CH-1-4 The Goals and Functions of Financial Management – Foundations of Financial Management : Chapter Notes

This Document Contains Chapters 1 to 4 Chapter 1 The Goals and Functions of Financial Management Author's Overview The instructor's initial comments should attempt to generate interest in the field of finance. A brief discussion of recent economic and financial developments will provide insight into the problems of financial management. Spending time with the financial pages of a national newspaper or website is invaluable. The major thrust of this chapter is to establish the objectives of financial management and the importance of the financial manager to the organization. The instructor should highlight the importance of shareholder wealth maximization as a goal and briefly relate it to valuation concepts associated with risk and return. In addition, the role of the financial markets in allocating capital and determining value should be emphasized, as well as the pressures of institutional investors on financial managers. The student should also be directed to the shortfalls of profit maximization as the ultimate goal of the firm. A short discussion of social responsibility, business ethics, corporate governance and their relationship to the financial objectives of the firm, as well as management/ shareholder conflicts is instructive. Learning Objectives 1. Illustrate how finance builds on the disciplines of accounting and economics. 2. Identify the analysis and decision-making nature of finance while considering return and risk. 3. Examine the primary goal of finance as the maximization of shareholder wealth as measured by share price. 4. Debate alternative goals of the firm on the basis of social or management interests. 5. Identify financial manager functions connected to the efficient raising and investing of funds. 6. Outline the role of financial markets in allocating capital, determining value and establishing yields. Annotated Outline and Strategy I. Financial management is critical for a firm’s success. A. Changing global economics, technology and consumer demand continually adjust the asset values of the firm. II. Finance relies upon the disciplines of economics and accounting. A. Economics provides structure to decision making, value determination and helps us to understand the economic environment in which the financial manager operates. B. Accounting provides the financial data needed for financial decision making and value determination. C. The demand for financial management skills exists in many sectors of our society, including corporate management, financial institutions and consulting. Perspective 1-1: The Finance in Action box, ‘The Foundations’ uses RIM, Teck and the Canadian dollar to highlight changing value and how economics and accounting can assist us in determining value. III. Finance as a field of study has evolved in response to changing business management needs. A. Finance achieved recognition as a separate field of study from economics at the turn of this century. B. Initially, finance concentrated on institutional detail, defining stocks, bonds, and institutions such as the markets, with little or no systematic analysis. C. With the Depression, emphasis shifted to preservation of capital, maintenance of liquidity, reorganization, and bankruptcy. Government intervention in business financial affairs resulted in: 1. The development of securities regulation 2. Published financial data on corporate performance and eventual analysis of that data [repeated in 2007-08] D. The most significant step in the evolution of financial management began in the mid-1950s. Emphasis was placed on the analytically determined employment of resources within the firm. The decision-making nature of financial management was manifested in the study of: 1. Capital asset management: capital budgeting 2. Efficient utilization of current assets 3. Capital structure composition 4. Market efficiency and asymmetric information E. In the 1960s into the 1980s, these theories migrated to corporate boardrooms with a focus on the risk/return relationship, accompanied by portfolio management theories that led firms to diversification strategies. By the 1990s diversification strategies were challenged in theory and in practice with firms refocusing on core businesses. F. The sharpened focus on financial objectives, it has been critically suggested, has left Canadian managers too averse to risk and concentrating too much on the short term. G. The derivatives market, developing from theory, has allowed management to reduce financial risks. Technological advances have increased business efficiencies and risks. H. E-commerce provides more efficient mechanisms to manage corporate assets. IV. The goals of the financial management. Perspective 1-2: This is a good place in the lecture to increase student interest by mentioning finance professors who have won Nobel Prizes for their work on issues related to risk and return, portfolio management and capital market theory. Names like Markowitz, Sharpe and Miller give finance a special place in business that cannot be matched in the other functional areas such as marketing or management. http://nobelprize.org A. Shareholders’ wealth maximization, the goal of the firm, is measured by the highest possible market price of the firm’s shares. Other possible goals of the firm should be suggested. B. Financial decision-making analysis is always predicated on this goal: to increase value to shareholders within a risk-return framework. This is a valuation approach. C. Shareholders' wealth maximization incorporates: 1. The risk associated with future earnings 2. The timing of benefits 3. Market judgment on accuracy of profit measurement 4. The present value model is useful in establishing asset values D. Maximizing profits is not the same as maximizing shareholder wealth. E. The efficiency of the capital market dictates that, with a given level of risk, capital will flow to those firms ‘promising’ the highest return. F. Management interests and risk perceptions may conflict with the goal of shareholder wealth maximization. This is the agency relationship. Institutional investor’s participation in corporate governance can help align management-shareholder goals. G. Maximization of shareholder wealth is tempered by social responsibility. H. Ethics from a finance standpoint is put in the context of market efficiency (chapter 14). Fairness (playing by the rules) and honesty (timely, relevant and reliable disclosure) are key elements. I. Good corporate governance practices with regulatory changes are outlined and tied to chapter topics of the text (page 10) in the context of value creation. Finance in Action: Functions of Finance Capital budgeting, capital structure and working capital are identified as the key areas of corporate decision making. Corporate governance practices are examined in: Are Executive Salaries Fair?” V. Functions of Financial Management: A financial manager is responsible for financing an efficient level and composition of assets by obtaining financing through the most appropriate means. PPT 11 of 22 Functions of the financial manager (Figure 1-1) A. Daily financial management activities 1. Credit management 2. Inventory control 3. Receipt and disbursement of funds B. Less-routine activities 1. Sale of stocks and bonds 2. Capital budgeting 3. Dividend decisions C. Forms of organization: The finance function may be carried out within a number of different forms of organizations. Perspective 1-3: The use of Figure 1-1 (covering functions of the financial manager and their relationship to shareholder wealth maximization) is a good way to tie a number of important concepts together. 1. Sole proprietorship a. Single ownership b. Simplicity of decision making c. Low organizational and operating costs d. Unlimited liability e. Earnings are taxed as personal earnings of the individual owner 2. Partnership a. Two or more partners b. Usually formed by articles of partnership agreement c. Unlimited liability for all partners. A limited partnership may provide limited liability for one or more partners, except for a general partner. d. Earnings are taxed as personal earnings of partners 3. Corporation a. Most important form of business in terms of revenue and profits b. Legal entity c. Formed by articles of incorporation d. Shareholders (owners) have limited liability e. Easy divisibility of ownership f. Managed by the board of directors g. Double taxation of earnings: Corporate earnings are subject to corporate income tax; dividends (distributed net income) are subject to personal taxation. The dividend tax credit attempts to reduce double taxation. VI. The Role of Financial Markets: Wealth maximization depends on the perception and expectations of the market. The market through daily share price changes of each publicly traded company provides managers with a performance report card. A. Structure and Functions of the Financial Markets: Money markets (Chapter 7) and Capital markets (Chapter 14) are identified. Students may find that some current examples from the Globe and Mail will create a sense of realism about this course. Finance in Action: The Pricing Mechanism of Financial Markets A discussion of noteworthy markets by which capital resources are allocated. B. Allocation of Capital. Market price reflects risk and return expectations and a company’s ability to raise funds is influenced by its financial performance and corporate behavior. The markets (primary and secondary) determine value. C. Risk. Many factors contribute to our collective perceptions of risk including: a. Debt: The typical firm makes extensive use of debt financing. The government has been a heavy user of debt markets. Debt versus deficit represents different but related measures. b. Interest Rates: The market interest rates are a key to determining required rates of return. Interest rates are volatile. c. Global competition: Emphasize the globalization of the capital markets and the worldwide pool of capital available to many companies. The creation of the Euro and impact of the setbacks in the Far East are worth noting. PPT 21 of 22 Prime rate versus percent change in the CPI (Figure 1-2) Summary Listing of Suggested PowerPoint Slides PPT 11 Functions of the financial manager (Figure 1-1) PPT 21 Prime rate versus percent change in the CPI (Figure 1-2) PowerPoint Presentation The Chapter 1 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 22 frames. Chapter 2 Review of Accounting Author’s Overview This chapter, either used in whole or in part, can prove invaluable to the instructor and the student. Though it is assumed that every student taking the introductory course in managerial finance has had course work in accounting, many students are in need of a review. By explicitly covering this review material early in the course, the student is able to grasp later material more easily and the instructor does not have to continually close the ‘accounting gaps’ during the course. The instructor must, of course, decide whether to lecture on this material or merely assign it as reading. Some may choose to forgo it altogether. It is suggested that emphasis be placed on the statement of cash flows, amortization and cash flow, and income tax considerations. We have also added IFRS and ASPE references for readers to consider in analyzing financial statements and the potential effect on decision making if differences are not considered. Learning Objectives 1. Demonstrate a reasonable ability to prepare the four basic financial statements. 2. Examine the limitations of the income statement as a measure of a firm’s profitability. 3. Examine the limitations of the balance sheet as a measure of a firm’s financial position. 4. Explain the importance of cash flows as identified in the statement of cash flows. 5. Explain and apply the effects of IFRS (International Financial Reporting Standards) on financial analysis. 6. Outline the impact of corporate tax considerations on after tax cash flow. 7. Identify the different forms of investment income and the different taxes payable on this income. 8. Explain the concept of tax savings for companies. Annotated Outline and Strategy I. Financial Statements PPT 8 of 45 Kramer Corporation-Income Statement (Table 2-1) A. The Income Statement 1. The income statement begins with the aggregate amount of sales (revenues) that are generated within a specific period of time. 2. The various expenses that occur in generating the sales are subtracted in stair-step format to arrive at the net income for the defined period. 3. The separation of the expense categories such as cost of goods sold, selling and administrative expenses, amortization, interest and taxes enables the management to assess the relative importance and appropriateness of the expenditures in producing each level of sales. 4. The ‘bottom line’ value, net income, is the aggregate amount available to the owners. 5. Valuation from the Income Statement: a. The EPS is a measurement of the return available to providers of equity capital to the firm. The return to the providers of debt capital, interest, appears earlier in the income statement as a tax-deductible expense. b. Shareholders are interested in the percentage of earnings paid as dividends. c. The earnings per share may be converted to a measure of current value through application of the price/earnings (P/E) ratio. The P/E ratio is best used as a relative measure of value because the numerator, price, is based on the future and the denominator, earnings, is a current measure. PPT 14 of 45 P/E ratios for selected companies (Table 2-3) d. Part of the investor’s return comes as dividends. This is related to the value of the investment. 6. The income statement reflects only income occurring to the individual or business firm from verifiable transactions as opposed to the economist’s definition of income, which reflects changes in real worth. 7. Income does not necessarily indicate cash available to shareholders. Accounting methods and policies allow for some flexibility in reporting income Finance in Action: Apparently Earnings are Flexible There has been increasing concern about manipulation of reported earnings. Several theories for this practice are identified. www.osc.gov.on.ca B. Balance Sheet 1. Whereas the income statement provides a summary of financial transactions for a period of time, the balance sheet portrays the cumulative results of transactions at a point in time. The balance sheet may present the position of the firm as a result of transactions for six months, one year, twenty-five years, or other periods. 2. The balance sheet is divided into two broad categories. The assets employed in the operations of the firm compose one category while the other, liabilities and net worth, is composed of the sources of financing for the employed assets. PPT 20 & 21 of 45 Kramer Corporation – Balance Sheet (Table 2-4A), ASPE format for private companies. PPT 22 & 23 of 45 (Table 2-4B), IFRS format for public companies. 3. Within the asset category, the assets are listed in their order of liquidity (ASPE) but reverse order, non-current listed first, for public companies (IFRS). a. Cash (including demand deposits) b. Marketable securities: investments of temporarily excess cash in highly liquid securities c. Accounts receivable d. Inventory e. Prepaid expenses: future expense items that have already been paid f. Investments: investments in securities and other assets for longer than one operating cycle g. Plant and equipment adjusted for accumulated amortization 4. The various sources of financing of a firm are listed in their order of maturity (ASPE) but in reverse order for public companies (IFRS). Those sources that mature earliest, current liabilities, are listed first. The more permanent debt and equity sources follow: a. Accounts payable b. Notes payable c. Accrued expenses: an obligation to pay is incurred; payment not yet made d. Long-term debt: all or a majority of the principal will be paid beyond the current period e. Preferred stock f. Common stock accounts: (1) Common stock (Contributed surplus; sometimes) (2) Retained earnings 5. Confusing balance-sheet-related terms a. Retained earnings: All of the assets of a firm are listed on the asset side of the balance sheet, yet many individuals envision a pile of money when the term retained earnings is used. Retained earnings is simply a cumulative total of the earnings of the firm, less dividends, since its incorporation until the date of the balance sheet that have not been paid to the owners. Earnings that are retained (cash) are used to purchase assets, pay liabilities, general expansion, etc. Regardless, there is no money available from a ‘container’ labeled retained earnings. b. Net worth or book value of the firm is composed of the various common equity accounts and represents the net contributions of the owners to the business. 6. Valuation from the balance sheet: a. Book value is a historical value and does not necessarily coincide with the market value of the shareholders equity. 7. Limitation of the balance sheet: Values are recorded at cost; replacement cost of some assets, particularly plant and equipment may greatly exceed their recorded value. Public companies (IFRS) updates yearly to market values. Finance in Action: Meeting the targets? The pressure on firms to meet performance targets is examined. C. Statement of cash flows 1. The statement of cash flows reports changes in cash and cash equivalents. 2. International standardization of financial statements is driven by the International Accounting Standards Board (www.iasb.org ) 3. The statement emphasizes the critical nature of cash flow to the operations of the firm. 4. The three primary sections of the statement are: a. cash flows from operating activities. b. cash flows from investing activities. PPT 30 of 45 Illustration of concepts behind statement of cash flows (Figure 2-1) c. cash flows from financing activities. 5. Income from operations may be translated from an accrual basis to a cash basis in two ways to obtain cash flow from operations. a. Direct method: each and every item on the income statement is adjusted from accrual accounting to cash accounting. Sales on the accrual basis must be converted to a cash basis. b. Indirect method: a less tedious process than the direct method is usually preferred, particularly by larger firms. Net income is used as the starting point and adjustments are made to convert net income to cash flows from operations. Beginning with net income, i. Add amortization for the current period, decreases in individual current asset accounts (other than cash) and increases in current liabilities; ii. Subtract increases in current asset accounts (other than cash) and decreases in current liabilities. 6. Cash flow from investing is found by summing the changes of investment in securities and plant and equipment. Increases are uses of funds and decreases are sources of funds. 7. Cash flow from financing activities is found by summing the sale or retirement of corporate securities and dividends. The sale of securities is a source of funds and the retirement of securities and payment of dividends are uses of funds. 8. Cash flows from operations, cash flows from investing, and cash flows from financing are combined to arrive at the statement of cash flows. The net increase or decrease shown in the statement of cash flows will be equal to the change in the cash balance on the balance sheet. 9. In analyzing cash flow, one is examining the sources and uses of funds to evaluate the firm’s solvency, liquidity and financial flexibility. II. Amortization and Funds Flow A. Amortization is an attempt to allocate an initial asset cost over its life. B. Amortization is an accounting entry and does not involve the movement of funds. C. As indicated in the statement of cash flows, amortization is added back to net income to arrive at cash flow. III. Free cash flow. A. Free cash flow is equal to cash flow from operating activities: Minus: Capital expenditures required to maintain the productive capacity of the firm. Minus: Dividends B. The amount of free cash flow is often available for special financing activities such as leveraged buy-outs. IV. Income Tax Considerations A. Most financial decisions are influenced by federal and provincial income tax considerations. After tax yield and marginal tax rates are important decision criterion. 1. Personal taxes at varying rates apply to earnings of proprietors, partners and individuals. Investment income is taxed differently as interest, dividends, or capital gains. 2. Corporate income is taxed at two levels-at the corporate level and at the personal level when received as dividends or as capital gain. Provincial tax rates also apply. B. The after tax cost of a tax-deductible business expense is equal to the (expense) × (1 – tax rate). Capital cost allowance (CCA) creates significant tax savings. C. Although amortization is a noncash expense, it does affect cash flow by reducing taxes. Tax reduction in cash outflow for taxes resulting from amortization charges may be computed by multiplying the (amortization expense) × (tax rate). Summary Listing of Suggested PowerPoint Slides PPT 8 of 45 Kramer Corporation-Income Statement (Table 2-1) PPT 14 of 45 P/E ratios for selected companies (Table 2-3) PPT 20 & 21 of 45 Kramer Corporation-Balance Sheet (Table 2-4) PPT 25 of 45 Comparison of market value to book value per share (Table 2-5) PPT 30 of 45 Illustration of concepts behind statement of cash flows (Figure 2-1) PPT 31 of 45 Steps in computing net cash flows provided by operating activities using the indirect method (Figure 2-2) PPT 32 & 33 of 45 Kramer Corporation-Comparative Balance Sheets (Table 2-6) PPT 34 of 45 Cash flows from operating activities (Table 2-7) PPT 37 & 38 of 45 Kramer Corporation: Statement of Cash Flows (Table 2-10) PPT 39 & 40 of 45 Comparison of accounting and cash flows (Table 2-11) PowerPoint Presentation The Chapter 2 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 45 frames. Chapter 3 Financial Analysis Author's Overview The student should be directed to view the thirteen ratios as an overall package that can be used to evaluate any firm. The use of the Saxton Company analysis provides continuity to the discussion. The student must be familiar with the calculation and meaning of each individual ratio. However, the primary emphasis of analysis should be on the inter-relationship between the ratios (such as that stressed by the Du Pont system of analysis). The instructor should emphasize that ratio comparisons only provide clues to potential problems or opportunities. Statements prepared on IFRS basis for public companies will not be comparable to previous years’ statements. Further hands-on investigation would be required. The discussion of inflation/disinflation and distortions in financial reporting represents an important lesson for the student: do not automatically accept the bottom line. Learning Objectives 1. Calculate 13 financial ratios that measure profitability, asset utilization, liquidity and debt utilization. 2. Assess a company's source of profitability using the DuPont system of analysis. 3. Examine the ratios in comparison to industry averages. 4. Examine the ratios and company performance by means of trend analysis. 5. Interpret ratios and identify corrective action for abnormal results. 6. Identify sources of distortion in reported income. Annotated Outline and Strategy I. Ratio analysis A. Uses of ratios: 1. Provide a basis for evaluating the operating performance of a firm. 2. Facilitate comparison with other firms. Perspective 3-1: The instructor may wish to emphasize that ratios give additional meaning to absolute values. Fifty thousand in sales may mean little, but a five percent profit margin may send out an important signal. Show how we use ratios in everyday life such as kilometers per hour, hockey save percentages, etc. B. Overall considerations in using ratios 1. There are 13 basic ratios (with variations) presented in the text. 2. There are four categories (profitability, asset utilization, liquidity, debt utilization). 3. Ratio analysis is like solving a mystery: what you learn from one ratio, you apply to another. Ratios are only indicators – other quantitative and qualitative data should be obtained for effective decision-making. PPT 12 & 13 of 34 Saxton Co. – Financial statements for ratio analysis (Table 3-1) PPT 6 of 34 The Classification system for ratios C. Classification and computation PPT 14 & 15 of 34 Profitability ratios for the Saxton Company 1. Profitability: Measures of returns on sales, total assets and invested capital. These measures are important to equity investors. a. Profit margin = Net income/ Sales b. Return on assets (ROA) (investment) = Net income/ Total assets c. Return on equity (ROE) = Net income/ Shareholders' equity = ROA × Equity multiplier ( Equity multiplier = Total assets/ equity) 2. DuPont system a. The DuPont Company was one of the first firms to stress the relationships of profitability. b. The profitability of a firm is determined by its ability to utilize its assets efficiently by generating profitable sales. 3. Asset utilization: Measures of the speed at which the firm is turning over accounts receivable, inventories, and longer term assets. These ratios focus on management abilities. a. Receivables turnover = Sales/ Receivables b. Average collection period = Accounts receivable/ Average daily credit sales c. Inventory turnover = Sales/ Inventory or COGS/ Inventory d. Inventory holding period = Inventory Average daily COGS e. Accounts payable turnover = COGS/ Accounts payable f. Accounts payable period = Accounts payable/ Average daily purchases (COGS) g. Capital asset turnover = Sales/ Capital assets h. Total asset turnover = Sales/ Total assets 4. Liquidity ratios: Measures of the firm's ability to pay off short-term obligations as they come due. Bankers and ST creditors focus on these ratios. a. Current ratio = Current assets/ Current liabilities PPT 23 of 34 Liquidity ratios b. Quick ratio = Current assets minus inventory/ Current liabilities 5. Debt Utilization Ratios: Measures the prudence of the firm's debt management policies. Debtholders are interested in these ratios. a. Debt to total assets = Total debt/ Total assets b. Times interest earned = EBIT/ Interest c. Fixed charge coverage = EBIT and fixed charges/ Fixed charges PPT 24 of 34 Debt utilization ratios PPT 25 & 26 of 34 Ratio analysis (Table 3-2) 6. Summary and evaluation of all ratios for the Saxton Company with conclusions 7. Trend analysis is as important as industry comparisons PPT 28-30 of 34 Trend analysis for the Saxton Company (Figure 3-2) Perspective 3-4: The instructor can use Figure 3-2 to illustrate the importance of trends to the Saxton Company. An even better illustration can be found in Table 3-3, with several years of profitability for the Bank of Montreal, and the Royal Bank. Notice how trends do not always continue. PPT 30 of 34 Trend analysis of competitors: BMO, Royal Bank. (Table 3-3) D. Interpreting financial ratios 1. Individually, financial ratios convey little meaning. 2. Collectively, financial ratios provide an evaluation for the firm's investors, creditors, and management. 3. Ratios must be viewed in light of the fact that: a. they are based on historical information b. they are often prepared on the basis of financial information from only one point in time affected by different basis of accounting (IFRS or ASPE). E. Trend analysis consists of computing the financial ratios of a firm at various points in time to determine if the firm is improving or deteriorating. F. Common size financial statements, as in Table 3-4, are sometimes prepared to identify relative changes in the components of the financial statements. G. Comparative analysis provides the management and external evaluators with information as to how successful the firm is relative to other firm's in the industry. II. Distortion in Financial Reporting A. Inflationary impact 1. First-in, first-out (FIFO) inventory valuation during inflation periods "understates" cost of goods sold and causes ‘inventory profits.’ 2. The use of replacement cost accounting reduces income and interest coverage during inflationary periods, but lowers debt to assets. B. Disinflation effect 1. A leveling off of prices referred to as disinflation may cause a reduction in profits. C. Valuation basics with changing prices 1. Assets on the balance sheet are shown at cost for private companies (ASPE) but at market values for public companies (IFRS) . 2. The replacement cost of long-term assets may greatly exceed the reported values. Cash flow from the amortization process may be insufficient to replace these assets as they wear out. 3. Investors generally require higher rates of return during periods of inflation. 4. Although earnings may drop because of disinflation, the declining rate of return demanded by investors may cause the value of a firm's securities to increase. 5. The movement away from financial assets (stocks and bonds) into tangible assets (gold, silver) by investors during periods of inflation makes it difficult and more expensive for firms to raise capital. Likewise the reverse trend during periods of low inflation enhances a firm's ability to issue securities. D. Accounting discretion and (IFRS vs ASPE) 1. Sales (revenues): a. A conservative firm may recognize long-term installment sales revenues when payments are received, whereas other firms report the full amount of the sale as soon as possible. 2. Expenses (COGS): a. A firm may use LIFO, FIFO, or average cost for financial reporting purposes each giving differing COGS figures. b. Research and development may receive varying treatment. 3. Asset write-downs: a. Gains/losses of a non-recurring nature are reported as additions/deductions from income by some firms but not shown as additions/deductions from income by others, based on discretion. PPT 32 of 34 Illustration of conservative versus high reported income firms (Table 3-7) Finance in Action: Taking a Big Bath The huge write-offs at Nortel and the impacts are highlighted. www.nortelnetworks.com Summary Listing of Suggested PowerPoint Slides PPT 6-10 of 34 The Classification system for ratios PPT 12 & 13 of 34 Saxton Company - financial statements for ratio analysis (Table 3-1) PPT 14 & 15 of 34 Profitability ratios for the Saxton Company PPT 16-18 of 34 DuPont analysis (Figure 3-1) PPT 19 of 34 Applying DuPont Analysis at Canadian Pacific (Finance in Action) PPT 20– 22 of 34 Asset utilization ratios PPT 23 of 34 Liquidity ratios PPT 24 of 34 Debt utilization ratios PPT 25 & 26 of 34 Ratio analysis (Table 3-2) PPT 28 of 34 Trend analysis for the Saxton Company (Figure 3-2) PPT 29 of 34 Trend analysis for competitors: Bank of Montreal, Royal Bank (Table 3-3) PPT 31 of 34 Distortions in financial reporting PPT 32 of 34 Illustration of conservative versus high reported income firms (Table 3-7) PowerPoint Presentation The Chapter 3 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 34 frames. Chapter 4 Financial Forecasting Author's Overview Developing pro forma statements is a fairly involved process. However, the rewards to students are high in terms of understanding the interaction of accounting data and financial forecasting. The development of pro forma financial statements is an integrative exercise, so there is little reward for a halfway approach. The ultimate goal is the determination of the financial needs of the firm. The percent-of-sales method, presented at the back of the chapter, is a second approach to financial forecasting. It has the virtue of being easily understood and quickly mastered, but does not have the full validity of developing pro forma statements. It is really a matter of instructor preference. Learning Objectives 1. Explain why financial forecasting is essential for the healthy growth of the firm. 2. Prepare the four financial statements for forecasting; the pro forma income statement, the pro forma retained earnings, the cash budget and the pro forma balance sheet. 3. Perform specific accounts method and the percent-of-sales method for forecasting on a less precise basis. 4. Determine the need for new funding resulting from sales growth. 5. Calculate the required new funds (RNF) and sustainable growth rate (SGR). 6 Assess and apply the effects of IFRS on forecasting financial statements. Annotated Outline and Strategy I. Need for Financial Planning A. Financial planning is a key component of a focused corporate strategy (thinking, decisions, planning, performance) B. Growth requires additions to assets; arrangements for financing such asset additions must be made in advance. C. Financial planning is necessary not only for success but for survival as well. Consensus must be built amongst the firm’s stakeholders. D. Lenders frequently require evidence of planning prior to making funds available. E. Financial forecasting is part of the larger financial planning process, including capital structure and capital budgeting decisions and strategies. Finance in Action: Real Time Forecasts at Dell Dell forecasts and knows customer demand in real time. www.dell.com II. The most comprehensive means for doing financial planning is through the development of pro forma financial statements; namely the pro forma income statement, statement of retained earnings, the cash budget, and the pro forma balance sheet. A. Pro Forma Income Statement: A projection of how much profit a firm will make over a specific time period 1. Establish a sales projection a. Forecast economic conditions Finance in Action: Oil Prices: How About a Forecast? A history of the volatility of oil prices around a long-term average price is explored. b. Survey sales and marketing personnel 2. Determine production needs, cost of goods sold, and gross profit based on the sales forecast a. Determine units to be produced: b. Determine the cost of producing the units i. Unit cost = materials + labour + overhead ii. Total costs = number of units to be produced  unit cost c. Compute cost of goods sold i. Estimate unit sales ii. Cost of goods sold = unit sales  unit cost (FIFO, WEIGHTED AVERAGE or LIFO) d. Compute gross profit Perspective 4-2: A number of steps are necessary to convert the sales forecast into production requirements, cost of goods sold and gross profit. There are no shortcuts here. Tables 4-2, 4-3, 4-4, 4-5, 4-6 and 4-7 are all brought together into one transparency, so the instructor can show all the relationships at once. PPT 12 – 18 of 38 Tables 4-2 to 4-7: Stock of beginning inventory, Production requirements, Unit costs, Total production costs, and gross profits. 3. Compute other expenses a. General and administrative b. Interest expense 4. Finally construct the pro forma income statement B. Cash budget: A summary of expected cash receipts and disbursements for a specific period of time 1. Estimate cash sales and collection timing of credit sales PPT 21 & 22 of 38 Summary of Monthly sales pattern (Table 4-9) and Monthly cash receipts (Table 4-10) 2. Forecast cash payments a. Payments for materials purchase according to credit terms b. Wages c. Capital expenditures d. Principal payments e. Interest payments f. Taxes g. Dividends Note: The beginning cash balance for each period of the cash budget is equal to the cumulative cash balance of the previous period in the absence of borrowing or investing of cash balances. 5. Determine cash excess or need for borrowing Cumulative cash balance (at end of period) Loan required or cash excess (desired cash balance – cumulative cash balance) PPT 27 of 38 Cash budget with borrowing and repayment (Table 4-15) Ending cash balance C. Pro Forma Balance Sheet: An integrated projection of the firm's financial position from its existing position, forecasted profitability (from pro forma income statement), anticipated cash flows (cash budget), asset requirements and required financing. 1. Construction of pro forma balance sheet a. Assets (source of information) i. Cash: (cash budget) ii. Marketable securities: (previous balance sheet and cash budget) iii. Accounts receivable: (sales forecast, cash budget) iv. Inventory: (COGS computation for pro forma income statement) v. Plant and equipment: (previous balance sheet + purchases  amortization) b. Liabilities and Net Worth i. Accounts payable: (cash budget work sheet) ii. Notes payable: (previous balance sheet and cash budget) iii. Long-term debt: (previous balance sheet plus new issues) iv. Common stock: (previous balance sheet plus new issues) v. Retained earnings: (previous balance sheet plus projected addition from pro forma income statement) III. Percent-of-Sales Method: Shortcut, less exact, alternative for determining pro forma financial statements. A. Assume balance sheet accounts maintain a given relationship to sales: B. Project asset levels on basis of forecasted sales (percent of sales of each asset  forecasted sales) C. Project spontaneous financing: Some financing is provided spontaneously when asset levels increase; for example, accounts payable increase when a firm buys additional inventory on credit. D. Project internal financing from profit = profit margin  forecasted sales E. Determine external financing = required new assets to support sales  spontaneous financing  retained earnings. The relationship is expressed as follows: IV. Sustainable growth rate A. Assuming a company's debt ratio should remain the same, its growth rate is limited to Summary Listing of Suggested PowerPoint Slides PPT 2 of 37 Development of pro forma statements (Figure 4-1) PPT 10 of 37 Projected wheel and caster sales (Table 4-1) PPT 11 – 17 of 37 Stock of beginning inventory, Production requirements, Unit costs, Total production costs, and gross profit. (Tables 4-2, 4-3, 4-4, 4-5, 4-6, & 4-7) PPT 18 Pro Forma Income Statement (Table 4-8) PPT 20 – 21 of 37 Summary of Monthly sales pattern (Table 4-9), and Monthly cash receipts (Table 4-10) PPT 22 – 24 of 37 Summary of component cost of manufactured goods (Table 4-11), Average monthly manufacturing costs (Table 4-12), All monthly cash payments (Table 4-13) PPT 25 of 37 Monthly cash flow (Table 4-14) PPT 26 of 37 Cash budget with borrowing and repayment provisions (Table 4-15) PPT 28 of 37 Development of a pro forma balance sheet (Figure 4-2) PPT 29 of 37 Balance Sheet (Table 4-16) PPT 30 of 37 Pro Forma Balance Sheet (Table 4-17) PPT 32 of 37 Balance Sheet and Percent-of-Sales (Table 4-18) PPT 35 of 37 Balance Sheet with sales increase (Table 4-19) PPT 36 of 37 Balance Sheet with sustainable sales increase (Table 4-20) PowerPoint Presentation The Chapter 4 PowerPoint Presentation, which covers the same essential points as the annotated outline, consists of 37 frames. Instructor Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015