FINANCIAL MANAGEMENT
MODULE 1: THE GOALS AND ACTIVITIES
OF FINANCIAL MANAGEMENT
FIELD OF FINANCE
• Finance fits between economics and
accounting.
• Economics provides a picture of the business
environment.
- Consider consumers and producers
• Accounting provides financial data
- Income statements, balance sheets, cash
flow statements
• Financial manager needs to know how to
understand and interpret financial statements.
• Finance is closely tied to accounting.
- CFO is often in charge of financial
planning, accounting, and tax systems.
• Finance is forward thinking vs accounting,
which measures business activity results.
FINANCE WITHIN THE ORGANIZATION
DEFINITION OF FINANCE
• It is the study of how individuals, institutions,
governments, and businesses acquire, spend,
and manage money and other financial
resources.
• Procurement or gathering of funds, effective
and efficient utilization of financial resources,
allocation of financial assets or resources.
INVESTMENTS VS CORPORATE FINANCE
Investments
• Investors use investment principles to value
stocks and bonds of companies.
• Investors choose which to purchase.
• Portfolio includes securities by multiple
companies.
Corporate Finance
• Principles are used to determine which assets
the firm should develop or buy.
Financial management
• The term can be used interchangeably with
corporate finance
•
•
Related to various investment topics
Include how outside investors evaluate the
company.
THE VALUE OF STUDYING FINANCE
Career opportunities include
® Corporate
financial
officers,
bankers,
stockbrokers, financial analysts, portfolio
managers, investment bankers, financial
consultants, and personal financial planners
® CEO reports directly to the BOD
® Marketing managers interested in return on
investment of marketing initiatives
ACTIVITIES
OF
FINANCIAL
MANAGEMENT
Financial managers perform numerous activities
- Daily activities include monitoring cash
balances,
managing
credit
decisions,
monitoring inventory levels, and collecting and
distributing cash.
- Less routine activities include negotiations
with banks for loans, the sale of stocks and
bonds, and the establishment of capital
budgeting and dividend plans.
Risk and return trade-off determined to maximize
the market value
- Influences operational side (capital versus
labor or Product A vs Product B)
- Influences financial mix (stock vs. bonds vs.
retained earnings)
FUNCTIONS
OF
FINANCIAL
MANAGEMENT
DAILY
Credit management, inventory control, receipt and
disbursement of funds
OCCASIONAL
Stock issue, bond issue, capital budgeting,
dividend declaration
PROFITABILITY
A trade-off between risk and return with the goal of
maximizing shareholder wealth
GOALS OF FINANCIAL MANAGEMENT
PRIMARY GOAL: Maximization of profit
Drawbacks
1. A change in profit may also represent a change
in risk.
2. Fails to consider timing of benefits
3. It is an impossible task to measure key variable
profit accurately.
4. Problems with inflation and international
currency transactions further complicate the
issue.
VALUATION APPROACH
The ultimate measure of performance – how
earnings are valued by investor
The time value of money concept is key.
•
•
•
Businesses are valued in the present
- Most cash flows are not realized for many
years
Shareholders are interested in future earnings
Investors want longer-term perspectives
THE TIME VALUE OF MONEY
Present Value
• Is the idea that a dollar received today is worth
more than a dollar that we expect to receive in
the future
• The future value of a dollar is greater than a
dollar
• Present value is today’s dollar value
FV = PV (1 + i)n
FV = future value
PV – present value
i = interest rate
n = number of periods
MAXIMIZING SHAREHOLDER WEALTH
• Shareholder wealth maximization is the broad
goal of the firm
- Achieved through high value for the
firm
• Residual claim – the value of their claims is not
fixed
• Financial managers cannot directly control the
firm’s stock price
- Can act in a consistent way with
shareholder desires
- Long-term wealth is more important
than daily value
SOCIAL RESPONSIBILITY AND ETHICAL
BEHAVIOR
Adopting policies that maximize value in the
market
¨ Attract capital
¨ Provide employment
¨ Offer benefits to society
Socially desirable actions like pollution control,
equitable hiring practices, and fair pricing
standards may be inconsistent with achieving
maximum valuation in the market.
Insider trading
¨ Using information not available to the public,
making an undue profit from trading in the
company’s publicly traded securities
¨ Unethical and illegal practices protected
against by SEC
¨ Has a negative impact on shareholder’s interest
Ethical behavior creates an invaluable
reputation.
CORPORATE GOVERNANCE
1. Sarbanes Oxley Act (SOX ACT)
Designed primarily to regulate corporate conduct
in an attempt to promote ethical behavior and
prevent fraudulent financial reporting.
• 301 – responsibilities of BOD and audit
committee, appointment and compensation.
• 302 – CEO and CFO to sign and certify that the
financial statements are accurate.
• 303, 304, 306 – ethical conduct by BOD,
Executives, and key employees
• 406 – public corporation to have code of ethics
for senior executive.
2. Dodd-Frank Act
• Wall street reform and consumer protection act
of 2010.
• First major financial regulatory change since
the great depression.
• Goal to reduce systemic risks that undermine
the financial system in the US.
3. Concluded
• Agency Theory
- Examines relationship and potential
conflict between owners and managers of
firm.
- Management operates versus owners
focused on shareholders.
• Institutional Investors
® Have more to say about how publicly
owned companies are managed.
® Able to vote large blocks of shares for
election of BOD.
ROLE OF FINANCIAL MARKETS
Financial markets – a meeting place for people,
corporations, and institutions.
® Have either a need to lend, borrow, or invest
money.
® Participants can be national, state, and local
governments.
- Their markets are public financial markets.
® Corporate participants raise funds in corporate
financial markets.
STRUCTURE
AND
FUNCTIONS
FINANCIAL MARKETS
Distinct parts of financial markets
1. Domestic and international markets
2. Corporate and government markets
3. Money and capital markets
OF
Money markets
® Deal with short-term securities with a life of
one year or less.
® Securities include
o Commercial paper sold by corporations to
finance daily operations
o Certificates of deposit with maturities of
less than one year sold by banks
Capital markets
® Deal with securities that have life or more than
one year
® Long-term markets
® Defined as either 1 to 10 years
(intermediate markets) or greater than 10
years (long-term markets)
® Securities include
o Common stock
o Preferred stock
o Corporate and government bonds
ALLOCATION OF CAPITAL
Primary market
• When corporation uses financial markets to
raise new funds, sale of securities made through
new issue is called initial public offering (IPO)
Secondary market
• Securities bought/sold amongst investors
• Prices of securities keep changing continually
• Financial managers given feedback about firms
performance
Return maximization and risk minimization
• Investors can choose a risk level that meets
objective, maximizes return for a given risk
level.
• Companies rewarded with high-priced
securities can raise new funds in money and
capital markets at lower cost than competitors.
• Firms may pay penalties for failing to perform
competitively.
INTERNATIONALIZATION OF
FINANCIAL MARKETS
Allocation of capital and search for lower-cost
sources of financing in global markets
The impact of international affairs and technology
has resulted in the need for managers to understand.
o International capital flows
o Computerized electronic fund transfer systems
FORMS OF BUSINESS ORGANIZATION
1. Sole proprietorship
2. Partnership
3. Corporation
(number of people in the organization, liability of
owners and complexity of state regulations)
Sole Proprietorship And Partnership
® Often set up through LLCs/LLPs.
Advantages
- Ease of formation
- Subject to few regulations – No corporate
income taxes
Disadvantages
- Difficult to raise capital
- Unlimited liability
- Limited life
Corporation
Advantages
- Unlimited life
- Easy transfer of ownership
- Limited liability
- Ease of raising capital
Disadvantages
- Double taxation
- Cost of setup and report filing
BALANCING SHAREHOLDER VALUE AND
SOCIETY INTEREST
The primary financial goal of management is
shareholder wealth maximization, which translates
to maximizing stock price.
-
The value of any asset is the present value of
the cash flow stream to owners.
Most significant decisions are evaluated in
terms of their financial consequences.
Stock prices change over time as conditions
change and as investors obtain new
information about a company’s prospects.
Managers recognize that being socially responsible
is not inconsistent with maximizing shareholder
value.
STOCK PRICES AND INTRINSIC VALUE
• In equilibrium, a stock’s price should equal its
“true” or intrinsic value.
• Intrinsic value is a long-run concept.
• To the extent that investor perceptions are
incorrect, a stock’s price in the short run may
deviate from its intrinsic value.
• Ideally, managers should avoid actions that
reduce intrinsic value, even if those decisions
increase the stock price in the short run.
WHAT IS THE FIRM’S INTRINSIC VALUE?
CURRENT STOCK PRICE? IS THE
STOCK’S “TRUE” LONG-RUN VALUE
MORE CLOSELY RELATED TO
INTRINSIC VALUE OR CURRENT PRICE
A firm’s intrinsic value is an estimate of a stock’s
“true” value based on accurate risk and return data.
It can be estimated but not measured precisely. A
stock’s current price is its market price—the value
based on perceived but possibly incorrect
information as seen by the marginal investor. From
these definitions, you can see that a stock’s “true”
long-run value is more closely related to its
intrinsic value rather than its current price.
WHEN IS A STOCK SAID TO BE IN
EQUILIBRIUM? AT ANY GIVEN TIME,
WOULD YOU GUESS THAT MOST
STOCKS ARE IN EQUILIBRIUM AS YOU
DEFINED IT?
Equilibrium is a situation where the actual market
price equals the intrinsic value, so investors are
indifferent between buying or selling a stock. If a
stock is in equilibrium, then there is no
fundamental imbalance, hence no pressure for a
change in the stock’s price. At any given time, most
stocks are reasonably close to their intrinsic values
and thus are at or close to equilibrium. However, at
times, stock prices and equilibrium values are
different, so stocks can be temporarily undervalued
or overvalued.
SUPPOSE 3 HONEST INDIVIDUALS GAVE
YOU ESTIMATES OF STOCK X’S
INTRINSIC VALUE (ROOMMATE,
PROFESSIONAL SECURITY ANALYST
AND COMPANY X’S CFO) THE 3
DIFFERED IN ESTIMATION, IN WHICH
ONE WOULD YOU HAVE CONFIDENCE
If the three intrinsic value estimates for Stock X
were different, you would have the most
confidence in Company X’s CFO’s estimate.
Intrinsic values are strictly estimates, and different
analysts with different data and different views of
the future will form different estimates of the
intrinsic value for any given stock. However, a
firm’s managers have the best information about
the company’s future prospects, so managers’
estimates of intrinsic value are generally better than
the estimates of outside investors.
IS IT BETTER FOR A FIRM’S ACTUAL
STOCK PRICE IN THE MARKET TO BE
UNDER, OVER OR EQUAL TO ITS
INTRINSIC VALUE
• If a stock’s market price and intrinsic value are
equal, then the stock is in equilibrium, and there
is no pressure (buying/selling) to change the
stock’s price. So, theoretically, it is better that
the two be equal; however, intrinsic value is a
long-run concept. Management’s goal should
be to maximize the firm’s intrinsic not its
current price.
• So, stockholders, in general, would probably
expect the firm’s market price to be under the
intrinsic value—realizing that if management is
doing its job that current price at any point in
time would not necessarily be maximized.
• However, the CEO would prefer that the
market price be high— since it is the current
price that he will receive when exercising his
stock options. In addition, he will be retiring
after exercising those options, so there will be
no repercussions to him (with respect to his job)
if the market price drops—unless he did
something illegal during his tenure as CEO.
DETERMINANTS OF INTRINSIC VALUE
AND STOCK PRICES
SHOULD STOCKHOLDER WEALTH
MAXIMIZATION BE THOUGHT OF AS A
LONG OR SHORT-TERM GOAL?
• Stockholder wealth maximization is a long-run
goal. Companies, and consequently the
stockholders, prosper by management making
decisions that will produce long-term earnings
increases. Actions that are continually
shortsighted often “catch up” with a firm, and,
as a result, it may find itself unable to compete
effectively against its competitors.
• There has been much criticism in recent years
that U.S. firms are too short-run profit-oriented.
A prime example is the U.S. auto industry,
which has been accused of continuing to build
large “gas guzzler” automobiles because they
had higher profit margins rather than retooling
for smaller, more fuel-efficient models.
SOME IMPORTANT BUSINESS TRENDS
1. Corporate scandals have reinforced business
ethics' importance and spurred additional
regulations and corporate oversight.
2. Increased globalization of business.
3. The effects of ever-improving information
technology have profoundly affected all
aspects of business finance.
4. Stockholders now have more control of
corporate governance.
FINANCIAL MANAGEMENT
MODULE 2: FINANCIAL
ANALYSIS- A SUMMARY
STATEMENT
GOAL OF ACCOUNTING
To provide information that allows decisionmakers to understand and evaluate the results of
business decisions. That is to provide information
in order to make decisions. Managers analyze
financial statements to evaluate past financial
performance and make future decisions
VERTICAL ANALYSIS
It focuses on important relationships between items
on the same financial statement. These items are
compared vertically, from one account balance
against another, and are typically expressed as
percentages to reveal the relative contributions
made by each financial statement item.
-
Line items on the Balance Sheet are
generally expressed as a percentage of total
assets.
Line items on the Income Statement are
generally expressed as a percentage of net
sales
HORIZONTAL ANALYSIS
It is conducted to help financial statement users
recognize important financial changes that unfold
over time. It compares information horizontally,
from one period to the next, with the general goal
of identifying significant sustained changes. These
changes are typically described in terms of peso
amounts and year-over-year percentages. To
compute for the percentage increases/decreases:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 − 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟
𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟
Problem 1: If year one equals P500,000.00, year
two equals P525,000.00, and year three equals
P560,000.00, the percentage to be assigned for year
three in a trend analysis, assuming that year one is
the base year is
Problem 2:
Assume the following sales data for a company:
Year
Sales
2013
P 600,000.00
2014
625,000.00
2015
750,000.00
2016
800,000.00
What is the percentage increase in sales from 2013
to 2014, assuming that 2013 is the base year?
RATIO ANALYSIS
Financial ratios
• Used to weigh and evaluate operating
performance of firm.
• Measured in relation to other values.
• Compares performance record against similar
firms in industry.
• Additional
evaluation
of
company
management, physical facilities, and other
factors is needed.
• Financial data reported by S&P, Moody’s, etc.
RATIO ANALYSIS – CLASSIFICATION
SYSTEM
A. PROFITABILITY RATIOS
-Measures firms’ ability to earn adequate returns.
e.g. Sales, Total Assets, Invested Capital
1. Profit margin
2. Return on assets (investment)
3. Return on equity
B. ASSET UTILIZATION RATIOS
-Measures speed at which firm turnover.
e.g. Accounts receivables, Inventory, Long-term
assets
1. Receivable turnover
2. Average collection period
3. Inventory turnover
4. Fixed asset turnover
5. Total asset turnover
C. LIQUIDITY RATIOS
- Emphasize firm’s ability to pay off short-term
obligations as they come due.
1. Current ratio
2. Quick ratio
D. DEBT UTILIZATION RATIOS
- Estimate overall debt position of the firm
- Evaluate in light of asset base, earning power
1. Debt to total assets
2. Times interest earned
3. Fixed charge coverage
Users of financial statements
-They have differing degrees of importance in
categories of ratios.
Potential investors and security analysts.
1. Primary considerations- profitability ratios.
2. Secondary considerations-liquidity and debt
utilization.
For banker or trade creditor.
1. Primary consideration—liquidity ratios.
For long-term creditors (bondholders).
1. Primary consideration—debt utilization ratios
(debt to total assets) and profitability ratios.
FINANCIAL STATEMENT FOR RATIO
ANALYSIS
THE ANALYSIS – DuPont SYSTEM OF
ANALYSIS
Satisfactory return on assets can be derived
through:
✓ High profit margin.
✓ Rapid asset turnover (generating more sales per
dollar of assets)
✓ Combination of both
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 (𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡) = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝐴𝑠𝑠𝑒𝑡
Satisfactory return on equity can be derived
through:
• High return on total assets
• Generous utilization of debt
• Combination of both
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 =
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 (𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)
(1 − 𝐷𝑒𝑏𝑡/𝐴𝑠𝑠𝑒𝑡𝑠)
DuPont ANALYSIS
THE ANALYSIS – ASSET UTILIZATION
RATIOS
Relate the balance sheet (assets) to the income
statement (sales).
THE ANALYSIS – PROFITABILITY
RATIOS
*This ratio may also be computed by using “cost
of goods sold” in the numerator
Return on Equity: Walmart versus. Target
Using the DuPont Method of Analysis
THE ANALYSIS – RATIO ANALYSIS
THE ANALYSIS – ASSET UTILIZATION
RATIOS
THE ANALYSIS – LIQUIDITY RATIOS
These ratios determine if the firm can meet each
maturing obligation as it comes due
THE ANALYSIS – DEBT UTILIZATION
RATIOS
Measures the prudence of the debt management
policies of the firm.
THE ANALYSIS – DEBT UTILIZATION
RATIOS
Fixed charge coverage measures the firm’s ability
to meet all fixed obligations rather than interest
payments alone.
Income before taxes
Lease payments
Income before fixed charges and
taxes
$ 550,000
50,000
$ 600,000
TREND ANALYSIS
Over course of business cycle, sales and
profitability expand and contract.
- Ratio analysis for any one year does not
reflect accurate picture of the firm.
Trend analysis reflects performance over a number
of years.
- Without industry comparisons, may not
reflect a complete picture.
- Gives picture of performance over number
of years against industry averages.
IMPACT OF INFLATION ON FINANCIAL
ANALYSIS
Major problem of inflation
1. Revenue stated in current dollars.
2. Plant, equipment, or inventory may have been
purchased at lower price levels.
3. Profits may be more function of increasing
prices than satisfactory performance.
Financial reports are distorted by not considering
inflation.
1. Affecting financial analysis.
Stein Corporation
Income Statement for 2020
Disinflation Effect
Disinflation—a situation of declining inflationary
pressures.
• It will not impair the purchasing power of the
dollar.
• Reduction in investors’ expectation of returns
on financial assets.
• Financial assets such as stocks and bonds have
the potential to do well.
• Tangible (real) assets like precious metals will
fall.
Deflation
• Actual declining of prices affecting everybody
from bankruptcies and declining profits.
Other Elements of Distortion in Reported
Income
2. Effect of changing prices
3. Reporting of revenues
4. Treatment of nonrecurring items
5. Tax write-off policies
Income Statement for 2021
Income Statements (Year 2018)
Comparison of Replacement Cost Accounting
and Historical Cost Accounting
Explanation of Discrepancies 1
Sales
• Conservative firms may defer revenue
recognition of the sale until each payment is
received.
• Other firms may attempt to recognize a fully
effected sale as early as possible.
Jeff Garnett and Geoffrey A. Hirt, “Replacement Cost Data: A Study
of the Chemical and Drug Industry for Years 1976 through 1978.”
An Illustration
Replacement cost—reduces income but increases
assets.
• Increase in assets lowers debt-to-assets ratio.
• Decreased debt-to-assets ratio indicates
decrease in financial leverage of firm.
• Declining income results in decreased ability to
cover interest costs.
Cost of goods sold
• Use of different accounting principles
o Company A uses LIFO
Company B using FIFO.
• Varying treatment of R&D costs, etc.
versus
Explanation of Discrepancies 2
Extraordinary gains/losses
• Including extraordinary events in computing
current income versus leaving them out.
Net income
• Use of different methods of financial
reporting.
o Such as inclusion vs. exclusion of
extraordinary gains and/or losses.
•
Each item must be examined in financial
statements, rather than accepting bottom-line
figures.
FINANCIAL MANAGEMENT
MODULE 3: FINANCIAL PLANNING AND
FORECASTING
FINANCIAL FORECASTING
Ability to plan ahead and make necessary
adjustments before events occur.
• The firm’s outcome through external events
involves.
• Risk-taking desires.
• Ability to hedge against risk with
careful planning.
• No growth or a decline in volume are not
necessarily the primary cause of a shortage of
funds.
• A comprehensive financing plan must be
developed for significant growth.
CONSTRUCTING PRO FORMA
STATEMENTS
Pro forma financial statements enable a firm to
estimate future receivables, inventory, and
payables, as well as anticipated profits and
borrowing requirements.
Statements are often required by bankers and other
lenders as guides for the future.
Systems approach to develop pro forma statements.
® Construct income statements based on sales
projections and the production plan.
® Translate this into a cash budget.
® Assimilate all materials into a pro forma
balance sheet.
DEVELOPING OF PRO FORMA
STATEMENTS
PRO FORMA INCOME STATEMENT
Provides projection on anticipated profits over the
subsequent period.
Important steps:
1. Establish sales projection.
2. Determine production schedule, associated
use of new material, direct labor, and
overhead to arrive at gross profit.
3. Compute other expenses.
4. Determine profit by completing actual pro
forma statement.
Assume Goldman Corporation has two primary
products: wheels and casters.
TABLE 4 -1 PROJECTED WHEEL AND CASTER SALES (FIRST 6 MONTHS 2022)
CLASSIFICATION SYSTEM CONCLUDED
Number of units produced depends on
a) Beginning inventory.
b) Sales projections.
c) Desired ending inventory.
To determine production requirements
Units
+ Projected sales
+ Desired ending inventory
− Beginning inventory
Production requirements
Goldman Corporation has in stock the items
shown.
TABLE 4 - 2 STOCK OF BEGINNING INVENTORY
TABLE 4 - 3 PRODUCTION REQUIREMEMENTS FOR 6 MONTHS
Cost to produce one unit.
After tax income
o Subtract taxes to determine after tax
income.
Contribution to retained earnings.
o Deduct dividends to ascertain the
contribution to retained earnings.
TABLE 4 – 4 UNIT COSTS
TABLE 4 – 5 TOTAL PRODUCTION COSTS
COST OF GOODS SOLD
Costs associated with units sold during the time
period.
Assumptions for illustration:
® F I F O accounting used.
® First allocates cost of current sales to
beginning inventory, then to goods
manufactured during period.
TABLE 4 – 8 INCOME STATEMENT
CASH BUDGET
Pro forma income statement must be translated
into cash flows.
• Divide longer-term pro forma income
statement into smaller units.
• More precise time frames are set to anticipate
seasonal and monthly patterns of cash inflows
and outflows.
® May represent highs or low sales volume.
® May require dividends, taxes, or capital
expenditures.
TABLE 4 – 6 ALLOCATION OF MANUFACTURING COST AND
DETERMINATION OF GROSS PROFIT
TABLE 4 – 9 MONTHLY SALES PATTERN
TABLE 4 – 7 VALUE OF ENDING INVENTORY
OTHER EXPENSE ITEMS
Must be subtracted from gross profits to arrive at a
net profit figure.
Earnings before taxes
o General and administrative expenses,
interest expenses are subtracted from gross
profit.
CASH RECEIPTS
In the case of Goldman Corporation.
• Break down the pro forma income statement
for first half of the year.
® Divided into monthly cash budgets.
• Analysis of past sales and collection records
show.
® 20 percent of sales collected in month of
sales.
® 80 percent collected in following month.
TABLE 4 – 13 SUMMARY OF ALL MONTHLY CASH PAYMENTS
TABLE 4 – 10 MONTHLY CASH RECEIPTS
Difference between monthly receipts and
payments is net cash flow for month.
® Allows firm to anticipate need for outside
funding at end of each month.
TABLE 4 – 11 COMPONENT COSTS OF MANUFACTURED GOODS
TABLE 4 – 14 MONTHLY CASH FLOW
CASH PAYMENTS
Primary considerations are monthly costs
associated with:
1. Inventory manufactured during period.
® Material
® Labor
® Overhead
2. Disbursements for general and administrative
expenses.
3. Interest payments, taxes, and dividends.
4. Cash payments for new plant and equipment
Assumptions for the next two tables.
® Costs incurred on an equal monthly basis over
a six-month period.
® Even production level to ensure maximum
efficiency.
® Payment for material is made once per month
after purchases have been made.
TABLE 4 -12 AVERAGE MONTHLY MANUFACTURING COSTS
Assumptions for Table 4-15.
® Firm wishes to maintain minimum cash
balance of $5,000.
® If balance goes below minimum, firm will
borrow.
® If balance goes above minimum, firm will use
excess to repay outstanding loan.
TABLE 4 – 15 CASH BUDGET WITH BORROWING AND REPAYMENT PROVISIONS
PRO FORMA BALANCE SHEET
Represents cumulative changes over time.
• Important to examine prior period’s balance
sheet.
• Some accounts remain unchanged, while
others take on new values.
® Information derived from pro forma
income statement and cash budget.
DEVELOPMENT OF A PRO FORMA
BALANCE SHEET
9. Common stock ($10,500) unchanged from
prior period’s value in Table 4-16.
10. Retained earnings ($39,024) equals the initial
value plus pro forma income ($20,500 +
$18,524).
ANALYSIS OF PRO FORMA STATEMENT
Growth ($25,642) was financed by accounts
payable, notes payable, and profit.
® Reflected by increase in retained earnings.
Total Assets 06/30/2022
Total Assets 12/31/22
Increase
TABLE 4 – 16 BALANCE SHEET DECEMBER 31, 2021
TABLE 4 -17 PRO FORMA BALANCE SHEET JUNE 30, 2022
EXPLANATION OF A PRO FORMA
BALANCE SHEET
1. Cash ($5,000) minimum cash balance in Table
4-15.
2. Marketable securities ($3,200) remains
unchanged from prior period’s value in Table
4-16.
3. Accounts receivable ($16,000) based on June
sales of $20,000 in Table 4-10.
® 20 percent will be collected that month.
® 80 percent will become accounts
receivable at the end of month.
4. Inventory ($6,200) shown in Table 4-7.
5. Plant and equipment: $27,740 (initial value) +
$18,000 (purchases) = $45,740.
6. Accounts payable ($5,732) based on June
purchases in Table 4-13.
7. Notes payable ($5,886) amount to be borrowed
to maintain $5,000 in cash in Table 4-15.
8. Long-term debt ($15,000) unchanged from
prior period’s value in Table 4-16.
$ 76,142
50,500
$ 25, 642
PERCENT OF SALES METHOD
Based on assumption that.
• Accounts on balance sheet will maintain given
percentage relationship to sales.
• Percentages are not computed for.
a) Notes payable.
b) Common stock.
c) Retained earnings.
• Not assumed to maintain a direct relationship
with sales volume.
Table 4-18 Balance Sheet and Percentage-of-Sales Table for Howard Corporation
PERCENT OF SALES METHOD
Establish funds required to finance growth.
Decide to finance based on
a) Notes payable.
b) Sale of common stock.
c) Use of long-term debt.
Company operating at full capacity—needs to
buy new plant and equipment to produce more
goods to sell:
Required new funds:
(RNF) = A/S (ΔS) – L/S (ΔS) – PS2 (1 – D)
Where:
A/S = Relationship of variable assets to sales [60%].
ΔS = Change in sales [$100,000].
L/S = Percentage of variable liabilities to sales [25%].
P = Profit margin [6%].
S2 = New sales level [$300,000].
D = Dividend payout ratio [0.50].
RNF = 60% (100,000) – 25% ($100,000) – 6%
($300,000) (1 – 0.50)
= $60,000 – $25,000 – $18,000 (0.50)
= $35,000 – $9,000
= $26,000 required sources of new funds (at full
capacity)
Company not operating at full capacity.
® Needs to add more current assets to increase
sales.
® Does not need to buy new equipment.
RNF=35% ($100,000) – 25% ($100,000) – 6%
($300,000) x (1 – 0.50)
= $35,000 – $25,000 – $18,000 (0.50)
= $35,000 – $25,000 – $9,000
= $1,000 required sources of new funds
(at less than full capacity)
FINANCIAL FORECASTING - AFN
EQUATION
An equation that shows the relationship of external
funds needed by a firm to its projected increase in
assets, the spontaneous increase in liabilities, and
its increase in retained earnings.
AFN=(A0*/S0)DS – (L0*/S0)DS – M(S1)(1 – Payout)
= 4M/5M x 1,000,000–500,000/5M x 1,000,000 - .05 (6M) (.30)
= 610,000
® The capital intensity ratio is measured as
A0*/S0. This firm’s capital intensity ratio is
higher than that of the firm in Problem 01;
therefore, this firm is more capital intensive—
it would require a large increase in total assets
to support the increase in sales.
AFN EQUATION: PROBLEM 03
Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the firm's additional
funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the
coming year?
Last year's sales = S0
Sales growth rate = g
Last year's total assets = A0*
Last year's profit margin = PM
$200,000
40%
$135,000
20.0%
Last year's accounts payable
Last year's notes payable
Last year's accruals
Target payout ratio
$50,000
$15,000
$20,000
25.0%
Last year's sales = S0
Sales growth rate = g
Forecasted sales = S0 × (1 + g)
ΔS = change in sales = S1 − S0 = S0 × g
Last year's total assets = A0* = A0* since full capacity
Forecasted total assets = A1* = A0* × (1 + g)
Last year's accounts payable
Last year's notes payable. Not spontaneous,
so does not enter AFN calculation
Last year's accruals
L0* = payables + accruals
Profit margin = PM
Target payout ratio
Retention ratio = (1 − Payout)
200,000
40%
280,000
80,000
135,000
189,000
50,000
15,000
20,000
70,000
20.0%
25.0%
75.0%
AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout)
AFN = 54,000 − 28,000 − 42,000 = −16,000
Additional funds needed (AFN)= Projected
increase in assets – Spontaneous increase in
liabilities – Increase in retained earnings
EXCESS CAPACITY ADJUSTMENTS
Changes made to the existing asset forecast
because the firm is not operating at full capacity.
AFN=(A0*/S0)DS – (L0*/S0)DS – M(S1)(1 – Payout)
CAPITAL INTENSITY RATIO – the ratio of
assets required per dollar of assets (A0*/S)
AFN EQUATION: PROBLEM 01
Carter Corporation’s sales forecast are expected to
increase from 5M in 2015 to 6M in 2016, or by
20%. Its assets totaled 3M at the end of 2015.
Carter is at full capacity, so its assets must grow in
proportion to projected sales. At the end of 2015,
current liabilities are 1M, consisting of 250,000 of
AP, 500,000 of NP and 250,000 of Accrued
Liabilities. Its profit margin is forecasted to be 5%,
and the forecasted retention ratio is 30%. Use the
AFN equation to forecast the additional funds
Carter will need for the coming year.
AFN= (A0*/S0)DS – (L0*/S0)DS – M(S1) (1– Payout)
= 3M/5M x 1,000,000 – 500,000/5M x 1,000,000 - .05 (6M) (.30)
= 410,000
EXCESS CAPACITY: PROBLEM 04
Walter Industries has 5B in sales and 1.7B in fixed
assets. Currently the company’s fixed assets are
operating at 90% capacity.
(a) What level of sales would Walter have obtained
if it had been operating at full capacity?
(b) What is Walter’s target fixed assets/sales ratio?
(c) If Walter’s sales increase by 12%, how large of
an increase in fixed assets will the company need
to meet its target fixed assets/sales ratio?
Sales = 5,000,000,000; FA = 1,700,000,000; FA
are operated at 90% capacity.
!,###,###,###
a. Full capacity sales =
=5,555,555,556
#.%#
',(##,###,###
AFN EQUATION: PROBLEM 02
Refer to Problem 01, what additional funds would
be needed if the company’s year-end 2015 assets
had been 4M? Assume that all other numbers are
the same. Why is the AFN different from the one
you found in Problem 01.
b. Target FA/S ratio = !,!!!,!!!,!!) = 30.6%
c. Sales increase 12%; DFA = ?
S1 = 5,000,000,000 ´ 1.12 = 5,600,000,000
No increase in FA up to 5,555,555,556
DFA = 0.306 ´ (5,600,000,000 – 5,555,555,556)
= 0.306 ´ (44,444,444)
= 13,600,000
EXCESS CAPACITY: PROBLEM 05
Last year Wei Guan Inc. had 350 million of sales,
and it had 270 million of fixed assets that were used
at 65% of capacity. In millions, by how much could
Wei Guan's sales increase before it is required to
increase its fixed assets?
GIVEN:
Sales
350M
Fixed Assets
270M
% of capacity utilized
.65
SOLUTION:
EXCESS CAPACITY ADJUSTMENTS
PROBLEM 07
Last year Handorf-Zhu Inc. had 850 million of
sales, and it had 425 million of fixed assets that
were used at only 60% of capacity. What is the
maximum sales growth rate the company could
achieve before it had to increase its fixed assets?
GIVEN:
Sales
850M
Fixed Assets
425M
% of capacity utilized
.60
Sales at full capacity (AS/%Capacity)= 538,461,538.46
SOLUTION:
Additional sales without adding FA = Full
capacity sales – Actual sales
Sales at full capacity (AS/%Capacity)= 1,416,666,666.67
538,461,538.46 – 350,000,000.00 = 188,461,538.46
SUSTAINABLE GROWTH RATE
The growth rate a firm can maintain given its
capital structure, ROE, and retention ratio.
SUSTAINABLE GROWTH RATE: PROBLEM 06
Suppose Weatherford Industries has the following
ratios: A0*/S0 = 1.6; L0*S0 = 0.4; profit margin =
0.10 and payout ratio = 0.45 or 45%. Sales last year
were 100M. Assuming that these ratios will remain
constant, use the AFN equation to determine the
maximum growth rate (sustainable growth rate)
Weatherford can achieve without having to employ
nonspontaneous external funds.
To solve this problem, we define DS change in
sales and g as the growth rate in sales, and then
we use the three following equations:
DS = S0 g
S1 = S0 (1+ g)
AFN=A0*/S0)DS – (L0*/S0)DS – M(S1)(1 – Payout)
Set AFN = 0, substitute in known values A0*/S0,
L0*/S0, M payout and S0 and then solve for g.
0 =1.6(100g) -.4(100g) -.10(100(1 + g)) (1 - .45)
0 = 160g - 40g - 5.5 – 5.5g
114.5g = 5.5
g = 5.5/114.5
g = .048 or 4.8%
® g = maximum growth rate without external
financing
Additional sales without adding FA = Full
capacity sales – Actual sales
1,416,666,666.67–850,000,000.00 = 566,666,666.67
% growth in sales = Additional Sales/Old sales
850,000,000
%growth in sales=!)),))),))).)( = 66.67%