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Financial Capital

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The funds a firm uses to acquire its assets and finance its operations -firms use some of their capital to meet short-term obligations, such as paying bills from suppliers, meeting payroll, repaying loans from banks, and paying taxes owed to the government. -used to finance long-term investments, such as the purchase of plant and equipment or the launch of a new product line

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Finance

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The functional area of business that is concerned with finding the best sources and uses of financial capital -The most widely accepted goal of financial management has been to \"maximize the value of the firm to its owners\"

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Risk

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The degree of uncertainty regarding the outcome of a decision

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Risk-Return Tradeoff

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The observation that financial opportunities that offer high rates of return are generally riskier than opportunities that offer lower rates of return.

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Financial Ratio Analysis

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Computing ratios that compare values of key accounts listed on a firm's financial statements

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Financial Managers have developed an impressive array of specific ratios. The most important fall into four basic categories:

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1) Liquidity 2) Asset Management 3) Leverage 4) Profitability

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Liquid Asset

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An asset that can quickly be converted into cash with little risk of loss

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Liquidity Ratios

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Financial ratios that measure the ability of a firm to obtain the cash it needs to pay its short-term debt obligations as they come due. -One of the most commonly used liquidity ratios is the current ratio (dividing a firm's current assets by its current liabilities) -The larger the current ratio, the easier it is for a firm to pay its short-term debts. A ratio below 1.0 signifies that a company does not have enough current assets to pay short-term liabilities.

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Asset Management Ratios (Activity Ratios)

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Financial ratios that measure how effectively a firm is using its assets to generate revenues or cash. -The inventory turnover ratio (dividing the firm's cost of goods sold by average inventory levels) ---> measures how many times a firm's inventory is sold and replaced each year. -A high turnover rate is good -However, inventory turnover can be too high---> the company isn't keeping enough goods in stock, causing stock outs. -For firms that sell a lot of goods on credit, the \"average collection period\" is another important asset management ratio (dividing accounts receivable by average daily credit sales) ----> 45 means takes the customer 45 days on average to pay for credit purchases. (smaller is better)

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Leverage Ratios

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Ratios that measure the extent to which a firm relies on debt financing in its capital structure

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Financial Leverage

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The use of debt in a firm's capital structure -A highly leveraged firm is one that relies heavily on debt

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Profitability Ratios

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Ratios that measure the rate of return a firm is earning on various measures of investment ---> provides measures of how successful they are at achieving this goal

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Current Ratio

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Type: Liquidity (measures ability to pay short-term liabilities as they come due) What it Measures: compares current assets (assets that will provide cash in the next year) to current liabilities (debts that will come due in the next year)

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Inventory Turnover Ratio

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Type: Asset Management (measures how effectively a firm is using its assets to generate revenue) What it Measures: How quickly a firm sells its inventory to generate revenue

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Average Collection Period Ratio

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Type: Asset Management (measures how effectively a firm is using its assets to generate revenue) What it Measures: How long it takes for a firm to collect from customers who buy on credit

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Debt-to-Assets Ratio

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Type: Leverage (measures the extent to which a firm relies on debt to meet its financing needs) What it Measures: Similar to debt-to-equity, but compares debt to assets rather than equity. This is another way of measuring the degree of financial leverage, or debt, the firm is using

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Return on Equity Ratio

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Type: Profitability (compares the amount of profit to some measure of resources invested) What it Measures: Indicates earnings per dollar invested by the owners of the company. Since common stockholders are the true owners, preferred stockholders' dividends are deducted from net income before computing this ratio

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Earnings Per Share Ratio

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Type: Profitability (compares the amount of profit to some measure of resources invested) What it Measures: Measures the net income per share of common stock outstanding

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Financial Planning must answer the following questions:

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1. What specific assets must the firm obtain to achieve its goals? 2. How much additional financing will the firm need to acquire these assets? 3. How much financing will the firm be able to generate internally (through additional earnings), and how much must it obtain from external sources? 4. When will the firm need to acquire external financing? 5. What is the best way to raise these funds?

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Budgeted Income Statement

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A projection showing how a firm's budgeted sales and costs will affect expected net income. ---uses information from the sales budget and various cost budgets ( as well as other assumptions) to develop a forecast of net income for the planning period. This can help the firm evaluate how much internal financing will be available--- (Also called a pro forma income statement)

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Budgeted Balance Sheet

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A projected financial statement that forecasts the types and amounts of assets a firm will need to implement its future plans and how the firm will finance those assets ---Also helps financial managers determine the amount of additional financing (liabilities and owner's equity) the firm must arrange to acquire those assets--- (Also called a pro forma balance sheet)

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Cash Budget

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A detailed forecast of future cash flows that helps financial managers identify when their firm is likely to experience temporary shortages or surpluses of cash

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Sources of Short-Term Financing

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1. Trade Credit -spontaneous financing 2. Factoring 3. Short-Term Bank Loans -line of credit -revolving credit agreement 4. Commercial Paper

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Trade Credit

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---One of the most important sources of short-term financing for many firms--- Spontaneous financing granted by sellers when they deliver goods and services to customers without requiring immediate payment ---> \"buy now, pay later\" ---Sometimes called spontaneous financing because it is granted when the company places its orders without requiring additional paperwork or special arrangements---

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Spontaneous Financing

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Financing that arises during the natural course of business without the need for special arrangements

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Factor

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A company that provides short-term financing to firms by purchasing their accounts receivables at a discount ---A factor makes a profit by purchasing the receivables at a discount and collecting the full amount from the firm's customers---

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Short-Term Bank Loans

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-Are usually due in 30-90 days -When a firm negotiates a loan with a bank, it signs a promissory note -Banks sometimes require firms to pledge collateral, such as inventories or accounts receivable, to back the loan.

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Line of Credit

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A financial arrangement between a firm and a bank in which the bank pre-approves credit up to a specified limit, provided that the firm maintains an acceptable credit rating

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Revolving Credit Agreement

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A guaranteed line of credit in which a bank makes a binding commitment to provide a business with funds up to a specified credit limit at any time during the term of the agreement

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Commercial Paper

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---Many large large corporations with strong credit ratings issue commercial paper--- Consists of short-term promissory notes (IOU's) issued by large corporations (and usually unsecured--> meaning it isn't backed by a pledge of collateral) ---In recent years, a new class of commercial paper has emerged, called \"asset-backed commercial paper\", which is backed by some form of collateral--- ---Commercial paper can be issued for up to 270 days, but most firms typically issue 30 days, and sometimes for as little as two days--- ---Commercial paper is popular with companies because it typically carries a lower interest rate than commercial banks charge on short-term loans--- Why use Commercial Paper? ---> According to the Consumerist, \"The commercial paper market works like a credit card for big companies\"

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Sources of Long-Term Funds

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1. Direct Investments From Owners -retained earnings 2. Long-Term Debt 3. Term Loans -covenant 4. Corporate Bonds

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Direct Investments From Owners

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--A key source of long-term funds for a firm is the money the owners themselves invest in their company-- ---For corporations, this occurs when it sells newly issued stock---

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Retained Earnings

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The part of a firm's income it reinvests. ---This source isn't a pool of cash; it simply reflects the share of the firm's earnings used to finance the purchase of assets, pay off liabilities, and re-invest in the business--- ---Retained Earnings are a major source of long-term capital for many corporations. When the economy is booming and profits are high, retained earnings tend to soar. But when the economy slides into a recession, most corporations find they have few earnings to reinvest---

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Long-Term Debt

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Firms can also raise long-term funds by borrowing from banks, and other lenders or by issuing bonds

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Term Loans

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Calls for a regular schedule of fixed payments sufficient to ensure that the principal (the amount initially borrowed) and interest are repaid by the end of the loan's term

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Covenant

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A restriction lenders impose on borrowers as a condition of providing long-term debt financing ---One common covenant requires the borrower to carry a specified amount of liability insurance. Another requires the borrower to agree not to borrow any additional funds until the current loan is paid of--- ---The purpose of covenants is to protect creditors by preventing the borrower from pursuing policies that might undermine its ability to repay the loan. While covenants are great for lenders, borrowers often view them as highly restrictive---

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Corporate Bonds

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---Rather than borrow from banks or other lenders, corporations sometimes issue their own formal IOU's, called corporate bonds, which they sell to investors. Bonds often have due dates (maturities) of ten or more years after issuance--- ---Like corporate stock, bonds are marketable, meaning that bondholders can sell them to other investors before they mature. But it is important to realize that unlike shares of stock, which represent ownership in a corporation, bonds are certificates of debt---

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Equity & Debt Financing

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Most firms use a combination of these to acquire needed assets and to finance their operations. ---When a company issues and sells new stock or uses retained earnings to meet its financial needs, it is using equity financing. But when it takes out a bank loan, or issues and sells corporate bonds, it is relying on debt financing---

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Equity Financing

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Funds provided by the owners of a company

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Debt Financing

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Funds provided by lenders (creditors)

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Pros and Cons of Debt Financing

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Pros: 1. The interest payments a firm makes on debt are a tax-deductible expense. 2. Enables the firm to acquire additional funds without requiring existing stock-holders to invest more of their own money or the sale of stock to new investors (which would dilute the ownership of existing owners) Cons: 1. The requirement to make fixed payments 2. Creditors often impose covenants on the borrower

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Pros and Cons of Equity Financing

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Pros: 1. Equity Financing is more flexible and less risky than debt financing 2. Equity imposes no required payments 3. A firm doesn't have to agree to burden some covenants to acquire equity funds Cons: 1. Doesn't yield the same tax benefits as debt financing 2. Existing owners might not want a firm to issue more stock, since doing so might dilute their share of ownership 3. A company that relies mainly on equity financing forgoes the opportunity to use financial leverage (leverage can be a two-edged sword)

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Dodd-Frank Act

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A law enacted in the aftermath of the financial crisis of 2008-2009 that strengthened government oversight of financial markets and placed limitations on risky financial strategies such as heavy reliance on leverage

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Cash Equivalents

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Safe and highly liquid assets that many firms list with their cash holdings on their balance sheet ---Commercial paper, U.S. Treasury Bills, and money market mutual funds are among the most popular cash equivalents--- ---The advantage of these cash equivalents is that they offer a better financial return (in the form of interest) than currency or demand deposits---

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U.S. Treasury Bills (T-bills)

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Short-Term marketable IOU's issued by the U.S. federal government ---Very active secondary market for T-bills, meaning that their owners can sell them to other investors before they mature. Thus, T-bills are highly liquid--- ---Unlike commercial paper, T-bills are backed by the U.S. government, so they are essentially risk-free---

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Money Market Mutual Funds

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A mutual fund that pools funds from many investors and uses these funds to purchase very safe, highly liquid securities ---Are an affordable way for small investors to get into the market for securities, which would otherwise be beyond their means--- ---Makes them an attractive cash equivalent for smaller firms---

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The key elements of managing accounts receivable should include:

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1. Setting Credit Terms 2. Establishing Credit Standards 3. Deciding on an Appropriate Collection Policy

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Managing Inventories

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---In recent years, many manufacturing firms have become very aggressive about keeping inventories as low as possible in an attempt to reduce costs and improve efficiency. This can be effective, but also leave the firm vulnerable to supply disruptions---

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Capital Budgeting

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The process a firm uses to evaluate long-term investment proposals

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The Capital Budgeting process evaluates proposals such as:

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1. Replacing old machinery and equipment with new models to reduce cost and improve the efficiency of current operations 2. Buying additional plant, machinery, and equipment to expand production capacity in existing markets 3. Investing in plant, property, and equipment needed to expand into new markets 4. Installing new, or modifying existing, plant and equipment to achieve goals not directly related to expanding production, such as reducing pollution or improving worker safety

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Time Value of Money

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---When financial managers compare cash flows that occur at different times, they must take the \"time value of money\" into account--- --->Reflects the fact that , from a manager's perspective, a dollar received today is worth more than a dollar received in the future because the sooner you receive a sum of money, the sooner you can put that money to work to earn even more money

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Certificate of Deposit (CD)

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An interest-earning deposit that requires the funds to remain deposited for a fixed term. Withdrawal of the funds before the term expires results in a financial penalty

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Present Value

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The amount of money that, if invested today at a given rate of interest (called the discount rate), would grow to become some future amount in a specified number of periods

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Net Present Value (NPV)

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The sum of the present values of expected future cash flows from an investment, minus the cost of that investment ---The most common method financial managers use to evaluate capital budgeting proposals is to compute their NPV--- ---A positive NPV means that the present value of the expected cash flows from the project is greater than the cost of the project --> benefits exceed the cost (financial mangers approve projects with positive NPV)--- ---A negative NPV means that the present value of the expected future cash flows from the project is less than the cost of the investment --> financial managers would reject proposals with negative NPV---

Foundations In Business: Chapter 9

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