FUNDAMENTAL

CONCEPT OF FINANCIAL
MANAGEMENT
Strategic Financial Management

Topic # 1

Fundamental Concept of Financial Management

Financial management in a business means planning and directing the use of
the companys financial resources -- the cash it generates through its
operations and the capital obtained from investors or lenders. Although a
company may have an accounting staff or an outside accounting firm to
provide financial guidance, financial management is one of the most important
aspects of the business owners job.
Cash Management
A goal of the cash management function is to make certain the business
enterprise always has the resources it needs to meet its financial
obligations on time. A cash deficit compared to what the owner forecast
can cause serious harm to the companys image and operations. For
example, the company may not be able to fill an important order because
it cannot pay for the raw materials needed to make the products.
Managing accounts receivable and accounts payable is part of effective
cash management. The business owner wants to make certain he is
collecting all the funds due the company -- the accounts receivable -- as
quickly as he can. Conversely, he seeks to stretch out the time he takes
to pay bills from outside vendors. In doing so, he doesnt want the
company to get a reputation for paying so slowly that his suppliers insist
on strict terms such as payment upon delivery.
Planning and Forecasting
The financial management aspect of planning involves accurately
forecasting the companys revenues, expenses and resulting net profit.
The business owner uses the forecast -- sometimes called a budget -- as
a tool to manage the company. Significant negative variances to forecast
indicate that the business environment and his companys performance
in the marketplace were not what he assumed they would be when he
created his annual plan. Analyzing these variances focuses his attention
on changes he needs to make to his strategies or operations to get the
company back on course to reaching its goals.
Financial Reporting

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A business owner and his management team require timely and accurate
reports in order to make decisions and run the company effectively. The
staff members responsible for financial management must determine the
key pieces of information the owner and his team need for decision
making. They then design reports to provide this information in a format
that is most useful to the management team. The most significant
metrics vary by the type of company. A hotel owner, for example, keeps a
close eye on occupancy -- the percentage of rooms used. A decline in
occupancy compared to the same month in the previous year would
prompt investigation by the financial staff into whether this was due to
unusual circumstances such as bad weather or indicative of competitors
taking business away from the hotel.
Capital Structure
Startup companies often need to obtain outside capital from wealthy
individuals or venture capital firms in order to fund the company until it
reaches the breakeven point. As the company grows, it may need
additional infusions of capital to fund expansion. The financial
management function determines the best form of capital for the venture
-- debt, equity or a combination -- how much is required and when it is
needed. Larger companies with stable cash flow can borrow funds from
financial institutions rather than having to give up an equity share to
investors in order to get the capital the company requires.
Basic Forms of Business Organization
It is important that the business owner seriously considers the different forms
of business organizationtypes such as sole proprietorship, partnership, and
corporation. Which organizational form is most appropriate can be influenced
by tax issues, legal issues, financial concerns, and personal concerns.
Sole Proprietor
A Sole Proprietorship consists of one individual doing business. Sole
Proprietorships are the most numerous form of business organization, however
they account for little in the way of aggregate business receipts.
Advantages
Ease of formation and dissolution. Establishing a sole
proprietorship can be as simple as printing up business cards
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or hanging a sign announcing the business. Taking work as a

contract carpenter or freelance photographer, for example, can
establish a sole proprietorship. Likewise, a sole proprietorship is
equally easy to dissolve.

Typically, there are low start-up costs and low operational

overhead.

Ownership of all profits.

Sole Proprietorships are typically subject to fewer regulations.

No corporate income taxes. Any income realized by a sole

proprietorship is declared on the owner's individual income tax
return.

Disadvantages
Unlimited liability. Owners who organize their business as a
sole proprietorship are personally responsible for the obligations
of the business, including actions of any employee representing
the business.

Limited life. In most cases, if a business owner dies, the

business dies as well.

It may be difficult for an individual to raise capital. It's common

for funding to be in the form of personal savings or personal
loans.

The most daunting disadvantage of organizing as a sole proprietorship is the

aspect of unlimited liability. An advantage of a sole proprietorship is filing taxes
as an individual rather than paying corporate tax rates. Some hybrid forms of
business organization may be employed to take advantage of limited liability
and lower tax rates for those businesses that meet the requirements.
Partnership
A Partnership consists of two or more individuals in business together.
Partnerships may be as small as mom and pop type operations, or as large as
some of the big legal or accounting firms that may have dozens of partners.
There are different types of partnershipsgeneral partnership, limited
partnership, and limited liability partnershipthe basic differences stemming
around the degree of personal liability and management control.
Advantages
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Synergy. There is clear potential for the enhancement of value

resulting from two or more individuals combining strengths.

Partnerships are relatively easy to form, however, considerable

thought should be put into developing a partnership agreement
at the point of formation.

Partnerships may
corporations.

There is stronger potential of access to greater amounts of

capital.

No corporate income taxes. Partnerships declare income by

filing a partnership income tax return. Yet the partnership pays
no taxes when this partnership tax return is filed. Rather, the
individual partners declare their pro-rata share of the net
income of the partnership on their individual income tax
returns and pay taxes at the individual income tax rate.

be

subject

to

fewer

regulations

than

Disadvantages
Unlimited liability. General partners are individually responsible
for the obligations of the business, creating personal risk.

Limited life. A partnership may end upon the withdrawal or

death of a partner.

There is a real possibility of disputes or conflicts between

partners which could lead to dissolving the partnership. This
scenario enforces the need of a partnership agreement.

As pointed out, unlimited liability exists for partnerships just as for sole
proprietorships. One way to alleviate this risk is through Limited Liability
Partnerships (LLP's). As with LLC's, LLP's may offer some tax advantages while
providing some risk protection for owners.
Corporation
A corporation is a legal entity doing business, and is distinct from the
individuals within the entity. Public corporations are owned by shareholders
who elect a board of directors to oversee primary responsibilities. Along with
standard, for-profit corporations, there are charitable, not-for-profit
corporations.
Advantages
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Unlimited commercial life. The corporation is an entity of its

own and does not dissolve when ownership changes.

Greater flexibility in raising capital through the sale of stock.

Ease of transferring ownership by selling stock.

Limited liability. This limited liability is probably the biggest

advantage to organizing as a corporation. Individual owners in
corporations have limits on their personal liability. Even if a
corporation is sued for billions of dollars, individual
shareholder's liability is generally limited to the value of their
own stock in the corporation.

Disadvantages
Regulatory restrictions. Corporations are typically more closely
monitored by governmental agencies, including federal, state,
and local. Complying with regulations can be costly.

Higher organizational and operational costs. Corporations have

to file articles of incorporation with the appropriate state
authorities. These legal and clerical expenses, along with other
recurring operational expenses, can contribute to budgetary
challenges.

Double taxation. The possibility of double taxation arises when

companies declare and pay taxes on the net income of the
corporation, which they pay through their corporate income tax
returns. If the corporation also pays out dividends to individual
shareholders, those shareholders must declare that dividend
income as personal income and pay taxes at the individual
income tax rates. Thus, the possibility of double taxation.

Business Cycle and Yield Curves

The Yield Curve indicates what investors expect rates to be in the future. In
relation to the business cycle, you could predict a recession/recovery by
examining what the future spot rates will be in comparison to today's spot rate.
For example, suppose a 5yr Treasury Bill produces a yield of 5% that's issued
today. Also suppose there's 10yr Treasury Bill issued at 2% that is also issued
today. According to Unbiased Expectations theory,, rates on a long-term
instrument are equal to the geometric mean of the yield on a series of short11 | P a g e F u n d a m e n t a l C o n c e p t

term instruments. Therefore, investors predict that the price of the 20yr T-Bill
will increase (price and interest rates have an inverse relationship), and they
want to lock-in that rate now, because they suspect that rate may actually be
below 2%, and they want to maximize their gains. In essence, the example
provided would show how an economy is in a recession because expectations of
the future rates are declining. When rates are in decline, investors are buying
more T-bills. When rates increase, people are buying less T-Bills. Generally,
when investors are buying T-Bills, they're implementing a "flight to quality,"
meaning their confidence in other, higher yielding securities (like AA,A, BBB,
BB, etc... Corporate Bonds) has significantly diminished. If rates are expected
to increase in the future, then investors are suggesting a recovery in the
economy, at the very least an improvement. When investors are switching to
these riskier securities, like corporate bonds, they are implementing a concept
known as "reach for yield." We can observe this when we see interest rates of
securities falling, because they're being purchased.
Time Value of Money
The idea that money available at the present time is worth more than the same
amount in the future due to its potential earning capacity. This core principle
of finance holds that, provided money can earn interest, any amount of money
is worth more the sooner it is received.
Some standard calculations based on the time value of money are:

Present value: The current worth of a future sum of money or stream of

cash flow, given a specified rate of return. Future cash flows are
"discounted" at the discount rate; the higher the discount rate, the lower
the present value of the future cash flows. Determining the appropriate
discount rate is the key to valuing future cash flows properly, whether
they be earnings or obligations.

Present value of an annuity: An annuity is a series of equal payments or

receipts that occur at evenly spaced intervals. Leases and rental
payments are examples. The payments or receipts occur at the end of
each period for an ordinary annuity while they occur at the beginning of
each period for an annuity due.

Present value of a perpetuity is an infinite and constant stream of

identical cash flows.

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Future value: The value of an asset or cash at a specified date in the

future, based on the value of that asset in the present.

Future value of an annuity (FVA): The future value of a stream of

payments (annuity), assuming the payments are invested at a given rate
of interest.

The following table summarizes the different formulas commonly used in

calculating the time value of money.[8]
Find

Given

Formula

Future value (F) Present value (P)

Present value (P) Future value (F)
Repeating
payment (A)

Future value (F)

Repeating
payment (A)

Present value (P)

Future value (F) Repeating payment (A)

Present value (P) Repeating payment (A)
Future value (F) Gradient payment (G)
Present value (P) Gradient payment (G)
Fixed
(A)

payment

Gradient payment (G)

Future value (F) Exponentially

payment (D)

increasing

Increasing percentage (g)

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(for i g)

(for i = g)

Present value (P)

Exponentially
payment (D)

increasing

Increasing percentage (g)

(for i g)
(for i = g)

Notes:

A is a fixed payment amount, every period

G is a steadily increasing payment amount, that starts at G and

increases by G for each subsequent period.

D is an exponentially or geometrically increasing payment amount, that

starts at D and increases by a factor of (1+g) each subsequent period.

Financial Statements and Cash Flows

Financial statements present the results of operations and the financial
position of the company. Four statements are commonly prepared by publiclytraded companies: balance sheet, income statement, cash flow statement and
statement of changes in equity.
Balance Sheet (Statement of Financial Position)
The Balance Sheet tells you whether the company can pay its bills on time, its
financial flexibility to acquire capital and its ability to distribute cash in the
form of dividends to the company's owners.
Balance sheet data can be used to compute key indicators that reveal the
company's financial structure and its ability to meet its obligations. These
include working capital, current ratio, quick ratio, debt equity ratio and debt to
capital ratio.
Income Statement
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The income statement (also known as the profit and loss statement or P&L)
tells you both the earnings and profitability of a business. The P&L is always
for a specific period of time, such as a month, a quarter or a year.
Income statement is used to compute the key profitability ratios of gross
margin, operating margin, and pretax margin that help readers assess the
ability of the company to generate income from its activities. Results from
continuing operations are of primary interest because they are ongoing and
can be predictive of future earnings; investors put less weight on discontinued
operations (which are about the past) and extraordinary items (unusual and
infrequent, thus unlikely to reoccur).
Statement of Changes in Owners Equity
A separate Statement of Changes in Stockholders' (or Owners) Equity is also
prepared that reconciles the various components of OE on the balance sheet
for the start of the period with the same items at the end of the period. The
statement recognizes the primacy of OE for investors and other readers of
financial
statements.
Statement of Cash Flows
The cash flow statement tells you the sources and uses of cash during the
period (in fact, the term "sources and uses statement" is a synonym). It also
provides information about the company's investing and financing activities
during the period.
Under accrual accounting and the matching principle, accountants seek to
record economic events regardless of when cash is actually received or used,
with a view toward matching the revenues for the period with the costs
incurred to generate them. But in addition to financial statements that include
accounting entries that are theoretical in nature, users are vitally interested in
the actual cash received and disbursed during the period. In fact, depending
on the company and the user, the cash flow statement may be of prime
importance. Like the income statement, the statement of cash flows is always
for some period of time.

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There are two methods for preparing the cash flow statement, direct and
indirect. Using the direct method, the accountant shows the items that affected
cash flow, such as cash collected from customers, interest received, cash paid
to suppliers, etc. The indirect method adjusts net income for any revenue and
expense item that did not result from a cash transaction.
Analysis of Financial Statements
Financial statement analysis (or financial analysis) is the process of reviewing
and analyzing a company's financial statements to make better economic
decisions. These statements include the income statement, balance sheet,
statement of cash flow, and a statement of retained earnings. Financial
statement analysis is a method or process involving specific techniques for
evaluating risks, performance, financial health, and future prospects of an
organization.
It is used by a variety of stakeholders, such as credit and equity investors, the
government, the public, and decision-makers within the organization. These
stakeholders have different interests and apply a variety of different techniques
to meet their needs. For example, equity investors are interested in the longterm earnings power of the organization and perhaps the sustainability and
growth of dividend payments. Creditors want to ensure the interest and
principal is paid on the organizations debt securities (e.g., bonds) when due.
Common methods of financial statement analysis include fundamental
analysis, DuPont analysis, horizontal and vertical analysis and the use of
financial ratios. Historical information combined with a series of assumptions
and adjustments to the financial information may be used to project future
performance.
Horizontal and vertical analysis
Horizontal analysis compares financial information over time, typically from
past quarters or years. Horizontal analysis is performed by comparing financial
data from a past statement, such as the income statement. When comparing
this past information one will want to look for variations such as higher or
lower earnings.

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Vertical analysis is a proportional analysis of financial statements. Each line

item listed in the financial statement is listed as the percentage of another line
item. For example, on an income statement each line item will be listed as a
percentage of gross sales. This technique is also referred to as normalization or
common-sizing.
Financial ration Analysis
Financial ratios are very powerful tools to perform some quick analysis of
financial statements. There are four main categories of ratios: liquidity ratios,
profitability ratios, activity ratios and leverage ratios. These are typically
analyzed over time and across competitors in an industry.

Liquidity ratios are used to determine how quickly a company can turn its
assets into cash if it experiences financial difficulties or bankruptcy. It
essentially is a measure of a company's ability to remain in business. A
few common liquidity ratios are the current ratio and the liquidity index.
The current ratio is current assets/current liabilities and measures how
much liquidity is available to pay for liabilities. The liquidity index shows
how quickly a company can turn assets into cash and is calculated by:
(Trade receivables x Days to liquidate) + (Inventory x Days to
liquidate)/Trade Receivables + Inventory.

Profitability ratios are ratios that demonstrate how profitable a company

is. A few popular profitability ratios are the breakeven point and gross
profit ratio. The breakeven point calculates how much cash a company
must generate to break even with their start up costs. The gross profit
ratio is equal to (revenue - the cost of goods sold)/revenue. This ratio
shows a quick snapshot of expected revenue.

Activity ratios are meant to show how well management is managing the
company's resources. Two common activity ratios are accounts payable
turnover and accounts receivable turnover. These ratios demonstrate how
long it takes for a company to pay off its accounts payable and how long
it takes for a company to receive payments, respectively.

Leverage ratios depict how much a company relies upon its debt to fund
operations. A very common leverage ratio used for financial statement
analysis is the debt-to-equity ratio. This ratio shows the extent to which

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management is willing to use debt in order to fund operations. This ratio

is calculated as: (Long-term debt + Short-term debt + Leases)/ Equity.

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