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Financial Management: An Introduction


Columban College

1st Semester AY 2011-12


The following slides are benchmarked from Prof. Joel Yu of University of the Philippines Diliman.

Outline
Finance: Overview Financial Statements Financial Ratio Analysis Financial Planning
Main Reference: Gitman, Lawrence, Principles of Managerial Finance, 12th edition

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Finance: An Overview
What is Finance? Major Areas in Finance Finance & Economics Finance & Accounting Goal of the firm

What is Finance?

Finance is the art and science of managing money. At the macro level, finance studies financial institutions and markets and how they operate within the financial system. At the micro level, finance covers financial planning, asset management, and fund raising for businesses and financial institutions.

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What is Finance?

Source: Gitman, Lawrence, Principles of Managerial Finance, 12th edition

What is Finance?

Source: Gitman, Lawrence, Principles of Managerial Finance, 12th edition

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Major Areas & Opportunities in Finance


Financial Services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and government. Career opportunities include banking, personal financial planning, investments, real estate, and insurance.

Major Areas & Opportunities in Finance


Managerial finance is concerned with the duties of the financial manager in the business firm. The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit. They are also more involved in developing corporate strategy and improving the firms competitive position.

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The Managerial Finance Function: Relationship to Economics The field of finance is actually an outgrowth of economics. In fact, finance is sometimes referred to as financial economics. Financial managers must understand the economic framework within which they operate in order to react or anticipate to changes in conditions.

The Managerial Finance Function: Relationship to Economics (cont.) The primary economic principle used by financial managers is marginal cost-benefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs.

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The Managerial Finance Function: Relationship to Accounting The firms finance (treasurer) and accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions.

The Managerial Finance Function: Relationship to Accounting (cont.) One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows. The significance of this difference can be illustrated using the following simple example.

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The Managerial Finance Function: Relationship to Accounting (cont.) The Nassau Corporation experienced the following activity last year:
Sales Costs $100,000 (1 yacht sold, 100% still uncollected) $ 80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under the accounting method versus the cash method.

The Managerial Finance Function: Relationship to Accounting (cont.)


INCOME STATEMENT SUMMARY ACCRUAL Sales Less: Costs Net Profit/(Loss) $100,000 (80,000) $ 20,000 $ CASH 0 (80,000) $(80,000)

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The Managerial Finance Function: Relationship to Accounting (cont.) Finance and accounting also differ with respect to decision-making. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decisionmaking purposes. The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.

Goal of the Firm: Maximize Profit???


Which Investment is Preferred?
Earnings per share (EPS) Investment Rotor Valve $ $ Year 1 1.40 $ 0.60 $ Year 2 1.00 $ 1.00 $ Year 3 0.40 $ 1.40 $ Total (years 1-3) 2.80 3.00

Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.

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Goal of the Firm: Maximize Shareholder Wealth!!!


Why? Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows. This can be illustrated using the following simple stock valuation equation: level & timing of cash flows risk of cash flows

Share Price

Future Dividends Required Return

Goal of the Firm: Maximize Shareholder Wealth!!! (cont.)

The process of shareholder wealth maximization can be described using the following flow chart:
Figure 1.3 Share Price Maximization

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Goal of the Firm: What About Other Stakeholders?


Stakeholders include all groups of individuals who have a direct economic link to the firm including employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of its stakeholders. Such a view is considered to be "socially responsible."

The Agency Issue: The Agency Problem


Whenever a manager owns less than 100% of the firms equity, a potential agency problem exists. In theory, managers would agree with shareholder wealth maximization. However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. This would cause managers to act in ways that do not always benefit the firm shareholders.

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The Agency Issue: Resolving the Problem Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. Agency Costs are the costs borne by stockholders to maintain a corporate governance structure that minimizes agency problems and contributes to the maximization of shareholder wealth.

The Agency Issue: Resolving the Problem (cont.) Examples would include bonding or monitoring management behavior, and structuring management compensation to make shareholders interests their own. A stock option is an incentive allowing managers to purchase stock at the market price set at the time of the grant.

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The Agency Issue: Resolving the Problem (cont.) Performance plans tie management compensation to measures such as EPS growth; performance shares and/or cash bonuses are used as compensation under these plans. Recent studies have failed to find a strong relationship between CEO compensation and share price.

Financial Statements
Income Statement Balance Sheet Statement of R/E Cash Flow Statement

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Financial Statements
Income Statement
The income statement provides a financial summary of a companys operating results during a specified period. Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

Financial Statements

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Financial Statements
Balance Sheet
The balance sheet presents a summary of a firms financial position at a given point in time. Assets indicate what the firm owns, equity represents the owners investment, and liabilities indicate what the firm has borrowed.

Financial Statements

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Financial Statements

Financial Statements
Statement of Retained Earnings
The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

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Financial Statements

Financial Statements
Cash Flow Statement
The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. This statement not only provides insight into a companys investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

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Financial Statements

Financial Ratio Analysis


Types of ratio comparisons An example Dupont system of analysis Cautions for doing financial ratio analysis

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Financial Ratio Analysis

Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firms financial condition and performance. It is of interest to shareholders, creditors, and the firms own management.

Financial Ratio Analysis Types of Ratio Comparisons

Trend or time-series analysis

Used to evaluate a firms performance over time

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Financial Ratio Analysis Types of Ratio Comparisons


Trend or time-series analysis Cross-sectional analysis

Used to compare different firms at the same point in time

Financial Ratio Analysis Types of Ratio Comparisons


Trend or time-series analysis Cross-sectional analysis Industry comparative analysis

One specific type of cross sectional analysis. Used to compare one firms financial performance to the industrys average performance

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Financial Ratio Analysis Types of Ratio Comparisons


Trend or time-series analysis Cross-sectional analysis Industry comparative analysis

Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis

Financial Ratio Analysis

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Financial Ratio Analysis

Source: Gitman, Lawrence, Principles of Managerial Finance, 12th edition

Financial Ratio Analysis: An Example

Using the Bartlett Company Financial Statements

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Liquidity Ratios
Current Ratio Current ratio = total current assets total current liabilities $1,233,000 = 1.97 $620,000

Current ratio

Liquidity Ratios

Quick Ratio = Total Current Assets - Inventory total current liabilities = $1,233,000 - $289,000 = 1.51 $620,000

Quick ratio

Quick ratio

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Activity Ratios

Inventory Turnover

Inventory Turnover = Cost of Goods Sold Inventory Inventory Turnover = $2,088,000 = 7.2 $289,000

Activity Ratios

Average Collection Period

ACP = Accounts Receivable Net Sales/365 ACP = $503,000 = 59.7 days $3,074,000/365

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Activity Ratios

Average Payment Period

APP =

Accounts Payable Annual Purchases/365 $382,000 = 95.4 days (.70 x $2,088,000)/365

APP =

Activity Ratios

Total Asset Turnover = Net Sales Total Assets

Total Asset Turnover

Total Asset Turnover

= $3,074,000 = .85 $3,579,000

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Financial Leverage Ratios

Debt Ratio

Debt Ratio = Total Liabilities/Total Assets Debt Ratio = $1,643,000/$3,597,000 = 45.7%

Financial Leverage Ratios

Times Interest Earned Ratio

Times Interest Earned = EBIT/Interest Times Interest Earned = $418,000/$93,000 = 4.5

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Financial Leverage Ratios

Fixed-Payment coverage Ratio (FPCR)

FPCR =

EBIT + Lease Payments Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR =

$418,000 + $35,000 = 1.9 $93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}

Profitability Ratios

Common-Size Income Statements

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Profitability Ratios

Gross Profit Margin

GPM = Gross Profit/Net Sales GPM = $986,000/$3,074,000 = 32.1%

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Profitability Ratios

Operating Profit Margin

OPM = EBIT/Net Sales OPM = $418,000/$3,074,000 = 13.6%

Profitability Ratios

Net Profit Margin

NPM = Net Profits After Taxes/Net Sales NPM = $221,000/$3,074,000 = 7.2%

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Profitability Ratios

Return on Total Assets (ROA)

ROA = Net Profits After Taxes/Total Assets ROA = $221,000/$3,597,000 = 6.1%

Profitability Ratios

Return on Equity (ROE)

ROE = Net Profits After Taxes/Stockholders Equity ROE = $221,000/$1,754,000 = 12.6%

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Profitability Ratios

Earnings Per Share (EPS)

EPS = Earnings Available to Common Stockholders Number of Shares Outstanding EPS = $221,000/76,262 = $2.90

Market Ratios

Price Earnings (P/E) Ratio

P/E = Market Price Per Share of Common Stock Earnings Per Share P/E = $32.25/$2.90 = 11.1

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Market Ratios
Market-to-Book Ratio BV/Share = Common Stock Equity Number of Shares of Common Stock BV/Share = $1,754,000/72,262 = $23.00 M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock M/B Ratio = $32.25/$23.00 = 1.40

Summarizing All Ratios

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Summarizing All Ratios

DuPont System of Analysis


The DuPont system is used to dissect the firms financial statements and to assess its financial condition. It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE The advantage of the DuPont system is that it allows you to break ROE into a profit on sales component, an efficiency-of-asset-use component, and a use-ofleverage component.

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DuPont System of Analysis

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Cautions for Doing Ratio Analysis


Ratios must be considered together; a single ratio by itself means relatively little. Financial statements that are being compared should be dated at the same point in time. Use audited financial statements when possible. The financial data being compared should have been developed in the same way. Be wary of inflation distortions.

Financial Planning
The financial planning process Profit planning Cash Planning

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The Financial Planning Process

Financial planning involves guiding, coordinating, and controlling the firms actions to achieve its objectives. Two key aspects of financial planning are cash planning and profit planning. Cash planning involves the preparation of the firms cash budget. Profit planning involves the preparation of both cash budgets and pro forma financial statements.

The Financial Planning Process

Pro forma financial statements are projected, or forecast, financial statements - income statements and balance sheets. The inputs required to develop pro forma statements using the most common approaches include: financial statements from the preceding year the sales forecast for the coming year key assumptions about a number of factors

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The Financial Planning Process

Cash Planning

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Cash Planning: Cash Budgets


The cash budget or cash forecast is a statement of the firms planned inflows and outflows of cash. It is used to estimate short-term cash requirements with particular attention to anticipated cash surpluses and shortfalls. Surpluses must be invested and deficits must be funded. The cash budget is a useful tool for determining the timing of cash inflows and outflows during a given period. Typically, monthly budgets are developed covering a 1-year time period.

Cash Planning: Cash Budgets


The cash budget begins with a sales forecast, which is simply a prediction of the sales activity during a given period. A prerequisite to the sales forecast is a forecast for the economy, the industry, the company and other external and internal factors that might influence company sales. The sales forecast is then used as a basis for estimating the monthly cash inflows that will result from projected sales and outflows related to production, overhead and other expenses.

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Cash Planning: Cash Budgets


General Format of a Cash Budget

Cash Planning: Cash Budgets An Example: Coulson Industries


Coulson Industries, a defense contractor, is developing a cash budget for October, November, and December. Halleys sales in August and September were $100,000 and $200,000 respectively. Sales of $400,000, $300,000 and $200,000 have been forecast for October, November, and December. Historically, 20% of the firms sales have been for cash, 50% have been collected after 1 month, and the remaining 30% after 2 months. In December, Coulson will receive a $30,000 dividend from stock in a subsidiary.

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Cash Planning: Cash Budgets An Example: Coulson Industries


Based on this information, we are able to develop the following schedule of cash receipts for Coulson Industries.

Cash Planning: Cash Budgets An Example: Coulson Industries


Coulson Company has also gathered the relevant information for the development of a cash disbursement schedule. Purchases will represent 70% of sales10% will be paid immediately in cash, 70% is paid the month following the purchase, and the remaining 20% is paid two months following the purchase. The firm will also expend cash on rent, wages and salaries, taxes, capital assets, interest, dividends, and a portion of the principal on its loans. The resulting disbursement schedule thus follows.

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Cash Planning: Cash Budgets An Example: Coulson Industries

Cash Planning: Cash Budgets An Example: Coulson Industries


The Cash Budget for Coulson Industries can be derived by combining the receipts budget with the disbursements budget. At the end of September, Coulsons cash balance was $50,000, notes payable was $0, and marketable securities balance was $0. Coulson also wishes to maintain a minimum cash balance of $25,000. As a result, it will have excess cash in October, and a deficit of cash in November and December. The resulting cash budget follows.

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Cash Planning: Cash Budgets An Example: Coulson Industries

Evaluating the Cash Budget


Cash budgets indicate the extent to which cash shortages or surpluses are expected in the months covered by the forecast.

The excess cash of $22,000 in October should be invested in marketable securities. The deficits in November and December need to be financed.

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Coping with Uncertainty in the Cash Budget


One way to cope with cash budgeting uncertainty is to prepare several cash budgets based on several forecasted scenarios (e.g., pessimistic, most likely, optimistic). From this range of cash flows, the financial manager can determine the amount of financing necessary to cover the most adverse situation. This method will also provide a sense of the riskiness of alternatives. An example of this sort of sensitivity analysis for Coulson Industries is shown on the following slide.

Coping with Uncertainty in the Cash Budget

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Profit Planning

Profit Planning: Pro Forma Statements


Pro forma financial statements are projected, or forecast, financial statements income statements and balance sheets. The inputs required to develop pro forma statements using the most common approaches include:
Financial statements from the preceding year The sales forecast for the coming year Key assumptions about a number of factors

The development of pro forma financial statements will be demonstrated using the financial statements for Vectra Manufacturing.

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Profit Planning: Pro Forma Financial Statements

Profit Planning: Pro Forma Financial Statements

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Profit Planning: Pro Forma Financial Statements


Step 1: Start with a Sales Forecast
The first and key input for developing pro forma financial statements is the sales forecast for Vectra Manufacturing.

Profit Planning: Pro Forma Financial Statements


Step 1: Start with a Sales Forecast (cont.)
The previous sales forecast is based on an increase in price from $20 to $25 per unit for Model X and from $40 to $50 per unit for Model Y. These increases are required to cover anticipated increases in various costs, including labor, materials, & overhead.

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Profit Planning: Pro Forma Financial Statements


Step 2: Preparing the Pro Forma Income Statement
A simple method for developing a pro forma income statement is the percent-of-sales method. This method starts with the sales forecast and then expresses the cost of goods sold, operating expenses, and other accounts as a percentage of projected sales. Using the Vectra example, the easiest way to do this is to recast the historical income statement as a percentage of sales.

Profit Planning: Pro Forma Financial Statements


Step 2: Preparing the Pro Forma Income Statement (cont.)
Using these percentages and the sales forecast we developed, the entire income statement can be projected. The results are shown on the following slide. It is important to note that this method implicitly assumes that all costs are variable and that all increase or decrease in proportion to sales. This will understate profits when sales are increasing and overstate them when sales are decreasing.

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Profit Planning: Pro Forma Financial Statements


Step 2: Preparing the Pro Forma Income Statement (cont.)

Profit Planning: Pro Forma Financial Statements


Step 2: Preparing the Pro Forma Income Statement (cont.)
Clearly, some of the firms expenses will increase with the level of sales while others will not. As a result, the strict application of the percent-of-sales method is a bit nave. The best way to generate a more realistic pro forma income statement is to segment the firms expenses into fixed and variable components. This may be demonstrated as follows.

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Profit Planning: Pro Forma Financial Statements


Step 2: Preparing the Pro Forma Income Statement (cont.)

Profit Planning: Pro Forma Financial Statements


Step 3: Preparing the Pro Forma Balance Sheet
Probably the best approach to use in developing the pro forma balance sheet is the judgmental approach. Under this simple method, the values of some balance sheet accounts are estimated and the companys external financing requirement is used as the balancing account. To apply this method to Vectra Manufacturing, a number of simplifying assumptions must be made.

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Profit Planning: Pro Forma Financial Statements


Step 3: Preparing the Pro Forma Balance Sheet (cont.) 1. A minimum cash balance of $6,000 is desired. 2. Marketable securities will remain at their current level of $4,000. 3. Accounts receivable will be $16,875 which represents approximately 45 days of sales on average [($16,875/$135,000)*365]. 4. Ending inventory will remain at about $16,000. 25% ($4,000) represents raw materials and 75% ($12,000) is finished goods. 5. A new machine costing $20,000 will be purchased. Total depreciation will be $8,000. Adding $20,000 to existing net fixed assets of $51,000 and subtracting the $8,000 depreciation yields a net fixed assets figure of $63,000.

Profit Planning: Pro Forma Financial Statements


Step 3: Preparing the Pro Forma Balance Sheet (cont.) 6. Purchases will be $40,500 which represents 30% of annual sales (30% x $135,000). Vectra takes about 73 days to pay on its accounts payable. As a result, accounts payable will equal $8,100 [(73/365) x $40,500]. 7. Taxes payable will be $455 which represents about one-fourth of the 2007 tax liability. 8. Notes payable will remain unchanged at $8,300. 9. There will be no change in other current liabilities, long-term debt, and common stock. 10. Retained earnings will change in accordance with the pro forma income statement.

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Profit Planning: Pro Forma Financial Statements


Step 3: Preparing the Pro Forma Balance Sheet (cont.)

Evaluation of Pro Forma Statements: Weaknesses of Simplified Approaches


The major weaknesses of the approaches to pro forma statement development outlined above lie in two assumptions:
That the firms past financial performance will be replicated in the future That certain accounts can be forced to take on desired values

For these reasons, it is imperative to first develop a forecast of the overall economy and make adjustments to accommodate other facts or events.

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