Introduction to Financial Management

Why FM?
- To make right choice so as to create value subsequently when implementing business
activities.
Objectives:
- To maximize firm value
- “good” = increase stock price (vice versa)

Financial decision:

Investment decisions - How much to invest?

- Which project?
Working Capital Decisions - Level of investment in current asset?
- How to manage short-term assets &
liabilities?
Financing Decisions - How to finance it?
- The optimal debt/equity ratio?
Distribution decisions - How much dividend to pay?

Business firm types:

Sole proprietorship Advantages:

- Simplest
- The least regulated form
- Owner keeps all profit
Disadvantage:
- Unlimited liability
- Limited capital sources
- Difficult to transfer ownership
Partnership General partnership (GP):
- All have unlimited liabilities
- share gains & losses under
partnership agreement
Limited partnership:
- 1 or more GP. run the business
- not actively participating
- liabilities = contributions
Advantages:
- informal agreement-> easy &
inexpensive
Disadvantages:
- terminates when GP wish to sell
(limited life)
- uneasy ownership transfer
- hard to find a partner to sell interest
Corporation - distinct legal entity owned by 1 or
more individual or entities
- more of rights, duties, privileges
 - can borrow money & own property,
can sue & be sued, can enter into
contracts
Advantages:
- limited liability
- easier ownership transferring
(separation of ownership & MGT)
- easier to raise capital
Disadvantages:
- agency problem (separation of
ownership & MGT)
- double taxation

Possible agency problems (owner & outsourced managers):

Career concern - mg.er being reluctant to take risk in

order not to lose their job
Empire building - mg.er tend to max. the amount of
resources over wt. they hv control
- intend to over expand to demonstrate
corporate power
Private benefits of control - mg.er use inside info. for personal
trading
- overuse corporate resources for
personal uses
Shirking - mg.er not putting their best effort
 Financial Statement Analysis

Balance sheet:
 Assets: future economic benefits are expected Net working capital=
(Current: has life less than a year e.g., Inventory) current asset - current
liabilities
(in/tangible Fixed: longer life e.g., building) Too little: unable to pay
 Liabilities: Currentmoney that have to pay within a bills
year Too much: reduce
Long-termdebt due after 1 year profitability (carry cost)
 Equity: Capital stockinitial investment
Retained earning earnings after tax & losses that are retained
 Financial leverage: use of debt in acquiring an asset (more debtgreater degree)

*Assets = Liabilities + Equity

Income statement:
 *Revenues – Expenses = Income
 Taxes: averagetotal taxes paid/ total taxable income
Marginalamount of tax payable on the next dollar earned

Cash Flow:
1. Cash flow from asset = Operate cash flow – Net capital spending – Change in net
working capital
2. Cash flow to creditors = interest paid – Net new borrowing
3. Cash flow to shareholders = dividend paid – Net new equity raised

*(1) = (2) + (3)

Operate cash flow = Earnings before interest & taxes + depreciation – taxes /
= sales – cost-taxes /
= net income + depreciation /
= (sales-cost) *(1-tax%) + depreciation*tax%
Net capital spending = end.net fixed asset – Beg.net fixed asset + depreciation
Net new borrowing = new (long term) debt – old (long term) debt
Net new equity raised = new – old common stock & paid in surplus
Depreciation= (initial cost-salvage) ÷ no. of yrs.
Book value= initial cost – accumulated depreciation
After tax salvage= salvage – tax%*(salvage – book value)

Liquidity ratios:

Current Ratio Current asset÷ current - Higher = more

liabilities
Quick ratio (acid-test (Current assets – inventory)
ratio) ÷ current liabilities
Cash ratio Cash÷ Current liabilities
protection
- Measure the ability
of a firm extinguish
current liabilities
using “near-cash”
assets
A ratio that short-term

Solvency ratios:
Total debt ratio
Times interest earned ratio
Cash coverage ratio
Debt-equity ratio
Asset management ratios:
Inventory turnover
Day’s sales in inventory
Receivables turnover
Average collection period
Asset turnover
Profitability ratios:
Profit margin
Return on assets (ROA)
Return on equity (ROE)
Market value ratios:
Earnings per share (EPS)
Price-earnings ratio (PE)
Price-sales ratio
Market-to-book ratio (MB)
Total liabilities÷ Total assets
Earning before interest &
taxes (EBIT) ÷ interest
(EBIT + depreciation) ÷
interest
Total liabilities÷
shareholder’s equity
COGS÷ Inventory
365÷ inventory turnover
Sales÷ account receivable
365÷ receivables turnover
Sales÷ total assets
Net income÷ sales
Net income÷ total assets
Net income÷ total equity
Net income÷ share
outstanding
Price per share÷ earnings per
share
Price per share÷ sales per
share
Market value per share÷
book value per share
creditor will be interested
Indication of total assets
financed by credit sources &
relative mix of funds
provided
Extent of operating profit
can be declined to pay
interest on long-term debt
Ability to cover cash
outflow for interest
/
How fast inventory items
move through a business
Avg. length of time items
spend in inventory
How fast credit sales are
collected
Avg. days needed to collect
Efficiency of using assets to
generate sales
/
/
ROE>ROA= the use of
financial leverage
/
How much investors are
willing to pay per dollar in
current earnings
Can be used when firm
report -ve. earnings
<1 could mean not
successful in creating value
 (t.equity÷ no. of shares
outstanding)
Linking ratios:

ROA Profit margin*asset turnover

ROE Profit margin*asset turnover*equity multiplier (total asset÷
total equity)

Sustainable growth (g):

= return on equity(ROE)*retention rate(b)
 Market efficiency

Characteristics associated with +ve NPVs:

- Economies of scale
- Product differentiation
- Cost advantages
- Access to distribution channels
- Favorable government policy

Zero NPV:
- Equity issued by firm is fairly priced
- Investors are willing to pay a price at or lower than the price of the ownership
- Firms are willing to sell at or higher than the price of the ownership
- The price eventually settled at the priceboth make zero NPV

Efficient capital markets:

- Stock prices fully reflect available info.
- Info. Is widely available to investors and reflected in security prices

Implications of efficient market hypothesis:

- Returns are just sufficient to compensate them for the time value/ the risk they bear
- Investors hope for high return
- Future prices differ from current prices only if buyers/ sellers get new info.

Forms of market efficiency:

Weak form - Stock prices reflect all info. (past$

and volume)
- Stock price movements are
independent of what in the past
- Cannot predict future movement
Semi-strong form - Stock prices reflect all publicly
available info. (= historic prices
&published accounting statement)
- Impossible to make consistent
superior returns
- profit opportunities disappear before
they are publicly known
Strong form - Stock prices reflect all public and
private info.
- Impossible to make consistent
superior returns (beat the market)