Cameron School of Business

UNIVERSITY OF NORTH CAROLINA WILMINGTON

An Introduction to
Finance:
Chapters 1 3 of
Essentials of Corporate
Finance

Edward Graham
Professor of Finance
Department of Economics and
Finance

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Outline of the Introduction to Finance Module

Introduction to Finance

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I.

The Three Primary Duties of the Financial Manager

II.

Evidence of the Results of Financial Decision-making: The

Financial Statement and Ratio Analysis

An Introduction to Finance
What is finance?
Finance is the study of the art and the science of money

management; it is based on the Latin root finis,

meaning the end. In managing ours or our firms money,
we consider historical outcomes or endings,
and we propose future results as a function of decisions
made today. Those outcomes or results are
typically portrayed using financial statements.

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I.

The Three Primary Duties of the

Financial Manager
Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:
The capital budgeting decision
The capital structure decision
The working capital decision

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The Capital Budgeting Decision

With the capital budgeting decision, the financial manager
decides where best to deploy monies long-term. The
purchase of a new delivery truck or a new warehouse
is a capital budgeting decision; the payment of a utility
bill is not.
With the making of this decision, we consider three features
of the cash flows deriving from the decision:
The size of the cash flows

The timing of the cash flows

The risk of the cash flows
We review a couple examples of capital budgeting decisions.

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The Capital Structure Decision

With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.
Perhaps most importantly, the decision to fund a firms growth with
equity - such as with funds invested by the firms founders, angel
investors, venture capitalists or public stock offerings or debt, is
a critical capital structure choice. Two features of this choice bear
mentioning:
The risk of the debt

The loss of control and reduced potential cash flows to the

founders with an equity or stock sale
We expand our review with a few capital structure decisions.
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The Working Capital Decision

With the working capital decision, current assets and current liabilities
become the focus of the financial manager.
Such items as cash balances, accounts receivable, inventory levels and
short-term accruals (such as prepaid rent or utilities) are included among
the short-term assets that comprise one component of working capital.
Also with the working capital decision, we concern ourselves with short-term
obligations such as accounts payable to vendors, and other debt that is
expected to be paid off within one year.
Net working capital is a meaningful outcome of the working capital decisionmaking matrix. Net working capital is merely the difference between
current assets and current liabilities.

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II.

Evidence of the Results of Financial Decisionmaking: The Financial Statement and Ratio
Analysis
Providing valid and timely information to the varied
stakeholders in the firm is key. These stakeholders, both
within and outside the firm, include the owners, the
employees, neighbors, the community-at large, suppliers,
lenders, bankers, and the competition.
This information is typically provided within financial
statements, and notes to those statements. Three
statements attract our attention:
The Income Statement
The Statement of Cash Flows
The Balance Sheet

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Ratio Analysis
Five types of ratios support our discussion, and underscore
important features of the information we are providing our
varied stakeholders:

Short term solvency

Long term solvency
Asset management
Profitability
Market value

We briefly discuss each of these in turn, with examples of

each type of ratio drawn from your earlier work in
accounting, and illustrated by the example in class.

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The Example in Class, Inc.

Balance Sheet at Years End
Assets
Current Assets
Cash
Receivables
Inventory
Total Current Assets

50,000
20,000
30,000
100,000

Fixed Assets

150,000

Total Assets

250,000

Liabilities & Owners Equity

Current Liabilities
Payables
50,000

Total C/Liabilities

50,000

Long Term Liab.

Total Liabilities

100,000
150,000

Owners Equity
Par Value
APIC
Ret. Earnings
Total Owners Eq.

10,000
40,000
50,000
100,000

Total Liab and O/E 250,000

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The Example in Class, Inc.

Short Term Solvency Ratios

Current Ratio: current assets/current liabilities = 100,000/50,000 = 2
Quick Ratio: (current assets inventories)/current liabilities
= (100,000 30,000)/50,000 = 1.4

Long Term Solvency (or Debt) Ratios

Debt Ratio: total liabilities/total assets = 150,000/250,000 = .6
Debt-to-Equity Ratio: total debt/total equity = 150,000/100,000 = 1.5
Equity Multiplier: total assets/total equity = 250,000/100,000 = 2.5

What is the meaning of the each of the metrics? For example, what does
a current ratio of 2 really mean? The quick ratio? The Long Term
Solvency measures?

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The Example in Class, Inc.

Assume our firm had sales in the most recent year of $200,000 and Net Income of
$20,000.

EIC, Inc. has 10,000 shares outstanding. Those shares were initially issued for $5
each with a par value of $1 per share. With net income of $20,000, EPS or
Earnings Per Share becomes 20,000/10,000 or $2. Book value per share is total
equity divided by shares outstanding or 100,000/10,000 or $10 per share.

Dividends were $1 per share or a total of $10,000. Thus, the firm paid out 50% of
earnings (dividends paid/net income = the dividend payout ratio of 10,000/20,000
or 50%)

Asset Utilization Ratios

Total Asset Turnover: sales/total assets = 200,000/250,000 = .8
Average Age of Receivables: 365 days/(sales/accounts receivable)
= 365 days/(200,000/20,000) = 36.5 days

And how best might we interpret these asset utilization ratios?

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The Example in Class, Inc.

Profitability Ratios
Profit Margin: net income/sales = 20,000/200,000 = .1
Return on Assets (ROA): net income/total assets
= 20,000/250,000 = .08

Return on Equity (ROE): net income/owners equity

= 20,000/100,000 = .20

Now assume EIC has a stock price of $40 per share

Earnings per share (EPS) was $2 or 20,000/10,000
(net income/shares outstanding)
Book value per share was 100,000/10,000 or $10
(owners equity/shares outstanding)

Market Value Ratios

Price-Earnings ratio: price per share/EPS = 40/2 = 20
Market-to-Book ratio: price per share/book value per share = 40/10 = 4
How do we interpret these final financial ratio examples?

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The Example in Class, Inc.

The DuPont Identity:
ROE = PM x T/A T/O x EM
or
ROE = NI/Sales x Sales/Total Assets x Total Assets/Equity
=(20,000/200,000) x (200,000/250,000) x (250,000/100,000)
NI/Sales reflects the impact of operations
Sales/Total Assets reflects the impact of the capital
budgeting decision
Total Assets/Equity reflects the impact of the capital
structure decision

For EIC: ROE = (.10) x (.8) x (2.5) = .20, as before.

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