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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?
What is Finance?
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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.
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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.
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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Share Price
The process of shareholder wealth maximization can be described using the following flow chart:
Figure 1.3 Share Price Maximization
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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
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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.
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One specific type of cross sectional analysis. Used to compare one firms financial performance to the industrys average performance
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Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis
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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
ACP = Accounts Receivable Net Sales/365 ACP = $503,000 = 59.7 days $3,074,000/365
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Activity Ratios
APP =
APP =
Activity Ratios
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Debt Ratio
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FPCR =
EBIT + Lease Payments Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}
FPCR =
Profitability Ratios
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Profitability Ratios
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Profitability Ratios
Profitability Ratios
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Profitability Ratios
Profitability Ratios
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Profitability Ratios
EPS = Earnings Available to Common Stockholders Number of Shares Outstanding EPS = $221,000/76,262 = $2.90
Market Ratios
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
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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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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.
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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Cash Planning
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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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Profit Planning
The development of pro forma financial statements will be demonstrated using the financial statements for Vectra Manufacturing.
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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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