Financial Management

Chapter 1: Introduction to Financial Management:

Financial management is the process of planning, directing, organizing, controlling and
monitoring of the monetary resources in order to achieve objectives and goals of the business.

Kinds of Business Organization:

● Sole proprietorship – this is owned by an individual, known as the sole proprietor, who
has the full authority in managing the assets of the business.
● Partnership – is a contract between two or more persons who bind themselves in
contributing money, property, or industry to a common fund with the intention of
dividing the profits among themselves.
● Corporation – is an artificial being created by the operation of the law, having the right of
succession and the powers, attributes, and properties expressly authorized by law or
incident to its existence.

Types of Corporations:
● As to Legal Status:
o De Jure Corporation – this is a corporation organized in accordance with the law.
o De Facto Corporation – this is a corporation that exists only in fact but not in law
because there is a flaw in its incorporation.
● As to Functions and Governing Laws:
o Public Corporation – these are organized by the state for the government to
promote general welfare of the public.
o Private Corporation – these are organized by private individuals for the purpose
of generating profit.
● As to existence of Stocks:
o Stock Corporation – a corporation in which capital stock is divided into shares
and is authorized to distribute to the holders.
o Nonstock Corporation – a corporation which has no stocks issuances and no
distribution of dividends to its members.
● As to Shares being traded in Stock Exchange:
o Publicly listed Company – this is a corporation whose shares are offered to public
or traded in the Philippine stock exchange.
o Privately owned Company – this is a corporation whose shares are not traded in
the stock market.
● As to the number of owners/shareholders:
o Regular Corporation – it is owned by more than one stockholder.
o One person Corporation – is a corporation with a single stockholder.

Corporations not acceptable in the Philippines:

● Limited Liability Company – this is a business structure which combines the tax
advantage of a partnership and limited liability advantage of a corporation.
● Professional Corporation – this is composed of persons with same professions.

Goals of the Corporation:

 The ultimate goal of a corporation is shareholder’s wealth maximization. This is
sometimes referred to as stock price maximization, which is the increase in the value of stock
price resulting to capital gains that shareholders will yield on their investments.

Financial Managers of the Corporation:

● Board of Directors – they are direct owners and are elected by the shareholders to
manage the corporation.
● Chief Financial Officer (CFO) – also known as the Vice President for Finance, who has
responsibility over financial planning and formulation of financial corporate strategies.
● Treasurer – one who focuses on the financial aspect of the corporation; wherein he has
the responsibility on raising and managing the capital funds of the company.
● Controller – one who focuses on the accounting and budgeting aspect of the corporation;
he is responsible for the custody of financial records, preparations of the financial
statements, and interpretation of financial data. Moreover, he is responsible for the
management of the budget for the efficient usage of funds.

Roles of Financial Managers:

● Investing decision – What assets should the corporation acquire in order to provide better
returns in the future?
● Financing decision – How to raise funds in order to finance the investments and
operating activities of the firm?
● Operating decision – How much funds will be allocated to support the day-to-day
transactions of the firm?

Agency Conflict and Resolutions:

● Compensation plan – the companies would offer incentives to their managers.
● Threat as to change in Board of Directors – may motivate them to become active in
governing the corporation.
● Threat as to Takeover – may motivate them to improve their poor performance and drive
them to manage the business well.
● Legal and Regulatory Requirements – these requirements imposed upon the corporation,
especially those publicly listed companies, aim to provide security on the part of the
shareholders or investors.
● Specialist Monitoring

Conflict between bondholder and stockholder:

Stockholder: Bondholder:
Investor of the firm’s equity Investors of the firm’s debt securities
Owners of the firm Lenders of the firm
Desire risky investments Oppose risky investments
Income depends on the dividend yield and Fixed income from interest payments
capital gains yield
Concerned on the dividend payments which is Concerned on the capacity of the firm to pay
usually dependent on the results of the firm’s interest irrespective of the result of the firm’s
operations and investments operations and investments
Ethical Consideration:
Ethics and the goal of maximizing shareholder wealth generally lean towards similar
ends because ethical behavior builds good reputation that will benefit the organization in the
long run. However, in the case of conflict between ethics and profit goals, the former shall
prevail because unethical dealings will provide results that taint the goodwill of the company.

Chapter 2: Financial Environment:

Financial environments are factors and situations that primarily affect the financial
aspects of the corporation. The principal factors are the sources of financing through (A)
Financial Markets and (B) Financial Intermediaries.
The main source of funds used for investments and operations come from the savings of
the investors. The financial managers acquire these funds through equity financing and debt
financing.

Different Types of Financial Markets:

Financial markets are the place where financial assets such as Equity Securities (shares of
Stock) and Debt Securities (Bond certificates) are issued and traded.
● Stock Market – this is a market where equity securities are being issued and traded. In
this market, the stockholders may sell their stock investments or the firm may issue
additional stocks if the stock price is overvalued or may purchase stocks if undervalued.
● Bond Market – this is a market where debt securities are being issued and traded. This is
also referred as the fixed-income market because the investors or so-called bondholders
receive fixed interest payments from their investments assuming they will hold the bond
until maturity or on a longer period of time.
● Money Market – this is a market where short-term debts with maturities of one year or
less are used as a source of financing.
● Capital Market – this is a market where long-term debt and equity securities are involved,
for financing.

Other Markets:
● Physical Market – also known as real asset or tangible markets because the products are
real estate, property plant and equipment, inventories, etc. Hence, those assets not
qualified as financial assets are sold in this market.
● Spot Market – this is a market where assets or goods are sold for and delivered on the
spot or today. Thus, the determination of price and delivery of goods is on the same date.
● Future Market – this is a market where future contracts are sold. A future contract is a
contract that gives the purchaser an obligation to buy an asset (and the seller an
obligation to trade an asset) at a predetermined price at a future date. Thus, the price is
agreed today but the delivery of goods is in the future.
● Private Market – this is a market where negotiation and agreement take place personally
between two parties. Hence, making the contract unique or tailor-made.
● Public Market – this is a market where a security or contracts with standardized features
are being traded and held by individuals.

Financial Intermediaries:
Financial intermediaries are the organizations that provide financing to the individuals,
corporations or other organizations by raising funds or money from investors.
 ● Mutual Fund (MF) – the investment company pools money from the investors then
invests these accumulated amounts in a portfolio of securities whether equity (shares of
stock), debt (bonds), or money market (short term securities).
● Unit Investment Trust Fund (UITF) – the investment company sells units of investment
to the investors to accumulate a trust fund, The trust fund may be invested also in equity,
debt, or balance of equity and debt. Hence, the investors own units of investments not,
shares of stock.
● Pension Fund – these are pooled contribution from the employees or from the employers
that serves as the investment plan for the retirement benefits of the employees.
● Financial Institution – this is a kind of financial intermediary that provide additional
financial services other than pooling and investing of funds.

Transfer of Securities:
● Direct Transfer – In a direct transfer of securities, the equity securities evidenced by
stock certificates and debt securities evidenced by bond certificates are issued directly to
the investors. In turn, these investors pay directly to the issuing company. Thus, the
securities do not pass through the possession of any financial intermediaries.
● Indirect Transfer – In an indirect transfer of securities, the issuing company seeks the aid
of the financial institution to easily issue their securities to the investors, thus there is
mediation between the issuer and the investor.
o Indirect transfer through Investment Bank – the securities of the company are
bought by the investment bank or the so-called underwriter with the intention of
reselling them to a prospective investor.
o Indirect transfer through Financial Intermediary – the securities of the company
are bought by these financial intermediaries without the intention of reselling the
said securities; rather they will sell their own securities to the new investors.

Stock Market Transactions:

Stock Markets are markets where shares of stocks of corporation are sold to new
investors and or existing stockholders.
● Initial public offering – are markets where the stocks of a closely held corporation, going
public, are offered to the public for the first time.
● Seasoned offering – is the issuance of additional shares of stocks of the company after its
time offering in order to finance the capital budget or to improve its capital structure.
● Primary market transaction – are involved with the issuance or selling of new shares of
stocks to the investors through the aid of the investment bankers. The cash proceeds from
primary market transaction goes to the corporation.
● Secondary market transaction – are involved with the sale of the outstanding shares of
stocks to the existing shareholders or to new investors. The cash proceed from secondary
market transaction goes to the selling shareholders, not the corporation.

Stock Market Efficiency:

Stock market may be considered efficient or inefficient market. If the stocks market
shows that the market prices of the stocks are about equal or close to intrinsic values, there is
market efficiency. In this situation, the stock price reflects all publicly listed information hence,
are fairly priced. Thus, investors returns or losses under efficient market are relatively low.
On the other hand, if the stock market is inefficient, the stock prices are considered as
highly overvalued or undervalued. Hence, the investors are not confident to invest unless they
knew some information over the others.

Levels of efficiency in Efficient Market Hypothesis (EMH):

 ● Weak form – this level shows that the information regarding past or historical prices of a
particular stock is not conclusive in predicting stock prices. Hence, an investor cannot
beat the market by simply analyzing the past performance of the stock.
● Semi-strong form – this level shows that all the available public information is already
incorporated in the stock prices. Hence, the investors cannot beat the market solely by
analyzing the published financial reports unless they have information from company
insiders.
● Strong form – this level shows that investors cannot beat the market even with insider
information. Hence, the investors in this efficient market cannot earn high returns.

The stock prices can be classified as:

● Market value – also known as perceived value, is the price of the stock which is
currently traded in the market.
● Intrinsic value – this is the true value of the stock. This is the price that the willing buyer
will bid and willing seller will ask provided that all necessary information about the
stock is available.

● If the so-called market value is equal to the intrinsic value, the stock price is at
equilibrium and the investor is neutral as to selling or buying stocks.
● If the market value of the stock is higher than the intrinsic value, the stock price is
deemed as overvalued and the stock holders are expected to sell than to buy shares.
● If the market value of the stock is lower than the intrinsic value, the stock price is
deemed as undervalued and the investors are expected to purchase more shares to take
advantage of lower price.

Chapter 3: Financial Statement, Taxes and Ratio

Analysis:
Financial Statement Analysis:

Horizontal Analysis:
Horizontal analysis of financial statements is a method of comparing the Peso value or
amount of the particular line item in the Statement of Financial Position, Statement of
Comprehensive Income or Cash Flow Statements over a two or more consecutive accounting
period. Moreover, this peso value can be converted into percentages for purposes of comparing
the performance of different companies in an industry.
Horizontal analysis, which is also known as trend analysis, provides assessment of the
significant increase or decrease in these different items in the financial statements. Thus, in
performing Horizontal analysis as a technique, we can use the (a) Peso value or (b) Percentage
change for comparison and evaluation of company’s performance.

To calculate the percentage change in values from prior period to the current period, we will use
the formula below:
● Percentage Change = (Current Year – Prior Year) / Prior Year
● Positive = increase in the peso value of the line item subject to evaluation
● Negative = decrease in the peso value

Vertical Analysis:
Vertical analysis of financial statements is a technique that involves assessment of the
different line items in a single period Financial Statement. These items which are commonly
shown in the Financial Statements using their Peso values shall be expressed in percentage of a
total amount or the base amount.
In this technique, the financial managers can appropriately evaluate the financial
information of companies of different sizes because using percentages for comparison provides
more useful and relevant conclusions than using the peso values in comparing these companies
of different sizes.
In addition, Vertical Analysis is performed on the Statement of Financial Position
(Balance Sheet) where in the base amount in calculating the percentages is Total Assets, while
the base amount for the Statement of Comprehensive Income (Income Statement) is Net Sales.
After using this technique, the financial statements prepared are known as common size financial
statements.

Financial Ratios:
Financial ratio is a tool and technique in a financial analysis, it is the comparison between
one of financial information with other financial information. This comparison formulates the
relationship that provides relevant information in evaluating the operating performance and
financial condition of the company.
● Liquidity ratio – measures the ability of the company to meet its short-term obligations.
● Leverage ratio – measures the ability of the company to meet its long-term obligations
when they fall due.
● Activity ratio – measures how the company productively uses or manages its assets.
● Profitability ratio – measures the overall financial performance of the firm and its return
on its investments.

Liquidity Ratio:
It measures the capacity of the company to convert short term assets into cash. The
liquidity ratios greater than 1 signifies that the company is in good financial standing and that the
current liabilities of the said company will be met.
● Current ratio:
o Also known as the working capital ratio, indicates whether or not the company
has sufficient resources to pay its debt obligations that are due within 12 months.
o Current Ratio = Total Current Assets / Total Current Liabilities
o If the current ratio is higher than the acceptable level of 2:1, this may signify that
the company is not utilizing its current assets efficiently. In contrary, low current
ratio means that the company will have difficulty in paying its short-term debts.
● Quick ratio:
o Also known as the Acid Test ratio, is a more stringent measurement of the ability
of the company to pay its short-term obligation using the quick assets of the
company.
o The quick assets used are composed of the most liquid asset which is cash and
those highly liquid current assets that are easily convertible into cash. Among the
current assets, the inventories are excluded as components of the quick assets
because of its difficulty to convert into cash.
o Quick Ratio = (Current Assets – Inventories) / Total Current Liability
● Cash ratio:
o Cash ratio is considered to be the most stringent and conservative among the
liquidity ratios because it only uses cash and cash equivalents in paying the short-
term obligations of the company.
o Cash Ratio = (Cash + Marketable Securities) / Total Current Liabilities
● Working Capital to Total Asset Ratio:
 o Also known as the Net Working Capital, the Working Capital measures the
company’s potential value of cash reserves, it is the difference between the total
current assets and total current liabilities.
o Working Capital to Total Asset Ratio = (Current Assets – Current Liabilities) /
Total Assets

Leverage Ratio:
Also known as solvency ratio, these ratios indicate the solvency of the company, thus,
showing whether or not there are sufficient financial resources to insure payment of the principal
and interests of lenders. A very high leverage ratio signifies that the company is facing high
operating and financial risks.
● Debt Ratio:
o Debt ratio is a ratio that shows the percentage of the total debt of the company
compared to tis total assets.
o Debt Ratio = Total Liability / Total Asset
o Higher weight of debt to total asset signifies that the company is highly levered,
thus, faces greater financial risks.
● Equity Ratio:
o Also known as net worth to total asset ratio, this indicates the proportion of the
total equity of the company compared to its total assets.
o Shareholder’s equity is the residual interest after deducting the total debt from
total assets of the company or this is sometimes referred as the net worth of the
company.
o Equity Ratio = Total Shareholder’s Equity / Total Assets
● Debt to Equity Ratio:
o It is a ratio that sows the proportion of company’s funds financed by debt
compared to funds financed by equity.
o Debt to Equity Ratio = Total Liability / Total Shareholder’s Equity
o The higher debt to equity ratio implies that the company is highly financed by
debt or creditors, thus increases the financial risk of the company.
o On the contrary, lower debt to equity ratio signifies that the contribution from the
stockholders is more than from creditors, thus the company has better standing in
terms of solvency yet it does not increase earnings through leverage.
● Times Interest Earned Ratio:
o Also known as interest coverage ratio, is a ratio that indicates the degree to which
interests are covered by earnings before interest and taxes (EBIT).
o Times Interest Earned Ratio = EBIT / Interest Expense
o If the TIER of a company is low, this implies that the ability of the company to
meet its interest expenses is impaired because of less earning generated from
operations. However, higher TIER shows a good financial standing of the
company.
● Cash Coverage Ratio:
o Cash Coverage Ratio is a ratio that indicates the extent to which interests are
covered not only by earnings but by the cash flows generated from operations.
o Cash Coverage Ratio = (EBIT + Depreciation) / Interest Expense
o This measures how many times the interest payment can be made by the company
through earnings before interest and taxes (EBIT) after adding back Depreciation.

Activity Ratio:
Also known as efficiency ratio or asset management ratio, this ratio indicates the
company’s capacity of converting its assets into the sales revenue.
● Asset Turnover Ratio:
o Also known as Sales to Asset ratio, indicates the value of peso sales generated by
each peso of asset employed by the company.
o Asset Turnover Ratio = Sales Revenue / Average Assets
o It is assumed that high asset turnover ratio signifies the effective use of
company’s assets. However, if the ratio is determined at a low level, which
implies an inefficient use of assets, there is a need to analyze the performance of
key assets such as receivables and inventories.
● Accounts Receivable Turnover Ratio:
o Indicates how many times the company collects its average accounts receivables
during an accounting period. Thus, measuring how fast the Collection Department
of the company collects its credit sales.
o Accounts Receivable Turnover Ratio = Credit Sales / Average Accounts
Receivable
o In addition, the higher the Accounts Receivable Turnover Ratio, the more
efficient the company is managing its credits granting to customers, and vice
versa.
● Day’s Sales Receivable:
o Also known as Average Collection Period, indicates how fast the company
collects it credit sales in terms of days.
o Day’s Sales Receivable = Average Receivables / Average Daily Sales
o Average Receivables = (Beginning AR + Ending AR) / 2
o Average Daily Sales = Sales / 360
● Inventory Turnover Ratio:
o Inventory Turnover Ratio measures the number of times the company replaces its
average inventories during an accounting period due to sales.
o Inventory Turnover Ratio = Cost of Sales / Average Inventory
o High inventory ratio implies better sales efficiency while low inventory ratio may
signify obsolete inventories or that too much inventory is held in stock.
● Day’s Sales in Inventory:
o Also known as Average Inventory Period, indicates how quick the company can
sell its inventories in terms of days or the number of days the company holds
these inventories before selling to customers.
o Day’s Sales Inventory = Average Inventory / Average Daily Sales
o Average Inventory = (Beginning Inventory + Ending Inventory) / 2
o Average Daily Sales = Cost of Sales / 360
● Accounts Payable Turnover Ratio:
o Indicates the number of times the company pays its outstanding average accounts
payable during an accounting period.
o Accounts Payable Turnover Ratio = Purchases / Average Accounts Payable
o This ratio shows the creditworthiness of the company or how it manages its
payments to its creditors. Thus, high accounts payable turnover ratio means that
the company pays its purchases on account in a short period of time.
● Normal Operating Cycle:
o This cycle starts from the purchase of materials from the supplier, followed by the
sale of finished goods inventory to the customers then finally the collection of
cash payments made by these customers.
o The delay of time between purchase of materials and the sale of finished goods is
called the Average Inventory Period (AIP); and the delay of time between sale of
finished goods and the collection of customer payment is the Average Receivable
Period (ARP).
 o Normal Operating Cycle is the summation of these two periods, thus, is the delays
in collecting cash payments.
o On the contrary, the delay of time between purchase of materials and the payment
made to the supplier is referred as Accounts Payable Period (APP).
● Cash Conversion Cycle:
o Measures the number of days from cash being paid to the suppliers up to the time
cash is received from sales. Hence, it is the period of time from the purchase of
raw materials up to the collection of receivables.
o Cash Conversion Cycle = AIP + ARP – APP

Profitability Ratio:
This measures the overall financial performance of the company as provided by returns
generated from investments and sales.
● As to Margins:
o Gross Profit Margin (GPM):
▪ Indicates the proportion of gross profit over the sales revenue generated by
the company from operations. This shows the earning capacity of the
company after taking into account the cost of production.
▪ Gross Profit Margin = Gross Profit / Sales
o Operating Profit Margin (OPM):
▪ Shows the percentage of operating profit or the EBIT over the sales
revenue generated by the company from operations.
▪ Operating Profit Margin = Operating Profit / Net Sales
o Net Profit Margin (NPM):
▪ Reveals the percentage of the Net Income After Tax (NIAT) over the sales
revenue generated from operations. This shows the earning capacity of the
company after paying all its expenses.
▪ Net Profit Margin = Net Income After Tax / Net Sales
● As to Returns:
o Return on Sales (ROS):
▪ Shows the proportion of profit, after payment of all expenses, over the
sales revenue.
▪ Return on Sales = Net Income / Net Sales
o Return on Assets (ROA):
▪ Measures the relationship of the peso value of income generated for every
peso of asset employed by the company. It shows how the company
efficiently uses its assets.
▪ Return on Assets = Net Income / Average Assets
o Return on Equity (ROE):
▪ Illustrates the relationship of the peso value of income earned per equity
investments by the shareholders. It shows how profitable the company is
through the use of investments from its owners.
▪ Return on Equity = Net Income / Average Equity
● As to Shareholder’s Interest:
o Earnings per Share (EPS):
▪ Indicates the ratio of the annual income and the common stocks of the
company. In addition, this shows how much of the total earnings may be
given to each share of common stocks.
▪ Earnings per Share = (Net Income – Preferred Dividends) / Number of
Outstanding Common Stocks
o Price-Earnings Ratio (PER):
 ▪ Reflects the ratio of the market price per share of common stock and the
earnings per share. This ratio is used by the investors or stockholders in
assessing the ability of the company to sustain growth and generate cash
flows in the future.
▪ Price Earnings per Share = Market Price per Share / Earnings per Share
o Pay-Out Ratio (POR):
▪ Shows the proportion of earnings that is paid out to shareholders as
dividends. Investors, who prefer short term returns like cash dividends
rather than capital gains, usually search for companies with high pay-out
ratio.
▪ Payout Ratio = Dividends per Share / Earnings per Share
o Plow Back Ratio (PBR):
▪ Also known as Retention Ratio, shows the proportion of earnings that is
not paid out to stockholders rather it is plowed back or reinvested to the
company to be used for its expansion and growth.
▪ The higher the payout ratio, the lower the plow back ratio.
▪ Plow Back Ratio = (Earnings per Share – Dividends per Share) / Earnings
per Share
▪ Plow Back Ratio = 1 – Payout Ratio
o Dividend Yield (DY):
▪ Indicates the return on investment for the stockholders in terms of
dividends paid. In addition, this implies how much the investors will
receive as dividend income for every peso invested in the company’s share
of stock.
▪ Dividend Yield = Dividends per Share / Market Price per Share

DuPont Technique:
It is a tool that analyzes the return on asset and return on equity of the company by
breaking it down into component ratios.

Return on Asset:
● ROA = Asset Turnover x Net Profit Margin
● Asset Turnover = Net Sales / Averages Assets
● Net Profit Margin = Net Income / Net Sales
Return on Equity:
● ROI = Leverage Factor x Asset Turnover x Net Profit Margin
● Leverage Factor = Average Asset / Average Equity