Английский язык. Практический курс для решения бизнес-задач
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Balance Sheet Approach to Valuation
Managers can make better decisions if they can predict the impact of those decisions on the firm’s value. A simple way of valuing the equity of a company is to subtract its liabilities from assets. However, this book value has little resemblance to the real value of the company. First, the assets are recorded at historical costs. Second, assets such as trademarks, loyal customers, and talented managers do not appear on the balance sheet but may significantly affect the firm’s ability to generate profits.
Cash vs. Profits
Another way to value the firm is to consider the future flow of cash. Since cash today is worth more than the same amount of cash tomorrow, a valuation model based on cash flow can discount the value of cash received in future years. Decisions about finances affect operations and vice versa. The firm’s working capital flows in a cycle, beginning with cash that may be converted into equipment and raw materials. Additional cash is used to convert the raw materials into inventory, which then is converted into receivables and eventually back to cash, completing the cycle. The goal is to have more cash at the end of the cycle than at the beginning.
The change in cash is different from accounting profits. A company can report consistent profits but still become insolvent. For example, if the firm extends customers increasingly longer periods of time to settle their accounts, even though the reported earnings do not change, the cash flow will decrease.
Note also the distinction between cash and equity. Shareholders’ equity is the sum of common stock at par value, additional paid-in capital, and retained earnings. Shareholders’ equity is on the opposite side of the balance sheet from cash. Shareholder equity changes due to three things: 1) net income or losses; 2) payment of dividends; 3) share issuance or repurchase. Changes in cash are reported by the cash flow statement, which organizes the sources and uses of cash into three categories: operating activities, investing activities, and financing activities.
Cash Cycle
The duration of the cash cycle is the time between the date the inventory is paid for and the date the cash is collected from the sale of the inventory. A company’s cash cycle is important as it affects the need for financing. The cash cycle is calculated as:
days in inventory + days in receivables – days in payables
Financing requirements will increase if either of the following occurs:
– Sales increase while the cash cycle remains fixed in duration.
– Sales remain flat but the cash cycle increases in duration.
Revenue, Expenses, and Inventory
A firm’s income is calculated by subtracting its expenses from its revenue.
However, not all costs are considered expenses; accounting standards and tax laws prohibit the expensing of costs incurred in the production of inventory. These costs must be allocated to inventory accounts and appear as assets on the balance sheet. Once the finished goods are drawn from inventory and sold, these costs are reported on the income statement as the cost of goods sold (COGS).
Assets
Assets can be classified as current assets and long-term assets. It is useful to know the number of days of certain assets and liabilities that a firm has on hand:
Accounts receivable (A/R)
Number of days of A/R = (accounts receivable / annual credit sales) (365).
This also is known as the collection period.
Inventory
Number of days of inventory = (inventory / annual COGS) (365).
This also is known as the inventory period.
Payables
Number of days of accounts payable = (accounts payable / COGS) (365),
assuming that all accounts payable are for the production of goods (payables period).
Financial Ratios
A firm’s performance can be evaluated using various financial ratios (see lesson 37).
Bank Loans
Bank loans can be classified according to their durations. There are short-term loans (one year or less), long-term loans (also known as term loans), and revolving loans that allow one to borrow up to a specified credit level at any time over the duration of the loan. Some
Sources and Uses of Cash
It can be worthwhile to know where a firm’s cash is originating and how it is being used. There are two sources of cash: reducing assets or increasing liabilities or equity. A company uses cash by increasing assets or decreasing liabilities or equity.
Firm Value, Equity Value, and Debt Value
The value of the firm is the value of its assets, or the present value of the unlevered free cash flow resulting from the use of those assets. In the case of an all-equity financed firm, the equity value is equal to the firm value. When the firm has issued debt, the debt holders have a priority claim on their interest and principal, and the equity holders have a residual claim. The sum of the value of the debt and the value of the equity then is equal to the value of the firm, ignoring the tax benefits from the interest paid on the debt. Considering taxes, the effective value of the firm will be higher since a levered firm has a tax benefit from the interest paid on the debt.
Capital Structure
The proportion of a firm’s capital structure supplied by debt and by equity is reported as either the debt to equity ratio (D/E) or as the debt to value ratio (D/V), the latter of which is equal to the debt divided by the sum of the debt and the equity.
Risk Premiums
Business risk is the risk associated with a firm’s operations. It is the undiversifiable volatility in the operating earnings (EBIT). Business risk is affected by the firm’s investment decisions. A measure for the business risk is the asset beta, also known as the unlevered beta. The return on assets of a firm can be expressed as a function of the risk-free rate and the business risk premium (BRP):
rA = rF + BRP
Financial risk is associated with the firm’s capital structure and magnifies the business risk of a firm. Financial risk is affected by the firm’s financing decision.
Total corporate risk is the sum of the business and financial risks and is measured by the equity (levered) beta. The business risk premium (BRP) and financial risk premium (FRP) are reflected in the levered (equity) beta, and the return on levered equity can be written as: