Assets & Capital Budget – Financial Management Test
These financial management chapters discuss Assets & Capital Budget – Test 1 is based on these chapters
Financial Statements
objective is to provide economic decision makers with useful information about a firm’s financial performance and change in financial positions
Source of information for managers, shareholders, creditors, and other stakeholders
reports the firm’s financial condition at a point in time. Snapshot
3 major elements of a balance sheet
Assets are probable future economic benefits controlled by an entity; used to generate revenue
Liabilities are probable future economic costs
owner’s Equity is the residual interest in the net assets of an entity that remains after deducting its liabilities.
Liquidity (financial ratio)
Short-term Solvency Ratios
Meet short-term obligations
Liquidity ratios
Current ratio, quick ratio, avg payment period
Avg payment period (formula)
= Accounts Payable /(Cost of Goods Sold⁄365)
Asset Management (financial ratio)
Turnover Ratios
How efficiently mgmt. is utilizing assets
Capital structure
The specific mixture of long-term debt and equity the firm uses to finance its operations.
Good understanding of the effects of equity and debt financing are important for financial managers.
A firm’s ________ __________ is really just a reflection of it’s borrowing policy
capital structure
Working capital
firm’s level of current assets.
Too little = liquidity problems
Too much= inefficiency
Effective working capital policies are crucial to LT growth and survival.
Three main forms of business
sole proprietorship, partnership, corporation
Proprietorship
single owner with unlimited liability for debts and legal obligations.
Advantages to a sole proprietorship
easy to establish, simple decisions, little regulation
Disadvantages to a sole proprietorship
unlimited liability, limited capital pool, ownership is difficult to transfer
Partnership
A form of business ownership in which the business is owned by two or more persons
General partnership
all partners share in the gain or losses of the business and all partners have unlimited liability for all partnership debts and other legal obligations
Limited partnership
One or more general partners run business and have unlimited liability. Limited partners liability limited to contributions, and cannot help run the business
Advantages to a partnership
Easy to establish, larger capital pools than sole proprietorship
Disadvantages to a partnership
Difficult to reach decisions, gen. partners have unlimited liability, limited partners have less control
__________ is generally more readily available for a partnership, but there are still significant limitations on the ability to raise large amounts of ________
Capital, capital
Corporation
owned by stockholders, liability is legally limited to the amount of money invested.
Can borrow money and own property, sue or be sued, enter into contracts
Advantages to a corporation
limited liability, large amounts of capital, corporation’s life is not limited to that of the owners
Disadvantages to a corporation
difficult to establish, double taxation, agency costs
Agency Conflicts question
Do managers always act and make decisions that reflect stockholder’s best interest?
Agency relationship
Relationship between principal and agent
Agency problem
the possibility of conflict of interest between the principal and the agent
Principals
Owners (stockholders, equity holders, equity owners)
Agents
Managers (people elected by owners to run company)
Sources of agency conflict
Shirking by the agent (avoiding responsibilities)
Diversion of resources by agent for private use
Differential time horizon of the agent and principal
Differential risk preferences of the agent and the principal
Agency costs
arise when management makes investment decisions that may result in a loss of value for shareholders
Monitoring of management, restrictions on mgmt. actions, loan covenants
Agency conflict factors
Managerial compensation
Oversight and accountability
Control of the firm
Managerial compensation
Compensation (stock options, bonus, promotion, etc.) can be used to align interests
Capital budgeting
The process of identifying and evaluating capital projects where the cash flow to the firm will be received over a period longer than a year.
The financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire
________ ________ may be the most important responsibility that a financial manager has
Capital budgeting
Evaluating the _____, ______, and ______ of future cash flows is the essence of capital budgeting
size, time, risk
Oversight and accountability
Additional independent auditors
Control of the firm
Ultimately rests with shareholders
Dissatisfied shareholders can fire management
Goal of the firm?
Maximize shareholder wealth
Financial managers make decisions that ________ the value of the owner’s equity?
Sarbanes-Oxley Act of 2002
set new and enhanced standards for all U.S public company boards, management and public accounting firms
Key titles in SOX Act?
Corporate responsibility
Corporate and Criminal Fraud Accountability
Auditor independence
Enhanced financial disclosures
Stakeholder
someone (in this case, other than a stockholder or creditor) who potentially has a claim on the cash flows of the firm..
Ex. Employees, customers, suppliers, government
Financial market
brings together buyers and sellers of debt and equity securities
Primary market is…
original sale of securities by governments and corporations.
Initial Public Offering (IPO)
Treasury Security Auction
Secondary market is…
market where existing securities are offered for resale
Financial securities (instruments)- claim to a cash flow
Primary market- $ goes to the company
Secondary market- Claims are traded
Primary markets
Corporation is the seller
Corporate stock or bond issues are almost always sold with the assistance of an investment bank.
In primary markets, new equity issues involve either
First time issues by firms whose shares are not currently traded (Initial Public Offerings)
New shares issued by firms whose shares are already trading in the marketplace (Seasoned Offering)
Private placement is a negotiated sale involving a specific buyer; generally, the buyer is a hedge fund
Secondary markets
provide the means for transferring corporate ownership.
The better the secondary the market, the easier it is for firms to raise external capital in the primary market.
NYSE is a…
auction market.
Have a physical location and attempt to match buyers with sellers
NASDAQ is…
dealer market or over the counter.
In a dealer market, most of the buying and selling is done by the dealer.
System of computers
Assets
provide probable future economic benefits controlled by an entity as a result of previous transactions.
Assets are used to generate sales (or revenue)
Current assets
cash and other assets that will likely be converted into cash or used up within one year or operating cycle.
Presented in order of their liquidity
Cash and cash equivalents (marketable securities), accounts receivable, inventories
Fixed assets
do not meet the definition of current assets because they will not be converted into cash or used up within one year or operating cycle
Long-term assets
Tangible assets
long term assets with physical substance
Ex: plant, equip, natural resources, land
Equity is created by
financing activities (primary mkt transaction) and operating activities
Accounting equation
Also known as the Accounting Identity, Balance Sheet Equation, Balance Sheet Identity
Assets = Liabilities + Owners’ Equity
Net working capital
difference between a firm’s current assets and current liabilities.
Not enough working capital may indicate liquidity problems;
Too much working capital may be an indication of inefficient use of assets.
Liquidity
refers to the ability to quickly convert investments into cash closest to fair market value
Multidimensional: Ease of conversion and loss of value
Use of debt in a firm’s capital structure is called…
financial leverage.
Increases potential reward, but increases risk of financial distress and business failure
Market value
true value of an asset, or the amount of cash that would be received if we sold the asset today
Book value
values on the balance sheet. How much it cost to obtain (historical cost)
Income statement
reports the revenues and expense of the firm over a period of time (it measures flows)
IS equation:
Revenues – Expenses = Net Income
Revenues are…
amounts reported from the sale of goods and services
Expenses are
amounts incurred to generate revenue and include costs of goods sold, operating expenses, interest and taxes.
Accrual method of accounting
revenue is recognized when earned and expense are recognized when incurred
firms can manipulate net income by recognizing revenue earlier or later by delaying or accelerating the recognition of expenses.
prior to 2018, marginal system of varying rates; 2018 is a flat-rate tax
Sole proprietorships and partnerships are taxed at individual rates; LLCs have different tax status
tax bill (taxes due) divided by taxable income
Marginal tax
extra tax the tax payer would pay if they earned one more dollar
Cash flow
difference between number of dollars that came in and went out
Operating cash flows
cash flows that result from the firms day-to-day activities of producing and selling
Net capital spending (net investment in fixed assets)
purchases of fixed assets minus the sale of fixed assets
Change in net working capital
amount spent on net working capital
OCF tells us…
whether a firm’s cash inflows from its business are sufficient to cover its everyday cash outflows
Change in net working capital (formula)
= ending NWC – beg. NWC
Financial statements are
framework for calculating financial ratios
Internal uses by managment
External uses: Investors, suppliers, lenders
To make financial comparison possible..
Standardize the financial statements
A common way to do this is to use common-size statements
Common-size financial statements
work with percentages instead of dollars
Common-size balance sheet
divide all of the accounts by expressing each as a percentage of total assets
Common Size Income Statement
divide all of the items by revenues. All items are expressed as a percentage of sales.
Financial ratios
provide a way to compare and investigate relationship between different pieces of financial information
used for internal comparisons and comparisons across firms
Limitations of financial ratios
not useful in isolation
Comparable ratios can be hard to find for companies in multiple industries
must be analyzed relative to one another
determining a range of acceptable values is difficult
Ratio analysis
Absolute numbers vs ratios
3 types of ratio analysis
trend or time series
cross-sectional
industry average
5 financial ratios
Liquidity
Asset management
Financial leverage
Profitability
Market value
Asset Management ratios
Total Asset Turnover, Inventory turnover, Avg payment period (Acc rec period)
Financial leverage (financial ratio)
Long-term Solvency Ratios
How efficiently mgmt. is using debt
Financial leverage ratios
Total debt ratio, equity multiplier, interest coverage/ times interest earned
Profitability (financial ratio)
Controlling costs, operation
Profitability ratios
Profit margin, return on assets, return on equity
ROA & ROE (formulas)
= Net Inc/ Total Assets (or Total SE)
Market value (financial ratio)
How the market values the firm
Market value ratios
Price/Earnings, EPS
DuPont Analysis
ROE=
(NI/Sales) x (Sales/TA) x (TA/TSE)
or
(PM) x (TAT) x (EM)
Intangible assets
long term assets that lack physical substance.
Ex: goodwill, copyright, etc
Liabilities
obligations owed by an entity from previous transactions that are expected to result in an outflow of economic benefits in the future
Current liabilities
obligations that will be satisfied within on year.
Non current liabilities
provide information about the firm’s long-term financing activities.
Current liabilities include..
accounts payable
taxes payable
current portion of long-term debt
Stockholder’s equity is…
residual interest in assets that remains after subtracting liabilities