Unit 1 Study Guide and Review: Introduction To Finance, Financial Statements, And Financial Analysis

1a. explain the primary goal of financial management
  • What is the goal of financial management?
  • Why are financial managers important to firms?
  • How are the roles of shareholders and financial managers interdependent?

The primary goal of financial management for financial managers is to maximize shareholder wealth, which is also referred to as maximizing the price of the firm's existing common stock. Financial managers have to consider many factors when making decisions. They are trusted agents in firms who must engage in ethical practices to meet the firm's goals. Maximizing shareholder wealth is a goal that takes into account the risks and realities of the firm's operating environment and the impact of financial decisions. Changes in financial market stock prices are a proxy for investor sentiment toward the decisions of the firm. If investors react positively, stock price increases or stock price decreases if investors react negatively to the firm's decisions. The value of the stock price is the measure of shareholder wealth. Shareholders are the ultimate owners of a firm, because each share represents a piece of the firm that has been bought. Therefore, the shareholder who purchased that stock has ownership and voting rights over the percentage of the company that shareholder owns. Financial managers should take care to make sound decisions, accounting for the appropriate operating context.

Firms are for-profit entities that provide a service or product to a market. Firms can have various organizational structures. A firm can be a sole proprietorship, self-corporation, a partnership, or a corporation. These organizational structures differ on a spectrum with regard to their taxation, legal risk, profit sharing, and the role of the financial manager. For more about what it means to own stock, watch this video.

1b. describe how stocks and bonds function and their effect on corporate structure
  • From where do firms get money to operate?
  • What is a stock?
  • What is a bond?
  • How do financial markets allocate resources to firms?

Firms have the choice between two sources of raising new capital: debt or equity. A firm's owners can raise capital by selling ownership in the firm, which is equity, or a firm can secure capital by borrowing funds through a loan, which is debt. Equity is often represented by issuing stock. Debt is reflected by a firm's issuance of bonds. Financial markets are a key component to the allocation of capital to firms and to facilitating financial transactions.

Once the firm is operating, it can generate cash through other methods, such as income from its financial investments, sale of assets, operating activities, or additional-paid-in-capital by its owners. Each of these ancillary methods has at its foundation elements of debt, equity, or some combination of the two.

Whichever source of capital or combination of sources of capital chosen by a firm, that choice also has an impact on the firm's corporate structure. A firm that raises money in the capital market through equity, issues a stock for sale to shareholders. In turn, those shareholders "own" a piece of the company, which provides them many entitlements, such as to vote in matters related to the firm, dividends paid on the value of the shares they own, and residual claims to the firm's assets if the firm dissolves. A firm can also raise money in the capital market by issuing a bond. When a firm issues a bond, every investor who purchases that bond is granting a loan to the firm under specified repayment terms for a specific length of time.

1c. explain how financial managers use the income statement, the balance sheet, and the statement of cash flows to make better informed decisions
  • Where do firms record their financial transactions?
  • How do firms report and track their activities to others?
  • What is the purpose of financial statements?
  • How are financial statements used to analyze a firm's operations and performance?

Firms keep official records of their operating activities, cash flows, and assets for tax purposes, general bookkeeping, regulatory reporting requirements, historical records, and information transparency to investors and other interested parties. These official records, of which there are multiple types, are collectively called financial statements. The reporting requirements can differ based on company size, firm organizational structure and whether or not a firm is publicly or privately owned. The three most common financial statements are: the balance sheet, the income statement, and the statement of cash flows. These statements are produced at least yearly and contain key accounts and activities of the firm. The statements stand individually, but they are also connected because they either share the same information or provide information that informs the creation of one of the other statements.

The balance sheet the first statement created. It gives a portrait of the company's financial position at one point in time, which is most commonly at the end of the firm's calendar year. It shows the relationship between a firm's assets (what the firm owns) and its liabilities and owner's equity (who has a claim on what the firm owns). The accounts on the balance sheet are grouped by whether they are assets, liabilities, or owner's equity. Within those categories, accounts are further separated by whether they are current (due or used within a year or less) or long-term (due or used in greater than a 12-month period). The balance sheet is governed by the equation assets = liabilities + owner's equity. For the statement to be correct, the sum of all assets must always equal the sum of liabilities and owner's equity. This maintains the balance.

The income statement is the statement of how the company has created and allocated its income over the year. The major source of a firm's income is called sales revenue. Therefore, the equation that defines the income statement is Sales – Expenses = Net Income. The income statement is connected to the balance sheet because some balance sheet accounts, especially those considered "current", are reflected as expenses on the income statement. Net Income is found at the bottom of the income statement. With net income, a firm can either reinvest it in the company by putting it into the retained earnings account, or it can pay dividends. The retained earnings account is listed on the balance sheet. A firm's tax liability and depreciation is also on the income statement.

The statement of cash flows depicts the inflow and outflows of cash within a year at a firm. It separates the cash-generating activities of the firm into three categories: operating activities, investing activities, and financing activities.

1d. compute the major financial ratios in order to evaluate a company's performance
  • How are financial statements used to analyze a firm's operations and performance?
  • How do firms compare their performance across time and with their peers?

Financial statements provide a source of comparison of the firm's financial activities over time. Financial ratios are another tool that help other evaluate a firm's performance. Financial ratios are a unique evaluation tool because they allow for the comparison of a firm's performance against its peers and against industry averages, not only against the firm's own performance. Financial ratios are percentages that are created by using various accounts on the financial statements. There are five categories of performance measured by financial ratios – liquidity or solvency, asset efficiency or turnover, profitability, financial leverage or debt, and market value. Comparisons across companies and within an industry can be done on a specific ratio, a category of ratios, or over time. Ratio analysis is a multi-dimensional analysis technique that facilitates benchmarking and trend analysis.

1e. analyze pro-forma financial statements in order to evaluate the future performance of a company
  • What would a firm use to plan operations for the future?
  • How can firms use historical performance to predict future performance?
  • How do investors value a company?
  • How do pro forma financial statements differ from standard financial statements?

A firm's financial statements, while important for assessing performance, are backward-looking statements. There is a lag between when activities occur and when the reports are created. Financial statements provide information about transactions and activities that have already happened at the firm. While analysis can be conducted from existing financial statements, there are times when it's necessary to have a forward-looking perspective about the firm's activities. Therefore, financial statements are forecasted into the future, using assumptions, to create what are called "pro-forma" financial statements. It is possible to create a pro forma balance sheet, a pro forma income statement, and a pro forma cash budget.

Pro forma financial statement analysis is useful when trying to assess the future state of a firm under assumed circumstances or an anticipated change in market conditions. Pro forma financial statements are also used as a valuation method for a firm. Many firms undergoing potential sale, acquisition, merger or buyout activities will use pro forma financial statements to estimate the firm's future worth. The assumptions used in building pro forma statements can come from market averages, benchmark metrics, or can be derived from the company's past performance as exhibited in its financial statements.

To create a pro forma statement, the firm or an analyst can use the most recent financial statement as a starting point, change assumptions for the percentage growth of each category on the financial statements, and then calculate that multiple against the current values on the financial statement used as a base. The resulting figure will be what is placed on the pro forma statement. Applying the multiple can be done for one period or many periods. The percentages applied can also be changed each iteration of creating a new statement. The result would be the creation of a pro forma statement that, using certain assumptions, gives an ideal of what the future financial condition of the company could be.

1f. prepare an analysis of a company's financial statements
  • What are the tools one can use to analyze a company's performance?

Financial statements contain a lot of valuable information about a firm. Analyzing financial statements is a critical exercise that allows key decisions to be made. There are many audiences for a firm's financial statements: investors, shareholders, government entities, regulatory bodies, employees, market analysts, students, and others who have an interest in learning about the organization. Being able to prepare an analysis of a firm's financial statements helps one to interpret the information on the statements. Analyzing financial statements requires one to know the equations that define the statements, the accounts and categories on the statements, the firm's baseline financial picture, and how to utilize financial ratios, common-size financial statements, and pro forma financial statements to analyze a firm. To start, it is helpful to have the balance sheet of the year in question and the balance sheet from the prior year. The firm's balance sheet from the prior year should be the starting point of the analysis because it provides the assets the company began with in the current year. The next element to examine is the income statement because it shows the sales revenue and expenses incurred from the firm's operations. The income statement also shows the additions to the retained earnings and additional-paid-in-capital accounts on the balance sheet. The depreciation expense on the income statement shows annual increases to the accumulated depreciation account on the balance sheet. Examining the statement of cash flows gives more insight into the movement of the cash account on the balance sheet it also provides insight into the operating activities on the income statement.

Unit 1 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Financial manager
  • Shareholder
  • Firm
  • Profit
  • Stock price
  • Sole proprietorship
  • Corporation
  • General partnership
  • Limited partnership
  • Limited liability company
  • Taxable income
  • Tax liability
  • Tax rate
  • Debt
  • Equity
  • Stock
  • Bond
  • Financial statement
  • Balance sheet
  • Income statement
  • Statement of cash flows
  • Ratio analysis
  • Pro forma financial statement
Last modified: Wednesday, August 1, 2018, 3:25 PM