EY

Introduction to Financial Management

Chapter 1: Introduction to Financial Management

Basic Areas of Finance

Finance is a broad field with several key areas:

  • Corporate Finance: Also known as business finance, it focuses on financial decisions made within a company.
  • Investments: This area deals with financial assets like stocks and bonds, including valuation, risk-return relationship, and asset allocation.
    • Job Roles: Includes stockbrokers, financial advisors, portfolio managers, and security analysts.
  • Financial Institutions: Companies that specialize in financial matters, including:
    • Commercial banks
    • Investment banks
    • Credit unions
    • Savings and loans
    • Insurance companies
    • Brokerage firms
  • International Finance: Focuses on cross-border financial activities, requiring knowledge of exchange rates, political risk, and foreign customs.
  • Fintech: Merges technology with finance, involving companies using the internet and mobile technology to provide financial services.

The Financial Manager and Their Decisions

Financial managers answer fundamental questions for a firm regarding:

  • Long-term investments to be made
  • Financing options for those investments
  • Managing daily financial activities

Key Positions in Finance:

  • Chief Financial Officer (CFO): The top financial manager who oversees:
    • Treasurer: Manages cash and financial planning.
    • Controller: Manages taxes and financial accounting.

Types of Financial Management Decisions:

  1. Capital Budgeting: Decision-making on long-term investments or projects.
  2. Capital Structure: Determining how to finance the company's assets, focusing on the use of debt or equity.
  3. Working Capital Management: Management of daily finances.

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Forms of Business Organization

In the U.S., the primary business organization types are:

  • Sole Proprietorship: Owned by one individual.

    • Advantages: Easy to start; owner retains all profits; taxed once as personal income.
    • Disadvantages: Unlimited liability; business ends with the owner's life; difficulty in selling.

  • Partnership: Owned by two or more individuals.

    • Advantages: Relatively easy to start; greater capital access; taxed once as personal income.
    • Disadvantages: Unlimited liability for partners; dissolves upon death or sale of interest.

  • Corporation: A legal entity separate from its owners.

    • Advantages: Limited liability; unlimited life; easy ownership transfer aids capital raising.
    • Disadvantages: Potential for agency problems; double taxation on corporate income and dividends.

The Goal of Financial Management

The primary goal of financial management is to maximize the company value for its owners by:

  • Maximizing the current value per share of stock
  • Maximizing market value of owners' equity

Ethical Considerations

  • The goal must account for ethical practices to prevent corporate scandals.
  • Sarbanes-Oxley Act (SOX) of 2002: Enacted to prevent accounting fraud and impose stricter regulations, although compliance incurs costs.

The Agency Problem and Corporate Control

An agency relationship is established when a principal hires an agent to act on their behalf.

  • Example: Shareholders (principals) hire managers (agents) to run the company.
  • Agency Problem: Conflict of interest arises if managers pursue personal goals over shareholder wealth.

Solutions to Agency Problems

  • Structuring managerial compensation with incentives to align interests between managers and shareholders.
  • The threat of a takeover can motivate managers to perform well to retain their positions.

Financial Markets and Cash Flow

Financial markets facilitate cash flow between a firm and investors:

  • Securities are issued by a firm to raise cash for investment in assets.
  • Cash flow generated from operations can be reinvested or distributed as dividends and debt payments.

Types of Financial Markets

  • Primary vs. Secondary Markets:

    • Primary Market: Initial issuance of securities.
    • Secondary Market: Trading of already issued securities between investors.

  • Dealer vs. Auction Markets:

    • Dealer Market: Dealers trade securities from their inventory.
    • Auction Market: Direct matching of buyers and sellers.

  • Listed vs. Over-the-Counter (OTC) Securities:

    • Listed Securities: Traded on organized exchanges like NYSE.
    • OTC Securities: Traded over networks like NASDAQ.

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Chapter 2: Financial Statements, Taxes and Cash Flows

The Balance Sheet

A balance sheet is a snapshot of a company's financial position, showing assets and liabilities at a specific time.

  • Fundamental Identity: Assets = Liabilities + Stockholders' Equity
    • Assets: Listed on the left, ordered by liquidity (ease and speed of converting to cash).
    • Liabilities and Owners' Equity: Listed on the right, ordered by due date.

Key Concepts of the Balance Sheet

  • Net Working Capital: ext{Net Working Capital} = ext{Current Assets} - ext{Current Liabilities}
    • A positive value indicates a healthy company.
  • Book Value vs. Market Value:
    • Book Value: Value recorded on the balance sheet.
    • Market Value: Actual price assets can be traded at; more crucial for financial decisions.

The Income Statement

The income statement measures financial performance over a period, often called the "bottom line" for yielding Net Income.

  • Basic Equation: ext{Net Income} = ext{Revenue} - ext{Expenses}

Key Principles

  • GAAP Matching Principle: Requires expenses to be recognized in the same period as the revenues generated.
  • Noncash Items: Expenses like depreciation that do not involve cash outflows.

Taxes

Understanding taxes requires comprehension of marginal and average tax rates:

  • Marginal Tax Rate: Tax percentage on the next dollar of taxable income.
  • Average Tax Rate: Total tax paid divided by total taxable income.
    • For financial decisions, the marginal tax rate is usually most relevant.

Current Tax Information

  • The federal corporate tax rate in the U.S. has been a flat 21% since 2017.

Cash Flow

Cash flow is vital for understanding the performance of the company's operations:

  • Core Identity of Cash Flow: ext{Cash Flow from Assets (CFFA)} = ext{Cash Flow to Creditors} + ext{Cash Flow to Stockholders}

Calculating Cash Flow from Assets (CFFA)

  • Formula: ext{CFFA} = ext{Operating Cash Flow (OCF)} - ext{Net Capital Spending (NCS)} - ext{Change in Net Working Capital (NWC)}
  • Each component's calculation:
    • Operating Cash Flow (OCF): ext{OCF} = ext{EBIT} + ext{Depreciation} - ext{Taxes}
    • Net Capital Spending (NCS): ext{NCS} = ext{Ending Fixed Assets} - ext{Beginning Fixed Assets} + ext{Depreciation}
    • Change in Net Working Capital (NWC): ext{Change in NWC} = ext{Ending NWC} - ext{Beginning NWC}
    • ext{NWC} = ext{Current Assets} - ext{Current Liabilities}

Cash Flow to Creditors and Stockholders

  • Cash Flow to Creditors: ext{Cash Flow to Creditors} = ext{Interest Paid} - ext{Net New Borrowing}
  • Cash Flow to Stockholders: ext{Cash Flow to Stockholders} = ext{Dividends Paid} - ext{Net New Equity Raised}

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Chapter 3: Standardized Financial Statements

Standardized financial statements are instrumental for financial comparisons across time or between companies, particularly in the same industry.

Common-Size Financial Statements

  • Common-Size Balance Sheets: Express all accounts as a percentage of total assets, allowing proportionate analysis.
    • Example: To find common-size cash: ext{Common-Size Cash} = rac{ ext{Cash Value}}{ ext{Total Assets}}
  • Common-Size Income Statements: Show each line item as a percentage of total revenue, aiding in revenue cost analysis.

Ratio Analysis

Ratio analysis enhances comparison over time or across firms. Common ratios are divided into five categories:

1. Short-Term Solvency (Liquidity) Ratios

  • Current Ratio: Measures current asset coverage of current liabilities.
    • ext{Current Ratio} = rac{ ext{Current Assets}}{ ext{Current Liabilities}}
  • Quick Ratio (Acid Test): More conservative, excludes inventory.
    • ext{Quick Ratio} = rac{ ext{Current Assets} - ext{Inventory}}{ ext{Current Liabilities}}
  • Cash Ratio: Focused solely on cash coverage of current liabilities.
    • ext{Cash Ratio} = rac{ ext{Cash}}{ ext{Current Liabilities}}

2. Long-Term Solvency (Financial Leverage) Ratios

  • Total Debt Ratio: Percentage of assets financed by debt.
    • ext{Total Debt Ratio} = rac{ ext{Total Assets} - ext{Total Equity}}{ ext{Total Assets}}
  • Debt-to-Equity Ratio: Compares total debt to total equity.
    • ext{Debt-to-Equity} = rac{ ext{Total Debt}}{ ext{Total Equity}}
  • Equity Multiplier: Financial leverage measurement by total assets financed per dollar equity.
    • ext{Equity Multiplier} = rac{ ext{Total Assets}}{ ext{Total Equity}}
  • Times Interest Earned (TIE): Measures ability to meet interest obligations.
    • ext{TIE} = rac{ ext{EBIT}}{ ext{Interest Paid}}
  • Cash Coverage Ratio: Similar to TIE but utilizes broader cash flow measures.
    • ext{Cash Coverage Ratio} = rac{ ext{EBIT} + ext{Depreciation}}{ ext{Interest Paid}}

3. Asset Management (Turnover) Ratios

  • Inventory Turnover: Times inventory is sold and replaced.
    • ext{Inventory Turnover} = rac{ ext{Cost of Goods Sold}}{ ext{Inventory}}
  • Days' Sales in Inventory: Days inventory is held before being sold.
    • ext{Days' Sales in Inventory} = rac{365 ext{ Days}}{ ext{Inventory Turnover}}
  • Receivables Turnover: Times accounts receivable are collected annually.
    • ext{Receivables Turnover} = rac{ ext{Sales}}{ ext{Accounts Receivable}}
  • Days' Sales in Receivables: Average days for collections of credit sales.
    • ext{Days' Sales in Receivables} = rac{365 ext{ Days}}{ ext{Receivables Turnover}}
  • Total Asset Turnover: Sales generated for every dollar of assets.
    • ext{Total Asset Turnover} = rac{ ext{Sales}}{ ext{Total Assets}}
  • Capital Intensity Ratio: Inversely measures assets needed per sales dollar.
    • ext{Capital Intensity Ratio} = rac{ ext{Total Assets}}{ ext{Sales}}

4. Profitability Ratios

  • Profit Margin: Net income per sales dollar.
    • ext{Profit Margin} = rac{ ext{Net Income}}{ ext{Sales}}
  • Return on Assets (ROA): Profit per dollar of assets.
    • ext{ROA} = rac{ ext{Net Income}}{ ext{Total Assets}}
  • Return on Equity (ROE): Profit per dollar of equity, key for stockholders.
    • ext{ROE} = rac{ ext{Net Income}}{ ext{Total Equity}}
    • Expanded formula: ext{ROE} = ext{Profit Margin} imes ext{Total Asset Turnover} imes ext{Equity Multiplier}

5. Market Value Ratios

Market value ratios relate stock market price to book value or earnings:

  • Earnings per Share (EPS): Net income per outstanding share.
    • ext{EPS} = rac{ ext{Net Income}}{ ext{Outstanding Shares}}
  • P/E Ratio: Investor's payment for earnings.
    • ext{P/E Ratio} = rac{ ext{Price per Share}}{ ext{Earnings per Share}}
  • Market-to-Book Ratio: Market value compared to book value of stock.
    • ext{Market-to-Book Ratio} = rac{ ext{Market Value per Share}}{ ext{Book Value per Share}}
  • EBITDA Ratio: Compares total company value to operating earnings.
    • ext{Enterprise Value}/ ext{EBITDA}

The DuPont Identity

  • Breaks down ROE:
    • ext{ROE} = ext{Profit Margin} imes ext{Total Asset Turnover} imes ext{Equity Multiplier}
  • Components:
    • Operating Efficiency: Measured by Profit Margin.
    • Asset Use Efficiency: Measured by Total Asset Turnover.
    • Financial Leverage: Extent of debt for financing.

Growth and Its Determinants

  • Dividend Payout Ratio: Percentage of net income paid out as dividends.
    • ext{Dividend Payout Ratio} = rac{ ext{Cash Dividends}}{ ext{Net Income}}
  • **Retention Ratio (