Chapter 3

Fundamentals of
Financial Management
Concise 8E
Fall 2017
TTU

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
2-1or in part.
 The Annual Report
• Balance sheet – provides a snapshot of a firm’s
financial position at one point in time.
• Income statement – summarizes a firm’s
revenues and expenses over a given period of
time.
• Statement of cash flows – reports the impact of a
firm’s activities on cash flows over a given period
of time.
• Statement of stockholders’ equity – shows how
much of the firm’s earnings were retained, rather
than paid out as dividends.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-2or in part.
 Why Study Financial
Statements?
Analyzing a firm’s financial statement can help
managers carry out three important tasks:
1. Assess current performance
2. Monitor and control operations
3. Plan and forecast future performance

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Nick’s Pizza & Pub
• Crystal Lake, Illinois
• Founder and CEO: Nick Sarillo
• Revenue: $6 million
• Employees: 200
• Nick Sarillo started Nick’s Pizza & Pub partly because he felt the community needed a family-friendly
restaurant. A former construction worker, he was frustrated with the options available for his own
family. In the next 15 years, Nick’s Pizza & Pub did indeed become a sort of community center.
Scarcely a week went by without fundraisers for local charities or people in need—and Nick’s would
contribute 15 percent of the gross profit generated by events. It also had a vibrant culture built
around what he called his “trust-and-track” (as opposed to command-and-control) approach to
managing. He was naïve about finance, however, and, out of ignorance, took on too much debt over
the years. The result: he was running out of cash and three weeks from bankruptcy in 2011. With all
other options exhausted, he wrote an email to customers explaining the situation, taking full blame
for it, and asking for help. The customers rallied and literally saved the company. Sales almost
doubled for the next two months. Some even called the bank, urging it to help Sarillo find a
solution. The company survived; Sarillo’s debt was restructured, and he learned a hard, but crucial,
lesson about the balance sheet.
• Read more about Small Giants of 2017 with the link below
• [Link]
small-companies/#64c95d974c32

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
1-4or in part.
 Overview of D’Leon Inc.
• Snack food company that underwent major
expansion in 2015.
• So far, expansion results have been unsatisfactory.
• Company’s cash position is weak.
• Suppliers are being paid late.
• Bank has threatened to cut off credit.
• Board of Directors has ordered that changes must
be made!

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-5or in part.
 The Balance Sheet
• Total liabilities: represent the total amount of
money the firm owes its creditors

• Total shareholders’ equity: refers to the difference in

the value of the firm’s total assets and the firms total
liabilities
• Assets=LIABILITIES+STOCKHOLDERS EQUITY
• Total assets: sum of total shareholders’ equity and
total liabilities, represents the resources owned
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 The Balance Sheet (cont.)
• Current assets: consists of firm’s cash plus other
assets the firm expect to convert to cash within 12
months or less, such as receivable and inventory

• Fixed assets: are assets that the firm does not

expect to sell with in one year. For example, plant
and equipment, land.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Balance Sheet: Assets
2016 2015
Cash 7,282 57,600
A/R 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1926802 1,124,000
Gross FA 1,202,950 491,000
Less: Dep. 263,160 146,200
Net FA 939790 344,800
Total Assets 2866592 1,468,800
Note, we need net fixed
assets to continue
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-8or in part.
 The Balance Sheet (cont.)
• Current liabilities: represent the amount that the
firm owes to creditors that must be repaid within
a period of 12 months or less such as accounts
payable, notes payable. (Accruals)

• Long-term liabilities: refer total debt with

maturities longer than a year such as bank loans

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Balance Sheet: Liabilities and
Equity
2016 2015
Accts payable 524,160 145,600
Accruals 489,600 136,000
Notes payable 636,808 200,000
Total CL 1650568 481,600
Long-term debt 723,432 323,432
Common stock 460,000 460,000
Retained earnings 32,592 203,768
Total Equity 492592 663,768
Total L & E 2866592 1,468,800

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-10or in part.
 Firm Liquidity and Net Working
Capital
Liquidity generally refers to the firm’s ability to
covert its current assets into cash so that it can pay
its current liabilities on time. We can thus measure a
firm’s liquidity by computing its ***net working
capital
(equal to current assets less current liabilities).

•Liquid- convert things into cash to pay bills= net

working capital

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 An Income Statement
An income statement will contain the following:
1. Revenues
2. Expenses
• Cost of goods sold, Selling expenses, General and
administrative expense, depreciation & amortization
expense, Interest expense, and Income tax expense
3. Net Income
• Difference between Revenue and all expenses

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Income Statement
2016 2015
Sales $6,034,000 $3,432,000
COGS 5,528,000 2,864,000
Other expenses Operating 519,988 358,672
Total oper. costs excl. profit -> (13,988) 209328
deprec. & amort. $6,047,988 $3,222,672
Depreciation and amortization 116,960 18,900
EBITEarning before interest and taxes $(130,948) $ 190,428
Interest expense 136,012 43,828
EBT (266,960) $ 146,600
Taxes GAIN-> (106,784) 58,640
Net income Not in test, we will $ 87,960
(160,176)
pay taxes
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-13or in part.
 Other Data
No. of shares 100,000 100,000

EPS -1.602 0.88

= earnings / # shares
DPS 0.11 0.22
=dividends / # shares
Stock Price 2.25 8.50

Lease Payments 40,000 40,000

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-14or in part.
 Statement of Stockholders’ Equity
(2016)
Total
Common Stock Retained Stockholders’
Shares Amount Earnings Equity
Balances,12/31/15 100,000 $460,000 $203,768 $663,768
2016 Net income (160,176)
Cash dividends (11,000)
Addition (subtraction)
to retained earnings (171,176)
Balances, 12/31/16 100,000 $460,000 $ 32,592 $492,592

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-15or in part.
 The Cash Flow Statement
The Cash Flow Statement is used by firms to explain
changes in their cash balances over a period of time
by identifying all of the sources and uses
of cash for the period spanned by the statement.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Cash Flow Statement
(cont.)
• Operating activities represent the company’s core
business, including sales and expenses.
• Investing activities include the cash flows that arise
out of the purchase and sale of long-term assets
such as plant and equipment.
• Financing activities represent changes in the firm’s
use of debt and equity such as issue of new shares,
the repurchase of outstanding shares, and the
payment of dividends.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Statement of Cash Flows
(2016)
Long
Term
- Investing Activities
Additions to property, plant,
&equipment ($711,950)
Net cash used in investing activities ($711,950)
Financing Activities
Increase in notes payable $436,808
Increase in long
t-erm debt 400,000
Payment of cash dividends (11,000)
Net cash provided by financing activities $825,808
Summary
Net decrease in cash ($ 50,318)
Cash at beginning of year 57,600
Cash at end of year $ 7,282

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-18or in part.
 Statement of Cash Flows
(2016)
Operating Activities
Net income ($160,176)
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accruals 353,600
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provide
d by operating activities ($164,176)

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-19or in part.
 Follow the money
• Is the company making money?
• Net cash from operations = -$164,176
• How is the firm going to pay its bills?
• The firm borrowed $836,808 to meet its cash
requirements.
• Even after borrowing, the cash account fell by $50,318.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
1-20or in part.
 How did D’Leon finance its
expansion?
• D’Leon financed its expansion with external
capital.
• D’Leon issued long-term debt which reduced its
financial strength and flexibility.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-21or in part.
 Would D’Leon have required external capital if
they had broken even in 2016 (Net income = 0)?

• YES, the company would still have to finance its

increase in assets. Looking to the Statement of
Cash Flows, we see that the firm made an
investment of $711,950 in net fixed assets.
Therefore, they would have needed to raise
additional funds.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-22or in part.
 Evaluating the expansion
• Did the expansion make the company more
money?
• create additional after-tax operating income?
• What effect did the expansion have on net operating
working capital?
• What is the free cash flow?
• Are they able to pay their bills?
• Pay suppliers on time?
• Sales price exceed cost?
• What about a sale to increase customers?

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
1-23or in part.
 Did the expansion create
additional
after-tax operating income?
AT operating income = EBIT(1 – Tax rate)

AT operating income16 = -$130,948(1 –

0.4)
= -$130,948(0.6)
= -$78,569

AT operating income15 = $114,257

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-24or in part.
 What effect did the expansion
have on net operating working
capital?
Current  Current Notes 
NOWC     
assets  liabilities payable

NOWC (16) ($7,282  $632,160  $1,287,360)

 ($1,650,568  $636,808)
$913,042

NOWC (15) $842,400

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-25or in part.
 Assessment of the Expansion’s
Effect on Operations
2016 2015
Sales $6,034,000 $3,432,000
AT oper. inc. -78,569 114,257
NOWC 913,042 842,400
Net income -160,176 87,960

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-26or in part.
 What was the free cash flow (FCF)
for 2014?
 [Link]   Capital 
FCF   EBIT(1  T)     NOWC
 on  expenditur
amortizati es 

FCF16 = [-$130,948(1 – 0.4) + $116,960] –

[($1,202,950 – $491,000) + $70,642]
= -$744,201

Is negative free cash flow always a bad sign?

Free Cash Flow: the amount of cash that could be withdrawn without
harming a firm’s ability to operate and to produce future cash flows

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-27or in part.
 Does D’Leon pay its suppliers on
time?
• Probably not.
• A/P increased 260%, over the past year, while
sales increased by only 76%.
• If this continues, suppliers may cut off D’Leon’s
trade credit.
• Are they getting paid on time? A/P increased
significantly, this is a sign that the company is not
paying their bills

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-28or in part.
 Does it appear that D’Leon’s sales
price exceeds its cost per unit sold?
• NO, the negative after-tax operating income and
decline in cash position shows that D’Leon is
spending more on its operations than it is taking
in.

• Is their sale price bigger than their cost? You want

to sell it for more than it cost to make

• Hints: if you spend more to operate, than you get

in operating income. Numbers should be positive.
If not covering costs than after tax operating
income will be negative.
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-29or in part.
What if D’Leon’s sales manager decided to offer
60-day credit terms to customers, rather than
30-day credit terms?
• If competitors match terms, and sales remain
constant...
• A/R would .
• Cash would .
• If competitors don’t match, and sales double...
• Short-run: Inventory and fixed assets  to meet increased
sales. A/R , Cash . Company may have to seek additional
financing.
• Long-run: Collections increase and the company’s cash
position would improve.

• Companys will do a “sale”: discounts, or don’t have to pay

interest for 60 days.
• Do your competitors do it to? Success will depend on it.
• IF COMPETITORS MATCH than it wont help your company
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-30or in part.
 What happens if D’Leon depreciates fixed assets
over 7 years (as opposed to the current 10
years)?

• No effect on physical assets.

• Fixed assets on the balance sheet would decline.
• Net income would decline.
• Tax payments would decline.
• Cash position would improve.

• SKIP SLIDE

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-31or in part.
 Evaluating the Managers

• Accounting statements insufficient for evaluating

managers’ performance because they do not
reflect market values.
• Performance Measures
MVA (market value added) =Difference between market
value and book value of a firm’s common equity.

How do we figure out if it’s the managers fault?

If you look at just the statements, you will miss out on

the stuff that is in working progress. So you also want
to look at the market value.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-32or in part.
 Evaluating the Managers

• Accounting statements insufficient for evaluating

managers’ performance because they do not
reflect market values.
• Performance Measures
MVA = Difference between market value and
book value of a firm’s common equity.
(P0 x Number of shares) – Book value <-(total equity)

EVA: Economic value added: estimate of a business true

economic profit for a given year.

Was their a meaningful improvement by the manager?

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-33or in part.
 Evaluating the Managers

• Accounting statements insufficient for evaluating

managers’ performance because they do not
reflect market values.
• Performance Measures
MVA = Difference between market value and
book value of a firm’s common equity.
(P0 x Number of shares) – Book value.
EVA = Estimate of a business’ true economic
profit for a given year.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-34or in part.
 Evaluating the Managers

• Accounting statements insufficient for evaluating

managers’ performance because they do not
reflect market values.
• Performance Measures
MVA = Difference between market value and
book value of a firm’s common equity.
(P0 x Number of shares) – Book value.
EVA = Estimate of a business’ true economic
profit for a given year.
Total invested Cost of
EBIT(1 – T) – x
capital capital
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-35or in part.
 What was D’Leon’s MVA in 2016
and 2015?
MVA16 = ($2.25 x 100,000) – $492,592
= -$267,592

MVA15 = ($8.50 x 100,000) – $663,768

= $186,232

Shareholder wealth has been destroyed!

Negative: manager is destroying value. Needs to

put out stock options chp 1.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-36or in part.
 What is the relationship between EVA
and MVA?
• If EVA is positive, then AT operating income > cost
of capital needed to produce that income.
• Positive EVA on annual basis helps to ensure MVA
is positive.
• MVA is applicable to entire firm, while EVA can be
calculated on a divisional basis as well.

• SKIP SLIDE

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-37or in part.
 Federal Income Tax System
• Individual Taxes
• Corporate Taxes

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-38or in part.
 Corporate and Personal
Taxes
• Individuals
• Rates begin at 10% and rise to 39.6% for single
individuals with incomes over $400,000 and married
couples filing jointly with incomes over $450,000.
• May be subject to state tax.

• Progressive tax system

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-39or in part.
 Corporate and Personal
Taxes
• Both have a progressive structure (the higher the
income, the higher the marginal tax rate).
• Corporations Earnings before taxes: (done interest and
• Also subject to state tax (around 5%). depreciation)
175,000.

WRONG: .39x175,000=68,250, how much

taxes are paid
50,000 RIGHT WAY:
25,000 50,000*1.5=7,500
25,000*.25=6,250
25,000*.34=8,500
75,000*.39=29,250
25,000 ------------
75,000 51,500
Balance remaining? 175,000-100,000=75,000
325,000
5,000,000

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-40or in part.
 Marginal and Average Tax
Rates
• Average tax rate is total taxes paid divided by the
taxable income.
• Example: What is the average and marginal tax
liability for a firm reporting $100,000 as taxable
income.
• Average tax rate:
• Paid in taxes/taxable income
• 51,500/175,000=29.43%
• Marginal tax rate 51,500/175,000

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Dividend Exclusion for Corporate
Shareholders
The dividend received by corporate stockholders are
partially exempt from taxation. The rationale is to avoid
double taxation at the corporate level. The percentage of
exempt taxes is based on the degree of ownership of the
firm.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Dividend Exclusion for Corporate
Shareholders
Example What will be the taxable income if firm A
receives $100,000 in dividends from firm B.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
 Tax Treatment of Various Uses and Sources
of Funds

• Interest paid: tax deductible for corporations

(paid out of pre-tax income), but usually not for
individuals (interest on home loans being the
exception).
• Interest earned: usually fully taxable (an
exception being interest from a “muni”).
• Dividends paid: paid out of after-tax income.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole
3-44or in part.