Financial management and decision-making
Financial management asks two questions: is the firm sound today, and is a project worth doing? Expect a balance sheet or income statement extract, ratio calculations with interpretation, and one investment appraisal. The interpretation sentences carry as many marks as the arithmetic.
Financial analysis
- Working capital (fondo de maniobra) = current assets − current liabilities. A positive figure means long-term funds finance part of current assets.
- Liquidity: current ratio = current assets/current liabilities (roughly 1.5–2 is healthy); acid test = (current assets − stock)/current liabilities (about 1).
- Solvency: debt ratio = liabilities/total assets; debt-to-equity = liabilities/equity. Leverage raises ROE in good years and insolvency risk in bad ones.
- Profitability: ROI = BAIT/total assets; ROE = net profit/equity; net margin = net profit/sales.
- Always finish with a sentence of meaning: "1.2 is below the sector norm, so short-term obligations are covered only narrowly."
Investment appraisal
- NPV (VAN) = −A + Σ CFt/(1+k)^t. Accept if NPV > 0.
- IRR (TIR) is the discount rate that makes NPV zero; accept if IRR > cost of capital.
- Payback is the time needed to recover A; it ignores the time value of money and everything after recovery.
- Use cash flows, not accounting profit: add depreciation back to net profit, include recovery of working capital at the end, ignore sunk costs and financing costs.
Worked example
A machine costs €100,000 and generates €40,000 a year for four years; cost of capital 10%. The four-year annuity factor at 10% is 3.170. NPV = 40,000 × 3.170 − 100,000 = 126,800 − 100,000 = +€26,800, so accept. The IRR lies where 40,000 × factor = 100,000, i.e. factor 2.5, which falls between 20% and 24% - well above 10%. Payback = 100,000/40,000 = 2.5 years.
Traps
- Discounting the initial outlay as if it occurred at year 1.
- Using accounting profit as the cash flow without adding depreciation back.
- Quoting a ratio against a sector benchmark without saying what the gap implies.
- Writing ROE as equity/assets instead of net profit/equity.
- Accepting a negative-NPV project because "payback is short".