Finance week 8 discussion

Chapter 1. An Overview of Financial Management and the Financial Environment

Finance – Week 1 Lecture

Introduction to Financial Management

This week you will be introduced to a wide variety of topics all pertaining to finance. Your goal is to get your feet wet, learn basic terms and concepts to prepare you for the rest of the course, and perhaps most importantly: find a reason to really want to learn more about finance. The truth is, all organizations, even your household, are impacted by finance. From small start-up companies, the local barber shop, to large multi-national organizations, they all rely on basic concepts of finance to function successfully.

You’ll learn about a lot of very important concepts throughout the next eight weeks. Financial analysis, the time value of money, debt, equity, stocks, and how much it costs to finance a business are all key topics you will dive into. Before you can approach all of these successfully, however, it’s important to find value in them. Take a bit of time in your first week and consider your current employer, your career path, and even your financial state at home. What do you currently know about how your employer finances their operations? Are you involved in the budgeting process or in choosing new projects to invest in? Do you know how much it costs your employer to obtain money to invest in and grow the business? Look at your own personal finances. Do you have any large projects you are considering? A new home, new car, additional education? How might you assess the return on these things to choose the best option? The concepts you will learn in this course will have a place in all of those situations and so many more. Once you can clearly see how beneficial the course concepts are, you’re far more likely to see useful and immediate application for what you are learning!

Take another moment to consider your current or previous employer. Do you know what kind of business structure it is? Is it owned and operated by just one person (maybe even you!)? If so, it’s a sole proprietorship. Is it owned and operated by two or more individuals? If so, it’s likely a partnership. Is it a large organization that has stockholders? That’s a corporation! Each type of business formation has very distinct advantages and disadvantages. It’s one of the first decisions we face when starting a business and will have a significant impact on the financial decisions that follow.

Sole proprietorships are a very common form of business structure and are very easy to establish. There are no required forms to file or complex partnership contracts to create. If you wake up one morning and say “I’m going into business by myself”, then you’re a sole proprietor. It’s that easy! Though easy to form, there are some key disadvantages as well. You are in it alone, so the financial burden falls squarely on your shoulders alone. You are also the only person to offer expertise and ideas for the business as well.

Now, if you head out to dinner with your neighbor and write down all your great ideas on a napkin you’ve also formed a new business, a partnership! Partnerships are also easy to form. Written partnership agreements are strongly encouraged, but not required, to start a partnership. You get the benefit of more people to share the financial burden and a wider mix of expertise and experience in the business. As a downside, however, now you also have the potential for more conflict or disagreement. You aren’t the only one running the show any more!

Finally, we could choose to form a corporation. Corporations offer a wide variety of benefits, but they are a bit more difficult to form. We can’t just wake up one morning say, “I’m incorporated”. Articles of incorporation must be written and filed with the Secretary of State. The extra work is often worth the effort though. Corporations enjoy limited liability, which standard partnerships and sole proprietorships do not. Limited liability means that the investors are limited in the amount of money they can lose. They can lose no more than the amount they have invested in the company. So, if a shareholder owns a few shares and the company suffers a fire and burns down, the shareholder will lose no more than the amount of their original investment. If, on the other hand, it was a sole proprietorship and the fire caused the whole block to burn down, the sole proprietor is solely responsible for the losses. This means that the proprietor’s personal assets are also fair game in being responsible for the loss. They are not limited to the amount they invested in the business.

Choosing a business structure is just one of many financial decisions businesses must make. Pay attention to your personal and professional life as you move through the course, trying to spot the concepts you are learning at work all around you! 

  Chapter 2. Financial Statements, Cash Flow, and Taxes

Chapter 3. Analysis of Financial Statements

Finance – Week 2 Lecture

Financial Statement Analysis

This week the focus will be on financial statements and how to use them to assess the performance of an organization. Before we can use them successfully, we need to know the basics. While we certainly do not need to be accounting experts, we do need to have baseline knowledge of what we are looking at. There are four basic financial statements: the income statement, balance sheet, statement of stockholder’s equity, and the cash flow statement. All four provide important information about the organization. While some financial statement users tend to prefer one statement over the other, all four are necessary in order to get a full picture of an organization’s health.

Let’s begin our exploration with the income statement. Though every income statement may look slightly different than the next, they will all still have the same basic elements: revenues and expenses. Income statements show us how much a company had for the period in sales and how much they spent in order to achieve those sales. Hopefully there are some funds left over, resulting in a profit. If we spend more on expenses than we bring in for sales, we end up with a net loss rather than a profit. It’s important to note that the income statement shows us performance over time. The most common time periods for income statements or any financial statement, is a month, quarter, or year. There are lots of ways that we can use the income statement to analyze an organization. We can look at several years of income statements to identify trends (trend analysis) to see if performance is improving or declining. We can translate the dollar figures on the income statement into percentages of sales and compare the organization to competitors, other organizations in the industry, or to industry averages. We can also calculate a wide range of profitability ratios to see how well the organization is performance in terms of profits. Ratios are a handy analysis tool as well. They allow us to easily compare the organization to others, history, and industry benchmarks.

Unlike the income statement, the balance sheet shows us only a snapshot in time. It does not show performance over a period of time. It does show us what the organization has for assets, liabilities, and equity on a given date. The balance sheet earns its name by doing just that: balancing. The balance sheet supports the accounting equation: assets = liabilities plus equity. I like to think of the equation as everything we have (assets) and where we got it from (liabilities or equity) = borrow money or someone invested money in us. Just as we are able to use the income statement for analysis, the balance sheet is just as helpful. We can also look at several periods of data for the balance sheet to identify trends. We can also translate our balance sheet dollar figures into percentages of assets to make comparisons to other organizations more meaningful. There are also many ratios we can use to analyze items on the balance sheet. For example, we might look at the debt-to-equity ratio to see how heavily the firm is financed by debt. Since debt is more risky than equity, knowing how heavily the firm relies on debt is a helpful ratio in measuring performance. We can also put the income statement and balance sheet data together to calculate several additional ratios such as return on assets which measures how profitably we are using the assets we own.

The statement of stockholder’s equity helps us see how what has happened in the equity section of the balance sheet in more detail. In this helpful statement we can see the beginning balance of stockholder equity, any dividends issued, stocks issued or retired, and income earned, and the ending balance for stockholder equity.

Finally, we have the statement of cash flows. This financial statement is often overlooked but holds crucial information about an organization. There is a common misconception that if an organization is profitable, they must have cash and if they are not making a profit then they will not have any cash. This actually isn’t true! An organization can be highly profitable but if they do not track and manage their cash flow properly, they can be profit rich and cash poor. The statement of cash flows shows where the organization’s cash came from and where it went. It allows investors to see the difference between profit (or loss) and cash flows of the organization. The statement is broken down into three categories: operating, investing, and financing. This allows anyone reviewing the statement of cash flows to easily see what type of business activities are providing or using the organization’s cash. A new creditor, for example, would be interested in the organization’s cash from operations which can provide an indication of the sustainability of the organization’s short term cash flow.

Chapter 4. Time Value of Money

Chapter 5. Bonds, Bond Valuation, and Interest Rates

Finance – Week 3 Lecture

Time Value of Money

The time value of money is a very important concept in the business world and in your own personal finances! Many students struggle with the underlying concepts when they first begin to explore this area. However, with a little patience, the time value of money can be a fun and highly useful concept to master. The elements are simple, the calculations are sometimes not so simple. The time value of money is based on the interest rate, how much time has passed, and the amount we started with or want to end with. A change in any of these three elements can significantly change the outcome of our calculation.

A great example that you may very well be able to relate to is your home mortgage or auto loan or student loan. The mortgage is a great one to pick on because they are generally so long. A standard mortgage is often 30 years long. The longer we have money invested or borrowed, the more powerful the time value of money is. Each period we accrue interest on the amount we owe on our mortgage. When we go to make our monthly mortgage payment, it must first cover the new interest that has accrued. Anything left over then goes to reduce the principle amount we borrowed. So the more interest we owe, the less principle we pay each month and the longer it takes to pay off the mortgage. Adding just $25 per month to your mortgage payment to pay extra on your principle can reduce the length of your loan potentially by years!

This is the power of the time value of money. It works the same way in business. When our investors put money into our organization they are expecting a return in exchange for allowing us to use their funds for a period of time. The same is true of a business loan. No matter where we get our capital, someone will be expecting a return! The longer we have their money tied up, the greater the return. Later in the course we’ll look at the capital budgeting process which relies heavily on time value of money calculations. We’ll see how we can evaluate potential projects we would like to complete all the while taking into consideration how much it costs us to tie up funds.

There are several different types of time value of money calculations and it’s important to understand which one to use in each situation. First, we must decide if we are looking to find the value of money right now (present value) or the value of money at some point in the future (future value). Then we have to assess how often the cash flow will occur: once (lump sum) or many times (annuity). Annuities are payments or receipts of money that happen more than once, always in the same time increments, and always in the same amount. For example, if we receive $100 for our birthday every year on the same day, that’s an annuity. Another common example of annuities in business would be capital lease payments or annual cash flows from a project.

Once we identify the type of calculation we need, we can use several different tools to help us calculate the time value of money. We may be looking for the present value of a lump sum ($10,000 to be received 2 years from now), the present value of an annuity ($1,000 received every year for ten years – what is it worth right now?), the future value of a lump sum ($10,000 invested right now, what is it worth in 5 years?) or the future value of an annuity ($1,000 received every year for ten years – what is it worth in ten years?). The time value of money factor charts can help us perform these calculations manually. A financial calculator can do all of these and more if we know the right buttons to push. There are also formulas for each one that we can perform long hand. No matter what approach works best for you, keep your resources handy (your time value of money charts or your financial calculator) since these calculations and concepts are at work in many areas of business and your personal finances.

We don’t have to look far to find the time value of money. It plays a role in how much you pay to use your credit card, your monthly mortgage payments, auto loans, student loans, bond interest, lease payments, the selling price of bonds, and various methods used to assess capital projects. Even winning the lottery requires time value of money calculations. The time value of money can be used to identify the rate of return offered by the lump sum versus annuity pay out on a large lottery win! Then you can decide which rate is more advantageous to you and whether or not you can invest your winnings and earn a rate higher than the lottery is offering in their annuity payments.

  Chapter 9. The Cost of Capital

Chapter 10. The Basics of Capital Budgeting: Evaluating Cash Flows

Finance – Week 5 Lecture

Cost of Capital and Capital Budgeting

Capital projects can be a lot of fun and a lot of work. A capital project is generally a project that requires a significant investment into something that will last a significant amount of time. For example, assume we are running our own small town bakery and wanted to invest in some new aprons. The aprons are low cost and will last only a few months before they are stained or worn and will need to be replaced. This is not a capital project for our bakery. We also would like to invest in a new, larger oven that will allow us to produce more baked goods daily and hopefully increase our sales. The oven requires a large investment and is expected to have a useful life of ten years or more. The oven is a great example of a capital project!

Now we have to figure out if our oven is worth the investment! Most organizations have a wish list of projects they would like to invest in that is a mile long. The funds they have available to spend on their projects, however, is not a mile long. Therefore they must assess each project and decide in which projects to invest.

Many methods are available to help us assess the possibility of investing in our new oven. The net present value method takes into the consideration the present value of all the future cash flows our oven might produce for us then compares that amount to how much we have to invest in our oven today. If the result is positive we would likely approve the project and get our oven. If the result is negative that means that the investment we make today is greater than the present value of all the funds we hope to gain from the project. Thus, we would reject the project and not get our new oven.

We could also choose to use the internal rate of return calculation to assess our oven project. The internal rate of return reflects the amount of return we could possible earn on our project given the rate at which our firm must borrow capital. If the internal rate of return is higher than our firms cost of capital (how much it costs us to use or borrow funds) then we would likely accept the project. If the internal rate of return is lower than our cost of capital that means our oven would be earning us less than what it costs us to borrow money. If that is the case we would likely reject the project.

It’s key to note that both the net present value and internal rate of return take into consideration the time value of money. In an earlier lecture we talked about the basic concepts of the time value of money and learned that it costs money to use money. If we use debt to fund our projects we will have to pay interest. If we use equity to fund our investments we will have to pay dividends. If we use our own idle cash we have to earn more on our project than we could have earned on other investments. No matter what source of funds we use, we have to ensure that our project is earning more than the funds are costing us.

Another popular method of assessing projects is the payback method. Unlike net present value and internal rate of return, the payback method is quite basic and does not take the time value of money into consideration. The payback method reflects how many periods it takes to recoup our initial investment. This helps management understand how long their funds will be tied up in the project before they come back in the form of higher sales or lower costs. While the payback method is helpful, it doesn’t take into consideration the time value of money nor does it give any indication of how profitable the project is after it reaches the point of payback.

Now that we know some of the basic assessment methods we could do some calculations to help us determine if our oven is a good investment or not and whether or not it’s a better investment than other projects we would like to do on our limited capital budget. It’s key to note that while the assessment methods are very helpful, there are other items that should be considered as well. Employee and customer safety is a key concern. For example, if our current oven were malfunctioning and posed a hazard to our employees, we may still want to invest in the new oven even if the calculations we perform show that the oven doesn’t provide a high return. The calculations used to assess capital projects are a great starting point but should be used in conjunction with other elements that are important to the organization such as long term strategy and customer and employee safety and satisfaction.

Chapter 11. Cash Flow Estimation and Risk Analysis

Chapter 12. Corporate Valuation and Financial Planning

Finance – Week 6 Lecture

Risk and Financial Planning

Many business managers and financial managers often find themselves wishing they had a crystal ball. Assembling a forecast, a short term plan, and a strategic plan all require some fancy footwork and lots of research in order to accurately plan what may happen in the future. There are lots of tools, however, that can help make the fancy footwork a bit easier without the use of a magic crystal ball.

In our sixth week we will be covering Chapters 11 and 12 (Part 6) in our text.  We’ll cover distribution to shareholders, dividends, repurchases, and capital structure decisions.  There is a fine line for all organizations on how much debt is too much.  It’s also important for each organization to carefully consider what type of debt will best fit their needs.  We’ll talk about forms of debt and how it impacts an organization’s capital structure.  Be sure to review the learning objectives, weekly schedule, and other resources available for week 6.  Start by reviewing the learning objectives as it will give you a good overview of what topics we’ll be discussing this week!

For example, sensitivity analysis is a very frequently used tool in many situations. Have you ever found yourself playing the what-if game? What if I move the sofa over here, then I would have to move the chair over here…. But what if I left the sofa where it is and moved the television over there… Or perhaps you are looking at your own personal financial plan. What if you paid off the car loan first, then used the extra monthly funds to apply towards your student loan. Or, what if you chose to pay down the student loan first, then…. You get the point. Sensitivity analysis, in its most basic form, is simply a game of what-if. When it comes to assessing risk and financial planning it’s generally a lot more complicated than choosing which debt to pay off first or how to rearrange the furniture in your living room. Sensitivity analysis, however, is a way to take a large number of variables and assemble them in a way that makes sense and allows us to ‘play’ with them. For example, I worked for a large firm years ago that was struggling financially. We were assembling a 12-month plan that would try to get us to a point of profitability. It wasn’t easy since it involved massive lay-offs, some divisions closing, some product lines being discontinued, and many other difficult decisions. We built our entire 12 month financial plan in a spreadsheet. Yes, accountants love spreadsheets! There are far more sophisticated software programs available, but at the time we had Excel. The beautiful thing, however, was that I built the entire (massive) plan in Excel using formulas. Everything was linked and tied together. So we made 15 copies of the file and began to ‘play’. What happens if we reduce our workforce by 20? A click on the personnel” tab in the spreadsheet, a minus twenty in the headcount cell, and the entire plan updated and kicked out new figures. Just one small change allowed us to see how everything else changed based on a change in just one factor. The other beautiful thing about sensitivity analysis is that we can change one thing or lots of things and then see the end result. We could cut pay rates by 10%, cut 20 headcount, eliminate training programs, discontinue one product line, then look at the ending financial figures and see the outcome. It’s a lot of work and a lot of data, but by having sensitivity analysis we were able to assemble a large amount of information and make an informed decision in how to move forward with our very difficult decisions.

Unfortunately not every organization has the knowledge and skills necessary to employ tools like sensitivity analysis. These types of tools can add a lot of value to the decision making process in both good and bad times.

The process is helpful not only in assessing options in a downsizing, but in lots of decisions. The capital budgeting process can benefit from sensitivity analysis, especially when project assessments rely heavily on cash flow forecasting. Identifying which cash flows are relevant and which are not is the first step in working with cash flows in the capital budgeting process. Then sensitivity analysis can be used to see how cash flows and the overall project profitability change when assumptions about the project are changed. Basic month to month forecasting is another area that can benefit from simple sensitivity analysis. Looking at a new product, a new manufacturing process, a new machine, the implications of an employee pay raise, are just a few examples of the many ways managers may use sensitivity analysis to see how one factor impacts another.

This week our topic tie together very nicely. You’ll learn about sensitivity analysis and follow that with corporate valuation and financial planning. The financial planning process can be a bit overwhelming if the proper tools aren’t employed. Financial planning requires managers to look a month, a quarter, six months, a year, and often several years in advance and formulate a prediction of the organization’s performance. The tools you have discovered so far enable financial managers to assemble what they know about finance, the industry, the organization’s mission, vision, values, and strategy, and tools like sensitivity analysis to assemble financial statements for the future, all without the help of a crystal ball

Chapter 14. Distributions to Shareholders: Dividends and Repurchases

Chapter 15. Capital Structure Decisions

Finance – Week 7 Lecture

Capital Structure

Capital structure can sound like a large, scary subject to students who may be new to finance. It’s a crucial area to understand and really isn’t all that scary once you understand what the two key components are: debt and equity. That’s it! Capital structure refers to how an organization is financed. In an earlier lecture I referred to our balance sheet and the accounting equation: assets = liabilities + stockholder’s equity. I said that I like to think of it as what we have (assets) and where we got it from (borrowed money or others invested their money). Capital structure simply refers to the “how we got it” side of my equation. By assessing the capital structure of an organization we can see how heavily the organization relies on debt or equity to finance their organization. So while the term capital structure may sound like a big, complex concept, it’s really just a matter of seeing how much debt an organization has in comparison to the amount of equity they have.

Debt can be short or long term and comes in various shapes and sizes. We can owe money to our trade partners which is commonly known as accounts payable. We may have notes payable to other companies or banks. They can be short or long term depending on the terms of the note. We may also have revolving lines of credit or other types of loans. None of these are generally free, so assessing how much debt we have can help us determine how much it’s costing the organization in interest. Debt is also a structured item which means we have specific terms for the interest that is paid and the due dates for incremental payments or payments in full at the end of a note. Debt presents more risk than equity since we are obligated to repay the debt and it requires us to pay interest. Debt, however, does not require the organization to give up ownership. It also offers a bit of a tax break in the form of interest expense. While paying interest does indeed cost money, interest expense is tax deductible, and thus lowers taxable income and income tax expense.

Equity, on the other hand, involves investors contributing money into the organization in exchange for partial ownership. Thus, it is not required that equity be paid back. It presents less risk since there are no payments nor is there any interest. This also means, however, that there are no tax breaks when equity is used. Dividends are not tax deductible. They are, however, optional. If the organization is not profitable or does not have the cash available, issuing a dividend is not required. The organization has, however, given up partial ownership in exchange for the investment. There are two common types of stock issued to investors: common and preferred. Common stock often has a lower par value and is not guaranteed a dividend. They do have the right to vote at board meetings. Preferred stockholders, on the other hand, generally do not have the right to vote, but are sometimes guaranteed a divided. Preferred stockholders also stand in line in front of the common stockholders should the organization fold and liquidate.

Both debt and equity have advantages and disadvantages. There is no magical “ideal” capital structure that will work for every organization. Each organization is different and must assess its needs, resources, and tolerance for risk before deciding on the balance of debt and equity that will be most effective. Some firms have a more stable cash flow and are able to assume more debt and risk without problem. Other firms, however, may not have the reliable cash flow and may shy away from debt and the risk it poses. The economy and industry in which the organization operates will also play a role in how readily available loans and investors are. New start-up businesses sometimes find it difficult to obtain investors and may rely more on debt to get the organization started. Other new firms may have lots of interest from investors but the owner isn’t willing to give up ownership. Some types of businesses have a history of high failure rates and struggle to find a band willing to take a risk and issue a loan. The attributes of the owner, organization, business, industry, location, and much more all come into play when approaching whether or not to use debt, equity, or both to fund the start-up and growth of an organization.

Whatever the elements are, the key is that management carefully consider all the advantages and disadvantages of debt and equity before choosing the structure that will best suit their needs. Each firm is unique and finding the right balance between debt, equity, or both, takes time and research. What works really well for one organization may very well drive another organization right out of business.

W8 Lecture

Finance – Week 8 Lecture

Summing it all Up

Throughout this course you have learned a wide variety of new skills that you can apply in the world of finance. The wonderful thing about courses of this nature is that the concepts covered can be applied in a wide variety of circumstances. While not every concept covered can be applied in every organization, most of them can. From small start-up companies to large multi-national organizations, the theories of finance apply. You can even apply many of these concepts at home in your own personal finances. Even something as simple as decision whether or not to purchase of a new appliance can benefit from the concepts learned in this course. Our family raises and grows all our own food, so we use a lot of freezer space during certain times of the year. Operating on three old chest-style freezers, our family did not enjoy a low electric bill! Using the time value of money and capital project assessment methods we were able to see what it would cost us to invest our money in just two larger and more energy efficient freezers. We then assessed how long it would take us to recoup the cost of the investment through lower electric bills. It takes a bit of work at first, but once you get used to employing these types of tools they become easy and dare I say fun to use. Take a look at your household, do you have purchasing or investment decisions that can benefit from concepts learned in this course? Do you have a mortgage? How much sooner would it be paid off and how much money in interest would you save over the life of the mortgage if you started sending an extra $25 to apply to the principle each month? An extra $50 each month? You will likely be amazed at how many applications you can find for your new financial skills if you look carefully.

Even if your career path doesn’t include positions such as a financial manager or a financial controller, your new skills can benefit you no matter what title you hold. If your company is working on the capital budgeting process and you have idea for projects, now you know how to properly assess your project to determine if it’s viable or not! You now understand risk as it applies to business, investments, and projects as well. Decisions you make on a daily basis will be more mindful of the risks involved and the returns you hope to gain given the risk you’ve accepted. You can also consider risks in your personal finance. Do you have a 401k or other investment account? How risky are the funds or allocations you have chosen to invest in? How does the level of the risk in your investment align to your risk tolerance as an individual?

Next time you are in the market for a new job and are applying for new positions, consider the financial assessment tools you have learned here. Look at your potential new employer and consider their risk and return, their capital structure, and other financial policies. Does the organization have a reasonable capital structure or are they heavily leveraged, posing a higher risk and potentially lower job security? Perhaps one of my favorite areas of finance is financial statement analysis. Take a look at a few of the organization’s key ratios. What do those ratios tell you about their performance? Is the organization doing well? Stable? Growing? Is this indicative of the type of organization you would hope to work for? You can also use just about any financial statement analysis tool on your own personal finances. Personally, I use trend analysis a lot. Is my income going up or down over time? Is my electric bill going up or down over time? How much are my educational expenses as a percentage of my total income?

We are all delighted that you completed the course. 

You might also consider looking at the debt structure in your personal finances. Divide your total debts by your total assets. How heavily is your household leveraged, or reliant upon debt? While you may not be involved in your organization’s capital structure you can certainly apply the concept and assess your own personal capital structure. How much is your debt costing you? What is your ideal capital structure? These are great questions to ask not only when you are considering a large purchase but also on a regular basis.

The concepts of finance are essential in every business and every household. Though our focus in the course has been on business finance, don’t let your new financial skills get rusty if you are not in a position to immediately apply all your new skills. Look carefully around you at work, in your own business, or in your own personal finances. You’ll find ways to use and apply what you’ve learned in this course all around you.