Chapter 1: Overview of Financial management (Summary)

1. Basically there are three main forms of business organizations there are: Proprietorship,
Partnership and the corporation
2. The primary objectives of management should be to maximize stockholders’ wealth, and this
means maximizing the company’s fundamental, or intrinsic or stock price.
3. Firms increase cash flows by creating value for customers, suppliers, and employees.
4. Free cash flows (FCFs) are the cash flows available for distribution to all of a firm’s investors
(shareholders and creditors) after the firm has paid all expenses (including taxes) and made the
required investment in operations to support growth.
5. The value of a firm depends on the size of the firm’s free cash flows, the timing of those cash
flows and their risk.
6. The weighted average cost of capital (WACC) is the average return required by all of the firm’s
investors. It is determined by the firm’s capital structure (the firm’s relative amounts of debt
and equity), interest rates, the firm’s risk, and the market’s attitude towards risk.
7. A firm’s fundamental or intrinsic value is defined by:

8. Transfer of capital between borrowers and savers take place (a) by direct transfers of money
and securities: (b) by transfer through investment banking houses, which act as middlemen: and
(c) by transfers through financial intermediaries, which create new securities.
9. Capital is allocated through the price system- a price must be paid to ‘rent’ money. Lenders
charge interest on funds they lend, while equity investors receive dividends and capital gains in
return for letting firms use their money.
10. Four fundamental factors affect the cost of money: (a) production opportunities, (b) time
preferences for consumption (c) risk and (d) inflation
11. There are many different types of financial securities. Primitive securities represent claims on
cash flows, such as stock and bonds. Derivatives are claims on other traded securities, such as
options.
12. Major financial institutions include commercial banks, savings and loan associations, mutual
savings banks, credit unions, pension funds, life insurance companies and mutual funds.
13. Other financial service corporations are investment banking, brokerage operations, insurance,
and commercial banking.
14. There are different types of financial markets such as: spot market and future market, Physical
assets market and financial assets market, Capital market and money market, Primary market
and secondary market, private markets and public markets.
15. Financial statement analysis generally begins with a set of financial ratios designed to reveal a
company’s strengths and weaknesses as compared with other companies in the same industry
and to show whether its financial position has been improving or deteriorating over time.
16. Liquidity ratios show the relationship of a firm’s current assets to its current liabilities, and thus
its ability, and thus its ability to meet maturing debts. Two commonly used liquidity ratios are
the current ratio and quick ratio or acid test ratio.
17. Asset management ratios measure how effectively a firm is managing its assets. These ratios
include inventory turnover, days sales outstanding, fixed assets turnover, and total assets
turnover.
18. Debt management ratios reveal (a) the extent to which the firm is financed with debt and (b) its
likelihood of defaulting on its debt obligations. They includes the debt ratio, times-interest-
earned ratio, and EBITDA coverage ratio.
19. Profitability ratios show the combined effects of liquidity, asset management, and debt
management policies on operating results. They include the profit margin on sale, the basic
earning power ratio, the return on total assets, and the return on common equity.
20. Market value ratios relate the firm’s stock price to its earnings, cash flow, and book value per
share, thus giving management an indication of what investors think of the company’s past
performance and future prospects. These include the price/earnings ratio, price/cash flow ratio
and market/book ratio.
21. Trend analysis, where one plots a ratio over time, is important, because it reveals whether the
firm’s condition has been improving or deteriorating over time.
22. Du Pont system is designed to show how the profit margin on sales, the assets turnover ratio,
and the use of debt interact to determine the rate of return on equity. The management can use
the Du Pont system to analyze ways of improving performance.
23. Benchmarking is the process of comparing a particular company with a group of similar,
successful companies.