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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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agenda
Agenda
  • Chapter 13: Evaluating and Managing Financial Performance
    • Accounting Statements
    • Working-Capital Management
    • Assessing Financial Performance
    • Capital Budgeting
accounting statements
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.
internal accounting controls
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
the income statement
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
the income statement7
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
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

the balance sheet
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

the balance sheet an overview
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
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

the cash flow statement
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.
flow of cash through a business
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

managing working capital
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
the working capital cycle
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
the working capital cycle16
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

working capital time line
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.

three month cash budget
Three-Month Cash Budget

May June July August SeptemberMonthly 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 36,000 39,000

Step 1 Total 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 $ 96,000 Rent 3,000 3,000 3,000

Wages and salaries 18,000 18,000 16,000

Step 2b Tax prepayment 1,000 Utilities (2% of sales) 2,600 2,600 2,400

Interest on long-term note 800

Step 2c Short-term interest (1% of short-term debt) 106 113

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

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

Step 4 Beginning cash balance 5,000 5,000 5,000

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

Step 6 Short-term borrowing (payments) 10,600 706 7,687 Ending cash balance $ 5,000 $ 5,000 $ 5,000

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

managing inventory
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.
assessing financial performance
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
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
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
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
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
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
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
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
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
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
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
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
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
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

Year After-Tax Profits 1 1,000 2 2,000 3 2,500 4 3,000

payback period
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-TaxYear Profits 1–2 1,000 3–6 2,000 7–10 2,500

After-Tax Cash Flows 2,500 3,500 4,000

Investment Recovery Year 1-2 Year 3-5 5,000 10,500

discounted cash flows
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
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
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
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