Principle of finance

Principle of Finance

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Introduction to Managerial Finance


WHAT IS FINANCE ?

The science and art of managing money.

financial perspective

Personal level

business level

How much of earnings will spend. How much they save. How will invest the savings.

How firms raise money from investors. How firms invest money to earn a profit. How firms decide whether to reinvest profits in

the business or distribute it back to investors.

LEGAL FORMS OF BUSINESS ORGANIZATION

Sole ProprietorshipPartnership

Corporation


business owned by one person who operates it for his or her own profit

Sole Proprietorships

of all businesses are sole proprietorships,73%Such as a bike shop, personal

trainer.Advantag

eworking

independently unlimited liabilityWeaknesses

Unlimited liabilityGiving creditors the right to make claims against the owner’s personal assets to recover debts owed by the business.

Lacks continuity when

proprietor dies

Low organizational costs

Ease of dissolution


A business owned by two or more people and operated for profit.

Partnerships

of all businesses are partnerships,7%

Such as the finance, insurance, and real estate industries.

Advantage More available brain

power and managerial skill

unlimited liabilityWeaknesses

Partnership is dissolved when a

partner diesDifficult to liquidate or

transfer partnership

Borrowing power enhanced by more

owners


An entity created by law.

Corporation

of all businesses are partnerships,20%Advantag

eOwners have limited

liability, which guarantees that they cannot lose more than they

invested

Taxes generally higher

Weaknesses More expensive

to organize than other business

formsLacks secrecy because

regulations require firms to

disclose financial results

Long life of firm


Corporate Organization


Goal of the FirmMaximize shareholder wealth

(increase the share price).Corporations commonly measure profits in terms of

earnings per share (EPS), which represent the amount earned during the period on behalf of each outstanding

share of common stock.

Marginal cost–benefit analysisEconomic principle that states that financial decisions should be made and actions taken only when the added benefits exceed the added costs.

Accrual basisIn preparation of financial statements, recognizes revenue at the time of sale and recognizes expenses when they are incurred.

Cash basisRecognizes revenues and expenses only with respect to actual inflows and outflows of cash.

finance

emphasis on

Accounting

Financial Tools

Financial Tools

THE THREE KEY FINANCIAL STATEMENTS

Balance sheet

Income Statement

Statement of cash flows

provides a financial summary of the firm’s operating results during a specified period.

Summary statement of the firm’s financial position at a given point in time

Summary of the firm’s operating, investment, financing cash flows , reconciles them with changes in its cash and marketable securities during the period

Financial Tools

Income Statement

Income Statement

Sales revenueCOGS

xxx(xxx)

Gross profit xxx

Operating expenses Selling expensesGeneral and admin. ExpensesLease expenses Deprecation expenses

XxxXxxXxxXxx

Total operating expenses (xxx)

Operating Profit ( EBIT) xxx

Interest expense (xxx)

Net profit before taxes xxx

Taxes (xxx)

Net profit after taxes xxx

Preferred stock dividends (xxx)

Earning available for common stockholders xxx

Earning per share (EPS) xxx

Financial Tools

Income StatementExample

:

Financial Tools

Balance Sheets

Balance Sheet

AssetsCashMarketable SecuritiesInventoriesAccount Receivable Prepaid expenses

xxxxxxxxxxxxxxx

Total current assets xxx

Land and building VehiclesMachinery and equipmentFurniture and fixture

xxxxxxxxxxxx

Gross fixed assets xxx

Accumulative deprecation (xxx)

Net fixed assets xxx

Total assets xxx

Assets

Financial Tools

Balance Sheets

Balance Sheet

Liabilities and stockholders equityAccount payableNotes /Taxes /Accrued payableAccruals

xxxxxxxxx

Total current Liabilities xxx

Long term debts xxx

Total Liabilities xxx

Preferred stock xxx

Common stock xxx

Retained earnings xxx

Total stockholder equity xxx

Total Liabilities and stockholder equity xxx

Liabilities

Stockholder equity

Financial Tools

Balance SheetsExample

:

Financial Tools

Statement of cash flows

Cash Flow from Operating activates

Net profit after taxesDeprecation expenses Account receivable Inventories Account payableAccruals

xxxxxx

(increase xxx) or decrease xxx(increase xxx) or decrease xxxincrease xxx or (decrease xxx)increase xxx or (decrease xxx)

Cash provided by operating activates xxx

Cash flow from investment activates Gross fixed assets (increase xxx) or decrease xxx

Cash provided by investment activates xxx

Cash flow from financing activates Note payableLong term debts Dividends paid

increase xxx or (decrease xxx)increase xxx or (decrease xxx)

(xxx)

Cash provided by financing activates xxx

Net increase/decrease in cash and marketable secu. xxx

Financial Tools

Statement of cash flows Example

:

Financial Tools

Using Financial RatiosRatio AnalysisInvolves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance.

A firm’s ability to satisfy its short-term obligations as they come due.Current ratioA measure of liquidity calculated by dividing the firm’s current assets by its current liabilities.

liquidity

Current ratio =Current assets

Current liabilitiesA higher current ratio indicates a greater degree of liquidity.

Activity RatiosMeasure the speed with which various accounts are converted into sales or cash inflows or outflows.Inventory Turnover

A measure of liquidity calculated by dividing the firm’s current assets by its current liabilities. Inventory turnover =

Cost of goods sold Inventory

The resulting is meaningful only when it is compared with other firms in the same industry or to the firm’s past inventory turnover.

Financial Tools

Using Financial Ratios

Average collection periodThe average amount of time needed to collect accounts receivable.

Average collection period =Accounts receivable

Annual sales365

The average collection period is meaningful only in relation to the firm’s credit terms.

Average payment periodThe average amount of time needed to pay accounts payable.

Average payment period =Accounts payable

Annual purchases365

This figure is meaningful only in relation to the average credit terms extended to the firm.

Debt RatioMeasures the proportion of total assets financed by the firm’s creditors.

Debt ratio =Total liabilitiesTotal assets

The higher this ratio, the greater the amount of other people’s money beingused to generate profits.

Financial Tools

Using Financial Ratios

Profitability RatiosThere are many measures of profitability. As a group, these measures enable analysts to evaluate the firm’s profits with respect to a given level of sales, a certain level of assets, or the owners’ investment.

Gross profit marginMeasures the percentage of each sales dollar remaining after the firm has paid for its goods.

gross profit margin = Sales - Cost of goods

sold Sales

EARNINGS PER SHARE (EPS)Measures the percentage of each sales dollar remaining after the firm has paid for its goods.

gross profit margin = Sales - Cost of goods

sold Sales

CASH FLOWS

Cash Flows

Classifying Inflows and Outflows of Cash

Operating Flows

Investment Flows

Financing Flows

Cash flows directly related to sale and production of the firm’s products and services.

Cash flows associated with purchase and sale of both fixed assets and equity investments in other firms.

Cash flows that result from debt and equity financing transactions; include incurrence and repayment of debt, cash inflow from the sale of stock, and cash outflows to repurchase stock or pay cash dividends.

The firm’s cash flows fall into three categories: (1) operating flows, (2) investment flows, and (3) financing flows.

Inflows and Outflows of Cash

Cash Flows

Preparing the Statement of Cash Flows

Sources Income Statement

Balance Sheets

Cash Flows

Preparing the Statement of Cash Flows

Cash FlowsSourcesIncome

StatementIncome StatementBalance Sheets

Balance SheetsBalance SheetsBalance Sheets

Balance Sheets

Balance SheetsBalance Sheets

Financial Planning

Financial Planning

Financial planning processPlanning that begins with long term, or strategic, financial plans that in turn guide the formulation of short-term, or operating, plans and budgets.

Financial planning process’ key aspects

Cash planning

Profit planning

Involves preparation of the firm’s cash budget.Involves preparation of pro forma statements.

long-term (strategic) financial plans

Short-term (operating) financial plansPlans that lay out a company’s

planned financial actions and the anticipated impact of those

actions over periods ranging from 2 to 10 years.

Specify short-term financial actions and the anticipated impact of those actions, that most often

cover a 1- to 2-year period.Fixed assets, research and

developmentactivities, marketing and product

development actions, capital structure, and major sources of

financing.

Focu s Sales forecast, production plans,

estimate direct labor requirements, factory overhead

outlays, and operating expenses. Fo

cu s

(Forecasting)

(Accrual)

Financial Planning

The short-term (operating) financial planning process

Short-term financial planning begins with the sales forecast. From it, companies develop production plans that take into account lead (preparation) times and include estimates of the required raw materials. Using the production plans, the firm can estimate direct labor requirements, factory overhead outlays, and operating expenses. Once these estimates have been made, the firm can prepare a pro forma income statement and cash budget. With these basic inputs, the firm can finally develop a pro forma balance sheet.

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A statement of the firm’s planned inflows and outflows of cash that is used to estimate its short-term

cash requirements.

cash

bu

dget

The prediction of the firm’s sales over a given period, based on external and/or internal data; used as the key input to the short-term financial planning

process.

sale

s fo

reca

st

Economy & Finance

Principle of finance