INTRODUCTION TO FINANCIAL

MANAGEMENT
Topic 1
Introduction: Financial Statements and Cash Flow
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LEARNING OBJECTIVES
Understand the goal of financial management
Understand the basic types of financial management
decisions and the role of the financial manager
Understand the basic Financial Statements
Understand the difference between Accounting Profit and
Cash Flows
Understand the different forms of business structure
Be able to briefly describe the financial markets
Understand a prescriptive approach to ethics
In particular in finance related issues

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INTRODUCTION
Why study finance?
All individuals are responsible for financial decisions in their
personal life
Sometime may need to borrow money
Need to plan for retirement (super)
All organisations must be financially sustainable and all
managers must be aware of the financial consequences
of their actions
What is Financial Management?
The management of money (cash/wealth)
What is the major objective of Financial Management?
To increase Shareholder Wealth
By increasing share price Share price/ EPS/ Divident
And/or increasing dividends to shareholders 4
THERE ARE FOUR BASIC AREAS OF FINANCE
Corporate Finance
Basic theories/ideas of finance
Raise fund equity/debt
assets LT, ST
Investments
Financial assets such as shares and bonds
Financial Institutions
Firms dealing in financial matters
International Finance
An area of specialisation consisting of the above three areas

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FINANCIAL MANAGEMENT, THREE ELEMENTS IN ANY
DECISION AND THREE KEY DECISIONS

Cash Profit is not equal to cash flow.

Larger profits do not always mean larger cash flow to
shareholders
Time - When will the cash flow occur
not which years profits should be maximised
Risk - Greater the risk - higher the return
Key Financial Decisions
Investment Decision
Finance Decision
Dividend Decision
All decisions require forecasting and planning
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 INVESTMENT DECISION
Identify potential investment opportunities that are worth
more to the firm than they cost
The present value of the cash flows generated by the
investment exceed its cost
Need to forecast the future hence uncertainty regarding
the realisation of future cash flows.
This uncertainty is referred to as risk.
Higher the risk the higher the return
Determines the assets the firm owns
Decision includes working capital
==== WC, CA, , PPE
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WHY CASH FLOW & NOT PROFITS
Fast Freighters sells Bucket Hauling Ltd an old table top
truck for $400,000 on 60 days credit. Fast Freighters
makes a $200,000 profit on the sale of the truck.
When does Fast get paid?
a) today on the day of the sale
b) in 60 days time
c) never
d) hopefully in around 60 days time
When did the profit get recorded?

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FINANCING DECISION
The finance decision determines the mix of debt
(borrowed money) and equity (owners money)
Business raise money by issuing financial securities
Equity is raised by issuing shares and long term debt is
raised by issuing bonds.
When organisations take on debt there is a contract to
pay interest and repay the principal
debt has a contractual claim on the cash flow of the firm
When a company issues shares there is no obligation on
the company to return the cash to the shareholders or
pay dividends
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DIVIDEND DECISION
How to reward shareholders
When the company makes a surplus it must decide
whether to distribute the cash to shareholders in the form
of dividends or retain the cash for further investment in
assets
The dividend decision can be considered a result of the
financing decision. How much of the profits are to be
retained for further investment?

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Topic 1 Introduction to Finance Spring 2016
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OVERVIEW OF FINANCIAL MARKETS
AUSTRALIAN FINANCIAL MARKETS
The Financial System consists of
Individuals; Companies; Governments and Financial
intermediaries
Efficient financial markets are important to enable
businesses to raise funds by issuing of debt securities
and shares
Financial Markets enable price discovery of securities
and to provide a mechanism for the transfer of
ownership.
It creates and enables the exchange of Financial Assets
Enables the creation of productive capital
Allocates capital amongst competing uses
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A SIMPLIFIED OVERVIEW OF FINANCE

Firms
Goal: Maximise
Market Value
Financial
Markets

Individuals
Goal: Maximise Utility
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of consumption
FINANCIAL MARKETS AND INTERMEDIATION
Financial intermediation is the operation of channelling
funds from the savings sector to the borrowing sector
efficiently
Capital market aim is increasing an economy's wealth
Control valve on the flow of funds
current rate of interest
Flow of funds is a product of supply and demand for
funds
Financial Markets are where people buy and sell
securities (Financial Assets)
Many financial markets
Foreign exchange Futures and options
Debt markets Share markets 15
FINANCIAL MARKETS CONTINUED
Primary markets are where companies raise money from
the original issues of securities
Markets where companies are the seller and receive the cash
Can be private sales or public offering
Secondary markets are where ownership of the
securities are transferred
financial assets are exchanged in a transaction that does not
involve the party that issued the financial asset
Secondary markets are important for liquidity

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Topic 1 Introduction to Finance Spring 2016
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LEGAL FORMS OF BUSINESS,
CORPORATE GOVERNANCE AND
ETHICS
THERE ARE THREE MAJOR LEGAL FORMS OF BUSINESS
Sole Proprietorship (Sole Trader); Partnership and
Company
Sole Trader
Owned by one person with unlimited liability
Equity component limited to sole traders wealth
Tend to be under capitalised
Life is limited and Least regulated
Partnership
Several individuals join together
All share in gains and losses but all partners have unlimited
liability
Equity limited by wealth of partners
Income taxed as personal income of partners
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Characterised by a partnership agreement
FORMS OF BUSINESS - COMPANY
Separate legal entity
As company grows management and shareholders are
usually separated
Unlimited life & limited liability for Shareholders
Ownership easily transferred
Most regulated form of organisation
Can be listed: Only small number of companies listed
What does it mean to be listed?
Gives greater access to both debt and equity finance
Management and shareholders are separated
Agency problem
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Corporate Governance
CORPORATE GOVERNANCE AND THE AGENCY PROBLEM
When the business is a sole trader the owner of the
business is also the manager of the business and is only
going to make business decisions that he believes will
increase his wealth.
In the corporate form of business organisation
shareholders and management are separated
When managers and shareholders are separated do
managers always act in the best interests of
shareholders?
The agency problem is the possibility of a conflict of
interest between these two parties
Agency costs refer to the direct and indirect costs arising
from this conflict of interest.
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Eg the cost of monitoring
AGENCY PROBLEM
Do managers always act in the best interest of
shareholders?
The answer to this will depend on two factors:
how closely management goals are aligned with shareholder
goals
the ease with which management can be replaced if it does
not act in shareholders best interests
The agency problem can be alleviated by the alignment
of goals
This can be achieved through:
Management compensation schemes
Management job prospects
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Threat of takeover
ETHICS IN FINANCE
In Financial Management you will learn tools and
techniques based on making financial decisions that will
increase the market value of owners equity
We are concerned with costs and benefits and believe
that financial sustainability is an essential part of
managing a business for the long term benefit of
stakeholders
When agents are used for advice it is expected that their
advice is unbiased and in the best interests of clients
Eg Brokers, insurance agents consultants etc.
A short video to watch
https://www.youtube.com/watch?v=K23cV1Jvhqw 23
LAW AND ETHICS
It has been found that some managers do not always act
in the best interest of shareholders and laws have been
introduced to reduce this
Accounts must be audited and presented to shareholders
(monitoring)
Directors have a fiduciary responsibility to creditors and must
not allow their organisation to trade whilst insolvent
A general expectation is businesses will do what is
right The good corporate citizen is often used
financial success should not be pursued by breaking the law
The Australian Securities and Investment Commission
(ASIC) is responsible for the enforcement of corporations
law and regulation 24
LAW AND ETHICS CONTINUED
The most important law for corporations generally is the
Corporations Act 2001
History shows past corporate failures are often associated
with deficiencies in auditing and financial reporting
ASX has issued a statement of core principles of
corporate governance
The law does not cover all situations and sometimes
there is conflict:
Whose law do you follow if a subsidiary operates in a country
where the laws are different to those of the parent?
In recent times there has been increased interest in
ethics in business
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The Global Financial Crisis (GFC)
ETHICS
Ethics can be described as a set of moral principles or
values
Business ethics are the principles, norms and standards
of conduct that operate within business
doing what is right.
It is society that will determine what is right
The material on Ethics is contained in Chapter 1 & 2 of
Managing Business Ethics by Linda K Trevino and
Katherine A Nelson and is prescribed reading

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DECIDING WHAT IS RIGHT, A PRESCRIPTIVE APPROACH
Trevino and Nelson outline in the reading three distinct
basis for theories regarding ethical decision making:
1. Focus on Consequences
What matters is the net balance of good consequences over
bad
The bottom line is will the action serve the greater good of
society
From a purely economic point of view will the benefits
outweigh the costs

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ETHICS A PRESCRIPTIVE APPROACH CONTINUED
2. Focus on Duties, Obligations and Principles
Certain ethical or moral principles (values) are binding
regardless of the consequences
Examples are honesty, fairness, loyalty, justice, human rights.
This focus leads to the Golden Rule. Do unto others as you
would have them do unto you.
There are difficulties with this approach. Is it OK to lie in some
circumstances?
3. Focus on Integrity
consider motivations, intentions & character of the individual.
Professional bodies have codes to guide the intentions and
purpose of the members
These codes can have good and bad consequences 28
A PRESCRIPTIVE APPROACH -8 STEPS
Trevino and Nelsons 8 steps to sound ethical decision
making are as follows:
Gather the facts
Define the ethical issues
Identify the affected parties (the stakeholders)
Identify the consequences
Identify the obligations
Consider your character and integrity
Think creatively about potential actions
Listen to your conscience (check your gut)

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HOMEWORK QUESTION TO BE DISCUSSED NEXT WEEK
SOURCE: MANAGING BUSINESS ETHICS: CH. 2
Please ensure you read from the above source and not
just the information provided below.
Jordons Printer Discount
The facts

Topic 1 Introduction to Finance Spring 2016

After placing a large order for computers and printers Jordon
is offered a 50% discount on a personal purchase
S182 of the corporations act states that A director, secretary,
other officer or employee of a corporation must not improperly
use their position to (a) gain an advantage for themselves or
someone else ----
Will it be illegal if Jordon accepts the discount? (possibly it
will depend on the legal interpretation of improperly which we
will not discuss)
Some companies would forbid accepting gifts (or discounts) if
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such gifts were not available to all employees
FINANCIAL STATEMENTS
FINANCIAL STATEMENTS
All organisations are required to keep accounts and
produce financial statements
Traditionally the accounts are based on the double entry
system of bookkeeping
The type and complexity of Financial Statements produced
depends on the size and type of organisation
The form of these statements is dictated by the users
Financial Accounts/Statutory Accounts
Produced to meet government and ASX regulations
used by analysts, creditors, banks, etc
Management Accounts
Internal users only- private information
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Tax Accounts - for the Tax Office
BALANCE SHEET
One of the major financial statements produced by a firm
is the Balance Sheet.
What the firm owns always equals what the firm owes
The basic accounting equation:-
Assets - Liabilities = Equity
All items recorded in monetary terms
The balance sheet values are generally historical costs
although revaluation of some assets does occur
In Finance we are more concerned with market values
not accounting values
Net Working Capital:-
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NWC = Current Assets - Current Liabilities
 BALANCE SHEET
What the Firm Owns What the Firm Owes
Current Assets Current Liabilities
Non-Current Assets Non Current Liabilities
Tangible Assets (Long Term debt)
Intangible Assets (incur costs)

(must produce income) Shareholders Funds

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DEBT AND EQUITY
Debt:-
Borrowed Funds
An agreement to pay interest and return the amount borrowed
Contractual Claim on the firms cash flow
Equity:-
Funds obtained with no obligation to repay
Residual claim on the firms cash flow
When a company raises money by issuing debt or equity
it is creating a financial asset
The financial asset has claims on the future cash flows of the
company
The financial asset is more sought after if it is marketable 35
i.e. liquid = many buyers and sellers
IMPORTANT CONCEPTS RELATING TO THE
BALANCE SHEET
Depreciation, represents the recovery of the cost of an
asset over its life
Charge dependent on accounting methods
Depreciation by itself is not a cash flow
It does reduce profits and hence tax payable
The reduction in tax payable is equivalent to a cash
inflow
Reserves and Provisions
Adjustments based on accounting policies
Not a cash flow
These items are at the discretion of management
It is a statement of financial position at a point in time 36
PROFIT AND LOSS STATEMENT
Sales (Revenue, i.e. Service Income) XXXX
Less:- Cost of Goods Sold XXX
Gross Profit XXXX
Less Expenses:-
Selling Expenses XX
Administration Expenses XX
Depreciation XX
Earnings Before Interest and Taxes XXX
Note: EBIT =earnings from operations

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PROFIT AND LOSS STATEMENT CONTINUED
EBIT XXXX
Less:-
Interest XX
Profit Before Tax XXX
Less:-
Tax Expense XX
Profit After Tax (Net Profit) XXX
Note Interest expense is a result of the financing
decision
EBITDA = Earnings Before Interest, Taxes, Depreciation and
Amortisation
Earnings per share = (Net Profit Pref Div)/No Shares issued
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Dividend per share = Dividend Paid/ No. Shares issued
IMPORTANT CONCEPTS PROFIT AND LOSS STATEMENT
The statement is for a period of time
Lists the income earned and the expense incurred in earning
that income
Income earned may not equal income received and
expenses incurred may not be paid in cash
Depreciation & amortisation
Accounting Profit is not equal to cash flow

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CASH FLOW
In Finance we are concerned with cash flows over time
not accounting profit
We are more interested in the Statement of Cash Flow
than the Balance Sheet or Profit and Loss statement
The Balance Sheet and the P & L Statement do however
provide all the information required to analyse cash flow
Cash flow is generated by three major activities:-
Operating Activities
Investment Activities
Financing Activities
The Profit and Loss Statement provides the information
on operating cash flow 40
CASH FLOW
The Balance Sheet position provides the information on
the investment and financing activities.
The balance sheet will reveal the sources and uses of
funds:
An increase in an asset (increased inventory) will represent a
use of cash (an investment)
An increase in a liability (increased term loan) will represent a
source of cash
A decrease in an asset = source of cash
A decrease in a liability = use of cash
One of the most important calculations from a finance
point of view is operating cash flow (OCF)
Accountants and Analysts unfortunately often use different
definitions of OCF 41
OPERATING CASH FLOW
In finance when looking at the Investment Decision we
are interested in the cash flows that occur as a result of
that decision.
We want to exclude the financing costs from our
Investment Decision i.e. exclude interest.
We do NOT want to incorporate into this cash flow what
is in fact part of the Financing Decision
The operating cash flow for the Investment Decision in
Finance then is:
OCF = EBIT(1-Tc) + Depreciation
Where: EBIT = Earnings before Interest and tax
Tc = company tax rate 42
OPERATING CASH FLOW
EBIT = Earnings before Interest and tax
Tc = company tax rate

= 1 +
= 1 +
= 1 +

Profit after Tax (without interest)

1 43

EBIT
EXAMPLE - CALCULATION OF OPERATING CASH FLOW
Tweed Corporation has sales for the period of
$2,500,000 with a cost of goods sold of $800,000 and
administration costs of $100,000.
The depreciation charge is $500,000 and the interest
paid is $400,000.
What is the Profit after tax for Tweed if the tax rate is
30%
What are the operating cash flows for Tweed

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PROFIT AND LOSS OF TWEED CORP.
Sales 2,500,000
Cost of Goods sold -800,000
Administration costs -100,000
Deprecation -500,000
Earnings before Interest and Tax 1,100,000
Interest -400,000
Profit before tax 700,000
Tax @30% -210,000
Profit after tax 490,000

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OPERATING CASH FLOW
Cash flow from operations less tax plus the tax effect on
depreciation
OCF = (Cash Inflow Outflow)(1-tc) +(depn)(tc)
OCF = (2,500,000-800,000-100,000)(1 -0.3)
+ 500,000(0.3)
OCF = (1,600,000)(0.7) + 500,000(0.3)
OCF = $1,270,000.
Alternate method is EBIT minus tax on EBIT plus
depreciation

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OPERATING CASH FLOW
EBIT $1,100,000
Tax(1,100,000 x 30%) -$330,000
Plus Depreciation $500,000
OCF $1,270,000
Note the text books treatment is different
It does not remove the tax effect of interest in their solution.

= 1 +

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MC QUESTION 1
The trade-off between expected return and risk has a:
A) horizontal slope.
B) downward slope.
C) vertical slope.
D) upward slope.

The answer is Return

Risk 48
0
MC QUESTION 2
Which of the following is an example of a principal-agent
problem?
A) Managers invest a firms earnings in high-value projects to
maximise shareholders wealth
B)Managers encourage investors to replace them if they fail to
satisfy investors objectives
C) Managers hang on to badly performing operations when
new managers could run them more profitably
D)All of the above are true
The answer is

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MC QUESTION 3
Financial intermediaries are firms whose principal
business is:
A) making investment decisions in property, plant and
equipment
B) taking deposits, making loans, and buying securities
C) ensuring that security prices follow a random walk
D) all of the above are true
The answer is

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 FOR THE ITEMS BELOW IDENTIFY IF THEY ARE AN
ASSET, LIABILITY, CAPITAL, REVENUE OR
EXPENDITURE

Cash at bank Purchases

Accounts receivable Sales
Creditors Sales on credit
Inventory - beginning Insurance
of the year Preference shares
Power and heating costs issued
Freight expense sales Long term bank loan
Interest paid Advertising
Sales personnel salaries Office buildings
Accumulated depreciation Closing stock end year
Asset revaluation Fixtures and fittings
reserve Rent received
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WORKSHOP QUESTION 1
Outback Fences has sales of $250,000; the cost of
fences for the year was $78,000 and the administration
costs were $12,000.
The depreciation charge was $45,000 and the interest
paid was $63,000.
What was the profit for the year and the operating cash
flows for Outback Fences if the tax rate is 30%

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SOLUTION WORKSHOP QUESTION 1
Profit and Loss of Outback Fences

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SOLUTION WORKSHOP QUESTION 1 CONTINUED

Alternate method is EBIT minus tax on EBIT plus

depreciation

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SOLUTION WORKSHOP QUESTION 1 CONTINUED
Operating Cash Flow

Note the text books treatment is different

It does not remove the tax effect of interest in their solution.

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WORKSHOP QUESTION 2
Adam smith has sales of $500,000, a cost of goods sold
of $125,000, cash operating expenses of $100,000,
depreciation of $75,000 and interest expense of $20,000
for the period.
If the tax rate is 30% prepare the income statement
showing EBIT and net profit and calculate the OCF for
the period

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SOLUTION WORKSHOP QUESTION 2
Income Statement

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SOLUTION WORKSHOP QUESTION 2 CONTINUED
OCF
)


Or OCF

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