AcMngt 211 FINANCIAL MANAGEMENT

INTRODUCTION

Financial management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
Finance is, in a real sense, a cornerstone of every business. A sound financial management
contributes greatly to the success of business firms, hence, to the country in general. Because of
its importance, financial management should be clearly understood.

The field of finance is relatively complex, and is always undergoing changes in response to
economic conditions. All of these make finance stimulating and exciting, but also challenging
and sometimes perplexing.

Students are encouraged to have their own researches of the topics presented to expand their
knowledge and deepen understanding. The way topics are presented here is intended only to
guide both the teacher and students.

I. OVERVIEW OF FINANCIAL MANAGEMENT

Scope and Environment of Finance

Finance has been defined as the art and science of managing money. In as much as business
transactions affect the financial resources of a firm, business finance or financial management,
may be defined as the art and science of managing financial resources of a company.

Finance is an exciting, challenging, and ever-expanding discipline concerned with identifying,

evaluating and managing the sources and uses of a company’s economic resources to increase
the value of the business to its present owners. It is built upon both economics and accounting.
Economics provides some of the theories underlying techniques for various purposes such as
decision-making, evaluation, etc. Economics is about the efficient allocation of scarce resources,
and finance involves obtaining resources at the least cost so that they can be put to their most
productive use in business. Finance is a tool that enables the decision-maker to solve the
economic problems with optimal allocation of investments and where to get financing, whereas
accounting provides the input or data on which decision making is based. It is a discipline called
the language of business. Accounting is informative because it is the system of measuring,
recording, summarizing, and interpreting financial transactions.

There are three interrelated areas in the theory and practice of finance:
1. Money and Capital Markets
2. Investments
3. Financial Management

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AcMngt 211 FINANCIAL MANAGEMENT

MONEY AND CAPITAL MARKETS

This is a field in finance that deals with decision-making for specialized firms, including banks,
insurance companies, mutual funds, and investment banking firms. As financial intermediaries,
financial institutions are custodians of funds of public and private investors. They channel these
funds to new financial assets to support the production of goods and services in the economy.

To succeed in this field, one needs knowledge of valuation techniques, the factors that cause
interest to rise and fall, the regulations for financial institutions, and various types of financial
instruments. One also needs a general knowledge of all aspects of business administration,
because the management of a financial institution involves accounting, marketing, personnel and
computer systems.

INVESTMENTS
This field of finance is concerned with the efficient selection of financial investments (portfolio).
This involves identifying suitable assets or use of funds, rather than finding sources of funds.
The three main functions in the investment area are sales, analyzing individual securities, and
determining the optimal mix of securities for a given investor.

FINANCIAL MANAGEMENT
Financial Management is the broadest of the three areas also called corporate finance. It is
important in all types of businesses, as well as in governmental operations. Financial managers
have the responsibility for making decisions like plant expansion, what types of securities to
issue, setting up credit terms, how much inventory the firm should carry, how much cash to keep
on hand, whether to acquire other firms, and how much of the firm’s earnings to retain into the
business and how much should be paid out as dividends.

There are three main forms of business organizations:

1. Sole proprietorship – the simplest form of business organization owned by one individual.
It can be easily formed and subject only to few government regulations. However, for a
sole proprietor, it is difficult to obtain large amount of funds, have unlimited personal
liability and to absorb alone the losses incurred by the organization. The life of the
business is limited also to the life of its proprietor. Thus, sole proprietorship is used only
for small-businesses.
2. Partnership – is a contract between to or more persons who commit themselves to
contribute money, property, or industry to a common fund with the intention of dividing
the profits among themselves. Just like the sole proprietorship, a partnership has also an
ease of formation; However, its disadvantages include: unlimited liability, limited life of
the organization, difficulties of transferring ownership and raising large sum of funds.
3. Corporation – is a juridical entity created by operation of law separate and distinct from
its owners. Its characteristics include: unlimited life – though they are provided a
maximum life of 50 years, which is renewable; transferability of ownership; limited
liability; and the presence of a governing body – the board of directors.

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AcMngt 211 FINANCIAL MANAGEMENT

The Goals of Finance

The primary goal of the management should be maximization of shareholders wealth, which
translates into maximizing the price of the firm’s existing common stock.

Profit maximization is frequently given as the goal of the firm. It stresses on the efficient use of
resources, but is not specific as to the time frame over which profits are to be measured. Another
problem of profit maximization is that it ignores the timing of the project’s returns, and the cost
of funds provided by the firm’s shareholders (owners).

In the goal of maximizing shareholder wealth, the goal of profit maximization is modified to deal
with the complexities of the operating environment. It considers the risk (uncertainty) and timing
associated with expected returns. The market price of the firm’s stock reflects the value of the
firm as by its owners. Firms do, of course, have other objectives. But still, stock price
maximization is the most important goal for most corporations. And as we follow this goal
throughout our discussions, we must keep in mind that the shareholders are the legal owners of
the firm.

In our discussions, we will focus primarily on publicly owned companies; hence, we operate on
the assumption that management’s primary goal is shareholder wealth maximization. At the
same time, the managers know that this does not mean mazimizing shareholder value “at all
costs”. Managers have an obligation to behave ethically, and they must follow the laws and other
society-imposed constraints.

Functions of Finance
Finance function is the most important function of a business. Finance is, closely, connected
with production, marketing and other activities. In the absence of finance, all these activities
come to a halt. In fact, only with finance, a business activity can be commenced, continued and
expanded.

Understanding the universality and importance of finance, finance manager is associated, in

modern business, in all activities as no activity can exist without funds.

All decisions mostly involve finance. When a decision involves finance, it is a financial decision
in a business firm. In all the following financial areas of decision-making, the role of finance
manager is vital.

Decisions in Finance
Four Major Decisions which Every Finance Manager has to Take:
1) Investment Decision
Relates to careful selection of assets which funds will be invested by the firms. A firm has
many options to invest their funds but the firm has to select the most appropriate investment

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which will bring maximum benefit for the firm and deciding or selecting the most appropriate
proposal is an investment decision.

The firm invests its funds in acquiring fixed assets as well as current assets. When decision
regarding fixed assets is taken it is also called capital budgeting decision.

2) Financing Decision
The second important decision which a finance manager has to take is deciding source of
financing. A company can raise funds from various sources such as by issue of shares,
debentures or by taking loan and advances. Deciding how much to raise from which source
is a concern of financing decision.

3) Dividend Decision
This decision is concerned with distribution of surplus funds. The profit of the firm is
distributed among various parties such as creditors, employees, debenture holders,
shareholders, etc.

Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so
what company or finance manager has to decide is what to do with the residual or left over
profit of the company. The surplus profit is either distributed to equity shareholders in the
form of dividend or kept aside in the form of retained earnings. Under dividend decision the
finance manager decides how much is to be distributed in the form of dividend and how much
to keep aside as retained earnings.

This decision is also called residual decision because it is concerned with distribution of
residual or left over income. Generally, new and upcoming companies keep aside more of
retained earnings and distribute less dividend whereas established companies prefer to give
more dividend and keep aside less profit.

4) Liquidity Decision
It is concerned with the management of current assets – working capital management. It is
concerned with the short-term survival – a prerequisite of long-term survival of the firm.

When more funds are tied-up in current assets, the firm would enjoy greater liquidity.
However, funds have economic cost. Idle current assets do not earn anything. Higher
liquidity is at the cost of profitability. A proper balance must be maintained between liquidity
and profitability of the firm. This is the key area where finance manager has to play
significant role. The strategy is ensuring a trade-off between liquidity and profitability

Agency Relationships
As the business continues to grow, professional managers are hired to manage its operations.
Managers are empowered by the owners of the firm – the shareholders – to make decisions.
Although the goal of the firm is to maximize shareholders’ wealth, an agency problem may
interfere in the implementation of this goal because of the conflict of interest known as the agency

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conflict, arising from the separation of management and the ownership of the firm. Because of
this separation, managers might make decisions that serve their personal interest but are
detrimental to the goals of the owners.

To at least minimize this agency problem, managers are encouraged to act for the best interest of
the shareholders through incentives to reward them for good performance, and punish them for
poor performance. Some mechanics used to motivate managers include:
Monitor managers by auditing financial statements and compensation packages
Direct intervention by shareholders
Threat of firing
Threat of hostile takeover
Requirements for insurance and bonding

Conflicts can also arise between shareholders and bondholders. Bondholders generally receive
fixed payment regardless of how well the company does, while stockholders do better when the
company does better. This situation leads to conflicts between these two groups1. Bondholders
attempt to protect themselves by including covenants in the bond agreements that limit firm’s
use of additional debt and constrain manager’s action in other ways.

II. FRAMEWORK OF FINANCIAL MANAGEMENT

Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structures, behavior,
and decision-making of an economy as a whole. This includes national, regional, and global
economies.

Macroeconomists study aggregated indicators such as GDP, unemployment rates, national

income, price indices, and the interrelations among the different sectors of the economy to better
understand how the whole economy functions. While macroeconomics is a broad field of study,
there are two areas of research that are emblematic of the discipline: the attempt to understand
the causes and consequences of short-run fluctuations in national income (the business cycle),
and the attempt to understand the determinants of long-run economic growth (increases in
national income).

Macroeconomic policy is usually implemented through two sets of tools: fiscal and monetary
policies. Both forms of policy are used to stabilize the economy, which can mean boosting the
economy to the level of GDP consistent with full employment. Macroeconomic policy focuses
on limiting the effects of the business cycle to achieve the economic goals of price stability, full
employment, and growth.
1
Managers represent stockholders; so saying “stockholders versus bondholders” is the same saying “managers versus
bondholders.”

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Two Ways that the Government can influence the Economy:

1) MONETARY POLICY
Monetary policy consists of the actions of a central bank, currency board or other regulatory
committee that determine the size and rate of growth of the money supply, which in turn affect
interest rates. Monetary policy is maintained through actions such as modifying the interest rate,
buying or selling government bonds, and changing the amount of money banks are required to
keep in the vault (bank reserves).

Two types of Monetary Policy

1. Expansionary monetary policy – increases the money supply in order to lower
unemployment, boost private-sector borrowing and consumer spending, and stimulate
economic growth. Often referred to as “easy monetary policy”.
2. Contractionary monetary policy – slows the rate of growth in the monetary supply or
outright decreases the money supply in order to control inflation, while sometimes
necessary, contractionary monetary policy can slow economic growth, increase
unemployment and depress borrowing and spending by consumers and businesses.

2) FISCAL POLICY
Fiscal policy refers to the measures employed by governments to stabilize the economy,
specifically by manipulating the levels and allocations of taxes and government expenditures.
Fiscal measures frequently used in tandem with monetary policy to achieve certain goals. In the
Philippines, this is characterized by continuous and increasing levels of debt and budget deficits,
though there have been improvements in the last few years.

Fiscal policy and monetary policy are two major drivers of a nation’s economic performance.
Through monetary policy, a country’s central bank influences the money supply. Regulators use
both policies to try to boost a flagging economy, maintain a strong economy, or cool off an
overheated economy.

Comparison
Economists usually favor monetary over fiscal policy because it has two major advantages. First,
monetary policy is generally implemented by independent central banks instead of the political
institutions that control the fiscal policy. Independent central banks are less likely to make
decisions based on political motives. Second, monetary policy suffers shorter inside lags and
outside lags than fiscal policy. Central banks can quickly make and implement decisions while
discretionary fiscal policy may take time to pass and even longer to carry out.

Business Cycles
The rising and falling of the GDP and GNP are tracked by most investors since business firms
are affected by the country’s economy. A boom occurs when national output is greater than the
expected trend of growth. This is reflected by a high demand in employment and goods.
Business firms increase production levels and/or their profit margin. When the economy is at its
peak, it is said to be at the top of the cycle.

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A boom is usually followed by a slowdown. A slowdown happens when the national output is
still increasing but at a slower rate. If it continues over time, it reaches a point when there is a
decline in the growth of the national output. And this is referred to as recession.

When the economy reaches a low point, the bottom of the cycle is called a trough. It is
characterized by high unemployment and low level of demand for the economy’s capacity to
produce, thus business profits become low.

When the GNP rises from the lowest point and starts to increase, it is called recovery, another
cycle of boom, slowdown, recession, and recovery follows. This is referred to as the business
cycle.

The Role of Money in the Economy

The first definition of money is to define money as the means of exchange between parties. It is
an item or verifiable record that is generally accepted as payment for goods or services and
repayment of debts in a particular country, or socio-economic context, or is easily converted to
such a form. The main functions of money are distinguished as: medium of exchange; a unit of
account; a store of value; and, sometimes, a standard of deferred payment.

Supply and Demand for Money

In economics, money is a broad term that refers to any financial instrument that can fulfill the
functions of money. These financial instruments together are collectively referred to as money
supply of an economy. In other words, the money supply is the number of financial instruments
within a specific economy available for purchasing goods or services. Since the money supply
consists of various types of deposits, the amount of money in an economy is measured by adding
together these financial instruments creating a monetary aggregate.

The old idea about the demand for money was that money was demanded for completing the
business transactions. In other words, the demand for money depended on the volume of trade
or transactions. As such the demand for money increased during boom period or when the trade
was brisk and it decreased during depression or slacking of trade.

The modern idea about the demand for money was put forward by the late Lord Keynes, the
famous English economists, who gave birth to what has been called the Keynesian Economics.
According to Keynes, the demand for money, or liquidity preference as he called it, means the
demand for money to hold.
Three main motives of which money is wanted:
1. Transactions motive
2. Precautionary motive
3. Speculative motive

Discussion for each of these motives are in the Working Capital Management topic.

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Environmental Policies and their implications for the management of the economy and the
firm

Environmental policy refers to the commitment of an organization to the laws, regulations, and
other policy mechanisms concerning environmental issues. These issues generally include air
and water pollution, waste management, ecosystem management, wildlife and endangered
species.

It is useful to consider the environmental policy which comprises two major terms : environment
and policy. Environment refers to the physical ecosystems, but can also take into consideration
the social dimension (quality of life, health) and an economic dimension (resource management,
biodiversity). Policy can be defined as a source of action or principle adopted or proposed by a
government, party, business or individual. Thus, environmental policy focuses on problems
arising from human impact on the environment, which retroacts onto good health or the ‘clean
and green’ environment.

The rationale for governmental involvement in the environment is market failure in the form of
forces beyond the control of one person, including the free rider problem and the tragedy of the
commons. An example of an externality is when a factory produces waste which may be dumped
into a river, ultimately contaminating water. The cost of such action is paid by society – at-large,
when they must clean the water before drinking it and is external to the cost of the factory. The
free rider problem is when the private marginal cost of taking action to protect the environment
is greater than the private marginal benefit, but the social marginal cost is less than the social
marginal benefit. The tragedy of the commons is a problem that, because no one person owns
the commons, each individual has an incentive to utilize common resources as much as possible.
Without governmental involvement, the commons is overused. Examples of tragedies of the
commons are overfishing and overgrazing.

Governments use different types of environmental policy instruments as tools to implement their
environmental policies. Examples are: economic incentives and market-based instruments such
as taxes and tax exemptions, tradable permits, and fees can be very effective to encourage
compliance with environmental policy. Corporate companies who engage in efficient
environmental management and are transparent about their environmental data and reporting
benefit from improved business performance.

Several instruments are sometimes combined in a policy mix to address a certain environmental
problem. Since environmental issues have many aspects several policy instruments may be
needed to adequately address each one. Furthermore, a combination of different policies may
give firms greater flexibility in policy compliance and reduce uncertainty as to the cost of such
compliance.

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The Efficient Market Hypothesis (EMH)

It asserts that well-organized capital markets are efficient markets, at least as a practical matter.
In other words, an advocate of EMH might argue that although inefficiencies may exist, they are
relatively small and not common.

Efficient markets are made up of many rational investors who reacts quickly and objectively to
new information. The efficient market hypothesis (EMH), which is the basic theory describing
the behavior of such a “perfect” market, specifically states that:
1.Securities are typically in equilibrium, which means that they are fairly priced, and that their
expected returns equal their required returns.
2.At any point in time, security prices fully reflect all information available about the firm and
its securities, and these prices react swiftly to new information.
3.Because stocks are fully and fairly priced, investors need not waste their time trying to find
underpriced (undervalued or overvalued) securities.

Forms of Market Efficiency:

1) Strong-form Efficiency – all information of every kind is reflected in stock prices. In
such a market, there is no such thing as inside information.
2) Semistrong-form Efficiency – current prices fully reflect all publicly available
information, including such things as annual reports and news items. This is the most
controversial form because it implies that a security analyst who tries to identify
mispriced stocks using, for example, financial statement information is wasting time
because the information is already reflected in the current price.
3) Weak-form Efficiency – suggests that, at a minimum, the current price of a stock reflects
the stock’s own historical sequence of prices. In other words, studying past prices in an
attempt to identify mispriced securities is futile if the market is weak form efficient.
Although this form of efficiency might seem rather mild, it implies that searching for
patterns in historical prices that will be useful in identifying mispriced stocks will not
work (this practice is quite common).

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III. ENVIRONMENT OF FIRMS AND INDUSTRY ANALYSIS

Internal and External Environment

The internal business environment includes factors within the organization that impact the
approach and success of the firm’s operations. The external environment consists of a variety of
factors outside the firm that it typically doesn’t have much control over. Managing the strengths
of the firm’s internal operations and recognizing potential opportunities and threats outside of
the firm’s operations are keys to business success.

Internal factors basically include the inner strengths and weaknesses. They can affect how a
company meets its objectives. Strengths are features which allow the company to work more
effectively than competitors. When you try to find your strengths, try to answer the following
questions:
o What is it that you do well?
o What benefits do you have over your competitors?
o What makes you stand out from the competitors?

The greatest thing about internal factors is that the firm has control over most of them. Some of
the factors are a result of the way the business is run. Examples of this include reputation, credit
worthiness, and image. Other factors depend on the firm’s business decisions like management
structure and staffing.

Weaknesses are the areas which have scope for improvement. Ask the following questions:
o What are you bad at?
o Is there anything you could be better at?
o What should you avoid?
o What leads to problems or complaints?

External factors are outside influences that can impact the ability of a business to achieve its
goals and objectives. These external factors might include competition: social, legal and
technological changes, and the economic and political environment. External factors basically
include opportunities and threats.

External opportunities provide an organization with a means to improve its performance and
competitive advantage in a market environment. Some opportunities can be foreseen, while some
may just fall into your lap. If you can think far enough ahead, you may even be able to create
some opportunities.

External threats are anything from the organization’s outside environment that can adversely
affect its performance or the achievement of its goals. Sometimes you can turn a threat into an
opportunity.

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A SWOT Analysis is a common tool to assess internal and external factors. It is a structured
planning method used to assess the strengths, weaknesses, opportunities, and threats.

Sample of SWOT analysis for business:

In-depth discussion, requirements, and presentation of SWOT analysis are done in the higher management courses.

Porter’s Five Forces Model

This model provides a framework for industry analysis to select which industry to invest in and
to choose the investee company in that industry. Companies use this model as a tool to develop
a competitive advantage over other firms in the industry. The model looks at the interaction
between five industry forces as shown below:

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The S-C-P Paradigm

As a guide for choosing investments, investors may conduct an industry analysis using the
(Structure-Conduct-Performance) S-C-P Paradigm. According to the paradigm, the ultimate
performance of industries depends upon the conduct of the industry participants or companies
along a number of dimensions: pricing strategies, product design, promotion and advertising
methods, innovation and legal tactics. The conduct of industry participants, in turn, depends on
the structure of the market within which they operate. Market structure includes market size,
market share, consumer buying habits, extent of competition and ease of entry of new
competitors.

Balanced Scorecard
The Balanced Scorecard is a management system that an organization uses to:
• Communicate what they are trying to accomplish
• Align the day-to-day work that everyone is doing with strategy
• Prioritize projects, products, and services
• Measure and monitor progress towards strategic targets

The Balanced Scorecard was originally developed by Dr. Robert Kaplan and Dr. David Norton
as a framework for measuring organizational performance using a more BALANCED set of
performance measures.

Kaplan and Norton describe the innovation of the balanced scorecard as follows:
“The balanced scorecard retains traditional financial measures. But financial measures tell the
story of past events, an adequate story for industrial age companies for which investments in
long-term capabilities and customer relationships were not critical for success. These financial
measures are inadequate, however, for guiding and evaluating the journey information age
companies must make to create future value through investment in customers, suppliers,
employees, processes, technology, and innovation.”

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The Four Legs of the Balanced Scorecard

Information is collected and analyzed from four aspects of a business. The four legs encompass
the vision and strategy of an organization and require active management to analyze the data
collected.
1) Learning and growth are analyzed through the investigation of training and knowledge
resources. It handles how well information is captured and how effectively employees
utilize the information to convert it to a competitive advantage over the industry.
2) Business processes are evaluated by investigating how well products are manufactured.
Operational management is analyzed to track any gaps, delays, bottlenecks, shortages or
wastes.
3) Customer perspectives are collected to gauge customer satisfaction with quality price and
availability of products or services. Customers provide feedback if their needs are being
met with current products.
4) Financial data such as sales, expenditures and income are used to understand financial
performance. These financial metrics may include amounts, financial ratios, budget
variances, or income targets.

Technical Analysis
Technical analysis is defining future market trends by crunching numbers generated by market
activities, such as price and volume of stocks traded. Technical analysts believe that by studying
stock price histories, it will give them clue on the thinking of buyers and sellers and they will be
able to anticipate future market movements. Historical data on prices are used to predict
continuation or reversal of price patterns to guide investors on when to buy or sell securities.
This is the facet of technical analysis.

Underlying assumptions of Technical Analysis:

1. Market action discounts everything - essentially means the market price of a security at
any given point in time accurately reflects all available information, and therefore
represents the true fair value of the security. This assumption is based on the idea the
market price always reflects the sum total knowledge of all market participants.
2. Prices move in trends - The notion that price changes are not random leads to the belief
of technical analysts that market trends, both short term and long term, can be identified,
enabling market traders to profit from investing according to the existing trend.
3. History repeats itself – states that recognizable patterns unfold along the way, and in the
long run, they will repeat themselves.

Methodologies
1. Price – Technical analysis starts with the construction of the price chart containing the
past prices of a particular stock or security. The price chart will be used in determining
patterns or trends in which investment decisions will be made.
2. Pattern recognition – is the basic tool of technical analysis. The concept of supports,
resistances, trendlines, and channels helps to identify these patterns.
3. Basic chart patterns - can either be a reversal, continuation, or a consolidation.

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o Head and Shoulders o Flag and Pennant

o Cup and Handle o Wedge
o Double Tops and Bottoms o Triple Tops and Bottoms
o Triangles o Rounding Bottom

Four Primary Types of Charts:

a. Line charts
b. Bar charts
c. Candlestick charts
d. Point and Figure charts

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Fundamental Analysis
Fundamental analysis is one asset assessment method that can help an investor narrow down his
choices. This method provides evaluation of a publicly listed company as it is affected by its
industry and economic environment. A good examination of economic activities will serve as a
basis for accurate stock market predictions and indicate which industries would prosper.

Fundamental analysis considers the following:

a) The company’s earnings
b) Management
c) Economic outlook
d) Competition
e) Market condition
f) The firm’s intrinsic value
Two approaches in assessing a company:
1) Bottom-up approach – focuses on a company’s products, competitive position, and
financial standing so you can easily assess how it will perform in the future. This combines
traditional economic and business concepts to examine or determine the value of the
company’s stock.
2) Top-down approach – focuses on how economic factors and the overall market can affect
the value of the stock prices. The business cycle should also be considered. After
evaluating the economy, individual companies can now be examined to determine the
earning potential and to estimate the intrinsic value of each.

Valuation Methods are discussed on the our ACCTG 326n subject.

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The Philippine Finance Environment

A financial environment is a part of an economy with the major players being firms, investors, and
markets. Essentially, this sector can represent a large part of a well-developed economy as
individuals who retain private property have the ability to grow their capital.

The Philippine Financial Market

Normally, suppliers/savers and demanders/issuers are brought together through a financial
institution or a financial market although there are instances, such as property transactions, where
buyers and sellers directly deal with one another.

Managerial finance operates within a financial market. Financial markets provide the legal and
tax framework/environment that bring together suppliers and demanders of funds to make safe and
quick financial transactions often through intermediaries such as organized securities exchanges.

Four major segments of the financial system:

1) Money Market
The money market is a financial market which deals with short-term maturities of financial
contracts. Most money market instruments are fixed-income debts. The available money
market instruments are T-bills, Small Investors Program Bills, Cash Management Bills, BSP
(Bangko Sentral ng Pilipinas) Revenue Repurchase, BSP Special Peso Deposit, Bankers
Acceptances, and short-term CPs (commercial papers).
2) Capital Market
It is a financial market which deals with beyond 1-year maturities. It is further subdivided into
two types of market: primary vs. secondary, and debt vs. equity.

Levels in the Capital Market:

a. Primary Market. In this market, new shares are issued and sold to the investing public for
the first time. It is where capital is actually raised by the company selling stock for the first
time directly to investors typically through an initial public offering (IPO). An underwriter
or investment banker assists the issuer of a new security in setting the offering price and in
marketing the securities to the public. Investors who have subscribed to the IPO have
provided the company with the necessary funds to continue its operation and expansion, and
become part owners of the company.

b. Secondary Market. The secondary market is where securities can be bought and sold after
they have been issued to the public in the primary market. Investors can only buy securities
from the existing holders who are willing to sell their securities. The proceeds from this
transaction do not go to the issuing corporation; instead they go to the investor who sold his
securities.

Secondary markets include the stock exchange and the over-the-counter (OTC) market.
Debt is a financial obligation that has to be repaid. The Philippine debt market is dominated
by public debt and the government remains to be the largest debtor in the country.

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The Philippine Stock Exchange (PSE), a secondary market, provides an active trading
platform in the Philippine equities market. By publishing stock prices, it represents
investors’ assessments of the values of these companies. However, not all secondary market
transactions pass through the PSE.

What is a stock market and stock exchange?

There are differences in their definition but real concept of a stock exchange and stock
market remains constant. Simply defined, a stock market is an organized activity involving
the buying and/or selling of securities done within a stock exchange.

Remember that the stock exchange is not a capital raising mechanism. As part of the
secondary market, it is only adjunct to the capital raising market or primary market. It is
merely a place or means where existing shareholders can sell their shares to those who are
ready to buy.

The stock exchange and the stock market facilitate the flow of savings into investments by
providing a ready market for the resale of securities. The inflow of funds in the stock market
is one efficient way of directing needed resources (in this case, money) into a growing
economy. As such, the stock exchange plays a key role in economic development by
providing a centralized environment that brings together the demanders and suppliers of
funds to make secure and fast transactions.

What is the over-the-counter market?

Stocks of corporations not listed and therefore not traded in the stock exchange but
registered and licensed by the Securities and Exchange Commission for sale to public are
only available in the so-called over-the-counter (OTC) market. This market is not a specific
organization but another way of trading securities. OTC transactions are carried out by
direct inquiries and negotiations among the buyers and sellers through the use of mail,
telephone, teletype, or other forms of communications.

Financial markets perform differently depending on their degree of development and

efficiency.

Who are the players in the stock market?

Investors are the ones who buy and sell securities in the hope of receiving dividend income
and making a profit through capital appreciation. These buyers and sellers are not the only
players in the stock market. Other persons or institutions ensure that the stock market is a
readily accessible, efficient, orderly and transparent market. These are:
1. Stockbroker - Anyone who wishes to buy shares of stocks or bonds must have a
stockbroker. He acts as an agent or middleman between the investor and other
buyers/sellers. As an intermediary, the stockbroker executes orders for clients,
purchasing or selling the stocks on the stock exchange. He is the only person or
corporation authorized and licensed by the Securities and Exchange Commission to

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trade in securities. They are commonly known as members, member-brokers, or

member-firms of the Philippine Stock Exchange.
2. Stock exchange - This is the organization that oversees the transactions of the buyers
and sellers placed through the member-brokers. Its professional management ensures
that the market is efficient, fair, transparent and orderly by enforcing its rules and
regulations.
3. Transfer agent - When shares are purchased and transferred from the seller to the buyer,
the transaction should be recorded in the stock books of every listed company which
record the complete shareholdings of each stockholder of the company. But most
companies have his record keeping done by a separate agency, called the transfer agent.
Thus, when a transaction has been done, the details are kept in a ledger or record book
by the company’s transfer agent. As such, the transfer agents maintains the ledgers for
each issuer company showing the name and address of, and the number of shares held
by each registered stockholder. Another function of a transfer agent, which is either a
commercial bank or trust company, is to cancel old certificates, issue new certificates
and change the name of the certificates into the buyer’s name when the shares have been
sold.
4. Clearing House - When a transaction has been made, the seller – through his stockbroker
– has to deliver the stock certificate to the buyer who in turn orders his stockbroker to
pay for the shares purchased. This seems to be an easy process. But considering the
thousands of transactions executed everyday and the nearly 200 stockbrokers involved,
broker-to-broker payments and delivery of certificates would become complicated. To
facilitate transactions and make the market more orderly, all payments by all
stockbrokers are done to a centralized institution, called the clearinghouse. Thus, all
stockbrokers will make payments to and receive payments from the clearinghouse for
purchases and sales they have made for their clients. At the same time, all stock
certificates will be delivered to and obtained from this central institution.
5. Listed company - A corporation that offers and lists its shares in the stock exchange is
called a listed company or issuer. A listed company is also known as a publicly owned
company in view of the fact that its shares were sold to the investing public. These are
the companies that raised their required funds through such issuance of securities to the
public. The capital raised provides the company with the necessary funds to be invested
in business facilities and equipment. An issuing company becomes a listed company,
whose shares are traded in the stock market, after it has met the strict listing
requirements imposed by the stock exchange.

Trading in the PSE

The PSE regulates trading and the actions of its stockbrokers. The PSE sets: (a) rules for
listing in the exchange; (b) requirements for continued listing; and (c) penalties for
companies which do not abide by the listing regulations, including the delisting of the shares
of companies.

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SEAT. A seat is a franchise granted to a broker that allows it to trade in the PSE. It has a
market value because it carries the future earnings potential of the business.

STOCK INDEX. A stock index is a measure of the price level of the shares listed in the
exchange by the indicated category. The index reflects the prices of the selected stocks.
The PSE tracks four indices: commercial and industrial, property, mining and oil. The
overall index is called PHISIX (Philippine stock index).

Prices for each stock reported at the end of a trading day are in terms of the following:
Open, Low, High, and Close.

Reminder:
At this point, you should start creating an account to the PSE Stock Trading Game (visit www.pse.com.ph). Your teacher
will give further instructions regarding this matter.

3) Foreign Exchange Market

The foreign exchange market (forex) refers to the market which deals with foreign currencies
like the Philippine peso, US dollar, and other major currencies. Trading in the forex market is
done through the Philippine Dealing System; it provides a platform for the buyers and the sellers
to meet with the provisions of real time weighted average rate and volumes of trade for the peso.
4) Derivatives Market
The derivatives market includes all financial contracts deriving their value from other
underlying assets. Derivatives provide a risk management tool in the financial system. The
BSP regularly issues circulars and guidelines affecting the trading of derivatives. It sets
standards and gives accreditation to financial institutions for derivatives transactions.

When is a market considered “developed”?

Companies require an adequate supply of money for a wide range of investment purposes and
financing needs like working capital, a start-up project, expansion of a successful plant, and
research and development. A capital market is developed if it offers a wide range of securities and
a sufficient supply of funds for each type of security.

Some indicators of underdevelopment of a capital market are low trading volume in the stock
market, lack of long-term capital, and capital for start-up ventures and medium-sized companies,
and absence of a bond market. The Philippine financial markets are considered underdeveloped.

When is a market considered “efficient”?

It is efficient if it provides funds to investors at a fair price. Prices are fair to issuers if they pay
the least cost and to buyers if they expect to earn their opportunity income. Efficiency is about the
correct pricing of securities. Managers trust prices in the securities markets because those prices
quickly and accurately reflect all available information about the value of underlying securities.
This means that expected risks and expected cash flows matter more to market participants than
do simpler things such as accounting changes and the sequence of past price changes in a specific
security.

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The Philippine Financial Securities and Institutions

A financial security is an agreement between the provider and user of funds that meets the
objectives of both parties. The issuer commits either to pay a sum of money in the future at a
certain interest rate or to allocate to the holder claims over the assets, future earnings and voting
rights of the company. If the amount of the financial commitment is definite, the security is a debt
security. When the holder’s claim is on uncertain future assets and income, the security is an
equity security. A security that exhibits both characteristics is a quasi-equity security.

Debt Security
The two basic forms of debt in the capital market are the negotiated debt and the debt security.
The most common form of negotiated debt is the long-term loan from commercial banks. The
borrower and the bank agree on terms and conditions of a loan. Their agreement is presented in
the term loan agreement. A company with large funding requirements may seek out a group of
banks, called syndicate, under a syndicated loan.

Debt securities trade in either the money market or the capital market, depending on the maturity.
For example, treasury bills are traded in the money market while bonds are traded in the PSE. In
the Philippine capital markets, the bond is not a common form of long-term financing among
private companies. The Philippine government issues Treasury notes (T-notes) with a maturity of
three to five years.

Preferred Stock
Like an equity security, a preferred stock has no maturity date. It also has some of the features of
a debt security like fixed dividends and seniority in payment at liquidation. It is an example of a
quasi-equity security.

Common Stock
This is the basic equity share of a company. Unlike debt securities, common stocks do not have
fixed claims against the assets of the company. The productivity of the company’s investments
determines a common stock value.

Common stockholders are residual owners of the business. Upon liquidation of the company, they
receive all remaining assets after paying off creditors and preferred stockholders. There are three
types of dividends that a common stockholder can receive: cash dividends, stock dividends, and
property dividends.

Transfers of capital between savers and those who need capital take place in three different ways:

1) Direct transfers. Occur when a business sells its stocks or bonds directly to savers, without
going through any type of financial institution. The business delivers its securities to savers,
who in turn give the firm the money it needs.

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2) Through investment banking houses. An underwriter serves as a middleman and facilitates the
issuance of securities. The company sells its stocks or bonds to the investment bank which in
turn sells these same securities to savers. The businesses’ securities and the savers’ money
merely “pass through” the investment banking house. However, the investment bank does not
buy and hold the securities for a period of time, so it is taking a risk – it may not be able to
resell them to savers for as much as it paid. Because new securities are involved and the
corporation receives the proceeds of the sale, this is a primary market transaction.

3) Through financial intermediary. Here the intermediary obtains funds from savers in exchange
for its own securities. The intermediary then uses this money to purchase and then hold
businesses’ securities. For example, a saver might give money to a bank, receiving from it a
certificate of deposit, and then the bank might lend the money to a small business in the form
of a loan. The existence of intermediaries greatly increases the efficiency of money and
financial markets.

A set of highly efficient intermediaries has evolved due to rapidly changing situations and different
institutions are performing services that were formerly reserved for others causing institutional
distinctions to become blurred. Still, there is a degree of institutional identity, and here are the
major classes of intermediaries:
Banking Institutions Non-Bank Financial Institutions
a. Commercial banks a. Savings and loan associations
b. Mutual savings banks b. Credit unions
c. Universal banks c. Life insurance companies
d. Rural banks d. Mutual funds
e. Thrift banks e. Investment houses
f. Offshore banks f. Securities dealers and brokers
g. Specialized government banks g. Lending investors

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IV. FINANCIAL ANALYSIS, CONCEPTS, AND TECHNIQUES

Financial Statements: Structure and Usefulness to Managerial Finance

Financial managers make decisions based on the impact on the company’s cash flows and market
values. But where does management get its information? This information comes from external
sources and internal accounting system. Accounting is a medium of communication through
which financial information are provided to its users for decision-making.

Financial statements are outputs of the financial accounting system. There are limitations on how
financial statements can be used for managerial finance because of the assumptions used by
accountants. However, prudent use of these statements can provide useful information.

Limitations of Financial Statements:

1) Recording assets at historical cost or appraised value
In financial accounting, assets are recorded at acquisition cost, or at appraised value as
another possible value. But this is not consistent with the measurement of value in managerial
finance. A finance manager would like to know the selling price of an asset. The cash to be
realized from the sale of an asset rather than its book value is the resource that is made available
for investment.

2) Variations in application of accounting principles

Although financial statements are prepared in accordance with generally accepted
accounting principles (GAAP), the application of these principles vary because of different
methods on how to measure financial performance and position.

Example:
Items to be measured Methods of Estimation
Inventory - FIFO, weighted average
Depreciation - Straight-line, units of output,
Sum-of-the-years’ digit, etc.
Bad debts - Aging of accounts receivable,
Percentage of sales, percentage
of accounts receivable

3) Financial statements are interim in nature although they give an impression of being accurate
The financial statements present only the result of operations and financial condition for a
given period only and not for the entire life of the business. They only show a snapshot of the
company’s financial performance for a specific period.

4) Financial statements do not reflect changes in the purchasing power of the monetary unit
Accounting records are prepared under GAAP, thus, financial statements are generally
based on historical cost so that the current market values of the assets are not reflected therein, and
the owner’s interest in the business is merely the residual value after deducting liabilities.

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5) Financial statements do not contain all the significant facts about the business
The statements are prepared based on recorded transactions only where there is an
exchange of values (value received and value parted with) so that other relevant information such
as quality of and demand for its products or services, quality of organization, etc.

Even if book values and financial statements are beset by limitations, are nonetheless useful to
finance managers. The use of market values, as an alternative, is not practical because market
values are not easily obtained. While data provided by financial statements are readily available
outputs of the firm’s own accounting system. The basic purpose of accounting (and its financial
statements) is stated in its definition, like the one given by the ASC:
“…to provide quantitative information about economic entities that is intended to be useful in
making economic decisions”.

INCOME STATEMENT
An income statement represents the financial results – revenues and expenses – of the business for
a given period of time.

The income statement begins with net sales (sales less sales discounts, returns and allowances),
from which cost of goods sold is subtracted to yield gross profit. Cost of goods sold represents
direct cost of production and sales; that is, costs that vary directly with the level of production and
sales. Next, operating expenses are subtracted from gross profit to yield operating income.
Operating expenses are indirect costs of administration and marketing; that is, costs that do not
vary directly with production and sales.

In addition to operating income from the company’s own operation, other income are added and
subtracting interest expense on debt yields income before tax – pretax income. Finally, subtracting
income taxes from pretax income yields net income or profit. Net income is often referred to as
the “bottom line” because it is normally the last line of the income statement.

BALANCE SHEET
This represents the financial position of the business entity as of a given date. It comprises the
assets, liabilities, and owner’s equity.
Asset – anything a company owns that has value.
Liability – a firm’s financial obligation.
Equity – an ownership interest in the company.
A fundamental accounting identity for balance sheet states that:
Assets = Liabilities + Equity

This identity implies that the balance sheet always “balances” because the left side is always equal
to the right side. If an imbalance occurs when a balance sheet is prepared, then an accounting error
has been made and needs to be corrected.

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Financial analysts often find it useful to condense a balance sheet down to its principal categories.
This has the desirable effect of simplifying further analysis while still revealing the basic structure
of the company’s assets and liabilities. How much a balance sheet can be condensed and still be
useful is a subjective judgment of the analyst.

STATEMENT OF CASH FLOWS

This is the third basic financial report prepared by the accountant. It provides information on the
sources and uses of funds of a company during a certain period. Inasmuch as funds are the
“lifeblood” of a business, this statement may be considered as the most dynamic of all the
statements. A cash flow statement indicates a company’s (a) capacity to generate cash flow from
regular business – Operating activities; (b) requirements for financing – Financing activities; and
(c) patterns of growth and investments – Investing activities.

Cash Flow Statement Analysis:

A cash flow statement provides insights into a company’s financial management policies and
performance, as follows:
a) Contribution of operations to cash flows
A company shows financial strength by generating a cash surplus from operations. The
viability of the business depends on its successful generation of cash from its revenue operations.

b) Growth and expansion in assets

Growth in fixed assets and expansion in other business areas foresaw new opportunities
and acted accordingly. A growth demonstrates a company’s long-term ability to compete.

c) Balance in growth of assets

Aggressive growth or rapid expansion exposes a company to additional risks. There are
two types of risks: underutilization of the new assets, or the need to invest further to balance the
expanded capacities. Past and expected growth in markets and sale should justify new
investments. Speculation and temporary opportunities are not sound bases for future investments.

d) Assessment of financing requirements and repayment capacity

Analysis of a cash flow statement can show patterns in a company’s financing
requirements. If a company is financially strong, it can fund its seasonal needs by using its cash
reserves. If financially weak, it can seek to gain access to external credit.
The sources of financing revealed in the cash flow statement provide insights on a
company’s future obligation. Reliance on debt means the shouldering of debt service burden in
the future. Any increase in equity funding increases the pressure on future dividends.

e) Balance in financing sources

A cash flow statement reveals whether a company has been prudently maintaining a
balance between debt and equity in sourcing its funds.

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Modifying Traditional Accounting Data for Managerial Purposes

In the preparation of financial statements, accountants follow generally accepted accounting
principles which are commonly used by creditors and other outside interested stakeholders.
Meaning, the presentations are geared towards general purpose financial statements rather than for
managerial use. Therefore, for managerial purposes, certain modifications shall be done for
corporate decision making. A financial analyst combines both accounting data and market values
to achieve appropriate evaluation of managerial performance.

The following modifications are additionally used for managerial decisions:

In modifying traditional accounting framework, the first step is to divide the total assets into two
categories: operating assets, and nonoperating assets.

Operating Assets. The cash and marketable securities, accounts receivable, inventories, and fixed
assets necessary to operate the business. These are further divided into working capital and fixed
assets.

Nonoperating Assets. Cash and marketable securities above the level required for normal
operations, investments in subsidiaries, land held for future use, and other nonessential assets.

The company’s primary source of capital are the investors (stockholders, bondholders, lenders,
etc.). Stockholders must be paid with their share in dividends, while payment of interest is
necessarily in case of a debt. So when a company acquires more assets, it raises also its capital –
which causes its capital cost to be unnecessarily high. However, not all capital are obtained from
investors. Some funds are acquired through spontaneous liabilities, e.g. accounts payable and
accrued expenses. Generally, both accounts payable and accrued expenses are “free” in the sense
that no explicit fee (like interest expense) is charged for their use. This means that not all of the
funds are investor – supplied capital.

For current assets that are used in operations are called operating working capital, and operating
working capital less accounts payable and accrued expenses is called net operating working
capital.
Net Operating Working Capital (NOWC) = All current assets – Spontaneous liabilities
Total Operating Capital = Net Operating Working Capital + Net Fixed Assets

Net Operating Profit After Tax. The profit a company would generate if it had no debt and held
nonoperating financial assets. This is considered as a better measurement of evaluating a
manager’s performance since the net income does not always reflect the true performance of a
company’s operations or the effectiveness of its operating managers and employees.
Net Operating Profit After Tax (NOPAT) = EBIT (1 – Tax rate)

Free Cash Flows. The cash flow actually available for distribution to investors after the company
has made all the investments in fixed assets, new products, and working capital necessary to sustain
ongoing operations. In a traditional accounting system, we determine net cash flow as being equal

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to net income plus noncash expenses typically like depreciation and amortization. However, we
cannot maintain this cash flow overtime because depreciable assets are actually replaced, thus,
necessitates acquisition of new assets. So the management is actually not completely free to use
its cash flow. In accounting, we know that net income is being emphasized. However, for
managerial decision making, the value of a company is determined by the capacity of its operations
in generating cash flows today and in the future.
Calculating Free Cash Flow:
Operating Cash Flow = NOPAT + Noncash adjustments
Net Investment in Operating Capital = Total Operating Capital, end
- Total Operating Capital, beginning
Gross Investment = Net Investment + Depreciation
Free Cash Flow = Operating Cash Flow – Gross Investment in Operating Capital
or FCF = NOPAT – Net Investment in Operating Capital

MVA and EVA1

Inasmuch as the goal of finance is to maximize shareholders’ wealth, the measurement of this is
the market value of the company’s stocks. And so financial analysts developed new measurements:
Market Value Added or the MVA, and Economic Value Added or the EVA.

Market Value Added. This refers to the difference between the market value of the firm’s stock
and the amount of equity capital that was supplied by shareholders. The MVA represents the fund
the stockholders have invested since its founding – including retained earnings – versus the cash
they could get if they sold the business, thus, measures the effects of managerial actions since the
very inception of the company. The higher the MVA, the better the job management is doing for
the firm’s shareholders.
MVA = Market value of the stocks – Equity capital supplied by shareholders
= (Shares outstanding)(Stock price) – Total common equity

Economic Value Added. This focuses on the value added to shareholders by management during
a given year. EVA is an estimate of the true economic profit for the year of the business, and is
sharply different from the accounting profit because of the consideration of the cost of equity
capital. EVA represents the residual profit that remains after the cost of all capital, including
equity capital, has been deducted, whereas accounting profit is determined without imposing a
charge for equity capital.
EVA = Net Operating Profit after taxes, or NOPAT – After-tax cost of capital used to
support operations
= EBIT (1 – Corporate tax rate) – (Operating capital)(After-tax % cost of capital)

1
The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders of the consulting
firm Stern & Stewart Company.

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Financial Ratio Analysis

The primary goal of financial management is to maximize the stock price, not to maximize
accounting measures such as net income or EPS. However, accounting data do influence stock
prices, and to understand why a company is performing the way it is and to forecast where it is
heading, one needs to evaluate the accounting information reported in the financial statements.

Methods of Financial Statement Analysis:

1) Horizontal Analysis – is the comparison of financial performance and condition of
company using financial statements (comparative financial statements) of two periods with
the earlier period as the base year.
2) Vertical Analysis – refers to the evaluation of the company’s financial performance and
condition for a given period only. Items in the financial statements are analyzed as a
percentage, or as a component of a base – net sales for the income statement, and total
assets for the balance sheet. Financial statements reduced to ratios in vertical analysis are
known as common size balance sheets and income statements.
3) Trend or Time Series Analysis – is the evaluation using two or more periods.
4) Financial Ratio Analysis – the combination of all the analysis previously stated above, and
the analysis of each item as being related to another. Ratios represent the relationships
among the items in the financial statements either taken as a whole or as separately used.

Major Groups of Users of Financial Analysis:

1) Providers of Capital 3) Company’s Management
Investors
Suppliers
Creditors
2) Regulators
SEC COA Other governmental agencies
BIR BSP

Limitations of Ratio Analysis:

a. It is sometimes difficult to identify the industry category to which a firm belongs when the
firm engages in multiple line of business.
b. Different accounting practices can distort comparisons.
c. Many firms experience seasonality in their operations.
d. Inflation may have badly distorted firm’s balance sheets – recorded values are often
substantially different from “true” values.
e. Firms can employ “window dressing” techniques to make their financial statements look
stronger.
f. It is difficult to generalize about whether a particular ratio is “good” or “bad”.

Standards in Ratio Analysis:

Financial evaluation should be based on standards of performance. Common standards used by
analysts include:
Past year’s performance Budgeted performance
Industry performance Nominal standards
Competitor’s performance

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Categories of Financial Statement Ratios:

a. Liquidity or short-term solvency ratios
b. Profitability ratios
c. Stability or long-term solvency ratios
d. Asset-utilization or asset management ratios

Time Value of Money

In accounting (and finance), the term time value of money is used to indicate the relationship between time and
money – that a peso received today is worth more than a peso received in the future. Intuitively, this idea is
easy to understand because of our familiarity with the concept of interest. Time value has come to be associated
with “interest rate” because problems of this type compare assets and liabilities in common financial terms,
i.e., cash flows. In which case, time value is the “rent paid for the use of money”.

As a financial expert (manager), you will be expected to make present and future value measurements and to
understand their implications.

Variables in Interest Computations:

1. Principal - the amount borrowed or invested.
2. Interest rate – a percentage of the outstanding principal.
3. Time – the number of years or fractional portion of a year that the principal is outstanding.

Simple Interest
Simple interest is the return on (or growth of) the principal for one time period. It is computed on the amount
of the principal only, expressed as follows:
Interest = Principal x Interest rate x Number of periods

To illustrate, if you borrow P100,000 for three years with a simple interest rate of 12% per year, the total
interest you will pay is computed as follows:
Interest = (P100,000) (12%) (3) = P36,000

Compound Interest
Compound interest is the return on (or growth of) the principal for two or more periods. It is computed on
principal and any interest earned that has not been paid or withdrawn.

To illustrate the difference between simple and compound interest, assume that you deposit P10,000 in the
ABC Bank where it will earn simple interest of 8% per year, and in XYZ Bank you deposit P10,000 where it
will earn interest of 8% compounded annually. You will not withdraw any interest until 3 years from the date
of deposit.

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ABC Bank XYZ Bank

Simple Interest Simple Accumulated Compound Interest Compound Accumulated
Calculations Interest Year-end Bal. Calculations Interest Year-end Bal.
Yr. 1 P10,000 x 8% P 800 P 10,800 Yr. 1 P10,000 x 8% P 800 P10,800
Yr. 2 P10,000 x 8% 800 11,600 Yr. 2 P10,800 x 8% 864 11,664
Yr. 3 P10,000 x 8% 800 12,400 Yr. 3 P11,664 x 8% 933.12 12,597.12
P2,400 P 597.12

Time Value of Money Factors:

FUTURE VALUE (FV). The amount to which a cash flow or series of cash flows will grow over a given
period of time when compounded at a given interest rate.

PRESENT VALUE (PV). The value today of a future cash flow or series of cash flows discounted at a given
interest rate.

With the use of

Formulas: Calculators

Future value of 1 (1 + i )n 1 + i xx =

Future value of an ordinary annuity of 1 (1 + i)n – 1 1 + i x x = -1 = ÷ i =

i

Future value of an annuity due of 1 FVOAf (1 + i)

Present value of 1 1 1+i ÷÷ =

(1 + i)n

Present value of an ordinary annuity of 1 1 1 + i ÷ ÷ = M+ MR

1 – (1 + i)n
i

Present value of an annuity due of 1 PVOA (1 + i)

Note: The number of times the equal (=) sign and the M+ are pressed depends on the number of periods involve.

Examples:
Future value of 1 for 3 periods compounded (1 + 25%)3 1 + 25% x x = =
at 25%
Answer: 1.953

Present value of 1 to be received after

3 periods discounted at 25% 1 1 + 25% ÷ ÷ = = = =
(1 + 25%)3
Answer: 0.512
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Annuity is a series of equal peso payments for a specified number of years. There are two basic types of
annuities:
a) Ordinary annuity – is an annuity in which the payments occur at the end of each period.
b) Annuity due – is an annuity in which the payments occur at the beginning of each period.

Valuation Methods for Fundamental Analysis

Fundamental analysis, in accounting and finance, is the analysis of a business’ financial statements (usually to
analyze the Business’ assets, liabilities, and earnings); health; and its competitors and markets.

It is performed on historical and present data, but with the goal of making financial forecasts.
There are several possible objectives:
o To conduct a company stock valuation and predict its probable price evolution;
o To make a projection on its business performance;
o To evaluate its management and make internal business decisions;
o And/or to calculate its credit risk;
o To find out the intrinsic value of the share.

Additional valuation methods include:

1. Net Asset Value (NAV) Method
This method uses the company’s balance sheet for valuation, and is usually used in valuing real estate
companies and mutual funds.
NAV = Market value of assets - Liabilities
Number of shares outstanding

Advantages:
§ This is easy to use since the information needed is in the balance sheet.
§ In liquidation of the assets of a business, this is most suitable.
§ Useful in valuing a company through periods of losses because the real value of assets lies in their
ability to generate earnings.

Disadvantages:
§ This can only measure the company’s value “as of” a certain point in time, which ignores the time
value of money.
§ Since the needed information is in the balance sheet, it uses past data. It does not take into account
the potential or future earnings of the company.

2. Capitalized Earnings Method (CEM)

This is an earnings-based approach which considers the common equity value of a given common stock as
a multiple of its average earnings. For this method, the company’s income statement is used. There are
two critical factors in this approach: the company’s earning power and the appropriate P/E ratio.

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Advantages:
§ Using the P/E ratio is convenient since it assumes that the company is exposed to the same risks
and opportunities as other companies in the same industry.
§ This approach also shows an investor the potential yield per peso of his investment in the company.

Disadvantages:
§ There is difficulty in trying to estimate an appropriate P/E ratio.
§ This approach is based only on earnings, which when taken alone, is inadequate.

3. Enterprise Multiple (EM)

High-growth firms use this method because this is better than price-earnings ratio. This allows for
comparing firms with different financial leverages, and it is used to determine the value of a company. The
enterprise multiple looks at a firm as a potential acquirer would, because it takes debt into account – an
item which other multiples like the P/E ratio do not include. Enterprise multiple is calculated as:
Enterprise Multiple = Enterprise value
EBITDA

a) Enterprise value – This is a measure of the actual economic value of a company at a given moment. It
is calculated as market capitalization plus debt and preferred shares, minus cash and cash equivalents.
b) EBITDA – This is a better measure of operating strength particularly for telecom companies, although
this can be inflated with additional capital in the business, thus it gives no indication on the return of
capital.

A low ratio would indicate that a company might be undervalued. Enterprise multiples vary depending on
the industry.

4. Discounted Cash Flow (DCF) Method – This uses the cash flow statement as basis for valuation. The
present value of the company’s projected cash flows is computed using a discount rate. In the DCF
approach, the value of the business is the present value of the expected cash flows derived from the business
over a certain period, at a discount rate that reflects the risks accompanying its operations. This approach
is widely used by companies in evaluating investment proposals, using investments having similar risks as
benchmarks. The DCF method could be criticized on the following grounds: the appropriateness of the
discount rate used and the reliability of the projected cash flow.

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V. WORKING CAPITAL POLICY AND MANAGEMENT

Working capital policy involves two basic questions: (1) What is the appropriate amount of current assets for
the firm to carry, both in total and for each specific account?, and (2) How should current assets be financed?

Working capital management involves both setting working capital policy and carrying out that policy in day-
to-day operations.

Net working capital is the excess of current assets over current liabilities.

Current assets are either temporary or permanent. A current asset is temporary if, once converted to cash in
the normal business cycle, it can be held as cash or used for other purposes without impairing operations.
Examples of temporary current assets: inventory buildup for seasonal peak sales, inventories and receivables
arising from one-time customer order, excess cash balances held during peak production periods, and cash
from profitable operations.

A current asset is permanent if it is necessary to support operations, examples: safety stocks of inventories,
accounts receivables from customers, minimum cash balances, and prepayments.

Creditors must be assured that a company has sufficient assets to pay its obligations. Losses erode capital and
may lead to insolvency. These losses may be due to three reasons:
a. Unprofitable operations
b. A decline in asset values
c. Technical insolvency

The Cash Conversion Cycle

The cash conversion cycle model focuses on the length of time between when the company makes payments
and when it receives cash inflows. The following terms are used in the model:
a. Inventory conversion period (Average age of inventory) – the average time required to convert materials
into finished goods and the sell those goods.

b. Receivables collection period (Days sales outstanding) – the average length of time required to convert the
firm’s receivables into cash.

c. Payables deferral period - average length of time between the purchase of materials and labor and the
payment of cash for them.

d. Cash conversion cycle – nets out the three periods defined and which therefore equals the length of time
between the firm’s actual cash expenditures to pay for productive resources and its own cash receipts from the
sale of products.
Cash conversion cycle = Inventory + Receivables - Payables
Conversion Conversion Deferral
Period Period Period
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Working Capital Investment and Financing Decisions

Objectives:
1) To maintain an investment in current assets that ensures repayment of maturing obligations and
supports profitable investment in fixed assets.
2) To keep insolvency risk at an acceptable level.

Three Alternative Working Capital Investment Policies (approaches):

a. Conservative approach – a large portion of total assets is in the form of current assets. Since current assets
are normally assumed to have a lower rate of return, this policy results in a lower profitability. However,
this policy increase the net working capital position (assuming current liabilities are held constant) thereby
resulting to a lower risk that the company will encounter financial difficulties.
b. Aggressive approach – current assets formed only a small portion of the company’s total assets. Expected
profitability and risk are both high.
c. Moderate approach – profitability and risk are falling between conservative and aggressive approaches.

Three Alternative Financing Plans:

a. Matching approach – maturity structure of company’s liabilities is made to correspond exactly to the life
of the assets. This is difficult to implement since uncertainty is associated with the lives of the individual
assets.
b. Conservative approach – relatively high proportion of long-term debt is maintained. This reduces the risk
that the company will not be able to refund its debt. But this also cuts down the expected return to
stockholders since cost of long-term debts are generally high.
c. Aggressive approach – relatively high proportion of short-term debt is maintained. The risk of not being
able to refund the debt is high. The risk is, however, offset by higher expected after-tax earnings because
the costs (interest) of short-term are generally lower.

Summary of Investment and Financing Approaches

Investment Financing Trade-off
Approaches CA NCA CL NCL Profitability Risk

a. Conservative

b. Aggressive

d. Moderate/Matching - - - - - -
The approaches to working capital management may differ among companies. If a company can manage its
current assets more efficiently and thereby operate with a smaller investment in working capital, this will
increase its profitability. At the same time, though, a company will have problems if it reduces its cash,
receivables, and inventory too much. Thus, the optimal current assets management policy is one that carefully
trades off the costs and benefits of holding working capital.

Cash Management
Cash management function is concerned with determining
The optimal size of a company’s liquid asset balance.
The most efficient methods of controlling collection and disbursement of cash.
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The appropriate types and amounts of short-term investments the company should make.
The various types of floats.

Cash management also employs the use of cash budget showing the forecasted cash receipts and disbursements
over the planning horizon of the company.

The objective of cash management is to maintain an investment in cash and short-term investments that would
enable the company to meet its maturing obligations while maximizing its income on idle funds.

Reasons why companies hold liquid asset balances:

a. Transactions Motive – because cash flows of the day-to-day operations are unsynchronized liquid assets
are maintained to serve as buffer between these flows.
b. Precautionary Motive – unexpected requirements of cash sometimes can happen in the future, and since
the ability to secure the funds needed is uncertain, liquid assets balances are necessary so as to maximize
opportunities. A cash balance is held as a reserve for random, unforeseen fluctuations in cash inflows
and outflows.
c. Speculative Motive – liquid assets balances are held for planned future use, or to enable the firm to take
advantage of any bargain purchases that might arise.
d. Compensating balance – a minimum amount that a firm must maintain to compensate the bank for services
rendered or as part of a credit-granting arrangement.

Costs associated with inadequate liquid asset balances (cash shortage)

Foregone cash discounts
Deterioration of the company’s credit rating
Higher interest rates
Possible financial insolvency

Determining the optimal cash needs may be derived using the following models:
1. Cash budget
2. Cash break-even chart
3. Optimal cash balance model (Baumol model for cash) – introduced by William Baumol

Equation: C = 2 (T) (F)

k
where:
C = optimal cash balance
T = total amount of new cash needed for transactions during the period (a year)
F = fixed costs of making securities trade or of obtaining a loan. (per transaction)
k = opportunity cost of holding cash, equal to the rate of return foregone on marketable
securities or the cost of borrowing to hold cash.

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Illustration:
The company has estimated total cash requirement of P4,000,000 over a six-month period with the payments steady over the period.
The transaction cost of raising cash (associated with the treasurer’s time in making placement decisions, clerical and other costs) is
estimated at P600 per transaction. The interest rate on money market securities is 24 percent per year or 12 percent for six months.
Find the optimal cash balance.

Solution: C= 2(4,000,000) (600) = P200,000

0.12

Conclusions:
a. The optimal cash balance is P200,000.
b. The average cash balance is P100,000 (P200,000/2).
c. The company should make 20 transactions for six months (4M/200T), i.e. the treasurer should program his placements
to obtain maturities of P200,000 every nine days.

Cash Management Techniques

Most cash management activities are performed jointly by the firm and its banks. Effective cash management
encompasses proper management of cash inflows and outflows, which entails:
1) Cash Flow Synchronization. A situation in which inflows coincide with outflows, thereby permitting a firm
to hold low transactions balances.
2) Speed up the check clearing process. Check clearing is the process of converting a check that has been
written and mailed into cash in the payee’s account. We cannot write our own checks against our deposit
until the check-clearing process has been completed. The bank must first make sure that the check we
deposited is good and the funds are available before it will give us cash.
3) Using float. Float is defined as the difference between the balance shown in a firm’s (or individual’s)
checkbook and the balance on the bank’s records. It represents the net effect of the delays in the payment
of checks a company writes (positive float) and the collection of checks the company receives (negative
float).
Mail/Delivery float – the delay between the time a payment is sent to the payee through the mail and
the time that payment arrives at the payee’s office.
Processing float – the delay between receipt of payment from a payor and the deposit of the receipt in
the payee’s account.
Check-clearing float – the delay between the time a check is deposited in the payee’s account and the
time the fund is available to be spent.
4) Acceleration of Receipts. Although cash collection is the financial manager’s responsibility, the speed with
which checks are cleared depends on the banking system. Several techniques are used both to speed
collections and to get funds where they are needed. Included are:
Lockbox system – in this system, incoming checks are sent to the post office boxes rather than to
corporate headquarters. A lockbox system reduces the time required for a firm to receive incoming
checks, to deposit them, and to get them cleared through the banking system so the funds are available
for use. Lockbox services can often increase the availability of funds by two to five days over the
“regular” system.
Payment by Wire or Automatic Debit – Firms are increasingly demanding payments of large bills by
wire, or even by automatic electronic debits, whereby funds are automatically deducted from one
account and added to another. This is, of course, the ultimate in a speeded-up collection process, and
computer technology is making such a process increasingly feasible and efficient.
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Marketable Securities
In many cases, companies hold marketable securities for the same reason they hold cash. Although these
securities are not the same as cash, in most cases they can be converted to cash on a short notice. Certain
criteria can provide the financial manager with a useful framework for selecting a proper marketable securities
mix. These considerations include:
1) Default risk – the risk that the company (investor) may not be able to get back its investment upon demand.
2) Interest rate risk – refers to the uncertainty of expected returns from a financial instrument attributable to
changes in interest rates.
3) Taxability – The tax treatment of the income a firm receives from its security investments does not affect
the ultimate mix of marketable securities portfolio as much as the other factors. However, some financial
managers seriously evaluate the taxability of interest income and capital gains.
4) Yields – this criterion involves an evaluation of the risks and benefits inherent in all the previously
mentioned criteria. A financial manager must focus on the risk-return trade-offs identified through
analysis.

Obtaining Short-term Funds

The hedging principles involves matching (take note of the matching approach to working capital financing
policy) the cash-flow-generating characteristics of an asset with the maturity of the source of financing.

Spontaneous sources – consist of trade credit and other accounts payable, accrued expenses, and deferred
income.

Negotiated or Discretionary sources – require an explicit decision of the management to seek additional
financing. Examples of these are bank credits, commercial papers, receivables loans, and inventory loans.

Costs of Short-term Funds

Annual Financing Cost (AFC) = Interest cost + Fees x 365 days

(Effective borrowing cost) Usable funds Maturity days

Cost of foregoing cash discounts:

AFC = Percentage Discount x 365 days

100% - %discount Credit period – Discount period

Receivables Management
Receivables management begins with the decision of whether or not to grant credit. A monitoring system is
important, because without it receivables will build up to excessive levels, cash flows will decline, and bad
debts will offset the profits on sales. Corrective action is often needed, and the only way to know whether the
situation is getting out of hand is with a good receivables control system.

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Total amount of accounts receivable outstanding at any given time is determined by two factors: (1) the volume
of credit sales, and (2) the average length of time between sales and collections. Instead of providing credit to
customers, a company can sell on a cash-and-carry basis or on cash-on-delivery. A company should assume
the burden of customer credit only if it expects to profit from the credit arrangement. The possible benefits of
credit are (a) increased sales, and (b) avoidance of lost sales.

Credit policy is a set of decisions that includes a firm’s credit period, credit standards, collection procedures,
and discounts offered.

Care should be taken in setting credit policy. The following must be considered:
a. Credit standards – are the criteria a company uses to screen credit applicants in order to determine which of
its customers should be offered credit and how much.
Five C’s of credit:
Character
Capacity
Capital (financial strength)
Collateral
Conditions
b. Credit terms – this specifies the conditions under which the customer is required to pay for the credit
extended to it, (e.g. length of the credit period, cash discounts, seasonal dating).
c. Collection efforts/policies – these consist of the methods a business employs in attempting to collect the
payment of past-due accounts. (sending notices, telephoning, taking legal action, etc.)

Costs associated with Accounts Receivable:

1. Credit analysis, accounting and collection costs
2. Capital costs/opportunity cost (cost of funds tied up in the receivables)
3. Delinquency costs (delays in payment)
4. Default costs/bad debts (failure to pay at all)

Summary of Trade-offs in Credit and Collection Policies

Trade-offs
Benefit Cost
1. Relaxation of credit standards a. Increase in sales a. Increase in processing costs
& total CM b. Increase in collection costs
c. Higher bad debts
d. Higher capital costs

2. Lengthening of credit period a. Increase in sales a. Higher capital costs

& total CM (opportunity costs)

3. Granting cash discounts a. Increase in sales a. Lesser profit

& total CM b. Increased bad debts
b. Opportunity income
on lower investment

4. Intensified collection efforts a. Lower default cost a. Higher collection cost

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Change in credit policies may be accepted or rejected using the following guidelines:
If:
a. Incremental profit > Incremental cost = accept the change in credit policy
b. Incremental profit < Incremental cost = reject the change in credit policy
c. Incremental profit = Incremental cost = be indifferent to the change

Illustration:
Sample Company has 12% opportunity costs of capital and currently sells on terms of n/20. It has current annual sales of P10
million, 80% of which are on credit. Current average collection period is 60 days. It is now considering to offer terms of 2/10, n/30
in order to reduce the collection period. It expects 60% of its customers to take advantage of the discount and the collection period
to be reduced to 40 days. Should the company change its terms from n/20 to 2/10, n/30?

Solution:
Present Proposed
Opportunity cost
(ROI x Average AR)
Present (12% x P1.333M) P160,000
Proposed (12% x P0.888M) P106,667
Sales discount given
(P8M x 60% x 2%) ________ 96,000
P160,000 P202,667

Conclusion: Maintaining the present policy of not granting cash discount is less costly; reject the proposal.

Inventory Management
Inventories may be classified as supplies, raw materials, work-in-process, and finished goods. Inventory levels
depend heavily upon sales, and inventory must be acquired ahead of sales. The necessity of forecasting sales
before establishing target inventory levels makes inventory management a difficult task. Also, since errors in
the establishment of inventory levels quickly lead either to lost sales or to excessive carrying costs, inventory
management is as important as it is difficult.

Objectives of Inventory Management:

a) To ensure that inventories needed to sustain operations are available.
b) To hold the costs of ordering and carrying inventories to the lowest possible level.

For inventory management, the trade-off is between two types of inventory costs: profits from stock-out
situations and cost of carrying inventory.

Costs associated with Inventories:

1) Carrying costs
Desired rate of return on investment
Risk of obsolescence and deterioration
Storage costs
Property taxes
Insurance
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2) Ordering costs (set-up costs)

Preparing purchase or production orders
Receiving (unloading, unpacking and inspection)
Processing related documents
Mailing and stationery costs
3) Stock-out costs – are costs of not carrying sufficient inventory
Lost sales
Added freight and charges to expedite special handling

Inventory Control Systems

The importance of inventory management to the firm depends on the extent of the inventory investment, and
it varies from industry to industry.

ABC Inventory Classification System. Inventory is classified into three classes: the “A” or high value or usage
class, “B” or medium value or usage class, and “C” or low value or usage class. The ABC classification applies
the technique of management-by-exception to inventory control. The “A” class is intensively monitored b y
management, while it does not focus attention to “C” class.

Red-Line Method. This is an inventory control procedure in which a red line is drawn around the inside of an
inventory-stocked bin to indicate the reorder point level. The inventory clerk places an order when the red line
shows.

Two-Bin Method. In this method, an order is placed when one of two inventory-stocked bins is empty, and
inventory is drawn from the second bin.

Computerized System. It is used to determine reorder point and to adjust inventory balances. As withdrawals
are made, they are recorded by the computer, and the inventory balance is revised. When the reorder point is
reached, the computer automatically places an order, and when the order is received, the recorded balance is
increased.

Just-in-Time System. This is a system of inventory control in which a manufacturer coordinates production
with supplies so that raw materials or components arrive just as they are needed in the production process.

Out-Sourcing. It is the practice of purchasing components rather than making them in-house. Out-sourcing is
often combined with just-in-time systems to reduce inventory levels. However, perhaps the major reason for
out-sourcing has little to do with inventory policy – one reason could be purchasing from a supplier is least
costly than making them.

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Inventory Decision Analysis Techniques

a. Economic Order Quantity (EOQ) – the optimal order size. It answers the question, “what quantity to order
minimize both ordering and carrying costs”.

EOQ = 2 x AD x OC
CC

where:
AD = annual demand
OC = Ordering cost
CC = carrying cost annually per unit of the inventory

b. Reorder Point – is the level at which inventory is allowed to fall before an additional order is placed.
Reorder point = Lead time usage + Safety stock
*Lead time = Lead time x demand
*Lead time is the time interval between placing and receiving the order.

Note: If the problem gives the maximum and normal lead time, reorder point is based on the maximum lead
time. The difference between the maximum and normal lead time x the demand (daily/weekly) is the safety
stock.

Safety Stocks – are inventory carried over and above the quantity determined by the EOQ formula to meet
unanticipated demand. They serve as a buffer against running out of stocks.

c. Inventory Turnover – refers to times the inventory is sold/consumed during the period.

d. Average Age of Inventory – number of days the inventory is being held by the company before it is sold.

Why it matters?
Working capital is a common measure of a company's liquidity, efficiency, and overall health. Because it
includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year, and
other short-term accounts, a company's working capital reflects the results of a host of company activities,
including inventory management, debt management, revenue collection, and payments to suppliers.
Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost
immediately. Negative working capital generally indicates a company is unable to do so. This is why analysts
are sensitive to decreases in working capital; they suggest a company is becoming overleveraged, is struggling
to maintain or grow sales, is paying bills too quickly, or is collecting receivables too slowly. Increases in
working capital, on the other hand, suggest the opposite. There are several ways to evaluate a company's
working capital further, including calculating the inventory-turnover ratio, the receivables ratio, days payable,
the current ratio, and the quick ratio.

When not managed carefully, businesses can grow themselves out of cash by needing more working capital to
fulfill expansion plans than they can generate in their current state. This usually occurs when a company has
used cash to pay for everything, rather than seeking financing that would smooth out the payments and make
cash available for other uses. As a result, working capital shortages cause many businesses to fail even though

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they may actually turn a profit. The most efficient companies invest wisely to avoid these situations.

Analysts commonly point out that the level and timing of a company's cash flows are what really determine
whether a company is able to pay its liabilities when due. The working-capital formula assumes that a company
really would liquidate its current assets to pay current liabilities, which is not always realistic considering some
cash is always needed to meet payroll obligations and maintain operations. Further, the working-capital
formula assumes that accounts receivable are readily available for collection, which may not be the case for
many companies.

It is also important to understand that the timing of asset purchases, payment and collection policies, the
likelihood that a company will write off some past-due receivables, and even capital-raising efforts can
generate different working capital needs for similar companies. Equally important is that working capital needs
vary from industry to industry, especially considering how different industries depend on expensive equipment,
use different revenue accounting methods, and approach other industry-specific matters. Finding ways to
smooth out cash payments in order to keep working capital stable is particularly difficult for manufacturers
and other companies that require a lot of up-front costs. For these reasons, comparison of working capital is
generally most meaningful among companies within the same industry, and the definition of a "high" or "low"
ratio should be made within this context.

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