Financial Management Unit VI

FIN 3301, Financial Management 1

Course Learning Outcomes for Unit VI Upon completion of this unit, students should be able to:

5. Prepare preliminary financial statements and ratio analyses. 5.1 Perform an analysis of a firm using various ratios. 5.2 Summarize key areas of an income statement and balance sheet.

6. Evaluate stock and bond valuation.

6.1 Assess the health of a firm using financial data. 6.2 Compare the financial metrics of two companies in the same industry.

Course/Unit

Learning Outcomes Learning Activity

5.1 Unit Lesson Chapter 14, pp. 432-458 Unit VI Scholarly Activity

5.2 Unit Lesson Chapter 13, pp. 391-420 Unit VI Scholarly Activity

6.1

Unit Lesson Chapter 13, pp. 391-420 Chapter 14, pp. 432-458 Unit VI Scholarly Activity

6.2

Unit Lesson Chapter 13, pp. 391-420 Chapter 14, pp. 432-458 Unit VI Scholarly Activity

Required Unit Resources Chapter 13: Business Organization and Financial Data, pp. 391-420 Chapter 14: Financial Analysis and Long-Term Financial Planning, pp. 432-458 Unit Lesson In this unit, we will study financial data and financial analysis. We will examine the different business organizations and the basic financial statements. Further, we will gain a better understanding of the ratios and how they assess a firm’s performance. Finally, we will learn about the link between financial analysis and long-term financial planning.

UNIT VI STUDY GUIDE Financial Data and Data Analysis

FIN 3301, Financial Management 2

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Corporations prepare financial statements to inform shareholders, creditors, and others about the financial position of the company on the date that the financial statements were prepared. The financial statements consist of the following:

• The income statement, which is a summary of the revenues and expenses of the business over the accounting period;

• The balance sheet, which is a summary of the assets and liabilities of the company on a specific date; and

• The cash flow statement, which is a summary of the net inflows and outflows of cash during an accounting period (Needles et al., 2011).

The statement of retained earnings is also considered an important financial statement; it shows the changes in retained earnings over the accounting period. The four statements are interrelated with the information on some statements dependent on the information in other statements (Brigham & Houston, 2015). The following sections discuss the relationship of the financial statements to the objective of the firm and corporate governance, financial statement analysis, and the use of financial statements for long-term financial planning.

Objective of the Firm The general objective of all firms in the private sector is to maximize profit for the shareholders. The financial statements provide information about the degree of success the firm has in increasing profit for shareholders although the financial statements report only on accounting profit (Thomas & Maurice, 2016). Investors can use the information in the financial statements to determine if their investment in the company is providing the required amount of return when considering factors such as the type of industry and the amount of risk involved in the business. The investors can also use the financial statements to determine whether managers have been successful in increasing shareholder value. Because financial statements in all companies have to use the same accounting standards such as Generally Accepted Accounting Standards (GAAP), the statements enable investors to compare the return on their investment with other similar companies in the same industry. Creditors also use financial statements to determine the amount of risk involved with loans to the firm. As a result, the financial statements can influence the cost of debt capital for the firm, which can affect profitability.

Corporate Governance Financial statements are useful for providing the board of directors as well as managers with information about the effect of past financial and operational decisions. The directors of a company can use the financial statements as a tool to help with the oversight of the company. The board of directors has an audit committee usually composed of directors who are not managers in the company that helps to ensure that the financial statements are a full and accurate representation of the financial position of the company (Lee, 2006). The directors can also use the financial statements to assess the performance of managers for achieving the basic objective of the firm (increasing shareholder value). The financial statements contain a substantial amount of information about the company to help managers assess the strengths and weaknesses of the company and take appropriate corrective action (Brigham & Houston, 2015). One of the ways that financial statements can help managers with controlling the activities of the company includes providing information for preparing budgets and determining whether budget objectives have been met. Financial statements can also assist managers with financial analysis, capital investment decisions, and cost and revenue estimation (Marsh, 2012). To use financial statements effectively, however, managers have to be familiar with the methods to analyze the statements.

All firms want to increase profits. Financial statements help measure this. (Photoking, 2018)

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Financial Statement Analysis Financial statement analysis determines how important items in the company's financial statements relate to the company's primary objective of increasing shareholder value (Needles et al., 2011). The objective of increasing shareholder wealth can be divided into different categories to assist with the analysis of the company's performance. In addition, ratios can be created from the information in the financial statements; these ratios can be used to assess the current effect of managerial decisions and to compare changes in the financial statements over time as well as comparing the financial statements of a company with industry peers (Brigham & Houston, 2015). Liquidity Ratios The liquidity ratios are a measure of the ability of a company to pay its liabilities that are due within one year and to have enough cash to meet unforeseen expenses. Liquidity is based on cash and assets that can be quickly converted to cash without substantially reducing the value of the asset. The most important of the liquidity ratios is the current ratio that is found by dividing current assets by current liabilities (Brigham & Houston, 2015). Current assets are cash and marketable securities while current liabilities are accounts payable or other bills payable within one year. A company should have a current ratio greater than one to ensure it can pay its liabilities without borrowing. The ratio should also be similar to industry peers. The quick ratio is useful for assessing the liquidity of companies that carry inventories. The quick ratio is calculated by subtracting the value of inventory from current assets then dividing by current liabilities (Brigham & Houston, 2015). The quick ratio is important for determining how dependent the company is on the sale of inventory to pay its current liabilities, which could be an important issue during periods of business slowdown. Asset Management Ratios The asset management ratios are a set of ratios that measure how effective managers are with using the company's assets to produce value for shareholders (Brigham & Houston, 2015). The accounts receivable turnover assesses how well the company manages its credit policy and is found by net credit sales divided by average accounts receivable. The ratio helps managers evaluate the tradeoff between increasing sales through easy credit policies and the costs of longer periods necessary for collection (Baker & Powell, 2005). A variation is receivables collection period, which can be found by dividing 365 by the accounts receivable turnover. Changes over time in the receivables collection period can provide information about the effectiveness of the credit policy. Additionally, the inventory turnover ratio provides an indication of whether the company is carrying too much inventory and is found by dividing the cost of goods sold by the average inventory. The total asset turnover ratio is an indication of the effectiveness of management for using the company's assets to produce value for shareholders. The ratio is found by dividing sales by total assets. The ratio varies across industries because some industries are more capital intensive than other industries. Financial Leverage Ratios The financial leverage ratios evaluate the effectiveness of the company in managing its debt and are of great interest to creditors. As the level of debt increases, the risk the debt represents to the company also increases. The debt ratio is found by the total liabilities divided by the total assets. A ratio less than one suggests the company is at risk of insolvency (Baker & Powell, 2005). The debt-to-equity ratio assesses the relationship of debt and equity in the capital structure and is found by total liabilities divided by total equity. The long-term debt ratio is found by dividing long-term debt by total assets; this provides a guide as to whether a company is excessively leveraged.

FIN 3301, Financial Management 4

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Profitability Ratios Profitability ratios are of interest to investors and evaluate how the company compares to competitors. Operating margin is found by dividing operating profit over sales and is a rough indicator of whether operating costs are too high. The net profit margin is found by dividing net income by sales and can be compared to industry averages to determine the effectiveness of management policies. The return on assets (ROA) is found by dividing net income by total assets, and it determines the effectiveness of management for using assets to produce value (Baker & Powell, 2005). The return on investment (ROI) is based on dividing net income by average total equity. Market Value Ratios

Market value ratios relate to the company's stock price and are theoretically affected by company earnings and value. The price earnings (P/E) ratio divides the stock price by the earnings and indicates how much investors are willing to pay for a share per dollar of earnings (Brigham & Houston, 2015). A high P/E ratio suggests that investors are optimistic about a company's future earnings. The market-to-book ratio divides the market value of equity by the book value of equity with a ratio greater than one indicating that the company has produced excess value for investors.

Long-Term Financial Planning Past financial statements provide information about trends in the company based on current policies and operations. As a result, financial statements can be useful for long-term financial planning by providing a basis for projecting the effect of different scenarios in the future. For example, a company could use pro- forma financial statements for future accounting periods to determine the effect of a 10% decrease in sales from a future recession on the ability of the company to meet its long-range debt obligations. The approach could be useful to support decisions about financing capital expansion with either debt or equity. The assumption in using past financial statements to make future financial projections is that the past conditions and trends will remain unchanged in the future except for one critical variable. In summary, we studied financial data and financial analysis and examined the different business organizations. We learned about the basic financial statements and gained a better understanding of the ratios. Finally, we explored the link between financial analysis and long-term financial planning.

References Baker, H. K., & Powell, G. (2005). Understanding financial management. Wiley-Blackwell. Brigham, E. F, & Houston, J. F. (2015). Fundamentals of financial management. Cengage. Dragon345. (2018). ID 71348428 [Image]. Dreamstime. https://www.dreamstime.com/stock-photo-blue-

ballpoint-pen-financial-ratios-analysis-check-lists-antique-clock-two-vintage-brass-keys-business- image71348428

Lee, T. A. (2006). Financial reporting and corporate governance. Wiley. Marsh, C. (2012). Financial management for non-financial managers. Kogan Page. Needles, B. E., Powers, M., & Crosson, S. V. (2011). Financial and managerial accounting. South-Western

Cengage.

Firms use ratios for many different financial aspects. (Dragon345, 2018)

FIN 3301, Financial Management 5

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Photoking. (2018). ID 131218859 [Image]. Dreamstime. https://www.dreamstime.com/profit-word-yellow- paper-wooden-steps-arrow-black-grunge-background-profit-word-steps-image131218859

Thomas, C., & Maurice, S. C. (2016). Managerial economics. McGraw Hill. Suggested Unit Resources In order to access the following resource, click the link below. The video below gives a quick lesson on the fundamentals of financial statements. In about five minutes, you will have a pretty good basic understanding of this concept. Costa, C. (2012, April 3). 5 minute finance lesson: Financial statement basics [Video]. Cielo24.

https://c24.page/yky7vp8wubugjcvu99bmmx7cdy A transcript and closed captioning are available once you access the video. Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. How well do you know the unit material? Take the Unit VI Knowledge Check Quiz to find out! (PDF of Unit VI Knowledge Check Quiz)