Financial Management
Lecture 1: Introduction
You need a clear strategy for financial management. It is important to stay in control.
Financial planning:
- Long term → 50 years
- Medium term → 5 years
- Short term → 1 year (budget)
Through income statements, balance sheets, cash flows, investments and ratios.
Regular reporting of actuals is necessary.
Revenue
The definition of revenue is inflows, enhancements of assets, or settlements of liabilities
from delivering or producing goods, rendering services, or other activities that are related to
the firm’s core business operations. Revenue can come from sales, interest, dividends or
rent. A gain is not related to the core business, for example, one-time selling of a product,
because you do not need it anymore. Both gain and revenue increase income. But they are
separated in the income statement.
Expense
The definition of expense is outflows, using-up of assets, or incurrence of liabilities from
delivering or producing goods, rendering services, or other activities that are related to the
firm’s core business operations. Depreciation expense means that you use up interests. A
loss is not related to the core business.
Costs
Cost is the value of a resource, such as the value of the time that a person works in a
company reflected in her salary. It can also be value of raw materials or the value of
production equipment.We can classify costs by behavior:
Variable costs:
o Costs which change with an increase or decrease in production volume; For example: cost
of surgical gloves;
Fixed costs:
o Costs which do not change with an increase or decrease in production
volume; For example: operating theater;
Mixed costs:
o Combination between variable and fixed; Even if there is no production, there are still
costs; If production increases, costs increases;
Step costs:
o Looks like a fixed cost, but jumps up radically at a certain level of activity.
Direct costs → have an identifiable causal relationship with the product or end service. We
also say that direct costs can be traced to a particular product or service. For example, when
a patient receives a pacemaker, the costs of the pacemaker are direct costs, because the
pacemaker is traceable to the individual patient.
1
, Financial Management
Indirect costs → lack a causal relationship and traceability and cannot be linked directly to
a product or service. The operating theatre manager is an indirect cost because it is not
directly traceable to the individual surgery that the patient receives.
Some resources are fully consumed in a period, and we call them expenses. Expenses have
no future value. Other resources are not fully consumed during the period, and we call them
assets. Assets have future value.
A financial report provides stakeholders of an organization with an overview of the
organization’s current and future financial situation and activities. A typical and very
important example of a financial report is the annual financial report.
The annual financial report has a reporting function for internal and external stakeholders.
Internally, the information contained in financial reports is used in decision-making related to
steering the organizations activities. Externally, the information contained in financial reports
is used to assess the organization's financial risk and creditworthiness, for example.
Secondly, the annual financial report serves as the basis for determining tax payments and
performance-related payments (such as dividends for shareholders). As such, it fulfills an
accountability function.
The accounting equation is: Assets = Liability + Equity
An asset is a resource that will produce future benefits.
A liability is an obligation to repay a debt in the future (future obligation).
An equity is a share of ownership (future profits).
The information obtained in financial reports is often quantified and interpreted by means
and ratios. These ratios allow the organization’s financial development to be analyzed over
time or for different organizations to be compared to each other. There are various ratios
which can help assess the profitability, solvency, and liquidity of organizations. The choice of
ratios to be considered depends on the organization and its context. Notably, they should
also be interpreted context dependent.
Profitability indicates how profitable an enterprise is. However, different calculations can
make to assess this, and its usage depends on the context. We distinguish between the
return on assets and return on equity.
Return on assets is an indicator of how profitable a company is, relative to its total assets. It
gives an idea as to how efficient management is at using its assets to generate earnings.
2
, Financial Management
Return on equity is a ratio that most concerns a company’s equity holders, since it
measures their ability to earn a return on their equity investments.
By solvency, we mean the extent to which an enterprise can meet its debt obligations if all
its assets are converted into cash. As in the prior explanation of profitability, solvency can be
measured in different ways. One solvency indicator is the ratio of equity to assets:
Having the accounting equation in mind, we can see that a high solvency ratio means that
the organization is predominantly owned by its shareholders. A low solvency ratio indicates
that the organization may be faced with high debts because equity is low, and the liabilities
are high. You can only increase solvency with profitability.
By liquidity of an enterprise, we mean the extent to which the organization can meet its
current liabilities from current assets. To derive a company’s liquidity from the balance sheet,
we can use the current ratio and the quick ratio. (if liquidity is low you can try to live with a
current ratio if you have enough cash flows or you can try to get a loan)
Sunk costs are important in strategic management, especially when assessing whether
capital should be replaced prematurely. To summarize, sunk costs are costs that have
already been incurred and cannot therefore be recovered. Consequently, they are excluded
from future business decisions. A sunk cost is irrelevant to decision making.
Opportunity costs are an important concept in (business) economics that are considered
while making decisions. An opportunity cost is essentially the benefit that you give up when
you choose something.
Financial accounting is the process of recording, summarizing, and analyzing an entity’s
financial transactions and reporting them in financial statements to its existing and potential
investors, lenders, and creditors.
Managerial accounting is the processing of identifying, measuring, interpreting, and
communicating information to management to assist them in planning, decision-making and
risk management.
3
