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FIN 300 CH 1-4

Fundamentals of Finance (Arizona State University)

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FIN 300

Chapter 1

Finance: the science of managing money matters

Three Areas of Finance
1. Managerial finance: concerned with the financial management of a firm
a. Buying/selling assets
b. Financing choices
c. Control costs
2. Investments: concerned with purchasing and holding assets and securities
a. Stocks and bonds
3. Financial Markets
a. Money market—short term securities are traded (stocks and bonds are not short term—treasury bills are, certificate of deposit,
CD)
b. Capital market—long term money; stock exchanges, bonds
c. Financial intermediaries—banks and credit unions
Major Principles of Finance
1. Risk—return tradeoff
a. The higher the risk, the higher the return you require
2. Time value of money—look at present and future value
3. Cash is king (not profits)—company can be profitable but not have a lot of cash (A/R and A/P)
4. Incremental cash flows
a. The change or improvement in cash flows
5. Competitive Markets
6. Efficient Capital Markets
a. Information spreads quickly and its reflected in stock price
7. Agency Issue
a. Who do manages really work for?—Stockholder is really your boss if you aren’t working for yourself
8. Tax Impact
a. Investment decisions should be viewed after tax—in the event of tax consequences
9. Diversification
a. Don't put all your eggs in one basket—safety
10. Ethics

The Financial Manager and the Firm (p.2)

 Leveraged buyout: transaction in which purchaser uses a lot of debt to help pay for the acquisition
o Managers of leveraged buyout firms are paid in a way that provides them with strong incentives to focus on value
creation—they create value by investing in companies when benefits exceed the cost, managing assets of the company
efficiently, and financing with the least expensive combination of debt and equity
The Role of the Financial Manager (p.2)
 Makes decisions in best interest of firm’s owners
 Should make decisions that maximize the value of the owner’s stock
o This helps maximize wealth (economic value of the assets someone possesses)
 Stakeholders: someone other than an owner who has a claim on the cash flows of the firm:
o Managers who want to be paid salaries and performance bonuses
o Other employees who want to be paid wages
o Suppliers who want to be paid for the goods or services they provide
o Creditors who want to be paid interest and principal
o Government which wants the firm to pay taxes
 It’s All About Cash Flows
o Productive assets: long term tangible (equipment, machinery) and intangible assets (patents, trademarks) a firm uses to
generate cash flows
o The decision making process through which the firm purchases productive assets is called capital budgeting—one of the most
important decision making processes
o Financing decisions determine the ways firms obtain and manage long-term financing to acquire and support their productive
assets. There are two basic sources: debt and equity
 Equity represents ownership in the firm—consists of capital contributions by the owners plus cash flows that have
been reinvested in the firm
o Working capital management is the management of current assets, such as money owed by customers who purchase on
credit, inventory and current liabilities
o Firms generate cash by selling goods/services—a firm is successful when cash inflows exceed outflows
 Residual Cash Flows: the cash remaining after a firm has paid operating expenses and what it owes creditors and in
taxes; can be paid to the owners as a cash dividend or reinvested in the business

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 The reinvestment of cash flows is most fundamental way businesses grow in size
o Unprofitable firms are forced into bankruptcy: legally declared inability of an individual or company to pay its creditors
 Company’s assets will be liquidated or bankruptcy will be reorganized
 Three Fundamental Decisions in Financial Management (p.4)
o Capital budgeting decisions: identifying the productive assets the firm should buy
 Long term assets
 List of productive assets management wants to purchase over a budget cycle (typically one year)
 Capital assets generate most of the cash flows for the firm and capital assets are long term in nature—they
determine success or failure of a firm
 Which productive assets should the firm purchase?
o Financing decisions: determining how the firm should finance for assets
 Long term debt and stockholder’s equity
 An advantage of debt financing is debt payments are tax deductible for many corporations but financing increases a
firm’s risk because it creates a contractual obligation to make periodic interest payments and repay the amount that is
borrowed—contractual obligations must be paid regardless if the firm is or is not making money
 Equity has no maturity and there are no guaranteed payments to equity investors—in a corporation, the board of
directors has the right to decide whether dividends should be paid to stockholders (if a dividend payment is reduced,
the firm will not be in default)—dividend payments are not tax deductible
 The mix of debt and equity on the balance sheet is capital structure—long term funds are considered capital and
these funds are raised in capital markets—financial markets where equity and debt instruments with maturities
greater than one year are traded
o Working capital management decisions: determining how day to day financial matters should be managed so that the firm
can pay its bills and how surplus cash should be invested
 Current assets and liabilities—cash, inventory, A/R
 Net working capital: the dollar difference between total current assets and total current liabilities
 Mismanagement of working capital can cause a firm to default on its debt and go into bankruptcy even though the
firm may be successful long term
 Inventory level can affect profitability
Forms of Business Organization (p. 6)
o Sole Proprietorships: a business owned by a single person
o Limited to the period that the owner is associated with the business because there is no ownership interest that can be
transferred—no stock or other interest that can be sold
o Simplest and least expensive form of business and is the least regulated—all you need is are businesses licenses required by
local and state governments
o Sole proprietor does not have to share decision making authority (advantage)
o Disadvantages: no stock or ownership interest to sell; (1) equity capital raised to finance business is limited to owner’s personal
wealth; (2) can be more costly to transfer ownership because assets of the business must be sold directly rather than indirectly
through the sale of an ownership interest in an operating business (the business must be re-established every time it is sold);
(3) because the proprietor provides all of the equity capital and manages the business, there is no separation of the management
and investment roles; (4) it is not possible to provide employees with compensation in the form of ownership interests (stock) to
motivate them; (5) unlimited liability—can lose personal wealth
o Profits flow through to the sole proprietor’s personal tax return meaning that the business does not pay taxes before profits are
distributed to the owner—not subject to income taxesprofits are not subject to double-taxation
o Partnerships: two or more owners who have joined together legally to manage a business and share it profits
o Details how much capital each person will invest, management roles, management decisions, transfer of ownership, etc.
o General partnership: all of the partners are owners of the business and active in managing it
o Limited partnership: has both general partners, who are owners and mangers, and limited partners who are owners but now
managers
o More costly than sole proprietorships because an attorney draws up and maintains partnership agreement which specifies the
nature of the relationship between partners
o Can be amended to allow for the business to continue when a partner leaves—increases liquidity
o Disadvantage of a general partnership is unlimited liability—general partner can be liable for all of the partnership’s debts
and obligations
o Unlimited liability is avoided by limited partnerships because partners can only lose the amount they have invested in the
business—the limited partners have limited liability
o Corporations: legal entity authorized under a state charter; in a legal sense it is a person distinct from its owners
o Can sue, be sued, enter into contracts, borrow money
o Can have an indefinite life
o Corporations hold majority of all business assets and generate the majority of business revenues and profits in the US—owners
of a corporation are stockholders
o More costly to start
o Advantages: (1) shares in a corporation can be sold to raise capital from investors, (2) stockholders have limited liability for
debts and other obligations—corporations are legal persons that take actions in their own names, not in the names of individual
owners

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o An S-corporation can be used by private businesses that meet certain requirements—can only have one class of stock and can’t
have more than one hundred stockholders or any stockholders that are corporations or nonresident alien investors—a C-
corporation (form used by public corporations) doesn't face these limits
 Advantages: all profits earned pass directly to stockholders—no taxes are paid at corporate level
 Disadvantage of a C-corporation: it must pay taxes on the income it earns and stockholders must pay taxes on
dividends they receive—subject to double taxation at corporate and personal level
o Can be public or private—public can raise large amounts of capital through public markets at a low cost
 Public markets: markets regulated by the Securities and Exchange Commission in which securities such as stock
and bonds are publically traded—NYSE, NASDAQ
 Privately held or closely held corporations: corporations whose stock is not traded in the public markets
o Limited Liability Partnerships and Companies (p.9)
 Limited Liability Partnership (LLP): came about because of sharp increases in professional malpractice cases—
combines some of limited liability characteristics of a corporation with the tax advantage of a partnership—generally
have more limited liability than general partners—typically not liable for any other partner’s malpractice—taxed
as personal income
 Limited Liability Company (LLC): another hybrid form of organization—provide limited liability to the people
who make the business decisions in the firm while enabling all investors to retain the flow through tax advantages of
a limited partnership
 LLPs and LLCs are flexible—can be indefinite or for a set period of time
Managing the Financial Function (p.10)
o CFO: Chief financial officer; most senior financial manger in a company—concerned with investing, financing and working capital
management decisions
o Organizational Structure
o Top position in the firm is the CEO (chief executive officer) (p.11 for table)—CFO reports to CEO
o Positions Reporting to the CFO
o Treasurer: looks after collection and disbursement of cash, investing, raising new capital, foreign exchanges, overseeing the
firm’s pension fund managers
o Risk manager: monitors and manages firms risk exposure in financial commodity markets
o Controller: chief accounting officer—prepares financial statements, maintains firm’s financial and cost accounting systems,
works with external auditors
o Internal Auditor: identifies and assess major risk facing the firm and performing audits in areas where firm might incur losses
—reports to the board of directors and CFO
o External Auditor: independent auditor that annually audits firm’s financial statements—decides if firm’s financial statements present
fairly—creditors and investors require independent audits
o The Audit Committee: sub committee of board of directors; oversees the accounting function and the preparation of the firm’s financial
statements—conducts investigations of fraud, theft, or malfeasance in firm—reports to audit committee
o Compliance and Ethics director: publicly traded companies must have a compliance and ethics director who oversees (1) a compliance
program that ensures that the firm complies with federal and state laws, (2) an ethics program that promotes ethical conduct among
executives and employees, (3) a compliance hotline, which must include a whistleblower program
The Goal of the Firm
o What Should Management Maximize?
o Problems with profit maximization
 Hard to pin down what is meant by profit
 It does not distinguish between getting a dollar today and getting a dollar some time in the future—timing of cash
flow is important
 Ignores the uncertainty or risk associated with cash flows—ignores differences in value caused by differences in risk
o Maximize the Value of the Firm’s Stock
 Value of an asset is determined by the cash flows it is expected to generate in the future
 When considering value of a firm’s stock, the following are taken into account
 The size of expected cash flows
 The timing of the cash flows
 The riskiness of the cash flows
 An appropriate goal for management is to maximize the current value of the firm’s stock
 For firm’s stock that is not publicly traded, the total value of the stockholder or partner interests in the business is
equal to the value of owner’s equitymaximize the current value of owner’s equity
 What is best for the firm’s owners also benefits other stakeholders
o Can Manager Decisions Affect Stock Prices? (p. 14)
o Yes—internal factors
 Line of business
 Financial management decisions
 Capital budgeting
 Financing the firm
 Working capital management
 Product quality and cost

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 Marketing and sales

 Research and development
 Magnitude
 Timing
 Risk
o No—uncontrollable external factors
 Wars
 Natural disasters
 Antitrust laws
 Environmental regulations
 Procedural and safety regulations
 Taxes
 Level of economic activity
 Level of interest rates
 Consumer sentiment
 Current stock market conditions
Agency Conflicts: Separation of Ownership and Control (p. 15)
o Ownership and control: in a large corporation, ownership is spread over a large number of small stockholders who may have little
control over management—managers may make decisions that benefit their own interests rather than those of the stockholders—smaller
firm owners are usually one and the same so there is not conflict of interest
o Agency Relationships: whenever one party (called the principle), hires another party (the agent), to perform some service on behalf of the
principal
o The relationship between stockholders and management is an agency relationship
o Agency Conflicts: conflicts of interest between a principal and an agent
o Do Managers Really Want to Maximize Stock Price? (p.16)
o Agency costs: the costs arising from conflicts of interest between a principal ad an agent—for example, between a firm’s
owners and its managers—managers control the money and have to opportunity to use it for their own benefit
o Aligning the Interests of Managers and Stockholders
o Board of Directors: has legal responsibility to represent stockholders’ interests—hire/fire CEOs, set compensation and monitor
performance—approves major decisions like annual capital budget
o Management Compensation: most effective means of aligning the interests of managers with those of stockholders is a well
designed compensation package that rewards managers when they do what stockholder want them to do—tie compensation
plan into performance of the firm. Usually include a base salary, bonus and some compensation tied to firm’s stock price
o Managerial Labor Market
o Other managers
o Large Stockholders
o The Takeover Market (p. 18)
 Corporate raider: a financier who makes a practice of making hostile takeover bids for companies, either to control
their policies or to resell them for a profit.
o The Legal and Regulatory Environment
o Sarbanes-Oxley and Other Regulatory Reforms
o Truth in Securities Act: requires audited financial statements to be made available to investors
o Sarbanes-Oxley Act
 Focuses on…
 Reducing agency costs in corporations
 Restoring ethical conduct within the business sector
 Improving the integrity of the accounting reporting system
 Overarching strategies
 Ensure greater board independence—fiduciary duty to act in interest of stockholders
 Establish internal accounting controls—internal accounting control systems
 Establish compliance programs
 Establish an ethics program
 Expand the audit committee’s oversight powers
The Importance of Ethics in Business (p. 20)
 Business Ethics
 Are Business Ethics Different from Everyday Ethics?
o Corruption creates inefficiencies in an economy, inhibits the growth of capital markets and slows a country’s rate of economic
growth
 Types of Ethical Conflicts in Business
o Agency Costs: financial mangers have agency obligations to act honestly and to see that subordinates act honestly with respect
to financial transactions
 Dishonesty, deception and fraud in financial matters can have a long lasting impact on the stock price
o Conflicts of Interest: when agent’s interest are different from those of the principal—resolved in one of two ways: complete
disclosure or the conflicted party can withdraw from serving the interests of one of the parties

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o Information Asymmetry: when one party in a business transaction has information that is unavailable to the other parties in
the transaction
 Commonplace in business relationships
 There are market-based and legal solutions for asymmetry
 Legal solutions often require sellers to disclose material facts to buyers or prohibit trading on information that is not
widely available
 The Importance of an Ethical Business Culture
o Market forces impose costs on individuals and institutions that engage in unethical behavior—provides incentives that foster
ethical behavior (financial losses, legal fines, jail time, bankruptcy)
o Laws and market forces are not enough
o Ethical business culture means people have a set of principles to make ethical judgments
 Serious Consequences

Chapter 2 (p. 26)

The Financial System and Level of Interest Rates
 Corporate financing trends
o Bonds—75.5% debt
o Preferred stock—4.1%
o Common Stock—20.4% equity
 Long term securities: stocks, bonds
 Short term: CDs, T Bills, Commercial paper
 Firms have two types of selling expenses (flotation costs) to pay
o Underwriters spread: gross price – net proceeds
o Issuance costs
 Common stock (most expensive)—get traded more often; more expensive to maintain
 Preferential stock
 Bonds (least expensive)
 Regulation:
 Securities Act of 1933: firms have to provide full disclosure on new issues.
 Securities Exchange of Act of 1934: put the SEC in charge of securities regulation.
 Securities Acts Amendments of 1975: creation of a national market system, no fixed commissions.
 Shelf registration: register stock issues in bulk while selling the stock over time.
 T-Bills or T-Bonds are considered risk free—guaranteed by US Treasury and safest investment in the world—reinvestment risk; since
the mature so quickly you have to keep reinvesting and interest rate goes down

o Risk free rate = T Bill or T Bonds rate

 Risk free rate = real rate + expected inflationary risk premium
o Nominal rate (observed or actual) rate of interest
 I = r + IRP + other risks (default, maturity, liquidity)
 Interest is tax deductible, that’s why bonds are cheaper—not bringing in more owners or diluting profits—riskier
 Dividends are not tax deductible

 One of the most important players in the financial system is the Federal Reserve System
o Power comes from the role as nation’s central bank—controls money supply
o Conducts monetary policy that affects how much money is available in the economy—sets target short-term interest rate large
money center banks lend to each other (federal funds rate), and buying and selling Treasury and federal agency securities to
achieve this rate
o Increases in the money supply put downward pressure on short-term interest ratescan lead to increases in the level of
economic activity and higher inflation
o Decreases in the money supply put upward pressure on short-term interest ratescan lead to lower level of economic activity
and lower inflation
The Financial System
 Financial market: includes different types of markets for the creation and exchange of financial assets (stocks and bonds)
o Purpose: bring the sources of capital and users of capital together
 Financial institutions: firms such as commercial banks, credit unions, insurance companies, pension funds and finance companies that
provide financial services to the economy
o Distinguishing feature: they invest their funds in financial assets (assets that are claims on the cash flows from other assets;
business loans stocks and bonds are financial assets) rather than real assets (nonfinancial assets such as plant and equipment—
productive assets are real assets; many financial assets are claims on cash flows from real assets)
 Critical role of financial system is to gather money from households, businesses and governments with surplus funds to invest and
channel that money to those who need it

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 The Financial System at Work

o If the financial system is competitive, the interest rate the bank pays on CDs will be at or near the highest rate that you can earn
on a CD of similar maturity and risk—competition among banks will drive CD rates up and loan rates down
o CD: certificate of deposit; debt instrument issued by bank that pay interest and are insured by the federal government
o The bank gathers money from you and other consumers in small dollar amounts, aggregates it and then makes loans in
much larger dollar amounts—saving by consumers in small dollar amounts is the origin of much of the money that funds
business loans
o An important function of the financial system is to direct money to the best investment opportunities in the economy—
businesses with high rates of return and good credit will be financed
 How Funds Flow through the Financial System
o The financial system moves money from lender-savers (whose income exceeds spending) to borrower-spenders (whose
spending exceeds income)
o Most important group of lender-savers in the economy are households—businesses are the borrower-spenders who borrow
the most in the economy
o Two basic mechanisms by which funds flow through the financial system
 Funds can flow directly through financial markets
o Direct financing: wholesale markets for the creation and sale of financial securities such as stocks, bonds
and money market instruments—large corporations and governments use financial markets to sell
securities directly to lender-savers
 Funds can flow indirectly through financial institutions
o Indirect financing: institutions such as commercial banks that invest in financial assets and provide
financial services—collect money from lender-savers
Direct Financing (p. 29)
o Lender-savers and the borrower-spenders deal directly with one another; borrower-spenders sell securities, such as stocks and bonds,
to lender-savers in exchange for money—these securities represent claims on the borrower’s future income or assets
o Financial markets in which direct transaction take place are wholesale markets with a typical minimum transaction size of $1 million
o Major buyers and sellers of securities in the direct market are commercial banks, insurance companies and business finance
companies—financial institutions are major buyers of securities in the direct market
o A Direct Market Transaction p. 30
o Investment Banks and Direct Financing
 Two important participants in the direct financial markets are investment banks and money center banks
 Investment banks specialize in helping companies sell new security issues (new debt or equity)
 Money center banks are large commercial banks that provide both traditional and investment banking
services throughout the world
 Financial Services Modernization Act: allows major money banks to provide investment banking services
 Origination: the process of preparing a security issue for sale—if securities are to be sold in the public market, the
issuer must also file a registration statement with the SEC—not the case for private markets
 Underwriting: investment banker helps the company sell its new security issue—most common arrangement is
called firm-commitment underwriting; the investment banker buys the new securities from the issuing company
and resells them to investors
 Once investment bankers buy the securities from the issuer, they offer to resell individual securities to
institutional investors and the public at a specific offering price
 Involves risk because it is difficult to estimate the price that will clear the market
 Underwriting spread: underwriter’s compensation—it is the difference between the offering price and
the price the investment banker pays for the security issue
 Distribution: process of marketing and reselling the securities to investors—quick resale is important because of
unexpected swings in price
 Underwriters often form sales syndicates—if securities are not sold within a few days, syndicate is
disbanded and individual syndicate members sell the unsold securities at whatever price they can get
Types of Financial Markets (p. 32)
o Primary and Secondary Markets
o Primary market: new security issues are sold by companies directly to investors (debt or equity)—transaction results in new
money going into firm
o Secondary market: the owners of outstanding securities can sell them to other investors—like selling a used car—enable
investors to buy and sell securities as frequently as they want—important to corporations because investors are willing to pay
higher prices for securities in primary markets if the securities have active secondary markets—no new money goes into the
firm when a secondary market transaction takes place
o Marketability v. Liquidity
 Marketability: the ease with which a security can be sold and converted into cash—depends on costs of trading and
searching for information (transaction cost)the lower the transaction costs, the greater a security’s
marketability
 Liquidity: the ability to convert an asset into cash quickly without loss of value
o Brokers v. Dealers

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 Brokers are market specialists who bring buyers and sellers together when a sale takes place, usually for a
commission—bear no risk of security ownership—matchmaker
 Dealers are market specialists who make markets for securities by buying and selling form their investors—bear
price risk (selling a security for less than they paid for it)
o Exchanges and Over-the-Counter Markets
o Financial markets can be classified as organized or over-the counter markets
o NYSE is organized market, physical meeting place for members to buy and sell securities or other assets
o Securities not listed on an exchange are bought and sold in the over-the-counter (OTC) market
o OTC market differs form organized exchanges in that the OTC market has not central trading location—investors can
execute OTC transactions by visiting or telephoning an OTC dealer or by using a computer based electronic trading system
linked to OTC dealer
o Most trades are now done electronically
o Money and Capital Markets
o Money markets are global market where short-term debt instruments, with less than one year maturities, are traded
 Are wholesale markets which the minimum transaction is $ 1 million
 Money market instruments are lower in risk than other securities—they are high liquidity and low default risk
 Largest and most important money markets are in New York City, London and Tokyo
 Large companies use money markets to adjust their liquidity positions
 A firm can invest idle cash in money market instruments then if the firm has shortfall of cash, it can raise cash
overnight by selling money market instruments
 NYSE, London and Tokyo stock exchanges are capital markets where long-term debt instruments are traded
 Capital market instruments are less marketable, have higher default risk and longer maturities
o Public and Private Markets
 Public markets: organized financial markets where general public buys and sells securities through stockbrokers
(NYSE)—SEC regulates public securities markets in US (oversees primary and secondary markets)
 Private markets: involve direct transactions between two parties—private placement: the sale of an unregistered
security directly to an investor such as an insurance company or a wealthy individual
 Company contacts investors directly and negotiates a deal to sell them all or part of a security
 Advantage: speed and low transaction costs
 Disadvantage: privately placed securities cannot legally be sold in the public markets because they lack
SEC regulation
 Futures and Options Markets
 New York Board of Trade and Chicago Board of Trade are future markets; The Chicago Board Options
Exchange is a options market
 Often called derivative securities—they derive value from some underlying assets
 Futures contracts are contracts for the future delivery of assets such as securities, foreign currencies,
interest cash flows, or commodities—these contracts reduce hedge risk exposure caused by fluctuation
in things such as foreign exchange rates or commodity prices
 Options contracts call for one open party (the option writer) to perform a specific act if called upon
to do so by the option buyer or owner
o Can be used to hedge risk in situations where firm faces risk from price fluctuations
Market Efficiency (p. 35)
o True (intrinsic) value: for a security, the value of the cash flows an investor who owns that security can expect to receive in the future
o Reflects all available information about the size, timing, and riskiness of the cash flows at the time the price was set
o Efficient market: market where prices reflect the knowledge and expectations of all investors
o The more efficient a market is, the more likely securities are to be priced at or near true value
o Overall efficiency of a market depends on its operation efficiency and its informational efficiency
o Market operational efficiency: the degree to which transaction costs of bringing buyers and sellers together are minimized—
minimize transaction costs
 If transaction costs are high market prices will be more volatile, fewer financial transactions will take place,
and prices will not reflect the knowledge and expectations of investors
o Market informational efficiency: the degree to which current market prices reflect relevant information and therefore the true
value of the security—in an informational efficient market, market prices adjust quickly to new information as it becomes
available
o Efficient Market Hypothesis
o Public financial markets are efficient in part because regulators such as SEC require issuers of publically traded securities to
disclose a great deal of information about securities to investors
o The ability of investors to easily observe transaction prices and trade volumes and inexpensively trade securities in public
markets contributes to the efficiency
o Efficient market hypothesis: a theory concerning the extent to which information is reflected in security prices and how
information gets incorporated into security prices
o Strong form efficiency—strong form of the efficient market hypothesis: the theory that security prices reflect all
information

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 If a security market were strong-form efficient then it would not be possible to earn abnormally high returns by
trading private information or information that is not available to all investors
o Semi-strong efficiency: weaker form of the efficient market hypothesis—holds that all public information—information
available to investors—is reflected in security prices
o Weak form efficiency: holds that all information contained in past prices of a security is reflected in current prices but that
there is both public and private information that is not
o An important conclusion of efficient market hypothesis is that at any point in time all securities with the same risk
should be priced to offer the same expected return
Financial Institutions and Indirect Financing (p. 36)
o When companies need funds for capital investments and can meet the financing requirements to make transacting in wholesale markets
cost effect, they borrow in the indirect market from a financial institution
o Financial intermediation: conversion of securities with one set of characteristics into securities with another set of characteristics
o Financial institutions—an intermediary—stands between the lender-saver and the borrower-spender
o Indirect Market Transactions
o The bank raises money from deposits to checking and savings accounts and by selling CDs and then uses the money to make
loans to businesses or consumers
o In direct market, as securities flow between lender-savers and borrower-spenders, the form of the securities remains
unchanged
o In indirect markets, however, as securities flow between lender-savers and borrower-spenders, they are repackaged
o Indirect markets are a much larger and more important source of financing to businesses than the more newsworthy
direct financial markets—true for all industrial countries
o Financial Institutions and Their Services
o Commercial Banks: most prominent and largest financial intermediaries in the economy and offer the widest range of financial
services to businesses—most common type of bank loan is a line of credit (revolving credit), works much like a credit card.
 A line of credit is a commitment by the bank to lend a firm an amount up to a predetermined limit, which can be
used as needed
 Leases
 Term loans with fixed rates
o Life and Casualty Insurance Companies (p. 38)
 Sell protection against loss of property from fire, theft, accidents, and other causes
 Cash flows for both are predictable so they are able to provide funding to corporations through the purchase of stocks
and bonds in the direct credit markets as well as funding for both public and private corporations
o Pension Funds
 Invest retirement funds on behalf of businesses or government agencies that provide retirement programs for
employees—obtain money form employee/er contributions during working years and provide monthly cash
payments upon retirement
 Pension fund managers invest in corporate bonds and equity securities purchased in the direct financial
markets
o Investment Funds
 Sell shares to investors and use funds to purchase securities
o Business finance companies
 Obtain majority of funds by selling short term debt called commercial paper to investors in direct credit markets—
often secured by accounts receivable or inventory
o Corporations and the Financial System (p. 38 table on p. 39)
o To start a new company, management’s first task is to sell equity and debt to finance the firm
 Initial public offering (IPO): first offering of a corporation’s stock to the public
Determinants of Interest Rate Levels (p. 40)
o Real Rate of Interest: the interest rate that would exist in the absence of inflation
o Inflation is the amount by which aggregate price levels rise over time
o The real rate of interest is (1) the inflation adjusted return earned by lender-savers and (2) the inflation-adjusted cost
incurred by borrower-spenders when they borrow
o Nominal rate of interest: the rate of interest that is unadjusted for inflation—the rate we actually observe in the
marketplace
o Determinants of the Real Rate of Interest
 Returns on Investments: the output generated by capital projects constitutes its return on investment which is measured
as a percentage—return on investment must exceed the cost of the funds used to be attractive
 Time Preference for Consumption: preference to consume goods today rather than tomorrow is positive time preference
for consumption—interest rate offered on financial instruments determines how much people will save—interest rates
must be raised to coax people to postpone current spending—at higher rates, people save more and spend less
 Equilibrium Condition: higher interest rates reduce business investment (spending) because fewer capital projects can
earn a high enough return on investment to cover the added interest cost—they also reduce demand for borrowing while
lender-savers spend less and want to lend more money—the real rate of interest depends on the interaction between
these two opposing factors
 Is a function of supply and demand

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 Fluctuations in the Real Rate: any economic factor that causes a shift in desired lending or desired borrowing will cause
a change in the equilibrium rare of interest (in the supply and demand framework above
 Ex. a technological breakthrough in technology should cause a shift to the right in the desired level of
borrowing schedule, increasing the real rate of interestnew technology spawns an increase in investment
opportunities increasing the desired level of borrowing
 Decreases in tax rates for individuals would shift the desired level of lending to the right
 A larger money supply would increase the amount of money available for lending
 Growth in population, demographic variables and culture differences
 Historically been around 3% for the US economy
o Loan Contracts and Inflation (p. 42)
o Real rate of interest does not account for inflation—if prices rise due to inflation during the life of a loan contract, the
purchasing power of the dollar decreases because the borrower repays the ends with inflated dollars with less buying power
o The Fisher Equation and Inflation
o To incorporate inflation expectations into a loan contract, we need to adjust the real rate of interest by the amount of inflation
that is expected during the contract period

o Cyclical and Long-Term Trends in Interest Rates (p. 45)

o Consumer Price Index: measures the change in prices of a market basket of goods and services that a typical consumer
purchases
 The level of interest rates tends to rise and fall with changes in the actual rate of inflation
 The level of interest rates tends to rise during periods of economic expansion and decline during periods of economic
contraction

Chapter 3
Financial Statements, Cash Flows and Taxes (p. 50)
Financial Statements and Accounting Principles
o The Annual Report: the most important report firms issue to their stockholders and make available to the general public
o Divided into three sections: (1) financial tables (information about operations and performance summary), (2) corporate public
relations piece discussing the firm’s product lines, services and contributions to communities, (3) audited financial statements: balance
sheet, income statement, R/E and statement of cash flows
o GAAP: generally accepted accounting principles—set of rules that defines how companies are to prepare financial statements
o Accounting principles and reporting practices for the US are promulgated by the Financial Accounting Standards Board (FASB)—
derives authority from Securities and Exchange Commission (SEC)
o Fundamental Accounting Principles
o The Assumption of Arm’s-Length Transactions: parties in a transaction are economically rational and free to act independently of
each other—the price you pay for something or the price for which you sell something is what gets recorded
 Buying a car from your dad below market value is not an arm’s length transaction
o The Cost Principle: value of an asset recorded on books reflects its historical cost—recorded as the book value or net value of an
asset or liability recorded on the financial statements
 Stocks are an exception to this principle (and other marketable securities), which are recorded at market value
 Accounting statements are based on historical costs/information not current market information
o The Realization Principle: revenue is recognized only when the sale is virtually completed and the exchange value for the goods or
services can be reliably determined—most revenues are recognized at the time of sale whether cash is received or not
o The Matching Principle: match revenue to with the expenses incurred in the period—actual cash outflows for expenses may not
occur at the same time the expenses are recognized—the figures on the income statement more than likely will not reflect the actual
cash inflows and outflows during the period
o The Going Concern Assumption: a business will remain in operation for the foreseeable future—allows accountant to record assets
at cost rather than their value in a liquidation sale
o International GAAP (p. 53)
o Accountants must adjust financial statements so meaningful comparisons can be made between firms that utilize different set of
accounting principles—cost of making adjustments adds to overall cost of international; business transactions
o International Financial Reporting Standards
The Balance Sheet
o Reports the firm’s financial position at a particular point in time
o Total assets = Total liabilities + Total Stockholders’ Equity
o SE: the residual claim of the owners on the remaining assets of the firm after all liabilities have been paid—can be positive, negative or equal to
0
o Assets are listed in order of liquidity (cash and marketable securities are at the top)

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o Two dimensions of liquidity: (1) the speed and ease the asset can be sold, (2) whether the asset can be sold without loss of value
o Liabilities are listed based on maturity (length of time remaining before obligation must be paid)—shortest maturities are listed at the top
o Current Assets and Liabilities
o Current assets are assets that are expected to be converted into cash within one year—cash, marketable securities, A/R. Current liabilities
are obligations payable within one year—A/P
o Net Working Capital
 Net working capital = total current assets – total current liabilities
 Measure of firm’s ability to meet its short-term obligations as the come due
o Accounting Inventory
 Current asset on the balance sheet but usually least liquid because of inventory cycle
 FIFO: during rising prices, has lowest COGS, highest net income and highest inventory value
 LIFO: during inflation, highest COGS, lowest net income, and lowest inventory value
 Financial analysts make adjustments to the financial statements for differences in inventory valuation methods
o Long Term Assets and Liabilities (p. 56)
 Long Term Assets: assets the firm uses to generate most of its income—tangible or intangible
 Goodwill is an intangible asset that arises only when a firm purchase another firm—measure of how much the price paid
for the acquired firm exceeds the sum of the values of the acquired firm’s individual assets—may arise from
improvements in efficiency, the reputation or brands associated with products
 Accumulated Depreciation: deterioration of an asset—expensed during the period in which the firm benefited from use
 Depreciation allocates the cost of a limited life asset to the period in which the firm is assumed to benefit form the asset
 Accumulated depreciation account
 Straight-line or accelerated depreciation
 Long Term Liabilities: include debt instruments due and payable beyond one year and other long term obligations (bonds,
term loans, mortgages, deferred compensation)—firms finance long term assets with long term liabilities
o Equity (p. 57)
 Common Stock Accounts: most important—represent true ownership of the firm—
 Common stock account identifies the funding from equity investors
 Paid in capital is the amount of capital received from the sale of common stock in excess of par
 Comes with rights:
 Right to vote on corporate matters
 Preemptive right (can purchase any additional shares of stock issued in proportion to the number of shares currently
owned)
 Right to receive cash dividends
 Right to all remaining assets after all creditors and preferred stock holders have been paid if liquidated
 Retained Earnings: represents earning that have been retained and reinvested in the business over time rather than being paid
out as cash dividends—change in retained earnings can be computed as the difference between net income and dividends
paid—not the same as cash—liability
 Treasury Stock: stock that the firm has repurchased from investors—can reissue in the future—when a company has excess
cash and management believes its stock price is undervalued it makes sense to purchase the stock with cash
 Preferred Stock: cross between common stock and long-term debt. Preferred stock pays dividends at a specified fixed
ratefirm cannot increase or decrease the dividend rate, regardless of the firm’s earnings—declared by board of directors and
can elect not to pay a preferred stock dividend but still has to pay dividends that have been skipped in the past before they can
pay dividends to common stockholders
Market Value Versus Book Value (p. 59)
o Market value: the price at which an item can be sold
o Best information about how much a company's assets can earn in the future comes form the current market value of those assets
and liabilities
o Market to market is the process of recording assets at their current market value
o Critics argue estimating value requires complex financial modeling, the numbers can be open to manipulation and it can
become inaccurate if market prices deviate from the fundamental values of assets and liabilities
o Assets
o For current assets, book value and market value may be close—short life cycle
o For long term assets, their market and book value are not likely to be equal—long life cycle
o Liabilities
o Generally close to actual market value for short term liabilities
o Long term debt book value and market value can differ substantially—affected by level of interest rates in the economy (if
interest rate increases, the market value will decline)
o Stockholders Equity
o One of the least informative items on the balance sheet—historical record
o On a balance sheet where both assets and liabilities are marked to market, the firm’s equity is more informative to management
and investors
 The difference between the market values of the assets and liabilities provides a better estimate of the market
value of stockholders’ equity than the difference in book values

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 Be aware this will not give an exact estimate of the market value of stockholders’ equity—the total value of a firm’s
assets depends on how these assets are utilized
o Marked to Market Balance Sheet p. 61
The Income Statement and the Statement of Retained Earning (p. 62)
o Income Statement: financial statement that reports a firm’s revenues, expenses, and profits or losses over a period
o Net income = Revenue – Expenses
o Revenues: arise from products and services it creates through its business operations
o Expenses: various costs that the firm incurs to generate revenues
o Value of long term assets consumed through business operations
o Costs incurred in conducting business
o Net Income: reflects its revenues relative to expenses during a period of time—if revenue exceeds expenses, the firm generate net income
o Reported on bottom line of the income statement—profits
o Earnings per share: net income divided by the number of common shares outstanding—tell a stock holder how much the firm
has earned/lost for each share of stock outstanding
o Expense Categories (p. 63)
o Depreciation expense: for tax purposes, firms elect to accelerate depreciation as quickly as permitted—results in a higher
depreciation expense to the income statement, which results in a lower earnings before taxes (EBT) and lower tax liability in the
first few years after an asset is acquired—straight line results in lower depreciation expense, higher tax liability and higher
earnings before taxes
 The higher EBT the higher net income
o Amortization expense: process of writing off expenses for intangible assets over their useful life—goodwill used to be
amortize but not after June 2001; now subject to impairment test
o Extraordinary items: non-operating gains or losses—floods, fires, earthquakes
o Step by Step to the Bottom Line (p. 64)
o EBITDA: earnings before interest, taxes, depreciation and amortization—what firm earned purely from operations
o EBIT: earnings before interest and taxes
o EBT: earnings before taxes
o Net Income
o The Statement of Retained Earnings
o When the firm reports and income or loss, or when the board of directors declares and pays a cash dividend it affects
retained earnings
Statement of Cash Flows (p. 65)
o Managers must have a complete understanding of the uses of cash and the sources of cash in the firm—pay wages, issue new securities to
raise cash, or purchase and sell long term productive assets—statement of cash flows provides managers with what amount to an
inventory of these transaction and helps them understand why the cash balance changed as it did from the beginning to the end of
the period
o Sources and Uses of Cash
o Statement of Cash Flows: financial statement that shows a firm’s cash receipts and cash payments and investments for a
period of time—look at net income during the period and at changes in balance sheet accounts form the beginning of the period
(end of previous period) to the end of the period
 Increases in assets or decreases in liabilities account and equity are uses of cash while decreases in assets or increases
in liabilities and equity are sources of cash
 Working Capital: an increase in current assets is a use of cash—the sale of inventory increases a firm’s cash
position—an increase in current liabilities is a source of cash (accounts receivable, inventory)
 Fixed assets: if a company purchases fixed assets during the year, it decreases cash because it must use cash to pay
for the purchase—if the firm sells a fixed asset, the firm’s cash position will increase
 Long Term liabilities and equity: an increase in long term debt or equity is a source of cash—retirement of debt or
purchase of treasure stock requires the firm to pay out cash reducing cash
o Organizing of the Statement of Cash Flows (p. 66)
 Operating activities: net cash flows related to principal business activities; net income, depreciation and
amortization
 Long-Term Investing: property, equipment, increase in goodwill
 Financing activities: cash obtained from or repaid to creditors or owners—payouts of dividends or purchases of
treasury stock
 Cash Reconciliation: beginning and ending cash positions
Tying Together the Financial Statements (p. 68)
o The statement of cash flows ties together the income statement with the balance sheets from the beginning and the end of the period. The
statement of retained earnings shows how the retained earning account has changed from the beginning to the end of the period
Cash Flows to Investors
o Revenues, expenses and net income reported in a firm’s income statement provide an incomplete picture of the cash flows available to
its investors
o Net Income Versus the Cash Flow to Investors
o Cash flow to investors: the cash flow that a firm generates for its investors in a given period, excluding cash inflows from the
sale of securities to investors—interest payments and repayment of principal to the firm’s debt holders

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 Cash flow to investors is different from net income because accountants do not necessarily count the cash
coming into the firm and the cash going out when the prepare financial statements—this is because (1) revenue
is recognized at the time a sale is substantially completed not when cash is paid—(2) accountants match revenue with
the costs of producing those revenues regardless of whether these are cash costs to the firm during the period—(3)
cash flows for capital expenditures occur at the time that an asset is purchased not when it is expensed through
depreciation/amortization
o Cash flow to investors is one of the most important concepts in finance—it identifies the cash flow in a given period that is
available to meet the firm’s obligations to its debt holder and that can be distributed to its stockholders—defines the value of
their investments in the firm
 Cash flow to investors from operating activity – cash flow invested in net working capital – cash flow invested in
long-term assets = Cash flow to investors
o Cash Flow to Investors from Operating Activity
 Accounting profits can be converted into cash flow to investors from operating activity by subtracting the taxes that
the firm paid during the period from earning before interest and taxes and adding back all of the firm’s noncash
expenses
 Reported in the cash flow statement because it does not include cash flows associated with working capital
accounts—different from net cash provided by operating activities
 CFOA = EBIT – Current taxes + noncash expenses
 Largest noncash expenses are usually depreciation; other noncash items include
 Depletion charges (natural resources)
 Deferred taxes (portion of firms income tax expense that is postponed because of differences in accounting
policies)
 Expenses that were paid in cash in a previous period
 Revenues previously received as cash but not yet earned (deferred revenues)
o Cash Flow invested in net working capital (p. 71)
 Change in net working capitals takes into account all the money that has been invested in current assets, including
cash and marketable securities, AR and inventories, all financing for current liabilities during the period
 CFNWC = NWC (current period) – NWC (previous period)
 Positive difference indicates current assets increased
 If a firm is a net investor (buys more than it sells) in long term assets during a given year, its cash flow to investors
will be reduced by the amount of net purchases
 CFLTA = long term assets (current period) – long term assets (previous period)

o Cash Flow to Investors: Putting it Together (p. 72)

o CFI = CFOA – CFNWC –CFLTA
 Net working capital and long term assets reduce the cash flow available to investors hence the subtraction
 Negative numbers indicate more cash was invested than produced by operating activity—difference is financed
by selling stock to investors or borrowing money
Federal Income Tax (p. 73)
o Taxes represent one of business’ largest cash outflows
o Tax code is not an economically rational document—it reflects the changing and sometimes conflicting political and social values of
Congress and the president over time
o Table on p. 74 of tax brackets
o Corporate Income Tax Rates
o Marginal tax rate varies from 15 to 39 percent
o Companies with lower taxable incomes have lower tax rates than larger companies with higher incomes because small
businesses and start ups stimulate new business formation
o Progressive system—as the level of income rises, the tax rate rises
o Tax Reform Act of 1986—marginal tax rates do not increase continuously though the income brackets
o Average versus Marginal Tax
o Average tax rate: the total taxes paid divided by taxable income
o Marginal tax rate: tax rate that is paid on the last dollar of income earned
o When you are making investment decisions for a firm, the relevant tax rate to use is usually marginal tax rate because
new investments are expected to generate new cash flows, which will be taxed at the firm’s marginal tax rate
o Unequal Treatment of Dividends and Interest Payments
o For C-corporations interest paid on debt obligations is a tax deductible business expense—dividends paid to common or
preferred stockholders are not deductible
o In effect it lowers the cost of debt financing compared with the cost of an equal amount of common or preferred stock
financing—there is a tax induced bias toward the use of debt financing
o Typically if a corporation receives dividends form another corporation it is entitle to a deduction of 70% (only pays taxes on 30%) of the
dividend it receives—if the corporation receiving the dividends owns 20% or more of the other corporation the amount of the deduction
increases to 80%--if the corporation receiving the dividends owns more than 80% of the distributing corporation is can deduct 100% of the
dividends received—we assume 70% for this class

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Chapter 4
Analyzing Financial Statements (p. 83)
Background for Financial Statement Analysis
 Financial statement analysis: use of financial statements to analyze a company’s performance and assess its strengths and weaknesses
 Perspectives on Financial Statement Analysis
o Stockholders’ perspective: concerned with value of stock and how much cash they can expect to receive form dividends and
capital appreciation overtime—how profitable is the firm, return on investment, how much cash is available
o Managers’ perspective: fiduciary responsibility to make decision that are in stockholders best interests—interested in
profitability, how much cash is available for stockholders, capital appreciation, ROI
 Day to day decision making that requires feedback to maximize S/E and assess short term impact of these
decisions on a firm’s financial statements and current stock price
 Have access to more detailed information than those outside the firm
o Creditor’s perspective: primary concern is whether and when they will receive the interest payments and when they will be
repaid the money they loaned
 Guidelines for Financial Statement Analysis
o Understand what perspective you are adopting (stockholder, manager, creditor)
o Use audited financial statements if they are available—these are independent and fair
o Use financial statements that cover three to five years (or more) to conduct analysis—trend analysis: analysis of trends in
financial data over time
o Compare a firm’s financial statements with those of competitors that are roughly the same size and that offer similar products
and services
o Benchmark: a standard against which performance is measured
Common-Size Financial Statements (p. 86)
 Common size financial statement: a financial statement in which each number is expressed as a percentage of a base number such as
total assets or net revenues (net sales)—dividing numbers by a common base to form a ratio is scaling—financial statements scaled in
this manner are also called standardized financial statements
 Make is easier to evaluate changes in a firm’s performance and financial condition over time
 Common Size Balance Sheets
o To create, we divide each of the asset accounts by total assets—we also divide each of the liability and equity accounts by
total assets since total assets = total liabilities + stockholder’s equity
 Common Size Income Statements
o Express each account as a percent of net sales—net sales = total sales – all sales discounts and sales returns and allowances
o As you move down the income statement you know exactly what happens to each dollar of sales that the firm generates
o Tells a lot about firm’s efficiency and profitability
Financial Ratios and firm Performance (p. 88)
 Why Ratios are better measures: accounting numbers are more easily compared and interpreted when they are scaled
o Financial ratio: one number from a financial statement that has been scaled by dividing by another financial number
o Return on Equity
 Net income/Stockholder’s equity
o Choice of Scale is Important
 Size factor must be relevant and make economic sense
 In business they type of variable most commonly used for scaling is a measure of size like total assets or total net sales—other
scaling variables can be used (i.e. revenue per available seat mile)
o Other Common Ratios (p. 89)
 Short-Term Liquidity Ratios
o Liquid assets have active secondary markets and can be sold quickly for cash without loss of value—short term marketable securities
are very liquid whereas plant and equipment can take months/years to sell
o Examine liquidity position when we want to know whether the firm can pay its bills when cash flow from operations is insufficient to
pay short-term obligations (payroll, invoices, etc.)
o Short term liquidity ratios focus on whether the firm has ability to convert current assets into cash quickly without loss of value
o Insolvency: inability to pay debts when they are due
o Current and quick ratio are the most important liquidity ratios
 Current Ratio: if you were to take this number and add it to the proceeds of liquidating other current assets, the current ratio is
how many times short term obligations could be covered
 Measured in “times”
 Current assets/Current liabilities
 Higher is desirable, too high of a ratio can be bad because too much is being tied up in current assets leaving less for
investors

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 Quick Ratio: inventory is subtracted from current assets in the numerator—acid test ratio
 Inventory is subtracted because it varies by industry, obsolesce, partial completion, etc.
 Measured in $ amount
 Current assets – Inventory/Current liabilities
 Efficiency ratios/Asset Turnover Ratios (p. 91)
 Measure how efficiently a firm uses assets
 Inventory Turnover
o COGS/Inventory
o COGS reflects the book value of inventory
o Measured in times
 Days in Sales Inventory
o 365 days/Inventory turnover
 Alternative Calculation for Inventory Turnover—Average inventory (used when a firm’s inventory fluctuates
widely)
o Average Inventory = Beginning Inventory + Ending inventory/2inventory turnover = COGS/Average
Inventory
 Accounts Receivable Turnover and Days’ Sales Outstanding
 Accounts receivable turnover: the speed at which a firm converts receivables into cash
o Accounts receivable turnover = Net Sales/Accounts receivable
o Days’ sales outstanding = 365 days/Account receivable turnover
o Days sales outstanding means on average how often the company converts its credit sales into cash
 Asset Turnover Ratio (p. 94)
 How efficiently management is using firm’s assets to generate sales—measures the amount of sales generated with
each dollar of total assets—an increase means management is squeezing more sales out of a constant asset base
 If too high for its industry management may want to invest in additional fixed assets if they want to increase sales
 Firms with more recent purchases of fixed assets will have a higher book value of assets and lower total asset turnover
 Big picture measure
 Fixed asset turnover: sales per dollar invested in fixed assets (plant and equipment)
o Leverage Ratios: measure extent a firm uses debt rather than equity financing and ability to meet long term financial obligations
(interest payments on debt, lease payments)
 Financial Leverage: use of debt in a firm’s capital structure; the more debt, the higher the financial leverage. When a firm uses
debt financing, the returns to stockholder may be magnified—occurs because the interest payments associated with long-term debt
and some short term debt are fixed—fixed debt holders continue to receive their fixed interest payments, and all of the increase
goes to the stockholders unless an operating loss occurs the loss is charged against stockholder’s equity
 Default (insolvency) risk: risk that firm will not be able to pay its debt obligations as they come due—debt must be paid
regardless if a profit is made
 Debt Ratios (p. 96)
o Total debt ratio: measures extent the firm finances its assets from sources other than stockholders—the amount
of debt for each dollar of total assets
 Total debt ratio = Total debt/Total assets
 Total debt = total assets – total equity
 Total debt ratio = debt to equity ratio/1 + debt to equity ratio
o Debt to equity ratio: tells us the amount of debt for each dollar of equity
 Total debt/Total equity
o Equity multiplier (p. 98): tells us the amount of assets that the firm has for every dollar of equity—directly
related to debt to equity ratio
 Total assets/total equity or 1 + total debt/total equity
 Coverage Ratios (p. 98)
o Leverage ratio that measures the firm’s ability to service its debt or how easily the firm can cover its debt
payments out of earnings or cash flow
o Lower than 1 indicates financial distress
o Times Interest Earned: measures extent to which operating profits cover the firm’s interest expenses
o Cash coverage: how much cash is available to cover interest payments—the cash a firm has available from
operations to meet interest payments is better measured by EBIT plus depreciation and amortization—EBITDA
coverage will be larger than times interest earned coverage
 Profitability Ratios: measure management’s ability to efficiently use the firm’s assets to generate sales and manage firm’s operations—of
interest to stockholders, creditors and managers—higher is better
o Gross Profit Margin: measures the percentage of net sales remaining after the cost of goods sold is paid—ability to manage the
expenses directly associated with producing the firm’s products/services
o Operating Profit Margin and EBITDA Margin
 Operating profit margin gives an indication of the profitability of the firm’s operations, independent of tis financing
policies or tax management strategies—operating profit is measured by EBIT
o Net Profit Margin: percentage of sales remaining after all of the firm’s expenses have been paid
o Return on Assets (p. 100): profitability as a percentage of investment in assets or equity

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o EBIT return on assets: tells how efficiently management utilized the assets under their commands, independent of
financing decisions and taxes
o Return on assets: information that this ratio provides about efficiency of asset utilization is obscured by the financing
decisions the firm has made and taxes it pays
o If you have a measure of income to stockholders in the numerator, only investments by stockholders should be in
denominator—if you have a measure of total profits from operations in the numerator, you want to divide by a measure of
total investments by debt and stock holders
o Return on equity: measures net income as a percentage of the stockholders’ investment in the firm
o Alternative Calculation of ROA and ROE
 Average asset or equity value = beginning value + ending value/2
o Market-value indicators (p. 102): combine market value data with data from a firm’s financial statements
o Earnings per Share: net income divided by number of shares outstanding
o Price-Earning ratio: relates earnings per share to price per share—ratio places the value of the ratio on every $1 of net income
o Stock prices reflect all future cash flows from earnings—a high P/E ratio can indicate that investors expect the firm’s
earnings to grow rapidly in the future but could also be due to low earnings in a particular year and investors might expect
earnings to recover to a normal level soon
o Market to book ratio: book value per share is an accounting number that reflects the cumulative historical investment into the firm’s
equity account on a per share basis—market value of equity per share is the price per share—a higher value indicates the firm has
been more effective at investing in projects that add value for its stockholders
The DuPont System: A Diagnostic Tool (p. 103)
 An Overview of the DuPont System
o Diagnostic tool that uses financial ratios to evaluate a company’s financial health; three steps
 Management assesses the company’s health using DuPont ratios
 If any problems are identified, management corrects them
 Management monitors the firm’s financial performance over time, looking for differences from ratios established as
benchmarks
o Decisions maximize the firm’s return on equity as opposed to maximizing the value of stockholders’ shares
o Identifies three areas where management should focus efforts to maximize ROE
 How much profit management can earn on sales
 How efficient management is in using the firms assets
 How much financial leverage management is using
o The ROA equation (p. 104)
 Net profit margin: managements ability to generate profits from sales by efficiently managing the firm’s (1)
operating expenses, (2) interest expenses and (3) tax expenses
 Total Asset turnover: measures how efficiently management uses the assets under its command—how much output
management can generate with a given asset base
 Net Profit Margin versus Total Asset Turnover (p.104)
o The ROE equation: determined by the firm’s ROA and its use of leverage (equity multiplier)—the greater the use of debt,
the greater the ROEincreasing the use of leverage (riskier)
o The DuPont Equation (p. 106): ROE = ROA x equity multiplier and ROA = net profit margin x total asset turnover, therefore:
 DuPont Equation
 ROE = (Net income/net sales) x (net sales/total assets) x (total assets/total equity)
o Applying the DuPont System
 The DuPont System tells us a firm’s ROE is determined by (1) net profit margin, (2) asset turnover, the equity
multiplier
 Identifies areas of concern, but not everything we need to know
o Is Maximizing ROE and Appropriate Goal?
 Maximizing share price and maximizing ROE are not the same
 ROE does not directly consider cash flow; it considers earning but not future cash flow.
 ROE does not consider risk
 ROE does not consider size of initial investment or size of future cash payments
 **The essence of any decision made in a business is what is the size of the cash flows, when do you except to
receive them and how likely are you to receive them (size, time, risk)
Selecting A Benchmark (p. 108)
 Trend analysis: uses history as its standard by evaluating a single firm’s performance over time—an increase or decrease in a ratio
value isn’t good or bad—a ratio value that is changing prompts financial manager to sort out issues surrounding the change
 Industry analysis: identify a group of firms with same product line, compete in the same market, and are similar size—the average ratio
values for these firms will be benchmarks
o Standard Industrial Classification (SIC) System: numerical system of coding developed by the US government to classify
businesses according to the type of activity they perform
o North American Industry Classification System (NAICS): intended to refine and replace older SIC codes, but slow to catch
on
o Classifications can be too broad and different databases may compute ratios differently—be aware to avoid distortions

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 Peer Group Analysis: identify a group of firms that compete with the company we are analyzing—similar lines of business, similar size
and direct competitors (peer group)
o Management can obtain the associated financial information and compute average ratio values against which the firm can
compare its performance
o Best way to establish a benchmark if financial data for peer firms are publically available
o Try to compare against market leader
Using Financial Ratios (p. 110)
 Limitations of Financial Statement Analysis
o It depends on accounting data based on historical costs—financial statements based on current market values more closely
reflect a firm’s true economic condition than do statements based on historical cost
o There is little theory to guide us in making judgments based on financial statement and ratio analysis

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