BUS601 Study Guide

Navigating this Study Guide

Study Guide Structure

In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit. 

Beneath each learning outcome are:

• questions for you to answer independently;
• a brief summary of the learning outcome topic; and
• and resources related to the learning outcome. 

At the end of each unit, there is also a list of suggested vocabulary words.

How to Use this Study Guide

1. Review the entire course by reading the learning outcome summaries and suggested resources.
2. Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.

By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.

Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!

Unit 1: Managerial Accounting

1a. Recognize the role of accounting and finance in a business

• What are the differences between financial accounting and managerial accounting?
• Who are the principal stakeholders of a corporation?
• What are the three primary responsibilities of management?

Every business enterprise spends a considerable amount of time reviewing the 'numbers'. Suppose you step back and look at the sources of money (revenue, interest payments, etc.) and how the business allocates its money (expenses). In that case, there will be dozens or even hundreds of accounts to analyze. When all the firm's financial transactions have been identified, they provide a picture of the firm's activities and how well they are performing to expectation.

Two primary audiences are interested in the financial performance of a business. The internal audience consists of executives, department heads, managers, and employees. This group uses the financial data to prepare budgets, evaluate investments, plan payrolls and operating expenses, and track the results of their efforts, and are the customers of managerial accounting. There is also an external audience that is interested in financial performance. This group consists of shareholders, government agencies (IRS), debt holders, and others, who do not want to see the fine details of each category but rather a summary, and these individuals are interested in financial accounting reports.

A business will have responsibilities to various stakeholders, depending on size and whether it is a private or public firm. Stakeholders are any parties interested in following the financial performance of a business and who rely on this information to make decisions. For a publicly-traded firm, shareholders are those who have acquired stock in the company and are interested in getting a return on their investment. But there are other interested parties as well. These can include employees and management (internal), government agencies (SEC, IRS), institutions holding the firm's debt, customers, local communities, and others. A principal responsibility of any company is to act in a way that meets or exceeds its stakeholders' expectations.

Whether a firm is large or small, management has three primary responsibilities: planning, controlling, and evaluating the business' decisions. Planning involves setting the goals and objectives of the company and usually includes a business plan and a strategic planning initiative. The controlling activity focuses on ensuring that the business is on track to achieve the desired results or take corrective action if not. Finally, evaluating involves a constant review of performance to help the firm achieve its financial goals for all stakeholders.

To review, see:

• The Role of Accounting in Society
• Accounting as a Tool for Managers

1b. Describe the accounting system

• What do you consider to be some of the critical functions of accounting?
• There are both internal and external users of the information that accounting reports on. What are examples of the customers from each group?
• Why is the application of Generally Accepted Accounting Practices (GAAP) important for public firms?

Simply put, it is the responsibility of accounting to identify and report on every financial transaction that the firm has. This includes all expenses necessary to support the business and all sources of revenue. Accounting tracks these transactions and reports all this activity to management on a regular basis, such as weekly, monthly, quarterly, etc. But there is more than just reporting on the numbers. A substantial amount of analysis is done so that the reports generated help management evaluate progress, identify opportunities and challenges, and make business decisions.

Consider the following examples of the information that the management team will be interested in:

• Actual expenses versus budgeted expenses;
• Sales activity, both historical, current, and projected;
• Amount of debt being held;
• The status of both receivables and payables;
• Profit margins on the sales of key products and/or services; and
• Tax liabilities.

It is also worth remembering the various users of this accounting information, including internal customers, external customers, and government entities. Understanding the responsibility and demands of the accounting function is one of the critical requirements for business.
 
To review, see The Role of Accounting in Society.

1c. Explain each statement in the corporate financial package

• What is the purpose of each statement contained in a firm's financial report (income statement, statement of retained earnings, balance sheet, and statement of cash flows)?
• What are two or three key pieces of information that a business owner or a firm's executive can get from each of these statements?
• What is the purpose and value of an independent audit?

The owners and managers of a business will spend a considerable amount of their time reviewing, analyzing, and evaluating the business' financial performance. The starting place for this activity is the firm's financial statement, which will include:

• an income statement (also known as the profit/loss statement) that reports income coming into the firm from all sources, expenses incurred by the business, and the resulting profit or loss from these activities.
• a statement of retained earnings that records the amount of earnings that the firm will retain (not return to shareholders) to continue business operations.
• a balance sheet that details the firm's assets (what is owned), liabilities (what is owed), and the difference, representing the amount of equity due to shareholders.
• a statement of cash flows that shows how cash is coming into or leaving the company due to operations, investing, and financing activities.

Each of these statements is an important part of describing the business' financial status. Each one provides specific information critical for evaluating how well the business is doing and if there is a need for some corrective action.
 
To increase the value of this information, it is usual for the financial package to compare the current results with the historical performance (last month, last quarter, etc.) and the firm's budgeted financials. This process produces a variance report that shows the current results as greater than, equal to, or less than the prior period or budget. This analysis can provide management with a great deal of information about the business and is the basis for creating various management reports that departments can use within the firm to chart their progress.
 
To review, see:

• Introduction to Financial Statements
• The Purpose and Content of an Independent Auditor's Report

Unit 1 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• balance sheet
• control (management responsibility)
• evaluate (management responsibility)
• external users
• financial accounting
• financial activities
• financial statements
• financial transactions
• income statement
• internal audience
• managerial accounting
• plan (management responsibility)
• shareholders
• stakeholders
• statement of retained earnings
• statement of cash flows
• variance report

Study Session: Unit 1, Part 1

Feel free to review the rest of Unit 1 of the Study Guide at your own pace.

Study Session: Unit 1, Part 2

Feel free to review the rest of Unit 1 of the Study Guide at your own pace.

Unit 2: Financial Statement Analysis

2a. Calculate financial ratios given a company's financial package

• What is common sizing, and how is it used in financial analysis?
• What are profitability, liquidity, and operating ratios, and what is the purpose of each?
• How can calculating the various financial ratios help executives to manage the business?

Imagine you are the firm's executive, and you have received this month's financial report for review. You appreciate the importance of understanding the financial position of your business and the need to evaluate its performance. Where is a reasonable starting point for your analysis as you look at the income statement, statement of retained earnings, balance sheet, and statement of cash flows?

A good initial step is to common-size the statements: restate the numbers as a percentage of a common value such as sales. Using percentages makes it easier to evaluate the performance of a specific item over time or when compared with the prior period or the current budget. This facilitates the identification of positive or negative trends in performance.

Financial ratios are a category of measures used to evaluate various financial performance measures to analyze and evaluate the health of the firm's financial position. While numerous financial ratios can be calculated, common ones include profitability ratios, liquidity ratios, and operating ratios. Profitability ratios help evaluate how well the firm is doing at generating a profit on the sales of its products and services. This ratio can include items like the gross margin, operating margin, and net profit margin. Gross margin is the firm's revenue minus the cost of goods sold (COGS), and the gross margin ratio is determined by dividing the gross profit by revenue. This is one method for evaluating the impact on profitability as the cost of goods increases or decreases. The operating margin compares how the firm manages operating costs such as salaries, selling expenses, marketing costs, etc., and is calculated by dividing the operating income by the revenue. Finally, the net profit margin analyzes the 'bottom line', or the profit that remains after all expenses and taxes have been paid.

Liquidity ratios allow management to evaluate the firm's ability to service its short-term debt, or debt that the company must repay in twelve months or less. Liquidity represents the amount of cash the firm can have available to meet these short-term debt obligations. Two common liquidity ratios are the current ratio and the quick ratio. The current ratio considers the difference between current assets (which are the most liquid) and current liabilities. The quick ratio is similar to the current ratio, except that it requires that the value of inventory be eliminated from current assets. This addresses the potential concerns of having obsolete inventory and could have a value of less than is currently reported.

For an overview of business performance and a measure of how well the decisions made are helping the firm meet its goals, operating ratios are quite helpful. Two standard and widely used measures are the return on assets (ROA) and the return on equity (ROE). Return on assets is a measure of the return that the business is generating from the assets that have been acquired and/or invested in. Return on equity is used to show the shareholders what return is being earned from the investments that they have made in the firm.

To review, see:

• Classification
• Profitability Ratios
• Liquidity Ratios

2b. Evaluate a firm's performance over time

• What is the price/earnings ratio (P/E), and why is it important to shareholders?
• What is the market/book ratio, and what information does it provide to a firm?

Executives are focused on increasing the value of their firms, which provides the basis for generating the returns expected by their shareholders and investors. With their acquisition of stock in a firm, investors expect that there will be returns on this investment equal to or greater than their potential returns from other investment opportunities. Two very common ratios are evaluated to determine the firm's success in increasing its value: the price/earnings ratio (P/E) and the market/book ratio.

As a firm's value increases, one would expect the price of a share of stock to be worth more. Consider the differences between a firm that has demonstrated a record of strong financial performance over time and has a positive forecast that shows a reasonable opportunity for the firm to maintain or even increase its performance. The stock for this firm will be trading at a premium, and one measure of this can be seen in the price/earnings ratio, which is equal to the market price per share divided by the annual company earnings per share. (Total earnings divided by the number of shares outstanding). Consider that a share of stock is selling for $40.00. The earnings per share over the last twelve months is 5. This stock has a P/E ratio of 8.

The market/book ratio looks at the current book value of the firm (balance sheet) compared to what the market says the firm is worth. Remember that the book value of the firm considers assets at their acquisition value less depreciation and does not consider what those assets might be worth at current market prices. If the market price per share is higher than the book price per share, it signals that the market expects the firm to be able to generate more value from their assets than the assets are worth.

To review, see Market Value Ratios.

2c. Compare a firm's performance to other companies in the same industry segment

• What is the value to a firm to compare their financial performance with competitors or other companies in the industry?
• What is benchmarking, and how can it be used by a company when reviewing its financial performance?

It is certainly useful to perform a detailed financial analysis of how well our firm is performing. It is an opportunity to compare our current results with prior periods. For example, consider comparing this month's revenue and expenses with the same month's activity from a year ago. If the firm has prepared a budget as part of its strategic plan, there can also be a comparison of the company's actual results for the month when measured against what was budgeted. As we have seen, various financial ratios are an essential component of this analysis.

However, it is not enough to only engage in an internal review. A major advantage of using financial ratios is conducting a comparative financial analysis or comparing our firm with other competitors in the market or our industry. For example, suppose that our firm is showing profit margins increasing each year from 4.6%, to 5.1%, to the current rate of 5.4%. This indicates that the decisions that have been made on salaries, material costs, inventories, etc., are being controlled and have resulted in increased profits. But a further analysis of the profit margins from our main competitor over the same period show results of 5.3%, 5.9%, and 6.2%. How does this additional information affect your analysis?

To review, see The DuPont Equation.

2d. Recognize areas where financial performance can be improved

• How is benchmarking the financial performance of a firm different from conducting an industry comparison?
• What is trend analysis, and why is it important?

One requirement for managing a successful enterprise, whether large, small, public, or private, is to spend sufficient time analyzing the business's financial performance. Throughout this course, you have been introduced to several methods of evaluating performance, and we will end this section with a brief review of an internal process and an external one.
 
Internally, the use of trend analysis is quite helpful in evaluating overall performance and identifying areas that may need some management intervention. Trend analysis considers historical performance, usually over several periods, and charts the recorded trends. A simple example can be the generation of revenue. Let's say that over the last three years, revenue has increased by 2.0%, 4.1%, and 1.5%. We can also chart key financial ratios such as return on equity, which was 5.3%, 3.6%, and 3.0% over the same period. The challenge is, of course, not in just charting the numbers but in investigating and understanding the 'story' behind the numbers. Even though sales did show an increase last year, it was less than the increase from the year before. What were the causes for this decrease? There may have been changes in competition, new products, etc. A trend analysis is important because it can identify areas for review and be the starting point for future forecasts.
 
While it is helpful to look internally and evaluate the firm's performance, it is equally important to look externally and compare our performance with our industry or the overall marketplace. One way to conduct this analysis is to research the key financial ratios that apply to our industry sector to compare the performance of our firm with the industry. Are we following the industry trend, or are we under- or over-performing in certain areas? Again, the need is to conduct research and understand what the comparisons can mean to our business and if there are decisions to be made.
 
Benchmarking takes the external analysis to a new level. When a firm identifies the top performer or competitor in its market and reviews its key financial ratios against those of that firm, the process is referred to as benchmarking. The value of this method is the focus on top performers and how well they are doing in the market. If our results are less than theirs, it can help identify opportunities, new goals, and objectives to improve our performance. Benchmarking data can also be used to demonstrate to investors and potential investors how well the firm is doing against other important companies in the market.
 
To review, see Profitability Ratios.

Unit 2 Vocabulary 

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• benchmarking
• book value
• common size
• comparative financial analysis
• current ratio
• financial ratios
• gross margin
• liquidity ratios
• market/book ratio
• market price
• net profit margin
• operating margin
• operating ratios
• price/earnings ratio
• profitability ratios
• quick ratio
• return on assets
• return on equity
• short-term debt
• trend analysis

Study Session: Unit 2

Feel free to review the rest of Unit 2 of the Study Guide at your own pace.

Unit 3: Financial Management

3a. Calculate the value of a dollar today, and at some time in the future

• What is the purpose of preparing a capital budget?
• What is the importance of a firm's rate of return target?
• What is the difference between present value and future value? How is each used when considering an investment?

One of the fundamental activities of business is the requirement to make investments. This process begins with the investment to start a new business and continues as that business invests in products, services, plants, and equipment to support and grow. Let's consider an established manufacturing company. As this company grows, it will need to invest in new equipment as the demand for its products increases. In fact, most companies plan for this type of growth by developing an annual capital budget. This budget allows the firm to plan for the cost of new equipment and to consider their alternatives for funding this investment.

Of critical importance for all investments made by the business is a focus on the rate of return. Simply stated, the rate of return measures the profit or loss that results from an investment over some period. The simple rate of return equals the current value of the investment, minus the initial cost of the investment, divided by the initial value. To express this as a percentage, you will multiply this result by 100. For example, an investment that costs $10,000 is valued at $12,000 in two years. The simple rate of return is ($12,000 -$10,000 / $10,000) × 100 = 20.0%, or a 20% return on this investment.

However, the firm will have to consider more than the simple rate of return. Obviously, the company will include more criteria when deciding to invest in a particular project. For example, there may be more than one investment opportunity, and depending on the availability of funds, the company may have to choose one over the other. For this discussion, the firm will look at the impact of time on the investment, referred to as the time value of money (TVM). This principle recognizes that money received in the future is worth less than money in hand today. Why? By investing now, you are giving up the interest that could be earned while waiting for future payments. Going back to our earlier example, suppose that the $10,000 used for the investment could be placed into an account that would earn 25% over the next two years. Was this a good use of the firm's money?

This concept forces the company to evaluate two fundamental investment principles: the present value (PV) and future value (FV) of a potential investment. The present value of an investment is stated in today's dollars. For our example, the present value is $10,000. If nothing is done with this money, it will erode in value over time. Putting it in a savings account will at least earn interest over the time the funds stay in the account. The future value is a calculation of how much this account will be worth at some point in the future, which can be as simple as calculating the compound interest on the account.

Some general rules for investing will include:

1. Money not allocated should be invested to earn interest.
2. Ensure that the expected returns on an investment will meet or exceed the target return.
3. Given a choice among investments, select the one that represents the greatest rate of return over the target rate.

To review, see Capital Budgeting Decisions.

3b. Calculate the internal rate of return (IRR) for an investment

• What is the discounted cash flow model, and how is it used?
• Why is it important for a firm to calculate the internal rate of return on investments?

When evaluating potential investments, a common practice is to forecast the projected cash flows that will come to the firm in the future. As previously discussed, money that will be received in the future must be evaluated against the present values of the investment. Given that the firm can put the present value in a risk-free investment that pays interest, such as a treasury bill, we must discount the future earnings by the interest we are giving up. This is known as the discounted cash flow model (DCF).

To calculate the value of an investment to the firm, the investment (present value), the interest rate that the firm can currently earn, the forecasted future cash flows, and the time involved to receive the return. The investment amount is already known. The discounted cash flow model takes the future cash flows and discounts them, using the identified interest rate, back to the present value. The difference between the present value of the investment and the discounted future cash flows results in the net present value (NPV).

If the net present value is '0', the investment will cover the initial cost but no additional return. If the NPV is positive, it will cover the initial cost and earn a return. If the NPV is a negative value, the investment will not cover the initial cost or generate a return. Looking at the NPV as a percentage, which is how most firms will report the rate of return, it is necessary to calculate the internal rate of return (IRR). This requires that the company determine the expected rate of return and use this in the NPV formula to get to an NPV of '0'.

To review, see Use Discounted Cash Flow Models to Make Capital Investment Decisions.

3c. Explain how the TVM impacts investment decisions faced by the firm

• What are the importance of the payback period, net present value, and internal rate of return in evaluating investment decisions?

From our review of the issues facing a firm considering investment opportunities, we have looked at different approaches for conducting an analysis. Each methodology has some advantages and disadvantages. The payback method provides a quick view of how long it will take the firm to recover its investment. An investment of $5,000 today that will return $1,000 per year has a payback period of 5 years. This does not include the loss of potential interest earnings or the effects of time on the investment. To incorporate the principles of the time value of money, we should calculate the present value (investment) and the future value (cash flows) of the project. The net present value (NPV) is the difference between the two, and we would be willing to invest in projects with an NPV that is zero or a positive number. Usually, the firm will have a target rate of return for investments calculated to cover the company's cost of capital and generate a return that will be acceptable to its shareholders. This is known as the hurdle rate, and the firm will accept projects that have a return equal to or greater than this rate. This is used in determining the internal rate of return, or the rate that will generate an NPV of zero.

To review, see Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions.

Unit 3 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• capital budget
• discounted cash flows
• future value
• hurdle rate
• internal rate of return
• net present value
• payback period
• present value
• rate of return
• simple rate of return
• time value of money

Study Session: Unit 3

Feel free to review the rest of Unit 3 of the Study Guide at your own pace.

Unit 4: Risk and Return

4a. Explain why accepting greater risk requires an expectation of greater returns 

• What is the definition of financial risk?
• What are some approaches to measuring risk?
• How are interest rates used in evaluating risk?

We are all familiar with the general concept of risk. It is usually applied when addressing issues that deal with an unknown outcome. For example, there is a risk that we will find the final exam in this course very difficult. Of course, there are also ways to mitigate, or lessen, this risk. We can make sure to study all of the material, complete all of the assignments, and use this study guide. These steps can reduce the risk. In the business world, we define financial risk as the potential that an investment will have a rate of return that is less than our expected rate.

Obviously, the firm will spend considerable time evaluating potential investment opportunities, and part of this research includes an analysis of the risks associated with any investment. There are several areas that the firm will review, including their degree of experience with the new initiative. For example, it is less risky for an automobile manufacturer to introduce a new car model than to launch a line of home appliances. There are issues with brand awareness, technology, sales channels, distribution networks, manufacturing capabilities, etc. We can add economic risks, business risks, and market risks, to name a few more. There are methodologies used to offer some ways to measure risk, including probability analysis, portfolio models, discounted cash flows, and forecasted interest rates.

When a company borrows funds from a financial institution, interest is involved. Interest represents income for the lender and an expense for the borrower. The interest rate that the lender will charge is based, in part, on the risk that the borrower will be able to repay the loan. The greater the risk of default by the borrower, the higher the interest rate. A firm knows its cost of capital, including the interest rate that it will pay for any borrowed capital. Recall that the calculations of the net present value and internal rate of return for evaluating investments require the use of interest rates.

To review, see:

• Understanding Return
• Types of Risk
• Measuring Risk

4b. Recognize the impact of interest rates on investment financing

• What is the difference between the rate of return and the expected rate of return for an investment?
• How is the Capital Asset Pricing Model (CAPM) used in the evaluation of a potential investment?

If you invest money in treasury bills or bonds, there is a stated interest rate which is the rate of return that will be applied over a given period. Suppose that you buy a $1,000 bond with an interest rate of 10% per year. In one year, you will receive your $1,000 plus $100 in interest for a total of $1,100. However, when a firm invests in new equipment to support its projections for growth, the rate of return is not specifically known. They must consider the market risk and the firm-specific risk.

Market risk (systematic risk) is based on considering the market as a whole and recognizing that fluctuations in the market can influence the financial market. The firm-specific risk (unsystematic risk) represents the risk associated with a particular investment made by a firm. A company can reduce this risk by investing in a balanced portfolio of projects. An investor can reasonably expect a return comparable to the overall market risk. A firm that wants to make investments that will be beneficial and of interest to its shareholders will add a premium to the expected rate of return, or the risk premium. The company will also need the risk-free rate, which is typically associated with a treasury bill (guaranteed).

With this information, it is possible to calculate the expected rate of return on a specific investment. Note that this is expected but can certainly be more or less given market changes and unforeseen issues with the initiative. You can use the capital asset pricing model (CAPM) to determine the expected rate.

To review, see Long-Term Financing: Bonds.

4c. Explain how stocks are valued

• What are debt financing and equity financing?
• What are the differences between common stock and preferred stock?
• What are some of the ways that can be used to determine the value of a share of stock?

In analyzing the benefits of any investment being considered, the firm evaluates the potential returns that will benefit the firm and the firm's shareholders. As the analysis starts to provide firm numbers on the cost of the investment, attention will be given to how the initiative will be financed. The firm will look at debt financing, which will come from lending sources and incur a liability for the company. This is accounted for as the debt to be repaid and the interest expense. The other source of funds will come from equity financing. Equity is a form of ownership. For example, the firm can raise money by issuing shares of stock. The funds raised from shareholders do not incur interest and do not need to be repaid. (Although shareholders would like to see a return on their investment!)

A company can offer two types of stock, namely common and preferred. Each type of stock has certain specific differences. Preferred stock has the benefit of having a guaranteed dividend payment. If the dividend payment is not made, the company cannot pay any dividends to common shareholders. Additionally, in the case of bankruptcy, preferred shareholders are at the top of the list of claimants for the firm's assets. Preferred shareholders have no voting rights for the corporation's board of directors. On the other hand, common stock does give the shareholder voting rights, but there is no guarantee of dividend payments. In the event of a bankruptcy, common shareholders have a residual claim on assets that remain after all other claims have been paid.

Investors buy stock in firms that they believe represent opportunities for financial growth and that will provide the expected rate of return. The value of each share is represented by its price and the potential earnings from dividend payments. If the firm's value increases, it is expected that the share price will increase. This represents a return for any shareholder who sells their stock at a greater price than they purchased it. Additionally, if the shareholder receives dividends and can forecast a stream of future dividend payments, that also represents a return.

A simple calculation of the value of a share is to take the owner's equity (balance sheet), assets minus liabilities, and divide it by the number of shares outstanding. That is what each shareholder is entitled to if the firm were to liquidate today. When considering the potential for dividend payments, remember your review of discounted future cash flows. Generally, depending on the firm and forecast for dividends, an investor can consider a constant dividend stream (same dividend payment) or a dividend stream with constant growth (growing at a constant rate).

To review, see:

• Shareholder's Equity
• Common and Preferred Stocks
• Dividend Discount Model

4d. Calculate the risk of an investment

• What is the meaning of financial risk?
• What is a stock portfolio?
• How does building a portfolio of investments reduce investment risk?

As previously noted, every project that requires cash today for some expected return in the future poses some risks for the investor. Financial risk is the possibility that our investment will produce a return that is less than what we expected (calculated). If there were no risks, and if the returns were guaranteed, there would be more investing taking place. The starting point for calculating risks for new investment is to find what return is available if there is no risk. We look for a treasury bill or bond that will repay the face value (investment cost) and a stated interest rate (risk-free rate). Given that the lower the risk, the lower the expected rate of return, the interest rate is modest. For investors, this is the starting point and represents the base return.

If the investor is willing to assume more risk (risk-taking), they will look for a larger return or an amount greater than the risk-free rate. The greater the risk, the greater the expected return. To get estimates on this larger return, there can be a review of the performance of similar products, services, and industries. Forecasts will be made regarding revenue generation and growth, expenses, and projected profit levels. This rate, plus the risk-free rate, is used to assign a value to the investors' expected rate of return.

One way that investors can reduce the financial risk of their investments is by building a stock portfolio of diversified investments. A portfolio can contain the stocks of various companies, each with a different level of financial risk, which, when combined (weighted), can provide some protection from the risks of an individual stock. Simply stated, don't put all of your eggs in one basket! Companies can also build a diversified portfolio of the projects that they invest in. This can include investments in different products, services, divisions, markets, etc., which can also lower the firm's financial risk.

To review, see:

• Risk and Return Basics
• Expected Return

4e. Explain how firms evaluate risk in investment decisions

• What are some of the risk factors to consider when evaluating an investment opportunity?
• How does calculating the standard deviation of potential outcomes help make an investment decision?
• How does the firm/investor calculate the return on invested capital?

A firm must spend resources and time evaluating potential investments. The firm is committed to making investments that will positively affect its value. A firm can accomplish this by identifying initiatives that can increase revenue generation, help with cost controls, increase operating efficiencies, improve the quality of products and services, and any number of additional projects that assist the company in increasing their stock prices, dividend payments, or both.

Identifying potential risks that come with every investment and finding ways to minimize those risks is critical. The market is filled with examples of firms that became great success stories, but even more that failed and lost their investor's money. A firm's risk factors can include the experience needed to succeed, comprehensive data collection, in-depth financial analysis, availability of capital, the time required to reach a return, uncertainty in the economy, and many more. The better the research, the more likely that the firm will identify issues and determine how much risk they represent.

Numerically, the firm can make an effort to calculate the standard deviation of the potential investment outcomes. If you remember from statistics, the standard deviation measures how different the results of this particular investment will be from the average of all outcomes. Often, historical data is used to obtain a set of actual outcomes. These outcomes can be assumed to have the same weight, or our research may identify the need for some adjustments. The average of these outcomes is the expected rate of return.

One method for demonstrating how efficient the firm is at investing its capital and creating value is calculating the return on invested capital (ROIC). The formula for determining the ROIC is: (net income – dividends) / (debt + equity). In other words, the firm has generated a certain amount of profit, after paying dividends to shareholders, based on their use of debt and equity financing. The higher the ROIC, the better the job that the firm is doing for their shareholders.

To review, see:

• Risk and Return Basics
• Expected Return

Unit 4 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• capital asset pricing model
• common stock
• constant dividend stream
• debt financing
• dividend stream with constant growth
• equity financing
• financial risk
• firm-specific risk
• interest rate
• market risk
• measuring risk
• preferred stock
• rate of return
• return on invested capital (ROIC)
• risk factors
• risk-free rate
• risk premium
• standard deviation
• stock portfolio

Study Session: Unit 4

Feel free to review the rest of Unit 4 of the Study Guide at your own pace.

Unit 5: Managing Capital

Study Session: Unit 5

Feel free to review the rest of Unit 5 of the Study Guide at your own pace.

Unit 6: Valuation

6a. Recognize the importance of increasing firm value 

• What are some of the factors that analysts and interested investors will consider when placing a value on a corporation?
• What information is available from the company's financial package to identify the firm's value?
• What are at least two ways of determining a firm's value?

A considerable amount of information has been presented in this course that discusses the importance of management's decisions that lead to increasing the value of the firm. As value increases, there are some positive outcomes for the company, including a stronger capital base, more options for developing the capital plan, additional opportunities for investment, and the added benefit of attracting new investors. Some of the factors that we can review to establish the value of the firm are the effectiveness of management, view of positive future earnings, the current market value of the firm's assets, and its capital structure.

A good place to start is to review the company's balance sheet. This is a record of the firm's current and non-current assets (what the firm owns), current and non-current liabilities (what the firm owes), and owner's equity. For shareholders, this is an important piece of information. If the business were to close today, they would liquidate the assets (convert them to cash), pay off the debts, and the owner's equity is what is left for the shareholders to divide up based on the number of shares they own. As the company makes good decisions on investments that will increase the company's operating efficiencies, cash flows, and add valuable assets, while reducing the weighted average cost of capital (the capital structure), one would expect owner's equity to increase.

In addition to the balance sheet, it is also possible to determine value through other financial models. For example, the firm can use the capital asset pricing model (CAPM) and the weighted average cost of capital (WACC). The firm can use both the CAPM and the WACC to evaluate investments to determine its expected rates of return. The asset approach considers the worth of the firm's assets, their potential for supporting operations and creating value, and the cost to replace these assets at current market prices. A potential shareholder will also take a market approach, look at the firm's position in the market, and evaluate how they perform against the industry participants as well as against specific competitors.

To review, see:

• Valuing the Corporation
• Discounted Dividend vs. Corporate Valuation
• The Balance Sheet

6b. Calculate various measures of corporate value 

• What does the market value added (MVA) calculation show about corporate value?
• What does the economic value added (EVA) calculation show about corporate value?

Let's accept the proposition that, as executives of a company, we are committed to our business's successful operation and growth. As we have stakeholders, including shareholders and other businesses holding our debt, we are focused on ways to demonstrate to them that our management decisions are having a positive impact on increasing value. Shareholders can expect to receive returns that meet or exceed their expected return rates. (As we have discussed many times so far in this course.) Two measures of corporate value that are widely used are the market value added (MVA), and the economic value added (EVA).

Market value added considers the firm's total market value minus the total amount of capital that the company's investors have made. When investors purchase shares of stock in a firm, they expect that the firm will use this capital to make investments that will increase its value and increase the value to each shareholder. MVA is a method for demonstrating if this is happening with this business. The calculation for MVA is:

MVA = market value of shares – book value of shareholder's equit

The market value of shares is the current price that a share of stock is trading at. The book value of shareholder's equity is found in the firm's financial reports on the balance sheet.

Economic value added analyzes the investments (projects) undertaken by the firm and looks to see if the returns from these investments were sufficient to cover the costs and generate additional wealth for shareholders. The calculation of the economic value-added measure is:

EVA = NOPAT – (WACC × capital invested)

In this formula, NOPAT is the net operating profit after taxes, WACC is the weighted average cost of capital, or what it costs the firm to acquire and use the capital needed for the investment opportunity, and the capital invested is the equity and any long-term debt at the start of the period.

To review, see:

• MVA and EVA
• The Association between Economic Value Added, Market Value Added, and Leverage

6c. Apply value creation methodologies to business decisions

• Define a merger and an acquisition. How are they similar?
• How can mergers and acquisitions (M&A) be used to create value?
• What are some advantages and disadvantages to forming a corporate alliance?
• When might a firm consider it appropriate to divest of parts of the business?

We have discussed some of the ways that firms look to increase the value of their business for their stakeholders. This process encompasses a wide range of activities, from implementing good management practices, creating strategic plans, developing a corporate culture that recognizes and rewards employees and fosters high levels of employee engagement, satisfying customers with quality products and services, and making investments that will support these goals. One area where firms can make investments externally is to evaluate opportunities involving mergers and acquisitions (M&A).

A merger involves reaching an agreement with another firm to combine their companies. After the merger, the companies will usually form a new company consisting of both firms. Decisions will be made on the management structure of the newly formed business, if all the assets of both firms will be kept in place, etc. In an acquisition, one company buys another company. The original firm retains its identity and incorporates the acquired firm into its organizational structure.

To be successful (that is, to increase the firm's value because of the M&A activity), this process requires substantial research and analysis. Some of the reasons for engaging in M&A activity can include:

• acquiring new technology or manufacturing processes
• increasing market share
• access to new distribution channels
• ability to have a larger global supply chain
• addition of new products and services
• opportunities to consolidate some functions and reduce costs economies of scale)
• new opportunities for offering customers a broader range of products
• addition of locations, local presence
• opportunities for diversification (air conditioning company adding a heating company)

Whatever the reasons, M&A activity should focus on the most important goal of the firm, which is to make decisions that will increase the firm's value, benefitting the firm's stakeholders.

One approach that can realize some or most of the advantages of M&As is for two or more firms to consider allying. With a corporate alliance, the parties remain independent but agree to work together on initiatives that can provide a benefit to each company that is greater than what they could achieve on their own. These activities might include sharing technology, distribution channels, shared expenses for entering a new market, or launching a new product. In an alliance, all parties share the risks that may be involved in any new venture. A benefit of this approach is that it is less complex than a merger or acquisition, less expensive, and can have a future end date.

A final activity that a business can consider for increasing its value is to decide to divest itself of, or eliminate, one or more of its existing business units. There are several reasons why it may make financial sense for a firm to divest part of its operation:

• the business unit is unprofitable or may require a large investment to continue;
• the company needs to obtain funds needed for more profitable investments;
• the company decides to focus on a core group of products and/or services; or
• regulatory actions require it, such as in the case of a monopoly.

As you can see, the executive management team for a corporation has a great deal to consider as they strive to produce financial results that the firm's stakeholders require.

To review, see Other Topics in M&A.

Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• acquisition
• asset approach
• balance sheet
• capital asset pricing model
• corporate alliance
• divest
• economic value added
• market approach
• market value added
• merger
• value of the firm
• weighted average cost of capital

Study Session: Unit 6

Feel free to review the rest of Unit 6 of the Study Guide at your own pace.

Unit 7: Financial Planning and Forecasting

7a. Evaluate decisions that the firm makes on future performance 

• What are the planning and control functions of management?
• Why is creating a strategic business plan an essential part of business success?
• What are the 5Ps of strategic management, and define each one?

Making decisions and managing the business daily is undoubtedly a critical management function. But that alone isn't enough to ensure that the business will survive and grow. Additional important roles for the manager to recognize involve planning for the future and exercising the appropriate controls to ensure that the firm is performing as expected. The role of planner requires the firm's leadership to look ahead and try to anticipate the future. Questions to consider include: what new products will the market be looking for; do we have sufficient skills and technical expertise to support growth; in what new directions is the competition moving; can we continue to add value to the business? These questions, and many more, are why companies will spend the time and resources needed to create a dynamic strategic plan for the business to follow going forward. Once the strategy has been approved, the manager's role becomes that of a controller. Control is reviewing progress against the strategic plan and taking corrective action where needed if the results are less than projected.

The business environment is dynamic, global, competitive, and faced with changing customer wants and needs. Today, it is essential that a firm takes the necessary time to carefully develop a strategic plan for the business that thinks strategically about what is happening in the market. The plan should identify growth opportunities, identify the firm's need for capital to make appropriate investments, and identify goals and objectives to increase revenue while controlling costs. The strategic plan is a blueprint that the organization can follow as it moves through the years that will serve to guide decisions and actions that the business will take. As the environment is dynamic, the strategies must be dynamic as well. This implies that they will require constant review, and decisions will need to be made to make course corrections depending on what is occurring in the market.

There are several approaches to the development of a strategic plan, but we will focus on the 5Ps of strategy, including 1) plan, 2) ploy, 3) pattern, 4) position, and 5) perspective. This is an easy way to think through the steps that you can follow to develop a strategy logically and objectively. The plan refers to the specific goals that the firm's executives have established to achieve identified goals. Ploy is one part of the strategy and involves keeping your competitors 'in the dark' about your product and service plans. Walmart, for example, does not announce where it will open new stores until the last minute. It goes as far as booking plane and hotel reservations in multiple locations to maintain secrecy. To make the strategic plan an effective part of the organization, the firm needs to follow a pattern or be consistent in implementing the strategy. One part of the strategic plan will address the firm's position relative to its competitors in the marketplace. This can include strategies where the firm chooses to be an innovator of technological products (large investment in R&D) or a follower of other companies. It is important for the members of the organization who will be developing and implementing the strategy to share their perspectives of the market, competition, and customers.

To review, see: 

• Defining Strategic Management and Strategy
• Understanding the Strategic Management Process

7b. Explain the various forecasting methods

• What is a budget, and why is it important for a business?
• What is an operating budget, and what are some of the items included in this budget?
• What is a financial budget, and how does it differ from the operating budget?
• How can a business use budgets to evaluate performance?

Business management usually conducts operations and makes decisions within their budgets. A budget provides a framework that covers management's best estimates of the revenue coming into the firm, the expenses required for operations, and a projection of expected profits. The budgeting process starts with a review of historical activity, which allows us to review what was accomplished in prior periods. Next, it is necessary to evaluate the current business environment, including customer demand trends, economic conditions, competitive activity, interest rates, etc. Finally, based on research, you need to make assumptions about what will happen in each of these categories in the future. With all of this analysis, management will create the budgets for the next year or even three years into the future.

A company's operations focus on the day-to-day activities required to plan for and produce the products or services that the firm will be offering to the market, and the operations budget addresses these activities. Specifically, this budget is made up of several other budgets, including:

• Sales budget – forecasted plan for what will be sold, how many will be sold, and when they will be sold;
• Production budget – expense projected for plant, equipment, and labor;
• Direct material budget – cost of materials, parts, and supplies to support operations;
• Direct labor budget – labor expense for personnel needed in production; and
• Overhead budget – projected expense to maintain the facilities, rent, taxes, office expenses, etc.

Budgeting must also consider the financial needs and expected performance of the company. The firm will also compile the financial budget, which includes a plan for cash flow, the financial report – especially the balance sheet – and a plan for capital expenses. The financial budget lays out the plan that management has on how they will generate revenue through sales, the collection expectations for this revenue, the cash flow expected from planned investments, including acquisitions, and the future capital requirements to replace plants and equipment. One important piece of information from these budgets is a recognition of when revenue will come in and when capital will need to be available for investments. This information is required for developing the firm's capital plan.

The operating and financial budgets provide useful information for the firm's management that they can use as plans are made for each department in the business. They provide guidance on how much funds have been projected for salaries, materials, production, sales and marketing initiatives, etc. Perhaps more importantly, these budgets are used to evaluate the firm's actual performance against the plan and provide a basis for identifying issues that require management intervention. For example, if the operating budget has a sales forecast of $5 million in the 1st quarter, and the actual sales are $3.5 million, there is a negative variance between forecast and actual. Management will evaluate why there is a difference and determine specific action plans to address the issues. There can also be a positive variance. For example, consider the financial budget forecasting cash flow of $2 million, and the actual result is $3.1 million. While this is a positive result, management will still want to understand how this happened and perhaps take steps to reinforce what contributed to the positive variance.

To review, see Budgeting.

7c. Calculate the additional funds needed (AFN) by the firm

• What is the concept of additional funds needed (AFN)?
• When is AFN required to manage a business?

It is generally accepted that businesses are interested in growing, expanding product and service offerings, increasing the generation of revenue, and realizing a profit. One way to do these things is by adding additional assets to the firm. Assets are anything of value and can be represented by several different categories. Consider a firm that has successfully introduced its product offerings into the marketplace but is producing at full capacity. For the business to increase sales, it will need to add additional equipment and perhaps more manufacturing space. Management knows that these capital expenditures are necessary to generate new and increasing sales. But will the additional revenue be sufficient to cover the capital needed and the cost of that capital? Additional funds needed (AFN) is frequently used to answer this question.

A good rule for applying the additional funds needed calculation is before management makes the final decision to acquire new assets dedicated to the firm's growth. It should be part of the financial analysis when considering this type of investment. The AFN equals the projected increase in assets minus the spontaneous increase in liabilities – any increase in retained earnings. To use the AFN formula, you will need to know the assets directly tied to sales, spontaneous liabilities, prior year sales, projected sales, profit margin, projected net income, and the retention ratio from net income. If the result of this calculation is a negative number, then no additional funds will be required. The return from the addition of new assets will cover the cost of the investment and generate additional income for the company's use.

To review, see Additional Funds Needed.

7d. establish basic guidelines for corporate governance 

• What is corporate governance?
• Who are parties that would be interested in corporate governance?
• Is there a role for government regulation and oversight of corporations? Why?

Throughout this course, we have discussed the responsibility that a firm's executives have to make decisions that provide the expected returns to shareholders and make decisions that support this goal. But the firm needs to determine its policies regarding how it will operate and how they will protect its stakeholders' interests and publish these policies internally and externally to the organization. There are legal and ethical issues involved. In the U.S., there is government oversight through the Securities and Exchange Commission (SEC), which provides regulations to ensure that stakeholders are protected, especially from fraudulent activities.

In a public corporation, the Board of Directors is responsible for providing oversight of management and the decisions made on behalf of shareholders. The firm must recognize that investors have provided funds to the business with the expectation that those funds will be used to make sound investment decisions that will increase the firm's value. The idea of a fiduciary responsibility states that decision-makers will use proper due diligence, including research and analysis when deciding to invest shareholders' money. The larger the firm, the greater number of interested parties, or stakeholders. These parties include shareholders, lenders, employees, suppliers, and local communities. A truly ethical firm will make every effort to meet the minimum requirements for good corporate governance and look for opportunities to exceed these requirements. This responsibility has been greatly increased with firms' global reach and participation in today's business arena.

To review, see:

• Corporate Governance: Linking Corporations and Society
• Governance and Accountability
• The Board of Directors: Role and Composition

Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• 5Ps of strategy
• additional funds needed
• budget
• controller
• fiduciary
• financial budget
• operations budget
• pattern
• perspective
• plan
• planner
• ploy
• position
• Securities and Exchange Commission
• strategic plan

Study Session: Unit 7

Feel free to review the rest of Unit 7 of the Study Guide at your own pace.

Course Review

• Final Exam Review Part 1
• Final Exam Review Part 2