Semester-I 2023/2024

1. Define finance and financial management

2. Identify basic types of financial management decisions and role of a financial
manager
3. Explain the goal of a firm/financial management
4. Articulate the financial implications of the different forms of business
organization
5. Explain the conflicts of interest that can arise between managers and owners.
Definition
The field of finance is broad and dynamic.
Finance influences everything that firms do, from hiring personnel to
building factories to launching new advertising campaigns.
It has many facets, which makes it difficult to provide one concise definition.
“the system that includes the circulation of money, the granting of credit, the
making of investments, and the provision of banking facilities.” Webster’s
Dictionary
“the science and art of managing money” Gitman
 Finance as taught in universities is generally divided into three areas:
1) Financial management,
Financial management, also called corporate finance, focuses on decisions
relating to:
how much and what types of assets to acquire,
how to raise the capital needed to purchase assets, and
how to run the firm so as to maximize its value.
whether to reinvest profits in the business or distribute them back to
investors.
2) Capital markets,
Capital markets relate to the markets where interest rates, along with stock
and bond prices, are determined. Also studied here are the financial
institutions that supply capital to businesses.
3) Investments.
 Investments relate to decisions concerning stocks and bonds and include a
number of activities:
i. Security analysis deals with finding the proper values of individual securities (i.
e., stocks and bonds).
ii. Portfolio theory deals with the best way to structure portfolios, or “baskets,” of
stocks and bonds.
Rational investors want to hold diversified portfolios in order to limit risks,
so choosing a properly balanced portfolio is an important issue for any
investor.
iii. Market analysis deals with the issue of whether stock and bond markets at any
given time are “too high,” “too low,” or “about right.”
Relationship with other fields
Finance, as we know it today, grew out of economics and accounting.
 Economics….. economists developed the notion that an asset’s value is
based on the future cash flows the asset will provide
 Accounting…. accountants provided information regarding the likely size of
those cash flows.
 statistics/mathematics e.g., forecasting tools
 marketing e.g., responsible for generating revenues
 production e.g., responsible for producing goods for sale
What is the goal of a firm/an organization?

Possible goals
Survive.
Avoid financial distress and bankruptcy.
Beat the competition.
Maximize sales or market share.
Minimize costs.
Maximize profits.
Maintain steady earnings growth.
Shareholder wealth maximization
Limitations of profit maximization
Subjective e.g., different revenue and expense measurement methods
Investment in a new branch
Items SL DDB
Gross profit Br.10,000 Br.10,000
Expenses other than depreciation (7,000) (7,000)
Income before depreciation expenses Br.3,000 Br.3,000
Depreciation expenses (1,800) (4,400)
Income (Loss) before taxes Br.1,200 (Br.1,400)

Shall we open the new branch?

 Vagueness
Maximize profits? Which year’s profits?
A corporation may be able to increase current profits by cutting back on
outlays for maintenance or staff training, but that will not add value
unless the outlays were wasteful in the first place.
Shareholders will not welcome higher short-term profits if long-term
profits are damaged.
A company may be able to increase future profits by cutting this year’s
dividend and investing the freed-up cash in the firm.
This is not in the shareholders’ best interest if the company earns only a
very low rate of return on the extra investment.
 Ignores timing of returns and time value of money
Forecasted net income (in millions of cash)
Investment
2018 2019 2020 2021 Total
New branch 400 800 900 900 3,000
New product 900 900 800 400 3,000

Which investment is attractive to the firm in terms of net income?

 Ignores cash flows available to shareholders – cash is means of transferring
wealth to shareholders
o Profits do not necessarily result in cash flows available to the stockholders.
 Ignores risk – the chance that actual outcomes may differ from those expected
Maximization of profit vs. maximization of wealth
Vague vs clear
Ignoring time value of money vs. considering time value of money
Increasing efficiency to maximize profit vs. increasing values of shares
Ignoring risk/uncertainty vs. considering risk inherent in company business
model
Short-term profit maximization vs. long-term maximization of value of equity
Goal of a firm
maximize wealth of shareholders measured in terms of share/stock price
Maximizing—or at least maintaining—value is necessary for the long-run survival
of the corporation.
Financial managers add value whenever the corporation can invest to earn a higher
return than its shareholders can earn for themselves.
If we ask managers to maximize value, can the corporation also be a good citizen?
Won’t the managers be tempted to try unethical or illegal financial tricks?
 Basis Wealth Maximization Profit Maximization
It is defined as managing It is defined as the
financial resources to increase management of financial
Definition
the value of the company’s resources to increase the
stakeholders. company’s profit.
Focuses on increasing the value Focuses on increasing the profit
Focus of the company’s stakeholders of the company in the short
in the long term. term.
It considers the risks and It does not consider the risks
Risk uncertainty inherent in the and uncertainty inherent in the
company’s business model. company’s business model.
It helps achieve a larger value It helps achieve efficiency in the
of a company’s worth, which company’s day-to-day
Usage
may reflect in the company’s operations to make the
increased market share. business profitable.
 Basic types of decisions/areas of concern within scope of financial management

Investment Financing
1.long-term = capital budgeting 1.long-term financing = capital structure
2.short-term = working capital management 2.profit distribution = dividend + retained
profit
Definition
Process of planning and managing long-term investment/investment in non-current assets
Decision to invest in tangible or intangible assets.
o Involves evaluating the size, timing, and risk of future cash flows
Investment decisions spend money.
Decision criteria
return on investment > cost of financing investment

Questions
What investment opportunities are there?
How much do they cost?
What is the level of risk and return?
Which ones shall a firm undertake?
Definition
Mixture of long-term debt and equity maintained by a firm to finance its operations…or
The choice between debt and equity financing …………………the capital structure decision.
Decision on the sources and amounts of financing
o Involves evaluating type of source, period of financing, cost of financing and the returns
thereby
Financing decisions raise money for investment.
Decision criteria
Cost of finance – least expensive source of finance/risk of bankruptcy

Questions
What long-term sources of finance are available for a firm?
What mixture of equity and debt is best/how much to borrow?
What are the least expensive sources of funds for the firm?
How and where to raise the money?
Definition
Working capital refers to a firm’s short-term assets, such as inventory, and
its short-term liabilities, such as money owed to suppliers.
a day-to-day activity that ensures that the firm has sufficient resources to
continue its operations and avoid costly interruptions.
o deciding on the optimal balances of current assets and current
liabilities
Decision criteria
Impact on liquidity vs. profitability
Question: how are working capital and liquidity/risk and working capital and
profitability relate?
Questions
How much cash and inventory should we keep on hand?
Should we sell on credit? If so, what terms will we offer, and to whom will we
extend them?
How will we obtain any needed short-term financing? Will we purchase on
credit, or will we borrow in the short term and pay cash? If we borrow in the short
term, how and where should we do it?
Shall we invest in short-term equity/debt securities? Shall we issue short-term
debt securities?
Definition
Process of evaluating allocation of profit between dividends and retained earnings

Decision criteria
Signal to the market/investors – thus, market value of shares
Fund requirement for expansion
Profit nd
e
Questions ivid
D
Shall we pay dividends, how much and when?
Shall we retain profit and reinvest it, how much and why?
What are the consequences of not paying dividend and not retaining profit?
How do financial management decisions affect goal of a firm?
Capital budgeting
Working capital management
Capital structure
Profit distribution
Sole-proprietorship Partnership
owned by one person more than one owners/partners
not a legal entity not a legal entity
unlimited liability unlimited liability to general partners
limited life liability limited to equity for limited
ownership transfer needs sale of entire partners
business limited life e.g., withdrawal of general
difficult to raise additional investment fund partner
difficult to transfer ownership
difficult to raise additional investment fund
Corporation  limited liability
legal entity/artificial person  unlimited life
do business in its own name  easy to raise additional funds
one/more owners (individuals or entities)  dual taxation (profit earned vs. dividends
separate ownership and management paid)
ownership divided into transferable units/  agency problem
shares
Which of the financial management decisions are applicable to a
1.Sole-proprietorship
2.Partnership
3.Corporation
How and why?
Definition
Sole proprietors face no conflicts in financial management.
o They are both owners and managers, reaping the rewards of good decisions and hard work and
suffering when they make bad decisions or slack off.
For large corporations, separation of ownership and management is a practical
necessity.
o Managers are agents for stockholders and are tempted to act in their own interests rather than
maximizing value.
 E.g. they may shy away from valuable but risky investment projects because they worry
more about job security than maximizing value.
 Agency relationship – relationship between principal and an agent
 shareholders vs. management; creditors vs. management
 shareholders vs. auditors; management vs. lower level employees
 Agency problem – conflict of interest between management and shareholders
 stakeholders – parties other than management and shareholders with interest in
a corporation e.g., employees, customers, suppliers/creditors, regulatory bodies,
general public, etc.
 Agency cost – Value lost from agency problems or from the cost of mitigating
agency problems.
 direct – management incentives/bonus, monitoring costs (e.g., auditor fees)
 indirect – loss of wealth due to suboptimal behavior of managers
Do you think managers will act in the best interest of stockholders/shareholders?
Why?
Managers are human beings, not perfect servants who always and everywhere
maximize value.
Causes
separation of ownership and management
o incompatible interest
o management may not act in the best interest of owners
o management may pursue its on goal at owners’ expense
How could agency problem be managed?
 Agency problems are controlled in practice in three ways:
1. Corporations set up internal controls and decision-making procedures to prevent wasteful
spending and discourage careless investment
2. Corporations try to design compensation schemes that align managers’ and shareholders’
interests
 incentives/compensation plans e.g., performance based bonus and share purchase
3. The corporations are constrained by systems of corporate governance.
• How corporate governance helps to align the interests of managers and shareholders.
 Legal Requirements… Good governance requires laws and regulations that protect investors from self-
dealing by insiders.
 Boards of Directors
 threat of firing e.g., through vote
 shareholders board of directors hire/fire managers
 threat of takeover – poorly managed firms more attractive for takeover because a greater profit
potential exists
 A shareholder activist
o direct intervention by shareholders e.g., institutional investors
The compensation packages of top executives are almost always tied to the
financial performance of their companies.
The package typically includes a fixed base salary plus an annual award tied to earnings or other
measures of financial performance.
compensation is not all in cash, but partly in shares.
Well-designed compensation schemes alleviate agency problems by encouraging
managers to maximize shareholder wealth.
Eg. Stock options
1. What are the basic areas of finance?
2. What are the basic types of financial management decisions, and what
questions are they designed to answer?
3. What are the three major forms of business organization?
4. What is the goal of a firm?
5. What are the objectives of financial management?
6. What are agency problems and how could they be managed?
7. Why do agency problems prevail within a corporation?
8. What are agency costs?
Understand purposes of financial analysis
Understand the tools for financial analysis
Common size financial statements
Comparative financial statements
Trend analysis
Ratio analysis
Calculate and interpret key measures of operating efficiency, leverage, liquidity,
profitability, and market value.
Show how profitability depends on the efficient use of assets and on profits as a
fraction of sales.
 Definition
 financial reports providing information about financial performance & financial
position
 contain information useful to make investment/credit decisions
 Types
 annual (yearly) versus interim (covering less than a year e.g., quarterly)
 consolidated, unconsolidated versus combined

 Accrual accounting = revenues and expenses are booked when they are incurred,
regardless of when they are actually received or paid.
 Components of basic financial statements/annual report
1. Statement of comprehensive income .
o It tells you whether a company is making a profit or
o It indicates how much profit or loss a company generates over a period of time
2. Statement of financial position .
o It gives a snapshot of the company’s financial situation.
o It tells you how efficiently the company is utilizing its assets and how well it is managing its
liabilities in pursuit of profit.
3. Statement of changes in owners’ equity
4. Statement of cash flows .
o Tells where the company’s cash comes from and where it goes.
• i.e the flow of cash in, through, and out of the company.
o It tells you whether a company is turning profits into cash.
5. Notes to financial statements
are a required, integral part of a company's external financial statements.
are used to explain the assumptions used to prepare the numbers in the financial statements
as well as the accounting policies adopted by the company.
6. Audit report
Financial analysis refers to an assessment of the viability, stability, and profitability
of a business, sub-business or project.
The primary purpose of financial analysis is
……..to determine how a business is performing in specific areas, such as:
o Efficient utilization of assets,
o Managing liquidity,
o Managing debt,
o managing cash flow, and
o collecting accounts receivable in a timely fashion
Individual investors or firms that are interested in investing in businesses use
financial analysis techniques in evaluating target companies' financial information.
Financial statements, by themselves, tells you quite a bit:
How much profit the company made, where it spend its money, how large its debts are….and so on.
But, how do you interpret all the numbers these statements provide?
Is the company’s profit small or large?
Is the level of debt healthy or not?
That is why we employ the financial analysis tools.
 Definition
 gathering and examining financial data to evaluate health of a firm
o liquidity – ability to meet current financial obligations
o financial flexibility – ability to exploit business opportunities
o solvency – confidence that the entity will survive/sustain doing business
o profitability/earning power – ability to earn return on investment
o efficiency – ability to efficiently utilize economic resources/assets
o market value – firm’s value relative to the market
 used as bases for investment/credit decisions, firm valuation and regulation
 Lenders (trade creditors) – interested to determine ability of a firm to pay its
debts
 Shareholders/investors – concerned with present and future profitability of a
firm
 Employees – concerned with financial status of their employer/firm
 Regulatory agencies – concerned with financial health and performance of a
firm/industry
 Management – interested in every aspect of financial analysis/a firm
 Horizontal – analysis
o relationships between elements of financial statements over multiple periods
o [changes] in elements of financial statements over multiple periods
 Vertical – analysis
o relationships between elements of financial statements within a give period
 Ratio analysis
 establishing meaningful relationship between two/more elements of
financial statements
 Comparative analysis
 comparing elements of financial statements over multiple periods
 Common-size analysis
 expressing each item on statement of financial position as a % of total
assets
 expressing each item on statement of financial performance as a % of
sales
 Trend analysis
 analyzing financial ratios over time to estimate likelihood of
improvement or deterioration
 Cash flow analysis
 analyzing inflows and outflows of actual cash (cash and cash
equivalents)
 summarizing operating, investment and financing cash flows
 shows short-term position of a firm
 Fund flow analysis
 analyzing changes in working capital
 shows long-term position of a firm
 Definition
 Provides a means of digging deeper into the information contained in the
financial statements.
 establishing relationship among elements of FS to evaluate performance by
comparing ratios of a firm
 over several years (a time-series comparison/trend/horizontal analysis)
 to that of other firms in the industry (cross-sectional comparison)
 to some absolute benchmark/industry norms assessing relationship among
elements of financial reports
 with its planned/budgeted amounts
 Definition, purpose and implications
 relationship between current assets and current liabilities
 measures ability of a firm to meet its current financial obligations
 lower ratios imply liquidity problems while higher ratios may imply
inefficiency in using assets (see activity ratio)
 Types and formula
a) current ratio
the prime measure of how solvent a company is.
it’s so popular with lenders……called banker’s ratio.
the higher the ratio, the better financial condition a company is in.

Total current assets – prepaid expenses

Current ratio = CR=?
Total current liabilities
b) quick/acid test
 Measures the ratio of a company’s assets that can be quickly liquidated and used to pay debts.
 Called acid-test ratio because it measure’s a company’s ability to deal instantly with its
liabilities
 Ability to pay obligations without relying on sales of inventories
o excludes inventory because they are least liquid

QR=?

c) Cash ratio
 Definition, purpose and implications
 also called asset management ratios
 measures efficiency of a firm in using and managing its resources to
generate maximum possible income
 higher ratios imply efficiency while lower ratios imply inefficiency
 Types and formula
a) accounts receivable/debtors turnover ratio (efficiency)
 number of times accounts receivable are generated and collected
 higher ratio imply efficiency in managing receivable (e.g., strict credit
follow-up) and/or strict credit policy adversely affecting sales

ARToR=?
b) receivable collection period/Days receivables
 number of days it takes to covert accounts receivable into cash
 How long it actually takes a company to collect what it’s owed?

ARCP= ?
c) inventory turnover (efficiency)
 number of times inventory is sold/consumed
 higher ratio implies efficiency in managing inventories, lost sales
opportunities due to inadequate inventory caused by production
problems/poor sales forecasting/weak coordination between sales
and production activities within a firm
 lower/declining ratio suggests a firm has continued to build up
inventory, weakening demand or may be carrying/reporting outdated/
obsolete inventory
IToR=?
d) inventory period/Days inventory
Measures how long it takes a company to sell the average amount of inventory
on hand during a given period of time.
The longer it takes to sell inventory, the more the company’s cash gets tied up
and the greater the likelihood that the inventory will not be sold at full-value.

IP=? days
e) accounts payable/creditors turnover
 number of times accounts payable are generated and paid
 lower ratio is better given that the firm timely pays its bills and satisfies
its financial obligations to its supplier

APToR=?
f) Working capital turnover ratio
 measures how effective a firm is at generating sales for every dollar of
working capital put to use

WCR=?
g) accounts payable payment period
 tells you how many days it takes to pay its suppliers
o number of days it takes to settle accounts payable
o The more days it takes, the longer a company has the cash to work with.
 longer payment period is preferred because accounts payable are cheaper source
of funds

APPP=? days
h) fixed asset turnover ratio
 indicates management’s effectiveness in using net fixed assets to generate sale
 fixed assets refer to property, plant and equipment

FAToR=?

i) total asset turnover ratio

 Shows how efficiently a company uses its assets

TAToR=?
 Definition, purpose and implications
 also called debt management/leverage ratio
 leverage = use of debt in financial structure
 This ratio tell you how, and how extensively, a company uses debt.
 indicates the relative mix of debt and equity financing
 measures long-term debt paying ability & financial viability of a firm
 increases potential reward to shareholders and potential for financial distress
and business failure
 Types and formula
a) debt ratio
 indicates percentage of total assets financed by debt
 affects financial flexibility (i.e., operating/investing/financing decision)

DR=?

b) debt-equity ratio

D-ER=?
c) interest coverage ratio/Times interest earned
 Measures a company’s margin of safety
o How many times over the company can make its interest payments
 indicates ability of a firm to make contractual interest payments

c) equity multiplier
 measures how much of a firm’s assets are financed through stockholders' equity

EM=?
 measures a company’s level of profitability by expressing sales and profits as a
percentage of various other items.
 measure earning power of a firm
 measure how efficiently a firm uses its assets and manages its operations
 measure management’s ability to control expenses in relation to sales
 the combined effects of liquidity, asset management, and debt management on
operating results
 reflect a firm’s operating performance, riskiness, and leverage
 Types and formula
a) gross profit margin
 measures gross profit earned from each birr/dollar sales
 shows relationship between sales and cost of sales
 percentage of each birr/dollar sales remaining after covering cost of sales

GPM=?
c) Operating profit margin
 is a way to measure how sales translate into bottom-line profit.
 measures income earned from operating activities of a firm
 income left after covering all costs and expenses excluding non-operating
income and expenses (e.g., interest, taxes, gains, losses, etc.)

OPM=?
d) Return on assets (ROA)/return on investment (ROI)
 provides quantitative description of how well a company has invested in its
assets
 measures income earned per each birr/dollar asset
 shows net profit generated from each dollar invested in total assets
 product of ability to generate net income per each dollar sale and effective use
of total assets to generate net sales
e) Return on equity (ROE)
 an accounting measure of maximization of wealth of shareholders
 shows the return on the portion of the company’s financing that is provided by
shareholders
 product of how profitability a firm employs its assets and the extent of which the
assets are financed through shareholders' equity
f) Earnings per share (EPS)
 shows profitability of a firm relative to its outstanding shares
A breakdown of ROA and ROE into component ratios.
 management efficiency in generating income from total assets
 financial leverage – use of equity to finance assets
 net profit margin – profit generated as a percentage of revenue/sales
 total assets turnover ratio – measures effective use of assets to generate
revenue/sales
 Definition, purpose and implications
 provide information on value of a firm relative to market
 assumes a publicly traded stock
 Types and formula
a) price-earnings ratio
 indicates how much investors are willing to pay per dollar of earnings
for shares of the firm’s
 indicates how the market perceives firm’s growth/profit opportunity
b) market-to-book value ratio
Ratio of market value of equity to book value of equity.
measures how much value a firm has created for its shareholders.
c) dividend yield/dividend-price ratio
 shows how much a firm pays out in dividends each year relative to its
share price

d) dividend payout ratio

 shows percentage of a firm’s per share earnings paid out as cash
dividends
 lack of meaningful industry average – e.g., firms operating different
divisions in different industries
 use of industry average ratios as benchmarks – setting goals for high-level
performance needs benchmarking on industry leaders’ ratios
 inflation – ratio analysis for one firm over time or a comparative analysis of
firms of different ages can be distorted by inflation
 seasonal factors – can distort a ratio analysis making comparison difficult
 uses of different accounting practices – can distort comparisons
 employing “window dressing” techniques – to make financial statements
look stronger
 e.g., a company
 takes out a 2-year Birr10,000,000 loan towards end of its fiscal year (Dec
25)
 total current asset before loan = Birr100,000,000
 total current liabilities before loan = Birr58,000,000
 compute current ratio before and after taking the loan
 if the company pays the loan back in January, then the transaction was
strictly window dressing
 Qualitative factors
 Revenues per key customers/key product
 Supplies of goods/services per key supplier
 Reliance on single customers, products, or suppliers increases risk
 Percentage of the company’s overseas business
 Exposure to risk of currency exchange volatility and political instability
 Probable actions of current competitors and likelihood of additional new
competitors
 Do prospects of the firm depend critically on the success of products
currently in the pipeline or on existing products?
 How does the legal and regulatory environment affect the company?