Introduction to
Finance
What is Finance?

Finance is the study of how people and
businesses evaluate investments and raise
capital to fund them.
Corporate Finance addresses the
following three questions:
What long-term investments should the firm
choose?
2. How should the firm raise funds for the selected
investments?
3. How should short-term assets be managed and
financed?
1.
3
Forms of Business Organization

The Sole Proprietorship

The Partnership

The Corporation
4
Sole Proprietorship

It is a business owned by a single individual
who is entitled to all of the firm’s profits and is
responsible for all of the firm’s debt.

The sole proprietors typically raise money by
investing their own funds and by borrowing
from a bank.
Sole Proprietorship (cont.)

Advantages:
 Easy
to start
 No need to consult others while making decisions
 Organization taxed at the personal tax rate

Disadvantages:
 Owner
is personally liable for the business’s debt
 The business ceases on the death of the proprietor
 Hard to raise money
Partnership: General
A general partnership is an association of two
or more persons who come together as coowners for the purpose of operating a business
for profit.
Partnership (cont.)

Advantages:
 Relatively
easy to start
 Organization taxed at the personal tax rate
 Access to funds from multiple sources or partners

Disadvantages:
 Partners
jointly share unlimited liability
 It is not always easy to transfer ownership
Partnership: Limited

In limited partnerships, there are two classes
of partners: general and limited.
 The
General Partner runs the business and faces
unlimited liability for the firm’s debts
 The Limited Partner does not run the business
and is only liable up to the amount invested.
Corporation
Are the big organizations. Generally established
when very large sums of money are required.
 Main defining characteristic is the separately
of ownership (shareholders) from control
(management)
 The
Board of directors are elected by the
shareholder, and the board appoints the senior
management of the firm.
Corporation (cont.)

Advantages
 Liability
of owners is limited to invested funds
 Life of corporation is not tied to the owner
 Easier to transfer ownership
 Easier to raise Capital

Disadvantages
 Greater
regulation
 Double taxation of dividends
Limited Liability Company (LLC)
Limited liability company (LLC) combines the
tax benefits of a partnership (no double taxation
of earnings) with the limited liability benefit of
corporation (the owner’s liability is limited to
what they invest).
Comparison
Five Basic Principles of Finance
1.
2.
3.
4.
5.
Time Value of Money
Risk-Return Trade-off
Cash is King
Market Prices Reflect Expectations/News
People do what is best for them, unless you
make them change their mind
14
Time Value of Money

A dollar today is worth more than a dollar
tomorrow
 We
can invest the dollar today and earn interest.
Therefore, in the future we have the dollar invested
plus interest
Risk-Return Trade-off

No one likes risk for its own sake. Therefore
people will only take on more risk if they are
compensated with higher returns
 Higher

the risk higher expected return
Note expected return may not be equal to the realized
return.
Cash is King

Profit, Earnings, Net Income are accounting
numbers designed to measure performance.
 These
numbers can be manipulated
Cash flows are the actual dollars flowing in
and out of the company and can’t be
manipulated as easy
 It is possible for a firm to report profits but
have no cash.

Cash is King: Follow on
Financial decisions should only consider
“incremental cash flow”
i.e. the difference between the cash flows the
company will produce with the new investment and
what it would make without the investment.
Market Prices Reflect News
Investors react quickly to news/information and
decisions made by managers.
Good News ==> Higher stock prices
Bad News ==> Lower stock price.
The Goal of Financial Managers

What is the correct goal?
 Maximize
profit?
 Minimize costs?
 Maximize market share?
 Maximize shareholder wealth?
20
The Financial Manager
The Financial Managers increase shareholder
wealth by:
1. Selecting value creating projects

2.
Capital Budgeting Decision
Making smart financing decisions

Capital Structure Decision
21
Financial Markets
Firms
Stocks and
Bonds
Money
Investors
securities
Bob
Sue
money
Primary Market
Secondary
Market
22
Quick Quiz
1.
2.
3.
4.
What are the three basic questions Financial
Managers must answer?
What are the three major forms of business
organization?
What is the goal of financial management?
What is the difference between a primary
market and a secondary market?
23
Financial Statements
and Cash Flow
Financial Statements

Company managers, investors, and outside analysts use
financial statements to conduct…
 Cash flow analysis
 Performance (ratio) analysis

The SEC requires U.S. companies to produce financial
statements conforming to Generally Accepted Accounting
Principles (GAAP), developed by the Financial
Accounting Standards Board (FASB).
25
Basic Financial Statements
The accounting and financial regulatory
authorities mandate the following four types of
financial statements:
Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholder’s Equity
1.
The Balance Sheet
 A snapshot of the firm’s accounting value at
a specific point in time
 What does the company look like today
 The Balance Sheet Identity is:
 Assets ≡ Liabilities + Stockholder’s Equity
 Left Hand Side of the balance sheet must
equal the Right Hand Side
27
Balance Sheet
Total Value of Assets:
Current Assets
Total Firm Value to Investors:
Current
Liabilities
Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
28
U.S. Composite Corporation Balance Sheet
2007
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets
$140
294
269
58
$761
2006
$107
270
280
50
$707
Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
(550)
(460)
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035
Total assets
$1,879
The assets are listed in order by
the length of time it would
normally take a firm with
ongoing operations to convert
them into cash.
Cash is the most liquid with
intangible assets being the least
liquid.
$1,742
29
Balance Sheet Analysis

When analyzing a balance sheet, the Finance
Manager should be aware of three concerns:
1.
2.
3.
Liquidity
Debt versus Equity
Value versus Cost
30
Liquidity

Refers to the ease and quickness with which assets
can be converted to cash—without a significant loss
in value
 Generally the
more liquid the asset the lower the rate of
return


Current assets are more liquid than fixed assets
The more liquid a firm’s assets, the less likely the
firm is to experience problems meeting short-term
cash obligations (Ex. payroll)
A
profitable but illiquid firm will experience financial
distress
31
Debt versus Equity

Debt → Liability
 Promise

Equity is the residual
 Assets

to payout cash, an IOU
– Liabilities ≡ Equity
Debt represents a senior claim on firm assets
 If
the firm goes bankrupt debt holders get paid
before equity holders
32
Value versus Cost

Accountants are historians, they care about
what something cost when purchase
 Under
GAAP, financial statements carry assets at
cost
Market value is the price at which assets,
liabilities, and equity could actually be bought
or sold, TODAY
 Cost and Market Value are two completely
different concepts

 What
for
did we pay for it, versus what can we sell it
33
The Income Statement

Measures financial performance over a
specific period of time
 How
has the company performed?
The accounting definition of income is:
Revenue – Expenses ≡ Income
 Generally the Income Statement is comprised
of several parts:

34
U.S.C.C. Income Statement
The operations
section of the
income statement
reports the firm’s
revenues and
expenses from
principal
operations.
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
$2,262
1,655
327
90
$190
29
$219
49
$170
84
$86
35
U.S.C.C. Income Statement
The non-operating
section of the
income statement
includes all
financing costs,
such as interest
expense.
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
$2,262
1,655
327
90
$190
29
$219
49
$170
84
$86
36
U.S.C.C. Income Statement
Usually a separate
section reports the
amount of taxes
levied on income.
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
$2,262
1,655
327
90
$190
29
$219
49
$170
84
$86
37
U.S.C.C. Income Statement
Net income is the
“bottom line.”
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
$2,262
1,655
327
90
$190
29
$219
49
$170
84
$86
38
Income Statement Analysis

There are three things to keep in mind when
analyzing an income statement:
Generally Accepted Accounting Principles
(GAAP)
2. Non-Cash Items
3. Time and Costs
1.
39
GAAP
•
•
The matching principal of GAAP dictates that
revenues be matched with expenses.
Thus, income is reported when it is earned,
even though no cash flow may have occurred.
40
Non-Cash Items
•
•
•
•
The income statements also makes allowances
for expense where no money changes hands
Depreciation is the most apparent example.
No firm ever writes a check for
“depreciation.”
Another non-cash item is deferred taxes,
which does not represent a cash flow.
Thus, net income is not cash.
41
Time and Costs
•
•
•
In the short-run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can
vary such inputs as labor and raw materials.
In the long-run, all inputs of production (and hence
costs) are variable.
Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that
distinguishes product costs from period costs.
42
Taxes



“In this world nothing is certain but death and
taxes.” Ben Franklin
Taxes represent a major cost to the firm
Taxes rules change, and are subject to political, not
economic forces
 What
this means is that taxes do not need to make
economic sense

Company is subject to two different tax rates
 Marginal – the percentage paid on the next
 Average – the tax bill / taxable income
dollar earned
43
Marginal versus Average Rates

Suppose your firm earns $4 million in taxable income.

What is the firm’s tax liability?

.15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000
– 100,000) + .34(4,000,000 – 335,000) = $1,356,100


Rate from table 2.3

What is the average tax rate?

What is the marginal tax rate?
If you are considering a project that will increase the firm’s
taxable income by $1 million, what tax rate should you use in
your analysis?
44
Net Working Capital
•
Net Working Capital (NWC)≡
Current Assets – Current Liabilities
•
NWC is usually positive for a growing firm
•
Why?
45
U.S.C.C. Balance Sheet
$252m = $707- $455
2007
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets
$140
294
269
58
$761
2006
$107
270
280
50
$707
Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
(550)
(460
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035
$275m = $761m- $486m
2007
Current Liabilities:
Accounts payable
Notes payable
Accrued expenses
Total current liabilities
$1,879
$1,742
$197
53
205
$455
Long-term liabilities:
Deferred taxes
Long-term debt
Total long-term liabilities
Here we see NWC grow
$117 to $104
471
458
$275 million in 2006 from
$588
$562
$252 million in 2005.
Stockholder's equity:
Preferred stock
$39
$39
$23
million
Common stock ($1 par value)
55
32
Capital surplus
347
327
This
increase
of
$23
million
is
Accumulated retained earnings
390
347
Lessinvestment
treasury stock
(26)
(20)
an
of the firm.
Total equity
Total assets
$213
50
223
$486
2006
$805
$725
Total liabilities and stockholder's equity $1,879
$1,742
46
Financial Cash Flow
As finance people what we are really
interested in is the firm’s actual cash flow
 Since there is no magic in finance, it must be
the case that the cash flow received from the
firm’s assets must equal the cash flows to the
firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)

47
U.S.C.C. Financial Cash Flow
Cash Flow from Assets
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow to Investors
$238
-173
-23
$42
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$36
6
$42
48
The Cash Flow Statement
The Cash Flow Statement is used by firms to
explain changes in their cash balances over a
period of time by identifying all of the sources
and uses of cash for the period spanned by the
statement.
The Statement of Cash Flows

The three components are:
 Cash
flow from operating activities
 Cash flow from investing activities
 Cash flow from financing activities
50
U.S.C.C. Cash Flow from Operations
Idea: Translate Net Income into cash
To calculate cash
flow from operations,
start with net income,
then add back noncash items like
depreciation and
adjust for changes in
current assets and
liabilities (other than
cash).
Operations
Net Income
Depreciation
Deferred Taxes
Changes in Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
Accrued Expenses
Notes Payable
Other
Total Cash Flow from Operations
$86
90
13
-24
11
16
18
-3
-8
$199
51
U.S.C.C. Cash Flow from Investing
Cash flow from investing activities involves changes in capital
assets: acquisition of fixed assets and sales of fixed assets (i.e.,
net capital expenditures).
The cash from sales of our buildings/machinery minus the cost
of buildings/machinery we bought
Acquisition of fixed assets
Sales of fixed assets
Total Cash Flow from Investing Activities
-$198
25
-$173
52
U.S.C.C. Cash Flow from Financing
Cash flows to and
from creditors and
owners include
changes in equity and
debt.
Retirement of debt (includes notes)
Proceeds from long-term debt sales
Dividends
Repurchase of stock
Proceeds from new stock issue
Total Cash Flow from Financing
-$73
86
-43
-6
43
$7
53
U.S.C.C. Statement of Cash Flows
The statement of
cash flows is the
addition of cash
flows from
operations,
investing, and
financing.
Operations
Net Income
Depreciation
Deferred Taxes
Changes in Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
Accrued Expenses
Notes Payable
Other
Total Cash Flow from Operations
Investing Activities
Acquisition of fixed assets
Sales of fixed assets
Total Cash Flow from Investing Activities
Financing Activities
Retirement of debt (includes notes)
Proceeds from long-term debt sales
Dividends
Repurchase of stock
Proceeds from new stock issue
Total Cash Flow from Financing
Change in Cash (on the balance sheet)
$86
90
13
-24
11
16
18
-3
-8
$199
-$198
25
-$173
-$73
86
-43
-6
43
$7
$33
54
Quick Quiz
1.
2.
3.
4.
What is the difference between book value and
market value? Which should we use for decision
making purposes?
What is the difference between accounting
income and cash flow? Which do we need to use
when making decisions?
What is the difference between average and
marginal tax rates? Which should we use when
making financial decisions?
How do we determine a firm’s cash flows? What
are the equations, and where do we find the
information?
55
Financial Statements
Analysis and LongTerm Planning
Financial Statements Analysis

Common-Size Balance Sheets
 Compute

Common-Size Income Statements
 Compute


all accounts as a percent of total assets
all line items as a percent of sales
Standardized statements make it easier to compare
financial information, particularly as the company
grows.
They are also useful for comparing companies of
different sizes, particularly within the same industry.
57
Ratio Analysis
Ratios allow for a better comparison through
time and/or between companies
 Give a sense for how the firm is doing
 As we look at each ratio, ask yourself:

 How
is the ratio computed?
 What is the ratio trying to measure and why?
 What is the unit of measurement?
 What does the value indicate?
 How can we improve the company’s ratio?
58
Categories of Financial Ratios
Short-term solvency, or liquidity ratios
 Long-term solvency, or financial leverage
ratios
 Asset management, or turnover ratios
 Profitability ratios
 Market value ratios

59
Liquidity Ratios

These measure the ability of the firm to meet it’s
short term obligations
 Why

Current Ratio = CA / CL
 708

/ 540 = 1.31 times
Quick Ratio (Acid Test) =(CA – Inventory) / CL
 (708

- 422) / 540 = 0.53 times
Cash Ratio = Cash / CL
 98

is this important?
/ 540 = 0.18 times
Where do the “raw” numbers come from?
60
Leverage Ratios

These measure the ability of the firm to meet it’s long
term obligations
 Why

is this important?
Total Debt Ratio = (TA – TE) / TA
 (3588

Debt/Equity = TD / TE
 (3588

– 2591) / 2591 = 38.5%
Equity Multiplier = TA / TE = 1 + D/E
1

- 2591) / 3588 = 28%
+ .385 = 1.385
Where do the “raw” numbers come from?
61
Coverage Ratios

These measure the ability of the firm to pay
it’s debt holders
 Why

Times Interest Earned = EBIT / Interest
 691

/ 141 = 4.9 times
Cash Coverage = (EBIT + Depreciation) /
Interest
 (691

do we care about paying the debt holders?
+ 276) / 141 = 6.9 times
Where do the “raw” numbers come from?
62
Inventory Ratios

These tell else how efficiently the firm manages it’s
inventory
 Why
do we care about this?
 Do we want these ratios to be high or low?
 Where do the “raw” numbers come from?

Inventory Turnover = Cost of Goods Sold / Inventory
 1344

/ 422 = 3.2 times
Days’ Sales in Inventory = 365 / Inventory Turnover
 365
/ 3.2 = 114 days
63
Receivables Ratios

These tell else how quickly the firm is paid?
 Why
do we care about this?
 Do we want these ratios to be high or low?
 Where do the “raw” numbers come from?

Receivables Turnover = Sales / Accounts
Receivable
 2311

/ 188 = 12.3 times
Days’ Sales in Receivables = 365 /
Receivables Turnover
 365
/ 12.3 = 30 days
64
Total Asset Turnover

This tells us how efficiently the firm is turning
assets into sales
 Why

do we care about this?
Total Asset Turnover = Sales / Total Assets
 2311
/ 3588 = 0.64 times
 It is not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets.
65
Profitability Measures

These measure how efficiently the firm operates
 Why
do we care about these?
 Where do the raw numbers come from?

Profit Margin = Net Income / Sales
 363

Return on Assets (ROA) = Net Income / Total Assets
 363

/ 2311 = 15.7%
/ 3588 = 10.1%
Return on Equity (ROE) = Net Income / Total Equity
 363
/ 2591 = 14.0%
66
Market Value Measures

These tell us how the market (people) feel
about the firm
 Where
do these raw numbers come from?
Market Price = $88 per share
 Shares outstanding = 33 million
 PE Ratio = Price per share / Earnings per share

 88

/ 11 = 8 times
Market-to-book ratio = market value per share
/ book value per share
 88
/ (2591 / 33) = 1.12 times
67
The Du Pont Identity




Created by Du Pont in 1920
Breaking ROE (NI/TE)into three parts, so we can
understand where our return comes from
ROE = PM * TAT * EM
Calculation
 ROE
= (NI / TE) (TA / TA)
 ROE = (NI / TA) (TA / TE) = ROA * EM
 ROE = (NI / TA) (TA / TE) (Sales / Sales)
 ROE = (NI / Sales) (Sales / TA) (TA / TE)
68
What does it mean?

ROE = PM * TAT * EM
 Profit
margin is a measure of the firm’s operating
efficiency – how well it controls costs.
 Total asset turnover is a measure of the firm’s
asset use efficiency – how well it manages its
assets.
 Equity multiplier is a measure of the firm’s
financial leverage.
69
Using Financial Statements
Ratios are not very helpful by themselves: they
need to be compared to something
 Time-Trend Analysis

 Used
to see how the firm’s performance is
changing through time

Peer Group Analysis
 Compare
to similar companies or within industries
 SIC and NAICS codes
70
Potential Problems to Remember when
Analyzing Financial Statement


There is no underlying theory, so there is no
definitive way to know which ratios are most relevant
Benchmarking is difficult
 Especially for

diversified firms
Firms use varying accounting procedures
 Ex. LIFO versus FIFO
 Globalization means different


accounting regulations
Firms have different fiscal years
Extraordinary, or one-time, events
71
Financing Growth

When growth is slow, the firm may be able to rely
on internal financing
 Just

using what they make
At higher growth rates, the firm will likely need
to go to the capital market for additional financing
72
The Internal Growth Rate


The internal growth using the funds it generates
The Internal Growth Rate can be calculated with
ROA and Plowback

Plowback ratio: how much of net income is being
reinvested in the company

 IGR
b = Addition to Retained Earnings / Net Income
= (ROA * b)/(1-ROA * b)
73
IGR Calculation


If a firm has an ROA of 0.132, and a plowback ratio
of 0.667, what is its IGR?
IGR = (ROA * b )/ (1 – ROA * b)
74
The Sustainable Growth Rate

The sustainable growth rate tells us how fast
the firm can grow by using internally
generated funds and issuing debt, without
changing the firm’s capital structure
Do
you expect this be higher or lower than the
internal growth rate?

The Sustainable Growth Rate is calculated
with ROE and Plowback

Just like IGR but use ROE instead of ROA
75
SGR Calculation
If the same firm has an ROE of 0.264, what is
its SGR? Remember plowback is 0.667
 (ROE * b )/ (1 – ROE * b)

76
Quick Quiz
1.
2.
3.
4.
5.
How do you standardize balance sheets and
income statements?
Why is standardization useful?
What are the major categories of financial ratios?
How do you compute the ratios within each
category?
What are some of the problems associated with
financial statement analysis?
77
Quick Quiz
6.
7.
8.
9.
10.
11.
What is the purpose of long-range planning?
What are the major decision areas involved in
developing a plan?
What is the percentage of sales approach?
What is the internal growth rate?
What is the sustainable growth rate?
What are the major determinants of growth?
78