PART IV

FINANCIAL MANAGEMENT:
AN OVERVIEW
Reading:

1.Mic ha el C . Ehrha rdt & Eugene F. B ri gha m (2011) F inanc i al M a na ge me nt :

The ory And Pr ac t ic e , 13 T H e d (Chapter 3, 10 )

What Is Financial Management?
Financial management is used to help make three major decisions:
1. Which assets should we invest in?
2. How will we pay for these assets?
3. What should we do with the earnings generated by the assets?
These are called the investment, financing, and dividend decisions.
It deals with how to raise and how to use money
What is financial analysis?
Financial analysis refer the use of financial data to evaluate the current and past
performance of a firm and to assess its sustainability.
The goal of financial analysis is to assess the performance of a firm in the
context of its stated goals and strategy
Objectives of Financial Analysis
• Understand reported financial data
• Better manage a business
• Provide a base for rational decision making
• Make a reasonable assessment of future financial condition based on
present and past financial conditions and on best available estimate of
future economic occurrences
Objectives of Financial Analysis
Why not accept prepared financial statements at face value?
◦ Prepared financial statements require some analysis as first step toward
extracting information from presented data.
◦ Decisions made on basis of financial analysis are important and accepting
presented financial data at face value is poor policy.
• There are two principal tools of financial analysis: ratio analysis and cash flow
analysis.
Ratio analysis
Ratio analysis involves assessing how various line items in a firm’s
financial statements relate to one another.
Ratios are used to develop a set of statistics that reveal key
financial characteristics of a company.
Ratio Analysis
Analyzing financial statements involves:

Comparison Tools of
Characteristics Bases Analysis

 Intracompany
 Profitability  Horizontal
 Industry
 Liquidity  Vertical
averages
 Solvency  Ratio
 Intercompany
Horizontal Analysis

Horizontal analysis, also called trend analysis, is a technique for

evaluating a series of financial statement data over a period of time.
 Purpose is to determine the increase or decrease that has taken place.

 Commonly applied to the balance sheet, income statement, and

statement of retained earnings.
Horizontal Analysis
Horizontal analysis of
balance sheets

Changes suggest that the

company expanded its asset
base during 2011 and financed
this expansion primarily by
retaining income rather than
assuming additional long-term
debt.
Horizontal Analysis
Horizontal analysis of
Income statements

Overall, gross profit and net income

were up substantially. Gross profit
increased
17.1%, and net income, 26.5%.
Quality’s profit trend appears
favorable.
Horizontal Analysis

Horizontal analysis of In the horizontal analysis of the balance sheet the ending retained earnings
retained earnings
statements increased 38.6%. As indicated earlier, the company retained a significant
portion of net income to finance additional plant facilities.
Vertical Analysis
Vertical analysis, also called common-size analysis, is a technique
that expresses each financial statement item as a percent of a base
amount.
 On an income statement, we might say that selling expenses are
16% of net sales.

 Vertical analysis is commonly applied to the balance sheet and the

income statement.
Vertical Analysis
Vertical analysis of
balance sheets

These results reinforce

the earlier observations
that Quality is
choosing to finance
its growth through
retention of earnings
rather than through
issuing additional
debt.
Vertical Analysis
Vertical analysis of
Income statements

Quality appears
to be a profitable enterprise
that is becoming even more
successful.
Vertical Analysis

Enables a comparison of companies of different sizes.

Intercompany income
statement comparison
Ratio Analysis
Ratio analysis involves assessing how various line items in a firm’s financial
statements relate to one another

Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short- Measures the Measures the

term ability of the income or ability of the
company to pay its operating success company to
maturing of a company for a survive over a long
obligations and to given period of period of time.
meet unexpected time.
needs for cash.
Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of
comparisons.
1. Intracompany comparisons

2. Industry average comparisons

3. Intercompany comparisons.
 Liquidity Ratios

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for
cash.

 Short-term creditors such as bankers and suppliers

are particularly interested in assessing liquidity.

 Ratios include the current ratio, the acid-test

ratio, accounts receivable turnover, and
inventory turnover.
Current Ratio

The current ratio is calculated by dividing current assets by

current liabilities.
Current assets normally include cash, marketable securities,
accounts receivable, and inventories.
Current liabilities consist of accounts payable, short-term
notes payable, current maturities of long-term debt, accrued
taxes, and other accrued expenses.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Current Ratio

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.
 Acid-Test Ratio

The quick, or acid test, ratio is calculated by deducting inventories and other prepaid expenses
from current assets and then dividing the remainder by current liabilities.
Acid-Test Ratio
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Balance Sheet (partial)
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Acid-Test Ratio

Acid-test ratio measures immediate liquidity.

Accounts receivable turnover ratio

It measures the number of times, on average, the

company collects receivables during the period.
 QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
QUALITY DEPARTMENT STORE INC.
For the Years Ended December 31
Balance Sheet (partial)
For the Years Ended December 31
Accounts Receivable Turnover

Assume the beginning receivable for 2010 is $200,000.

 Accounts Receivable Turnover

$2,097,000
= 10.2 times
($180,000 + $230,000) / 2
A variant of the accounts receivable turnover ratio is to convert it
to an average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

 Inventory Turnover

Measures the number of times, on average, the inventory is sold during the
period
It is defined as cost of goods sold divided by average inventories
(beginning plus ending divided by two).
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Inventory Turnover

.
Inventory Turnover

$1,281,000
= 2.3 times
($500,000 + $620,000) / 2

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

 Profitability Ratios

Measure the income or operating success of a company for a

given period of time.
 Income, or the lack of it, affects the company’s ability to obtain
debt and equity financing, liquidity position, and the ability to
grow.
 Ratios include the profit margin, asset turnover, return on
assets, return on common stockholders’ equity, earnings
per share, price-earnings, and payout ratio.
 Profit Margin

Measures the percentage of each dollar of sales that results

in net income.
It is calculated by dividing net income by sales.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31
Profit Margin
 Asset Turnover

Measures how efficiently a company uses its assets to

generate sales.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Asset Turnover
 Return on Asset
The ratio of net income to total assets measures the return on total assets (ROA) after interest
and taxes
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Return on Asset
 Return on Common Stockholders’ Equity
Shows how many dollars of net income the company earned for each dollar
invested by the owners.
ROE is a comprehensive indicator of a firm’s performance because it provides an
indication of how well managers are employing the funds invested by the firm’s
shareholders to generate returns
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Return on Common Stockholders’ Equity
Earnings Per Share (EPS)

A measure of the net income earned on each share of common stock.

QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Earnings Per Share (EPS)
Price-Earnings Ratio

Calculated market price of the share/earning per

share
Assume the market price of the share is $12 in 2011
and $8 in 2010
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Price-Earnings Ratio
Payout Ratio

Measures the percentage of earnings distributed in the form of cash dividends.

QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Payout Ratio
 Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.
 Debt to Assets and
 Times Interest Earned

are two ratios that provide information about debt-paying

ability.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Debt to Total Assets Ratio

Measures the percentage of the total assets that creditors provide.

QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Times Interest Earned

Provides an indication of the company’s ability to meet interest

payments as they come due.
Summary of Ratios
Summary of Ratios
Cash flow Analysis
The ratio analysis discussion focused on analyzing a firm’s income statement
(net profit margin analysis) or its balance sheet (asset turnover and financial
leverage).
The analyst can get further insights into the firm’s operating, investing, and
financing policies by examining its cash flows
Capital Budgeting
 Capital Budgeting is the process of making capital expenditure
decisions in business.

 Amount of possible capital expenditures usually exceeds the

funds available for such expenditures.

 Involves choosing among various capital projects to find the

one(s) that will maximize a company’s return on investment.
Evaluation Process

Many companies follow a carefully prescribed process in capital

budgeting. Corporate capital budget
authorization process
 Evaluation Process
 Providing management with relevant data for capital budgeting
decisions requires familiarity with quantitative techniques.

 Most common techniques are:

1. Annual Rate of Return

2. Cash Payback

3. Discounted Cash Flow

 Annual Rate of Return

Indicates the profitability of a capital expenditure by dividing

expected annual net income by the average investment.
Illustration: Reno Company is considering an investment of $130,000 in
new equipment. The new equipment is expected to last 5 years. It will have
zero salvage value at the end of its useful life. Reno uses the straight-line
method of depreciation for accounting purposes. The expected annual
revenues and costs of the new product that will be produced from the
investment are:
Computing Average Investment
Formula for computing
average investment

130,000 + 0
= $65,000
2

Expected annual $13,000

= 20%
rate of return $65,000

A project is acceptable if its rate of return is greater than

management’s required rate of return.
Principal advantages:

 Simplicity of calculation.

 Management’s familiarity with the accounting terms used in the

computation.

Major limitation:

 Does not consider the time value of money.

 Cash Payback
Cash payback technique identifies the time period required to
recover the cost of the capital investment from the net annual
cash inflow produced by the investment.

Computation of net annual

cash flow

Cash payback formula

$130,000 ÷ $39,000 = 3.3 years

The shorter the payback period, the more attractive the
investment.

In the case of uneven net annual cash flows, the company

determines the cash payback period when the cumulative net
cash flows from the investment equal the cost of the
investment.
Illustration: Chen Company proposes an investment in a new
website that is estimated to cost $300,000. Net annual cash flow
schedule

Cash payback should not be the only basis for capital budgeting
decision as it ignores expected profitability of the project.
Discounted Cash Flow

 Generally recognized as the best conceptual approach.

 Considers both the estimated total net cash flows from
the investment and the time value of money.
 Two methods:
► Net present value.
► Internal rate of return.
Net Present Value Method
 Net cash flows are discounted to their present value and then
compared with the capital outlay required by the investment.
 Interest rate used in discounting is the required minimum rate
of return.
 Proposal is acceptable when NPV is zero or positive.
 The higher the positive NPV, the more attractive the
investment.
 Net present value decision
A proposal is criteria

acceptable when net

present value is zero
or positive.
 Equal Net Annual Cash Flows
Illustration: Reno Company’s net annual cash flows are $39,000.
If we assume this amount is uniform over the asset’s useful life,
we can compute the present value of the net annual cash flows.

Calculate the net present value.

Illustration: Calculate the net present value.

The proposed capital expenditure is acceptable at a required rate

of return of 12% because the net present value is positive.
Unequal Net Annual Cash Flows

Illustration: Reno Company management expects the same

aggregate net annual cash flow ($195,000) over the life of the
investment. But because of a declining market demand for the
new product over the life of the equipment, the net annual cash
flows are higher in the early years and lower in the later years.
Unequal Net Annual Cash Flows
Computing present value of
unequal annual cash flows
Unequal Net Annual Cash Flows
Illustration: Calculate the net present value. Analysis of proposal using net
present value method

The proposed capital expenditure is acceptable at a required rate

of return of 12% because the net present value is positive.
Internal Rate of Return Method
 IRR method finds the interest yield of the potential
investment.
 IRR is the rate that will cause the PV of the proposed capital
expenditure to equal the PV of the expected annual cash
inflows.
 Two steps in method:
► Compute the interval rate of return factor.

► Use the factor and the PV of an annuity of 1 table to find the

IRR.
Internal Rate of Return Method

Step 1. Compute the internal rate of return factor.

For Reno Company:

$130,000 ÷ $39,000 = 3.3333

 Internal Rate of Return Method

Step 2. Use the factor and the present value of an annuity of 1 table
to find the internal rate of return.

Assume a required rate of return for Reno of 10%.

Decision Rule: Accept the project when the IRR is equal to or
greater than the required rate of return.
Comparing Discounted Cash Flow Methods
End of Part 4