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Principles of Finance

1.2 The Role of Finance in an Organization

Principles of Finance1.2 The Role of Finance in an Organization

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Describe the finance function.
  • Explain the role of finance and its importance within an organization.

The Finance Function

Finance has many functions within an organization, and there are many job titles to reflect the varied job responsibilities. The comptroller, or more commonly a controller, in a for-profit business relies heavily on a knowledge of accounting. Controllers are in charge of financial reporting and the oversight of the accounting activities necessary to develop those reports. Controllers are concerned with payroll functions, accounts receivable, and accounts payable including taxes, inventory control, and any number of short-term asset and liability tracking and monitoring activities. They aid internal and external auditors and are responsible for monitoring and implementing the day-to-day financial operations of the firm.

In most organizations, the treasurer might assume many of the duties of the controller. However, the treasurer is also responsible for monitoring cash flow at a firm and frequently is the contact person for bankers, underwriters, and other outside sources of financing. A treasurer may be responsible for structuring loan and debt obligations and determining when and from whom to borrow funds. Treasurers are also responsible for investing excess funds. Where a controller may face inward toward the organization, the treasurer often faces outward as a representative to the public.

The vice president of finance (VP-F) is an executive-level position and oversees the activities of the controller and treasurer. The chief responsibility of the VP-F is to create and mentor a sufficient and qualified staff that generates reports that are timely, accurate, and thorough.

The chief financial officer, or CFO, is in a “big picture” position. The CFO sets policy for working capital management, determines optimal capital structure for the firm, and makes the final decision in matters of capital budgeting. The CFO is also forward looking and responsible for strategic financial planning and setting financial goals. Compared to a VP-F, a CFO is less of a “hands-on” manager and engages more in visionary and strategic planning.

Financial Planning

Financial planning is critical to any organization, large or small, private or public, for profit or not-for-profit. Financial planning allows a firm to understand the past, present, and future funding needs and distributions required to satisfy all interested parties. For-profit businesses work to maximize the wealth of the owners. These could be shareholders in a publicly traded corporation, the owner-managers of a “mom and pop” store, partners in a law firm, or the principal owners of any other number of business entities. Financial planning helps managers understand the firm’s current status, plan and create processes and contingencies to pursue objectives, and adjust to unexpected events. The more thoughtful and thorough the financial planning process, the more likely a firm will be able to achieve its goals and/or weather hard times. Financial plans typically consider the firm’s strategic objectives, ethical practices, and sources and costs of funds, as well as the development of budgets, scenarios, and contingencies. The financial plan Bacon Signs developed was thorough enough to anticipate when and how growth might occur. The plan that was presented to commercial banks allowed the firm to be guaranteed new financing at critical moments in the firm’s expansion.

Good financial planning has a number of common features.

  • It uses past, current, and pro forma (forward-looking) income statements. Pro forma income statements are created using assumptions from past events to make projections for future events. These income statements should develop likely scenarios and provide a sensitivity analysis of key assumptions.
  • Cash flow statements are a critical part of any financial planning. Cash flow statements estimate the timing and magnitude of actual cash flows available to meet financial obligations.
  • Balance sheets are critical for demonstrating the sources and uses of funds for a firm. One of the most important aspects of business is accounting (see Figure 1.5).
  • Forecasting in the form of expected sales, cost of funds, and microeconomic and macroeconomic conditions are essential elements of financial planning.
  • Financial analysis including ratio analysis, common-size financial statements, and trend statements are important aspects of financial planning. Such analysis aids in the understanding of where a firm has been, how it stacks up against the competition, and the assessment of target objectives.
An illustration of an accounting system shows three steps. The first step shows a laptop computer that classifies, summarizes, and analyzes data. This leads to the second step, the preparation of financial reports, shown as three papers with many rows and columns. In the third step, the financial reports are used to evaluate the firm and make decisions. This is illustrated by a line graph.
Figure 1.5 The Accounting System The accounting system relies on accurate data used to prepare all the financial reports that help to evaluate a firm.

Forecasting and Budgeting

Forecasting and budgeting are common practices for businesses, governmental agencies, not-for-profit firms, and individual households. As with many of the financial topics introduced in this chapter, these activities are valuable for individuals and businesses alike. Budgeting, or planning for the amount, sources, and uses of cash, occurs early in the planning process. It is common for businesses to have developed an annual budget well before the start of the year. With budgeting, a firm establishes objectives for the upcoming period by developing financial statements based on historical data and expectations, as well as aspirations for the future. The budgeting process helps the firm identify what actions need to be undertaken to achieve its objectives. However, no matter how strong the budgeting process, actual events can change the timing and magnitude of expected cash flows.

Financial forecasting addresses the changes necessary to the budgeting process. Budgeting can help identify the differences or variance from expectations, and forecasting becomes the process for adapting to those changes. We attribute to President Eisenhower the saying that “plans are worthless, but planning is everything.” That statement applies to business today as well as it did during his service in the military and government. The budgeting or planning process is a road map for organizations, and forecasting helps navigate the inevitable detours toward the firm’s objectives.

The budgeting process develops pro forma financial statements such as income and cash flow statements and balance sheets. These provide benchmarks to determine if firms are on course to meet or exceed objectives and serve as a warning if firms are falling short. Budgeting should involve all departments within a firm to determine sources and uses of funds and required funding to meet department and firm objectives. The process should look to emulate successful processes and change or eliminate ineffective ones. Budgeting is a periodic renewal and reminder of the firm’s goals.

Financial forecasting often starts with the firm’s budget and recommends changes based on differences between the budgeted financial statements and actual results. Forecasting adjusts management behavior in the immediate term and serves as a foundation for subsequent budgets.

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