PRINCIPLES OF

FINANCE
PAARA
ASHOT GRIGORYAN, Ph.D
Accounting Statements and Cash Flow

• THE BALANCE SHEET is an accountant’s snapshot of the firm’s

accounting value
Assets = Liabilities + Stockholders’ equity
BALANCE SHEET
• When analyzing a balance sheet, the financial manager should
be aware of three concerns:
• Accounting liquidity - refers to the ease and quickness with
which assets can be converted to cash
• Debt versus equity – Sh. Equity = Assets – Liabilities
• Value versus cost – create a value for the firm that is higher than
its cost
THE INCOME STATEMENT
• The income statement measures performance over a specific
period of time. Revenue – Expenses = Income

Notes: There are 29 million

shares outstanding. Earnings
per share and dividends per
share can be calculated as
follows:
• Earnings per share =
Net income/
Total shares outstanding =
86/29 = $2.97

• Dividends per share =

• Dividends / Total shares
outstanding = $43/29 =
$1.48
 NET WORKING CAPITAL & CASH FLOW
Current assets - Current liabilities = Net working capital
CF(A) = CF(B) + CF(S)
Operating CF In $ Millions
Earnings before interest and taxes $219
Depreciation 90
Current taxes (71)
Operating cash flow $238

In $ Millions
Acquisition of fixed assets $198
Sales of fixed assets (25)
Capital spending 173
 CASH FLOW STATEMENT
Operating CF In $ Millions
Earnings before interest and taxes $219
Depreciation 90
Current taxes (71)
Operating cash flow $238

In $ Millions
Acquisition of fixed assets $198
Sales of fixed assets (25)
Capital spending 173

In $ Millions
Operating cash flow $238
Capital spending (173)
Additions to net working capital (23)
Total CF $42
 CASH FLOW STATEMENT
Cash Flow Paid to Creditors
(in $ millions)
Interest 49
Retirement of debt 73
Debt service 122
Proceeds from long-term debt (86)
sales
Total 36

Cash Flow to Stockholders

(in $ millions)
Dividends 43
Repurchase of stock 6
Cash to stockholders 49
Proceeds from new stock issue (43)
Total 6
FINANCIAL STATEMENT ANALYSIS
• Short-term solvency—the ability of the firm to meet its short-run
obligations.
• Activity—the ability of the firm to control its investment in assets.
• Financial leverage—the extent to which a firm relies on debt
financing.
• Profitability—the extent to which a firm is profitable.
• Value—the value of the firm.
 SHORT-TERM SOLVENCY ROTIOS

𝑇𝑂𝑇𝐴𝐿 𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝐴𝑆𝑆𝐸𝑇𝑆

• CURRENT RATIO =
𝑇𝑂𝑇𝐴𝐿 𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝐿𝐼𝐴𝐵𝐼𝐿𝐼𝑇𝐼𝐸𝑆

𝑄𝑈𝐼𝐶𝐾 𝐴𝑆𝑆𝐸𝑇𝑆
• QUICK (ACID TEST) RATIO =
𝑇𝑂𝑇𝐴𝐿 𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝐿𝐼𝐴𝐵𝐼𝐿𝐼𝑇𝐼𝐸𝑆

𝐶𝐴𝑆𝐻+𝑀𝐴𝑅𝐾𝐸𝑇𝐴𝐵𝐿𝐸 𝑆𝐸𝐶𝑈𝑅𝐼𝑇𝐼𝐸𝑆+𝑅𝐸𝐶𝐸𝐼𝑉𝐴𝐵𝐿𝐸𝑆
• QUICK (ACID TEST) RATIO =
𝑇𝑂𝑇𝐴𝐿 𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝐿𝐼𝐴𝐵𝐼𝐿𝐼𝑇𝐼𝐸𝑆
ACTIVITY RATIOS…
• Ratios of activity are constructed to measure how effectively the
firm’s assets are being managed
• These ratios provide some information on the success of the firm
in managing its investment in accounts receivable

• If the asset turnover ratio is high, the firm is presumably using its
assets effectively in generating sales.
• If the ratio is low, the firm is not using its assets to their capacity
and must either increase sales or dispose of some of the assets
… ACTIVITY RATIOS
𝑇𝑂𝑇𝐴𝐿 𝑂𝑃𝐸𝑅𝐴𝑇𝐼𝑁𝐺 𝑅𝐸𝑉𝐸𝑁𝑈𝐸𝑆
• TOTAL ASSET TURNOVER =
𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇𝑆 (𝐴𝑉𝐸𝑅𝐴𝐺𝐸)

This ratio is to indicate how effectively a firm is using all of its assets.

𝑇𝑂𝑇𝐴𝐿𝑂𝑃𝐸𝑅𝐴𝑇𝐼𝑁𝐺 𝑅𝐸𝑉𝐸𝑁𝑈𝐸𝑆
• RECEIVABLES TURNOVER = =8
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝑅𝐸𝐶𝐸𝐼𝑉𝐴𝐵𝐿𝐸𝑆

𝐷𝐴𝑌𝑆 𝐼𝑁 𝑃𝐸𝑅𝐼𝑂𝐷
• AVERAGE COLLECTION PERIOD = = 365/8
𝑅𝐸𝐶𝐸𝐼𝑉𝐴𝐵𝐿𝐸𝑆 𝑇𝑈𝑅𝑁𝑂𝑉𝐸𝑅
ACTIVITY RATIOS

𝐶𝑂𝑆𝑇 𝑂𝐹 𝐺𝑂𝑂𝐷𝑆 𝑆𝑂𝐿𝐷

• INVENTORY TURNOVER = =6
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝐼𝑁𝑉𝐸𝑁𝑇𝑂𝑅𝑌

𝐷𝐴𝑌𝑆 𝐼𝑁 𝑃𝐸𝑅𝐼𝑂𝐷
• DAYS IN INVENTORY = = 365/6 = 60.8
𝐼𝑁𝑉𝐸𝑁𝑇𝑂𝑅𝑌 𝑇𝑈𝑅𝑁𝑂𝑉𝐸𝑅

• The inventory ratios measure how quickly inventory is produced

and sold
FINANCIAL LEVERAGE

𝑇𝑂𝑇𝐴𝐿 𝐷𝐸𝐵𝑇 𝐿𝑂𝑁𝐺 𝑇𝐸𝑅𝑀 𝐷𝐸𝐵𝑇

• DEBT RATIO = OR =
𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇𝑆 𝐿𝑇𝐷+𝐸𝑄𝑈𝐼𝑇𝑌

𝑇𝑂𝑇𝐴𝐿 𝐷𝐸𝐵𝑇
• DEBT − TO − EQUITY RATIO =
𝑇𝑂𝑇𝐴𝐿 𝐸𝑄𝑈𝐼𝑇𝑌

• Debt ratios provide information about protection of creditors

from insolvency and the ability of firms to obtain additional
financing for potentially attractive investment opportunities
PROFITABILITY RATIOS
𝑁𝐸𝑇 𝐼𝑁𝐶𝑂𝑀𝐸
• NET PROFIT MARGIN =
𝑇𝑂𝑇𝐴𝐿 𝑂𝑃𝐸𝑅𝐴𝑇𝐼𝑁𝐺 𝑅𝐸𝑉𝐸𝑁𝑈𝐸

𝐸𝐵𝐼𝑇
• GROSS PROFIT MARGIN =
𝑇𝑂𝑇𝐴𝐿 𝑂𝑃𝐸𝑅𝐴𝑇𝐼𝑁𝐺 𝑅𝐸𝑉𝐸𝑁𝑈𝐸

𝑁𝐼+𝐴𝐹𝑇𝐸𝑅−𝑇𝐴𝑋 𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇
• OPERATING PROFIT MARGIN =
𝑇𝑂𝑇𝐴𝐿 𝑂𝑃𝐸𝑅𝐴𝑇𝐼𝑁𝐺 𝑅𝐸𝑉𝐸𝑁𝑈𝐸

• In general, profit margins reflect the firm’s ability to produce a product

or service at a low cost or a high price.
PROFITABILITY RATIOS

𝑁𝐸𝑇 𝐼𝑁𝐶𝑂𝑀𝐸
• NET RETURN ON ASSETS =
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇𝑆

𝐸𝐵𝐼𝑇
• GROSS RETURN ON ASSETS =
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇𝑆

𝑁𝐸𝑇 𝐼𝑁𝐶𝑂𝑀𝐸
• NET RETURN ON EQUITY =
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝑆𝐻𝐴𝑅𝐸𝐻𝑂𝐿𝐷𝐸𝑅𝑆 ′ 𝐸𝑄𝑈𝐼𝑇𝑌
DuPont SYSTEM OF FINANCIAL
CONTROL
𝑁𝐸𝑇 𝐼𝑁𝐶𝑂𝑀𝐸
• NET RETURN ON ASSETS =
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇𝑆

𝑁𝐸𝑇 𝐼𝑁𝐶𝑂𝑀𝐸 𝑇𝑂𝑇𝐴𝐿 𝑂𝑃𝐸𝑅𝐴𝑇𝐼𝑁𝐺 𝑅𝐸𝑉𝐸𝑁𝑈𝐸𝑆

• ROA = x
𝑇𝑂𝑇𝐴𝐿 𝑂𝑃𝐸𝑅𝐴𝑇𝐼𝑁𝐺 𝑅𝐸𝑉𝐸𝑁𝑈𝐸 𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇𝑆 (𝐴𝑉𝐸𝑅𝐴𝐺𝐸)

• ROA = 𝑃𝑅𝑂𝐹𝐼𝑇 𝑀𝐴𝑅𝐺𝐼𝑁 x 𝐴𝑆𝑆𝐸𝑇 𝑇𝑈𝑅𝑁𝑂𝑉𝐸𝑅

 DuPont SYSTEM OF FINANCIAL
CONTROL
𝑁𝐸𝑇 𝐼𝑁𝐶𝑂𝑀𝐸
• NET RETURN ON EQUITY =
𝐸𝑄𝑈𝐼𝑇𝑌

𝐴𝑆𝑆𝐸𝑇𝑆 𝑆𝐴𝐿𝐸𝑆 𝑁𝐼+𝐴𝐹𝑇𝐸𝑅−𝑇𝐴𝑋 𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇 𝑁𝐼

• ROE = x x x
𝐸𝑄𝑈𝐼𝑇𝑌 𝐴𝑆𝑆𝐸𝑇𝑆 𝑆𝐴𝐿𝐸𝑆 𝑁𝐼+𝐴𝐹𝑇𝐸𝑅−𝑇𝐴𝑋 𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇

LEVERAGE
RATIO ASSET “DEBT BURDEN”
OPERATING
TURNOVER PROFIT MARGIN

• Notice that the product of the two middle terms is the return on assets.
INFLATION: Interest Rates and Inflation
• Suppose that the one-year interest rate that the bank pays is 10
percent. This means that an individual who deposits $1,000 at
date 0 will get $1,100 ($1,000 1.10) in one year.
• Now suppose that the rate of inflation is 6 percent over the year
and it affects all goods equally.
• For example, a restaurant that charges $1.00 for a hamburger at
date 0 charges $1.06 for the same hamburger at the end of the
ye.ar
Calculation of Real Rate of Interest
Real v Nominal Interest Rate
• Economists refer to the 3.8% number as the real interest rate
• Economists refer to the 10% rate as the nominal interest rate or
simply the interest rate
• The formula between real & nominal cash flows can be written as:
1+Nominal interest rate=(1+Real interest rate)x(1+Inflation rate)

1 + Nominal interest rate

Real interest rate = −1
1 + Inflation rate
Inflation
• The approximation of Fisher equation:
Real interest rateNominal interest rate-Inflation rate
• The little-known monarchy of Gerberovia recently had a nominal
interest rate of 300% and an inflation rate of 280%. Please
calculate the inflation rate using approximate and exact formulas.
Example
• Burrows Publishing has just purchased the rights to the next book
of famed romantic novelist Barbara Musk. Still unwritten, the
book should be available to the public in four years. Currently,
romantic novels sell for $10.00 in softcover. The publishers believe
that inflation will be 6 percent a year over the next four years.
Since romantic novels are so popular, the publishers anticipate
that the prices of romantic novels will rise about 2 percent per
year more than the inflation rate over the next four years.
• Calculate the price of the book.
• The firm anticipates selling 100,000 copies. Calculate the
expected real cash flow from the sales.
Discounting: Nominal or Real?
• Nominal cash flows must be discounted at the nominal rate.
• Real cash flows must be discounted at the real rate.

• Example
• Shields Electric forecasts the following nominal cash flows on a
particular project:

• The nominal interest rate is 14 percent, and the inflation rate is forecast
to be 5 percent. What is the value of the project (NPV)?
Treat Inflation Consistently

• Suppose your firm usually forecasts cash flows in nominal terms and
discounts at a 15 percent nominal rate.
• It would be inconsistent to discount these real cash flows at 15
percent.
• You have two alternatives:
– Restate the cash flows in nominal terms and discount at 15 percent,
– Restate the discount rate in real terms and use it to discount the real cash flows
 Treat Inflation Consistently

• Assume that inflation is projected at 10 percent a year

• Then the cash flow for year 1, which is $35,000 in current dollars, will be…
– 35,000 x 1.1 = $38,500 in year-1 dollars.

• Similarly the cash flow for year 2 will be

– 50,000 x 1.12 = $60,500 in year-2 dollars, and so on.
 Treat Inflation Consistently
• Instead of converting the cash-flow forecasts into nominal terms,
we could convert the discount rate into real terms by using the
following relationship:

1.15
• Real discount rate = − 1 = 0.045 = 4.5%
1.1