FINC 331-WEEK 2:Accounting
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Module 1: Finance and Financial
Performance
Topics
Introduction to Financial Management
Standard Financial Reporting
Evaluating Financial Performance
Financial Plans and Forecasts
Because it introduces the field of finance, the material in this module covers an unusually wide
spectrum of financial subjects, ranging from the definition of finance to the evaluation of
financial performance using ratio analysis.
Introduction to Financial Management
In this section, we address three important subjects in financial management. First, we critically
examine the question of what is the proper goal of the firm. Second, we examine the key
interactions between the firm and the various market entities. Third, we discuss some of the
generally recognized fundamental principals of financial management that form the foundations
of financial management analyses and decision making.
The Goal of the Firm
To measure the financial performance of a firm, it is necessary to establish a fundamental goal
against which to evaluate financial performance and financial decision making. In determining a
"proper" financial goal for the firm, three essential requirements should be satisfied. First, the
goal must be theoretically sound; second, it must be quantitative; and third, it must be easy to
apply in practice.
A review of current economic and business theory reveals two potential goals for a firm.
Traditional economic theory espouses maximizing profit, and modern finance theory advocates
maximizing shareholder wealth. Logically, there can be only one goal for evaluating financial
performance, therefore we must examine each proposed goal against the above-listed
requirements to determine which is superior.
In comparing our two candidates, it is apparent that both goals are quantitative and relatively
easy to measure and apply in decision making. The profit maximization goal would be
quantitatively measured based on accounting profit—total revenues generated less total costs
incurred. The goal of maximizing shareholder wealth would be measured by calculating the
market capitalization value—the number of shares of stock outstanding times the current market
price per share.
When examined from the perspective of theoretical validity, however, the goal of profit
maximization exhibits several significant weaknesses. Although this goal does stress the efficient
use of capital resources, by itself it is too narrow, in that it assumes away many of the financially
significant complexities of the real world. Specifically, the profit maximization goal has the
following two major weaknesses.
1. It assumes away the inherent uncertainty of the expected returns (e.g., it ignores any
consideration of risk).
2. It disregards the timing differences as to when the profits are received (e.g., it ignores the
time value of money).
As we shall see later, both of these weaknesses are critical considerations for proper financial
decision making and cannot be disregarded. Conversely, the maximization of shareholder wealth
goal does implicitly assume consideration of the time value of money, risk, and all the other
factors that are not directly profit related, but that should be considered in rational financial
decision making. Therefore, we conclude that maximizing shareholder wealth is the superior
primary goal for all businesses.
The Firm and Its Financial Environment
Fundamental to understanding finance is recognizing that the firm is the primary creator of
wealth, which it does by interacting with various sectors of the marketplace. To explain how
these basic interactions create wealth, we will develop a simplified transaction model of the firm.
This model will begin with a new startup company and trace the basic cash transactions and the
resulting counterflows of securities, goods, and services until a sustained profit generation is
achieved. In our simplified model, the worldwide marketplace will consist of the following
players:
• the firm—the creator of value-added wealth
• the investors—the source of capital
• the supply market—the source of materials, equipment, and required services
• the labor market—the source of labor
• the customers—the purchasers of the firm's goods and services
• the government—the controller of taxes
The Fundamental Principles of Finance
A set of principles of finance has been established, tested over the years, and become accepted as
the basic philosophical foundation upon which to build or test financial theories, concepts, and
formulas. These principles can be found in many texts, form the paradigm of financial theory,
and are widely used in today's business practices and academic research.
Various other academics and practitioners differ on the exact number of principles and their
precise wording. Most of these differences relate to wording and to the lower-priority principles,
where it is arguable as to whether or not the subject is of sufficient merit to warrant being called
a principle of finance. Of most significance for our study of finance, however, is the almost
universal acceptance by all recognized authorities of the three core financial principles described
below.
1. Risk-return tradeoff—This principle states that rational investors or financial managers
will not accept additional risk in an investment unless they are compensated with an
acceptable corresponding additional expected return.
This principle will be a key factor in the later development of valuation formulae for
stocks, bonds, and capital project analysis.
2. Time value of money—This principle states that a dollar today is worth more than a
dollar tomorrow because the dollar received today can be reinvested to earn money today.
This fundamental concept leads to the financial convention of bringing future expected
cash flows back to the present for comparable evaluation. This concept will be significant
in the later development of valuations of future payments, annuities, perpetuities, stocks,
bonds, and project analysis.
3. Measure cash, not profit—According to this principle, cash flows, or cash received less
cash disbursed, are the proper measures of wealth. Cash is tangible; only cash in hand can
be spent or invested. Profits are intangible, an accounting concept, and cannot be spent or
invested
Cash flows, or more specifically free cash flows, are the base currency for all financial
analysis and decision making related to maximizing wealth, be it future payments,
annuities, perpetuities, stocks, bonds, or project return.
These core principles are referenced repeatedly throughout the study of finance and explicitly
used in developing advanced financial theories, concepts, and formulas. We encourage you to
refer back to these definitions from time to time to reinforce your understanding of exactly how
the principles apply.
To summarize these principles, you could combine them into this one-sentence philosophic
financial analysis mission statement: The key determinant for most financial decision making is
the net value of the incrementally generated free cash flow stream after proper discounting for
the time value of money and adjustment to compensate for risk.
Callout
Practice Exercises
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
Complete the following practice exercises - Please go to My Tools -> Self Assessments -> to
complete this self assessment.
Standard Financial Reporting
In this section, we address one of the essentials of financial management—the ability of
management to measure and report their firm's financial performance and cash flow in a standard
and consistent manner. Finance students must have at least a working knowledge of the three
standard financial statements—the income statement, the balance sheet, and the cash flow
statement—because they are the primary sources of information regarding a firm's financial
performance.
In addition to understanding financial performance, as presented in the financial statements, you
must also understand and be able to measure the firm's free cash flows. Referring back to core
financial principal 3, "Measure cash, not profit," you must be able to reconcile the difference
between the two accrual-based accounting statement reports, the income statement and balance
sheet, and the calculation of free cash flows. We stress principle 3 because the discipline of
finance uses cash exclusively in analysis and decision making.
The Standard Financial Statements
Three basic financial statements, together, suffice to report the financial health of the firm. These
statements are prepared in accordance with Financial Accounting Standards Board (FASB) pronouncements and Generally Accepted Accounting Principles (GAAP), and normally are
independently audited for conformance with these requirements. Each statement serves a specific
purpose. The purpose of the income statement is to report the firm's net income or loss over a set
period of time—usually a month, a quarter, or a year. The purpose of the balance sheet is to
show the firm's assets, liabilities, and residual or owners' equity at a certain time. The purpose of
the free cash flow statement is to show the net change in actual cash, or the free cash flow,
generation or loss, over a period of time.
Reemphasizing, the income statement and cash flow statements, respectively, report earnings and
cash generated during a period of time, and the balance sheet reports asset, liability, and equity
positions at a specific time. Again, the income and cash generation represents the flow of activity
between two balance sheet positions. We will now describe each of these three standard financial
statements and illustrate them in a minipresentation.
The Income Statement—Measuring a Firm's Profits and Losses
The income statement reports the firm's net income or net loss (profit or loss) results obtained
from operating the business over a set period of time, typically a month, quarter, or year. Other
common names for the income statement are the profit and loss statement (P&L) and the
earnings statement. The income statement begins by identifying all sources of revenue for the
period and then sequentially subtracts all the costs that were incurred in generating that revenue.
Normally, the income statement comprises five major categories, one related to revenue and four
related to costs and expenses as shown below:
1. revenues—the proceeds from selling the product(s) or services(s)
2. costs—the costs of producing or acquiring the product(s) or service(s)
3. period expenses—the expenses incurred in marketing, administration, and R&D
4. interest—the financing costs of debt financing
5. taxes—the taxes owed based on a firm's taxable income
The Balance Sheet—Measuring a Firm's Book Value
The balance sheet provides a snapshot of the firm's financial position at a specific time and
presents the firm's asset holdings, liability obligations, and owners' residual equity as of that
time. It is important to recognize that the balance sheet is an algebraic equation that relates and
balances the three components—assets, liabilities, and equity. In traditional accounting format,
the fundamental accounting equation is presented as follows:
Assets = liabilities + equities
Succinctly, this equation states that at any point in time the value of the firm's assets must be
exactly equal to the value of its liabilities and equity. For a more intuitive understanding, it is
sometimes helpful to algebraically rearrange this equation to read as follows:
Assets – liabilities = equities
Interpreting the rearranged equation, we can now more clearly interpret the meaning of equity.
Equity is the residual value the owners can claim after the value of all the liability obligations
has been subtracted from the value of the firm's assets. It is important to note that the balance
sheet measures "book" value and is not intended to represent the current market value of the
firm. Under the accounting rules, the balance sheet records the value of all assets, liabilities, and
equities at their historical purchase cost at the time of acquisition.
Assets
Assets represent the historical value of all the resources the firm owns. There are three categories
of assets in the balance sheet. These assets are listed in sequence based on the amount of time
that is expected to pass before they can be converted to cash.
1. Current assets, by definition, have an expected conversion life of less than one year.
Included in current assets are cash, marketable securities, accounts receivable,
inventories, and prepaid expenses. All of these assets are considered to be liquid, which
means they can quickly be converted into cash if required.
2. Fixed or long-term assets, by definition, have an expected conversion life of more than
one year. Included in fixed assets are equipment, buildings, and land. These assets are
considered nonliquid because normally they cannot be quickly converted into cash.
3. Other assets is a default category that includes all the firm's remaining assets not
otherwise included in the current assets or fixed assets categories. Typical examples of
other assets are patents, long-term investments in securities, and goodwill.
Liabilities
Liabilities represent legal financial obligations of the firm. There are two major categories of
liabilities in the balance sheet. They are listed in sequence based on the amount of time that is
expected to pass before they can be liquidated through the payment of cash. These obligations
are normally incurred either from trade credit received from suppliers in the course of normal
business or from the firm's use of debt financing to procure company assets.
1. Current liabilities, by definition, have an expected conversion life of less than one year.
Included in current liabilities are accounts payable, taxes payable, and short-term debt
financing obligations that must be paid within one year.
2. Long-term liabilities, by definition, have an expected conversion life of more than one
year. Included in long-term liabilities are long-term notes and long-term bond
obligations.
Equity
Equity includes the stockholders' investment in the firm, both capital at par and additional paid-
in capital, and the cumulative profits and losses retained in the business from its inception up to
the date of the balance sheet.
The Cash Flow Statement and the Concept of Free Cash Flows
Although an income statement measures a company's profits, as stated earlier, the reported
profits are not the same as cash. Accounting profit, or book profit, is calculated on a noncash
accounting accrual basis where revenues and expenses are matched in time and certain noncash
transactions such as depreciation and amortization are recorded. Under these accounting rules,
revenue is earned and cost incurred whether or not the actual cash has been received or disbursed
in that period. Therefore, in finance we require a method to translate the accrual-based
accounting profit back to its cash component. The statement that converts the accrual-based
accounting statements into a cash basis is called the free cash flow statement.
By definition, the free cash flows that are generated from the firm's operations and investments
in assets must always be equal to the free cash flows paid to or received from the company's
investor financing. Therefore, free cash flows can be calculated from two perspectives, the
operating perspective and the financing perspective.
Calculating Free Cash Flows: An Operating Perspective
A firm's free cash flows, from an operating perspective, are the after-tax cash flows generated
from operations, less the firm's after-tax cash flow investments in assets. The firm's free cash
flows for a given period can be calculated from an operations perspective using the following
three-step process:
1. Calculate the firm's after-tax cash flows from operations.
2. Subtract any investment (increase) in net operating working capital.
3. Subtract any investments in fixed assets (plant and equipment) and other assets.
Yields operating-perspective free cash flow
Calculating Free Cash Flows: A Financing Perspective
A firm's free cash flows from a financing perspective are simply the net cash flows received by
the firm's investors, or if negative, the cash flows the investors are paying into the firm. In the
latter situation, where the investors are putting money into the firm, it is because the firm's free
cash flow from operations is negative, which in turn requires an additional infusion of capital
from the investors to maintain the firm as a going concern. The firm's free cash flows for a given
period can be calculated from an investment perspective using the following two-part process:
Part 1. Calculations related to debt financing
Step 1 Calculate the interest payments to creditors.
Step 2 Add any decrease in debt principal.
Step 3 Subtract any increase in debt principal.
Part 2. Calculations related to equity financing
Step 4 Add any dividends paid to stockholders.
Step 5 Add any decrease in stock.
Step 6 Subtract any increase in stock.
______________________________________________________
Yields Financing-perspective free cash flow
As a final reinforcement when calculating free cash flows, remember that the free cash flow from
an operating perspective must equal the free cash flow from a financing perspective. This
identity can be used as one validity check to assure that your calculations are correct.
An Excel worksheet for the calculation of free cash flow.
Callout
Practice Exercises:
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
Complete the following practice exercises.
Evaluating Financial Performance
In this section, we will learn about one of the primary analytical tools commonly used to
evaluate the financial performance of the firm—financial ratio analysis. Its use provides a
financially sound, analytically powerful, and widely accepted approach for evaluating many
critical aspects of a firm's financial performance.
Over the years, many standard financial ratio formulas have been developed and employed to
evaluate various and specific aspects of a firm's financial performance. The art of this technique
now rests in organizing these ratios for effective implementation, properly applying them in
practice, and knowing the limitation of this technique. Because most textbooks cover this subject
in detail and adequately develop the theory behind each financial ratio, in this section we will
concentrate on two supplemental topics: (1) organizing the key financial ratios according to their
application and (2) providing some additional perspectives regarding the uses and limitations of
these techniques.
Organizing Financial Ratios by Application
The purpose of a financial ratio is to define a theoretically meaningful relationship between
selected activities of the firm's financial statements that can provide insight into the firm's
financial performance. Different practitioners and textbooks sometimes group the financial ratios
differently. There are at least 15–20 standard financial ratios plus variations of some of them.
Therefore, it is easy to lose sight of the forest for the trees.
Also, different practitioners and textbooks often group the financial ratios differently. One of the more logical and useful ways to group these ratios is by their ability to answer the following four
key questions related to financial performance evaluation.
1. How liquid is the firm?
2. How effective is the firm in generating profits on its assets?
3. How is the firm financing its assets?
4. Are the shareholder returns adequate?
Using these four questions, the financial ratios can be grouped by category and be readily
available to analyze a firm according to four different perspectives. Here is a detailed chart that
organizes 10 key standard financial ratio formulas by the above four perspectives.
The Uses and Limitations of Financial Ratios
Who Uses Financial Ratio Analysis?
In addition to the management of the firm, a wide variety of individuals and organizations, for a
variety of purposes, use financial ratios to evaluate the financial statements of publicly traded
firms. The following is a list of some of the major users of financial ratios and their general
purposes for doing so.
1. Investors and investment brokers use analysis to
• evaluate alternative investments' risks versus returns
• identify trends as indicators of a firm's future performance
• identify opportunities and risks in future investment
2. Banks use analysis to
• evaluate loans to firms
• evaluate loans to individuals (personal financial statements)
• establish interest rates (higher risk equals higher interest rate)
• manage clients' investment portfolios
3. Government regulatory agencies use analysis to
• evaluate new public stock issues [Securities and Exchange Commission (SEC)]
• conduct government audits [General Accounting Office (GAO)]
• establish rates for government contracting [the Defense Contract Auditing
Agency (DCAA)]
4. The firm uses analysis for
• management planning
• financial planning
• credit management (who to give trade credit and on what terms)
• shareholder reporting
• evaluating potential mergers and acquisitions
• evaluating competitors
• identifying operational problems
• assuring compliance with loan covenants (normal with bank loans)
The Use of Financial Ratio Analysis
The reliability and value of the information gained from financial ratio analysis can vary
significantly, depending on how it was conducted and on the quality and comparability of the
financial statements, which provide the financial data. By itself, a ratio is just a number and not
inherently meaningful. Stand-alone financial ratios are like stand-alone numbers. They have
limited value unless associated with other references. For an obvious example, 3 by itself means
little unless associated with some base, such as 3 degrees on the centigrade temperature scale.
The two basic approaches for meaningfully associating financial ratios are trend analysis and
comparative analysis. In fact, it is the careful integration of trend analysis with ratio analysis that
provides the single most powerful technique for evaluating financial performance. Normally,
trend analysis is performed on annual or quarterly data because public companies have to report
this information to the stockholders.
Of the two sources of data, the annual data are generally considered to be the more significant
because of the annual audit requirement. The two approaches can also be used together to
provide a more comprehensive picture of financial performance, such as "a comparative analysis
of a firm's performance against the industry average over a three-year period."
The reliability of comparative financial ratio analysis is primarily a function of the accuracy and
comparability of the two sets of source financial data. The analyst must be aware of the
following factors.
1. Different companies may use differing, but GAAP-acceptable, accounting treatments,
which can distort comparison of the financial statements and the ratios based on them.
2. Industry standards, although useful, combine many variations in accounting treatments
and may also contain inaccurate or incomplete input information from industry members.
3. It should be obvious that comparing significantly differing firms over differing time
periods will likely add such distortion as to render any analysis highly questionable.
In summary, the more comparable the financial statements and the more comparable the firms,
the more meaningful will be the results of the financial ratio analysis—and vice versa.
Financial Ratio Limitations and Cautions
Remember that financial ratios, although important, are only one piece of the financial
performance picture and are best used in conjunction with all other available financial
information. In employing financial ratio analysis, it is important to be aware of their implicit
weaknesses and limitations, as well as their explicit strengths. Be particularly aware of the
following points in using financial ratio analysis.
1. A financial ratio is only as reliable as the accuracy of the financial data.
2. GAAP accounting allows significant variation between companies.
3. Accounting data are historical and therefore may not project current performance.
4. Industry averages can contain significant dispersion and approximations.
5. Industry classifications have problems with multi-product-line companies.
6. Many firms have pronounced seasonal and cyclical variations that can affect ratios.
7. Different fiscal year endings can affect comparability.
8. Any financial ratio evaluation is relative, not absolute.
9. Firms, to the extent possible, try to look their best at reporting time.
Callout
Practice Exercises
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
Complete the practice exercises.
Financial Plans and Forecasts
In this section, we examine the critical function of financial planning. Most of management's
time is spent on addressing the crisis of the day and understanding and explaining the past
performance of the firm to themselves and other interested parties, such as the investors and the
banks. As a result, it is easy in this reaction-based environment to lose focus and direction and
become vulnerable to an unexpected future shock.
One of the key marks of superior business and financial management is the ability to project
future performance with reasonable accuracy and consistency, and to anticipate both future
opportunities and future risks in time to prepare appropriate actions or contingencies. In this
section, we expand the traditional discussion of financial planning by providing some
supplemental perspectives on the benefits, types, and methods of financial planning and by
addressing the issue of uncertainty in financial planning.
Direct Benefits of Financial Planning
Financial planning and forecasting have direct benefits—that is, the primary reasons they were
undertaken—and often some indirect and synergistic benefits, which can also be significant.
Starting with the direct benefits, there are five clear benefits to be secured from disciplined
financial planning and forecasting, which are described below.
1. Financial planning provides a clear measurement of management's performance because
the firm's actual financial performance can, and will, be compared against the firm's
planned performance. At the end of the plan, it must be remembered that: • Wall Street evaluates publicly traded firms on their performance to plan/forecast
• CEOs evaluate their managers on their performance to plan/forecast
2. Financial planning generates detailed financial projections of cash flow to determine
future financing requirements and timing.
3. Financial planning provides management a better insight into its business operations and
the expected effect of operational matters on financial performance. Properly used, this
insight can identify potential future operational opportunities and risks.
4. The more uncertain the future, the greater the need for forecasting/planning. The weaker
the firm's financial or competitive position, the greater the need for forecasting/planning.
5. Financial planning provides a solid benchmark to
• quantitatively explain actual versus plan variances
• quantify the expected effect of economic or operational factors
• identify bad financial planning assumptions or estimates
• continuously refine the financial planning process
Indirect Benefits of Financial Planning
In addition to the above direct benefits of projecting future financial performance and cash
requirements, the planning process also generates the following synergistic benefits for the firm.
1. It develops a comprehensive, coordinated set of critical business assumptions and facts
for management review.
2. It integrates economic assumptions with marketing sales plans and operating production
programs to assure a coherent, comprehensive picture of the firm's strategic and tactical
objectives.
3. It nondestructively develops and tests the viability of various business tactics and
programs designed to achieve the firm's business strategy.
Types and Methods of Financial Planning
The various types of planning, or forecasting, are generally a function of three variables, (1) the
objective of the plan, (2) the duration of the plan, and (3) the plan's requirement for accuracy and
detail. While we are concentrating on financial planning, it is important to recognize that all
plans/forecasts have both a business function component and a financial component. The types
of planning used by most firms are summarized below.
1. Long-range planning (normally five years)
• strategic business planning
• acquisition/merger planning
• long-range business planning
• capital appropriation or project planning
2. Mid-range planning (normally one-two years)
• annual budget
• financial plan
• marketing plan
• technology plan
3. Short-range planning (normally less than one year)
• quarterly forecasts/financial projections
• monthly forecasts/financial projections
• monthly, weekly, and daily cash position projections
The Basic Methodologies of Financial Planning
There are two basic methods of financial planning and forecasting, each of which has a multitude
of variations to fit a company's specific requirements and situation. The two methods are the
trend and ratio method (percent-of-sales method) and the financial modeling method. The trend
and ratio method is far too simplistic and inaccurate to be reliable for financial planning and is
seldom used in real-world decision making. Its major weaknesses are that it assumes everything
in the business varies as a constant percent of sales and that all business parameters have a linear
relationship to sales. In general, this approach becomes complex as you attempt to adjust the plan
to reality, and it is inferior in every respect to the alternative method of financial modeling.
Financial modeling uses powerful user-friendly computerized models and programs to model the
firm's business and financial transactions. These models range from simple Excel spreadsheet
models to complex custom-designed stochastic-based models. When financial planning is
combined with a sound business model, this method allows rigorous and flexible financial
planning to any degree of detail with superior accuracy.
Financial Planning under Conditions of Uncertainty
Uncertainties and risk are a fact of life in all financial and business planning, and they must be
addressed and accounted for to the extent possible. Financial planning must be able to address
uncertainty for both the anticipated potential events and for the completely unexpected events.
The following are two typical methods used in financial planning to address uncertainty and risk.
1. Contingency provision—plan for a specific known or potential event
o What-if approach—Revise the base plan for a single contingency.
o BEW approach—Prepare plans for three outcomes: best, expected, and worst.
2. General uncertainty provision—plan for multiple unknown and unexpected events
o Sensitivity analysis—This form of analysis varies selected key plan parameters
by percentages or dollars to project the financial impact of a significant incident
without identifying the specific cause. The four major key parameters are price,
sales volume, cost, and capital expenditures.
o Simulation—This approach applies probability and statistical analysis to each
key variable, which in conjunction with sophisticated computerized financial
models can be used to generate a probabilistic range of possible outcomes, based
on thousands of simulation runs.
Callout
Practice Exercises
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
Complete the following practice exercises:
1. Identify three significant benefits that the firm obtains from financial planning.
2. If you were running a financial model to determine the firm's financing requirements,
which uncertainty approach would you use? Why?
3. What are the major disadvantages of the percent-of-sales method of financial
forecasting?
