Analysis of Financing Activities Chapter F10 Analysis of Financing Activities Electronic Presentation by Douglas Cloud Pepperdine University

Once you have completed this chapter, you should be able to: Objectives 1. Define capital structure, and explain why it is important to a company. 2. Explain when it is beneficial for a company to use financial leverage. 3. Explain why cash flows are important for a company’s financing decision. 4. Use financial statements to evaluate the financing activities of different companies. Once you have completed this chapter, you should be able to: Continued

Objectives 5. Determine and explain the effect of financial leverage on a company’s risk and return. 6. Use cash flow and liquidity measures to evaluate financing decisions. 7. Explain why financing activities are important for determining company value.

Objective 1 Define capital structure, and explain why it is important to a company.

Financing Decisions Capital structure is the relative amounts of debt and equity used by a company to finance its assets.

A firm either can borrow money, or it can issue stock. Financing Decisions A firm either can borrow money, or it can issue stock.

Projected Sales and Income for Mom’s Cookie Company Exhibit 1 Projected Sales and Income for Mom’s Cookie Company (in thousands) Year 1 Year 2 Year 3 Sales $ 3,000 $3,600 $4,320 Cost of goods sold (1,800) (2,160) (2,592) Operating expenses (1,000) (1,000) (1,000) Operating income 200 440 728 Income taxes (60) (132) (218) Net income $ 140 $ 308 $ 510

Projected Summary Balance Sheet for Mom’s Cookie Company Exhibit 2 Projected Summary Balance Sheet for Mom’s Cookie Company (in thousands) Year 1 Year 2 Year 3 Assets: Current assets $1,000 $1,200 $1,440 Plant assets 4,000 4,000 4,000 Total assets $5,000 $5,200 $5,440 Liabilities: Current liabilities $ 800 $ 960 $1,152 Long-term debt 0 0 0 Total liabilities 800 960 1,152 Stockholders’ equity 4,200 4,240 4,288 Total liabilities and equity $5,000 $5,200 $5,440

Financing Decisions Return on equity (ROE) is net income divided by stockholders’ equity. It measures net income relative to the amount invested by stockholders in a company.

Financing Decisions Investors and financial analyst use ROI to compare the performance of companies.

Financing Decisions It can be used to compare one company with another or to compare a company’s performance in one period with its performance in another period.

Return on Equity for Mom’s Cookie Company Exhibit 3 Return on Equity for Mom’s Cookie Company (in thousands) Year 1 Year 2 Year 3 Net income $ 140 $ 308 $ 510 Stockholders’ equity $4,200 $4,240 $4,288 Return on equity 3.3% 7.3% 11.9% Stockholders will earn 3.3 cents for each dollar invested. Stockholders will earn 7.3 cents for each dollar invested.

Objective 2 Explain when it is beneficial for a company to use financial leverage.

Effect of Financial Leverage What are debt-to-equity and debt-to-asset ratios?

Effect of Financial Leverage These ratios are used frequently as measures of capital structure. It’s not uncommon to have a debt-to-asset ratio of 70% or more.

Effect of Financial Leverage Exhibit 5 provides a graph that helps explain the effect of using debt.

The Effect of Financial Leverage on Return on Equity Exhibit 5 The Effect of Financial Leverage on Return on Equity

Return on Equity = Return on Assets x Financial Leverage Effect of Financial Leverage Return on Equity = Return on Assets x Financial Leverage ROE ROA FL = x Net Income Stockholders’ Equity = Net Income Total Assets x Stockholders’ Equity

Effect of Financial Leverage Assume Mom’s Cookie Company uses no long-term debt the first year. ROE = ROA x FL $140 $4,200 = $5,000 x 3.3% = 2.8% x 1.19

Effect of Financial Leverage Assume Mom’s Cookie Company uses $2.5 million of liabilities. ROE = ROA x FL $21 $2,500 = $5,000 x 0.8% = 0.4% x 2.0

Objective 3 Explain why cash flows are important for a company’s financing decisions.

Effects of Financing Decisions on Cash Flow and Liquidity Consider our cash flow. We will have a lot of cash outflows next year to increase the size of the business.

Effects of Financing Decisions on Cash Flow and Liquidity If we add interest payments to our cash demands, we could face cash flow problems, especially if sales are less than expected.

Effects of Financing Decisions on Cash Flow and Liquidity We won’t be able to borrow much additional money because creditors will be concerned about getting their money from us.

Effects of Financing Decisions on Cash Flow and Liquidity And who will buy stock in a company that can’t pay its debts?

Effects of Financing Decisions on Cash Flow and Liquidity Investors aren’t going to give us their money without expecting something in return. And if we pay dividends, we’ll be facing the same cash flow problems we would if we use debt.

Effects of Financing Decisions on Cash Flow and Liquidity Stockholders benefit from their investments in two ways: receiving dividends and having the value of their stock increase over time.

Effects of Financing Decisions on Cash Flow and Liquidity Exhibit 6 illustrates the benefit to stockholders of paying dividends and investing in productive assets.

Exhibit 6 Stockholders Benefit from Dividends and from Investment of Cash in Productive Assets

Objective 4 Use financial statements to evaluate the financing activities of different companies.

Evaluating Financing Activities 1. Identify financing activities for one or more companies and fiscal periods. 2. Measure capital structure for the companies and periods. 3. Evaluate the effect of the companies’ financing decisions on risk and return. 4. Evaluate the effect of financing decisions on cash flows and determine the ability of companies to make debt and interest payments. 5. Examine the relationship between a company’s financing decisions and its value to stockholders.

Interpretation of Financing Activities Our analysis begins with a general overview of two companies—Krispy Kreme and Starbucks

Selected Income Statement and Balance Sheet Information Exhibit 7 Selected Income Statement and Balance Sheet Information

Interpretation of Financing Activities A common method for comparing the income of different companies is to compute return on assets for each company.

Krispy Kreme vs. Starbucks 2000 2001 Net Income Total Assets Return on Assets = $14,725 $171,493 Krispy Kreme = = 8.6% 5.7% $181,210 $1,851,039 Starbucks = = 9.8% 6.3%

Interpretation of Financing Activities Starbucks was more profitable than Krispy Kreme in both 2000 and 2001.

Interpretation of Financing Activities As a second step, we compare the capital structures of the two companies by using ratios such as debt to assets and assets to equity.

Debt-to-Asset Ratio Comparison 2000 2001 Total Liabilities Total Assets Debt-to-Asset Ratio = $45,814 $171,493 Krispy Kreme = = 26.7% 54.5% $480,041 $1,851,039 Starbucks = = 25.9% 23.0%

Interpretation of Financing Activities Another measure of capital structure is financial leverage: the ratio of total assets to total stockholders’ equity.

Krispy Kreme vs. Starbucks 2000 2001 Total Assets Stockholders’ Equity Financial Leverage = $171,493 $125,679 Krispy Kreme = = 1.36 2.20 $1,851,039 $1,375.927 Starbucks = = 1.35 1.30

Interpretation of Financing Activities The financial leverages of the two companies were about the same in 2001.

Interpretation of Financing Activities Note that a company that uses more debt in its capital structure has a higher debt-to-equity ratio or asset-to-equity ratio than one that uses less debt.

Objective 5 Determine and explain the effect of financial leverage on a company’s risk and return.

The Effect of Financial Leverage on Risk and Return A third step in our analysis is to to determine the effect of financial leverage on the risk and return of our companies.

The Effect of Financial Leverage on Risk and Return A ratio commonly used for this purpose is return on equity.

Return on Equity = Return on Assets x Financial Leverage The Effect of Financial Leverage on Risk and Return Return on Equity = Return on Assets x Financial Leverage Net Income Stockholders’ Equity = Total Assets x 2001 Krispy Kreme 11.7% = 8.6% x 1.36 Starbucks 13.2% = 9.8% x 1.35

The Effect of Financial Leverage on Risk and Return Exhibit 8 The Effect of Financial Leverage on Risk and Return

Objective 6 Use cash flow and liquidity measures to evaluate financing decisions.

Other Risk Considerations The fourth step in the analysis of financing activities involves evaluating the ability of each company to make debt and interest payments.

Other Risk Considerations Default risk is the likelihood that a company will not be able to make debt and interest payments when they come due.

Other Risk Considerations Creditors may impose limitations on a company’s ability to borrow additional money, require it to maintain a certain debt ratio, or limit its ability to pay dividends.

Other Risk Considerations These limitations are called debt covenants, and they protect the interest of creditors against a company becoming too risky or paying cash to stockholders when it has too much debt.

Other Risk Considerations A commonly used liquidity measure is the current ratio. Current Assets Current Liabilities

Other Risk Considerations If this ratio is low or decreases substantially over time, the risk that a company may not be able to pay its current obligations increases.

Other Risk Considerations 2000 2001 Current Assets Current Liabilities Current Ratio = $67,611 $38,168 Krispy Kreme = = 1.77 1.39 $593,925 $445,264 Starbucks = = 1.33 1.47

Other Risk Considerations Exhibit 9 in the next slide provides selected cash flow information for Krispy Kreme and Starbucks.

Selected Cash Flow Information for Krispy Kreme and Starbucks Exhibit 9 Selected Cash Flow Information for Krispy Kreme and Starbucks

Other Risk Considerations Of the two companies, only Krispy Kreme paid dividends in 2000 and 2001. A measure of the relative size of the dividend payment is the dividend payout ratio.

Other Risk Considerations Dividend Payout Ratio Current Assets Current Liabilities Krispy Kreme = $7,005 $14,725 = 47.8% 2001 Krispy Kreme = $1,518 $5,956 = 25.5% 2000

Objective 7 Explain why financing activities are important for determining company value.

Financing Activities and Company Value The final step in the evaluation of financing activities is assessing the relationship between financing decisions and company value.

Financing Activities and Company Value Financial leverage can work for or against a company and it stockholders.

Financing Activities and Company Value When a company is not doing well, financial leverage is detrimental.

Financing Activities and Company Value A measure of a company’s value to investors is the market-to-book value ratio.

Financing Activities and Company Value Market value is the price of a company’s stock times the number of shares outstanding.

Financing Activities and Company Value Book value is the amount of stockholders’ equity reported by a company on its balance sheet.

Financing Activities and Company Value 2000 2001 Market Value Book Value Market-to-Book Value = Krispy Kreme = 3.52 0.98 Starbucks = 6.08 3.93

Summary of Ratios for Krispy Kreme and Starbucks Exhibit 10 Summary of Ratios for Krispy Kreme and Starbucks

CHAPTER F10 THE END