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

2. 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

3. 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.

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

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

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

7. Projected Sales and Income for Mom’s Cookie Company
Exhibit 1
Projected Sales and Income for Mom’s Cookie Company
(in thousands) Year 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
Income taxes (60) (132) (218)
Net income $ $ $ 510

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

9. 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.

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

11. 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.

12. Return on Equity for Mom’s Cookie Company
Exhibit 3
Return on Equity for Mom’s Cookie Company
(in thousands) Year Year 2 Year 3
Net income $ $ $ 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.

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

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

15. 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.

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

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

18. 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

19. 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% = % x

20. 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% = % x

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

22. 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.

23. 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.

24. 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.

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

26. 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.

27. 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.

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

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

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

31. 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.

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

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

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

35. 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%

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

37. 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.

38. 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%

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

40. 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,
Starbucks =
= 1.35
1.30

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

42. 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.

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

44. 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.

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

46. 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

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

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

49. 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.

50. 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.

51. 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.

52. 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.

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

54. 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.

55. 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

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

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

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

59. 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

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

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

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

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

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

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

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

67. 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

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

69. CHAPTER F10
THE END