Finance 206 Evaluating a firm’s Financial Performance

Finance 206 Evaluating a firm’s Financial Performance Instructor Paul Derby PhD Candidate

Sole Proprietorship One of the easiest business entity (or form of business) to setup. A business owned and controlled by a single individual Advantages The gains are based on your personal income tax and much less than corporation tax rates. You are the boss, and you make the decisions. All business related expenses can be used to lower the tax due. Disadvantages The owner is personally responsible for all debts of the business (if the business defaults on a loan or is sued the owners personal assets can be seized). Requirements for New Mexico for a business license. 1) Business name 2) Address & telephone 3) Owners name, address, telephone, and social security number. 4) Location of the business (some residential homes are not allowed to have a business. Check your zoning areas. 5) Type of business activity. 6) File for a tax ID number from the State.

Partnerships The primary difference between a partnership and a sole proprietorship is that the partnership has more than one partner. Two formations: 1) General partnership: Each owner is responsible for liabilities incurred by the partnership. 2) Limited partnerships: May have investors who do not participate in the everyday running of the business, but may share in the profits.

S Corporation An S corporation is a regular corporation that lets you enjoy the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner.(Bplans, 2009). Also known as C corporations. Advantages All business profits are paid by the owners. All business profits are paid as personal income in taxes. An S corporation can allow the owners to subtract business losses on the personal tax returns of the owners. The taxable gain on the S corporation is much less that the regular corporation. Disadvantages Each shareowner must be a U.S. Citizen. Each of the owners must be people and not other corporations. LLC "Limited Liability Company" Relaxed tax laws that treat the LLC like a partnership. The LLC must not be treated too much like a corporation or it will be taxed like one. References BPlans (2009). S corporation fasts and options. Retrieved August 22, 2009 at egal-issues/business-s-corporation-facts-and-options/139

Corporation A corporation Is considered a legal entity separate from the owners and managers. Advantages The owner's personal assets cannot be liable. The corporation owners are the shareholders. Corporate income can be distributed periodically to the shareholders in the form of dividends. The most a stockholder can lose is the original investment in the organization. Disadvantages The corporate income is taxed twice. 1) Business income is taxed at the corporate rate. 2) The owners' dividends are taxed at the personal income rate.

Let's look at stocks When you purchase a share of stock you are buying into the organization as an investment in hopes your money will grow quickly and with better returns than keeping your money in the bank. You are placing your money in a riskier investment as the stock value may go down. Let's say the company you are purchasing stock into has 1 million shares outstanding and you buy 1000 of these stocks, you will be.01% shareholder of XYZ organization. Your purchase price is 20 Dollars per share. $20 x 1000 shares = $20,000. It recently has been discovered the food XYZ Corporation sells is very unhealthy. Several major newspapers published an article on XYZ Corporation and this decreases the traffic into their stores and starts to drive the stock downward. The opposite can be true if the food my organization sells is now sold in every Wal-Mart stores across the world. This time the news reports are positive and reports the food is healthy. The foot traffic increases, higher sales, and higher profit margins. My investment may raise by.20% in one year. N= 1 I/Y = 20 PV = PMT = 0 CPT FV = $24000 Less the initial investment of $20000 = $4000 Increase for the year.

Let's look at Bonds When you buy a bond of an organization you are NOT purchasing ownership in the organization. You are loaning the organization your money for a set time period for a return of a set interest rate. The set interest rate is generally 5% to 7 % annually. If the bond lasts for 10 years your principle money will be returned to you.

Compound Interest Simple Interest Compound semi- annually If quarterly If monthly tch?v=h57TUS87Jkc&feature =related

Corporate Income Tax at $300,000 Tax Liability 15% $ 50,000 = $7,500 25% $25,000 = $6,250 34% $25,000 = $8,500 39% $200,000 =$78,000 $300,000 = $100,250

10 principles in finance to guide you in this course. 1) If you are required to take actions with risk for your firm remember the compensations for those actions must also be higher. (Risk and Return must be positively correlated). 2) Consider the TIME VALUE of MONEY. A dollar received sooner is worth more than a dollar received later. 3) CASH is more important than profits. 4) Consider incremental cash flows when making a financial decision. Only undertake a project that will give you more money at the end then you had when you started. 5) Be careful, competitive markets makes it very difficult to find exceptionally profitable projects. 6) Remember we deal in quick efficient markets. Where the values of all assets at a given time fully reflect all available information. 7) Agents of your firm must not put their own engender above the firms. "Watch them closely". 8) Measure the value of a project or an investment on an after tax basis. 9) Manage your risk. There are many kinds. Some risks can be diversified other cannot. 10) Mind your manners. There are many Ethical issues you must consider when you make financial decisions.

K= K*rf + IRP + DRP + MP + LP (1)(2) (3)(4) 3-Month Treasury Bills % 30 year Treasury Bond % Aaa- Rated CorporateInflation Rate % Bonds % Yr Yr Yr (1) - (4) = K* _________________(Add K* + IRP + DRP + MP + LP = k) (4) = IRP _________________ (3) - (2) = DRP _________________ (2) -(1) = MP _________________ Given = LP __________________ 3 basis points k= the observed or nominal rates of interest on a specific fixed-income security (pg 48) K*rf = the real risk-free rate of interest. IRP = the inflation-risk premium DRP = the default -risk premium MP = the maturity premium LP = the liquidity premium The forecast of the observed interest rate on Big Truck's new issue of bonds. The observed rate (k) that is forecast to satisfy the market turns out to be 6.27 If the bonds were offered at a too high rate they would not be purchased.

Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 ($ millions)) Sales 600 Cost of Goods Sold460 Gross Profit140 Operating expenses Selling expenses $ 20 General and administrative exp 15 Depreciation exp. 30 Total operating expenses $ 65 Operating Income (EBIT) 75 Interest 15 Earnings before Taxes 60 Income Taxes 18 Net Income 42 Number of Common Shares outstanding 20 Earnings per share (EPS) 2.10 Dividends per share (EPS) 0.50

Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 64 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

Finance 206 Evaluating a firm’s Financial Performance Chapter 4

Finance 206 Evaluating a firm’s Financial Performance How Liquid is the Firm? Are the firm’s managers generating adequate operating profits on the firm’s assets? How is the firm financing its assets? Are the firm’s managers creating shareholders value?

Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 ($ millions)) Sales 600 Cost of Goods Sold460 Gross Profit140 Operating expenses Selling expenses $ 20 General and administrative exp 15 Depreciation exp. 30 Total operating expenses $ 65 Operating Income (EBIT) 75 Interest 15 Earnings before Taxes 60 Income Taxes 18 Net Income 42 Number of Common Shares outstanding 20 Earnings per share (EPS) 2.10 Dividends per share (EPS) 0.50

Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 64 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

Current Ratio has a relationship of “current assets to current liabilities”. Current Ration indicates the firm’s ability to pay all of its short-term obligations. The formula for Current Ratio is; Current Ratio = Current Assets Current Liabilities Current Assets are assets that are in cash or equal to cash and which can be easily converted into cash in a very short time (less than 12 months). Such as securities, some investments, AR, other debts owed and prepaid expenses. Current Liabilities are liabilities which will be repaid within 12 months. These include outstanding expenses, AP, bank overdrafts, income tax payable, and dividends payable, etc.

Objective The objective of calculating current ratio is to see if the firm can meet its short-term liabilities quickly (eDewcate). There is no exact rule of a reasonable current ratio. Our best guess is a current ratio of 2 – 2.2 is considered satisfactory. The idea of having double the current assets compared to current liabilities is best. Let us look at an example on the next slide.

Let us look at the balance sheet and compare the firm’s “liquid“ assets (current assets) to short-term) liabilities. CURRENT RATIO: Current assets Current ratio = ____________ Current Liabilities 143 M Current ratio = ____________ = M Based on the current ratio, Davies, Inc. is more liquid than the average firm in the peer group. The company has $2.23 in current assets for every $1 in short-term debt, compared to a peer-group ratio of $1.80 The measurement of liquidity is a measurement for the future. The best numbers are between 1.5 and 2. When the number is too much above the value of 2 it indicates the firm may be holding on two much cash. If less than 1.5 it may not be able to pay its upcoming bills in the next 12 months. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 64 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

Let us look at the balance sheet and compare the firm’s “liquid“ assets (current assets) to short-term) liabilities. CURRENT RATIO: Current assets Current ratio = ____________ Current Liabilities ____ M Current ratio = ____________ = ____ ____M Let us look at the new numbers for Total Current Assets and the Total Current Liabilities. Lets calculate the Current ratio By this example what is the Current ratio and now the Total current Liabilities. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 189 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 88 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

Cash + Accounts Receivable Acid-test ratio = ________________________ Current Liabilities 20 M + 36 M acid-test ratio = ____________ = M Peer group acid-test ratio 0.94 Based on the acid-test, Davies Inc. appears to be slightly less liquid. It has $0.88 in cash and accounts receivable per $1 in current debt, compared to $0.94 for the average company in the peer group. This value should be about the number 1 range, otherwise a cash flow problem could arise. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 64 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

Cash + Accounts Receivable Acid-test ratio = ________________________ Current Liabilities ___ M + ___ M acid-test ratio = ____________ = _____ ___ M Peer group acid-test ratio 0.94 Based on the acid-test, Davies Inc. appears to be slightly less liquid. It has $0.88 in cash and accounts receivable per $1 in current debt, compared to $0.94 for the average company in the peer group. This value should be about the number 1 range, otherwise a cash flow problem could arise. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 39 Accounts receivable 40 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 74 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

How long does it take to convert the firm’s receivables into cash? We can answer this by computing a firm’s sales outstanding, or its average collection period. Average Collection period = Accounts receiable _________________ annual credit sales/365 Average Collection period = 36 M _________________ 600 M/365 Average Collection period = 36 M __________________ 1.64M/day = Days days Davies Inc. collects accounts receiable compared to 25 days for the peer group,, which suggests the firm’s is more liquid than those of competing firms. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 INCOME STATEMENT Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 Sales 600 Cost of Goods Sold460 Gross Profit140

How long does it take to convert the firm’s receivables into cash? We can answer this by computing a firm’s sales outstanding, or its average collection period. Average Collection period = Accounts receivable _________________ annual credit sales/365 Average Collection period = ____ M _________________ ____ M/365 Average Collection period = ____ M __________________ _____M/day = Days days Davies Inc. collects accounts receivable compared to 25 days for the peer group,, which suggests the firm’s is more liquid than those of competing firms. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 26 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 INCOME STATEMENT Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 Sales 500 Cost of Goods Sold460 Gross Profit140

How many times are Account Receivable are “rolled over” during the year, using the account receivable turnover ratio. Average receivable turnover = Annual credit sales _________________ Accounts receivable Average receivable turnover = 600 M _________________ 36 M = Days Peer group accounts receivable turnover X Davies Inc, collects accounts receivable more quickly than its competing firms. [This ratio depends on the type of business is being measured. It is best to compare the inventory turnover for several years and it will be best to see this number increase each year.] Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 INCOME STATEMENT Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 Sales 600 Cost of Goods Sold460 Gross Profit140

How many times are Account Receivable are “rolled over” during the year, using the account receivable turnover ratio. Average receivable turnover = Annual credit sales _________________ Accounts receivable Average receivable turnover = _____ M _________________ ______M = _____ Days Peer group accounts receivable turnover X Davies Inc, collects accounts receivable more quickly than its competing firms. [This ratio depends on the type of business is being measured. It is best to compare the inventory turnover for several years and it will be best to see this number increase each year.] Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 42 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 INCOME STATEMENT Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 Sales 550 Cost of Goods Sold460 Gross Profit140

eDewcate Current Ratios Retrieved September 11, 2009 at dGwE0http:// dGwE0