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Finance Basics

Rania A. AzmiE-mail: rania.a.azmi@gmail.com

University of Alexandria, Department of Business Administration

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Finance

• Finance can be thought of as the study of the following three questions:

1- In what long-lived assets should the firm invest?

2- How can the firm raise cash for required capital expenditures?

3- How should short-term operating cash flows be managed?

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Financial Statement Analysis

• The objective is to show how to rearrange information from financial statements into financial ratios that provide information about five areas of financial performance:

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Financial Statement Analysis (Cont.)

1. Short-term solvency

2. Activity

3. Financial Leverage

4. Profitability

5. Value

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Short-Term Solvency

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Short-Term Solvency

• Ratios of short-term solvency measure the ability of the firm to meet recurring financial obligations (that is, to pay its bills).

• The most widely used measures of accounting liquidity are the current ratio and the quick ratio.

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Short-Term Solvency

• Current ratio= Total current assets/ Total current liabilities

• Quick ratio= *Quick assets/ Total current liabilities

* Quick assets= Total current assets- inventories

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Activity

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Activity

• Ratios of activity are constructed to measure how effectively the firm’s assets are being managed.

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Activity

• Total asset turnover= Total operating revenues/ Total assets

• This ratio is intended to indicate how effectively a firm is using all of its assets. If the asset turnover ratio is high, the firm is presumably using its assets effectively in generating sales.

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Activity

• Receivables Turnover= Total operating revenues/ Receivables

• Average collection period= Days in period(365)/ Receivables turnover

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• The receivables turnover ratio and the average collection period provide some information on the success of the firm in managing its investment in accounts receivable.

• The actual value of these ratios reflects the firm’s credit policy. If a firm has a liberal credit policy, the amount of its receivables will be higher than would otherwise be the case.

• One common rule of thumb that financial analysts use is that the average collection period of a firm should not exceed the time allowed for payment in the credit terms by more than 10 days.

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Activity

• Inventory Turnover= Cost of goods sold/ Inventory

• The inventory ratio measures how quickly inventory is produced and sold. It is significantly affected by the production technology of goods being manufactured.

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Financial Leverage

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Financial Leverage

• Financial leverage is related to the extent to which a firm relies on debt financing rather than equity.

• Measures of financial leverage are tools in determining the probability that the firm will default on its debt contracts. The more debt a firm has, the more likely it is that the firm will become unable to fulfill its contractual obligations (too much debt can lead to a higher probability of insolvency and financial distress).

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Financial Leverage

• Debt ratio= Total debt/ Total assets

• Debt-to-equity ratio= Total debt/ Total equity

• Equity multiplier= Total assets/ Total equity

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Financial Leverage

• Debt ratios provide information about protection of creditors from insolvency and the ability of firms to obtain additional financing for potentially attractive investment opportunities.

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Financial Leverage

• Interest Coverage= Earnings before interest and taxes/ Interest expense

• Interest expense is an obstacle that a firm must surmount if it is to avoid default. The ratio of interest coverage is directly connected to the ability of the firm to pay interest.

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Profitability

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Profitability

• Profitability ratios measure the extent to which a firm is profitable.

• The most important conceptual problem with accounting measures of profitability is they do not give us a benchmark for making comparisons.

• In general, a firm is profitable in the economic sense only if its profitability is greater than investors can achieve on their own in the capital markets.

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Profitability

• Net profit margin= Net income/ Total operating revenues

• Gross profit margin= Earnings before interest and taxes/ Total operating revenues

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Profit Margins

• In general, profit margins reflect the firm’s ability to produce a product or service at a low cost or a high price.

• Profit margins are not direct measures of profitability because they are based on total operating revenue, not on the investment made in assets by the firm or the equity investors.

• Trade firms tend to have low margins and service firms tend to have high margins.

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Profitability

• Net Return on Assets= Net income/ Average total assets

• Gross return on assets= Earnings before interest and taxes/ Average total assets

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Profitability

• One of the most interesting aspects of return on assets (ROA) is how some financial ratios can be linked together to compute ROA. One implication of this is usually referred to as the DuPont system of financial control.

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Profitability

• Return on Equity (ROE)= Net income/ Average stockholders’ equity

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Profitability

ROE= Profit margin * Asset turnover * Equity multiplier

= (Net income/ TOR* ) * (TOR/ ATA * *) * (ATA/ ASE* * * )

* TOR: Total Operating Revenue

** ATA: Average Total Assets

*** ASE: Average stockholders’ equity

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Value

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Value

• One very important characteristic of a firm that cannot be found on an accounting statement is its market value.

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Value

1- Market price

2- Price-to-earnings (P/E) ratio

3- Dividend Yield

4- Market-to-book (M/B) value ratio

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Value

1- Market price: The market price of a share of common stock is the price that buyers and sellers establish when they trade the stock. The market value of the common equity of a firm is the market price of share of common stock multiplied by the number of shares outstanding.

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Value

2- Price-to-earnings (P/E) ratio: One way to calculate the P/E ratio is to divide the current market price by the earnings per share of common stock for the latest year.

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Value

3- Dividend Yield= Dividends per share/ Market price per share.

Dividends yields are related to the market’s perception of future growth prospects for firms. Firms with high growth prospects will generally have lower dividend yields.

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Value

4- Market-to-book (M/B) value ratio:

It is calculated by dividing the market price per share by the book value per share.

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Conclusions

Accounting statements provide important information about the value of the firm.

Financial analysts and mangers learn how to rearrange financial statements to squeeze out the maximum amount of information.

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Conclusions (Cont.)

You should keep in mind the following points when trying to interpret financial statements:

1- Measures of profitability such as return on equity suffer from several potential deficiencies as indicators of performance. They do not take into account the risk or timing of cash flows.

2- Financial ratios are linked to one another. For example, return on equity is determined from the profit margins, the asset turnover ratio, and the financial leverage.