Ch7. Financial Management and Accounting — Core Finance for the Consulting Exam

Financial Statements

Balance Sheet (Statement of Financial Position):
Assets = Liabilities + Equity
Current assets · Non-current assets
Current liabilities · Non-current liabilities

Income Statement:
Revenue − Cost of Goods Sold = Gross Profit
− Operating Expenses = Operating Income (EBIT)
± Non-operating items = Pre-tax Income
− Income Tax = Net Income

Statement of Cash Flows:
Three sections: Operating · Investing · Financing activities
Indirect method: start with net income, then adjust

Financial Ratio Analysis

Profitability:
ROE = Net Income / Shareholders' Equity
ROA = Net Income / Total Assets

Liquidity:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets − Inventory) / Current Liabilities

Leverage (Solvency):
Debt-to-Equity = Total Debt / Shareholders' Equity
Interest Coverage = EBIT / Interest Expense

Activity (Efficiency):
Asset Turnover = Revenue / Total Assets
Inventory Turnover = COGS / Average Inventory

Capital Budgeting — Investment Decision Framework

NPV Method:
NPV = ΣCFt/(1+r)^t − Initial Investment
NPV > 0 → Accept the project
Explicitly accounts for time value of money

IRR Method:
IRR = discount rate at which NPV = 0
IRR > Cost of Capital → Accept
When projects are mutually exclusive, NPV takes precedence

Payback Period:
Time to recover initial investment
Weakness: ignores time value of money and cash flows after breakeven

Profitability Index:
PI = PV of future cash flows / Initial Investment
PI > 1 → Accept

Capital Structure and Dividends

Modigliani-Miller (MM) Theorem:
Under perfect market assumptions, capital structure is irrelevant to firm value

In practice:
Tax shield benefit of debt → some leverage is advantageous
Financial distress costs → excessive debt creates risk
Optimal capital structure = balance between these two forces

Dividend Policy:
Payout Ratio = Dividends / Net Income
Stable dividend: maintain a fixed dollar amount per share
Residual dividend: pay out what remains after funding investments

Key Concept Cards

ROE = Net Income / Equity ★★★★★ : Return on Equity — measures performance from the shareholder’s perspective. Memory hook: ROE = shareholders’ return

NPV > 0 = Accept ★★★★★ : A positive NPV means the project adds value to the firm. Memory hook: NPV positive → invest

Debt-to-Equity Ratio ★★★★☆ : Below 1.0x is generally healthy; higher ratios increase financial risk. Memory hook: D/E = debt ÷ equity

Practice Quiz

Q. Does a high ROE always mean a company is healthy?

Not necessarily. ROE = Net Income / Equity. A small equity base — meaning the company is heavily leveraged — can produce a high ROE even when underlying profitability is weak. Always compare ROE alongside ROA. If ROE significantly exceeds ROA, the company is using leverage to amplify returns, which introduces financial risk. Sustainable ROE is what matters.

Q. When NPV and IRR point to different decisions, which takes priority?

NPV takes priority for mutually exclusive investments. The flaw in IRR is that it ignores the scale of investment — it can make a small, high-yield project look better than a large, lower-yield project that generates far more total value. Theoretically, NPV directly measures value creation and is the correct criterion. In practice, IRR is widely used because it is easier to communicate to non-finance stakeholders.