Term
| Non-Financial Measures of Performance |
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Definition
The number of new customers contacted
The frequency of late deliveries
The number of patents generated by the R&D group
Employee absenteeism
Market share
Number of products in the R&D pipeline at different stages |
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Term
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Definition
| The balance sheet lists all of the assets the firm owns and all of the claims against those assets |
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Term
| Assets = Liabilities + Stockholders’ Equity |
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Definition
Everything the firm owns is an asset: cash, securities, promises of customers to pay, inventory, plants and equipment, land, and so on
Everything the firm owes is a liability, and the difference between assets and liabilities is stockholders’ equity (comparable to owners’ equity in a home as the difference between the value of the home and the mortgage, and sometimes referred to as shareholders’ equity, owners’ equity, or net worth) |
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Term
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Definition
Publicly traded firms (those listed on a stock exchange) must provide quarterly and annual financial reports to investors
Thus, at a minimum, the balance sheet, income statement, and cash flow statement must be constructed every three months
For internal purposes, most firms examine financial data monthly
When monthly statements are available, the firm can simply combine them to construct quarterly and annual statements
In principle, nothing prevents a firm from continually monitoring its financial position using the statements, but managers typically have better things to do |
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Term
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Definition
Accountants list assets and liabilities on the balance sheet in order of decreasing liquidity
Assets lists cash, marketable securities (which can easily be sold), accounts receivable, and then plants, equipment, land, and other relatively fixed assets
Liabilities lists short-term loans and accounts payable at the top, then long-term loans, and then stockholders’ equity at the bottom |
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Term
| Current vs. Long-Term Assets and Liabilities |
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Definition
Accountants arbitrarily define any asset or liability that is expected to turn into cash (either received or paid) within one year as current
All other assets and liabilities are labeled long-term
Inventory is a current asset because the firm expects to sell the inventory before the end of one year
Accounts payable are short-term liabilities because they must be paid within one year
The principal current assets are: cash, accounts receivable, inventories of raw materials, and inventories of finished goods
The principal current liabilities are accounts payable |
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Term
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Definition
Examples of possible categories include
Common stock
Other contributed capital
Retained Earnings (income not paid out as dividends)
Treasury Stock (stock in the firm that has been repurchased by the firm itself; this amount is typically recorded as a negative to indicate that it should be subtracted from the other totals |
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Term
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Definition
Indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the "bottom line")
The income statement addresses this by partitioning observed changes in stockholders’ equity into revenues and expenses
Revenues are sales (price per unit multiplied by the amount of output sold); they increase stockholders’ equity
Expenses are costs; they decrease stockholders’ equity; the difference between revenue and expenses is net income |
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Term
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Definition
Net income is often referred to as “earnings” or “profits” and may also be called “net earnings” or “net profits”
Similarly, revenues are often called “net sales” or “net revenues”
There are several different types of expenses, such as “cost of sales,” which can also be called “cost of goods sold,” and other costs such as “operating expenses” and taxes |
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Term
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Definition
Revenue is not the same as cash received
According to the accrual principle, revenue is recognized as soon as “the effort required to generate the sale is substantially complete and there is reasonable certainty that payment will be received”
Put more plainly, revenue is recorded when the sale is made, not when cash changes hands
The difference between revenue and cash received is recorded in accounts receivable |
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Term
| Measuring Earnings: Depreciation |
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Definition
There are two main ways to depreciate assets
The straight-line method depreciates the asset by a constant amount each year
For a $10 million asset with a life of 10 years and a scrap value of $5 million, this implies depreciation of $500,000 per year
The accelerated depreciation method charges more depreciation in early years; it alters the timing of the recognition of depreciation
Assets that lose their value quickly can be depreciated using accelerated depreciation, and some assets that become obsolete rapidly may simply be expensed |
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Term
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Definition
Most large U.S. firms keep two sets of financial records: one for managing the firm and reporting to shareholders and the other for determining taxes
The objective of the first set is to accurately illustrate the firm’s financial performance and assist in decision making
The objective of the second set is to minimize taxes
Dual reporting implies that actual cash tax payments usually differ from the provision for income taxes appearing on a firm’s income statement
Several accounts on the balance sheet accommodate the difference, such as “prepaid income taxes” on the assets side and “income taxes payable” and “deferred income taxes” on the liabilities side |
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Term
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Definition
Current R&D and marketing outlays provide benefits over several future periods
This suggests that the outlays should be spread over several future periods in the form of a non-cash charge like depreciation
However, because the magnitude and duration of the prospective payoffs from R&D and marketing are difficult to estimate, accountants record the entire outlay as an expense (an operating cost just like paying for labor) |
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Term
| Operating vs. Non-Operating Income |
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Definition
Net Income answers the question, “How did the firm perform in the previous period?” but it might be misleading about how the firm will perform in the future
Net income is the “bottom line”
Operating income may be more informative about future performance
Operating income is profit realized from day-to-day operations excluding taxes, interest income and expenses, and any extraordinary items (items that are unusual in nature and infrequent in occurrence)
The income statement is typically divided into operating and non-operating segments |
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Term
| Other Ways of Defining Earnings |
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Definition
Pro Forma Earnings are total revenues minus total expenses, omitting expenses the firm believes might could investor perceptions of the true earning power of the business
This definition is up to the firm and it can change from year to year
Dotcom executives often referred to pro forma earnings at the height of the dotcom boom
EBIT is earnings before interest and taxes is often used to measure the firm’s income before it is divided among creditors, owners, and the taxman |
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Term
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Definition
The cash flow statement follows changes in the firm’s cash over time
The focus of the cash flow statement is solvency
The statement segregates changes in cash into three categories; cash provided or consumed by
Operating activities
Investing activities
Financing activities |
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Term
| Using Cash Flow Statements |
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Definition
How important is external financing to this firm? What portion of the firm’s cash needs are derived from internal as opposed to external sources?
Are the firm’s cash needs dominated by investments in working capital or fixed assets, or payments to creditors?
Did the firm experience unusual cash needs during the most recent period?
Cash flow from operations is often of particular interest: Start with net income, add non-cash expenses (depreciation), increases in current liabilities and decreases in current assets (if any), and differences between income tax expenses and income tax payments, and then subtract increases in current assets and decreases in current liabilities (if any) |
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Term
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Definition
There is one instance in which intangible assets such as brand names and patents end up on a firm’s balance sheet
When Firm A buys Firm B for $100 million, and Firm B’s assets have an estimated replacement value (not book value) of $60 million, the accountant of Firm A records the $60 million in assets and then adds the remaining $40 million to an asset account called goodwill
This maintains the accounting identity: the firm spends $100 million in cash, for example, so assets fall by $100 million, but then the firm gets $60 + $40 million in assets in return, so assets rise by $100 million |
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Term
| Economic Income vs. Accounting Income |
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Definition
Accountants distinguish between realized and unrealized income
If you receive $100,000 in salary during the year and your house appreciates by $40,000, economists would say your income was $140,000
In this view, income is what you can spend during the period and be just as well off at the end as you were at the start
Accountants would say your income was $100,000
The additional $40,000 is not recognized until it is realized through a sale |
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Term
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Definition
Return on Equity = Net Income / Stockholders’ Equity
ROE is a measure of the efficiency with which the firm employs its owners’ capital
It measures the percentage return to owners on their investment |
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Term
| The Three Determinants of ROE |
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Definition
ROE can be expressed as a product of three components
ROE = (Net Income/Sales) (Sales/Assets) (Assets/Stockholders’ Equity)
In words,
ROE = Profit Margin * Asset Turnover * Financial Leverage
Thus, the three levers managers can use to control ROE are
The earnings obtained from each dollar of sales
The sales generated from assets employed
The amount of equity used to finance the assets (which can be rewritten as (L+SE)/SE = L/SE + 1 to show the dependence on the debt-equity ratio) |
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Term
| Comparing ROEs Using the Three Components |
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Definition
Banks typically have high profit margins and very high financial leverage compared to other firms (all of the deposits are liabilities), but very low asset turnover (the loans are assets)
Drug firms, biotechnology firms, and other life sciences firms typically have high profit margins, low asset turnover, and low leverage (they rely much more on equity than loans to finance their activities)
Grocery stores and other large retailers typically have very low profit margins, very high asset turnover, and financial leverage can vary |
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Term
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Definition
The profit margin depends on the firm’s pricing strategy and its ability to control operating costs
In general, any variable that affects how sales translate into profits affects the profit margin
Profit margins and asset turnover tend to vary inversely
Firms that add a lot of value to their products tend to obtain high profit margins, but adding a lot of value requires a lot of assets, so these firms tend to have low asset turnover
Firms that add little value to their products, like grocery stores (who simply buy and sell goods without changing them) have low profit margins, but they sell a lot compared to their assets |
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Term
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Definition
Return on Assets (ROA) combines the profit margin and asset turnover:
ROA = Profit Margin * Asset Turnover = Net Income / Assets
ROA is a basic measure of the efficiency with which the firm allocates and manages its resources
It differs from ROE because the denominator is money provided from all sources (owners and creditors) rather than just owners |
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Term
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Definition
Firms with a relatively high proportion of fixed costs are more vulnerable to changes in demand for their products, because they cannot reduce fixed costs when demand falls
Accounting methods do not distinguish between variable and fixed costs, but as an approximation, assume that the expenses in “cost of sales” are variable, while other operating costs are fixed
Sales must be at least Operating Expenses / Gross Margin in order for the firm to break even |
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Term
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Definition
An ideal firm would produce income with no assets at all; no investment would be required
This ideal cannot be reached, but we would still like to produce sales with as few assets as possible; maximize asset turnover |
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Term
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Definition
Inventory Turnover = Cost of Goods Sold / Ending Inventory
We use cost of goods sold instead of sales in the numerator because sales includes a profit markup that is absent from inventory
To determine the average number of days a typical item sits in inventory, divide the number of days in the year (365) by inventory turnover |
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Term
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Definition
The collection period highlights the firm’s management of accounts receivable:
Collection Period = Accounts Receivable / Credit Sales per Day
The collection period is measured as a number of days; it measures the average time lag between the sale and the receipt of cash
It is important to work with credit sales and not total sales because only credit sales generate accounts receivable |
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Term
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Definition
Days’ Sales in Cash = Cash and Securities / Sales per Day
The units are the number of days
How many days worth of sales does the firm have in highly liquid form?
The optimal number of days depends on how important liquidity is to the firm
The ratio basically normalizes highly liquid assets by dividing by a measure of the firm’s size (its sales) |
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Term
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Definition
While increasing the profit margin and asset turnover holding other things equal is desirable, it is not necessarily optimal to increase leverage as much as possible
It is important to strike a prudent balance between debt and equity financing, and later in the course we will discuss factors affecting this decision
In general, businesses with stable and predictable cash flows and high scrap values can rely more on debt financing
Those with unstable and unpredictable cash flows where many of the “assets” are highly intangible (like key employees that can leave the firm) rely more on equity financing |
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Term
| Balance Sheet Ratios for Measuring Financial Leverage |
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Definition
Common measures of financial leverage compare the book value of liabilities to the book value of assets or equity:
Debt-to-Assets Ratio = Total Liabilities / Total Assets
Debt-to-Equity Ratio = Total Liabilities / Stockholders’ Equity
Ultimately, the financial burden a firm faces by using debt financing depends not on these ratios but on its ability to meet the annual cash payments its debt requires
Thus, balance sheet ratios are of interest primarily in a liquidation, when the proceeds of asset sales must be distributed among creditors and owners |
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Term
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Definition
Two ratios compare the annual burden debt imposes to the cash flow available for debt service:
Times Interest Earned = Earnings Before Interest and Taxes / Interest Expense
Times Burden Covered = EBIT /
(Interest + (Principal Repayment / (1 – Tax Rate)))
EBIT is appropriate because interest payments are before-tax expenses
A value of times interest earned much greater than 1 indicates that the firm can easily meet its interest expenses
Principal repayments also must be made to avoid default, and they are not tax deductible, so we need to divide by 1 – Tax Rate |
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Term
| Is ROE a Reliable Measure of Financial Performance? |
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Definition
ROE suffers from three important defects as a measure of financial performance:
The Timing Problem
The Risk Problem
The Value Problem |
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Term
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Definition
Managers must be forward looking
ROE is backward looking
Further, it focuses on only a single year
If a firm incurs high startup costs to launch a new product line, ROE will fall
Such an action likely creates substantial value, so ROE is misleading |
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Term
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Definition
ROE says nothing about the standard risk-return tradeoff
In general, when expected returns are high, risks are also high
A high ROE may simply indicate that the firm is bearing unacceptable risks, and perhaps that it is taking on far too much debt
To circumvent the distorting effects of leverage, Higgins suggests using
Return on Invested Capital = EBIT (1 – Tax Rate) /
(Interest Bearing Debt + Equity)
The numerator is the after tax earnings the firm would obtain if it was all equity financed, and the denominator is the sum of all sources of capital that require a return |
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Term
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Definition
ROE uses the book value of equity in the denominator
This is misleading, because you could not obtain this return unless you could buy equity for its book value, which you cannot do; typically, the market value of equity exceeds the book value substantially
The Earnings Yield (the inverse of the price-earnings ratio) may be used:
Earnings Yield = Net Income / Market Value of Equity
= Earnings per Share / Price per Share
The problem with this as a measure of financial performance is that the price per share is very sensitive to future expectations, because a share entitles its owner to future earnings as well as current earnings; a low earnings yield may be a better indicator of good performance than a high one |
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Term
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Definition
Most academics argue that stock price is the ultimate performance measure
Management’s goal should be to maximize the stock price, regardless of the impact doing so has on accounting-based measures of performance
The stock price represents the value of the owners’ investments in the firm, and firms should make choices to attempt to maximize firm value
Practitioners point out that it is often difficult to determine exactly how particular operating decisions will affect stock price
If we cannot determine this impact, we cannot use stock price to formulate decisions
Managers also often believe that they have more information about their firm than outside investors
Thus, relying on the market’s assessment of value may be seen as relying on uninformed evaluators of the firm’s performance
Another practical problem is that stock prices fluctuate because of many factors outside managerial control
This is also true of earnings, but to a lesser extent; stock prices fluctuate because of expectations about the future direction of the economy, competitor actions, government behavior, and so on |
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Term
| Pro Forma Financial Statements |
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Definition
A pro forma statement predicts what the firm’s financial statements will look like at the end of the forecast period
The predictions may be precise or crude, but the basic nature of the pro forma statement remains the same |
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Term
| Steps in a Percent-of-Sales Forecast |
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Definition
Examine historical financial statements to determine which items can be expressed as a simple function of sales (typically a constant fraction of sales)
Forecast sales
Use the forecasted sales and the functions determined in 1. to estimate the non-sales financial statement items |
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Term
| Forecasting Net Fixed Assets (Primarily Net Property, Plant and Equipment) |
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Definition
To forecast next period’s net fixed assets, we need to reduce current net fixed assets by the amount of next period’s depreciation and then add next period’s investment
Net fixed assets next period = net fixed assets this period - depreciation adjustment + investment |
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Term
| Forecasting retained earnings |
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Definition
| Retained earnings next period = Retained earnings in the current period + Earnings next period – Dividends next period |
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Term
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Definition
There are a variety of ways you might forecast sales
Trend extrapolation is a common technique; examine previous periods to determine the trend in sales, and then assume the trend will continue
Simple linear or log linear functions of time can be employed
Sales diffusion curves can also be used; there are a variety of S-shaped diffusion curves that can be estimated
Given that other estimates will typically be tied to the sales forecast, ensuring robustness is important, and several alternative reasonable assumptions about sales should be tried to evaluate the sensitivity of the forecast |
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Term
| Computer-Based Forecasting |
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Definition
Spreadsheets make it relatively easy to construct a variety of alternative pro forma forecasts
This makes it easy to examine how different assumptions affect forecasted financial performance and external financing requirements
Assumptions can be specified in one part of the spreadsheet and the formulas that compute the implications can be specified in another |
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Term
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Definition
Sensitivity analysis simply involves changing the assumptions underlying the forecast to evaluate how the outcomes vary
This exercise provides information about the range of possible outcomes
For example, under reasonable variations in sales growth, external financing needs might vary between $1 million and $2 million
This would inform management to have a backup plan to borrow up to an additional $1 million if needed
This exercise also reveals which assumptions are most critical to the forecast, and managers can concentrate their data gathering, forecasting, and managerial efforts on those factors |
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Term
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Definition
Scenario Analysis is similar to sensitivity analysis, but in this case multiple assumptions are changed at the same time to approximate the financial implications of particular economic events (scenarios)
The first step is to identify plausible scenarios
Examples include, the loss of a major customer, the success of a major product launch, the failure of a major product launch, or the entry of a new competitor
Determine the appropriate financial variables for each scenario and conduct one pro forma forecast for each scenario
A further step might assign probabilities to the various scenarios and compute expected performance |
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Term
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Definition
Software is available (for purchase) to go beyond simple sensitivity or scenario analyses
It is possible to specify probability distributions for every financial variable (shape, mean, variance, higher moments)
Then generate a large number of random draws from each distribution to generate a large number of possible scenarios
In each case, compute the external funds required; the result will be a probability distribution of the external funds required
The principal advantage is added realism; the principal disadvantage is that the results can be difficult to interpret and base decisions on |
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Term
| The Sustainable Growth Rate |
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Definition
the maximum rate at which sales can increase without requiring additional external equity
To determine the sustainable growth rate, make the following assumptions:
The firm has a target capital structure (debt/equity ratio) and a target dividend policy it wishes to maintain
The firm is unable or unwilling to issue new equity |
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Term
| The Life Cycle of a Typical Firm |
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Definition
The startup phase: the firm loses money while developing products and establishing a foothold in the market
The rapid growth phase: the firm is profitable but growing so rapidly that it needs regular infusions of external funds
Maturity: growth declines and the firm generates more cash than it can profitably reinvest
Decline: the firm is marginally profitable, it generates more cash than it can invest internally, and sales fall |
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Term
| Sustainable growth rate formula |
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Definition
SGR=PRAT
where R = 1-dividend payout ratio
P = profit margin
A = asset turnover
T = assets to equity using bop (beginning of period) equity |
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Term
| When Growth Exceeds Sustainable Growth |
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Definition
If the problem is temporary and the growth rate is likely to slow in the near future, the firm can probably just borrow in the meantime
Once the growth rate drops below the sustainable rate, the firm will generate excess cash and it can repay the loans
For longer term problems, the firm must pursue some combination of:
Sell new equity, increase leverage or reduce the dividend payout, eliminate marginal activities, outsource some production, increase prices, or merge or form an alliance with a cash cow firm |
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Term
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Definition
If the firm can raise new equity by selling shares, the sustainable growth problem vanishes
This may be undesirable because it might require that current shareholders effectively give up control of the firm
The expense of working with investment bankers to raise equity may also pose problems
Small firms (which are often growing rapidly and are most likely to run into the sustainable growth constraint) may find it particularly difficult to raise equity |
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Term
| 2. Increase Leverage or Reduce the Dividend |
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Definition
Increasing leverage is necessary if no other steps can be taken to bring the actual growth rate closer to the sustainable one
Increasing leverage can be risky, though, and firms should be careful to avoid taking on excessive debt
The debt market will effectively impose this constraint on the firm, because debt will become increasingly expensive as the firm’s leverage increases (lenders will demand higher interest rates) |
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Term
| 3. Eliminate Marginal Activities |
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Definition
Instead of pursuing multiple lines of business, the firm can sell off ones that are not essential
The asset sales generate additional cash, eliminate several costs, and also reduce sales |
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Term
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Definition
When a firm outsources, it releases assets that would otherwise be tied up in performing the outsourced activity
This increase asset turnover
The key in this process is to determine the firm’s unique abilities and resources, which are the main source of profits above the norm |
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Term
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Definition
The firm can raise its prices to reduce demand, which will reduce sales
Higher prices can also increase the profit margin, which will raise the sustainable growth rate |
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Term
| 6. Merge or Form an Alliance with a Cash Cow Firm |
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Definition
A cash cow is a mature firm that generates excess cash flow
Such a firm may be willing to supply funds to a rapidly growing firm in need of funds
Evidence suggests that mergers motivated solely by financing are a suboptimal way to use excess cash (cash cows typically overpay for the growing firm)
In order to be worthwhile, mergers or alliances should involve synergies: fixed cost reductions, economies of scope, or other benefits |
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Term
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Definition
Find new investments with returns sufficient to compensate the firm’s investors for the risks involved
Return the cash to shareholders by increasing dividends
Return the cash to shareholders by buying back the firm’s shares |
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Term
| Why Not Rely More on Equity? |
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Definition
Retained earnings and new borrowing is often sufficient to finance growth
Equity is expensive to issue; costs may be 5-10% of the amount raised, or even more for small issues. This is at least twice as high as a comparable debt issue (of course, equity can remain outstanding forever, so the annualized cost is much lower than that of debt)
Attempting to raise equity poses a signaling problem for the firm. If the firm is willing to sell equity at the current price, the current price likely exceeds what insiders believe shares in the firm are worth. Investors understand this, and as a result they will tend to revise their estimates of share value downward. Thus, attempting to raise equity can cause share prices to fall.
Share prices fluctuate because of market forces, and given this, executives may be reluctant to adopt growth plans that depend on equity prices. Also, managers may perceive current share prices to understate firm value |
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