(a) Financial Management

TBS 980 Lecture 1

(a) Introduction to Financial Management (b) Financial Reporting (c) Financial Analysis
1

Economics and Accounting for Finance Economics: risk analysis, pricing theory, comparative return analysis, GDP, interest rate, inflation, central bank, taxes A Accounting: fi ti financial d t i i l data, income statement, t t t balance sheet, cash flow statement Financial Management: financial managers use economics and interpret accounting reports in decision-making about raising capital and getting the highest return
2

Issues in Finance
Old: allocating financial capital by purchasing real capital (long-term plant and equipment) Recent: capital structure theory (Miller), (Miller) inflation and disinflation on forecasting, required rate of return for capital budgeting Computer technologies to run businesses

Financial Managers
Allocate funds to current and fixed assets Get the best mix of financing (debt and equity) D Develop appropriate di id d policy l i t dividend li Maximize shareholders wealth

Functions of the Financial Manager

Risk-Return Trade-Off
Influences operational side (capital versus labor/ Product A versus Product B) Influences financial mix (stocks versus bonds versus retained earnings)
Stocks are more profitable but riskier. Savings accounts are less profitable and less risky (or safer)

Financial manager must choose appropriate combinations

5 6

Corporate Governance
Agency theory: conflict between managers and stockholders. Management has an agency position of making decisions that are best for stockholders interests There is a tradeoff between maintaining a status quo and maximizing stockholders wealth Social responsibility and ethical behavior
7

Roles of Corporations
Maximizing values in the market by attracting capital, providing employment, and offering benefits to communities. Pollution controls is a hot topic nowadays Unethical and illegal financial practices (like insider trading) should never go unpunished. Who controls? SEC?

Financial Markets
Anyone who needs money or have money to lend or invest can use financial markets Short-term products are in Money Markets L Long-term products are in Capital M k t t d t i C it l Markets

Structure and Functions of the Financial Markets

Money markets
Securities in this market include commercial paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.

Capital markets
Long-term markets Securities include common stock, preferred stock and corporate and government bonds.

10

How to allocate funds?

Invest in a diversified portfolio of securities (stocks, Gov. bonds, Corp. bonds, ) by, first, setting a risk level that meets return objectives, and second objectives and, second, maximizing return for that level of risk. Certainly competition provides better offers but with different levels of risk.

Financial Management Decisions

The Financial Markets Shareholders

Capital Structure
Bondholders

Capital The Firm Financial Manager Budgeting Working Capital Projects Management g
Make decisions that increase the value of the stock (maximize shareholders wealth)
What long-term investments should the firm take? How should the firm manage its everyday financial activities?
12

Where the firm get the long-term financing to pay for investments?

11

(b) Financial Reporting

Balance Sheet Profit and Loss Statement Price/Earnings Ratio Statement of Cash Flows

The Account and The Accounting Equation

The account is a device used to enable the recording of increases and decreases, in each item of the companys financial records. p y The basic form of account is called the T account E.g Cash at bank Debits= Credits In other words we need both sides of the T account to balance
13 14

Debits and Credits

A T-account represents a ledger account and is a tool used to understand the effects of one or more transactions.
T T- Account (Left side) (Right side) Debit Credit

Financial Statements
Balance Sheet reports financial position of a business at a specific point in time. Profit & Loss Statement reports results of earning activities for a specific time period. Statement of Cash Flows reports cash inflows and outflows from operating and other activities over a reporting period.
16

15

Balance Sheet (Statement of Financial Position)

The statement of financial position or balance sheet is defined as a statement at one point in time which shows all the resources controlled (i.e. the assets) by the enterprise and all the obligations due by the enterprise (i e the (i.e. liabilities) A Balance Sheet shows what a firm owns and what it owes Remember ALOE! Assets = Liabilities + Owners Equity
17

Accounting Equation
Assets = Liabilities + Owners Equity Assets: Service potential or future economic benefits controlled by entity as result of past transactions or other events. E.g. land buildings equipment accounts receivable patents patents Liabilities: Future sacrifices of service potential or future economic benefits that an entity is presently obliged to make as a result of past transactions or other events. E.g. accounts payable mortgages payable wages & salaries payable Owners equity: Residual interest of owner/s in the assets (less liabilities) of the entity. E.g. Net assets Proprietorship Capital
18

Balance Sheet Items

Liquidity: Asset accounts are listed in order of liquidity.
Current assets: items that can be converted to cash within 12 months or within the normal operating cycle of the firm. Marketable securities: temporary investment of excess cash. Accounts receivable: allowance for bad debts, to determine their anticipated collection value.
19

Balance Sheet Items (contd)

Inventory: includes raw materials, goods in progress or finished goods. Prepaid expenses: represents future expense items, that are already p y paid for.
Example: insurance premiums or rent

Investments: long-term commitment of funds (at least one year).

Includes stocks, bonds or investments in other companies.
20

Balance Sheet Items (contd)

Plant and equipment: carried at original cost minus accumulated depreciation.
Accumulated depreciation: sum of all past and present depreciation charges on currently owned assets. t Depreciation expense is the current years charge.

Balance Sheet Items (contd)

Total assets: Financed through liabilities or stockholders equity.

Short-term obligations
Accounts payable: amounts owed on open accounts to suppliers. Notes payable: short-term signed obligations to bankers and other creditors. Accrued expense: payment yet to be made towards - service already provided or an obligation incurred.
22

21

Stockholders Equity
Represents total contribution and ownership interest of preferred and common stockholders.
Preferred stock. stock Common stock. Capital paid in excess of par. Retained earnings.

Statement of Financial Position (Balance Sheet)

23

24

Income Statement
Device to measure the profitability of a firm over a period of time.
It covers a defined period of time. It is presented in a stair step or progressive stair-step fashion
To examine the profit or loss after each type of expense item is deducted.

25

26

Return to Capital
Three primary sources of capital:
Bondholders Preferred stockholders Common stockholders

Statement of Retained Earnings

E i Earnings per share h

Interpreted in terms of number of outstanding shares. May be paid out in dividends or retained by company for subsequent reinvestment.

Statement of retained earnings

Indicates the disposition of earnings.
27 28

Statement of Cash Flows

Emphasizes the critical nature of cash flow to the operations of the firm.
It represents cash or cash equivalents items easily convertible to cash within 90 days days.

Concepts Behind the Statement of cash Flows

Cash flow analysis helps in combating the discrepancies faced through the accrual method of accounting.

29

30

Determining Cash Flows from Operating Activities: Indirect Method

Cash Flows from Operating Activities

31

32

Determining Cash Flows from Investing Activities

Investing activities:
Long-term investment activities in mainly plant and equipment.
Increasing investment is a use of funds. Decreasing investments is a a source of funds.

Comparison of Accounting and Cash Flows

Financial activities apply to the sale or retirement of:

Bonds Common stock Preferred stock Other corporate securities Payment of cash dividends.
Sale of firms securities is a source of funds. Payment of dividend and the repurchase of securities is a use of funds.

33

34

Depreciation and Fund Flows

Depreciation attempts to allocate the initial cost of an asset over its useful life. Charging of depreciation does not directly influence the movement of funds It is a funds. non-cash item and does not affect cash flow. Straight Line and Reducing Balance

Depreciation Methods
A depreciation method based on the expiration of times means that depreciation expense is recognised at the end of each period regardless of the quantity of use obtained from the asset.

Straight Line
Asset value $

Reducing B l R d i Balance
Asset value $

35

Life of asset (years)

Life of asset (years)

36

(c) Financial Analysis

What is financial analysis? Is to provide information in order to assist users in making informed decisions concerning their resource allocation What does financial analysis involve ? Evaluating a firms financial performance Examining relationships by using trend analysis and horizontal analysis Analysing ratios or numerical calculations Comparing a company to its industry

Ratio Analysis
Financial ratios
Used to weigh and evaluate the operating performance of a firm. Used to compare performance record as against other firms in the industry. Analyzing ratios and numerical calculations. Such data is provided by various organizations.

Ratios and their Classification

A. Profitability ratios ( How efficiently the firm uses its assets and manages its operations )
1. Profit margin. [desirable if it is high] 2. Return on assets (investment). [profit per $ of assets] 3. Return on equity. [accounting sense of profit generation per $ of equity]

Ratios and their Classification

C. Liquidity ratios (The firms ability to pay its bills over the short run without undue stress; They are interesting to short-term creditors )
9. Current ratio. [short-term liquidity] 10. Quick (or acid-test) ratio. [without inventory]

B. Asset utilization ratios ( How efficiently the firm uses its assets to generate sales )
4. 5. 6. 7. 8. Receivable turnover. [how fast a firm collects its credits] Average collection period. [=365/RT, on average] Inventory turnover. [times the firm sold off the entire inventory] Fixed asset turnover. [sales generated for every $ in fixed assets] Total asset turnover. [sales generated for every $ in total assets]

D. D Debt utilization ratios (The firms long run ability to meet its obligations, or firm s long-run obligations its financial leverage )
11. Debt to total assets. [how capital structure matters] 12. Times interest earned. [how well a firm has its obligations covered] 13. Fixed charge coverage. [ability to meet all fixed obligations rather than interest payments alone]

10

Financial Statement for Ratio Analysis

Profitability Ratios

A1

Du Pont System of Analysis

A satisfactory return on assets might be derived through:
A high profit margin A rapid turnover of assets (generating more sales per dollar of its assets) Or both Return on assets (investment) = (Profit margin) X (Asset turnover)

Du Pont System of Analysis (contd)

A satisfactory return on equity might be derived through:
A high return on total assets; A generous utilization of debt; Or a combination of both. Return on equity = Return on assets (investments) [1 (Debt/ Assets)]

11

Slide 42 A1 Replace equations with appropriate graphics.

Administrator, 24/05/2006

Du Pont Analysis: It tells us that ROE is affected

by three things: 1. Operating efficiency (PM) 2. Asset use efficiency (TAT) 3. Financial leverage

Examples for Analysis using the Du Pont System

Asset Utilization Ratios

These ratios relate the balance sheet to the income statement.

Asset Utilization Ratios (contd)

12

Liquidity Ratios

A2

Debt Utilization Ratios

firm

A3

Measures the prudence of the debt management policies of the

Debt Utilization Ratios (contd)

Fixed charge coverage measures the firms ability to meet the fixed obligations. Interest payments alone are not considered. considered
Income before interest and taxes..$550,000 Lease payments $50,000 Income before fixed charges and taxes$600,000

Summary of Ratio Analysis

13

Slide 49 A2 Replace equations with appropriate graphics

Administrator, 24/05/2006

Slide 50 A3 Replace equations with appropriate graphics

Administrator, 24/05/2006

Importance of Ratios
Which ratio is most important? It depends on your perspective. Suppliers and banks (lenders) are most interested in liquidity ratios. Shareholders are most interested in profitability ratios. A long-run trend analysis over a 5-10 year period is usually performed by an analyst.

Limitations of Financial Statement Analysis

Differences in accounting methods between companies sometimes make comparisons difficult.

We use the weighted average method to value inventory.

We use the FIFO method to value inventory.

Inventory Accounting Methods

Three cost flow assumptions: FIFO (First In, First Out) LIFO (Last In, First Out) Average cost

Inventory Accounting Methods

Cost of Goods Sold ( (Income Statement) ) first purchases last purchases (close to current cost) average of all purchases Inventory Valuation ( (Balance Sheet) ) last purchases (close to current cost) first purchases average of all purchases

Accounting Method FIFO LIFO Average Cost

14

Example:

A company sells 3 of the following items at the end of the year. Item #1 #2 #3 #4 #4 Purchase Price $5 $7 $8 $9 $11

During Inflation
LIFO
Produces the highest COGS expense and the lowest ending inventory valuation

Accounting Method Cost of Goods Sold (Income Statement) FIFO LIFO Average Cost #1, #2, #3 =$20 #5, #4, #3 =$28 [Total cost/5] x 3 =$24

Inventory Valuation (Balance Sheet) #4, #5 = $20 #2, #1 = $12 [Total cost/5] x 2 = $16

FIFO
Produces the lowers COGS expense and the highest inventory valuation

Explanation of Discrepancies

Explanation of Discrepancies
Sales
Use of defer recognition until each payment is received or full recognition at the earliest p possible date.

Cost of goods sold

Use of different accounting principles - LIFO versus FIFO.

15