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Finance T1 & T2 (Topic One: Introduction (Ch1) (1.4 Five basic…
Finance T1 & T2
Topic One: Introduction (Ch1)
1.1 Finance covers deciding on (4):
Working capital budgeting
- How can the firm best manage its cash flows as they arise in its day-to-day operations?
Capital budgeting
- What long-term investments should the firm undertake?
Capital structure -
How should the firm raise money to fund those investments?
1.2 Entity structures (5)
Sole trader
Partnership
Corporation/Company (Ltd)
See table 1.1 for summary of differences (7)
1.3 Goal of financial manager (8)
Maximising shareholder wealth
While respecting the needs of other stakeholders
These goals are considered complimentary, not contradictory
Ethics and Trust
1.4
Five basic principles of finance
(12)
There is a risk-return trade-off
Cash flows are the source of value
Money has a time value
Market prices reflect information
Individuals respond to incentives
Topic Two: Accounting Concepts and Statement - Financial Analysis (Ch 3 & 4)
Financial analysis (Ch 4)
Common-size financial statement (82)
Income statement - divide all numbers by total sales to convert them to percentages
Balance sheet - divide all numbers by total assets to convert them to percentages
Particularly helpful for comparing different sized organisations
Analysis to:
Same company over different time periods
Different companies over same time period (benchmarking)
Liquidity ratios (86)
Current ratio = current assets / current liabilities - nowadays around 1 appears to be ok, depending on industry
Quick ratio (acid-test ratio) = (current assets - inventory) / current liabilities
Q: Can the org pay its bills on time?
Working capital management ratios (efficiency ratios) (87)
Average collection period (days) = AR / (Annual Credit Sales/365 days)
Accounts receivable turnover ratio (times) = Annual credit sales / AR : gives number of times AR is turned over in the year
Inventory turnover (88) (times) = Annual COGS / Current Inventory
Q: How efficiently is the org using its assets to generate sales?
NB: Using average AR over the year will give greater accuracy to either of above calculations, but a point in time is fine too.
Use one or other of AR ratios, not both, they give basically the same information
You can then calculate the 'days sales in inventory' by dividing 365 by the number above, giving you the average number of days inventory is in stock
See p.90 for brief overall ratio analysis example
Capital structure (leverage) ratios (91)
Debt ratio
Result tells you how much borrowing has taken place to purchase assets
50-60% is normal for a large company
= liability / assets
Interest coverage ration
= OP / interest expense
Outlines how many times an org could pay their interest from their OP and also how much their OP could shrink and still pay their interest expense
Q: How has the org financed the purchase of assets?
Total asset turnover ratio = sales / total assets (92)
Fixed asset turnover ratio = sales / Net PPE (95)
See p.92 for table outline above two ratios
Profitability ratios (96) also see table on p.103
Q: Has the org earned adequate return on investments? (ROI)
Gross profit margin = GP / Sales (96)
Operating profit margin = OP / Sales (96)
EBIT
EBITDA (often used in business valuations, a business being worth 5 x its EBITDA)
Net profit margin = NP / Sales (97)
Return on assets (ROA) (97)
= OP / Total assets
Shows how well a firm is using assets to generate profit
Return on equity (ROE) (100)
= Net income / ordinary equity
Benchmark = 20%+ very good, 10-20% average, <10% not good
Market value ratios
Q: Are the orgs management creating value for shareholders?
Uses internal data along with stock market information
Price earnings (P/E) ratio (103)
Most P/E ratios are between 10 and 30
= Market price per share / net income per share
Reflects expected future earnings growth
Market-to-book ratio (104) = market value per share / book value per share
See p.91 for summary table of both liquidity and working capital ratios
DuPont Analysis (101)
Qs: What is the major influence in the orgs ROE? / What is causing org ROE to diverge from market benchmarks?
Uses Net profit margin, total asset turnover, and...
Collectively compares, profitability, efficiency and leverage
Equity multiplier = total assets / ordinary equity (101)
Benchmarking (109)
Trend analysis
Within organisation over different periods in time (time-series comparison)
Peer-group comparisons
Against a peer company
Against industry averages
Accounting basics (Ch 3)
Accounting statements
Cash flow statement (60)
Balance sheet (51)
Statement of changes in equity
Income statement (P&L) (42)
Accounting principles
Revenue recognition principle (accrual accounting basis)
The matching principle
The historical cost principle
Equations
BS: Assets = Liabilities + Equity (51)
Liquidity: Net working capital = Current assets - Current liabilities (54)
Cash flow sources and uses table (62)