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Analysis of Financing Activities

Chapter F10. Analysis of Financing Activities. Electronic Presentation by Douglas Cloud Pepperdine University. Objectives. 1. Define capital structure, and explain why it is important to a company. 2. Explain when it is beneficial for a company to use financial leverage.

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Analysis of Financing Activities

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  1. Chapter F10 Analysis of Financing Activities Electronic Presentationby Douglas Cloud Pepperdine University

  2. Objectives 1.Define capital structure, and explain why it is important to a company. 2.Explain when it is beneficial for a company to use financial leverage. 3. Explain why cash flows are important for a company’s financing decision. 4. Use financial statements to evaluate the financing activities of different companies. Once you have completed this chapter, you should be able to: Continued

  3. Objectives 5. Determine and explain the effect of financial leverage on a company’s risk and return. 6. Use cash flow and liquidity measures to evaluate financing decisions. 7.Explain why financing activities are important for determining company value.

  4. Objective 1 Define capital structure, and explain why it is important to a company.

  5. Financing Decisions Capital structure is the relative amounts of debt and equity used by a company to finance its assets.

  6. Financing Decisions A firm either can borrow money, or it can issue stock.

  7. Projected Sales and Income for Mom’s Cookie Company Exhibit 1 (in thousands) Year 1 Year 2 Year 3 Sales $ 3,000 $3,600 $4,320 Cost of goods sold (1,800) (2,160) (2,592) Operating expenses (1,000) (1,000) (1,000) Operating income 200 440 728 Income taxes (60) (132) (218) Net income $ 140 $ 308 $ 510

  8. Projected Summary Balance Sheet for Mom’s Cookie Company Exhibit 2 (in thousands) Year 1 Year 2 Year 3 Assets: Current assets $1,000 $1,200 $1,440 Plant assets 4,000 4,000 4,000 Total assets $5,000 $5,200 $5,440 Liabilities: Current liabilities $ 800 $ 960 $1,152 Long-term debt 0 0 0 Total liabilities 800 960 1,152 Stockholders’ equity 4,200 4,240 4,288 Total liabilities and equity $5,000 $5,200 $5,440

  9. Financing Decisions Return on equity (ROE) is net income divided by stockholders’ equity. It measures net income relative to the amount invested by stockholders in a company.

  10. Financing Decisions Investors and financial analyst use ROI to compare the performance of companies.

  11. Financing Decisions It can be used to compare one company with another or to compare a company’s performance in one period with its performance in another period.

  12. Return on Equity for Mom’s Cookie Company Exhibit 3 (in thousands) Year 1 Year 2 Year 3 Net income $ 140 $ 308 $ 510 Stockholders’ equity $4,200 $4,240 $4,288 Return on equity 3.3% 7.3% 11.9% Stockholders will earn 3.3 cents for each dollar invested. Stockholders will earn 7.3 cents for each dollar invested.

  13. Objective 2 Explain when it is beneficial for a company to use financial leverage.

  14. Effect of Financial Leverage What are debt-to-equity and debt-to-asset ratios?

  15. Effect of Financial Leverage These ratios are used frequently as measures of capital structure. It’s not uncommon to have a debt-to-asset ratio of 70% or more.

  16. Effect of Financial Leverage Exhibit 5 provides a graph that helps explain the effect of using debt.

  17. The Effect of Financial Leverage on Return on Equity Exhibit 5

  18. Net Income Stockholders’ Equity Net Income Total Assets Total Assets Stockholders’ Equity x = FL ROE ROA x = Effect of Financial Leverage Return on Equity = Return on Assets x Financial Leverage

  19. $140 $4,200 $140 $5,000 $5,000 $4,200 x = Effect of Financial Leverage Assume Mom’s Cookie Company uses no long-term debt the first year. ROE = ROA x FL 3.3% = 2.8% x 1.19

  20. $21 $2,500 $21 $5,000 $5,000 $2,500 x = Effect of Financial Leverage Assume Mom’s Cookie Company uses $2.5 million of liabilities. ROE = ROA x FL 0.8% = 0.4% x 2.0

  21. Objective 3 Explain why cash flows are important for a company’s financing decisions.

  22. Effects of Financing Decisions on Cash Flow and Liquidity Consider our cash flow. We will have a lot of cash outflows next year to increase the size of the business.

  23. Effects of Financing Decisions on Cash Flow and Liquidity If we add interest payments to our cash demands, we could face cash flow problems, especially if sales are less than expected.

  24. Effects of Financing Decisions on Cash Flow and Liquidity We won’t be able to borrow much additional money because creditors will be concerned about getting their money from us.

  25. Effects of Financing Decisions on Cash Flow and Liquidity And who will buy stock in a company that can’t pay its debts?

  26. Effects of Financing Decisions on Cash Flow and Liquidity Investors aren’t going to give us their money without expecting something in return. And if we pay dividends, we’ll be facing the same cash flow problems we would if we use debt.

  27. Effects of Financing Decisions on Cash Flow and Liquidity Stockholders benefit from their investments in two ways: receiving dividends and having the value of their stock increase over time.

  28. Effects of Financing Decisions on Cash Flow and Liquidity Exhibit 6 illustrates the benefit to stockholders of paying dividends and investing in productive assets.

  29. Stockholders Benefit from Dividends and from Investment of Cash in Productive Assets Exhibit 6

  30. Objective 4 Use financial statements to evaluate the financing activities of different companies.

  31. Evaluating Financing Activities 1. Identify financing activities for one or more companies and fiscal periods. 2. Measure capital structure for the companies and periods. 3. Evaluate the effect of the companies’ financing decisions on risk and return. 4. Evaluate the effect of financing decisions on cash flows and determine the ability of companies to make debt and interest payments. 5. Examine the relationship between a company’s financing decisions and its value to stockholders.

  32. Interpretation of Financing Activities Our analysis begins with a general overview of two companies—Krispy Kreme and Starbucks

  33. Selected Income Statement and Balance Sheet Information Exhibit 7

  34. Interpretation of Financing Activities A common method for comparing the income of different companies is to compute return on assets for each company.

  35. Krispy Kreme vs. Starbucks 2000 2001 Net Income Total Assets Return on Assets = $14,725 $171,493 5.7% Krispy Kreme = =8.6% $181,210 $1,851,039 6.3% Starbucks = =9.8%

  36. Interpretation of Financing Activities Starbucks was more profitable than Krispy Kreme in both 2000 and 2001.

  37. Interpretation of Financing Activities As a second step, we compare the capital structures of the two companies by using ratios such as debt to assets and assets to equity.

  38. Debt-to-Asset Ratio Comparison 2000 2001 Total Liabilities Total Assets Debt-to-Asset Ratio = $45,814 $171,493 54.5% Krispy Kreme = =26.7% $480,041 $1,851,039 23.0% Starbucks = =25.9%

  39. Interpretation of Financing Activities Another measure of capital structure is financial leverage: the ratio of total assets to total stockholders’ equity.

  40. Krispy Kreme vs. Starbucks 2000 2001 Total Assets Stockholders’ Equity Financial Leverage = $171,493 $125,679 2.20 Krispy Kreme = =1.36 $1,851,039 $1,375.927 1.30 Starbucks = =1.35

  41. Interpretation of Financing Activities The financial leverages of the two companies were about the same in 2001.

  42. Interpretation of Financing Activities Note that a company that uses more debt in its capital structure has a higher debt-to-equity ratio or asset-to-equity ratio than one that uses less debt.

  43. Objective 5 Determine and explain the effect of financial leverage on a company’s risk and return.

  44. The Effect of Financial Leverage on Risk and Return A third step in our analysis is to to determine the effect of financial leverage on the risk and return of our companies.

  45. The Effect of Financial Leverage on Risk and Return A ratio commonly used for this purpose is return on equity.

  46. Net Income Stockholders’ Equity Net Income Total Assets Total Assets Stockholders’ Equity = x 11.7% = 8.6% x 1.36 Starbucks Krispy Kreme 13.2% = 9.8% x 1.35 The Effect of Financial Leverage on Risk and Return Return on Equity = Return on Assets x Financial Leverage 2001

  47. The Effect of Financial Leverage on Risk and Return Exhibit 8

  48. Objective 6 Use cash flow and liquidity measures to evaluate financing decisions.

  49. Other Risk Considerations The fourth step in the analysis of financing activities involves evaluating the ability of each company to make debt and interest payments.

  50. Other Risk Considerations Default risk is the likelihood that a company will not be able to make debt and interest payments when they come due.

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