Introduction

to
Financial Management
What is Finance?
Definition of Finance:
Finance is the art and science of managing
wealth.
It is about making decisions regarding what assets
to buy/sell and when to buy/sell these assets.
Its main objective is to make individuals and their
businesses better off.
Definition of Financial Management
Financial management is generally defined as
those activities that create or preserve the
economic value of the assets of an individual,
small business, or corporation.
Financial management comes down to making
sound financial decisions.

The Money Cycle The Cycle of Money
Financial intermediaries assist in the
movement of money, from lenders to
borrowers and back again.
This process is termed the cycle of money, and its
main objective is to make all the participants
better off.
Example: The Money Cycle
Example: A mutual fund issues shares which are bought by
individuals
The pooled funds are invested by the mutual fund company in
shares that are issued by firms
The firms pay dividends periodically which are received by the
mutual fund and passed through to their shareholders, or
reinvested in additional shares and the cycle of money starts
again.
The mutual fund managers earn fees;
the firms whose securities are bought are able to raise capital for
growth and future returns; and
the mutual fund shareholders earn dividends and capital gains.
Thus, all participants are generally better off.
Overview of Finance Areas
4 main interconnected and interrelated
areas.

1. Corporate Finance Introductory course
2. Investments
3. Financial Institutions and Markets
4. International Finance
Financial Markets
Forums where buyers and sellers of financial assets and
commodities meet.

Financial markets can be classified by:
Type of asset traded
Maturity of the financial asset
Money market
Capital market
Owner of the financial asset
primary market
secondary market
Nature of transaction
dealer markets
auction markets


The Finance Manager and
Financial Management

Finance Manager
Has to determine the best repayment structure for
borrowed funds
Makes sure that debt obligations are met on time
Ensures that sufficient funds are available for
carrying out daily operations.

The Finance Manager and Financial
Management (continued)

Financial management involves 3 main functions
Capital Budgeting
Capital Structure
Working Capital Management

Objective of the Finance Manager
To make investment and financing decisions that
increase the cash flow of the firm, thereby
maximizing the current stock price

Profit maximization vs. Stock price maximization

Why are they not the same?
Which one is more important?

Internal and External Players
Financial managers have to interact with
various internal and external stakeholders
Internal players include all the departmental
managers and other employees
External parties include:
Customers
Suppliers
Government
Creditors
A Basic Organizational Chart for a Company
The Legal Forms of Business
There are three main legal categories of business
organizations:
1. Sole proprietorship
2. Partnership
3. Corporation

Besides these 3 main forms some other forms of
business organizations include:
Hybrid Corporations
Not-for-Profit Corporations

The Legal Forms of Business
Sole Proprietorship
Advantages
1. Simplest and easiest form of business.
2. Least amount of legal documentation.
3. Least regulated.
4. Owner keeps all profits
Disadvantages
1. Owner pays personal tax rate on profits
2. Obligations of the business are sole responsibility of owner, and
personal assets may be necessary to pay obligations (personal and
business assets are commingled).
3. Business entity limited to life of owner.
4. Can have limited access to outside funding for the business.
The Legal Forms of Business
Partnership
Advantages
1. Agreements between partners may be easily formed
2. Involves more individuals as owners and therefore usually more
expertise
3. Larger amount of capital usually available to the business (compared
to proprietorship)
Disadvantages
1. Assets of general partners are commingled with assets of the
business
2. Profits treated as personal income for tax purposes
3. Difficult to transfer ownership

The Legal Forms of Business
Corporation
Advantages
1. Business is legal, separate entity from owners
2. Owners have limited liability to obligations of the business
3. Easy to transfer ownership
4. Usually greater access to capital for business
5. Owners do not have any personal liability for default
Disadvantages
1. Most difficult business operation to form
2. Double taxation of company profits
3. Most regulated.
Proprietorships & Partnerships
Advantages
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages
Difficult to raise capital
Unlimited liability
Limited life

Corporation
Advantages
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages
Double taxation
Cost of set-up and report filing
Why Study Finance?
Understand how and why financial decisions are
made in large and small companies.
Helps individuals increase their own compensations,
Improves contributions to the success of the
companies that people work for.
Understand the tradeoffs we face in making personal
financial choices and help us to select the most
appropriate action.

The Role of Financial
Management
The Role of Financial
Management
Why care about Financial Management ?
Prepare for the workplace of tomorrow.
Broadening expectations of financial
knowledge and skills.
Use and understand financial terminology
and concepts in team communication.
Developing cross-functional capabilities.
Critical thinking.
What is Financial Management?
Concerns the acquisition,
financing, and management of
assets with some overall goal
in mind.
Investment Decisions
What is the optimal firm size?
What specific assets should be acquired?
What assets (if any) should be reduced or
eliminated?
Most important of the three decisions.
Financing Decisions
What is the best type of financing?
What is the best financing mix?
What is the best dividend policy (e.g.,
dividend-payout ratio)?
How will the funds be physically acquired?
Determine how the assets (LHS of balance
sheet) will be financed (RHS of balance sheet).
Asset Management Decisions
How do we manage existing assets efficiently?
Financial Manager has varying degrees of
operating responsibility over assets.
Greater emphasis on current asset
management than fixed asset management.
What is the Goal of the Firm?
Maximization of
Shareholder Wealth!
Value creation occurs when we
maximize the share price for current
shareholders.
Corporate Social Responsibility
What role should CSR and/or sustainability
have on living the goal of the firm?
Corporate Social Responsibility (CSR): A business outlook that
acknowledges a firms responsibilities to its stakeholders and the
natural environment.
Sustainability: Meeting the needs of the present without
compromising the ability of future generations to meet their
own needs.
What Goals do some Firms have?
Creating superior shareholder value is our top priority. Associated
Banc-Corp 2006 Annual Report.
The desire to increase shareholder value is what drives our actions.
Phillips 2006 Annual Report.
FedExs main responsibility is to create shareholder value. FedEx
Corporation, SEC Form Def 14A for the period ending 9/25/2006.
the Board of Directors plays a central role in the Companys
corporate governance system; it has the power (and the duty) to direct
Company business, pursuing and fulfilling its primary and ultimate
objective of creating shareholder value. Pirelli & C. S.p.A. Milan
Annual Report 2006.
Shortcomings of Alternative Perspectives
Could increase current profits while harming firm
(e.g., defer maintenance, issue common stock to
buy T-bills, etc.).
Ignores changes in the risk level of the firm.
Profit Maximization
Maximizing a firms earnings after taxes.
Problems
Shortcomings of Alternative Perspectives
Does not specify timing or duration of expected
returns.
Ignores changes in the risk level of the firm.
Calls for a zero payout dividend policy.
Earnings per Share Maximization
Maximizing earnings after taxes divided by
shares outstanding.
Problems
Strengths of Shareholder Wealth
Maximization
Takes account of: current and future profits
and EPS; the timing, duration, and risk of
profits and EPS; dividend policy; and all
other relevant factors.
Thus, share price serves as a barometer for
business performance.
The Modern Corporation
There exists a SEPARATION between owners
and managers.
Modern Corporation
Shareholders Management
Role of Management
An agent is an individual authorized by
another person, called the principal, to
act in the latters behalf.
Management acts as an agent for
the owners (shareholders) of the
firm.
Agency Theory
Agency Theory is a branch of economics
relating to the behavior of principals and
their agents.
Jensen and Meckling developed a
theory of the firm based on agency
theory.
Agency Theory
Incentives include, stock options, perquisites,
and bonuses.
Principals must provide incentives so
that management acts in the principals
best interests and then monitor results.
Corporate
Social Responsibility
Wealth maximization does not preclude the
firm from being socially responsible at the
corporate level.
Assume we view the firm as producing both
private and social goods.
Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
Corporate Governance
Corporate governance: represents the system
by which corporations are managed and
controlled.
Includes shareholders, board of directors,
and senior management.
Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
Corporate Governance and
Business Ethics
Corporate governance deals with.
how a company conducts its business and implements controls to
ensure proper procedures and ethical behavior.
Sarbanes-Oxley Act of 2002
The CEO and CFO attest to the fairness of the financial reports.
The company maintains an effective internal control structure around
financial reporting.
The company and its auditors assess the effectiveness of the controls
over the most recent fiscal year.

Sarbanes-Oxley Act of 2002
Sarbanes-Oxley Act of 2002 (SOX): addresses
corporate governance, auditing and accounting,
executive compensation, and enhanced and timely
disclosure of corporate information.
Imposes new penalties for violations of securities laws.
Established the Public Company Accounting Oversight
Board (PCAOB) to adopt auditing, quality control, ethics,
disclosure standards for public companies and their
auditors, and policing authority.
Generally increasing the standards for corporate
governance.
Organization of the Financial
Management Function
Board of Directors
President
(Chief Executive Officer)
Executive Vice
President
(Operations)
Executive Vice
President
(Marketing)
Executive Vice
President
(Finance - CFO)
Board of Directors
Typical responsibilities:
Set company-wide policy;
Advise the CEO and other senior executives;
Hire, fire, and set the compensation of the CEO;
Review and approve strategy, significant investments, and
acquisitions; and
Oversee operating plans, capital budgets, and financial
reports to common shareholders.
CEO/Chairman roles commonly same person in US,
but separate in Britain (US moving in this direction).
Vice President (Treasurer)
Capital Investment
Cash Management
Commercial/investment banking
relationships
Credit Management
Dividend Disbursement
Financial Analysis/Planning
Investor Relations
Mergers and Acquisitions
Pension Management
Insurance/Risk Management
Tax Analysis/Planning
Organization of the Financial
Management Function
EVP of Finance
Controller
Cost Accounting
Cost Management
Data Processing
General Ledger
Government Reporting
Internal Control
Preparing Financial Statements
Preparing Budgets
Preparing Forecasts
Conflicts Between Managers and
Stockholders
Managers are naturally inclined to act in their own
best interests (which are not always the same as the
interest of stockholders).
But the following factors affect managerial behavior:
Managerial compensation plans
Direct intervention by shareholders
The threat of firing
The threat of takeover
Responsibility of the Financial Staff
Maximize stock value by:
Forecasting and planning
Investment and financing decisions
Coordination and control
Transactions in the financial markets
Managing risk
Financial Goals of the Corporation
The primary financial goal is shareholder
wealth maximization, which translates to
maximizing stock price.
Do firms have any responsibilities to society
at large?
Is stock price maximization good or bad for
society?
Should firms behave ethically?
Factors that affect stock price
Projected cash
flows to
shareholders
Timing of the cash
flow stream
Riskiness of the
cash flows
Stock Prices and Intrinsic Value
In equilibrium, a stocks price should equal its
true or intrinsic value.
To the extent that investor perceptions are
incorrect, a stocks price in the short run may
deviate from its intrinsic value.
Ideally, managers should avoid actions that
reduce intrinsic value, even if those decisions
increase the stock price in the short run.
Determinants of Intrinsic Value and Stock
Prices (Figure 1-1)
Some Important Trends
Recent corporate scandals have reinforced
the importance of business ethics, and have
spurred additional regulations and
corporate oversight.
The effects of changing information
technology have had a profound effect on
all aspects of business finance.
The continued globalization of business.
Understanding Financial
Statements
Understanding Financial
Statements
Key Financial Statements
Balance Sheet provides a snapshot of a firms
financial position at one point in time.
Income Statement summarizes a firms
revenues and expenses over a given period of
time.
Statement of Retained Earnings shows how
much of the firms earnings were retained,
rather than paid out as dividends.
Statement of Cash Flows reports the impact
of a firms activities on cash flows over a given
period of time.
Balance Sheet: Assets

Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2005
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2004
57,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800
Balance Sheet:
Liabilities and Equity

Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2005
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2004
145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
1,468,800
Income Statement

Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest Exp.
EBT
Taxes
Net income
2005
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
2004
3,432,000
2,864,000
358,672
209,328
18,900
190,428
43,828
146,600
58,640
87,960
Other Data

No. of shares
EPS
DPS
Stock price
Lease pmts
2005
100,000
-$1.602
$0.11
$2.25
$40,000
2004
100,000
$0.88
$0.22
$8.50
$40,000
Statement of Retained Earnings
(2005)
Balance of retained
earnings, 12/31/04
Add: Net income, 2005
Less: Dividends paid
Balance of retained
earnings, 12/31/05

$203,768
(160,176)
(11,000)

$32,592
Statement of Cash Flows (2005)
OPERATING ACTIVITIES
Net income
Add (Sources of cash):
Depreciation
Increase in A/P
Increase in accruals
Subtract (Uses of cash):
Increase in A/R
Increase in inventories
Net cash provided by ops.

(160,176)

116,960
378,560
353,600

(280,960)
(572,160)
(164,176)
Statement of Cash Flows (2005)
L-T INVESTING ACTIVITIES
Investment in fixed assets

FINANCING ACTIVITIES
Increase in notes payable
Increase in long-term debt
Payment of cash dividend
Net cash from financing

NET CHANGE IN CASH

Plus: Cash at beginning of year
Cash at end of year

(711,950)


436,808
400,000
(11,000)
825,808

(50,318)

57,600
7,282
What can you conclude about the companys
financial condition from its statement of CFs?
Net cash from operations = -$164,176,
mainly because of negative NI.
The firm borrowed $825,808 to meet its
cash requirements.
Even after borrowing, the cash account fell
by $50,318.
Did the expansion create additional net
operating after taxes (NOPAT)?
NOPAT = EBIT (1 Tax rate)

NOPAT
05
= -$130,948(1 0.4)
= -$130,948(0.6)
= -$78,569

NOPAT
04
= $114,257
NOWC =
Operating
-
Non-interest

current assets bearing CL

NOWC
05
= ($7,282 + $632,160 + $1,287,360)
($524,160 + $489,600)
= $913,042

NOWC
04
= $842,400
What effect did the expansion have on net
operating working capital?
What effect did the expansion have on
operating capital?
Operating capital = NOWC + Net Fixed Assets

Operating Capital
05
= $913,042 + $939,790
= $1,852,832

Operating Capital
04
= $1,187,200
What is your assessment of the
expansions effect on operations?

Sales
NOPAT
NOWC
Operating capital
Net Income
2005
$6,034,000
-$78,569
$913,042
$1,852,832
-$160,176
2004
$3,432,000
$114,257
$842,400
$1,187,200
$87,960
What effect did the expansion have on net cash
flow and operating cash flow?
NCF
05
= NI + Dep = ($160,176) + $116,960
= -$43,216
NCF
04
= $87,960 + $18,900 = $106,860
OCF
05
= NOPAT + Depreciation and amortization
= ($78,569) + $116,960
= $38,391
OCF
04
= $114,257 + $18,900
= $133,157
What was the free cash flow (FCF)
for 2005?
(

A +
(

+ = NOWC
es expenditur
Capital
-
on amortizati
and Depr
T) - (1 EBIT FCF
FCF
05
= [-$130,948(1 0.4) + $116,960]
[($1,202,950 $491,000) + $70,642]
= -$744,201

Is negative free cash flow always a bad sign?
Economic Value Added (EVA)
EVA = NOPAT Annual dollar cost of capital

In order to generate positive EVA, a firm has to
more than just cover operating costs. It must
also provide a return to those who have
provided the firm with capital.
EVA takes into account the total cost of capital,
which includes the cost of equity.
What is the firms EVA? Assume the firms after-tax
percentage cost of capital was 10% in 2004 and
13% in 2005.
EVA
05
= NOPAT (A-T cost of capital) (Capital)
= -$78,569 (0.13)($1,852,832)
= -$78,569 $240,868
= -$319,437

EVA
04
= $114,257 (0.10)($1,187,200)
= $114,257 $118,720
= -$4,463
Did the expansion increase or
decrease MVA?
MVA = Market value __ Equity capital
of equity supplied

During the last year, the stock price has
decreased 73%. As a consequence, the
market value of equity has declined, and
therefore MVA has declined, as well.
Does the company pay its suppliers
on time?
Probably not.
A/P increased 260%, over the past year,
while sales increased by only 76%.
If this continues, suppliers may cut off
DLeons trade credit.
Does it appear that the companys sales
price exceeds its cost per unit sold?
NO, the negative NOPAT and decline
in cash position shows that the
company is spending more on its
operations than it is taking in.
What if the companys sales manager decided to
offer 60-day credit terms to customers, rather than
30-day credit terms?
If competitors match terms, and sales remain constant

A/R would
Cash would
If competitors dont match, and sales double
Short-run: Inventory and fixed assets to meet
increased sales. A/R , Cash . Company may
have to seek additional financing.
Long-run: Collections increase and the companys
cash position would improve.
How did the company finance its
expansion?
The company financed its expansion with
external capital.
The company issued long-term debt
which reduced its financial strength and
flexibility.
Would the company have required external capital if
they had broken even in 2005 (Net Income = 0)?
YES, the company would still have to
finance its increase in assets. Looking to
the Statement of Cash Flows, we see that
the firm made an investment of
$711,950 in net fixed assets. Therefore,
they would have needed to raise
additional funds.
What happens if the company depreciates fixed
assets over 7 years (as opposed to the current 10
years)?
No effect on physical
assets.
Fixed assets on the
balance sheet would
decline.
Net income would decline.
Tax payments would
decline.
Cash position would
improve.
Income Tax System Corporate and Personal Taxes
Both have a progressive structure (the higher the
income, the higher the marginal tax rate).
Corporations
Rates begin at 15% and rise to 35% for corporations with
income over $10 million, although corporations with
income between $15 million and $18.33 million pay a
marginal tax rate of 38%.
Also subject to state tax (around 5%).
Individuals
Rates begin at 10% and rise to 35% for individuals with
income over $319,100.
May be subject to state tax.
Tax treatment of various uses and
sources of funds
Interest paid tax deductible for corporations (paid
out of pre-tax income), but usually not for individuals
(interest on home loans being the exception).
Interest earned usually fully taxable (an exception
being interest from a muni).
Dividends paid paid out of after-tax income.
Dividends received Most investors pay 15% taxes.
Investors in the 10% tax bracket pay 5% on dividends.
Dividends are paid out of net income which has already
been taxed at the corporate level, this is a form of double
taxation.
A portion of dividends received by corporations is tax
excludable, in order to avoid triple taxation.
Analysiing Financial
Statements
Analyzing Financial
Statements
Analysis of Financial Statements
Ratio Analysis
Du Pont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
Balance Sheet: Assets

Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2005
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2006E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
Balance sheet:
Liabilities and Equity

Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2005
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2006E
436,800
300,000
408,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
Income statement

Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest Exp.
EBT
Taxes
Net income
2005
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
2006E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
Other data

No. of shares
EPS
DPS
Stock price
Lease pmts
2006E
250,000
$1.014
$0.220
$12.17
$40,000
2005
100,000
-$1.602
$0.110
$2.25
$40,000
Why are ratios useful?
Ratios standardize numbers and facilitate
comparisons.
Ratios are used to highlight weaknesses
and strengths.
Ratio comparisons should be made
through time and with competitors
Trend analysis
Peer (or Industry) analysis
What are the five major categories of ratios,
and what questions do they answer?
Liquidity: Can we make required payments?
Asset management: right amount of assets vs.
sales?
Debt management: Right mix of debt and
equity?
Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
Market value: Do investors like what they see as
reflected in P/E and M/B ratios?
Calculate the companys forecasted current
ratio and quick ratio for 2006.
Current ratio = Current assets / Current liabilities
= $2,680 / $1,145
= 2.34x
Quick ratio = (CA Inventories) / CL
= ($2,680 $1,716) / $1,145
= 0.84x
Comments on liquidity ratios
2006E 2005 2004 Ind.
Current Ratio 2.34x 1.20x 2.30x 2.70x
Quick Ratio 0.84x 0.39x 0.85x 1.00x
Expected to improve but still below the industry average.
Liquidity position is weak.
What is the inventory turnover vs. the
industry average?
2006E 2005 2004 Ind.
Inventory
Turnover
4.1x 4.70x 4.8x 6.1x
Inv. turnover = Sales / Inventories
= $7,036 / $1,716
= 4.10x
Comments on
Inventory Turnover
Inventory turnover is below industry
average.
The company might have old inventory, or
its control might be poor.
No improvement is currently forecasted.
DSO is the average number of days after
making a sale before receiving cash.
DSO = Receivables / Avg sales per day
= Receivables / (Annual sales/365)
= $878 / ($7,036/365)
= 45.6 days
Appraisal of DSO
2006E 2005 2004 Ind.
DSO 45.6 38.2 37.4 32.0
The company collects on sales too slowly,
and is getting worse.
The company has a poor credit policy.
Fixed assets and total assets turnover
ratios vs. the industry average
FA turnover = Sales / Net fixed assets
= $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets
= $7,036 / $3,497 = 2.01x

Evaluating the FA turnover and TA
turnover ratios
2006E 2005 2004 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x
FA turnover projected to exceed the industry average.
TA turnover below the industry average. Caused by
excessive currents assets (A/R and Inv).
Calculate the debt ratio, times-interest-
earned, and EBITDA coverage ratios.
Debt ratio = Total debt / Total assets
= ($1,145 + $400) / $3,497
= 44.2%

TIE = EBIT / Interest expense
= $492.6 / $70 = 7.0x

Calculate the debt ratio, TIE, and EBITDA
coverage ratios.
EBITDA
=
(EBITDA + Lease pmts)
coverage Int exp + Lease pmts + Principal pmts


=
$609.6 + $40
$70 + $40 + $0
= 5.9x
How do the debt management ratios
compare with industry averages?
2006E 2005 2004 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
EBITDA
coverage
5.9x 0.1x 3.0x 8.0x
D/A and TIE are better than the industry average,
but EBITDA coverage still trails the industry.
Profitability ratios:
Profit margin and Basic earning power
Profit margin = Net income / Sales
= $253.6 / $7,036 = 3.6%

BEP = EBIT / Total assets
= $492.6 / $3,497 = 14.1%
Appraising profitability with the profit
margin and basic earning power
2006E 2005 2004 Ind.
PM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%
Profit margin was very bad in 2005, but is projected to
exceed the industry average in 2006. Looking good.
BEP removes the effects of taxes and financial leverage,
and is useful for comparison.
BEP projected to improve, yet still below the industry
average. There is definitely room for improvement.
Profitability ratios:
Return on assets and Return on equity
ROA = Net income / Total assets
= $253.6 / $3,497 = 7.3%

ROE = Net income / Total common equity
= $253.6 / $1,952 = 13.0%
Appraising profitability with the return
on assets and return on equity
2006E 2005 2004 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%
Both ratios rebounded from the previous year, but
are still below the industry average. More
improvement is needed.
Wide variations in ROE illustrate the effect that
leverage can have on profitability.
Effects of Debt on ROA and ROE
ROA is lowered by debt--interest lowers
NI, which also lowers ROA = NI/Assets.
But use of debt also lowers equity,
hence debt could raise ROE = NI/Equity.
Problems with ROE
ROE and shareholder wealth are correlated, but
problems can arise when ROE is the sole
measure of performance.
ROE does not consider risk.
ROE does not consider the amount of capital invested.
Might encourage managers to make investment
decisions that do not benefit shareholders.
ROE focuses only on return and a better measure
would consider risk and return.
Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.
P/E = Price / Earnings per share
= $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share
= $12.17 / [($253.6+$117.0) 250]
= 8.21x
Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.
M/B = Market price / Book value per share
= $12.17 / ($1,952 / 250) = 1.56x
2006E 2005 2004 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
P/CF 8.21x -5.2x 8.0x 11.0x
M/B 1.56x 0.5x 1.3x 2.4x
Analyzing the Market Value Ratios
P/E: How much investors are willing to pay for $1
of earnings.
P/CF: How much investors are willing to pay for $1
of cash flow.
M/B: How much investors are willing to pay for $1
of book value equity.
For each ratio, the higher the number, the better.
P/E and M/B are high if ROE is high and risk is low.
The Du Pont system
) (TA/Equity (Sales/TA) (NI/Sales) ROE
multiplier
Equity

turnover
assets Total

margin
Profit
ROE
=
=
Focuses on expense control (PM), asset utilization
(TA TO), and debt utilization (Equity multiplier.)
Extended DuPont equation:
Breaking down Return On Equity
ROE = (NI / Sales) x (Sales/TA) x (TA/Equity)

= 3.6%

x 2

x 1.8
= 13.0%
PM TA TO EM ROE
2004 2.6% 2.3 2.2 13.3%
2005 -2.7% 2.1 5.8 -32.5%
2006E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
An example:
The effects of improving ratios
A/R $ 878 Debt $1,545
Other CA 1,802 Equity 1,952
Net FA 817 __ __
TA $3,497 Total L&E $3,497

Sales / day = $7,035,600 / 365 = $19,275.62

How would reducing the firms DSO to 32 days
affect the company?
Reducing accounts receivable and the days
sales outstanding
Reducing A/R will have no effect on sales
Old A/R = $19,275.62 x 45.6 =

$878,000
New A/R = $19,275.62 x 32.0 = $616,820
Cash freed up:

$261,180

Initially shows up as addition to cash.

Effect of reducing receivables on balance
sheet and stock price
Added cash $ 261 Debt $1,545
A/R 617 Equity 1,952
Other CA 1,802
Net FA 817 ______
Total Assets $3,497 Total L&E $3,497

What could be done with the new cash?
How might stock price and risk be affected?
Potential uses of freed up cash
Repurchase stock
Expand business
Reduce debt
All these actions would likely improve the
stock price.
Potential problems and limitations of
financial ratio analysis
Comparison with industry averages is
difficult for a conglomerate firm that
operates in many different divisions.
Average performance is not necessarily
good, perhaps the firm should aim higher.
Seasonal factors can distort ratios.
Window dressing techniques can make
statements and ratios look better.
More issues regarding ratios
Different operating and accounting practices
can distort comparisons.
Sometimes it is hard to tell if a ratio is good
or bad.
Difficult to tell whether a company is, on
balance, in strong or weak position.
Qualitative factors to be considered when
evaluating a companys future financial
performance
Are the firms revenues tied to one key
customer, product, or supplier?
What percentage of the firms business is
generated overseas?
Competition
Future prospects
Legal and regulatory environment
Preparing Financial
Statements
Preparing Financial
Statements
Accounting
Is the official language of finance
provides managers and business owners vital
information via financial statements, which
can be used:
to assess the current health of the business,
to figure out where it has been, how it is doing,
to chalk up a planned route for its future
performance.


Understanding and Analyzing F/S
First, need to know how to read F/S
Second, understand how the F/S are linked
together in calculating the cash flow of a
company.
Essential to:
Assess the conditions of the firms that they are
associated with
Plan and forecast for future growth


Financial Statements
Four main financial statements:
Balance sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flow
Our focus..
Interrelationship between the balance sheet and the
income statement
The process by which these statements can be used to
project a firms future cash flows
Financial Statements
(A) Balance Sheet
Represents the assets owned by the company
and the claims against those assets

Based on the accounting identity:
Assets Liabilities + Owners Equity

(A) Balance Sheet
(A) Balance Sheet

Has 5 main sections:
1. Cash account
Where did the $65 million decline come from?
2. Working capital accounts
Net working capital = Current assets Current liabilities (2.2)
3. Long-term asset accounts
Plant and equipment; land and buildings
Gross value accumulated depreciation = Net value
4. Long-term liabilities (debt) accounts
Loans maturing in over 1 year
5. Ownership accounts
Shareholders equity
Retained earningsaccumulated total since inception



(B) The Income Statement
Shows the expenses and revenues generated by a
firm over a past period, typically a quarter or a
year.
Net income = Revenues expenses (2.3)
EBIT = Revenues operating expenses (2.4)




(B) Income Statement example
(B) The Income Statement
Net income is not the same as cash flow
Firm earned an income of $5,642 million
Cash account decreased by 65 million
3 reasons:
Accrual accounting
Non-cash expense items --depreciation
Preference to classify interest expense as part of
financial cash flow

(C) The Statement of Retained Earnings
(D) Cash Flow Identity and the
Statement of Cash Flows
The cash flow identity states that the cash flow
on the left-hand side of the balance sheet is
equal to the cash flow on the right-hand side of
the balance sheet.

CASH FLOW CASH FLOW CASH FLOW
FROM ASSETS = TO CREDITORS + TO OWNERS


Cash Flow Identity and Components
(D.1)The First Component:
Cash Flow From Assets
3 components:
Operating cash flow (OCF)
Net capital spending (NCS)
Change in net working capital (NWC)
Cash flow from assets = OCF NCS - NWC

OCF = EBIT + Depreciation Taxes
= Net income + Depreciation + Interest

NCS = Ending Net Fixed Assets Beginning N.F.A.
+ Depreciation

NWC = Ending NWC Beginning NWC
(D.1)The First Component:
Cash Flow From Assets
OCF = EBIT + Depreciation Taxes
= Net income + Depreciation + Interest
(D.1) The First Component:
Cash Flow From Assets
NCS = End. Net Beg. Net + Depreciation
Fixed Assets Fixed Assets
NCS= ($11,961 - $10,788) + $1,406 = $2,579
(D.1) The First Component:
Cash Flow From Assets
NWC=Ending NWC Beginning NWC
Net working capital = Total current assets Total current liabilities
Net working capital for 2011 = $9,130 - $6,860 = $2,270 (E- NWC)
Net working capital for 2010 = $10,454 - $9,406 = $1,048 (B-NWC)
Change in NWC = $2,270 - $1,048 = $1,222
(D.1) The First Component:
Cash Flow From Assets
Putting it all together.

Cash flow from Assets = OCF NCS - NWC
=$7,287-$2,579-$1,222
=$3,486
(D.2) The Second Component:
Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense Net New Borrowing
from Creditors

Net New Borrowing = Ending Long-term Liabilities Beginning Long-Term
Liabilities
Cash Flow to Creditors = $239 (-$378) $617

(D.3) The Third Component:
Cash Flow To Owners
Cash flow to owners = Dividends - Net new borrowing
from owners

= $2,869 - $0

= $2,869
(D) Putting It All Together: The Cash
Flow Identity

Cash flow from assets =
cash flow from creditors + cash flow to owners

$3,486 = $617 + $2,869
Problem 1
Balance Sheet. Chuck Enterprises has current
assets of $300,000, and total assets of
$750,000. It also has current liabilities of
$125,000, common equity of $250,000, and
retained earnings of $85,000. How much long-
term debt and fixed assets does the firm
have?

Problem 2
Income Statement. The Top Class Company had
revenues of $925,000in 2009. Its operating expenses
(excluding depreciation) amounted to $325,000,
depreciation charges were $125,000, and interest costs
totaled $55,000. If the firm pays a marginal tax rate of
34 percent, calculate its net income after taxes.

Problem 3
Retained Earnings: The West Hanover Clay Co. had, at
the beginning of the fiscal year, November 1, 2009,
retained earnings of $425,000. During the year ended
October 31, 2010, the company generated net income
after taxes of $820,000 and paid out 35 percent of its
net income as dividends. Construct a statement of
retained earnings and compute the year-end balance of
retained earnings.

Problem 4
Working Capital: D.K. Imports, Incorporated reported the following
information at its last annual meeting:

Cash and cash equivalents = $1,225,000;
Accounts payables = $3,200,000
Inventory = $625,000;
Accounts receivables = $3,500,000;
Notes payables = $1,200,000;
Other current assets = $125,000.

Calculate the companys net working capital.
Problem 5
Cash Flow from Operating Activities: The Mid-American Farm Products
Corporation provided the following financial information for the quarter
ending September 30, 2009:
Depreciation and amortization $75,000
Net Income $225,000
Increase in receivables $95,000
Increase in inventory $69,000
Increase in accounts payables $80,000
Decrease in marketable securities $34,000.

What is the cash flow from operating activities generated during this quarter
by the firm?