INTRODUCTION TO FINANCIAL MANAGEMENT

What is Finance?

It’s hard to define finance- the term has many facets, which make it difficult to provid
concise definition.

1-1a Finance versus Economics and Accounting

Finance, as we know it today, grew out of economics and accounting. Economist developed the n
an asset's value is based on the future cash flows the asset will provide, and accountants
information regarding the likely size of those cash flows. People who work in finance need kno
both economics and accounting. In the modern corporation, the accounting department falls
control of the chief financial officer.

1-1b Finance within an Organization

Most business and not-for-profit organizations have an organization chart similar to the one shows
1.1. The board of directors is the top governing body, and the chairperson of the board is gen
highest-ranking individual. The CEO comes next, but note that the chairperson of the board often al
as the CEO. Below the CEO comes the chief operating officer (COO), who is often also designat
firm's president. The COO directs the firm's operations, which include marketing, manufacturing,
other operating departments. The CFO, who is generally a senior vice president and the third-ranki
is in charge of accounting, financing and credit policy, decisions regarding asset acquisitions and
relations, which involve communications with stockholders and the press.

If the firm is publicly owned, the CEO and the CFO must both certify to the Securities and Exchange
(SEC) that reports released to stockholders, and especially the annual report, are accurate. If inac
emerge, the CEO and the CFO could be fined or even jailed. This requirement was instituted in 2
the Sarbanes-Oxley Act. The Act was passed in the wake of a series of corporate scandals involvin
companies such as Enron and WorldCom, where investors, workers and supplies lost billions of
false information released by those companies.

1-1c Corporate Finance, Capital Markets, and Investments

Finance as taught in universities is generally divided into three areas:

1. financial management
2. capital markets
3. investments

Financial management, also called corporate finance, focuses on decisions relating to how much
types of assets to acquire, how to raise the capital needed to purchase assets, and how to run th
as to maximize its value. The same principles apply to both for-profit and not-for-profit organizatio

Capital markets relate to markets where interest rates, along with stock and bond prices, are de
Included here are financial institutions that supply capital to businesses. Banks, investmen
stockbrokers, mutual funds, insurance companies, and the like bring together "savers" who have
invest and businesses, individuals, and other entities that need capital for various purposes.

Investments relate to decisions concerning stocks and bonds and include a number of activities:

1. Security analysis deals with finding the proper values of individual securities (i.e. stocks an
2. Portfolio theory deals with the best way to structure portfolios, or "baskets", of stocks and bo
1-2 JOBS IN FINANCE
Finance prepares students for jobs in banking, investments, insurance, corporations, and gov
Accounting students need to know finance, marketing, management and human resource; they a
to understand finance, for it affects decisions in all those areas.
It is also worth noting that finance is important to individuals regardless of their jobs. Some years
businesses provided pensions to their employees, so managing one’s personal investments was no
important. That’s no longer true. Most firms today provide what’s called “defined contribution
plans, where each year the company puts a specific amount of money into an account that belon
employee. The employee must decide how those funds are to be invested-how much should b
among stocks, bonds, or money funds and how much risk they’re willing to take with their stock
investment.
FORMS OF BUSINESS ORGANIZATION

The basics of financial management are the same for all businesses, large or small, regardless of
are organized. Still, a firm’s legal structure affects its operations and thus should be recognized.
four main forms of business organization:

1. Proprietorship
A proprietorship is an unincorporated business owned by one individual. Going into business
proprietor is easy-a person begins business operations with advantages below:
 They are easily and inexpensively formed.
 They are subject to few government regulations.
 They are subject to lower income taxes than corporations.

However, proprietorships also have three important limitations:

 Proprietors have unlimited personal liability for the business debts, so they can lose more th
of money they invested in the company.
 The life of the business is limited to the life of the individual who created it; and to bring i
investors require a change in the structure of the business.
 Because of the first two points, proprietorships have difficulty obtaining large sums of c
proprietorship are used primarily for small businesses.

1. Partnership
A partnership is a legal arrangement between two or more people who decide to do business
Partnerships are similar to proprietorships in that they can be established relatively easily and inexp
Moreover, the firm’s income is allocated on a pro rata basis to the partners and is taxed on an
basis. This allows the firm to avoid the corporate income tax.
However, all partners are generally subject to unlimited personal liability, which means if a p
goes bankrupt and any partner is unable to meet his or her pro rata share of the firm’s liabilities, the
partners will be responsible for making good on the unsatisfied claims. Unlimited liability makes it
partnerships to raise large amounts of capital.

2. Corporation
A corporation is a legal entity created by the state, and is separate and distinct from its ow
managers. It is this separation that limits stockholders’ losses to the amount they invested in th
corporation can lose all of its money, but its owners can lose only the funds that they invest
company. Corporations also have unlimited lives, and it is easier to transfer shares of stock in a co
than one’s interest in an unincorporated business. These factors make it much easier for corp
raise the capital necessary to operate large businesses.
A major drawback to corporations is taxes. Most corporations’ earnings are subject to double
the corporation’s earnings are taxed; and then when its after-tax earnings are paid out as dividen
earnings are taxed again as personal income to the stockholders.
When deciding on its form of organization, a firm must trade off the advantages of incorporation
possibly higher tax burden. However, for the following reasons, the value of any business oth
relatively small one will probably me maximized if it is organized as a corporation:
 Limited liability reduces the risks borne by investors; and other things held constant, the
firm’s risk, the higher its value.
 A firm’s value is dependent on its growth opportunities, which are dependent on its ability
capital. Because corporations can attract capital more easily than other types of busines
are better able to take advantage of growth opportunities.
 The value of an asset also depends on its liability, which means the time and effort it takes
asset for cash at a fair market value. Because the stock of a corporation is easier to tra
potential buyer than is an interest in a proprietorship or partnership, and because more inve
willing to invest in stocks than in partnerships (with their potential unlimited liability), a
investment is relatively liquid. This too enhances the value of a corporation.

BALANCING SHAREHOLDER VALUE AND THE INTERESTS OF SOCIETY

The primary goal of a corporation should be to maximize its owners’ value, but a proprie
might be quite different. Throughout this book, we focus primarily on publicly owned companies;
operate on the assumption that management’s primary goal is shareholder wealth maximization. A
time, the managers’ know that this does not mean maximize shareholder value “at all costs.” Mana
an obligation to behave ethically, and they must follow the laws and other society-imposed constra
Indeed, most managers recognize that being socially responsible is not consistent with
shareholder value.
Firms have a number of different departments, including marketing, accounting, productio
resources, and finance. The finance department’s principal task is to evaluate proposed decisions a
how they will affect the stock price and thus shareholder’s wealth. For example, suppose the p
manager wants to replace some old equipment with new automated machinery that will reduce lab
The finance staff will evaluate that proposal and determine whether the savings seem to be worth
Most significant decisions are evaluated in terms of their financial consequences.

STOCK PRICES AND SHAREHOLDER VALUE

The primary financial goal of management is shareholder wealth maximization, which tr
maximizing stock price. Thus, stock price maximization requires us to take a long-run view of ope
Ideally, manager adhere to this long-run focus.
Despite the best intentions, stock-based compensation does not always work as planned
managers an incentive to focus on stock prices, stockholders (acting through boards of directors
executives stock options that could be exercised on a specific future date. An executive could ex
option on that date, receive stock, immediately sell it, and earn a profit. The profit was based on
price on the option exercise date, not over the long run. That, in turn, led to some horrible abuse
are managers that overstated its profit, temporarily boosted stock price, exercised their option
inflated stock, and left outsiders “holding the bag” when the true situation was revealed. E
WorldCom are examples of companies whose managers did this, but there were many others. Fo
most executives are honest. But even for honest companies, it is hard for investors to determine
price of a stock. Figure 1.2 illustrates the situation. The top box indicates that managerial actions,
with the economy, taxes and political conditions, influence the level and riskiness of the compan
cash flows which ultimately determine the company’s stock price. As you might expect, investors
expected cash flows, but they dislike risk; so, the larger the expected cash flows and the lower the
risk, the higher the stock’s price.
The second row of boxes differentiates what we call “true” expected cash flows and “true”
“perceived” cash flows and “perceived” risk. By “true”, we mean the cash flows and risk that invest
expect if they had all of the information that existed about the company. “Perceived” means what
expect, given the limited information they actually have.
The third row of boxes shows that each stock has an intrinsic value, which is an estima
stock’s “true” value as calculated by a competent analyst who has the best available data, and
place, which is the actual market price based on perceived but possibly incorrect information as se
IMPORTANT BUSINESS TRENDS
1. Increased globalization of the business. Developments in communications technology have
possible for Walmart, for example, to obtain real -time data on the sales of hundreds of thousand o
stores from China to Chicago and to manage all of its stores from different countries.
2. A second trend that’s having a profound effect on financial management is ever-improving in
technology. Improvements in IT are spurring globalization, and they are changing financial manag
it is practice elsewhere.
3. A third trend relates to corporate governance, or the way the top managers operate and i
stockholders.

BUSINESS ETHICS
As a result of financial scandals occurring during the past decade, there has been a stron
improve business ethics. This is occurring on several fronts due to company’s improper acts; US
passed the Sarbanes-Oxley bill to impose sanctions on executives who sign financial statements la
to be false. Dodd-Frank Act to implement an aggressive overhaul aimed at preventing reckless ac
would cause another financial crisis; and business schools trying to inform students about prop
improper business actions.
Over the past few years, ethical lapses have led to a number of bankruptcies. The collapse
and WorldCom as well as the accounting firm Arthur Andersen dramatically illustrate how unethica
can lead to a firm’s rapid decline. Some of these executives are now in jail, and Enron’s CEO h
heart attack while waiting the sentence after being found guilty of conspiracy and fraud. Moreov
Lynch and Citigroup, which were accused of facilitating these frauds, were fined hundreds of m
dollars.

What Companies Are Doing?

Most firms today have strong written codes of ethical behavior, companies also conduc
programs to ensure that employees understand proper behavior in different situations. When conf
involving profits and others, ethical considerations sometimes are so obviously important that they d
In other cases, however the right choice is not clear.

How Should Employees Deal with Unethical Behavior?

Far too often the desire for stock options, bonuses, and promotions drives managers to take
actions such a fudging the books to make profits in the manager’s division look good, hold
information about bad products that would depress sales, and failing to take costly but needed me
protect the environment.

CONFLICTS BETWEEN MANAGERS, STOCKHOLDERS, AND BONDHOLDERS

1. Managers versus Stockholders

It has long been recognized that managers’ personal goals may compete with sharehold
maximization. In particular, managers might be more interested in maximizing their own wealth
stockholder’s wealth; therefore, managers might pay themselves excessive salaries. Good
compensation plans can motivate managers to act in their stockholders’ best interests. Useful mo
tools include:
 Reasonable compensation packages.
 Firing of managers who don’t perform well.
 The threat of hostile takeover.

2. Stockholders versus Bondholders

Conflicts can also arise between stockholders and bondholders. Bondholders generally rece
payment regardless of how well the company does, while stockholders do better when the comp
better. These situation leads to conflicts between these two groups.
Another type of conflict arises over the use of additional debt. The debt a firm uses to financ
 MODULE 2 (FUNDAMENTALS OF FINANCIAL MANAGEMENT)

PART I. FINANCIAL STATEMENTS AND REPORTS

The annual report is the most important report that corporation issue to stockholders, and it
types of information. First, there is a verbal section, often presented as a letter from chairp
describes the firms operating results during the past year and discusses new developments that
future operations. Second, the report provides these four basic financial statements:

1. The balance sheet, which shows what assets the company owns and who has claims on th
of a given date-for example, December 31, 2012.
2. The income statement, which shows the firm’s sales and costs (and thus profits) during so
example, 2012.
3. The statement of cash flows, which shows how much cash the firm began the year with, ho
it ended up with, and what it did to increase or decrease its cash.
4. The statement of stockholders’ equity, which shows the amount of equity the stockholde
start of the year, the items that increased or decreased equity, and the equity at the end of

These statements are related to one another; and taken together, they provide an accounting
firm’s operations and financial position.
The quantitative and verbal materials are equally important. The firm’s financial statements re
actually happened to its assets, earnings and dividends over the past few years, whereas manage
statements attempt to explain why things turned out the way they did and what might happen in th

THE BALANCE SHEET

A balance sheet states a business's assets, liabilities, and shareholders' equity at a sp
time. They offer a snapshot of what your business owns and what it owes as well as the amount in
owners, reported on a single day. A balance sheet tells you a business's worth at a given time, so y
understand its financial position.
Items on the Balance Sheet
Assets
The assets section of the balance sheet breaks down what your business owns of value
converted into cash. Your balance sheet will list your assets in order of liquidity; that is, it reports a
of how easily they can be converted to cash.

Assets are divided into two major categories: current assets and fixed, or long-term ass
assets consist of assets that should be converted to cash within one year; and they include ca
equivalents, accounts receivable, and inventory. Long-term assets are assets expected to be u
than one year; they include plant and equipment in addition to intellectual property such as
copyrights. Plant and equipment are generally reported net of accumulated depreciation sometim
net fixed assets.
The claims against assets are of two basic types-liabilities (or money the company owes t
stockholders’ equity. Current liabilities consist of claims that must be paid off within one year, includ
payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks that a
one year. Long-term debt includes bonds that mature in more than a year.
Stockholders’ equity can be thought of in two ways. First, it is the amount that stockholde
company when they bought shares the company sold to raise capital, in addition to all of the
company has retained over the years:

Stockholders’ equity = Paid-in capital + Retained earnings

The retained earnings are not just the earnings retained in the latest year-they are cumulat
of the earnings the company has earned during its life. Stockholders’ equity can also be thought of

Stockholders’ equity = Total assets – Total liabilities

If a company had invested surplus funds in bonds backed by subprime mortgages and the
fell below their purchase price; the true value of the firm’s assets would have declined. The
liabilities would not have changes-the firm would still owe the amount it had promised to pay
Therefore, the reported value of the common equity must decline.
Assets must, of course, equal liabilities and equity; otherwise, the balance sheet does not

Several additional points about the balance sheet should be noted:

1. Cash versus other assets.
Although assets are reported in dollar terms or any currency, only the cash and equival
represent actual spendable money. Accounts receivable represent credit sales that have not yet be
Inventories show the cost of raw materials, work in progress, and finished goods. Net fixed assets
cost of the buildings and equipment used in operations minus the depreciation that has been ta
assets.

2. Working Capital
Current assets are often called working capital because these assets “turn over”; that is, they
then replaced throughout the year. When the company buys inventory items on credit, its suppli
lend it the money used to finance the inventory item. The company could have borrowed from the
stock to obtain the money, but it received the funds from its suppliers. These loans are shown
payable, and they typically are “free” in the sense that they do not bear interest.
Net working capital = Current assets – current liabilities
Current liabilities include accounts payable, accruals, and notes payable to the bank. Finan
often make an important distinction between the “free” liabilities (Accruals and accounts payable)
bearing notes payable (which incur interest expense that is included as a financing cost on the
statement). With this distinction in mind, analysts often focus on net operating working capital (N
differs from net working capital because interest-bearing notes payable are subtracted from curren
Net operating working capital (NOWC) = Current assets - (current liabilities – notes payable)
 4. Depreciation.
Most companies prepare two sets of financial statements-one is based on IRS (Internal Rev
rules and is used to calculate taxes; the other is based on GAAP and is used for reporting to inve
often use accelerated depreciation for tax purposes but straight line depreciation for stockholder re

5. Market values vs book values.

Companies generally use GAAP to determine the values reported on their balance sheets. In
these accounting numbers (or “book values”) are different from what the assets would sell for if t
up for sale (or “market values”). Under GAAP, the company must report the value of this asset a
cost (what it originally paid for the building) less accumulated depreciation.

6. Time dimension.
The balance sheet is a snapshot of the firm’s financial position at a point in time-for example,
31, 2020. The balance sheet changes every day as inventories rise and fall, as bank loans are
decreased, and so forth.

THE INCOME STATEMENT

Income statement is report summarizing a firm’s revenues, expenses, and profits durin
period, generally a quarter or a year.
A typical stockholder focuses on the reported EPS, but professional security analysts a
differentiate between operating and non-operating income. Operating income is derived from the
core business. Operating income is also called EBIT, or earnings before interest and taxes.
equation:

Operating income (or EBIT) = Sales revenues – Operating costs

While the balance sheet represents a snapshot in time, the income statement reports on oper
period of time.
Taking a closer look at the income statement, we see that depreciation and amortization
components of operating costs. Recall from accounting that depreciation is an annual charge ag
that reflects the estimated dollar cost of the capital equipment and other tangible assets that wer
production process. Amortization amounts to the same thing except that it represents the declin
intangible assets such as patents, copyrights, trademarks, and goodwill. Because depreciation and
are so similar, they are generally lumped together for purposes of financial analysis on the incom
and for other purposes. They both write off, or allocate, the costs of assets over their useful lives.
Even though depreciation and amortization are reported as costs on the income statements
cash expenses-cash was spent in the past, when the assets being written off were acquired, but
out to cover the depreciation. Therefore, managers, security analysts, and bank loan officers who a
with the amount of cash a company is generating often calculate EBITDA, acronym for earnings be
taxes, depreciation, and amortization.
Finally, note that the income statement is tied to the balance sheet through the retained earn
on the balance sheet. Net income as reported on the income statement less dividends paid is
earnings for the year. Those retained earnings are added to the cumulative retained earnings fro
to obtain the year-end balance for retained earnings and are also reported in the statement of
equity.
STATEMENT OF CASH FLOWS
Net income as reported on the income statement in not cash; and in finance, “cash is king.”
goals is to maximize the price of the firm’s stock and the value of any asset, including a share of st
on the cash flows the asset is expected to produce. Therefore, managers strive to maximize th
available to investors. Statement of cash flows shows how much cash the firm is generating. The
divided into four sections as follows:

I. Operating activities – deals with items that occur and part of normal ongoing operations.
a. Net income – the first operating activity is the net income, which is the first source of ca
If all sales were for cash, if all costs required immediate cash payments, and if the firm were
in a static situation, net income would equal cash from operations.
 c. Increase in accounts receivable – if a company choose to sell on credit when it makes
not immediately get the cash that it would have received had it not extended credit. It
the inventory that is sold on credit.
d. Increase in accounts payable – accounts payable represent a loan from suppliers if a com
goods in credit.
e. Increase in accrued wages and taxes – same logic applies to accruals as to accounts p
f. Net cash provided by operating activities- all of the previous items are part of the norm
they arise as a result of doing business. When we sum them, we obtain the net c
operations.

II. Long-Term Investing Activities – all activities involving long-term assets are covered in th
example, acquisition of some fixed assets.
a. Additions to property, plant and equipment – if a company spend on fixed assets durin
year, this is an outflow but if a company sold some of its fixed assets, this would have
inflow.
b. Net cash used in investing activities – sum of the investing activities.

III. Financing Activities

a. Increase in notes payable – if a company borrowed from the bank for this purpose its
the company repays the loan, this will be an outflow.
b. Increase in bonds (long-term debt) – if the company borrowed from long-term investors,
in exchange for cash, this is an inflow. When bonds are repaid by the firm, it is an outf
c. Payment of dividends to stockholders- paid to stockholders and to be shown as negativ
d. Net cash provided by financing activities-sum of the financing activities.

IV. Summary -this section summarizes the change in cash and cash equivalents over the yea
a. Net decrease in cash (I,II,III) – net sum of the operating activities, investing activities
activities is shown here.
b. Cash and equivalent at the beginning of the year.
c. Cash and equivalent at the end of the year.

STATEMENT OF STOCKHOLDERS’ EQUITY

Statement of stockholders’ equity is a statement that shows by how much a firm’s equity chang
year and why this change occurred. Changes in stockholders’ during the accounting period are re
statement of stockholders’ equity.

LIMITATIONS OF FINANCIAL STATEMENT

1. There are variations in the application of accounting principles.
3. Financial statements do not reflect changes in the purchasing power of the peso.
Financial statements are prepared based on the historical cost and do not reflect the current m
the assets.

4. Financial statements do not contain all the significant facts about the business.
Investors do not rely only on quantitative factors presented in the financial statement. They
heavily on other pieces of information about the company such as the stockholders, composition o
directors, projects undertaken, and the overall performance of the company relative to the ind
others.

MODULE 3
ANALYSIS OF FINANCIAL STATEMENT
Financial Statement Analysis
Financial statement analysis is an evaluation of the past and current performance of th
forecast in the future. It allows comparison of one company with another. Since financial statem
looks at relationships inside and outside of the firm, a firm of one size can be directly compare
firms or with industry averages or norms to determine how the company is faring vis-à-vis its com
Financial statement analysis involves calculations. Firms compute by combining accounts
an income statement to the balance sheet or vice-versa or by simply relating an account within th
These calculations help the management assess the deficiencies and take necessary action
performance.

We divide the ratios into five categories:

1. Liquidity ratios, which give us an idea of the firm’s ability to pay off debts that are mat
year. This ratio help answer the question: Will the firm be able to pay off its debts as they
thus remain a viable organization? If the answer is no, liquidity must be the first order o
liquid asset is one that trades in an active market and thus can be quickly converted to
going market price. Two most commonly used liquidity ratios are below:

a. Current Ratio – the primary liquidity ratio which is calculated by dividing current asse
liabilities.
Current Assets
Current ratio =
Current liabilities

$1,000
= = 3.2x
$ 310
If a company is having financial difficulty, it typically begins to pay its account payable more slowly a
more from its bank, both of which increase current liabilities. If current liabilities are rising faster tha
assets, the current ratio will fall; and this is the sign of possible trouble.

b. Quick, or Acid Test Ratio – the second liquidity is the quick, or acid test ratio, which
by deducting inventories from current assets and then dividing the remainder by curre
Current assets - Inventories
Quick or acid test ratio =
Current liabilities

$385
= = 1.2x
above (1.2x) ratio is relatively low. Still, if the accounts receivable can be collected, the compan
its current liabilities even if it has trouble disposing its inventories.

2. Asset management ratios, which give us an idea of how efficiently the firm is using its
asset management ratio, measures how effectively the firm is in managing its assets. This
this question: Does the amount of each type of asset seem reasonable, too high, or too l
current projected sales? These ratios are important because the company and other comp
assets, they must obtain capital from banks or other sources and capital is expensive.

a. Inventory Turnover Ratio

“Turnover ratios” divide sales by some asset: Sales/Various assets. As the name i
ratios show how many times the particular asset is “turned over” during the year
inventory turnover ratio:
Sales
Inventory turnover ratio = ---------------
Inventories
$3,000
= = 4.9 x
$615
Inventory average = 10.9x

Based on this example, inventory turnover of 4.9 is much lower than the industry average
suggests that it is holding too much inventory. Excess inventory is of course, unproductive and r
investment with a low or zero rate of return. Low inventory turnover ratio also makes us questi
ratio and with such, the firm may be holding obsolete goods that are not worth their stated value. If
is highly seasonal or if there has been a strong upward or downward sales trend during the year, i
useful to make an adjustment. To maintain comparability with the industry averages, other compa
end rather than average inventories.

b. Days Sales Outstanding

Accounts receivable are evaluated by the days sales outstanding (DSO) ratio, a
average collection period (ACP). It is calculated by dividing accounts receivable by
daily sales to find how many days sales are tied up in receivable by the average daily
how many days sales are tied up in receivables.
Receivables Receivables
DSO = =
Average sales per day Annual sales/365

$375 $375
= -------------------- = -------------- = 45.625 days = 46 days
$3,000/365 $8.2192

Industry Average = 36 days

c. Fixed Assets Turnover Ratio

The fixed assets turnover ratio, which is the ratio of sales to net fixed assets, measures how e
firm uses its plant and equipment:
Sales
Fixed assets turnover ratio = --------------------------- Net
fixed assets
 d. Total Assets Turnover Ratio
The final asset management ratio, the total assets turnover ratio, measures the turnover of a
assets; and it is calculated by dividing sales by total assets:
Sales
Total assets turnover ratio = -------------------
Total assets
$3,000
= = 1.5x
$2,000
Industry average = 1.8x

This ratio is somewhat below the industry average, indicating that it is not generating e
given its total assets.

3. Debt management ratios, which give us an idea of how the firm has financed its assets a
firm’s ability to repay its long-term debt.

a. Total Debt to Total Assets

The ratio of total debt to total assets, generally called the debt ratio, measures the percen
provided by creditors. This is the ratio of total debt to total assets.

Total debt
Debt ratio = -------------------
Total assets
$310 + 750 $1,060
= = = 53.0%
$2,000 $2,000

Industry average = 40%

Total debt includes all current liabilities and long-term debt. Creditors prefer low debt rati
the lower the ratio, the greater the cushion against creditors’ losses in the event of
Stockholders, on the other hand, may want more leverage because it can magnify expected

4. PROFITABILITY RATIO
Accounting statements reflect events that happened in the past, but they also provide
what’s really important-what’s likely to happen in the future. The liquidity, asset managem
ratios covered thus far tell us something about the firm’s policies and operations. The prof
which reflect the net result of all of the firm’s financing policies and operating decisions.

a. Operating Margin
The operating margin, calculated by dividing operating income (EBIT) by sales, gives
profit per dollar of sales:
EBIT
Operating margin = ------------
Sales
$278
= ---------- = 9.3%
 Net income
Profit margin = ---------------
Sales
$146.30
= -------------- = 4.9%
$3,000
Industry Ave = 5.0%

Profit margin is below the industry average of 5.0%, and this subpar result occurred for tw
• Firm’s high operating costs
• Profit margin is negatively impacted by heavy use of debt

c. Return on Total Assets

Net income divided by total assets gives us the return on total assets (ROA):
Net income
Return on total assets (ROA) = ---------------
Total assets
$146.3
= ----------- = 7.3%
$2,000
Industry average = 9.0%

The result is not good since it is obviously better to have a higher than a lower return on
though, that a low ROA can result from a conscious decision to use a great deal of debt, in wh
interest expenses will cause net income to be relatively low.

d. Basic Earning Power (BEP) Ratio

The basic earning power (BEP) ratio is calculated by dividing operating income (EBIT) by total ass

EBIT
Basic earning power (BEP) =------------------
Total Assets
$278
=------------- = 13.9%
$2,000
Industry average = 18.0%

This ratio shows the raw earning power of the firm’s assets before the influence of taxes a
it is useful when comparing firms with different debt and tax situations. Because of its low turnov
poor profit margin on sales.

e. Return on Common Equity

The most important, or bottom-line, accounting ratio is the return on common equity (RO
follows:
Net income
Return on common equity (ROE) = ------------------
Common equity
$146.3
= = 15.6%
$940
 into play. For example, financial leverage generally increases the ROE but also increases the fir
a high ROE is achieved by using a great deal of debt, the stock price might end up lower than i
been using less debt and had a lower ROE. We use the final set of ratios-the market value ratios
the stock price to earnings and book value price-to help address this situation. If the liq
management, debt management, and profitability ratios all look good and if investors think the
continue to look good in the future, the market value ratios will be high, the stock price will be a
be expected, and management will be judged to have been doing a good job.
The market value ratios are used in three primary ways: (1) by investors when they are de
or sell a stock, (2) by investment bankers when they are setting the share price for a new stock is
and (3) by firms when they are deciding how much to offer for another firm in a potential merger.
a. Price/Earnings Ratio
The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported p
Price per share
Price / Earnings (P/E) ratio = -----------------------------
Earnings per share
$23.06
= ----------- = 11.8x

$1.95

Industry average = 11.3x

If P/E ratio is below its industry average; this suggests that the company is regarded as be
risky, as having poor growth prospect, or both.

b. Market / Book Ratio

The ratio of a stock’s market price to its book value gives another indication of how investo
company. Companies that are well regarded by investors – which means low risk or high grow
M/B ratios.
We need to first identify its book value per share:
Common equity
Book value per share = -----------------------
Shares outstanding
$940
= ------------ = $18.80
50
We then divide the market price per share by the book value per share to get the mark
ratio.
Market price per share
Market/book (M/B) ratio =
Book value per share
$23.06
= = 1.8x
$12.53
Industry Average = 1.7x

In this example, investors are willing to pay more for a dollar of the company’s book value than
average processing company which means that investors are willing to pay for more stocks than th
 • The first term, the profit margin, tells us how much the firm earns on its sales. This r
primarily on costs and sales price-if a firm can command a premium price and hold dow
profit margin will be high, which will help its ROE.
• The second term is the total assets turnover. It is a multiplier that tells us how many tim
margin is earned each year.
• The third term, the equity multiplier, which is the adjustment factor

POTENTIAL MISUSE OF ROE

• ROE does not consider risk. Shareholder care for both, the ROE and the risk.
• ROE does not consider the amount of invested capital. • ROE focus on ROE can cause
turn down profitable projects.

USING FINANCIAL RATIOS TO ASSESS PERFORMANCE

While financial ratios help us evaluate financial statements, it is often hard to evaluate a
just looking at the ratios.

a. Comparison to Industry Average

One way to assess performance is to compare the company’s key ratios to the industry averag
reference, refer to table below.
 2. Benchmarking
Ratio analysis involves comparisons with industry average figures. Many other firms also compar
with a subset of top competitors in their industry. This is called benchmarking, and the compa
comparison are called benchmark companies.

3. Trend Analysis
As a final comparison, it is important to analyze trends in ratios as well as their absolute levels, fo
clues as to whether a firm’s financial condition is likely to improve or deteriorate. It is an analys
financial ratios over time; use to estimate the likelihood of improvement or deterioration in its financ

USES AND LIMITATIONS OF RATIOS

As noted earlier, ratio analysis is used by main three groups: (1) managers, whoo use ratios to
control and thus improve their firms’ operations; (2) credit analysts, including bank loan officers an
  Many firms have divisions that operate in different industries, and for such companies,
develop a meaningful set of industry averages. Therefore, ratio analysis is more usefu
focused firms than for multidivisional ones.
 Most firms want to be better than average, so merely attaining average performance is n
good. As a target for high-level performance, it is best to focus on the industry leaders’ ra
 Inflation has distorted many firms’ balance sheets-book values are often different from m
Market values would be more appropriate for most purposes, but we cannot generally get
figures because assets such as machinery are not traded in the marketplace.
Further, inflation affects asset values, depreciation charges, inventory costs, and
Therefore, a ratio analysis for one firm over time or a comparative analysis of firms of d
must be interpreted with care and judgement.
 Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ra
processor will be radically different of the balance sheet figure used for inventory is the o
versus just after the close of the canning season.
 Firms can employ “window dressing” techniques to improve their financial statements. It
employed by firms to make their financial statements look better than they really are.
 Different accounting practices can distort comparisons. Inventory valuation and depreci
can affect financial statements and thus distort comparisons among firms.
 It is difficult to generalize about whether a particular ratio is “good” or “bad.” For example,
ratio may indicate strong liquidity position which is good, but it can also indicate excessiv
is bad because excess cash in a bank is a nonearning asset. Similarly, a high fixed assets
may indicate that the firm uses its assets efficiently, but it could also indicate that the fi
cash and cannot afford to make needed fixed assets investment.
 Firms often have ratios that look “good” and others that look “bad,” making it difficult to
company is, on balance, strong or weak.

MODULE 4
TIME VALUE OF MONEY

Time value analysis has many applications, including planning for retirement, valuing stock
setting up loan payment schedules, and making corporate decisions regarding investing in
equipment. In fact, all financial concepts, time value of money is the single most important concep

The first step in time value analysis is to set up a timeline, which will help you visualize what’s
particular problem. A timeline is an important tool used in time value analysis; it is a graphical re
used to show the timing of cash flows. As an illustration, consider the following diagram, where P
$100 that is on hand today and FV is the value that will be in the account on a future date:

The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or months. Time 0 is
is the beginning of Period 1; time 1 is one period from today, and it is both the end of period 1 and
of period 2 and so forth. Although the periods are often years, periods can also be quarters or mo
days. Note that each tick mark corresponds to both the end of one period and the beginning of
Thus, if the periods are years, the tick mark at Time 2 represents the end of Year 2 and the begin
3. Cash flows are shown directly below the tick marks, and the relevant interest rate is shown ju
timeline. Unknown cash flows, which you are trying to find, are indicated in question marks. Her
FUTURE VALUES
A dollar in hand today is worth more than a dollar to be received in the future because if you ha
could invest it, earn interest, and own more than a dollar in the future. The process of going to
(FVs) from the present values (PVs) is called compounding. It is the arithmetic process of determ
value of a cash flow or series of cash flows when compound interest is applied.

Step-by-step Approach
The time line used to find the FV of $100 compounded for 3 years at 5%, along with some ca
shown. Multiply the initial amount of each succeeding amount by (1+I) = (1.05):

You start with $100 in the account- that is shown at t = 0:

• You earn $100(0.05) = $5 of interest during the first year, so the amount at the end of yea
$100 + $5 = $105.
• You begin the second year with $105, earn 0.05(105)= $5.25 on now larger beginning-of –p
and end the year with $110.25. Interest during year 2 is $5.25; and it is higher than th
interest, $5.00, because you earned $5(0.05)=$0.25 interest on the first year’s interest.
compounding, and interest earned on interest is called compound interest.
• This process continues; and because the beginning balance is higher each successive yea
earned each year increases.
• The total interest earned, $15.76, is reflected in the final balance, $115.76.

The step-by-step approach is useful because it shows exactly what is happening. H

approach is time-consuming, especially when a number of years are involved; so streamline
have been developed.

Formula Approach
In this approach, we multiply the amount at the beginning of each period by (1+I) = (1.05). If N = 3
by (1+I) three different times, which is the same as multiplying the beginning amount by (1+I) 3 .
can be extended, and the result is this key equation:

FVN = PV(1+I)N

FV3 = $100 (1.05)3 = $115.76

SPREADSHEETS

Students generally use calculators for homework and exam problems but in business, people g
spreadsheets.

Excel Approach:
Summary of Future Value Calculations
  When calculating time value of money problems in Excel, interest rates are entered as p
decimals (e.g., .05 or 5%). However, when using the time value of money function on
calculators you generally enter the interest rate as a whole number (e.g., 5).
 When calculating time value of money problems in excel, the abbreviation for the numbe
Nper, whereas for most financial calculators the abbreviation is simply N. Throughout th
use these terms interchangeably.
 When calculating time value of money problems in Excel, you will often be prompted to ente
refers to whether the payments come at the end of the year (in which case Type = 0, o
omit), or at the beginning of the year (in which case Type = 1). Most financial calcu
BEGIN/END mode function that you toggle on or off to indicate whether the payments
beginning or at the end of the period.

PRESENT VALUES
Finding a present value is the reverse of finding a future value with the basic present value equat
FVN
Present Value = PV = --------
(1+I)N

Example:
A broker offers to sell you a Treasury bond that will pay $115.76 three years from now. Banks
offering a guaranteed 5% interest on 3-year certificates of deposit (CDs); and if you don’t buy the b
buy a CD. The 5% rate paid on the CDs is defined as your opportunity cost. This is the rate
could earn on an alternative investment of similar risk:
115.76
PV = -------------- = $100
(1.05)3

The $100 is defined as the present value, or PV, of $115.76 due in 3 years when the appropriate
is 5%. In general, the present value f a cash flow due N years in the future is the amount which
hand today, would grow to equal the given future amount. Because $100 would grow to $115.76
a 5% interest rate, $100 is the present value of $115.76 due in 3 years at 5% rate. Finding pres
called discounting; and as noted above, it is the reverse of compounding-if you know the PV, you c
to find the FV, while if you know the FV, you can discount to find the PV.
Solution using excel
Excel has financial solution function that solves for an unknown interest rate. RATE (nper, pm
return the fixed interest rate that equates an annuity of magnitude pmt that lasts for nper period
present value (pv) or its future value (fv).
Where:
Nper = number of periods
Pmt = payments
PV = present value (-PV)
FV = future value

I = RATE (10,0,-100,150)
I = 4.14%

FINDING THE NUMBER OF YEARS

We sometimes need to know how long it will take to accumulate a certain sum of money, given o
funds and the rate we will earn on those funds. For example, suppose we believe that we could retir
if we had $1 million. We want to find how long it will take us to acquire $1 million, assuming w
$500,000 invested at 4.5%.
NPER (rate,pmt,-pv,fv)
=NPER(0.045,0,-500000,1000000)
=15.7473 years

Simple versus Compound Interest

When money is borrowed, the amount borrowed is called the principal. The consideration paid f
money is called interest.
• The rate of interest can be thought of as a price per period for the use of money.
• From the perspective of the lender, interest is earned; from the perspective of the borr
is paid.

Simple Interest

Simple interest refers to the situation in which interest is calculated on the original principal
With simple interest, the base on which interest is calculated does not change, and the amo
earned each period also does not change.

Compound Interest

Compound interest refers to the situation in which interest is calculated on the original prin
accumulated interest.
With compound interest, interest is calculated on a base that increases each period, and t
interest earned also increases with each period.

Application of Simple Interest

Suppose someone invests $100 for 50 years and receives 5% per year in simple interest
simple interest, multiply the beginning balance by the rate 0.05 × $100 = $5. The growth in the
depicted in the table below:
With simple interest, each year´s interest is based on the original principal amount only.
Application of Compound Interest

Assume the same investment of $100 for 50 years, but at compound interest:

With compound interest, interest is earned on both the original principal and accumul
Interest is earned on interest.
In the preceding example, with simple interest, the accumulated amount after 50 years is on
compound interest, the accumulated amount is $1,147. As the term increases, the difference betw
amounts with compound interest versus simple interest becomes more and more dramatic.

"Miracle of Compound Interest"

In a well-known transaction, Dutch colonists bought Manhattan Island in 1624 for the equivalent o
• This seems like a steal, but if the seller had deposited the $24 and earned an annual ra
future compound amount would have been about $141 billion in the year 2010.
• This is roughly equal to the total assessed value of all land and improvements in the Ci
of San Francisco in the year 2010.
• Over the same time period (386 years), the future value of $24 at simple interest of 6%
been only $580.
• From a lender´s (or investor´s) perspective, compound interest is a good thing; the
interest on interest from the borrower. Conversely, from a borrower´s perspective, comp
is not so good. The borrower, in effect, pays interest on interest throughout the term of
Compound Interest Functions
Six compound interest functions are used to solve time value of money problems. Not surp
the functions are based on compound, not simple, interest. Each compound interest function is
formula, which is the basis for calculating the compound interest factors for that function. Each for
a periodic interest rate and the number of periods

Most time value of money problems involve the use of only one compound interest functio
but some require the use of two or more.
Understanding the compound interest functions, and how the factors derived from them are used
value of money problems, is the heart of this subject matter. Each compound interest formula, an
derived from it, involves three variables:

1. An interest rate,
 Published tables of compound interest factors are used to solve time value of money problems.
refer to a table of factors than to calculate the desired factor from one of the formulas each time yo

ANNUITIES

Calculating Present and Future Value of Annuities

Most of us have had the experience of making a series of fixed payments over a period of t
rent or car payments—or receiving a series of payments for a period of time, such as interest fr
certificate of deposit. These recurring or ongoing payments are technically referred to as "annuiti
confused with the financial product called an annuity, though the two are related).

Two Types of Annuities

Annuities, in this sense of the word, break down into two basic types: ordinary annuities and annu

• Ordinary annuities: An ordinary annuity makes (or requires) payments at the end of eac
example, bonds generally pay interest at the end of every six months.
• Annuities due: With an annuity due, by contrast, payments come at the beginning of each
which landlords typically require at the beginning of each month, is a common example.

Calculating the Future Value of an Ordinary Annuity

• Future value (FV) is a measure of how much a series of regular payments will be worth at
the future, given a specified interest rate. So, for example, if you plan to invest a certain
month or year, it will tell you how much you'll have accumulated as of a future date. If yo
regular payments on a loan, the future value is useful in determining the total cost of the lo
• Consider, for example, a series of five $1,000 payments made at regular intervals

Because of the time value of money — the concept that any given sum is worth more now than it
future because it can be invested in the meantime—the first $1,000 payment is worth more than
and so on. So, let's assume that you invest $1,000 every year for the next five years, at 5% inte
how much you would have at the end of the five-year period.
Using the example above, here's how it would work:

Note that the one-cent difference in these results, $5,525.64 vs. $5,525.63, is due to roundin
calculation.

Calculating the Present Value of an Ordinary Annuity

In contrast to the future value calculation, a present value (PV) calculation tells you how m
would be required now to produce a series of payments in the future, again assuming a set intere

Using the same example of five $1,000 payments made over a period of five years, here is h
value calculation would look. It shows that $4,329.58, invested at 5% interest, would be sufficie
those five $1,000 payments.

This is the applicable formula:

If we plug the same numbers as above into the equation, here is the result:
 To account for payments occurring at the beginning of each period, it requires a slight mod
formula used to calculate the future value of an ordinary annuity and results in higher values, as s

The reason the values are higher is that payments made at the beginning of the period have more
interest. For example, if the $1,000 was invested on January 1 rather than January 31 it would have
month to grow.

The formula for the future value of an annuity due is as follows:

Here, we use the same numbers, as in our previous examples:

Again, please note that the one-cent difference in these results, $5,801.92 vs. $5,801.91, is due
the first calculation.

MODULE 5
FINANCIAL ASSETS (Interest Rates)

The Basics of Interest Rates

The cost of money is the opportunity cost of holding cash instead of investing it, depending on the
An interest rate is the rate at which a borrower pays interest for using money that they borrow f
Market interest rates are driven mainly by inflationary expectations, alternative investments, risk o
and liquidity preference. The term structure of interest rates describes how interest rates change o

The cost of money is the opportunity cost of holding money instead of investing it, depending
interest.

The Cost of Money

The four most fundamental factors affecting the cost of money are:
1. Production opportunities – the investment opportunities in productive (cash generating) assets
  On the riskiness of the loan
 On the expected future rate of inflation

Producers expected returns on their business investments set an upper limit to how much the
savings, while consumers’ time preferences for consumption establish how much consumption th
to defer and, hence, how much they will save at different interest rates. Higher risk and higher infla
to higher interest rates.

THE DETERMINANTS OF MARKET INTEREST RATES

In general, the quoted (or nominal) interest rate on a debt security, r, is composed of the
free rate, r*, plus several premiums that reflect inflation, the security's risk, its liquidity (or marketa
the years to its maturity. This relationship can be expressed as follows: Quoted Interest Rate =
+ DRP + LP + MRP Where:
r = the quoted, or nominal, rate of interest on a given security
r* = the real risk-free rate of interest. r* is pronounced "r-star", and it is the rate that wo
a riskless security in a world where no inflation was expected. It changes over time depending o
conditions, especially on:
• The rate of return that corporations and other borrowers expect to earn
assets and
• People's time preferences for current versus future consumption.
• The rate of interest that would exist on default-free US treasury securities
were expected.
*
rRF = r + IP. It is the quoted rate on a risk-free security such as Treasury bill, which is ve
is free of most of types of risk. Note that the premium for expected inflation, IP, is included in rRF..
correct, the risk-free rate should be the interest rate on the totally risk-free security-one that has no
no maturity risk, no liquidity risk, no risk of loss if inflation increases and no risk of any other type.
The rate of interest on a security that is free of all risk, rRF is proxied by the T-bill
rate, this also includes an inflation premium.
IP = inflation premium. IP is equal the average expected rate of inflation over the life of
The expected future inflation rate is not necessarily equal to current inflation.
• To illustrate, suppose you saved $1,000 and invested in a Treasury bill th
interest rate and matures in one year. At the end of the year, you will receive
original $1,000 plus $30 on interest. Now suppose the inflation rate during th
out to be 3.5% and it affected all goods equally. I heating oil had cost $1 pe
beginning of the year. It would cost$1,035 at the end of the year. Therefore
would have bought $1,000/$1 = $1,000 gallons at the beginning of the y
$1,030/$1.035 = 995 gallons at the end of the year.
• Inflation premium is equal to expected inflation that investors ass to the rea
of return

DRP = default risk premium. This premium reflects the possibility that the issuer will not pay
interest or principal at the stated time. DRP is zero for Treasury securities, but it rises as the ris
issuer increases.
• The risk that a borrower will default, which means a borrower will not ma
interest or principal payments, also affects the market interest rate on a bond
the bond's risk default, the higher the market rate. LP = liquidity (or
premium. This is the premium charged by lenders to reflect the fact that so
cannot be converted to cash on short notice at a reasonable price. LP is
Treasury securities and for securities issued by large, strong firms; but it is
on securities issued by small, privately held firms.
Because rRF = r* + IP, we can rewrite Equation as follows:
Nominal, or quoted, rate = r = rRF + DRP + LP + MRP
• A liquid asset can be converted to cash quickly at a "fair market value." Re
generally less liquid than financial assets, but different financial assets
liquidity. Because they assets that are more liquid, investors include a liqu
 • In recent years, the maturity risk premium on a 2-year T-bonds has general
range of one to two percentage points.

EXAMPLE:
The real risk-free rate interest, r*, is 3%; and it is expected to remain constant over t
is expected to be 2% per year for the next 3 years and 4% per year for the next 5 years. The
premium is equal to 0.1 x (t – 1)%, where t = the bond's maturity. The default risk premium for a
bond is 1.3%.
a. What is the average expected inflation rate over the next 4 years?
Average Inflation = (2% + 2% + 2% + 4%) = 2.5%

b. What is the yield on a 4-year Treasury bond?

T4 = rRF + MRP4
= r* + IP4 + MRP4
= 3% + 2.5% + (0.1) 3%
= 5.8%

c. What is the yield on a 4-year BBB rated corporate bond with a liquidity premium of 0
C4, BBB = r* + IP4 + MRP4 + DRP + LP
= 3% + 2.5% + 0.3% + 1.3% + 0.5%
= 7.6%

d. What is the yield on an 8- year Treasury bond?

T8 = r* + IP8 + MRP8
= 3* + (3 x 2% + 5 x 4%)/8 + 0.7%
= 3% + 3.25% + 0.7%
= 6.95%

THE TERM STRUCTURE OF INTEREST RATE

A major factor that influences the interest rate is its term to maturity or the period of borrowing.
remaining same, bonds with different maturity period earn different interest rates. The curve showin
between yield and term to maturity (other things remaining constant) is called the ‘yield curve’.
The term of the structure of interest rates has three primary shapes; upward-sloping, flat, and down
(downward sloping is often referred to as an inverted yield curve).

1. Upward sloping- it reflects that interest and on long-term bonds are higher than interest on sho
This is considered to be the “normal” slope of the yield curve and signals that the economy is in
mode.

2. Downward sloping – indicates short -term yields are higher than long-term yields. Known as
‘Inverted’ yield curve and signifies that the economy is in, or about to enter, a recessive period

3. Flat- very little variation between short and long-term yields. Signals that the market is uns
future direction of the economy.

Yield curves can also have more complicated shapes in which they first slope up and then down,

A good theory of term structure of interest rates must explain the following three important empiri
1. Interest rates on bonds of different maturities move together over time.
2. When short-term interest rates are low, yield curves are more likely to have an upward slope
term interest rates are high, yield curves are more likely to slope downward and be inverted.
3. Yield curves almost always slope upward.
after five years so that the average short-term interest rate over the coming 20 years is 11%, the
rate on the 20-year bonds would equal 11% and would be higher than the interest rate on five-yea

A simple numerical example might clarify what the expectations theory in equation is saying. If one
rate over the next five years is expected to be 5,6,7,8 and 9%. The interest rate on the two – yea
be:

II.

The expectations theory is an elegant theory that provides an explanation of why term
interest rates (as represented by yield curves) changes at different times.

II. THE SEGMENTED MARKETS THEORY

III. THE LIQUIDITY PREMIUM THEORY

Liquidity premium theory asserts that bondholders greatly prefer to hold. Short-term bonds
long-term bonds. Short-term bonds have less interest rate risk than long-term bonds, becaus
change less for a given changes in interest rates.

The yield curve is the investors’ most common and closely examined investment pattern. These
can be created and plotted for all types of bonds, like corporate bonds, and bonds with different
 One made investments in two government bonds – Bond A and Bond B. The below gra
effect of the maturity period or the duration of an asset held for several years. Instrument A is a
bond with a longer maturity period than instrument A, a government bond investment. Instrument A h
period of 20 years, while instrument B has 15 years only. In this case, Bond B has a coupon rate
of approximately 12%. In comparison, Bond A enjoys the additional 3%.
This additional benefit in your investment returns is known as the liquidity premium. T
representation above shows that one can provide this premium if the bond holds for a longer ma
This premium gets paid to the investor only on the maturity of the bond held.