BRIEF OVERVIEW OF FINANCIAL
MANAGEMENT



WHAT IS FINANCE?
Art and science of managing money.
The art and science of managing the financial
resources of a business.
Study of how individuals, institutions,
governments and businesses acquire, spend and
manage money and other financial assets.
FUNCTIONS OF BUSINESS FINANCE
 Allocation of financial resources
 Procurement of funds
 Efficient and effective utilization of financial
resources
1. ALLOCATION OF FUNDS
 Is the project necessary?
 What is its social relevance?
 Are there other alternatives?
 How will the proposal affect our current
operations?
 What resources of the company can be used in
the project?
 How much is the estimated capital
requirement?
 What is the economic life of the project?
 How much are the estimated cash returns?
 How long will it take to recover our investment
or what is the payback period?
 What is the rate of return on investment?
 Is the rate of return higher than the cost of
capital to be used?
 What are the risks involved in the proposal?
2. PROCUREMENT OF FUNDS
 The process of obtaining funds and the costs
involved.
 Financing happens here.
WHAT IS MANAGEMENT?
It is the process of POSDCON
P - PLANNING
O - ORGANIZING
S - STAFFING
D - DIRECTING/LEADING
CON – CONTROLLING
WHAT IS FINANCIAL MANAGEMENT?
Involves financial planning, asset management
and fundraising decisions to enhance the value of
businesses.
GOAL OF FINANCIAL MANAGEMENT
To maximize the wealth of the shareholders, to
allocate funds to current and fixed assets, to obtain the
best mix of financing alternatives, and to develop an
appropriate dividend policy within the context of the
firm’s objectives.
FINANCIAL MANAGEMENT IN DIFFERENT
PERSPECTIVES:
GOVERNMENT FM – scary spending, no need to
return excess.
PRIVATE COMPANY FM – conservative because it
has responsibility to the shareholders to give returns in
a form of dividend (if corporation).
PERSONAL FM – sustainability of financial
resources.
3 FORMS OF BUSINESS ORGANIZATIONS
(1) SOLE PROPRIETORSHIP
(2) PARTNERSHIP
(3) CORPORATION
SOLE PROPRIETORSHIP
A form of organization where there is only one
owner/proprietor.
After operating for some time, he/she invites or
gets invited to form a partnership or a corporation.
WHAT IS FINANCING?
The process of providing funds for business
activities, making purchases or investing.
PARTNERSHIP
An association of two or more persons who
bind themselves to contribute money, property, or
industry to a common fund, with the intention of
dividing profits among themselves.
3. EFFICIENT AND EFFECTIVE UTILIZATION
OF FINANCIAL RESOURCES
 Efficient – financial resources are actually
being used for what they have been intended.
 Effective – refers to their use towards the
attainment of predetermined objectives.
CORPORATION
It is an artificial being created by operation of
law, having the right of succession and the powers,
attributes and properties expressly authorized by law or
incident to its existence.
RIGHT OF SUCCESSION
A corporation has the right to continuous
existence irrespective of death, withdrawal, insolvency
or incapacity of the individual members or shareholders
and regardless of the transfer of their interests or shares
of stock.
CHAPTER 1: AN OVERVIEW OF FINANCIAL
MANAGEMENT
CHARACTERISTICS OF SUCCESSFUL
COMPANIES
 successful companies have skilled people
 successful
companies
have
strong
relationships
 successful companies have enough funding
2. More Than One Owner: A Partnership - two
or more persons or entities associate to conduct
a noncorporate business for profit.
General Partnership - a business arrangement
by which two or more individuals agree to share
in all assets, profits, and financial and legal
liabilities of a jointly-owned business.
Limited Partnership - certain partners are
designated general partners and others limited
partners. Limited partners can lose only the
amount of their investment in the partnership,
while the general partners have unlimited
liability. Limited partners typically have no
control—it rests solely with the general
partners—and their returns are likewise limited.
A Bird’s-eye View of Finance
Limited Liability Partnership (LLP) and a
Limited Liability Company (LLC), all partners
(or members) enjoy limited liability with regard
to the business’s liabilities, and their potential
losses are limited to their investment in the
LLP.
3. Many Owners: A Corporation - a legal entity
created under state laws, and it is separate and
distinct from its owners and managers.
THE CORPORATE LIFE CYCLE
1. Starting Up as a Proprietorship - an
unincorporated business owned by one
individual
Advantages:
a) It is easily and inexpensively formed.
b) It is subject to few government regulations.
c) Its income is not subject to corporate taxation
but is taxed as part of the proprietor’s personal
income.
Limitations:
a) It may be difficult for a proprietorship to obtain
the funding needed for growth.
b) The proprietor has unlimited personal liability
for the business’s debts, which can result in
losses that exceed the money invested in the
company.
c) The life of a proprietorship is limited to the life
of its founder.
Major Advantages:
a) unlimited life
b) easy transferability of ownership interest
c) limited liability
Advantages over Partnership:
a) Corporate earnings may be subject to double
taxation—the earnings of the corporation are
taxed at the corporate level, and then earnings
paid out as dividends are taxed again as income
to the stockholders.
b) Setting up a corporation involves preparing a
charter, writing a set of bylaws, and filing the
many required state and federal reports, which
is more complex and time-consuming than
creating a proprietorship or a partnership.
Professional Corporation (PC) or a
Professional Association (PA) - wherein
professionals such as doctors, lawyers, and
accountants form a corporation.
S corporations - corporations that meets all the
requirements but elect to be taxed as if a
proprietorship or partnership.
4. Growing a Corporation: Going Public - also
called initial public offering (IPO) because it
is the first time the company’s shares are sold
to the general public.
GOVERNING A CORPORATION
Agency Problem - a conflict of interest that exists in any
relationship in which one party is expected to act in the
best interests of the other.
IPOs are often aided by investment banks with
brokerage firms that employs brokers who are
registered with the SEC to buy and sell stocks
on behalf of clients.
Corporate Governance - a set of rules that control the
company’s behavior toward its directors, managers,
employees, shareholders, creditors, customers,
competitors, and community.
Seasoned Equity Offering - when public
company raises more funds by selling (i.e.,
issuing) additional shares of stock.
MAXIMIZING STOCKHOLDER WEALTH
Maximizing Shareholder Wealth is a fiduciary duty for
most corporations but this does not mean that managers
should break laws or violate ethical considerations, or
that that managers should be unmindful of employee
welfare or community concerns.
“Angel” or Venture Capitalists - individuals or
businesses that provides funding for companies
that are too risky for banks
Securities and Exchange Commission (SEC)
➔ regulates stock trading, to sell shares in a
public stock market
➔ where a company applies to be a listed stock
on an SEC-registered stock exchange.
5. Managing a Corporation’s Value
“What determines a corporation’s value?” it’s a company’s ability to generate cash flows
now and in the future.
THREE (3) PROPERTIES OF ITS CASH FLOWS:
1. The size of the expected future cash flows is
important—bigger is better.
2. The timing of cash flows counts—cash
received sooner is more valuable than cash that
comes later.
3. The risk of the cash flows matters—safer cash
flows are worth more than uncertain cash flows.
Benefit corporation (B-Corp) - a corporate form that
expands directors’ fiduciary responsibilities to include
interests other than shareholders’ interests.
INTRINSIC STOCK VALUE MAXIMIZATION
AND SOCIAL WELFARE
Illegal Actions:
 Fraudulent accounting
 Exploiting monopoly power
 Violating safety codes
 Failing environmental standards

ORDINARY CITIZENS AND THE STOCK
MARKET
Households own mutual funds, directly
or indirectly owns stocks through pension
funds. When managers increase intrinsic value
of stocks, they improve people’s quality of life.

CONSUMERS
AND
COMPETITIVE
MARKETS
Value maximization requires efficient,
low-cost businesses that produce high-quality
goods and services at the lowest possible cost.
Companies that maximize their stock price
must generate growth in sales by creating value
for customers in the form of efficient and
courteous service, adequate stocks of
merchandise, and well-located business
establishments.

EMPLOYEES AT VALUE-MAXIMIZING
COMPANIES
In general, companies that successfully
increase stock prices also grow and add more
employees, thus benefiting society. Moreover,
studies show that newly privatized companies
tend to grow and thus require more employees
when they are managed with the goal of stock
Managers increase the firm’s value by
increasing the size of the expected cash flows, by
speeding up their receipt, and by reducing their risk.
Free Cash Flows (FCF) - they are available (or free)
for distribution to all of the company’s investors,
including creditors and stockholders
Weighted Average Cost of Capital (WACC) - the rate
of return required by investors, a cost from the
company’s point of view
Market Price - the price that we observe in the financial
markets, should be equal to the intrinsic value.
price maximization.
ETHICS AND INTRINSIC STOCK VALUE
MAXIMIZATION
There are very few, if any, legal and ethical
shortcuts making significant improvements in the
stream of future cash flows. Managers at some
companies have taken illegal and unethical actions to
make estimated future cash flows appear better than
truly warranted, which can drive the market stock price
up above its intrinsic value.
3. The activities occur in a variety of financial
markets.
THE DETERMINANTS OF INTRINSIC VALUE
Sarbanes-Oxley (SOX) Act of 2002 and the DoddFrank Wall Street Reform and Consumer Protection
Act of 2010 strengthened protection for whistleblowers
who report financial wrongdoing.
AN OVERVIEW OF FINANCIAL MARKETS
The Net Providers and Users of Capital
Net Savers
 Public / Individuals
Net Borrowers
 Nonfinancial corporations
 Financial corporations
 Government
THE CAPITAL ALLOCATION PROCESS
Capital - an essential component of starting and
maintaining a successful business. In the most basic
sense, it’s the money and assets needed by a business to
produce the products or services it offers.
Transfers of capital from savers to users:
1. Direct Transfers
2. Indirect Transfers through an Investment Bank
3. Indirect Transfers through a Financial
Intermediary
CHAPTER 2: NATURE, PURPOSE & SCOPE OF
FINANCIAL MANAGEMENT
Any company's financial health is crucial. Finances, like
most other resources, are, however, finite. Wants, on the
other hand, are often limitless. As a result, it is important
for a company to effectively control its finances.
It is important for any company to invest the funds it
receives in such a way that the investment yields a
higher return than the cost of capital. Financial
management, in a nutshell –



Endeavours to reduce the cost of finance
Ensures sufficient availability of funds
Deals with the planning, organizing, and
controlling of financial activities like the
procurement and utilization of funds
DEFINITIONS OF FINANCIAL MANAGEMENT
“Financial management is the activity
concerned with planning, raising, controlling and
administering of funds used in the business.” –
Guthman and Dougal
“Financial management is that area of business
management devoted to a judicious use of capital and a
careful selection of the source of capital in order to
enable a spending unit to move in the direction of
reaching the goals.” – J.F. Brandley
There are three important features of the capital
allocation process:
1. New financial securities are created.
2. Different types of financial institutions often act
as intermediaries between providers and users.
“Financial management is the operational
activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient
operations.” – Massie
NATURE, SIGNIFICANCE, AND SCOPE OF
FINANCIAL MANAGEMENT
Any company's financial management is a
natural part of its operation. To procure physical
resources, carry out manufacturing activities and other
business operations, pay compensation to vendors, and
so on, every company requires funds. There are several
financial accounting theories:
Core Financial Management Decisions
Managers of companies make the following decisions
in order to reduce the costs of obtaining finance and to
use it in the most efficient way possible:
1. Some experts believe that financial
management is all about getting a company the
money it needs on the most attractive terms
possible while keeping its goals in mind. As a
result, this strategy is mainly concerned with
the acquisition of assets, which can include
instruments, institutions, and fundraising
activities. It also looks after the legal and
accounting aspects of a company's relationship
with its funding source.
❖ Investment Decisions: Managers must determine
the amount of investment available from existing funds,
both long- and short-term.
2. Another group of experts believes that money
is all in finance. Since all business transactions,
whether directly or indirectly, include cash,
finance is concerned with everything the
company does.
3. The third and most commonly held viewpoint
is that financial management encompasses both
the acquisition and effective use of funds. In
the case of a manufacturing company, for
example, financial managers must ensure that
funds are sufficient for the installation of the
manufacturing plant and machinery. It must
also ensure that earnings are sufficient to cover
the costs and risks faced by the company.
Many companies can easily raise capital in a
developed market. The real issue, however, is
maximizing capital use through successful financial
planning and control.
Furthermore, the company must ensure that it
handles activities such as allocating funds, handling
them, investing them, controlling expenses, predicting
financial needs, preparing income and calculating
returns on investment, evaluating working capital, and
so on.
THE SCOPE OF FINANCIAL MANAGEMENT
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

Investment Decisions
Financing Decisions
Dividend Decisions
There are two kinds of them:
 Capital Budgeting, also known as Long-term
investment decisions, imply committing funds
for a long time, similar to fixed assets. These
decisions are normally irreversible and involve
those involving the purchase of a building
and/or property, the acquisition of new
plants/machinery or the replacement of old
ones, and so on. These choices influence a
company's financial goals and results.
 Working capital management, also known as
short-term investment decisions, refers to
committing funds for a short period of time,
such as current assets. These decisions include
cash, bank deposits, and other short-term
investments, as well as inventory investment.
They have a direct impact on a company's
liquidity and profitability.
❖ Financing Decisions: Managers must also make
decisions on raising funds from long-term (Capital
Structure) and short-term sources (called Working
Capital).
There are two kinds of them:
 Financial Planning Decisions that include
estimating the origins and applications of funds.
It entails anticipating a company's financial
needs in order to ensure that sufficient funds are
available. The primary goal of financial
planning is to prepare ahead of time to ensure
that funds are available when needed.
 Capital Structure Decisions that include
locating funding sources. They also include
decisions on whether to raise funds from
external sources such as selling shares, bonds,
or borrowing from banks, or from internal
sources such as retained earnings.
❖ Dividend Decisions: These are decisions over how
much of a company's earnings will be paid as dividends.
Shareholders often seek a higher dividend, while
management prefers to keep income for operational
purposes. As a result, this is a difficult managerial
decision.
One issue that the financial manager faces is
meeting the goals of many stakeholders at the same
time. Reducing salaries, for example, will increase
profits and please shareholders, but it is unlikely to
satisfy workers. As a result, a distinction between
maximising and satisfying must be made in practice.
CHAPTER 3: RELATIONSHIP OF FINANCIAL
OBJECTIVES TO ORG STRATEGY & OTHER
ORG OBJECTIVES
A. Maximising – seeking the best possible
outcome
B. Satisfying – finding a merely adequate
outcome.
FINANCIAL OBJECTIVES AND
ORGANIZATIONAL STRATEGY
OBJECTIVES IN NOT-FOR-PROFIT
ORGANIZATIONS
Not-for-profit organisations include charities,
state health services, and police forces, which are run
for the purpose of providing a service rather than profit.
Despite the importance of good financial management
in these organisations, it is not possible to set financial
goals in the same way as businesses do. As a result,
these organizations place a premium on value for
money, or trying to get the most benefits for the least
amount of money.
Value for money is described as obtaining the
best possible combination of services by using the
fewest resources possible, i.e., maximizing benefits at
the lowest possible cost. This is commonly understood
to necessitate the use of economy, effectiveness and
efficiency.
SHAREHOLDER WEALTH MAXIMIZATION
I.
Most companies are owned by shareholders and
originally set up to make money for those
shareholders. The primary objective of most
companies is thus to maximize shareholder
wealth. (This could involve increasing the share
price and/or dividend payout.)
II.
Shareholder wealth maximization is a
fundamental
principle
of
financial
management. Many other objectives are also
suggested for companies including:
A. profit maximization
B. growth
C. market share
D. social responsibilities
To achieve a certain amount of outputs, the
economy must obtain the required quantity and quality
of inputs at the lowest possible cost. For example, the
economy in which a school purchases equipment can be
calculated by comparing real costs to budgets, previous
year's costs, government/local authority requirements,
or other schools' spending.
The degree to which stated objectives/goals are
met is referred to as effectiveness. The proportion of
students who go on to higher or further education, for
example, may be used to assess the efficacy of a school's
goal of producing quality teaching.
The relationship between inputs and outputs is
known as efficiency. The efficiency in which a school's
IT laboratory is used, for example, may be calculated in
terms of the percentage of the school week that it is
used.
STAKEHOLDERS
While a private sector corporation's theoretical
goal may be to increase its shareholders' wealth, other
individuals and organizations are interested in what the
company does and may be able to influence its
corporate goals. Stakeholders are people who are
interested in a company's operations or success because
they have a stake or an interest in what happens.
It's common to divide stakeholders into groups,
each with its own set of priorities and concerns. The
following are the most common types of stakeholder
groups in an organization:

Internal:
a) Directors
b) Employees

Connected:
a) Shareholders
b) Leaders
c) Customers
d) Suppliers
e) Labour union

External:
a) Government
b) Society as a whole
Goal incongruence between stakeholders
For example, bondholders seek a steady stream
of income in the form of interest and the assurance that
their principal will be repaid. Shareholders, on the other
hand, seek rising dividends and, as a result, rising stock
prices. Risky projects are avoided by the former, while
risky projects are welcomed by the latter because the
higher the risk, the higher the return. This exemplifies
the goal inconsistency between bondholders and
stockholders.
AGENCY PROBLEM
The conflict of interests between different
stakeholders of a corporation, such as shareholders and
bondholders or employees and shareholders, is referred
to as an agency issue. They can appear in a variety of
ways.


Moral hazard – A boss has a vested interest in
reaping the rewards of his or her job. All of the
perks that come with status, such as a company
vehicle, use of a company plane, lunches, and
so on, are included.
Effort level – Managers could put in less effort
than if they were the company's owners. In a
large corporation, the issue would occur at both
the middle and senior management levels.

Earnings retention – Rather than earnings, the
size of the business is also used to determine the
remuneration of directors and senior managers.
Rather than paying out dividends, management
is more likely to want to reinvest profits in order
to grow the business.

Risk aversion - Executive directors and senior
managers typically receive the majority of their
profits from the organization for which they
work. As a result, they care about the company's
stability because it will secure their job and
future earnings. This may indicate that
management is risk averse and unable to invest
in higher-risk ventures.

Time horizon - Shareholders are concerned
about their company's longterm financial
prospects because the value of their shares is
based on long-term assumptions. Managers, on
the other hand, could be only concerned with
the short term. This is partly due to the fact that
they may be paid annual bonuses based on
short-term results, and partly due to the fact that
they may not plan to stay with the organization
for more than a few years.
Agency costs include direct and indirect costs.
 Direct costs include remuneration and audit
fees.
 Indirect costs include the cost of lost
opportunity because of agency problems.
Reducing the agency problem
Several methods of reducing the agency
problem have been suggested. These include:
A. Creating a compensation plan for executive
directors and senior managers that encourages
them to behave in the best interests of the
company's shareholders. Offering managers
share options, for example, is one way to
motivate them to behave in ways that maximize
shareholder capital. Managers will be enticed to
make choices that are likely to result in higher
share prices (such as investing in projects with
positive net present values), as this will increase
their share option incentives.
B. Having a sufficient number of qualified nonexecutive directors on the board. They are not
full-time workers and do not hold any executive
positions in the company. They have the ability
to behave in the shareholders' best interests.
C. Where there is (or may be) a conflict of interest
between executive directors and the company's
best interests, independent non-executive
directors may also make decisions. Nonexecutive officers, for example, may be in
charge of remuneration arrangements for
executive directors and other senior managers.
D. The possibility of a hostile takeover. If a
company is poorly run, the stock price would be
low in comparison to its future value. When the
stock price is poor, competing management
teams are more likely to launch a hostile
takeover. In most cases, the current
management will be dismissed. As a result,
managers are compelled to optimize share
prices.
INCENTIVE SCHEMES
A remuneration package for executive directors
or senior managers may have a variety of structures, but
most remuneration packages have at least three
components.
1. A basic salary – it needs to be high enough to
attract and retain individuals with the required
skills and talent.
2. Annual performance incentives – The
performance target might be stated as profit or
earnings growth, EPS growth, achieving a
profit target, etc. Some managers might also
have a non-financial performance target.
3. Long-term performance incentives – Which
are linked in some way to share price growth.
Long term incentives are usually provided in
the form of share awards or share options of the
company.
CORPORATE GOVERNANCE
The collection of procedures, customs, rules,
laws, and institutions that regulate how a corporation (or
company) is guided, managed, or regulated is known as
corporate governance. The relationships between the
stakeholders and the purposes for which the company is
regulated are discussed in corporate governance.
There are a number of key elements in corporate
governance:
a) Risk management and mitigation is a central
theme in all conceptions of good governance,
whether specifically specified or implicitly.
b) Most concepts are based on the idea that good
organizational
frameworks
and
management practice within set best practice
guidelines improve overall efficiency.
c) From the perspective of all stakeholder groups
affected, good governance provides a basis for
an organization to execute its policy in an
ethical and efficient way, as well as
protections against the misuse of physical or
intellectual capital.
d) Good governance necessitates not only the
application of externally defined laws, but also
the ability to apply both the spirit and the
letter of the law.
e) Accountability is generally a major theme in
all governance frameworks.
Corporate governance codes of good practice
generally cover the following areas:
A. The board should be responsible for taking
major policy and strategic decisions.
B. Directors should have a mix of skills and their
performance should be assessed regularly.
C. Appointments should be conducted by formal
procedures administered by a nomination
committee (or selection committee).
D. Division of responsibilities at the head of an
organisation is most simply achieved by
separating the roles of chairman and chief
executive.
E. Independent non-executive directors have a key
role in governance. Their number and status
should mean that their views carry significant
weight.
F. Directors' remuneration should be set by a
remuneration committee consisting of
independent non-executive directors.
G. Remuneration should be dependent upon
organisation and individual performance.
H. Accounts should disclose remuneration policy
and (in detail) the packages of individual
directors.
I.
Boards should regularly review risk
management and internal control, and carry out
a wider review annually, the results of which
should be disclosed in the accounts.
J. Audit committees of independent nonexecutive directors should liaise with external
auditors, supervise internal audit, and review
the annual accounts and internal controls.
K. The board should maintain a regular dialogue
with shareholders, particularly institutional
shareholders. The annual general meeting is a
significant forum for communication.
L. Annual reports must convey a fair and balanced
view of the organisation. This might include
whether the organisation has complied with
governance regulations and codes, and give
specific disclosures about the board, internal
control reviews, going concern status and
relations with stakeholders.
CHAPTER 4: FUNCTIONS OF FINANCIAL
MANAGEMENT
Financial management, or the art and science of
handling a company's resources in order to achieve its
objectives, is not solely the domain of the finance
department. Any business decision has a monetary
impact. Financial workers must work closely with
managers in all departments.
Sales of the company's goods should be the
primary source of funding. However, sales revenue does
not always arrive when it is required to pay the bills.
Financial managers must keep track of how money
enters and exits the company. They collaborate with the
firm's other department heads to decide how funds will
be allocated and how much money is needed. Then they
decide on the best ways to get the capital they need.
A financial manager, for example, would keep
track of daily operating details including cash
collections and disbursements to ensure that the
organization has enough cash to fulfill its obligations.
The manager will research whether and when the
organization can open a new manufacturing plant over
a longer time period. The project manager will also
recommend the best way to fund the project, collect the
necessary funds, and oversee its implementation and
execution.
Accounting and financial reporting are
inextricably linked. In most companies, the vice
president of finance or CFO is in charge of both regions.
However, the accountant's primary responsibility is to
gather and present financial data. Financial managers
make financial decisions based on financial
statements and other details prepared by
accountants. They prepare and monitor the company's
cash flows to ensure that cash is allocated when it's
needed.
The Financial Manager’s Responsibilities and
Activities
Financial managers have a difficult and
dynamic role. They examine financial details prepared
by accountants, keep track of the company's finances,
and develop and execute financial strategies. They
could be working on a better way to automate cash
collections one day and reviewing a potential
acquisition the next.
The financial
include:
manager's
main
responsibilities

Financial planning: Preparing the financial
plan, which projects revenues, expenditures,
and financing needs over a given period.

Investment (spending money): Investing the
firm’s funds in projects and securities that
provide high returns in relation to their risks.

Financing (raising money): Obtaining
funding for the firm’s operations and
investments and seeking the best balance
between debt (borrowed funds) and equity
(funds raised through the sale of ownership in
the business).
The Goal of the Financial Manager
The financial manager's key aim is to optimize
the firm's value to its owners. The share price of a
publicly traded corporation's stock is used to determine
its worth. The value of a private corporation is
determined by the price at which it may be sold.
The financial manager must weigh both the
short- and long-term ramifications of the firm's
decisions in order to maximize the firm's worth. Profit
maximization is one strategy, but it should not be the
only one. Short-term benefits are prioritized over longterm objectives in this strategy.
What if a company in a highly technical and
competitive industry didn't invest in R&D?
Profits will be high in the short term due to the
high cost of research and development. However, the
company's ability to compete could be harmed in the
long run due to a lack of new products. This is valid
regardless of the scale or stage of a company's life cycle.
2. The INCOME STATEMENT reports the
results of operations over a period of time, and
it shows earnings per share as its “bottom line.”
3. The STATEMENT OF STOCKHOLDERS’
EQUITY shows the change in retained earnings
between balance sheet dates. Retained earnings
represent a claim against assets, not assets per
se.
4. The STATEMENT OF CASH FLOWS reports
the effect of operating, investing, and financing
activities on cash flows over an accounting
period.
BALANCE SHEET
CHAPTER 5: FINANCIAL STATEMENTS,
CASH FLOW, TAXES
INCOME STATEMENT
FINANCIAL STATEMENTS
The four basic statements contained in the
annual report are the balance sheet, the income
statement, the statement of stockholders’ equity, and
the statement of cash flows.
1. The BALANCE SHEET shows assets on the
left-hand side and liabilities and equity, or
claims against assets, on the right-hand side.
(Sometimes assets are shown at the top and
claims at the bottom of the balance sheet.) The
balance sheet may be thought of as a snapshot
of the firm’s financial position at a particular
point in time.
STATEMENT OF STOCKHOLDER’S EQUITY
STATEMENT OF CASH FLOWS
TOTAL NET OPERATING CAPITAL (which means
the same as operating capital and net operating assets)
is the sum of net operating working capital and
operating long-term assets. It is the total amount of
capital needed to run the business.
NOPAT is NET OPERATING PROFIT AFTER
TAXES. It is the after-tax profit a company would have
if it had no debt and no investments in non-operating
assets. Because it excludes the effects of financial
decisions, it is a better measure of operating
performance than is net income.
NET CASH FLOW differs from accounting profit
because some of the revenues and expenses reflected in
accounting profits may not have been received or paid
out in cash during the year. Depreciation is typically the
largest non-cash item, so net cash flow is often
expressed as net income plus depreciation.
OPERATING CURRENT ASSETS are the current
assets that are used to support operations, such as cash,
inventory, and accounts receivable. They do not include
short-term investments.
OPERATING CURRENT LIABILITIES are the
current liabilities that occur as a natural consequence of
operations, such as accounts payable and accruals. They
do not include notes payable or any other short-term
debts that charge interest.
FREE CASH FLOW (FCF) is the amount of cash flow
remaining after a company makes the asset investments
necessary to support operations. In other words, FCF is
the amount of cash flow available for distribution to
investors, so the value of a company is directly related
to its ability to generate free cash flow. FCF is defined
as NOPAT minus the net investment in operating
capital.
NET OPERATING WORKING CAPITAL is the
difference between operating current assets and
operating current liabilities. Thus, it is the working
capital acquired with investor-supplied funds.
OPERATING LONG-TERM ASSETS are the longterm assets used to support operations, such as net plant
and equipment. They do not include any long-term
investments that pay interest or dividends.
Uses of Free cash flow (FCF)
1. Pay interest to debtholders, keeping in mind
that the net cost to the company is the after-tax
interest expense.
2. Repay debt holders; that is, pay off some of the
debt.
3. Pay dividends to shareholders.
4. Repurchase stock from shareholders.
5. Buy short-term investments or other nonoperating assets.
FCF is the cash flow available for distribution
to investors. Therefore, a company’s fundamental value
depends primarily on its expected future FCF.
Is negative FCF bad?
Not necessarily; it depends on why the free cash
flow is negative. It’s a bad sign if FCF is negative
because NOPAT is negative, which probably means the
company is experiencing operating problems. However,
many high-growth companies have positive NOPAT
but negative FCF because they are making large
investments in operating assets to support growth.
Return On Invested Capital - shows how much
NOPAT is generated by each dollar of operating capital
Intrinsic Value, MVA, and EVA
There is a relationship between MVA and EVA,
but it is not a direct one. If a company has a history of
negative EVAs, then its MVA will probably be
negative; conversely, its MVA probably will be positive
if the company has a history of positive EVAs.
The stock price, which is the key ingredient in
the MVA calculation, depends more on expected future
performance than on historical performance.
A company with a history of negative EVAs
could have a positive MVA, provided investors expect
a turnaround in the future
Operating Profitability ratio (OP) - measures the
percentage operating profit per dollar of sales
Capital Requirement ratio (CR) - measures how much
operating capital is tied up in generating a dollar of sales
Market Value Added (MVA) represents the difference
between the total market value of a firm and the total
amount of investor-supplied capital. If the market
values of debt and preferred stock equal their values as
reported on the financial statements, then MVA is the
difference between the market value of a firm’s stock
and the amount of equity its shareholders have supplied.
MVA measures the effects of managerial actions since
the inception of a company.
Economic Value Added (EVA) is the difference
between after-tax operating profit and the total dollar
cost of capital, including the cost of equity capital. EVA
differs substantially from accounting profit because no
charge for the use of equity capital is reflected in
accounting profit. EVA represents the residual income
that remains after the cost of all capital, including equity
capital, has been deducted. Economic Value Added
measures the extent to which the firm has increased
shareholder value.
EVAs or MVAs are used to evaluate managerial
performance as part of an incentive compensation
program, EVA is the measure that is typically used. The
reasons are:
1. EVA shows the value added during a given
year, whereas MVA reflects performance over
the company’s entire life, perhaps even
including times before the current managers
were born.
2. EVA can be applied to individual divisions or
other units of a large corporation, whereas
MVA must be applied to the entire corporation.
by: eca .