The Finance Function and Business Strategy

Accounting

Accounting is the process of measuring, interpreting, and communicating financial information to support internal and

external business decision making.

Business Activities

Involving

Accounting Financing activities provide necessary

funds to start a business and expand it after it begins operating.

Investing activities provide valuable assets required to run a business.

Operating activities focus on selling goods and services, but they also consider expenses as important elements of sound financial management.

• Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time.

• Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S.

• Sarbanes-Oxley Act responded to cases of accounting fraud.– Created the Public Accounting Oversight Board, which sets audit

standards and investigates and sanctions accounting firms that certify the books of publicly traded firms.

– Senior executives must personally certify that the financial information reported by the company is correct.

– Resulted in increase in demand for accountants.

The Foundation of

Accounting Systems

The Accounting

Cycle

Accounting process - set of activities involved in converting information about transactions

into financial statements.

• Assets - anything of value owned or leased by a business.• Liability - claim against a firm’s assets by a creditor.• Owner’s equity - all claims of the proprietor, partners, or

stockholders against the assets of a firm, equal to the excess of assets over liabilities.

• Basic accounting equation - relationship that states that assets equal liabilities plus owners’ equity.

• Double-entry bookkeeping - process by which accounting transactions are entered; each individual transaction always has an offsetting transaction.

The Accounting

Equation

Balance sheet - statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time.

Photograph of firm’s assets together with its liabilities and owner’s equity

Follows the accounting equation

Balance Sheet

Sample Balance

Sheet

Income Statement - financial record of a company’s revenues and expenses, and profits over a period of time.

Firm’s financial performance in terms of revenues, expenses, and profits over a given time period.

Reports profit or loss.

Focus on revenues and costs associated with revenues.

Sample Income

Statement

Statement of

Owner’s Equity

Statement of Owner’s Equity - is designed to show the components of the change in equity from the end of one fiscal year to the end of the next.

Begins with the amount of equity shown on the balance sheet.

Net income is added, and cash dividends paid to owners are subtracted.

Sample Statement

of

Owner’s Equity

The Statement of

Cash Flows

Statement of cash flows - a firm’s cash receipts and cash payments that presents information on its sources and uses of cash.

Accrual accounting - method that records revenue and expenses when they occur, not necessarily when cash actually changes hands.

Sample Statement

of Cash Flows

Financial Ratios

Analysis

Ratio analysis - tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, as well as the effectiveness of

management’s resource utilization.

Liquidity Ratios

Acid-test (or quick) ratio measures the

ability of a firm to meet its debt payments on

short notice.

Cash and equivalents + short-term investments + accounts receivable

Total current liabilities

Current ratio compares current assets to current liabilities.

Total current assets

Total current liabilities

Activity Ratios

Inventory turnover ratio indicates the number of times

merchandise moves through a business.

Net sales

Average of inventory

Total asset turnover ratio indicates how much in

sales each dollar invested in assets generates.

Net sales

Average of total assets

Profitability

RatiosProfitability ratios measure the organization’s overall financial

performance by evaluating its ability to generate revenues in excess of operating costs and other expenses.

• Leverage ratios measure the extent to which a firm relies on debt financing.

• Total liabilities to total assets ratio > 50 percent indicates that a firm is relying more on borrowed money than owners’ equity.

Leverage Ratios

• Budget - planning and control tool that reflects a firm’s expected sales revenues, operating expenses, and cash receipts and outlays.

• Management estimates of expected sales, cash inflows and outflows, and costs.

• Budgets are a financial blueprint that serves as a financial plan.

• Cash budget - tracks the firm’s cash inflows and outflows.

Budgets

Capital Budgeting, Finance and Decision making

Project Types Capital Budgeting Decision Criteria

◦ Net Present Value (NPV)◦ Internal Rate of Return (IRR)◦ Payback Period

Understand how to calculate and use the 3 capital budgeting decision techniques:, NPV, IRR, and Payback.

Understand the advantages and disadvantages of each technique.

Understand which project to select when there is a ranking conflict between NPV and IRR.

Which of the following investment opportunities would you prefer?

1) Give me $1 now and I’ll give you $2 at the end of class.

2) Give me $100 now and I’ll give you $150 at the end of class.

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firm’s future.

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine k = WACC (Weighted Average Cost of Capital).

4. Find NPV and/or IRR.

5. Accept if NPV > 0 and/or IRR > WACC.

Brand new line of business Expansion of existing line of business Replacement of existing asset

Independent vs. Mutually Exclusive Normal vs. Non-normal

NPV = PV of inflows minus Cost = Net gain in wealth.

Acceptance of a project with a NPV > 0 will add value to the firm.

Decision Rule: ◦ Accept if NPV >0, ◦ Reject if NPV < 0

NPV

CF

kt

nt

t 0 1

.

NPV: Sum of the PVs of inflows and outflows.

.

10

1

CFk

CFNPV t

tn

t

Cost often is CF0 and is negative.

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.

t

nt

t

CF

kNPV

0 1.

t

nt

t

CF

IRR

0 10.

NPV: Enter k, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

Internal Rate of Return is a project’s expected rate of return on its investment.

IRR is the interest rate where the PV of the inflows equals the PV of the outflows.

In other words, the IRR is the rate where a project’s NPV = 0.

Decision Rule: Accept if IRR > k (cost of capital).

Non-normal projects have multiple IRRs. Don’t use IRR to decide on non-normal projects.

For normal independent projects, both methods give same accept/reject decision.◦ NPV > 0 yields IRR > k in order to lower NPV NPV > 0 yields IRR > k in order to lower NPV

to 0.to 0. However, the methods can rank mutually

exclusive projects differently. What to do, then?

Measures how long it takes to recovers a project’s cost (CF0 = initial outlay).

Easy to calculate and a good measure of a project’s risk and liquidity.

Decision Rule: Accept if PB < some maximum period of time.

If cash inflows are equal each year (in the form of an annuity), PB = CF0/Annual CF

Ignores time value of money! Ignores cash flows beyond payback period.

The Discounted Payback Period addresses the first problem.

Disc. PB tells how long it takes to recover capital and financing costs for a project.

Discount rate = cost of capital.