Chapter 8 Financial Strategy

hi and welcome to chapter eight today we're going to talk about implementing strategies focusing on Finance and Accounting issues so our learning objectives are going to be to determine what's the most appropriate capital structure for the company how to measure performance using earnings per share and ebit which is earnings before interest in tax to compare relative attractiveness between debt and stock and look at strategies of sourcing Capital look at projecting financial statements the impact of recommendations and Associated costs uh determine the cash value of a firm and discuss the financial ratios and things like initial public offerings issuing bonds and strategic decisions related to accounting and finance okay so this fits in here in uh chapter eight so we've gone through the introduction and discussion of vision and mission statements we talked about internal and external factors strategies in action strategy analysis and choice implementing strategic um strategies using management and marketing themes and techniques and now we're filing to Finance and Accounting okay so first of all what is capital structure capital structure is the sources of funding a company chooses to raise capital in finance and in business Capital was just another fancy word for money so a company needs to determine their capital structure and they need to find a capital structure that's going to have the lowest weighted average cost and the cost of the capital structure is the interest you pay on bonds dividends you might pay on stock interest on bank loans things of that nature now most strategies that companies develop are going to require additional capital this means they're going to need money to expand to make an acquisition to buy equipment and Machinery to do corporate training to hire more employees they're going to need sources of money to fund these new strategies so there should develop a fully fleshed out Pro form of financial statements which are also called projected financial statements to show the impact that these um strategic recommendations will have on the finances of the company and then the company would need to perform a corporate valuation to see whether or not um the financial uh situations they're getting into is going to be valuable to the corporation so whether it's receiving an offer to be purchased or if it's buying another division or another small company or merging with two companies we have to perform this corporate valuation to see if there truly is value in the Strategic direction of the company okay so analyzing financial ratios is a big part of uh analyzing a company's performance so financial ratios come in uh usually five categories that measure financial and management performance of a company we'll talk more on this later now the initial public offering is when a company decides to sell a piece of itself to new shareholders so new shareholders buy the stock and they get a percentage of ownership in the company and this helps to bring new cash into the company now cash levels in the company are also affected by its retained earnings the amount of money the company makes by doing its operations and after taxes and interest they can keep they can reinvest in the company and of course corporate bonds the amount of money that companies could raise by issuing debt in a form of corporate bonds to be paid back in usually a 30-year term and uh going interest rate now capital structure we're looking at what's the um percentage difference between the portion of debt uh to the portion of equity we call this debt to equity so on the balance sheet this can be referred to as a capital structure how much of the firm's Equity is financed by stock and how much is financed by bonds so what is a firm's Equity so if you take all the assets you might install the liabilities um and you get Equity so the equity needs to be those assets need to be financed by either uh debt or equity and Equity can come in the form of issuing stock retained earnings uh as the two biggest sources so if we're performing a earnings per share or ebit analysis this is a common way to determine what the appropriate capital structure of the company is needed so if a company you know has a lot of earnings it might be more appropriate to borrow in debt because it has the money to pay the dividends if the company is low on cash it might be more amenable to issue stock to help raise new funds now let's talk about some accounting terms EPS this is earnings per share which is simply the net income divided by the number of outstanding shares this is a very important ratio because it looks at for if for each share of stock that's outstanding so if you're an investor that owns one share of stock and they say that shares 25 is the current market price of that share and the earnings per share are five dollars per share that's how much of the earnings can be contributed to one share of stock and the higher the earnings per share the more valuable that per share of stock is and typically as earnings per share increases so does the stock price increase ebit is earnings before interest in tax sometimes called operating income so this is the money that the business makes and it's very important that you know some companies can look profitable but you want to look at the underlying business is it generating the profits um outstanding shares is the amount of shares that are issued and are out to the public now um the shares issued include treasury stocks so treasury stock is um shares the company has purchased has purchased back and it goes into treasury stock under the equity section so outstanding shares the shares available to trade and the shares issued or all the shares available trade plus treasury stock so shares authorizes number shares of firm is approved to issue in total so a company might be approved to issue 100 million shares of stock but they may choose to only issue 50 million shares at this time and they can do a follow-on issuing some stock at a later time EBT is earnings before tax e-a-t is earnings after tax so this is just common accounting terms you should be aware of now the earnings per share to EB it analysis so we're looking at whether or not you know okay so we have ebit which is operating income uh earnings per share is going to take the operating income and subtract the taxes subtract the interest and then we get our earnings per share so what um the difference between two will denote uh how much debt is used so it's a combination of the two uh best alternatives for raising Capital implementing strategy so it's either debt or equity so when we look at the difference or look at the percentage of earnings per share the ebit it gives us the impact the debt has uh versus the stock financing because it gives us a ratio and this analysis is going to give a four-step process so let's look at the inputs needed so we have a practical PNG which is a pretty good company and we have the amount of capital needed they need 5 000 million dollars or we'll just say 5 million I think that's how it should read uh or earnings earnings um before interest in tax range is going to be anywhere from 10 to 18 million interest rates five percent tax rates 23 stock price is ninety four dollars and now saying shares is 200. 2 550 million okay so um now let's calculate the earnings for sharing ebit analysis everything's in millions here except the earnings per share row so here's our and we're looking at we're doing the common stock forecasting and the debt for financing common stock financing debt financing in three scenarios pessimistic realistic and optimistic so we have our operating income the interests um earnings before tax taxes earnings after tax number shares and earnings per share in these various scenarios so if we look at the um if we're doing 60 stock and 40 percent uh debt this is how that would overlay as far as you know if it's 60 if it's 60 percent stock 40 dead this is how we kind of project pessimistic optimistic and realistic so between 10 and 18 million and then how that's going to translate into different earnings per share of course optimistic will have the highest earnings per share compared to pessimistic now we can see if we're looking at the cash flow um the common stock financing so that is this this green line here the common stock financing so we can see that if we Finance with stock here is the change in overall earnings per share now that when we Finance with stock earnings per share is muted because we're issuing new shares of stock so we don't see as big of a change in earnings per share because the new shares of stock we're issuing is diluting the the profits from the new project okay debt financing if you look at debt financing in the purple this is going to have the biggest kick up in earnings per share because we're issuing no new shares so we get although we do have to pay interest but we're getting to keep all the profits and it's going all to the current shareholders so you see the biggest change in earnings per share when you do debt financing and the common combination of equity and debt financing we see a sort of a the middle ground between the two so you would probably say well why a firm should always use debt financing because it Returns the most amount of earnings to investors that's true however the more debt financing you take on the more costly it becomes interest rates go up risks go up so it gets to the point where debt financing no longer is a significant contributor to earnings per share and that's why most firms do a mix of debt to um stock when they're doing their capital structure especially if they're looking to borrow a lot of money over a long period of time so let's just go back for a minute Okay so oops this four-step process step one just because I don't think I made this clear before Step One is gathering the data the data that you need step two is putting is is uh setting up a computational table similar to to this where we have um all common stock financing all debt financing or a combination of debt and stock financing and step three would be putting inputting the numbers into these tables and then step four would be graphing the results so those are the four steps um to doing that process now let's talk about those limitations and considerations one is flexibility so a firm's capital structure you know the way it's designed is going to affect the flexibility as far as future Capital needs so if you issue all your stock you can issue new stock in the future unless you get unless you go through a lot of paperwork to get an increased amount of shares to be allowed to issue if you issue all debt you may have a very high interest rate and it may limit your your borrowing and debt in the future so using all dead or all stock is going to you know create these obligations um and sometimes these obligations might include restrictive covenants which means that bonds can start saying what your business can and can't do so the flexibility can be issued dilution of ownership if you issue too much too many shares of stock you're diluting the ownership of the current investors and you're diluting the earnings per share the timing so interest rates change sometimes there's inflation sometimes interest rates go up very high sometimes they're not attractive so the timing as to when you want to issue stock or or bonds is a big deal so sometimes the stock market has years where there's a huge amount of IPOs coming out and sometimes they have years like 2022 where very few IPOs are coming out because stocks are going down and stock prices are not appreciating and people are just sort of not putting a lot of money in the stock market um but you know a year like 2022 is particularly challenging because interest rates are going up so it's making Bond borrowing more expensive and stocks are going down which is making issuing new shares stock less attractive so this is one of the things that's done by design by the FED trying to hope that the slow the economy so timing can be a big issue uh leverage uh situation so firms that are highly leveraged you know this is going to show up if you borrow a lot of debt this is going to show up in your um your ratios in your in your leverage ratios uh and this is going to make your company appear more risky which could make the required way to return your stock higher continuity so as far as you know the analysis is assuming a certain stock price of certain tax rates certain interest rates um and all three scenarios pessimistic optimistic and realistic but those scenarios when they occur is going to have a different effect on stock prices and debt and interest so you know there one of the limitations is kind of looking at everything the same way which is not reality um operating income ranges you know estimates based on prior year but businesses change for other reasons other than you know it could just be consumer demand uh competitors there's a lot more into operating the effects operating income than just trying to predict it from one year to the next and of course dividends um if earnings per share values um go up in The Firm pays dividends then it's going to have less funds if it's committed to paying dividends because that comes out of the firm's cash okay projected financial statements um now projecting financial statements is something that companies have to do and these oftentimes we call these pro forma financial statements and what we're trying to do here is figure out what the future is going to look at look like based if we make certain strategic decisions and we expect certain expenses to occur uh and we expect certain growth of revenues we want to project the financial statements to allow us to have better control over where our financial ratios are going and better understanding of how our financial results will be next year okay so let's look at some of the steps in developing projected financial statements okay so one we're going to prepare the projected income statement before the balance sheet so the income statement comes first so we start by forecasting the revenues as you know exactly as possible so if we are going to for recommendations or to open up 100 new stores and this is going to increase revenues by 10 percent that's where we start so we increase the revenues by 10 so we and we could do that in three different scenarios so maybe the pessimistics 10 the most likely is 15 and the most optimistic is a 20 increase in sales so it all starts with projecting our sales and so these you know this Revenue growth is going to be a factor of the Strategic decisions we're going to make so um this is the result that we're we are expecting our strategy to result in any increase in sales and sometimes some strategies can result in a decrease in sales if there's a retrenchment or a closing of stores or a reduction of operations um so that's just things we want to keep in mind at two we're going to use a percentage of sales method to calculate cost of goods sold uh operating expenses and other variables on the income statement so the percentage of sales method is basically saying that if sales go up 10 then our cost of goods should go up 10 which means our gross profits should go up 10 so we're just linking the sales growth to a growth percentage for many of the variables on the income statement step three we're going to calculate the projected income statement and then step four we're going to subtract any net income that we extract dividends from the income that need to be paid for the year or we've already committed to paying uh step five is now just take a step back just let me just go back for a second when we have net when a company has net income there are two things they can do with the net income they can either keep it as retained earnings which means they can keep the money and invested back into business or they can pay dividends so retained earnings will go over to the balance sheet and we're going to add this to it's sort of a rolling a roll forward of the money that the company has made and is kept so retained earnings is a source of equity that we're going to store the on the balance sheet and it's going to be used to complete your Equity section and that money can be used to buy assets and run the company so you know think of you know think of this if the company makes net income there's two things they can do that you either pay dividends or keep the money and if they keep the money it's called retained earnings okay so that's just something to think about okay so step five we want to project the balance sheet items working from the bottom to the top we begin with the retained earnings so if if the net income is produced some retained earnings we want to calculate that and we want to add that into the equity section and then we're going to move it up to the forecasting and long-term liabilities and current liabilities uh assets and so forth and again this a lot of this information is if we're not retaining earnings the additional money that we're going to need to run the fund the company is going to have to come through debt of long-term uh debt so we can use the cash account as sort of our plug figure which means that you know we're going to project every line item on the balance sheet except cash and we're going to use the cash account to make uh the assets equal to the sum of the liabilities and shareholders Equity so to make the adjustment for example a cash needs to be changed so that the balance sheet will balance and this is just you know you know it's not a forecast of where cash is going to be it's basically going to be just something to help you know show the difference between the assets liabilities and the equity so for example if the cash is too high we might want to consider paying off some long-term debt or we could reevaluate projected increase in various liabilities uh because the possibility firm may have enough cash to cover them or cover the increases in the business uh we may want to buy stock back if we have a lot of excess cash and create some treasury stock so the cash account is very important here and seven we'd list any um remarks that we have about the projected income statements you know to clarify the risks the carefully to clarify the changes we made or the decisions we made as far as increasing our revenues or how our strategic decisions are going to impact our financial statements for next year specifically but not limited to you know any increase in potential taxes by be increasing from increasing our overall revenues and profits okay so let's talk corporate valuation so corporate valuation is basically trying to figure out how much a company is worth now a company that has stock issued it's it's kind of simple because whatever the outstanding shares are times the stock current stock price we get we would get um the valuation of the company but a number of companies are not publicly traded so we don't have the stock to help us so the corporate valuation is I guess it's an estimate of the value of the firm and the value of the firm how the firm is valued is up to how the um financial analyst wants the value of the firm because there's many different techniques so but all these techniques have been rely on financial facts of the company and hopefully good experience or good judgment of how the company um has performed in the past so the different valuation methods of course usually always resulted to different values so the company has to use what they feel would be most accurate for their particular company so a couple of different methods you could use you have the net worth method which is the shareholders Equity minus any Goodwill or intangible assets you have the income method which is just income times five you have the price to earnings ratio method where we take the stock price divided by the earnings per share and then times the net income you have the outstanding shares method which is the number of outstanding shares times the stock price is kind of the method I had method mentioned uh before so let's just talk about each of these methods in a little bit more detail the net worth method of course if we're looking at shareholders Equity from the balance sheet and we want to minus out uh Goodwill and intangibles so let's see what is shareholders Equity um it's you know we can think of this as owners Equity or total Equity or net worth if those are just different names for the same thing and it's always near the bottom of the balance sheet uh it represents the sum of common stock additional paid in capital retained earnings and treasury stock so after calculating the shareholders Equity we want to track Goodwill and intangibles so these items appear in the firm's balance sheet where intangible potentials include copyrights patterns and trademarks things that don't have a physical aspect to them and Goodwill is from when a current a company acquires another company and pays more than the book value of that firm and that'll be put into a good will section so that's why we want to minus these two out because they're really not uh easy to value or that can easily be manipulated in the way that it's better to leave them off of the net worth method um and sometimes these intangibles can result in a negative valuation so how can a company worth be worth Negative they usually just distort um that's why we want to take them away from the net worth method so that net income method uh is another approach you can use and it's the measuring the monetary value of the company that grows out of the belief that the worth of any business should be largely based on the fumed on the first on the firm's future benefits um that it that is going to create money and create uh profits so the rule of thumb is established you know the business's worth is five times the firm's current annual profit uh sometimes this could be amended to be uh sort of the net income method the cash flow method can be five times the business is cash flow since cash flow is a little bit more pure of a um the money that the company generates because then income consume is distorted by taxes okay the price to earnings ratio model so this is um is going to use the the P E ratio and it's going to divide the stock price for the firm's annual earnings per share and then we're going to multiply this by the firm's net average income for the past five years and this is going to give us a valuation of the company now valuation method number four is the outstanding shares method which is the number of shares times the stock price so it's just quite simply the market capitalization something I had mentioned before because the stock market's already valuing The Firm so we can just use the value that the stock market places on the firm now here's an example of the inputs that commonly be used for these valuation methods and then if we look at the results we see the results of the four methods so uh each of them have very greatly varying results as far as um how the valuation model is resulting in the valuation of the company they an average the method average is 135 million but you can see that some of these might be overvaluing the company some of these might be undervaluing the company so you can see that this is why a company really needs to pick evaluation method that is the best representation they feel the company is valued at because some of these methods just won't work for some companies this will be distorted amount of valuation so let's talk about the financial ratio analysis that I had mentioned earlier so this is how thicker financial ratios like a report card so you know so you have your grades and your grades give you a GPA and GPA is like a quick ratio of how you're overall doing that semester or overall that year overall your whole degree so these are ratios that look at financial statement categories and and and put them in a ratio that's more comparable between years and between companies so you can compare it once a company creates a sort of ratios from the income statements they can compare their company to the industry and they can compare themselves to key competitors because the ratios are comparable where just the full numbers from the income statements are not easily comparable because companies come in different size different sizes of the business now just to back up on this slide a little bit on the financial ratios so there's a number of financial ratios that we can talk about typically a company is going to have to look at liquidity ratios like current ratio and quick ratio total debt to asset ratio total debt to equity ratio times interest earned ratio so these are all looking at debt and liquidity of the company looking at the current assets the current liabilities total debt to assets total debt to to equity the amount of interest that the company is is paying in relationship to its earnings so these are all looking at the liquidity or the debt of the company and seeing how risky a company is on these ratios now keep in mind that these financial ratios we're not going to cover them extensively here because they have been covered in financial accounting and finance and maybe many other courses kind of give you a full list of financial ratios but they also include some some operation ratios we're looking at fixed asset turnover inventory turnover total asset turnover accounts receivable turnover average collection period so these will be activity ratios or management ratios looking at the actual change in the business the change in the inventory the change in the assets related to the sales how quickly accounts receivable is being collected um how quickly accounts payable is being paid then finally we'll have more of a president profitability ratio so we'll have a gross profit margin the operating profit margin return on assets return on Equity so these really are looking at comparing and analyzing the profits of the company through various stages the initial growth stage which is just the products minus the costs to the operation stages which is the gross profits minus the operating costs to the net income or net profit which is the taxes and interests and finally you might have some ratios in the market measures as far as earnings per share book uh book to equity I'm sorry a book value per share book to price these are just different types of ratio so there's a lot of financial ratios that companies can utilize to compare themselves to that to previous um years compared this year's results to this quarter the results of previous years recorded results and to also compare against competitors in the industry okay moving on to IPO and corporate bonds so if a company is doing well and it's starting out and say you take a company like Shake Shack which originally started with you know a handful of stores in New York City they started doing well they started expanding uh they got to a point where they needed a lot more money to continue the expansion of their corporate owned store so they're not franchise they're financing these stores exclusively exclusively themselves so they chose to do an IPL which means they're going to issue Shake Shack stock and the Stock's going to be issued to the public and it's raised millions of dollars for them to reinvest in the company so it's a good way of a company to raise uh Capital now also we might have um an issue where we can't raise any more stock Equity it's just not um worth it to dilute the current shareholders or there's just no appetite for it or in the marketplace so we might decide to issue bonds instead so raising uh money through issuing bonds is basically issuing um a bond for 30 years and a thousand dollars per Bond and the we promised to pay a dividend on these bonds and then when the bonds come due we pay the principal back to the investors now generally an investment bank is utilized to help a company go public or help a company issue corporate bonds because both these processes are very um labor intensive and takes a lot of regulations and a lot of accounting and a lot of legal purposes so oftentimes um 99 out of 100 times a corporation is going to go to an investment Bank to help to get this work done but those the two main funding sources for large companies smaller companies may do raise some funds by uh taking a bank loan by having the owners of the company take personal loans having doing some fundraising going to equity investors um that would be sort of people who want to invest in the company early on before it goes public to raise some Capital investors things like that to raise some money and typically a company has an evolution where they start out small and as they get bigger and bigger they go for uh bigger bigger sources of capital to keep growing the company okay our last slide here we're going to look at how to gain this is a common slide that appears and the most chapters and this is how to gain in sustained competitive Advantage so basically as we had that we had said you need a Clear Vision and mission statement that helps you to formulate uh strategies collect and analyze data and and make clear strategic plan then we Implement that strategic plan as far as you know getting it done and getting to what we need and then part of the evaluation and monitoring of results is a lot of this uh Finance and Accounting where we're looking at you know tracking the results of the spending the earnings the profits and then then uh taking that into consideration to clarify our mission or our strategic formulation so this is continuous circles a continuous circle of of work a company does to continually gain sustain their competitive advantage over other companies okay so that's chapter eight um implementing Finance and Accounting issue uh issues in Strategic Management I look forward to talking to you for chapter nine take care