The Finance Function and Business Strategy
Accounting is the process of measuring, interpreting, and
communicating financial information to support internal and
external business decision making.
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Financing activities provide necessary funds
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Investing activities provide valuable assets
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Operating activities focus on selling goods
to start a business and expand it after it
begins operating.
required to run a business.
and services, but they also consider
expenses as important elements of sound
financial management.
• Generally accepted accounting principles (GAAP) encompass the
conventions, rules, and procedures for determining acceptable
accounting practices at a particular time.
• Financial Accounting Standards Board (FASB) is primarily
responsible for evaluating, setting, or modifying GAAP in the U.S.
• Sarbanes-Oxley Act responded to cases of accounting fraud.
– Created the Public Accounting Oversight Board, which sets audit
standards and investigates and sanctions accounting firms that certify the
books of publicly traded firms.
– Senior executives must personally certify that the financial information
reported by the company is correct.
– Resulted in increase in demand for accountants.
Accounting process - set of activities involved in converting information
about transactions
into financial statements.
• Assets - anything of value owned or leased by a business.
• Liability - claim against a firm’s assets by a creditor.
• Owner’s equity - all claims of the proprietor, partners, or
stockholders against the assets of a firm, equal to the excess of
assets over liabilities.
• Basic accounting equation - relationship that states that
assets equal liabilities plus owners’ equity.
• Double-entry bookkeeping - process by which accounting
transactions are entered; each individual transaction always has
an offsetting transaction.
 Balance sheet - statement of a firm’s financial position—what it owns
and the claims against its assets—at a particular point in time.
 Photograph of firm’s assets together with its liabilities and owner’s
equity
 Follows the accounting equation
 Income Statement - financial record of a company’s revenues and
expenses, and profits over a period of time.
 Firm’s financial performance in terms of revenues, expenses, and
profits over a given time period.
 Reports profit or loss.
 Focus on revenues and costs associated with revenues.
 Statement of Owner’s Equity - is designed to show the components
of the change in equity from the end of one fiscal year to the end of the
next.
 Begins with the amount of equity shown on the balance sheet.
 Net income is added, and cash dividends paid to owners are
subtracted.
 Statement of cash flows - a firm’s cash receipts and cash payments
that presents information on its sources and uses of cash.
 Accrual accounting - method that records revenue and expenses when
they occur, not necessarily when cash actually changes hands.
Ratio analysis - tool for measuring a firm’s liquidity, profitability,
and reliance on debt financing, as well as the effectiveness of
management’s resource utilization.
Total current assets
Current ratio compares
current assets to current
liabilities.
Total current liabilities
Acid-test (or quick)
ratio measures the
ability of a firm to meet
its debt payments on
short notice.
Cash and equivalents
+ short-term investments
+ accounts receivable
Total current liabilities
Net sales
Inventory turnover
ratio indicates the
number of times
merchandise moves
through a business.
Average of inventory
Net sales
Total asset turnover ratio
indicates how much in
sales each dollar invested
in assets generates.
Average of total assets
Profitability ratios measure the organization’s overall financial
performance by evaluating its ability to generate revenues in excess of
operating costs and other expenses.
• Leverage ratios measure the extent to which a firm relies on
debt financing.
• Total liabilities to total assets ratio > 50 percent indicates that a
firm is relying more on borrowed money than owners’ equity.
• Budget - planning and control tool that reflects a
firm’s expected sales revenues, operating
expenses, and cash receipts and outlays.
• Management estimates of expected sales, cash
inflows and outflows, and costs.
• Budgets are a financial blueprint that serves as a
financial plan.
• Cash budget - tracks the firm’s cash inflows and
outflows.
Capital Budgeting, Finance and Decision making
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Project Types
Capital Budgeting Decision Criteria
◦ Net Present Value (NPV)
◦ Internal Rate of Return (IRR)
◦ Payback Period
Understand how to calculate and use the 3
capital budgeting decision techniques:,
NPV, IRR, and Payback.
 Understand the advantages and
disadvantages of each technique.
 Understand which project to select when
there is a ranking conflict between NPV
and IRR.
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Which of the following investment
opportunities would you prefer?
1) Give me $1 now and I’ll give you $2 at the
end of class.
2) Give me $100 now and I’ll give you $150
at the end of class.
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Analysis of potential additions to fixed
assets.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine k = WACC (Weighted Average Cost of Capital).
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
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Brand new line of business
Expansion of existing line of business
Replacement of existing asset
Independent vs. Mutually Exclusive
Normal vs. Non-normal
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NPV = PV of inflows minus Cost = Net gain in
wealth.
Acceptance of a project with a NPV > 0 will
add value to the firm.
Decision Rule:
◦ Accept if NPV >0,
◦ Reject if NPV < 0
NPV: Sum of the PVs of inflows and outflows.
n
CFt
NPV  
.
t
t  0 1  k 
Cost often is CF0 and is negative.
n
CFt
NPV  
 CF0 .
t
t 1 1  k 
0
1
2
CF0
CF1
CF2
Cost
Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
3
CF3
NPV: Enter k, solve for NPV.
n
CFt
 NPV.

t
t  0 1  k 
IRR: Enter NPV = 0, solve for IRR.
n
CFt
 0.

t
t  0 1  IRR
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Internal Rate of Return is a project’s expected
rate of return on its investment.
IRR is the interest rate where the PV of the
inflows equals the PV of the outflows.
In other words, the IRR is the rate where a
project’s NPV = 0.
Decision Rule: Accept if IRR > k (cost of
capital).
Non-normal projects have multiple IRRs.
Don’t use IRR to decide on non-normal
projects.
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For normal independent projects, both
methods give same accept/reject decision.
◦ NPV > 0 yields IRR > k in order to lower NPV to 0.
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However, the methods can rank mutually
exclusive projects differently.
What to do, then?
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Measures how long it takes to recovers a
project’s cost (CF0 = initial outlay).
Easy to calculate and a good measure of a
project’s risk and liquidity.
Decision Rule: Accept if PB < some
maximum period of time.
If cash inflows are equal each year (in the
form of an annuity), PB = CF0/Annual CF
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Ignores time value of money!
Ignores cash flows beyond payback period.
The Discounted Payback Period addresses the
first problem.
Disc. PB tells how long it takes to recover
capital and financing costs for a project.
Discount rate = cost of capital.