Finance basics ppt @ bec doms mba finance

1. Finance Basics
1

2. Finance
 Finance can be thought of as the study of the
following three questions:
1- In what long-lived assets should the firm invest?
2- How can the firm raise cash for required capital
expenditures?
3- How should short-term operating cash flows be
managed?
2

3. Financial Statement Analysis
 The objective is to show how to rearrange
information from financial statements into
financial ratios that provide information about
five areas of financial performance:
3

4. Financial Statement Analysis (Cont.)
1. Short-term solvency
2. Activity
3. Financial Leverage
4. Profitability
5. Value
4

5. Short-Term Solvency
5

6. Short-Term Solvency
 Ratios of short-term solvency measure the
ability of the firm to meet recurring financial
obligations (that is, to pay its bills).
 The most widely used measures of accounting
liquidity are the current ratio and the quick
ratio.
6

7. Short-Term Solvency
 Current ratio= Total current assets/
Total current liabilities
 Quick ratio= *Quick assets/ Total
current liabilities
* Quick assets= Total current assets- inventories
7

8. Activity
8

9. Activity
 Ratios of activity are constructed to
measure how effectively the firm’s
assets are being managed.
9

10. Activity
 Total asset turnover= Total operating
revenues/ Total assets
 This ratio is intended to indicate how
effectively a firm is using all of its assets. If
the asset turnover ratio is high, the firm is
presumably using its assets effectively in
generating sales.
10

11. Activity
 Receivables Turnover= Total
operating revenues/ Receivables
 Average collection period= Days in
period(365)/ Receivables turnover
11

12.  The receivables turnover ratio and the average collection
period provide some information on the success of the
firm in managing its investment in accounts receivable.
 The actual value of these ratios reflects the firm’s credit
policy. If a firm has a liberal credit policy, the amount of
its receivables will be higher than would otherwise be the
case.
 One common rule of thumb that financial analysts use is
that the average collection period of a firm should not
exceed the time allowed for payment in the credit terms
by more than 10 days.
12

13. Activity
 Inventory Turnover= Cost of goods sold/
Inventory
 The inventory ratio measures how quickly
inventory is produced and sold. It is
significantly affected by the production
technology of goods being manufactured.
13

14. Financial Leverage
14

15. Financial Leverage
 Financial leverage is related to the extent to which a
firm relies on debt financing rather than equity.
 Measures of financial leverage are tools in
determining the probability that the firm will
default on its debt contracts. The more debt a firm
has, the more likely it is that the firm will become
unable to fulfill its contractual obligations (too
much debt can lead to a higher probability of
insolvency and financial distress).
15

16. Financial Leverage
 Debt ratio= Total debt/ Total assets
 Debt-to-equity ratio= Total debt/ Total
equity
 Equity multiplier= Total assets/ Total
equity
16

17. Financial Leverage
 Debt ratios provide information about
protection of creditors from insolvency
and the ability of firms to obtain
additional financing for potentially
attractive investment opportunities.
17

18. Financial Leverage
 Interest Coverage= Earnings before
interest and taxes/ Interest expense
 Interest expense is an obstacle that a firm must
surmount if it is to avoid default. The ratio of
interest coverage is directly connected to the ability
of the firm to pay interest.
18

19. Profitability
19

20. Profitability
 Profitability ratios measure the extent to which a
firm is profitable.
 The most important conceptual problem with
accounting measures of profitability is they do
not give us a benchmark for making
comparisons.
 In general, a firm is profitable in the economic
sense only if its profitability is greater than
investors can achieve on their own in the capital
markets.
20

21. Profitability
 Net profit margin= Net income/ Total
operating revenues
 Gross profit margin= Earnings before
interest and taxes/ Total operating
revenues
21

22. Profit Margins
 In general, profit margins reflect the firm’s
ability to produce a product or service at a low
cost or a high price.
 Profit margins are not direct measures of
profitability because they are based on total
operating revenue, not on the investment made
in assets by the firm or the equity investors.
 Trade firms tend to have low margins and
service firms tend to have high margins.
22

23. Profitability
 Net Return on Assets= Net income/
Average total assets
 Gross return on assets= Earnings before
interest and taxes/ Average total assets
23

24. Profitability
 One of the most interesting aspects of return
on assets (ROA) is how some financial ratios
can be linked together to compute ROA.
One implication of this is usually referred to
as the DuPont system of financial control.
24

25. Profitability
 Return on Equity (ROE)= Net
income/ Average stockholders’ equity
25

26. Profitability
ROE= Profit margin * Asset turnover * Equity multiplier
= (Net income/ TOR* ) * (TOR/ ATA * *) * (ATA/ ASE* * * )
* TOR: Total Operating Revenue
** ATA: Average Total Assets
*** ASE: Average stockholders’ equity
26

27. Value
27

28. Value
 One very important characteristic of a
firm that cannot be found on an
accounting statement is its market value.
28

29. Value
1- Market price
2- Price-to-earnings (P/E) ratio
3- Dividend Yield
4- Market-to-book (M/B) value ratio
29

30. Value
1- Market price: The market price of a share of
common stock is the price that buyers and
sellers establish when they trade the stock.
The market value of the common equity of a
firm is the market price of share of common
stock multiplied by the number of shares
outstanding.
30

31. Value
2- Price-to-earnings (P/E) ratio: One way to
calculate the P/E ratio is to divide the current
market price by the earnings per share of
common stock for the latest year.
31

32. Value
3- Dividend Yield= Dividends per share/
Market price per share.
Dividends yields are related to the market’s
perception of future growth prospects for
firms. Firms with high growth prospects will
generally have lower dividend yields.
32

33. Value
4- Market-to-book (M/B) value ratio:
It is calculated by dividing the market price
per share by the book value per share.
33

34. Conclusions
Accounting statements provide important
information about the value of the firm.
Financial analysts and mangers learn how to
rearrange financial statements to squeeze out
the maximum amount of information.
34

35. Conclusions (Cont.)
 You should keep in mind the following points when
trying to interpret financial statements:
1- Measures of profitability such as return on equity
suffer from several potential deficiencies as indicators
of performance. They do not take into account the risk
or timing of cash flows.
2- Financial ratios are linked to one another. For
example, return on equity is determined from the
profit margins, the asset turnover ratio, and the
financial leverage. 35