Finance 101

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Finance 101

• Interactive Presentation, please ask questions
  at any time
• Discuss types of Financial Statements

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Types of Financial Statements

• A business financial performance is measured
  using three related financial statements
• Balance Sheet
• Income Statement
• Statement of Cash Flow

We will discuss all three!
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Balance Sheet
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Balance Sheet

• The balance sheet (also called the Statement of
  Financial Position) reports the assets,
  liabilities, and equity of a business at a given
  point in time.
• Assets The things of value that a company owns.
• Liabilities (Creditors) Stockholders Equity
  (Owners/Shareholders) Claims against an
  entitys assets.

Assets Liabilities Stockholders Equity
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Balance Sheet Format

• Assets
• Current assets
• Cash
• Marketable securities
• Accounts and notes receivable
• Inventories
• Prepaid expenses
• Property, plant equipment
• Less accumulated depreciation
• Other assets
• Total assets
• Liabilities
• Current liabilities
• Accounts payable
• Short term borrowing
• Income taxes payable
• Other accrued current liabilities
• Long term borrowing
• Deferred taxes

Assets
Liabilities
Stockholders Equity
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Balance Sheet - Definitions

• Assets - Resources owned or controlled by the
  company. They include monetary assets (cash,
  marketable securities and receivables) and
  non-monetary assets (inventories, prepaid
  expenses and equipment).
• Current Assets - Cash plus those assets which are
  expected to be converted to cash or consumed
  during the coming year.
• Liabilities - Outsider claims against company
  resources. Examples include accounts payable
  and bank loans.
• Current liabilities - Liabilities that mature
  within the coming fiscal year.
• Net Working capital - current assets less current
  liabilities.
• Stockholders equity - The contributed capital
  plus any other increments in capital from
  profitable operations.
• Retained earnings - Net earnings that remain in
  the business (as part of stockholders equity)
  after the payment of dividends

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Working Capital Example
WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE WORKING CAPITAL ACCOUNTS RECEIVABLE INVENTORIES - ACCOUNTS PAYABLE
2009 2010 Delta
Accounts Receivable Accounts Receivable 200,000 150,000 -50,000 Positive Positive
Inventories Inventories 100,000 80,000 -20,000 Positive Positive
Accounts Payable Accounts Payable 100,000 80,000 -20,000 Negative Negative
Working Capital Working Capital 200,000 150,000 -50,000 Positive Positive
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Operating Performance Ratios
Performance ratios help put our financial data
into perspective

• Use performance ratios to
• review for trends
• compare to competitors, industry benchmarks and
  business unit objectives

• Liabilities
• Days payable outstanding (DPO)
• Liquidity ratios
• Debt ratio

• Assets
• Days Sales Outstanding (DSO)
• Inventory Days Supply (IDS)
• Working Capital Turnover
• Permanent Investment Turnover
• Return on Net Assets

• Equity
• Return on Equity

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Balance Sheet Strength

• What does this mean?
• Means a company generates enough cash to service
  its debt, fund operations, pay a dividend to
  shareholders and invest for the future.
• Gives a company staying power to weather
  difficult economic cycles.

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Income Statement
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Income Statement

• Revenues (Sales and other income) - The amounts
  invoiced to outside customers for the sale of
  products or services less returns, allowances and
  discounts and non-sales income such as
  royalties, gain/loss on asset sales, interest
  income
• Expenses - An outflow or other using up of assets
  -- or incurring of liabilities -- from the
  rendering of goods or services
• Variable Costs - A cost which is constant per
  unit, but which varies in total directly and
  proportionately with production or sales volume.
• Fixed Costs - A cost which does not vary
  significantly with changes in volume within a
  relevant time period (one year) and range of
  activity.

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Accrual Accounting
Revenues and expenses are recorded in the period
in which they are earned and incurred, whether or
not such transactions have been finally settled
by the receipt or payment of cash or its
equivalent .
Two Ways to Account For It
What is Revenue? Checks Received Revenue is
recorded when it is earned
What is Expense? Checks Written Cost of raw
materials is expensed when product is sold, not
when materials are purchased Cost of buildings
and equipment is expensed over time as facilities
are utilized (depreciated), not when initially
paid for Other expenses recorded when the
liability is incurred
(1) Cash System (2) Accrual System
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Financial Metrics

• Sales Growth Rate
• Variable Contribution Margin (Sales revenue
  less variable costs) / Sales Revenue
• Must be sufficient to cover fixed costs plus
  provide a profit
• ATOI Margin Percent ATOI / Sales

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Cash Flow
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Why Cash Flow?

• Cash is a strategic resource used to pay company
  obligations and a return to shareholders
• Purchases
• Salaries
• Taxes
• Dividends
• Earnings is one element of cash flow, but it
  includes depreciation which is a non-cash charge
• Cash may come in or go out for reasons not
  reflected on the income statement

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Cash Flow Our Bank Account

• We begin with earnings
• We add-back the non-cash cost of depreciation
• We account for changes in working capital - we
  can either use cash to increase working capital
  or recover cash by decreasing working capital.
  Therefore it is the working capital changes that
  impact cash flow
• We account for cash spent on new permanent
  investment capital expenditures
• We account for cash required for financing costs
  corporate dividends and interest

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What Cash Flow Tells Us

• Cash flow could be either positive or negative,
  depending on the mission of the business.
• Cash flow information tells us how much financing
  is required to ensure operations can continue.
• Positive cash flow indicates that funds may be
  available for future investment.

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Cash Flow And The Product Life Cycle

• Growth businesses
• Negative cash flow due to high capital
  expenditures
• Mature
• Positive cash flow earnings plus depreciation
  exceed capital expenditures
• Declining
• Positive to negative cash flow earnings are not
  growing and capital expenditures are small - is
  it sustainable?

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Sample Cash Flow Statement

• ATOI
• Depreciation Amortization
• Working Capital (Increase) Decrease
• CASH FLOW FROM OPERATIONS
• Capital Expenditures
• FREE CASH FLOW

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Investment Analysis Concepts
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Investment Analysis Terms
Net Present Value (NPV) - The difference between
the present value of cash inflows and the present
value of cash outflows. NPV is used to analyze
the profitability of an investment or
project. Discounted cash flow (DCF) analysis
Used to evaluate investment opportunities by
projecting free cash flow and then discounting
(using cost of capital) to arrive at a present
value. Terminal Value (TV) - used to determine
the value of a project for all the years beyond
the reliable discount cash flow projections..
IRR (Internal Rate of Return) - The discount
rate used in evaluating investment opportunities
which makes the net present value of all cash
flows from a particular project equal to zero.
 CAGR Compounded Annual Growth Rate
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Cost of Capital (COC)

• Weighted average cost of financing from all
  sources - debt (outside borrowing) and equity
  (shareholders)
• Example
• Equity 13.5 x 85 11.475
• Debt 4.5 x 15 .675
• COC (Wt. Avg.) 12.150
• Discounting at the COC allows us to compare the
  value of future cash flows

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Decision Making Metrics
Net Present Value - the difference between
discounted cash inflows outflows

• Highlights -
• Considers time value
• Analyzes investments entire life
• Reflects shareholder value added
• Impacted by size of investment

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Decision Making Metrics

• Discounted Payback Period - time it takes to
  recoup an investments cost - using discounted
  cash flow
• Highlights -
• Easy to compute - discounted flows
• Understandable
• Measure of time funds are at risk
• Does not consider benefits past the payback
  period

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Decision Making Metrics
Internal Rate of Return - The true return of an
investment - the DR where NPV Zero

• Represents the percentage yield of an investment
• The discount rate which equates the present value
  of cash inflows with the present value of
  outflows NPV zero
• The after-tax interest rate an investor could pay
  for funds and breakeven
• Allows comparison without bias of size
• Does not account for risk
• Biased towards investment with quick payback
• Doesnt account for size

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Decision Making Metrics

• Profitability Index (PI) - a ratio of discounted
  cash inflows and outflows.

PI DCI/DCO where DCI the sum of the
disc. cash inflows DCO the sum
of the disc. cash outflows
Values of PI are positive! PI gt 1, then
investments return gt COC PI lt 1, then
investments return lt COC PI 1, then
investments return COC

• Productivity measure
• More reliable than IRR
• Good tool for ranking projects

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Determining Cash Flows for NPV

• Inflows
• Sales revenue
• Decrease in working capital

• Outflows
• COGP
• Marketing and distribution expense
• RD expense
• General admin expense
• Capital
• Increase in working capital

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FINANCIAL VALUATION FINANCIAL VALUATION FINANCIAL VALUATION NPV   855
Marketing Project Marketing Project T.V. of NPV T.V. of NPV 51.3
(000's)
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Term. Value
Sales Sales
Volume (MT) - 100 105 110 116 139 167 200 240 288
Selling Prices (/kg) Selling Prices (/kg) - 4.00 4.00 4.00 4.20 4.20 4.20 4.20 4.20 4.20
Sales Revenue Sales Revenue - 400 420 441 486 583 700 840 1,008 1,210

COGS COGS
COGP(/kg) - 2.00 2.00 2.00 2.18 2.18 2.18 2.18 2.18 2.18
COGP - 200 210 221 253 303 364 437 524 629
COGS COGS - 200 210 221 253 303 364 437 524 629

Gross Profit Gross Profit - 200 210 221 233 280 336 403 484 581
of Sales 50 50 50 48 48 48 48 48 48

SGA SGA 350 200 100 50 50 50 50 50 50 50

PTOI PTOI (350) - 110 171 183 230 286 353 434 531
Income Taxes Income Taxes (133) - 42 65 70 87 109 134 165 202
ATOI ATOI (217) - 68 106 114 143 177 219 269 329 1,371
of Sales 0 16 24 23 24 25 26 27 27

Cash Inflow Cash Inflow (217) - 68 106 114 143 177 219 269 329 1,371

Cash Outflow Cash Outflow
Change in Working Capital Change in Working Capital Change in Working Capital 72 4 4 9 18 21 26 31 37

Cash Outflow Cash Outflow - 72 4 4 9 18 21 26 31 37 153

Net Cash Flow Net Cash Flow (217) (72) 65 102 105 125 156 194 238 292 1,218
DCF DCF (217) (72) 58 81 75 79 89 98 108 118 439
Cumulative DCF Cumulative DCF (217) (289) (232) (150) (76) 4 92 190 298 416 855
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FINANCIAL VALUATION FINANCIAL VALUATION FINANCIAL VALUATION NPV   119
Capital Project T.V. of NPV T.V. of NPV 83
(000's)
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Terminal
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Value
Revenue Revenue 100.0 150.0 200.0 220.0 300.0 350.0 350.0 400.0 425.0 425.0
Growth Rate 50.0 33.3 10.0 36.4 16.7 0.0 14.3 6.3 0.0

COGP COGP 80.0 105.0 140.0 158.4 216.0 252.0 252.0 288.0 306.0 306.0
Depreciation Depreciation 10.0 10.0 10.0 10.0 14.0 14.0 16.0 17.0 17.0

Gross Profit Gross Profit 20.0 35.0 50.0 51.6 74.0 84.0 84.0 96.0 102.0 102.0
Gross Margin 20.0 23.3 25.0 23.5 24.7 24.0 24.0 24.0 24.0 24.0

SGA SGA 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0

EBIT EBIT 10.0 25.0 40.0 41.6 64.0 74.0 74.0 86.0 92.0 92.0

ATOI (After-Tax Earnings) ATOI (After-Tax Earnings) 6.2 15.5 24.8 25.8 39.7 45.9 45.9 53.3 57.0 57.0
of Sales 6.2 10.3 12.4 11.7 13.2 13.1 13.1 13.3 13.4 13.4

Depreciation Depreciation - 10.0 10.0 10.0 10.0 14.0 14.0 16.0 17.0 17.0

Cash Inflow Cash Inflow 6.2 25.5 34.8 35.8 49.7 59.9 59.9 69.3 74.0 74.0

Capital Expenditures Capital Expenditures 200.0 - - - - - - - - -
Change in Working Capital Change in Working Capital - 7.5 8.1 3.5 13.0 8.1 - 8.1 4.1 -

Cash Outflow Cash Outflow 200.0 7.5 8.1 3.5 13.0 8.1 - 8.1 4.1 -

Net Cash Flow Net Cash Flow (193.8) 18.0 26.7 32.3 36.7 51.7 59.9 61.2 70.0 74.0 308.5
DCF DCF (193.8) 16.0 21.3 23.0 23.3 29.4 27.1 24.7 25.2 23.8 99.3
Cumulative DCF Cumulative DCF (193.8) (177.8) (156.5) (133.5) (110.2) (80.8) (53.7) (29.0) (3.8) 20.1 119.4
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What Applications Can You See for These
Discounted Metrics?

• Construction/equipment projects
• Acquisitions (max purchase price)
• Divestitures (min selling price)
• Business strategy analysis
• Advertising spending
• Prioritizing RD projects
• New markets
• Developing sales contracts
• Lease vs buy

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Project Sensitivity Analysis

• Shows that gt75 of the variability is
  associated with the top three sensitivities
• Shows targets for further analysis

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Determining Cash Flows for NPV
A Project example using a discounted cash flow
analysis and specific assumptions (e.g. 12 cost
of capital)

Based on a ten year time horizon post launch