Financial Management
Financial management questions test how firms raise, allocate, and control money, and how statements and ratios reveal financial health.
Financial statements
The balance sheet is a snapshot: assets = liabilities + owners' equity. The income statement reports revenues minus expenses over a period, ending in net income. The statement of cash flows splits operating, investing, and financing activities and explains why profit and cash differ. Depreciation reduces reported income but is a noncash expense.
Ratios
Liquidity: current ratio = current assets ÷ current liabilities; the quick ratio excludes inventory. Leverage: debt-to-equity. Efficiency: inventory turnover = cost of goods sold ÷ average inventory, plus receivables turnover and days' sales outstanding. Profitability: gross margin, net margin, return on assets, return on equity. Ratios mean something only against prior periods, competitors, or industry norms.
Working capital and budgeting
Working capital = current assets − current liabilities and funds day-to-day operations. Managing the cash conversion cycle means collecting receivables faster, turning inventory quicker, and stretching payables carefully. Budgets translate plans into dollars; a cash budget projects receipts and disbursements and reveals seasonal shortfalls before they become crises.
Capital budgeting and financing
Payback counts years to recover an investment and ignores later cash flows and the time value of money. Net present value discounts future cash flows at the cost of capital and accepts projects above zero, making it theoretically preferred. IRR is the discount rate producing zero NPV. Debt financing keeps ownership but requires fixed payments and raises financial risk; equity financing dilutes control but shares risk. Leverage magnifies both gains and losses.
Worked example
Fixed costs are $60,000, price is $20, and variable cost is $8 per unit. Contribution margin is $12, so break-even quantity = $60,000 ÷ $12 = 5,000 units. To earn $18,000 of profit, required units = ($60,000 + $18,000) ÷ $12 = 6,500. Raising price to $22 lifts the margin to $14 and cuts break-even to about 4,286 units.
Traps
Treating a healthy current ratio as proof of liquidity when inventory is unsalable; counting depreciation as a cash outflow; mixing break-even dollars with break-even units; and preferring payback over NPV when cash flows continue past the payback date.