finance 101, finance overview, basics, and best practices
It. Turns out that numbers are everywhere you, might say that you want a numbers person but. That statement, does not make numbers go away whether. You are in marketing, HR, supply. Chain or strategy, numbers. Are a key element of, all, discussions. Relating, to productivity, and performance. People. Who understand, the numbers and appreciate, how they are used within an organization. Have, a leg up on those who just dismiss numbers is not being important, or understandable. Our. Objective, with this course is to help you understand. The two most common, areas involving, numbers within a company accounting. And Finance, you will find that the numbers are just a way to quantify, your intuition. Numbers. Help us to be systematic. In our analysis, numbers. Impose a discipline. On us that helps us to consider, and quantify. All factors. Relevant to a decision the numbers, assist us with our decision, making it is, important, to always remember, that we, don't work for the numbers the. Numbers work for us the. Numbers, are just a tool to help us make better decisions, and that, is what we all want to do make. Better decisions. Rather. Than fear the numbers or dismiss, the numbers or cop out and say you're not a numbers, person, together. Let, us get comfortable. Understanding. And using the numbers let's, see how we can increase, our skill set by, getting comfortable, with the disciplines, and terms associated, with these numbers, we. Will begin with a discussion, of Finance, what. Is finance let's. Start with a broad definition. Finance. When we're thinking about organizations. Individuals. Families, companies, governments, is first, about identifying, what things I need, second. How, do I get the money to buy those things and, third. How, do I manage, those things efficiently, once I have them now, let's drill down inside, a company first, how, do I decide what things I need well. There are long term decisions, that I need to make do, I need to buy some land do, I need to buy a building do, I need to buy machines, that. Decision, making process, is part of Finance then. There are short term decision, how much cash do I need how much inventory should I have on hand making. Those decisions as part of Finance other, operating, items how about my level of staffing, do I have a research and development department what. About my marketing, budget all, of these issues are issues of Finance and they all require money, so. That leads into the second area of financing, how do I get that money do I borrow it do, I ask shareholders. Or partners to pull their personal, savings and put it into the company so that we can use that to buy the things we need or do, I use internally. Generated profits and third. Once. I have all those things that I've paid for them how, do I manage them that's, an issue of timing scheduling. Budgets, interface. With my outside suppliers, my, staff and I. Also need to decide how to protect, the things inside my company, I need. To have controls, and procedures in place inside. My company, to, effectively, manage the things that I have now, that's, a broad description, and definition of finance but, when most people say, finance, they, have a more narrow set of issues in mind they. Are only focusing, on one of the three broad issues how, do I get the money to, buy the things, I need, how. Does the company get the money should they borrow it should, they seek it from investors, they, have to get the money from somebody, outside of the company so, those Outsiders. Do they want to invest, in this company or do, they want to invest in that company, and there. Are third parties involved, financial, institutions, that put these parties, together a, company. Needs to borrow money you want to lend money somebody's. Got to put the two of you together so when most people talk about finance realize, they're just focusing, on this one narrow sliver, of finance, finance.
Broadly, Defined involves, deciding what you need to buy how. You're going to get the money to buy those items and then, how to manage those things once. They're inside your company. Now. Let's think about what's going on outside of companies, with regard to finance let's, think about all the economic, activity in the world as a sea an ocean, with three kinds of players swimming, around in that ocean first. There, are the entrepreneurs, the creators, the doers, organizations. With ideas, objectives. These. Are the companies looking for funding they're swimming around out there, there. Are also investors. Swimming around out there, these are the entities, individuals. Companies who have saved money in the past and are, now ready to lend it or invest it in somebody, else, finally. There are facilitators. Swimming, around out there specialized. Institutions. That will match up the entrepreneurs, who have ideas but don't have money with. The investors, who've got the money that's. The economic environment that we're talking about so, we've got the entrepreneurs. Who are running companies, we've already talked about what goes on inside companies with regard to finance, entrepreneurs. Need to decide what to buy how. To get the money to buy it and how to manage it once they have it so. Let's think about what goes on outside the, company in the rest of the economic, sea what, about those investors, and savers, what. Are they thinking about they're, looking at their investment, opportunities, under, what conditions, under what circumstances. Should they provide money to entrepreneurs. Should they lend the money should. They invest the money what, about their portfolio. Of investments they, don't want to invest everything, in one company so what different, things should they invest in, then. There are the facilitators, there are all kinds of them out there there are banks, there are mutual funds there are private equity funds there are insurance companies there, are investment. Banks who put deals together, there. Are all kinds, of entities swimming, around out there trying, to match those who need money with. Those who have money, finance. Allows, us to look at each one of these entities and how they interact, one with another. Finance. Is identifying, the necessary, resources for an organization. Determining. How to get the money to buy those resources, and then, how to manage, those resources efficiently once, you have them that's, the broad definition of finance when. We talk about finance. We're, usually talking, about just the middle one determining. The best way to get the money to buy the needed resources, should, I borrow the money should, it be invested, if I'm, an outside investor, under what circumstances. Under what conditions, should I provide that capital, and then. Finally, what, about those financial, institutions, that bring savers, and entrepreneurs. Together, how. These three, groups work together is, a narrow, definition, of finance but, it's probably the most common but. Keep in mind that within a company, finance. Is much, bigger than just obtaining funding. Determining. If funding is needed the amount, of funding needed and how, to manage the resources associated with that funding is also. Part of Finance. Now. Let's turn our attention to accounting, what is accounting first accounting, is quantitative. You knew that it's, numbers. Second. Accounting, is financial, in nature that means money, numbers. About money, third, accounting. Is meant to be useful it's a very practical, field, of study well, useful for what that's, the fourth aspect of accounting, useful. In making, decisions. Accounting. Helps you use the past right. Now in the, present to change the future, accounting. Is quantitative. Numbers. About money to help people you, and me make. Better decisions, that's, accounting, now. There are four different types of accounting first the. Most fundamental, type of accounting is bookkeeping just. The routine, gathering. Of the information, making, sure that everything, gets recorded because. If it doesn't get recorded we'll never know about it so, bookkeeping. Is the systematic. Gathering of financial, information, the. Second, flavor of accounting is called financial accounting, this. Is reporting, to people outside your organization just. Summary reports, not the details. Financial. Accounting is for people who want periodic. Reports, as to a firm's performance, so, you prepare, and provide them with a report, of the economic, resources you have and the, economic, obligations, you've incurred you. Report as to whether you made money last year did you lose money last year just.
Summary, Reports, to people outside of your company who might be thinking of loaning you money or might. Be thinking, of investing, in your company that's. Called financial accounting, reporting, to outsiders, now. The third field of accounting is managerial, accounting, this. Type of accounting, involves the details, within, a company those. Are the detailed, proprietary. Data that individuals, use inside. Their organizations. To make decisions, detailed. Decisions, decisions, such, as should, I raise my prices should. I stop selling, shirts and start selling shoes should. I build my factory, in Wyoming, or should I build it in Alabama, those. Detailed, decisions, that business, people and people running organizations make. Every day and this. Is information that is known only to those inside. A company, they, don't reveal this to outsiders, it's confidential. Information. That's. Called managerial, accounting, and finally. The, fourth kind of accounting, is income, taxes, this, is the accounting, that makes sure that you're in compliance, with the tax laws well. Those are the four types of accounting bookkeeping financial. Accounting manager, early accounting and income. Taxes, both. Accounting, and finance deal with using numbers, to make better more. Informed decisions. The. Numbers, certainly, do not drive the decisions, but they provide a significant. Input into the decision making process. Accounting. Involves gathering and compiling information, for decision, makers both within the company and outside. Of the company this. Information, is often used by those in the field of finance to determine, what resources are needed and how best. To acquire, and utilize, those resources. Accounting. And Finance do not involve magic, they. Involve understanding, our. Objective, here is to help you gain, some of that understanding not. So that you can become accountants, but, rather so that you can understand, and appreciate where, those numbers come from and what. Those numbers are used for who knows perhaps. You'll find that numbers can become your friends. We've. Talked about how accounting, and finance involved, compiling, and using quantitative, information, and making decisions how's. That information, conveyed how. Do users, see and digest that information, well, within, a company. Quantitative. Information can, take on many shapes and sizes there. Are no rules as to how information is used within, a company a company. Can use information that it develops within a firm in whatever way helps that company to make the best decisions, but. Once you step outside of a firm, there, are rules. Information. Used by potential, investors and creditors is, governed, by rules so. That information can, be compared, across time, for the same company and across. Companies, at the same point in time now. We won't get bogged down in how those rules are created suffice, it to say that there is a formal, rulemaking process. To ensure that the information given, by firms to those outside of the firm is, relevant. And reliable. Financial. Statements, are a method in which the effects of lots of transactions. Are summarized, and reported, in a manner that is useful, to users of financial statements who are standing outside the, company the. Three most common financial, statements, are the balance sheet the income statement, and the statement of cash flows we. Will look at these three statements in a bit of detail as they are quite common if you. Are evaluating, a competitor's, financial, position, if you, are evaluating, a suppliers, long-term, viability, if you, are a member of a labor union negotiating. With a company, if you're assessing a customer's, ability to pay you. Will use these three financial, statements as part of your assessment let's. Take a look at each of these in turn. We. Will start with the mother, all financial statements, the balance sheet the, balance, sheet embodies, the accounting, equation one, of the greatest inventions of the human mind invented, in Italy over 500. Years ago a listing. Of things we own assets. Is easy anybody can list assets, but, the insight, from the accounting, equation is to then also list, where did we get the money to buy those assets, the liabilities, and the equities now. Assets, they're valuable resources, they, are the items that will provide us benefit, in the future cash, for example, is the asset that we can all quickly identify, if you, look for example at the balance sheet of Apple, you'll, see that Apple had on September, 27 2014.
13.8. Billion dollars in cash now that's, a lot of money but that's not even close to being Apple's biggest asset, accounts. Receivable, that's money that's owed by other people to a company that's another common asset, continuing. The Apple example, at. The end of September, 2014. Customers. Old Apple almost seventeen, point five billion dollars. Apple. Also had inventory, all those iPods iPads IMAX. And iphones at the end of September 2014. Apple, had inventory. Totaling, over two billion dollars. Another. Asset, land buildings, equipment all of these are resources, that a company uses in accomplishing, and subjective. Apple. Had twenty point six billion dollars in property plant equipment but. Apples biggest, asset, as of September, 27, 2014. Was, long-term, marketable, securities, these, are the stocks and bonds of other companies, that Apple, has purchased that. Amount totaled over one hundred and thirty billion, dollars. Apples. Total assets, at the end of September, 2014. Totaled, almost two, hundred and thirty, two billion, dollars Wow. Again. Assets. Are resources, available to a company, that will benefit, that company in the future, now. How. Does it company finance its assets, how. Did Apple finance, that two hundred and thirty two billion dollars in assets if, a company has assets, then that same company also has to have sources, of financing, to buy those assets. What, are these sources well, one possible, source are liabilities. Liabilities. Are obligations. To repay money or to provide a service in the future, consider. For example Walmart. Where. Does Walmart get most of its inventory that's the things that Walmart has on its shelf to sell the you and me while, suppliers, finance, it suppliers. Say you, can pay us later we. Call those accounts, payable other liabilities. Disney. Has borrowed money on a long-term basis, sometimes very, long term a hundred, years would. You loan money to somebody for a hundred years well, maybe not everybody but you'd loan money to Disney, to pay you back in a hundred years, United. Airlines has a very, interesting liability. When you and I fly on United, Airlines we. Pay first and fly later in the, interim United. Airlines owes us a ride on a plane that's an obligation turns. Out that's a liability that's listed on United Airlines balance, sheet at the, end of 2014. That obligation, to provide airplane rides to people who had already paid totaled, over. 3.7. Billion dollars, so. Let's go back to Apple their. Biggest, liability was accounts payable companies, that they'd purchased, assets, from but hadn't yet paid for the.
Amount Of their accounts payable, was thirty point, two billion dollars their. Second, largest liability. Was long-term, debt totaling, about thirty billion dollars now, you might ask why would a company with almost 14, billion in cash and 130, billion in marketable, securities, be borrowing money but. That's a discussion for another day. Suffice. It to say that Apple's, liabilities, as of, the end of September, 2014. Total to 120. Billion dollars. Now. The second, source of financing to buy assets is owner's equity money, provided, to the company by owners owners. Can do this in two general, ways they. Can take money out of their pocket, and invest, it in the business we call this paid, in capital that's. The first way that owners invest in their company a second. Way that owners invest in the company is by leaving profits, of the company in the business we call these retained, earnings, the. Profits of a business belong to the owners the. Owners can take the profits out and use them to buy groceries or to buy a boat or whatever else they want to do or the, owners can say let's put those profits, back into the business, we, call those retained. Earnings paid. In capital and retained earnings are the amount of money that are provided, to the company by the owners, to, then buy assets, in the, case of Apple owners. Have invested, about twenty three point three billion dollars into the business that's, paid in capital and, they, have elected to leave in the business since the business was started about eighty nine billion dollars, to. Review remember that Apple had assets of two hundred thirty two billion dollars well how did they finance those assets, a hundred. And twenty billion dollars, worth were funded through liabilities. And the, remainder, were financed by owners to the tune of about a hundred and twelve million dollars, now. The first thing to note is that they call this financial statement a balance sheet for a reason, it balances. The. Accounting, equation requires, assets. To equal liabilities, plus owner's equity it has to balance by, definition, the. Accounting, equation always. Holds always. We. Can look at a couple of other companies to show how their balance sheet balances, consider. The following these, three companies United. Airlines General, Motors in Google vary, in size and they vary in the degree to which they finance their assets, with liabilities, but, they all have one thing in common their, assets, exactly. Equal their liabilities, plus their owner's equity even. Though these are sophisticated, companies. Selling. Products that are quite innovative and technologically, advanced, they, still, follow that same accounting, equation that was invented by the Italians, over 500, years ago, assets. Equal, liabilities plus. Equity check. It for each one and you'll see that they add up they always add up. The. Second, primary financial statement, is the income statement, the income statement tells us revenues, minus, expenses and. That equals net income we, use the term revenues, and expenses all the time so let's make sure we know what these words mean in an, accounting, context. Revenue. Means the amount of assets generated. In doing business and, different. Companies generate, assets in different, ways Walmart. For example generates. Assets, by putting things on shelves that, you and I buy we. Pay Walmart, more for the inventory than they themselves paid, for it that's, how Walmart creates assets.
Microsoft. Creates assets, by creating, software and hardware that. You and I then buy and we pay Microsoft, for those things Disney. Has a consumer, products they, have cruises, they have theme parks, we, pay to use those things or to buy those products, and that's how Disney generates, assets. Revenue. Is the amount of assets generated, in doing business hopefully. The, assets generated, are less than the assets consumed. Expenses. Are the amount of assets consumed, in doing business for, example, Microsoft. Consumes. Assets, by paying programmers, and by paying for equipment. Walmart. Consumes assets, by buying the inventory, that they then sell the you and me and then paying rent by having buildings, depreciate, by paying its employees. McDonald's. Consumes resources by, buying food buying paper by renting facilities, in each. Case the, revenues, hopefully. Are more, than the expenses, that are consumed, in generating, business all. Of this is put together in the income statement net. Income equals. Revenues, minus, expenses. Now. Net. Income is a very sophisticated economic. Measure it's, the net amount of assets generated, by a business, through its business operations this. Is the income statement, now. Let's look at the income statement, for some companies of which you've heard Facebook. Google, Microsoft, and, Apple, all. Of these companies have income statements, that they released to the public on a regular basis now, take a look at these first. Of all you see a difference in scale Apple. Is so much larger than Facebook, in fact, Facebook, is the smallest company, on this list and terms of Revenue yet, we talk about Facebook, so much, this. Illustrates, an important point the, financial, statements, are only one measure of a company's performance a very. Important, measure but, only one measure now. Why do we talk about Facebook, so often because, for Facebook, its, operations. Now, are, only a small fraction of what we think they're going to be in the future, Facebook. Is expected, to grow substantially in, the future, so we talk a lot about them now the. Point with the income statement is this a company. Increases its net assets, through profitable, operations, you, can see that for each of these four companies they've all been very profitable, as a result, their, net assets, increase year after year. The. Third primary financial, statement, is the statement of cash flows, conceptually. The statement of cash flows is quite simple cash in cash. Out the. Inside, of accountants, is to separate those cash flows into three categories, operating. Activities, investing activities. And, financing. Activities. Those. Three categories of cash flows are what are reported, in the statement, of cash flows now. Operating. Activities, are what companies do every, single day they collect cash from customers, they. Pay cash to buy inventory they pay cash to employees, for rent, for advertising, for research, and development all. Of those things are operating activities, think. Of operating, activities, as the things that their business, does every, single day and hopefully.
A Company. Would generate cash from its operating activities, you would hope that a business would be collecting, more cash than it spends on a daily basis. The. Second, category in the statement of cash flows is investing, activities, investing. Means investing, in the productive capacity, of the business buying, machines, buying land buying buildings those. Are investing, activities, in contrast. To operating activities, which happen every single day investing. Activities, happen occasionally, you, don't buy land and buildings every single day you do that on occasion. Operating. Activities, are things that a business does every. Day investing. Activities, investing, in the productive capacity, of the business happen. Occasionally. The. Third category in the statement of cash flows is financing, activities, and that is exactly what, it sounds like financing. Borrowing. Money repaying, those loans getting cash or investors, paying dividends, to investors, getting. The capital or financing, to buy the assets that a business needs now. A way to think of the statement of cash flows is with, financing, activities, on getting the financing, that is the capital to buy the assets, the, investing, activities to. Then conduct the operations, the operating, activities these, are the things that our business does the. Statement of cash flows is built around operating. Investing. And financing activities, let's. Look at examples, of the statement of cash flows for three companies about which you may have heard coca-cola. Exxon. Mo and Walmart. First. Thing I want you to look at is well, look at the statement, of cash flows for ExxonMobil, particularly. Look, at their investing, activities. Billions. Upon billions, of dollars of investing, activities, investing, in the productive capacity of, these businesses, this. Business, needs larger, machines and buildings and equipment and lots of land and you see that reflected in the investing, cash outflows, of ExxonMobil these. Are often called capital. Expenditures, or capex. Now. I want you to look at the statement of cash flows for coca-cola and Walmart we, call these cash cows the. Reason we call them cash cows is their, operations. Generate, more, than enough cash to pay for all of their investing, activities, with cash leftover, they're, generating, a lot of cash wouldn't. You like to be a personal cash cow where, your daily cash flows were enough to pay for all your cars and your houses and, your land and everything else you needed to buy in cash. That's, coca-cola that's, Walmart, and that's, ExxonMobil, now. Let's, step back and remind ourselves why. An understanding, of these three financial statements, is important, if you. Are ever in a position of, negotiating, with another company and find yourself wondering, about the company's long-term viability, you. Will want to know a little something about their financial position well. Their financial, position is summarized, quite nicely with using, these three financial statements these.
Three Financial statements, may not tell you everything, about a company's future but. They do tell you a lot. In. This. Section we will discuss how common, external, financial, reports are used by those who are standing on the outside of a company and trying to assess the financial viability on the, inside of a company of course. It would be preferable if we could just get inside the company to do our analysis but. Companies do not like outsiders poking. Around on the inside of their company there's, just too much proprietary. Information that, they do not want exposed to outsiders, things. Like cost structures, pricing. Margins, and R&D efforts, to name a few we must, make do with the information that is available, another. Point to keep in mind is that the analysis, techniques, that we will practice on the external, financial, statements can be developed, and applied within. A firm using. Proprietary firm, specific information in other, words we. Will practice, the techniques, on commonly, available information and, you. Can develop unique, techniques, within your company for analyzing, firm specific, information so. Let's, begin first. Of all let's ask the question what, is financial, ratio analysis, we'll. Begin our discussions, by looking at a company most of us are familiar with Ford, Motor Company the car company, in. 2014. They reported, income of 3.2. Billion dollars is. That a lot at. December, 31st, 2014. They reported, total assets of 208 point five billion dollars, is that, a lot and what they do with those assets, at. The end of December 2014. They had liabilities. Of a hundred and eighty three point three billion dollars is that, a lot and what. Did they use that money for to, answer these and other questions we'll, need to carefully, analyze Ford's. Financial, statements, that. Brings us to financial, ratio analysis, which is simply the examination. Of relationships, among financial statement numbers we're. Going to do a lot of dividing, one number by another to, draw our conclusions, when, it comes to ratio analysis, we're. Going to do two types one, we're. Going to compare the same company, across time, to see how the company is performed, over time and, secondly. At the same point in time we're going to compare across companies. For, example, let's continue with Ford in. 2014. They had return on sales of 2.2, percent return. On sales is simply net income, divided by sales which. Is a measure of how much profit they earned per dollar in. 2014. 2.2. Percent, in. 2013. They had a return on sales of four point nine percent the. Obvious question why, how, did that happen, now. Comparing, forward to General Motors during, 2014. General. Motors had a return on sales of 2.6. Percent Ford. Again 2.2. Percent again why, what. Has happened to Ford's profitability, from 2013. To, 2014. And, during. 2014. Why, is General Motors more, profitable, than Ford those. Are good questions and, we're going to answer them now. When it comes to financial ratio analysis, I like to borrow a quote from Winston Churchill he. Said the following the. Further backward, you look the, further forward. You can see we. Analyzed financial, statements, to tell us if a company has done well or poorly in the past and to, help us see how the company, might do in the future, when. It comes to financial, ratio analysis, there's a four step process in, this.
Course We're going to introduce you to step one the DuPont, framework, to, breakdown return on equity into its component, parts so, let's. Do that next. Return. Equity is a general, overall, measure of how well a firm is doing the, DuPont framework, brakes return on equity down into three parts profitability. Efficiency. And leverage. Let's. Use an example to illustrate we. Have uncertain, balance, sheet and their income statement, what, can we conclude by looking at this for starters we can see that they had total assets, of fourteen, thousand five hundred dollars, sales. Of twenty thousand, dollars and income of seven, hundred dollars is that good is that, bad it's. Hard to tell so let's compare them with benchmark. Company, what. Can we conclude by, looking at benchmark, and uncertain, side by side well. The, first thing we notice is benchmark, is bigger and if, we do a little mental, math we can conclude well, it looks like their net incomes higher relative, to their sales but. Just a raw comparison. Of benchmarks, financial, statements, with uncertain. Spine an shil statements, that's tough to do there. Has got to be a way to compare, these two different companies of different sizes so, we're going to begin with our first financial. Ratio my favorite, and most people's favorite return. On equity, return. On equity is computed, by dividing net, income by, stockholders, equity it's. A measure of the amount of profit earned per dollar of investment and it's affectionately known as our OE return. On equity, our OE now. Let's compare uncertain. And benchmarks. Our OE as. You can see the return on equity for uncertain, was nine point three percent compare. That with benchmark. At twenty point three percent, what. Does that nine point three percent mean, well, it means for every $100, that's been invested by uncertain, Zoners those. Owners earned a return of nine dollars and 30 cents in the most recent year is that. Good is that bad, well. It's certainly not as good as benchmark, but, nine point three percent by itself, what, does that tell us well. In general with respect to return on equity or our OE greater. Than twenty percent is very, good less. Than 10 percent nuts. Are good and typically. Companies are between ten and twenty percent, between, 10 and 20 percent is normal, so, in the case of uncertain, that 9.3%. Well, that's, not good as an. Example let's take a look at some companies, with which we're all familiar it's. No surprise that Apple. And Microsoft have. Very good return on equities, no surprises at all in the. Case of GAAP a retail clothing chain their, return on equity in 2014. Was a stunning, forty two point three percent above, both Apple, and Microsoft. Walmart. At 19, percent finds, itself in the normal range and you, can see for both Ford, and General Motors that they are at twelve point nine percent and. 11.1%. Respectively. At the lower end of the normal range, when. It comes to return on equity it is, a general, overall, measure of a company's performance for a given period of time and it, is the foundation for. One of the most amazing creations. In accounting, history, the, DuPont, framework. Okay. As we saw uncertain. How to return on equity of 9.3. Percent not, good, benchmark. Had a return on equity of 20.3%. Very, good now. Anybody. Can see that benchmark, is higher than uncertain, when it comes to return on equity turns, out we can now either, be a problem, pointer, or a problem. Solver, anybody. Can see that uncertain, has a problem, what. We want to know is why, do they have a problem and that brings us in all, its glory to, the DuPont framework, now. The DuPont, framework, has three components profitability. Efficiency. And leverage. Let's. Start with leverage, because that's the thing we do first when, it comes to leverage, that's an indication of how much money have we borrowed, to purchase assets and why. Do we purchase assets we, purchase, assets in hopes of generating sales, the. Leverage, measure tells, us of our, assets, how many were acquired, with the equity, that's been put into the company we've. Borrowed to buy it, gives us a measure of how much we've borrowed, to buy assets and why, do we buy assets, to. Generate sales that's. What the efficiency, ratio is measuring, we, buy assets, to, generate sales, the, more sales we can generate per, dollar of assets, the better and why, do we want sales that. Leads us to our profitability, measure, the. More sales we have the. Higher our income, is going to be so, first of all we borrow money to buy assets, we. Buy assets, to generate sales, we. Generate, sales to, generate income our. Return, on equity, measure tells, us how, much income would did we generate, given. A fixed amount of stockholders, equity that's been invested by the owners in the firm, now.
With That framework let's take a look at uncertain, vs. benchmark, and use the DuPont, framework, to identify not, only how uncertain, is done but. Why they have performed poorly relative, to benchmark so. We can see the two company's return on equity and the, DuPont, framework, ratios, here, uncertain. With 9.3 percent return, on equity benchmark, with, 20 point three percent and we can also see the profitability, measures the. Efficiency, measures and the, leverage measures, for uncertain, and benchmark, to, review we, look at leverage efficiency, and profitability for, uncertain, and benchmark, and the first thing we notice is that, leverage, is the same for both companies. So. In explaining, the difference in return on equity between uncertain, and benchmarks it can't, be attributed, to leverage so. Then we look at efficiency and we, find out that uncertain, generates a dollar and 38 cents in sales for every, dollars worth of assets it has compared. To benchmark which. Generates, a dollar and 70 cents in sales for every dollars worth of assets they, have. Then. We look at profitability when. It comes to profitability, uncertain. Is generating, 3 dollars and 50 cents in profit for every hundred dollars in sales compared. To benchmark which is generating, 6 dollars and 20 cents in profit for every hundred dollars worth of sales so. Why is benchmarks, return on equity so much higher than uncertain. Profitability. And efficiency. Benchmark. Is much better at generating sales, with its assets, and generating. Earnings, with the sales that it has so. Now, do we have any other questions well. When it comes to efficiency, which. Specific, assets, are being used inefficiently, by, uncertain, which. Expenses, are too high which would account for their lower profitability, we. Want to know the answer, to those questions and, we would do further analysis, to get there. Okay. We've now completed step, one using, the DuPont framework to break down return on equity, into its component, parts now, what well. It turns out that the numbers can tell you what has happened, additional. Analysis, can shed light on why, things happen, the, numbers, as we're going to find sell. Them provide the answers to questions the, numbers, point you in the direction of, the next question, and eventually. We're going to end up talking to an individual, so. To review the DuPont framework, analysis, is the first step we. Do that first we take return on equity and break it down into a profitability, efficiency. And leverage the. Second, step in our analysis, would be to prepare common, sized financial, statements, common. Size financial, statements allow us to compare companies of different sizes both. Across time or at the same point in time across, companies step. Two would be common, size financial, statements based. On that analysis. We then have additional, ratios we could use we, have profitability. Ratios, we, have efficiency, ratios, and we have leverage, ratios, as we. Saw with Ford versus General Motors we had differences, relating, to efficiency, GM. Was more efficient, at using assets to generate sales well. We can then go and analyze individual. Assets, to see which, assets, are generating, more sales and which assets are not in addition, we. Saw that with Ford and GM GM, was more profitable, there. Are ratios that allow us to drill down to find out specifically. Where. We might be missing on profitability, where's. The difference between Ford, and General Motors when it comes to profitability with. A little, further analysis, we could answer that question the. First three, steps are simply doing analysis, with available, information, to lead us to the next clue we. Drill down a little more and a little more for. Example we didn't need to drill down with leverage because we saw that Ford was much more highly leveraged than with General Motors we, don't have additional questions there, but, if we did there. Are ratios related. To leverage that we could look at all. Of this analysis. Eventually. Leads us to the right person who. Can tell us why we are different from our competitor, or why. We were different, from last year we. Do this analysis, to get us to the right person, to ask the right question, that's where we're headed with all this now. As I said before the. Objective, with this course is not to run through the entire menu. Of financial, ratio tools that, one can use to analyze the numbers if you want more of that go, visit our course on understanding.
Financial Ratios. Our. Primary objective here. Was to show that a careful, analysis, of the numbers can, allow us to draw certain conclusions about. The operations, of a business we. Have used publicly available information to, do that but you can do a similar, analysis. Within the firm that is available only, to, you the. Point is this a careful. Analysis, of numbers across time can allow us to identify issues that deserve further. Attention, you, do not need to be a numbers, person to, do that. Everyone. Numbers, person or not knows that cash is the lifeblood of, a business without. Cash you will not be in business for very long you can have a great marketing plan you. Can have a great location, you, can have a great product or service but if you don't turn your cash into more cash you will not be in business for very long to. Begin we'll talk first about a company's operating cycle, how long it takes from when a company buys inventory, and then, turns that inventory into a receivable, and then, returns that receivable, into cash if. The, operating cycle is too long things. Get pretty tough pretty, quick for a company, in other, words if my cash is tied up in other assets, receivables. In inventory, that. It's not available for me to utilize in the business. Remember. When we are talking about finance we are talking about identifying. Those resources, that we need determining. The best way to get the money to buy those resources, and then, managing, those resources, effectively, to do that I need detailed, timely. Information, in this. Section we're going to talk about short-term financial, management we are going to illustrate that using, the operating, cycle of a wholesale building supply company you, will notice in this diagram that we've got various points on the clock, we. Begin with cash we, take that cash and we have to purchase inventory so. We have to have relationships, with our suppliers we. Have got to have suppliers that we can count on to get us what we need when, we need it once. We've purchased that inventory we now have to manage our inventory the, last thing we want is not enough, inventory the. Worst thing that can happen to a business, is to run out of inventory. When. A contractor, comes in and needs sheetrock, we've got to have it we. Don't want to ever run out of inventory but then we don't want too much inventory we've. Got to have what they need when, they need it then. We will have customers, come in to make the purchase they will want to buy stuff from us well, we've got to manage relationships. With our customers we will have large customers, we. Will have small customers, we will have customers, we like and we, will have customers, that just are our favorites, we've. Got to ensure that we have a system to manage those relationships you will note that once we make the sale then we end up with a receivable, we. Have got to manage our receivables, as well to ensure that we have prompt collections, we. May provide our contractors, with terms but if we don't send them a bill they're just not going to magically pay us we. Have got to manage our receivables, to ensure that this operating, cycle this conversion from inventory to, receivables, to cash works. And that, we eventually get our cash in a timely fashion we. Are going to have to manage this operating cycle continuously.
And We will need information to do that in this. Chapter we are going to talk about managing, our cash, numbers. Person or not we need to watch cash flow the, objective, of a business, is not to have a lot of inventory the. Objective, of a business is not to have a lot of people owe us money the. Objective, is to manage, our inventory and our receivables, so that we convert our inventory, into cash as quickly as, is, reasonably, possible. So. Let's begin by talking about, cash management how, to manage, the cash we have why, should we have any cash at all as we know cash. Is a low yielding asset you don't make a lot of return on cash so you don't want to have too much but. Then you don't want to have too little either well, why have cash at all well. It turns out that bills have to be paid in cash employees. Have to be paid in cash rent has to be paid in cash insurance. Has. To be paid in cash we've got to manage our cash to ensure that we have it when, we need it that, requires computers, that require staff that. Requires, sophisticated, projections. To ensure that we, can forecast, are we going to have enough cash when we need it a cash, shortfall, would be inconvenient. And potentially. Costly for example, if payroll. Is due on Friday and it turns out that you don't have the cash there the, consequences. Are going to be tragic, so, we have to make sure we have sufficient, cash why. Not have a lot well, as I said earlier cash. Is a low yielding asset, to, have cash sitting in your savings account you're, not to going to get a very large return, on that the, opportunity. Cost of holding cash can be very high so. To ensure we have not, too much and not, too little there. Are tools that we have to manage our cash one. Common, tool is a cash budget we. Can carefully plan, and solve cashflow, problems, in advance, it. Turns out over time we can predict with some degree of certainty when. Will our customers, pay us we. Can predict with some degree of certainty when. Are we going to have to pay our suppliers and what. We want to do is identify well. In advance when, are we going to need cash we, don't need to guess we. Can determine ahead of time by making a cash budget so. A cash, budget allows, us to determine when. Are we going to have shortfalls, of cash and when. Are we going to have excesses, in cash and then. We can have strategies, to ensure we're ready for both of these, eventualities. Okay. We just talked about cash management now let's, talk about receivables. Management, recall. That receivables. Are the amounts of money owed to us by customers, we. Want to manage our receivables to ensure that they turn into cash but. Let's ask the question why would anybody have receivables, in the first place why, not just sell for cash well. It turns out credit sales are a marketing, technique it. Turns out if we will offer credit, we will get more sales if. I'm offering you a product and you have to pay cash here, and my, competitor, down the road is allowing you to pay in 30 days for the same product, you'll. Go down there although the things being equal, now. If credit sales increase sales, why not have for credit to everyone well. It turns out if you offer credit to anyone and everyone there, will be a lot of people who won't pay you you'll. Have bad debts associated, with that and so it's a trade-off I'll increase my sales but. I'll have people who won't pay me I've, got to measure that trade-off to ensure that those increased, sales are worth it, I've. Got to be careful who I extend credit to in addition, if you're going to get into the credit business you got to keep track of that very.
Rarely Will someone come in and say I know how are your money but, I don't know how much will you tell me and will you take my money they. Will send you money when you send them a bill so, you've got to keep track of who owes you and how much, they owe and you've, got to send them a bill to ensure that they pay you in addition. By. Tying up money into receivables, that is an opportunity, lost it, turns out if you had had that cash instead, you, can invest it so there's another part of the trade off for example. Boeing, in 2014. Had accountable, of seven, point seven billion dollars that, is customers, owed them seven, point seven billion dollars at year-end if. They had that seven point seven they could have invested, it and earned, a return on it but I'm sure they've done the calculation, that offering credit increased, their sales and more. Than makes up for any implicit, interest, cost that they've lost now. When it comes to determining who do we offer credit, to companies. Have to manage, what their standards are going to be many. Companies, are careful, who they offer credit, to to ensure that they receive payment, and reduce their bad debts, how, long are you going to offer credit are, people going to pay you in 30 days 60. Days 90. Days if they. Pay early will you offer a discount if they pay late will you charge interest, those. Are decisions when, it comes to managing receivables, that have to be made and if, they don't pay you what, do your practice is going to be to ensure that eventually you do collect your receivables, all, of those things have to be determined when you're managing receivables. Now, what. Starts this off inventory, we, buy inventory and we turn it into a receivable, that receivable. Is eventually turned into cash when. It comes to inventory how, are we going to manage our inventory to ensure that we have the right amount of inventory, well. Why. Have inventory at all well. It turns out if somebody walks into your store and you don't have the product they will go somewhere else and they may not come back, companies. Carry inventory to ensure that when a customer needs inventory, they can find it at your store, well, then why not just have a lot of inventory why. Not make sure we never run out of inventory well. It turns out there are costs associated with inventory as well if our, money is tied up in inventory it's. Not available to be tied up anywhere, else we, can't do anything, with that money if we've already got it tied up in inventory we. Can't buy equipment we, can't expand our building if our money's tied up in inventory so, we don't want to have too much, when. It comes to inventory we've got to implement the Goldilocks, principle not. Too much and not too little when. It comes to inventory we want to make sure it's just right. So. Again why, is this important, to you regardless. Of your position in an organization. Cash is still King decisions. That you make perhaps. Far, away from the front lines of a business can push cash further, away or draw. Closer to collection, virtually. Every, decision in a business has cashflow implications. And remember. That cash is the lifeblood of a business, those. Who can see beyond, their own area, of responsibility and. Recognize. The cash flow implications, to the business of decisions, that they make are more. Valuable than those who don't again. You, don't have to become a numbers, person but. It is helpful to the business, and to, you if you. Can appreciate the, effect of your decisions, on the numbers, of the business particularly. The, cash flow numbers. What. Can be so hard about pricing, a product don't, you just figure out what your costs are and then add some sort of markup for profit, oh that. It were that easy, if your. Price is too high regardless, of your cost someone.
In The market will underpriced you assuming, that the quality of product or service is similar in many. Cases, you, will be a price taker and you, will have to manage your costs so that you can earn a profit given. A certain. Price is determined by the market now let me say that again in most. Instances, you, don't price your product to cover your costs instead, you. Determine, if given. A certain market price your. Cost structure is such that you can earn a profit, the. Biggest mistake small. Business owners make in product pricing, is not considering. And covering, all of their costs when entering a market now. It is true that when you are initially, trying to penetrate a market you may be willing to lose a little money to gain market share but. That strategy is not sustainable, over time over. The long term you must cover all your cost all. Your, costs. Now. Let's. Consider a really simple example to illustrate a, very complex, point it's. Summer time and I'm going into the snow cone business, you know finely crushed ice that is flavored, perfect. For those hot summer days I have. Figured that on average the paper cone costs, about 3 cents per snow cone the, ice and the snow cone, costs about 2 cents per snow cone that's, 5 cents, per cone oh and. Let's, not forget about the flavoring I estimate. That on average those flavors, will cost about 45, cents per cone so. The cost of a snow cone is about 50, cents each and I, figure that on those hot summer days I can, sell a snow cone for $2, each after, all that's the going rate at other snow cone shacks that means. I will make a dollar fifty, per snow, cone that. Sounds, like a money machine to me, but. Not, so fast to, this point I have only considered my variable cost those. Costs, that vary depending, on the number of cones I produce another. Way to think about it is that these costs, stay the same for. Each cone they vary, in direct proportion to the number of cones I sell the. More cones sold the higher the cost of cups the cost of ice and the cost of flavoring but. What. About my fixed cost those, costs, that are fixed whether I sell one snow cone or a thousand. Costs. Like the machine to crush the ice the. Snow cone shack to house my equipment, the bottle is holding the flavors and then, there are my employees, they. Get paid whether I have one customer or a hundred, customers, these. Costs, are incurred regardless of. The number of customers in other words these costs, are fixed and these, fixed, costs have, to be covered so the, dollar fifty that I initially thought of as profit. Is actually. A term called contribution. Margin. Contribution. Margin is the difference, between the selling price $2. Per snow cone in this example and my, variable costs 50, cents the, contribution. Margin contributes. To cover my fixed costs once. My fixed costs are covered then. Each subsequent, sale, is contributing, a dollar 50 towards profits, but, until, my fixed costs are covered by the cumulative, contribution.
Margin I'm not making any profits, these. Fixed, costs are often considered overhead. Costs, and overhead, costs, must be covered now. Why are they called overhead costs well, look up many. Of those costs, are the costs over your head the. Building, the lights the other utilities, and they, all have to be covered, have. You ever taken your car and to get the oil changed you get 4 quarts of oil and a new oil filter and someone, takes 15, minutes to drain your oil and replace it and it, costs you 50 bucks for quarts. Of oil at about $3 per quart and a, new oil filter for five dollars and fifteen, minutes of someone's time and you, get charged $50. Someone, is making some money there but wait. What. About the mechanics, equipment, the building, the, computer, system to process payments and track your car's history the other overhead items all. Those costs have to be covered and if, they are not all covered, then, this business, is not going to be in business for very long now. Back to the snow cone business. If I am not making enough money on the sno-cones I'm selling, then I will just raise the price, remember. There, are snow cone shacks all over if your price gets too high then, your customers, become someone else's customers, they will vote with their feet, often. You cannot just set your price and assume, people will pay what you are asking, it, is a competitive, environment out, there whether, you are selling snow cones changing, oil and cars or selling, software, on the Internet it, is very rare that one can simply ignore market. Forces in charge what they want the, market is too competitive for that more. Often than not companies. Are price takers you. Must take the price that the market is offering and then, determine, if your cost structure is competitive, and when. You are considering, your cost structure you. Have to consider all, of, your costs. In. The, previous video we talked about the necessity of considering, all your costs when trying to determine if you can compete in a market okay. So now the big question can. We be profitable. Given, a market price of two dollars per snowcone that's, a tough question to answer and, it's. Also the wrong question, to ask but. If we're determined, to remain a not, numbers, person our entire life those. Are the types of questions we will be asking, the wrong questions, the, right question, to ask is how, many people, must come for, us to be profitable, clearly. If a million people stop by and buy snow cones we will be profitable, if only ten people stop by then we will have a problem and it, turns out we can calculate how many people will, need to stop by for us to what is called breakeven. We. Can compute our break-even point, that is the point at which we exactly, cover our fixed costs, in other words we, haven't made money and we haven't lost money we've broken, even so. How do we do that well. We now need to track our fixed costs, recall. That we need machinery, to crush the ice we, need containers, for our flavors we. Need a structure, to house our business, and store our ice and we need to pay employees, for. Simplicity's. Sake we, will assume that these are all of our fixed costs let's, assume that these fixed costs totaled $3,000, per month, recall. That our contribution, margin per sale was a dollar fifty if we, divide our contribution. Margin into our fixed costs we, are able to compute, our break-even point we. Are able to compute the number of sno-cones we will need to sell to break-even in, this. Instance, we divide, $3,000. By a dollar fifty with the result being two, thousand sno-cones we. Need to sell two thousand, snow cones to exactly. Cover our fixed costs, rather. Than ask the question, can we be profitable, selling snow cones at $2 each a better, question, is at, $2. Per snow cone will. We be able to sell 2,000. Each month, two. Thousand snow cones per month means we will need to sell on average, 67. Snow cones each day assuming. 30 days in a month that we are open every day, assuming. We are open eight hours per day will. We be able to sell on average, about 8.4, sno-cones, each and, every hour we are open some. Hours we may sell more and some, hours we may sell less but on average can, we sell 8.4.
Sno-cones, Per hour, that. Is a nice number to know before, you decide to get into the snowcone business, now. You, can go sit across the street from your nearest competitor, and watch how many customers they have each hour if you, observe that they have 20. Customers per hour then, this might be a business you want to get into if they, service on average about five customers, per hour you, might want to rethink this business opportunity, and. Isn't, it nice to know this information before. You rent the building and the, machine to crush the ice and before. You buy the flavor containers, and hire employees, can. This business, be profitable, well, that depends, on how many customers you can expect and we. Can compute the number of customers, we will need through a careful, analysis, of our fixed, and variable costs. But, wait no. Business is started with the objective, of simply breaking, even you, don't open the doors of a new business hoping, that you make nothing. You. Start a new business hoping, to make a profit can. We build a target profit into our computations. We, sure can let's. Assume we're getting into the business with the intent of generating, a profit of $2,000. Per month you. Simply treat that number similar, to a fixed cost in. Other words now, our contribution, margin needs to cover our fixed, costs of $3,000. Per month and. A desired profit of $2,000. Per month for a total of $5,000, per month we, divide this $5,000. By our contribution, margin of a dollar fifty per sno-cone and the result is. 3333. In other. Words to generate, a target, profit of $2,000. We, will need to sell. 3333. Sno-cones each and, every, month or a hundred. And eleven per, day or given. An eight-hour day about, fourteen, sno-cones, on average, per, hour, can. We start this business and generate a profit of $2,000. Per month. Numbers person would say I hope so I think. So, probably. But, with a little effort and using, a few numbers we, can quantify our costs, and ask a better question can. We sell an average of 14, snow cones each hour if the. Answer to that is yes then, you are well on your way to running a profitable, business. Nobody. Likes to talk about budgeting. Especially. Individuals who consider, themselves non. Numbers, people, budgeting. Is for the accounts, to do and to worry about let the people who are good with the numbers worry, about the numbers let them worry about budgeting, well, that's, one way to think about it another. Way to think about it is this, those. Who demonstrate, that they are good stewards over a few things will typically, be given the opportunity, to grow and develop to become good stewards over many things as we. Said in a previous module, cash, is the lifeblood of, a business, individuals. Who are good stewards over the lifeblood, of the business, are valuable, and will, generally be given more responsible. Opportunities. So. Let's, talk about budgeting, step. One when it comes to budgeting is to write your budget, down another. Way to think about a budget is just to think of it as a plan a map and the, plan needs to be in writing how, will you know if you achieved your plan if it's, not written down now. There are various types of budgets some, budgets, involve, inflows, and outflows for, example, a budget. For an entire company will involve cash collections. And cash, expenditures, a budget. For a department, within a company may only involve expenditures. Step. 2 when it comes to budgeting, is to identify those areas for which you are responsible, and which you, control. Responsibility. Accounting, generally holds individuals, accountable only, for those inflows, and outflows over, which they have control. Let's. Use a simple example to, illustrate the, effective, use of budgeting, let's. Suppose that I am the purchasing, agent for a company that manufactures. Wood tables, my. Job is to purchase the wood that, goes into the table tops what. Then would I be responsible for, well. It makes sense to me that, I should be responsible for the price paid for the wood as well. As for the quality of the wood that is purchased if poor. Quality, wood is purchased, and that wood cannot be used in the production of the tables that is my fault and I should be held accountable in, addition. It is my job to negotiate the best possible, price on the quality wood purchases. Those. Are the two items that ought to be considered as I prepare my budget, the price of the wood purchased, and the, amount of waste and spoilage, relating, to poor quality wood. Step. Three in the budgeting process is, to quantify expected. Results, that is to forecast, or budget, quantities. For the budget period let's say a month in this case the. Production forecast. For the upcoming month, indicates, that the company will produce 500 tables, the. Company's standard, is that 15 board feet going to a table and that the price is $4, per board foot, doing. The math indicates. That I will need to acquire 7500. Board feet of wood at a cost of $30,000. To.
Keep Things simple let's assume that I have no beginning or ending inventory of wood I just buy what I need for that month's production my. Budget, is as simple as that you, will note that my budget doesn't just deal with dollars, in this case I am responsible for materials, usage as well this. Is a quantitative, number that tells me something about the efficiency, with. Which assets. Are used in this case wood, the. Fourth, step in budgeting, is to compare actual results, to the budget let's. Assume that production, forecast was right on and that exactly, 500 tables were produced you. Can see here, that we actually purchased. 7700. Board feet to, produce those 500, tables at a cost of 4 dollars and 25 cents per board foot from. This analysis, it looks like I overspent by two thousand, seven hundred twenty-five dollars for the month and I, should be responsible for explaining, how that two thousand seven hundred twenty-five, dollars came about and that. Leads us to the fifth step we need to ask questions to determine why, the deviations. From the plan occurred did. We need two hundred more board feet because I purchased, lower quality, wood or, was it because those involved in the production process were, inefficient I want, to know the answer to that question was, this my problem or was, the overage, the result of someone else's doing also, I paid. 25 cents more per board, foot than I had planned what happened there was. It poor planning on my part or have, prices, increased to the point where, the new normal, is now going to be four dollars and 25 cents per board foot I want, to know the answer to that question, you. Can see with this simple example that I can now use the numbers, to ask questions, that need to be answered and I, can only ask these questions because I had a plan I made, a budget, a budget. Allows, us to take a look into the future and make our best guess and when, we get into the future we, can then look back and see, how our actual, results compared to what we had planned once. We identify, the differences, we can then start asking questions, but without a plan without, a budget all, we can do is wonder what happened. Let's. Review the steps associated, with a simple, budgeting process, step, 1 write, your budget down I like, the quote a goal unwritten is just a wish if our.
Budget Isn't in writing we might as well just cross our fingers close. Our eyes and hope, for the best, step. 2 identify, those, areas for which you, are responsible in, which you, control it's. Not fair and that means generally, that it's not good business to. Have someone, be accountable, and answerable. For something over which they have no control. Step. 3 is to quantify expected. Results, this, is the budget or the plan those. Quantities, may be in dollars as was, the case with the price per board foot in our example, or they may be in units as was, the case with the number of board feet to be purchased, a budget, is not necessarily, about money it is about responsibility if you. Are responsible for the money then, your budget should reflect the money if you, are