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Module 1-3: Finance for Business Leaders

1. THE FINANCIAL GOALS OF A FIRM

Many business leaders define the ultimate financial goal of a firm as to maximize shareholder wealth or the creation of shareholder wealth. Both terms may be used interchangeably but essentially the goal is to have the price of its stock as high as possible. In order for a companys stock to grow in value you must have profitable growth. Profitable growth means that a companys profit grows at a greater rate than revenue. This however might be difficult to achieve over a long period of time. At the minimum, companies try to make sure that their profit is growing at the same rate as their revenue. Profitable growth begins with the growth in a companys revenue or top line but that is not enough. What a company really aims at is growth in profits or bottom line growth. It is the growth in profits that investors seek from a company in order to be willing to buy its shares, thus creating demand for the shares and increasing their price. As we mentioned in the audio segment, the value of the company is measured by multiplying the price of each share by the number of shares outstanding. The result is also referred to as total market capitalization.1 Key Learning Point: Meaning and Measurement of Profitable Growth Lets take a look at some other measures that indicate if a company is achieving profitable growth. An important measure is return on equity or ROE. ROE is:

Where equity is the total ownership of the company by stockholders as shown on the companys accounting books. Return on equity shows how much a company is earning on what the shareholders invested.

Total market capitalization and other indicators of how well a company does in creating value for its owners are discussed in greater detail in the next chapter. 1

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Module 1-3: Finance for Business Leaders Another measure of profitable growth is return on assets or ROA. This defines the percent that the company is earning on its total assets (which include such items as cash, accounts receivable, inventory and fixed assets land, buildings and equipment). ROA is:

There are also other measures that can be used, such as return on capital or ROC. Capital is defined as equity plus interest-bearing debt. ROC is:

One other financial indicator must be mentioned, earnings per share or EPS and is taught in succeeding Learning Bursts. EPS is:

This measure is often used by financial analysts to judge a companys performance. In many instances, when companies strive to grow profit faster than revenue, the profit they are referring to is EPS. Does your company have specific target levels for ROE or ROA or ROC? If so what are they?

For example, several companies that we have worked for have stated their targets as ROE = 25% and ROA = 10%.

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Quiz 1. Which financial target is used to measure a companys market share? a. profit b. cash flow c. sales d. return-on-investment 2. Which of the following is not used as a measure of a companys return-oninvestment? a. Return on capital b. Return on sales c. Return on equity d. Return on assets 3. According to financial analysts, the most important financial objective of a company is to? a. Survive b. Grow its revenue c. Achieve a high net profit margin d. Increase the companys value to its owners

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2. THE IMPORTANCE OF CREATING SHAREHOLDER VALUE

From a business perspective, the most important thing that a company can do is to create value for its owners. Indeed, if it is possible, it should try to maximize this value. All employees of a company, regardless of whether they own shares of stock in the company should strive to achieve value maximization. It is more rewarding, both in compensation, job, or career opportunities to work in financially healthy companies that are maximizing shareholder value. The negative consequences for employees of companies that fail to improve or maximize shareholder value are all too well known. Key Learning Point: Share price and market value For publicly held companies whose shares are traded in the stock market, their stock price (also called their share price) is a primary measure of market value. In fact, the term total market value or total market capitalization is simply a measure of the share price multiplied by the number of a companys shares outstanding. That is:

Key Learning Point: Total Shareholder Return (TSR) This ratio is a measure of increases in a firms stock price (also called stock price appreciation) plus its dividends paid out, in relation to the original purchase price of a share of stock. That is:

WHERE

Priceend = share price at end of period Pricebegin = share price at beginning of period D = dividends paid

An annual total shareholder return of about 10% is considered to be a solid return for a typical investment. After all, if you received a 10% annual total shareholder return and assuming you reinvested your dividends; you would double your money in about 7 years, which is not bad! 4

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For the past five years, what is your companys TSR?

What conclusions can you draw from this?

Key Learning Point: Price-Earnings Ratio (also called P-E Ratio, P-E Multiple, and Earnings Multiple) This ratio measures the relationship between a companys stock price per share and its earnings per share. The formula below shows how the P-E ratio is computed:

If last years earnings are used, then this ratio is referred to as the Trailing P-E Ratio. If the projections of next years earnings per share are used, then the term Forward P-E Ratio is used. The average P-E ratio of companies on the major stock exchanges in the United States in past years is about 16. Here are some important points to think about when you evaluate the P-E ratio of any company: 1. Is the companys ratio comparable to that of similar types of companies? 2. What is the average P-E ratio of this companys industry? How does the company compare with the industry average? Remember that P-E ratios can differ among different industries. 3. What is the companys growth potential? Generally companies with higher growth potentials have higher P-E ratios. What is your companys EPS? For last year, what is your companys P-E Ratio? What is your industrys average P-E ratio? How do the two compare? What steps can your company take to try to increase the P-E ratio?

Note: Because the potential growth of a company is an important factor that influences its P-E ratio, many companies try to make sure that investors recognize their growth 5

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Module 1-3: Finance for Business Leaders potential. For example, companies stress their increasing market presence in the rapidly growing BRIC (Brazil, Russia, India and China) countries.

Does your company have a BRIC Strategy? If so, what is it?

Key Learning Point: Market-to-Book Ratio This ratio shows the relationship between a companys total market value and its book value. Simply put, a companys book value is the value of its owners equity. The basic idea is that at any given point in time, the equity on a companys balance sheet indicates the total worth of the company to its owners based on the book value of its assets minus all of the firms obligations to its creditors (i.e. its liabilities). The formula to compute the Market-to-Book Ratio of a company is:

Lets use a simple balance sheet to illustrate this. Using the simple balance sheet shown below, we see that the Beacon Companys Market-to Book Ratio is:

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Module 1-3: Finance for Business Leaders We can also compute this ratio on a per-share basis by dividing the price of the stock by the Equity per share. That is:

Now suppose that there are 100 shares of the companys stock outstanding. Then the formula would be:

If the total market value of a firms shares of stock is greater than the value of the owners equity then, in effect, the managers of the company have created a market value for the owners that is greater than the book value of the owners investment. As long as the market value is greater than its book value, then we consider this company to be creating value. In other words, if a companys market value is greater than its book value, then the Market-to-Book ratio will be greater than one. There is no specific numerical criterion for evaluating this ratio, other than to say that the higher the better. Solid performing companies generally have Market-to-Book ratios of around 4. A company whose market value falls below the book value (i.e. its market-to-book ratio is less than one), is a poor performer. Think about it this way. Suppose this company were to go out of business and liquidate its assets based on the book value of these assets on its balance sheet. After it receives the cash for the sale of these assets, and pays off all the creditors such as the suppliers, the employees, the banks, whatever is left would be the book value of the owners equity and we assume this would be paid out to the owners. This further means that its owners would receive more cash from the liquidation of the company than the sale of its stock as a going concern! Using the numerical example above, suppose the companys market value is 100. Assuming 100 shares outstanding, the market price per share is $1.00. If it liquidated its $1,000 of assets at book value and paid off its liabilities of $800, then the owners would receive $200 or $2.00 per share (refer to Balance Sheet on page 10.)

What is your companys current Market-to-Book Ratio? Over the past few years, how is it trending? Up, down, or remaining the same? 7

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If you were conducting a quarterly results call with 15 analysts, what would you say to them about your companys performance? What message would you want to communicate to the team you lead?

Quiz (check your answers in Appendix B) 1. The Price-Earnings Ratio is a. The price per share divided by earnings b. The price per share divided by EPS c. Stock price divided by profit d. Stock price divided by a multiple of earnings 2. Which of the following indicates that a company is successful in creating value for its owners? a. b. c. d. The Market-to-Book Ratio is equal to the P-E ratio Total Shareholder return is positive The Market-to-Book Ratio is positive The P-E ratio is greater than 20

3. Which one of these ratios most closely measures the actual return that owners of a company have received from their investment in a company? a. b. c. d. The P-E Ratio The Market to Book Ratio Total Shareholder Return All of them indicate the actual return earned by owners of a company

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Module 1-3: Finance for Business Leaders

3. WHY THE BALANCE SHEET BALANCES

The balance sheet is a statement of a firms financial condition at a particular point in time. The right side of the balance sheet shows the sources of companys cash (i.e. its liabilities and equity) and the left side of the balance sheet shows its uses of cash (i.e. its long term investment in fixed assets and its short term investment in current assets). Simply put, the balance sheet balances because the sources of its cash equals the uses of its cash at any one period of time. Key Learning Point: Balance Sheet as one of the three statements of financial performance In this Learning Burst, we introduce The Balance Sheet, one of the three basic statements of financial performance that are presented in a companys annual report. It is a snapshot of a business financial condition at a specific moment in time, usually at the close of an accounting period. Its more formal name is Statement of Financial Position. We refer to it throughout these Learning Bursts by its more common name, The Balance Sheet. The Balance Sheet is what finance people call a stock measure or concept. (This should not be confused with a companys shares of stock.) In this case, stock refers to any financial entity that measures a value at point in time. Besides the balance sheet, other examples of stock measures are the amount of money that you have in your checking account or the market value of your home, such as As of December 31, 200X, this is what the companys balance sheet looks like. Right now I have $1,000 in my checking account. Today, the average price of a home is 10 percent higher than one year ago. Here is a simple presentation of the three financial statements and their key components. We talked briefly about the income statement in Learning Burst 4. The Income Statement and the Statement of Cash Flow are discussed in subsequent Learning Bursts.

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Module 1-3: Finance for Business Leaders Here is a simple Balance Sheet and how it operates relative to the Income Statement and Statement of Cash Flows.

It comprises assets, liabilities, and owners or stockholders equity. At any given time, assets must equal liabilities plus owners equity. The Balance Sheet along with the Income Statement and Statement of Cash Flows make up The Principal Elements of the Financial Report. Key Learning Point: Why the Balance Sheet Balances Every accounting student learns on the first day of class what accountants call the accounting equation. That is: assets (A) must be equal to Liabilities (L) and Equity (E). In other words:

To understand why, lets look at definitions of each term. Assets: Resources that a company invests in that are intended to generate future streams of revenue, profit, and cash. Examples of assets are property, plant and equipment, inventory, and accounts receivable. Liabilities: Money that a company has borrowed and is obligated to repay. It includes such obligations as money owed to creditors such as banks or suppliers. Equity: (Also called Total Equity, Owners Equity or Shareholders Equity) this is the monetary value that represents the owners investment in the business. Essentially, the balance sheet balances because the right-hand side of the balance sheet (or the right side of the accounting equation) represents money that the companys creditors and owners have put into the company. The left-hand side of the balance sheet (or the left side of the accounting equation) indicates what the managers did with this money.

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Lets try a short exercise to test your understanding. Question 1: On the balance sheet where did the company get its cash?

Answer 1: From creditors and owners. Question 2: Where did the cash go?

Answer 2: It was used to purchase the companys assets. Question 3: Why?

Answer 3: Because this investment in assets is intended to generate future revenue, profit and cash flow. Enough to meet the obligations of the creditors and the expectations of the owners for a return on their investment in the company. This is why we say in the audio segment: Where from? (Liabilities and Equity) Where to? (Assets) and So what? (Revenue, Profit, Cash Flow). Key Learning Point: Major Components of Assets, Liabilities, and Equity We now look at the main components of a companys assets, liabilities, and equity. Sometimes, to make the distinction between each of these categories and their specific components, finance people use the term total. Unless specified, you can assume that when the term is used without any particular designation, it refers to the total. For example, assets means total assets. Total Assets Current Assets: These are either cash or components that the company believes will be converted into cash with a short period of time (less than one year from the time the balance sheet is stated). The other components are: accounts receivable (money owed to the company by its customers) and inventory (goods bought or produced but not yet sold). Fixed Assets: Fixed assets are investments that tie up a companys cash for more than one year. Examples are property, plant, and equipment.

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Module 1-3: Finance for Business Leaders Intangible Assets: As the name implies, these are fixed assets that are intangible, i.e. they cannot be touched or felt. Examples are software and intellectual property, such as patents and goodwill.2 For simplicity, throughout the Learning Bursts, we will consider both tangible fixed assets and intangible assets to be part of the category Fixed Assets. What are some of your companys Fixed Assets?

Total Liabilities Current Liabilities: These are obligations that the company must satisfy to its creditors within one year of the statement of the balance sheet. Examples of these are accounts payable (money owed to suppliers) and notes payable (money owed to banks). Long-term Liabilities: These are obligations that the company must satisfy more than a year after the statement of the balance sheet. An example of this is a 5-year bond. What are some of your companys Liabilities?

Total Equity (Also called Shareholders or Owners Equity) Capital Stock: This is the value of the shares of stock when first issued to the owners of the company. Accumulated Retained Earnings (also called reinvested earnings): This is the total amount of net profit that the company has earned each year, accumulated from the

To avoid getting too technical, let us simply say that goodwill represents the premium that a company pays when it buys another company. This premium could represent the companys brand, its customer list, or the special skills and knowledge of its employees, all of which can be considered intangible. 12

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Module 1-3: Finance for Business Leaders time the company was started, minus the pay-out of dividends over this same time period.

Key Learning Point: How the Balance Sheet is Constructed Lets demonstrate how the Balance Sheet works using the example from the audio segment about Phil starting a restaurant and buying refrigerators from Daves appliance store. February 1st. Phil starts his restaurant with an equity investment from his family, friends, and his personal savings. He issues 90 shares of stock at a price of $1,000 per share. Thus, we can say that his capital stock is 90 x $1,000 or $90,000. Phil was also able to obtain a small business loan of $10,000 from his local bank. During the month of February, he took the money to buy an already existing restaurant for $75,000. The equipment was worth $40,000. In addition, he made $10,000 of capital improvements in the restaurant. Therefore his fixed assets are $50,000. There also was goodwill established by the previous owner worth $25,000. This is how his balance sheet looked like at the end of the month.

Notice how the right-hand side of the balance sheet in effect is financing the lefthand side of the balance sheet. In the audio, we explain that the right side shows where the money is coming from in order for Phil to start his restaurant. In this case, it comes from an equity investment of $90,000 and a loan of $10,000. Other sources of future funding could come from additional loans and profits that are not paid out in dividends to the owners (called accumulated retained profit). It could also come from the current term such as accounts payable.

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Module 1-3: Finance for Business Leaders The best way to become familiar with the balance sheet and its components is to work on some exercises. Try the following. Put the following items into their proper place on the balance sheet. Check your work by making sure that the balance sheet balances.

Check you answer on the next page.

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Module 1-3: Finance for Business Leaders And the answer is

Heres another exercise that you can do, this time using your own companys balance sheet. Review your companys balance sheet and identify the value of the following: Total Assets Total Liabilities Total Shareholders Equity Accounts Receivable Accounts Payable Cash on Hand ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________

Quiz (check your answers in Appendix B) 1. Which of the following is a current asset? a. Inventory b. Accounts Payable c. Machinery d. Share Capital 2. What is the difference between a short-term liability and a long-term liability? a. Short-term liability does not have to be repaid b. Short-term liability must always match current assets c. Short-term liability must be repaid within one year, long-term, beyond one year 15

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Module 1-3: Finance for Business Leaders d. Short-term must be repaid within one month, long-term liability, beyond one month 3. Which item is not included in Owners Equity? a. Cash b. Accumulated retained earnings c. Capital stock d. All are included

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4. FROM TOP LINE TO BOTTOM LINE

The top line of a companys income statement is revenue or sales, and the bottom line is net profit or net income.3 In between there are different levels of profit such as gross profit, operating profit, and pre-tax profit. Other important line items on an income statement are cost of goods sold, expenses, interest and taxes. Knowing these items helps to analyze the different levels of profit. Key Learning Point: The Distinction between Measures of Stock and Flow A measure of financial performance for a given point in time is called a stock measure, and a measure of performance for a given period of time is called a flow measure. The Balance Sheet is a stock measure and the Income Statement is a flow measure. Therefore, any item on the Balance Sheet (e.g. cash, inventory, accounts receivable, and fixed assets) is a stock measure. Any item on the Income Statement (e.g., revenue, cost of goods sold, expenses, interest, and taxes) is a flow measure.

Question: In addition to the Balance Sheet and the Income Statement, there is a third important financial statement in a companys annual report called the Statement of Cash Flows. Is this a stock or a flow measure? Answer: As the name implies, it is a flow measure. Perhaps you thought we gave you a trick question?

The term net profit (or simply profit) is most commonly used in everyday financial discussions. The term net income is the term generally used in the income statement in a companys annual report. 17

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Key Learning Point: Brief Description of the Major Items on an Income Statement A typical Income Statement contains the following major items.

Revenue (also called Sales): Total monetary amount received or to be received later from customers from the sale of products or provision of services during a given reporting period. Cost of Goods Sold (also called Cost of Sales or Cost of Revenue): Total cost of the goods that were sold during the reporting period. For a manufacturer, this would involve the cost of making the products that they shipped. For a retailer, this would involve the wholesale cost of the goods that were sold to its retail customers. For a provider of services, this would involve the cost of providing billable services, particularly labor cost. Operating Expenses: All expenses other than cost of goods sold. The main items usually listed by companies are selling (includes marketing), general, and administrative expenses (S, G, and A) and research and development (R&D). Depreciation: Portion of the original cost of certain fixed assets (e.g., buildings, machinery, equipment, tools, furniture, etc.) that is recorded as a cost or expense during the reporting period. Interest: Total interest payments on the firms debt owed during the reporting period. Taxes: Total income taxes due to the government during the reporting period.

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Module 1-3: Finance for Business Leaders Net Income: Total amount of money that the firm earned during the reporting period after all accrued expenditures have been subtracted from revenue. Other terms for Net Income include: Net Profit, Net Profit After Taxes, Earnings, Net Earnings, Net Earnings After Taxes, or simply the Bottom Line.

Key Learning Point: The Treatment of Depreciation on the Income Statement As explained in Learning Burst 7, depreciation is considered to be an expenditure even though it is not reflective of the actual cash expended by a company for the purchase of a fixed asset. Depreciation can be considered either as part of the cost of goods sold or as expenses, depending on how the fixed assets being depreciated are used in company operations. For example, in a manufacturing company, the depreciation of plant and equipment used in making products would be considered part of cost of goods sold. The depreciation of fixed assets in such activities as sales and marketing, customer support, and research and development would be part of the expenses in an Income Statement. Sometimes, depreciation is expressed as a separate line item in the formal presentation of an Income Statement in a companys annual report. However, usually a company reports depreciation expenses in a footnote to the Income Statement. So if you are really interested in knowing a companys depreciation expenses, youll have to be prepared to read the fine print. (Note: Depreciation is also reported in the Statement of Cash Flows.) Key Learning Point: The Bottom Bottom Line One step below the bottom line of Net Income is the measure called Earnings Per Share or EPS. We have introduced this term in several other Learning Bursts, so we just want to remind you that this is an important measure, particularly for financial analysts who really want to know how much profit a company has made for its shareholders. We also explained that this measure plays in important part in determining a companys Price-Earnings Ratio. Income Statement Exercise The best way to become familiar with all of the items in an Income Statement is do an actual numerical exercise. (Note: We also give you more opportunity to practice in our Learning Burst simulation.) Construct an income statement based on the following activities. Note: Some of the items do not belong on the income statement.

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Module 1-3: Finance for Business Leaders And the answer is

Quiz (check your answers in Appendix B) 1. In which case would the depreciation of computers be considered a part of cost of goods sold? a. Computers used for in the companys billing system (e.g. invoicing and accounts receivable management) b. Computers used in its research laboratories c. Computers used in its manufacturing facilities d. Personal computers used in its training facilities 2. In a typical Income Statement, which measure of profit would come after operating income but before net income? a. Gross Profit b. EBIT c. Gross Income d. PTI

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5. UNDERSTANDING THE DIFFERENT MEASURES OF PROFIT AND PROFIT MARGIN

A key number in a companys Income Statement is the bottom line or net profit. In order to evaluate a companys ability to earn a profit during a given time period, we compute the different levels of profit as a percentage of revenue. In so doing, we are measuring what is called profit margin. Key Learning Point: The Gross Profit Margin The formula for gross profit margin is:

The key factors that affect Gross Profit Margin are: Price per unit sold Cost of Goods Sold per unit Mix of the goods and services sold (i.e. the product mix)

Price per unit sold. If you can increase price without increasing unit cost, then Gross Profit will increase. Cost of Goods Sold per unit. If you can reduce unit cost without a price decrease, then you will realize a Gross Profit increase. Remember, Gross Profit = Revenue COGS. On a unit basis we can also say that Gross Profit = Price Unit Cost. Whenever we calculate Gross Profit Margin, we can either use the TOTAL or the UNIT number to obtain the percentage. The following simple illustration shows this.

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As you can see, you can arrive at Gross Profit Margin either by using the Total numbers or the Per Unit numbers. Both result in a 33% margin. Mix of the goods and services sold. If a company can sell more products with a high Gross Profit Margin, then its overall Gross Profit Margin will increase. For example, in Learning Burst 13, we talk about a restaurant improving its overall profit margin by selling lots of high gross margin items such as specialty coffees, desserts, and, of course, alcoholic beverages. Key Learning Point: The Operating Profit Margin The formula for operating profit margin is:

Other frequently used terms for this measure are: OI Margin (Operating Income Margin), and EBIT Margin (Earnings Before Interest and Taxes Margin.) Operating Profit Margin is a reflection of a companys Gross Profit Margin and its ability to manage expenses relative to its gross profit margin. A useful indicator of this ability is the ratio of a companys expenses to its revenue. Financial people may call this Expense to Revenue Ratio or simply the E to R. Here it is as a formula.

Typical E to R ratios can range from 5 percent to as high as 30 percent. To analyze a companys ability to manage its expenses, you have to know and understand its gross profit margin. Companies with high gross profit margins can afford to spend more on expenses such as marketing and research and development and still end up with a respectable net profit margin. Companies with low gross profit margins cannot afford 23

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Module 1-3: Finance for Business Leaders to spend much on expenses because their net profit margin will quickly turn from positive to negative. The diagram below shows a spectrum of possible gross profit margins from low to high. The cut-off levels used to determine the lower, middle, and upper levels are rough approximations. The higher the gross profit margin, the more that a company can afford to spend on expenses.

Question: What do you think is the gross profit margin of a typical pharmaceutical company?

What do you think is their E to R.

Answer: It is common for pharmaceutical companies to have gross profit margins between 70 to 80 percent. This is clearly on the extreme right of our gross margin chart. The E to R of these companies, including their selling, general, and administrative expenses and their research and development is in the range of 25 to 35 percent. Key Learning Point: The Earnings Model To further understand the interrelationship between a companys gross profit margin, expense to revenue ratio, and operating profit margin, lets look at what finance and accounting people call an Earnings Model (also called a Profit Model, and an Income Model another term for this is Common Size Income Statement.

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Take a closer look at the different elements of each companys Income Statement as they relate to revenue and each other. For ease of comparison, we show that company A and B have the same amount of revenue. Question: Company Bs Expense to Revenue Ratio is higher than company As. (40% vs. 30%). Yet, its Operating Profit Margin and Net Profit Margins are higher. Why?

Answer: It is clear that company A has a greater Cost of Goods Sold and therefore a lower Gross Profit Margin. In terms of Net Profit, company Bs net profit of 11% is over twice that of company As at 5%. Conclusion: The advantage that company B has in Gross Profit Margin outweighs the higher percentage of revenue that it incurs in expenses.

Key Learning Point: Horizontal Analysis Another way of looking at a companys Income Statement is to track its changes over time. This is called a Horizontal Analysis or Trend Analysis.

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Gross Profit varies over the 5 year period but end up in year 5 higher than in year 1. Notice what has happened to Operating Profit Margin over the same 5 years it has declined even though Gross Profit Margin has increased. Question: What do you think happened to cause these results?

Answer: It appears that the company has not been able to control its expenses while growing Revenue and improving its Gross Profit Margin. Look at how its E to R grew from 25% in year 1 to 29.2% in year 5. Key Learning Point: Net Profit and Pre-tax Profit The two remaining levels of profit are Pre-tax Profit and Net Profit. Both of these types of profit margin are affected by the gross and operating margins. Throughout these Learning Bursts we talk much more about Net Profit Margin than Pre-tax Profit Margin. But you should be aware of both measures. The difference between Pre-tax Profit and Net Profit is obviously the accrued amount of a companys income tax expense. Some companies are very good at managing their income tax expenses, because they have skilled specialists who are very familiar with tax laws and tax rates for any of the countries of the world in which a company might be operating. As a measure of financial performance, Pre-tax Profit Margin does not consider this particular skill in running a business. We will elaborate further on Net Profit Margin in subsequent Learning Bursts.

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Quiz
1. Which of the following shows a companys financial performance over a number of years? a. Earnings model b. Common size income statement c. Horizontal analysis d. Profit model 2. E to R stands for a. earnings to revenue b. expenses to revenue c. expenses to returns d. expenditures to risk 3. Which of the following gross profit margins would a successful software company be most likely to have? a. 35% b. 50% c. 60% d. 75%

ANSWERS TO QUIZZES Module 1: 1 c, 2 b, 3-d Module 2: 1-b,2-c Module 3: 1-a, 2-c,3-a Module 4: 1-c 2-d Module 5: 1-c,2b,3-d

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Glossary of Terms
ACCOUNTING EQUATION An equation that states that assets equal liabilities + shareholders' equity. A = L + SE The equation must always hold because assets represent the historical value of what the company owns, and liabilities and equity represent the claims on these assets. The company is responsible for the liabilities to the creditors first and then the equity of the owners. Therefore, equity is the residual or balancing factor in the difference between assets and liabilities. That is: SE = A L Seen in this way the balance sheet must always "balance" because the value of shareholders equity will change depending on the difference between assets and liabilities. ACCOUNTS PAYABLE An obligation to pay for goods or services that have been purchased on credit from suppliers. This is a current liability in a firms balance sheet because it is payable within a year. ACCOUNTS RECEIVABLE The amount owed to a company from customers who purchased goods or services on credit. ACCOUNTS RECEIVABLE TURNOVER A ratio showing the average amount of time that a company holds its receivables before collecting them. Usually, companies also use a related term called "Days Sales Outstanding" (DSO). Accounts Receivable Turnover = Revenue Average Accounts Receivable

ACCRUAL ACCOUNTING The accounting method that recognizes revenue when it is earned, without regard to when the cash is collected, and recognizes expenses when they are incurred, regardless of when cash is paid to meet these obligations. ACCRUED EXPENSE Those expenses incurred, but not yet paid, at the end of an accounting period; also called accrued liabilities. Example: A company purchases $25,000 worth of office supplies on credit on December 29 and its accounting period ends on December 31. It shows the $25,000 as an accrued expense on the balance sheet for the year. ACCUMULATED DEPRECIATION The total depreciation to date on a particular asset as shown in the balance sheet. AMORTIZATION The process of allocating the portion of an intangible asset's value (e.g. patents or goodwill) that has been consumed during the current period against revenues. Similar to a companys depreciation of tangible assets.

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Generally Accepted Accounting Principles (GAAP) states that the amortization of an intangible asset cannot exceed 40 years and that it must be done on a straight-line basis.

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Module 1-3: Finance for Business Leaders

ANNUAL REPORT A detailed statement that a company prepares at the end of its reporting year; the reporting year can be either on a calendar or fiscal basis. This report contains a company's income statement, balance sheet, statement of cash flows, statement of shareholders' equity, management's discussion and analysis of operations, notes to the financial statements, and audit opinion. The Financial Accounting Standards Board (FASB) also requires that companies include in their annual reports operations in different industries, export sales, foreign operations, major customers, and government contracts. ASSET An economic resource of a company. Assets include money, land, buildings, property, and property rights and machinery. Characteristics: Must provide future economic benefits, etc. Must be controlled by its owner Must be the result of a previous event or transaction (e.g. the purchase of a new machine) Assets can be tangible or intangible: Tangible: Assets that can be seen or felt Intangible: Assets that have no physical substance (e.g. patents and goodwill) Assets can be current or non-current: Current: Assets that have future benefits that will be realized in one year or less Non-current (fixed or other): Assets that have future benefits that will be realized in more than one year ASSET TURNOVER (also called Total Asset Turnover) A ratio that measures the productivity of a company's total assets. (Also called a measure of activity or efficiency). It shows how many dollars of revenue are created by a $ of assets. Asset Turnover = Revenue Assets

BALANCE SHEET A statement representing a company's financial position at a specific date, usually at the end of an accounting period; also called a "statement of financial position." It is composed of assets, liabilities, and net worth. BOOK VALUE (1) The amount shown for an asset on a balance sheet. For fixed and other assets, it is based on historic cost or the amount that was paid for the asset when it was purchased. For example, the "book value" of a machine is its initial cost less its accumulated depreciation. (2) Book value of a company can also be the amount shown as a company's stockholders' equity on a balance sheet. Seen in this way, the book value of a company is the value of its "net worth" (assets less liabilities).

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BOOK VALUE PER SHARE The assets of a company made available to its shareholders. Book Value per Share = Total Stockholders Equity Average Shares Outstanding

BREAK-EVEN ANALYSIS (also called Profit-Volume-Cost Analysis.) The calculation of the point at which sales revenue equals all costs and expenses. Break-even Volume = Total Fixed Cost Price - Average Variable Cost

CAPITAL Unless preceded by the term "working" (see Working Capital) this is the amount on the balance sheet that represents the long term commitment of funds in a company, long-term debt, and shareholders' equity. Note: If the term "share capital" is used, it refers only to the value of the shares originally purchased by the owners. This, along with accumulated retained earnings, is part of shareholders equity. CAPITAL STOCK The shares representing the ownership of a company. Issued capital stock that remains in the hands of stockholders is categorized as "outstanding." Stock that is repurchased and not reissued by the company is called "treasury stock. CASH FLOW The cash receipts less the cash disbursements from a given operation or asset for a particular period of time. There are a number of different measures of this term, depending on what cash disbursements are taken into account for the particular time period. A clarification of these different terms is best done using a "Statement of Cash Flows," provided in a company's annual report. Here are a few examples: "Basic Cash Flow" Net income + depreciation (often a quick and easy method for estimating a company's operating cash flow, particularly for companies that have large fixed asset investments). "Cash Flow From Operations" Net income + depreciation and amortization + or - changes in noncash working capital (a measure of cash flow now required to be shown in all companies annual reports in their statement of cash flows). "Free Cash Flow" Cash Flow From Operations less Capital Expenditures and Dividends (a measure of cash flow that indicates how much cash a company has generated in a given accounting period after meeting its operating and major financial requirements). CONTRIBUTION MARGIN (CM) The amount by which a company's sales revenue exceeds the variable cost of its production or service. Used to help determine the break-even point of a firms operations. (See "Breakeven Analysis.") This term is used in cost accounting. A similar, but not equal term used in financial accounting is "gross profit margin." COST ACCOUNTING A method of accounting for the costs of operating a business by allocating these costs to the goods a company produces or the services it renders. The methods of cost allocation are determined by the company for its internal use. They do not have to follow GAAP, the standard that companies must follow for Financial Accounting for external reporting purposes. 31

COST OF GOODS SOLD (also called COST OF SALES) Typically abbreviated as COGS, (often just CGS) this is the cost of producing, converting or buying an item that the firm subsequently sells. When subtracted from sales revenue, it shows the amount of a firm's gross profit. Revenue - Cost of goods sold Gross Profit CURRENT ASSET Any asset shown on a firm's balance sheet that has a useful economic life of one year or less. It can also be considered cash or any item that the company believes will become cash within the one year period. This includes short-term marketable securities, accounts receivable, inventory, and prepaid expenses. CURRENT LIABILITY A debt that is payable within one year (based on the date shown on its balance sheet). Typical current liabilities include accounts payable, short-term notes payable, and the current portion of a firm's long-term debt. DAYS IN INVENTORY (also called Days Sales in Inventory) A measure of the number of days it takes to sell the average amount of inventory on hand during a particular period of time. As a rule, the longer it takes to sell inventory, the greater the risk of not being able to sell it at full value. Also, if a firms days inventory starts to increase, it may indicate a drain on its cash flow. To calculate days in inventory, we first calculate the inventory turnover, as shown below: Days In Inventory = 365 days Inventory Turnover Ratio Cost of Goods Sold Average Inventory on Hand

Inventory Turnover Ratio =

Example: If a company has an Inventory turnover of 5.25 days, its day inventory would be 365/5.25 or 69.5. DEPRECIATION An accounting method of spreading the cost of a fixed asset, such as plant and equipment, over its useful life. The basic concept behind depreciation is that the value of every asset is reduced through use or obsolescence. Through depreciation, a relationship is established between the asset's ability to generate revenue and the reduction of its value. This relationship is in accordance to the "matching principle." The three methods of depreciation are: 1) Straight line 2) Sum-of-the-years' digits 3) Double declining balance In addition to deciding on the method to use, a company must also determine the estimated expected useful life of the asset and the assets salvage value. The higher the rate of depreciation used, the lower the company's accounting income that is reported in its financial statement. However, higher rates of depreciation could have a positive 32

impact on a firm's cash flow by reducing its tax obligations at an earlier rather than later time in the life of the fixed assets. DISCOUNTED CASH FLOW A method used to reduce a forecasted stream of cash flows to its present value. The amount of the reduction is based on a company's cost of capital. This method is the basis for a company's capital budgeting or long-term cash allocation decisions. DIVIDEND The distribution of a company's earnings to stockholders. Cash dividends are most common, although dividends can be issued in other forms such as stock or property. EARNINGS PER SHARE (EPS) A measure of a company's profit shown in terms of each share of common stock. EPS = Net Income - Preferred Dividend Average Common Stock Outstanding

EQUITY (also called stockholders Equity or owners' Equity) The monetary value that represents ownership interest in a business. The two most important components of equity are: 1) Capital stock 2) Accumulated retained earnings. Also called retained earnings or even reinvested earnings Two other items often listed are 1) Treasury stock 2) Foreign exchange translation adjustments Because accountants define equity as equal to assets minus liabilities, equity is also referred to as the net worth of a company. (See "Book Value.") FINANCIAL ACCOUNTING An accounting method that records, interprets, and reports the historical cost transactions of a company. Publicly held companies must follow financial accounting principles laid down by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA). Together, these principles are referred to as "Generally Accepted Accounting Principles (GAAP). The Securities and Exchange Commission (SEC) is ultimately responsible for establishing financial reporting standards for publicly owned companies, yet it lets the FASB and AICPA set up the ground rules. FINANCIAL STATEMENTS Reports containing financial information about a company. The three major financial statements found in an annual report are: 1. Balance sheet 2. Income statement, and 3. Statement of cash flows FIXED ASSET An item purchased for the operation of a business that has physical substance, useful economic life greater than one year and is not to be sold to customers. FIXED COST Costs and expenses that stay constant regardless of increases or decreases in business activity. 33

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) The policies, standards, and rules followed by accountants in the preparation of financial statements. GOODWILL The value of intangible assets, such as reputation, name recognition, and customer relations, that gives a company an advantage over competitors. Goodwill appears in a company's financial statements only if it has been paid for in a business combination using the "purchase method." In this case, the value of the goodwill is the difference between the purchase price of the company and the book value of its assets. The amortization of goodwill can be done over a period of not more than 40 years. It is shown on the firm's financial statement but is not tax deductible. GROSS PROFIT (also called Gross Margin) The excess of revenue over cost of goods sold. INCOME STATEMENT (also called Profit and Loss statement or "P&L). A formal statement of the elements used in determining a companys net income. There is no uniform method of presenting an income statement in an annual report. However, a typical statement could look like this: Revenue (also Sales, Net Sales, or Sales Revenue) Cost of Goods Sold GROSS PROFIT Selling, general, and administrative expenses (S,G&A) Research and Development OPERATING INCOME (Profit) + Other income Other expenses such as interest INCOME BEFORE TAXES Provision for income taxes INCOME FROM CONTINUING OPERATIONS + or Extraordinary items + or Cumulative effect of change in accounting principle NET INCOME INTERNAL RATE OF RETURN (IRR) The discount rate at which the net present value of all future cash flows equals zero. This rate is often used to determine the financial desirability of a long-term investment. If the IRR is greater than the firm's cost of capital (the opportunity cost of its money), then the project is considered to be economically justified. INVENTORY Any goods available for resale at any given time. It is recorded at the lower of cost or market value and reported on the balance sheet. The three types of inventory in manufacturing are: 1. Raw materials 2. Work-in-process 34

3. Finished goods

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INVENTORY TURNOVER A measure of the number of times that the average amount of inventory on hand is sold within a given period of time. Inventory Turnover = Cost of Goods Sold Average inventory on hand

Sometimes sales revenue is used instead of cost of goods sold. This is not a good method unless cost of goods sold is not available. LIABILITY An obligation payable in money, services, or goods. Liabilities are reported on the balance sheet and include, among others, accounts payable, accrued expenses and debt (both shortterm and long-term.) MARKET-TO-BOOK RATIO An indicator of the degree to which the management of a company has been able to increase the value of shareholder investment. The higher the ratio, the better. If management has increased the market value over the book value (the amount of investment by stockholders), the ratio will be greater than 1. If the ratio is less than one, then value has been destroyed. Market-to-Book Ratio = Market Value Book Value

Market Value = price of a share of stock Book Value (per share) = equity/shares outstanding NET INCOME (also called net profit, net after-tax profit, and net income after taxes) The result of subtracting all costs, expenses, and taxes from revenue. NET PRESENT VALUE (NPV) The present value of the future cash to be received from an investment in excess of the cost of the investment. An NPV greater than zero indicates an economically justified investment opportunity. NOTE PAYABLE A contract to pay a creditor at a future date. Reported on the balance sheet either as a current or noncurrent liability, depending on when the principal is due. PRICE-EARNINGS RATIO (P-E Ratio) A commonly used measure of a company's investment potential. This ratio depends on investors' perceptions of a company's potential. Factors such as risk, quality of management, growth potential, earnings history, and industry conditions all come into play. P-E Ratio = Price per Share Earnings per Share

P-E Ratios in the high teens and twenties generally indicate that investors are very optimistic about the company's earnings potential.

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PROFIT MARGIN A measure of a firm's profit-earning ability relative to its dollar volume of sales. The type of profit margin depends on which measure of profit is being used. Gross Profit Margin = Gross Profit Revenue Operating Profit Revenue Net Profit Revenue

Operating Profit Margin =

Net Profit Margin =

Generally, the higher the gross profit margin, the greater the chances of a firm having a high operating and net profit margin. 40% is typical of manufacturers, 25% is typical of supermarkets and low-end retailers, 45% is typical of high-end retailers, and 80% is typical of software companies. Manufacturers typically end up with around a 5% net profit margin, while successful software companies (such as Microsoft) have net margins over 20%. RETAINED EARNINGS (also called accumulated retained earnings or profit, or reinvested earnings, income, or profit.) These are the total earnings of a company, less dividends, since its inception. This is a major portion of a company's equity shown on its balance sheet. RUN RATE A term often used in budget analysis in reference to projected costs based on past expenditures. The benchmark used for past expenditures varies among companies. Some firms simply use the previous month. Others may take the average of previous months (e.g. past 3 months, 6 months, etc.). For example, if the previous three months expenditures are 10, 12 and 12, then the run rate is 11.33. RETURN ON INVESTMENT (ROI) A measure of the productivity of a firms assets. There are three commonly used versions of this measure. Return on Assets (ROA) = Net Profit Average Total Assets Net Profit Average Equity Net Profit Average Debt + Equity

Return on Equity (ROE) =

Return on Capital Employed (ROCE) =

REVENUE (also called sales and sales revenue) Gross income received by a company before any deductions for expenses, discounts, returns, etc. TURNOVER RATIO A measure of activity of any asset such as inventory, receivables, fixed assets or total assets. See accounts receivable turnover, asset turnover, and inventory turnover.

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WORKING CAPITAL A measure of a company's ability to service its short-term financial obligations. It is defined as current assets minus current liabilities.

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NOTE: THIS DOCUMENT CONTAINS CHAPTERS FROM BUSINESS ACUMEN: YOUR KEY TO SUCCESS, A SELF-DIRECTED COURSE PRODUCED BY LEARNING BURST ACADEMY. ALL RIGHTS RESERVED BY P&D L EARNING, LLC

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