The Finance Function and Business Strategy

Accounting Accounting is the process of measuring, interpreting, and communicating financial information to support internal and external business decision making.

Business Activities Involving Accounting  Financing activities provide necessary funds to start a business and expand it after it begins operating.  Investing activities provide valuable assets required to run a business.  Operating activities focus on selling goods and services, but they also consider expenses as important elements of sound financial management.

Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time.GAAP Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S.FASB Sarbanes-Oxley Act responded to cases of accounting fraud. –Created the Public Accounting Oversight Board, which sets audit standards and investigates and sanctions accounting firms that certify the books of publicly traded firms. –Senior executives must personally certify that the financial information reported by the company is correct. –Resulted in increase in demand for accountants. The Foundation of Accounting Systems

The Accounting Cycle Accounting process - set of activities involved in converting information about transactions into financial statements.

Assets - anything of value owned or leased by a business. Liability - claim against a firm’s assets by a creditor. Owner’s equity - all claims of the proprietor, partners, or stockholders against the assets of a firm, equal to the excess of assets over liabilities. Basic accounting equation - relationship that states that assets equal liabilities plus owners’ equity. Double-entry bookkeeping - process by which accounting transactions are entered; each individual transaction always has an offsetting transaction. The Accounting Equation

Balance sheet - statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time. Photograph of firm’s assets together with its liabilities and owner’s equity Follows the accounting equation Balance Sheet

Sample Balance Sheet

Income Statement - financial record of a company’s revenues and expenses, and profits over a period of time. Firm’s financial performance in terms of revenues, expenses, and profits over a given time period. Reports profit or loss. Focus on revenues and costs associated with revenues.

Sample Income Statement

Statement of Owner’s Equity Statement of Owner’s Equity - is designed to show the components of the change in equity from the end of one fiscal year to the end of the next. Begins with the amount of equity shown on the balance sheet. Net income is added, and cash dividends paid to owners are subtracted.

Sample Statement of Owner’s Equity

The Statement of Cash Flows Statement of cash flows - a firm’s cash receipts and cash payments that presents information on its sources and uses of cash. Accrual accounting - method that records revenue and expenses when they occur, not necessarily when cash actually changes hands.

Sample Statement of Cash Flows

Financial Ratios Analysis Ratio analysis - tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, as well as the effectiveness of management’s resource utilization.

Liquidity Ratios Acid-test (or quick) ratio measures the ability of a firm to meet its debt payments on short notice. Cash and equivalents + short-term investments + accounts receivable Total current liabilities Current ratio compares current assets to current liabilities. Total current assets Total current liabilities

Activity Ratios Inventory turnover ratio indicates the number of times merchandise moves through a business. Net sales Average of inventory Total asset turnover ratio indicates how much in sales each dollar invested in assets generates. Net sales Average of total assets

Profitability Ratios Profitability ratios measure the organization’s overall financial performance by evaluating its ability to generate revenues in excess of operating costs and other expenses.

Leverage ratios measure the extent to which a firm relies on debt financing. Total liabilities to total assets ratio > 50 percent indicates that a firm is relying more on borrowed money than owners’ equity. Leverage Ratios

Budget - planning and control tool that reflects a firm’s expected sales revenues, operating expenses, and cash receipts and outlays. Management estimates of expected sales, cash inflows and outflows, and costs. Budgets are a financial blueprint that serves as a financial plan. Cash budget - tracks the firm’s cash inflows and outflows. Budgets

Capital Budgeting, Finance and Decision making

 Project Types  Capital Budgeting Decision Criteria ◦ Net Present Value (NPV) ◦ Internal Rate of Return (IRR) ◦ Payback Period

 Understand how to calculate and use the 3 capital budgeting decision techniques:, NPV, IRR, and Payback.  Understand the advantages and disadvantages of each technique.  Understand which project to select when there is a ranking conflict between NPV and IRR.

 Which of the following investment opportunities would you prefer?  1) Give me $1 now and I’ll give you $2 at the end of class.  2) Give me $100 now and I’ll give you $150 at the end of class.

 Analysis of potential additions to fixed assets.  Long-term decisions; involve large expenditures.  Very important to firm’s future.

1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC (Weighted Average Cost of Capital). 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

 Brand new line of business  Expansion of existing line of business  Replacement of existing asset  Independent vs. Mutually Exclusive  Normal vs. Non-normal

 NPV = PV of inflows minus Cost = Net gain in wealth.  Acceptance of a project with a NPV > 0 will add value to the firm.  Decision Rule: ◦ Accept if NPV >0, ◦ Reject if NPV < 0

NPV: Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative.

0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR.

Internal Rate of Return is a project’s expected rate of return on its investment. IRR is the interest rate where the PV of the inflows equals the PV of the outflows. In other words, the IRR is the rate where a project’s NPV = 0. Decision Rule: Accept if IRR > k (cost of capital). Non-normal projects have multiple IRRs. Don’t use IRR to decide on non-normal projects.

For normal independent projects, both methods give same accept/reject decision. ◦ NPV > 0 yields IRR > k in order to lower NPV to 0. However, the methods can rank mutually exclusive projects differently. What to do, then?

 Measures how long it takes to recovers a project’s cost (CF0 = initial outlay).  Easy to calculate and a good measure of a project’s risk and liquidity.  Decision Rule: Accept if PB < some maximum period of time.  If cash inflows are equal each year (in the form of an annuity), PB = CF0/Annual CF

 Ignores time value of money!  Ignores cash flows beyond payback period.  The Discounted Payback Period addresses the first problem.  Disc. PB tells how long it takes to recover capital and financing costs for a project.  Discount rate = cost of capital.