The Role of Managerial Finance

Finance and the Firm

• Finance can be defined as the science and art of managing money. It involves:
raising money from investors.
investing money in an attempt to earn a profit.
deciding whether to reinvest profits in the business or distribute them back
to investors.
• Firm is a business organization sells goods or services.

What is the Goal of the Firm?

• Maximize Shareholder Wealth
The primary goal is to maximize the wealth of the firm’s owners which is
equal to maximizing the stock prices.

Debt
Assets
Equity

Shareholders provide the equity

• Maximize Profit?
Profits are measured in terms of EPS (earning per share): EPS = Net
income/Number of shares
Profit maximization doesn’t lead to the highest possible share price
because timing, cash flows and risks affect share prices differently.
• Maximizing Stakeholder’s Welfare?
Stakeholders are groups such as employees, customers, suppliers,
creditors and others who have a direct economic link to the firm but are
not owners.
Some suggest a balanced consideration of the welfare of shareholders and
other stakeholders.
The stakeholder perspective is intrinsically difficult to implement but this
shouldn’t be ignored.

• CFO: Chief financial officer

• DCF: Discounted cash flow
• Intermediary: A person or a businessman that is interacting between two
parties.
• Brokerage houses: Intermediary between personal investors and companies.
 • Default: non-payment
If a country’s economy is default, there is a big problem.
• Public companies: The companies with shareholders. (In Turkey, there should
be at least 250 shareholders.)
• SEC (USA) / SPK (TR) is the controlling board for the public companies.
• NCUA (USA) / BDDK (TR) is the controlling board for the banks.

Managing the Firm

Financial Managers’ Key Decisions

• Investment Decisions
Company’s money spending on long-term projects
• Financing Decisions
Company’s money/capital raising for investment opportunities
• Working Capital Decisions
Company’s money for short-term resources

Principles That Guide Managers’ Decisions

• The Time Value of Money
• The Tradeoff between Return and Risk
Benjamin Franklin: “Nothing ventured, nothing gained.”
• Cash is King
Bills must be paid in cash.
• Competitive Financial Markets
Daily news on a company, constantly reflect on its stock price.
• Incentives are Important

• Principle-Agent Problem is a problem that arises because the owners of a

firm and its managers are not the same people and the managers fail to act in
the interest of the owners.
The Financial Market Environment
Financial Institutions
• Financial institutions are intermediaries that channel the savings of individuals,
businesses, and governments into loans or investments.
• In general, individuals are net suppliers of funds, while businesses and
governments are net demanders of funds.
• Commercial Banks: Institutions that provide savers with a secure place to
invest their funds and that offer loans to individual and business borrowers.
• Investment Banks: Assist companies in raising capital, advise firms on major
transactions such as mergers or financial restructuring, and engage in trading
and market-making activities. They serve to HNWIs as well.
• Shadow Banking System: A group of institutions that engage in lending
activities, much like traditional banks, but that do no accept deposits and
therefore are not subject to the same regulations as traditional banks.
• HNWI: High Net Worth Individual
• IPO: Initial Public Offering

Financial Markets
• Financial markets are the forums in which suppliers of funds and demanders
of funds can transact business directly.
• Money market —> Short-term (less than a year) marketable securities
• Capital market —> Long-term (longer than a year) marketable securities
• Private placement/investment involves the sale of a new security directly to
the investors.
• Most firms raise money through a public offering of securities.
• Primary market is the market in which securities are initially issued while
secondary market is the market which preowned securities are traded.

• stocks/shares
• bonds

• negotiable = tradable
• deposit = not negotiable
• certificate of deposit (CD) = negotiable
• Repurchase agreements (REPO) = not negotiable
• Most money market transactions are made in marketable securities which are
short-term debt instruments (with a very low risk)
US Treasury bills (T-Bills) issued by the federal government
Commercial paper issued by businesses
Negotiable certificates of deposit issued by financial institutions

• Eurocurrency Market is the international equivalent of the domestic money

market, either US dollars or other major currencies can be deposited.
• A Russian bank made a dollar deposit to an American bank in 1700s. This is
the first action happened in the Euro market.
• Reputable companies can do that with the governments.

• Nearly all Eurodollar deposits are time deposits.

• Floating rate —> The rate changes in every 6 months accordingly to the Libor
which changes daily.
• Rate = Libor + Spread

• Bonds are the long-term investments to raise money.

• Common stock is the unit of ownership interest in a corporation.

• Broker markets are the markets which brings the seller and the buyer
together for security exchanges.
• In the dealer markets, like NASDAQ, the orders are executed by security
dealers who “make markets” in the given security. There are no centralized
trading floors.
 • Ask price: The lowest price a seller is willing to accept for a security.
• Bid price: The highest price a buyer is willing to pay for a security.
• Spread: Difference between bid and ask prices.
• Bid/Ask prices: Quotation

• Eurobond Market is the market where corporations and governments

typically issue bonds denominated in dollars and sell them to investors
located outside the United States (issued in multiple markets).
• Foreign Bond Market is a market for bonds issued by a foreign corporation
or give that is denominated in investor’s home currency and sold in the
investor‘s home market. (issued in single market).

• The efficient market hypothesis says in an efficient market, prices may be

undervalued or overvalued sometimes, but it is correct on average. New
information, which is unpredictable, affects the prices.

The Securities Issuing Process

• Angel investors are wealthy individual investors who make their own
investment decisions and are willing to invest in promising startups in exchange
for a portion of the firm’s equity.
• Venture Capitalists (VCs) are formal business entities that take in private equity
capital from many individual investors who make private equity investment
decisions on their behalf.

• When a firm wishes to sell its stock in the primary market, there are three
options:
Private placement: The firm sells new securities directly to the investors.
Rights Offering: The firm sells new shares to existing stockholders.
Public Offering: The firm sells new shares to the general public.
• Initial Public Offering (IPO): The first public sale of a firm’s stock, typically
made by small, rapidly growing companies that either require additional capital
to continue growing or have met a milestone for going public that was
established in an earlier agreement to obtain VC funding.
• Investment banks promote the stock and facilitate the sale of the IPO shares.
Their role is to bear the risk of reselling, at a profit, the securities purchased
from an issuing corporation at an agreed-on price.
 • IPO Offer Price is the price at which the issuing firm sells its securities.
• IPO Market Price is the final trading price on the first day in the secondary
market.
• Total Proceeds = IPO Offer Price x Number of IPO Shares Issued
• Market Capitalization = Market Price x Number of Shares Outstanding
• IPO Underpricing = IPO Initial Return = (Market Price - Offer Price) / Offer
Price
It’s called underpricing because usually the offer price is set below what
secondary market investors are willing to pay.

Financial Statements and Ratio Analysis

The Four Key Financial Statements
Income Statement
• Provides a financial summary of the firm’s operating results during a
specified period. Public companies file quarterly and annual income
statements.
• Dividend per Share (DPS): The dollar amount of cash distributed during the
period to each outstanding share of common stock.

Earnings
INCOME STATEMENT
Before
Sales Interests and
- COGS Taxes
Gross Profit
- Operational Expenses (OPEX)
Operational Profits (EBIT)
- Internal Expenses
Profits Before Taxes (EBT)
- Taxes
Net Profits / Earnings After Taxes (Net Income)
- Preferred Stock Dividends
Earnings Available for Common Stockholders

EBITDA: Earning Before Interests, Taxes, Depreciation and Amortization

Balance Sheet
• Summary statement of the firm’s financial position at a given point in time.
• Current Assets: Short-term assets, expected to be converted into cash
within one year.
• Current Liabilities: Short-term liabilities, expected to be paid within one
year.
• Long-Term Debt: Debt for which payment is not due in the current year.
• Paid-in-Capital in Excess of Par: The proceeds in excess of the par value
received from the original sale of common stock.
• Retained Earnings: The cumulative total of all earnings, net of dividends,
that have been retained and reinvested in the firm since its inception.

• Goodwill: Excess of money paid when buying a company. A company is

worth $10B and purchased for $12B. The goodwill here is $2B.

Statement of Retained Earnings

• Reconciles the net income earned during a given year, and any cash
dividends paid, with the change in retained earnings between the start and
the end of that year.

Statement of Cash Flow

• Provides a summary of the firm’s operating, investment, and financing cash
flows and reconciles them with changes in its cash and marketable securities
during the period.
• Income statement and beginning and ending balance sheets provide the
data for cash flow statements.
used for
strategic
purposes

all activities 500

related with - 347
financing - 61
92

generated
cash

invested in
cash - M/S (92)
=0
(S = U)

Notes to the Financial Statement

• Explanatory notes keyed to relevant accounts in the statements; they provide
detailed information on the accounting policies, procedures, calculations, and
transactions underlying entries in the financial statements.

Using Financial Ratios

• Ratio analysis is a method for evaluating financial performance on a relative
basis. Shareholders, creditors and managers are interested in the ratios.
• Cross-Sectional analysis is comparison of different firms’ financial ratios at
the same point in time; involves comparing the firm’s ratios with those of other
firms in its industry or with industry averages. Never compare companies from
different sectors!
• Benchmarking is a type of cross-sectional analysis in which the firm’s ratio
values are compared with those of competitors or with other firms that it
wishes to emulate.
• Time-Series analysis is evaluation of the firm’s financial performance over
time using financial ratio analysis.
• Combines analysis combines cross-sectional and time-series analysis.
 Cautions About Using Financial Ratios
• Ratios that reveal large deviations from the norm merely indicate the
possibility of a problem.
• A single ratio does not generally provide sufficient information on which to
judge the overall performance of the firm.
• The ratios being compared should be calculated using financial statements
dated at the same point in time during the year.
• It is preferable to use audited financial statements.
• The financial data being compared should have been developed in the same
way.
• Results can be distorted by inflation.

Liquidity Ratios
• Liquidity is a firm’s ability to satisfy its short-term obligations as they come
due.

Current Assets
Current Ratio =
Current Liabilities
Large enterprises generally have well established relationships with banks
that can provide lines of credit and other short-term loan products in the
event that the firm has a need for liquidity. Smaller firms may not have the
same access to credit, and therefore they tend to operate with more
liquidity.

Current Assets - Inventory

Quick (acid-test) Ratio =
Current Liabilities

Activity Ratios
• The speed with which various accounts are converted into sales or cash.
• Measure how efficiently a firm manages inventory, disbursments, and
collections.
COGS
Inventory Turnover =
Inventory

the higher, the better

 Average Age of Inventory = 365
Inventory Turnover
Average number of days’ sales in inventory

Average Collection Period = Accounts Receivable = Accounts Receivable

Annual Sales per Day Annual Sales ÷ 365

Average Payment Period = Accounts Payable = Accounts Payable

Annual Purchases per Day Annual Purchases/365

Total Asset Turnover = Sales

Total Assets

Debt Ratios

Debt Ratio = Total Liabilities

Total Assets
Measures the proportion of total assets financed by the firm’s creditors.

Total Liabilities
Debt-to-Equity Ratio =
Common Stock Equity

Times Interested Earned Ratio = EBIT

Interest Expense
Profitability Ratios

Gross Profit Margin = Sales - COGS = Gross Profits

Sales Sales

Operating Profits
Operating Profit Margin =
Sales

Net Profit Margin = Earnings Available for Common Shareholders

Sales

Earnings Per Share (EPS) = Earnings Available for Common Shareholders

Number of Shares of Common Stock Outstanding

Return on Total Assets (ROA) = Earnings Available for Common Shareholders

Total Assets
a.k.a. ROI = Return on Investment

Return on Equity (ROE) = Earnings Available for Common Shareholders

Common Stock Equity

Market Ratios

Price Earnings (P/E) Ratio = Market Price per Share of Common Stock
Earnings per Share

Book Value per Share Common Stock Equity

=
of Common Stock Number of Shares of Common Stock Outstanding
equity

Market/book (M/B) Ratio = Market Price per Share of Common Stock

Book Value per Share of Common Stock
A Complete Ratio Analysis
• DuPont System of Analysis is a system used to dissect the firm’s financial
statements and to assess its financial condition.

ROA = Net Profit Margin x Total Asset Turnover

= Earnings Available for Common Stockholders / Total Assets

Financial Leverage Multiplier = Total Assets / Common Stock Equity

ROE = ROA x Financial Leverage Multiplier (FLM)

= Earnings Available for Common Stockholders / Common Stock Equity
Analysts can decompose the total return to owners into these important
components.
Cash Flow and Financial Planning
Analyzing the Firm’s Cash Flow
• Firm’s cash flows fall into three categories:
Operating Flows: Cash flows directly related to sale and production of the
firm’s products and services.
Investment Flows: Cash flows associated with purchase and sale of both
fixed assets and equity investments in other firms.
Financing Flows: Cash flows that result from debt and equity financing
transactions; include incurrence and repayment of debt, cash inflow from
the sale of stock, and cash outflows to repurchase stock or pay cash
dividends.

Inflows and Outflows of Cash

 Sources Uses
(+) (-)
500
38
150
150
100

200
188
200

100
Disregard

Retained Earnings Statement

REbeginning 500
Profits 180
Profit Dividends (10)
Common Dividends (70)
REending 600
 + Net Income
+ Depreciation
All changes in CA
except M/S
All changes in CL
except NP

ngterm