COLLEGE OF BUSINESS AND

MANAGEMENT

COURSE MODULE IN

FINANCIAL
ANALYSIS AND
REPORTING
COURSE FACILITATOR: ARMALYN S.
CANGQUE, MBA
FB/MESSENGER: Armalyn Segura Cangque
Email: [email protected]

1
MODULE
 MISSION

Northern Negros State College of Science and technology envisions a skillful and productive

manpower, qualified and competent professionals endowed with leadership qualities, commitment to

public service, a common shared values, and capacities to integrate and use new knowledge and skills in

various vocations and professions to meet the challenges of the new millennium.

VISION

To train and develop semi-skilled manpower, middle level professionals and competent and

qualified leaders in the various professions responsive to the needs and requirements of the service areas

providing appropriate and relevant curricular programs and offerings, research projects and

entrepreneurial activities, extension services and develop progressive leadership to effect socio-economic

change and thereby improve the quality of life.

INSTITUTIONAL OUTCOMES

1. Demonstrate logical thinking, critical judgment and independent decision-making on any

confronting situations
2. Demonstrate necessary knowledge, skills and desirable attitudes expected of one’s educational
level and field of discipline
3. Exhibit necessary knowledge, skills and desirable attitudes in research
4. Exhibit proactive and collaborative attributes in diverse fields
5. Manifest abilities and willingness to work well with others either in the practice of one’s profession
or community involvement without compromising legal and ethical responsibilities and
accountabilities.
PROGRAM LEARNING OUTCOMES (CMO #75 s.2017)

The program shall produce a graduate who can:

1. Articulate and discuss the latest developments in the specific field of practice.
2. Effectively communicate orally and in writing using both English and Filipino.
3. Work effectively and independently in multi-disciplinary and multi-cultural teams.
4. Act in recognition of professional, social and ethical responsibility.
5. Preserve and promote “Filipino historical and cultural heritage”.
6. Perform the basic functions of management such as planning, organizing, staffing, directing and
controlling.
7. Apply the basic concepts that underlie each of the functional areas of business (marketing, finance,
human resource management, production and operations management, information technology,
and strategic management) and employ these concepts in various business situations.
8. Select the proper decision-making tools to critically, analytically and creatively solve problems and
drive results.
9. Express oneself clearly and communicate effectively with stakeholders both in oral and written
forms.
10. Apply information and communication technology (ICT) skills as required by the business
environment.
11. Work effectively with other stakeholders and manage conflict in the workplace.
12. Plan and implement business related activities.
13. Demonstrate corporate citizenship and social responsibility.
14. Exercise high personal moral and ethical standards.
15. Analyse the business environment for strategic decision.
16. Prepare operational plans.
17. Innovate business ideas based on emerging industries.
18. Manage a strategic business unit for economic sustainability.
19. Conduct business research.
20. Apply current and relevant practices and trends in the business environment.
21. Conceptualize, utilize and commercialize business research outputs.
22. Demonstrate social responsiveness to the needs of the community in the field of business and
management.
Warm greetings!

Welcome to the second semester of School Year 2020-2021! Welcome to the College of Business and
Management and welcome to NONESCOST!

Despite of all the happenings around us, there is still so much to be thankful for and one of these is the
opportunity to continue learning.

You are right now browsing your course module in BAPF106. As you read on, you will have an overview of
the course, the content, requirements and other related information regarding the course. The module is
made up of 2 lessons. Each lesson has seven parts:

INTRODUCTION- Overview of the lesson

LEARNING OUTCOMES- Lesson objectives for you to ponder on

MOTIVATION- Fuels you to go on

PRESENTATION- A smooth transition to the lesson

TEACHING POINTS- Collection of ideas that you must discover

LEARNING ACTIVITIES – To measure your learnings in the lesson where you wandered

ASSESSMENT – To test your understanding in the lesson you discovered

Please read your modules and learn the concepts by heart. It would help you prepare to be effective and
efficient professional in your respective fields. You can explore more of the concepts by reading the
references and the supplementary readings.

I encourage you to get in touch with me in case you may encounter problems while studying your modules.
Keep a constant and open communication. Use your real names in your FB accounts or messenger so I can
recognize you based on the list of officially enrolled students in the course. I would be very glad to assist
you in your journey. Furthermore, I would also suggest that you build a workgroup among your classmates.
Participate actively in our discussion board or online discussion if possible and submit your
outputs/requirements on time. You may submit them online through email and messenger. You can also
submit hard copies. Place them in short size bond paper inside a short plastic envelop with your names and
submit them in designated pick up areas.

I hope that you will find this course interesting and fun. I hope to know more of your experiences, insights,
challenges and difficulties in learning as we go along this course. I am very positive that we will successfully
meet the objectives of the course.

May you continue to find inspiration to become a great professional. Keep safe and God bless!

Course Outline in BAPF106 – SPECIAL TOPICS IN FINANCIAL MANAGEMENT

Course BAPF103
Number
Course Title FINANCIAL ANALYSIS AND REPORTING
Course
Description A 3-unit course that deals with common financial problems. The primary focus is on equity
(share) valuation, with some attention given to credit analysis and the valuation of debt.
The methods of fundamental analysis will be examined in detail and applied in cases and
projects involving listed companies. Topics include models of shareholder value and a
comparison of accounting and discounted cash flow approaches to valuation, methods of
financial statement analysis, testing the quality of financial reports, designing value added
metrics, forecasting earnings and cash flows, pro-forma analysis for strategy and planning
and the determination of price/earnings and market-to-book ratios.

No. of Units 3 units

Pre-requisites Acctg. 1, and 2 and Fin 1 & 2
Course 1. Explain roles of financial reporting and statement analysis.
Intended 2. Analyze the Basic Financial Statements, applying Financial Analysis Techniques.
Learning 3. Evaluate the importance of financial forecasting, planning and control in financial
Outcomes management.
4. Analyze models of shareholder value and compare of Accounting and discounted
cash flow approaches.
5. Financial Statements Reporting and Analysis Applications
6. Determine Capital Budgeting Process, Project Proposal Generation and Evaluation.
Content I. Understanding Financial Statements
Coverage II. Analysis of Financial Statements
References 1. Management Accounting, Concepts and Application, 2010 Edition, by Ma. Elenita
Balatbat Cabrera.
2. Lawrence J. Gitman, Principles of Managerial Finance 13 th Ed., Pearson Education
South Asia PTE. LTD., 2010
3. Financial Management in Philippine Setting, Text and Cases, by Cesar G. Saldana
 4. Foundations of Finance, the Logic and Practice of Financial Management, 7 th
Edition by Arthur J. Keown, John D. Martin & Will
Course 1. Quizzes
Requirements 2. Examinations
3. Term Paper
Prepared by: ARMALYN S. CANGQUE, MBA
MODULE
Reviewed and Approved by:
1
Subject Area Coordinator: JOHN RICK B. OGAN, MBA

Dean, CBM : RICHEL P. ALOB, Ph. D.

GAD Director : MARY ANN T. ARCEŇO, Ph.D.

CIMD, Chairperson : MA. JANET S. GEROSO, Ph.D.

QA Director : DONNA FE V. TOLEDO, Ed. D.

VP- Academic Affairs : SAMSON M. LAUSA, Ph. D

LESSON
 1 UNDERSTANDING FINANCIAL STATEMENTS

9 HOURS

This lesson will introduce the students to the different types and functions of financial statements.
This lesson discusses the balance sheet, income statement and cash flow statement. Also, the students will
learn how to analyze and use financial information needed to record in financial statements.

Learning objectives
1. Discuss the concepts of financial statements analysis, reporting mechanics and standards.
2. Share prior knowledge about the financial statements.
3. Know and explain basic financial statement concepts.
4. Identify the different kinds of financial statements and know their functions.
5. Discuss the the importance of notes to financial statements and supplementary information.

Imagine when you are giving a “statement” about something, what do you give to your recipients?
You are providing them information or data about the topic that you are discussing. In the world of
finance, are financial statements meant to be written or it is important for managers to communicate the
values found on records? What it is with the financial statements that present the firm’s financial
performance?

Financial statements are written records that convey the business activities and the financial performance
of a company. Financial statements are often audited by government agencies, accountants, firms, etc. to
ensure accuracy and for tax, financing, or investing purposes. Financial statements include: balance sheet,
income statement, statement of retained earnings and cash flow statement. We will tackle these in this
lesson.
INTRODUCTION TO THE FINANCIAL STATEMENTS

What is a financial statement?

Financial statements are written records that convey the business activities and the financial
performance of a company. Financial statements are often audited by government agencies, accountants,
firms, etc. to ensure accuracy and for tax, financing, or investing purposes. 

Financial statement is a structured representation of the financial position (Balance Sheet), financial
performance (Income Statement) of an entity and the inflow and outflow of cash (cash flow statement).

The objective of financial statements is to provide information about the financial position, financial
performance and cash flows of an entity. Financial statements also help to assess the probability that an
enterprise will be able to make future cash.

The basic financial statements include:

 Balance Sheet
 Income Statement
 Statement of Cash Flows

The balance sheet is a listing of all asset, liability, and equity account balances that do not appear on the
income statement.
The income statement shows revenues and expenses.
The statement of cash flows shows how the company receives and spends its cash.

These primary financial statements answer basic questions such as:

1. What is the company’s current financial status?
2. What was the company’s operating results for the period?
3. How did the company obtain and use cash during the period?

The Balance Sheet : The balance sheet is the summary of the financial position of a company at a particular
date. It represents a record of a company's assets, liabilities and equity at a particular point in time. The
balance sheet includes:
 1. Assets represent the resources that the business owns or controls at a given point in time. This
includes items such as cash, accounts receivable, inventory, machinery land, buildings, equipment
and intangible items, etc.;
a. Fixed assets are items owned by the company which last a long time like for example, buildings,
vehicles, equipment. Fixed asset costs a lot of money but it could be sold to increase capital.
b. Current Asset includes items used and replaced regularly like the raw materials or inventories.
Current assets may also include the current cash on hand or in the bank account.

2. Liabilities represent debt such as accounts payable, notes payable, short-term and long-term loans,
mortgages payable, etc.; and
a. Current liabilities may refer to the money that the firm owes to its creditors for the goods
purchased on credit. This may include short term notes payable or short term loans.

3. Owner’s Equity or Capital represents the total value of money that the owners have contributed to
the business – including retained earnings, which is the profit made in previous years. It also refers
to the net assets after all obligations (or liabilities) have been paid or satisfied.
Remember the formula for owner’s equity: A- L = OE, where A = assets, L= liabilities and OE or C =
Owner’s Equity or Capital. This includes the firm’s preferred stock, common stock, and retained
earnings.

The balance sheet resolves questions such as:

 What are the resources of the company? ( Look in to the assets)
 What are the company’s existing obligations? (Liabilities)
 What are the company’s net assets? (Capital/ Owner’s Equity)

The Accounting Equation

ASSETS= LIABILITIES + OWNER’S EQUITY

To explain,
Assets are the resources use by the firm to generate revenues or income.
Liabilities and owner’s equity are the sources of funding. Liabilities represent creditors’ claims against the
resources of the firm.
Owner’s equity on the other hand, represents owners’ claims against the resources of the firm.

A balance sheet is only a statement and not an account. It has no debit side or credit side. The headings of
the two sides are ‘Assets’ and ‘Liabilities’. It is prepared at a particular point of time and not for a particular
period. The information contained in it is true only at the particular point of time at which it is prepared. It
is a summary of balances of those ledger accounts which have not been closed by transfer to the Trading
and P & L Account. It shows the nature and value of assets and the nature and the amount of liabilities at a
given date. 

An example of a simple balance sheet is presented below:

General Format of a Balance Sheet

Note: In a balance sheet, total assets must be equivalent to total liabilities and owner’s equity. Therefore,
you must always remember the accounting equation. Most students practice the “force balancing” of
balance sheet which is not right, you must know which items are considered either as assets, liabilities or
owner’s equity so that you will derive to the right way of balancing your balance sheet.
Why do we need Balance sheet?
 Balance sheet provides investors with a snapshot of a company's health as of the date provided on
the financial statement.
 If a company’s assets are large relative to liabilities, it's in good shape. Conversely, if a company
with a large amount of liabilities relative to assets has risk to creditors.
 The higher the debt ratio, the greater risk will be associated with the firm's operation. In addition,
high debt to assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the
firm's financial flexibility.

Balance Sheet Analysis

Balance sheet, as a management tool, is used to measure the financial condition of the business. It is
used to compare a firm to its firm of similar business. It is also used to compare to the same business over
time. Lenders use balance sheet analysis to make lending decisions and to monitor the financial progress of
their customers.

Measures of liquidity: Current Ratio and Working Capital

Measures of Solvency: Debt/ Asset Ratio, Equity/Asset Ratio and Debt/ Equity Ratio

EXAMPLE:
The Concept of Liquidity. Measuring liquidity is a short-term measure. Liquidity measures the ability of a
firm to meet its financial obligations as they come due and without disturbing the normal revenue
generating activities. Liquidity is also defined as the ability of the firm to generate cash for running the
business.

Current Ratio :
Total Current ASSETS / Total Current LIABILITIES

Considering the given balance sheet of Teddy Fabrics, we substitute the values and derived:
Total Current Assets = 149,000/
Total Current Liabilities = 47,000
Current Ratio = 3.17 or 3.17:1
Values that are greater than (>) 1 are preferred because it is considered as a safety margin.
Larger ratios imply more liquidity or the firm is more liquid and has a high ability to meet its financial
obligations as they come due without disturbing the normal revenue generating activities.
Working Capital:
Total Current Assets – Total Current Liabilities

In our example,
Total Current Assets= 149,000 –
Total Current Liabilities = 47,000
Working Capital = P102,000
Working capital is the amount or value that is left after selling all current assets and paying off all
current liabilities.

The Concept of Solvency. Solvency measures the degree to which liabilities are backed up by assets. It also
measures liabilities relative to owner’s equity and the ability of the firm to pay off all liabilities if all assets
were sold.

STRATEGIC PLANNING FOR MY COLLEGE

On a separate sheet of paper, write two headings: Chief Financial Manager and Chief Accountant. List at
least five functions for each. Write a short discussion after your table detailing the functions of a chief
financial manager and chief accountant.

Chief Financial Chief Accountant

Manager

Answer the following questions in not less than 5 sentences.

1. Differentiate what is a chief financial manager from chief accountant. (10 points)
2. Explain why knowing the status of the economy is important in making financial decisions? (5
points)
 3. The end-of-year parties at Yearling, Inc., are known for their extravagance. Management provides
the best food and entertainment to thank the employees for their hard work. During the planning
for this year’s bash, a disagreement broke out between the treasurer’s staff and the controller’s
staff. The treasurer’s staff contended that the firm was running low on cash and might have trouble
paying its bills over the coming months; they requested that cuts be made to the budget for the
party. The controller’s staff felt that any cuts were unwarranted as the firm continued to be very
profitable. Can both sides be right? Explain your answer. (25 points)
4. What does it mean to say that managers should maximize shareholder wealth “subject to ethical
constraints”? What ethical considerations might enter into decisions that result in cash flow and
stock price effects that are less than they might otherwise have been? (15 points)
5. As a student majoring in Financial Management, what career path would you like to take in the
future? Explain why.(15 points)

LESSON

2 THE ROLE OF STRATEGY-MAKING PROCESS

9 HOURS

This chapter focuses on the the role of a Financial Manager in a strategic organization. This lesson also
presents what are the long term and short term business strategies and discusses the importance of
strategy making process in business organizations.

1. Identify business strategy-making process.

2. Discuss the business strategy-making process in relation to business organizations.
3. Know and classify the roles of managers in the business strategy making process.
4. Understand the financial planning process, including long-term (strategic) financial plans and
short-term (operating) financial plans.

WHAT DO YOU TO ACHIEVE YOUR PLANS OR GOALS IN LIFE?

 Certainly, you have plans, ambitions and dreams or goals that you want to achieve. Now,
you ask yourself how will you achieve your plans or goals in life. Do you strategize or you just wait
and sit down?

It is essential that financial managers would strategize to do their functions well. Business strategy
is a complex process. Financial managers must know what are the underlying strategies to make the
business plan a success.

THE FINANCIAL PLANNING PROCESS

Financial planning is an important aspect of the firm’s operations because it provides road maps for
guiding, coordinating, and controlling the firm’s actions to achieve its objectives. Two key aspects of the
financial planning process are cash planning and profit planning. Cash planning involves preparation of the
firm’s cash budget. Profit planning involves preparation of pro forma statements. Both the cash budget and
the pro forma statements are useful for internal financial planning. They also are routinely required by
existing and prospective lenders. The financial planning process begins with long-term, or strategic,
financial plans. These, in turn, guide the formulation of short-term, or operating, plans and budgets.
Generally, the short-term plans and budgets implement the firm’s long-term strategic objectives.

Long-term (strategic) financial plans lay out a company’s planned financial actions and the anticipated
impact of those actions over periods ranging from 2 to 10 years. Five-year strategic plans, which are
revised as significant new information becomes available, are common. Generally, firms that are subject to
high degrees of operating uncertainty, relatively short production cycles, or both, tend
to use shorter planning horizons.

Long-term financial plans are part of an integrated strategy that, along with production and
marketing plans, guides the firm toward strategic goals. Those long-term plans consider proposed outlays
for fixed assets, research and development activities, marketing and product development actions, capital
structure, and major sources of financing. Also included would be termination of existing projects, product
lines, or lines of business; repayment or retirement of outstanding debts and any planned acquisitions.

Short-term (operating) financial plans specify short-term financial actions and the anticipated impact of
those actions. These plans most often cover a 1- to 2-year period. Key inputs include the sales forecast and
various forms of operating and financial data. Key outputs include a number of operating budgets, the cash
budget, and pro forma financial statements

Short-term financial planning begins with the sales forecast. From it, companies develop production
plans that take into account lead (preparation) times and include estimates of the required raw materials.
Using the production plans, the firm can estimate direct labor requirements, factory overhead outlays, and
operating expenses. Once these estimates have been made, the firm can prepare a pro forma income
statement and cash budget. With these basic inputs, the firm can finally develop a pro forma balance
sheet.

WORKING CAPITAL MANAGEMENT

Working capital management involves the relationship between a firm’s short-term assets and its short-
term liabilities. The goal of working capital management is to ensure that a firm is able to continue its
operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming
operational expenses. The management of working capital involves managing inventories, accounts
receivable and payable, and cash.

Factors influencing working capital requirements:

1. Nature of business
2. Seasonality of operations
3. Production policy
4. Market conditions
5. Conditions of supply

Nature of business. The nature of business may be classified in to two, first, the short-operating cycle which
is operating in cash and has a modest working capital and second, the long-operating cycle which is
operating in credit and has a substantial working capital.

The working capital requirements of a firm are closely related to the nature of its business. For example, a
service firm, like an electricity undertaking or a transport corporation, which has a short operating cycle
and which sells on cash basis, has modest working capital requirements. On the other hand, a
manufacturing concern like a machine tools unit, which has a long operating cycle and which sells on
credit, has very substantial working capital requirements.

Why firms hold cash?

The finance profession recognizes the three primary reasons offered by economist John Maynard Keynes
to explain why firms hold cash. The three reasons are for the purpose of speculation, for the purpose of
precaution, and for the purpose of making transactions. All three of these reasons stem from the need for
companies to possess liquidity.

It is important to recall what is the meaning of the word “liquidity.” Liquidity is the ability of a firm’s asset
to turn in to cash.

Speculation: Economist Keynes described this reason for holding cash as creating the ability for a firm to
take advantage of special opportunities that if acted upon quickly will favor the firm. An example of this
would be purchasing extra inventory at a discount that is greater than the carrying costs of holding
the inventory.

Precaution: Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows
are not received as expected cash held on a precautionary basis could be used to satisfy short-term
obligations that the cash inflow may have been bench marked for.

Transaction: Firms are in existence to create products or provide services. The providing of services and
creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy
the cash inflow and cash outflow needs that they have.

Cash Management is the process of collecting, managing and using cash for investing.

 If a firm’s need to hold cash is reduced, the funds can be invested in a number of different short-term
securities including Treasury bills, certificates of deposit, commercial paper, repurchase agreements,
banker’s acceptances, and short-term tax exempts. If there is cash deficit, the business borrows cash, when
there is cash surplus, it invests. Companies often have surplus funds for short periods of time before they
are required for capital expenditures, loan repayment, or some other purpose. Instead of allowing these
surplus funds to accumulate in current account where they earn no interest, companies invest them in a
variety of short-term instruments like term deposits with banks, money market mutual funds, and so on.
Managing the investment of surplus funds is a very important responsibility of the financial manager.

What is a Float?
A float is not your Soda Float drink. In Finance, Float is defined as the difference between the book
balance and the bank balance of an account. For example, assume that you go to the bank and open a
checking account with $500. You receive no interest on the $500 and pay no fee to have the account.

Now assume that you receive your water bill in the mail and that it is for $100. You write a check for
$100 and mail it to the water company. At the time you write the $100 check you also record the payment
in your bank register. Your bank register reflects the book value of the checking account. The check will
literally be “in the mail” for a few days before it is received by the water company and may go several
more days before the water company cashes it.

The time between the moment you write the check and the time the bank cashes the check there is a
difference in your book balance and the balance the bank lists for your checking account. That difference is
float. This float can be managed. If you know that the bank will not learn about your check for five days,
you could take the $100 and invest it in a savings account at the bank for the five days and then place it
back into your checking account “just in time” to cover the $100 check.

Float is calculated by subtracting the book balance from the bank balance.
 Float at Time 0:  $500 − $500 = $0
 Float at Time 1:  $500 − $400 = $100
 Float at Time 2:  $400 − $400 = $0

Ways to Manage Cash

Firms can manage cash in virtually all areas of operations that involve the use of cash. The goal is to receive
cash as soon as possible while at the same time waiting to pay out cash as long as possible. Below are
several examples of how firms are able to do this.

Policy For Cash Being Held: Here a firm already is holding the cash so the goal is to maximize the benefits
from holding it and wait to pay out the cash being held until the last possible moment. Previously there
was a discussion on Float which includes an example based on a checking account. That example is
expanded here.
Assume that rather than investing $500 in a checking account that does not pay any interest, you invest
that $500 in liquid investments. Further assume that the bank believes you to be a low credit risk and
allows you to maintain a balance of $0 in your checking account. This allows you to write a $100 check to
the water company and then transfer funds from your investment to the checking account in a “just in
time” (JIT) fashion. By employing this JIT system you are able to draw interest on the entire $500 up until
you need the $100 to pay the water company. Firms often have policies similar to this one to allow them to
maximize idle cash.

Sales: The goal for cash management here is to shorten the amount of time before the cash is received.
Firms that make sales on credit are able to decrease the amount of time that their customers wait until
they pay the firm by offering discounts.
For example, credit sales are often made with terms such as 3/10 net 60. The first part of the sales term
“3/10” means that if the customer pays for the sale within 10 days they will receive a 3% discount on the
sale. The remainder of the sales term, “net 60,” means that the bill is due within 60 days. By offering an
inducement, the 3% discount in this case, firms are able to cause their customers to pay off their bills early.
This results in the firm receiving the cash earlier.

Inventory: The goal here is to put off the payment of cash for as long as possible and to manage the cash
being held. By using a JIT inventory system, a firm is able to avoid paying for the inventory until it is needed
while also avoiding carrying costs on the inventory. JIT is a system where raw materials are purchased and
received just in time, as they are needed in the production lines of a firm.

Seasonality of Operations. Firms which have seasonality in their operations usually have highly fluctuating
working capital requirements. Consider a firm manufacturing ceiling fans. The sale of ceiling fans reaches a
peak during summer and drops sharply during winter. The working capital requirements of such a firm are
likely to increase in summer and decrease significantly during winter. On the other hand, a firm
manufacturing a product like lamps, which have fairly even sales round the year, tends to have stable
working capital requirements.

Therefore, during peak season, there is a high demand, thus, it requires also that businesses must have
high working capital. On the other hand, during low season, where there is low demand, businesses also
have a low working capital.

Production Policy.  A firm marked by seasonal fluctuations in its sales may pursue a production policy
which may reduce variations in working capital requirements. For example, a manufacturer of ceiling fans
may maintain a steady production throughout the year, rather than intensify the production activity during
the peak business season. Such a production policy may reduce the fluctuations in working capital
requirements.

Market Conditions. The degree  of competition in the market is important for working capital needs. When
competition is strong, a larger inventory of finished goods is required to promptly serve customers who
may not be motivated to wait because other manufacturers are ready to meet their needs. Further,
generous credit terms may have to be offered to attract customers in a highly competitive market. Thus,
working capital requirements tend to be high because of greater investment in finished goods inventory
and accounts receivable. If the market is strong and competition weak, a firm can manage with a smaller
inventory of finished goods because customers can be served with some delay. Further, in such a situation
the firm can insist on cash payment and avoid lock-up of funds in accounts receivable—it can even ask for
advance payment, partial or total.

In summary,
1. Strong Competition: credit: quick sales: high working capital
2. Weak Competition: cash: delayed sales: low working capital

Conditions of Supply. The inventory of raw materials depends on the conditions of supply. If the supply is
quick, the firm can manage with small inventory. However, if the supply is unpredictable, then the firm, to
ensure continuity of production, would have to carry larger inventory. A similar policy may have to be
followed when the raw material is available only seasonally and production operations are carried out
round the year.

Level of Investment in Current Assets

Again, by this time, you must already know what is a current asset and what assets are classified as
current.

Conservative Policy. Under a flexible policy ( also referred to as a conservative policy), the investment in
current assets is high. This means that the firm maintains a huge balance of cash and marketable securities,
carries large amounts of inventories, and grants generous terms of credit to customers which leads to a
high level of debtors.

Aggressive Policy. Under a restrictive policy (also referred to as an 'aggressive policy'), the investment in
current assets is low. This means that the firm keeps a small balance of cash and marketable securities,
manages with small amounts of inventories, and offers stiff terms of credit which leads to a low level of
debtors.

Moderate Policy. A moderate policy would tread a middle path between the aggressive and conservative
approaches. It should be noted that the working capital policies of a company can be characterized as
aggressive, moderate or conservative only by comparing them with the working capital policies of similar
companies.
What are the consequences of flexible and restrictive policies?
Answer: A flexible policy results in fewer production stoppages, ensures quick deliveries to customers, and
stimulates sales because liberal credit is granted to customers. Of course, these benefits come at the cost
of higher investment in current assets. A restrictive policy, on the other hand, may lead to frequent
production stoppages, delayed deliveries to customers, and loss of sales. These are the costs that the firm
may have to bear to keep its investment in current assets low.

Current Assets Financing Policy

After establishing the level of current assets, the firm must determine how these should be financed. The
firm must be able to answer the question, “What mix of long-term capital and short-term debt should the
firm employ to support its current assets?”

Strategies:
 Strategy A: Long-term financing is used to meet fixed asset requirements as well as peak working
capital requirements. When the working capital requirement is less than its peak level, the surplus
is invested in liquid assets (cash and marketable securities). Note: Cash is the most liquid asset.
 Strategy B: Long-term financing is used to meet fixed asset requirements, permanent working
capital requirements, and a portion of fluctuating working capital requirements. During seasonal
upswings, short-term financing is used; during seasonal downswings, surplus is invested in liquid
assets.
 Strategy C: Long-term financing is used to meet fixed asset requirements and permanent working
capital requirements. Short-term financing is used to meet fluctuating working capital
requirements.

The capital requirements change over time for a growing term, of course, change is constant. To fully
understand, assets are divided into two classes, fixed assets and current assets. Fixed assets are assumed
to grow at a constant rate which reflects the secular rate of growth in sales. Current assets, too, are
expected to display the same long term rate of growth; however, they exhibit substantial variation around
the trend line, thanks to seasonal (or even cyclical) patterns in sales and/or purchases. The investment in
current assets may be broken into two parts: permanent current assets and temporary current assets. The
former represents what the firm requires even at the bottom of its sales cycle; the latter reflects a variable
component that moves in line with seasonal fluctuations. Several strategies are available to a firm for
financing its capital requirements.
*CA: Current Asset
*WC: Working Capital

The Matching Principle

The Matching Principle is related to moderate policy. According to this principle, the maturity of the
sources of financing should match the maturity of the assets being financed. This means that fixed assets
and permanent current assets should be supported by long-term sources of finance, whereas fluctuating
current assets must be supported by short-term sources of finance.  A conservative funding policy uses
long-term funds to finance not only fixed assets and permanent current assets, but some fluctuating
current assets as well. As there is less reliance on short-term funding, the risk of such a policy is lower, but
the higher cost of long-term finance means that profitability is reduced as well. An aggressive funding
policy uses short-term funds to finance not only fluctuating current assets, but some permanent current
assets as well. This policy carries the greatest risk to solvency, but also offers the highest profitability and
increases shareholder value. 

The rationale for the matching principle is straightforward. If a firm finances a long term asset (say,
machinery) with a short- term debt (say, commercial paper), it will have to periodically re- finance the
asset. Whenever the short-term debt falls due, the firm has to refinance the assets. This is risky as well as
inconvenient. Hence, it makes sense to ensure that the maturity of the assets and the sources of financing
are properly matched.

Short-Term Finance

Short-term loan:  A short-term loan is a fixed amount of debt finance borrowed by a company from a bank,
with repayment to be made in the near future, for example after one year. The company pays interest on
the loan at either a fixed or a floating (i.e. variable) rate at regular intervals, for example quarterly. A
short-term bank loan is less flexible than an overdraft, since the full amount of the loan must be borrowed
over the loan period and the company takes on the commitment to pay interest on this amount, whereas
with an overdraft interest is only paid on the amount borrowed, not on the agreed overdraft limit. As with
an overdraft, however, security may be required as a condition of the short-term loan being granted.

Trade Credit: Trade Credit is an agreement to take payment for goods and services at a later date than that
on which the goods and services are supplied to the consuming company. It is common to find one, two or
even three months’ credit being offered on commercial transactions and trade credit is a major source of
short-term finance for most companies.
 Short-term sources of finance are usually cheaper and more flexible than long-term ones. Short-term
interest rates are usually lower than long-term interest rates, for example, and an overdraft is more
flexible than a long-term loan on which a company is committed to pay fixed amounts of interest every
year. However, short-term sources of finance are riskier than long-term sources from the borrower’s point
of view in that they may not be renewed (an overdraft is, after all, repayable on demand) or may be
renewed on less favourable terms (e.g. when short-term interest rates have increased).

RECEIVABLES MANAGEMENT
Receivables are also known as accounts receivables, trade receivables, customer receivables, rent
receivable, etc.

Establishing a credit policy involves three steps:

1. Establishing credit standards
2. Establishing credit terms
3. Establishing a collection policy

CREDIT POLICY

ESTABLISHING CREDIT ESTABLISHING CREDIT TERMS: ESTABLISHING A COLLECTION

STANDARDS: Firm decides on the length of POLICY:
Assessing the credit risk of the period of payment and Sending inquiry or charging
each customer before feciding chooses whether to offer a interest on payment after the
whether to grant credit or not discount (% and period) deadline
Establishing Credit Standards. Management must first decide on its credit standards.
Will it extend credit to anyone who applies for it?
Or will it be selective and extend credit only to those customers who have very low credit risk?

Unless the firm adopts the former policy, it will need to assess the credit risk of each customer before
deciding whether to grant credit. Large firms often perform this analysis in-house with their own credit
departments. • Many small firms purchase credit reports from credit rating agencies. The decision of how
much credit risk to assume plays a large role in determining how much money a firm ties up in its
receivables. While a restrictive policy can result in a lower sales volume, the firm will have a smaller
investment in receivables. Conversely, a less selective policy will produce higher sales, but the level of
receivables will also rise.

Establishing Credit Terms. After a firm decides on its credit standards, it must next establish its credit
terms. The firm decides on the length of the period before payment must be made (the “net” period) and
chooses whether to offer a discount to encourage early payments. If it offers a discount, it must also
determine the discount percentage and the discount period. If the firm is relatively small, it will probably
follow the lead of other firms in the industry in establishing these terms.
Establishing a Collection Policy. The last step in the development of a credit policy is to decide on a
collection policy. The content of this policy can range from doing nothing if a customer is paying late
(generally not a good choice), to sending a polite letter of inquiry, to charging interest on payments
extending beyond a specified period, to threatening legal action at the first late payment.

Components of Credit Policy

1. Terms of sale: The terms of sale establish how the firm proposes to sell its goods and services. A
basic decision is whether the firm will require cash or will extend credit. If the firm does grant credit
to a customer, the terms of sale will specify (perhaps implicitly) the credit period, the cash discount
and discount period, and the type of credit instrument.
2. Credit analysis: In granting credit, a firm determines how much effort to expend trying to
distinguish between customers who will pay and customers who will not pay. Firms use a number
of devices and procedures to determine the probability that customers will not pay; put together,
these are called credit analysis.
3. Collection policy: After credit has been granted, the firm has the potential problem of collecting the
cash, for which it must establish a collection policy.

Terms of sale how the firm proposes to sell its goods and services Cash or credit? Credit analysis
distinguishing between customers who will pay and customers who will not pay Collection policy
Identifying potential problem of collecting the cash.  In evaluating credit policy, there are five basic factors
to consider:

1. Revenue effects: If the firm grants credit, then there will be a delay in revenue collections as some
customers take advantage of the credit offered and pay later. However, the firm may be able to
charge a higher price if it grants credit and it may be able to increase the quantity sold. Total
revenues may thus increase.
2. Cost effects: Although the firm may experience delayed revenues if it grants credit, it will still gain
the costs of sales immediately. Whether the firm sells for cash or credit, it will still have to acquire
or produce the merchandise (and pay for it).
3. Cost effects: When the firm grants credit, it must arrange to finance the resulting receivables. As a
result, the firm’s cost of short-term borrowing is a factor in the decision to grant credit.
4. The probability of non-payment: If the firm grants credit, some percentage of the credit buyers will
not pay. This can’t happen, of course, if the firm sells for cash.
5. The cash discount: When the firm offers a cash discount as part of its credit terms, some customers
will choose to pay early to take advantage of the discount.

Hence, if the firm grants credit, then there will be a delay in revenue collections but the firm may also
be able to charge a higher price cost effects. Although, the firm may experience delayed revenues if it
grants credit, it will still gain the costs of sales immediately. When the firm grants credit, it must arrange to
finance the resulting receivables. The probability of non-payment If the firm grants credit, some
percentage of the credit buyers will not pay, when the firm offers discount some customers will choose to
pay early.

INVENTORY MANAGEMENT
The firm’s financial manager must arrange the firm’s inventory policy and ensure the firm’s overall
profitability. Therefore, the role of the inventory manager is to balance the costs and benefits associated
with inventory. Because excessive inventory uses cash, efficient management of inventory increases firm
value.

Types of Inventories:
1. Raw Materials – use to make the final product
 2. Work-in process – immediate stage of production
3. Finished goods – goods that are ready to sell

Raw materials are materials and components that are inputs in making the final product.
Work-in process, also called stock-in-process, refers to goods in the intermediate stages of production.
Finished goods consist of final products that are ready for sale. While manufacturing firms generally hold
all the three types of inventories, distribution firms hold mostly finished goods.

Inventories represent the second largest asset category for manufacturing companies, next only to
plant and equipment. The proportion of inventories to total assets generally varies between 15 and 30%.
Decisions relating to inventories are taken primarily by executives in production, purchasing, and
marketing departments. Raw material policies are shaped by purchasing and production executives. Work-
in-process inventory is influenced by the decisions of production executives. Finished goods inventory
policy is evolved by production and marketing executives. Yet, as inventory management has important
financial implications, the financial manager has the responsibility to ensure that inventories are properly
monitored and controlled.

Benefits of Holding Inventory

A firm needs its inventory to operate for several reasons. First, inventory helps minimize the risk that
the firm will not be able to obtain an input it needs for production. If a firm holds too little inventory (or
stock-outs), it will lead to lost sales. Disappointed customers may switch to one of the firm’s competitors.
Second, firms may hold inventory because factors such as seasonality in demand mean that customer
purchases do not perfectly match the most efficient production cycle

Thus, if Inventory ↓ - production ↓ - goods ↓ - sales ↓ - profit↓ too little

Costs of Inventory
1. Ordering Costs: Ordering costs relating to purchased items would include expenses on the
following: requisitioning, preparation of purchase order, expediting, transport, and receiving and
placing in storage. Ordering costs pertaining to items manufactured in the company would include
expenses on the following: requisitioning, set-up, and receiving and placing in storage.
2. Carrying Costs: Carrying costs include expenses on the following: interest on capital locked up in
inventory, storage, insurance, and obsolescence. • Carrying costs generally are about 25% of the
value of inventories held.
3. Shortage Costs: Shortage  costs arise when inventories are short of requirement for meeting the
needs of production or the demand of customers. Inventory shortages may result in one or more of
the following: high costs concomitant with 'crash' procurement, less efficient and uneconomic
production schedules, and customer dissatisfaction and loss of sales. Measurement of shortage
costs when shortage results in failure to meet customer demand is relatively difficult because the
effects are both long-term and short-term and somewhat intangible in nature. When a firm orders
large quantities, in a bid to reduce the total ordering costs, the average inventory, other things
being equal, tends to be high thereby increasing the carrying costs. Also, when a firm carries a large
safety stock to reduce shortage costs its carrying costs tend to be high. In view of such
relationships, minimization of overall costs of inventory management would require a consideration
of trade-offs among these costs.

Cost of Holding Inventory: Just In Time Management

Some firms seek to reduce their carrying costs as much as possible. With “just-in-time” ( JIT) inventory
management, a firm acquires inventory precisely when needed so that its inventory balance is always zero,
or very close to it. This technique requires:
1. exceptional coordination with suppliers
 2. predictable demand for the firm’s products
3. good production planning is also essential

Just In Time (JIT) Inventory approach began in Japan, and it is a fundamental part of Japanese
manufacturing philosophy. The goal of JIT is to have only enough inventory to meet immediate production
needs. The result of the JIT system is that inventories are reordered and restocked frequently. Making such
a system work and avoiding shortages requires a high degree of cooperation among suppliers. Japanese
manufacturers often have a relatively small, tightly integrated group of suppliers with whom they work
closely to achieve the needed coordination. These suppliers are a part of a large manufacturer’s (such as
Toyota’s) industrial group, or keiretsu. Each large manufacturer tends to have its own keiretsu. It also helps
to have suppliers located nearby, a situation that is common in Japan.

Inventory Management Technique: The ABC Approach

The ABC Approach is a simple approach to inventory management in which the basic idea is to divide
inventory into three (or more) groups. The underlying rationale is that a small portion of inventory in terms
of quantity might represent a large portion in terms of inventory value. For example, this situation would
exist for a manufacturer that uses some relatively expensive, high-tech components and some relatively
inexpensive basic materials in producing its products.

The figure above illustrates an ABC comparison of items in terms of the percentage of inventory value
represented by each group versus the percentage of items represented. As Figure shows, the A Group
constitutes only 10% of inventory by item count, but it represents more than half of the value of inventory.
The A Group items are thus monitored closely, and inventory levels are kept relatively low. At the other
end, basic inventory items, such as nuts and bolts, also exist; but, because these are crucial and
inexpensive, large quantities are ordered and kept on hand. These would be C Group items. The B Group is
made up of in-between items.

On a separate sheet of paper, write three headings: Cash, Receivables, Inventory. List at least five
strategies used in managing each respectively. Write a short discussion after your table detailing how cash,
receivables and inventories are managed.
CASH RECEIVABLES INVENTORIES

Quiz

Answer each question in not less than five (5) sentences. (15 points each)

1. Explain briefly why do financial managers need to manage the business firm’s cash, accounts
receivable and inventory?
2. Based on what you have read and learned, which strategy is commonly used by financial managers?
Long-term or short-term strategy? Explain your answer
3. Discuss why is it important for business firms to hold cash? Give an example of a realistic situation
in a business firm where holding cash is essential in that specific situation.
4. Why is it important for business firms to do credit analysis? What do you think will happen is
business firms will not do credit analysis?
5. Explain briefly the working capital requirement in the following situations:
a. Nature of business
b. Seasonality of operations
c. Production policy
d. Market conditions
e. Conditions of supply