Introduction to

Finance

1

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.

3

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

5

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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