ESSENTIAL CONCEPTS IN MANAGERIAL FINANCE

Analysis of Financial Statements (Chapter 2)

• Financial Statements and Reports—financial reporting is used to disclose information about the
firm to investors, creditors, governments, and other interested parties; information about the firm is
used to determine what has been accomplished in the past and forecast what is likely to be
accomplished in the future; a corporation constructs an annual report that includes (1) a general
discussion about the firm’s activities during the past year as well as developments that are expected
to be implemented in the near future (i.e., next year) and (2) the financial statements of the firm for
the most recent years (the year just ended and up to four or five previous years); the annual report
generally includes the following financial statements:
o Balance Sheet—records the financial position of the firm at a particular point in time by
showing the assets (investments) and the liabilities and equity (financing) of the firm; some
points about the balance sheet include:
 Cash versus other assets—on the assets side of the balance sheet, only cash represents
actual funds that can be invested; the other assets represent investments that have been
made in the past that are expected generate (or help generate) funds in the future (some
sooner than others—that is, current assets); the values reported on the balance sheet do not
necessarily represent the values of the assets outside the firm (that is, in the marketplace)
because the “book” values of assets are based on the original purchase prices of the assets
rather than their current market values.
 Liabilities versus stockholders’ equity—the liabilities of a firm represent the debt, or
money, the firm owes to lenders, while equity represents the ownership position of the
stockholders; the net worth of the firm is defined as the value of the total assets minus the
value of the total liabilities, which is the amount that would be left to distribute to
stockholders if the firm’s assets could be sold at book value and the firm’s debt (liabilities)
could be paid off at book value.
 Preferred versus common stock—all corporations have one type of stock called common
stock; some firms have equity called preferred stock that has preference with respect to
dividend payments and other cash distributions made by the firm (that is, preferred
stockholders are paid before common stockholders); the per share dividend paid to
preferred stockholders generally is a fixed amount; preferred stockholders do not have
voting rights, while common stockholders do.
 Common equity account—the common equity section of the balance sheet generally is
divided into three accounts: (1) common stock, which equals the number of shares
outstanding times the par value of each share; (2) paid-in capital, which represents the
amount above the par value for which common stock was issued; and (3) retained earnings,
which represents income the firm earned in the past that was “retained” and reinvested in
the firm, not paid to stockholders as dividends; retained earnings is an amount that has been
accumulated since the firm started operating; the amount in retained earnings usually is not
the same as the amount in the cash account because the funds represented by retained
earnings have been reinvested in other assets during the life of the firm.
 Accounting alternatives—in many instances, the same business activity can be recorded

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 using one of several accepted accounting methods—for example, inventory valuation can
be based on either the FIFO (first-in, first-out) method or the LIFO (last-in, first-out)
method; two identical firms would have different numbers on their financial statements if
different accounting methods are used.
 Time dimension—the balance sheet is a “snapshot” of where the firm is at a specific point
in time, while the income statement (the statement of cash flows also) shows the results of
the firm’s activities over a period of time.
o Income Statement—provides a summary of the revenues recognized and the expenses incurred
during a particular operating period; the revenues and expenses are not necessarily indicative of
the cash inflows and cash outflows; records activity over a particular period; prepared at least
once a year and usually on a quarterly basis.
 Does net income determine value? No, value is determined by cash flows; if a firm sells all
of its products for cash and pays all of its bills using cash, its net cash flow is computed as:

Net cash flow = Net income + Depreciation and amortization

o Statement of Cash Flows—reports the effect of the firm’s activities—operating, investing, and
financing—over some period on its cash position
 Income versus cash flows—the revenues and expenses that appear on the income statement
are recognized when incurred, not when cash is affected—for example, revenues are
recognized when sales are made rather than when the cash payments associated with sales
are received, which means that when a firm sells on credit the revenues are reported for
income purposes before payments for the sales are received
♦ Non-cash items—some non-cash items appear on the income statement, such as
depreciation; depreciation represents the reduction in value that is associated with the
use of an asset that was purchased (paid for) at some earlier time, perhaps 15 years ago.
♦ Accounting profit—net income, or the “bottom line” on the income statement; even
though net income generally is not the same as the net cash flows generated by the firm
over a particular period, there generally is a significant correlation between the two.
♦ Operating cash flows—cash flows generated from the normal operating activities of the
firm—that is, the manufacture and sale of inventory.
 Cash flow cycle—general operating activities affect various balance sheet accounts and
cash flows; for example, selling a product on credit immediately decreases inventory,
immediately increases accounts receivable, generates a profit that is recognized in retained
earnings (assuming the product is sold for more than it cost to manufacture), and, when the
customer pays for the product at some future date, decreases receivables and increases cash.
 Constructing a statement of cash flows—when constructing a statement of cash flows,
apply the following simple rules:

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 Sources of Cash: Uses of Cash:
 Asset Account  Asset Account
Selling inventory or collecting Buying inventory or other assets
receivables provides cash. uses cash.

 Liability or Equity Account  Liability or Equity Account

Borrowing funds or selling stock Paying off a loan, buying back stock,
provides the firm with cash. or paying dividends uses cash.

o Statement of Retained Earnings—shows the change in the retained earnings account since the
last balance sheet was constructed.

• How Do Investors Use Financial Statements?—investors use financial statements to collect

information that is useful when making financial decisions; some information that is contained in
financial statements includes:
o Working (Operating) Capital—short-term assets that are necessary to keep the firm “working;”
spontaneous assets, which represent assets that arise as a result of normal business operations;
generally spontaneous assets are financed with spontaneous liabilities, which represent debt
(generally short-term) that arises as a result of normal business operations.

Net working capital (NWC) = Current assets – Current liabilities

When NWC is positive, then some of the firm’s current assets are financed using long-term
liabilities.

Net operating  Current assets   Non-interest bearing 

= - 
working capital (NOWC)  required for operations   current liabilities 

o Operating Cash Flows—cash generated from the normal operations of the firm:

Operating cash flow (OCF) = NOI(1 – Tax rate) + Depreciation and amortization expense

o Free Cash Flow (FCF)—cash flow that the firm is free to pay out to investors

FCF = OCF - Investments

o Economic Value Added (EVA)—the amount by which the firm’s value changes after
compensating investors for the funds they provide the firm

EVA = NOI(1- Tax rate) – [(Invested capital) x (After-tax cost of funds as a percent)]

EVA is an estimate of the economic (true) profit that the firm generates.

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• Financial Statement (Ratio) Analysis—provides a method to evaluate how financial positions (1)
change on a year-to-year basis for a single firm and (2) compare between two firms, even if they
differ in size; such analyses are useful to managers inside the firm and investors and creditors
outside the firm who want to try to predict future financial positions of firms.
o Liquidity ratios—give an indication of how well the firm can meet its current obligations; help
measure the liquidity position (ability to convert assets into cash quickly without significant
loss of principal) of the firm; too little, or too much liquidity could be considered a “bad
sign”—too little liquidity could suggest that the firm will have problems paying its current
obligations in the future, whereas too much liquidity might suggest the firm is not investing its
funds wisely (that is, the firm is earning a lower return than it should):
 Current ratio—shows the relationship between current assets and current liabilities; a higher
value for the current ratio suggests greater liquidity, and vice versa:

Current assets
Current ratio =
Current liabilities

 Quick, or Acid-Test, Ratio—similar to the current ratio, except the value of inventories is
subtracted from current assets in the numerator; inventories represent the least liquid of the
current assets:
Current assets - Inventories
Quick, or acid-test, ratio =
Current liabilities

o Asset Management Ratios—give an indication of how well (effectively) the firm manages its
assets; show how often the firm is “turning over” its assets to generate funds; generally, when
assets are not turned over quickly enough, it is because sales have slowed or current assets,
such as inventory and receivables, are too high; if assets are turned over too quickly, it could
mean that the firm is not producing enough, and vice versa:
 Inventory turnover—shows how many times during a period (e.g., a year) the average
inventory is turned over due to sales activities:

Cost of goods sold

Inventory turnover =
Inventories

 Days sales outstanding—indicates the average time, in days, it takes customers to pay for
credit purchases—that is, the length of time it takes the firm to collect for credit sales; if the
value is much greater than the credit terms offered by the firm, then many customers are
paying extremely late (they are delinquent accounts):

Days sales Receivables Receivables

= DSO = =  Annual sales 
outstanding Average sales per day  360 

 Fixed assets turnover—gives an indication of how efficiently the firm uses its fixed assets
(excludes current assets) to produce revenues; measures how many dollars of sales are
generated for each dollar invested in fixed assets; generally, a higher value indicates a more
efficient use of fixed assets than a lower value does:

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 Sales
Fixed assets turnover ratio =
Net fixed assets

 Total assets turnover—similar to the fixed assets turnover, except the value of total assets
(includes current assets) is used in the denominator:

Sales
Total assets turnover ratio =
Total assets

o Debt management ratios—indicate how the amount of debt the firm has affects its financial
position; financial leverage refers to the use of debt (primarily long-term debt); leverage helps
to magnify returns, on both the positive and the negative sides, because debt represents a
contractual obligation for which the same amount is repaid no matter how successful (or
unsuccessful) the firm is:
 Debt ratio—provides an indication of the capital structure of the firm; measures the percent
debt used by the firm for the purposes of financing assets; generally, the higher the debt
ratio, the greater the chance of bankruptcy; if the debt ratio is too low, however, it might
suggest the firm is not using leverage wisely (leverage will be covered in greater detail in
subsequent notes):

Total debt Total liabilities

Debt ratio = =
Total assets Total assets

 Times-interest-earned (TIE) ratio—indicates whether the firm generates sufficient operating

income (not cash) to meet its interest obligations each year; a higher value suggests the firm
is better able to pay interest on its loans:
EBIT Operating income
Times- interest- e arned ratio = =
Interest charges Interest charges

EBIT = Earnings before interest and taxes.

 Fixed charge coverage ratio—like the times-interest-earned ratio, except all fixed payments
related to financing are included; generally, in addition to interest, the firm must consider
principal repayments on debt and payments made for lease financing arrangements:

Fixed charge EBIT+ (Lease payments )

=
coverage ratio  Interest   Lease  Sinking fund payments
 + +
 charges   payments 
(
1-tax rate )

Funds available to cover financing obligations

=
Fixed financing obligations

o Profitability ratios—show how the firm’s management of its liquidity position, assets, and debt
has affected normal operating activities, and vice versa:

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  Net profit margin—shows what percent of sales revenues is left over after expenses related
to operations and financing and taxes; a low value might indicate that the firm’s expenses
are too high:

Net income
Net prof it margin =
Sales

 Return on total assets (ROA)—a measure of the return on investment earned by the firm;
assets provide the means by which a firm produces and sells inventory, and thus generates
cash flows; ROA represents a return on all invested funds (both debt and equity):
Net income
Return on total assets (ROA) =
Total assets

 Return on common equity (ROE)—similar to ROA, ROE is a measure of the return on the
original funds invested by stockholders:

Return on common Income available to common stockholders

=
equity (ROE) Common equity

Income available to common stockholders = (Net income) – (Preferred dividends). Because

most firms do not have preferred stock, generally the amount of income available to
common stockholders is the same as net income.
o Market Value ratios—measures that consider the value of the firm’s stock in the financial
markets—that is, how well investors perceive the firm is creating value:
 Price/earnings (P/E) ratio—gives an indication of how much investors pay for each dollar
of income generated by the firm; high growth firms generally have higher P/E ratios, while
riskier firms often have lower P/E ratios:

Earnings Per Income available to common stockholders

=
Share (EPS) Number of common shares outstanding

Market price per share

Price/ earnings ratio =
EPS

 Market/book ratio—indicates the relationship between the selling price of the common
stock and its book value; generally new firms and firms experiencing financial difficulty
have lower market/book ratios:

Market value per share Market value per share

Market/book value= =
Book value per share ( Common equity
Number of common shares outstanding )
o Trend and comparative analysis—ratios should be evaluated (1) at a particular point in time in
comparison to some norm, such as an industry average, to determine the current financial
position of the firm (comparative analysis) and (2) over time to determine whether the current

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 financial position is improving or deteriorating (trend analysis); such analyses will help
interested parties forecast the future financial position of the firm.

• Summary of Ratio Analysis—The Du Pont Analysis—shows the relationship between the return on
investment and both the total assets turnover and the net profit margin; can be used to determine in
more detail where weaknesses or strengths exist; if ROA is relatively low, it might be due to a low
profit margin, a slow turnover of assets, or both:

ROA = Net profit margin × Total assets turnover

Net income Sales
= ×
Sales Total assets

ROE = ROA × Equity multiplier

Net income Total assets
= ×
Total assets Common equity
 Net income Sales  Total assets
=  ×  ×
 Sales Total assets  Common equity

• Comparative Ratios (Benchmarking)—a firm’s ratios are compared to those of other firms in the
same industry to determine how the firm’s financial position relates to the financial positions of its
peers.

• Uses and Limitations of Ratio Analysis—financial statement analysis provides useful information
about a firm’s financial position, but there are caveats/limitations that must be considered when
interpreting the information:
o Classifying a very large firm into a single industry often is difficult because many of the firm’s
divisions are involved with different types of products.
o Using a single norm, or “target,” ratio for comparisons might be misleading because many
firms strive for above-normal performances.
o Because the values on balance sheets are historical costs, the computed values of the ratios
might not portray a “true” picture—for example, during high inflationary times, inventory
values and the costs of goods sold would be greatly affected.
o Many firms experience seasonality, which means the values of ratios might be significantly
different depending on what time of the year they are computed; be sure to compare a firm’s
ratios during similar operating periods with respect to seasonality; averages can also be used.
o Sometimes firms use “window dressing” techniques to make their financial statements look
better than they actually are; this is temporary, and probably cannot be continued for extended
periods, which emphasizes the need for trend analysis.
o If firms use different accounting methods, comparisons between firms can be difficult.
o Do not make general conclusions about the firm’s financial position by examining only one or
a few ratios; ratio analysis should be comprehensive.
o The most important part of ratio analysis is the judgment used when interpreting the results, not
the computation of the ratios.

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• Chapter 2 Summary Questions—You should answer these questions as a summary for the chapter
and to help you study for the exam.
o What information is provided by each financial statement contained in a firm’s annual report?
o What information does each of the five categories of ratios mentioned in the text provide to
those who interpret the ratios?
Liquidity ratios
Asset management ratios
Leverage ratios
Profitability ratios
Market value ratios
o Who uses ratios?
o Why is the Statement of Cash Flows considered an important financial statement?
 What would be a source of cash?
 What would be a use of cash?
o What are the limitations associated with ratio analysis?
o Why is the interpretation of the ratios considered more important than the computation of the
ratios?

Financial Environment: Markets, Institutions, and Investment Banking (Chapter 3)

• Financial Markets—systems/mechanisms where those who have excess funds (investors/lenders)

are brought together with those who need funds (borrowers).

• Importance of Financial Markets

o Flow of Funds—generally individuals (1) borrow money when they begin their career to
purchase such high-ticket items as houses and cars, (2) save/invest money during their careers,
especially when at their peak earnings periods, and (3) draw on their savings/investments to
support themselves when they retire.
o Funds are transferred from lenders to borrows via three processes:
 Direct transfer—financial institutions are not used; funds a loaned directly to borrowers.
 Investment banker—an organization that specializes in issuing stocks and bonds; serves as
an agent that gets borrowers and lenders together; gets paid a commission/fee for services
rendered.
 Financial intermediary—a firm that issues its own securities (either stocks or bonds) to get
funds from savers, and then lends the funds to borrowers; earns the difference between the
rate that is charged on the loans and the rate that is paid to attract funds. Today, many
financial intermediaries offer a variety of services, including taking deposits, lending funds
to individuals and businesses, and other financial services, such as investments and related
services.
o Market Efficiency—when efficient, the financial markets increase an economy’s standard of
living
 Economic efficiency—funds are allocated to their best use at the lowest cost (interest).

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  Informational efficiency—market prices/values adjust quickly when new information
becomes available in the financial markets.
♦ Weak-form efficiency—market prices reflect information contained in past price
movements
♦ Semistrong-form efficiency—market prices reflect all publicly available information,
including past price movements, firms’ current financial statements, recent
announcements, and so forth.
♦ Strong-form efficiency—market prices reflect all information, both publicly available
information and private information

• Types of Finance Markets

o Money markets versus capital markets—securities with maturities equal to one year or less are
traded in the money markets, whereas securities with maturities greater than one year are traded
in the capital markets.
o Debt markets versus equity markets—loans are traded in debt markets, whereas stocks are
traded in equity markets. Debt associated with real estate is traded in mortgage markets,
whereas such consumer debt as automobile loans, loans for appliances and education, and so
forth is traded in consumer credit markets.
o Primary markets versus secondary markets—new issues of stocks and bonds are sold in the
primary markets, whereas previously issued (outstanding) securities are traded in the secondary
markets.
o Derivatives Markets—where options, futures, swaps, and other “derivative” financial
instruments are traded; derivatives are securities whose values are determined (“derived”) from
the values of other assets.

Financial markets can be local, regional, national, or global, depending on the coverage of the
securities traded and the nature of the participants in the markets.

• Stock Markets—market in which equity (stock) is traded

o Types of Market Activities
 Secondary market—trading outstanding securities—that is, securities that were issued some
time earlier
 Primary market—publicly-owned companies issue stock to raise new funds for investments
in assets
 Initial public offering (IPO)—privately-held firms “go public” by selling stock to the
general public for the first time.
o Physical Stock Exchanges—organized physical stock exchanges are physical locations where
stocks are traded; the New York Stock Exchange (NYSE) is the largest organized exchange;
generally only those who have “seats” can trade on organized exchanges. Many stock
exchanges are converting from organizations that have mutual not-for-profit ownership to for-
profit stock ownership, which is called demutualization
 Exchange membership—each member category has a different trading responsibility
♦ Floor brokers—agents who buy and sell securities for investors; house brokers are
employed by brokerage firms, whereas independent brokers freelance their services to
various brokerage firms

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 ♦ Specialists—“market makers” who bring buyers and sellers together by adjusting the
prices of securities; when there are too many buyers, specialists will increase the price
of securities, and vice versa
 Listing requirements—each exchange has certain minimum financial requirements for a
firm to be listed; generally large national exchanges have more stringent listing
requirements
o The Over-the-Counter (OTC) Market and the Nasdaq
 OTC—a network of brokers and dealers around the country that are linked electronically
 The Nasdaq (National Association of Security Dealers Automated Quotation system)
evolved from the OTC, and has become a very organized investment network
 Electronic communications networks (ECNs)—systems that transfer information to
facilitate securities transactions; buy and sell orders are automatically matched for a large
number of orders
o Competition Among Stock Markets—competition is very fierce among various stock markets
 Dual listing—a stock that is eligible to be traded on multiple exchanges
 “Trade-through rule”—when a stock is traded in more than one market, investors should
have information about the prices in the various markets such that transactions are made at
the best possible prices

• Regulation of Securities Markets—the Securities and Exchange Commission (SEC) is responsible

for regulating stock markets; regulations have been passed to help ensure that security prices are
not manipulated.

• The Investment Banking Process—investment bankers specialize in helping corporations,

governments, and other organizations issue stocks and bonds to raise capital
o Raising Capital: Stage I Decisions—(1) How much does the firm need? (2) What type(s) of
securities should be used to raise the funds? (3) Should the firm require investment bankers to
bid on the issue, or should the firm negotiate with one investment banker? (4) Which
investment banker will be given/awarded the issue?
o Raising Capital: Stage II Decisions—(1) Reevaluate the initial decisions. (2) Decide whether
the issue will be an underwritten arrangement or a best efforts arrangement. In an underwritten
arrangement, the investment banker purchases the issue from the firm and then resells it to
investors; the difference between the purchase and selling prices represents the investment
banker’s gross profit. In a best efforts arrangement, the investment banker puts forth a “best
effort” to sell the securities and is paid a commission for the amount that is sold; unsold
securities are returned to the issuing company. (3) Determine the cost of issuing the
securities—that is, determine the flotation costs associated with issuing the securities. (4) Set
the offering price for the securities.

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• Selling Procedures
o Registration statement—gives financial, legal and technical information about the issue and the
issuer
o Underwriting syndicate—the investment banker can spread risks by enlisting investment firms
and other investment bankers to help sell the issue
o Shelf registration—securities are registered with the SEC for sale at a later date; held on the
“shelf” until the issue
o Maintenance of a secondary market—it is important that the investment banker support the
price of the issue immediately after its issue to ensure that the price does not fluctuate too
wildly

• International Financial Markets—trading activity in the United States accounts for less than 50
percent of worldwide trading
o Euroland—countries that comprise the European Monetary Unit (EMU); has become huge
competition to U.S. financial markets
o Financial markets in most developed countries operate similarly; U.S. markets generally are
more heavily regulated

• Financial Intermediaries and Their Roles in Financial Markets

o Financial intermediaries facilitate the transfer of funds from lenders to borrowers.
o Benefits associated with financial intermediaries include:
 Reduced cost of borrowing—economies of scale help to reduce interest rates
 Risk/diversification—loans are spread out over number of borrowers and wide geographical
areas, which reduces default risks
 Funds divisibility/pooling—by collecting deposits from numerous sources, intermediaries
can package loans of various types and sizes
 Financial flexibility—intermediaries offer a variety of types of loans
 Related services—intermediaries offer more than just loans; some offer checking services,
trust operations, and so forth.

• Types of Financial Intermediaries

o Commercial banks—historically provided services to commerce (i.e., businesses).
o Credit unions—cooperative associations in which members have a common bond, such as the
same type of employment; traditionally have serviced consumer needs, such as automobile
financing.
o Savings and loans (thrifts) —traditionally served individual savers and residential real estate
borrowers.
o Mutual funds—investment companies that collect (pool) funds from savers and reinvest the
funds in financial assets, such as stocks and bonds; money market mutual funds include short-
term investments only
o Whole life insurance companies—whole life insurance includes a (small) savings function;
invest in long-term securities; some offer tax-deferred savings plans.
o Pension funds—retirement plans; invest in long-term securities.

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• Financial Organizations in Other Parts of the World—compared to the United States, financial
institutions in other countries are much larger with many more branches; in most other countries
there are few, but very large financial organizations that service the entire population; past
regulation has restricted the ability of U.S. financial organizations from branching freely and from
becoming extremely large; deregulation during the past few decades has helped U.S. financial
institutions to become more competitive internationally.

• Chapter 3 Summary Questions—You should answer these questions as a summary for the chapter
and to help you study for the exam.
o What is a financial market? What are some of the different types of financial markets?
o What is a financial intermediary?
o How do financial intermediaries help improve our standard of living?
o What is an investment banking organization? What does an investment bank do?
o How do financial markets in other countries differ from those in the United States?

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