Chapter 1

The Role of
Managerial
Finance
Goal of the Firm:
Maximize Profit?
Which Investment is Preferred?

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Figure 1.3
Financial Activities

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Matter of Fact—Forbes.com
CEO Performance vs. Pay

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Figure 2.1
Flow of Funds

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Matter of Fact

According to the World Federation of Exchanges:

1. NYSE Euronext is the largest stock market in the world, as
measured by the total market value of securities listed on
that market. NYSE Euronext has listed securities worth
more than $14.1 trillion in the U.S. and $2.1 trillion in
Europe.
2. The second largest exchange is Nasdaq, with listed
securities valued at $4.6 trillion.
3. The Tokyo Stock Exchange has securities valued at $3.5
trillion.
4. The fourth largest exchange, the London Stock Exchange,
has securities valued at $3.3 trillion.

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What Do you Think?

– Bryan Shaw received inside information

on Herbalife and Skechers from Scott
London, a KPMG auditor. Using this
information, Shaw made $1.3 million in
trading profits..

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Integrative Case: Merit Enterprise Corp.

Merit Enterprise Corporation’s CEO would like to

dramatically expand the company’s production
capacity. This would require the company to raise up
to $4 billion in addition to the $2 billion of excess
cash that they have accumulated. Merit is currently a
private company and is considering two options for
raising the much needed capital.

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Integrative Case: Merit Enterprise Corp.

Option 1 – Merit could approach JPMorgan Chase, a

bank that had served Merit well for many years
with seasonal credit lines as well as medium-term
loans. Lehn believed that JPMorgan was unlikely to
make a $4 billion loan to Merit on its own, but it
could probably gather a group of banks together to
make a loan of this magnitude. However, the banks
would undoubtedly demand that Merit limit further
borrowing and provide JPMorgan with periodic
financial disclosures so that they could monitor
Merit’s financial condition as it expanded its
operations.

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Integrative Case: Merit Enterprise Corp.

Option 2 – Merit could convert to public ownership,

issuing stock to the public in the primary market.
With Merit’s excellent financial performance in
recent years, Sara thought that its stock could
command a high price in the market and that many
investors would want to participate in any stock
offering that Merit conducted.

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Integrative Case: Merit Enterprise Corp.

a. Discuss the pros and cons of option 1, and

prioritize your thoughts. What are the most
positive aspects of this option, and what are the
biggest drawbacks?
b. Do the same for option 2.
c. Which option do you think Sara should
recommend to the board and why?

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Table 3.1 Bartlett Company Income
Statements ($000)

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Table 3.2 Bartlett Company Balance
Sheets ($000)

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Table 3.2 Bartlett Company Balance
Sheets ($000) (cont.)

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Table 3.3 Bartlett Company Statement of
Retained Earnings ($000) for the Year
Ended December 31, 2015

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Table 3.4 Bartlett Company Statement of Cash
Flows ($000) for the Year Ended December 31,
2015

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)

• Caldwell Manufacturing’s calculated inventory

turnover for 2015 and the average inventory
turnover were as follows:

Inventory turnover, 2015

Caldwell Manufacturing 14.8
Industry average 9.7

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Figure 3.1 Combined Analysis

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Liquidity Ratios

The current ratio measures the ability of the firm

to meet its short-term obligations.

Current ratio = Current assets ÷ Current liabilities

The current ratio for Bartlett Company in 2015 is:

$1,223,000 ÷ $620,000 = 1.97

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Liquidity Ratios (cont.)

The quick (acid-test) ratio excludes inventory,

which is generally the least liquid current asset.

The quick ratio for Bartlett Company in 2015 is:

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Activity Ratios

Inventory turnover measures the activity, or liquidity,

of a firm’s inventory.

Inventory turnover = Cost of goods sold ÷ Inventory

Applying this relationship to Bartlett Company in 2015

yields:

$2,088,000 ÷ $289,000 = 7.2

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Activity Ratios (cont.)

The average age of inventory is the average

number of days’ sales in inventory.

Average Age of Inventory = 365 ÷ Inventory turnover

For Bartlett Company, the average age of inventory in 2015

is:

365 ÷ 7.2 = 50.7 days

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Activity Ratios (cont.)

The average collection period is the average

amount of time needed to collect accounts receivable.

– The average collection period for Bartlett Company in 2015

is:

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Activity Ratios (cont.)

The average payment period is the average amount

of time needed to pay accounts payable.

– If we assume that Bartlett Company’s purchases equaled

70 percent of its cost of goods sold in 2015, its average
payment period is:

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Activity Ratios (cont.)

Total asset turnover indicates the efficiency with

which the firm uses its assets to generate sales.

– Total asset turnover = Sales ÷ Total assets

The value of Bartlett Company’s total asset turnover in

2015 is:

$3,074,000 ÷ $3,597,000 = 0.85

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Debt Ratios

The debt ratio measures the proportion of total

assets financed by the firm’s creditors.

Debt ratio = Total liabilities ÷ Total assets

The debt ratio for Bartlett Company in 2015 is

$1,643,000 ÷ $3,597,000 = 0.457 = 45.7%

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Debt Ratios (cont.)

The debt-to-equity ratio measures the relative

proportion of total liabilities and common stock equity
used to finance the firm’s total assets.

Debt to equity = Total liabilities ÷ Common stock equity

The debt-to-equity ratio for Bartlett Company in 2015 is

$1,643,000 ÷ $1,754,000 = 0.937 = 93.7%

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Debt Ratios (cont.)

The times interest earned ratio measures the

firm’s ability to make contractual interest payments;
sometimes called the interest coverage ratio.
Times interest earned ratio = EBIT ÷ interest expense

The figure for earnings before interest and taxes (EBIT) is

the same as that for operating profits shown in the income
statement.

Applying this ratio to Bartlett Company yields the following

2015 value:

$418,000 ÷ $93,000 = 4.49

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Profitability Ratios

Gross profit margin measures the percentage of

each sales dollar remaining after the firm has paid for
its goods.

Bartlett Company’s gross profit margin for 2015 is:

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Profitabiity Ratios (cont.)

Operating profit margin measures the percentage

of each sales dollar remaining after all costs and
expenses other than interest, taxes, and preferred
stock dividends are deducted.

Operating profit margin = Operating profits ÷ sales

Bartlett Company’s operating profit margin for 2015 is:

$418,000 ÷ $3,074,000 = 13.6%

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Profitability Ratios (cont.)

Net profit margin measures the percentage of each

sales dollar remaining after all costs and expenses,
including interest, taxes, and preferred stock
dividends, have been deducted.

Net profit margin = Earnings available for common

stockholders ÷ Sales

Bartlett Company’s net profit margin for 2015 is:

$221,000 ÷ $3,074,000 = 0.072 = 7.2%

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Profitability Ratios (cont.)

Earnings per share represents the number of

dollars earned during the period on the behalf of each
outstanding share of common stock.

Bartlett Company’s earnings per share (EPS) in 2015 is:

$221,000 ÷ 76,262 = $2.90

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Profitability Ratios (cont.)

The return on total assets measures the overall

effectiveness of management in generating profits
with its available assets.

Return on total assets (ROA) = Earnings available for

common stockholders ÷ Total assets

Bartlett Company’s return on total assets in 2015 is:

$221,000 ÷ $3,597,000 = 0.061 = 6.1%

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Profitability Ratios (cont.)

The return on equity measures the return earned on

common stockholders’ investment in the firm.

Return on Equity (ROE) = Earnings available for common

stockholders ÷ Common stock equity

This ratio for Bartlett Company in 2015 is:

$221,000 ÷ $1,754,000 = 0.126 = 12.6%

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Market Ratios

The price/earnings (P/E) ratio measures the

amount that investors are willing to pay for each
dollar of a firm’s earnings.

Price Earnings (P/E) Ratio = Market price per share of

common stock ÷ Earnings per share

If Bartlett Company’s common stock at the end of 2015 was

selling at $32.25, using the EPS of $2.90, the P/E ratio at
year-end 2015 is:

$32.25 ÷ $2.90 = 11.12

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Market Ratios (cont.)

The market/book (M/B) ratio provides an

assessment of how investors view the firm’s
performance.

where,

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Market Ratios (cont.)

• Substituting the appropriate values for Bartlett

Company from its 2015 balance sheet, we get:

• Substituting Bartlett Company’s end of 2015

common stock price of $32.25 and its $23.00 book
value per share of common stock (calculated
above) into the M/B ratio formula, we get:

$32.25 ÷ $23.00 = 1.40

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Table 3.8 Summary of Bartlett Company Ratios
(2010–2015, Including 2015 Industry Averages)

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Table 3.8 Summary of Bartlett Company Ratios
(2010–2015, Including 2015 Industry Averages)
(Cont.)

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Table 3.5 Financial Ratios for Select Firms
and Their Industry Median Values

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DuPont System of Analysis:
Modified DuPont Formula

• The modified DuPont Formula relates the firm’s

return on total assets to its return on common
equity. The latter is calculated by multiplying the
return on total assets (ROA) by the financial
leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
ROE = ROA  FLM
• Substituting the appropriate formulas into the
equation and simplifying results in the formula
given earlier,

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Figure 3.2
DuPont System of Analysis

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Table 4.3
Inflows and Outflows of Cash

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Table 4.6 Baker Corporation Statement of Cash
Flows ($000) for the Year Ended December 31,
2015

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Operating Cash Flow

• A firm’s operating Cash Flow (OCF) is the cash

flow a firm generates from normal operations—from
the production and sale of its goods and services.
• OCF may be calculated as follows:

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Operating Cash Flow (cont.)

• Substituting for Baker Corporation, we get:

OCF = [$370 ×(1.00 – 0.40] + $100 = $222 + $100 = $322

• Thus, we can conclude that Baker’s operations are

generating positive operating cash flows.

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Free Cash Flow

• Free cash flow (FCF) is the amount of cash flow

available to investors (creditors and owners) after
the firm has met all operating needs and paid for
investments in net fixed assets (NFAI) and net
current assets (NCAI).

• Where:

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Free Cash Flow (cont.)

• Using Baker Corporation we get:

NFAI = [($1,200 - $1,000) + $100] = $300
NCAI = [($2,000 - $1,900) + ($800 - $700)] = $0
FCF = $322 - $300 - $0 = $22

• Thus, the firm generated adequate cash flow to

cover all of its operating costs and investments and
had free cash flow available to pay investors.

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The Financial Planning Process

• The financial planning process begins with long-

term, or strategic, financial plans that in turn guide
the formulation of short-term, or operating, plans
and budgets.
• Two key aspects of financial planning are cash
planning and profit planning.
– Cash planning involves the preparation of the firm’s cash
budget.
– Profit planning involves preparation of pro forma
statements.

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Figure 4.1
Short-Term Financial Planning

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Table 4.10 A Cash Budget for Coulson
Industries ($000)

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Table 4.14 2016 Sales Forecast for Vectra
Manufacturing

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Profit Planning: Pro Forma Income
Statement

• A simple method for developing a pro forma income

statement is the percent-of-sales method.
• This method starts with the sales forecast and then
expresses the cost of goods sold, operating
expenses, interest expense, and other accounts as
a percentage of projected sales.
• Using the Vectra example, the easiest way to do
this is to recast the historical income statement as
a percentage of sales.

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Profit Planning: Pro Forma Income
Statement (cont.)

• By using dollar values taken from Vectra’s 2015

income statement (Table 4.12), we find that these
percentages are

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Table 4.15 A Pro Forma Income Statement, Using the
Percent-of-Sales Method, for Vectra Manufacturing for the
Year Ended December 31, 2016

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Profit Planning: Pro Forma Income
Statement (cont.)

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Profit Planning: Pro Forma Balance Sheet
(cont.)
1. A minimum cash balance of $6,000 is desired.
2. Marketable securities will remain at their current
level of $4,000.
3. Accounts receivable will be approximately $16,875
which
represents 45 days of sales (about 1/8th of a year)
on average [(45/365)  $135,000].
4. Ending inventory will remain at about $16,000. 25%
($4,000) represents raw materials and 75%
($12,000) is finished goods.
5. A new machine costing $20,000 will be purchased.
Total depreciation will be $8,000. Adding $20,000 to
existing net fixed assets of $51,000 and subtracting
the $8,000 depreciation yields a net fixed assets
figure of $63,000.

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Profit Planning: Pro Forma Balance Sheet
(cont.)
6. Purchases will be $40,500 which represents 30% of
annual sales (30%  $135,000). Vectra takes about
73 days to pay on its accounts payable. As a result,
accounts payable will equal $8,100 [(73/365) 
$40,500].
7. Taxes payable will be $455 which represents one-
fourth of the 1998 tax liability.
8. Notes payable will remain unchanged at $8,300.
9. There will be no change in other current liabilities,
long-term debt, and common stock.
10.Retained earnings will change in accordance with
the pro forma income statement.

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Table 4.16 A Pro Forma Balance Sheet,
Using the Judgmental Approach, for
Vectra Manufacturing (December 31, 2016)

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