Financial Management
Dr. Andrea Rigamonti
andrea.rigamonti@econ.muni.cz
Lecture 1
Content:
• The corporation and the financial market
• Financial statements
The corporation and the financial market
In the US there are four major types of firms:
• Sole proprietorships: owned and run by one person
who has unlimited personal liability for the debts.
• Partnerships: has more owners, who are fully liable,
except for limited partnership, where general
partners are fully liable while limited partners’
liability is limited to their investment.
• Limited liability companies (LLC): it is a limited
partnership without a general partner.
• Corporations
The corporation and the financial market
The corporation is a legal entity separate from its
owners (i.e., the latter are not liable for the obligations
of the former, and vice versa).
The ownership is divided into shares. The set of shares
owned by an investor is called “stock”, but these terms
are often used interchangeably to indicate shares.
The collection of all the outstanding shares of a
corporation is known as the equity of the corporation.
The corporation and the financial market
The owners can profit from:
• dividends payment;
• capital gain.
The direct control of the corporation is held by the
board of directors and the CEO.
Agency problem
These issues are dealt with by corporate governance.
The corporation and the financial market
Some or all the shares of a corporation can be privately
held, and they are traded on private markets.
A company can go public via an Initial Public Offering (IPO).
Publicly traded stocks are traded on the stock market.
Primary market: where new shares are first issued.
Secondary market: where existing shares are traded.
The corporation and the financial market
Liquid stocks can be easily converted into cash without
affecting its market price. This allows for flexible
investments and efficient pricing of the investment.
Bid-ask spread: the difference between the price at
which it is possible to buy the stock (bid price) and the
price at which it is possible to sell the stock (ask price).
Bid price is always higher than ask price, but this spread
is small if the market is liquid.
The corporation and the financial market
Market makers are intermediaries that quote both a
buy and a sell price to profit on the bid-ask spread.
They increase the liquidity.
Limit order book: the collection of all limit orders
(orders to buy or sell a set amount at a fixed price).
They provide liquidity.
These and other issue are studied by a branch of
finance called market microstructure.
The corporation and the financial market
Time value of money: the difference in value between
money today and money in the future.
Interest rate: The rate at which we can exchange money
today for money in the future
Risk-free interest rate (Rf): the rate at which money can
be borrowed or lent without risk over a certain period.
The corporation and the financial market
Arbitrage: the practice of buying and selling equivalent
goods in different markets to profit from a price difference
Security: an investment opportunity that trades in a
financial market
Short selling: selling a security you do not own by
borrowing it and returning it to the owner at a later date.
The corporation and the financial market
Trading securities implies facing transaction costs:
• the commissions paid to the broker
• the bid-ask spread
Arbitrage keeps the prices of equivalent goods and
securities close to each other: prices cannot deviate
more than the transaction costs of the arbitrage.
Financial statements
Financial statements record the financial activities and
positions of the company. There a four of them:
• Balance sheet
• Income statement
• Statement of stockholders’ equity
• Statement of cash flows
Financial statements – Balance sheet
The balance sheet lists the firm’s assets and liabilities.
Current assets include:
• Cash and other marketable securities (i.e., investments
that are very liquid and very low risk)
• Accounts receivable: amounts owed to the firm
• Inventories: raw materials and goods
• Other (e.g., rents or insurances paid in advance)
Financial statements – Balance sheet
Fixed assets (or long-term assets):
• Net property, plant and equipment. They depreciate
over time
• Intangible assets (e.g., patents, trademarks)
• Financial investments that do not qualify as marketable
securities
On the balance sheet we find the book value of an asset,
which can differ significantly from its market value.
Financial statements – Balance sheet
Current liabilities are those to be satisfied within one
fiscal year. They include:
• Account payable: amounts owed by the firm
• Short-term debt (or notes payable), and current
maturities of long-term debt: all repayments of debt
that will occur within the next fiscal year
• Due salaries and taxes that have not yet been paid
• Deferred or unearned revenue for services paid for by
customers but not yet provided
Financial statements – Balance sheet
The difference between current assets and current
liabilities is the firm’s Net Working Capital (NWC), also
called Net Current Assets.
Long-term liabilities include:
• Long-term debt: loans, mortgages, bonds, etc.
• Capital leases
• Deferred taxes
Financial statements – Balance sheet
The difference between the firm’s total assets and liabilities
is the book value of equity (or stockholders’ equity).
The market value of equity, usually called market
capitalization, equals the number of shares outstanding
times the firm’s market price per share:
Market Cap = Shares outstanding x Market price per share
The market to book ratio (also called the price to book
[P/B] ratio) is:
Market to Book Ratio =
Market Value of Equity
Book Value of Equity
Financial statements – Balance sheet
If the market-to-book ratio exceeds 1, it indicates that the
value of the firm’s assets when put to use exceeds their
historical cost.
The book-to-market ratio is simply the inverse of the
market-to-book ratio. The former is more commonly used
by investors to evaluate stocks, while the latter is more
commonly used in financial statement analysis, but they
convey the same information.
Financial statements – Balance sheet
Firms with high book-to-market ratio (or low market-to-book
ratio) are called value stocks; those with low book-to-market
ratio (or high market to book ratio) are called growth stocks.
The enterprise value of a firm (also called total enterprise
value or TEV) assesses the value of the underlying business
assets, unencumbered by debt and separate from any cash
and marketable securities. We compute it as follows:
Enterprise Value = Market Value of Equity + Debt - Cash
Financial statements – Income statement
The income statement lists the firm’s revenues and
expenses over a period of time. It includes:
• Gross profit = sales revenues – costs
• Operating income = gross profit – operating expenses
(operating expenses include salaries, administrative, R&D
and marketing expenses, devaluation and amortization)
• Net income = Operating income + non-operating income
(non-operating income are not deriving from the firm’s
core business, e.g., income from financial investments)
Financial statements – Income statement
• Earnings before interest and taxes (EBIT) = Net income +
Interest + Taxes
• Pre-tax income, or Earning before tax (EBT), or Taxable
income = EBIT – Taxes
• Earnings per share (EPS) =
Net income
Shares outstanding
• Diluted EPS: the EPS in case all stock options are
exercised and all convertible bonds are converted into
shares (both actions increase the total number of shares)
Financial statements – Statement of stockholders’ equity
The statement of stockholders’ equity breaks down the
stockholders’ equity computed on the balance sheet into
the amount that came from issuing shares versus retained
earnings (i.e., net income not distributed to stockholders).
It is not very useful for financial statements analysis
purposes.
Financial statements – Statement of cash flows
The statement of cash flows determines how much cash the
firm has generated and how it has been allocated, starting
from the income statements. It consists of three sections:
• Operating activity: takes the net income and adds back all
non-cash entries related to the firm’s operating activities
(e.g., depreciation)
• Investment activity: deducts the capital expenditures (i.e.,
purchase of new property, plant or equipment, which are
listed as depreciation expenses in the income statement)
and the cost of other assets or financial investments
• Financing activity: subtracts the cost of raising cash, (i.e.,
issuing debt, paying dividends, etc.)