Business Finance: Key Concepts

• Business finance involves managing a company's money, including acquiring, investing, and managing financial resources.
• The primary goal is to maximize shareholder wealth by making sound financial decisions.
• It encompasses various activities such as financial planning, budgeting, investment decisions, and risk management.

Key Areas of Business Finance

• Capital budgeting: Evaluating potential investments to determine which ones to undertake.
• Capital structure: Determining the optimal mix of debt and equity financing.
• Working capital management: Managing short-term assets and liabilities to ensure smooth operations.
• Dividend policy: Deciding how much of the company's earnings to distribute to shareholders.

Financial Statements

• Balance sheet: A snapshot of a company's assets, liabilities, and equity at a specific point in time.
  • Assets = Liabilities + Equity
  • Assets are what a company owns (e.g., cash, accounts receivable, inventory, equipment).
  • Liabilities are what a company owes to others (e.g., accounts payable, loans).
  • Equity represents the owners' stake in the company (e.g., common stock, retained earnings).
• Income statement: Reports a company's financial performance over a period of time.
  • Revenue - Expenses = Net Income
  • Revenue is the money earned from sales of goods or services.
  • Expenses are the costs incurred to generate revenue (e.g., cost of goods sold, operating expenses).
  • Net income is the profit after all expenses have been deducted.
• Statement of cash flows: Tracks the movement of cash both into and out of a company over a period of time.
  • Operating activities: Cash flows from the normal day-to-day activities of the business.
  • Investing activities: Cash flows from the purchase and sale of long-term assets.
  • Financing activities: Cash flows from debt, equity, and dividends.

Financial Ratio Analysis

• Liquidity ratios: Measure a company's ability to meet its short-term obligations.
  • Current ratio = Current assets / Current liabilities
  • Quick ratio = (Current assets - Inventory) / Current liabilities
• Profitability ratios: Measure a company's ability to generate profits.
  • Gross profit margin = (Revenue - Cost of goods sold) / Revenue
  • Net profit margin = Net income / Revenue
  • Return on equity (ROE) = Net income / Shareholders' equity
• Solvency ratios: Measure a company's ability to meet its long-term obligations.
  • Debt-to-equity ratio = Total debt / Shareholders' equity
  • Times interest earned = Earnings before interest and taxes (EBIT) / Interest expense
• Efficiency ratios: Measure how efficiently a company is using its assets.
  • Inventory turnover = Cost of goods sold / Average inventory
  • Accounts receivable turnover = Revenue / Average accounts receivable

Time Value of Money

• The concept that money available today is worth more than the same amount in the future due to its potential earning capacity.
• Future value (FV): The value of an asset at a specified date in the future, based on an assumed rate of growth.
  • FV = PV (1 + r)^n, where PV is present value, r is interest rate, and n is the number of periods.
• Present value (PV): The current value of a future sum of money or stream of cash flows, given a specified rate of return.
  • PV = FV / (1 + r)^n, where FV is future value, r is discount rate, and n is the number of periods.

Risk and Return

• Risk: The uncertainty associated with an investment's potential returns.
• Return: The gain or loss on an investment over a specified period, expressed as a percentage of the initial investment.
• Higher risk investments typically offer the potential for higher returns, but also carry a greater chance of losses.
• Diversification: Reducing risk by investing in a variety of assets.

Cost of Capital

• The minimum rate of return a company must earn to satisfy its investors.
• Weighted average cost of capital (WACC): The average cost of a company's debt and equity financing, weighted by their respective proportions in the capital structure.
  • WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of equity, D is the market value of debt, V is the total market value of the firm (E+D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate.
• Cost of equity: The return required by equity investors, which can be estimated using models like the Capital Asset Pricing Model (CAPM).
  • CAPM: Re = Rf + Beta * (Rm - Rf), where Rf is the risk-free rate, Beta is the asset's beta, and Rm is the expected market return.
• Cost of debt: The effective interest rate a company pays on its debt.

Capital Budgeting Techniques

• Net present value (NPV): The difference between the present value of cash inflows and the present value of cash outflows.
  • A positive NPV indicates that the investment is expected to increase the value of the firm.
• Internal rate of return (IRR): The discount rate that makes the NPV of an investment equal to zero.
  • If the IRR is greater than the cost of capital, the investment is considered acceptable.
• Payback period: The time it takes for an investment to generate enough cash flow to recover its initial cost.
  • Shorter payback periods are generally preferred.

Working Capital Management

• Managing short-term assets (e.g., cash, accounts receivable, inventory) and short-term liabilities (e.g., accounts payable, short-term debt).
• Goal: To ensure that a company has enough liquidity to meet its short-term obligations.
• Cash management: Optimizing cash flow to meet day-to-day needs and invest surplus cash.
• Accounts receivable management: Establishing credit policies and collection procedures to minimize bad debts.
• Inventory management: Balancing the costs of holding inventory with the need to meet customer demand.
• Accounts payable management: Managing payments to suppliers to take advantage of early payment discounts while maintaining good relationships.

Sources of Financing

• Debt financing: Borrowing money from lenders (e.g., banks, bondholders).
  • Advantages: Interest payments are tax-deductible, and debt does not dilute ownership.
  • Disadvantages: Debt must be repaid, and excessive debt can increase financial risk.
• Equity financing: Raising money by selling ownership shares in the company.
  • Advantages: Equity does not need to be repaid, and it can strengthen the company's balance sheet.
  • Disadvantages: Equity dilutes ownership, and dividends are not tax-deductible.
• Internal financing: Using retained earnings to fund investments.
  • Advantage: No transaction costs.
  • Disadvantage: May not be sufficient for large investments.

Dividend Policy

• Decisions about how much of the company's earnings to distribute to shareholders as dividends.
• Factors influencing dividend policy:
  • Company's financial performance
  • Investment opportunities
  • Legal and contractual constraints
  • Shareholder preferences
• Types of dividend policies:
  • Constant dividend payout ratio
  • Stable dividend policy
  • Residual dividend policy

Mergers and Acquisitions (M&A)

• Mergers: The combination of two or more companies into a single entity.
• Acquisitions: The purchase of one company by another.
• Reasons for M&A:
  • Synergy
  • Economies of scale
  • Increased market share
  • Diversification
• Valuation in M&A: Determining the fair price for a target company, often using techniques like discounted cash flow analysis, comparable company analysis, and precedent transaction analysis.