FINC 301: INTRODUCTION TO BUSINESS
FINANCE
2022/2023
Professor Godfred A. Bokpin
BSc Admin (Accounting), MPhil (Finance),
PhD (Economics), Email: gabokpin@ug.edu.gh
COURSE DESCRIPTION AND
OBJECTIVES

As an introductory finance course, it offers an overview of the
finance function from the perspective of the corporate financial
manager. Specifically, this course will cover: (i) the role of the
finance manager and a working knowledge of financial
markets, (ii) corporate financial concepts such as the time
value of money, financial statement analysis, sources of
financing to a firm, and (iii) some basic decision-making
frameworks, namely, working capital management and shortterm financing. This course also introduces students to the
nature and workings of financial markets and their use by
corporations and investors.
Course Overview



No matter how brilliant a business idea is,
without funding, it cannot generate wealth.
On the other hand, given that financial resources
are limited, these resources must always be
utilized in the most efficient manner given the
goals of the firm.
This course seeks to situate the finance function
within the broader organizational setting and
outline its role in achieving stellar financial
performance.
Slide 3
Course Objectives

You will learn how to use financial management for problem-solving and
decision-making in your personal life and professional role as managers,
financial analysts etc. Specifically, on successful completion of this
subject, students would be able to:
i. Explain the various decision roles of a financial manager, ii. Diagnose the
financial health of an organization, prepare financial analysis reports and
offer appropriate financial advice, iii. Determine the relevant components
that drive profits for a business venture, iv. Determine the growth potential
of an organization based on its funding capacity, Select the appropriate
funding method for an organization’s growth agenda, v. Determine the
appropriate balance between working capital management and firm
performance, vi. Make simple investment decisions by applying the time
value of money concept
TGBTG
Slide 4
Overview of Corporate Financial
Management and the Financial Environment


Effective financial management is the defining characteristic between successful
firms and failed firms. Finance plays a critical role in business and society. This
session seeks to introduce students to the financial manager’s role and the financial
management decisions. It also exposes students to the competing goals to the
ultimate goal of value maximization.
At the end of this session, students should be able to:
– Differentiate between the financial implications of the different forms of
business organization
– Explain the basic types of financial management decisions and the role of the
financial manager
– Explain the goal of financial management
– Illustrate the agency problem and the role of corporate governance.
– Identify the various types of financial markets, transactions and financial
institutions
Session Objectives
At the end of the session, the student will
1. Explain the decision roles of the finance
manager
2. Identify the various forms and implications of
business organizations available
3. Explain the concept of financial markets and
related issues
4. Explain the concept of wealth maximization,
agency and governance
Slide 6
Session Outline
The key topics to be covered in the session are as follows:




Topic 1 - The Various Forms of Business Organizations
Topic 2 - The Role and Goal of the Finance Manager
Topic 3 -Ownership versus control of corporations and
Agency Issues
Topic 4 - Financial Markets
Slide 7
FORMS OF BUSINESS
ORGANIZATION
In Practice, businesses can be setup using any one of
the following forms of business organizations:
– Sole proprietorship
– Partnership
– Corporation (center of our financial management
sessions)
 Which form of business organisation is dominant
in Ghana and why
 What kind of support do they need to excell
 Are these support mechanisms available & working
Sole Proprietorship




A business that is organized as a sole proprietorship has a
single owner who usually provides all the capital from
personal resources.
Banks, friends and relatives are the primary sources available
to the sole proprietor for raising borrowed funds.
A sole proprietor is personally liable for all the debts of the
business.
For tax purposes in most settings, all income of the business
is treated as the proprietor's personal income and taxed at tax
rates applicable to personal income.
The Sole Proprietorship



This business is normally owned and run by one person(in numbers)
and typically has few, if any, employees
Advantages
– No formal charter required (easy to create)
– Less or possibly no regulation
– Significant tax savings
– Minimal organizational costs
– Profits and control not shared with others
Disadvantages
– Limited ability to raise large sums of money
– Unlimited liability for the owner
– Limited to the life of the owner
– Usually no tax deductions for employees health, life or disability
Slide 10
insurance
Partnership




A partnership is an agreement between two or more persons
to operate a business; (2-20 for Ghana).
The partners are "jointly and severally" responsible for the
debts of the partnership.
A partnership is not taxed as a business. Instead, the income
of the business is allocated to the partners and each partner's
share of the income is taxed as if it were income from a
proprietorship.
In general a partnership interest cannot be sold without the
consent of the other partners.
The Partnership


Advantages
– Minimal organizational effort and costs
– Easy to raise capital
Disadvantages
– Unlimited liability for the individual partners
– Limited ability to raise large sums of money
– Dissolved upon the death or withdrawal of any of
the partners
Slide 12
The Corporation

Corporation is a legal entity separate from its owners
– Owners are known as stockholders/shareholders,
– Ownership is evidenced by the possesion of shares or stocks
– Most important of all the business organizations in terms of



Total sales, Assets ,Profits, Contribution to national income
Has many of the legal powers individuals have such as the ability
to enter into contracts, own assets, and borrow money
The corporation is solely responsible for its own obligations. Its
owners are not personally liable for any obligation the
corporation enters into.
Slide 13
The Corporation

Advantages
– Unlimited life
– Limited liability for its owners, as long as no personal guarantee on a
business-related obligation such as a bank loan or lease
– Ease of transfer of ownership through transfer of stock
– Ability to raise large sums of capital

Disadvantages
– Difficult and costly to establish, as a formal charter is required
– Subject to double taxation on its earnings and dividends paid to
stockholders
– Bankruptcy, even at the corporate level, does not discharge tax
obligations
Slide 14
Limited Liability Company



Ownership interest is called "equity" which is
represented by "shares".
A limited liability company is an independent legal
entity.
A limited liability company is a taxable entity and
pays tax on its taxable income at the corporate tax
rate. Dividends are taxed in the hands of
shareholders as their personal income. Thus the
limited liability company is subject to "double
taxation".
Limited Liability Company
Many limited liability companies are "private"
or "closely held" in the sense that they do not
issue shares to the public. Companies that can
legally issue shares to the public are called
"public companies".
 One of the advantages of the limited liability
company is that it can raise capital by
borrowing and issuing additional shares

The Corporation


Advantages
– Unlimited life
– Limited liability for its owners, as long as no personal guarantee on
a business-related obligation such as a bank loan or lease
– Ease of transfer of ownership through transfer of stock
– Ability to raise large sums of capital
Disadvantages
– Difficult and costly to establish, as a formal charter is required
– Subject to double taxation on its earnings and dividends paid to
stockholders
– Bankruptcy, even at the corporate level, does not discharge tax
obligations
Slide 17
Concept of Finance




Finance as a subject is thought to relate to three areas of studies
constituting Economics, Accounting and Mathematics. But studying
finance is not the same as studying any of these related disciplines but
an understanding of the basic relationship is necessary for the finance
student. Finance theory is a set of concepts that help think through
resource allocation over time. Finance may then be looked at as the
study of allocation of scarce resources over time. Finance can be
understood as an extension of economics, but studying finance is not
identical to studying economics
Finance can be said to be applied economics or economics of time and
risk
Finance concerns more about valuation reflecting passage of time and
risk or a science of valuation
Finance also involves decision making including: investment, financing
and working capital management/dividend policy decisions
FINANCE FUNCTIONS IN A COMPANY
I. PLANNING
III. ADMINISTRATION OF FUNDS
– Long and Short-term corporate plans
– Manage cash; Manage investments
– Budgeting for capital expenditures and
– Make banking arrangements
operations
– Receive, keep and disburse the firm’s money
– Sales forecasting
– Credit and Collection management
– Performance evaluation
– Management of provident/pension funds
– Pricing
IV. ACCOUNTING AND CONTROL
– Economic appraisal
– Establishment of accounting policies
– Analysis of acquisitions and disinvestments,
– Development and reporting of accounting
etc.
II. PROVISION OF CAPITAL
– Establish and execute plans to acquire
capital
PROTECTION OF ASSETS
– Provision of insurance coverage
– Assure protection of business assets
and loss prevention through internal
and external auditing
– Real estate management
–
–
–
–
–
–
data
Cost standards
Internal auditing
Systems and procedures (accounting)
Government reporting
Report and interpretation of results of
operations to management
Comparison
of
performance
with
operating plans and standards
FINANCE FUNCTIONS IN A COMPANY
Finance Function
Finance Function
VI. TAX ADMINISTRATION
VIII. EVALUATION AND CONSULTING
– Establishment and administration
– Consultation and advice to other
of tax policies and procedures
corporate executives on company policy,
operations, objectives and effectiveness
– Relations with tax agencies
thereof
– Preparation of tax reports
IX.
MANAGEMENT
INFORMATION
– Tax planning
SYSTEMS
– Development and use of electronic data
VII. INVESTOR RELATIONS
processing facilities
– Establishment and maintenance of
– Development and use of management
liaison with investment community
information systems
– Establishment and maintenance of
– Development and use of systems and
communications with company
procedures
stockholders
– Counseling with analysts - public
financial information
The Goal of Financial Management


Main goal of the financial manager is to add value to
the organisation
Stock holder wealth maximization
– Modern managerial finance theory operates on the
assumption that the primary aim of the firm is to
maximize the wealth of its stock holders.
• Alternative Goals of Financial Management
Profit maximization
 Managerial reward maximization
 Behavioral goals and
 Social responsibility

Slide 21
The Goal of Financial Management

Stock holder wealth maximization
– Modern managerial finance theory operates on the
assumption that the primary aim of the firm is to
maximize the wealth of its stock holders.
• Alternative Goals of Financial Management




Profit maximization
Managerial reward maximization
Behavioral goals and
Social responsibility
Slide 22
The Goal of Financial Management
Slide 23
Wealth Maximization


How can the financial manager affect stockholder’s wealth
maximization?
By influencing the
– Present and future earnings per share (EPS)
– Size, timing and the risk of these earnings
– Dividend policy
– Manner of financing the firm
In essence, how excellently the financial manager executes
these functions determine the ultimate success of the
business.
Slide 24
Session 1: Exercise 1

Discuss the advantages and disadvantages of
pursuing Managerial reward maximization,
behavioral goals and social responsibility as goals
of the finance function in an organisation.
Slide 25
OWNERSHIP VERSUS CONTROL
OF CORPORATIONS AND
AGENCY ISSUES
TGBTG
Slide 26
Separation of Ownership & Control




A situation in which the owners of a business do not manage it or control
it. This applies particularly in large publicly-owned companies.
It can also apply to smaller family-owned companies where the business is
run by managers.
This separation of ownership and management gives rise to an agency
relationship: when one or more persons(principals) employ one or more
other persons (agents) to perform some task.
Primary agency relationship exist between
– Shareholders and managers
– Managers and creditors

These relationships are major source of agency problems
Slide 27
PRINCIPAL-AGENT PROBLEM






In economic terms, the manager’s mandate will be to maximize owner’s
wealth.
That is, there is now a SEPARATION OF OWNERSHIP from
MANAGEMENT
This gives rise to a Principal-Agent relationship
Management need not know anything about shareholder tastes or
consumption preferences. His/Her task is to maximize the value of
investment.
However, owners run the risk that managers may look after their own
interest at the expense of owners who provide the funds.
The potential that this may happen is referred to as the, PRINCIPALAGENT PROBLEM or AGENCY PROBLEM
28
Agency Problem


The agency problem is a conflict of interest inherent
in any relationship where one party is expected to act in
another's best interests including in democracy.
In business/corporate finance, the agency problem
usually refers to a conflict of interest between a
company's management and the company's
shareholders.
– For E.g. Managers take decisions which are not in
line with the goal of maximizing stock holders
wealth
– Managers work less eagerly and benefit themselves
in terms of salaries and perks
Slide 29
Agency Costs and Corporate Governance



Agency costs are thus the tangible and intangible
expenses borne by shareholders because of
disagreement between shareholders and managers or
the self-serving actions of managers.
These costs can be explicit, out-of-pocket expenses
– E.g. the costs of auditing financial statements to
verify their accuracy
Or more implicit ones
– e.g. Reduced stock price.
Slide 30
Corporate Governance



In order to minimize this agency problems and its
associated costs, a corporate governance system is
instituted.
Corporate governance is typically explained as the
manner in which firms are governed.
The most visible mode of corporate governance is the
corporate board of directors, which is a group of persons
acting as representatives of a firm’s shareholders and responsible
for establishing corporate management related policies and
making decisions on major company issues.
 In
essence, the expertise and integrity of the board determines how
successful a firm will be.
Slide 31
FINANCIAL MARKETS
TGBTG
Slide 32
Financial Markets Explained



A financial market is a broad term describing any marketplace
where buyers and sellers participate in the trade of financial
assets such as equities, bonds, currencies, and derivatives.
Is a system rather than a physical location including its
regulation that brings suppliers of funds and users together
and not a central location necessarily
The importance of financial markets for the development of a
country's economy cannot be overemphasized. The financial
market gives strength to the economy by making finance
available in the right place.
Slide 33
Financial Markets & Corporate Governance

Market for financial securities
– Money Markets and Capital Markets
– Suppliers of funds
– Users of funds
– Financial securities/assets/vehicles/instruments
– Intermediaries
– Regulators


Efficient financial markets allow for efficient allocation of
resources from units with surpluses to units in need
What does this mean?
34
The Classification of Financial Markets


There are different ways of classifying financial markets. One way is to
classify financial markets by the type of financial claim.
– The Debt market is the financial market for fixed claims of debt
instruments and
– the Equity market is the financial market for residual claims or equity
instruments.
A second way is to classify financial markets by the maturity of claims.
– The market for short-term financial claims is referred to as Money
Market and
– the market for long-term financial claims is called the Capital market.
– Traditionally, the cutoff between short-term and long-term financial
claims has been one year – though the dividing line is arbitrary, it is
widely accepted.

Since short-term financial claims are invariably debt claims, the money market
is the market for short-term debt instruments. The capital market is the
market for long-term instruments and equity instruments.
TGBTG
Slide 35
The Classification of Financial
Markets



A third way to classify financial markets is based on whether the claims
represent new issues or outstanding issues.
– The market where issuers sell new claims is referred to as the Primary
market and
– the market where investors trade outstanding securities is called the
Secondary market.
A fourth way to classify financial markets is by the timing of delivery.
– A Cash or Spot market is one where the delivery occurs immediately and
– a Forward or Futures market is one where the delivery occurs at a predetermined time in the future.
A fifth way to classify financial markets is by the nature of its organizational
structure.
– An Exchange-traded market is characterized by a centralized organization
with standard procedures.
– An Over-the-counter market is a decentralized market with customized
procedures.
TGBTG
Slide 36
Cash flows to and from the firm
Slide 37
Financial Markets issues
 Risk - return tradeoff/risk that determines
returns.
 Time value of money.
 Focus on Cash - not
profits
 Incremental cash flows
count.
 The curse of competitive
markets.
 Efficient capital markets.
 The agency problem.
 Taxes bias business
decisions.
 All risk is not equal.
 Ethical dilemmas are
everywhere in finance
 All cash flows occur at
the year end
 Rates are always quoted
per annum.
FINANCIAL STATEMENT ANALYSIS
39
LEARNING OBJECTIVES
1. Describe and discuss financial
performance evaluation by internal and
external users.
2. Describe and discuss the standards for
financial performance evaluation.
3. State the sources of information for
financial performance evaluation.
40
LEARNING OBJECTIVES
(CONT’D…)
4. Identify Tools and Techniques of
Performance Evaluation.
5. Discuss Major Categories of Accounting
Ratios.
6. Discuss Significance and Limitations of
Ratio Analysis.
41
Financial Performance Evaluation by
Internal and External Users
OBJECTIVE 1
Describe and discuss financial
performance evaluation by internal
and external users.
42
The Purpose of Accounting:
Financial Information
Financial analysis is a process of selecting, evaluating, and
interpreting financial data, (along with other pertinent
information) with the purpose of formulating an assessment
of a company’s present and future financial condition and
performance
Financial Statement Analysis is the process of identifying the
financial strengths and weaknesses of a business by establishing a
relationship between the elements of the balance sheet and
income statement.
The focus is typically on the financial statements, as they are a
disclosure of financial performance of a business entity but
other reports are also important

Financial Performance Evaluation


Financial performance evaluation, also called financial
statement analysis, comprises all the techniques employed by
users of financial statements to show important relationships
in the financial statements and the trend in those numbers
over time.
Users of financial statements fall into two broad categories:
internal users and external users. Users of a financial
statement may be classified into those with direct financial
interest and indirect financial interest
44
A Hierarchy of Accounting Qualities
Traditional Assumptions
of the Accounting Model
• Business Entity
• Going Concern or
Continuity
• Time Period
• Monetary Unit
• Historical Cost
• Conservatism
• Realization
•
•
•
•
•
•
•
•
Matching
Consistency
Full Disclosure
Materiality
Industry Practices
Transaction Approach
Cash Basis
Accrual Basis
Financial Statement Analysis:
Players in the Communication Process…
Management
Preparation
CFO, CEO, Accounting Staff
Guided by GAAP
Management
Accounting
input
Independent Auditors
Verification
Partners, Managers, Staff
Guided by GAAS
Information
Intermediaries
Government
Regulators
Financial analyst/services
SEC,GSE
Analysis and Advice
Verification
Guided by Code.
Guided by SEC regs.
Users
Analysis and Decision
Investors, Lenders, etc.
47
Public
companies only
Financial Statement Analysis:
Common Objectives
1.
2.
Assessing the historical operating performance and
financial health of a supplier, customer, or competitor.
To understand the economics of a firm in order to
forecast its future profitability and risks
– Profitability is an increase in wealth
– Risk is the probability that a specific level of
profitability will not be achieved.
48
Financial Statement Analysis:
Common Objectives (Cont’d…)
3.
An assessment of future profitability and risks is often meant
to provide a basis for
– making an investment in a firm’s common/ordinary or preferred
stock.
– extending credit (short or long-term)
– valuing a firm in settings such as an IPO, an acquisition candidate,
in court-directed bankruptcy hearings, or in liquidation actions.
– forming an opinion on a client’s financial statements with respect to
whether the client is a “going concern.”
– assessing whether combinations in an industry might generate
unreasonable (monopoly) returns, thus prompting antitrust action
by government regulators.
49
The Users of Accounting Information
DECISION MAKERS
Management
Various
functional
areas in
Organizations
Those with
Direct Financial
Interest
Those with
Indirect
Financial
Interest
Owners
Government
Creditors
Agencies
Labour Unions
Public
50
Internal User
Management is an internal user



Management’s primary objective is to increase the
wealth of the owners or stockholders of the
business.
Management’s main responsibility is to carry out
plans to achieve the financial performance
objectives.
Management develops monthly, quarterly, and
annual reports that compare actual performance
with objectives for key financial measures.
51
External Users
Creditors make loans in various forms.
 Investors buy shares, from which they
hope to receive dividends and an increase
in value.
 Both groups face risks and for both the
goal is to achieve a return that makes up
for the risk.

52
Others Users of Financial
Information



Government and its Agencies
Employees and Trade Unions
Company’s Publics
53
Standards for Financial Performance
Evaluation (Benchmarking)
OBJECTIVE 2
Describe and discuss the standards for
financial performance evaluation.
54
Standards for Financial Performance
Evaluation (Benchmarking)
The general standards of comparison include:
 Company’s own set of data
– Past data
– Future data
 Inter-firm comparison (Benchmarking against a
competitor etc)

Industry Average
55
Sources of Information
OBJECTIVE 3
State the sources of information for
financial performance evaluation.
56
Reports Published by the Company


The annual report of a company is an important source
of financial information.
The main parts of an annual report are:
– Management's analysis of the past year's operations.
– The financial statements.
– The notes to the statements, including the principal
accounting procedures used by the company.
– The auditors' report.
– A summary of past operations.
57
Tools and Techniques of Performance
Evaluation
OBJECTIVE 4
Apply horizontal analysis, trend
analysis, and vertical analysis and
Ratio Analysis to financial
statements.
58
Tools and Techniques of
Financial Performance Evaluation



Few numbers are very significant when
looked at individually.
It is the relationship between various
numbers or their change from year to year
that is important.
The tools of financial performance
evaluation are intended to show
relationships and changes.
59
Horizontal Analysis
Horizontal analysis is the process of computing changes in like items
from one year to another
The horizontal analysis begins with the computation of changes from the
previous year to the current year. The base year is the first year
considered.
Then dividing the cedi amount of change by the base period amount.
The horizontal analysis uses both cedi amounts and percentages.
Percentage Change = 100 x
(
)
Amount of Change
Base Year Amount
60
Financial Statement Analysis: Horizontal
Analysis Tool
Increase (Decrease)
1998
Sales
1997
Amount
Percent
9.5%
$18,284
$16,701
$1,583
3,141
3,205
(64)
Net income
Prepared by F. AboagyeOtchere & J.K. Otieku
61
(2.0%)
Financial Statement Analysis:
Trend Analysis Tool

A form of horizontal analysis that examines more than a
two- or three-year period
– Use a selected base year whose amounts are set equal to
100 percent
– Compute trend percentages, each item for following years
is divided by the corresponding amount during the base
year
– Trend analysis is important because it may point to basic
changes in the nature of a business.
Any year $
Trend % =
Base year $
62
Financial Statement Analysis:
Trend Analysis Tool (Cont’d…)
(in millions)
1998
Net Sales
$18,284
Cost of products sold
4,856
Gross profit
13,428
1997
1996
1995
1994
1993
$16,701
4,464
12,237
$15,065
3,965
11,100
$13,767
3,637
10,130
$11,984
3,122
8,862
$11,413
3,029
8,384
The resulting trend percentages follow:
1998
1997
1996
1995
1994
1993
Net sales
160%
Cost of products sold 160
Gross profit
160
146%
147
146
132%
131
132
121%
120
121
105%
103
106
100%
100
100
Sales, cost of products sold, and gross profit have trended
63
upward at almost identical rates throughout
the five-year period
Vertical Analysis




Percentages are used to show the relationship of the
different parts to a total in a single statement.
The analyst sets a total figure in the statement equal to
100% and computes each component’s percentage of that
total.
The statement of percentages is called a common-size
statement.
Vertical analysis is useful for comparing the importance of
specific components in the operation of a business and
changes in the components from one year to the next.
64
Financial Statement Analysis:
Vertical Analysis Tool


Vertical analysis of a financial statement reveals the
relationship of each statement item to a specified base,
which is the 100% figure
Every other item on the financial statement is then
reported as a % of that base (common-size ratios)
– When an income statement is analyzed vertically, net
sales is usually the base
– Vertical analysis of balance sheet amounts are shown as
a percentage of total assets
Vertical analysis % =
Each income statement item
Net Sales
65
Financial Statement Analysis:
Vertical Analysis Tool (Cont’d...)
FINC 301 COMPANY
Income Statement (Adapted)
Years Ended December 31, 1998 and 1997
Dollar amounts in millions
Net sales
$18,284 100.0%
Cost of products sold
4,856
26.6
Gross profit
13,428
73.4
Operating expenses :
Marketing, selling,
and administrative
4,418
24.2
Advertising and products
promotion
2,312
12.6
Research and development
1,577
8.6
Special charge
800
4.4
Provision for restructuring
201
1.1
Other
(148)
(0.8)
Earnings before income taxes 4,268
23.3
Provision for income taxes
1,127
6.1
66
Net earnings
$ 3,141
17.2%
$16,701
4,464
12,237
100.0%
26.7
73.3
4,173
25.0
2,241
1,385
13.4
8.3
225
(269)
4,482
1,277
$ 3,205
1.3
(1.5)
26.8
7.6
19.2%
Ratio Analysis




The way to compare companies of different sizes is to use standard
measures
Financial ratios are standard measures that enable analysts to compare
companies of different sizes
A Financial Ratio is a relationship between two accounting figures
expressed mathematically.
Ratios are guides or shortcuts that are useful in:
– Evaluating a company’s financial position and operations.
– Making comparisons with results in previous years or
with other companies.

The primary purpose of ratios is to point out areas needing further
investigation.
67
Major Categories of Ratios
OBJECTIVE 5
Discuss major categories of
Accounting ratios.
68
Financial Statement Analysis:
Ratio Analysis

The ratios used to make business decisions may be
classified broadly as follows:
– Ratios that measure the company’s ability to pay or the
risks of not meeting current liabilities [liquidity ratios]
– Ratios that measure the company’s ability to sell
inventory, collect receivables, etc [activity ratios]
– Ratios that measure the company’s ability to pay or the
risks of not meeting long-term debt [solvency ratio]
– Ratios that measure the company’s profitability
– Ratios used to analyze the company’s shares as an
investment [investment ratios]
69
Evaluating Liquidity


Liquidity is a company's ability to pay bills when they are
due and to meet unexpected needs for cash.
All ratios that relate to liquidity involve working capital
or some part of it.
– Current ratio: measures short-term debt-paying
ability.
– Quick ratio: measures short-term debt-paying ability.
– Acid-Test ratio: measures short-term debt-paying
ability.
70
Analysis of Risk and Liquidity
• Factors that affect risk of a firm
–
–
–
Economy-wide factors such as inflation
Industry-wide factors such as competition
Firm-specific factors such as potential for a labour strike
• Questions or issues on liquidity
a) Can the firm pay short-term obligations like workers' wages?
That is, what are measures of short term risk?
b) Can the firm pay long-term obligations like debt? That is, what
are long-term measures of risk?
71
Liquidity Ratio
Current Ratio = Current Assets
Current Liabilities
Quick Ratio =
Current Assets - Stock
Current Liabilities
Acid-Test Ratio =
Cash + cash Equivalents
Current Liabilities
72
Working Capital Financing Policy

Working capital financing policies may include
– Moderate: Match the maturity of the assets with the
maturity of the financing.
– Aggressive: Use short-term financing to finance
permanent assets.
– Conservative: Use permanent capital for permanent
assets and temporary assets.
73
Evaluating Profitability



Profitability reflects a company's ability to earn a satisfactory income.
A company's profitability is closely linked to its liquidity because
earnings ultimately produce cash flow.
Profitability ratios include:
– Profit margin: measures net income produced by each sales cedi.
– Asset turnover: measures how efficiently assets produce sales.
– Return on assets: measures overall earning power.
– Return on equity: measures profitability of shareholder investments.
74
Profitability Ratios
Return on Assets =
Net Income
Total Assets
Profit Margin =
Net Income
Net Sales
Asset Turnover =
Net Sales
Average Total Assets
Return on Equity =
Net Income
Stockholders’ Equity
Evaluating Activity Ratios


Activity ratios measure how efficient a firm is at
using the firm's resources.
Activity ratios include:
– Rate of Stock Turnover
– Average Collection period
– Average Payment Period
– Fixed Assets Turnover
76
Activity Ratios
Rate of Stock Turnover = Cost of Sales
Average Stock
Average Collection Period = Receivables * 360 Days
Credit Sales
Average Payment Period = Trade Creditors * 360 Days
Credit Purchases
Fixed Assets Turnover
=
Fixed Assets
Turnover
77
Activity Ratios
Rate of Stock Turnover =
Cost of Sales
Average Stock
Average Collection Period = Receivables * 360 Days
Credit Sales
Average Payment Period = Trade Creditors * 360 Days
Credit Purchases
Fixed Assets Turnover =
Fixed Assets
Turnover
Evaluating Long-Term Solvency


Long-term solvency has to do with a
company's ability to survive for many years.
The aim of long-term solvency analysis is to
detect early signs that a company is headed for
financial difficulty.
Early signs that a company is on the road to
bankruptcy include:
– Declining profitability and liquidity ratios.
– Unfavorable debt to equity ratio.
– Unfavorable interest coverage ratio.
79
Solvency Analysis
 A company’s business risk is determined,
in large part, from the company’s line of
business.
 Financial risk is the risk resulting from a
company’s choice of how to finance the
business using debt or equity.
 We use solvency ratios to assess a
company’s financial risk.
 There are two types of solvency ratios:
component percentages and coverage
ratios.
◦ Component percentages involve
comparing the elements in the capital
structure.
◦ Coverage ratios measure the ability to
meet interest and other fixed financing
costs.
Risk
Business Risk
Financial Risk
Sales Risk
Operating Risk
80
Long-Term Solvency
Debt to Equity Ratio =
Long-term Liabilities
Stockholders’ Equity

Measures capital structure and leverage.

Failure to honor debt can result in bankruptcy, so debt is risky.

BUT debt provides flexible financing:
– It can be temporary.
– Interest is tax deductible.
– It leverages stockholders’ investments if the company earns a
return on assets greater than the cost of interest.
Long-Term Solvency
(Cont’d…)
Interest Coverage Ratio = Income Before Income Taxes + Interest Expense
Interest Expense

Measures creditors’ protection from default on interest payments.
82
Summary of Solvency ratios
Component-Percentage
Solvency Ratios
Proportion of assets financed with debt.
Proportion of assets financed with long-term
debt.
Debt financing relative to equity financing.
Reliance on debt financing.
Coverage Ratios
Ability to satisfy interest obligations.
Ability to satisfy interest and lease obligations.
Ability to satisfy interest obligations with cash
flows.
Length of time needed to pay off debt with
cash flows.
83
Evaluating Investment Ratios


Investment ratios are used to analyze and
evaluate a company’s shares as an investment.
Investment ratios include:
– Earnings per share
– Price-Earnings ratio (P/E ratio)
– Dividend Yield etc.
84
Earnings per Share
• This ratio is the profit that is attributable to each share of
common stock.
• It would be simply the net income less preferred dividends
divided by the number of common shares.
• However, the number of common shares is complicated by
certain securities that may become (converted to) common
share. How to account for these is a complex issue.
• For example, if there are 100 common shares but 50
preferred shares that could convert to 50 common shares,
do you divide earnings by 100 or 150? The answer depends
on how likely it is that the convertible securities will
convert.
85
Earnings Per Share (Cont’d…)
•
•
Most companies strive to increase EPS by about 10 -15% annually
EPS does not consider the amount of assets or capital required to
generate earnings; making it of limited use in comparing two firms.
•
For investment purposes, the price to earnings ratio (P/E ratio) or
P/E multiple is preferably used
86
Price-Earnings Ratio (P/E)
• This is the return to the purchaser of a share.
– P/E = (market price of a share of stock)/(EPS)
– The PE ratio measures the market’s perception of the
quality of a company’s earnings by indicating the price
multiple the capital market is willing to pay for the
company’s earnings.
– Presumably, this ratio reflects the info provided by all
financial info. in that, the market price reflects analysts’
perceptions of the company’s growth potential, stability
and risk.
87
Price-Earnings Ratio (Cont’d…)
»
The P/E ratio commonly serves as a useful proxy for the expected growth rate
in dividends or earnings.
– In fact, a common Wall Street rule of thumb is that the growth rate ought
to be roughly equal to the P/E ratio e.g., see Peter Lynch’s book “One Up
on Wall Street”.
– Ceterus paribus, riskier firms will have lower P/E ratios because they have
higher rates of return.

There are two types of price earnings (PE) ratios or multiples.
– The trailing PE equals the current market price per share of common stock
(CS) divided by the last year’s EPS.
– The forward PE equals the current price per share of CS divided by next
year’s forecasted EPS.
Dividend Yield


»
Dividend yield is the ratio of dividends per share of stock to the
stock’s market price per share
This ratio measures the percentage of a stock’s market value that is
returned annually as dividends
Dividend Payout ratio
– expresses the % of earnings that is distributed to shareholders
as dividends. It is calculated by dividing dividends per share by
earnings per share.
– it provides an indication of a firm’s managerial or reinvestment
strategy. A low payout suggests that a firm is retaining a large
portion of earnings for reinvestment e.g., growth industries
89
Significance and Limitations of Ratio
Analysis
OBJECTIVE 6
Discuss the significance and
limitation of ratio analysis.
90
Significance of Ratio Analysis
 Ratio Analysis is a powerful tool which is used to
gauge the financial strengths and weaknesses of
a business organization,
 Assess profitability
 Risk associated with an investment decision
 Performance of management
 Control operations
91
Limitations of Ratio Analysis
There are some limitations associated with the use
of accounting ratios.
 The financial statements used are historical
in nature
 Using quantitative data to take decisions that
are qualitative
 Standard of comparison
 Skills required
92
The DuPont Formulas
 The DuPont formula uses the
relationship among financial
statement accounts to decompose a
return into components.
 Three-factor DuPont for the return
on equity:
◦ Total asset turnover
◦ Financial leverage
◦ Net profit margin
 Five-factor DuPont for the return
on equity:
◦ Total asset turnover
◦ Financial leverage
◦ Operating profit margin
◦ Effect of nonoperating items
◦ Tax effect
Return on Equity
Net Profit
Margin
Total Asset
Financial
Turnover
Leverage
Operating Profit
Margin
Effect of Non-operating
Items
Tax
Effect
93
Five-Component DuPont Model
94
Example: The DuPont Formula
Suppose that an analyst has noticed that the return on equity of
the D Company has declined from FY2012 to FY2013. Using the
DuPont formula, explain the source of this decline.
(millions)
Revenues
2013
2012
$1,000
$900
$400
$380
$30
$30
$100
$90
Total assets
$2,000
$2,000
Shareholders’ equity
$1,250
$1,000
Earnings before interest and taxes
Interest expense
Taxes
95
Example: the DuPont Formula
2013
2012
Return on equity
0.20
0.22
Return on assets
0.13
0.11
Financial leverage
1.60
2.00
Total asset turnover
0.50
0.45
Net profit margin
0.25
0.24
Operating profit margin
0.40
0.42
Effect of non-operating items
0.83
0.82
Tax effect
0.76
0.71
96
Financial Analysis Report


A financial analysis report is, basically, a document that
attracts high interest of investors as it contains a
detailed appraisal of a company’s financial health.
A comprehensive financial analysis report accentuate
the strengths and weaknesses of a company.
Communicating the company’s strengths and
weaknesses in an accurate and honest manner is helpful
for attracting investors.
TGBTG
Slide 97
The Basics of Financial Reports





An “Executive Summary” of important findings from the
financial analysis.
Set up an introduction emphasizing the objectives of the
report. Also define financial terms necessary for
understanding those objectives
A section which includes a comprehensive analysis returns,
balance sheets, income statement, and productivity ratios.
Also comment on each of these factors in addition to
providing support for your statements with graphs and
tables.
Evaluate results from various periods in a section titled
“Analysis of Variance”.
Conclude the report with a statement projecting future
performance on the basis of past years’ performance.
TGBTG
Slide 98
Financial Planning for Growth:
Sub-Topics
Percent of sales approach to growth;
Indifference analysis;
Breakeven analysis
Session Overview



Every firm that wants to exist and effectively operate in
the foreseeable future needs to ascertain its financial
needs and actively prepare beforehand to achieve them.
Corporate financial planning enables managers to select
the most appropriate investments and activities that
would be of help in achieving financial objectives. Also,
it helps a firm to adequately prepare for and take
advantage of opportunities.
Students will be well equipped with the financial
planning process and making major decisions for
growth after going through this session.
Session Objectives

At the end of this session, students should be able to:
1. Understand the financial planning process and how
decisions are interrelated
2. Be able to develop a financial plan using the
percentage of sales approach and be able to
compute external financing needed
3. Understand the four major decision areas involved
in long-term financial planning and identify the
determinants of a firm’s growth
4. Understand how capital structure policy and
dividend policy affect a firm’s ability to grow.
Session Objectives
5. Understand growth and external financing.
6. Understand indifference analysis
7. Understand the break even analysis
8. Use breakeven analysis to make business decisions
for profit
What is Financial Planning?
• The process of determining a company's
financial needs or goals for the future and how
to achieve them.
• Corporate financial planning involves deciding
what investments and activities would be most
appropriate under both the company's
individual
and
broader
economic
circumstances.
• Financial planning establishes the way in which
financial objectives can be achieved
Objectives of Financial Planning




To ascertain required Investment in new assets
To determine the Degree of financial leverage required
by the business in order to achieve its strategic goals.
– This includes decisions of debt- equity ratio- both
short-term and long- term.
To determine cash that can be paid to shareholders in
view of the firm’s growth agenda
To assess the liquidity requirements of a firm and
ensure that the limited financial resources are maximally
utilized in the best possible manner
The Importance of a Corporate
Financial Plan
•
•
•
•
It ensures that adequate funds are available to support the
future agenda of the business.
Financial Planning helps in ensuring a reasonable balance
between outflow and inflow of funds so that stability is
maintained.
Financial Planning reduces uncertainties with regards to
changing market trends which can be faced easily through
enough funds.
Financial Planning helps in reducing the uncertainties
which can be a hindrance to growth of the company. This
helps in ensuring stability and profitability in concern.
Percentage of Sales Approach


The percentage-of-sales method is a type of financial
statement analysis tool in which all relevant accounts
are expressed as a ratio of sales.
– In other words, financial statement line items such as
cash, inventory, accounts receivable/payable, net
income, and cost of goods sold, are each calculated
as a percentage of revenue.
All historical expense percentages are then applied to
the forecasted sales level in the budget period.
Pro Forma Analysis
Estimate
typical
relation
between
revenues
and salesdriven
accounts.
Estimate
fixed
burdens,
such as
interest
and taxes.
Forecast
revenues.
Estimate
salesdriven
accounts
based on
forecasted
revenues.
Estimate
fixed
burdens.
Construct
future
period
income
statement
and
balance
sheet.
107
Issues to Note


Some items vary directly with sales, while others do not
Income Statement: Costs may vary directly with sales - if this is the case, then the
profit margin is constant
– Depreciation and interest expense may not vary directly with sales – if this is the
case, then the profit margin is not constant
– Dividends are a management decision and generally do not vary directly with sales
– this influences additions to retained earnings

Balance Sheet: Initially assume all assets, including fixed, vary directly with sales
– Accounts payable will also normally vary directly with sales
– Notes payable, long-term debt and equity generally do not vary directly with sales
because they depend on management decisions about capital structure
– The change in the retained earnings portion of equity will come from the dividend
decision
Issues to Note


The percentage of sales method thus generates a
set of pro forma or forecasted balance sheets and income
statements for the firm.
The analyst projects what will happen to the
firm’s accounts over time, which supports an
estimate of the firm’s external financing needs
for a particular period.
Percentage of Sales Approach – Steps:



Step 1: Express balance sheet items that vary directly
with sales as a percentage of sales.
– Items that do not vary directly with sales e.g. long
term debt, retained earnings, common stock &
property/plant/equipment are designated as not
applicable (n/a).
Step 2: Estimate sales revenue for the future period
Step 3: Multiply the percentages from step 1 by the
sales projected (step 2) to obtain the amounts for
future periods.
TGBTG
Slide 110
Percentage of Sales Approach-Steps:
(Cont’d…)



Step 4: Where no percentage applies (e.g. for long term debt,
common stock or retained earnings numbers), take the figures
from the present balance sheet in the column for the future period.
Step 5: Calculate the projected retained earnings and add to the
retained earnings account in the balance sheet
Step 6: Total up the assets account to obtain a total projected
assets value, then add projected liabilities & equity accounts to
determine the total shortfall.
– This shortfall indicates the total external financing that is
required to keep the company running at present operational
levels.
TGBTG
Slide 111
Pro Forma Income Statement
FINC 301 Company Income Statement (in millions)
Sales revenues
Cost of goods sold
Gross profit
Selling, General &Admin
Year 0
€1,000.0
600.0
€400.0
100.0
One Year
Ahead
€1,050.0
630.0
€420.0
105.0
 Growth at 5%
 60% of revenues
 Revenues less cost of goods sold
 10% of revenues
Operating income
€300.0
€315.0  Gross profit less operating exp.
Interest expense
Earnings before taxes
32.0
€268.0
33.6  8% of long-term debt
€281.4  Operating income less interest exp.
Taxes
Net income
Dividends
93.8
€174.2
€87.1
98.5  35% of earnings before taxes
€182.9  Earnings before taxes less taxes
€91.5  Dividend payout ratio of 50%
112
Pro Forma Balance Sheet
FINC 301 Company Balance Sheet, End of Year (in millions)
One Year
Year 0
Ahead
Current assets
€600.0
€630.0  60% of revenues
Net plant and equipment
1,000.0
1,050.0  100% of revenues
Total assets
€1,600.0
€1,680.0
Current liabilities
Long-term debt
Common stock and paid-in capital
Treasury stock
Retained earnings
Total liabilities and equity
€250.0
400.0
25.0
925.0
€1,600.0
€262.5  25% of revenues
420.0  Debt increased by €20 million to
maintain the same capital
structure
25.0  Assume no change
(44.0)  Repurchased shares
1,016.5  Retained earnings in Year 0, plus
net income, less dividends
€1,680.0
113
Example
Balance Sheet
December 31, 2020
Assets
1000 Debt
Equity
Total
1000 Total
Income Statement
For Year Ended December 31, 2020
400
600
Revenues
2000
Less: costs
(1600)
1000 Net Income
400
Slide 114 4-114
Example: Pro Forma Income Statement
• Initial Assumptions
– Revenues will grow at
15% (2,000*1.15)
– All items are tied
directly to sales, and
the
current
relationships
are
optimal
– Consequently,
all
other items will also
grow at 15%
Pro Forma Income Statement
For Year Ended 2017
Revenues
2,300
Less: costs
(1,840)
Net Income
460
Slide 115 4-115
Example: Pro Forma Balance Sheet
• Case I
– Dividends are the plug variable
(adjusted variable), so equity
increases at 15%
Pro Forma Balance Sheet
Case 1
Assets
1,150 Debt
460
Equity
• Case II
– Debt is the plug variable and
no dividends are paid, all
profits transferred to the equity
account, requiring adjustment
in debt to balance the balance
sheet.
Total
Assets
1,150 Total
TGBTG
1,150
Pro Forma Balance Sheet
Case 2
1,150 Debt
Equity
Total
690
1,150 Total
90
1,060
1,150
Slide 116 4-116
Growth and External Financing
• At low growth levels, internal financing (retained
earnings) may exceed the required investment in
assets
• As the growth rate increases, the internal
financing will not be enough, and the firm will
have to go to the capital markets for money
• Examining the relationship between growth and
external financing required is a useful tool in longrange planning
Slide 117 4-117
Growth and External Financing
• It is important to note that the extent of growth of a firm is
largely dependent on the financial capacity of the firm,
especially from external sources.
• Firms that are constrained in terms access to external
financing can therefore only grow as much as the retained
earnings available for expansion
Slide 118 4-118
The Internal Growth Rate
ROA  b
Internal Growth Rate 
1 - ROA  b
.1263  .5

 .0674
1  .1263  .5
 6.74%
Slide 119 4-119
The Sustainable Growth Rate
ROE  b
1 - ROE  b
.2927  .5

 .1714
1  .2927  .5
 17.14%
Sustainabl e Growth Rate 
Slide 120 4-120
Indifference Analysis


Given a level of EBIT, a particular combination of
different sources of finance will yield a particular EPS
and therefore, for different financing patterns, there
would be different levels of EPS.
Indifference point analysis is the process of
determining the point at which any two modes of
external financing yield the same impact on earnings
per share (EPS)
– Its value lies in the ability to forecast, ahead of time,
which mode of financing will deliver the best in
terms of shareholder wealth maximization.
Slide 121
Indifference Point Formula
Slide 122
Breakeven Analysis



In the case of new businesses or projects, financial
planning also entails an analysis of the point where the
business is able to cover all of its fixed and variable
costs.
The point at which total of fixed and variable costs of a
business becomes equal to its total revenue is known as
break-even point (BEP).
In essence, it determines the minimum level of sales
needed to keep the business afloat.
TGBTG
Slide 123
Benefits of BEP Analysis




Facilitates appropriate pricing
Provides insights into cost structures and facilitates cost
efficiency moves
Predicts the effect of price changes on profit
Informs production levels and possible implications of
changes in plant size
Slide 124
Break Even Analysis
Mathematical Presentation of BEP
Slide 126
Caveats


In financial planning processes such as forecasting
financial statements or breakeven analysis, the output is
only as good as the input.
In other words, unrealistic assumptions, wrong
estimates, or inappropriately defined relationships
would yield useless output that have no relevance for
the strategic planning process.
Slide 127
Operating Leverage

Fixed cost do not change as quantity changes

Variable costs increase as quantity of output rises


Firms often face a trade-off between fixed and variable
costs
Example, a firm can build its factory incurring a high level
of fixed costs in the process or it can outsource production
to a supplier, typically generating lower fixed costs but high
variable costs
Operating Leverage




Fixed cost must be paid even at the lower level of sales,
leaving the firm with the possibility of large losses.
And with fixed costs replacing variable costs, any
additional sales generate low marginal costs, leaving the
firm with a substantial increase in profit
Firms with high fixed costs and low variable costs are
generally said to have high operating leverage
Operating leverage measures a company’s fixed costs
as a percentage of its total costs
Cash Forecasting
The Cash Forecasting Model
•
What to look out for:

Accurate forecasting of Receipt

Accurate forecasting of Payments

Automation of the Receipts and Payments
•
•
The Bullwhip Effect of cash Forecasting: This occurs when a
company runs into a materials or capacity shortage and informs its
customers that they are being put on an allocation basis. Customers
usually increase their orders, but reduce it later when company is able to
continue its supply.
Company can minimize effect of this if inventory orders are adjusted
by unusual hikes.
TGBTG
130
Cash Forecasting
The Cash Forecasting Model
•
Business Cycle Forecasting
Forecasting cash into the longer periods needs to be adjusted by business
cycles. The following steps can be taken to accurately forecast business
cycles.

Report on published forecasts: Information forecasted is accurate but may
not be relevant to chosen industry.

Subscribe to a forecasting service: may be expensive for smaller company

Develop an in-house forecasting model
1
131
Cash Forecasting
The Cash Forecasting Controls
•
Investigate significant variances: Relevant for periodic cash forecasts
•
Obtain the approval of a knowledgeable person
•
Match latest forecast against preceding forecasts.
•
Match forecast against standard forecast checklist.
•
Obtain approvals.
•
Retain a copies of previous cash forecasts.
1
132
Cash Budget




Forecast of cash inflows and outflows over the next short-term
planning period
Primary tool in short-term financial planning
Helps determine when the firm should experience cash
surpluses and when it will need to borrow to cover workingcapital requirements
Allows a company to plan ahead and begin the search for
financing before the money is actually needed
133 18-133
Cash Forecasting
Question: Prepare a Cash forecast for the below information
The sales and purchases for Ahemba Ltd are as follows:
Month
Credit Sales
April
$160,000
Credit Purchase $ 68,000
May
June
$140,000
$192,000
$64,000
$80,000
The company will pay wages of $8,000, $7,000 and $8,400 in April, May and June
respectively. Interest payments are 3,000 per month during the period. The
company will purchase equipment costing $50,000 and $4,000 in June. Ahemba
Ltd estimates that 10% of its sales will be collected in the month of the sales; and
the rest of its sales will be collected in the following month. Purchases on trade
accounts will be paid in the month following the purchase. In March the sales were
$180,000. The company has $20,000 cash at the end of March and normally keeps
$10,000 minimum cash balance each month against contingencies.
1
134
Example: Cash Budget Information

Pet Treats, Inc. specializes in gourmet pet treats and receives all income from sales

Sales estimates (in millions)
Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550

Accounts receivable: Beginning receivables = GHS250
– Average collection period = 30 days

Accounts payable
– Purchases = 50% of next quarter’s sales
– Beginning payables = 125
– Accounts payable period is 45 days

Other expenses: Wages, taxes, and other expense are 30% of sales
– Interest and dividend payments are GHS50
– A major capital expenditure of GHS200 is expected in the second quarter

The initial cash balance is GHS80, and the company maintains a minimum balance of GHS50
135 18-135
Example: Cash Budget – Cash
Collections
• ACP = 30 days; this implies that 2/3 of sales are collected in the quarter made
and the remaining 1/3 are collected the following quarter
• Beginning receivables of GHS250 will be collected in the first quarter
Q1
Q2
Q3
Q4
Beginning Receivables
250
167
200
217
Sales
500
600
650
800
Cash Collections
-583 -567
-633
-750
Ending Receivables
167
217
267
200
18-136
Sources and Uses of Cash

Balance sheet identity (rearranged)
 NWC + fixed assets = long term debt + equity
 NWC = cash + other CA – CL
 Cash = long term debt + equity + CL – CA other than cash –
fixed assets

Sources
– Increasing long-term debt, equity, or current liabilities
– Decreasing current assets other than cash, or fixed assets

Uses
– Decreasing long-term debt, equity, or current liabilities
– Increasing current assets other than cash, or fixed assets
137 18-137