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Foundations of Business

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1 Foundations of Business
Bring handouts: BOARD: For next class, bring: Using Ratios (abridged) Calculator Ratios lecture slides Value Line sheets Ratio Calculations Table Income Statements 2 Balance Sheets This lecture is the core of your Financial Application Assignment (Part 3) AND ALSO WORKS WITH ALL OF THE ACCOUNTS ON THE TWO FINANCIAL STATEMENTS WE COVERED, so let’s review them (take them out!): What is the Balance Sheet Equation: A = L + OE What types of Assets do we have? (current and fixed) => examples! What types of Liabilities might we have? (current and long-term); A/P, Wages Payable, Add TAXES PAYABLE Q: Whose business is going well? How would you determine that? (2 groups) Q: How much have you sold? How much profit are you making? ( Which of these two businesses is doing better?) BOARD: Sales $ 1500 $100 NI $50 $ 50 ( = 50% PROFIT MARGIN) 50/1500= /100=0.5 What we just did was calculate a ratio. Ratios are meaningful relationships between two numbers (or among several #s). There are 5 major types of ratios. Financial Ratios & Ratio Analysis to Evaluate and Compare Company Performance

2 Financial Ratios 5 Types of Financial Ratios:
Ratios are meaningful relationships between 2 numbers (or among several numbers). 5 Types of Financial Ratios: Liquidity ratios Operating ratios Debt management ratios Profitability ratios Valuation ratios (Ratios are meaningful relationships between 2 or more numbers. They are used to evaluate the performance of a company. Ratios also allow us to compare one company to another in the same industry. Q: Which of these ratios does our example represent? Hand out Ratio Handout! Review briefly the meaning of Current Assets Current Liabilities Equity

3 Champ Creemee Company Liquidity Ratios
The higher the Liquidity ratio, the better the company’s ability to pay current obligations with current assets. The higher the Liquidity ratio, the more liquid the company is. 1. Current Ratio: 2. Quick Ratio: * LOAD Creemee BALANCE SHEET & INCOME STATEMENT . Read the definition. Q: What do we mean by LIQUIDITY? (refer to current assets on BALANCE SHEET!) CURRENT RATIO Q: What kinds of current assets does Champ Creemee Company have? Q: What do we mean by CURRENT OBLIGATIONS? Who do we owe something to? How can we pay it? Show general formula, then specific formula. Q: What is the liquidity for our Creemee Company? (6X) Are we comfortable with this? Why? QUICK RATIO Discuss the difference (inventory). Q: Why might we want to exclude inventory? (least liquid)  Let’s see how we might use these ratios. Creemee Balance Sheet Creemee Income Statement

4 Liquidity: Trends and What If ???
We have a lot of money tied up in inventory! Q: What do you notice when you compare 2003 and 2004? (Current and Quick Ratios have decreased) Q: Is that good or bad? (The higher the ratio, the higher the liquidity, and the better ability to pay current liabilities with current assets.) Q: What if our CR is 6.1X and our QR is .6X? (less than 1  problems paying company’s debts) Q: What can we as a company do? (sell more inventory  We have lots of $$$ tied up in inventory)) The Current Ratio should be 1X or higher so that the company is able to pay its current liabilities with current assets. We may have to sell inventory to pay our company’s debts!

5 Champ Creemee Company Operating Ratios
How efficiently a company uses assets The higher the ratio, the more efficient 1. Total Assets Turnover 2. Inventory Turnover How many times inventory must be restocked to meet sales The Total Assets Turnover ratio must be compared with other companies in the industry. Read the definition first. TOTAL ASSETS TURNOVER The TA/TO is .2X.  Does that tell you if the company is efficient or not? (No, need to compare it.)  What do you need to compare it to?  What if the Creemee stand down the road has a TA/TO of 10X. What does that tell you? need to compare to other companies in the industry That is the reason we have you calculate the financial information for two companies. You need to compare your own company with another company or the industry average. Next, we would have to see which one of our assets we are not managing efficiently. Q: Would you eat the ice cream if you stock up on ice cream only once a year? ISSUE: What is the appropriate amount of inventory? What if we were Boeing? Would they stock up once a year? (yes, heavy investment in inventory, long work-in-process) The inventory turnover depends on the industry. The inventory turnover ratio is different in different industries. Creemee Balance Sheet Creemee Income Statement

6 Champ Creemee Company Debt Management Ratios Leverage Ratios
= Using outside sources of financing to increase the return to stockholders. Degree of Financial risk Ability to repay money borrowed The higher the ratio, the greater the financial risk 1. Debt/Equity Ratio = Relationship of money owed to Stockholders’ Investment in the Company Definition: LEVERAGE means using outside sources of financing to increase the company’s return.  This requires a balance of increased capital vs. increased financial risk. Q: What kinds of outside sources of financing can the company use? (loans from the bank) Q: What is the lender, the bank, concerned about when it lends money to a company?  Financial risk is the risk of bankruptcy resulting from borrowing money. The amount of risk changes from industry to industry. In order to measure risk, we look at the LEVERAGE RATIOS. Formula: The most important Leverage Ratio is the D/E Ratio. Q: What do we mean by L.-T. (long-term) debt? What are the 2 major components of EQUITY? (common stock & retained earnings) The D/E Ratio is 47%  How do I know if that’s high or low?  compare! Q: What if another Creemee Stand had a D/E Ratio of 60%? Q: What if …. 20%? Creemee Balance Sheet Creemee Income Statement

7 Champ Creemee Company Debt Management Ratios Coverage Ratios
2. Times Interest Earned (TIE) Ability of company to pay (cover) interest expense The higher the ratio, the better the ability to cover The higher the ratio, the lower the financial risk Q: When we borrow money from the bank, what does the company need to cover? (principal and MONTHLY interest expense) The TIE ratio measures how easily the company can pay back its interest expense. EBIT = Earnings before interest and taxes(= after you have paid all other expenses, except for interest and taxes) Look at the ratio.  How would you feel about lending money to this company? (What does the result indicate?) Creemee Balance Sheet Creemee Income Statement

8 Champ Creemee Company Profitability Ratios
How profitable is the company? What kind of return is the company generating on sales for stockholders? The higher the ratio, the better the profitability. 1. Profit Margin (Return on Sales) What percentage of sales dollar ends up as net income ? This is the ratio that we looked at at the beginning of class. The PM is always expressed as a percentage. It tells us how much money from every dollar ends up in net income. How much in this case? 13 cents from every $1 of sales The next ratio you calculated for your Business Plan. What is it?

9 Champ Creemee Company Profitability Ratios
2. Return on Equity = Return generated on stockholders’ investment in the company ROE = Remember: Stockholders’ Equity = Common Stock + Retained Earnings What does this ROE result (3.7%) tell us?  From every dollar of investment, how much has been generated as a return to stockholders? (3.7 cents) NEXT, put on the BOARD to explain the concept of ROE and using LEVERAGE: One company borrows $100 (What will it do with the loan?  invest! It has to pay interest also.) interest $ 10 Assume Retained Earnings $ 15 ($10 had to be paid for interest; $5 is left  who gets the benefit?  stockholders) You’ve just used someone else’s money (the bank’s) to make more money for the stockholders! Wouldn’t you like to use my $ for your company? However, if you do too much of it, what happens? (increased financial risk = risk of bankruptcy) This is the problem with the airlines (huge loans to buy new planes). Creemee Balance Sheet Creemee Income Statement

10 Impact of Leverage on ROE
CO. A EBIT $100 Interest Exp Earnings before taxes Taxes Net Income $54 Debt $500 Equity Assets $1000 Return on /1000 Assets = 5.4% Return on /500 = 0.108 Equity = 10.8% the “loan company” CO. B $100 100 40 $60 1000 $1000 60/1000 = 6.0% 60/1000 = 0.06 The “stock company” Borrowing increases ROE, but borrowing also increases RISK. Stockholders require an increased return to balance the risk. Explain and compare, line by line CO. A borrowed money  therefore has to pay interest expense CO. B didn’t borrow money but issued stock instead. It therefore has no interest expense and more equity in the company. The higher NI of B does not mean we should invest in it. The ROE is higher for A because they are using someone else’s money to make money for themselves. 2 principles: BORROWING increases ROE. BORROWING increases RISK.  This shows that increased risk requires an increased return (by stockholders). ROE was Net Income / Total Equity (math principle: Co. A has less equity, therefore a lower denominator  the result of the division is a higher number.) The ROE for Co. A is greater, but there is a risk! This is a game that companies play; it’s a good game, but it comes at a risk. (What if ROE is negative?  The company is financing all of its operations with debt.) (What if both companies have negative ROEs? The higher negative value indicates higher risk.) Net Income / Total Assets Net income / equity

11 Champ Creemee Company Earnings Per Share (EPS)
= $ earned per share of common stock Spreads the net income across the shares EPS is not a ratio, just a definition. It shows how the NET INCOME is spread across all of the shares that stockholders own. It’s like dividing up a pizza and figuring out how much each person gets.

12 Champ Creemee Company Valuation Ratios
How is the company valued compared to other companies Relatively more or less expensive??? Price/Earnings Ratio: How many dollars investors are willing to pay for a dollar of future/projected net income Q: Who places a value on companies? (the stock market, investors) Investors have to be able to compare the value of one company to that of another in order to make a good investment decision. Q: What is meant by projected EPS? Do I care more about this year’s EPS or next year’s? (Research analysts on Wall Street calculate this; they look at many factors—the economy, industry, etc.) P/E =

13 Price / Earnings Ratio Compare the two companies—
What are reasons why investors might want to pay more for company A? (earnings are growing; less financial risk) NOTE: The stock price alone doesn’t mean anything.

14 Champ Creemee Company The Concept of Market Value
Market Value: Current aggregate value in the market for all the common shares outstanding (issued) MV = Number of common shares outstanding x current stock price MV = $ 50 stock price x 1,000 shares = $ 50,000 NEXT: Hand out Ratio Calculation Assignment and look at the situation.  The company with the greater financial risk will get the higher interest rate. Why? You’re a lender. Why would you give a higher interest rate …?

15 Champ Creemee Company Balance Sheet (as of 12/31/07)
Accounts Payable $2,000 Wages Payable Current Liabilities ,500 Notes Payable (L.T.) 5,000 Total Liabilities 7,500 Common Stock 10,000 Retained Earnings Total Shareholders’ Equity 10,690 Total Liab. & SH Equity $18,190 Cash $8,690 Accounts Receivable 3,000 Inventory 3,500 Current Assets ,190 Equipment ,000 Total Assets $18,190

16 Champ Creemee Company Income Statement (for the Year ending 12/31/07)
Sales Expenses: Cost of Goods sold Gross Profit Waste/Spoilage Wages Salaries Payroll Remittances Rent/Permits Advertising Maintenance and Repair Operating Expenses Operating Profit (EBIT) Interest Pre-Tax Profit Taxes (35%) Net Income $3,000 (1,000) 2,000 50 500 100 (900) 1,100 (500) 600 (210) $ 390 This is a standard form of an income statement. It states the name of the business and PERIOD of time for which the income statement was prepared. Q: What period is covered on this income statement? (one YEAR  2005; does NOT have to coincide with the calendar year; here it goes from Sept. to Sept.) Q: What are we selling? BOARD: ice cream cones, milkshakes, sundaes SALES: We total up all of the ice cream cones, milkshakes, sundaes sold EXPENSES: Let’s look at what it cost us to make these ice cream cones, milkshakes, sundaes.  COGS NEXT SLIDE! GROSS PROFIT: difference between what customers bought and cost  tells us how much $ we have left over to cover all other expenses, such as WASTE/SPOILAGE  What kinds of waste/spoilage do we have?  drop some ice cream on the floor, break some cones …  Is this a FIXED or VARIABLE cost? (variable  make more cones, drop more) WAGES  paid per hour; SALARIES  set, no matter # of hrs; managers  Which one is more variable? (wages) Q: What are PAYROLL REMITTANCES? Q: What is taken out of paycheck?  taxes, social security, unemployment insurance.  Variable or fixed? (depends on whether wages or salaries) RENT/PERMITS  fixed or variable? (Fixed) ADVERTISING  Who determines the amount of advertising?  management decision; so, it does not increase with production. Q: If sales go up, does advertising increase? (no)  fixed MAINTENANCE & REPAIR: for our machines; Variable or Fixed? (variable; use machines more  more repairs) EBIT/OPERATING PROFIT = How much it cost us to run the business—before we pay the bank and government INTEREST EXPENSE (on a loan); fixed or variable? (fixed) Pre-TAX PROFIT: Who cares about this number? IRS; this number determines the amount of income tax; the standard corporate tax is 35%  NET INCOME (= profit = bottom line) Q: What can we do with this profit? 1. reinvest it (buy another Creemee stand); 2) pay out as dividends to stockholders  FINANCIAL APPLICATION ASSIGNMENT

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