Introduction to Business Finance and Financial Statements

Introduction to Business Finance and Financial Statements

Learning Objectives

  • Broadly define corporate finance and its basic functions.
  • Discuss the basic types of financial management decisions and the role of the financial manager.
  • Identify the goal of financial management.
  • Identify and contrast different forms of business organisation.
  • Describe the conflicts of interest that can arise between managers and owners.
  • Understand a basic balance sheet and income statement.

Basic Areas of Finance

  • Corporate Finance: Involves managing financial resources for a business.
  • Investments: Focuses on working with financial assets like shares and bonds.
  • Financial Institutions: Companies that specialize in financial matters, e.g., banks, insurance companies, brokerage firms.

What is Corporate Finance?

  • Corporate finance pertains to acquiring, managing, and financing a company's resources—both tangible (like inventory and equipment) and intangible (like intellectual property).

Important Questions Addressed in Corporate Finance

  1. What long-term investments should the firm undertake?
  2. Where will financing for these investments come from?
  3. How will day-to-day financial activities be managed?

Financial Managers

  • They are responsible for answering crucial financial questions related to:
  • Capital Budgeting: Determining which long-term investments or projects to pursue.
  • Capital Structure: Deciding how to finance assets—using debt or equity.
  • Working Capital Management: Managing the firm’s day-to-day finances.

Basic Corporate Finance Functions

  1. Capital Budgeting: Making decisions on investments.
  2. Funds Procurement: Capital structure decisions on funding sources.
  3. Working Capital Management: Overseeing current liabilities and assets.
  4. Risk Management: Assessing the risks associated with investments.
  5. Corporate Governance: Ensuring legal and ethical guidelines are followed.

Forms of Business Organisation

Major Forms

  1. Sole Proprietorship:
  • Advantages: Easy to start, less regulated, keeps all profits, taxed once.
  • Disadvantages: Limited life, limited equity options, unlimited liability, and hard to sell ownership.
  1. Partnership:
  • Advantages: More capital available, easier to start, income taxed once.
  • Disadvantages: Unlimited liability, dissolves on partner changes, hard to transfer ownership.
  1. Corporation:
  • Advantages: Limited liability, unlimited life, easier capital raising, easy transfer of ownership.
  • Disadvantages: Management and ownership separation, potential taxation issues.

Ownership of Public Corporations

  • Represented by shares of stock; shareholders entitled to voting rights and dividends.

The Stock Market

  • Primary Market: New shares issued.
  • Secondary Market: Shares traded among investors.
  • Liquidity: Ability to sell/buy assets quickly at market value.

Goal of Financial Management

  • Aim to maximize the market value of shareholders’ equity, rather than simply maximizing profit or minimizing costs.

The Agency Relationship

  • Principals and Agents: Shareholders (principals) hire managers (agents); potential conflicts in interests lead to agency costs.

Addressing Agency Problems

  • Strong Board of Directors: Ensures management accountability.
  • Managerial Compensation: Aligning manager incentives with shareholder goals.
  • Effective Control Markets: Takeover threats to improve management performance.
  • Monitoring & Regulations: External audits and controls.

Financial Statements

Balance Sheet

  • Snapshot of assets and liabilities:
  • Assets: Left-hand side (current/fixed based on liquidity).
  • Liabilities and Equity: Right-hand side (current/long-term based on payment timelines).
  • Balance Sheet Identity: Assets = Liabilities + Shareholders’ equity.

Example: Trans-Tasman Company Balance Sheet

  • Liquidity: Current assets - current liabilities; a healthy firm should show positive net working capital.
  • Equity Calculation: Shareholders’ equity = Assets - Liabilities.

Income Statement

  • Measures performance over a set period (quarter/year):
  • Reports revenues and deducts expenses.
  • Net Income: Sum of revenue minus expenses; critical for calculating dividends and retained earnings.

Example: Trans-Tasman Company Income Statement

  • Simple Ratios:
  • Profit Margin = Net income / Sales
  • Return on Assets (ROA) = Net income / Total assets
  • Return on Equity (ROE) = Net income / Total equity

Market Value Measures

  • Market Capitalisation: Shares outstanding × Price per share.
  • Earnings per Share (EPS): Net income / Shares outstanding.
  • Price-to-Earnings (P/E) Ratio: Price per share / EPS.
  • Market-to-Book (M/B) Ratio: Price per share / Book value per share.

Key Takeaways

  • Understanding corporate finance functions and their impact on financial decisions is crucial for successful management.
  • Recognizing different business structures informs on liability, taxation, and management issues.
  • Financial statements are essential tools in assessing a firm's performance and value.