Finance Basics

Rania A. Azmi
E-mail: rania.a.azmi@gmail.com
University of Alexandria, Department of Business Administration

1
 Finance

• Finance can be thought of as the study of the

following three questions:

1- In what long-lived assets should the firm invest?

2- How can the firm raise cash for required capital
expenditures?
3- How should short-term operating cash flows be
managed?
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Financial Statement Analysis

• The objective is to show how to

rearrange information from financial
statements into financial ratios that
provide information about five areas of
financial performance:

3
Financial Statement Analysis (Cont.)

1. Short-term solvency
2. Activity
3. Financial Leverage
4. Profitability
5. Value

4
Short-Term Solvency

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 Short-Term Solvency

• Ratios of short-term solvency measure

the ability of the firm to meet recurring
financial obligations (that is, to pay its
bills).

• The most widely used measures of

accounting liquidity are the current ratio
and the quick ratio.
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 Short-Term Solvency

• Current ratio= Total current

assets/ Total current liabilities

• Quick ratio= *Quick assets/ Total

current liabilities

* Quick assets= Total current assets- inventories

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Activity

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 Activity

• Ratios of activity are constructed

to measure how effectively the
firm’s assets are being managed.

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 Activity

• Total asset turnover= Total

operating revenues/ Total assets

• This ratio is intended to indicate how

effectively a firm is using all of its
assets. If the asset turnover ratio is
high, the firm is presumably using its
assets effectively in generating sales.
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 Activity

• Receivables Turnover= Total

operating revenues/ Receivables

• Average collection period= Days

in period(365)/ Receivables
turnover
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• The receivables turnover ratio and the average
collection period provide some information on
the success of the firm in managing its
investment in accounts receivable.

• The actual value of these ratios reflects the firm’s

credit policy. If a firm has a liberal credit policy,
the amount of its receivables will be higher than
would otherwise be the case.

• One common rule of thumb that financial

analysts use is that the average collection period
of a firm should not exceed the time allowed for
payment in the credit terms by more than 10
days. 12
 Activity

• Inventory Turnover= Cost of goods

sold/ Inventory

• The inventory ratio measures how quickly

inventory is produced and sold. It is
significantly affected by the production
technology of goods being manufactured.
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Financial Leverage

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 Financial Leverage

• Financial leverage is related to the extent to

which a firm relies on debt financing rather
than equity.

• Measures of financial leverage are tools in

determining the probability that the firm will
default on its debt contracts. The more debt a
firm has, the more likely it is that the firm will
become unable to fulfill its contractual
obligations (too much debt can lead to a higher
probability of insolvency and financial
distress).
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 Financial Leverage

• Debt ratio= Total debt/ Total assets

• Debt-to-equity ratio= Total debt/

Total equity

• Equity multiplier= Total assets/ Total

equity
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 Financial Leverage

• Debt ratios provide information

about protection of creditors from
insolvency and the ability of firms to
obtain additional financing for
potentially attractive investment
opportunities.

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 Financial Leverage

• Interest Coverage= Earnings before

interest and taxes/ Interest expense

• Interest expense is an obstacle that a firm

must surmount if it is to avoid default. The
ratio of interest coverage is directly
connected to the ability of the firm to pay
interest.
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Profitability

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 Profitability

• Profitability ratios measure the extent to

which a firm is profitable.

• The most important conceptual problem

with accounting measures of profitability
is they do not give us a benchmark for
making comparisons.

• In general, a firm is profitable in the

economic sense only if its profitability is
greater than investors can achieve on their
own in the capital markets. 20
 Profitability

• Net profit margin= Net income/ Total

operating revenues

• Gross profit margin= Earnings

before interest and taxes/ Total
operating revenues

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 Profit Margins

• In general, profit margins reflect the

firm’s ability to produce a product or
service at a low cost or a high price.

• Profit margins are not direct measures of

profitability because they are based on
total operating revenue, not on the
investment made in assets by the firm or
the equity investors.

• Trade firms tend to have low margins and

service firms tend to have high margins. 22
 Profitability

• Net Return on Assets= Net income/

Average total assets

• Gross return on assets= Earnings

before interest and taxes/ Average
total assets

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 Profitability

• One of the most interesting aspects of

return on assets (ROA) is how some
financial ratios can be linked together
to compute ROA. One implication of
this is usually referred to as the
DuPont system of financial control.

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 Profitability

• Return on Equity (ROE)=

Net income/ Average stockholders’
equity

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 Profitability

ROE= Profit margin * Asset turnover * Equity multiplier

= (Net income/ TOR* ) * (TOR/ ATA * *) * (ATA/ ASE* * * )

* TOR: Total Operating Revenue

** ATA: Average Total Assets
*** ASE: Average stockholders’ equity

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Value

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 Value

• One very important characteristic of

a firm that cannot be found on an
accounting statement is its market
value.

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 Value

1- Market price
2- Price-to-earnings (P/E) ratio
3- Dividend Yield
4- Market-to-book (M/B) value ratio

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 Value

1- Market price: The market price of a

share of common stock is the price that
buyers and sellers establish when they
trade the stock. The market value of the
common equity of a firm is the market
price of share of common stock
multiplied by the number of shares
outstanding.
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 Value

2- Price-to-earnings (P/E) ratio: One way

to calculate the P/E ratio is to divide the
current market price by the earnings per
share of common stock for the latest
year.

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 Value

3- Dividend Yield= Dividends per share/

Market price per share.

Dividends yields are related to the

market’s perception of future growth
prospects for firms. Firms with high
growth prospects will generally have
lower dividend yields.
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 Value

4- Market-to-book (M/B) value ratio:

It is calculated by dividing the market

price per share by the book value per
share.

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 Conclusions

Accounting statements provide important

information about the value of the firm.

Financial analysts and mangers learn how

to rearrange financial statements to
squeeze out the maximum amount of
information.
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 Conclusions (Cont.)

You should keep in mind the following points

when trying to interpret financial statements:

1- Measures of profitability such as return on equity

suffer from several potential deficiencies as
indicators of performance. They do not take into
account the risk or timing of cash flows.

2- Financial ratios are linked to one another. For

example, return on equity is determined from the
profit margins, the asset turnover ratio, and the 35
financial leverage.