FIN2704

Financial Management Overview

Finance
A discipline concerned with determining value (what something is worth today) and making
decisions based on that value assessment. This function allocates resources.
Main areas: Investments, Financial Markets and Intermediaries, Corporate Finance

Investments
The study of financial transactions from the perspective of investors outside the firm.

Financial Markets and Intermediaries

The study of markets where financial securities are bought and sold.
The study of financial institutions that facilitate the flow of money from savers to demanders of
money.

Corporate Finance
Makes the following decisions:
Capital budgeting decision – What long term investments should the firm take on?
Capital structure decision – Where will the firm get the long term-financing to pay for the
investment?
Working capital management decision – How will the firm manage its everyday financial activities?

Investment Vehicle Model

Goal of Financial Management

Primary goal: shareholder wealth maximisation – maximizing stock price.
This is best realised when the firm uses finance’s systematic value maximizing investment and
financing decision criteria.

Maximizing Stock Price

Intrinsic value – an estimate of a stock’s ‘true’ value based on accurate risk and return data.
Intrinsic value is determined by amount of cash flows expected by shareholders, timing of the cash
flow stream, and riskiness of the cash flow stream.
Agency Costs
Direct agency cost: expenditure that benefit management, monitoring costs
Indirect agency cost: lost opportunities which would increase firm value in the long run, if accepted
Agency problem
Agency problem: conflict of interest between principal and agent (usually aligned, except only during
situations like bankruptcy)
How to solve: compensation plans, close monitoring, threat of firing poor performance, raise
awareness about good corporate governance.

Firm and Sources of Funds

Money markets – where debt securities of less than a year are traded, loosely connected dealer
markets, e.g. banks
VS
Capital markets – where equity and long-term debt claims are traded, e.g. auction markets (SGX)
Primary markets – for government and corporations’ initially issued securities, public offering,
private offering
VS
Secondary markets – where existing financial claims are traded, and getting market value of
securities is easier.

Financial Statement Analysis

Annual Report
Balance Sheet – firm’s financial position at one point in time
Assets = Liabilities + Equity
Income statement – firm’s revenues and expenses over a given period of time
Statement of retained earnings – how much of firm’s earnings were retained, rather than paid out as
dividends
*note difference between profits and cash flows!
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Statement of cash flows – impact of a firm’s activities on cash flows over a period of time.
Operating, investment and financing activities
∆𝐶𝑎𝑠ℎ = ∆𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + ∆𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − ∆𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝑜𝑡ℎ𝑒𝑟 𝑡ℎ𝑎𝑛 𝑐𝑎𝑠ℎ
− ∆𝑛𝑒𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 + ∆𝑙𝑜𝑛𝑔𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 + ∆𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
Operating Working Capital (OWC)
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Cash Flow From Assets (CFFA)

𝐶𝐹𝐹𝐴 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤(𝑂𝐶𝐹) − 𝑁𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔(𝑁𝐶𝑆) − ∆𝑁𝑂𝑊𝐶
𝐶𝐹𝐹𝐴 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑡𝑜 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 + 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑡𝑜 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑂𝐶𝐹 = 𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝑁𝐶𝑆 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐵𝑒𝑔. 𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
∆𝑁𝑂𝑊𝐶 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑁𝑂𝑊𝐶 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑁𝑂𝑊𝐶
= (𝐸𝑛𝑑𝑖𝑛𝑔 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐸𝑛𝑑𝑖𝑛𝑔 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑡𝑖𝑡𝑖𝑒𝑠) − (𝐵𝑒𝑔. 𝐶𝐴
− 𝐵𝑒𝑔. 𝐶𝐿)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 ∗ 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒

Enterprise Value
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒
= 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ
+ 𝑎𝑛𝑦 𝑜𝑡ℎ𝑒𝑟 𝑛𝑜𝑛𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
Ratio Analysis
1. Liquidity Ratios (Short-Term Solvency) – ability to pay bills
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑡𝑖𝑒𝑠
 𝐶𝐴 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝐿
𝐶𝑎𝑠ℎ
𝐶𝑎𝑠ℎ 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝐿
𝐶𝐴
𝐼𝑛𝑡𝑒𝑟𝑣𝑎𝑙 𝑀𝑒𝑎𝑠𝑢𝑟𝑒 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠

2. Long-Term Solvency (Financial Leverage) Ratios – how heavy in debt

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡⁄𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 1 +
𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜
𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡
𝐿𝑜𝑛𝑔 − 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 + 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
Coverage Ratios:
𝐸𝐵𝐼𝑇
𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 𝑅𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐸𝐵𝐼𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑎𝑠ℎ 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

3. Asset Management (Turnover / Efficiency) Ratios – how productively assets are used
Inventory Ratios:
𝐶𝑂𝐺𝑆
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
365
𝐷𝑎𝑦𝑠 ′ 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Receivable Ratios:
𝑆𝑎𝑙𝑒𝑠
𝑅𝑒𝑐. 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝐴𝑐𝑐 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑆𝑎𝑙𝑒𝑠
𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔(𝐷𝑆𝑂) = =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠 365
365
=
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Fixed Asset and Total Asset Turnover Ratios

𝑆𝑎𝑙𝑒𝑠
𝐹𝐴 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝑆𝑎𝑙𝑒𝑠
𝑇𝐴 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

4. Profitability Ratios – return on investments

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠
𝐸𝐵𝐼𝑇
𝐵𝑎𝑠𝑖𝑐 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑃𝑜𝑤𝑒𝑟(𝐵𝐸𝑃) =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠(𝑅𝑂𝐴) =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
ROA is lowered by debt as interest expense lowers net income.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦(𝑅𝑂𝐸) =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦
ROE increases if the use of debt lowers equity more than net income.
 ROE does not consider risk, the amount of capital invested, focuses only on return.

5. Market Value Ratios – prospects and how firm is valued by market

Price / Earnings = How much investors are willing to pay for $1 of earnings
Market price per share / Book value per share = how much investors are willing to pay for $1 of book
value equity

The Dupont System

Links profitability and efficiency
𝑁𝐼
𝑅𝑂𝐸 = = 𝑃𝑀 ∗ 𝑇𝐴𝑇𝑂 ∗ 𝐸𝑀
𝑇𝐸
Potential Problems / Limitations of Ratio Analysis
Difficult to compare with industry averages if firm operates many different divisions
Seasonal factors can distort ratios
Window dressing techniques may be deceiving
Companies have different accounting and operating practices