What is the Sarbanes-Oxley Act, and what is its focus? Why does it focus in these areas? Note – Please note that the requirement is to post your Initial Response (300 words). M

Fundamentals of Corporate Finance Fourth Edition

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.

Chapter 1

The Financial Manager and the Firm

Chapter 1: The Financial Manager and the Firm

2Copyright ©2018 John Wiley & Sons, Inc.

Learning Objectives

1. Identify the key financial decisions facing the financial manager of any business

2. Identify common forms of business organization in the United States and their respective strengths and weaknesses

3. Describe the typical organization of the financial function in a large corporation

4. Explain why maximizing the value of the firm’s stock is the appropriate goal for management

5. Discuss how agency conflicts affect the goal of maximizing stockholder value

6. Explain why ethics is an appropriate topic in the study of corporate finance

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The Role of the Financial Manager (1 of 2)

• Maximize Shareholder Wealth

o Maximizing the price of a firm’s stock will maximize the value of a firm and the wealth of its shareholders/owners

• Stakeholders

o Managers, employees, suppliers, creditors, and the government

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The Role of the Financial Manager (2 of 2)

• It’s All About Cash Flows

o Positive residual cash flow may be paid to firm owners as dividends or invested in the firm

o The larger the positive residual cash flow, the greater the value of a firm

o Negative residual cash flow, over the long run, leads to bankruptcy or closing a business

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The Role of the Financial Manager

• Three Fundamental Decisions in Financial Management

o Capital Budgeting: identify which long-term assets to acquire to maximize net benefits for the firm

o Financing: determine how to pay for short-term and long-term assets by finding the best combination of short-term debt, long-term debt, and equity

o Working Capital: decide how to manage short-term resources and obligations by adjusting current assets and current liabilities to promote growth in cash flow

• Poor decisions about capital budgeting, financing, or working capital may lead to bankruptcy or business failure

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8Copyright ©2018 John Wiley & Sons, Inc.

Forms of Business Organization

• Sole proprietorships

• Partnerships

• Corporations

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Sole Proprietorship

• Owned by a single person who is financially responsible for the actions and obligations of the business

• Advantages

o Easiest to create and control

o Easiest to dissolve

o Right to all profits

• Disadvantages

o Owner’s personal assets at risk due to unlimited liability for firm obligations

o Equity only from owner or business profit

o Business income taxes as personal income

o Difficult to transfer ownership

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Partnership

• A business owned by more than one person; one or more of them is financially responsible for the actions and obligations of the business

• Advantages

o Limited protection of owner’s personal assets

o Owner’s limited liability for firm obligations

o More sources of equity

o More sources of expertise

• Disadvantages

o Shared control

o Shared profit harder to dissolve

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Corporation • A business owned by more than one person; none of them are financially

responsible for the actions and obligations of the business. The corporation is responsible for its obligations and actions.

• Advantages

o Protects personal assets

o No shareholder liability for business

o Easiest to change ownership

o Greatest access to sources of funds

• Disadvantages

o Most difficult and expensive to establish

o Dilutes individual control over the firm

o Overall higher taxes on income for shareholders

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Hybrid Forms of Business Organization

• Limited Liability Partnerships (LLPs)

• Limited Liability Companies (LLCs)

• Both combine limited liability with tax advantages of a partnership

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Managing the Financial Function

• Organizational Structure

o Chief Financial Officer (CFO), responsible for the quality of the financial reports received by the Chief Executive Officer (CEO)

o Positions Reporting to the CFO

• Treasurer

• Risk Manager

• Controller

• Internal Auditor

o External Auditor

o Audit Committee

o Compliance and Ethics Director

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16Copyright ©2018 John Wiley & Sons, Inc.

The Goal of the Firm

• Why not maximize market share?

o Giving away goods or services for free will maximize a firm’s market share for a while, but the firm will not be able to pay its bills and stay in business

• Why not maximize profits?

o Accounting profit differs from economic profit

o Profit earned may not equal cash received

• Maximize the value of the firm’s stock

o Future cash flows are considered

o The timing of future cash flows is considered

o The risks associated with having to wait to for cash flows are considered

• Management decisions affect cash flows and therefore stock prices

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18Copyright ©2018 John Wiley & Sons, Inc.

Agency Relationship

• An agency relationship is created when the owner (a principal) of a business hires an employee (an agent)

• The owner surrenders some control over the enterprise and its resources to the employee

• Separating ownership from control creates the potential for agency conflicts

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Agency Conflicts

• An agency relationship exists between stockholders (principals) and the firm’s hired management (agents)

• Ownership and Control

o In large corporations, shared ownership among many shareholders may result in relatively little control over management

o Shareholders own the corporation, but managers control the firm’s assets and may use them for their own benefit

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Agency Costs

• Agency Costs are costs that arise from incurring and preventing conflicts of interest between a firm’s owners and its managers

• These costs may reduce positive residual cash flow, stock price, and shareholder wealth

• Agency costs can be reduced by

o Increased oversight

o Aligning incentives

• Giving agents the right incentives to reduce agency costs

o Managers tend to focus on wealth maximization when their compensation depends on stock price

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Aligning the Interests of Managers and Stockholders • Board of Directors has oversight over the CEO and

major capital decisions

• Managerial labor market provides incentives to run the company well

• Internal competition among managers

• Large stockholders also monitor managerial decisions

• Corporate raiders search for takeover targets

• Legal and regulatory constraints limit managerial behavior

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Sarbanes-Oxley and Regulatory Reform (1 of 2) • Better corporate governance reduces agency costs by

requiring

o More effective monitoring of managers’ activities

o Programs that promote appropriate behavior by managers

o Penalties for executives who do not fulfill their fiduciary responsibilities

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Sarbanes-Oxley and Regulatory Reform (2 of 2) • The new regulations require all public corporations to

implement the following strategies:

o Ensure greater board independence

o Establish internal accounting controls

o Establish compliance programs

o Establish an ethics program

o Expand the audit committee’s oversight powers

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25Copyright ©2018 John Wiley & Sons, Inc.

The Importance of Ethics in Business

• What are Ethics?

o Ethics are society’s standards for judging whether an action is right or wrong

o Business Ethics are society’s standards for acceptable behavior applied to business and financial markets

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Ethics in Corporate Finance (1 of 2)

• Examples of Ethical Conflict in Business

o Agency Cost

• Employee’s unacceptable use of employer’s computer

• Conflict of Interest

o Mortgage contract which a home-buyer is unlikely to fulfill but earns a mortgage broker more money–

• Information Asymmetry

o Seller knows about prior damage to the vehicle but the potential buyer does not

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Ethics in Corporate Finance (2 of 2) • Business Behavior

o Regulation and market forces are not enough to maintain integrity in the marketplace

o Business norms must be based on ethical beliefs, customs, and practices

• Ethical Behavior

o It is sometimes difficult to judge whether behavior is ethical or not

• Was the manager too careful?

• Did the manager take too much risk?

• Consequences of Unethical Behavior

o Inefficiency in the economy and costs to society

o High legal and social costs

o Problems such as the recent financial crisis in the U.S.

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29Copyright ©2018 John Wiley & Sons, Inc.

Copyright

Copyright © 2018 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of this work beyond that permitted in

Section 117 of the 1976 United States Act without the express written permission of the

copyright owner is unlawful. Request for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up

copies for his/her own use only and not for distribution or resale. The Publisher assumes

no responsibility for errors, omissions, or damages, caused by the use of these programs

or from the use of the information contained herein.

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Fundamentals of Corporate Finance Fourth Edition

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.

Chapter 4

Analyzing Financial Statements

Chapter 4: Analyzing Financial Statements

2Copyright ©2018 John Wiley & Sons, Inc.

Learning Objectives

1. Explain the three perspectives from which financial statements can be viewed

2. Describe common-size financial statements, explain why they are used, and be able to prepare and use them to analyze the historical performance of a firm

3. Discuss how financial ratios facilitate financial analysis and be able to compute and use them to analyze a firm’s performance

4. Describe the DuPont system of analysis and be able to use it to evaluate a firm’s performance and identify corrective actions that may be necessary

5. Explain what benchmarks are, describe how they are prepared, and discuss why they are important in financial statement analysis

6. Identify the major limitations in using financial statement analysis

3Copyright ©2018 John Wiley & Sons, Inc.

Perspectives on Financial Statement Analysis

• Stockholders focus on net cash flows, risk, rate of return, and the market value of the firm’s stock

• Managers focus on rate of return, efficient use of assets, controlling costs, increasing net cash flows, increasing the market value of the firm’s stock, and job security

• Creditors focus on the predictability of revenues and expenses, the ability to meet short-term obligations, the ability to make loan payments as schedule, and avoidance of changes in risk

4Copyright ©2018 John Wiley & Sons, Inc.

Guidelines for Financial Statement Analysis

• Understand which perspective: stockholder, manager, or creditor

• Use audited financial statements

• Use 3 to 5 years of statements to enable trend analysis

• Benchmark to competitors of similar size with similar products and services

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Common-Size Financial Statements

• Common-size financial statements show the dollar amount of each item as a percentage of a reference value

o Common-size balance sheet may use total assets as the reference value; each item is expressed as a percentage of total assets

o Common-size income statement may use net sales as the reference value; each item is expressed as a percentage of net sales

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Common-Size Balance Sheet

• The Common-Size Balance Sheet standardizes the amount in a balance sheet account by converting the dollar value of each item to its percentage of total assets

o Dollar values on a regular balance sheet provide information on the number of dollars associated with a balance sheet account

o Percentage values on a common-size balance sheet provide information on the relative size or importance of the dollars associated with a balance sheet account

7Copyright ©2018 John Wiley & Sons, Inc.

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Common-Size Income Statement

• The most useful way to prepare a common size income statement is to express each account as a percentage of net sales

• Each expense is interpreted as the cost incurred to generate $1 in sales

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Financial Ratios and Firm Performance

• Financial ratios establish a common reference point across firms, even though the numerical value of the reference point will differ from firm-to-firm

o Ratios make it easier to compare the performance of large firms to that of small firms

o Ratios make it easier to compare the current and historical performance of a single firm as the firm changes over time (trend analysis)

11Copyright ©2018 John Wiley & Sons, Inc.

Categories of Common Financial Ratios

• Liquidity ratios

• Efficiency ratios

• Leverage ratios

• Profitability ratios

• Market Value ratios

12Copyright ©2018 John Wiley & Sons, Inc.

Short-Term Liquidity Ratios

• Liquidity ratios indicate a firm’s ability to pay short-term obligations with short-term assets without endangering the firm. In general, higher ratios are a favorable indicator

Equation 4.1

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 Equation 4.2

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

13Copyright ©2018 John Wiley & Sons, Inc.

14Copyright ©2018 John Wiley & Sons, Inc.

Efficiency Ratios (1 of 2) • Efficiency ratios indicate a firm’s ability to use assets to

produce sales. These are also called turnover ratios. In general, higher numbers are a favorable indicator. For Days Sales in Inventory, however, a lower number is favorable.

Equation 4.3

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 Equation 4.4

𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 365 𝑑𝑎𝑦𝑠

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

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Efficiency Ratios (2 of 2)

Equation 4.5

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

Equation 4.6

𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 = 365 𝑑𝑎𝑦𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

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Asset Turnover Ratios

Equation 4.7

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Equation 4.8

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

17Copyright ©2018 John Wiley & Sons, Inc.

Leverage Ratios

• Leverage ratios indicate whether a firm is using the appropriate amount of debt financing. In general, higher ratios indicate greater potential return and greater bankruptcy risk. Equation 4.9

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Equation 4.10

𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Equation 4.11

𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

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Coverage Ratios

• For the following ratios, a higher number generally indicates less bankruptcy risk and (possibly) lower potential return Equation 4.12

𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 = 𝐸𝐵𝐼𝑇

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

Equation 4.13

𝐶𝑎𝑠ℎ 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 = 𝐸𝐵𝐼𝑇𝐷𝐴

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

19Copyright ©2018 John Wiley & Sons, Inc.

Profitability Ratios (1 of 2)

• Profitability ratios indicate whether a firm is generating adequate profit from its assets. In general, higher ratios indicate better performance.

Equation 4.14

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Equation 4.15

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝐸𝐵𝐼𝑇

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

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Profitability Ratios (2 of 2) Equation 4.16

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 Equation 4.17

𝐸𝐵𝐼𝑇 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐸𝑅𝑂𝐴 = 𝐸𝐵𝐼𝑇

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 Equation 4.18

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Equation 4.19

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

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Market Value Indicators

• Market value ratios indicate how the market is valuing the firm’s equity. Higher ratios indicate greater shareholder wealth. Equation 4.20

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Equation 4.21

𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑎𝑡𝑖𝑜 = 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Equation 4.22

𝑀𝑎𝑟𝑘𝑒𝑡 𝑡𝑜 𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

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The DuPont System

• Diagnostic tool for evaluating a firm’s financial health

• Uses related ratios that link the balance sheet and income statement

• Based on two equations that connect a firm’s ROA and ROE

• Used by management and shareholders to understand factors that drive ROE

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ROA and ROE Equations Equation 4.23

𝑅𝑂𝐴 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Equation 4.24

𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟

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The DuPont Equation

Equation 4.25

𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟

Equation 4.26

𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 ×

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Equations 4.25 and 4.26 show that ROE is driven by profitability, operating efficiency, and amount of leverage (debt)

26Copyright ©2018 John Wiley & Sons, Inc.

27Copyright ©2018 John Wiley & Sons, Inc.

Selecting a Benchmark

• A ratio or ratio analysis is relevant only when compared to an appropriate benchmark

o Trend Analysis – comparison to the firm’s historical performance

o Industry Analysis – comparison to the aggregate of firms in the same industry

• Standard Industrial Classification (SIC) System

• North American Industry Classification System (NAICS)

o Peer Group Analysis – comparison to a select group of firms in the same industry

28Copyright ©2018 John Wiley & Sons, Inc.

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