Bu-121 Lecture 11
Finance: Financial Management is made up of:
1. Accounting – provides information
2. Finance – makes decisions about the acquisition, disposition and management of capital
with the help of accounting information
Ultimate objective: Maximize shareholder wealth
1. Viability – Liquidity and Stability
2. We want to keep money in a form that can be used to pay bills (short term). Stability =
· Risk – Return Trade-off
Finance Department‟s Responsibilities:
1. Determining financial resources required
2. Budgeting – disposition
3. Obtaining financial resources required
4. Financing – acquisition
5. Managing the financial recourses effectively
6. Working capital management
Decisions – Balance Sheet
SEE SLIDES FOR CHART!
Budgeting: Three Steps:
1. Forecasting Financial Needs
o Short term – cash flow forecast
o Long term
2. Developing budgets to meet those needs
o Master budget
§ Operating Budget
§ Capital Budget
§ Cash Budget
3. Establishing Financial Control
Advantages of Budgeting
Compels managers to plan
Promotes communication and coordination among subunits of the organization –
· By clarifying goals and providing yardstick for rating performance – source
· Establishing goals or standards against which actual performance can be
measured – facilitates control Negative Aspects of Budgeting – Abuses
· Means to reward waste and penalize thrift
· Individuals subjected to guidelines not consulted
· Evaluate device – perceived as a threat
· Convenient scapegoat or lost opportunities
· Management of cash flows
· Management of working capital cycle
Beginning Case Balance
= Total Cash Available
= Cash Excess / (Deficiency)
Minimum Cash Balance Desired
Borrowing Required/Surplus or Repayment
Ending Cash Balance
*Worksheet based on historical measures of amounts and timing of cash flows in working capital
Accounting: Provides information
Finance: Makes decisions about the acquisition, disposition, and management of capital with the
help of accounting information
Ultimate objective: Maximize shareholder wealth.
o Remember this is achieved through all critical success factors (so don‟t forget them)
o Achieve objective through 2 goals...
Liquidity (to keep business afloat in the short term)
Stability (to keep the business afloat in the long-term.)
Risk. Vs Return Trade-off: Always a trade off between viability and
Example: If you keep $1 as cash to increase liquidity, you improve
viability but you could have invested it to POSSIBLY increase
You must strike a perfect balance
o Determining Financial resources Required
Budgeting – Disposition
o Obtaining Financial Resources Required
o Managing the financial resources effectively
Working capital – (Day-to-day fund management)
Investing – (Long-term fund management)
o Decisions – Balance Sheet 2 sides (Assets and Equities)
Assets = Investing Decisions
Equities = Financing
Balance sheets also divide short term / long term
Current assets vs. Capital Assets
Current Liabilities vs. Long-term Liabilities
Short-Term Assets (Things to Consider)
Working Capital Management
Working Capital Cycle (con
Cash Budgeting (tool)
Long-Term Assets (Things to Consider)
Amount and mix
o CVP analysis
Long-term Equities (Things to Consider)
EBIT analysis (Tool)
Dividends (Major Decision area)
A budget is a plan
1) Forecast financial needs
Short term – cash flow forecast
2) Developing budgets to meet those needs
Master budget (comprised of)
Cash budget (one we will focus on)
3) Establish financial control
Look at deviations from budget (difference between budget and actual
Advantages of Budgeting (Forces
Compels managers to plan
Promotes communicating and coordinating among subunits of the organization “systems”
approach. When you budget you are FORCED to make sure your budget makes sense when
integrated with the rest of the company
Clarifies goals and provides a yardstick for rating performance – source of motivation
Establishes goals or standards against which actual performance can be measured- facilitates
Negative aspects of budgeting- (caused by ABUSES of budgeting process)
Error: Means to reward waste and penalize thrift.
o If you are under budget, the excess money is often taken away. This is flawed because it
motivates people to unnecessarily spend so that their funding is not reduced.
PENALIZING THRIFT o If you are over budget, the excess money is generally handed down. This is flawed
because it DOESN‟T motivate people to save money.
Error: Individuals subjected to guidelines are often not consulted. They therefore feel trapped by
the budget. THEY SHOULD BE PART OF THE PROCESS.
Error: Evaluative evidence –perceived as a threat
Error: Convenient scapegoat: you can be lazy because things are “not in your budget”. This can
lead to lost opportunities because you cannot afford things that SHOULD be included.
Management of cash flows
Management of working capital cycle
Beginning Cash Balance
+ Receipts (cash you earned) * difficult to work with*
= Total Cash Available
- Disbursements (cash you must spend) *difficult to work with*
= Cash Excess / Deficiency
*You should have a minimum cash balance desired*
This will lead to Borrowing Required/ Surplus or Repayment
= Ending Cash Balance
*Worksheet: Based on historical measures of amounts and timing of cash flows in working capital cycle.
Used to determine how much cash you will get.
In new venture: Look at the industry standard for how many people pay early, how many pay on time,
how many don‟t pay at all, etc.
- You need to prepare a cash budget for months of June, July, August
- Minimum cash balance requirement = $6000 dollars
- Beginning cash balance in June = min. Cash balance
- Assume that sales are forecasted at $10 000, $20 000, $30 000, $15 000, $25 000, and $20, 000
from April to Sept. Respectively
- Assume also that you expect to collect 30%
Worksheet: April May June July Aug. Sept.
30% month of sale $3000
60% month follow $6 000
10% 2 month $1000
Total Receipts $22 000 $24 5000 $19 500
75% next month sales
20% month of purchase.
80% month follow
Place; Implications of using marketing intermediaries - Demand-Backward Pricing
- Push vs. Pull Promotion
Finance: Objective, Goals, Trade-off
Ex. See Slideshow for values, Cash Budget
Clicker: Your sales revenue for January is forecasted to be $100,000. Historically 20% of your
sales are in cash, and the remaining 80% are on credit. 60% of credit sales are from customers
that pay within the prescribed payment period - in the month following sale, and the remainder
is from customers who pay late but before 90 days. Which of the following would be correct with
respect to your cash budget?
A. You would need your sales revenue from October through December to determine total
receipts for January
B. You would receive $20,000 in January, $48,000 in February, and $32,000 in March from
C. You may need to forecast your sales revenue for February and later months to complete the
cash budget for January.
D. All of the above
E. B and C only. * Because 90 days goes back to only November. Everything that happened
in October is done.
Keys to Cash Budgeting: The Three Possibilities
1. Deficiency: If this happens you are going to need to borrow for the deficiency + minimum.
This means that your ending balance = minimum required.
2. Excess > Minimum: This means that you will have a surplus, which can be used to repay an
borrowing. If you do use this money to repay borrowing, then the ending balance is going to be
3. Excess < Minimum. If this happens then you will borrow to = the minimum required, making
the ending balance = the minimum required.
EBIT Analysis: To determine the best mix of debt and equity in the firm‟s capital structure. The
objective is to maximize shareholder wealth, (which is measured by the EPS).
Earnings Per Share: (common stockholders)
= Earnings available to common stockholders
______= Net Income - Preferred Dividends____
= # of shares of common stock
EBIT: The Earnings before Interest and Taxes - Interest
= Earnings before Taxes - EBT
= Net Income - EAT
- Preferred Dividends
Earnings Available to Common Stockholders
/ # of shares of Common Stock
= Earnings per share - EPS
Ex. ABC company requires an additional $4 million in external long-term financing. The EBIT
are assumed to be $6 million next year, and ABC‟s tax rate is 50%. The existing capital structure
$5 million in 10% bonds, (10 percent interest rate)
$3 million in 6% preferred stock
1M shares of common stock at 10$/share
$500,000 in retained earnings
ABC has 2 alternatives to raise this money
$3 million in 11% bonds, and 1 million in 7% preferred stock
$2 million in 8% preferred stock and $2 million in common stock at $10/share
Debt - Interest = $ debt x % interest date
Preferred Stock - Preferred Dividends = $ preferred stock x % dividend rate
Common Stock - # shares = $ common stock / price
SEE SLIDES FOR CALCULATIONS
* Note: The EBIT needs a common starting point!
* Choose the option which results in the highest EPS while realizing that there is always a trade-
off between risk and return.
* RISK - comes from leverage; what happens when you have more debt than equity in your
capital structure? You should be able to calculate your degree of leverage.
Ex. $5 million + $3 million debt
= $ 3 + 1 million preferred + 10 M common + 500k retained earnings
= 8 / 14.5 = 0.55:1, (Average)
* Calculate the Interest Coverage Ratio: Which is paid by the earnings right before the interest is
deducted, which is the EBIT.
Ex. = 6M / $830k = 7.2x, The general rule is 3
DECISION: Choose alternative #1 because:
- It has the least dilutive impact on EPS. They will both drop, but which drops the least? While having acceptable levels of risk as measure by the interest coverage ratio.
Therefore: Maximizing shareholder wealth, while balancing risk and return.
Bu-121 Lecture 13
Finding EBIT, adding in present financing.
Decision Criteria & Justification
Maximize shareholder wealth - “least dilutive impact”
Balance Risk & Return
Measure Risk - Interest Coverage Ratio
Looking for acceptable risk = >3x
If not, than choose the next best alternative
Ratio Analysis: It is a tool that is used for;
Analyzing accounting information to help make better decisions - about other firms, or about our
firm by outsiders.
Analyzing the results of those decisions.
Recall: a ratio is a mathematical comparison using information from the financial statements.
It detects crude trends/overall problems that require further investigation
Ratio Analysis - 3 Steps
1. To assess overall financial well-being, look at all 5 types of ratios:
A) Liquidity: Looks at the companies ability to cover its short term cash needs. Looks
at the risk in the short-term.
B) Stability: Is the company able to meet its long term financial needs. It looks at the
risk involved over the long term.
C) Profitability: Is the company profitable, looks at short term.
D) Growth: Is the company growing, looks at long term profitability.
E) Marketability: how happy are the shareholders
2. Compare the ratio to something else. The ratio is meaningless until it is compared to
- Same ratio of other firms in the industry, (strongest competitors, industry leaders
- Industry Averages.
- “Rule of Thumb” - An average for everybody.
- Look at the same ratio for a series of past years, within the same company.
- Compare it to a different ratio.
3. Pull apart the numerator and the denominator into component parts to see where the problem
lies. Without doing this, then you do not know which of them is causing the issue, and you do
not know what to do about it. Ratio Analysis Ratio’s.
LIQUITIY: A measure of a company‟s ability to meet its current and short-term obligations. It
looks at the short-term viability. It is used to assess the adequacy of a firm‟s working capital
management. In addition, it is used to assess whether net working capital provides a sufficient
cushion to meet current debts as they come due. (This is known as a working safety-net).
NET WORKING CAPITAL: = CURRENT ASSETS - CURRENT LIABILITIES
You are trying to maximize shareholder wealth by balancing risk and return. How is this done?
Speed of the working capital cycle
Knowledge of/ability to predict the Working Capital Cycle (WCC)
Cash Cycle: See Diagram. Note that the cycle depicts the profit vs. cash differentiation that was
discussed for the first midterm.
Current Ratio: Current Assets / Current Liabilities
- “Rule of Thumb” > 2:1, < 4:1: This suggest is that the net working capital should be at least as
large as the current liabilities. CA (2) - CL(1) = NWC (1) = CL
Acid Test / Quick Ratio: Current Assets - (Inventories + supplies + prepaids) / CL‟s
- rule of thumb, should be greater than 1:1
1. Average Collection Period: Avg. (closing) accounts receivable x 365 days
Annual credit sales
Compare to credit terms ex. 2/10, net 30 vs. 59 days.
Check industry terms, discount, penalty, credit, granting procedures.
Why is it so important to take advantage of the discount?
2. Accounts Receivable Turnover:
= annual (credits) sales / avg. (closing) A/R
- What is the trade-off? This looks at the benefits of paying early, vs. holding off and paying after the credit period has passed. Done in formula 2/15 net 45.
= 2% credit if paid within 15days, otherwise due in 45 days.
3. Inventory Turnover = cost of goods sold / average inventory
Or Sales / average inventory
Trade-off: need to achieve a balance - not to slow, not too fast. You have to have the capacity to
meet the demand.
If a firm‟s inventory turnover is higher than the industry average, it would need a lower net
working capital all other things being equal.
Theory in Use: “Raiding a Company‟s Hidden Cash”.
What are the short and long term benefits of operating without a net working capital balance?
What is the key to operating without a net working capital?
Stability: A measure of a company‟s ability to met its long-term obligations by measuring the
relationship between components of a firm‟s capital structure. This is the LONG TERM
VIABILITY: it shows the results of financing decisions.
Debt to Equity or Debt to Net Worth
= total debt/ shareholders‟ equity (net worth)
= current liabilities + long-term liabilities
= common stock + pref. stock + retained earnings
** Rule of Thumb, for industrial firm < 1:1
Investors / shareholders?
Leverage: Long-term debt / shareholder equity (net worth)
- measures the degree to which a company has locked itself into fixed financial costs
- Implies that a given change in sales will result in a greater change in profit
Rule of Thumb < 5:1 low , 5:1 1:1 average , >1:1 high
Advantage to holding 1:1 debt: long term debt is the cheapest source of capital because the
interest is tax deductible, dividends are not. Therefore you will see a higher RETURN.
Disadvantage: higher long-term debt means higher interest payments which are a legal
obligation whereas dividends are not, therefore you are incurring greater risk.
Example: Currently each firm has 1M in common stock outstanding, and each needs to finance
and additional 1M.
A Difference B EBIT
- taxes @ 50%
Interest costs 100,000 - tax savings $50,000
= real interest 50k / 1M debt
= 5%, not 10% -- lower cost of capital
If return on capital is 15%
- A 15% return, - 5% cost = 10% overall
- B 15% return - 10% cost = 5% overall
If you have lower leverage, you will have lower risk but a higher cost of capital, resulting in a
If you have higher leverage, you will have higher risk but lower cost of capital. This will lead to
a higher return.
Business Lecture 14:
1. Presentation Points Suggested in Slides
2. Ratio Analysis Lecture 2.
Key Points from last class:
1. Ratio Analysis; Steps and Comparisons
2. Liquidity concepts
- Sufficient level of net working capital
- Working capital cycle and effect on the NWC
- Risk vs. Return
- Ratios for measuring management of WCC and interpretation
3. Stability Concepts
- Advantages and Disadvantages of debt and equity
- Ratios for measuring and interpretation. Why is DEBT cheaper than EQUITY
Interest Coverage Ratio: = EBIT / ANNUAL INTEREST
Helps asses the risk inherent in being highly levered
The Rule of Thumb: for an industrial firm is >3x, but should look at the long-run trend in earnings, and variability in earnings.
** ANYTHING BY ITSELF MEANS NET BY DEFAULT
Gross Profit Margin (GPM)
= Gross Profit / Sales
Net Profit Margin (NPM)
= Net Profit / Sales
- You need to check the components of the Income Statement
= Net Income / Shareholder‟s Equity (net worth)
- Most important thing for Investor‟s
Growth: measures the rate of growth of any Balance Sheet of Income Statement account
STEPS: Use formula for the general rate of change
= present year‟s _”----” - past years _”----”____
Past years _”-----”
Earnings Per Share: (EPS)
= earnings available for common stockholders
# of shares of common stock
- Net Income - Preferred Stock Dividends # shares of common stock
- Calculate fully diluted if P/S is convertible. If this happened than the number of shares would
increase because the denominator would increase, and the number dividends would go down.
Price / Earnings Ratio:
= market price / share
- helps gauge stock value and growth prospects
This is saying that the higher this ratio, the less likely that investors are to bid up the price,
because it would not be worth it.
Yield: = dividends / share
Price / share
** Where price is the price you paid, or the price you will pay if you are doing this before you
have the stock.
Payout = Dividends / Share
Relationships to P/E ratio? A high price earnings ratio tells you that it‟s a growing firm, and
growing firms re-invest their earnings. This means that the more that a firm is growing the lower
the payout ratio will likely be, (possibly 0). This is because you do not have to pay dividends, so
firms that need the money will keep it.
Investors are not as interested in the company if they are not investing in both a growth company
and one that pays dividends.
DECISIONS: BALANCE SHEET SLIDE!!!!! SUMMARY:: LEARN IT!
Bu-121 Lecture 15: Key Points From Last Class
Operations: Know the difference between a service and manufacturing business.
Types of Business
Trends, ex. (sustainability)
Cradle to cradle design, the closed loop approach to design.
Biomimicry, where you are inspired by nature mimicking it.
Product Stewardship: taking responsibility for the product after the sale
Sustainability through servicing.
Sustainability of the Supply Chain: “a network of facilities that procure raw materials, transform
them into intermediate goods and then final products, and deliver the products to customers
through a distribution system”.
Wal-Mart: have launched a pilot program with suppliers of seven common items - to measure and reduce the amount of energy used in making and distributing them.
Home Depot: gives marketing and store display preference to Eco-Options lien of
environmentally friendly products
Starbucks: before it launched a new line containing cocoa - sourced primarily from regions in
West Africa that rely on forms of child labour - invested in rural and community development,
provided rewards for
Timberland: “If you are going to design carbon out of a product, you have to understand every
place in the lifecycle where that carbon comes in”.
Making rubber is carbon-intensive - working with Vebram (making rubber soles to use more
Pesticides and Herbicides
Earth-keepers 2.0 program that recycles the rubber into new boots.
Locations: Cost, Proximity, Convenience. These have implications for the eco-options for the
product. Ex. Proximity: You should be close to your suppliers for economics, because it will be
cheaper, but you should also be closer to minimize the pollution involved in the transportation of
Process: the opposite of the product, focus on the many different processes.
Fixed Position: the layout used for product that do not move down a production line. Ex. An
Airplane, or Boat. This means that instead of it moving, we move.
Capacity - goods/high & low contact services.
Note: You can shift your demand through pricing, which will effect your capacity. Your
capacity is determined by your demand, which will affect how many customers you can
In a high contact industry, you should put your capacity at the peak demand. Ex. A lunch
restaurant in the downtown core.
In a low contact industry, you should set your capacity at the average demand. Ex. A tax
Capacity requirements are driven by demand just as the ability to meet demand is affected by
In a manufacturing business capacity should always be set slightly ahead of demand.
Methods of determining required capacity:
Speed up service - „fail‟ points. At the speed that you need to operate at, ex. Restaurant. Your customers do not want to wait. Also, you can look at the fail points, and try to limit the things
that can go wrong.
Limit human discretion to increase consistency: Ex. Starbucks. There is a certain streamline that
they do with the callouts that insure that the drinks that they make are correct. The marks on
the cup are called out in that exact order.
Worker interaction with customers. The connection with the customer is important as it must be
a positive one. Ex. Blockbuster, you cannot get in without them greeting your.
Scheduling: You have to schedule things so that they get done by a certain date, although these
things in a service business you do not have this lead time. Because of this a service business can
only really do reservations. Ex. Flights, (overbooked).
Materials management, - design, material flows, and inventory.
Process Control, - worker training, just in time, quality. Just in time has to do with inventory, as
the process control insures that a minimum level of inventory builds up. This involves
Worker Training: People need to know what they have to do in both service and
manufacturing businesses, because this process management streamlines the
MODERN PRODUCTION TECHNIQUES:
The mass production technology vs. New Economy:
The mass production technology and the assembly line inventory line obsolete. This is because
our economy is characterized through rapid change. The idea that you do the same thing over
and over again is the definition of stability. In our industry, you need to be constantly changing,
and therefore this is in inefficient.
Customer-Driven Marketing Environment- Effectiveness vs. Efficiency: What we are realizing
is that if we are making a lot of something, but the customer doesn‟t like it we are wasting our
time. It‟s not doing things right, but doing the right things right.
Customization and Innovation vs. Repetition: We are going to have to adjust constantly. We
need to be always adjusting, not doing the same shit over and over again. The lessons that we
learned in mass production are correct, although these things have changed.
What we are producing,
Not doing the same thing over and over
READ: “The customized, digitized, have it your-way economy.
* What is the mass-customization, and what makes it possible
* What implications does this new economy have on a company‟s marketing and
Economic Order Quantity (EOQ): The formula that allows you to figure out the best level of
inventory to order. The most economic quantity to order. This is old, and now this is
incorporated into the MRP.
Materials Requirement Planning. (MRP), (MRPII). The software based approach to the planning
needs for inventory levels. MRPII takes the information from a standard MRP system to other
area, ex. Costs involved fed to finance.
Enterprise Resource Planning (EFP) The term used to describe everyone being linked by a
computer system with the idea mentioned with the MRPII.
Just-in-Time Inventory Control: (JIT): The product does not sit in inventory, but goes out to the
customers just in time. The flow of inventory never stops.
Flexible Manufacturing: Using equipment that can adapt to your changing needs. Usually
machinery requires physical changes, but now computers can change them using different
Lean Manufacturing: You are manufacturing with as little waste as possible. You are therefore
eliminating the excess waste, using as little material as possible.
Robotics: Replacing humans with machinery that is computer based. Anything that is really
monotonous, people don‟t want to do. These tasks are done by robots.
Mass Customization: In our environment, you need to customize your product to the customer,
but do so in the most economic possible way.
CAD: CAM: Computer aided design, and computer aided manufacturing. These two systems
should work together. This is known as CIM, computer integrated manufacturing, where the
design and manufacturing systems are integrated.
Productivity-Quality Connection: You cannot be truly productive unless you produce quality
goods at a sufficiently high level. Through the evolution of how the production process has
developed, this makes sense.
TQM: total quality management, where everything from the person sweeping the floor, to those
answering the phones must be of the highest quality.
W. Edwards Deming: This is the guy who was the founder of the TQM. He realized that the
mass production area is not the right way, where we should not just make stuff because it sells.
This guy went to Japan, and fixed their economy after the WWII. Now look at them. Statistical Process Control: You cannot wait until your done making something before you check
to see if its ok or not. They are checking statistics and monitoring the consistency throughout the
Quality Circles; If everyone is involved with the production, then quality should be higher. If
you gather your employees and ask them wtf is up, then you are more likely to get correct
responses and produce a better product. Bringing workers together, And access quality.
Benchmarking: whoever the leader in the industry is, use them as your role model. What are they
doing and how do we compare to them. How do we be like them.
ISO: Stands for equal., 9000, 10000 etc. They have procedures to insure quality. The iso
designation is world widely accepted as the common denominator for quality. It levels the
playing field. Therefore, now small and large companies can compete on the same level.
Required to do business worldwide
Six SIGMA: developed by Motorola, which is a process to maintain quality.
Lecture # 4 – BU121 – Olivia Saccucci
Key Points from Last Class…
o Risk of Leverage – Interest Ratio
o Margin vs ROI
o EPS (earnings per share) –