Finance Decisions Help Explanations Information on Rules/Procedures

Finance Decisions Help Explanations Information on Rules/Procedures The finance decisions screen provides you with detailed information relating to your company s quarterly cash inflows and outflows and projections of the company s year-end financial situation. Going into Year 6, the company has a B+ credit rating and a $100 million line of credit at Global Community Bank, the principal bank with which the company does most of its business. At the end of Year 5, the company had outstanding loans of $25 million against its $100 million credit line, giving it the ability to borrow an additional $75 million should circumstances require. The interest rates charged by Global Community Bank are tied to the company s annual credit rating; the present interest rate on the company s outstanding loans is 6.5%. Officials at Global Community Bank review the company financial status annually, determine how much credit they are willing to extend to the company, and adjust the line of credit up or down. Bank officials have expressed a commitment to providing the company with additional credit to help the company finance growth in unit sales and revenues, provided the company maintains decent profitability. However, they have also indicated the line of credit may be reduced if the company s financial condition deteriorates to the point where its ability to repay its loans is jeopardized. Should the company fall into dire financial straits and have to borrow more than the credit line maximum, the bank is prepared to make an emergency loan at a 12% (or perhaps higher) annual interest rate. Outside credit rating agencies review the company s financial statements and performance annually and assign it a credit rating ranging from A+ to C-; currently, an A+ rating carries an interest rate of 5% and a C- rating entails an interest rate of 11% (these rates may change as the game progresses). The finance screen reports both your company s current interest rate and credit rating. Companies are automatically put on special credit watch status when their rating falls to C+ or lower. A company s credit rating is a function of four factors: (1) the debtequity ratio (annualized over all four quarters); (2) the times-interest-earned ratio (defined as annual operating profit divided by annual interest payments); (3) the percentage of the credit line used (a lower percentage is better than a high percentage); and (4) how many years it will take to pay off the company s outstanding loans based on the most recent year s free cash flow (defined as net income plus depreciation minus total dividend payments) the number of years to pay off the debt equals the amount of loans outstanding divided by free cash flow. The seasonal nature of the company s business makes it common for the company to have to borrow money in the third quarter of each year to help cover the sharp quarter 3 seasonal run up in production costs and operating expenses retailers do not pay for cameras shipped in one quarter until the following quarter. Hence, there is a one-quarter lag between shipping cameras and the actual receipt of payments from retailers. However, revenues from camera sales are booked when the cameras are shipped, not when payment is received, as a consequence, revenues in a quarter/year will not match cash receipts from retailers because of the one-quarter lag in payment. Copyright 2009 GLO-BUS Software, Inc. Page 1

Loan Repayment Decisions Understanding the Finance Decisions Using cash on hand and positive cash flows from operations to pay down debt has the advantages of reducing interest costs and improving the company s credit rating. Draws against your company s line of credit are long-term loans in the sense that they are repaid at the discretion of company management, subject to having sufficient cash on hand to make a repayment. There is no definite repayment schedule on the company s draw against its line of credit, although it is obviously advantageous to escape interest payments whenever possible. It may well be that you are not able to make any loan repayment in a given quarter because of insufficient incoming cash flows. In such a case simply enter 0 in the decision box for paydown of loans outstanding. Further, there will be frequent occasions when you want to raise cash through additional draws against your company s line of credit. As you will discover by watching the calculations in the Draw on Credit Line entry in the Cash Inflows section at the top of the Finance decisions screen, additional draws against your credit line occur automatically when total cash inflows from collection of receivables and common stock issues is not sufficient to cover all of the required cash payments during the period (as itemized on the Cash Outflows section of the Cash Flow Summary at the top of the Finance Decisions screen). Hence no decision entry is needed to take out additional loans the World Community Bank automatically replenishes your checking account via additional draws against your credit line in an amount sufficient to cover any negative cash flows. Dividend Decisions The company paid a dividend of $0.25 per quarter in Year 5; you and your co-managers have the authority to declare a higher dividend or, if the need arises, to reduce the quarterly dividend. Higher dividends are welcomed by shareholders and have a positive effect on the company s stock price (unless dividend payments exceed earnings per share for several quarters running and can t be sustained at present levels). However, investors much prefer a steadily rising dividend as opposed to roller coaster dividend payments; thus, a decision to raise the dividend should be made only if you think your company can afford to pay higher dividends over the long term. If your company gets in a cash bind and needs to divert all or part of the cash required to make dividend payments over to paying down its credit line, then you should not be hesitant in cutting the dividend (a little or a lot) until the company s financial position improves and cash flows are sufficiently and reliably positive to justify the resumption of higher dividends. Companies with a credit rating below a B or B- level are well-advised to consider reducing the company s dividend and using the cash-savings from lower dividend payments to pay off some of the loans outstanding. Keep in mind here that dividends declared in one quarter are not paid until the following quarter. Thus, this quarter s cash requirements for dividend payments are fixed; however, declaring a smaller dividend in the current quarter will reduce next quarter s cash outlays for dividend payments. Also, bear in mind that any earnings not paid out as dividends are retained in the business and add to the amount of shareholders equity investment. Retaining a large fraction of earnings year after year can have the effect of eroding the company's ROE. Copyright 2009 GLO-BUS Software, Inc. Page 2

The maximum allowable dividend entry is 2 times projected quarterly earnings per share. Projected year-end shareholder equity must always remain at or above $50 million after any and all dividend payments. No dividend can be paid if projected shareholder equity falls below the $50 million minimum established by the company's board of directors (a policy that is enthusiastically endorsed by the credit rating agencies). Decisions to Issue Additional Shares of Stock From time to time, you and your co-managers may conclude that the company should raise additional equity capital by issuing additional shares of common stock. New issues of common stock, of course, have the effect of diluting earnings per share and should be done cautiously and infrequently. Nonetheless, the need to raise additional equity capital can present itself when (a) the company s credit rating is eroding (because of burdensome interest costs or because the company has used up most of its credit line) and additional cash is needed to repay a portion of the outstanding loans or (b) the company has already draw heavily on its line of credit and needs additional cash to help pay for facilities expansion and/or additional workstations. The company s board of directors has established a 5-million share maximum limit on the number of shares that can be issued in any one year (at the end of Year 5 the company had 10 million shares outstanding). Each time you make an entry in the decision box specifying how many shares are to be issued, GLO-BUS provides on-screen calculations showing the total amount of new equity capital you can raise from issuing a particular number of shares (see the cash inflows section) and the price at which investors will agree to buy the shares (the price declines as more shares are issued because of the dilution effects of additional shares on earnings per share). You can try several what if entries, checking out the effects on earnings per share, return on investment, and the amount of money raised, in reaching a final decision how many shares to issue. Common stock issues result in additional cash in the quarter in which the shares are issued. The cash inflow that results from issuing additional shares equals the number of shares issued multiplied by the issue price per share. Decisions to Repurchase Outstanding Shares of Stock Using cash on hand to repurchase and retire outstanding shares has the advantage of boosting earnings per share, the company s returns on investment, and stock price. The company s board of directors has decreed that: No shares can be repurchased if the stock price is below $10.00 (since such a low price reflects weak financial performance and a need to avoid spending money for share repurchases). The company must maintain a minimum total shareholder equity of $50 million. Total shareholder equity, as reported on the company's balance sheet, equals the sum of Common Stock plus Additional Capital plus Retained Earnings. Your company's total shareholder equity at the end of Year 5 was $99.9 million. Hence, you and your co- Copyright 2009 GLO-BUS Software, Inc. Page 3

managers have some leeway to adjust the company's debt-equity structure and still comply with the Board's required minimum of $50 million in shareholder equity. The company must maintain a minimum of 7.5 million shares outstanding. While you have the authority to initiate stock repurchases, the Board of Directors has reserved the right to limit the number of shares repurchased in any given year such limits vary from year to year and are shown on this screen just to the right of shares repurchased entry field but these limits are also subject to all three conditions above. Each time you make an entry in the decision box specifying how many shares are to be repurchased, GLO-BUS provides on-screen calculations showing (1) the cash required to complete the share repurchases (see the cash outflows listings) and (2) the price at which investors will agree to sell the shares you want to buy back (the price rises as more shares are repurchased because of the upward impact on earnings per share and the bigger fraction of ownership that fewer shares represent). You can try several what if entries, checking out the effects on earnings per share, return on investment, and the amount of money your company will have to pay for repurchased shares, in reaching a final decision how many shares you can afford to repurchase each year. Shares of stock purchased in a quarter represent an immediate use of cash. The amount of cash required to pay for shares repurchased equals the number of shares repurchased times the price at which the shares are bought back from shareholders. Generally you need to have sufficient cash to cover the share repurchase without having to borrow the funds (and draw against your credit line). However, there may be times when your company is sufficiently strong financially (a B+ or better credit rating) to finance the repurchase of shares with borrowed money and then pay interest on the borrowed funds. Companies with credit ratings of B or below should be very wary of repurchasing shares when they are already in a precarious financial condition. All Finance Decisions Are Crucial: Exercise Caution and Good Business Judgment The four finance decisions are very important in keeping your company in sound financial condition. There s on-screen information showing how your company stacks up each quarter on the four key measures that determine your company s credit rating; you ll find this valuable in making decisions that will steer your company toward a strong credit rating and away from credit rating downgrades (especially those that put you below a B rating). And you ll be able to try various what-if entries to see if paying down the loans outstanding and issuing or retiring shares of stock will help produce a better credit rating. Cash Flow Summary Calculations Understanding the On-Screen Calculations The cash flow summary calculations at the top of the Finance Decision screen are important. Presented below are item-by-item descriptions of each term in the cash flow summary: Copyright 2009 GLO-BUS Software, Inc. Page 4

Beginning Cash Balance The beginning cash balance represents cash on hand left over from the previous quarter. It is available for use during the period. The Global Community Bank pays the company an annual interest rate on beginning cash balances equal to the prime rate it charges on loans to companies with an A+ credit rating less 2.5%. Cash Inflows The collection of receivables entry represents cash flowing in from the sales of cameras the prior quarter. Retailers pay for cameras the quarter following the one in which the cameras were ordered and shipped thus there is a one-quarter lag between the booking of sales revenues (which occurs in the quarter cameras are shipped) and the receipt of these revenues. This one-quarter lag means that your company cannot expect to generate more cash flow from additional sales in a particular quarter cash flows from additional sales in one quarter will occur the following quarter. However, retailers do not pay for unsold cameras left over in inventories until the second quarter after receiving shipment (because the company allows retailers 120 days to pay for any cameras received during a quarter which remain in their quarter-ending inventories). Common stock issues result in additional cash in the quarter in which the shares are issued. The cash inflow that results from issuing additional shares equals the number of shares issued multiplied by the issue price per share. New draws against the company s line of credit are an immediate source of cash. Your management team is authorized to draw against the line of credit at any time for any reason. The difference between the line of credit limit and the loans already outstanding against the limit represents the maximum amount of cash you can obtain from this source. Should your company run over its line of credit limit and have to obtain emergency loans, then cash inflows from emergency loans will also appear on this cash inflow item. Cash Outflows Cash expenses for operations cover (1) payments to suppliers for components (cash outflows for this purpose are based on prior-quarter uses of materials since there is a onequarter or 90-day lag between the time components are delivered and the time these deliveries have to be paid for), (2) labor costs, (3) all other production-related expenses except depreciation (depreciation is not a cash expense), (4) shipping costs and duty fees, (5) marketing costs (retailer support costs, tech support costs, and advertising costs), and (6) administrative expenses. Cash outflows for new fixed asset investments for facilities and workstations occur in the quarter in which facilities are expanded or workstations are added. There is also an automatic additional $5,000 investment in fixed assets for each 1,000-unit increase in prioryear companywide sales volumes; such cash outlays occur in quarter 1 of the year following such volume increases. The number shown represents all such expenditures. Cash outlays for interest payments on outstanding loans represent current interest owed adjusted downward for the amount of interest income received on prior-year cash balances Copyright 2009 GLO-BUS Software, Inc. Page 5

at the World Community Bank. Interest payments on loans outstanding are determined by multiplying the quarterly equivalent of the company s annual interest rate by the priorquarter s outstanding loan balance. Interest earned on cash balances is also paid quarterly, with interest earnings being equal to the ¼ of the annual rate paid on cash balances times the cash balance at the end of the prior quarter. Thus cash outflows for interest payments equal interest owed minus interest income received. If interest income received exceeds interest payments, then this item on the cash flow will appear as a negative number (and will reduce cash outflows). Paydowns of your company s line of credit (including any emergency loans) obviously require cash; the amounts shown are a direct result of the decision entries made for paydowns of outstanding loans on the Finance Decisions screen, except if there are any emergency loans which are automatically repaid (without any action on management s part). Cash outlays for common stock repurchases are equal to the number of shares repurchased times the price per share at which the repurchase occurred (which appeared on the Finance Decision screen at the time the number of shares repurchased was entered). Cash outflows for tax payments are equal to 30% of prior-quarter companywide net profits. Current outlays for taxes payable always lag the earning of net profits by one quarter. Cash outflows for dividend payments are based on the size of the quarterly dividend declared the prior quarter times the number of shares outstanding in the quarter the dividend was declared (not the number of shares outstanding in the quarter in which the dividend is actually paid). Cash outlays for dividend payments due in the current quarter cannot be altered; however, the company can cut its declared dividend for current and future periods and thus cut future cash outlays for dividend payments. Ending Cash Balance The company s ending cash balance is always equal to the beginning cash balance plus cash inflows minus cash outflows. Key Financial Ratios Three financial ratios appear at the bottom of this screen. All three ratios are used by credit rating analysts in determining your upcoming year s credit rating. The ratios are shown as onscreen calculations to help you and your co-managers monitor the direction in which these ratios are moving and whether they signal stronger or weaker creditworthiness on your company s part. Since the peak third quarter production and sales results in significant quarter-to-quarter variations in the ratios, all three of these on-screen ratios for individual quarters are calculated on the basis of the company s financials for the most recent 4 quarters, not on the basis of the numbers for that one quarter. The percentages of the company s capital structure that are financed by debt versus stockholders equity The percentage of a company s capital structure that is debtfinanced is calculated by dividing the amount of a company s outstanding debt on its yearend balance sheet (which includes all loans outstanding on the company s line of credit, including any emergency loans) by the total capital employed in the business (where total Copyright 2009 GLO-BUS Software, Inc. Page 6

capital is equal to total outstanding debt plus total stockholders equity, as reported on the company s year-end balance sheet). Thus if a company has drawn down its line of credit by $50 million (which means it has total loans outstanding, including any emergency loans, of $50 million) and has stockholders equity of $100 million, then the has a capital structure consisted of $50 in debt and $100 million in equity. The corresponding percentage of total capital financed by debt is thus 33.3% and the capital structure percentage financed by stockholders equity is 66.7%. Or, to put it another way, the company's capital structure is comprised of 33% debt and 67% shareholders' equity (which means, in effect, that shareholders have contributed to $2 in capital for every dollar contributed by creditors in the form of loans against the company s line of credit). As a rule of thumb, it will take a debt percentage close to 10% to achieve an A+ credit rating and a percentage around 25% to achieve an A- credit rating (assuming the other measures of credit worthiness are also quite strong). Debt levels above 50% of total capital investment are generally considered risky by creditors and signal too much use of debt and creditor financing to operate the business in a sound and secure financial manner. A company s balance sheet is considered to be weaker the higher the percentage of its capital structure that is debt-financed. Conversely, a company s balance sheet is considered to be stronger the higher the percentage of its capital structure that is equity-financed. Times-interest-earned ratio This ratio is defined as annual operating profit (summed for the most recent four quarters) divided by the sum of the company s net interest payments over the past four quarters. Your company s times-interest-earned ratio is used by credit analysts to measure the safety margin that creditors have in assuring that company profits from operations are sufficiently high to cover annual interest payments. A times-interest-earned ratio of 2.0 is considered rock-bottom minimum by credit analysts. A times-interest-earned ratio of 5.0 to 10.0 is considered much more satisfactory for companies in the digital camera industry because of quarter-to-quarter earnings volatility over each year, intense competitive pressures which can produce sudden downturns in a company s profitability, and the relatively unproven management expertise at each company. It usually takes a double-digit times-interest-earned ratio to secure an A- or higher credit rating. Debt payoff capability in years The payoff capability in years based on the number of years it will take to pay off the company s outstanding loans based on the company s free cash flow (summed for the most recent four quarters). Free cash flow is defined as net income plus depreciation minus total dividend payments. The number of years to pay off the company s outstanding debt (for each quarter and year shown on the on-screen calculations) equals the amount of the company s long-term debt (or loans outstanding at the end of the quarter/year) divided by the sum of the company s free cash flow for the most recent four quarters. A short debt payback period (less than 3 years) is a much stronger sign of creditworthiness and financial strength than a long payback period (8 to 10 years or more) Projections of Companywide Performance (at the middle-left of each decision screen) On the left side of every GLO-BUS decision screen there is a box containing projections of the company s overall performance for the upcoming year on the following measures: Revenues defined as worldwide revenues (after taking into account all exchange rate adjustments and promotional discounts) from the combined sales of both entry-level and multi-featured cameras in all four geographic regions. Revenues are booked at the time of Copyright 2009 GLO-BUS Software, Inc. Page 7

shipment, not when the company receives the cash payments from camera retailers (which occurs the quarter following shipment). Net profit defined as worldwide profit after all expenses and taxes. Earnings per share defined as net profit divided by the number of shares of common stock outstanding at the end of the year. Earnings per share is one of your company s five annual performance targets. ROE defined as net profit for the year divided by total shareholders equity investment at the end of the year. An annual ROE of 15% or higher is one of your company s annual performance targets. Credit rating Your company s credit rating is established by credit analysts using four measures: the percentages of debt and equity that comprise your company s total capital investment, times-interest-earned ratio, debt payoff capability (in years), and the % of the line of credit which you have used (loans outstanding divided by the total line of credit your company has established with its bank). The credit rating shown at the bottom of the screen is the projected credit rating for next year, given the company s projected performance it is not the current credit rating (which is reported in each issue of the GLO-BUS Statistical Review). The company s Board of Directors and investors/shareholders expect that your company will achieve a credit rating of B+ each year. Image rating Your company s image rating is based on (1) its P/Q ratings for both entrylevel cameras and multi-featured cameras, (2) its market shares for both entry-level and multi-featured cameras in each of the four geographic regions, and (3) your company s actions to display corporate citizenship and conduct operations in a socially responsible manner over the past 4-5 years. The company s Board of Directors and investors/shareholders have established a target image rating of 70 or higher for your company to achieve each year. Revenues defined as worldwide revenues (after taking into account all exchange rate adjustments and promotional discounts) from the combined sales of both entry-level and multi-featured cameras in all four geographic regions. Revenues are booked at the time of shipment, not when the company receives the cash payments from camera retailers (which occurs the quarter following shipment). Net profit defined as worldwide profit after all expenses and taxes. Why These On-Screen Projections Are So Important and How to Use Them Properly. Each time you make a new decision entry, all of the above companywide performance projections are instantly recalculated, thereby showing you the incremental impacts of that decision entry. It is easy enough then to simply enter a trial decision and determine whether the resulting projections look better or worse than before. By entering several different trial decisions, you can quickly and readily compare the projected outcomes of what if we do this against what if we do that. After entering a number of different trial decisions, you ll be able to identify which decision entry seems best or most acceptable, given all the different onscreen calculations that are provided. This GLO-BUS feature provides you with powerful capability to explore all kinds of what if scenarios and make wise numbers-based decisions. Always bear in mind that the projections do not represent a valid indication of your company s projected performance until you and your co-managers have made a Copyright 2009 GLO-BUS Software, Inc. Page 8

complete set of decisions (covering all decision screens) for the upcoming year. In other words, while you are working your way through the early decision screens the projections will be updated with each entry, but the numbers shown will only be a rough approximation and lack finality because the projections are not yet based on all the decision entries you plan to make for the upcoming year. Once you have gone through all the decision screens and entered what you think are reasonable decisions for all the boxes, then it is time to really scrutinize all the various company performance projections and determine whether the projected outcomes of your strategy and decision-making look acceptable. If not, then you need to tour back through the decision screens, make different trial decisions here and there as seem appropriate, and not stop tweaking and fine-tuning until you arrive at a set of company projections that appears to be the best you can come up with. But even then, the projections are still only projections they do not represent guaranteed outcomes. Why? Because there remain a host of uncertainties about what competitors will actually do (what prices will they charge, how much they will spend on advertising, how many different camera models they will offer, what warranties they will offer, and so on). These will not be known until the deadline for the decision round arrives, at which time the GLO-BUS server will process the decision entries of all companies and determine the actual outcomes of competition in the marketplace for digital cameras. Copyright 2009 GLO-BUS Software, Inc. Page 9