PRINCIPLES OF
FINANCIAL
ANALYSIS
Week 1: Lecture 1
Chapter 1
An Overview of
Managerial Finance
Learning Goals
 DETERMINE THE ROLE OF MANAGERIAL
FINANACE
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Why should I study Finance?
In order to answer this we need to first answer: ‘What role does
finance play in the in the successful operation of a firm’.
Answer: Proper financial management (managerial finance) will
help any business provide better products to its customers at
lower prices , pay higher salaries to its employees and still
provide greater returns to its investors who put up the funds
needed to form and operate the business. Because he national
and worldwide economy consists of consumers , employees
and investors, good financial management contributes to the
well being of both individuals and the general population.
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Career Opportunities in Finance
The study of finance consists of three interrelated
areas:
 Financial Markets and Institutions (deals with many of the
topics covered in macroeconomics)
 Investments
(focuses on the decisions of individuals and financial
institutions to choose securities for their investment portfolio)
 Managerial Finance (or ‘business finance’ which involves the actual
management of the firm)
Each of these areas is related to each other, so an individual who works in
one of the areas should have a good understanding of the other areas as
well. The career opportunities within each field are many. In this course we
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will focus on the Managerial Finance!
Managerial Finance
 Managerial Finance is the broadest of the three categories and
the one with the greatest job opportunities because it is
important in all types of business weather they are public or
private ,deal with financial services or are manufacturers. In
the job of Managerial Finance you have to deal with
tasks such as: make decisions regarding business expansions
and choosing what types of securities to issue to finance
expansion, deciding the credit terms under which customers
can buy, how much inventory the firm should keep, how much
cash to keep on hand, whether to acquire other firms and how
much of the firm’s earnings to keep into the business and
reinvest versus pay out as dividends.
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The Financial Manager’s Responsibilities
1. Forecasting and planning : The financial manager must
cooperate with other executives and make the plans that will
shape the firm’s future position.
2. Major investment and financing decisions: A successful
firm generally has rapid growth in sales which requires
investment in plant, equipment and inventory. The financial
manager must help decide on the specific assets to acquire
and the best way to finance those assets. For example should
the firm raise funds by borrowing (debt) or by selling stock
(shares)? If the firm uses debt should be long term or short
term?
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3. Coordination
and
control:
The
financial
manager must interact with the other managers so as to make
sure that the firm is operating as efficiently as possible: all
business decisions have financial implications and all managers
financial and other need to take this into account. E.g.
marketing decisions affect sales growth which in turn affect
investment requirements. Thus marketing decision makers
must consider how their actions affect ( and are affected by)
factors such as the availability of funds, inventory policies and
plant ability.
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4. Dealing with financial markets: The financial manager
must deal with the money and capital markets (local &
abroad). Each firm affects and is affected by the general
financial markets where funds are raised, where the firm’s
securities are traded and where its investors are either
rewarded or penalized.
In summary financial managers make decisions regarding which
assets their firms should acquire, how those assets should be
financed and how to manage their firms existing resources. If these
responsibilities are performed optimally, financial managers will help
to maximize the long term welfare of those who buy from or work
for the company, as well as the community where the firm is
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located.
Alternative Forms of
Business Organization
There are three main forms of business
organization :
Proprietorship
Partnership
Corporation
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Proprietorship
Proprietorship is an unincorporated business owned
by one individual.
 Advantages:
 It is easy and inexpensively formed but in most cases must
be licensed by the municipality in which it operates.
 Subject to few government regulations
 No corporate income taxes, it is taxed like an individual
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 Limitations:
 The owner has unlimited personal liability on business
debts which can result in losses that exceed the money
the owner has invested in the company.
 Difficult to raise capital because the firm’s financial
strength is based on the financial strength of the sole
traded
 Transferring ownership is difficult – selling of the
business is similar to selling a house and the proprietor
has to seek out and negotiate with a potential buyer.
 Limited life of the business equal to the life of the
individual who created it.
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Partnership
 Like a proprietorship, except there are two or more owners.
 A partnership has roughly the same advantages and
limitations as a proprietorship.
Regarding liability the partners can lose all of their personal
assets even those not invested in the business because under
partnership law all each partner is liable for the business’
debts. Thus if any partner is unable to meet his or her
prorate claim in the event the partnership goes bankrupt, the
remaining partners must cover the unsatisfied claims.
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Corporation
A corporation is a legal entity created by a status. It is
separate and distinct from its owners and managers.
 Advantages:
 Unlimited life: it can continue after its original owners are
dead.
 Easy transfer of ownership: ownership can be divided into
shares of stock which in turn can be transferred far more
easily than the other two form of organizations.
 Limited liability: the loss of a shareholder in case of
bankruptcy is limited to the amount he/she initially invested
 Ease of raising capital in the financial markets for the above
reasons (sell shares e.t.c), because investors will have limited
liability and since many will invest funds can be invested in
growth opportunities which will increase the value of the13 firm.
There are two main disadvantages for the
corporations:
 Disadvantages:
 Double taxation of earnings: the earnings of the
corporation are taxed and then the earnings paid as
dividends are taxed again as income to the stockholders
 Setting up a corporation and filing required lawyer to
prepare
regulations and rules
regarding the
management of the company and reports given to the
government , is more complex and time consuming the
other two forms of organizations.
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Place of Finance in the Organizational
Structure of the Firm
Board of Directors
President
Vice-President:
Sales
Vice-President:
Operations
Treasurer
Credit
Manager
Inventory
Manager
Director of
Capital
Budgeting
Vice-President:
Finance
Vice-President:
Information Systems
Controller
Cost
Financial
Tax
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Accounting Accounting Department
Organization of Finance Functions
 CFO – Chief Financial Officer
 Treasurer responsibilities:
 Financial planning, fund raising, capital
expenditure decisions, dividend payment,
cash and credit management.
 Controller responsibilities:
 Corporate accounting, cost accounting,
and tax management.
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Goals of the Corporation
Business decisions are not made without objectives: the
primary goal is
stockholder wealth maximization
maximizing the value of the firm - the value of stock
price
Do managers operate for the best interest of the stockholders
or they are taking advantage of them?
Managers of course have also other objectives:
Personal satisfaction – high salaries, employees welfare – safe
working environment and in the good of the community and of
society at large – avoid polluting the air or water, produce safe
products e.t.c.
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It is difficult to know how managers act!
Stock Price Maximization and
Social Welfare
 SP max. Requires:
 efficient low-cost plants that produce high quality
goods & services at the lowest possible cost
 produce goods needed by people  so new
technology, new products and new jobs emerges
 efficient services, well-located businesses , etc…
These factors are necessary to produce sales and profits and also
these actions are beneficial to society. Managerial Finance
has an important role in the operation of successful firms
and successful firms are necessary for a productive and
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healthy economy.
Factors Influenced by Managers that
Affect Stock Price
 Concentrate on increasing earnings per share- this is
more important than total profits (for e.g. one share costs
€4- this is EPS)
 How risky is he project undertaken to increase earnings
per share: one project is possible to give more EPS but
is very risky and uncertain if it will go finally well.
 Use of debt (capital structure) – the greater the use of
debt the greater the threat of bankruptcy.
 Dividend policy: how much of the current earnings to
pay out as dividends and how much to keep and
reinvest: the optimal policy is the one that maximizes
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the firm’s stock price.
Comparative Income Statement for years ending 31st Dec
(millions of Euros except the per share data)
Net Sales
Cost of Goods Sold
Gross Profit
Fixed operating expenses
Depreciation
Earnings before interest and taxes (EBIT)
Interest
Earnings before Taxes (EBT)
Taxes (40%)
Net Income
Dividends of preference shares
Earnings available to common stockholders (EAC)
Common Dividends
Addition to retain earnings
2000
1500
(1230)
270
(90)
(50)
130
(40)
90
(36)
54
0
54
(29)
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Per Share data(25,000,000 shares):
Shares issued (quantities)
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Common stock price
€23
Earnings per share
€2.16
Chara Charalambous CDA COLLEGE
Dividends per share
€1.16
1999
1435
(1176.7)
258.3
(85)
(40)
133.3
(35)
98.3
(39.3)
59
0
59
(27)
32
25
€23
€2.36
20
€1.08
Comparative Balance sheets as at 31 Dec (millions of Euros)
Fixed Assets
Plant and Equipment
Less: Accumulated Depreciation
Current Assets
Inventory
Debtors
Cash
Total Assets
Equity and Liabilities
Owner’s equity
Paid – in Capital
Common stock (25,000,000 shares)
Retained Earnings
Long Term Loans
Current Liabilities
Creditors
Accruals
Total Equity and Liabilities
2000
680
(300)
270
180
15
380
465
845
1999
600
(250)
200
160
40
350
400
750
0
130
285
415
300
0
130
260
390
255
30
100
845
15
90
750
Chara Charalambous CDA COLLEGE
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Evaluating a Firm’s EPS
 We can use the income statement to determine the earnings per share
(EPS) and dividends.
 EPS = Net income/Number of shares outstanding
 Example 1: A firm reports a net income €54 million and has 25 million
shares outstanding, what will be the earnings per share (EPS)?
 EPS = Net income ÷ Number of shares
= €54 million ÷ €25 million
= €2.16
•
•
•
•
Book value per share = (Common equity)/Shares €16.60
Market value per share (stock price) €23.00
Earnings per share = (Net income)/Shares €2.16
Dividends per share = (Common dividends)/Shares €1.16
(29/25)
Chara Charalambous CDA COLLEGE
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EPS Formula
EPS is calculated as follows:
What do the shareholders get?
Do they get earnings per share plus the dividend declared or just the
dividend declared?
Shareholders get a dividend if a dividend is declared. When companies have earnings
they can either pay them out to the shareholders or reinvest them in the company.
The latter is usually true with growing companies. You'll find that companies which
aren't as focused on growth will pay more of their earnings out to stockholders.
Technically as a shareholder you own a portion of the profits, but unless you are a
board member, you don't get to decide whether those profits get paid out or
reinvested.
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Agency Relationships
 An agency relationship exists whenever a
principal (person) hires an agent to act on their
behalf.
 Within corporations, agency relationships exist
between:
 Stockholders and managers, and
 Stockholders and creditors.
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Stockholders versus Managers
 Managers are naturally tending to act in their
own best interests.
 But the following factors affect managerial behavior:
 The threat of firing
 The threat of takeover. In an antagonistic takeover the
managers of the acquired firm generally are fired and any
who are able to stay on ,lose the power they had prior to
the acquisition.
 Structuring managerial incentives: Firms are tying
managers compensation to the company’s performance
and this motivates managers to operate in a manner
consistent with stock price maximization.
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Stockholders versus Creditors
 Creditors decide to loan money to a corporation based on the
riskiness of the company, its capital structure (how mush debt
and how much own funds) and expectations of the future
riskiness and future capital structure. All of these factors will
affect creditors when determining the level of the interest
rate they will charge in the company. Stockholders, however,
have control of such decisions through the managers.
Since stockholders will make decisions based on their best
interest, a potential agency problem exists between the
stockholders and creditors. They might try to take on new
projects that are risky.
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 But the following factors hold on stockholders from
unethical decisions:
If creditors see that a firm will try to take advantage of them
in unethical ways they will either refuse to deal with the
firm or else will require a much higher than normal
rate of interest to compensate for the risks of such ‘tricky’
actions. Thus firms that try to deal unfairly with creditors
either lose access to the debt markets or are charged with
higher interest rates, both of which decreases the long run
value of the stock.
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Managers as agents of both the creditors
and the stockholders must act in manner
that is fairly balanced between the interest
of these two classes of security holders.
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Importance of Ethics
The standards of conduct or moral judgment:
 Honesty, trustworthiness, fair dealing are
foundations of sustainable business relations:





With
With
With
With
With
customers,
suppliers,
creditors,
employees,
owners.
 Ethical behavior is necessary to achieve the goal
of maximizing shareholder wealth.
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Summary of Major Factors Affecting Stock Prices
External
Constraints:
1. Antimonopoly
Laws
2. Environmental
Regulations
3. Product and
Workplace Safety
Regulations
4. Employment
Practices Rules
5. Central Bank
Policy
6. International
Developments
Strategic Policy
Decisions
Controlled by
Management
1.Types of products
and services
produced
Level of
Economic
Activity and
Corporate Taxes
Stock
Market
Conditions
Expected
Profitability
2.Production
methods used
Timing of Cash
Flows
3.Relative use of debt
financing
Degrees of Risk
Stock
Price
4.Dividend policy
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APPENDIX
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 Share capital is the money invested in a
company by the shareholders. Share
capital is a long-term source of finance.
 In return for their investment, shareholders gain
a share of the ownership of the company.
 Shareholders benefit from the protection offered
by limited liability – they are only liable for the
amount they invest in share capital rather than
the overall debts of the company
 The shareholder obtains a return on this
investment through dividends (payments out
of profits) and/or increases in the value of the
company when it is eventually sold.
 A start-up company can also raise finance by
selling shares to external investors
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Types of Shares
A. Ordinary
Shares
B. Preference Shares
(Preferred Shares)
(Equity Shares)
Cumulative
preference
shares
Non-cumulative
Preference Shares
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Ordinary Shares: are the normal shares issued
by a company and the ordinary shareholders are the
real owners of the business.
 Carry voting rights
 Shareholders receive a divided at the discretion of
the company directors
 Dividends is paid out of profits after the preference
shareholders receive their dividend.
Preference Shares:
 Do not generally carry voting rights
 Shareholders receive a fixed dividend (calculated as
% of nominal value of shares held)
 Dividends is paid out in priority to ordinary dividend
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Dividends
 Dividends are the share of profits paid out
to shareholders.
 Dividends on preference shares are a fixed
amount. (calculated as % of nominal value
of shares held)
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