manages the activities that affect its income.


    Measuring return on investment24 l.jpg

    Measuring Return on Investment

    • Total Asset Turnover

      • A ratio of sales to total assets, showing the efficiency with which the firm’s assets are used to generate sales.

    • Fixed Asset Turnover

      • A ratio that measures the relationship of sales to fixed assets


    Measuring return on investment25 l.jpg

    Measuring Return on Investment

    Operating

    income

    Sales

    Operating incomereturn on investment

    =

    X

    Sales

    Total

    assets

    Operating incomereturn on investment

    Operating

    income

    =

    Total

    Assets

    Operating incomereturn on investment

    Operatingprofit margin

    Total assetturnover

    =

    X

    • Operating Income Return on Investment


    How is the firm financing its assets l.jpg

    How is the Firm Financing Its Assets?

    • Financial Leverage

      • The use of debt in financing a firm’s assets

      • Can increase ROE but use it wisely!

    • Debt (or Debt-Equity) Ratio

      • The ratio of total debt to total assets (or equity)

    • Times Interest Earned Ratio

      • The ratio of operating income to interest charges; shows the number of times a firm earns the amount it must pay in interest


    Return on owners investment l.jpg

    Return on Owners’ Investment

    • Return on equity (ROE)

      • The rate of return that owners earn on their investment.


    Financial ratios for retail computer and software stores l.jpg

    Financial Ratios for Retail Computer and Software Stores

    Source: Adapted from RMA 2001–2002 Annual Statement Studies published by Robert Morris Associates, Philadelphia, Pa. Copyright Robert Morris Associates, 2001.


    Return on invested capital an overview l.jpg

    Return on Invested Capital: An Overview

    Capital invested

    by the

    Firm's

    firm's creditors

    becomes

    total assets

    and

    equity investors

    (owners)

    Profits and

    cash flows

    compute

    Rate of return

    on total capital

    Shared by

    equals

    Equity

    Creditors

    investors

    Operating income

    compute

    compute

    Total assets

    Return on

    Return on

    creditor's

    equity

    capital

    capital

    equals

    equals

    Net income

    Interest rate

    charged on debt

    Common equity


    Capital budgeting l.jpg

    Capital Budgeting

    • An analytical method that helps managers make decisions about long-term investments such as:

      • Developing new products

      • Replacing equipment

      • Constructing new facilities

      • Expanding sales territories

    • Seeks to answer the question:

      • “Do future benefits from the investment exceed the cost of making the investment?”

    • Good decisions can add value to the firm; bad decisions can put the firm out of business.


    Three rules of capital budgeting l.jpg

    Three Rules of Capital Budgeting

    • Investors judging the attractiveness of an investment prefer:

      • More cash rather than less cash.

      • Cash sooner rather than later.

      • Less risk rather than more risk.


    Capital budgeting techniques l.jpg

    Capital Budgeting Techniques

    • Capital Budgeting Decisions Involve:

      • Accounting return on investment

        • How many dollars in average profits are generated per dollar of average investment?

      • Payback period

        • How long will it take to recover the original investment outlay?

      • Discounted cash flows (net present value or internal rate of return)

        • How does the present value of future benefits from the investment compare to the investment outlay?


    Accounting roi l.jpg

    Accounting ROI

    ,

    ,

    ,

    ,

    1

    000

    2

    000

    2

    500

    3

    000

    +

    +

    +

    Accounting returnon investment

    4

    =

    ,

    10

    000

    0

    +

    2

    2,125

    =

    0.425,

    or

    42.5%

    =

    5,000

    • Accounting ROI

      • Evaluation of a capital expenditure based on the average annual after-tax profits relative to the average book value of an investment.

    Initial investment = $10,000

    YearAfter-Tax Profits11,00022,00032,50043,000


    Payback period l.jpg

    Payback Period

    • Payback period

      • Measuring the amount of time it will take to recover the cash outlay of an investment.

    Original Investment = $15,000

    Annual Depreciation = $1,500

    Acceptable payback period= 5 years

    Payback period = 4.86 years

    After-TaxYearProfits1–21,0003–62,0007–102,500

    After-Tax Cash Flows2,5003,5004,000

    Investment RecoveryYear 1-2Year 3-55,00010,500


    Discounted cash flows l.jpg

    Discounted Cash Flows

    • Discounted Cash Flows (DCF)

      • An analysis comparing the present value of future cash flows with the cost of the initial investment.

      • Considers that cash received today is more valuable than cash to be received in the future—the time value of money.

      • Net present value (NPV)

        • The current value of cash that will flow from a project over time less the initial investment outlay.

      • Internal rate of return (IRR)

        • The rate of return that a firm expects to earn on a project; rate must exceed cost of capital.


    A firm s cost of capital l.jpg

    A Firm’s Cost of Capital

    • Cost of Capital

      • The rate of return required to satisfy a firm’s debt holders and investors.

    • Opportunity Cost

      • The rate of return that could be earned on another investment of similar risk.

    • Weighted Cost of Capital

      • The cost of capital adjusted to reflect the relative costs of debt and equity financing.


    Using the cost of debt as an investment criterion l.jpg

    Using the Cost of Debt as an Investment Criterion

    • Favorable Financial Leverage

      • A benefit gained by investing at a rate of return that is greater than the interest rate on a loan.

    • Debt Capacity

      • The limit at which a firm cannot assume more debt without additional equity investment by its owners.


    Capital budgeting practices of small firms l.jpg

    Capital Budgeting Practices of Small Firms

    • Factors Affecting the Capital Budgeting Analysis Process:

      • Nonfinancial (personal) variables

      • Undercapitalization and liquidity problems

      • Uncertainty of cash flows within the firm

      • Lack of established market value for the firm

      • Small size, scope, and length of firm’s projects

      • Lack of managerial experience and talent in firm


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