Financial Management

1
Financial Management

• Understanding Financial Statements
• Analysis of Financial Statements
• Introduction to Financial Management

2
Understanding Financial Statements

• Objective of this section is
• To get an understanding about the Financial
  Statements
• Income Statement (Earnings Statement)
• Balance Sheet
• Statement of Changes in Equity
• Statement of Cash Flows
• Accounting Policies Notes

3
Uses of financial statements?

• allow user to assess
• financial position of the company
• success of its operations
• policies and strategies of management
• insight into future performance
• Financial statements are history BUT they can
  help project the future

4
Accounting Period

• Although the firms life is continuous (going
  concern), financial data is presented for
  arbitrary time periods - year, quarter, etc.
• Leads to make adjustments and estimates Ex.
  Accruals, depreciations.

5
Income Statement

• For a given Period
• (Ex. Year, semi annual etc.)
• Realization Principle
• Matching Concept
• Accrual Vs. Cash

6
Income Statement cont) Ex.

• Revenue
• Cost of sales ()
• Gross profit
• Other income
• Distribution Cost ()
• Admin. Expenses ()
• Other ()
• Operating Costs ()
• Operating Profit
• Finance Cost ()
• Profit before tax
• Tax ()
• PAT
• Extraordinary Items ()
• NPAT

7
Issues of the Income Statement

• Accrual basis
• Estimates, Ex. depreciation provision for bad
  debts)
• Cash flow Vs. Income statement.
• Opportunity cost is not considered.

8
Balance Sheet

• A statement of financial condition
• On a particular date (a snapshot)
• Assets Liabilities Equities

9
Balance Sheet cont Ex.

• Assets Note Rs.
• Non Current Assets
• Property, Plant equipment ()
• Investments ()
• Intangible Assets ()
• Current Assets
• Inventories ()
• Debtors ()
• Cash Bank ()
• Total Assets
• Capital Liabilities
• Share Capital ()
• Reserves ()
• Accumulated Profits ()
• Non- current Liabilities
• Debentures ()
• Current Liabilities

10
Issues of the Balance Sheet

• Historical cost
• Tangible (ex. Fixed assets)
• Intangible (ex. TM, Goodwill)
• Estimates (ex. depreciation)
• Non-Comparability (ex. Assets acquired at
  different time periods)

11
Statement of Equity

• Documents changes in balance sheet equity
  accounts from one accounting period to the next
• Provides an important link between the balance
  sheet and the income statement

12
Cash Flow Statement

• A positive net income on the income statement is
  ultimately insignificant unless a company can
  translate its earnings into cash
• Only source in financial statement to learn about
  the generation of cash from operations is the
  statement of cash flows

13
Components of Cash Flow Statement

• OPERATING ACTIVITIES
• INVESTING ACTIVITIES
• FINANCING ACTIVITIES
• Which do you think is most important in assessing
  the firms prospects? Why?
• Defining these activities may help answer the
  question...

14
The most important component of a cash flow

• All sources and uses of cash represent important
  information
• But, only cash flows from operating activities
  represent cash generated internally
• In order to SURVIVE, a firm needs to generate
  positive cash flows internally, i.e. from what
  it does for a living...

15
Notes

• Are an INTEGRAL part of the statements
• Provide summary of accounting policies
• Present detail about particular accounts (e.g.
  inventory, investments, etc.)
• Include other information (e.g. leasing
  arrangements, pending legal proceedings, income
  taxes, etc.)

16
Profitable, yet in Trouble?

• A firm is defined as profitable if it has a
  positive net income
• A positive net income results from accrual-based
  revenues exceeding accrual-based expenses
• A firm may have a positive net income, but this
  does not guarantee that the firm has the CASH to
  meet its obligations!
• However, the idea is that, financial statements
  will be much more of a map

17
Analysis of Financial Statements

• The objective is to understand
• How financial statement analysis helps to assess
  the firms health.
• The basic tools of financial statement analysis
  (e.g. trend, cross-sectional, and ratio analysis)

18
Basic Tools

• Common size financial statements
• Financial ratio analysis
• Trend analysis
• Cross-sectional analysis

19
Common Size Statements

• Common size income statement
• expresses each income statement category as a
  percentage of net sales
• Common size balance sheet
• expresses each item on balance sheet as a
  percentage of total assets
• Both statements facilitate structural analysis of
  the firm

20
Ratio Analysis

• A ratio measures the relationship between two or
  more variables.

Motivation for use of ratios

1. Gives a summary statistic
2. Helps to identify benchmarks
3. Standardizes financial statements
4. Easy to measure relationships
5. Easy to make comparisons

21
Ratio Analysis cont
Five Categories of Ratios

• Profitability ratios
• Liquidity ratios
• Debt ratios
• Asset activity ratios
• Market value ratios

22
Ratio Analysis cont
Profitability Ratios

• Profit Vs. Profitability
• Profitability ratios measure the overall
  effectiveness of the firms management.
• There are two profitability ratios
• Profit on Sales
• Profit on Investment

23
Profitability Ratios
Gross Profit Margin Gross Profit Sales Measures a firm's ability to control its expenses relative to its sales.
Operating profit margin Operating Income Sales How effective is the firm in keeping costs of production low
Net Profit Margin Net Income Sales How much net profit is being generated from sales
Return On Assets Net Income Total Assets How effectively is the firm generating net income from its assets
Return On Equity Net Income Common Equity How well is the firm generating return to its equity providers
24
Profitability Ratios cont
Profit Margin
Profit margin ratio measures a firm's ability to
control its expenses relative to its sales.
Gross Profit Sales
Gross Profit Margin
How effective is the firm in generating revenue
in excess of its cost of goods sold?
25
Balance Sheet Beta Company Ltd.
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Bonds Rs.600 Plant
Equipment Rs.2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock Rs.300 Net Fixed
Assets Rs.1,300 Capital in Excess of Par 600
Total Assets Rs.2,530 Retained Earnings 800 Tota
l Owners Equity Rs.1,700 Total Liabilities
and Owners Equity Rs.2,530
Income Statement Beta Company Ltd.
Gross Profit Margin
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Net Operating Income Rs.330 Interest Expense
60 Income Before
Taxes Rs.270 Taxes (40) 108 Net
Income Rs.162 Dividends Paid 100 Addition to
Retained Earnings Rs.62
Gross Profit Sales
575 1,450
Gross Profit Margin
39.7
26
Profitability Ratios cont
Operating profit margin
Operating Income Sales
Operating Profit Margin
How effective is the firm in keeping costs of
production low?
27
Balance Sheet Beta Company Ltd.
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
Rs.115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in
Excess of Par Rs.600 Total Assets Rs.2,530 Retai
ned Earnings Rs.800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Income Statement Beta Company Ltd.
Operating Profit Margin
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
Operating Income Sales
330 1,450
Oper. Profit Margin
22.8
28
Profitability Ratios cont
Net Profit Margin
Net Income Sales
Net Profit Margin
How much net profit is being generated from sales?
29
Balance Sheet Beta Company Ltd
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
Rs.115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in
Excess of Par Rs.600 Total Assets Rs.2,530 Retai
ned Earnings Rs.800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
Net Profit Margin
Net Income Sales
162 1,450
Net Profit Margin
11.2
30
Profitability Ratios cont
Return On Assets
Net Income Total Assets
Return on Assets

• How effectively is the firm generating net income
  from its assets ?
• ROA does not consider leverage

31
Balance Sheet Beta Company Ltd
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
Rs.115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in
Excess of Par Rs.600 Retained
Earnings Rs.800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Total Assets Rs.2,530
Income Statement Beta Company Ltd
Net Income Total Assets
Return on Assets
Sales Rs.1,450 Cost of Goods Sold Rs.875 Gross
Profit Rs.575 Operating Expenses Rs.
45 Depreciation Rs. 200 Operating
Income Rs.330 Interest Expense Rs. 60 Income
Before Taxes Rs.270 Taxes (40) Rs.108 Net
Income Rs.162 Dividends Paid Rs.100 Addition to
Retained Earnings Rs.62

162 2,530
ROA
6.4
32
Profitability Ratios cont
Return On Equity
Net Income Common Equity
Return on Equity
How well is the firm generating return to its
equity providers?
33
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
Rs.115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in
Excess of Par Rs.600 Retained
Earnings Rs.800 Total Liabilities and
Owners Equity Rs.2,530
Total Assets Rs.2,530
Total Owners Equity Rs.1,700
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
Net Income Common Equity
Return on Equity
162 1,700
ROE
9.53
34
Liquidity Ratios
Measure the ability of the firm to meet its
short-term financial obligations.
Current Ratio Current Assets Current Liabilities Are there sufficient current assets to pay off current liabilities? What is the cushion of safety
Quick/Acid-test ratio Current Assets - Inventory Current Liabilities What happens to the firms ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted
35
Liquidity Ratios

• Measure the ability of the firm to meet its
  short-term financial obligations.

Current Assets Current Liabilities
Current Ratio
Are there sufficient current assets to pay off
current liabilities? What is the cushion of
safety?
36
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs. 230
Current Assets Rs.1,230 Long-term DebtRs.
600 Plant Equipment Rs.2,500 Owners Equity
LessAcc. Depr (1,200) Common Stock Rs.300 Net
Fixed Assets Rs.1,300 Capital in Excess of Par
600 Total Assets Rs.2,530 Retained Earnings
800 Total Owners Equity Rs.1,700
Total Liabilities and Owners Equity Rs.2,530
Current Assets Current Liabilities
Current Ratio
1,230 230
Current Ratio
5.35
37
Liquidity Ratios cont
Quick/Acid-test ratio
Current Assets - Inventory Current Liabilities
Acid-Test Ratio
What happens to the firms ability to repay
current liabilities after what is usually the
least liquid of the current assets is subtracted?
38
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories
625 Current Liabilities Rs. 230 Current
Assets Rs.1,230 Long-term Debt Rs. 600 Plant
Equipment Rs.2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock Rs.300 Net Fixed
Assets Rs.1,300 Capital in Excess of Par
600 Total Assets Rs.2,530 Retained Earnings
800 Total Owners Equity Rs.1,700
Total Liabilities and Owners Equity Rs.2,530
Current Assets - Inventory Current Liabilities
Acid-Test Ratio
1,230 -625 230
2.63
Acid-Test Ratio
39
Debt Ratios
Measure the relative size of the firms debt and
the firms ability to pay off the debt.
Debt Ratio Total Debt Total Assets What proportion of firms assets are financed with debt
Debt To Equity Ratio Total Debt Common Equity What is the proportion of debt relative to equity financing for the firm
Times Interest Earned ratio Operating Income Interest Expense What is the firms ability to repay interest payments from their income
40
Debt Ratios

• Measure the relative size of the firms debt and
  the firms ability to pay off the debt.

Total Debt Total Assets
Debt Ratio

• What proportion of firms assets are financed
  with debt?

41
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in
Excess of Par 600 Total Assets Rs.2,530
Retained Earnings 8 00 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses
45 Depreciation 200 Operating Income Rs.330 Intere
st Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
Total Debt Total Assets
Debt Ratio
230 600 2,530
Debt Ratio
33
42
Debt Ratios cont
Debt To Equity Ratio
Debt to Equity Ratio
Total Debt Common Equity

What is the proportion of debt relative to equity
financing for the firm?
43
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current
Liabilities Rs.230 Current Assets Rs.1,230 Long-
term Debt Rs.600 Plant Equipment Rs.2,500 Owner
s Equity LessAcc. Depr. (1,200)
Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capi
tal in Excess of Par 600 Total
Assets Rs.2,530 Retained Earnings 800 Total
Owners Equity Rs.1,700 Total Liabilities
and Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
Debt to Equity Ratio
Total Debt Common Equity

230 600 1,700
D/E
48.8
44
Debt Ratios cont
Times Interest Earned ratio
Operating Income Interest Expense
Times Interest Earned Ratio

• What is the firms ability to repay interest
  payments from their income?

45
Times Interest Earned Ratio
Operating Income Interest Expense
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in
Excess of Par 600 Total Assets Rs.2,530Retain
ed Earnings 800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
330 60
5.5
TIE Ratio
46
Asset Activity Ratios
Average Collection Period Accounts Receivable Avg. Daily Credit Sales How long does it take for the firm to collect its credit sales from customers
Inventory Turnover ratio Sales Inventory How many times the inventory is translated into sales
Fixed Asset Turnover Ratio Sales Net Fixed Assets How effective is the firm in using its fixed assets in generating sales
Total Asset Turnover Ratio Sales Total Assets How effective is the firm in using total assets to generate sales
47
Asset Activity Ratios

• Help to assess how effectively the firm is using
  assets to generate sales.

Accounts Receivable Avg. Daily Credit Sales
Average Collection Period
How long does it take for the firm to collect its
credit sales from customers?
48
Average Collection Period
Accounts Receivable Avg. Daily Credit Sales
Balance Sheet Beta Company Ltd
Assets Liabilities
Additional Info We assume all sales are
credit sales.
Cash Rs.175 Accounts PayableRs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 BondsRs.600 Plant
Equipment Rs.2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock Rs.300 Net Fixed
Assets Rs.1,300 Capital in Excess of Par 600
Total Assets Rs.2,530 Retained Earnings800 Total
Owners Equity Rs.1,700 Total Liabilities
and Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold
875 Gross Profit Rs.575 Operating
Expenses 45 Depreciation 200 Operating
Income Rs.330 Interest Expense 60 Income Before
Taxes Rs.270 Taxes (40) 108 Net
Income Rs.162 Dividends Paid 100 Addition to
Retained Earnings Rs.62
430 1,450/365
ACP
108.24 days
Days in a year
49
Asset Activity Ratios cont
Inventory Turnover ratio
Sales Inventory
Inventory Turnover Ratio
How many times the inventory is translated into
sales?
50
Inventory Turnover Ratio
Sales Inventory
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in
Excess of Par 600 Total Assets Rs.2,530 Retain
ed Earnings 800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
1450 625
Inventory Turnover
2.3
51
Asset Activity Ratios cont
Fixed Asset Turnover Ratio
Sales Net Fixed Assets
Fixed Asset Turnover Ratio
How effective is the firm in using its fixed
assets in generating sales?
52
Fixed Asset Turnover Ratio
Sales Net Fixed Assets
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Capital
in Excess of Par 600 Total Assets Rs.2,530 Ret
ained Earnings 800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
1,450 1,300
Fixed Asset Turnover
1.12
53
Asset Activity Ratios cont
Total Asset Turnover Ratio
Sales Total Assets
Total Asset Turnover Ratio
How effective is the firm in using total assets
to generate sales?
54
Total Asset Turnover Ratio
Sales Total Assets
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in
Excess of Par 600 Total Assets Rs.2,530 Retain
ed Earnings 800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
55
Market Value Ratios
Price to Earnings Ratio Market Price per Share Earnings per Share How much are investors willing to pay per rupee of earnings of the firm/(Indicator of investors attitudes toward future prospects of the firm.)
Market to Book Ratio Market Price per Share Book Value per Share How much are investors willing to pay per rupee of book value
56
Market Value Ratios
Measure the relationships between financial
statement figures and market value of shares
Market Price per Share Earnings per Share
Price to Earnings Ratio
How much are investors willing to pay per rupee
of earnings of the firm? (Indicator of
investors attitudes toward future prospects of
the firm.)
57
P/E Ratio
Market Price/Share EPS

Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in
Excess of Par 600 Total Assets Rs.2,530 Retain
ed Earnings 800 Total Owners
Equity Rs.1,700 Total Liabilities and
Owners Equity Rs.2,530
Additional Info 100 shares Rs.20.00 per share
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest Expense 60
Income Before Taxes Rs.270 Taxes (40) 108 Net
Income Rs.162 Dividends Paid 100 Addition to
Retained Earnings Rs.62

20 162/100
P/E ratio
12.35
58
Market Value Ratios cont
Market to Book Ratio
Market Price per Share Book Value per Share
Market to Book Ratio
How much are investors willing to pay per rupee
of book value?
59
Additional Info 100 shares Rs.20.00 per share
Balance Sheet Beta Company Ltd
Assets Liabilities
Cash Rs.175 Accounts Payable Rs.115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities Rs.230
Current Assets Rs.1,230 Long-term
Debt Rs.600 Plant Equipment Rs.2,500 Owners
Equity LessAcc. Depr. (1,200) Common
Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in
Excess of Par 600 Total Assets Rs.2,530 Retained
Earnings 800 Total Owners Equity Rs.1,700 To
tal Liabilities and Owners Equity Rs.2,530
Income Statement Beta Company Ltd
Sales Rs.1,450 Cost of Goods Sold 875 Gross
Profit Rs.575 Operating Expenses 45 Depreciation 2
00 Operating Income Rs.330 Interest
Expense 60 Income Before Taxes Rs.270 Taxes
(40) 108 Net Income Rs.162 Dividends
Paid 100 Addition to Retained Earnings Rs.62
Market to Book
Price/Share Common Equity/
shares
60
Comparing the Beta Ltd with Industry Average
Ratio Industry Beta Ltd.
Profitability Gross Profit Margin
38 39.7 Operating Profit
Margin 20 22.8 Net Profit Margin 12 11.2 Retur
n on Assets 9.0 6.4 Return on Equity 13.4 9.5

• Beta Ltd
• May be Good at keeping operating costs down
• May not be good at controlling total costs
• ROA and ROE are low could be due to
  productivity problems.

61
Comparing the Beta Ltd with Industry Average
Cont..
Ratio Industry Beta Ltd.
Liquidity Current Ratio 5.00x 5.35x Acid-Test
Ratio 3.00x 2.63x

• Beta Ltd
• Current Ratio more liquid than the
  industry
• Acid Test Ratio -
• Not as liquid as the industry
• Could be due to high inventory levels

62
Comparing the Beta Ltd with Industry Average
Cont..
Ratio Industry Beta Ltd.
Debt Debt Ratio 35 33 Times Interest
Earned 7.00 5.5 Debt to Equity
49 48

• Beta Ltd
• Interest cover is poor than the industry.
• Since the debt ratios are almost similar, this
  could be due to higher interest rates.
• Debt ratio Debt to equity ratio are almost
  equal to the industry.

63
Comparing the Beta Ltd with Industry average
Cont..
Ratio Industry Beta Ltd.
Asset Activity Avg. Collection Period 90
days 108 days Inventory Turnover 3.00 2.32 Fixed
Asset Turnover 1.00 1.12 Total Asset
Turnover 0.75 .57

• Beta Ltd
• Collection policies need examining
• Inventory turnover is low may be due to high
  inventory levels
• Efficient at converting Fixed Assets in to Sales
• It may be due to lower book value of fixed assets

64
Comparing the Beta Ltd with Industry average
Cont..
Ratio Industry Beta Ltd.
Market Value Price Earnings 18.0
12.35 Market to Book
2.5 1.18

• Beta Ltd
• Investors are not willing to pay as much per
  rupee of earnings or per rupee of book value for
  shares of Beta
• This signals that they consider the firms
  prospects to be lower than the average.

65
Relationships Among RatiosThe Du Pont Analysis

• Ratio Analysis generally involves an examination
  of related ratios.
• Ex. Du pont Analysis.

66
Ex. The Du Pont Analysis
67
Limitations of Ratio Analysis

• Ratios based on financial data share the same
  limitations of financial data (ex. Accrual
  basis).
• 2. Changes in many ratios relate with other
  ratios so a direct interpretation of a change in
  a ratio is not always apparent.
• 3. Comparing ratios over time is complicated due
  to the fact that economic conditions may change.
• 4. Comparing ratios between two firms is
  complicated due to different
• Economic environments
• Technologies even though they produce the same
  product
• Industries
• Strategies

68
Trend / Time series analysis

• Compare present with past.
• Forecast the future.

69
Trend / Time series analysis
70
Cross-Sectional Analysis

• Compare with similar firms
• Compare with industry benchmarks.

Ratio Alfa Competitor Industry
ROS 20 22 20
ROI 16 18 16
ROE 15 19 15.5
71
Time Series Cross-Sectional Analysis
ROE Analysis ROE Analysis ROE Analysis
Year Alfa Competitor
2001 15 16
2002 14 15.5
2003 15.5 15
2004 14.5 15
2005 16 18
2006 15.5 18
2007 10 16
72
Introduction to Financial Management

• Financial management is concerned with the
  financial aspect of the firm.
• It is part of the decisions and control
  sub-systems of the firm.

73
Managers need to answer

• Will particular investment be profitable?
• Where will the funds come from to finance the
  investment?
• Does the firm have adequate cash?
• Which customer should be offered credit?
• How much inventories should be held?
• Is merger or acquisition advisable
• How should profits be used or distributed?
• What is the optimal dividend policy
• How risk and return are balanced?

74
Organization of the Financial Management Function
75
Organization of the Financial Management
DGM/VP of Finance
76
Objective of the Firm

• Profit Maximization
• OR
• Wealth Maximization

77
Objective of Shareholder
Objective of Financial Management ( FM )
Wealth Maximization (SWM) Profit maximization EPS
maximization
?
Social Responsibility

• Ethical issues will constantly confront with
  financial managers as they try to achieve the
  goal of the firm ( SWM ).

78
Maximization of wealth?

• Wealth?
• How can it be determined?
• Market Value?
• Book Value?
• Liquidation value?
• Example
• You have purchased 1,000 of a listed company from
  the open market. To purchase the shares you have
  paid Rs. 23.50. The other information about the
  share as follows.
• par value Rs. 10.00each
• Book value is 17.50 each
• Current market price 22.75.
• Your wealth?

79
Stockholders elect a board of directors
Board of directors then hire management (
officers )
80
Agency Consideration in Financial Management

• Agents A persons who performs activities for
  another person , called principle. Managers are
  the agents of the form
• Principal A individual who establishes a
  compensation scheme to motivate an agent to
  choose activities to the principal. Shareholders
  are the principals of the firm

81
Agency Consideration in Financial Management

• Principal - Agent problem
• The possibility that an agent will act in her or
  his own self interest to the determent of the
  principal for whom she or he is acting

82
Financial Environment The Role of Financial
System

• provides the mechanism by which funds can be
  transferred from those with surplus funds to
  those who wish to borrow.
• acts as an intermediary between surplus and
  deficits

83
The Flow of Funds
Indirect Finance
Financial Intermediaries
Funds
Funds
Borrowers (Spenders) 1. Households 2. Business
Firms 3. Government 4. Foreigners

• Lenders (Savers)
• Households
• Business Firms
• Government
• Foreigners

Funds
Funds
Financial Markets
Direct Finance
84
Financial Intermediaries (FI)

• Individuals or institutions which bring borrowers
  and lenders of funds together to trade.
• The FI aid in arranging financial transactions
• between surplus units and deficit units
• banks as the main financial intermediary involve
  in most of financing activities, (from the
  underwriting of shares to the issuing of bonds).

85
Types of Financial Intermediaries

• 1. Commercial Banks.
• Major suppliers of short-term and medium-term
  loans to businesses for various purposes.
• Accept time deposits and demand deposits.
• Provides these funds as loans to individuals,
  businesses and governments.
• 2. Investment companies
• Include mutual funds and real estate investment
  trusts.
• Pool funds from many savers and invest them in
  various types of assets.
• 3. Investment Bankers

86
Types of Financial Intermediaries Cont

• 4. Pension funds.
• Pool pension contributions from employers and
  their employees and invest them in a variety of
  financial assets.
• 5. Insurance companies
• The premiums collected on insurance policies are
  invested in variety of assets.
• The proceeds from these assets are used to pay
  claims against insured events/losses such as
  death, disability, accident, fire, etc.
• 6. Finance companies.
• Raise funds by issuing their own debt or by
  borrowing from commercial banks.
• These funds are lended out to individuals and
  businesses.
• 7. Brokers

87
Types of Markets Cont.

• Market
• Any organized system which facilitates for
  meeting buyers and sellers.
• Markets may exist in a specific physical location
  or not
• Money/Capital
•  
• Money Market
• Market for the short term securities having
  maturities less than one year.
• Capital Market
• market for the Long-term securities having
  maturities greater than one year.

88
Types of Markets Cont

• Primary/Secondary
• Primary markets  Primary markets are markets
  that involve new issues of securities and hence,
  provide a direct flow of cash to the issuing
  entity.
• Initial Public Offering (IPO) issuing equity to
  the public for the first time by a company.
• Seasoned Offering (SEO) is simply selling more
  stocks by a firm is already publicly traded
• Secondary Market
• A market for the securities issued already.
• Secondary market exists for the trading of common
  and preferred stock, warrants, bonds, and put and
  call options.

89
Types of Markets Cont..

• Secondary Market for Equity Shares
• Common stocks, preferred stocks, and warrants
  are traded.
• Auction markets
• are involving an auction process in a specific
  physical location.
• Negotiated markets
• are involving a network of dealers who make a
  market by standing ready to buy and sell
  securities at specific prices. Negotiated market
  involves the over-the-counter market.

90
     Financial Instruments

• A financial instrument can be defined as a
  claim to the payment of a sum of money at some
  future dates.

91
Characteristics of Financial Instruments

• Risk
• The future outcome of the instruments is not
  known with certainty. Ex. uncertainty of the
  price, default risk of the capital or income
  stream.
• Liquidity
• It refers to the ease and speed at which a
  financial instrument can be turned into cash
  without any loss.
• Real Value certainty
• Effect of changes of the general price level
  (Inflation or deflation)

92
Characteristics of Financial Instruments Cont

• Terms of maturity
• FI vary widely according to their maturity. Sight
  deposits at bank have zero term to maturity, as
  they can be withdrawn on demand.
• Currency denomination
• the return on non-domestic instruments are
  affected on the appreciation or depreciation of
  the relevant exchange rates.
• Divisibility
• the degree to which the instruments can be
  subdivided into small units for transaction
  purposes.

93
Corporate Securities

• Security
• "A legal contract representing the right to
  receive future benefits under a stated set of
  conditions."
• The piece of paper defining the property
  rights is the security.

94
Financial Instruments Available in Sri Lanka

• CAPITAL MARKET
• Common stock 
• Preferred stocks 
• Corporate Bonds 
• Treasury Bonds 
• Sri Lanka Development Bonds 
• Rupee Loans 
• Mutual funds unit trust 
• Deposits 
• Whole-life insurance policy
• Nation Building Bonds

• MONEY MARKET
• Treasury Bills
• Repurchase (Repo)
• Reverse-repurchase agreement  
• Commercial paper 
• Banker Acceptances 
• Eurodollar

95
The Securities and Exchange Commission of Sri
Lanka

• regulates the disclosure of information in new
  security offerings and sets disclosure
  requirements for nearly all firms trading
  publicly.
• The SEC also regulates "insider" trading, which
  includes trading done by directors, officers, and
  major shareholders of a corporation.
• All trading by insiders must be reported to the
  SEC.
• the SEC attempts to prevent insiders from
  secretly trading securities on the basis of
  private information that outside shareholders do
  not possess.

96
Colombo Stock Exchange

• The Colombo Stock Exchange (CSE)
• CSE is a company limited by guarantee, and
  established under the Companies Act No. 17 of
  1982.
• The policy making body (Board of Directors)
• There are 9 Directors (the members elect five
  Directors and the Minister of Finance appoints
  four Directors).
• CDS is used in the CSE for dealing shares.

97
The Central Depository System
Colombo Stock Exchange cont

• The CDS provides depository facilities and
  clearing services for securities traded on the
  CSE.
• The CDS is a 100 owned subsidiary of the CSE.
• A Board of Directors constitutes the CDS's
  policy-making body.
• The Board consists of nine Directors. Five
  directors are elected to office by the members of
  the CSE and four directors are nominated by the
  Ministry of Finance.

98
Colombo Stock Exchange Cont

• The Colombo Stock Exchange (CSE) currently has
  235 listed companies representing 20 business
  sectors. The market capitalization as at 03rd
  September 2009 was 842.3 billion rupees.
• 21 Member firms
• As at 03rd Sep. 2009 and 9th Dec. 2011
• ASPI 2,630.8, 6027.1
• MPI 2, 983.6, 5248.9
• TRI for all shares 3,110.1
• TRI for Milanka shares 3, 546.28

99
Market Indices

• The four Indices are 
• All Share Price Index (ASPI), which comprises all
  listed companies on the market.
• Milanka Price Index (MPI), which is based on 25
  selected companies.
• Total Return Index (TRI)
• Sector price indices

100
Market Indices Cont

• All Share Price Index
• ASPI Market Capitalization of All Listed
  Companies x 100
• Base Market Capitalization
• BMC Number of shares at Base year (1985) x Base
  Market Price

101
Market Indices Cont

• Milanka Price Index
• MPI Market Capitalization of 25 Selected
  Companies x100
• Base Market Capitalization of those 25
  Companies as at 31st December 1998
• The MPI is revised annually and the
• Total Return Index