Financial Management and Accounting
Core Concepts
Financial management involves planning, acquiring, and utilizing funds to maximize firm value. Key areas: financial statements (balance sheet, income statement, cash flow statement), ratio analysis (liquidity, solvency, profitability, efficiency), time value of money (TVM), capital budgeting (NPV, IRR, payback), and cost of capital (WACC). Accounting principles include accrual basis, matching principle, and revenue recognition.
Traps in Questions
- Confusing profit with cash flow: a profitable firm can run out of cash if receivables are high or inventory builds up. Questions often ask why a profitable company failed-answer: poor cash management.
- Misapplying NPV vs IRR: NPV is preferred for mutually exclusive projects; IRR can mislead with non-conventional cash flows or scale differences.
- Mixing up liquidity ratios (current ratio, quick ratio) with solvency ratios (debt-to-equity, interest coverage).
- Forgetting that WACC uses market values, not book values, for weights.
- Assuming depreciation is a cash expense: it’s non-cash but affects taxes.
Worked Example / Rule of Thumb
A project requires an initial investment of $100,000 and generates $30,000 annually for 5 years. The firm’s WACC is 10%. NPV = -100,000 + 30,000 × [1 - (1+0.10)^-5] / 0.10 = -100,000 + 30,000 × 3.7908 = -100,000 + 113,724 = $13,724. Since NPV > 0, accept. Rule: Always compare NPV to zero; for independent projects, accept if NPV > 0.
Ratio Analysis
Understand how ratios interact: e.g., a high current ratio may indicate inefficient use of assets. DuPont analysis: ROE = Net Profit Margin × Asset Turnover × Equity Multiplier. A trap is to interpret a high ROE as necessarily good without checking leverage.