Ch5. Financial Management and Accounting — Reading Financial Statements and Valuing a Business

What Is Financial Management?

Financial Management covers three fundamental decisions: where to raise capital (financing decisions), where to invest it (investment decisions), and how to distribute profits (dividend decisions).

Every manager must be able to answer three core financial questions:

Which investments should we make? (Capital budgeting)
How should we finance those investments? (Capital structure)
Should we reinvest profits or distribute them as dividends? (Dividend policy)

Reading Financial Statements

Financial statements are the comprehensive report card of a business. Three core reports are essential.

Balance Sheet

Shows the assets, liabilities, and equity of a company at a specific point in time.

The fundamental equation: Assets = Liabilities + Equity

Assets	Liabilities + Equity
Current assets (cash, receivables, inventory)	Current liabilities (short-term debt, payables)
Non-current assets (buildings, equipment, land)	Long-term liabilities (bonds, long-term debt)
	Equity (paid-in capital, retained earnings)

How to read it: Assess the quality of assets (liquidity), the debt ratio (financial stability), and the equity composition.

Income Statement

Shows how much the company earned and spent over a period of time.

Revenue
− Cost of Goods Sold (COGS)
= Gross Profit
− Selling, General & Administrative Expenses (SG&A)
= Operating Income (EBIT)
− Interest Expense
= Pre-tax Income (EBT)
− Income Tax
= Net Income

EBITDA: Operating Income + Depreciation & Amortization. A widely used proxy for cash-generating ability and a common basis for enterprise valuation.

Cash Flow Statement

Shows how the company actually generates and uses cash. A profitable company can still go bankrupt if it runs out of cash.

Operating cash flow: cash from the core business
Investing cash flow: capital expenditures, asset purchases and sales
Financing cash flow: borrowings, repayments, dividends, share buybacks

Key principle: Profit and cash are different. A healthy company generates consistently positive operating cash flow.

Key Financial Ratio Analysis

Financial ratios reveal relationships between numbers on financial statements and diagnose the health of a business.

Profitability Ratios

Ratio	Formula	Meaning
Gross margin	Gross profit / Revenue	Basic product margin
Operating margin	Operating income / Revenue	Core business profitability
ROA	Net income / Total assets	Efficiency of asset utilization
ROE	Net income / Shareholders’ equity	Return on shareholders’ capital

Liquidity Ratios

Ratio	Formula	Meaning
Current ratio	Current assets / Current liabilities	Short-term debt coverage (≥2.0 preferred)
Quick ratio	(Current assets − Inventory) / Current liabilities	Immediate coverage excluding inventory

Leverage Ratios

Ratio	Formula	Meaning
Debt-to-equity ratio	Total debt / Shareholders’ equity	Reliance on borrowed capital
Interest coverage ratio	EBIT / Interest expense	Ability to service debt (< 1.0 = danger zone)

Cost of Capital and WACC

Cost of Capital

The minimum return a company must earn on invested capital to satisfy its investors. Projects earning below this rate destroy value.

Cost of Equity (CAPM): Ke = Rf + β(Rm − Rf)

Rf: risk-free rate (e.g., 10-year Treasury yield)
β (Beta): the stock’s sensitivity to market movements
Rm − Rf: equity risk premium

Cost of Debt: interest rate × (1 − tax rate). Interest expense generates a tax shield.

WACC (Weighted Average Cost of Capital)

The blended cost of capital when a company funds itself with both equity and debt.

WACC = (E/V) × Ke + (D/V) × Kd × (1 − T)

E: equity, D: debt, V: E + D
Ke: cost of equity, Kd: cost of debt, T: tax rate

WACC is the discount rate for investment decisions. An investment must return more than WACC to create shareholder value.

Investment Decision-Making: NPV and IRR

Net Present Value (NPV)

The sum of future cash flows discounted to present value, minus the initial investment.

NPV = −Initial Investment + Σ(Future Cash Flow / (1+r)^t)

NPV > 0 → invest (value-creating)
NPV < 0 → do not invest (value-destroying)
NPV = 0 → indifferent

Use WACC as the discount rate (r).

Internal Rate of Return (IRR)

The discount rate that makes NPV equal to zero — in other words, the actual return generated by the investment.

Decision rule: Invest if IRR > WACC.

NPV vs. IRR: NPV is generally the more reliable criterion. IRR can produce multiple solutions or give misleading rankings for mutually exclusive projects.

Business Valuation

DCF (Discounted Cash Flow)

Project the firm’s future free cash flows (FCF) and discount them at WACC to derive present value.

The most theoretically rigorous method — but highly sensitive to assumptions about future cash flows.

Comparable Company Analysis (Comps)

Apply valuation multiples from similar public companies.

Common multiples:

P/E (Price-to-Earnings): how many times earnings the market is paying
EV/EBITDA: enterprise value as a multiple of cash earnings
P/B (Price-to-Book): market value relative to book value

Learning Checklist

Can explain the balance sheet equation (Assets = Liabilities + Equity)
Can trace the income statement from revenue to net income
Can explain the three sections of the cash flow statement
Can calculate and interpret ROA, ROE, current ratio, and debt-to-equity ratio
Can explain WACC and apply the NPV decision rule

Key Concept Cards

STP Strategy (Segmentation, Targeting, Positioning) ★★★★★ : Segmentation: classify the market by demographic, psychographic, behavioral, or geographic criteria. Targeting: choose a strategy — undifferentiated, differentiated, or concentrated. Positioning: occupy a distinct, favorable place in the target customer’s mind versus competitors (positioning map).

Marketing Mix 4P (→ 7P for Services) ★★★★★ : Product (product lines, brand, packaging). Price (cost-plus, penetration, skimming, competitor-based). Place (direct/indirect channels, distribution intensity). Promotion (advertising, sales promotion, PR, personal selling). Services marketing 7P adds: People, Process, Physical evidence.

Product Life Cycle (PLC) and Strategy ★★★★★ : Introduction: low revenue, losses, heavy advertising, skimming or penetration pricing. Growth: revenue rising, profits improving, expand market share. Maturity: peak revenue, intense competition, differentiate or cut costs. Decline: falling revenue, exit or niche strategy. Memory tip: Introduction → Growth → Maturity → Decline

Practice Quiz

Q. Which is more reliable — NPV or IRR — and why?

NPV is more reliable. IRR can produce multiple solutions when cash flows change sign more than once, and it assumes reinvestment at the IRR itself (often unrealistic). NPV measures the direct increase in firm value, providing an unambiguous decision criterion.

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