Project
Statement of Cash Flows
It is said that cash is king in finance. Just like people, corporations like it (or cash equivalents) too. Having assets is good, but unless you turn it into cash, it is meaningless. The statement of cash flows is about the movement of cash into a company (inflow) and out (outflows) and why these flows occur.
To create the statement of cash flows, the company divides cash flows into three categories: operating activities, investing activities, and financing activities. The end of each category lists the net cash flow as either positive or negative.
Operating Activities
Essentially, cash flows from operating activities result from the primary functions of the company. The activities include cash received from customers or cash paid to suppliers and employers. Certain accounts such as savings accounts generate interest. This interest comes in the form of cash, so the interest is included here. Note that this does not include interest generated from investments because investments are not part of the company's primary operations. Interest paid and income taxes paid are included as well.
Investing Activities
Any cash flow changes that result from the purchase or sale of investment assets go into the cash flows from investment activities. If a company pays for any type of investment (stock or bond) with cash, that influences the cash flow, so purchases of investments belong here. If a company sells the investments for cash (in full or partially), the proceeds are included in investment activities. Even if the company sells the investments at a net loss, strictly speaking this increases the company's cash level. Another biggie is the purchase (or sale) of property, plant, and equipment (PPE). The purchase of PPE typically refers to a company's purchase of long-term assets. Add up all these positive and negative values from investment activities and you will have the net cash from investing activities.
Financing Activities
Financing is a category in the cash flow statement that accounts for external activities such as expansion, adding or changing loans (affects liabilities), or issuing and selling more stock (affects owners' equity). Loans received and collected by cash transactions result in an increase or decrease of cash from financing activities. When the company sells its own stock, it is considered a financing activity, which contributes to an increased cash balance. When the company pays out dividends, it contributes to a decrease.
When you combine all the net cash provided by the three types of activities, then you get the total cash flows. A positive change means that the company increased its total amount of cash; a negative one is the reverse. A negative change is not necessarily a bad situation as long as the operations are generating value. It would be bad news if the company consistently experiences negative cash flows (it implies that the company is having trouble turning assets into cash, which is a liquidity problem).
When you analyze the financial statements, it is important to remember that statements themselves tell the story of now. You will want to use the financial metrics to predict what the company will do. These metrics will be covered in the later modules.
Financial Statements Analysis
Financial statements analysis has two purposes: to evaluate a firm's past financial performance and its future prospects. There are financial metrics, or analysis equations, that turn the information to explanation. In this module, you will learn three primary metrics you can apply to analyze a company's performance. They are liquidity, profitability, and debt analysis.
Liquidity Metrics
Liquidity metrics tell you a company's ability to pay its bills. Poor liquidity may indicate a fundamental operational problem of the company.
Net Working Capital
Net working capital is the different between the current assets and the current liabilities:
Net Working Capital=Current Assets-Current Liabilities
Companies look for positive net working capital because it indicates that they are able to pay their bills, at least in the short term.
Current Ratio
The current ratio is equal to current assets divided by current liabilities:
If a company has the current ratio of 2, then there are twice as many current assets as it has current liabilities. This ratio is of somewhat limited use for various reasons. For example, it can fluctuate quite a bit depending on how the firm carries on inventory.
Quick (or Acid-Test) Ratio
Some companies sell large items such as farm equipment, and they may take a long time to clear their inventories. The quick ratio tells how many times a company could pay off the debt that's due within the next 12 months by looking at the assets other than inventory (or prepaid expenses). The formula is:
Other Ratios
Other popular liquidity ratios are cash ratio and activity (asset utilization) ratios (accounts receivable turnover shown below).
Profitability Metrics
A company exists to make money. No one wants to do business with a company that doesn't make profits. Measuring how well a company generates profits is then a good indication of how effectively it is managed and its ability to earn a satisfactory profit. Some of the operating metrics are explained below.
Net Profit Margin
The most common profitability metric is the net profit margin. It measures the proportion of revenues that don't go towards business costs. Note that a low margin doesn't necessarily mean low profits, because the company can make it up with a greater volume of sales. The formula is:
Total Asset Turnover
A company may have lots of assets, but how effectively is it turning them into generating sales? Total Assets Turnover calculates this. The formula is:
You use the total assets from the two most recent years to calculate the average total assets.
Return on Assets (ROA)
Similar to Total Assets turnover, Return on Assets can show you how effectively the company is turning them into generating income. The formula is:
The DuPont Formula utilizes the following relationship and expands it into their respective ratios to highlight the tie-in between the profit margin and the return on total assets.
Return on Investment (ROI)
Return on Investment is an extremely popular measure that determines how well a company is using its investments to generate profits. The formula is:
ROI is a key measure of performance, but it is also prone to distortion.
Ratios Related to Operations
A few other key ratios related to operations are listed below.
Debt Metrics
Debt (or leverage) can help a company but also can break it. It is so crucial that a company's capital structure (covered in later modules) depends primarily on how it manages its debt. Debt also incurs interest charges that need to be paid off. Here are some of the debt metrics you can use.
Debt Ratio
A company with too much debt is in serious trouble, so there are many reasons why it is important to know the debt ratio. One reason, for example, is to gauge whether a company is at risk of default on the debt. The formula is:
If this ratio is more than 1, it means the company has more debt than it is worth.
Debt to Equity Ratio
When you want to measure a company's capital structure, you want to calculate the debt to equity (D/E) ratio. This ratio is a significant measure of solvency (company's ability to meet its long-term obligations). A high D/E ratio may mean that the company may have trouble paying interests or is at risk of running out of cash. The formula is:
Times Interest Earned (Interest Coverage) Ratio
When you want to know if a company can pay the interest it owes on the debt it (do you see a theme here?) has incurred, you use times interest earned:
If, for example, you compare this ratio from two consecutive periods and the ratio has declined, it could mean that the company had trouble generating the same level of earnings to meet interest charges (negative sign).
Use and Limitation of Ratio Analysis
The financial statements present the summarized data of its assets, liabilities, and equities. Calculating ratios help you evaluate the financial health of a business. You can do so by making two types of comparison: industry comparison and trend analysis. To compare a firm's performance with that of its peers, you compare the ratios to the industry averages or direct values of similar firms. Trend analysis is used to evaluate the trend in a company's performance over the years.
Although ratio analysis is useful, it does have its limitations. For example, comparison analysis is sometimes difficult because it is rare that two companies operate in the exact manner, making the analysis somewhat meaningless. A ratio does not insure the quality of its components. Management may exaggerate some numbers or inventory may be obsolete. Lastly, the ratios are static and do not necessarily imply future trends.
Time Value of Money
Time Value of Money (TVM) is a crucial concept behind most of financial and investment decisions. Discounting, or the calculation of present value, is used to evaluate future cash flows associated with capital budgeting projects. Most of you have already seen the concepts, so the summary of formulas is shown below and will be tied to the "big picture."
Time Value of Money Formulas
The most basic formula is the future value:
FV=PV x (1+r)t
where FV = future value
PV = present value r = interest rate t = number of periods
If you rearrange the FV formula, you can get the present value formula:
The present value of a perpetuity is the sum of an infinite number of constant cash flows (CCF). The formula is:
An annuity is similar to a perpetuity except that it has a finite number of cash flows. You use the PV formula to calculate the value of an annuity.
Take a look at the sample spreadsheet linked below for examples of calculating those values. These formulas are key to analysis because you will often see "embedded" annuities, where you have a series of constant cash flows between fluctuating cash flows, or the terminal value calculation, which captures the value of a business beyond the projection period.
Illustration
The bond purchase price is the present value of specific interest payments for a stated number of years plus the discounted value of the maturity value, usually $1,000. A bond then represents an annuity plus a lump sum. Calculate the bond purchase price assuming that it is a $1000 bond that pays interest at 12%, redeemable at the end of 10 years. You want the yield of 10% compounded semiannually. Capital Budgeting
When you think of investments, what comes to mind? You probably thought of stocks and bonds. They are called financial investments because they are based on financial products. When a company makes an investment, it makes a different type of investment called a capital investment. It does so through capital budgeting. Capital budgeting, at minimum, involves the following:
1. Rates of Returns on capital
2. Value of cash flows
3. Payback period
4. Present value of cash flows
Rates of Returns on Capital
Accounting rate of return (ARR) measures profitability from the conventional accounting perspective. Under this rule, you choose the project with the higher rate of return. Since this method ignores time value of money, it is not very useful in financial analysis. An alternative is the Internal Rate of Return (IRR). It is defined as the rate of interest that equates the investment with the PV of the future cash flows. Under this rule, you accept the project if the IRR exceeds the cost of capital; otherwise, reject. Use Excel's IRR(values, [guess]) function to compute this ratio.
Value of Cash Flows
So far, we have ignored the signs of the cash flows (+ or -), which indicate the direction of the cash flows because it was implicit. However, projects will always have two sets of cash flows: inflows (money that the firm receives, and we will assign a positive sign) and outflows (money that company invests, and we will assign a negative sign). In general, we categorize the cash flows into three: 1) initial investment, 2) incremental cash flows, and 3) terminal cash flow. The initial investment is the original cash outflow necessary to get the project going (asset purchase, for example). The incremental cash flows are after-tax cash inflows (net earnings after taxes + depreciation). The terminal cash flow typically is the salvage value of the project with any taxes gains or losses.
Payback Period
The payback period is the length of time required to recover the amount of initial investment. You choose the project with a shorter payback period. The idea is that the shorter the payback period, the less risky project. You can use either the payback period calculation or the discounted payback period. The difference is that the discounted payback period takes the time value of money into account.
Present Value of Cash Flows
The Net Present Value (NPV) rule will be the one you will always remember. It is possibly the best (but not necessarily the only) decision rule among several we discussed so far. It is intuitive and simple to compute. The rule is: if NPV is positive, accept the project; otherwise reject. Typically, the project with a bigger NPV, the better choice. The NPV is also additive, which will come into play later. The formula is:
NPV = PV(CCFs) - I
Looking at the formula, you see the intuition behind this rule. You are accepting the project(s) that are worth more than they cost. Even if the NPV is small, say $100, it's worth it, because it ultimately adds value above and beyond the opportunity cost.
See the spreadsheet linked below for how to compute NPV.
Net Present Value Rule's Key Features
Among the decision-making rules discussed above, the NPV rule leads to better investment decisions than others. Some companies use the payback period to make investment decisions. The problem with it is that it is too simplistic: it ignores the time value of money and the opportunity cost of capital. The IRR is commonly used so you should know how to compute it. The IRR's problem is that it is easily manipulated (intentionally or unintentionally) and so can be easily misapplied. The NPV rule has three features that make it a better rule. First, the NPV rule integrates the time value of money principle. Second, it solely depends on the forecasted cash flows from the project and the opportunity cost. It eliminates the many pitfalls (manager's preferences, accounting methods, among others) that will lead to inferior decisions. Lastly, because the present values are measured in today's dollar, you can add up NPVs. For example, for two projects A and B, the NPV of the combined investments is:
NPV(A + B) = NPV(A) + NPV(B)
Say NPV of A is negative. The combined NPV of A and B will then have a lower NPV than B on its own. Therefore, it will be difficult to mislead the decision makers to accept a poor project (A) just because it is packaged together with a good one (B). No other rule has this additive property.
P=PV($60 paid over 20 periods each at 5%)+PV($1000 at maturity) =$747.73+$376.89=$1124.62
See the spreadsheet for details.
Bond Valuation
The process of bond valuation includes three elements:
1. cash flows to the investor in the form of periodic interest payments (annually or semiannually), or coupons, plus the par value at maturity
2. the periods to maturity (T)
3. the investor's required return (r). Recall that r is different from the coupon interest rate (rcoupon).
The value of a bond is then the present value of all cash flows. This is the formula:
You should become familiar with different types of bonds (corporate bonds, government bonds, zero-coupon bonds, etc.)., bond ratings (AAA vs. A), and reading bond information (price, par, volume, ask, bid, etc.) . Particularly, yield (or current yield) refers to the amount of returns that a bond generates at a given price. Yield differs from yield to maturity (YTM), which is the total amount of returns generated by holding the bond to maturity rather than over the course of a year. How is the yield related to the bond price?
The spreadsheet shows how to calculate an element (T, Par, r, Coupon, Price) of bond pricing given others.
Stock Valuation
Like the bonds, the value of a common stock is the present value (P0) of all future cash inflows expected by the investor. The cash inflows are in the form of dividends (Dt), and the future value (price P1) at the time of the sale. Typically common stock is held for many years (and not sold), so the general common stock model is:
The dividend can grow in three ways: 1) no growth, 2) constant growth, and 3) irregular growth. If there no growth in dividend, the formula reduces to:
which is a perpetuity. In the case of constant growth (at rate g), the model becomes:
It is a constantly growing perpetuity. Note that r > g.
In reality, firms typically go through life cycles. During a growth cycle, their growth is faster than the economy; then the growth slows down to a constant rate. To find the stock price in case of irregular growth, you find the present value of the dividends during the growth cycle, and then add it to the present value of stock price at the end of the growth cycle. See the dividend discount model below in the spreadsheet for an example.
Risk Defined
Risk (or uncertainty) is the variability of expected returns associated with a given investment. It is an inherent component in business finance (meaning it is unavoidable). The goal is then to manage the financial risk for a given decision to determine whether the potential losses and probabilities associated with them exceed the potential returns.
The expected return is the weighted average of possible returns from a given investment (use SUMPRODUCT() function in Excel). The risk is measured in standard deviation. The smaller the standard deviation, the lower the risk of the investment. Refer to your statistics textbook or the links below for further information.
Measures of Risk - Variance and Standard Deviation
Types of Risk
In general, risk falls into the following categories:
· Business risk depends on the operations of the firm. The variables are demand, sales price, purchase price, debt ratio, etc.
· Market risk is the risk that depends on the entire economy. Prices of all stocks are correlated to a certain degree with broad fluctuations in the stock market.
· Credit risk is the risk that a borrower cannot repay the loan.
· Liquidity risk involves not having enough money on hand to pay the bills when they are due.
· Interest rate risk results from swings in the value of an asset as interest rates change. It's also a risk that your returns may be below the rate of inflation.
· Foreign exchange risk involves losing asset value due to fluctuations in foreign exchange rates.
Since the firm holds more than one type of asset, your job is to conduct risk-return analysis through portfolios and the gains (and losses) from diversification. See the links below for more on diversification and calculating portfolio return and risk.
Measuring Risk
Exactly how to measure risk is a contentious issue, even today. See, for example, this article: Tracking Risk Isn't So Easy . Modern portfolio theory offers two primary approaches to measuring risk: Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT). We will cover the CAPM here.
Capital Asset Pricing Model
Under the CAPM assumptions, the relationship between expected returns on a particular asset (r) and the expected returns of the (market) portfolio (rm) is written as:
You may recall ß from your statistics class. It is the slope coefficient from a linear regression. Here, it is the level of risk on the specific asset. rf refers to the return on risk-free assets.
CAPM is sometimes called the Security Market Line (SML), because ß in the equation measures the asset's volatility relative to that of an average asset. For example, a beta of 0.5 means that this particular asset is half as volatile (or risky) as the average asset. If ß = 1.0, then the asset is equally as volatile as the average asset. See below for an illustration of a SML.
Components of Capital Asset Pricing Model
The component
Assumptions of Capital Asset Pricing Model
How does the CAPM work in the real world? Well, it depends. The model is far from perfect. It assumes perfect data, a perfect market portfolio, equal risk for the same type of investment. It also ignores human behavior. Why, then, do we bother with this model?
We use the CAPM as a starting point. Just like in physics when you assume no friction as the starting point, there is nothing wrong to assume a perfect world in finance. You just have to make adjustments to the model to make it useful.
Cost of Capital
All companies calculate their cost of capital as part of their investment analysis process. Capital is required to fund internal projects and this capital comes with a cost. Once a company's cost of capital is identified, it is used as the hurdle rate when evaluating a project. If the project earns a return in excess of the cost of capital, it will proceed; otherwise, it is rejected. Note that the cost of capital relates to the long-term projects. Investors provide long-term capital to the firm to fund the long-term projects, and this is why it is called the cost of capital.
Weighted Cost of Capital
The cost of capital for a company is comprised of the cost of its debt (rd) and the cost of its equity (re), weighted by the proportion of debt and equity in the company's capital structure (V). The firm value is the sum of D and E (). This weighted-average cost of capital (WACC) is calculated by:
Tc is the marginal corporate tax rate. Note that this calculation is the after-tax WACC, because the cost of debt is calculated after tax. This reflects the tax advantages of debt financing. For more on the effect of taxes, do some research on Modigliani and Miller's (MM's) theorem.
Cost of Debt
For the cost of debt, we will use the Yield to Maturity on the bond cash flows. See the spreadsheet linked below on calculating YTM. Use Excel's RATE() function.
Cost of Equity
For the cost of equity, we have a few options. The cost of common stock, re, is generally viewed as the rate of return investors seek in a firm's common stock. We will use the CAPM approach to calculate re. If the firm has preferred stock, the rate for it (rp) is calculated by a constant dividend model as below:
where dp is the preferred stock dividend and p is the net proceeds from the sale of the preferred stock. For example, if the preferred share sells for $100 per share, and the floating (or underwriting) cost is 3%, then the net proceeds are $97.
Value of a Firm
To calculate the relative weights of debt and equity in the capital structure, we use the current market values (sometimes called market capitalization or market cap). The market value of a firm's common equity is the total current value of its shares. The market value of preferred stock is calculated similarly. We would ideally want to use the market value of debt, but this is sometimes difficult because many firms have different debt or bond issues. We instead use the book values of debt as the proxies.
Illustration
Here is some balance sheet information for Harley-Davidson as of Dec. 31, 2012 (from Yahoo! Finance ):
Optimal Capital Structure
Among the many duties financial managers perform, one of the most important of these is to raise capital to fund the internal investments of the firm. Businesses seek and approve investment opportunities, and the financial managers choose the most efficient way to fund them.
The decision criteria for the appropriate funding are based on the firm's cost of capital. The cost of capital is used as a hurdle rate to determine whether the project is good or poor; therefore, it is important that the cost of capital is managed properly.
As you can see from the WACC formula, the cost of capital depends on the debt-to-equity ratio. The optimal capital structure then is the one that utilizes the best debt-to-equity ratio for a firm to maximize its value. In theory, debt financing (or financial leverage) generally offers the lowest cost of capital because the interest payment is tax deductible. However, too much leverage carries its own risks. Some of these risks are:
· Bankruptcy costs increase
· Agency costs increase
· Increase in the cost of equity begins to outweigh tax benefits
Bankruptcy costs increase as too much debt puts the firm in danger of insolvency. At some level of leverage, especially if the firm runs into a bad spell, it may not be able to meet all of its debt obligations. Managers need to start considering the increasing probabilities of bankruptcy.
Agency costs arise because there is a conflict of interest between stockholders and bondholders. Bondholders would want to preserve the steady stream of cash flows, so they may want the firm to stay conservative. Stockholders, on the other hand, want the firm to maximize its value. This conflict may force the managers to be inflexible; therefore, it may result in the increased cost of borrowing.
Since stockholders bear the risk of increasing financial leverage, they demand more return on their equity. This results in the increased cost of equity, and the value of the firm's shares will decline.
As you can see, the right mix of debt and equity is difficult to pin down. There are no specific rules to determine the optimal capital structure of the firm. The right mix is mostly a compromise. What you as a financial manager can strive for is to continuously look for opportunities to reduce the cost of the capital, so that the firm can increase its wealth better than the competitors or the industry as a whole.