Foundations of Financial Management: An Analysis (part 5)

All money is a matter of belief.

Adam Smith

Review of Accounting (part B)

by

Charles Lamson

Balance Sheet

 The balance sheet indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest. While the income statement (see last post) purports to show the profitability of the firm, the balance sheet delineates the firm's holdings and obligations. Together, these statements are intended to answer two questions: How much did the firm make or lose, and what is a measure of its worth? A balance sheet for the Kramer Corporation is presented in Table 1.

Table 1

Note that the balance sheet is a picture of the firm at a point in time---in this case December 31st, 2019. It does not purport to represent the result of transactions for a specific month, quarter, or year, but rather is a cumulative chronicle of all transactions that have affected the corporation since its inception. In contrast, the income statement measures results only over a short, quantifiable period. Generally, balance sheet items are stated on an original cost basis rather than at current market value. 

Interpretation of the Balance Sheet

Asset accounts are listed in order of liquidity (convertibility to cash). The first category of current assets covers items that may be converted to cash within one year or within the normal operating cycle of the firm. A few items are worthy of mention. Marketable securities are temporary Investments of excess cash. The value shown in the account is the lower of cost or current market value. Accounts receivable include an allowance for bad debts (based on historical evidence) to determine their anticipated collection value. Inventory may be in the form of raw material, goods in process, or finished goods, while prepaid expenses represent future expense items that have already been paid, such as insurance premiums or rent.

Investments, unlike marketable securities, represent a longer-term commitment of funds for at least one year. They may also include stocks, bonds, or investments in other corporations. Frequently, the account will contain stock in companies that the firm is acquiring.

Plant and equipment is carried at original cost minus accumulated depreciation. Accumulated depreciation is not to be confused with the depreciation expense item indicated in the income statement (see last post). Accumulated depreciation is the sum of all past and present depreciation charges on currently owned assets, while depreciation expense is the current year's charge. If we subtract accumulated depreciation from the original value, the balance ($500,000) tells us how much of the original cost has not been expensed in the form of depreciation.

Total assets are financed through either liabilities or stockholders' equity. Liabilities represent financial obligations of the firm and move from current liabilities (due within one year) to longer-term obligations, such as bonds payable in 2030. 

Among the short-term obligations, accounts payable represents amounts owed on open account to suppliers, while notes payable are generally short-term signed obligations to the banker or other creditors. An accrued expense is generated when a service has been provided or an obligation incurred and payment has not yet taken place. The firm may owe workers additional wages for services provided or the government taxes on earned income.

In the balance sheet we see $1,000,000 in total assets of the Kramer Corporation was financed by $300,000 in debt and $700,000 in the form of stockholders' equity. Stockholders equity represents the total contribution and ownership interest of preferred and common stockholders. 

The preferred stock investment position is $50,000 based on 500 shares at $100 par. in the case of common stock, 100,000 shares have been issued at a total par value of $100,000, plus an extra $250,000 in capital paid in excess of par for a sum of $350,000. We can assume that the 100,000 shares were originally sold at $3.50 each as shown below.

Finally, there is $300,000 in retained earnings in Table 2. This value, previously determined in the statement of retained earnings (from last post), represents the firm's cumulative earnings since inception minus dividends and any other adjustments. 

Concept of Net Worth

Stockholders' equity minus the preferred stock component represents the net worth, or book value, of the firm. There is some logic to the approach. If you take everything that the firm owns and subtract the debt and preferred stock obligation, the remainder belongs to the common stockholder and represents net worth. In the case of the Kramer Corporation, using data from Table 1 we show:

The original cost per share was $3.50; the net worth, or book value, per share is $6.50; and the market value (based on assumed P/E ratio of 15 and earnings per share of $1) is $15. This last value is of primary concern to the financial manager, security analyst, and stockholders.

Limitations of the Balance Sheet

Lest we attribute too much significance to the balance sheet, we need to examine some of the underlying concepts supporting its construction. Most of the values on the balance sheet are stated on a historical or original cost basis. This may be particularly troublesome in the case of plant and equipment and inventory, which may now be worth two or three times the original cost or---from a negative viewpoint---may require many times the original cost for replacement. 

*SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED, PP. 28-30*

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MONGOLIA

Foundations of Financial Management: An Analysis (part 4)

The avoidance of taxes is the only intellectual pursuit that still carries any reward.

John Maynard Keynes

Review of Accounting (part A)

 by

 Charles Lamson

 The language of finance flows logically from accounting. To ensure that one is adequately prepared to learn significant financial concepts, we must look in the preparatory material from the accounting area. Much of the early frustrations suffered by people who have difficulty with finance can be overcome if such concepts as retained earnings, shareholders' equity, depreciation, and historical/replacement cost accounting are brought into focus.

In the next few posts, we examine the three basic types of financial statements---the income statement, the balance sheet, and the statement of cash flows---with particular attention paid to the interrelationships among these three measurement devices. As special preparation for the financial manager, we briefly examine income tax considerations affecting financial decisions.

Income Statement

The income statement is the major device for measuring the profitability of a firm over a period of time. An example of the income statement for the Kramer Corporation is presented in Table 1.

Table 1

First, note that the income statement covers a defined period of time, whether it is one month, three months, or a year. The statement is presented in a stair-step or progressive fashion so we can examine the profit or loss after each type of expense item is deducted.

We start with sales and deduct the cost of goods sold to arrive at gross profit. The $500,000 thus represents the difference between the cost of purchased or manufactured goods and the sales price. We then subtract selling and administrative expense and depreciation from gross profit to determine our profit (or loss) purely from operations of $180,000. It is possible for a company to enjoy a high gross profit margin (25-50) percent but a relatively low operating profit because of heavy expenses incurred in marketing the product and managing the company. 

Having obtained operating profit (essentially a measure of how efficient management is in generating revenues and controlling expenses), we now adjust for revenues and expenses not related to operational matters. In this case we pay $20,000 in interest and arrive at earnings before taxes of $160,000. The tax payments are $49,500 leaving after tax income of $110,500. 

Return to Capital

Before proceeding further, we should know that there are three primary sources of capital---the bondholders, who received $20,000 in interest (item 7); the preferred stockholders, who receive $10,500 in dividends (item 11) and the common stockholders. After the $10,500 dividend has been paid to the preferred stockholders, there will be $100,000 in earnings available to the common stockholders (item 12). In computing earnings per share, we must interpret this in terms of the number of shares outstanding. As indicated in item 13, there are 100,000 outstanding, so the $100,000 of earnings available to the common stockholders may be translated into earnings per share of $1. Common stockholders are sensitive to the number of shares outstanding---the more shares, the lower the earnings per share. Before any new shares are issued. The financial manager must be sure they will eventually generate sufficient earnings to avoid reducing earnings per share. 

The $100,000 of profit ($1 earnings per share) may be paid out to the common stockholders in the form of dividends or retained in the company for subsequent reinvestment. The reinvested funds theoretically belong to the common stockholders, who hope they will provide future earnings and dividends. In the case of the Kramer Corporation, we assume $50,000 in dividends will be paid out to the common stockholders, with the balance retained in the corporation for their benefit. A short supplement to the income statement, a statement of retained earnings (Table 2) usually indicates the disposition of earnings.

Table 2

We see a net value of $50,000 has been added to previously accumulated earnings of $250,000 to arrive at $300,000.

Price-Earnings Ratio Applied to Earnings per Share

A concept utilized throughout this analysis is the price-earnings ratio. This refers to the multiplier applied to earnings per share to determine current value of the common stock. In the case of the Kramer Corporation, earnings per share were $1.00. If the firm had a price-earnings ratio of 20, the market value of each share would be $20 ($1 * 20). The price earnings ratio (or P/E ratio, as it is commonly called) is influenced by the earnings and the sales growth of the firm, the risk for volatility and performance, the debt-equity structure of the firm, the dividend payment policy, policy of management, and a number of other factors. Since companies have various levels of earnings per share, price-earnings ratios allow us to compare the relative market value of many companies based on $1 of earnings per share. 

The P/E ratio indicates expectations about the future of a company. Firms expected to provide returns greater than those for the market in general with equal or less risk often have P/E ratios higher than the market P/E ratio. Expectations of returns and P/E ratios to change over time.

Price-earnings ratios can be confusing. When a firm's earnings are dropping rapidly or perhaps even approaching 0, its stock price, though declining to, may not match the magnitude of the fall off in earnings. This process can give the appearance of an increasing P/E ratio under adversity. This happens from time to time in the steel, oil, chemical, and other cyclical Industries.

Limitations of the Income Statement

The economist defines income as the change in real worth that occurs between the beginning and the end of a specified time. To The economist an increase in the value of a firm's land as a result of a new airport being built on adjacent property is an increase in the real worth of the firm and therefore represents income. Similarly, the elimination of a competitor might also increase the firm's real worth and therefore result in income in an economic sense. The accountant does not ordinarily employ such broad definitions. Accounting values are established primarily by actual transactions, and income that is gained or lost during a given period is a function of veritable transactions. While the potential sales price of a firm's property may go from $100,000 to $200,000 as a result of new developments in the area, stockholders may perceive only a much smaller gain or loss from actual day-to-day operations.

Also, as will be pointed out in a future post that will be covering financial analysis, there is some flexibility in the reporting of transactions, so similar events may result in differing measurements of income at the end of a time period. The intent of this section is not to criticize the accounting profession, but to alert you to imperfections already well recognized within the profession. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 24-28*

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Dien Bien Phu, Vietnam to Muang Ngoi Neua, Laos by bus and boat

Venice, Island Treasure - Documentary

Foundations of Financial Management: An Analysis (part 3)

Money was never a big motivation for me, except as a way to keep score. The real excitement is playing the game.

Donald Trump

You may wonder how a financial manager knows whether he or she is maximizing shareholder value and how ethical (or unethical) behavior may affect the value of the company. This information is provided daily to financial managers through price changes determined in the financial markets. What are the financial markets? Financial markets are the meeting place for people, corporations, and institutions that either need money or have money to lend or invest. In a broad context, the financial markets exist as a vast global network of individuals and institutions that may be lenders, borrowers, or owners of public companies worldwide. Participants in the financial markets also include national, state, and local governments that are primarily borrowers of funds for highways, education, welfare, and other public activities their markets are referred to as public financial markets. Corporations such as Coca-Cola, Nike, and General Motors, on the other hand, raise funds in the corporate financial markets. 

Structure and Functions of the Financial Markets

Financial markets can be broken into many distinct parts. Some divisions such as domestic and international markets, or corporate and government markets, are self explanatory. Others such as money and capital markets need some explanation. Money markets refer to those markets dealing with short-term securities that have a life of one year or less. Securities in these markets can include commercial paper sold by corporations to finance their daily operations, or certificates of deposit with maturities of less than one year sold by banks. Examples of money market securities are presented more fully in future posts.

The capital markets are generally defined as those markets where securities have a life of more than one year. While capital markets are long-term markets, as opposed to short-term money markets, it is often common to break down the capital markets into immediate markets (1 to 10 years) and long-term markets (greater than 10 years). The capital markets include securities such as common stock, preferred stock, and corporate and government bonds. Capital markets are fully presented in later posts. Now that you have a very basic understanding of the makeup of the financial markets, you need to understand how these markets affect corporate managers.

Allocation of Capital

A corporation relies on the financial markets to provide funds for short-term operations and for new plant equipment. A firm may go to the markets and raise financial capital either by borrowing money through a debt offering of corporate bonds or short-term notes, or by selling ownership in the company through an issue of common stock. When a corporation uses the financial markets to raise new funds, the sale of securities is said to be made in the primary market by way of new issue. After the securities are sold to the public (institutions and individuals), they are traded in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell Securities based on their expectations of a corporation's prospects. It is also in the secondary market that financial managers are given feedback about their firm's performance.

How does the market allocate capital to the thousands of firms that are continually in need of money? Let us assume that you graduate from college as a finance major and are hired to manage money for a wealthy family like the Rockefellers. You are given $250 million to manage and you can choose to invest the money anywhere in the world. For example, you could buy common stock in Microsoft, the American software company, or Nestle, the Swiss food company, or TELMEX, the Mexican telephone company; you could choose to lend money to the U.S. or Japanese government by purchasing its bonds; or you could lend money to ExxonMobil or British Petroleum. Of course these are only some of the endless choices you would have.

How do you decide to allocate the $250 million so that you will maximize your return and minimize your risk? Some investors will choose a risk level that meets their objective and maximize return for that given level of risk. By seeking this risk-return objective, you will bid up the prices of securities that seem underpriced and have potential for high returns and you will avoid securities of risk equal risk that, in your judgment, seem overpriced. Since all market participants play the same risk-return game, the financial markets become the playing field, and price movements become the winning or losing score. Let us look at only the corporate sector of the market and 100 companies of equal risk. Those companies with expectations for high return will have higher relative common stock prices than those companies with poor expectations. Since the securities prices in the market reflect the combined judgement of all the players, price movements provide feedback to corporate managers and let them know whether the market thinks they are winning or losing against the competition. 

Those companies that perform well and are rewarded by the market with high priced securities have an easier time raising new funds in the money and capital markets than their competitors. They are also able to raise funds at a lower cost. Go back to the $250 million dollar you are managing. If ExxonMobil wants to borrow money from you at 9% and Chevron is willing to pay 8% but also is riskier, to which company will you lend money? If you chose ExxonMobil you are on your way to understanding finance. The competition between the two firms for your funds will eventually cause Chevron to offer higher returns than ExxonMobil, or they will have to go without funds. In this way the money and capital markets allocate funds to the highest quality companies at the lowest cost and to the lowest quality companies at the highest cost. In other words, firms pay a penalty for failing to perform competitively.

Institutional Pressure on Public Companies to Restructure

Sometimes an additional penalty for poor performance is a forced restructuring by institutional investors seeking to maximize a firm's shareholder value. Institutional investors have begun to flex their combined power, and their influence with corporate boards of directors has become very visible. Nowhere has this power been more evident than in the area of corporate restructuring. Restructuring can result in changes in the capital structure (liabilities and equity on the balance sheet). It could also result in the selling of low-profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities. Sometimes restructuring results in the removal of the current management team or large reductions in the workforce. Restructuring also has included mergers and acquisitions of gigantic proportions unheard of in earlier decades. Rather than seeking risk reduction through diversification, firms are now acquiring greater market shares, brand name products (i.e., British Petroleum acquiring Amoco), hidden assets values, or technology or they are simply looking for size to help them compete in an international arena.

The restructuring and management changes in many major multinational corporations is a result of institutional investors affecting change by influencing the boards of directors to exercise control over all facets of the company's activities. Quite a few boards of directors were viewed as rubber stamps for management before this time. Large institutional investors have changed this perception. Without their attempt to maximize the value of their investments, many restructuring deals would not take place. And without the financial markets placing a value on publicly held companies, restructuring would be much more difficult to achieve.

Internationalization of the Financial Markets

International trade is a growing trend that is likely to continue. Global companies are becoming more common and international brand names like Sony, Coca-Cola, Nestle, and Mercedes-Benz are known the world over. McDonald's hamburgers are eaten throughout the world, and McDonald's raises funds on most major international money and capital markets. The growth of the global company has led to the growth of global fundraising as companies search for low-priced sources of funds.

This discussion demonstrates that the allocation of capital and the search for low-cost sources of financing is now an international game for the multinational companies. As an exclamation point consider all the non-U.S. companies who want to raise money in the United States. More and more foreign companies have listed their shares on the New York Stock Exchange.

We live in a world where international events impact economies of all industrial countries and where capital moves from country to country faster than was ever thought possible. Computers interact in a vast international financial network and markets are more vulnerable to the emotions of investors than they have been in the past. The corporate financial manager has an increasing number of external impacts to consider. Future financial managers will need to have the sophistication to understand international capital flows, computerized electronic funds transfer systems, foreign currency hedging strategies, and many other functions. The remaining parts of this analysis should help you learn how corporations are managing these challenges. 

The Internet and Changes in the Capital Markets

Technology has had a significant impact on the capital markets. The biggest impact has been in the area of cost reduction for trading securities. Those firms and exchanges that are at the front of the technology curve are creating tremendous competitive cost pressures on those firms and exchanges that cannot compete on a cost basis. This has caused consolidations among markets and among brokerage firms. Advances in computer technology have helped create electronic markets. These markets enable institutions to trade over the Internet at much lower costs than they would have been able to trade on the New York Stock Exchange. These cost pressures have caused exchanges such as the New York Stock Exchange and NASDAQ to become publicly-traded for-profit companies (Palmer, B., June 21, 2020, Can I Invest in the Nasdaq or NYSE?, Investopedia). This restructuring of the markets will have ramifications on the capital markets for years to come.

Another area where the Internet has played its role is in the area of retail stock trading. Firms like Charles Schwab, E-Trade, Ameritrade, and other discount brokerage firms allow customers to trade using the Internet and have created a competitive problem for full-service brokers such as Merrill Lynch and Solomon Smith Barney. These discount firms have forced the full-service retail brokers to offer Internet trading to their customers, even though Internet trading is not as profitable for them as trading through their brokers.

The trend is to a lower-cost environment for the customers and a profit squeeze on markets and brokers. These issues and others will be developed more fully in the capital market section of this analysis. 

Next Post: "Financial Analysis and Planning: Review of Accounting"

*MAIN SOURCE: BLOCK & HIRST, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 13-18*

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Foundations of Financial Management: An Analysis (part 2)

In this world nothing can be said to be certain, except death and taxes.

Benjamin Franklin

Goals of Financial Management

by

Charles Lamson

 Let us look at several alternative goals for the financial manager as well as the other managers of the firm. One may suggest that the most important goal for financial management is to earn the highest possible profit for the firm. Under this criterion, each decision would be evaluated on the basis of its overall contribution to the firm's earnings. While this seems to be a desirable approach, there are some serious drawbacks to profit maximization as the primary goal of the firm.

First, a change in profit may also represent a change in risk. A conservative firm that earned $1.25 per share may be a less desirable investment if its earnings per share increase to $1.50, but the risk inherent in the operation increases even more.

A second possible drawback to the goal of maximizing profit is that it fails to consider the timing of the benefits. For example, if we could choose between the following two alternatives, we might be indifferent if our emphasis were solely on maximizing earnings.

Both Investments would provide $3.50 in total earnings, but Alternative B is clearly superior because the larger benefits occur earlier. We could reinvest the difference in earnings for Alternative B one period sooner.

Finally, the goal of maximizing profit suffers from the almost impossible task of accurately measuring the key variable in the case, namely, "profit." As you will observe throughout this analysis, there are many different economic and accounting definitions of profit, each open to its own set of interpretations. Furthermore, problems related to inflation and international currency transactions complicate the issue. Constantly improving methods of financial reporting offers some hope in this regard, but many problems remain.

Evaluation Approach

While there is no question that profits are important, the key issue is how to use them in setting a goal for the firm. The ultimate measure of performance is not with what the firm earns, but how the earnings are valued by the investor. In analyzing the firm, the investor will also consider the risk inherent in the firm's operation, the time patterns over which the firm's earnings increase or decrease, the quality and reliability of reported earnings, and many other factors. The financial manager, in turn, must be sensitive to all of these considerations. He or she must question the impact of each decision on the firm's overall valuation. If a decision maintains or increases the firm's overall value, it is acceptable from a financial viewpoint; otherwise, it should be rejected. This principle will be demonstrated throughout this analysis.

Maximizing Shareholder Wealth 

The broad goal of the firm can be brought into focus if we say the financial manager should attempt to maximize the wealth of the firm's shareholders through achieving the highest possible value for the firm. Shareholder wealth maximization is not a simple task, since the financial manager cannot directly control the firm's stock price, but can only act in a way that is consistent with the desires of the shareholders. Since stock prices are affected by expectations of the future as well as by the economic environment, much of what affects stock prices is beyond management's direct control. Even firms with good earnings and favorable financial trends do not always perform well in a declining stock market over the short-term.

The concern is not so much with daily fluctuations in stock value as with long-term wealth maximization. This can be difficult in light of changing investor expectations. In the 1950s and 1960s, the investor emphasis was on maintaining rapid rates of earnings growth. In the 1970s and 1980s, investors became more conservative, putting a premium on lower risk and, at times, high current dividend payments.

In the early and mid-1990s, investors emphasized lean, efficient, well-capitalized companies able to compete effectively in the global environment. But by the late 1990s, there were hundreds of high-tech internet companies raising capital through initial public offerings of their common stock. Many of these companies had dreams, but very little revenue and no earnings, yet their stock sold at extremely high prices. Some in the financial community said that the old valuation models were dead, didn't work, and were out of date; earnings and cash flow didn't matter anymore. Alan Greenspan, former chairman of the Federal Reserve board, made the now-famous remark that the high-priced stock market was suffering from "irrational exuberance." By late 2000, many of these companies turned out to be short-term wonders. By 2003, hundreds were out of business. 

Management and Stockholder Wealth

Does modern corporate management always follow the goal of maximizing shareholder wealth? Under certain circumstances, management may be more interested in maintaining its own tenure and protecting private spheres of influence than in maximizing stockholder wealth. For example, suppose the management of a corporation receives a tender offer to merge the corporation into a second firm; while this offer might be attractive to shareholders, it might be quite unpleasant to present management. Historically, management may have been willing to maintain the status quo rather than to maximize stockholder wealth.

As mentioned earlier, this is now changing. First, in most cases "enlightened management" is aware that the only way to maintain its position over the long run is to be sensitive to shareholder concerns. Poor stock price performance relative to other companies often leads to undesirable takeovers and proxy fights for control. Second, management often has sufficient stock option incentives that motivate it to achieve market value maximization for its own benefit. Third, powerful institutional investors are making management more responsive to shareholders. 

Social Responsibility and Ethical Behavior

Is our goal of shareholder wealth maximization consistent with the concern for social responsibility for the firm? In most instances the answer is yes. By adopting policies that maximize volumes in the market, the firm can attract capital, provide employment, and offer benefits to its community. This is the basic strength of the private enterprise system.

Nevertheless, certain socially desirable actions such as pollution control, equitable hiring practices, and fair pricing standards may at times be consistent with earning the highest possible profit or achieving maximum valuation in the market. For example, pollution control projects frequently offer a negative return. Does this mean firms should not exercise social responsibility in regard to pollution control? The answer is no---but certain cost increasing activities may have to be mandatory rather than voluntary, at least initially, to ensure that the burden falls equally over all business firms.

Unethical and illegal financial practices on Wall Street by corporate financial "dealmakers" often make news headlines. Insider trading is one of the most widely publicized issues. Insider trading occurs when someone has information that is not available to the public and then uses this information to profit from trading in a company's publicly traded securities. This practice is illegal and protected against by the Securities and Exchange Commission (SEC). Sometimes the insider is a company manager; other times it is the company's lawyer, investment banker, or even the printer of the company's financial statements. Anyone who has knowledge before public dissemination of that information stands to benefit from either good news or bad news.

Such activities as insider trading serve no beneficial economic or financial purpose, and it could be argued that they have a negative impact on shareholder interests. Illegal security trading destroys confidence in U.S. securities markets and makes it more difficult for managers to achieve shareholder wealth maximization. 

Next Post: "The Role of the Financial Markets."

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 11-13*

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