FINANCIAL MANAGEMENT SUMMARY
WEEK 1
Chapter 1
There are 4 types of firms:
• Sole proprietorships: a business owned and run by one person. Usually very small, with few,
if any, employees. Do not account for much sales revenue, but most common type of firm.
Key characteristics:
o Straightforward to set up so a lot of businesses use this form
o The principal limitation is that there is no separation of firm and owner. Other
investors cannot hold an ownership stake in the firm.
o Owner has unlimited personal liability for any of the firm’s debts. The lender can
and will require the owner to repay the loan from personal assets, may lead to
personal bankruptcy
o The life of the sole proprietorship is limited to the life of the owner. Difficult to
transfer the ownership
• Partnerships: identical to a sole proprietorship except that it has more than one owner. Key
characteristics:
o All partners are liable for the firm’s debt. A lender can require any partner to repay
all debts
o The partnership ends on the death or withdrawal of any single partner, although
liquidation can be avoided if the partnership agreement provides alternatives such as
buyout
Some old and established businesses remain partnerships such as law/accounting firms as
the personal liability increases clients confidence. A limited partnership has 2 kinds of
owners: general and limited partners. General partners have the same rights and liabilities as
regular partners. Limited partners have:
• Liability limited to their investment. Their private property cannot be seized to pay
off debt
• Their withdrawal does not dissolve the partnership
• No management authority
• Cannot legally be involved in managerial decision making for the business
Example of limited partnerships are private equity funds and venture capital funds.
• Limited liability companies (LLC): a limited partnership, but without a general partners. All
owners have limited liability, but they can run the business.
• Corporations: a legally defined, artificial being separate from its owners. Has many of the
legal powers people have and the owners are not liable for any obligations the corporation
enters into, nor vice versa.
o Formation of a corporation. Corporations must be legally formed, as a ‘citizen’ of the
state in which it is formed. A corporate charter is created by lawyers which specifies
the initial rules under which a corporation is run, which is costly.
o Ownership of a corporation. No limit on the number of owners. The entire
ownership stake is divided into shares or stock. The collection of all the outstanding
shares is the equity of the corporation. An owner of a share of stock is a
shareholder, stockholder or equity holder and is entitled to dividend payments,
proportional to the amount of stock they own. No limitation on who can own stock.
,Shareholders of a corporation pay taxes twice:
• The corporation pays tax on its profits, then the remaining profits are distributed to the
shareholders
• The shareholders pay their own personal income tax on this income
When divided by taxation, there are 2 kinds of corporations:
• S corporations: the firm’s profit and loss are not subject to corporate taxes, but instead
allocated directly to the shareholders, who must include it on their income taxes. Taxed only
once
• C corporations: subject to both income and corporate taxes. Taxed twice
In a corporation, the shareholders (the owners) are separate from the corporate management team,
consisting of the board of directors and the ceo, those who possess direct control.
The shareholders elect the board of directors. Usually, each share of stock gives 1 vote in the
election of the BoD, so whoever owns the most shares has the most influence. Shareholders with a
large proportion of outstanding stock may be on the BoD themselves or have the right to appoint a
number of directors.
In some companies, the CEO is also the chairman of the BoD. The most senior financial manager is
the chief financial officer (CFO) who reports directly to the CEO.
Within the corporation the financial managers are responsible for 3 main tasks:
• Investment decisions. Most important job, weighs costs and benefits of all investments and
decides which qualify
• Financing decisions. Once decided which investments to make, also decided how they are
paid for, e.g. by raising equity or borrowing money (debt)
• Cash management. Ensure the firm has enough cash to meet day-to-day obligations.
,Agency problems are when managers, despite being hired as the agents of the shareholders, put
their own self-interest ahead of the interests of shareholders. In practice this is usually addressed by
minimizing the number of decisions managers must make for which their self-interest differs
substantially from that of the shareholders, e.g. by tying compensations of managers to the stock
price. The downside of this is that it could lead to managers taking more risk than necessary. Further
ethical conflict may arise when some stakeholders benefit and others lose.
The stock price can be seen as a barometer for the CEO and gives them feedback on shareholders
opinions. When stock performs poorly, BoD may replace the CEO.
In a hostile takeover an individual or organization can acquire enough stock to replace the BoD and
CEO. The mere threat of this is often enough to discipline ‘bad’ managers.
If a corporation borrows money, the holders of the debt also become investors. If the firm is unable
to repay/renegotiate with the debt holders, the control of the corporations assets will be transferred
to them: control/ownership goes from equity to debt holders. Thus bankruptcy does not need to
result in liquidation of the firm.
An investment is liquid if it is possible to sell it quickly and easily for a price very close to the price at
which you could buy it. This is attractive to outside investors, as it provides flexibility.
When a corporation itself issues new stocks, it does so on the primary market. After this, shares are
traded in the secondary market between investors.
Market makers or specialists match buyers and sellers. They post 2 prices:
• The price at which they are willing to buy the stock: the bid price
• The price at which they are willing to sell the stock: the ask price
Market makers provide liquidity by ensuring that market participants always have someone to trade
with.
Difference NYSE and NASDAQ: NASDAQ is virtual and has multiple market makers/stock who
compete.
The difference between ask and bid prices is the bid-ask spread, which is the transaction cost
investors pay.
Lately there has been a change in the market structure, with the role of an official market maker
disappearing, because almost all transactions now occur by computers. Anyone can make a stock
order by posting a limit order to buy/sell at a fixed price. The bid-ask spread is determined by the
outstanding limit orders.
The lowest limit sell order is the ask price, the highest limit buy order is the bid price. The collection
of all limit orders is the limit order book.
Market orders are orders that trade immediately at the best outstanding limit order. These are
‘takers’ of liquidity. ‘providers’ of liquidity earn the bid-ask spread, but risk their orders becoming
stale. High frequency traders (HFTs) update, cancel and execute many trades/second profiting both
by providing liquidity and taking advantage of stale limit orders.
Dark pools are trading systems that do not make their limit order book visible. Instead they offer the
ability to trade at a better price, with the tradeoff that the order might not be filled. Attractive to
traders who do not want to reveal their demand (usually large quantity).
, Chapter 2
US public companies must issue their financial statements both quarterly, in the 10-Q form and
annually, the 10-K form. They must also send an annual report to their shareholders.
Financial statements can be prepared according to two principles:
• Generally Accepted Accounting Principles (GAAP), these may differ per country
• International Financial Reporting Standards (IFRS)
Corporations are required to hire a neutral 3rd party, an auditor to check if the annual financial
statements are reliable and according to either one of the two financial principles.
Each financial statement consists of 4 things: the balance sheet, the income statement, the
statement of cash flows and the statement of stockholder’s equity.
Balance sheet or statement of financial position. This lists the firm’s:
o Assets: the cash, inventory, property, plant and equipment and other investments the
company made. Can be divided into short- and long-term assets.
▪ Current assets are either cash or assets that could be converted into cash within
one year. This includes:
• Cash and other marketable securities such as low-risk investments
• Accounts receivable amounts owed to the firm by customers who have
purchased on credit
• Inventories such as raw materials and unfinished goods
• Other current assets such as pre-paid expenses
▪ Long-term assets
• Net property, plant and equipment. Since equipment tends to wear out
over team, each year a depreciation expense is deducted. The
accumulated depreciation is the total amount deducted over its lifetime.
Book value of an asset = acquisition cost – accumulated depreciation
• Intangible assets or goodwill for example the value on top of the book
value of a company bought. If these intangibles decline over time, the
amount it reduces is listed as the amortization or impairment charge.
o Liabilities: the firm’s obligations to creditors. Also divided into short- and long-term:
▪ Current liabilities, those that will be satisfied within one year, includes:
• Accounts payable the amounts owed to suppliers for products
purchased with credit
• Short-term debt or notes payable and current maturities of long-term
debt
• Items such as salary/taxes owed but not yet paid
▪ Long-term liabilities all that extend beyond one year
• Long-term debt
• Capital leases long-term lease contracts
• Deferred taxes taxes owed, but not yet paid
o Stockholder’s equity or book value of equity: the difference between the firm’s assets
and liabilities, an accounting measure of the firm’s net worth.
The balance sheet identity:
Assets = Liabilities + Stockholder’s equity
