Introduction to
Finance
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What is Finance?
Finance is a broad term that describes two related activities: (1) the study of how money
is managed and (2) the actual process of acquiring needed funds.
Three sub-categories: personal finance, corporate finance and public finance.
All three categories are concerned with activities such as pursuing sound investments,
obtaining low-cost credit, allocating funds for liabilities, and banking.
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Importance
Decisions made without properly understanding relevant financial implications may lead to reduced profits - or even losses – as well as a reduction in stakeholder value.
For example, what if a manager doesn’t manage cash effectively, runs out of cash, and can’t
pay their employees on time?
By raising financial awareness, managers are better able to manage the businesses’
revenues, costs, profits, and cash and individuals are better able to make educated
investment decisions.
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Accounting- a Key to Manage
Finances
“the system of recording and summarizing business and
financial transactions and analyzing, verifying, and reporting
the results”
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Three Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
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Importance of Financial Statements
Information on the changes in a business’s performance and financial position that can
be used to make financial and operating decisions, both within and outside the business.
Financial statements are the medium by which a business discloses information
concerning its financial performance.
Analysts use financial reports to forecast a business’s ability to generate future earnings
and to assess the business’s value or worth.
Banks, investors, and creditors use financial reports to evaluate a business’s economic health.
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Five key terms in Accounting and
Finance
Revenue or Income: money the company earns from its sales of
products or services, and interest and dividends earned from
marketable securities
Expenses: money the company spends to produce the goods or services that it sells (e.g. office supplies, utilities, advertising)
Assets: tangible and intangible items that the company owns that
have value (e.g. cash, computer systems, patents, accounts rec.)
Liabilities: money that the company owes to others (e.g. mortgages,
vehicle loans, accounts payable)
Equity: that portion of the total assets that the owners or stockholders of the company fully own; have paid for outright
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Three types of Financial Statements
Income Statement
The income statement measures a business’s performance over a specific
time frame
Balance Sheet
The balance sheet represents a record of a business’s assets, liabilities and
equity at a particular point in time
Think of the balance sheet as a snapshot of a business’s performance
Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows
and outflows over a period of time.
The cash flow statement is important because it's very difficult for a
business to manipulate its cash situation; many investors use the cash flow
statement as a conservative measure of a business’s performance.
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#1.) Income Statement
This statement contains the numbers most often discussed when a business
communicates its performance – numbers such as revenue, earnings, and earnings
per share
Put simply, this statement shows how much money came into the business
(earnings/revenue) and how much money went out of the business (costs/expenses)
When it comes to analyzing financial statements, the income statement lets investors
know how well the business is performing
Ideally, businesses ought to bring in more money (earnings/revenue) than they spend
(costs/expenses), or they won’t stay in business very long
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Income Statement- Revenue Side
The best revenue are those that continue year in and year out; temporary
revenue increases, such as those that might result from a short-term promotion,
are less valuable and should garner a lower price-to-earnings ratio for any given
business
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Revenue, also commonly known as sales and sometimes turnover, is generally the most
straightforward part of the income statement
Often, there is just a single number that represents all the money a business brought in during a
specific time period, although larger businesses sometimes break down revenue by business
segment or geography
The best way for a business to improve its profitability is by increasing sales revenue
Revenue Examples
Sales - for many businesses, such as retail stores and manufacturing businesses,
most revenue is from the sale of goods
Services - service businesses, such as law firms and barber shops, receive most of
their revenue from rendering services
Fees and Interest - lending businesses, such as car rentals and banks, receive most of their revenue from fees and interest generated by lending goods or assets to
other organizations or individuals
Commissions – in some businesses, such as real estate, revenue may be earned through commissions
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Income Statement- Expenses Side
There are many kinds of expenses, but the two most common are
(i)the cost of goods sold (COGS)
(ii) selling, general and administrative expenses (SG&A)
Cost of goods sold represents the costs of producing the goods or services sold by the business
For example, if Starbucks pays a supplier $1 per pound of coffee, which it then sells to its customer for $10 per pound, it’s cost of goods sold for each pound of coffee would be $1
Selling, general, and administrative costs represent costs involved in operating the business involve wages and salaries, marketing, utilities, technology expenses and other general costs associated with running a business
SG&A also includes depreciation
Depreciation is a reduction in the value of an asset with the passage of time, (e.g., wear and tear).
There are also financial costs, such as taxes and interest payments.
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Expenses Examples
Rent – office space, storage, retail areas
Utilities – electricity, telephone, internet services
Insurance – healthcare and unemployment coverage for employees
Fees – business registrations and renewals, accountant fees, attorney fees
Wages – workers’ pay and benefits
Taxes – local, provincial, federal, and property taxes
Interest – the cost of borrowing money or interest for loans, credit, or mortgages
Supplies – paper, pens, folders, paper clips, and ink cartridges
Depreciation – office equipment that depreciates over time (i.e. computers, copiers, fax
machines, vehicles, tractors, and trailers)
Maintenance – the cost of cleaning work areas and repairing equipment
Travel, Meals, and Entertainment – travel expenses, entertaining employees and clients
Training – courses, books, seminars, and continued education
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Profits
Profit, most simply put, is equal to total revenue minus total expenses
However, there are several commonly used profit subcategories that tell investors how
the business is performing
Gross profit is calculated as revenue minus cost of sales
Returning to the Starbucks example, the gross profit from the sale of a pound of coffee
would be $9 ($10 sales price less the $1 cost of goods sold = $9 gross profit)
Operating profit is equal to revenues minus the cost of sales and SG&A (but not financial)
This number represents the profit a business made from its actual operations; in other words,
it is equivalent to revenues minus the cost of rent, wages, utilities, marketing, etc.
Net income represents the business’s profit after all expenses, including financial expenses,
have been paid
This number is often called the "bottom line" and is generally the figure people refer to
when they use the word "profit" or "earnings“; it is equivalent to the operating profit minus
financial expenses
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Net Income /EBITDA Net Income is also referred to as EBITDA; EBITDA: it sounds scary, but it isn’t…
EBITDA = earnings before interest, taxes, depreciation (and amortization)
EBIT = earnings before interest and taxes
EBT = earnings before taxes
EBITDA = Revenue - Expenses (excluding tax, interest, and depreciation)
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Income Statement Formula
Revenue
- Cost of Goods Sold
= Gross Profit
- Operating Expenses
= Net Income Before Taxes
- Taxes
= Net Income or Net Loss
(net losses are represented in parentheses)
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EBIT = earnings
before interest
and taxes
EBT = earnings
before taxes
Minority Interest
= outstanding
shares
(financial cost)
*round
computations
to the nearest
10,000
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Group Activity – Part 1
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Group Activity: Assessing Income Statements
First, consider each company’s income statement independently
Based on a comparison of the most recent year and a previous year,
do you think the company is improving or worsening?
Second, compare companies’ income statements
Compare sales, expenses, and income of companies.
If you were an investor, which company would you invest in? Why?
Briefly share your assessments with the class.
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#2.) Balance Sheet
The balance sheet, also known as the statement of financial condition, offers a
snapshot of a business’s health
The balance sheet highlights the financial condition of a business and is an integral part
of the financial statements
This statement tells you how much a business owns (its assets), and how much it owes
(its liabilities)
The difference between what it owns and what it owes is its equity, also commonly called "net assets" or "shareholders equity“
Remember : assets – liabilities = equity
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Balance Sheet- The Assets Component
There are two main types of assets: current assets and non-current assets
Current assets are likely to be used up or converted into cash within one business cycle -
usually treated as twelve months
Three very important current asset items found on the balance sheet are: cash,
inventories and accounts receivables
Non-current assets (fixed assets) are defined as anything not classified as a current asset
This includes items that are fixed assets, such as land, buildings, other property, machinery
and equipment
Unless the business is in financial distress and is liquidating assets, investors need not pay
too much attention to fixed assets
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Current Assets
Cash: available funds
Growing cash reserves often signal strong financial performance, however, if loads of cash are more or less
a permanent feature of the business’s balance sheet, investors need to ask why the money is not being put
to use
Inventories: finished products that haven't yet sold
Inventory turnover (cost of goods sold divided by average inventory) measures how quickly the business is
moving merchandise through the warehouse to customers
Accounts Receivable: uncollected or outstanding bills
Getting money right away is preferable to waiting for it - since some of what is owed may never
get paid
The quicker a business gets its customers to make payments, the sooner it has cash to pay for
salaries, merchandise, equipment, loans, dividends and growth opportunities
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Balance Sheet- The Liabilities Component
Current liabilities and Non-current liabilities
Current liabilities are obligations the business must typically pay within a year, such as
payments owing to suppliers. Current liabilities are of two types:
Accounts payable includes the money owed to vendors for the purchase of goods and services
Notes payable includes the money owed to banks or other lending institutions; generally short-
term loans (up to one year) used to finance short-term needs
Non-current liabilities represent what the business owes in more than a year, such as bank
and bondholder debt
Generally speaking, if a business has more assets than liabilities, then it is likely in good financial health
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Balance Sheet- The Equity Component
Equity represents what shareholders own, so it is often called shareholder's equity
Equity is equal to total assets minus total liabilities
The three important equity items are paid-in capital, common stock, & retained earnings
Paid in capital (or Contributed capital) is the amount of money shareholders paid for their shares
when the stock was first offered to the public; it basically represents how much money the
business received when it sold its shares
Common stock is the stated or par value of the shares of stock that have been issued
Retained earnings are a tally of the money the business has chosen to reinvest in the business rather than pay to shareholders; investors pay close attention to how a business puts retained
earnings to use and how well it generates a return
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A balance
sheet MUST
balance!
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What’s not on the Balance Sheet
Most of the information about debt can be found on the balance sheet - but some
assets and debt obligations are not disclosed there, such as hard-to-measure
intangible assets
Corporate intellectual property (items such as patents, trademarks, copyrights
and business methodologies), goodwill and brand recognition are all common
assets in today's marketplace that are not listed on business’s balance sheet
There is also off-balance sheet debt to be aware of - this is form of financing in which large capital expenditures are kept off of a business’s balance sheet through various
classification methods
Businesses will often use off-balance-sheet financing to keep the debt levels low
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Group Activity – Part 2
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Group Activity: Assessing Balance Sheets
First, consider each company’s balance sheet independently
Based on a comparison of the most recent year and a previous
year, do you think the company is improving or worsening?
Second, compare companies’ balance sheets
Compare each assets, liabilities, and equity accounts of companies
Based on your comparison, which accounts (i.e. “Goodwill”) do
you find most concerning? Why?
Briefly share your assessments with the class.
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#3.) The Cash Flow Statement
It is closely related to matters concerning the daily
operation of a business
This statement shows where the money comes from (in-flows)
and where the money goes (out-flows) during a specified
period of time
Unlike the Income Statement or Balance Sheet, the Cash
Flow Statement shows why cash increased or decreased
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Sections of the Cash Flow Statement
Because the Cash Flow Statement shows how much actual cash a business
has generated, it is critical to understanding a business’s financials; it shows
how the business is able to pay for its operations and future growth
Businesses produce and consume cash in different ways, so the cash flow
statement is divided into three sections:
Basically, the sections on operations and financing show how the business
gets its cash, while the investing section shows how the company spends its
cash
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1. Operating Activities
2. Investment Activities
3. Financing Activities
Cash Flows from Operating Activities
This section shows how much cash comes from sales of the business’s goods and services,
less the amount of cash needed to make and sell those goods and services
Investors tend to prefer businesses that produce a net positive cash flow from operating
activities
High growth businesses, such as technology firms, tend to show negative cash flow
from operations in their formative years
Changes in cash flow from operations typically offer a preview of changes in net future income; it’s typically a good sign when cash flows are increasing
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Cash Flows from Investing Activities
This section largely reflects the amount of cash the business has spent on capital
expenditures, such as new equipment or anything else that needed to keep the business
going
Investing activities also includes acquisitions of other businesses and monetary
investments, such as money market funds
Ideally, businesses ought to re-invest capital in the business; if it doesn’t re-invest, it might
show artificially high cash inflows in the current year which may not be sustainable
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Cash Flow From Financing Activities
This section describe what’s going on with cash that is associated with outside
financing activities
Typical sources of cash inflow would be cash raised by selling stock and bonds or by
bank borrowings
Likewise, paying back a bank loan would show up as a use of cash flow, as would
dividend payments and common stock repurchases
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Cash Flow
Statement
Example
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Group Activity – Part 3
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Group Activity: Assessing Cash Flow Statement
First, consider each company’s cash flow statement independently
Compare cash flows from operating activities, investing activities, and
financing activities. Which specific accounts stand out with regard to each
company? How have these accounts changed from the most recent year to previous years?
Second, compare companies’ cash flow statements
Compare companies’ operating activities, investing activities, and financing
activities. Where is each company strong or weak compared to
their competitor? Why?
Briefly share your assessments with the class.
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Re-cap
Income Statement
Balance Sheet
Statement of Cash Flows
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Income Statement
Revenue
- Cost of Goods Sold
= Gross Profit
- Operating Expenses
= Net Income Before Taxes
- Taxes
= Net Income or Net Loss
(net losses are represented in parentheses)
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A balance
sheet MUST
balance!
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Cash Flow
Statement
Example
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Financial ratios
Profitability ratios (gives a general idea about a firm’s profitability)
An example of profitability ratios is:
Profit margin = Net income/revenue
Liquidity ratios (indicates how quickly a firm’s assets can be converted to cash)
An example of liquidity ratios is:
Receivable turnover = Net credit sales/Average accounts receivable
Solvency ratios (indicates how well can a firm deal with long term obligations and develop future assets)
An example of liquidity ratios is:
Receivable turnover = Net credit sales/Average accounts receivable
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