FAQ: Role of Finance and Ratios

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1 Question 1: To what does the term finance refer, and what is its role in the enterprise? Answer 1: Over the years, the field of finance has been redefined and expanded. It no longer relegates borrowing and investing the excess resources of a firm. Finance, in the broader sense, involves providing relevant financial analysis to improve management s decision-making capabilities, which will have an impact on the wealth of the firm s owners (Finkler, 1983). In today s world, finance is principally responsible for planning and utilizing all of the firm s resources. This role encompasses taking full responsibility for financial forecasting, analyzing, defining cash needs and sources, and ensuring all of the firm s assets are protected. Question 2: How does finance add value to a firm? Answer 2: Interestingly, finance s primary goal relative to the company is to add value to the firm. In doing so, practitioners must be aware of the legal and ethical challenges, while they pursue the goal of wealth maximization for the firm s owners. These challenges emanate from environmental regulations mandating pollution control equipment; workplace safety standards that must be strictly followed; civil laws that must be obeyed; intellectual property laws that regulate the use of other s ideas; and fair treatment of employees, customers, the community, and society as a whole (Andrew & Gallagher, 2000). To add value to a firm, practitioners, besides being mandated financial experts, must be well-acquainted with the full spectrum of the organization, its products, production processes, technology, and ethical/legal statutes. There has recently been a movement to transfer oversight of corporate compliance and social responsibility to this evolving discipline. Finance adds value as a provider of strategic decision-making alternatives and by acting as a watchful compliance officer. Question 3: Is there a better way to measure a firm s performance other than by using financial ratios? Answer 3:Companies were faced with increasing competition during the latter part of the 20th century, and they recognized that they needed to have better methods of assessing organizational performance rather than 1

2 traditional financial measures, such as ratios. They surmised that the traditional financial measures were out of step with the skills and competences that firms are expected to have in the current environment (Chan & Lynn, 1991; Kaplan & Norton, 1992). As a result of recognizing this dilemma, a variety of performance measurement innovations integrating financial and non-financial measurements have surfaced. Two in particular have been effective: the balance scorecard, which incorporates operational measurements along with financial measurements, and the analytic hierarchy process (AHP), which integrates both financial and non-financial measurements into a unified rating (Ittner & Larcker, 1998). Despite having these and other broad-based performance measurement approaches, many firms rely traditionally on financial measurements. In essence, the measurement of choice is the traditional accounting-based performance measurement. The measurements (which are numeric in character) are conducive to quantitative analysis and afford stakeholders, scholars, and researchers a common base from which to assess the performance of the organization. Question 4: How would one describe the five categories of financial ratios, and how would one identify some of the specific ratios? Answer 4: The five categories of ratios profitability, liquidity, debt, asset, and market value each contain a number of specific ratios that can be used to gain insight into the different aspects of the firm s financial health. Ratios are one of the excellent financial tools for the finance practitioners. Ratios should not, however, be taken on a stand-alone basis, but instead they should be coupled with other measurements to ensure objectivity. Question 5: How is the product margin determined? Answer 5: Most companies have employees (usually cost accountants) who devote their time to collecting and analyzing the cost associated with producing the firm s salable goods. The primary role of the cost accountants is to collect and to report on which costs have been incurred to determine the product cost. The cost of a product usually includes three sections: the raw material cost, 2

3 the direct input labor cost, and the associated overhead cost (supervision and supplies). Three costing systems are process costing, job-order costing, and standard costing. Process costing determines the unit cost by comparing total units made to the total cost. Job-order costing relies on accumulating the cost of each particular job, whereas the cost per unit is assessed based on resources consumed. The standard cost methodology uses a predetermined estimate of the cost per unit for each product (Finkler, 1983). Question 6: How does one evaluate a variance? Answer 6: In the course of planning, whether forecasting sales, cost, or cash flows, the results can often vary from what has been anticipated. When this occurs, a variance is experienced. The total variance consists of the price, volume, and quantity variances, which equates to the difference between the comparable items (Finkler, 1983). By using these variances, the financial analyst can gain helpful insight into the firm s performance. The price variance is the portion of the variance that is attributed to the difference in price for the specific comparable items (Finkler, 1983). The volume variance represents the portion of the total variance, which reflects the difference between the volumes of the specific comparable items (Finkler, 1983). The quantity variance reflects the differences between the quantities of the comparable items (Finkler, 1983). Question 7: Is incremental cash flow the same as the cash flow presented on the cash flow statement? Answer 7: Profits have historically been the key gauge for determining an investment s worthiness; however, profits do not convey the whole story. Incremental cash flows are more encompassing; they consider both the income determination and the balance sheet activity. Incremental cash flows reflect the changes in the true value of the organization and are derived by looking at the increased revenues, the corresponding increase in expenses, and the contribution to the organization (Andrews & Gallagher, 2002). The resulting incremental cash flows are generated from the proposed project; in other words, investment is evaluated by using one or the following mathematical models: payback period, net present value, or internal rate of return. Unlike the payback method, both the net present value and internal rate of return integrate the time value of money (Finkler, 1983). 3

4 Question 8: What is a balance sheet? Answer 8: The balance sheet is like a still photograph; it tells nothing about the firm's financial position before or after one specific point in time. It is configured to reflect what the firm owns, starting with the most liquid resource, and the stockholders' equity. Assets are shown on the statement in order of their liquidity (the ease with which an asset can be converted to cash). Those with the greatest degree of liquidity are classified as current. Normally, this category's makeup consists of cash, short-term investments, accounts receivable, and inventory. The remainder of the assets is noted as being long-term in nature and supports the generation of revenue (Andrews & Gallagher, 2000). Question 9: What is an income statement? Answer 9: The income statement measures a firm's profitability over a period of time (one month, quarter, or year). The statement focuses on the operations of the firm and answers what products were produced and sold. The income statement summarizes which revenues were generated, the cost to generate the revenues, and the results of the effort (Andrews & Gallagher, 2002). The income statement shows the results of the firm s operations. Specifically, it displays the amount sold and the production cost. The income statement's intent is to report the firm's profitability in a meaningful and clear manner (Finkler, 1983). Question 10: How did finance change from a Treasury function to what it is today? Answer 10: Finance in its modern form, according to Merton Miller (1999), rests on three pillars: Marklowitz's theory of portfolio selection; William Sharpe's capital asset pricing model, and the Modigliani-Miller propositions. Marklowitz's theory gives a precise definition of risk and return, William Sharpe's theory implies "that the distribution of expected return across all risky assets is a linear function of a single variable, namely, each asset's sensitivity to or covariance with the market portfolio, the famous beta, which becomes the natural measure of a security risk" (Miller, 1999). Modigliani- Miller's theorems deal with the common characteristics of finance that were considered to be central to the finance discipline: capital structure, dividends 4

5 and debt (Siegel, 1998). References Andrew, J. D., & Gallagher, T. J. (2000). Financial management. Upper Saddle River, NJ: Prentice Hall. Finkler, S. A. (1983). The complete guide to financial accounting for nonfinancial managers. Englewoods Cliffs, NJ: Prentice Hall. Ittner, C., & Larcker, D. (1998). Innovations in performance measurement: Trends and research implications. Journal of Management Accounting Research, 10, Kaplan, R. S., & Norton, D. P. (1992). The balanced scorecard Measures that drive performance. Harvard Business Review, 70(70), Miller, M. (1999). The history of finance. Journal of Portfolio Management, 25(4),