Principle of Finance

1. Principle of Finance
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2. Introduction to
Managerial
Finance

3. Introduction to Managerial Finance
WHAT IS FINANCE ? The science and art of managing
money.
financial perspective
Personal
level
business
level
 How much of earnings will spend.
 How much they save.
 How will invest the savings.
 How firms raise money from investors.
 How firms invest money to earn a profit.
 How firms decide whether to reinvest profits in
the business or distribute it back to investors.
LEGAL FORMS OF BUSINESS ORGANIZATION
Sole Proprietorship
Partnership
Corporation

4. Introduction to Managerial Finance
business owned by one person who operates it for his or
her own profit
Sole Proprietorships
of all businesses are sole proprietorships,
73%
Such as a bike shop, personal trainer.
Advantage working independently unlimited liabilityWeaknesses
Unlimited liability
Giving creditors the right to make claims against the owner’s personal assets to recover debts
owed by the business.
Lacks continuity when
proprietor dies
Low organizational costs
Ease of dissolution

5. Introduction to Managerial Finance
A business owned by two or more people and
operated for profit.
Partnerships
of all businesses are partnerships,
7%
Such as the finance, insurance, and real estate industries.
Advantage More available brain
power and managerial
skill
unlimited liabilityWeaknesses
Partnership is
dissolved when a
partner dies
Difficult to liquidate or
transfer partnership
Borrowing power
enhanced by more
owners

6. Introduction to Managerial Finance
An entity created
by law.
Corporation
of all businesses are partnerships,
20%
Advantage Owners have limited
liability, which guarantees
that they cannot lose
more than they invested
Taxes generally higherWeaknesses
More expensive to
organize than other
business forms
Lacks secrecy because
regulations require
firms to disclose
financial results
Long life of firm

7. Introduction to Managerial Finance
Corporate Organization

8. Introduction to Managerial Finance
Goal of the Firm
Maximize shareholder wealth (increase the
share price).
Corporations commonly measure profits in terms of earnings per
share (EPS), which represent the amount earned during the period on
behalf of each outstanding share of common stock.
Marginal cost–benefit analysis
Economic principle that states that financial decisions should be made and actions taken only
when the added benefits exceed the added costs.
Accrual basis
In preparation of financial statements, recognizes revenue at the time of sale and recognizes
expenses when they are incurred.
Cash basis
Recognizes revenues and expenses only with respect to actual inflows and outflows of cash.
finance
emphasis on
Accounting

9. Financial Tools

10. Financial Tools
THE THREE KEY FINANCIAL STATEMENTS
Balance sheet
Income Statement
Statement of cash flows
provides a financial summary of the firm’s operating results during a specified period.
Summary statement of the firm’s financial position at a given point in time
Summary of the firm’s operating, investment, financing cash flows , reconciles them with changes in its
cash and marketable securities during the period

11. Financial Tools
Income Statement Income Statement
Sales revenue
COGS
xxx
(xxx)
Gross profit xxx
Operating expenses
Selling expenses
General and admin. Expenses
Lease expenses
Deprecation expenses
Xxx
Xxx
Xxx
Xxx
Total operating expenses (xxx)
Operating Profit ( EBIT) xxx
Interest expense (xxx)
Net profit before taxes xxx
Taxes (xxx)
Net profit after taxes xxx
Preferred stock dividends (xxx)
Earning available for common stockholders xxx
Earning per share (EPS) xxx

12. Financial Tools
Income Statement
Example:

13. Financial Tools
Balance Sheets Balance Sheet
Assets
Cash
Marketable Securities
Inventories
Account Receivable
Prepaid expenses
xxx
xxx
xxx
xxx
xxx
Total current assets xxx
Land and building
Vehicles
Machinery and equipment
Furniture and fixture
xxx
xxx
xxx
xxx
Gross fixed assets xxx
Accumulative deprecation (xxx)
Net fixed assets xxx
Total assets xxx
Assets

14. Financial Tools
Balance Sheets Balance Sheet
Liabilities and stockholders equity
Account payable
Notes /Taxes /Accrued payable
Accruals
xxx
xxx
xxx
Total current Liabilities xxx
Long term debts xxx
Total Liabilities xxx
Preferred stock xxx
Common stock xxx
Retained earnings xxx
Total stockholder equity xxx
Total Liabilities and stockholder equity xxx
Liabilities
Stockholder
equity

15. Financial Tools
Balance Sheets
Example:

16. Financial Tools
Statement of cash flows Cash Flow from Operating activates
Net profit after taxes
Deprecation expenses
Account receivable
Inventories
Account payable
Accruals
xxx
xxx
(increase xxx) or decrease xxx
(increase xxx) or decrease xxx
increase xxx or (decrease xxx)
increase xxx or (decrease xxx)
Cash provided by operating activates xxx
Cash flow from investment activates
Gross fixed assets (increase xxx) or decrease xxx
Cash provided by investment activates xxx
Cash flow from financing activates
Note payable
Long term debts
Dividends paid
increase xxx or (decrease xxx)
increase xxx or (decrease xxx)
(xxx)
Cash provided by financing activates xxx
Net increase/decrease in cash and marketable secu. xxx

17. Financial Tools
Statement of cash flows
Example:

18. Financial Tools
Using Financial Ratios
Ratio Analysis
Involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance.
A firm’s ability to satisfy its short-term obligations as they come due.
Current ratio
A measure of liquidity calculated by dividing the firm’s current assets by its
current liabilities.
liquidity
Current ratio =
Current assets
Current liabilitiesA higher current ratio indicates a greater degree of liquidity.
Activity Ratios
Measure the speed with which various accounts are converted into sales or cash inflows or outflows.
Inventory Turnover
A measure of liquidity calculated by dividing the firm’s current assets by its
current liabilities. Inventory turnover =
Cost of goods sold
Inventory
The resulting is meaningful only when it is compared with other firms in the
same industry or to the firm’s past inventory turnover.

19. Financial Tools
Using Financial Ratios
Average collection period
The average amount of time needed to collect accounts receivable.
Average collection period =
Accounts receivable
Annual sales
365
The average collection period is meaningful only in relation to the firm’s
credit terms.
Average payment period
The average amount of time needed to pay accounts payable.
Average payment period =
Accounts payable
Annual purchases
365
This figure is meaningful only in relation to the average credit terms extended
to the firm.
Debt Ratio
Measures the proportion of total assets financed by the firm’s creditors. Debt ratio =
Total liabilities
Total assets
The higher this ratio, the greater the amount of other people’s money being
used to generate profits.

20. Financial Tools
Using Financial Ratios
Profitability Ratios
There are many measures of profitability. As a group, these measures enable analysts to evaluate the firm’s
profits with respect to a given level of sales, a certain level of assets, or the owners’ investment.
Gross profit margin
Measures the percentage of each sales dollar remaining after the firm has
paid for its goods.
gross profit margin =
Sales - Cost of goods sold
Sales
EARNINGS PER SHARE (EPS)
Measures the percentage of each sales dollar remaining after the firm has
paid for its goods.
gross profit margin =
Sales - Cost of goods sold
Sales

21. CASH FLOWS

22. Cash Flows
Classifying Inflows and Outflows of Cash
Operating Flows
Investment Flows
Financing Flows
Cash flows directly related to sale and production of
the firm’s products and services.
Cash flows associated with purchase and sale of both
fixed assets and equity investments in other firms.
Cash flows that result from debt and equity financing transactions; include incurrence and repayment of debt,
cash inflow from the sale of stock, and cash outflows to repurchase stock or pay cash dividends.
The firm’s cash flows fall into three categories: (1) operating flows, (2) investment
flows, and (3) financing flows.
Inflows and Outflows of Cash

23. Cash Flows
Preparing the Statement of Cash Flows
Sources Income Statement Balance Sheets

24. Cash Flows
Preparing the Statement of Cash Flows
Cash Flows
Sources
Income Statement
Income Statement
Balance Sheets
Balance Sheets
Balance Sheets
Balance Sheets
Balance Sheets
Balance Sheets
Balance Sheets

25. Financial
Planning

26. Financial Planning
Financial planning process
Planning that begins with long term, or strategic, financial plans that in turn guide the
formulation of short-term, or operating, plans and budgets.
Financial planning process’ key aspects
Cash planning
Profit planning
Involves preparation of the firm’s cash budget.
Involves preparation of pro forma statements.
long-term (strategic) financial plans Short-term (operating) financial plans
Plans that lay out a company’s planned
financial actions and the anticipated
impact of those actions over periods
ranging from 2 to 10 years.
Specify short-term financial actions and the
anticipated impact of those actions, that
most often cover a 1- to 2-year period.
Fixed assets, research and development
activities, marketing and product
development actions, capital structure,
and major sources of financing.
Focus
Sales forecast, production plans, estimate
direct labor requirements, factory overhead
outlays, and operating expenses.
Focus
(Forecasting)
(Accrual)

27. Financial Planning
The short-term (operating) financial planning process
Short-term financial planning begins with the sales forecast. From it, companies develop production plans that take
into account lead (preparation) times and include estimates of the required raw materials. Using the production
plans, the firm can estimate direct labor requirements, factory overhead outlays, and operating expenses. Once
these estimates have been made, the firm can prepare a pro forma income statement and cash budget. With these
basic inputs, the firm can finally develop a pro forma balance sheet.
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A statement of the firm’s planned inflows
and outflows of cash that is used to
estimate its short-term cash
requirements.
cashbudget
The prediction of the firm’s sales over a
given period, based on external and/or
internal data; used as the key input to the
short-term financial planning process.
salesforecast