Agency problems are defined as problems happening due to conflicts of interests between a principal and an agent. An agent is hired by a principal and is supposed to perform on behalf of the principal with the aim of maximizing the principal’s benefits. However, the agent also has his own interests, and, during the time working for the principal, he may diverge from the ultimate purpose of working for the principal and may perform for his own benefit. In the financial field, there are two primary types of agency problems: between shareholders and managers, and between equityholders and debtholders. First one is the agency problem between shareholders and managers. When a company is set up, the founder is the owner and manager. He will act on behalf of himself to create more wealth. If the owner sells a part of his ownership to outsiders, the owner-manager will not possess 100% Continue reading
Financial Management Tools
Advantages and Disadvantages of Ratio Analysis
Ratios are an expression of one number in terms of another. This form of analysis facilitates comparison between the financial performances of different businesses or industries. Ratio, vertical and horizontal analysis are commonly used by financial analysts because they are useful tools for planning, controlling and monitoring an organisational performance. A range of financial ratios are there, including: liquidity, solvency, profitability, efficiency and investor ratios. Advantages of ratio analysis include: Ratio analysis enables the users of the financial statement to make comparisons between the financial performances of two or more businesses, even if they are of different sizes or from different industries, by converting financial numbers into standardized form using pre-defined formulas. Ratios are easy to calculate and do not consume significant amount of time. Ratio analysis is a useful tool to monitor and control a business organisation’s performance. The users of the financial statements are often interested in assessing Continue reading
Real Options Method in Capital Budgeting
Real options method is one of the investment appraisal techniques for capital budgeting which can deal with the limitations of the Net Present Value (NPV) method. Real options method is a method of evaluating and managing strategic investments decisions in an uncertain business environment. Using real option methods has been recognized that the application of standard NPV techniques can lead to wrong conclusions in the presence of unrecognized embedded options. The central role of NPV techniques in financial decision making therefore makes it imperative that real option structures in investing opportunities are identified and accounted for. It turns out that real options can be found in most live environments where uncertainty or risk, waiting, investment irreversibility, growth opportunity, asymmetric information, staged investments, competitor response, economies of scale, project switching, suspension, abandonment and start-up are important. In fact, these include the full spectrum of investment decision making, including those concerning capital Continue reading
Prospect Theory in Behavioral Finance
The Prospect Theory was originally conceived by Kahneman and Tversky (1979) and later resulted in Daniel Kahneman being awarded the Nobel Prize for Economics. The work by the authors is considered as path breaking in behavioral finance. They introduced the concept of prospect theory for the analysis of decision making under risk. This theory is considered to be seminal in the literature of behavioral finance. It was developed as an alternative model for expected utility theory. It throws light on how individual evaluate gain or losses. The prospect theory has three key aspects. People sometimes exhibit risk aversion and sometimes risk loving behaviors depending on the nature of the prospect. This is due to the fact that people give lower weight age to the outcomes which are probable as compared to those that are certain. This makes them risk averse for choices with sure gains while risk seekers for choices Continue reading
Cash Flow Statement – Meaning, Components and Preparation Methods
The cash flow statement was previously known as the flow of funds statement. The cash flow statement reflects a firm’s liquidity. The balance sheet is a snapshot of a firm’s financial resources and obligations at a single point in time, and the income statement summarizes a firm’s financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These noncash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Noncash activities are usually reported in footnotes. The Continue reading
Use of Return on Investment (ROI) to Assess the Performance of Organizations
Analysis of financial statements has being part of the bed rock of finance itself. For publicly traded companies, the greater level of participation by the general publics and sometimes global stakeholders has meant comprehensive assessments are done on their financial statements. Some of the basic reasons for the assessment of the financial statement of companies include the evaluation of current operations, compare the current performance with past performance, make comparison against other firms and industry standards, study the effectiveness and efficiency of operations and the level of efficiency in the utilization of resources. The rationale behind the assessment of a firm’s financial statement is such that a firm has being given resources; it is supposed to convert those resources into profit through the production of goods and the provision of services. Accounting ratios are meant to measure the relationships between resources and financial flows to show ways in which the Continue reading