Module 1 Finance 320

Major Areas of Finance (ICC - Ice Cream Cake)

1. Investment

   1. financial asset valuation, investments in risk and return

   2. stocks, bonds

2. corporate finance

   1. capital budgeting (evaluating investments like building a new factory)

   2. raising funds through IPOs, bond issuance, or loans)

   3. mergers and acquisitions (buying or merging w/ another company)

   4. working capital management (manage day to day operations)

3. capital markets + financial institutions

   1. primary vs. secondary market

   2. gov issuing treasurign bonds or corps issuing a corporate bond.

Investment facts

• we invest to increase wealth

what do we invest in?

• financial assets

• physical assets

capital budgeting

process organizations use to evaluate, select, and fund major, long-term investments or projects, such as new equipment, facilities, or products, to ensure they align with strategic objectives and provide expected cash flows

ex: purchasing or replacing significant fixed asset like PPE (new manufacturing plant, equipment, opening new locations)

cost of capital

how expensive are our capital

should we use debt or equity

working capital management

process of ensuring a company is using its financial resources in the most effective way possible.

Managing a company's current assets (like cash, inventory, and accounts receivable) and current liabilities (like accounts payable and short-term loans) to ensure there's enough cash to cover daily operational expenses, meet short-term financial obligations, and avoid liquidity problems

ex: what should be credit policy? how much cash balance the firm keeps?

financial markets

intermediaries between investors and company (ex: bank, stock exchange)

primary vs. secondary markets

primary market-where firms and government raise money from investors by selling newly issued stocks/ bonds to them.

secondary markets - where trading of financial assets takes place between investors

3 major areas of business

1. sole proprietorship

2. partnership

3. corporations

pros and cons of a sole proprietorship

Pros

• easy to start and manage

• owner keeps all profit

• taxed once as personal income

cons

• limited to life of owner

• limited equity capital

• unlimited liability

• difficult to sell ownership interest

partnership pros and cons

pros

• easy to start

• more capital available

• income tax once as personal income

cons

dissolved when partner dies
hard to transfer ownership

corporations pros and cons

pros

• limited liability

• easy to make more money (easier access 2 capital and 2 sell stock)

• easy to transfer ownership + exist beyond owners life

cons

• double taxation problem

  • (corporate profits taxed and again as dividends)

• complex and expensive setup

• Extensive record-keeping and reporting requirements

• less flexibility

• agency problem

CFO

responsible for all finances within business

Difference between treasurer and controller responsibilities

treasurer - external financial strategy, cash management, credit management, capital expenditures + financial planning, investment, debt, relationships w/ bank

controller - internal managerial, reporting, compliance, accuracy, oversees taxes, cost accounting, financial accounting and data processing

agency problem

conflict of interest between principal (stockholders) and agents (managers)

(when stockholders hire managers whose values don’t always align with the companies interest.

Of the following, which is NOT one of the three main
areas of finance?

A) Banking
B) Corporate finance
C) Investments
D) Capital market and financial institution

A) Banking

Which of the following is NOT typically thought of as an
investment activity?
A) Forming a portfolio of assets to achieve the best trade-off
between risk and return
B) Deciding what assets, physical or financial assets, to buy.
C) Managing account receivables and account payables
D) Evaluating the riskiness of a stock
E) All of the above are investment activities

C) Managing account receivables and account payables

True or false:
If a company offers stock for sale for the first time and
the proceeds go to the company, then this is a sale in the
primary market

True

The means by which a company is financed refers to the firm’s
_________.
A. Capital budgeting
B. Capital structure
C. Accounts receivable management
D. Working capital management

B. Capital structure

Which of the following is not a capital budgeting question?
A. The choice of which long-term assets to purchase to meet the firm’s
business goals
B. The choice of what type of business a firm wants to operate
C. The proper mix of stocks and bonds to finance (or pay for) assets
D. None of the above

C. The proper mix of stocks and bonds to finance (or pay for) assets

When the management of a business is conducted by individuals other
than the owners, the business is more likely to be a:
A. Corporation
B. Sole proprietorship
C. Partnership
D. General partner
E. None of the above

A. Corporation

Which of the following is NOT a DISADVANTAGE of a
partnership?
A) Unlimited liability to at least some of the owners
B) The limited life of the business
C) The potential difficulty in transferring ownership
D) All are disadvantages of a partnership.

A) Unlimited liability to at least some of the owners

Double taxation refers to which of the following scenarios?
A.Both bondholders and shareholders of a corporation must pay
taxes on proceeds received.
B.The corporation pays taxes on its earnings, and creditors pay taxes
on interest received.
C.The corporation pays taxes on its earnings, and shareholders pay
taxes on dividends received.
D.All of the above statements are correct

C.The corporation pays taxes on its earnings, and shareholders pay
taxes on dividends received.

In a firm with both a treasurer and a controller, which of the following
would most likely be handled by the controller?
A. Internal auditing
B. Credit management
C. Banking relationships
D. Capital expenditure
E. None of the above

A. Internal auditing

The problem of motivating one party to act in the best
interest of another party is known as the ________.
A) leadership directive
B) management priority
C) principal-agent problem
D) Six sigma structure

C) principal-agent problem

3 main financial statements

1. balance sheet

   1. assets & liabilities of business

   2. snapshot of what firm owns or owes

2. income statement

   1. shows a company's revenues and expenses over a period

3. statement of cash flows

   1. details the movement of cash into and out of the company from operating, investing, and financing activities

basic accounting equation (ALOE)

assets = liabilities + owners equity

Balance sheet basic structure

current assets

• cash & securities

• receivables

• inventory

+ fixed assets

• tangible assets

• intangible assets

= total assets

= (this side should be equal with) =

current liabilities

• payables

• short term debt

long term liabilities

+

shareholders equity

= total liability + shareholders equity

current asset

liquid asset that can be converted to cash quickly

asset

represent the uses of a firm’s funds (i.e show what the firm owns)

liquid asset can

be converted easily into cash at fair value

current vs fixed

current - can be turned liquid (into cash) quickly

fixed - not as easy to convert

practice problem

rank from most to least liquid

A. marketable securities

B. Inventory

C. Account receivable

a. ABC

b. ACB

c. BAC

d. BCA

b. ACB

marketable securities

liquid financial asses that are easily bought & sold (ex: stocks, bonds, CD’s)

why are marketable securities so liquid

securities can be easily sold, A/R takes a few weeks to months to collect and inventory takes the longest to be sold for cash because it is storage

tangible asset

PPE (property, plant, equipment)

intangible asset

trademark, patented tech, movies

PRACTICE PROBLEM

which of following is current asset?

a. equipment

b. land

c. unsold inventory

d. patent

c. unsold inventory

(equipment and land are part of tangible asset PPE)

(patent intangible)

liabilities

represent the source of a firm’s funding (i.e represent what the firm owes)

networking capital equation

(remember for a practice problem)

current assets - current liabilities

shareholders equity

difference between total assets and total liabilities

equity represents

shareholders investment in the firm

2 parts of equity

1. paid in capital

2. retained earnings (R/E)

retained earnings (R/E)

accumulated net profits not paid out to shareholders since inception

paid in capital

amt of equity raised from shareholders

income statement

show’s expenses + revenues generated by a firm over a past period, typically a quarter or a year (summarizing firm’s operations over a period)

cash expenses vs non cash expenses

cash expenses - wages, utility

noncash expenses - depreciation amortization

operating expenses

incurred by normal day to day operation of business

(wages, rent, utilities)

non-operating expenses

not directly related to operation (ex: interest expenses, taxes)

net income equation

revenues - total expenses

top line on income statement

bottom line on income statement

TOP LINE - revenue

BOTTOM LINE - net income/ net profit

operating profit (AKA EBIT) =

revenue - operating expenses

EBIT =

practice problem info

(aka operating profit) = revenue - operating expenses (before deducting interest expenses, taxes, and other non operating expenses

depreciation is a

NON CASH EXPENSE

operating expenses =

(practice problem info)

COGS, depreciation, SGA (selling, general, administrative expenses)

Practice Problem

Income statement begins w/ revenue + subtracts various OE until arriving at earnings before interest and taxes. Next, interest expense is subtracted to find the ___ for the period

A. operating profit

b. after tax income

c. net income

d. taxable income

d. taxable income

EBT (earnings before taxes) =

practice problem info

EBIT - interest expense

(subtracting interest expense taxes away the I in EBIT of income taxable (the earnings before tax (the amount that can be taxed)

EBT (AKA)

practice problem info

taxable income, amount of profit used to determine taxes (or tax = EBT tax rate)

EBIT (AKA)

practice problem info

operating profit, after tax income is the same as net income

interest expense is not

an operating cost its a financing cost

dividends

part of net income paid to shareholders

(firm gets to retain the remainder of net income for reinvestment) - addition to the retained earnings

net income is not the same as

(CASH FLOW)

3 Major reasons for differences between net income & cash flow

1. non cash expense item (depreciation)

   1. net income but not cash flow

2. changes in networking capital

   1. they are written different. Net income on income statement

3. non operating cashflow

Increase in AR means a

decrease in cash flows

increase in current assets means a

decrease in cash flows

increase in current liabilities means a

increase in cash flows

statement of cash flows

shows the firm’s cash receipts and cash payments

free cash flow (not the same as cash flows)

cash available for distribution to investors after the firm pays for new investments or additions to working capital

statement of cash flows structure

cash flow from operations

• complicated cause from day to day we use alternate bc its too complicated

+ cash flows from investments

• inflow sells subsidiary

• outflow - buying/ investing

+ cash flow from financing

• inflow/ outflow from financing

• ex: issues bonds of gets loan = inflow

= change in ash balance

• shows outflow _ inflow & is link to the balance sheet to statement cash flows

3 major reasons for differences in net income and cash flow

• Definition

  • Net Income = Profit after all revenues and expenses are recorded (includes non-cash items like depreciation).

  • Cash Flow = Actual inflow and outflow of cash in a period.

• Non-Cash Items (DEPRECIATION)

  • Net Income includes non-cash expenses (e.g., depreciation, amortization).

  • Cash Flow only tracks real cash movements — no accounting adjustments.

• Timing

  • Net Income follows the accrual principle (records revenue when earned, expenses when incurred, even if cash hasn’t moved).

  • Cash Flow reflects when money actually comes in or goes out of the business.

changes in network capital refer to

increases or decreases to current assets or liabilities

decrease in current asset means a

increase in cash flow

decrease in current liabilities

decrease in cash flow

PRACTICE QUESTION

which will result in a decrease in cash flows?

a. decrease in AP

b. decrease in inventories

c. decrease in AR

d. increase in other liabilities

a. decrease in AP

bc its a current liability

PPE and Intangible assets are both

fixed assets NOT current assets

Short term bank note

a legally binding document for a loan, where the borrower promises to pay a specific amount of money to the lender within one year or less

How to find net income -

PRACTICE PROBLEM

Sales

- COGS or cost

- SG&A

= EBDIT

- depreciation

= EBIT

- interest

= EBT

- tax

= net income/ net profit

delete

delete

TOE (total owners equity) =

common stock + retained earnings

structure of cash flow-

ability to generate cash not just profit

3 major areas for statement of cash flows

1. Financing activities- collecting necessary funds to support business (ex: issue shares of common stock)

2. Investing activities - acquiring resources necessary to run the business (ex: cash spent on new equipment)

3. Operating activities - putting the resources of the business into action to generate a profit 

why net income and cash flow are not the same

bc net income uses accural accounting, revenue is recognized when a sale is made, and expenses are recognized when incurred, regardless of whether cash is received or paid at that moment

Cash flow focuses only on the actual movement of cash into and out of the business, while also including the non cash items like depreciation and changes in working capital to reconcile the differences. Only actual cash transactions are considered, so money received from sales on credit or cash paid for a prepaid expense doesn't immediately impact the cash flow statement in the same way it affects net income. 

the reason cash flow and current assets are inverse

is because you have to pay for these assets so gaining an asset decreases your cash flow and increases your current asset.

the reason liability and cash flow go together

bc liabilities represent future cash outflows

when you borrow money (incur a liability) you increase your cash flow immediately

when you pay off the liability your cash flow decreases

how does interest expense affect cash flow

interest exp = financing expense or non operating expense

capital structure

the particular distribution of debt and equity that makes up the finances of a company.

ex: a tech startup has a 40% equity, 60% debt capital structure by raising $2 million in equity from investors

optimal debt and equity mixture

leverage

the use of borrowed funds (debt) to increase the potential return on an investment

A company’s debt situation should be looked at by considering both how much debt it has and how easily it can pay the interest on that debt. If a company owes a lot but earns enough to comfortably cover interest payments, it’s making smart use of the tax benefits from borrowing. But if it has a lot of debt and struggles to pay interest, it could be at risk of going bankrupt.

must be analyzed as a combination of debt level and coverage. If a firm is heavily leveraged but has good interest coverage, it is using the interest deductibility feature of taxes to its benefit. Having a high leverage with low coverage could put the firm into a risk of bankruptcy

market value ratios features

• potential investors and analysts often use these ratios as part of their valuation analysis

• typically if a firm has high price to earnings and a high market to book value ratio, it is an indication that investors have a good perception about the firm’s performance.

• however if these ratios are very high it could also mean that a firm is over valued

• with the price/ earnings to growth ratio (PEG ratio) the lower it is, the more of a bargain it seems to be trading at a vis-a-vis its growth expectations.

How to compare financial statement of firms of different sizes

create common size financial statement

• express each income statement as % of sales

• express each balance sheet item as % of total assets

purpose of time-series analysis trend analysis

• compare oneself against its past

• compare firm’s current performance against that of its own performance over a 3-5 yr period

• examine growth rate in various key items like sales, costs, profits

financial ratios

relationship between different accounts from financial statements, usually the income statement & the balance sheet - that serve as performance indicators

• allow for meaningful comparisons between competitors and w/ industry averages

5 key functional ratios

1. liquidity ratios - can company meet short term debt obligations

2. solvency ratios- (AKA financial leverage ratios) can the company meet long term debt obligations?

3. asset management ratios - how effectively is the company managing its assets to generate sales?

4. profitability ratios - how well has the company performed overall?

5. market value ratios - how does the market (investors) view the company’s financial prospects? Link financial statement date to market data.

liquidity ratios

can company meet short term debt obligations

solvency ratios

(AKA financial leverage ratios) can the company meet long term debt obligations?

asset management ratios -

how effectively is the company managing its assets to generate sales? how much cash is being tied up in other assets such as receivables and inventory

profitability ratios -

how well has the company performed overall? profitability ratios such as net profit margin return on assets and return on equity, measure a firm’s effectiveness in turning sales or assets into profits

market value ratios -

how does the market (investors) view the company’s financial prospects? Link financial statement date to market data. used to gauge how attractive or reasonable a firm’s current price is relative to its earnings, growht rate & book value

3 key liquid ratios

1. current ratios = current asset/ current liabilities

2. quick ratio (or acid ratio test) = (current assets - inventories) / current liabilities

3. cash ratio = cash/ current liabilities

A/R is more liquid than

inventory

long term solvency ratio

measure company’s ability to meet its long term debt obligations based on its overall debt level and earnings capacity

• failure to meet its interest obligation could put a firm into bankruptcy

2 sets of long term solvency ratios

• leverage ratios measure the degree of liability

• debt service ratios measure the firm’s ability & meet its interest payment obligation