Presentation on theme: "Foundations of Business"— Presentation transcript:
1 Foundations of Business Bring handouts: BOARD: For next class, bring:Using Ratios (abridged) CalculatorRatios lecture slides Value Line sheetsRatio Calculations Table Income Statements2 Balance SheetsThis 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 + OEWhat 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 PAYABLEQ: 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 $100NI $50 $ 50 ( = 50% PROFIT MARGIN)50/1500= /100=0.5What 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 Analysisto 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 ratiosOperating ratiosDebt management ratiosProfitability ratiosValuation 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 ofCurrent AssetsCurrent LiabilitiesEquity
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 RATIOQ: 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 RATIODiscuss the difference (inventory).Q: Why might we want to exclude inventory? (least liquid) Let’s see how we might use these ratios.Creemee Balance SheetCreemee 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 assetsThe higher the ratio, the more efficient1. Total Assets Turnover2. Inventory TurnoverHow many times inventory must be restocked to meet salesThe Total Assets Turnover ratio must be compared with other companies in the industry.Read the definition first.TOTAL ASSETS TURNOVERThe 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 industryThat 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 SheetCreemee 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 riskAbility to repay money borrowedThe higher the ratio, the greater the financial risk1. Debt/Equity Ratio = Relationship of money owed to Stockholders’ Investment in the CompanyDefinition: 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 SheetCreemee Income Statement
7 Champ Creemee Company Debt Management Ratios Coverage Ratios 2. Times Interest Earned (TIE)Ability of company to pay (cover) interest expenseThe higher the ratio, the better the ability to coverThe higher the ratio, the lower the financial riskQ: 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 SheetCreemee 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 salesThe 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 companyROE =Remember:Stockholders’ Equity = Common Stock + Retained EarningsWhat 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 $ 10Assume 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 SheetCreemee Income Statement
10 Impact of Leverage on ROE CO. AEBIT $100Interest ExpEarningsbefore taxesTaxesNet Income $54Debt $500EquityAssets $1000Return on /1000Assets = 5.4%Return on /500 = 0.108Equity = 10.8%the “loan company”CO. B$10010040$601000$100060/1000= 6.0%60/1000 = 0.06The “stock company”Borrowing increases ROE, but borrowing also increases RISK. Stockholders require an increased return to balance the risk.Explain and compare, line by lineCO. A borrowed money therefore has to pay interest expenseCO. 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 AssetsNet income / equity
11 Champ Creemee Company Earnings Per Share (EPS) = $ earned per share of common stockSpreads the net income across the sharesEPS 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 companiesRelatively more or less expensive???Price/Earnings Ratio: How many dollars investors are willing to pay for a dollar of future/projected net incomeQ: 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 priceMV = $ 50 stock price x 1,000 shares= $ 50,000NEXT: 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 $2,000Wages Payable Current Liabilities ,500Notes Payable (L.T.) 5,000Total Liabilities 7,500Common Stock 10,000Retained Earnings Total Shareholders’ Equity 10,690Total Liab. & SH Equity $18,190Cash $8,690Accounts Receivable 3,000Inventory 3,500Current Assets ,190Equipment ,000Total Assets $18,190
16 Champ Creemee Company Income Statement (for the Year ending 12/31/07) SalesExpenses:Cost of Goods soldGross ProfitWaste/SpoilageWagesSalariesPayroll RemittancesRent/PermitsAdvertisingMaintenance and RepairOperating ExpensesOperating Profit (EBIT)InterestPre-Tax ProfitTaxes (35%)Net Income$3,000(1,000)2,00050500100(900)1,100(500)600(210)$ 390This 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, sundaesSALES: We total up all of the ice cream cones, milkshakes, sundaes soldEXPENSES: Let’s look at what it cost us to make these ice cream cones, milkshakes, sundaes. COGSNEXT SLIDE!GROSS PROFIT: difference between what customers bought and cost tells us how much $ we have left over to cover all other expenses, such asWASTE/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) fixedMAINTENANCE & 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 governmentINTEREST 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