JRPN Notes

INTRODUCTION TO FINANCIAL MANAGEMENT

1. Finance is the study of how people and businesses evaluate investments and raise capital to fund
them.
a. It is a system that includes the circulation of money, the granting of credit, the making of
investments, and the provision of banking facilities.
b. In simple terms, it is the art and science of managing wealth.
i. It is about making decisions regarding what assets to buy/sell and when to buy/sell
these assets.
ii. Its main objective is to make individuals and their businesses better off.

2. Usual Questions Addressed by the Study of Finance:

a. What long-term investments should the firm undertake? (capital budgeting decisions)
b. How should the firm fund these investments? (capital structure decisions)
c. How can the firm best manage its cash flows as they arise in its day-to-day operations?
(working capital management decisions)

3. Basic Areas of Finance

a. Financial Management
b. Capital markets
c. Investments

4. Financial Management is planning, directing, monitoring, organizing, and controlling of the monetary
resources of an organization.
a. Also called corporate finance
b. Concerns the acquisition, financing, and management of assets with the goal of maximizing
the value of the firm

5. Capital Markets relate to the markets where interest rates, along with stock and bond prices are
determined.
a. Also studied are the financial institutions that supply capital to businesses.

6. Investments relate to decisions concerning stocks and bonds and include a number of activities: (1)
security analysis; (2) portfolio theory; (3) market analysis

7. The Chief Financial Officer (CFO) or the VP for Finance is the top financial manager within the
firm. Under the CFO are the following:
a. Treasurer - oversees cash management, credit management, capital expenditures, and
financial planning
b. Controller - oversees taxes, cost accounting, financial accounting, and data processing

8. Role of Finance in a Typical Business Organization

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9. Forms of Business Organization

a. Sole proprietorship
b. Partnership
c. Corporation

10. Sole Proprietorship

a. Advantages:
i. Easiest to start
ii. Least regulated
iii. Single owner keeps all of the profits
iv. Taxed once as personal income
b. Disadvantages:
i. Limited to life of owner
ii. Equity capital limited to owner’s personal wealth
iii. Unlimited liability
iv. Difficult to sell ownership interest

11. Partnership
a. Advantages:
i. Two or more owners
ii. More capital available
iii. Relatively easy to start
b. Disadvantages:
i. Unlimited liability
ii. Partnership dissolves when one partner dies or wishes to sell
iii. Difficult to transfer ownership

12. Corporation
a. Advantages:
i. Limited liability
ii. Unlimited Life
iii. Separation of ownership and management
iv. Transfer of ownership is easy

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v. Easier to raise capital

b. Disadvantages:
i. Separation of ownership and management (agency problem)
ii. Double taxation (income taxed at the corporate level and then dividends taxed at
personal level)

13. The Agency Problem is the conflict of interest between principal and agent
a. Stockholders (principals) hire managers (agents) to run the company (Stockholder-Manager
Conflicts)
b. Management goals and agency costs
i. Managers are naturally inclined to act in their own best interests –
ii. Factors affecting managerial behavior:
1. Managerial compensation plans – compensation should be sufficient to attach
and retain able managers
2. Direct intervention by shareholders
3. The threat of firing
4. The threat of takeover - happens when a company is acquired by outside
parties against the will of its management.

14. Stockholder-Debtholder Conflicts

a. Stockholders are more likely to prefer riskier projects because they receive more of the
upside if the project succeeds
b. Debtholders receive fixed payments and are more interested in limiting risk

15. Financial Goals of the Corporation

a. The primary financial goal: wealth maximization which translate to maximizing stock price
b. BUT it is important to ask these questions:
i. Do firms have any responsibilities to society at large?
ii. Is stock price maximization good or bad for society?
iii. Should firms behave ethically?

16. Business Ethics can be thought of as a company’s attitude and conduct toward its employees,
customers, community, and stockholders.
a. It is important to observe and follow ethical behaviour in business so that frauds, misleading
accounting practices, etc. can be avoided and punished appropriately.
b. Bad reputation will lower their future profit potential and value.

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FINANCIAL STATEMENTS ANALYSIS

1. Financial Statement Analysis interprets financial statement data and presents in summary form to
simplify users’ analysis.

2. Uses and Purpose of Financial Performance Analysis

a. To set goals and targets
b. To compare the firm’s performance to others
c. To measure financial strength for granting purposes
d. To spot trends, weaknesses and potential problem areas
e. To evaluate alternative courses of action
f. To understand interactions that financial changes have on a firm’s financial position.

3. Limitations in Using FS Analysis

a. No one ratio can tell a story.
b. Industry averages are just that – averages
c. Ratios must be defined uniformly and consistently,
d. More ratios do not necessarily make a better analysis.
e. Off-balance sheet events and factors impact the interpretation of financial ratios.
f. Firms can employ “window dressing” techniques to improve their financial statements.

4. Financial Performance Analysis can be classified into two interrelated areas:

a. Risks areas measure the financial safety of the firm.
i. Capital Adequacy
ii. Asset Quality
iii. Liquidity
b. Return areas measure the financial success of the firm.
i. Growth
ii. Earnings
iii. Market Performance

5. Business Risk vs. Financial Risks

a. Business Risks are risks associated with projections of a firm’s future returns on assets or
returns on equity if the firm uses no debt.
b. Financial Risks are additional risk placed on the common stockholders as a result of the
firm’s decision to use debt.

6. Types of FS Analysis
a. Common Sized Analysis expresses line items or accounts in the financial statements as
percentages.
i. Horizontal Analysis or Comparative Statements – data from two time periods are
compared or a comparison between actual and budgets or two versions of budgets.
ii. Vertical Analysis or Percentage Composition Statement - all statement values are
expressed as a percentage of a base number which is set equal to 100%.
1. Income Statement: Net Sales = 100%
2. Balance Sheet: Assets = 100%

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b. Ratio Analysis is defined as selecting one variable as the numerator and another variable as
the denominator which can be expressed as a %, a ratio or merely a number.

7. Example of horizontal analysis:

Year 1 Year 2
Peso Percent Peso Percent
Net sales P100,000 100% P150,000 150.0%
Cost of Goods Sold (P60,000) 100% (P80,000) 133.33%
Gross Margin P40,000 100% P70,000 175.0%
Operating (P20,000) 100% (P24,000) 120.0%
Expenses
Income Taxes (P8,000) 100% (P16,000) 200.0%
Net income P12,000 100% P30,000 250.0%

8. Different classification of Ratio Analysis – the module only provides for 3 ratios but there are more
that classifications that we will discuss
a. Liquidity Ratios – used to assess the short-term debt-paying ability of a company
i. “What liquid assets are available or accessible to meet demands for cash from
expected and unexpected sources?”
b. Leverage Ratios or Capital Adequacy Ratio - can help an individual to evaluate a
company’s debt-carrying ability.
i. provide a measure of the degree of protection provided to a company’s creditors
ii. “How much capital is necessary to protect creditors and shareholders against losses?”
and “How little capital is necessary to allow shareholders to enjoy maximum favorable
returns on equity and dividends?”
c. Asset Quality or Asset Utilization Ratio – measures the efficiency of the use of the assets
to create income
d. Profitability Ratio or Earnings Ratio - give an idea how profitably the firm is operating
i. “Is net income adequate to satisfy investors’ dividend and rate of return expectations
and to support growth?”
e. Market Performance – measures the evaluation of the financial markets to the condition of
the firm

9. Liquidity Ratios:
Ratio Formula Measure

Current Ratio Current Assets Ability to meet maturing short term

Current Liabilities obligations

Quick Ratio/ Acid Test Ratio (Cash + Marketable Securities + Receivables) Ability to meet maturing short-term
Current Liabilities obligations and more stringent measure
compared to current ratio

Cash Ratio (Cash + Marketable Securities) Ability to meet maturing short-term

Current Liabilities obligations for companies with

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problematic inventory and receivable

levels.

Net Working Capital Current Assets – Current Liabilities Liquidity level of the company in
absolute amounts

10. Leverage Ratios or Capital Adequacy Ratio

Ratio Formula Measure

Debt to Equity Ratio Total Debt Indicates how much of the debt is matched
Equity by investment by owners.

Debt Ratio Debt Level of debt as matched to the assets

Total Assets owned by the company

Capital Multiplier Total Assets Indicates how much total investment can be
Total Equity financed from owner-provided equity

Times Interest Earned (TIE) Earnings before Interest and Taxes Ability of the company to pay-off interest
Interest Expense charges from operating income; measure
of credit worthiness of the company

Fixed Payment Coverage Earnings before Interest Taxes and other Ability of the company to pay-off fixed
Ratio Fixed Payments charges from operating income; measure
Interest and Other Fixed Payments + PreTax of credit worthiness of the company
(Principal Payments + Preferred Dividends)

Book Value per Share Total SHE – Liquidation Value of Preferred Indicates the worth of each share of
Stocks – Preferred Dividends in Arrears common stock based on historical cost.
Common Shares Outstanding

Dividend Payout Percentage Dividends Level of earnings that is declared and

Earnings distributed as dividends to stockholders

11. Asset Quality or Asset Utilization Ratio

Ratio Formula Measure

Accounts Receivable SALES Rate (speed) and efficiency of collection of

Turnover Ave. Accounts Receivable outstanding accounts

Cost of SALES Level of inventory movement

Inventory Turnover Ave. Inventory

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Fixed Asset Turnover SALES Level of usage of fixed assets in generating

Average Fixed Assets sales

Asset Turnover SALES Level of usage of assets in generating sales

Average Assets

Payables Turnover Purchases Indicates the liquidity of the firm’s

Average Accounts Payable payables

Days Sales in Receivables 365 Average credit terms extended to customers

(Average Collection Period) ARTO

Days Sales in Inventory 365 Average days inventory is kept in company

(Average Inventory Period) ITO premises

Days’ Payables Outstanding 365 Indicates how the firm handles obligations
Payables Turnover of its suppliers.

Note: Authors differ whether to use 365 days or 360 days as the numerator. For the purposes of our
discussion, we will use 365 unless otherwise stated.

12. Profitability Ratio or Earnings Ratio

Ratio Formula Measure

Return on Sales Net Income Amount of Net income generated from

Sales Sales

Return on Assets Net Income Amount of Net Income generated from use
Average Assets of Assets

Return on Equity Net Income Amount of Net Income generated from

Average Stockholders’ Equity Investment by Owners

Earnings per Share Net Income (for Common Stockholders) Income earned by each share of
Outstanding Shares (Common Shares) outstanding common stock

Gross Margin Gross Margin Portion of sales attributed to Gross Margin

Sales

Operating Expenses Operating Expenses Portion of sales attributed to Operating

Percentage Sales Expenses

13. Market Performance

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Ratio Formula Measure

Price Earnings Ratio Price Market’s willingness to pay for every peso
Earnings Per Share earning of the company; determines the market’s
confidence level towards the company’s growth
potential

Dividend Yield Dividend Amount of dividends earned in relation to the

Market Value current market value of the stock