business finance (MGT-227)

Week #1

Topic:-

1) finance a quick look

2) business finance and finance manager

3) forms of business organization

4) Goals of business finance

5) Agency problem

Finance a quick look

Business Finance

Addresses the following three questions:

 What long-term investments should the firm engage in?

 How can the firm raise the money for the required investments?

 How much short-term cash flow does a company need to pay its bills?

Investments

Deal with financial assets such as stocks and bonds.

 It covers the following issues:

Pricing Financial Assets

Associated Risks and Rewards

Determining best mixture of financial investment

Career opportunities in investment

Stock Brokerage

Portfolio Management

Security Analysis

Financial Institutions
 Businesses dealing in financial matters

Banks and Insurance companies

International Finance

Covers international aspects of corporate finance, investment and financial institutions.

Financial manager
A Financial Manager is a professional who is responsible for the financial health of an
organization. They create accurate data analysis and advise senior management on profit-
maximizing ideas to ensure long-term success.

Financial Manager responsibilities include:

 Providing financial reports and interpreting financial information to managerial staff while
recommending further courses of action.
 Advising on investment activities and provide strategies that the company should take
 Maintaining the financial health of the organization.

Responsibilities

 Provide financial reports and interpret financial information to managerial staff while
recommending further courses of action.
 Advise on investment activities and provide strategies that the company should take
 Maintain the financial health of the organization.
 Analyze costs, pricing, variable contributions, sales results and the company’s actual
performance compared to the business plans.
 Develop trends and projections for the firm’s finances.
 Conduct reviews and evaluations for cost-reduction opportunities.
 Oversee operations of the finance department, set goals and objectives, and design a framework
for these to be met.
 Manage the preparation of the company’s budget.
 Liase with auditors to ensure appropriate monitoring of company finances is maintained.
 Correspond with various other departments, discussing company plans and agreeing on future
paths to be taken.

Forms of business organization

There are main 4 types of business organization.

- Sole proprietorship
- Partnership
- Corporation
- Limited company
Sole proprietorship

This popular form of business structure is the easiest to set up. Sole proprietorships have one
owner who makes all of the business decisions, and there is no distinction between the business
and the owner.

Advantages of a sole proprietorship include:

 Total control of the business: As the sole owner of your business, you have full control
of business decisions and spending habits.
 No public disclosure required: Sole proprietorships are not required to file annual
reports or other financial statements with the state or federal government.
 Easy tax reporting: Owners don't need to file any special tax forms with the IRS other
than the Schedule C (Profit or Loss from Business) form.
 Low start-up costs: While you may need to register your business and obtain a business
occupancy permit in some places, the costs of maintaining a sole proprietorship are much
less than other business structures.

Disadvantages include:

 Unlimited liability: You are personally responsible for all business debts and company
actions under this business structure.
 Lack of structure: Since you are not required to keep financial statements, there is a risk
of becoming too relaxed when managing your money.
 Difficulty in raising funds: Investors typically favor corporations when lending money
because they know that those businesses have strong financial records and other forms of
security.

Some typical examples of sole proprietorships include the personal businesses of freelancers,
artists, consultants and other self-employed business owners who operate on a solo basis.

Partnership

You can classify a business partnership as either general or limited. General partnerships allow
both partners to invest in a business with 100% responsibility for any business debts. They don't
require a formal agreement. In comparison, limited partnerships require owners to file paperwork
with the state and compose formal agreements that describe all of the important details of the
partnership, such as who is responsible for certain debts.

Some advantages of partnerships include:

 Easy to establish: Compared to other business structures, partnerships require minimal

paperwork and legal documents to establish.
 Partners can combine expertise: With more than one like-minded individual, there are
more opportunities to increase their collaborative skillset.
  Distributed workload: People in partnerships commonly share responsibilities so that
one person doesn't have to do all the work.

Disadvantages to consider:

 Possibility for disagreements: By having more than one person involved in business
decisions, partners may disagree on some aspects of the operation.
 Difficulty in transferring ownership: Without a formal agreement that explicitly states
processes, business may come to a halt when partners disagree and choose to end their
partnership.
 Full liability: In a partnership, all members are personally liable for business-related
debts and may be pursued in a lawsuit.

An example of a partnership is a business set up between two or more family members, friends
or colleagues in an industry that supports their skill sets. The partners of a business typically
divide the profits among themselves.

Corporation

A corporation is a business organization that acts as a unique and separate entity from its
shareholders. A corporation pays its own taxes before distributing profits or dividends to
shareholders. There are three main forms of corporations: a C corporation, an S corporation and
an LLC, or limited liability corporation.

Advantages of corporations include:

 Owners aren't responsible for business debts: In general, the shareholders of a

corporation are not liable for its debts. Instead, shareholders risk their equity.
 Tax exemptions: Corporations can deduct expenses related to company benefits,
including health insurance premiums, wages, taxes, travel, equipment and more.
 Quick capital through stocks: To raise additional funds for the business, shareholders
may sell shares in the corporation.

Disadvantages include:

 Double taxation for C-corporations: The corporation must pay income tax at the
corporate rate before profits transfer to the shareholders, who must then pay taxes on an
individual level.
 Annual record-keeping requirements: With the exception of an S-corporation, the
corporate business structure involves a substantial amount of paperwork.
 Owners are less involved than managers: When there are several investors with no
clear majority interest, the management team may direct business operations rather than
the owners.
Common examples of corporations include a business organization that possesses a board of
directors and a large company that employs hundreds of people. About half of all corporations
have at least 500 employees.

Limited liability company

The most common form of business structure for small businesses is a limited liability company,
or LLC, which is defined as a separate legal entity and may have an unlimited amount of owners.
They are typically taxed as a sole proprietorship and require insurance in case of a lawsuit. This
form of business is a hybrid of other forms because it has some characteristics of a corporation as
well as a partnership, so its structure is more flexible.

Some advantages of an LLC include:

 Limited liability: As the name states, owners and managers have limited personal
liability for business debts, whereas individuals assume full responsibility in a sole
proprietorship or partnership.
 Pass-through taxation: Owners of LLCs may take advantage of "pass-through" taxation,
which allows them to avoid LLC and corporation taxes, and owners pay personal taxes
on business profits.
 Flexible management: LLCs lack a formal business structure, meaning that their owners
are free to make choices regarding the operation of their businesses.

Some disadvantages include:

 Associated costs: The start-up costs associated with an LLC are more expensive than
setting up a sole proprietorship or partnership, and there are annual fees involved as well.
 Separate records: Owners of LLCs must take care to keep their personal and business
expenses separate, including any company records, whereas sole proprietorships are less
formal.
 Taxes: In regards to unemployment compensation, owners may have to pay it
themselves.

Common examples of limited liability companies include start-ups and other small businesses.
Family-owned businesses and companies with a small number of members may operate as an
LLC because it is a flexible business model that allows members to be active or passive in their
roles.

Goals of business finance

Common financial business objectives include

- Increasing revenue
- Increasing profit margins
- Retrenching in times of hardship
- Earning a return on investment
Agency problem

An agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, an agency problem usually
refers to a conflict of interest between a company's management and the company's
stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed
to make decisions that will maximize shareholder wealth even though it is in the manager’s best
interest to maximize their own wealth.

KEY TAKEAWAYS

 An agency problem is a conflict of interest inherent in any relationship where one party
is expected to act in the best interest of another.
 Agency problems arise when incentives or motivations present themselves to an agent to
not act in the full best interest of a principal.
 Through regulations or by incentivizing an agent to act in accordance with the
principal's best interests, agency problems can be reduced.

Week#2

Topic

Balance sheet

Income statement

Taxes

Cash flow

Balance sheet

The Balance Sheet An accountant’s snapshot of the firm’s accounting value as of a particular
date.

 The Balance Sheet Identity is:

 Assets ≡ Liabilities + Stockholder’s Equity When analyzing a balance sheet, the financial
manager should be aware of three concerns:

 Accounting Liquidity, Debt versus Equity, and Value versus Cost

Balance sheet Model

Income Statement

 If we think of the balance sheet as a snapshot then we can think of income statement as a
video

 recording covering before and after the picture. The income statement measures performance
over a specific period of time.

 The accounting definition of income is:

Revenue – Expenses ≡ Income

Income Statement Analysis

There are three things to keep in mind when analyzing an income statement:

o Generally Accepted Accounting Principles (GAAP)

o Non-Cash Items

o Time and Costs Income Statement Analysis Generally Accepted Accounting Principles
(GAAP)

o “The Realization principle” is to recognize revenue when the earning process is complete, i.e.
revenue is recognized at the time of sale, which need not be the same as time of collection.
Usually a separate section reports as a separate item t
he amount of taxes levied on income.

Week#3

Analyzing the financial statement

Standardized Financial statement

Ratio analysis

The Du-point identity

Internal and sustainable growth

Using financial statement information

Standardized Financial statement

 One obvious thing we want to do with a company’s financial statements is to compare them to
those of other.

 It is almost impossible to directly compare the financial statements for two companies because
of differences in size. So we will try to standardize the financial statements.

 So, a standardized financial statement presenting all items in percentages is called a common-
size statement.

 Although an organization’s common-size statements provide a better analytical insight into its
strength and standing, yet its performance and efficiency can be better judged by comparing
these with those of the firm’s competitors.
Ratio analysis

Another way of avoiding the problems involved in comparing companies of different sizes, is to
calculate and compare financial ratios.

One problem with ratios is that different people and different sources frequently don’t compute
them in exactly the same way.

While using ratios as a tool for analysis, you should be careful to document how you calculate
each one, and, if you are comparing your numbers to those of another source, be sure you know
how their numbers are computed.

For each of the ratios we discuss, several questions come to mind:

How is it computed?

What is it intended to measure, and why might we be interested?

What is the unit of measurement?

What might a high or low value be telling?

How might such values be misleading?

How could this measure be improved?

Financial ratios are traditionally grouped into the following categories:

 Short-term solvency, or liquidity,

ratios Ability to pay bills in the short-run

 Long-term solvency, or financial leverage,

ratios Ability to meet long-term obligations

 Asset management, or turnover, ratios

Intensity and efficiency of asset use

 Profitability ratios

Ability to control expenses

 Market value ratios

Going beyond financial statements

Liquidity Ratios
Also known as Solvency Ratios, and as the name indicates, it focuses on a company’s current
assets and liabilities to assess if it can pay the short-term debts. The three common liquidity
ratios used are current ratio, quick ratio, and burn rate. Among the three, current ratio comes in
handy to analyze the liquidity and solvency of the start-ups.

S. No. RATIOS FORMULAS

1 Current Ratio Current Assets/Current Liabilities

2 Quick Ratio Liquid Assets/Current Liabilities

3 Absolute Liquid Ratio Absolute Liquid Assets/Current Liabilities

Profitability Ratios
These ratios analyze another key aspect of a company and that is how it uses its assets and how
effectively it generates the profit from the assets and equities. This also then gives the analyst
information on the effectiveness of the use of the company’s operations.

S. RATIOS FORMULAS
No.

1 Gross Profit Ratio Gross Profit/Net Sales X 100

2 Operating Cost Ratio Operating Cost/Net Sales X 100

3 Operating Profit Ratio Operating Profit/Net Sales X 100

4 Net Profit Ratio Net Profit/Net Sales X 100

5 Return on Investment Ratio Net Profit After Interest And Taxes/ Shareholders Funds or
Investments X 100

6 Return on Capital Employed Net Profit after Taxes/ Gross Capital Employed X 100
Ratio

7 Earnings Per Share Ratio Net Profit After Tax & Preference Dividend /No of Equity Shares

8 Dividend Pay Out Ratio Dividend Per Equity Share/Earning Per Equity Share X 100

9 Earning Per Equity Share Net Profit after Tax & Preference Dividend / No. of Equity Share

10 Dividend Yield Ratio Dividend Per Share/ Market Value Per Share X 100
 11 Price Earnings Ratio Market Price Per Share Equity Share/ Earning Per Share X 100

12 Net Profit to Net Worth Ratio Net Profit after Taxes / Shareholders Net Worth X 100

Working Capital Ratios

Like the Liquidity ratios, it also analyses if the company can pay off the current debts or
liabilities using the current assets. This ratio is crucial for the creditors to establish the liquidity
of a company, and how quickly a company converts its assets to bring in cash for resolving the
debts.

S. RATIOS FORMULAS
No.

1 Inventory Ratio Net Sales / Inventory

2 Debtors Turnover Ratio Total Sales / Account Receivables

3 Debt Collection Ratio Receivables x Months or days in a year / Net Credit Sales for the
year

4 Creditors Turnover Ratio Net Credit Purchases / Average Accounts Payable

5 Average Payment Period Average Trade Creditors / Net Credit Purchases X 100
 6 Working Capital Turnover Net Sales / Working Capital
Ratio

7 Fixed Assets Turnover Ratio Cost of goods Sold / Total Fixed Assets

8 Capital Turnover Ratio Cost of Sales / Capital Employed

Capital Structure Ratios

Each firm or company has capital or funds to finance its operations. These ratios, i.e., the Capital
Structure Ratios, analyze how structurally a firm uses the capital or funds.

S. No. RATIOS FORMULAS

1 Debt Equity Ratio Total Long Term Debts / Shareholders Fund

2 Proprietary Ratio Shareholders Fund/ Total Assets

3 Capital Gearing ratio Equity Share Capital / Fixed Interest Bearing Funds

4 Debt Service Ratio Net profit Before Interest & Taxes / Fixed Interest Charges

Overall Profitability Ratio

True to its name, these ratios measure how profitable a particular firm or company is, or how it
can turn its assets and capital into profits for future use.

S. No. RATIOS FORMULAS

1 Overall Profit Ability Ratio Net Profit / Total Assets

Du-point identity.

The difference between the two profitability measures, ROA and ROE, is the use of debt
financing, or financial leverage.

The relationship between these measures can be illustrated by decomposing ROE into its
component parts.

Recall,

ROE = Net income/Total equity

ROE = ROA × Equity Multiplier ROE = ROA × (1 + Debt-Equity Ratio)

The Du Pont identity tells us that ROE is affected by three things:

- Operating efficiency (as measured by profit margin)

- Asset use efficiency (as measured by total assets turnover)

- Financial Leverage (as measured by equity multiplier)

Retention Ratio Anything A2Z does not pay out in form of dividends must be retained in the firm. So
retention ratio is:

Retention ratio = Retained earnings /Net income

Internal and Sustainable Growth

 Firm’s Return on Assets and Return on Equity are frequently used to calculate two additional
numbers, both of which have to do with the firm’s ability to grow.
Investors and others are frequently interested in knowing how rapidly a firm’s sales can grow.

But the important thing to recognize is that if sales are to grow, assets have to grow as well, at
least over the long run.

 Further if assets are to grow, then the firm must somehow obtain money to pay for the
purchases.

 So, the growth has to be financed. And more so, a firm’s ability to grow depends on its
financing policies.

 A firm has two broad sources of financing:

- Internal financing simply refers to what the firm earns and subsequently plows
back into the business.
- External financing refers to funds raised by either borrowing money or selling
stock.

Internal Growth Rate

A firm having a policy of internal financing, won’t borrow funds and won’t sell any new stock.
Internal growth rate represents how rapidly the firm grows.

Internal Growth Rate = ROA*b/1-(ROA*b)

Where ROA is return on assets and b is the retention ratio

Sustainable Growth Rate

 If a firm only relies on the internal financing, then through time, its total debt ratio will decline,
because assets will grow but total debt will remain the same (or even fall if some is paid off).

Frequently, firms have a particular total debt ratio or equity multiplier that they view as optimal.

 With this in mind we now consider how rapidly a firm can grow if:

- it wishes to maintain a particular total debt ratio; and

- it is unwilling to sell new stock

Given these assumptions, the maximum growth rate that can be achieved is called the
Sustainable Growth Rate:

Sustainable Growth Rate= ROE*b/1-(ROE*b)

USING FINANCIAL STATEMENTS INFORMATION

 Now we take a look at some practical aspects of the financial statements analysis.

- Reasons for doing financial statements analysis

- Benchmarking the information o Problems arising in the process

Why Evaluate Financial Statements

 Primary reason for looking at the accounting information is that we don’t have and can’t
expect to get market value information. But if we have such information, we will use it instead of
accounting data.

• If there is a conflict between accounting and market data, market data would be preferred.

Why Evaluate Financial Statements

 Financial statements analysis is an application of management by exception and boils down to

comparing ratios for one business with some average or representative ratios.

 The ratios differing considerably from averages are studied further.

Internal Uses

 Performance Evaluation

- Profit margin and return on equity

- Comparing the performance of different divisions

Planning for the future

- Historical information used for generating projections

- Checking the realism of assumptions for the projections

External Uses

Customers:

- To evaluate the credit standing of a new customer

- Large customers would eye on the sustainability of the firm

Suppliers:

- Evaluate the financial worth of the supplier

- Suppliers would be concerned about the creditworthiness of the firm
 Week#4

Time value of Money

Future value

Present value

Relationship between future value and present value

Annuities

Future and present value of cash flow

Impact of higher compounding frequency

Inflation and time value of money

Time Value of Money

 It refers to the fact that a dollar in hand today is worth more than a dollar promised at some time in
future.

The trade-off between money today and money later depends on, among other things, the rate one
can earn by investing the money today for some interest income.

I.Symbols:

PV = Present value, what future cash flows are worth today

FVt = Future value, what cash flows are worth in the future

r = Interest rate, rate of return, or discount rate per period

t = number of periods

C = cash amount

II. Future value of C dollars invested at r percent per period for t periods:
 - FV= C x (1 + r)t
- The term (1 + r)t is called the future value factor.

III. Present value of C to be received in t periods at r percent per period:

- PV = C/(1 + r)t
- The term 1/(1 + r)t is called the present value factor.

IV. The basic present value equation giving the relationship between present and future value is:

- PV = FVt/(1 + r)t

Future value

Future value (FV) is the value of a current asset at a future date based on an assumed rate of
growth. The future value is important to investors and financial planners, as they use it to
estimate how much an investment made today will be worth in the future. Knowing the future
value enables investors to make sound investment decisions based on their anticipated needs.
However, external economic factors, such as inflation, can adversely affect the future value of
the asset by eroding its value.

Understanding Future Value

The FV calculation allows investors to predict, with varying degrees of accuracy, the amount of
profit that can be generated by different investments. The amount of growth generated by
holding a given amount in cash will likely be different than if that same amount were invested
in stocks; therefore, the FV equation is used to compare multiple options.

Determining the FV of an asset can become complicated, depending on the type of asset. Also,
the FV calculation is based on the assumption of a stable growth rate. If money is placed in
a savings account with a guaranteed interest rate, then the FV is easy to determine accurately.
However, investments in the stock market or other securities with a more volatile rate of return
can present greater difficulty.

FV= PV (1+i)^n

Present value

Present value (PV) is the current value of a future sum of money or stream of cash flows given a
specified rate of return. Future cash flows are discounted at the discount rate, and the higher
the discount rate, the lower the present value of the future cash flows. Determining the
appropriate discount rate is the key to properly valuing future cash flows, whether they
be earnings or debt obligations.
KEY TAKEAWAYS

 Present value states that an amount of money today is worth more than the same amount
in the future.
 In other words, present value shows that money received in the future is not worth as
much as an equal amount received today.
 Unspent money today could lose value in the future by an implied annual rate due to
inflation or the rate of return if the money was invested.
 Calculating present value involves assuming that a rate of return could be earned on the
funds over the period.

PV= FV/(1+i)^n

Annuity

The term "annuity" refers to an insurance contract issued and distributed by financial
institutions with the intention of paying out invested funds in a fixed income stream in the
future. Investors invest in or purchase annuities with monthly premiums or lump-sum payments.
The holding institution issues a stream of payments in the future for a specified period of time
or for the remainder of the annuitant's life. Annuities are mainly used for retirement purposes
and help individuals address the risk of outliving their savings.

KEY TAKEAWAYS

 Annuities are financial products that offer a guaranteed income stream, usually for
retirees.
 The accumulation phase is the first stage of an annuity, whereby investors fund the
product with either a lump sum or periodic payments.
 The annuitant begins receiving payments after the annuitization period for a fixed period
or for the rest of their life.
 Annuities can be structured into different kinds of instruments, which gives investors
flexibility.
 These products can be categorized into immediate and deferred annuities and may be
structured as fixed or variable.

How an Annuity Works

Annuities are designed to provide a steady cash flow for people during their retirement years
and to alleviate the fears of outliving their assets. Since these assets may not be enough to
sustain their standard of living, some investors may turn to an insurance company or other
financial institution to purchase an annuity contract.

As such, these financial products are appropriate for investors, who are referred to as annuitants,
who want stable, guaranteed retirement income. Because invested cash is illiquid and subject to
withdrawal penalties, it is not recommended for younger individuals or for those
with liquidity needs to use this financial product.

Present Value for Annuity cash flows

The present value of an annuity is the current value of future payments from an annuity, given a
specified rate of return, or discount rate. The higher the discount rate, the lower the present value of
the annuity.

 For annuity calculation, we use a variation of present value equation.

 The present value of an annuity of C dollars per period for t periods when interest rate is r is:

PV= A/R{1-(1+i)^n}

Future value of annuity

The future value of an annuity is the value of a group of recurring payments at a certain date in
the future, assuming a particular rate of return, or discount rate. The higher the discount rate the
greater the annuity's future value.

KEY TAKEAWAYS

 The future value of an annuity is a way of calculating how much money a series of
payments will be worth at a certain point in the future.
 By contrast, the present value of an annuity measures how much money will be required
to produce a series of future payments.
 In an ordinary annuity, payments are made at the end of each agreed-upon period. In an
annuity due, payments are made at the beginning of each period.

Example of the Future Value of an Annuity

The formula for the future value of an ordinary annuity is as follows. (An ordinary annuity pays
interest at the end of a particular period, rather than at the beginning, as is the case with
an annuity due.)

P=PMT×r{(1+r)^n−1}

where:

P=Future value of an annuity stream

PMT=Dollar amount of each annuity payment

r=Interest rate (also known as discount rate)

n=Number of periods in which payments will be made