every decision that bussiness make has financial implication .broadly every thing that does abussiness fits under corporate finance .
three major decision
allocation decision : where do you invest your scare resources . wht make for good investment
financing decision : how we raise the fund for this investment . how mix of equity & debt we use .
divedend decision : how much money reinvested & how much is returened to the owners.
principales of corporate finance :
invest in project that yield return greater than the minimum acceptable hurdle rate
the hurdle rate should be higer for riskier project & reflect the financing mix used
choose the financing mix that minimize the hurdle rate & matching the asset being financed.
objective of decision making :
maximize the value of the fim
narrower objective is to maximize stockholder welath when the stock traded & the market is efficient the objective is to maximize the stock prise.
working capital management :
current assets minus current liabilties.
working capital management concerns the optimal level mix & use of current assets & current liabilites the objecthve is to mionmize the cost of holding capital while guarding insolvency.
working capital increase when current assets financed by noncurrent liabilties.
the greater the liquity the easier to obtain loan at favorable term.
risk vs return :
a company that adopt conservative working capital minimize liquidity risk by increasing working capital the result is that the firm forgoes the potentionally higer returns available from using the additional working capital to aquire long term assets.
reason for holding cash :
.as mdium of exchange for some bussiness transaction.
as precautionary measure for emergencies.
for speculation to take advantage of bagain purchase opportunties.
as compensating balance in exchange for bank service.
methods of expeding cash inflow :
-factoring account receivables
a factor purchasing a company receivables & assumes the risk of collection.
company that uses a factor can eliminate credit department receivables staff & bad debts.
assume a factor charge 2% fee plus an interest rate of 18% on all monies advanced to the company
monthly sales are $100000 & the factor advances 90% of the receivables submitted after deducting the
2% fees & the interest credit term are net 60 days
what is the cost to the company?
Methods of slowing cash inflows :
Slowing the cash disbursement by payemnt beyond normal credit term may incur interst charges
The cost of not taking adiscount
360 days x discount %
total pay period – discount period 100% - discount%
2/10 net 30 means if the buyer pays within 10 days ( the discount period ) there is 2% discount the total payment period is 30 days
for example 2/10 net 30 results in the following calculation:
(360 ÷ 20) x (2 ÷ 98) =36.7% annualized interest
banks may require a borrower to keep a certain percentage of the face value of the loan in his account
which raise the real interest rate to the borrower
the effective interest rate on loans requiring compensating balance :
zero balancing checking accounts :
offered by some banks the account balance is maintained at zero untill a check comes in the resulting
overdraft is covered by a transfer from an account earning a high rate of interest .the disadvantage
is that the bank may charge a fee for this service.
Cost-benefit analysis :
The reduction in average cash times the interest rate ( cost of capital or investment yield rate ) is the benefit .
Costs of having insufficient cash include incremental personnel cost . lost discount & lost vendor goodwill.
The trade off on elements of working capital:
Effect of increasing elements
element Positve aspects Negative aspects
Inventory Fewer lost sales –lower re-ordering cost Storage costs-cash tied up in inventory
Accounts receivables More revenues Bad debts - cash tied up in receivables
Accounts payables Used to finance inventory & receivables Increased credit risk – implicit cost (if there is discount for prompt payment )
Investment in marketable securties:
Firms often invest in marketable securties which can range from short term government (treasury bills)
Securties with no default (financial) risk to securties (commercial paper,corporate bonds &stocks) in other
Firms which can have substantial risk.
Tresuaries commercial corporate equity equity
papers bonds in public firms in private bussiness
investment in riskless securties:
investment in riskless securties will generally earn lower returns than investments in risky projects.
Short term credit
are a draft drawn on deposit at a bank the acceptance by the bank is a guarantee Of payment at maturity.
Involve sales by a dealer in government securties who agrees to repurchase at agiven time for a specific price. This agreement is in essence a secured loan.
Loans secured by receivables (pleading receivables):
A bank will often lend up to 80% of outstanding receivables.
Money market mutual fund:
Investment in a portfolios of short term securties.
Uses inventory as a security for a loan.
. Economic Order Quantity (EOQ)
A. Basic Formula
The economic order quantity is the purchase order size that minimizes the total of inventory order cost and inventory carrying costs. It is important to note: (1) this formula can be used by a manufacturer to determine the optimum size for a production run by replacing "order cost" with the "set-up costs" necessary for a production run, (2) the formula assumes that periodic demand for the good is known, (3) inventory cost flow assumptions, such as LIFO and FIFO, do not affect the computation, and (4) neither the actual cost per inventory unit, the cost of carrying safety stock, nor the cost of a stock out are used in the formula.
Lead Time and Reorder Point:
Lead time is the time lag between placing an order and the receipt of the goods. If safety stock is ignored, the reorder point is computed as the anticipated demand during the lead time. If safety stock is considered, the reorder point is computed as the anticipated demand during the lead time plus the level of safety stock.
If the demand during the lead time is not known with certainty, it may be important to keep extra inventory (known as safety stock) on hand so as to avoid the possibility of a stock out in case the lead time demand was higher than average. Its level is determined by balancing the cost of a stock out (i.e., lost business and customer goodwill) against the cost of carrying extra inventory.
Financial Statement Analysis
Financial statement analysis is an attempt to evaluate a business entity for financial and managerial decision-making purposes. In order to draw valid conclusions about the financial health of an entity, it is essential to analyze and compare specific types and sources of financial information. This analysis would include (1) a review of the firm's accounting policies, (2) an examination of recent auditors' reports, (3) analysis of footnotes and other supplemental information accompanying the financial statements, and (4) the examination of various relationships among items presented in financial statements (i.e., ratio analysis).
Financial ratios measure elements of the firm's operating performance and financial position so that internal as well as industry-wide comparisons can be made on a consistent basis. Ratio analysis provides an indication of the firm's financial strengths and weaknesses and generally should be used in conjunction with other evaluation techniques. Ratio analysis is used primarily to draw conclusions about the solvency, operational efficiency, and profitability of a firm.
Basic Financial Statement Analysis
A Summary of Financial Ratios
Ratio Formula Purpose or Use
1. Current ratio Current assets
Current liabilities Measures short-term debt-paying ability
2. Quick or acid-test ratio Cash, marketable securities,
and receivables (net)
Current liabilities Measures immediate short-term liquidity
3. Current cash debt coverage ratio Net cash provided by
Average current liabilities Measures a company's ability to pay off its current liabilities in a given year from its operations
4. Receivable turnover Net sales
Average trade receivables (net) Measures liquidity of receivables
5. Inventory turnover Cost of goods sold
Average inventory Measures liquidity of inventory
6. Asset turnover Net sales
Average total assets Measures how efficiently assets are used to generate sales
7. Profit margin on sales Net income
Net sales Measures net income generated by each dollar of sales
8. Rate of return on assets Net income
Average total assets Measures overall profitability of assets
9. Rate of return on common stock equity Net income minus preferred
Average common stockholders' equity Measures profitability of owners' investment
10. Earnings per share Net income minus preferred
Weighted shares outstanding Measures net income earned on each share of common stock
11. Price earnings ratio Market price of stock
Earnings per share Measures the ratio of the market price per share to earnings per share
12. Payout ratio Cash dividends
Net income Measures percentage of earnings distributed in the form of cash dividends
13. Debt to total assets Total debt
Total assets or equities Measures the percentage of total assets provided by creditors
14. Times interest earned Income before interest
charges and taxes
Interest charges Measures ability to meet interest payments as they come due
15. Cash debt coverage ratio Net cash provided by
Average total liabilities Measures a company's ability to repay its total liabilities in a given year from its operations
16. Book value per share Stockholders' Equity
Outstanding Shares Measures the amount each share would receive if the company were liquidated at the amounts reported on the balance sheet