Finance Topic #1 Responses
jandreg
topic_1_responses.docx· Select and respond to 3 posts listed below. Advance the conversation; provide a real-world application and experiential examples;
· Conceptually discuss your key [most significant] learning insight or take-away from the selected forum topic comments.
· Responses should be a minimum of 150-250 words , supported by at least one reference outside of the textbook, either supporting or refuting the position of the author of the forum topic response or peer response.
Discussion Topic #1: Discounted cash flow
Top of Form
Discounted cash flow (DCF) is one of the methods used to estimate the intrinsic value of a company or an investment opportunity using the concepts of time value of money. Many a times, I wonder how for instance stock analysts come up with their figures. The answer to this can be found in DCF. Although quite complex with many variables and assumptions, DCF offers more flexibility compared to other methods of valuation. The first step to using DCF entails estimating the future cash flows of the company. In estimating the future cash flows, many variables such as the future’s sale growth and the company’s profit margin are taken into consideration (Morningstar, 2013). When estimating the revenue growth rate, a host of factors are considered such as the industry trend, economic data and the company’s competitive advantage over other companies such as market shares (Morningstar, 2013). Cost is a major decisive factor when calculating or estimating profit margin. Increase in the operational costs may lead to contraction of the profit margin most especially when the costs cannot be passed to the customers by increasing the sales price. Therefore, when considering the company’s cost is the first step when estimating the future’s profit margin.
There are actually two models of DCF; equity valuation that is obtained by discounting free cash flow to equity whereas firm valuation on the other hand can be obtained by discounting the expected cash flows to the firm. Free cash flow to equity is the available cash to the equity shareholder of the company. This is the residual cash after all other expenses, interest, principal payments and tax obligations have been accounted for (Anonymous, 2012). Free cash flow to the firm is the residual cash available to the bondholders and the shareholders after meeting all expenses and tax but prior to debt repayment (Anonymous, 2012).
A dollar today is worth more than a dollar in the future and hence the importance to investment. This is the concept of net present value (NPV). Having projected the future cash flows of the company, using appropriate discount rates, the NPV of the cash flows are calculated. When using discounted cash flow, it is critical to use appropriate discount rates i.e. the discount rate must be consistent with the cash flow that is being discounted. Discounting free cash flow to equity requires “cost of equity” as the appropriate discount rate whereas “cost of capital” is the appropriate discount rate for free cash flow to firm (Anonymous, 2012)
The cost of capital or weighted average cost of capital is the sum of the different components of financing used by the company weighted by market value proportions. The components include both debt and equity. In another perspective, cost of capital constitutes investors required rate of return on their investment. Ideally, the more risky a company is, the higher the cost of capital and the more stable a company is, the lower the cost of capital. This means that the future’s cash flow of a risky company are worth less compared to a more stable company in present value terms. Cost of equity is the rate of return required by the equity investors in the company. Unlike other costs that could be easily observed, cost of equity is unobservable and can only be estimated (Anonymous, 2012).
There are three (3) major drawbacks of using DCF. Despite this, DCF is still the most common method used in stock valuation. The most important factor in calculating DCF is estimating the cash flows projection. There are host of problems with this approach. There is uncertainty in cash flow projection and this increases with each year in the forecast (Harman, nd). DCF models often use five (5) and sometimes even 10 years worth of estimates that could be difficult to predict and hence a potential source of error in stock valuation. Analyst might accurately predict the operational cash flows in the current year and the following year and thereafter the ability to predict future projections decreases drastically. Cash flows projection in a given year is mostly based on the results of the preceding years. Therefore, any error in the assumptions in the preceding years will greatly amplify the operation cost variances in the later years of the model and invariably the intrinsic value of a stock or a company (Harman, nd). Again, free cash flow projection involves estimating capital expenditure. Although there are varied numbers of methods to calculate capital expenditure such as fixed asset turnover ratios and percentages of revenue methods, changes or differences in assumptions can affect valuation using DCF. There is high degree of uncertainty associated with calculating capital expenditure that increases with additional years in the model. Management can decide to curb or keep tight rein on the capital expenditure and vice versa. This makes any assumption on capital expenditure very risky.
The growth rate and discount rate assumptions of DCF model seem to be the most contentious model of DCF. Cost of capital and CAPM (capital asset pricing model) are mostly used by analysts as the discount rate. These are merely theoretical and may not applicable in the real world. Likewise, some investors use hurdle rate, which is the minimum required rate of return on an investment or project by the manager or the investor (Harman, nd). Which is the right discount rate to select? Changes in the discount rates will greatly affect the stock valuation. Perpetual growth rate assumption is one of most common assumptions when using growth rate. According to this theorem, companies mature in such a way that there sustainable growth rates are geared towards long-term rate of economic growth. A company’s growth rate seldom remains the same. It varies from one year to the other and from decade to decade. Peradventure, the company matures to the expected growth rate, the growth rate will not remain at the figure but fluctuates.
References
Anonymous (2012). Valuation 101: how to do a discounted cashflow analysis. Retrieved from http://www.stockopedia.com/content/valuation-101-how-to-do-a-discounted-cashflow-analysis-63489/
Harman, B (nd). Top 3 pitfalls of discounted cash flow analysis. Retrieved from http://www.investopedia.com/articles/07/dcf_pitfalls.asp
Morningstar (2013). The discounted cash flow method. Retrieved from http://www.morningstar.co.uk/UK/NEWS/65385/THE-DISCOUNTED-CASH-FLOW-METHOD.ASPX
Bottom of Form
Discussion Topic #2: The Goals of Financial Management
When talking about what the goals of financial management are you would first want to know what a financial manager does in general. To begin financial managers in the long run help the management of a company make sound financial decisions. We can see how they go about making these sound financial decisions with a process of reviewing company financial reports and finding ways to either reduce the company’s costs or by analyzing the current market trends and possibly finding opportunities to expand the company or acquire another company. Financial managers are also responsible for supervising employees that are in charge of the financial reporting and budgeting by making sure that everything meets legal requirements. Lastly, financial managers are responsible for preparing the statements of financial status, reports of the business activity, and the forecasts of the company (Bureau of Labor Statistics, 2014).
A financial manager is a highly important individual within the business world. For a business to grow successfully it depends on the operations and strategies being financially beneficial for the company. This is one of the many overall goals of a financial manager. However, to pursue this one must have a sound financial management team that will put the best interest of the company first and try to help the company grow by looking at the sales, inventory valuation, capital expansion, financial reporting, purchases, and profit distribution. Once the financial management team looks at all of this they can come up with ways to plan, direct, organize, monitor and control the company’s current and future financial resources and the events of the business. Now with all of this in mind, we can see that one of the goals of the financial management team is to maximize the original value from insufficient financial resources, which depends on both short-term and long-term activities of the company (Cole-Ingait, P., n.d.).
There are three decisions that the financial management team has to make that can greatly affect a company financially. The first decision that the financial management team would have to look at would be the Investment Decision which is where the financial manager has to decide where and how much to invest into a fund. The second decision that the financial management team would have to look at would be the Financing Decision which is where the financial manager has to decide where and how much to raise the in funds. The third decision that the financial management team would have to look at would be the Dividend Decision which is where the financial manager has to decide how much to pay in dividends and how much to keep for upcoming or future expansions. The financial manager would have to keep in mind what the clear objective of the company is trying to achieve and work towards that financial goal. All companies worldwide are looking for ways of making a profit and expanding themselves to make more profit (Business Studies, n.d.). In my personal opinion I would have to agree that all companies want to make the most amount of profit possible.
There are two ways that companies can maximize their prosperity. The first is by Profit Maximization. Profit Maximization is a well-known goal that all companies worldwide want to make the maximum profits possibly attainable. If a business has this type of reputation of attaining such max profits it shows how sound the company is and it reassures the economic interests of this particular company. These economic interests are the shareholders, creditors, and employees who are directly or indirectly connected to the company. The owners of the company are the shareholders that have invested their funds within the company and intend to get a higher dividend on their investment. The second is by Wealth Maximization. Wealth Maximization, also known as Value Maximization or Net Present Worth Maximization, is the value of an asset should be viewed in terms of benefits it can produce over the cost of capital investment (Business Studies, n.d.).
The goals of the financial management team should be to provide monthly, quarterly and annual financial information to stakeholders both internally and externally. Financial reports are highly important as they inform on the stability of the company and allow the government to examine tax obligations of the company (Cole-Ingait, P., n.d.).
Another importance of financial management team is risk management. Risk management can be used to reveal the weaknesses of the company. It can be used to help supply the most appropriate contingency measure for operational and strategic risks. This aspect is one of the most important aspects of financial management because it helps the business owners and their employees reduce or even abolish the risks of theft, fraud, and embezzlement alongside of both the internal and external auditing processes (Cole-Ingait, P., n.d.). Now the best way to ensure that there are no illegal financial activities is to have the financial management team apply internal controls over the financial resources. This way the financial management team can investigate the financial transactions to ensure that both the owners and employees are not violating any financial principles or undermining transparencies (Cole-Ingait, P., n.d.). “Failure to exert internal financial controls could spell unprecedented consequences for the business, as was the case of financial reporting scandals by Enron, Tyco and WorldCom in the early 2000s (Jickling, 2002).”
A great example of why financial management and a financial management team are so important would have to be the fall of Enron. Back in the 1990's the reported annual revenue was under ten billion dollars which grew to one hundred and one billion dollars in the year 2000, which ranked Enron in seventh on the Fortune 500. However, the company was using accounting techniques involved in unconsolidated partnerships and special purpose entities to disguise a significant loss from showing up on the financial statements and to hide the gravity of its indebtedness. These questionable accounting tactics brought about the fall of Enron when revealed, almost all of the profits reported since 2000 disappeared (Jickling, 2002).
In conclusion, the goal of financial management and a financial management team is to achieve the max amount of profits by the assessments of financial quantification. Now the purpose of a financial manager is to notice the performance of the company by reviewing all the data and making a clear judgment or plan on what the next step will be. The use of managerial accounting and corporate finance are what make up managerial finance. Financial management is a way for a company to manage their money and use it in a more productive fashion. Financial management is not only important for companies, but for every individual and their specific financial needs just like any company (EconomyWatch, 2010).
References
Bureau of Labor Statistics. (2014). Financial Managers. Retrieved from http://www.bls.gov/ooh/management/financial-managers.htm#tab-2
Business Studies. (n.d.). What are the goals of Financial Management? Retrieved from http://www.publishyourarticles.net/knowledge-hub/business-studies/goals-of-financial-management.html
Cole-Ingait, P. (n.d.). Primary Goals of Financial Management. Retrieved from http://smallbusiness.chron.com/primary-goals-financial-management-69952.html
EconomyWatch. (2010). Financial Management. Retrieved from http://www.economywatch.com/finance/financial-management.html
Jickling, M. (2002). The Enron Collapse: An Overview of Financial Issues. Retrieved from http://fpc.state.gov/documents/organization/9267.pdf
Discussion Topic #3: Balance sheet
All businesses on the globe issues different type of financial statements to their stockholders in order to review their form's operational and financial performance for the specific period of time. Balance Sheet in one of the important financial statement used by accountants and business owners along with other statements as Income Statement, cash flow statement, and stock holders' equity statement. It gives us written report of any changes took place in assets, earning, and dividend during current period compare to previous years. "The balance sheet may be thought of as a snap shot of firm's financial position at a particular time" (Ehrhardt 106). Most companies report their balance sheet on the last day of the given period but the snapshot actually changes daily due to inventories bought and sold, fixed assets are sold or added, or liabilities goes up or down with time. It means that balance sheet of the same company will show different balances at different time.
For example, the amounts reported on a balance sheet dated December 31, 2013 reflect that instant when all the transactions through December 31have been recorded. The balance sheet as the name describes it balances the assets versus claims against assets, i.e. assets are shown on left side and liabilities and equities on the right side of the equation. The left side of balance sheet lists assets i.e. things the company owns and listed in order of liquidity or actual time required to convert it into actual cash in the fair market value. The right side of it is a list of claims that different groups have against the company's assets. They all are various type of claims listed in order in which they must be paid. For an example suppliers may have "account payable" claim which must be paid within 30 days, other claim is "notes payable" that must be paid within 90 days to the banks, and stockholder's claim comes last that are not due for 20 years or more. Their claim represents ownership or equity and need never be "paid off" and they may receive payment only after all other claimant has been paid. "The amounts shown on the balance sheets are called book values since they are based on the amounts recorded by bookkeepers when assets are purchased or liabilities are issued.
Assets
Cash, short-term investment, accounts receivable, prepaid insurance and inventories are considered as current asset, because businesses are going to convert them into cash within a year. All assets are stated in dollars and cash is actual money that is available to spend any time. There are market securities called "cash equivalent" which are included along with cash because these securities can be converted quickly into cash at the price close to their book value.
When the company makes such sale to the customer which has not been paid immediately, then the customer has an obligation toward company as "account receivable".
Inventories raw material, work in process, and finished goods for sale are part of business assets which are shown in dollars. While analyzing the balance sheet we must find out what inventory system company is using to determine the inventory value because inventory valuation have significant effect on financial statements. Some companies use FIFO i.e. first in fist out or LIFO i.e. last in first out. If company uses FIFO at the time of inflation the company's balance sheet will reflect higher reported profit, higher inventory value and lower cost of goods sold in the income statement or otherwise if it uses LIFO.
The cost of long-term assets such as factory, plant equipment are spread over the asset's useful life rather than treating the purchase cost as an expense in the purchase year. The amount of purchase cost charged per year is called as depreciation expense for that year. Some companies report the total cost of long term asset as "gross plant and equipment" and some companies report the total amount of depreciation charged on those assets called "accumulated depreciation", and some companies report net plant and equipment, which is gross plant equipment less accumulated depreciation.
Liabilities and Equities
The current liabilities on balance sheet are accounts payable, notes payable, and accruals because they are expected to be paid in one year period. Account payable occurs when companies buys supplies but doesn't pay immediately rather takes obligation to pay in future. On the other side if company takes out loan from bank that must be paid in one year period is called notes payable. And accruals are accumulated with time when company doesn't pay its taxes or employees wages on daily basis. Long-term bonds are claims which can be called liabilities because they are held by other than stakeholders of the company.
There are preferred stock and acts as a cross between common stock and debt because preferred stock ranks below debt but above common stock in the case company applies for bankruptcy. Also preferred stock holders do not get benefit if its earning grows because their dividend is fixed. When company sells share of stock the proceeds are recorded in common stock account and retained earnings are the accumulative amount of earning that has been not paid out as dividend. The sum of these two i.e. common stock and retained earnings is called "common equity". "If company's asset could actually be sold at their book value , and if the liabilities and preferred stock were actually worth their book values, then company could sell its assets, payoff its liabilities and preferred stock, and the remaining cash would belong to common stockholders and there for common equity is called net worth which is assets net of the liabilities" (Ehrhardt 106).
The balance sheet represent two different aspects of the same entity, the totals must always be identical. Any change in the amount for one item must always be accompanied by an equal balance sheet changes in some other item. For example, if the company pays $500 to one of its creditors, the cash balance will go down by $500, and the balance in accounts payable will go down by the same amount.
Balance sheet is extremely useful information for current investors, potential investors, company management, suppliers, customers, competitors, government agencies, and labor unions. As a creditor I will look for hidden facts through balance sheet, then determine whether or not a company qualifies for loans.
References
Block, B.S. & Hirt, A. G. (eds.). (2008). Foundations Of: Financial Management. New York, NY: Mcgraw-Hill/Irwin.
Ehrhardt, C. M. & Brigham, F. E. (Eds.). (2009). Corporate Finance: A Focused Approach. Mason, OH: South-Western Cengage Learning.
Lowdown: The balance sheet. (2008). Investors Chronicle, Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/236323793?accountid=40195
MEET THE BALANCE SHEET. (1999, Jan 28). Palm Beach Post Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/322143482?accountid=40195
Discussion Topic #4: The Goal of Financial Management
In order to understand the goal of financial management, we first have to define what financial management is. According to Cole-Ingait, “Financial management is a process that enables a business to plan, direct, organizes, monitor and control its current and future financial resources and events” (Cole-Ingait, 2015). By management of money, it includes how the spending, the budgeting and raising of money by each organization are handled. With this we see how vital this branch of business is to an organization because without money, an organization does not exist and if it does exist, money has to be constantly raised to help with the maintenance and success of the company or organization. Also, Das states that the financial management teams in any organization have three important decisions to make and they include, investment decisions (Where to invest fund and in what amount), financing decision (from where to raise funds and in what amount) and dividend (how much to pay dividend and how much to retain for future expansion). In order to meet the goals these decisions have to been taken and looked at effectively in order to carry out the goals of the team.
Now that the definition has been established, we will look at the goals of financial management in an organization. Organizations cannot thrive without investors and the investors have to make sure that their investments will yield great profits in return. With this said, one goal is Profit Maximization. “The shareholders, the owners of the business, invest their funds in the business with the hope of getting higher dividend on their investment” (Das, 2014). In addition to making the investors happy, when a company is able to maximize their profits, they look good to the public and attract other investors and shareholders as well leading to the longevity of the company. The financial management team needs to make sound monetary decisions in order to accomplish this task of profit maximization.
With profit maximization, there are three important profit margin ratios used by the financial management teams to show in the books. They are:
· Gross Profit Margin: this tells us the profit a company makes on its cost of sales or cost of goods sold (Investopedia, 2015).
Gross profit margin = (sales –cost of Goods sold)/Sales
By doing the gross profit margin, a company is able to show how they generate their profit based on the sales made and cost allocated to their goods. The higher the gross profit margin, the more profit generated by a company.
· Operating Profit Margin: Operating Profit Margin = EBIT/Sales; where EBIT is earnings before interest and taxes. The operating profit margin outlines how successful in creating profits for the company by how they manage their operational costs. Operating costs include costs of materials, labor put in making a product, administration and selling costs. Also, higher operating profit margin shows that a company has better control on their spending habits, knowing where to cut costs and getting profit on their returns at the end of the year.
· Net Profit Margin: Net Profit Margins = Net Profits after Taxes/ Sales
Net profit margins are those generated from all phases of a business, including taxes (Investopedia, 2015). The importance of Net profit margins comes into play during hard times. For example, with the financial hardship of 2008 when the economy was down, the companies that had higher net profit margins where ones that survived.
These aspects of maximizing profit are things that shareholders and investors use to assess any company or organization before they put their money into the company.
Secondly, another goal is that of Wealth of Maximization. “Wealth maximization aka value maximization is when the value of an asset is viewed in terms of benefits it can produce over the cost of capital investment” (Das, 2015). It is imperative that research and numbers are calculated before purchasing an asset to make sure that money won’t be lost as a result of the purchase. Also knowing when to advise their shareholders to sell their shares in order to acquire a substantial amount of profit is required. With a sound financial management team, such mistakes won’t be made which might lead to the downfall of the company.
Another goal is that of Minimizing costs for a company. In as much as maximizing profit and market shares are priority for the financial team, it is also imperative that a company minimizes the operational costs and expenses in order to be profitable. “By identifying and evaluating all of the business’s expenses, management can determine whether those costs are reasonable and affordable” (Investopedia, 2015). Any financial management team that are able to master the art of knowing when and where to cut costs for the company or organization will generate great profits. Such minimization range from finding cheaper means for production or procurement of materials used to controlling phone, internet and utility bills
Furthermore, managing risks is one of the numerous goals achieved by the financial management team. “Insurance and automated financial management systems help business owners and employees to prevent or reduce the risks from fraud, theft and embezzlement” (Cole- Ingait, 2015). Risk management reduces unnecessary money being wasted by the company and helps increase the profit margins of any company or organization.
REFERENCES
Cole-Ingait, P. (2015). Primary Goals of Financial Management. Retrieved January 6, 2015
From http://smallbusiness.chron.com/primary-goals-financial-management-69952.html
Das, B. (2015). What are the goals of Financial Managemtent? Retrieved January 6, 2015
From http://www.publishyourarticles.net/knowledge-hub/business-studies/goals-of-financial-management.html
Investopedia (2015). Complete Guide To Corporate Finance: Goals Of Financial Management.
Retrieved January 6, 2015 from
http://www.investopedia.com/walkthrough/corporate-finance/1/goals-financial-management.aspx
Discussion Topic #5: Goals of Financial Management
Top of Form
There are several different goals that can be discussed when it comes to successfully managing your finances. When an individual is looking to successfully compile a financial portfolio, often times the main goal for this person is to maximize their wealth and the short-term, and also maximize their wealth for the long-term. Often times, financial management see if you find a way in which a patient can invest money and certain fun, whether by stocks and bonds or other forms of investment, with an overall goal to provide themselves with long-term income extending toward the future. These firms will seek to call poly portfolio consisting of successful investment, which will turn a profit for the customer over the long-term. (Farinde, 2014)
In terms of a company, the same concept applies. A company will feed to manage their finances in a way so that they may be able to sustain their business over the long-term. The money that they make from their business, is very important and order to sustain business, dust they need a way to properly and sure that they will have this income over the long-term. The bottom line of this is simple: earn money through the business by improving their bottom line, and staying in the black as some referred to it as, and also be able to save this and come for future business endeavors at the end of the day, the concept is rather simple and that companies will try to operate under a net profit, overall their business will not be able to remain over the long term.
Successful financial management means taking hard-earned money, and investing it and a manner in which more money can be accrued with a goal of optimizing maximum long-term profits. To accomplish this, financial management advisers often use mathematical equation, which can help project be possible gain or loss of funds for a company over the long-term. By using these specific mathematics equations, the figures that they come up with will help to provide a forecast by with these companies can take and use this data before making important business decision that will affect your company's prognosis of the long-term.
The first of these equations that a company may use can be referred to as the gross profit margin. This figure can be calculated by taking the total amount of sales that a company has, and subtracting the total cost that a company spent producing the sold goods. (Investor Answers, 2014) This number is then divided by the amount of revenue that the company made in sale in order to come up with a figure referred to as the gross profit margin. The key concept behind this particular equation is efficiency. By using this equation, a company will be able to tell how efficiently they are producing and selling the good which by they do business. After a company receives this data and make the proper calculations, they can then go back and tweak their current business model in order to decrease costs of labor, and production of the good with their selling in order to maximize their overall profit efficiency.
The next equation that can be used in order to successfully manage a company's finances is called the operating profit margin this equation assesses the company's earnings before interest and taxes are applied, and dividing it by the revenue that they generated in sales. By operating at a high profit, a company may achieve this by having good control over the cost themselves, however they may also achieve a high operating profit if sales are simply that the sales of a particular good the company is selling are increasing at a rate that is faster then the increasing costs that the company must pay in order to produce that particular good. By analyzing these numbers, it allows a company to trend a good they are selling, providing a live-action look into the evolution and changes that are taking place in sales and the selling price.
By taking this equation a step further, we can now analyze the net profit margin of a business. This figure uses the earnings including interest and taxes, by coming up with this figure we can calculate the total net profit after taxes and interest by using all of the after mentioned variables, coming up with the net profit margin provides us with the most accurate assessment of how well a manager is running a business at a given time. Furthermore, by using each of the three after mentioned equations, a company can come up with revenues generated at various stages both before and after taxes, so that they can pinpoint where exactly they are operating at a profit or a loss, and make the appropriate changes in order to maximize the long-term generate revenue by the business.
Another way that a company may look to operate their financial management is by minimizing all of the costs of their spending on the production of a good. By analyzing the amount they're spending to produce a good, and using the financial equations mentioned before, a company can then try to seek new endeavors by which they can decrease the production cost for a particular good. In America, this can often be shown by how companies outsource jobs by hiring employees to produce a particular good which will except earning less salary than those house here in America, the company will decrease their overall expenditure when it comes to the production have a good, and when plugging the figure into the equation, will result in higher figures in terms of each of the before describe equations. (Way, 2015)
At the end of the day, there are several ways to achieve successful financial management. This is such an important concept to understand, and although it is complex, if a company takes the time to learn and analyze their own finances, or go through the trouble of hiring someone to do this for them, they will be setting themselves up for success in the future. There are many methods by which companies can increase their long-term profits and decrease their long-term costs, however they all operate under the same goal, and that is to operate at a profit and increase their long-term net income, whether it is by increasing the maximize profits and selling the goods for the maximal value, or decreasing the overall cost of producing these goods, both will result in a better financial prognosis for the company over the long-term. By hiring the right people to manage a company's finances, it is probably the wisest investment a business can make in order to look out for the future of their company.
Farinde, Abimbola. 2014. Goals of Financial Management: Value Maximization. http://aameda.org/p/bl/et/blogid=63&blogaid=245
Investor Answers. 2015. Gross Profit Margin. http://www.investinganswers.com/financial-dictionary/ratio-analysis/gross-profit-margin-2076
Way, Jay. 2015 What Steps Do Companies Take to Maximize Profit or Minimize Loss. http://smallbusiness.chron.com/steps-companies-maximize-profit-minimize-loss-41526.html
Discussion Topic #6: The Balance Sheet
Introduction
Every businessman prepares financial statements to record the financial transactions and events of the business and to judge the performance of the business. Financial statements include income statement, balance sheet, statement of retained earnings and cash flow statement. This paper reveals information on balance sheet.
Balance sheet is one of the important financial statements which can be used by both external and internal parties of the business. It is the statement which shows the financial position of the company at a particular point of time or at specified date. For instance, balance sheet as on 31st March shows that all the transactions till date are recorded and the ultimate position is shown in the statement. This statement is also known as “Statement of Financial Position”. Generally this statement is prepared on monthly, quarterly, semi-annually or annually basis; depends upon the need of the organization. The parties who would be interested in the balance sheet include current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions (Avekamp, n. d.). For instance, a company is in need of a loan, before sanctioning loan to a company, bank manager will assess the financial position of the company by analyzing the balance sheet. In a nutshell, we can say that it is the mirror of the organization which displays the position of the organization.
Balance sheet plays an important role in every organization and helps in various decisions making. By depicting financial position, it enable to plan future activities on the other hand by showing amount of debt, it alerts organization. In fact, the external parties like Underwriter also use the information of the balance to know the financial ability of the business.
Components of Balance Sheet
The balance sheet is an accountant’s snapshot of a firm’s accounting value on a particular date, as though the firm stood momentarily still (Ross, Westerfield and Jaffe, 2013). Basically there are three major components of balance sheet; they are described as under:
Assets
These are resources of the organization which are used for the production/sale of goods and services. In other words, we can the sum total of things owned by the business are considered under assets only. Assets can be classified into currents assets, fixed assets investments, intangible and others.
Current assets: Those assets which can convertible into cash within a year of time. It represents liquidity of the company and is actively used for the daily operations of the business. Cash, bank balance, stock, prepaid expenses are some of the examples of current assets.
Fixed or Long term assets: The assets which are owned by the company and used for the production or sale of goods and services. The examples of fixed assets can be land, building, plant and machinery, equipments and more. A fixed asset not only helps organization in revenue generation but also enables management to perform its duties in a better way.
Investment: It can be categorized into two types- short term investments and long term investment. If the investments are hold for less than one year by the company, then it will be considered as short-term investments. On the other hand, if investments are hold more than one year, then it will be taken as long term investments. Investment in bonds, stocks, funds held for construction and more are some of the examples of long-term investments.
Intangible assets: These assets do not have any physical form nor can be seen by eyes. These can be only be felt by the people. Trademark, copyright, patents, goodwill are some of the examples of intangible assets.
Others: The asset which does not considered in current, fixed, investment or intangible are taken under this head. Deferred revenue expenditure, bond issue cost can be the example of “Other assets”.
Liabilities
The things which are not owned by the company of have to pay back after a period of time are considered under the head “Liabilities”. In other words, we can say it is sum total of all the things which a company owes to others. It can be classified into- Long term liabilities, secured loans, unsecured loans, current liabilities and contingent liabilities.
Long-term liabilities: The obligations which are due for more than a year are called as long term liabilities. The example can be 5 years loan, debentures, deferred tax liability and more.
Current Liabilities: The amounts which are to be paid within a year of time are considered as current liabilities. In those rare cases where the operating cycle of a business is longer than one year, a current liability is defined as being payable within the term of the operating cycle (Accounting Tools, 2015). Accrued expenses, bills payable and more are some of the examples of current liabilities.
Contingent Liabilities: The liability which depends upon the happening or non-happening of future event is known as contingent liabilities. For instance, a parent company decided to pay a sum of money to its holding company in case the company becomes insolvent. Here, the future event is insolvency and contingent liability is the promised amount.
Owner’s Equity
It is also called as “Book value of the assets”. Generally, owner’s equity has credit balance. It can be derived by deducting total liabilities from total assets.. In the Equation form, it can be represented as:
Owner’s Equity = Total Assets- Total Liabilities
For instance, the total assets of the companies are $100 million and total liabilities are $70 million, then owner’s equity will be 30 million that is $100 million minus $ 70 million. In sole proprietorship, this term is indicated by the word “Capital” but in case of other corporations like company, it has number of classifications such as common stock, preferred stock, retained earnings, reserves and more.
All in all, we can say that balance sheet is used to assess the value of the business at any given point. It helps you keep track of finances, and ensure that your liabilities don't outweigh your assets a- which helps keep you out of serious debt and financial trouble (Smarta, n. d.).
References
Accounting Tools (2015). Current liability. Retrieved from
http://www.accountingtools.com/current-liability
Avekamp, H. (n. d.). Balance sheet. Retrieved from Accounting Coach
http://www.accountingcoach.com/balance-sheet/explanation
Ross, S.A., Westerfield, W.R. & Jaffe, J (2013). Corporate Finance (10th Edition) New York McGraw- Hill/ Irwin.
Smarta (n. d.). Understand a balance sheet. Retrieved from
http://www.smarta.com/advice/accounting-and-tax/bookkeeping/understand-a-balance-sheet/
Discussion Topic #7: Discounted cash flow valuation
Discounted cash flow valuation is an important concept to understand when completing financial analysis. This method takes into account not along the value of the firm but also the value of future assets to the firm when projecting if a business has a positive long-term projection for value. The first item to understand before looking into discounted cash flow though is what is a cash flow report. The statement of cash flow reports cash generated during a set accounting period. This can be any amount of time that is set by the company. It is typically broken down into four main categories. Operating activities, investing activities, financing activities and supplemental information. Operating activities takes items from the income statement from the accrual basis of accounting to cash. It can include things like depreciation expense and increase/decrease of accounts receivable. Investing reports the purchase of long-term investments and property such as sale of equipment. On the other hand financial activities cover issuance of company's own bonds and stocks such as cash used to cover long term not payable and issuance of common stock. Lastly supplemental covers items that did not involve cash such as taxes.
As referenced by (Wild, 2011) the purpose of the cash flow statement is to show the overall health of the company. Ideally a company should have a higher cash flow than net income as a reflection of good health. Some investors refer to this as being "High quality" This can also translate to being of good value for investors to invest in. This is because at the end of the day cash is not theoretical as credit may be, it is a hard fact how much cash a company has or does not have. Outside of identifying the health of the company and if it is good to invest in it also can prove helpful on finding missed items that may not have been reported on the income statement. The cash flow statement is a key component in the valuation process and it is imperative that it is done correctly. When and initial cash flow statement is done incorrectly it then becomes almost impossible to create a fair and correct valuation for the company.
This is where the concept of discounted cash flow valuation starts to come into play. There are many methods of company valuation all of which have their time and place depending on the type of business that is being valued at a given time. For the purpose of this paper though I have chosen to discuses the use of Discounted Cash Flow. Vorster, 2007 explained that DCF can be used to determine if an investment opportunity is a positive business decision for a company. The discounted cash value plays off of the concept that a dollar in hand is worth more than a dollar arising from a future transaction. This is due to the ability for the dollar in hand to gain interest, be invested and be used. The DCF uses future free cash projections and discounts them to arrive at a present value, which is used in order to evaluate the potential for an investment opportunity. When the company value arrived at through DCF is higher than the current cost of the investment in question, the opportunity is then viewed as a good one for the company. As a whole DCF looks at equity value and firm value and makes a projection based off the results of this analysis. The value of the firm is found by discounting expected cash flow to the firm, which is the cash flow after meeting all tax and operation expenses. It does not take into account though debt payments. The final part to the valuation is choosing the correct weighting to find market values. The final portion to this is finding the equity value. The equity value is found in much a similar way except for the fact that it takes in cash flow value to the firm and takes into consideration items such as principal payments and the overall cost of having equity in general for a company.
As addressed though by Dial, 2012 the discounted cash flow valuation model does have problems if not used correctly. Dial, 2012 refers to these as the seven major disconnects a few of which will be addressed here. The most common one is the rate of return and projected cash flows. In this problem the analyst often mismatches the cash flow used and the cost of capital. When this happens the original forecast for the company becomes higher in terms of earning than the updated forecast for the future of the company. This can cause the original forecast to appear disproportionably risky, when in reality it is not at all. The second major problem is incorrect adjustment of terminal year capital needs. When this happens the analyst uses the previous years cash flow in the long-term growth rate formula. If this cash flow does not match the current cash flow then it can cause incorrect percentages for the projected growth of the company. The third and final disconnect that I chose to mention I this paper is the existence of long-lived assets. Often when taking into account the profitability of a company it is not taken into consideration the long lived assets that the company has such as buildings and equipment. Or often these assets are taken into the equation but the depreciate value is miss calculated. When this happens it creates an incorrect value for the company that is put into the DCF formula, making the company look less valuable than it actually is.
Taking all of the factors about cash flow statements and discounted cash valuation into consideration there are many factors that must be explored when a company is being valued. The company also has to look at all of the different methods available when deciding which is the best method for the type of business that the company is involved in.
References:
Dial, R., & Totagamuwa, S. (2012). 7 frequent disconnects by discounted cash flow method users. Valuation Strategies, 16(2), 32-37. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/1266004976?accountid=40195
Vorster, M. (2007). Discounted cash flow, explained. Construction Equipment, 110(6), 77-78. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/206698611?accountid=40195
Wild, J., & Shaw, K. (2011). Fundamental accounting principles (20th ed.). New York: McGraw-Hill Irwin.
Bottom of Form
