NVD Exam II Materials

Report
New Venture Development
Exam II Materials
Analysis of Financial Statements
Vertical analysis
on the income
statement uses total
or net revenues for
the denominator
Answers the
question: How
much of our total
revenues were
consumed by each
expense?
Vertical analysis
on the balance
sheet uses total
assets for the
denominator
Answers the
question: How
much of our total
assets are
represented by each
asset category?
Horizontal
analysis on the
income statement
and balance sheet
use the previous
period’s entry as
the denominator
and the difference
between the current
and previous
periods for the
numerator.
(CashQ2 – CashQ1) X 100
CashQ1
Chapter 4
Analysis of Financial Statements
Learning Objectives
• Understand the purpose of financial
statement analysis.
• Perform a vertical analysis of a company’s
financial statements by:
– Comparing those accounts on the income
statement as a percentage of net sales and
comparing those accounts on the balance sheet
as a percentage of total assets for a period of
two or more accounting cycles.
– Determining those areas within the company
that require additional monitoring and control.
Learning Objectives (continued)
– Perform a horizontal analysis of a company’s
financial statements by:
• Comparing the percentage change of components on
a company’s income statement and balance sheet for
a period of two or more years.
• Determining those areas within the company that
require additional monitoring and control.
– Perform ratio analysis of a company and
compare those ratios to other companies within
the same industry using industry averages.
Learning Objectives (continued)
– Analyze the relationships that exist between the
several categories of ratios in determining the
health of a business.
– Distinguish between liquidity, activity,
leverage, profitability, and market ratios.
– Know how to obtain financial statements and
financial information from various sources.
Three Methods of Analyzing
Financial Statements
• Vertical analysis
• Horizontal analysis
• Ratio analysis
Vertical Analysis
• Vertical analysis is the process of using a
single variable on a financial statement as a
constant and determining how all of the other
variables relate as a percentage of the single
variable.
Vertical Analysis of an Income
Statement
• The vertical analysis of the income
statement is used to determine, specifically,
how much of a company’s net sales
consumed by each individual entry on the
income statement.
• Constant is net sales. The formula is:
Percentage
of Net Sales 
Income Statement
Item in $
Net Sales in $
 100
Horizontal Analysis
• Horizontal analysis is a determination of
the percentage increase or decrease in an
account from a base time period to
successive time periods.
• The basic formula is:
Percentage Change


New time period amount
- Old time period amount
Old time period amount
 100
Table 4-1 Sample Income Statement Data
Markadel Retail Store
Income Statement Data
From January 1 through December 31, 2005 and 2006
Account
Year 2005
Gross sales
$ 300,580
Less returns
5,124
Net sales
295,456
Cost of goods sold
101,250
Gross profit
194,206
Operating expenses
Administration
74,983
Advertising
35,214
Overhead
27,120
Operating income
56,889
Interest
7,000
Earnings before taxes
49,889
Taxes
7,483
Net profit
$
42,406
Year 2006
$ 315,487
9,253
306,234
120,002
186,232
Vertical
Analysis
2005 (%)
101.73
1.73
100.00
34.27
65.73
Horizontal
Analysis 20052006 (%)
4.96
80.58
3.65
18.52
(4.11)
76,450
37,250
28,300
44,232
6,250
37,982
5,697
$ 32,285
25.38
11.92
9.18
19.25
2.37
16.89
2.53
14.35
1.96
5.78
4.35
(22.25)
(10.71)
(23.87)
(23.87)
(23.87)
Vertical Analysis of a Balance
Sheet
• Vertical analysis of the balance sheet is
always carried out by using total assets as a
constant, or 100 percent, and dividing every
figure on the balance sheet by total assets.
• The formula is:
Percentage
of Total Assets

Balance Sheet Item in $
Total Assets in $
 100
Table 4-2 Sample Balance Sheet Data
Markadel Retail Store
Balance Sheet Data
As of December 31, 2005 and 2006
Category
Current assets
Cash
Notes receivable
Accounts receivable
Inventory
Total current assets
Fixed assets
Land
Buildings
Accumulated depreciation
Equipment
Accumulated depreciation
Total fixed assets
Total assets
Current liabilities
Accounts payable
Notes payable
Total current liabilities
Long-term debt
Mortgage payable
Bank loan payable
Total long-term debt
Total liabilities
Owner’s equity
Total liabilities and owner’s equity
Year 2005
Year 2006
$
$
$
$
10,210
5,280
15,320
35,020
65,830
25,000
135,000
(47,000)
58,250
(23,150)
148,100
213,930
8,175
8,102
18,025
50,515
84,817
25,000
135,000
(50,000)
58,250
(28,150)
140,100
$ 224,917
Vertical
Analysis
2005 (%)
Horizontal
Analysis
2005-2006 (%)
4.77
2.47
7.16
16.37
30.77
(19.93)
53.45
17.66
44.25
28.84
11.69
63.10
21.97
27.23
10.82
69.23
100.00
0.00
0.00
6.38
0.00
21.60
(5.40)
5.14
34,250
25,000
59,250
40,003
33,035
73,038
16.01
11.69
27.70
16.80
32.14
23.27
65,000
10,000
75,000
134,250
79,680
213,930
63,000
15,000
78,000
151,038
73,879
$ 224,917
30.38
4.67
35.06
62.75
37.25
100.00
(3.08)
50.00
4.00
12.51
(7.28)
5.14
Ratio Analysis
• Ratio analysis is used to determine the
health of a business, especially as that
business compares to other firms in the
same industry or similar industries.
• A ratio is nothing more than a relationship
between two variables, expressed as a
fraction.
Types of Business Ratios
• Liquidity ratios determine how much of a
firm’s current assets are available to meet
short-term creditors’ claims.
• Activity ratios indicate how efficiently a
business is using its assets.
• Leverage (debt) ratios indicate what
percentage of the business assets is financed
with creditors’ dollars.
Types of Business Ratios
(continued)
• Profitability ratios are used by potential
investors and creditors to determine how
much of an investment will be returned
from either earnings on revenues or
appreciation of assets.
• Market ratios are used to compare firms
within the same industry. They are
primarily used by investors to determine if
they should invest capital in the company in
exchange for ownership.
Liquidity Ratios
• Current Ratio: The current ratio is
calculated by dividing total current assets
by total current liabilities.
• The current ratio is given by the following:
Current
Ratio 
Current
Current
Assets
liabilitie s
Liquidity Ratios (continued)
• Quick, or Acid Test, Ratio: This ratio does
not count the sale of the company’s
inventory or prepaids. It measures the
ability of the firm to meet its short-term
obligations without liquidating its
inventory.
• The acid test ratio is given by the following:
Quick Ratio 
Current assets - inventory
Current liabilitie
- prepaids
s
Activity Ratios
• Inventory turnover ratio (or, simply,
inventory turnover) indicates how
efficiently a firm is moving its inventory. It
basically states how many times per year
the firm moves it average inventory.
• Inventory turnover is given as follows:
Inventory
turnover
COGS

Average Inventory
Average
inventory

Beginning
 Ending
inventory
2
at Cost
inventory
Activity Ratios (continued)
• Accounts receivable turnover ratio allows
us to determine how fast our company is
turning its credit sales into cash.
• Accounts receivable turnover is given by
the following:
Accounts
receivable
turnover

Credit sales
Accounts
receivable
Activity Ratios (continued)
• Average collection period is the average
number of days that it takes the firm to
collect its accounts receivable.
• Average collection period is given by the
following:
Average collection
Days per year
period 
Accounts
receivable
turnover
Activity Ratios (continued)
• Fixed asset turnover ratio indicates how
efficiently fixed assets are being used to
generate revenue for a firm.
• Fixed asset turnover is given by the
following:
Fixed asset turnover

Net sales
Fixed assets
Activity Ratios (continued)
• Total asset turnover ratio indicates how
efficiently our firm uses its total assets to
generate revenue for the firm.
• Total asset turnover is given by the
following:
Total asset turnover

Net sales
Total assets
Leverage Ratios
• Debt-to-equity ratio indicates what
percentage of the owner’s equity is debt.
• Debt-to-equity is given by the following:
Debt - to - equity ratio 
Total liabilitie s
Owner'
s equity
or
Debt - to - equity
ratio 
Total
liabilitie
s
Total assets - Total liabilitie
s
Leverage Ratios (continued)
• Debt-to-total-assets ratio indicates what
percentage of a business’s assets is owned
by creditors.
• Debt-to-total-assets is given by the
following:
Debt - to - total - asset ratio 
Total liabilitie
Total assets
s
Leverage Ratios (continued)
• Times-interest-earned ratio shows the
relationship between operating income and
the amount of interest in dollars the
company has to pay to its creditors on an
annual basis.
• Times-interest-earned is given by the
following:
Times - interest
- earned ratio 
Operating
income
Interest
Profitability Ratios
• Gross profit margin ratio is used to
determine how much gross profit is
generated by each dollar in net sales.
• Gross profit margin is given by the
following:
Gross profit margin ratio 
Gross profit
Net sales
Profitability Ratios (continued)
• Operating profit margin ratio is used to
determine how much each dollar of sales
generates in operating income.
• Operating profit margin is given by the
following:
Operating
profit margin ratio 
Operating
income
Net sales
Profitability Ratios (continued)
• Net profit margin ratio tells us how much
a firm earned on each dollar in sales after
paying all obligations including interest and
taxes.
• Net profit margin is given by the following:
Net profit margin ratio 
Net profit
Net sales
Profitability Ratios (continued)
• Operating return on assets ratio is also
referred to as operating return on
investment and allows us to determine how
much we are actually earning on each dollar
in assets prior to paying interest and taxes.
• Operating return on assets is given by the
following:
Operating
return
on assets 
Operating
Total
income
assets
Profitability Ratios (continued)
• Net return on assets (ROA) ratio is also
referred to as net return on investment and
tells us how much a firm earns on each
dollar in assets after paying both interest
and taxes.
• Net return on assets is given by the
following:
Net return
on assets
ratio 
Net profit
Total
assets
Profitability Ratios (continued)
• Return on equity (ROE) ratio tells the
stockholder, or individual owner, what each
dollar of his or her investment is generating
in net income.
• Return on equity (ROE) is given by the
following:
Return on equity ratio 
Net Profit
Owner' s equity
Net Profit
Return on equity ratio 
or
Total assets - Total liabilitie
s
Profitability Ratios (continued)
• Return on equity (ROE) can also use
the relationship between the return on
assets and the amount of debt to assets. It
can be expressed with the following
formula:
Return on equity ratio 
ROA
Debt 

1 
Assets 

Market Ratios
• Earnings per share ratio is nothing more
than the net profit or net income of the firm,
less preferred dividends (if the company has
preferred stock), divided by the number of
shares of common stock outstanding (issued).
• Earnings per share is given by the following:
Earnings
per share ratio 
Net income - Preferred
Number
of common
dividends
shares
Market Ratios (continued)
• Price earnings ratio is a magnification of
earnings per share in terms of market price
of stock.
• Price earnings ratio is given by the
following:
Price earnings
ratio 
Market price of stock
Earnings
per share
Market Ratios (continued)
• Operating cash flow per-share ratio
compares the operating cash flow on
the statement of cash flows to the
number of shares of common stock
outstanding.
Operating
Operating
cash flow per share 
Common
cash flow
shares of stock outstandin
g
Table 4-3 Balance Sheet, Sample Company
Category
2005
Vertical
Analysis 2005
Current assets
Total fixed assets
Total assets
$
7,000,000
8,000,000
15,000,000
Current liabilities
Long-term debt
$
3,000,000
4,000,000
20.00% $
26.67%
8,000,000
53.33%
Owner’s equity
Total liabilities &
owner’s equity
$ 15,000,000
2006
46.67% $ 9,000,000
53.33%
6,000,000
100.00%
15,000,000
Vertical
Analysis 2006
60.00%
40.00%
100.00%
1,000,000
4,000,000
6.67%
26.67%
10,000,000
66.67%
100.00% $ 15,000,000
100.00%
Table 4-4 Sample Balance Sheet
Current assets
Total fixed assets
Total assets
$
Current liabilities
Long-term debt
$
Owner’s equity
Total liabilities &
owner’s equity
2005
2006
7,000,000 $
9,000,000
8,000,000
6,000,000
15,000,000
15,000,000
3,000,000 $
4,000,000
8,000,000
$
15,000,000
$
Horizontal
Analysis
28.57%
-25.00%
0.00%
1,000,000
4,000,000
-66.67%
0.00%
10,000,000
25.00%
15,000,000
0.00%
Table 4-5 Starbucks Corporation Consolidated Balance Sheet*
CONSOLIDATED BALANCE SHEETS
In thousands, except share data
Fiscal Year Ended
Oct 2, 2005
Oct 3, 2004
ASSETS
Current assets:
Cash and cash equivalents
Short-term investments — available-for-sale securities
Short-term investments — trading securities
Accounts receivable, net of allowances of $3,079 and
Inventories
Prepaid expenses and other current assets
Deferred income taxes, net
$ 173,809
95,379
37,848
190,762
546,299
94,429
70,808
$ 145,053
483,157
24,799
140,226
422,663
71,347
63,650
1,209,334
60,475
201,461
1,842,019
72,893
35,409
92,474
1,350,895
135,179
167,740
1,551,416
85,561
26,800
68,950
$3,514,065
$3,386,541
$ 220,975
232,354
44,496
78,293
277,000
$ 199,346
208,927
29,231
62,959
—
198,082
175,048
748
123,684
121,377
735
1,226,996
—
2,870
193,565
746,259
21,770
3,618
144,683
90,968
39,393
1,939,359
20,914
956,685
39,393
1,444,892
29,241
Total current assets
Long-term investments — available-for-sale securities
Equity and other investments
Property, plant and equipment, net
Other assets
Other intangible assets
Goodwill
TOTAL ASSETS
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable
Accrued compensation and related costs
Accrued occupancy costs
Accrued taxes
Short-term borrowings
Other accrued expenses
Deferred revenue
Current portion of long-term debt
Total current liabilities
Deferred income taxes, net
Long-term debt
Other long-term liabilities
Shareholders’ equity:
Common stock ($0.001 par value) and additional paid-in
capital — authorized, 1,200,000,000 shares; issued and
outstanding, 767,442,110 and 794,811,688 shares,
respectively, (includes 3,394,200 common stock units in
Other additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Total shareholders’ equity
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
2,090,634
2,470,211
$3,514,065
$3,386,541
Table 4-6 Starbucks Corporation Consolidated Statement of Earnings
CONSOLIDATED STATEMENTS OF EARNINGS
In thousands, except earnings per share
Fiscal Year Ended
Net revenues:
Company-operated retail
Specialty:
Licensing
Foodservice and other
2-Oct-05
$
5,391,927
Oct 3, 2004
$
4,457,378
Sept 28, 2003
$
3,449,624
673,015
565,798
409,551
304,358
977,373
271,071
836,869
216,347
625,898
Total net revenues
Cost of sales including occupancy
Store operating expenses
Other operating expenses
Depreciation and amortization
General and administrative expenses
6,369,300
2,605,212
2,165,911
197,024
340,169
357,114
5,294,247
2,191,440
1,790,168
171,648
289,182
304,293
4,075,522
1,681,434
1,379,574
141,346
244,671
244,550
Subtotal operating expenses
Income from equity investees
5,665,430
76,745
4,746,731
59,071
3,691,575
36,903
Operating income
Interest and other income, net
780,615
15,829
606,587
14,140
420,850
11,622
Earnings before income taxes
Income taxes
796,444
301,977
620,727
231,754
432,472
167,117
Net earnings
$
Net earnings per common share —
$
Net earnings per common share —
$
Weighted average shares outstanding:
Basic
Diluted
Source: Securities and Exchange Commission,
Date: 12/16/2005.
494,467
0.63
0.61
Total specialty
$
$
$
388,973
0.49
0.47
$
$
$
265,355
0.34
0.33
789,570
794,347
781,505
815,417
822,930
803,296
Washington DC, Edgar Online, Form 10-K, Filing
Table 4-7 Starbucks Corporation Consolidated Statement of Cash Flows*
CONSOLIDATED STATEMENT OF CASH FLOWS
In thousands
Fiscal Year Ended
OPERATING ACTIVITIES
Net earnings
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization
Provision for impairments and asset disposals
Deferred income taxes, net
Equity in income of investees
Distributions of income from equity investees
Tax benefit from exercise of nonqualified stock options
Net accretion of discount and amortization of premium on marketable securities
Cash provided/(used) by changes in operating assets and liabilities:
Accounts receivable
Inventories
Accounts payable
Accrued compensation and related costs
Deferred revenue
Other operating assets and liabilities
Net cash provided by operating activities
INVESTING ACTIVITIES
Purchase of available-for-sale securities
Maturity of available-for-sale securities
Sale of available-for-sale securities
Acquisitions, net of cash acquired
Net additions to equity investments, other investments and other assets
Net additions to property, plant and equipment
Net cash used by investing activities
FINANCING ACTIVITIES
Proceeds from issuance of common stock
Borrowings under revolving credit facility
Principal payments on long-term debt
Repurchase of common stock
Net cash provided/(used) by financing activities
Effect of exchange rate changes on cash and cash equivalents
Net increase in cash and cash equivalents
CASH AND CASH EQUIVALENTS
Beginning of period
End of period
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest
Income taxes
Oct 2, 2005
Oct 3, 2004
Sept 28, 2003
$ 494,467
$ 388,973
$ 265,355
367,207
20,157
(31,253)
(49,633)
30,919
109,978
10,097
314,047
13,568
(3,770)
(31,801)
38,328
63,405
11,603
266,258
7,784
(6,767)
(21,320)
28,966
36,590
5,996
(49,311)
(121,618)
9,717
22,711
53,276
56,894
(24,977)
(77,662)
27,948
54,929
47,590
36,356
(8,384)
(64,768)
24,990
42,132
30,732
8,554
923,608
858,537
616,118
(643,488)
469,554
626,113
(21,583)
(7,915)
(643,989)
(887,969)
170,789
452,467
(7,515)
(64,747)
(412,537)
(481,050)
218,787
141,009
(69,928)
(47,259)
(377,983)
(221,308)
(749,512)
(616,424)
163,555
277,000
(735)
(1,113,647)
137,590
—
(722)
(203,413)
107,183
—
(710)
(75,710)
(673,827
283
(66,545)
3,111
30,763
3,278
45,591
33,735
28,756
145,053
99,462
$ 173,809
$ 145,053
$
65,727
$
1,060
$ 227,812
$
370
$ 172,759
$
265
$ 140,107
99,462
Source: Securities and Exchange Commission, Washington DC, Edgar Online, Form 10-K, Filing Date: 12/16/2005.www.sec.gov
Chapter 5
Profit, Profitability, and
Break-Even Analysis
Learning Objectives
• Understand the difference between
efficiency and effectiveness.
• Distinguish between profit and profitability.
• Compare accounting and entrepreneurial
profit.
• Understand the relationship of profit margin
and asset turnover on the earning power of a
company.
Learning Objectives (continued)
• Given the variable costs, revenue, and fixed
costs of a business, determine the breakeven point and contribution margin.
• Construct and analyze a break-even chart
when given variable costs, revenue, and
fixed costs of a business.
Learning Objectives (continued)
• Understand the use of leverage and its
relationship to profitability and loss.
• Distinguish between Chapters 11, 13, and 7
bankruptcy.
• Compare and contrast the degree of
operating, financial, and combined leverage
and their effect on the profitability of a
corporation.
Efficiency and Effectiveness
• Efficiency is obtaining the highest possible
return with the minimum use of resources.
• Effectiveness, on the other hand, is
accomplishing a specific task or reaching a
goal.
Profit Versus Profitability
• Profit is an absolute number that is earned
on an investment.
– Accounting profit, for a business, is typically
shown at the bottom of an income statement as
net income.
– Entrepreneurial profit is the amount that is
earned above and beyond what the entrepreneur
would have earned if he or she had chosen to
invest time and money in some other enterprise.
Profit Versus Profitability
(continued)
• Profitability can be measured in a
business by using a ratio that is
obtained by dividing net profit by total
assets. Profitability, therefore, is our
Return on Assets.
Earning Power
• The earning power of a company can be
defined as the product of two factors:
– The company’s ability to generate income on
the amount of revenue it receives, which is also
known as net profit margin; and
– Its ability to maximize sales revenue from
proper asset employment, also known as total
asset turnover.
Earning Power Formulas
• Earning power is equal to net profit
margin multiplied by total asset turnover
which is equal to return on investment
(total assets).
Earning
power  Net profit margin

x Total asset turnover
Net profit (income)
Net sales
Earning
power

Net profit (income)
Total assets
x
Net sales
Total assets
Break-Even Analysis
• Break-even analysis is a process of
determining how many units of
production must be sold, or how much
revenue must be obtained, before we
begin to earn a profit.
• For break-even quantity:
BEQ 
FC
P - VC
Table 5-1 Cost Data for Carl’s Toy Trucks
Cost Category
Payment Basis
Cost ($)
Rent
Salaries
Employee benefits
Insurance
Property taxes
Wood
Paint and finishing
Labor
Packing and shipping
Monthly
Monthly
Annually
Quarterly
Annually
Per truck
Per truck
Per truck
Per truck
2000.00
5000.00
7000.00
1500.00
3000.00
1.25
0.25
2.50
2.00
Break-Even Analysis (continued)
• Break-even dollars:
BE $ 
FC
VC
1
P
Where VC is variable cost expressed as a
percentage of sales (revenue).
– For retail firm: VC percentage =(Cost of
Goods Sold)/(Net Sales)
– For manufacturing firm: VC percentage =
(Variable cost of a unit)/(Selling price)
Break-Even Analysis (continued)
• Contribution margin is the amount of
profit that will be made by a company on
each unit that is sold above and beyond the
break-even quantity.
• Contribution margin is also the amount
the company will lose for each unit of
production by which it falls short of the
break-even point.
Profit and Break-Even
• Desired profit with break-even analysis in
quantity to produce.
Total quantity

FC  Desired
profit
P - VC
– VC is variable cost per unit
• Desired profit with break-even analysis in
dollars.
BE $ 
FC  Desired profit
1 - VC (as a percentage
of the sales dollar)
– VC is a percentage of sales dollar (e.g., cost of
goods sold as a percent).
Break-Even Charts
Figure 5-1 Break-Even Chart for Carl's Toy Trucks
700
Total Revenue
600
Profit
Area
Dollars in Thousands (000)
500
400
Total Cost = FC + VC
300
200
Break-Even Point
100
Loss
Area
Fixed Costs (FC)
0
0
10
20
30
40
Units Sold in Thousand (000)
50
60
70
Leverage
• Leverage uses those items that have a fixed
cost to magnify the return to a company.
Fixed costs can be related to company
operations or related to the cost of
financing.
– Interest expenses paid on the amount of debt
incurred is the fixed cost of financing.
– A firm is heavily financially leveraged if the
fixed costs of financing are high.
Leverage (continued)
• Degree of operating leverage (DOL)
is the percentage change in operating
income divided by the percentage
change in sales.
DOL 
Percentage
change in operating
Percentage
income
change in sales
Leverage (continued)
• Degree of financial leverage (DFL) is
the percentage change in earnings per
share divided by the percentage
change in operating income.
DFL 
Percentage
change in earnings
Percentage
change in operating
per share
income
Leverage (continued)
• Degree of combined leverage (DCL) is
the percentage change in earnings per
share divided by the percentage change in
sales.
 Percentage change in operating income
DCL  
Percentage change in sales

  Percentage
 x 
  Percentage
 Percentage change in earnings per share 

DCL  
Percentage change sales


per share 

change in operating income 
change in earnings
Chapter 7
Working Capital Management
Learning Objectives
• Understand the general concept of working capital
management.
• Describe the asset categories that are included in
working capital management.
• Determine the methods of managing disbursement
and collection of cash to increase business
profitability.
• Understand how a business balances extending
credit and its ability to manage increased accounts
receivable.
Learning Objectives (continued)
• Explain how accounts receivable are analyzed.
• Understand the role that proper inventory
management plays in the profitability of a
business enterprise.
• Understand how a business’s current liabilities are
managed.
• Understand the relationship of accrued liabilities
management and obligations to federal and local
government agencies.
• Understand the relationship of trade and cash
discounts to the minimization of accounts payable.
Working Capital
• Working capital consists of the current
assets and the current liabilities of a
business.
• Current assets are gross working capital.
– Cash, marketable securities, accounts
receivable, and inventory
• Net working capital is the difference
between a business’s total current assets and
its total current liabilities.
Working Capital Management
• Working capital management is our
ability to effectively and efficiently control
current assets and current liabilities in a
manner that will provide our firm with
maximum return on its assets and will
minimize payments for its liabilities.
Current Asset Management
•
•
•
•
Cash management
Marketable securities management
Accounts receivable management
Inventory management
Cash Management
• The goal of cash management is to obtain
the highest return possible on cash. Cash
consists of:
–
–
–
–
Petty cash
Cash on hand
Cash in bank, checking
Cash in bank, savings
Cash Management (continued)
• Float
– The disbursement float is the time that elapses
between payment by check and the check’s
actually clearing the bank, at which point funds
are removed from our checking account.
– Collections float is the amount of time that
elapses between your depositing a debtor’s
check in your account and the check’s clearing,
at which point the funds are actually placed in
your account.
Cash Management (continued)
• Float (continued)
– Managing collection float:
• A lockbox is a post office box that is opened by an
agent of the bank, and checks received there are
immediately deposited in our account.
• Electronic funds transfer is accomplished when
funds are immediately transferred from one bank
account to another via computer.
Marketable Securities
Management
• Marketable securities normally are those
investment vehicles that include U.S.
treasury bills, government and corporate
bonds, and stocks.
• Excess cash should be placed in the above
vehicles because they increase in value
more than cash itself.
Accounts Receivable
Management
• The goal of accounts receivable
management is to increase sales by
offering credit to customers.
– Options to offering credit include:
• The business issuing its own credit card or line of
credit.
• Factoring—selling accounts receivable to another
firm at a discount off of the original sales price.
Accounts Receivable
Management (continued)
• The 3 C’s of credit:
– A customer’s character is favorable if that
customer has paid his or her bills on time in the
past and has favorable credit references from
other creditors.
– Capacity to pay refers to whether the customer
has enough cash flow or disposable income to
pay back a loan or pay off a bill.
– Collateral is the ability to satisfy a debt or pay
a creditor by selling assets for cash.
Accounts Receivable
Management (continued)
• Credit terms are the requirements that our
business establishes for payment of a loan
(the use of credit by a customer).
– To speed up collections, cash discounts are
often offered to a business customer. An
example would be 2/10 net 30. If the customer
pays the bill within 10 days of the invoice a 2
percent discount is given. Otherwise the entire
net is due 20 days later or at the 30th day.
Accounts Receivable
Management (continued)
• Analyzing accounts receivable:
– Accounts receivable turnover:
Accounts
recievable
turnover

Credit
Accounts
Sales
receivable
– Example:
Accounts
recievable
turnover

$300,000
6
$50,000
– Collection days is 365 days in a year divided by
accounts receivable turnover:
Collection
days 
365
6
 60 . 833 days  61 days
Accounts Receivable
Management (continued)
• Use of collection days:
– If collection days exceed our credit terms, then
we have to speed up collections.
• Example: If we give terms of 30 days and we collect
in 61 days as previously shown, then we have to
speed up collections in order to better manage
accounts receivable. We may also have to reevaluate our credit policies.
– If collection days are less then our terms, then
we have increased our liquidity. May also
consider loosening credit policy.
Accounts Receivable
Management (continued)
• Aging of accounts receivable is
accomplished by determining the amounts
of accounts receivable, the various lengths
of time for which these accounts have been
due, and the percentage of accounts that
falls within each time frame.
Table 7-1 Aging of Accounts Receivable
Outstanding
Days
Customer
Balance
Outstanding
1 $
5,000
30
2
7,000
45
3
15,000
30
4
12,000
70
5
8,000
90
6
15,000
60
7
6,000
120
8
10,000
100
9
13,000
45
10
9,000
90
Total
$ 100,000
Aging Schedule
Days Outstanding
0–30
Customer
1
2
3
4
5
6
7
8
9
10
Totals
Percentage
Outstanding
$
31–60
61–90
90+
5,000
$
7,000
15,000
$ 12,000
8,000
15,000
$ 6,000
10,000
13,000
$
20,000
20%
$
35,000
35.00%
9,000
$ 29,000
29.00%
$ 16,000
16.00%
Inventory Management
• The overall goal of inventory management
is to minimize total inventory costs while
maximizing customer satisfaction.
• Two primary decisions must be made:
– Establish the reorder quantity (the number of
items to order)
– Establish the reorder point (that level of
inventory at which a new order will be placed).
Inventory Management (continued)
• Economic Order Quantity Formula:
– Attempts to balance ordering costs against
storage costs and provide us with the most
economic quantity to order to minimize overall
inventory costs.
EOQ 
2 DS
IP
– Where
Inventory Management
(continued)
– Determining EOQ with quantity discounts
requires the following procedures:
• Compute EOQ for each discounted price.
• If the computed EOQ falls within the discounted
quantity area, then order the EOQ.
• If the EOQ does not fall within the discounted
quantity area, then compute total inventory costs.
• Order the minimum quantity that provides the
lowest overall total inventory costs.
Table 7-2 EOQ with Quantity Discounts
Warehouse storage cost (I) =
0.40
Ordering cost (S) =
$ 10.00
Annual demand (D) =
16,000
Total costs for each quantity
Price
Discount
Quantity
$ 20.00
$ 19.00
$ 18.90
0–500
501–1,000
Over 1,000
2 DS
EOQ 
200.00
205.20
205.74
QIP
2

Total Cost
200 $ 321,600.00
501 $ 306,223.16
1,001 $ 306,343.62
( 2 )( 16 , 000 )($ 10 )

IP
TC  DP 
Quantity
to Order
EOQ
 205 . 20
( 0 . 40 )($ 19 )
DS
Q
TC  (16 , 000 )($ 19 ) 
( 501 )( 0 .$)($ 19 )
2

(16 , 000 )($ 10 )
501
 $ 306 , 223 . 16
Inventory Management
(continued)
• Reorder Point Calculations
– The reorder point (ROP) has three factors that
are used in determining the quantity of an item
that exists when we actually place an order:
• Lead-time (L) is the time that lapses from order
placement to order receipt.
• Daily demand (d) is the quantity of a product that is
used per day.
• Safety Stock (ss) the quantity of stock you keep for
variations in demand.
ROP  Ld  ss
Current Liabilities Management
• Current liabilities management consists
of minimizing our obligations and payments
for short-term debt, accrued liabilities, and
accounts payable. It consists of:
– Short-term debt management
– Accrued liabilities management (servicing
long-term debt)
– Accounts payable management
Current Liabilities Management
(continued)
• Short-term debt management
– Short-term debt consists of business
obligations that will be paid within the current
accounting period. They consist of the
following:
•
•
•
•
•
Current payments on long-term debt
Bank lines of credit
Notes payable
Accounts payable
Short-term loan for one year or less
Current Liabilities Management
(continued)
• Lines of credit:
– A line of credit is similar to a credit card.
• With it, we obtain a credit limit, but we are not
obligated to make payments unless we actually
borrow the money.
• A line of credit is normally obtained from our
primary bank.
• A line of credit is used when our cash outflow
exceeds our cash inflow.
Accrued Liabilities Management
(continued)
• Accrued liabilities are those obligations of
the firm that are accumulated during the
normal course of business and are primarily
payroll taxes and benefits, property taxes,
and sales taxes.
Accounts Payable Management
• Accounts payable are the debts of a
business which are owed to vendors.
Vendors offer several types of discounts.
They are:
– Trade discounts
– Cash discounts
– Quantity discounts
Accounts Payable Management
(continued)
• Trade discounts are amounts deducted
from list prices of items when specific
services are performed by the trade
customer.
– Trade discounts may be expressed as a single
amount, such as 30 percent, or in a series, such
as 30/20/10.
Accounts Payable Management
(continued)
• Trade discount examples
– 2/10 net 30 - buyer must pay within 30 days of the invoice date, but will
receive a 2% discount if they pay within 10 days of the invoice date.
– 3/7 EOM - buyer will receive a cash discount of 3% if the bill is paid
within 7 days after the end of the month indicated on the invoice date.
– 3/7 EOM net 30 - buyer must pay within 30 days of the invoice date, but
will receive a 3% discount if they pay within 7 days after the end of the
month indicated on the invoice date
– 2/15 net 40 ROG - buyer must pay within 40 days of receipt of goods, but
will receive a 2% discount if paid in 15 days of the invoice date.
– Trade discounts may be expressed as a single amount, such as 30 percent,
or in a series, such as 30/20/10.
Accounts Payable Management
(continued)
• Calculation of trade discounts:
– Calculation of trade discounts can be
accomplished by moving backward from the
list price.
List price - trade discount
$300 - ($300x0.3)
$210 - ($210x0.2)
$168 - ($168x0.1)
 Discounted
 $210
 $210 - $42  $168
 $168 - $16.80  $151.20
Price
Accounts Payable Management
(continued)
• Calculation of trade discounts (continued)
– The net cost rate factor is the actual
percentage of the list price paid after taking all
successive trade discounts—50.4 percent in this
case.
– One minus the net cost rate factor is the single
equivalent discount.
Accounts Payable Management
(continued)
• Calculation of trade discounts (continued)
– A second simpler way of determining the net
cost rate factor and the invoice price is to
multiply the complements of the trade discounts
as shown below:
First complement
Second complement
Third complement
 1 - .03  0.7
 1 - 0.2  0.8
 1 - 0.1  0.9
Net cost rate factor  (0.7)(0.8) (0.9)  0.504
Accounts Payable Management
(continued)
• Calculation of trade discounts (continued)
– The invoice price (the price that you actually
pay the vendor) can be simply calculated by the
following formula:
Invoice
price  List price x net cost rate factor
Invoice
price  ($ 300 )( 0 . 504 )  $ 151 . 20
Accounts Payable Management
(continued)
• Cash discounts are offered to credit customers to
entice them to pay promptly.
– The seller views a cash discount as a sales discount.
– The customer views it as a purchase discount.
– The terms of a cash discount play an important role in
determining how the invoice will be paid.
• “Preferred payment” method discount
– Some retailers (particularly small retailers with low
margins) offer discounts to customers paying with cash,
to avoid paying fees on credit card transactions.
Accounts Payable Management
(continued)
• Cash discounts will normally appear on an
invoice in terms such as 2/10 n30.
– This means that the customer may deduct 2 percent off
of the invoice price if he or she pays within 10 days.
– If the customer does not pay within 10 days, he has the
use of 98% of the money owed for the next 20 days.
– If the customer pays within 30 days, the net, or total
amount, of the invoice is due.
– If he or she pays after 30 days, the credit agreement
with the seller normally stipulates that a monthly
interest charge be added to the unpaid balance.
Accounts Payable Management
(continued)
• Calculations used in cash discounts:
– A $10,000 invoice with terms of 2/10 n30
– Option 1: Pay off the $10,000 with a payment
of $9,800 within 10 days of the invoice date.
• This is computed by multiplying the invoice price
by 1 minus the discount (1 - 0.02 = 0.98, and
$10,000 x 0.98 = $9,800).
• Or by taking the invoice price times the discount
and subtracting it from the invoice price ($10,000 x
0.02 = $200, and $10,000 - $200 = $9,800).
Accounts Payable Management
(continued)
• Calculations used in cash discounts
(continued):
– A $10,000 invoice with terms of 2/10 n30
– Option 2: Pay the invoice price of $10,000 on
the 30th day after the invoice date. If this option
is chosen, he will pay the equivalent of 36.7
percent annual interest because of his delaying
payment. The logic is shown on the following
page.
Accounts Payable Management
(continued)
• Calculations used in cash discounts
(continued):
– $200 is the cost paid on $9,800 for 20 days, or
an interest rate of 2.04 percent ([$200 
$9,800] x 100).
– This will result in an effective annual interest
rate of 36.7 percent (2.04 x [360  20days]).
– The effective annual interest rate is obtained by
multiplying the time period interest rate by the
number of time periods in an accounting year
(360  20).
Accounts Payable Management
(continued)
• Quantity discounts are offered by vendors
to increase their own cash flow when they
offer discounts to customers who purchase
items in large quantities.
Table 7-5 Quantity Discounts
Item Number
10010
Quantity
1–99
100–499
500–999
Unit Cost
$
15.00
14.50
14.00
Capital budgeting
Chapter 10
Adelman & Marks
Key terms
• Capital budgeting
– The method used to justify the acquisition of
capital goods
• Capital goods
– Assets that have a useful life greater than 1 year
Why capital budgeting?
• A company should make the decision to enter into
a specific project, acquire another company, or
purchase a specific long-term asset if the present
value of the benefits exceeds the the present value
of the costs.
• Remember that assets are tools your business uses
to help generate revenues
• Example: Capital budgeting helps a business to
make the most profitable decisions regarding
purchase of delivery vehicles.
Factors Affecting Capital
Budgeting
• Changes in regulations (CFC banned in air
conditioning)
• Research and Development investments
(half of all new products fail)
• Changes in business strategy (when
economy changes or opportunities/threats
arise
Five Steps in Capital Budgeting
1. Write a proposal that identifies projected costs
and benefits
2. Evaluate the data with respect to expected
benefits and costs
3. Make a decision that provides greatest value
while minimizing costs
4. Follow up on decision through post-audit to
compare costs to benefits
5. Take corrective action if post-audit indicates
benefits are not meeting expectations
Costs in capital budgeting
• Start-up costs – total $ spent to start a project
(equipment, training costs, maintenance, service
agreements, hiring new people, storage space, etc)
• Working capital costs – cash, investments, A/R,
and inventory to show bank you can make
monthly payments ($ is legally committed to
lender, so it’s an opportunity cost)
• Tax factor costs – additional taxes that have to be
paid
Benefits in capital budgeting
• Investments in capital equipment should
increase cash flows
• Capital equipment investments can be
written off and provide reduced tax liability
• MACRS! (see MACRS worksheet)
Techniques
•
•
•
•
•
•
Payback
Net present value (NPV)
Profitability index (PI)
Internal rate of return (IRR)
Accounting rate of return (ARR)
Lowest total cost (LTC)
Payback
• # of years it takes to get back the money it
invested in project or asset
• Payback = C / ATB
– C = cost of project
– ATB = annual after-tax benefit of project
• Example – invest in $25,000 project that creates
$3,000 in ATB
• Payback occurs in $25,000/$3,000 = 8.33 yrs
Net present value
• Uses time value of $ by discounting future costs
and benefits to present
• Combines:
– PV of stream of payments for even cash flows and
– PV of future lump sum of unequal yearly cash flows
• Important considerations – (1) interest rate of
lender and (2) interest rate you could make by
investing in some other project or asset
Weighted Average Cost of
Capital
• Multiplies cost of debt by its proportion of total
funds raised and multiplies cost of equity
(opportunity cost to owner) by its proportion of
total funds raised
• Key terms:
– Real rate of return (return received after factoring out
inflation)
– Inflation premium (expected average inflation for term
of investment)
– Risk premium (rate added to interest rate to account for
risk of investment) (see Techniques)
Getting to NPV
•
•
•
•
NPV = PVB - PVC
NPV is net present value of investment
PVB is present value of the benefit
PVC is present value of the cost of the
investment
• If NPV is negative, do not make the
investment (see example)
Profitability Index
• PI = PVB / PVC
• From example: $170,394/$100,000 = 1.70
• This project returns $1.70 for every $1
invested
Accounting rate of return
• ARR = (average annual income)/(average
cost of investment over its life)
• Does not incorporate time value of $
• Example: spend $10,000 on software that
will help you earn $3,000/yr for 4 yrs
• ARR = $3,000/$10,000 = 30%
Lowest total cost
• Include all costs associated with two or
more competing investments
• Calculate PVs of these costs
• Add the present value of any residual
benefits (salvage value) that investment can
provide
• Select investment with lowest total cost
Recommendations
• Use NPV for new projects or assets
• For existing operations (replacing
equipment and service contracts) use LTC

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