Finance at its core
Individuals, families, businesses, governments, and virtually all organizations depend on finance. We will examine Walmart's financial reports in this course. We're going to observe Toys"R"Us's erratic cash flow behavior. We'll discuss the capital asset pricing model's trade secrets.
What you must understand
This course has no prerequisites because it is an introduction to finance in general. No specialist expertise is required. All you need is an interest in finances. So let's begin with The Institute of Financial Studies' Beginner's Introduction to Finance course (IFS).
The directors talk about finance
The board of a consumer products firm meets once every three months to discuss broad strategic problems. Inventory management, business acquisitions, borrowing guidelines, share buybacks, and the huge institutions that control your company's stock are among the topics covered. The board debates whether or not to issue additional equity shares.
Finance inside businesses
The process of figuring out what I need and how to acquire the money to get it is known as finance. Finance in a business refers to both long- and short-term financial decisions. Choosing how much cash I have on hand, if I should allow consumers to purchase on credit, and how much merchandise I should have on hand are all examples of short-term financial decisions. Making decisions on what to purchase, where to acquire the money to buy it, and how to manage it once it is within the business are all parts of finance. Both the firm seeking the money and the investors supplying the money are affected by the problem of getting money.
Outside company finances
We may examine each of these entities and how they relate to one another via the lens of finance. Entrepreneurs must make choices about what to purchase, where to obtain the funds to do so, and how to use their newfound wealth. Financial institutions bring together investors with money and entrepreneurs that need it.
A description of financial statements
The balance sheet, income statement, and cash flow statement are the three main financial statements. The significant assets and resources of a corporation are listed on the balance sheet. An income statement is a document that details the profits a firm produced over the course of a month, quarter, or year.
Financial statement overview
Accounting is a branch of finance that deals with quantitative information and money-related data. And accounting is designed to be helpful and practical. We make judgments in the present to alter the future using accounting data from the past. We'll talk about the balance sheet, income statement, and statement of cash flows in the financial statements. The balance sheet, the income statement, and the statement of cash flows are the three different kinds of financial statements.
A balance sheet is a summary of your assets and liabilities as of a certain moment in time. An income statement lists your earnings for a given time frame, such as a month, quarter, or year.
The balance sheet
The assets and obligations, or liabilities, of a firm are shown on the balance sheet. On January 31st, 2018, Walmart has slightly over $204 billion in assets. Inventory, or the goods on the shelf that Walmart must sell you, is valued at $44 billion, or around $4 million each location. Owner's equity, liabilities, and assets are listed in Walmart's balance sheet. There are two main funding sources for purchasing assets.
You may invest the money by having shareholders invest it or you can borrow the money. Walmart was given permission by its suppliers to buy merchandise on credit. Additionally, the business took out long-term loans totaling more than $30 billion.
The income statement
Walmart reported $495 billion in retail sales for the fiscal year that concluded on January 31st, 2018. No business has ever sold more in a calendar year than that in the history of the globe. Apple sold 229 billion in the same year, in contrast. What did the item cost Walmart if it is being sold to you for $1 at Walmart? The net income of Walmart is roughly $10 billion.
How much profit is left for Walmart once all of its costs, including the cost of sales and operational expenditures, have been paid? After deducting all of their expenditures, if you give them $100, they will have roughly $2 left over. Walmart must thus generate a lot of revenue at each location in order to be successful.
The cash flow statement
The financial statements' infant is the statement of cash flows. It includes a cash in and cash out report broken down into three categories. Cash is generated via funding operations through borrowing and new shareholder investments. The payment of dividends to shareholders, debt repayment, and share buybacks all require cash. $18 billion of total was utilized to purchase new property, structures, and machinery.
Additionally, the business distributed $6 billion in dividends to its investors. Walmart had such a large cash excess that it repurchased stock for $8 billion with corporate funds.
Debt and current ratios are typical ratios
Leverage is determined by a company's debt ratio. Walmart has $124 billion in total liabilities as of January 31st, 2018, compared to $204 billion in total assets. Target, in contrast, has borrowed 70% of the total amount required to purchase its assets. Walmart's current ratio is 0.76, or $60 billion in assets to $79 billion in liabilities. It's frightening, but Walmart is obviously not required to halt today and cover all of its present liabilities with its available current assets. Walmart has a current ratio that is less than one given the daily cash flow.
Common ratios include ROE, asset turnover, and return on sales
Walmart's return on sales is calculated as 2% by dividing its $10 billion in net income by its $500 billion in sales. This indicates that Walmart can create 2.4 dollars in annual sales for every dollar invested in assets. Target's profit margin is a healthy 4% in contrast. 12% was the return on investment for Walmart stockholders for the fiscal year that concluded on January 31, 2018. Shareholders in Target received a 25% return on stock.
That is a substantial sum. Walmart's ROE is calculated as 12% by dividing its $10 billion in net income by its $81 billion in equity.
Price-earnings ratio is a typical ratio
The market value of a company's shares divided by its net income results in the price-earnings ratio. It shows what the market believes will happen to Walmart's earnings and growth in the future. In the middle of 2018, you would have needed to spend 280 billion dollars to own all of Walmart's shares. Apple is the first publicly listed corporation in history to have a market valuation greater than $1 trillion.
Financial statement projections
Financial statement forecasting is yet another use for financial statements. We can construct a disciplined, high-level projection of the future using the accounting system. Determine a company's current finance requirements with the use of financial statement projections. Wages, utilities, accounts payable, and other costs inevitably rise as sales do. Some products increase spontaneously as sales rise, while others increase as a consequence of long-term planning.
Some things only increase as a result of actions; we may use this information to predict the future quantitatively for the coming year. These ideas can be used to determine our finance requirements.
Financial planning for the near future
Nike produces clothing and footwear. The corporation often offers credit when selling to retail establishments. For Nike, the typical collecting time is around 50 days. The operational cycle for Nike is 130 days, which is the result of adding these two figures together. Nike often purchases raw materials on credit and makes payment for them after around 40 days.
But it takes Nike a total of 130 days to receive the money from the sale of the final shoes and athletic apparel. Because of this, businesses need to handle their purchases, sales, and cash receipts properly.
Operational cycle
Operating cycle management is similar to conducting an orchestra. The management must ensure that inventory movements, cash withdrawals, and cash inflows all take place at the appropriate times. We'll use the business cycle of a wholesale distributor of building supplies to demonstrate this.
Managing money
The return on the cash I hold in my bank account is less than 1%, making it a poor yielding asset. A business wants to avoid having too much low-yielding cash, but it still has to have access to enough of it to meet daily demands. To make sure that the cash is there when needed, a business must manage its cash. With practice, we can anticipate when we will receive cash payments from consumers and when we must make cash payments to suppliers. You may visit a bank and arrange the specifics of a short-term loan well in advance if you have a trustworthy cash budget. Toys R Us is aware that they'll want money in October.
Managing inventories and receivables
Credit sales are a tried-and-true marketing strategy. Customers will buy more from us if we give them credit. Many people use credit cards but never make payments. The enhanced sales from selling on credit are exchanged for the projected cost of these bad debts. Boeing had $10 billion in accounts receivable in 2017.
Companies maintain inventory to guarantee that a consumer may discover a certain inventory item when they need it on our website. If our money is invested in inventory, it cannot be utilized for other purposes, such as repaying debt.
Getting immediate funding
Short-term bank loans can be obtained in a number of ways. One strategy is to just ask for a loan and state that you'll pay it back in a few months. Another option is to make all of these preparations beforehand by acquiring a credit line. You may be pre-approved for these recurring loans if the bank has confidence in your reputation. There are pre-approved lines of credit at a ton of businesses.
You may obtain financing on the commercial paper market if you are General Electric or IBM. These short-term loans have extremely low interest rates. These commercial paper IOUs are only issued by businesses with excellent credit.
Knowledge of internal controls
Internal controls ensure that businesses follow procedures and that every activity is recorded. A system of internal controls must be in place for every publicly listed US corporation. An outside auditor must confirm the existence of these measures. Separation of roles and data gathering methods are two examples of effective internal control procedures. Internal controls safeguard the company's assets, ensure that the records are accurate, and guarantee that it fulfills its responsibilities.
Physical asset security, locking up cash, and password-protecting computers are a few examples of internal control procedures. Another internal control is the requirement for employees to take frequent holidays, which is occasionally put in place by businesses.
Adding risk and reward
What hazards would you have to factor into your business strategy if you were running an airline? The dangers are listed below. Passenger demand is uncertain, dependent on fluctuations in the world economy. Fuel costs, work stoppages, and technical difficulties. Risk and return are related concepts.
Describe risk
Risk is the unpredictability of future events. Business risk may take many various forms, including pricing risk, cash flow risk, credit risk, interest rate risk, and rate of change risk. Price risk is the unpredictability of an asset's future price. Will the cost increase or decrease?
Businesses come with a variety of dangers, and there are firms who may assist me in reducing those risks. The risk associated with cash flow is the unpredictability of future cash generation or consumption. Risk is why insurance companies are necessary. They have to take on the danger instead of me, and I'll compensate them for it.
Reasons why we dislike danger
The majority of the time, humans dislike danger. People who participate in extreme sports especially climbers in the Himalayas appear to like danger. People often require compensation to incur danger. For instance, you may anticipate a return of less than 1% if you invest in a savings account with a U.S. bank.
Diversity reduces risk
Put simply, diversification is not putting all of your eggs in one basket. Some hazards can be prevented, while others cannot. Don't anticipate receiving more compensation for taking on risk that may be reduced. Wearing a hardhat can reduce danger significantly, but you won't be compensated if you don't.
Beta: The idea
The Capital Asset Pricing Model (CAPM) is arguably the most well-known financial model. Market-wide risks that cannot be completely reduced through diversification are measured by systematic risk. For instance, from 2000 to 2002, we all saw a decline in our financial situation. You couldn't defend yourself against that since it affected everyone. Dollar bills are always dollars.
It has a financial value. Beta for cash is zero. Builders of homes are particularly susceptible to changes in global economic trends. When the local economy is thriving, homes are being built everywhere. Construction sites, however, slow down when business isn't doing so well.
Beta: Illustrations
Large banks like Bank of America thrive when the overall economy is strong. These banks are severely harmed and face a high beta risk when the economy declines. Beta versions of Google, Microsoft, and Apple are all close to one. This illustrates the wide-ranging significance of technology in our economy. These businesses perform well when the economy is robust.
They decrease little when the economy declines. A corporation with a low beta is one that is not significantly influenced by large economic changes. Altria is another sector that is essentially resistant to wider economic repercussions.
Unrisky rate
The capital asset pricing model includes the risk-free rate as a crucial component. There are a few reasons why the interest rate won't be 0. Over the coming year, price increases of 2, 3, or 5% are possible. There is also the concept of "time worth of money." The general time value of money and anticipated inflation will be combined to determine the risk-free rate on an investment. The risk-free rate has averaged around 5% during the past 50, 60, and 70 years globally.
Risk premium for equity
There should be a greater rate of return because investing in company shares is riskier than investing in a bank account, for example. For instance, returns on investments in stocks or equities in the United States during the past 50, 60, and 70 years have averaged roughly 11%. An investment in a diverse stock portfolio yields roughly 11%. We will employ a 6% equity risk premium, which is the difference between five and eleven. There are a lot of cautionary statements here, so if you are a finance professor, please calm down.
Capital asset pricing model (CAPM)
The least return we must receive on any investment is the risk-free rate. The returns on investments in a company's shares must be higher. This discrepancy is known as the equity-risk premium. The standard risk premium, which is 6%, is multiplied by 1.8 to get the total equity risk premium, or 10.8%. I won't invest in Ford Motor Company if I don't believe I can earn 15.8% on the investment.
Walmart has minimal beta risk since its financial situation is essentially unaffected by changes in the national economy. The risk-free rate plus an equity risk premium equals the return that a person must anticipate in order to undertake an investment.
Making available long-term finance
In the month of June 2018, the median selling price for new houses sold in the US was $310,000. Whether you can deliberately choose the mix of borrowing and owner investment to affect the value of an asset, such as a home, or an entire firm is one of the major concerns in corporate finance. If you have a mortgage loan, the likelihood that financial difficulty may lead you to lose your home is significantly higher. You won't have to worry about payments if you own the home outright. A modest mortgage lowers the likelihood that you may lose your home due to financial hardship, but it also lowers the amount of income taxes you must pay to the government.
Is capital structure relevant?
Is capital structure a factor in value in terms of corporate finance? Professors Modigliani and Miller conducted the first in-depth investigation of topic in 1958. When there are expenses and frictions, the capital structure does have an effect on a company's value, with income taxes playing an important role. Any payments I make to the people who gave the business the capital are referred to as interest expenditure if I borrow money. This is significant since my income tax form lists interest expenditure as a tax deduction.
The variables that affect the ideal capital structure
The ideal capital structure will vary depending on the unique business conditions. Should a corporation have more or less borrowing in its capital structure if income tax rates are high? A corporation is more likely to borrow more money if the collateral is excellent. Banks will demand that you borrow a significantly smaller amount due to erratic cash flows. Walmart's business strategy does not offer lenders strong collateral in the event of a disaster.
Only 23% of Google's long-term finance has been borrowed; 77% of it has come through owner investment. There is an ideal capital structure, and depending on the situation, the amount of leverage will change.
Cost of capital: financing with only debt or only equity?
Cost of capital, which is a combination of borrowing and equity investment, is the price of getting external finance. Which initiatives are excellent and which are harmful for a corporation are determined by the cost of capital. Consider an ice cream company that produces a lot of strawberry ice cream but only $220 million in cash flow annually. Lily's ambition is to launch an ice cream business, but she is unable to do so due to the high cost of funding. In the first scenario, Lily locates investors willing to offer $200 million as an investment rather than a loan. In contrast to the loan rate of 12%, these investors seek a 15% projected return.
Divided debt-equity financing has a lower cost of capital
Whether or not a project will proceed depends on the cost of funding. In this instance, the lenders only accept 5% but the investors demand a return rate of 17%. Even if it is predicted that the cash flow would be 222 million dollars, the plan still won't function. In this scenario, the lenders are anticipated to charge an interest rate of 11%, while the equity holders will all anticipate a return of 20%. The project will cost 224 million dollars in capital overall, but it will only generate 220 million in revenue. Because there is only a 20 million dollar equity buffer in this situation, the lenders are likewise in a riskier position.
Weighted-average cost of capital
How expensive it is to seek outside finance depends on a company's financial structure. What does it cost us to raise capital? is what a firm learns from its weighted average cost of capital. The firm then assesses the appeal of various initiatives using that WACC value. Finding the capital structure with the lowest WACC is the goal of corporate finance.
Introducing the stock market
A publicly listed company's directors are elected by its shareholders. Company management and the current board members make the final choice. Undoubtedly, we had a fiduciary obligation to manage the firm because we acted as the shareholders' representatives. Individual stock ownership may be a stressful endeavor.
What separates a stock from a bond
Stocks and bonds, the two primary forms of securities, reflect fundamentally distinct transactions. Owning stock is demonstrated by a share. A bond serves as proof that the corporation that issued it owes the bondholder money. Let's examine the distinction between pure equity and pure debt. Interest payments are a requirement of debt.
In a bankruptcy, equity investors receive any remaining funds after debt holders have been paid. If a corporation fails, the assets that might still be there belong to the debt holders.
Stock exchanges
Simply put, a stock market or stock exchange is a location, physical or digital, where individuals may gather and trade stocks. The New York Stock Exchange is the biggest stock exchange in the world. The majority of stock trading takes place online through computers, yet it all began in 1792 on Wall Street under a sycamore tree. This vehicle may be purchased for $15,000 when it is used after five years. Because purchasers are more inclined to purchase new automobiles when they know they won't be tied down to them indefinitely, this aids the new car dealer in selling new vehicles. In the first place, shareholders are more willing to invest and purchase shares when there is a stock market.
Bond markets
Bonds come in a wide variety of forms. Government bonds, often known as sovereign bonds, are sometimes issued by nations. Some bonds, known as asset-backed bonds, are backed by a collection of assets, such as the accounts receivable of a business. For instance, the securitization of home loans aided in the collapse of the global economy in 2008. The majority of corporate bond trading takes place over-the-counter, which implies that each bond deal is set up separately.
A share of stock in a particular firm is a homogeneous commodity when it comes to stocks, making them simple to trade. There are tens of thousands of corporations in the United States that have issued bonds.
Shares that are traded publicly: What influences the share price?
In the market, no one sets the price. In a market that is operating freely, interactions between buyers and sellers determine price. When a seller and a buyer agree that the share price is reasonable in light of the available information, they engage in trading. The market share price at that time is then regarded as being that trading price. The great majority of businesses across the world don't trade openly.
Being a publicly listed firm comes with advantages and disadvantages. If your company is publicly listed, many impatient individuals are keeping an eye on you. Planning for the future may no longer allow you to consider the big picture.
Microsoft's first public offering (IPO)
On March 13, 1986, Microsoft went public. Since 1975, the business had operated as a privately held business. Prior to its initial public offering, in 1985, Microsoft reported earnings of $1.10 per share. That is a fair estimation of the initial share price of Microsoft. The initial share price was determined by Bill Gates and his financial advisors at $21 per share.
Accounting data, industry data, and investor interest discovered during the road show are all used to determine the IPO price. The price of their stock increased to $27.75 at the close of the first trading day.
The stock market allows for stock picking
It appears that Warren Buffett consistently chooses profitable stocks. Why am I unable to do the same? Well, if you make the same kind of professional connections that Warren Buffett does. And if you had access to the same sources of knowledge as Warren Buffett does in business, politics, and the media. My brother and his wife ran a seven-year stock-picking experiment when they were young and naive.
They used their little Stice Speculation Fund to ride the internet boom all the way up to over $9,000. They lost $658 in all, or the 1,342 they had in the end less the initial sum.
Financial entities are introduced
I open an account for each grandchild as soon as they are born. I start with three thousand bucks and then add one hundred each month. How long will you keep doing this? Well, I'm not sure. Lily, my 10-year-old grandchild, is the oldest.
Companies that manage money, risk, and intricate transactions on behalf of people like you and me are known as financial institutions. The management fees for this mutual fund provider to do this for all 12 of my grandchildren will run me a total of $250 this year.
Standard banks
Financial institutions come in a wide variety. banks, insurance providers, investment banks, and funds for investments. A conventional bank fulfills the traditional function of connecting business owners with investors and/or savers. It takes out loans from depositors and lends the money to business owners at higher interest rates.
Bank of investments
A bank is not truly what an investment is. A distinct type of financial institution is an investment bank. Investment banks primarily serve two purposes. One is guiding new businesses through the process of going public. The second option is to trade investments for extremely large clientele.
The two main roles of investment banks are to guide businesses through agreements and to engage in investment trading. Here are two instances of investment banks assisting businesses with a transaction. First, acting as an underwriter to assist a firm in becoming public. aiding businesses with mergers and acquisitions is the second.
Index funds are investment vehicles
The ability to lower our risk via diversity is an important component of investing. I pay an investing fund provider to assist me in this diversification. Investment funds come in a variety of forms, including hedge funds, managed funds, private equity funds, and index funds. It's a highly effective technique for us to diversify our investments as individual investors. Because of their extremely cheap management fees, index funds are well-liked.
Standard & Poor's, or simply S&P, is the name of a firm. The number 500 signifies the 500 largest American corporations. For those who just want to invest their money and see it increase over time, index investing is great.
Managed funds, private equity funds, and hedge funds are all types of investment funds
A managed fund is a group of specialists who spend the entire day reviewing financial and economic information. A managed fund has an edge over an index fund in terms of raw performance. However, managed fund stock pickers must be compensated for their services. The most well-known investor in the country is Warren Buffet, who annually drafts a president's letter for Berkshire Hathaway, his firm. He demonstrates how the S&P 500 Index has increased by around 10% annually since he took over management of the business in the 1960s. Buffet's business, however, has produced a 20% return on investment.
Insurance businesses
Insurance has societal benefit because it transfers risk from common people like you and me to a big insurance firm. There are two ways that insurance firms can make money. They first excel at determining the size of their losses before determining how much to charge for insurance. Second, they promise to make a financial contribution to our family should we pass away. Insurance firms also profit from investments in addition to balancing the cost of claims against the sum of premiums received.
While they wait to pay for incoming insurance claims, insurance firms make a lot of money on their investments. Financial firms charge a fee for their financial competence.
Introducing capital budgeting
Over the course of its useful life, this machine will generate $1 billion in revenue. You'll ultimately receive your full billion dollars back if you give me a billion dollars for it now. A dollar now does not have the same value as a dollar in a billion years. Your $1 billion investment will be fully repaid during the course of the machine.
Overview of capital budgeting
Making judgments about the long-term asset purchases is capital budgeting. You will have long-term assets for a very long period. If we make a mistake with these significant expenditure choices, we could have trouble surviving. When creating a capital budget, we must consider how much return we can reasonably expect from the item we want to purchase. Choosing not to purchase the dumpling machine at a 16% interest rate is the right course of action.
On alternative investments, we might have made 16% annually. The time worth of money was not taken into account. The timevalue of money is crucial to take into account while making long-term decisions, such as whether to purchase a dumpling machine with a 10-year lifespan.
Time is money, according to
In a year, $100 today will be worth $110 if the interest rate is 10%, or vice versa. Making long-term investment decisions by quantitatively considering the time worth of money is known as discounting. In capital budgeting, we project what the future cash flows will be and then discount those cash flows to the present. In the capital budgeting process, future cash flows are identified and discounted using present value techniques. Obtaining $100,000 in a year is similar to receiving $90,910 now. For the following two years, Project B will provide a cash inflow of $50,000 at the conclusion of each year.
Consider purchasing an automobile in Hong Kong
When Bob Stice and his wife Ramona relocated to Hong Kong, they made a capital budgeting choice. In Hong Kong, a car costs $40,000. If you save $10,000 year for five years, your savings would be worth $37,908 today. In terms of present value, we would lose $2092 if we bought the automobile. In a financial sense, the worst thing you can say about anything is that it has a negative net present value project. In this instance, my wife Ramona and I opted against purchasing the automobile due to the figures.
The non-financial benefits in terms of transportation flexibility were not appropriately considered. So keep in mind that the figures are just the beginning of the decision-making process when making a capital budgeting choice.
Establishing individual financial planning
A financial strategy is most likely scam if it sounds too wonderful to be true. This straightforward commitment—spending less than you make—forms the basis of personal financial planning.
The key to monetary safety
The key to financial stability seems a bit too straightforward in our modern day. Our spending patterns may force us to lead unaffordable lifestyles. A budget is a necessary component in developing sustainable spending patterns. An investment offer is definitely a scam if it sounds too good to be true.
The value of creating personal budgets
The best course of action for maintaining financial flexibility is to keep your fixed costs as low as possible. All of these constant costs—house payments, vehicle payments, cable, internet, and phone bills—amount to a significant sum. The greater your commitment to paying these set monthly expenses out of your income, the less financial freedom you have. Most people find that they have no more control over their spending than they do over their income. A budget must be written down and a plan must be created; these are its two key components. We have financial freedom because to a responsible way of life and a set spending limit.
Simple investing and savings strategies
A personal savings or investment strategy that you are thinking about is almost likely a terrible idea if it appears sophisticated or complex. the seven baby stages that Dave Ramsey describes on his website, daveramsay.com. Financial flexibility is quite high for people who have three to six months' worth of living costs in savings. Most people become wealthy via long-term, consistent saving. Investments for the long term should be made in diversified funds, such as S&P 500 index funds.
Although they are always feasible, high returns cannot be ensured. Having a long-term planning horizon is the ideal strategy because investing entails short-term risk.
Conclusion - Looking at corporate finance
Choosing what to acquire and how to handle it after you have it is what finance is all about. We talked about short-term financial planning and how important it is to take time worth of money into account. Personal financial planning may be summed up in two straightforward principles: spend less than you earn and stay away from get-rich-quick scams.
Comments