3.

FINANCIAL MANAGEMENT

FINANCIAL ANALYISIS
A. INTRODUCTION
 Accounting: it is the summary and analysis of a firm´s financial conditions.
o Firms use accounting to report their financial condition, support
decisions and control business operations
o Accounting allows managers and external third parties to understand
the value of a firm´s assets, the amount of profits it has generated in a
certain period, and its capability to pay debts
o TYPES OF ACCOUNTING
 Managerial accounting – internal reporting
 Detailed information for managers (costing, budgeting,
forecasting…)
 Decision – making and control purposes
 No need to comply with any accounting standards
 Financial accounting – external reporting
 Firms must report accurate financial data periodically
 Compliance with accounting standards: generally
accepted accounting principles (GAAP)
 Double – entry bookkeeping system – register
transactions and accounts
 Report to whom? Shareholders, investors, creditors,
external auditors, government
 Generates financial statements (balance sheet,
income statement…)
B. FINANCIAL STATEMENTS
 TYPES OF FINANCIAL STATEMENTS
o Balance sheet: shows the value of al assets liabilities and owner’s
equity of a firm at a given point in time
o Income statement: shows the revenues, costs, and earnings of a firm
over a period
o Cash-flow statement: shows the movement in cash and bank balances
over a period
o Statement of retained earnings: shows the changes in owner´s equity
over a period
 BALANCE SHEET
o It is a financial statement that
reports the company´s assets,
liabilities, and shareholder equity
o The balance sheet is one of the four
core financial statements that are
used to evaluate a business
o It provides a snapshot of a company
´s finances (what it owns and owes)
as the date of publication
3. FINANCIAL MANAGEMENT

o Basic accounting equation:

Assets ( activo )=Owner ´ s Equiti ( patrimonio neto )+ Liabilities (pasivo)
o Asset: anything owned by a firm which can be converted into cash

o Liab
ility:

anything owed by a firm (debt)

o Ow
ner
´s
equity: the value remaining to owners after all liabilities have been
repaid

 INCOME STATEMENT (cuenta pérdidas y ganancias)

o It is a financial statement that shows you the company´s income and
expenditures
o ELEMENTS
 Net sales: the total sales minus any discounts or returns granted
to customers
 Cost of goods sold: the cost of the materials used to produce the
goods that were sold
 Gross profit: net sales minus the cost of goods sold
 Operating expenses: expenses not directly linked to production
(e.g. selling and administrative expenses)
 Earnings before interest and taxes (EBIT): gross profit –
operating expenses
 Earnings before taxes (EBT): EBIT – interest expenses
3. FINANCIAL MANAGEMENT

 Net income (a.k.a. earnings after taxes): EBT – taxes

C. ECONOMIC AND FINANCIAL ANALYSIS
 ANALYSIS – WHAT FOR
o Analyzing financial statements allows managers:
 To understand the firm´s financial condition
 To examine its evolution
 To compare it to other firms
 ANALYSIS – WHAT IS ANALYSED?
o Financial ratios: liquidity, efficiency, financial leverage and
profitability
 Liquidity: It is the firm´s ability to meet short-term obligations.
 Higher levels of current assets compared to current
liabilities  higher firm´s liquidity
 Ratios to measure liquidity
Current Assets
o Current Ratio ( CR ) =
Current Liabilities
Current Assets−Inventories
o Quick Ratio ( QR ) =
Current Liabilities

 A high degree of liquidity can enhance

firm´s safety
 But excessive liquidity can reduce firm´s
return (wasted resources)
 Efficiency
 Inventory turnover: shows how many times a firm has
sold and replaced its inventory.
o Firms prefer very low inventory levels, but this
may lead to shortages (lost sales)
o Low turnover implies weak sales or excess
inventory
o High turnover implies strong sales or insufficient
inventory
Cost of goods sold
o Inventory Turnover=
inventory
 Use cost of goods sold instead of sales to
increase precision (exclude sales markup)
3. FINANCIAL MANAGEMENT

 Use average inventory value when

available, otherwise use year-end
inventory:
Average Inventory Value = Initial Inventories + Final Inventories

 Asset turnover: measures the efficiency of a company

´s assets in generating revenue or sales
o Firms prefer to support a high level of sales with a
relatively small amount of assets
o Firms that maintain excess assets are not
investing their fund wisely
Net Sales
o Asset Turnover=
Total Assets
 FIXED ASSET TURN OVER: Use fixed assets
instead of total assets
 CURRENT ASSET TURN OVER: use current
assets instead of total assets

 Financial leverage: it is the degree to which a firm uses

borrowed funds to finance its assets
 High leverage  more risk  higher rewards (spread
profits over fewer owners)
 Low leverage  less risk  lower rewards (spread profits
over many owners)
 Debt-to-Equity Ratio (D/E) (es la que se suele usar)
Long−term Debt
o D/ E=
Owner ´ s equity
 Times Interest Earned (TIE)
Earnings Before Interest∧Taxes (EBIT )
o TIE=
Annual Interest Expense
 3. FINANCIAL MANAGEMENT

 Profitability measures: they indicate the performance of a

firm during a given period of time
 Ratios to measure Profitability
o Beneficio Neto

Net income
Net Profit Margin ( PM )=
Net Sales
 Gross sales: q ∙ p
EBIT
 Net sale: including discounts and taxes
Rentabilidad
Net income Económica (esta fórmula se
Gross income o Returnon Assets ( ROA /ROI )=
Total Assets usa poco)

Rentabilidad Financiera
Net income
o Returnon Equity ( ROE )=
Owner ´ s equity
 Relationship between ROA and ROE
EBIT Rentabilidad Económica (se
o Returnon Assets ( ROA )= suele usar esta fórmula)
Total Assets
o Sometimes known as Returns on Total Assets
(ROTA). It is useful when comparing firms acrss
different industries
o If ROA = EBIT/Total Assets, ROE relates to ROA in
the following way:
 ROE = ROA + (ROA – i) ∙ D/E
 Where i = interest rate (or average
cost of debt) and D/E = debt to
equity ratio
3. FINANCIAL MANAGEMENT

o Net working capital (FONDO DE MANIOBRA)

 Working capital: a firm´s investment in current assets
 Net Working capital: a firm´s ability to pay its current debts
 Net Working Capital = Current Assets – Current Liabilities
Current Assets
 Linked to Current Ratio (Liquidity) 
Current Liabilities
 NWC > 0 (CR > 1)  financial equilibrium (can face short-
term debt)
 NWC < 0 (CR < 1)  financial disequilibrium (unable to
face short-term debt)

o Cash conversion cycle (CCC) (PMMf)

 CCC measures how much time the firm needs to:
 Transform inventories into sales (Inventory Conversion
Period)
 Collect receivables from such sales (Receivables
Conversion Period)
 Pay its bills at due time (Payables Conversion Period)
 CCC = Inventory Conversion Period + Receivables Conversion
Period – Payables Conversion Period
 All periods usually are measured in days

INVESTMENT DECISIONS
A. CHARACTERIZING AN INVESTMENT PROJECT?
 WHAT IS AN INVESTMENT PROJECT
o Sacrifice current consumption for the hope of greater future
consumption
 Firms invest funds in long-term projects (by acquiring a
real or financial asset)
 To generate a new business or to expand/improve the
current business
 Feasibility of an investment: firms conduct capital
budgeting (costs VS benefits)
o Firms often have to decide between two or more investment
projects
 If only one of the alternatives can be chosen, then
projects are mutually exclusive
 If adopting project does not affect the adoption of the
other (s), they are independent
 MAIN ELEMENTS OF AN INVESTMENT PROJECT
o Initial payment (K)
o Cash-flows (CF)
3. FINANCIAL MANAGEMENT

o Expected moments when the CF will be generated (t)

o Duration of the project (n)

B. PAYBACK PERIOD
 How long it takes to recover the initial investment?
 It is the amount of time which is necessary to recover the initial
investment through the net cash flows
o A simple way to evaluate project risk
o Shorter payback periods are preferred
o Useful for projects with a
very high initial investment
o When CF are constant, PP =
K/CF
C. THE TIME VALUE OF MONEY
 The main drawback of the payback period method is that it doesn´t
consider that de value of money is not constant over time
o A bottle of Coke cost 5 cents in the 1940s
o A pair of Levi´s jeans cost around $5 in the 1950s
o A McDonald´s burger was around 20 cents in the 1960s
 A dollar now is worth more than a dollar tomorrow – Why?
o Prices increase over time (inflation)
o Money can be used to generate more money
o The sooner the money is received, the greater the potential to
generate wealth
o Future is uncertain  compensate for the risk of not receiving
the money now
 When evaluating an investment project, the TVM is reflected in the
interest rate, which captures
o The cost of accessing money (the cost of financing)
o The opportunity cost of not investing in the best alternative
project
 The interest rates allows comparing money from different moments of
time
 Future values can be obtained by updating present values
V n=V 0 ¿
 Present value can be obtained by discounting future values
Vn
V 0=
¿¿
o N = the number of time
o Vn = the value at the moment
o V0 = the present value
o R = the interest rate (or discount rate)
D. NET PRESENT VALUE – NPV (VAN)
3. FINANCIAL MANAGEMENT

 NPV represents the present value of the project´s cash flows minus the
initial payment
CF 1 CF 2 CF n
NVP=−K + + + …+
( 1+ r ) ( 1+r ) 2
(1+r )
n

o n = the number of time periods

o K = initial investment
o CF1, CF2… CFn = the net cash flows in the periods 1, 2 … n
o r = the interest rate (or discount rate)
 Implications
o As opposed to PP, NPV uses all cash-flows and considers the
TVM
o NPV > 0  the investment is worth making
o When comparing several projects, the one with the highest NPV
is preferred

 Limitations
o Because future is uncertain,
cash-flows are based on
estimations  Margin of error
o Two projects with the same
NPV may not be equally
uncertain, and this is not
captured by NPV
o Decisions based on NPV will
change if discount rates
changes
E. INTERNAL RATE OF RETURN – IRR (TIR)
 IRR: the exact interest rate (discount rate that makes discounted cash-
flows the same as the initial payment
 That is, IRR is the exacta value of r so that
CF 1 CF 2 CF n
NVP=−K + + + …+ =0
( 1+r ) ( 1+ r )
¿ ¿2
( 1+ r ¿ )
n

o When IRR is larger than the cost of financing (when r* > r), the
project is profitable
o In case of several alternative projects, the one with the highest
IRR is preferred
F. IRR vs NPV
 IRR is more difficult to compute than NPV because IRR requires solving
an nth degree equation
 As a consequence of IRR being an nth degree equation, there will be
several IRRs for one same project
 IRR and NPV might lead to opposite conclusions (in such cases, NPV is
often preferred)
3. FINANCIAL MANAGEMENT

FINANCING
A. INTRODUCTION
 WHAT IS FINANCING
o When people want to create a firm (i.e. startup), money is
needed to establish the company and make the initial
investments and money will continue to be needed to expand
the business and for further investments in the future.
o The process of obtaining funds to make business operations or
investment decisions is what is known as “financing”
 TYPES OF FINANCING
o Based on duration:
 Long-term funds: equity, stock issuance, retained
earnings, long-term loans, bonds
 Short-term funds: short-term loans, accounts payable,
commercial papers

o Based on ownership
 Equity financing: equity shares and retained earnings
 Debt financing: loans, bonds, commercial papers
o Based on origin
 Internal funds: retained earnings, collection of
receivables, sale of fixed assets and surplus inventories
 External funds: stock issuance, loans, bonds, commercial
papers, accounts payable
o DEBT FINANCING AND EQUITY FINANCING
 Debt financing: the firm borrows funds  requires
payment of principal and interests
 Equity financing: the firm receives investment from
owners  does not require payments (only dividend
payments if the firm can afford them)
Financing from debt or equity has different implications for
financing costs:
Debt financing affects the firm´s interest expenses
Equity financing affects the number of owners and
earnings distribution

B. DEBT FINANCING
 Most businesses rely on debt financing to some degree at most stages
of their life
 When the firm is newly born, entrepreneurs may need to borrow from
family, friends (FFF), or business angels / venture capitalists, if they are
lucky
 In the long-term, however, they will likely need to borrow more money
to grow
3. FINANCIAL MANAGEMENT

 Firms need funds to invest in machinery, facilities, technology… The

degree of capital required depends on the nature of the business (type
of product, industry…)
 Borrowing more capital implies higher interests and higher risk, so firms
need to consider aspects like the interest rate and the financial leverage
 LOANS
o Firms try to obtain financing from financial institutions, such as
commercial banks, savings institutions, and finance companies
o The lender will asses the creditworthiness of a firm based on
information on:
 The firm´s projection of cash-flows
 The firm´s current and past financial statements
 The firm´s strategy and business plan
 The characteristics of the industry and environmental of
the firm
 Whether the firm has available collateral

o If the lender decides the firm is creditworthy, it will establish the

terms of loan:
 The amount to be borrowed
 The duration of the loan
 The collateral
 The interest rate
o Loan rate:
 Banks determine the average rate of interest that they
pay on their deposits (which represents their cost of
funds) and add on a premium
 The premium depends on the credit risk (related to the
firm´s creditworthiness)
 The loan rates conferred to the most creditworthy firms
is known as the prime rate
 Fixed-rate vs Floating-rate
o Types of loans
 Short-term loans: to cover expenses of operating process
 Long-term loans: to invest in fixed assets
 Line of credit: allows the firm to borrow up to a certain
amount within a given period
 BONDS
o Bonds are long-term debt securities purchased by investors
o How do bonds work – IOU (“I owe you”)
 The firm issues (sells) bonds to bondholders at a par
value which is redeemable after a certain maturity period
(10, 30, 1000 years…)
 The firm must also pay interests (normally annually or
semi-annually) according to the coupon rate, which is
expressed as a % of the par value
3. FINANCIAL MANAGEMENT

 At maturity date, the firm must repay that par value

o Some considerations:
 Bondholders are creditors, not owners
 Usually, raised funds are larger than in loans, and interest
rates are lower
 The coupon rate depends on the firm´s risk of default and
on the maturity period… but also on the general level of
interests at the time of issuance
 Bonds can be callable  the issuer firm can redeem the
bonds before the maturity date
 Bonds can be backed by collateral (secured) or not
(unsecured)
 Bondholders can sell their bonds at a market value
different than the par value

C. EQUITY FINANCING
 RETAINED EARNINGS
o A firm can obtain equity financing by retaining earnings rather
than distributing them among its owners through dividend
o The board of directors of each firm decides how much of the
earnings should be retained (reinvested in the firm) vs
distributed as dividends
o The dividend policy:
 There is no optional dividend policy
 Small firms tend to retain most of their earnings to
support expansion
 Large firms can more easily obtain debts financing, so
they can afford to pay dividends
 Need to manage shareholders´ expectations
 STOCK ISSUANCE: firms may also raise funds by issuing stock
o COMMON STOCK
 A security that represents partial ownership of a firm
 Only owners of common stock have voting rights
 When new shares of common stock are issued, the
number of shareholders increases
o PREFERRED STOCK
 A security that represents partial ownership and offers
priorities over common stock
 The firm must pay dividends to preferred stockholders
before paying anything to common stockholders
 If the firm goes bankrupt, preferred stockholders have
priority claim to the firm´s assets over common
stockholders (not over creditors)
 Do not confer voting rights
3. FINANCIAL MANAGEMENT

o STOCK ISSUANCE
 Firms can issue stock privately to a venture capital firm
 A firm composed of individuals who invest in
high-risk high-potential startups
 Venture capital firms invest in many startups
(some may under-perform, others will make up
for it)
 Entrepreneurs can present their business ideas at
venture capital forums
 Some VC (Venture Capital) firms can manage billions of
dollars in investments across multiple firms
 Examples: New Enterprise Associates, Insight Venture
Partners, Goldman Sachs, Sequoia Capital, Accel…

 Private firms may consider an Initial Public Offering (IPO)

of stock (going public)
 The first issuance of stock to the public
 Main buyers: insurance companies, pension
funds, stock mutual funds…
 Firms can raise large amounts of funds without
increasing debt or retaining earnings
 How does IPO work?
 1. The firm hires an underwriter (an investment
bank such as Goldman Sachs)
 2. The underwriter determines firm´s valuation
and guides the firm in the IPO process
 3. The underwriter also helps the firm to get listed
on the Stock Exchange Market
 4. When the IPO date comes, public investors can
purchase firm´s shares
 5. Private stock holders may decide to sell (some
of) their stocks for cash
 IPO Disadvantages
 Disclosure of information and preparation of
financial reports periodically
 Some small private firms may have too low
valuations from underwriters
 Ownership structure is diluted – control and
profits are now spread over more shareholders
 Investment banks charge high fees, plus there are
legal fees, accounting fees, and printing fees
(around 10% of raised funds)
D. CAPITAL STRUCTURE
 Capital structure  the amount of debt vs equity financing
 No optimal capital structure:
3. FINANCIAL MANAGEMENT

o Debt offers the advantage that interest payments are tax-deductible

o Higher debt  higher default risk  higher potential reward
o When debt capacity is reached, firms retain more earnings or issue
stock to obtain capital
 Firms revise their capital structure continually to:
o Reduce debts when economic conditions are poor or interest rates
are too high
o Repurchasing shares can help reconfigure capital structure and rises
stock price
 ROE can be significantly affected by capital structure decisions:
Net Income
 ROE= =ROS+(ROA−i)∙ D/ E
Owner ´ s Equity
 Rising D/E increases ROE, if ROA > i, but excessive D/E exposes the firm to
default risk
 Creditors and investors prefer firms with lower D/E ratios, as they are less
risky
 Optimal D/E varies across industries, but the rule of thumb is that D/E ≤ 2