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ACCT-123 Review

Financial Management 

Financial management is activity involved in raising funds and buying assets in order to obtain the highest possible return. Financial management embraces four broad activities: bookkeeping, accounting, analysis, and decision-making.

  • Bookkeeping involves collecting, classifying, and recording information that arises form the multitude of transactions taking place in a business.
  • Accounting is the activity that arranges the information into separate and distinct financial statements.
  • Analysis consists of interpreting financial statements.
  • Decision-making improves the financial performance and financial structure of the businesses.

Return on Assets = Profit after taxes / Investment in assets

Financing decision:        Decisions related to borrowing from lenders and shareholders

Matching principle:         Process of selecting the most appropriate financing source when buying an asset

Sources of Financing:     institutions that provide funds

Cost of borrowed funds:     Effective after-tax cost of raising funds from different sources (lenders
and shareholders)

Gross margin:     Difference between sales revenue and cost of goods sold.

Financial Statements:     Financial statements are financial reports, which include the income statement, the statement of retained earnings, the balance sheet and the statement of changes in financial position.

Income Statement:     Financial statement that shows a summary of revenues and expenses for a specified period of time


**** Inc.

Income Statement for the Year Ended

December 31, 2000

Operating Section

Net Sales                                                                                                         ****

Cost of goods sold                                                                                           ****

Gross Margin                                                                                                  ****

Operating expenses


Selling expenses:

            Sales salaries                                                            ****

            Advertising expenses                                                  ****                              

Total selling expenses                                                            ****


Administrative expenses:

            Office salaries                                                            ****

            Depreciation                                                              ****

Total administration expenses                                                 ****

Total operating expenses                                                                                ****

Operating income                                                                                           ****

Non-Operating Section

Other income                                                                         ****

Other expenses (interest)                                                       ****                  ****

Income before taxes                                                                                       ****

Owners' Section

Income taxes                                                                                                 ****

Income after taxes                                                                                         ****

Statement of retained earnings

Financial statement that shows the amount of income retained in a business since it was started

**** Inc.

Retained Earnings Statement for the Year Ended

December 31, 2000


Retained earnings (beginning balance)                                                                 ****


Earning for the year                                                                 ****

Dividends                                                                               ****                              


Retained earnings (ending balance)                                                                      ****                                                                  


Balance sheet:     Financial statement that shows a "snapshot" of a company's financial condition (assets. liabilities, and equity)

**** Inc.

Balance Sheets as at

December 31, 2000




Current Assets


Cash                                                                                                             ****

Accounts receivable                                                                                         ****

Inventory                                                                                                       ****

Total current assets                                                                                         ****


Capital assets (Cost)                                                                                      ****

Accumulated depreciation                                                                                ****

Capital assets (net)                                                                                        ****

Total Assets                                                                                                    ****



Current liabilities

Accounts payable                                                                                             ****

Accrued expenses                                                                                            ****

Notes payable                                                                                                 ****

Total current liabilities                                                                                      ****

Long-term debts                                                                                              ****


Common shares                                                                                              ****

Retained earnings                                                                                           ****

Shareholders' equity                                                                                        ****


Total liabilities and equity                                                                              ****


Statement of changes in financial position:     Financial statement that shows where funds come form and where they went


The Statement of Change in Financial Position

**** Inc.

For the Year Ended December 31, 2000


Operating activities


Income after taxes                                                                  ****

Depreciation                                                                            ****

Net change in non-cash working capital accounts                          ****

Total                                                                                                                ****   

Financing activities

Payment of dividends                                                              (****)

Long-term debt                                                                        ****

Common shares                                                                       ****

Total                                                                                                                ****

Investing activities

Purchase of capital assets                                                                                   ****

Net increase (decrease) in cash                                                                            ****

Cash at beginning of year                                                       ****

Cash at end of year                                                               ****


Changes in non-cash working capital accounts


Sources or Uses

Prepaid expenses                                                                    ****

Accounts payable                                                                     ****

Working capital loan                                                                ****

Accounts receivable                                                                  ****

Inventory                                                                                 ****

Net increase (decrease) in non-cash working capital accounts           ****


Business transactions are recorded under five major groupings or accounts

  • assets, or what a business owns
  • liabilities, or what it owes to creditors
  • equity, or what it owes to shareholders
  • revenue, or how much it earned as a result of selling its goods or services
  • expenses or how much it cost to produce and sell its goods or services

The Accounting Equation:    Assets = Liabilities + Equity or Assets - Liabilities = Equity

The Bookkeeping & Accounting Cycle

There are several steps involved from the time that a transaction is processed in a business to the time that it is reported in one of the financial statements. This bookkeeping and accounting cycle includes five steps:

Step 1:  Business transaction (e.g., buying a equipment, investing money in the business)

Step 2:  Each transaction is accompanied by a document (e.g., a deposit slip from the bank, a purchase document)

Step 3:  Each transaction is recorded in different sets of books: journals and ledgers through the bookkeeping systems.

Step 4:  Transfer the amounts recorded in the journals into ledgers.

Step 5:  Close the books. It is done at the end of an accounting period. (e.g., the end of a month of the end of a fiscal year)

Use Ratios to Analyze Financial Statements:

Liquidity Ratios: examine the relationship between current assets and current liabilities. It measures the ability of a firm to meet its cash obligations.


Current ratio = Current assets/Current liabilities (Gauges general business liquidity)

Quick ratio = Quick assets/Current liabilities (Shows relationship between the more liquid current assets and all current liabilities)

Debt/Coverage Ratios: Measure the capital structure of a business and its debt-paying ability

Debt-To-Total-Assets Ratio = Total debts/Total Assets (Measures how much debt a business uses to finance all assets)

Debt-To-equity Ratio = Total debts/Total shareholders' equity (Measures the proportion of debt sed compared to equity to finance all assets)

Times-interest-earned ratio = (Income before taxes + Interest charges) / interest charges (Measures to what extent a business can service its interest on debt)

Fixed-charges-coverage ratio = (Income before taxes + Interest charges + Rent) / (Interest charges + Rent)


Asset-Management Ratios: Evaluate how efficiently managers use the assets of a business

Average Collection Period = Accounts Receivable / Average daily sales (Measures how many days it takes for customers to pay their bills)

Inventory turnover = Cost of goods sold/inventory (Measures the number of times a year a company turns over its inventory)

Capital assets turnover = Sales/capital assets (Measures how intensively a firm's capital assets are used to generate sales)

Total assets turnover = Sales/Total assets (Measures how intensively a firm's total assets are used to generate sales)


Profit Ratios: Measure the overall effectiveness of a business

Profit margin on sales = Operating income/Sales (Measures the operating efficiency of a business)

Return on sales = Income after taxes/Sales (Measures a company's overall ability to generate profit from each sales dollar)

Return on total assets = Income after taxes / total assets (Gauges the performance of assets employed in a business)

Return on Equity = Income after taxes/owners' equity (Measures the yield shareholders each on their investment)


Market-Value Ratios: Measurement tools to gauge the way investors react to a company's market Performance


Earnings per share = Income to common shareholders/number of shares outstanding (Measures how much net income is available to each outstanding share)

Price/earnings ratio = Price per common share / earnings per common share (Indicates how much investors are willing to pay per dollar of reported profits)


Cost-volume-profit analysis: Tool used for analyzing how volume, price, product mix, and product costs relate to one another

Fixed costs: costs that remain constant at varying levels of production.

The following are typical examples of fixed costs:

Rent                                         Interest on mortgage                              Property insurance

Property taxes                           Office salaries                                        Depreciation

Protection services                     Telephone                                             Professional fees

Variable costs: costs that fluctuate directly with changes in volume of production.

The following are typical examples of variable costs:

Sales commission                     Direct labor                                            Packing materials

Electricity                                  Overtime premiums                                Equipment rentals

Materials                                   Freight-out                                             Fuel

 Break-Even Analysis: Level of production where sales revenue equals total costs                          

  • Unit break-even point = Fixed cost/(Price per unit-Variable cost per unit)
  • Unit Cash BEP = (Fixed cost-Depreciation)/(Price per unit-Variable cost per unit)
  • Unit Profit BEP = (Fixed cost Profit)/(Price per unit-Variable Cost)
  • Revenue break-even point = Fixed Cost/PV
  • Revenue Profit BEP = (Fixed cost + Profit) / PV

Contribution Margin: The difference between sales revenue and variable costs

PV Ratio: Profit-volume ratio; the contribution margin expressed on a per-unit basis

PV = Unit contribution/Unit selling price

Relevant Costs: Cost alternatives that managers can choose from to operate a business


Capital Investment Decision:

Capital Investment vs. Expense Investment

Capital investment: project that requires extensive financial resources (cash outflow) made for the purpose of generating a return (cash inflow).

Expense investment: A fully tax-deductible cost that should produce favorable effect on the profit performance.


Compulsory Investment vs. Opportunity Investment

Compulsory Investments: Investments made in capital assets that do not require in-depth analytical studies.


Opportunity Investments: Investments made in capital assets that are of a strategic nature and usually have far-reaching financial implications.

The payback method: the number of years required for a capital investment to generate enough undiscounted cash inflow to just cover the initial cash outflow.


Payback = I / NCF         

I: is the original investment

NCF: is the net cash inflow when cash inflow is equally distributed annually or when the irregular annual cash inflow is averaged out


Net present value (NPV): The present value of the future cash flow of an investment, less the initial cash outflow.


Internal rate of return (IRR): specific interest rate used to discount all future cash inflows so that their present value equals the initial cash outflow.


Profitability index: ratio of the present value of cash inflow to the present value of the cash outflow discounted at a predetermined rate of interest.

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