Finance
Finance provides a common language and set of tools that help managers and the owners of capital understand each other. Managers need access to money to help their business grow, and they have to make difficult choices about the forms of financing they use. Business owners (whether public shareholders or private funds) are seeking a return on the money they provide and a clear understanding of the risks involved.
Of all the subjects in this book, finance has the potential to be the most confusing due to the many technical terms being used. Once you start reading through this section, you will find that much of finance, at least at this level, relies on basic arithmetic. Moreover, learning to interpret the results of financial analysis is, arguably, at least as important as knowing which figures to add or multiply together.
For managers in a firm, a central question they must address is the price they currently have to pay for money (their ‘cost of capital’), because it is linked to the types of returns their investors expect and therefore what types of projects they should invest in. Computing the firm’s weighted average cost of capital will give an indication of how much a firm pays to its shareholders and debt-holders. Included in the calculation will be the expectation of returns from shareholders (the cost of equity), and from debt-holders (the cost of debt). The capital asset pricing model is the most widely used way to estimate an expected return for a firm’s equity-holders. Deciding where best to deploy investors’ money is a big part of a senior manager’s job, and this is the focus of the capital budgeting section, which outlines the various models for evaluating investment options.
Shifting to the view of investors, ratio analysis is an important tool for making sense of a company’s financial statements, and comparing its performance and its financial situation with that of its competitors. There are also a number of different models and tools available for valuing the firm, and these are important both for investors and for managers who are thinking of buying or selling businesses.