Financial Management
This is where you can determine whether or not your business can actually stay afloat and make money. There are dozens of formulas used for different indicators of a business’s success and/or failures that seem overwhelming at times (Possibly all the time!) However, don’t let these confuse or overwhelm you. You simply need to know that your financials help to show you how money is coming in and out of your business; that is its sole purpose. When you begin to understand how the money is flowing, you can make educated decisions about where to distribute your funds in order to produce higher profits.
The most fundamental concept to understand is how to generate profits. To make a profit, you basically need to ensure your revenues exceed your expenses. For example, if you sell your product at a price of $4, and it costs $2 to make, you have made a $2 profit. Now you can allocate the $2 to create another product or to another area that makes financial sense for your business. However, if expenses exceed your revenues, then you need to adjust your current strategy. Understanding your numbers does not have to be complicated. If you know where to direct your attention, you can make the right decisions to grow your business.
The most fundamental concept to understand is how to generate profits. To make a profit, you basically need to ensure your revenues exceed your expenses. For example, if you sell your product at a price of $4, and it costs $2 to make, you have made a $2 profit. Now you can allocate the $2 to create another product or to another area that makes financial sense for your business. However, if expenses exceed your revenues, then you need to adjust your current strategy. Understanding your numbers does not have to be complicated. If you know where to direct your attention, you can make the right decisions to grow your business.
Investment (Risk and Return)
Everyone wants to own shares in a highly profitable company one day. As we pursue this, we can easily get caught up in the glamorous side of finance. The ugly side ‘in the trenches’ involves monetary management itself, which we’ll discuss later. For now, there are 2 important questions we should focus on when making an investment: what is the potential income, and how risky is the venture?
An established concept in finance is that the return should be commensurate with the risk. If it is well-known that an investment is a “sure thing,” then you should expect a lower rate of return as compensation for the lower risk. An example of this is certificates of deposit insured by the Federal Deposit Insurance Corporation (FDIC). Because of the low risk, they pay out low rates of return. Another example can be seen in oil. For example, searching for oil contains a high level of risk, but it also promises a huge return if you do find it.
This idea can be summarized as follows: the higher the risk the higher the return, and the lower the risk the lower the return.
There are two types of risk that most individuals involved in business are exposed to. The first is called systematic risk, and this applies to entire classes of assets, such as the markets for stocks, bonds, and real estate. When investing in these types of markets, you will be exposed to the systematic risk of the market. During a bull market, your investment will do well, but you should be aware that the market regularly experiences downturns (bear market), with the most recent occurring in 2008, 2000, 1987, and 1929.
The second risk is called unique, or unsystematic risk. This type of risk belongs to a small group of assets. This is when you own risk in one company, and if that one company receives negative publicity, for example, the value of the stock will decline. If you implement a diversification strategy then you can avoid this risk by owning several different investments rather than just one. This serves as a balancing act and helps moderate the overall fluctuations of a portfolio.
Good examples of diversification are the S&P 500, Dow Jones, Wilshire 5000, and the Nikkei index. These are well-diversified market portfolios that help owners reduce the risk of holding one particular investment instead of owning a very large portfolio.
The behavior of the market is very important because most large investment decisions are made in the context of a large portfolio, or collection, of investments. Most investors will rely heavily on Mutual Funds to help keep them diversified and protected from the ups and downs of the market.
Capital Assets Pricing Model for Stocks
The capital asset pricing model (CAPM) determines the required rate of return of an investment by adding the unsystematic risk and systematic risk of owning this asset. CAPM states that the required rate of return is the risk-free rate plus a premium for unsystematic risk.
Suppose you wanted to know in 2004 what returns Facebook should generate in order to be a worthwhile investment. The media publications all stated something different in the numbers based on historical data from similar companies in the past. We need to do some research in order to find the market risk premium (MRP). One formula to follow would be:
Required Return on an Equity Investment = Risk-Free Rate + (Avg. Market Return Rate – Risk-Free Rate) x Beta
These values depend on your research and the percentage obtained. This would allow you to analyze whether to sell the stock or not. If the return rate exceeded the required rate as determined by the CAPM, then the market price is presenting a bargain, and investors should buy the stock. But, remember that CAPM tells only the required rate of return, not what the investment is actually returning.
Investment Valuations
“A dollar held today is worth more than a dollar received in the future.”
Here we will be focusing on three different markets for our valuation of investments: bond, stock, and option marketplaces.
The Bond Market: A bond’s value is based on future cash flows. They can be issued by a company or government to help raise money at a fixed interest rate. Most will pay interest to bondholders, and the longer the maturity, the higher the interest rate that a company will have to pay investors.
There are four types of bonds: zero coupon, consul or perpetuity bonds, convertible bond, and callable bond. Zero coupon has no interest and pays only a lump sum at maturity. A perpetuity never repays the principal but continues to pay interest forever; these are very rare. A convertible bond converts to common stock at a predetermined conversion ratio. This type of bond usually pay lower interest rates because it provides the investor with an additional option. A callable bond allows issuers to repurchase their bonds from the public if interest rates fall significantly after the issue date.
The Stock Market: The most well-known marketplace for any investor is the stock market. Stocks have no contractual terms of payment and no maturity. If there are substantial earnings, then most companies will pay dividends to stockholders, but this is not guaranteed. Bond owners will be paid first with profits, then if there is anything leftover, the company may distribute some profits to stockholders
There are four types of stocks: growth stocks, blue-chip stocks, cyclical stocks, and penny stocks. Growth stocks are rapidly growing companies (i.e. Google, Amazon, Airbnb, Uber, Netflix, etc.). Blue-chip stocks are very large companies (Coca-Cola, Microsoft, Facebook, etc.). Cyclical stocks operate in industries that will fluctuate greatly depending on economic conditions (i.e. Ford, Jeep, United Airlines, Delta, Mortgage Companies, etc.). Penny stocks are risky, small companies with very low share prices (i.e. Reckor Systems, Biocept Inc., etc.)
Since we only want to discuss the basics here, we will not cover any of the formulas or methods sometimes used to determine theoretical stock prices.
The Options Market: Options are contractual rights to buy or sell any asset at a fixed price on or before a stated date. The most well-known options are real estate, bonds, gold, oil, currencies, or even mortgages. This is the best way to control an asset with little money. This allows for high profitability and a high risk/reward.
A derivative is an option right, but not the asset itself; in other words, it is any security that is valued based on the value of another. Examples include stock options, stock warrants, index options, commodity options, and commodity futures.
There are two types of options: call and put. The call option allows buyers to purchase the right to the appreciation. On the other hand, a put option allows depreciation of a stock for a period of time.
Beyond these simple definitions, the option markets becomes complex just like stock market valuations. That type of in-depth analysis is typically not necessary to successfully run your business.
Capital Budgeting
Business Investment Decisions versus Financing Decisions
Investment decisions for your company pertain to finding the best place to utilize your extra profits, in order to generate even more profits in the future. Financing decisions involve finding capital at the lowest cost for the level of risk that management is willing to undertake.
Mergers and Acquisitions
This is by far one of the most exciting areas of finance. Here we spend money to acquire profitable assets and improve our company. As a business, you can diversify the company based on political landscape changes, improve sales and earnings based on brand management, purchase an undervalued company (like Warren Buffet does), and lower operating costs by increasing efficiency and reducing overhead.
There are four types of acquisitions we will discuss: merger, hostile takeover, friendly takeover, and leveraged buyout. A merger occurs when two companies decide to join forces and become one. Hostile takeovers happen when one company buys another company even though there is a disagreement about the acquisition. In contrast, the friendly takeover is when both companies are in agreement with the acquisition at hand. The leveraged buyout is when a third party uses a loan and down payment to buyout another company. This carries a high amount of debt and involves additional interest/principal payments.
The main step in merger and acquisitions is The Valuation Process. This involves assessing the value of targets and ensuring that their cash flow is positive. A business’s cash flow is the result of operations, investing, and financing activities. There are five steps to evaluate a company’s cash flow:
There are many approaches you can use to value a firm’s cash flow, but these are the primary steps that will be used. In addition, employees could suffer because the finance team look at wage concessions, layoff margins, lower production costs, reducing working capital needs, pension funds, real estate of office buildings, selling patents and rights, closing divisions or product lines, and cutting back on unnecessary luxuries for executives. Once the calculations are completed, you can submit a bid and begin negotiations.
Finance practices will help to maximize the firm’s value by financing cash needs at the least cost possible and a tolerable risk. Finance is also used to provide the necessary funding by selling shares or bonds to obtain capital.
Everyone wants to own shares in a highly profitable company one day. As we pursue this, we can easily get caught up in the glamorous side of finance. The ugly side ‘in the trenches’ involves monetary management itself, which we’ll discuss later. For now, there are 2 important questions we should focus on when making an investment: what is the potential income, and how risky is the venture?
An established concept in finance is that the return should be commensurate with the risk. If it is well-known that an investment is a “sure thing,” then you should expect a lower rate of return as compensation for the lower risk. An example of this is certificates of deposit insured by the Federal Deposit Insurance Corporation (FDIC). Because of the low risk, they pay out low rates of return. Another example can be seen in oil. For example, searching for oil contains a high level of risk, but it also promises a huge return if you do find it.
This idea can be summarized as follows: the higher the risk the higher the return, and the lower the risk the lower the return.
There are two types of risk that most individuals involved in business are exposed to. The first is called systematic risk, and this applies to entire classes of assets, such as the markets for stocks, bonds, and real estate. When investing in these types of markets, you will be exposed to the systematic risk of the market. During a bull market, your investment will do well, but you should be aware that the market regularly experiences downturns (bear market), with the most recent occurring in 2008, 2000, 1987, and 1929.
The second risk is called unique, or unsystematic risk. This type of risk belongs to a small group of assets. This is when you own risk in one company, and if that one company receives negative publicity, for example, the value of the stock will decline. If you implement a diversification strategy then you can avoid this risk by owning several different investments rather than just one. This serves as a balancing act and helps moderate the overall fluctuations of a portfolio.
Good examples of diversification are the S&P 500, Dow Jones, Wilshire 5000, and the Nikkei index. These are well-diversified market portfolios that help owners reduce the risk of holding one particular investment instead of owning a very large portfolio.
The behavior of the market is very important because most large investment decisions are made in the context of a large portfolio, or collection, of investments. Most investors will rely heavily on Mutual Funds to help keep them diversified and protected from the ups and downs of the market.
Capital Assets Pricing Model for Stocks
The capital asset pricing model (CAPM) determines the required rate of return of an investment by adding the unsystematic risk and systematic risk of owning this asset. CAPM states that the required rate of return is the risk-free rate plus a premium for unsystematic risk.
Suppose you wanted to know in 2004 what returns Facebook should generate in order to be a worthwhile investment. The media publications all stated something different in the numbers based on historical data from similar companies in the past. We need to do some research in order to find the market risk premium (MRP). One formula to follow would be:
Required Return on an Equity Investment = Risk-Free Rate + (Avg. Market Return Rate – Risk-Free Rate) x Beta
These values depend on your research and the percentage obtained. This would allow you to analyze whether to sell the stock or not. If the return rate exceeded the required rate as determined by the CAPM, then the market price is presenting a bargain, and investors should buy the stock. But, remember that CAPM tells only the required rate of return, not what the investment is actually returning.
Investment Valuations
“A dollar held today is worth more than a dollar received in the future.”
Here we will be focusing on three different markets for our valuation of investments: bond, stock, and option marketplaces.
The Bond Market: A bond’s value is based on future cash flows. They can be issued by a company or government to help raise money at a fixed interest rate. Most will pay interest to bondholders, and the longer the maturity, the higher the interest rate that a company will have to pay investors.
There are four types of bonds: zero coupon, consul or perpetuity bonds, convertible bond, and callable bond. Zero coupon has no interest and pays only a lump sum at maturity. A perpetuity never repays the principal but continues to pay interest forever; these are very rare. A convertible bond converts to common stock at a predetermined conversion ratio. This type of bond usually pay lower interest rates because it provides the investor with an additional option. A callable bond allows issuers to repurchase their bonds from the public if interest rates fall significantly after the issue date.
The Stock Market: The most well-known marketplace for any investor is the stock market. Stocks have no contractual terms of payment and no maturity. If there are substantial earnings, then most companies will pay dividends to stockholders, but this is not guaranteed. Bond owners will be paid first with profits, then if there is anything leftover, the company may distribute some profits to stockholders
There are four types of stocks: growth stocks, blue-chip stocks, cyclical stocks, and penny stocks. Growth stocks are rapidly growing companies (i.e. Google, Amazon, Airbnb, Uber, Netflix, etc.). Blue-chip stocks are very large companies (Coca-Cola, Microsoft, Facebook, etc.). Cyclical stocks operate in industries that will fluctuate greatly depending on economic conditions (i.e. Ford, Jeep, United Airlines, Delta, Mortgage Companies, etc.). Penny stocks are risky, small companies with very low share prices (i.e. Reckor Systems, Biocept Inc., etc.)
Since we only want to discuss the basics here, we will not cover any of the formulas or methods sometimes used to determine theoretical stock prices.
The Options Market: Options are contractual rights to buy or sell any asset at a fixed price on or before a stated date. The most well-known options are real estate, bonds, gold, oil, currencies, or even mortgages. This is the best way to control an asset with little money. This allows for high profitability and a high risk/reward.
A derivative is an option right, but not the asset itself; in other words, it is any security that is valued based on the value of another. Examples include stock options, stock warrants, index options, commodity options, and commodity futures.
There are two types of options: call and put. The call option allows buyers to purchase the right to the appreciation. On the other hand, a put option allows depreciation of a stock for a period of time.
Beyond these simple definitions, the option markets becomes complex just like stock market valuations. That type of in-depth analysis is typically not necessary to successfully run your business.
Capital Budgeting
Business Investment Decisions versus Financing Decisions
Investment decisions for your company pertain to finding the best place to utilize your extra profits, in order to generate even more profits in the future. Financing decisions involve finding capital at the lowest cost for the level of risk that management is willing to undertake.
Mergers and Acquisitions
This is by far one of the most exciting areas of finance. Here we spend money to acquire profitable assets and improve our company. As a business, you can diversify the company based on political landscape changes, improve sales and earnings based on brand management, purchase an undervalued company (like Warren Buffet does), and lower operating costs by increasing efficiency and reducing overhead.
There are four types of acquisitions we will discuss: merger, hostile takeover, friendly takeover, and leveraged buyout. A merger occurs when two companies decide to join forces and become one. Hostile takeovers happen when one company buys another company even though there is a disagreement about the acquisition. In contrast, the friendly takeover is when both companies are in agreement with the acquisition at hand. The leveraged buyout is when a third party uses a loan and down payment to buyout another company. This carries a high amount of debt and involves additional interest/principal payments.
The main step in merger and acquisitions is The Valuation Process. This involves assessing the value of targets and ensuring that their cash flow is positive. A business’s cash flow is the result of operations, investing, and financing activities. There are five steps to evaluate a company’s cash flow:
- Analyze operating activities
- Analyze the investments necessary to replace and to buy new property, plant, and equipment.
- Analyze the capital requirements of the firm.
- Project the annual operating cash flows and terminal value of the firm.
- Calculate the NPV of those cash flows to determine the firm’s value.
There are many approaches you can use to value a firm’s cash flow, but these are the primary steps that will be used. In addition, employees could suffer because the finance team look at wage concessions, layoff margins, lower production costs, reducing working capital needs, pension funds, real estate of office buildings, selling patents and rights, closing divisions or product lines, and cutting back on unnecessary luxuries for executives. Once the calculations are completed, you can submit a bid and begin negotiations.
Finance practices will help to maximize the firm’s value by financing cash needs at the least cost possible and a tolerable risk. Finance is also used to provide the necessary funding by selling shares or bonds to obtain capital.
