FINANCIAL

MANAGEMENT

Ariel Dizon Pineda, CPA

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Module Table of Contents

I. Introduction to Financial Management

Financial Management, Defined

Importance of Financial Management
Fundamental Concepts in Financial Management
Role of the Financial Manager

II. Cash Flow Statement

Objectives of Cash Flow Statement

Cash Flow Activities
Methods of Cash Flow Preparation

III. Financial Statement and Analysis

Understanding the Basic Financial Statements

Overview on Financial Statement Analysis
Horizontal and Vertical Analysis
Ratio Analysis

IV. Time Value of Money

Overview on Time Value of Money

Present Value Concept
Future Value Concept
Risk and Return

V. Bonds and Stocks Valuation

Concept of Bonds and Stock

Valuation Method for Bond and Stocks

VI. Cost of Capital

Cost of Capital, defined

Weighted Average Cost of Capital
Cost of Borrowing
Cost of Debt
Cost of Equity
Cost of Funds

VII. Capital Budgeting Techniques

Significance and Importance of Capital Budgeting

Payback Period.
Discounted Payback Period.
Accounting Rate of Return.
Net Present Value.
Internal Rate of Return.
Profitability Index.

VIII. Working Capital Management

Working Capital Management, defined

Elements of Working Capital
Types of Working Capital
Objectives of Working Capital
Working Capital Cycle
Approaches to Working Capital

IX. Corporate Financial Planning

Financial Planning Process

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I. Introduction to Financial Management

Financial Management, Defined

Importance of Financial Management
Fundamental Concepts in Financial Management
Role of the Financial Manager

Learning Outcomes:

At the end of the chapter, the learner must be able to:

a) define and discuss what is financial management

b) explain the importance of financial management
c) identify various fundamental concepts of financial management
d) recognize the role of the financial manager in a business entity

Financial Management, Defined

Financial Management is a functional part of a business organization that sets policies towards
organizing, planning, controlling, and directing the proper use and allocation of its financial resources.
It carries with it an interlocking coordination within the business structure such as production, marketing,
logistics and personnel functions.

Financial management is considered to be one of the most significant responsibilities within the business
entity. Various business activities require considerable amount of decision making that will affect
company’s financial condition, structure, performance and profitability.

Importance of Financial Management:

Financial management function focuses on the areas of (a) investment decision such as capital budgeting
or financial plan preparation (b) financing decision such as creating the best financing mix or capital
structure; and (c) operating decision such as cost control or strategies to increase in revenue.

As such, financial management decisions are interrelated among investing, financing and operating
activities. These decisions add value and set the directions of the company to accomplish its business
objectives. The use of various analytical tools helps in the analysis, planning and control in terms of
proper allocation and utilization of the company’s financial resources.

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The financial management function is important in business organization since it deals to:

➢ guarantee rational and attractive return on investment made in the business.

➢ examines business financial performance for growth and expansion.
➢ plans, directs and controls the use of financial resources
➢ ensure maximum and efficient flow of operations
➢ create pleasant and amiable relations with company stakeholders
➢ harmonize operations of different facets of the business.
➢ build up appropriate controls to secure proper use of financial resources.

Fundamental Concepts in Financial Management

Financial management is in charge of efficient planning and control of the cycle of flow of funds inflow
and outflow of funds.

1. The appropriate magnitude or volume of funds needed for efficient operations (capitalisation);

2. The wise allocation of financial resources to particular resources;

3. The short and long term fund raising activities .

Businesses have many stages or phases of operations to manage to keep things working smoothly.
Finance is just one of these areas. Because finances impact virtually everything else the company does,
it's probably the most important thing a manager must address. However, there are both advantages and
disadvantages to financial management in business. Usually the pros outweigh the cons, but managers
still must be prepared to face the negative consequences of tracking the money a business has and
spends.

Research, Time and Knowledge

Businesses would require a significant amount of financial information. These information would normaaly
take some time to collect and are product of past business transactions. Even if the data are collected, it
would undergo a process of analysis and interpretation so it can be used to make economic decisions.
Thus, an extensive amount of research, time and in depth knowledge is needed to make these financial
information relevant.

Cost

Cost is one of the consideration in financial management. Since financial data would require analysis and
interpretation, the company would need experts or knowledgeable professionals to do the job. As such,
an appropriate cost is necessary to attract these type of personnels.

Revision and Attention

Internal and external factors surely affect the financial needs of a business. Thus, constant study and
undivided attention will be needed to identify these factors and make adjustments on the company’s
financial plans and objectives.

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Power

Financial Managers are given the power to make judgement call specially when the operations of the
business will be affected. Not all financial decisions may be popular to stakeholders and thus might lead
to unpleasant situation or misunderstanding within the company’s organizational structure.

Money Availability and Planning

Managing finances results to being able to identify the sources and uses of it. It gives financial managers
the edge of knowing when funds will be available. Given this knowledge, financial managers may be able
to predict money availability or possible shortage of it. As such, appropriate measures can be made to
avoid untoward situation that may affect company operations.

Accountability

Financial management focuses on various control procedures related to the use of financial resources. It
places a heavy burden on accountability as those involved need to monitor and make sure compliance
are done to every set of procedures and policies with regard to the management of company’s financial
resources.

Confidence

Financial management add value and develop more confidence in the business entity. It add value and
confidence in the sense that this aspect of management put strong emphasis on efficient planning and
control on the inflow and outflow of funds. As such, stakeholders can be assured that proper procedures
and policies are in place to safeguard company’s financial resources.

Role of the Financial Manager

Business financial activities are considered as one of the most significant yet complicated activities within
the company. Given the complexities of financial activities, the company needs to have a well rounded
financial manager who can take care of all the important financial functions of an organization. The said
person should be far sighted to ensure that the financial resources are properly allocated and utilized in
the most efficient manner. His actions directly affect the financial condition and performance of the
business entity. Among the most important functions of the financial managers are:

1. Raise Needed Funds for the business operations

It is the role of the financial manager to ensure that the company meet the obligation and
required funds needed for the business. He needs to constantly monitor company’s liquidity,
solvency and profitability by way of establishing prudent financial procedures and policies. The
company can raise funds either thru equity and debt financing. Equity financing refers to the
issuance of company stocks while debt financing would involve loan or fund borrowing. The
financial manager should decide on the type of financing the company would opt to choose.

2. Proper Allocation of Financial Resources

The moment funds are raised, the financial manager should be able to make proper allocation on
where to use the said funds. The following needs to be considered in order to make proper
allocation of funds:

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 ➢ The business entity size and its capability for possible growth
➢ Status of assets where the funds will be used ; either for long-term or short-term
➢ Manner on which the funds are raised
3. Profit Planning

Being able to generate profit is one of the most desired outcome of any business organization.
Profit is an inherent component to ensure business sustainability and survival. As such, profit
planning requires tremendous amount of rational forecasting of revenues and management of
cost and expenses.

Many factors would have an impact on business profit and this will include factors such as
product pricing, competition, economic status, demand and supply, product cost and output. The
financial manager should be able to keep a keen eye on all these factors in order to make
desirable and realistic financial plans to achieve the desired profit for the company.

4. Knowledge of Capital Markets

The financial manager should be able to have an in depth knowledge and a clear understanding
of capital market. Capital market is where securities or company shares are traded and this
would involve a high amount of risk. Therefore, a financial manager should be able to make
strong calculation and analysis of the various risk involved in the trading of shares and securities.

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II. Cash Flow Statement

Objectives of Cash Flow Statement

Cash Flow Activities
Methods of Cash Flow Preparation

Learning Outcomes:

At the end of the chapter, the learners must be able to ;

a) recognize and explain the various activities in the cash flow statement
b) categorize the various business transactions related to activities in the cash flow statement
c) construct a cash flow statement

STATEMENT OF CASH FLOW

A cash flow statement, also known as statement of cash flows or funds flow statement, is a financial
statement that shows how changes in balance sheet accounts and income affect cash and cash
equivalents, and breaks the analysis down to operating, investing, and financing activities.

Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business.
The statement captures both the current operating results and the accompanying changes in the balance
sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability
of a company, particularly its ability to pay bills.

The cash flow statement is intended to :

1. provide information on a firm's liquidity and solvency and its ability to change cash flows in future
circumstances
2. provide additional information for evaluating changes in assets, liabilities and equity
3. improve the comparability of different firms' operating performance by eliminating the effects of
different accounting methods
4. indicate the amount, timing and probability of future cash flows

Operating activities

Operating activities include the production, sales and delivery of the company's product as well as
collecting payment from its customers. This could include purchasing raw materials, building inventory,
advertising, and shipping the product. Operating cash flows include:

• Receipts from the sale of goods or services

• Receipts for the sale of loans, debt or equity instruments in a trading portfolio
• Interest received on loans
• Dividends received on equity securities
• Payments to suppliers for goods and services
• Payments to employees or on behalf of employees
• Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US
GAAP)

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Items which are added back to [or subtracted from, as appropriate] the net income figure (which is
found on the Income Statement) to arrive at cash flows from operations generally include:

• Depreciation (loss of tangible asset value over time)

• Deferred tax
• Amortization (loss of intangible asset value over time)
• Any gains or losses associated with the sale of a non-current asset, because associated cash
flows do not belong in the operating section.(unrealized gains/losses are also added back from
the income statement)

Investing activities

Examples of Investing activities are

• Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities,
etc.)
• Loans made to suppliers or received from customers
• Payments related to mergers and acquisitions

Financing activities

Financing activities include the inflow of cash from investors such as banks and shareholders, as well as
the outflow of cash to shareholders as dividends as the company generates income. Other activities
which impact the long-term liabilities and equity of the company are also listed in the financing activities
section of the cash flow statement.

• Proceeds from issuing short-term or long-term debt

• Payments of dividends
• Payments for repurchase of company shares
• Repayment of debt principal, including capital leases
• For non-profit organizations, receipts of donor-restricted cash that is limited to long-term
purposes

Items under the financing activities section include:

• Dividends paid
• Sale or repurchase of the company's stock
• Net borrowings
• Payment of dividend tax

Disclosure of non-cash activities

Non-cash investing and financing activities are disclosed in footnotes to the financial statements. Under
US General Accepted Accounting Principles (GAAP), non-cash activities may be disclosed in a footnote or
within the cash flow statement itself. Non-cash financing activities may include

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 • Leasing to purchase an asset
• Converting debt to equity
• Exchanging non-cash assets or liabilities for other non-cash assets or liabilities
• Issuing shares in exchange for assets

Preparation methods

The direct method of preparing a cash flow statement results in a more easily understood report. The
indirect method is almost universally used, because FAS 95 requires a supplementary report similar to the
indirect method if a company chooses to use the direct method.

Direct method

The direct method for creating a cash flow statement reports major classes of gross cash receipts and
payments. , Dividends received may be reported under operating activities or under investing activities. If
taxes paid are directly linked to operating activities, they are reported under operating activities; if the
taxes are directly linked to investing activities or financing activities, they are reported under investing or
financing activities.

Sample cash flow statement using the direct method :

Cash flows from (used in) operating activities

Cash receipts from customers 29,500

Cash paid to suppliers and employees (12,000)

Cash generated from operations (sum) 17,500

Interest paid (2,000)

Income taxes paid (3,000)

Net cash flows from operating activities 12,500

Cash flows from (used in) investing activities

Proceeds from the sale of equipment 17,500

Dividends received 13,000

Net cash flows from investing activities 30,500

Cash flows from (used in) financing activities

Dividends paid (25,000)

Net cash flows used in financing activities (25,000)

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Net increase in cash and cash equivalents 18,500

Cash and cash equivalents, beginning of year 10,000

Cash and cash equivalents, end of year 28,500

Indirect method

The indirect method uses net-income as a starting point, makes adjustments for all transactions for non-
cash items, then adjusts from all cash-based transactions. An increase in an asset account is subtracted
for net income, and an increase in a liability account is added back to net income. This method converts
accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.[14]

Rules (Operating Activities)

To Find Cash Flows
from Operating Activities
using the Balance Sheet and Net Income

For Increases in Net Inc Adj

Current Assets (Non-Cash) Decrease

Current Liabilities Increase

For All Non-Cash...

*Expenses (Decreases in Fixed Assets) Increase

*Non-cash expenses must be added back to NI. Such expenses may be represented on the balance
sheet as decreases in long term asset accounts. Thus decreases in fixed assets increase NI.

The following rules can be followed to calculate Cash Flows from Operating Activities when given only a
two year comparative balance sheet and the Net Income figure. Cash Flows from Operating Activities can
be found by adjusting Net Income relative to the change in beginning and ending balances of Current
Assets, Current Liabilities, and sometimes Long Term Assets. When comparing the change in long term
assets over a year, the accountant must be certain that these changes were caused entirely by their
devaluation rather than purchases or sales (ie they must be operating items not providing or using cash)
or if they are nonoperating items.[15]

• Decrease in non-cash current assets are added to net income

• Increase in non-cash current asset are subtracted from net income
• Increase in current liabilities are added to net income
• Decrease in current liabilities are subtracted from net income

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 • Expenses with no cash outflows are added back to net income (depreciation and/or amortization
expense are the only operating items that have no effect on cash flows in the period)
• Revenues with no cash inflows are subtracted from net income
• Non operating losses are added back to net income
• Non operating gains are subtracted from net income

The intricacies of this procedure might be seen as :

Net Cash Flows from Operating Activities = Net Income + Rule Items

Illustration :

Consider a hotel company that has a net income of P1,000,000 this year, and its Accounts Receivable
(A/R) increased by P 250,000 since the beginning of the year.

If the balances of all other current assets, long term assets and current liabilities did not change over the
year, the cash flows could be determined by the rules above as P1,000,000 – 250,000 = Cash Flows from
Operating Activities = P750,000.

The logic is that, if the hotel company made P1,000,000 that year (net income), and they are using the
accrual accounting system (not cash based) then any income they generated that year which has not yet
been paid for in cash should be subtracted from the net income figure in order to find cash flows from
operating activities. The increase in A/R meant that P250,000 of sales occurred on credit and have not
yet been paid for in cash.

In the case of finding Cash Flows when there is a change in a fixed asset account, say the Buildings and
Equipment account decreases, the change is subtracted from Net Income. The reasoning behind this is
that because Net Income is calculated by :

Net Income = Revenue – Cost of Sale - Depreciation Expense – Other Expenses

The Net Income figure will be decreased by the building's depreciation that year. This depreciation is not
associated with an exchange of cash, therefore the depreciation is added back into net income to remove
the non-cash activity.

Rules (Financing Activities)

Finding the Cash Flows from Financing Activities is much more intuitive and needs little explanation.
Generally, the things to account for are financing activities:

• Include as outflows, reductions of long term notes payable (as would represent the cash
repayment of debt on the balance sheet)
• Or as inflows, the issuance of new notes payable
• Include as outflows, all dividends paid by the entity to outside parties
• Or as inflows, dividend payments received from outside parties
• Include as outflows, the purchase of notes stocks or bonds

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 • Or as inflows, the receipt of payments on such financing vehicles.

In the case of more advanced accounting situations, such as when dealing with subsidiaries, the
accountant must

• Exclude intra-company dividend payments.

• Exclude intra-company bond interest.

Illustration : Cash Flow of DME Hotel Company

DME Hotel Company Cash Flow Statement

(all numbers in millions of P.)

Period ending 03/31/2010 03/31/2009 03/31/2008

Net income 21,538 24,589 17,046

Operating activities, cash flows provided by or used in:

Depreciation and amortization 2,790 2,592 2,747

Adjustments to net income 4,617 621 2,910

Decrease (increase) in accounts receivable 12,503 17,236 --

Increase (decrease) in liabilities (A/P, taxes payable) 131,622 19,822 37,856

Decrease (increase) in inventories -- -- --

Increase (decrease) in other operating activities (173,057) (33,061) (62,963)

Net cash flow from operating activities 13 31,799 (2,404)

Investing activities, cash flows provided by or used in:

Capital expenditures (4,035) (3,724) (3,011)

Investments (201,777) (71,710) (75,649)

Other cash flows from investing activities 1,606 17,009 (571)

Net cash flows from investing activities (204,206) (58,425) (79,231)

Financing activities, cash flows provided by or used in:

Dividends paid (9,826) (9,188) (8,375)

Sale (repurchase) of stock (5,327) (12,090) 133

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Increase (decrease) in debt 101,122 26,651 21,204

Other cash flows from financing activities 120,461 27,910 70,349

Net cash flows from financing activities 206,430 33,283 83,311

Effect of exchange rate changes 645 (1,840) 731

Net increase (decrease) in cash and cash equivalents 2,882 4,817 2,407

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III. Financial Statement and Analysis

Understanding the Basic Financial Statements

Overview on Financial Statement Analysis
Horizontal and Vertical Analysis
Ratio Analysis

Learning Outcomes

At the end of the chapter, the learners must be able to ,

a) identify the various information provided by the basic financial statements

b) appreciate the relevance and importance of financial statement analysis
c) perform vertical and horizontal method of financial statement analysis
d) compute, analyze and interpret financial ratios in terms of liquidity, solvency, profitability and solvency

Understanding the Basic Financial Statements

The Statement of Financial Position

The statement of financial position, also called “ balance sheet” is a financial "snapshot" of your business
at a given date in time. It provides information about the financial condition , position and structure of
the company in terms of its assets, liabilities, and the difference between the two, which is the equity or
net worth. The accounting equation (assets = liabilities + owner's equity) is the basis for the statement
of financial position or balance sheet.

The Statement of Financial Position is usually presented in comparative form. Comparative financial
statements include the current year's statement and statements of one or more of the preceding
accounting periods. For example, companies often provide five- or ten-year statements , which make
them useful for evaluating and analyzing trends and relationships.

Notes added to the statement of financial position provide additional information not included in the
accounts on the financial statements as well as explanations of figures presented. Moreover, additional
information can be disclosed by means of supporting schedules or parenthetical notation.

Illustrative Example of the Corporation Statement of Financial Position

a) Report Form – The Statement of Financial Position can be presented in vertical format known as the
Report Form, with the Assets Section above the Liabilities and Equities sections that, together, balance it.

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b) Account Form - The entire statement of financial position is normally presented in horizontal layout,
with an Assets Page on the left, and a page for Liabilities and Equities on the Right. This is known as the
Account Form .

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Statement Of Comprehensive Income

In the context of corporate financial reporting, the income statement summarizes a company's revenues
(sales) and expenses quarterly and annually for its fiscal year. The final net figure, as well as various
others in this statement, are of major interest to the investment community as it represents the
company’s financial performance for the current year.

Income statements come with various monikers. The most commonly used are "statement of income,"
"statement of earnings," "statement of operations" and "statement of operating results." Many
professionals still use the term "P&L," which stands for profit and loss statement, but this term is seldom
found in print these days. In addition, the terms "profits," "earnings" and "income" all mean the same
thing and are used interchangeably.

Forms and Presentation of the Statement of Comprehensive Income

a) Multi Step Approach - The statement of comprehensive income using the multistep approach
shows the various profitability stages from gross profit , operating profit up to the net profit which is
essential in terms of cost control and management.

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 DP Company
Income Statement
31-Dec-2017
( in thousand P )

Sales 785,000

Less : Sales Discount (16,500)

Sales Return & Allowances (53,200) 715,300

Less : Cost of Goods Manufactured & Sold 335,000

Gross Profit 380,300

Less: Selling and Administrative Expenses
Selling Expenses 133,000

Administrative Expenses 165,000 298,000

Net Operating Profit 82,300

Less : Interest Expense 12,000

Net Profit Before Tax 70,300

Less : Income Taxes (30%) 21,090

Net Profit after Tax 49,210

Supporting Statement :
Cost of Goods Manufactured and Sold
Direct Materials
Raw materials inventory beginning 125,000
+ Raw Materials Purchases 225,000
Total Materials Available 350,000
- Raw Materials , ending 215,000 135,000
Direct Labor 95,000
Factory Overhead 115,000
Total Manufacturing Cost 345,000
Add : Work In Process, beginning 185,000
Total goods placed in process 530,000
Less; Work in process, end 225,000
Total Cost of Goods Manufactured 305,000
Add: Finished Goods , beginning 95,000
Total Goods Available for Sale 400,000
Less: Finished Goods, end 65,000
Cost of Goods Sold 335,000

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b) Single Step Approach- The service type of statement of comprehensive income was shown using a
single step approach as it simply identifies the income that comes from Professional Fee and all expenses
grouped together to arrive to a net profit .

ADP Tax & Accounting Services

Income Statement
31-Dec-2017
( in thousand P )

Professional Fee 227,500

Less: Operating Expenses

Office Supplies 21,650

Depreciation 10,000

Rent 12,000

Salaries 48,000 91,650

Net Profit Before Taxes 135,850

Less : Income Taxes (30%) 40,755

Net Profit After Tax 95,095

Statement Of Changes In Equity

A statement of changes in equity shows all changes in owner’s equity for a period of time. According to
Philippine Accounting Standard # 1 (PAS 1) , this statement of financial reporting is one the five
components of complete financial statements ( statement of financial position , income statement,
statement of changes in equity, statement of cash flow and notes to financial statements.

The purpose of the statement of changes in equity is to provide readers with the useful information on
how the capital or fund of an entity is utilized and used. Since it shows the movements of equity and
accumulated earnings and losses, the readers can depict on where the company’s equity came from and
where did it go.

Illustrative Example of the Statement of Changes in Equity

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Overview Of Financial Statement Analysis

Financial statement analysis is the process of identifying financial strengths and weaknesses of the firm
by properly establishing relationship between the items of the balance sheet and the income statement
account.

There are various methods or techniques that are used in analyzing financial statements, such as
comparative statements, schedule of changes in working capital, common size percentages, funds
analysis, trend analysis, and ratios analysis.

Uses of Financial Statement Analysis

Financial statements are prepared to meet external reporting obligations and also for decision making
purposes. They play a dominant role in setting the framework of managerial decisions. But the
information provided in the financial statements is not an end in itself as no meaningful conclusions can
be drawn from these statements alone.

However, the information provided in the financial statements is of immense use in making decisions
through analysis and interpretation of financial statements. What you can look for when reading financial
statement analysis report and how do you use it ?

Trends - The results given in generally cover at least the previous three full accounting years
therefore any fluctuations in any area can be easily pinpointed

Benchmarks -The average results for each ratio together with the industry profile of the average
company in the sector can both be used as benchmarks to compare individual company
performance.

Size - All the major companies in the sector are ranked on the basis of sales, profits, total assets
and employee numbers (PERFORMANCE LEAGUE TABLES – Section 4). The largest and smallest
of the key players can be easily identified, while the relative size of any company can be
assessed.

Growth - The average annual growth of each company's sales, profits, total assets and number of
employees over the three-year period being analysed is calculated and ranked.

This key information highlights strong and weak performers, which companies are expanding or losing
market share, increasing or decreasing asset investment, or taking on or shedding employees. The
industry results are also given for comparison purposes. This information is perfect for all kinds of
planning and decision-making including:

Competitor Analysis - The depth of financial analysis provided on each company in each report
offers you a comprehensive insight into the performance of individual businesses over recent
years. The performance ratios let you easily identify the financial strengths and weaknesses of
competitors in terms of profitability, liquidity, gearing, efficiency and employee performance

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 Simple Benchmarking - You can choose to benchmark your company against a major competitor,
or assess the overall industry average performance. And you can focus on the criteria that are
important to your business, such as profitability, employee performance or sales growth. Setting
realistic performance targets becomes easier for you; with ratio reports, you will know that they
are based on solid facts about your industry.

Tracking Performance Trends - With at least three years of financial data for each company and
the entire industry you can identify performance trends instantly.

Identifying Acquisition Targets - ratio reports make it simple for you to identify potential
acquisitions.

Advantages of Financial Statement Analysis

There are various advantages of financial statements analysis. The major benefit is that the investors get
enough idea to decide about the investments of their funds in the specific company.

Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the
company is following accounting standards or not.

Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to
the company. Moreover, company can analyze its own performance over the period of time through
financial statements analysis.

Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it has two limitations. These two limitations
involve the comparability of financial data between companies and the need to look beyond ratios.

a) Comparison of Financial Data

Comparison of one company with another can provide valuable clues about the financial health of an
organization. Unfortunately, differences in accounting methods between companies sometimes make it
difficult to compare the companies' financial data.

For example if one firm values its inventories by LIFO method and another firm by the average cost
method, then direct comparison of financial data such as inventory valuations and cost of goods sold
between the two firms may be misleading. Sometimes enough data are presented in foot notes to the
financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind
the lack of comparability of the data before drawing any definite conclusion. Nevertheless, even with this
limitation in mind, comparisons of key ratios with other companies and with industry average often
suggest avenues for further investigation.

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b) The Need to Look Beyond Ratios

An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgment
about the future. Nothing could be further from the truth. Conclusions based on ratios analysis must be
regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as
starting point, as indicators of what to pursue in greater depth. they raise many questions, but they
rarely answer any question by themselves.

In addition to ratios, other sources of data should be analyzed in order to make judgment about the
future of an organization. The analyst should look, for example, at industry trends, technological
changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm
itself. A recent change in a key management position, for example, might provide a basis for optimization
about the future, even though the past performance of the firm (as shown by its ratios) may have been
mediocre.

Tools and Techniques of Financial Statement Analysis

Horizontal Analysis or Trend Analysis:

Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis.
Horizontal analysis is facilitated by showing changes between years in both peso and percentage form.

Illustrative Example 1 - Horizontal Analysis

EJS Resort Corporation
Comparative Statement of Financial Position
December 31, 2018 and 2017
( in thousand P )
Horizontal Analysis
2018 2017 Inc (Dec) %

Assets
Current Assets

Cash 600 1,175 (575) -48.94%

Accounts Receivable,net 3,000 2,000 1,000 50.00%

Inventory 4,000 5,000 (1,000) -20.00%

Prepaid Expenses 150 60 90 150.00%

Total Current Assets 7,750 8,235 (485) -5.89%

Non Current Assets

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 Land 2,000 2,000 - 0.00%

Buildings , net 3,000 2,500 500 20.00%

Equipment, net 2,000 1,000 1,000 100.00%

Furniture & Fixtures, net 1,000 750 250 33.33%

Total Non Current Assets 8,000 6,250 1,750 28.00%

Total Assets 15,750 14,485 1,265 8.73%

Liabilities and Stockholders

Equity

Current Liabilities

Accounts Payable 2,900 2,000 900 45.00%

Accrued Payable 450 200 250 125.00%

Notes Payable, short term 150 300 (150) -50.00%

Total Current Liabilities 3,500 2,500 1,000 40.00%

Non Current Liabilities

Mortgage Payable 2,750 2,000 750 37.50%

Bonds Payable , 5% 1,000 2,000 (1,000) -50.00%

Total Non Current Liabilities 3,750 4,000 (250) -6.25%

Total Liabilities 7,250 6,500 750 11.54%

Stockholders Equity
Preferred Stock , P100 ,
6% 1,000 1,000 - 0.00%

Common Sock , P12 par 3,000 3,000 - 0.00%

Additional Paid In Capital 500 500 - 0.00%

Total Paid In Capital 4,500 4,500 0.00%

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 -

Retained Earnings 4,000 3,485 515 14.78%

Total Stockholders Equity 8,500 7,985 515 6.45%

Total Liabilities and

Stockholders Equity 15,750 14,485 1,265 8.73%

The above shows the changes in 2018 and 2017 by comparing both years. For example Cash , we
compute the change by Cash in 2018 less Cash in 2017 = P 600 – P 1,175 = ( P575 ). Then , the
amount of ( P575 ) is divided to P 1,175 = ( 48.94 % ) . The same formula is to be followed for all
assets , liabilities and stockholders equity account .

This is also the same formula to follow in doing the horizontal analysis for the Income Statement as
shown below :

Illustrative Example 2 : Horizontal Analysis

EJS Resort Corporation
Comparative Income Statement
December 31, 2018 and 2017
( in thousand P )

Horizontal Analysis
2018 2017 Inc (Dec) %

Sales , net 26,000 24,000 2,000 8%

Less : Cost of Sales 18,000 15,750 2,250 14.29%

Gross Margin 8,000 8,250 (250) -3.03%

Less: Selling and Administrative
Expenses

Selling Expenses 3,500 3,250 250 7.69%

Administrative Expenses 2,930 3,050 (120) -3.93%

Total S & A Expenses 6,430 6,300 130 2.06%

-
Net Operating Income 1,570 1,950 (380) 19.49%

Less : Interest Expense 320 350 (30) -8.57%

-
Net Income Before Taxes 1,250 1,600 (350) 21.88%
Less : Income Taxes (35%) -

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 375 480 (105) 21.88%
-
Net Income 875 1,120 (245) 21.88%

Trend Percentage:

Horizontal analysis of financial statements can also be carried out by computing trend percentages.
Trend percentage states several years' financial data in terms of a base year. The base year equals
100%, with all other years stated in some percentage of this base.

To illustrate, let us look at the summary of EJS Resort Company sales and net income from 2013 to 2018:

Sales and Net Income in Peso

2013 2014 2015 2016 2017 2018

Sales 18,000 19600 21000 24,300 26,000 24,000

Net
Income 535 665 715 795 875 1,120

The data below shows sales and net income in percentages and this is computed as :
Base Year = 2013 = P18,000 = 100 % for sales and P 535 = 100% for net income.

Using the base year we compute for the succeeding years as :

Sales Net income
2014 = P19,600 /18,000 = 109% P665 / 535 = 124 %
2015 = P21,000 /18,000 = 117% P715 / 535 = 134 %
2016 = P24,300 / 18,000 = 135% P795 / 535 = 149%
2017 = P26,000 / 18,000 = 144% P875 / 535 = 164%
2018 = P24,000 / 18,000 = 133 % P1,120 / 535 = 209 %

Sales and Net Income in Percentage

2013 2014 2015 2016 2017 2018

Sales 100% 109% 117% 135% 144% 133%
Net
Income 100% 124% 134% 149% 164% 209%

Sales Trend Percentages Chart

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 160%

140%
120%

100%
Sales

80% Series1

60%

40%

20%

0%
1 2 3 4 5 6
Year

Net income Trend Percentages Chart

Net Income

250%

200%
Net Income

150%
Series1
100%

50%

0%
1 2 3 4 5 6
Year

Vertical Analysis:

Vertical analysis is the procedure of preparing and presenting common size statements. Common size
statement is one that shows the items appearing on it in percentage form as well as in peso form. Each
item is stated as a percentage of some total of which that item is a part. Key financial changes and
trends can be highlighted by the use of common size statements.

Illustrative Example 1 : Common Size Comparative Balance Sheet

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 EJS Resort Corporation
Common Size Comparative Statement of Financial Position
December 31, 2018 and 2017
( in thousand P )
Common Size %
2018 2017 2009 2010
Assets
Current Assets

Cash 600 1,175 3.81% 8.11%

Accounts Receivable,net 3,000 2,000 19.05% 13.81%

Inventory 4,000 5,000 25.40% 34.52%

Prepaid Expenses 150 60 0.95% 0.41%

Total Current Assets 7,750 8,235 49.21% 56.85%

Non Current Assets

Land 2,000 2,000 12.70% 13.81%

Buildings , net 3,000 2,500 19.05% 17.26%

Equipment, net 2,000 1,000 12.70% 6.90%

Furniture & Fixtures, net 1,000 750 6.35% 5.18%

Total Non Current Assets 8,000 6,250 50.79% 43.15%

Total Assets 15,750 14,485 100.00% 100.00%

Liabilities and Stockholders

Equity

Current Liabilities

Accounts Payable 2,900 2,000 18.41% 13.81%

Accrued Payable 450 200 2.86% 1.38%

Notes Payable, short term 150 300 0.95% 2.07%

Total Current Liabilities 3,500 2,500 22.22% 17.26%
Non Current Liabilities

Mortgage Payable 2,750 2,000 17.46% 13.81%

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 Bonds Payable , 5% 1,000 2,000 6.35% 13.81%
Total Non Current Liabilities 3,750 4,000 23.81% 27.61%
Total Liabilities 7,250 6,500 46.03% 44.87%
Stockholders Equity

Preferred Stock , P100 , 6% 1,000 1,000 6.35% 6.90%

Common Sock , P12 par 3,000 3,000 19.05% 20.71%

Additional Paid In Capital 500 500 3.17% 3.45%

Total Paid In Capital 4,500 4,500 28.57% 31.07%

Retained Earnings 4,000 3,485 25.40% 24.06%

Total Stockholders Equity 8,500 7,985 53.97% 55.13%

Total Liabilities and

Stockholders Equity 15,750 14,485 100.00% 100.00%

Please note that the figures of each asset account expressed in percentages is computed as :
Each asset item / total assets , which for example Cash in 2018 = P 600 / P 15,750 = 3.81%

The same is true with the liabilities and stockholders equity account expressed in percentage :
Each liability & stockholders equity accounts / total liabilities which if we take Accounts Payable in 2018
= P 2,900 / P15,750 = 18.41 % and for Retained Earnings in 2018 = P4,000 / P15,750 = 25.40%.

Based on the above illustrative example , you can observe significant changes in current assets in 2018
compared to 2017 . For example , Accounts receivable increased while cash and inventory decreased .
The company now can take a closer look what happened and might found out that there could be some
difficulty in collecting payment from customers.

In the case of the non current assets , the decrease is brought by the increase in depreciation ( tear &
wear cost ) of building, equipment and furniture & fixtures affecting their book value as shown in the
example . Since the total of the non current assets is reduced , thus Land account also gets affected but
shows an increase in percentage even if the peso value remains constant.

Looking at our current liabilities , both accounts and accrued payable decreased while notes payable
increased . This can also be a factor in our cash balance decrease since we made payment to our
creditors . The notes payable can be attributed that the company probably opted to issue promissory
notes for some of its purchases.

The same is true with non current assets , where the company mortgage payable decreases since
payment had been made while bonds payable increases because the company opted to borrow from
creditor in the form of bonds.

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Nothing can be said on the stockholders equity section since only the retained earning resulted to a
decrease which we could attribute that probably the company paid some dividends .

Overall , the year 2018 is a much better year for the company based on the above comparative
statement and if we are to look at the percentages . However , it is important to go deeper before
arriving to a final conclusion .

Illustrative Example 2: Common Size Comparative Income Statement

EJS Resort Corporation
Common Size Comparative Income Statement
December 31, 2018 and 2017
( in thousand P )

Common Size %
2018 2017 2018 2017

Sales , net 26,000 24,000 100% 100%

Less : Cost of Sales 18,000 15,750 69.23% 65.63%

Gross Margin 8,000 8,250 30.77% 34.38%

Less: Selling and Administrative
Expenses

Selling Expenses 3,500 3,250 13.46% 13.54%

Administrative Expenses 2,930 3,050 11.27% 12.71%

Total S & A Expenses 6,430 6,300 24.73% 26.25%

Net Operating Income 1,570 1,950 6.04% 8.13%

Less : Interest Expense 320 350 1.23% 1.46%

Net Income Before Taxes 1,250 1,600 4.81% 6.67%

Less : Income Taxes (35%) 375 480 1.44% 2.00%

Net Income 875 1,120 3.37% 4.67%

In the income statement, the basis of the percentage figure is the net sales. For example, cost of good
sold percentage is computed as : cost of good sold / net sales = P 18,000 / P26,000 = 69.23%.

Thus in income statement , each account item is divided over the net sales to get the percentage figure .
In the example above , we can see that net income in 2017 ( 4.47% ) is better than in 2018 ( 3.37 % ) .

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Ratio Analysis

The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one
number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship
between two or various figures can be compared or measured. Ratios can be found out by dividing one
number by another number. Ratios show how one number is related to another

1. Profitability Ratios

Profitability ratios measure the results of business operations or overall performance and effectiveness of
the firm. Some of the most popular profitability ratios are as under:
• Gross profit ratio

Formula: Gross Profit Ratio = (Gross profit / Net sales) × 100]

Example:
Total sales = P260,000; Sales returns = P 10,000; Cost of goods sold P200,000

Calculation:
Gross profit = [(260,000 – 10,000) – 200,000] = 50,000
Gross Profit Ratio = ( 50,000 / 250,000) × 100 = 20%

Significance:

Gross profit ratio reflects efficiency with which a firm produces its products. As the gross profit is found
by deducting cost of goods sold from net sales, the higher the gross profit, the better it is. There is no
standard GP ratio and it varies from business to business. However, the gross profit earned should be
sufficient to recover all operating expenses and to build up reserves after paying all fixed interest charges
and dividends.
• Net profit ratio

Formula: Net Profit Ratio = (Net profit / Net sales) × 100

Example: Using same example above except that net profit is P20,000

Calculation:
Net sales = (260,000 – 10,000) = 250,000
Net Profit Ratio = [( 20,000 / 250,000) × 100] = 8%

Significance:

This ratio measures the overall profitability and very useful to proprietors or owners of the company.
This ratio also indicates the firm's capacity to face adverse economic conditions such as price
competition, low demand, and similar situations. The higher the ratio the better is the profitability.
• Operating ratio

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Formula : Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100

Example:
Cost of goods sold is P90,000 and other operating expenses are P15,000 and net sales is P150,000.

Calculation:

Operating ratio = [( 90,000 + 15,000) / 150,000] × 100 = [115,000 / 150,000] × 100 = 70%

Significance:

Operating ratio shows the operational efficiency of the business. Lower operating ratio shows higher
operating profit and vice versa. An operating ratio ranging between 75% and 80% is generally
considered as standard for manufacturing concerns. This ratio is considered to be a yardstick of operating
efficiency but it should be used cautiously because it may be affected by a number of uncontrollable
factors beyond the control of the firm.

• Return on shareholders investment or net worth

Formula:
Return on share holder's investment = [ Net profit (after interest and tax) / Share holder's fund ] × 100

Example:

Suppose net income in an organization is P 30,000 where as shareholder's investments or funds are
P200,000.

Calculation : Return on share holders investment = ( 30,000 / 200,000) × 100 = 15%

This means that the return on shareholders funds is 15 centavos per peso.

Significance:

This ratio is one of the most important ratios used for measuring the overall efficiency of a firm. This ratio
is of great importance to the present and prospective shareholders as well as the management of the
company . The ratio reveals how well the resources of the firm are being used and the higher the ratio,
the better are the results.
• Return on equity capital

Formula of return on equity capital ratio is:

Return on Equity Capital = (Net profit after tax − Preference dividend) / Equity share capital] × 100

Example:

Equity share capital (P 50): P 500,000; 9% Preference share capital: P250,000; Taxation rate: 35% of
net profit; Net profit before tax: P200,000.

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Calculation:
Return on Equity Capital (ROEC) ratio = [(200,000 − 70,000 − 22,500) / 500,000 )× 100] = 21 %

Significance:

This ratio is more meaningful to the equity shareholders who are interested to know profits earned by the
company and those profits which can be made available to pay dividends to them. The ratio is similar to
the interpretation of return on shareholder's investments and the higher the ratio , the better it is.
• Dividend yield ratio

Formula : Dividend Yield Ratio = Dividend Per Share / Market Value Per Share

Example:

If a company declares dividend at 10% on its shares, each having a paid up value of P4.00 and market
value of P12.50.

Calculation:

Dividend Per Share = ( 10 ( % on shares ) / 100 ) × 4 = P 0.40

Dividend Yield Ratio = ( P 0.40 / 12.50 ) × 100 = 3 %

Significance of the Ratio:

This ratio helps as intending investor is knowing the effective return he is going to get on the proposed
investment. Once again , the higher the ratio , the better .
• Dividend payout ratio

Formula : Dividend Payout Ratio = Dividend per Equity Share / Earnings per Share

A complementary of this ratio is retained earnings ratio. Retained Earning Ratio = Retained Earning Per
Equity Share / Earning Per Equity Share

Example:
Net Profit 5,000 No. of equity shares 1,500
Provision for taxation 2,500 Dividend per equity share P 0.25
Preference dividend 1,000

Payout Ratio = (P0.25 / P1) × 100 = 25 %

Retained Earnings Ratio = (P0.75 / P1) × 100 = 75 %

Significance of the Ratio:

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The payout ratio and the retained earning ratio are the indicators of the amount of earnings that have
been ploughed back in the business. A lower payout ratio or higher retained earnings ratio means a
stronger financial position of the company.
• Earnings Per Share (EPS) Ratio

Formula : Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) / No. of equity
shares (common shares)

Example:

Equity share capital ( P100 ): P1,000,000; 9% Preference share capital: P500,000; Taxation rate: 35% of
net profit; Net profit before tax: P400,000.

Calculation:
EPS = ( P400,000- 100,000 – 45,000 ) / ( P1,000,000 /100 ) = P255,000 / 10,000 = P 25.50 per
share.

Significance:

The earnings per share is a good measure of profitability and when compared with EPS of similar
companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio
calculated for a number of years indicates whether or not the earning power of the company has
increased.
• Price earning ratio

Formula: Price Earnings Ratio = Market price per equity share / Earnings per share

Example:
The market price of a share is P 15 and earning per share is P3.

Calculation:

Price earnings ratio = P15 / P 3 = P 5

The market value of every one peso earned is five times or P 5.

Significance of Price Earning Ratio:

Price earnings ratio helps the investor in deciding whether to buy or not to buy the shares of a particular
company at a particular market price. Generally, higher the price earning ratio the better it is. If the P/E
ratio falls, the management should look into the causes that have resulted into the fall of this ratio.

2. Liquidity Ratios

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Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are calculated
to comment upon the short term paying capacity of a concern or the firm's ability to meet its current
obligations. Following are the most important liquidity ratios.
• Current ratio

Formula: Current Ratio = Current Assets / Current Liabilities

Example:
Current assets are P 600,000 and total current liabilities are P300,000.

Calculation:

Current Ratio = P 600,000 / P 300,000 = 2 : 1

Significance:

This ratio is a general and quick measure of liquidity of a firm. It is an index of the firms financial
stability, technical solvency and strength of working capital. A high current ratio is an indication that
the firm is liquid and has the ability to pay its current obligations in time and when they become due. A
ratio equal to or near 2 : 1 is considered as a standard or normal or satisfactory. The idea of having
double the current assets as compared to current liabilities is to provide for the delays and losses in the
realization of current assets.
• Liquid / Acid test / Quick ratio

Formula : [Liquid Ratio = Liquid Assets / Current Liabilities]

Example:

Cash P90; Accounts Receivable P 730 ; Inventory P900 ; Marketable Securities P800
Accounts Payable P350 ; Notes Payable P 500 ; Accrued Expenses P75 ; Tax payable P 550.

Liquid Assets = P 90 + P730 + P 800 = P 1,620

Current Liabilities = P350 + P500 + P75 + P550 = P1,475

Liquid Ratio = P 1,620 / 1,475 = 1.10 : 1

Significance:

The quick ratio/acid test ratio measures the firm's capacity to pay off current obligations immediately and
is more rigorous test of liquidity than the current ratio. It is more rigorous test of liquidity than the
current ratio because it eliminates inventories and prepaid expenses as a part of current assets. Usually a
high liquid ratios an indication that the firm is liquid and has the ability to meet its current or liquid
liabilities in time and on the other hand a low liquidity ratio represents that the firm's liquidity position is
not good. As a convention, generally, a quick ratio of "one to one" (1:1) is considered to be satisfactory.

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3. Activity Ratios

Activity ratios are calculated to measure the efficiency with which the resources of a firm have been
employed. These ratios are also called turnover ratios because they indicate the speed with which assets
are being turned over into sales. Following are the most important activity ratios:
• Inventory turnover ratio

Formula of Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory

Example:
The cost of goods sold is P 300,000. The beginning inventory is P50,000 and the ending inventory is
P90,000 .

Calculation:

Inventory Turnover Ratio (ITR) = P 300,000 / {( 50,000 + 90,000) / 2 } = 4.29 times

This means that an average one peso invested in inventory will turn into 4.29 times in sales

Significance :

Inventory turnover ratio measures the velocity of conversion of inventory into sales. A low inventory
turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-
investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of
obsolete and slow moving goods and low profits as compared to total investment.
• Debtors / Receivables turnover ratio

Formula of Debtors Turnover Ratio: Net Credit Sales / Average Trade Receivables

Example:
Credit sales P250,000; Sales Returns P 10,000; Trade Receivables , beginning P 35,000 and Trade
Receivables , ending , P55,000

Calculation:

Receivable Turnover = { P250,000 -10,000 } / [{ P35,000 + P55,000 } /2]

= P 240,000 / 45,000 = 5.33 times

Significance of the Ratio:

Accounts receivable turnover ratio or debtors turnover ratio indicates the number of times the debtors
are turned over a year. The higher the value of debtors turnover the more efficient is the management of
debtors or more liquid the debtors are
• Average collection period

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Formula of Average Collection Period: 360 days / Receivable Turnover

Example:
Using the example in receivable turnover which gives a result of 5.33 times .

Calculation: 360 days / 5.33 times = 67.5 days or 68 days

Significance of the Ratio:

This ratio measures the quality of debtors. A short collection period implies prompt payment by debtors.
It reduces the chances of bad debts. Similarly, a longer collection period implies too liberal and inefficient
credit collection performance. It is difficult to provide a standard collection period of debtors.
• Creditors / Payable turnover ratio
Formula:
Creditors / Payable Turnover Ratio = Net Credit Purchase / Average Trade Creditors

Average Payment Period:

Average payment period ratio gives the average credit period enjoyed from the creditors. It can be
calculated using the following formula:
Average Payment Period = 360 days / Payable Turnover ratio

Example :
Purchases P 450,000 , Purchase Returns P 35,000 , Accounts Payable beginning P 65,000 and
Accounts Payable ending P 85,000

Calculation :

Payable Turnover Ratio = { P450,000 – P 35,000 } / [ { P65,000 + P85,000 } /2 ]

= P 415,000 / P 75,000 = 5.53 times
Average Payment Period = 360 days / 5.53 times = 65 days

Significance of the Ratio:

The average payment period ratio represents the number of days by the firm to pay its creditors. A high
creditors turnover ratio or a lower credit period ratio signifies that the creditors are being paid promptly.
This situation enhances the credit worthiness of the company. However a very favorable ratio to this
effect also shows that the business is not taking the full advantage of credit facilities allowed by the
creditors.
• Working capital turnover ratio

Formula of Working Capital Turnover Ratio:

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

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Example:
Cash 5,000
Accounts Receivables 2,000
Notes Receivables 15,000
Inventory 10,000
Accounts Payable 25,000
Cost of sales 125,000

Calculation:

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

Current Assets = P 25,000 + P2,000 + P 45,000 + P10,000 = P 82,000
Current Liabilities = P 45,000
Net Working Capital = Current assets – Current liabilities = P 82,000 − P45,000 = P 37,000
Working Capital Turnover Ratio = 165,000 / 37,000 = 4.46 times

Significance:

The working capital turnover ratio measure the efficiency with which the working capital is being used by
a firm. A high ratio indicates efficient utilization of working capital and a low ratio indicates otherwise. But
a very high working capital turnover ratio may also mean lack of sufficient working capital which is not a
good situation.

• Fixed assets turnover ratio

Formula : Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Assets

Example : Land P 1,200,000 ; Building ( net ) P 550,000 ; Equipment (net ) P 350,000 ; Cost of Sales
P 365,000

Calculation: {P1,200,000 + P550,000 + P350,000} / P365,000 = P2,100,000 / P365,000 = 5.75 times

Significance :

Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio measures the efficiency
and profit earning capacity of the concern. The higher the ratio, the greater is the intensive utilization of
fixed assets. Lower ratio means under-utilization of fixed assets.

4. Long Term Solvency or Leverage Ratios

Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment
schedules of its long term obligations. Following are some of the most important long term solvency or
leverage ratios.
• Debt-to-equity ratio

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Formula of Debt to Equity Ratio: Total Liabilities / Total Shareholders Equity

Example:
From the following figures calculate debt to equity ratio:
Equity share capital 750,000
Capital reserve 250,000
Retained Earnings 100,000
Bonds Payable 300,000
Mortgage Payable 120,000
Accounts Payable 200,000

Calculation:

Total Liabilities = P 300,000 + P 120,000 + 200,000 = P 620,000

Shareholders Equity = P 750,000 + P 250,000 + P 100,000 = P 1,100,000
P 620,000 / P 1,100,000 = .56 : 1

Significance of Debt to Equity Ratio:

Debt to equity ratio indicates the proportionate claims of owners and the outsiders against the firms
assets. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm.
The owners want to do the business with maximum of outsider's funds in order to take lesser risk of their
investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders.
A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot be rule of thumb or
standard norm for all types of businesses. Theoretically if the owners interests are greater than that of
creditors, the financial position is highly solvent.
• Proprietary or Equity ratio
Formula : Proprietary or Equity Ratio = Shareholders Equity / Total Assets

Example:
Let us use the example above , except that the total assets is P 2,500,000.

Calculation:

Proprietary or Equity Ratio = P 1,100,000 / P 2,500,000 = .44 : 1

Significance:

This ratio throws light on the general financial strength of the company. The higher the ratio or the share
of shareholders in the total capital of the company, better is the long-term solvency position of the
company. A low proprietary ratio will include greater risk to the creditors.

This ratio may be further analyzed into the following two ratios:
1. Ratio of fixed assets to shareholders/proprietors' funds

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Formula:

Fixed Assets to Proprietors Fund = Fixed Assets / Proprietors Fund

The fixed assets are considered at their book value and the proprietor's funds consist of the same items
as internal equities in the case of debt equity ratio.

Example:

Suppose the depreciated book value of fixed assets is P 18,000 and proprietor's funds are 24,000 the
relevant ratio would be calculated as follows:
Fixed assets to proprietor's fund = 18,000 / 24,000 = 0.75 or 0.75 : 1

Significance:

The ratio of fixed assets to net worth indicates the extent to which shareholder's funds are sunk into the
fixed assets. Generally, the purchase of fixed assets should be financed by shareholder's equity including
reserves, surpluses and retained earnings. If the ratio is less than 100%, it implies that owners funds are
more than fixed assets and a part of the working capital is provide by the shareholders. When the ratio is
more than the 100%, it implies that owners funds are not sufficient to finance the fixed assets and the
firm has to depend upon outsiders to finance the fixed assets.

2. Ratio of current assets to shareholders/proprietors' funds

Formula:
Current Assets to Proprietors Funds = Current Assets / Proprietor's Funds

Example:
This may be expressed either as a percentage , or as a proportion. To illustrate, if the value of current
assets is P13,000 and the proprietors funds are P90,000 the relevant ratio would be calculated as follows:
Current Assets to Proprietors Funds = P13,000 / P90,000 = .14 or 14%

Significance:
Different industries have different norms and therefore, this ratio should be studied carefully taking the
history of industrial concern into consideration before relying too much on this ratio.

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Chapter IV Time Value of Money

Overview - Time Value of Money Concepts

Future Value of Money
Present Value of Money
Risk and Return Concept

Learning Outcomes

At the end of the chapter, the learners must be able to,

a) describe the concept of the time value of money

b) compute and calculate the future and present value of money
c) discuss the concept of risk and return

Overview on Time Value of Money (TVM)

Time value of money is the concept that the value of a peso to be received in future is less than the
value of a peso on hand today. One reason is that money received today can be invested thus generating
more money. Another reason is that when a person opts to receive a sum of money in future rather than
today, he is effectively lending the money and there are risks involved in lending such as default risk and
inflation.

Time value of money principle also applies when comparing the worth of money to be received in future
and the worth of money to be received in further future. In other words, TVM principle says that the
value of given sum of money to be received on a particular date is more than same sum of money to be
received on a later date.

Few of the basic terms used in time value of money calculations are:

Present Value

When a future payment or series of payments are discounted at the given rate of interest up to the
present date to reflect the time value of money, the resulting value is called present value.

Future Value

Future value is amount that is obtained by enhancing the value of a present payment or a series of
payments at the given rate of interest to reflect the time value of money.

Interest

Interest is charge against use of money paid by the borrower to the lender in addition to the actual
money lent.

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Interest is the cost of borrowing money, where the borrower pays a fee to the owner for using the
owner's money. The interest is typically expressed as a percentage and can be either simple or
compounded. Simple interest is only based on the principal amount of a loan, while compound interest is
based on the principal amount and the accumulated interest.

For example, a student obtains a simple interest loan to pay one year of her college tuition, which costs
P18,000, and the annual interest rate on her loan is 6%. She repaid her loan over three years and the
amount of simple interest she paid was P3,240, or P18,000*0.06*3. The total amount she repaid was
P21,240, or P18,000+ P3,240.

Conversely, compound interest, is calculated by multiplying the principal amount by one plus the annual
interest rate raised to the number of compound periods minus one. As opposed to simple interest,
compound interest accrues on the principal amount and the accumulated interest of previous periods.

For example, suppose another student obtains a compound interest loan to pay one year of his college
tuition, which costs P20,000, and the annual interest rate on his loan is 8%. Unlike the simple interest,
the compound interest accrues on both the principal and the accumulated interest. He repaid his loan
over four years and the amount of compound interest he paid was P7,209.77, or P20,000*((1+0.08)^4 -
1) and the total amount he repaid was P27,209.77, or P20,000+ P7,209.77.

For example,P4000 is deposited into a bank account and the annual interest rate is 8%.

How much is the interest after 4 years?

Use the following simple interest formula:

I = p× r × t

where p is the principal or money deposited

r is the rate of interest

t is time

We get:

I = p× r × t

I = 4000× 8% × 4

I = 4000× 0.08 × 4

I = P 1280

However, coumpound interest is the interest earned not only on the original principal, but also on all
interests earned previously.In other words, at the end of each year, the interest earned is added to the
original amount and the money is reinvested

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If we use compound interest for the situation above, the interest will be computed as follow:

Interest at the end of the first year:

I = 4000× 0.08 × 1

I = P320

Your new principal per say is now 4000 + 320 = 4320

Interest at the end of the second year:

I = 4320× 0.08 × 1

I = P 345.6

Your new principal is now 4320 + 345.6 = 4665.6

Interest at the end of the third year:

I = 4665.6× 0.08 × 1

I = P 373.25

Your new principal is now 4665.6 + 373.25 = 5038.85

Interest at the end of the fourth year:

I = 5038.848 × 0.08 × 1

I = P 403.10

Your new principal is now 5038.85 + 403.10 = 5441.95

Total interest earned = 5441.95 − 4000 = 1441.95

The difference in money between compond interest and simple interest is 1441.96 - 1280 = 161.96

As you can see, compound interest yield better result, so you make more money.

Therefore, before investing your money, you should double check with your local bank if coumpound
interest will be used.

APPLICATION OF TIME VALUE OF MONEY PRINCIPLE

There are many applications of time value of money principle. For example, we can use it to compare the
worth of cash flows occurring at different times in future, to find the present worth of a series of
payments to be received periodically in future, to find the required amount of current investment that

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must be made at a given interest rate to generate a required future cash flow, etc. Money loses its value
over a period of time and there are several reasons why money loses value over time. Most obviously,
there is inflation which reduces the buying power of money.

But quite often, the cost of receiving money in the future rather than now will be greater than just the
loss in its real value on account of inflation. The opportunity cost of not having the money right now also
includes the loss of additional income that you could have earned simply by having received the cash
earlier.

Moreover, receiving money in the future rather than now may involve some risk and uncertainty
regarding its recovery. For these reasons, future cash flows are worth less than the present cash flows.

Time Value of Money concept attempts to incorporate the above considerations into financial decisions by
facilitating an objective evaluation of cash flows from different time periods by converting them into
present value or future value equivalents. This ensures the comparison of 'like with like'.

The present or future value of cash flows are calculated using a discount rate (also known as cost of
capital, WACC and required rate of return) that is determined on the basis of several factors such as:

Higher the rate of inflation, higher the return that investors would require on
● Rate of inflation
their investment.

Higher the interest rates on deposits and debt securities, greater the loss of
● Interest Rates interest income on future cash inflows causing investors to demand a higher
return on investment.

Greater the risk associated with future cash flows of an investment, higher
● Risk Premium the rate of return required by an investors to compensate for the additional
risk.

Consider a simple example of a financial decision below that illustrates the use of time value of money.

Example

Suppose that you have earned a cash bonus for an outstanding performance at your job during the last
year. Your pleased boss gives you 2 options to choose from:

● Option A: Receive P10,000 bonus now

● Option B: Receive P10,800 bonus after one year

Further information which you may consider in your decision:

- Inflation rate is 5% per annum.
- Interest rate on bank deposits is 12% per annum.

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Which option would you choose?

Solution

Although in absolute terms Option B offer the higher amount of bonus, Option A gives you the choice of
receiving bonus one year earlier than Option B. This can be beneficial for the following reasons:

• To start with, you can buy more with P10,000 now than with P10,800 in one year's time due to
the 5% inflation.
• Secondly, if you receive the bonus now, you could invest the cash in a bank deposit and earn a
safe annual return of 12%. in contrast, you stand to lose this interest income if you choose
Option B.
• Thirdly, future is uncertain. In worst case scenario, the company you work for could become
bankrupt during the next year which would significantly reduce your chances of receiving any
bonus. The probability of this happening might be remote, but there would be a slim chance
none the less.

The above considerations must be incorporated into the decision analysis by factoring them into a
discount rate which will then be used to calculate the future values and present values as illustrated
below.

Discount Rates

As the interest rate on bank deposits is higher than the rate of inflation, we should set the discount rate
at 12% for our analysis because it represents the highest opportunity cost for receiving the bonus in one
year's time rather than today.

For this example, we may assume that the risk of not getting the bonus after one year (e.g. due to the
company becoming bankrupt) is minimal and is therefore ignored. If such a risk is considered significant,
we would have to increase the discount rate to reflect that risk.

Using the 12% discount rate, we could either calculate future value or present value of the 2 options to
assess which option is better in financial terms. Both are included here for completeness sake although
they shall lead to the same conclusion.

Future Values

The future value of Option A will be the amount of bonus plus the interest income of 12% which could be
earned for one year.

Option A

Bonus P10,000

Interest Income P 1,200 (P10,000 x 12%)

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Future Value P11,200 after 1 year (P10,000 + P1,200)

Option B

Bonus P10,800

Interest Income - *

Future Value P10,800 after 1 year

* No interest income shall accrue on P10,800 as it shall be received after one year.

Based on the future values, Option A is preferable as it has the highest future value.

Present Values

The present value of Option B will be the amount required today that shall equal to P10,800 in one year's
time after having accrued an interest income of 12%.

Option A

Bonus P10,000

Interest Income 1.0 *

Present Value P10,000 ($10,000 x 1.0)

*No need to discount as P10,000 is already stated in its present value terms.

Option B

Bonus P10,800

Interest Income 0.8928 (1 ÷ [1 + 0.12] )

Present Value P9,642* (P10,800 x 0.8928)

*The present value of P9,642 represents the amount of cash that, if invested in a bank deposit @ 12%
p.a., shall equal toP10,800 in one year. This can be confirmed as follows:

P9,642 x 1.12 ≈ P10,800

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Based on the present values, Option A is preferable as it has the highest present value.

Note

Both present and future value analysis lead to the same conclusion (i.e. Option A is preferable over
Option B). This is because both methods are a mirror image of the other.

You may wonder why the difference between the 2 future values (i.e. P400) and the 2 present values
(P358) is not the same. The difference is just a timing difference similar to that of other cash flows (i.e.
future value is calculated 1 year ahead of present value). The difference can be reconciled by calculating
either the future value of P358 (i.e. P358 x 1.12 ≈ P400) or the present value of P400 (i.e. P400 x 0.8928
≈ P358).

Using Tables to Solve Future Value Problems

Compound interest tables have been calculated by figuring out the (1+I) n values for various time periods
and interest rates ( see appendix) . You will notice that this table summarizes the factors for various
interest rates for various years. To use the table, simply go down the left-hand column to locate the
appropriate number of years. Then go out along the top row until the appropriate interest rate is located.
Note there are three pages containing interest rates 1% through 19%.

For instance, to find the future value of P100 at 5% compound interest, look up five years on the table,
then go out to 5% interest. At the intersection of these two values, a factor of 1.2763 appears.
Multiplying this factor times the beginning value of P100.00 results in P127.63, exactly what was
calculated using the Compound Interest Formula previously. Note, however, that there may be slight
differences between using the formula and tables due to rounding errors.

An example shows how simple it is to use the tables to calculate future amounts. You deposit P2000
today at 6% interest. How much will you have in 5 years?

Using Tables to Solve Future Value of Annuity Problems

An annuity is an equal, annual series of cash flows. Annuities may be equal annual deposits, equal annual
withdrawals, equal annual payments, or equal annual receipts. The key is equal, annual cash flows.

When cash flows occur at the end of the year, this makes them an ordinary annuity. If the cash flows
were at the beginning of the year, they would be an annuity due. Annuities due will be covered a later.

Annuities work as follows:

• Annuity = Equal Annual Series of Cash Flows.

• Assume annual deposits of P100 deposited at end of year earning 5% interest for three years.

Year 1: P100 deposited at end of year =P100

Year 2: P100 × .05 = P5.00 + P100 + P100 =P205
Year 3: P205 × .05 = P10.25 + P205 + P100=P315.25

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Again, there are tables for working with annuities ( see appendix). Basically, this table works the same
way as the previous table. Look up the appropriate number of periods, locate the appropriate interest,
take the factor found and multiply it by the amount of the annuity.

For instance, on the three-year, 5% interest annuity of P100 per year. Going down three years, out to
5%, the factor of 3.152 is found. Multiply that by the annuity of P100 yields a future value of P315.20.

Another example of calculating the future value of an annuity is illustrated. You deposit P300 each year
for 15 years at 6%. How much will you have at the end of that time?

Using Tables to Solve Present Value Problems

Present value is simply the reciprocal of compound interest. Another way to think of present value is to
adopt a stance out on the time line in the future and look back toward time 0 to see what was the
beginning amount.

Present Value

Present Value = P0 = Pn / (1+I)n

TVM Table 3 shows Present Value Factors. Notice that they are all less than one. Therefore, when
multiplying a future value by these factors, the future value is discounted down to present value.

The table is used in much the same way as the previously discussed time value of money tables. To find
the present value of a future amount, locate the appropriate number of years and the appropriate
interest rate, take the resulting factor and multiply it times the future value.

An example illustrates the process.

How much would you have to deposit now to have P15,000 in 8 years if interest is 7%?

Using Tables to Solve Present Value of an Annuity Problems

To find the present value of an annuity, use TVM Table 4: Present Value Of Annuity Factors. Find the
appropriate factor and multiply it times the amount of the annuity to find the present value of the
annuity.

An example illustrates the process.

Find the present value of a 4-year, P3,000 per year annuity at 6%.

Net Present Value Analysis

Any capital investment involves an initial cash outflow to pay for it, followed by cash inflows in the form
of revenue, or a decline in existing cash flows that are caused by expense reductions. We can lay out this

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information in a spreadsheet to show all expected cash flows over the useful life of an investment, and
then apply a discount rate that reduces the cash flows to what they would be worth at the present date.
This calculation is known as net present value analysis.

Net present value is the traditional approach to evaluating capital proposals, since it is based on a single
factor – cash flows – that can be used to judge any proposal arriving from anywhere in a company.

Net Present Value Example

ABC International is planning to acquire an asset that it expects will yield positive cash flows for the next
five years. Its cost of capital is 10%, which it uses as the discount rate to construct the net present value
of the project. The following table shows the calculation:

Year Cash Flow 10% Discount Factor Present Value

0 -P500,000 1.0000 -P500,000

1 +130,000 0.9091 +118,183

2 +130,000 0.8265 +107,445

3 +130,000 0.7513 +97,669

4 +130,000 0.6830 +88,790

5 +130,000 0.6209 +80,717

Net Present Value -$7,196

The net present value of the proposed project is negative at the 10% discount rate, so ABC should not
invest in the project.

The Discount Rate

In the “10% Discount Factor” column, the factor becomes smaller for periods further in the future,
because the discounted value of cash flows are reduced as they progress further from the present day.
The discount factor is widely available in textbooks, or can be derived from the following formula:

Future cash flow

Present value of a = -------------------------------------------------------------------
future cash flow (1 + Discount rate)squared by the number of periods of
discounting

To use the formula for an example, if we forecast the receipt of $100,000 in one year, and are using a
discount rate of 10 percent, then the calculation is:

Present P100,000

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value = -----------
(1+.10)1

Present value = $90,909

Contents of a Net Present Value Analysis

A net present value calculation that truly reflects the reality of cash flows will likely be more complex than
the one shown in the preceding example. It is best to break down the analysis into a number of sub-
categories, so that you can see exactly when cash flows are occurring and with what activities they are
associated. Here are the more common contents of a net present value analysis:

• Asset purchases. All of the expenditures associated with the purchase, delivery, installation, and
testing of the asset being purchased.
• Asset-linked expenses. Any ongoing expenses, such as warranty agreements, property taxes, and
maintenance, that are associated with the asset.
• Contribution margin. Any incremental cash flows resulting from sales that can be attributed to
the project.
• Depreciation effect. The asset will be depreciated, and this depreciation shelters a portion of any
net income from income taxes, so note the income tax reduction caused by depreciation.
• Expense reductions. Any incremental expense reductions caused by the project, such as
automation that eliminates direct labor hours.
• Tax credits. If an asset purchase triggers a tax credit (such as for a purchase of energy-reduction
equipment), then note the credit.
• Taxes. Any income tax payments associated with net income expected to be derived from the
asset.
• Working capital changes. Any net changes in inventory, accounts receivable, or accounts payable
associated with the asset. Also, when the asset is eventually sold off, this may trigger a reversal
of the initial working capital changes.

By itemizing the preceding factors in a net present value analysis, you can more easily review and revise
individual line items.

Cautions when using Net Present Value

Net present value does not consider the presence of a constraint in the system of generating cash flow,
which could restrict the total amount of cash actually generated. The result can be an estimated net
present value that cannot be realized.

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A positive net present value means a better return, and a negative net present value means a worse
return, than the return from zero net present value. It is one of the two discounted cash flow techniques
(the other is internal rate of return) used in comparative appraisal of investment proposals where the
flow of income varies over time.

Definition of 'Risk Return Trade Off'

Higher risk is associated with greater probability of higher return and lower risk with a greater probability
of smaller return. This trade off which an investor faces between risk and return while considering
investment decisions is called the risk return trade off.

For example, Rohan faces a risk return trade off while making his decision to invest. If he deposits all his
money in a saving bank account, he will earn a low return i.e. the interest rate paid by the bank, but all
his money will be insured up to an amount of P 1 MILLION PESO.

However, if he invests in equities, he faces the risk of losing a major part of his capital along with a
chance to get a much higher return than compared to a saving deposit in a bank.The world of investing
can be a cold, chaotic, and confusing place.

The Risk Return trade-off

Deciding what amount of risk you can take while remaining comfortable with your investments is very
important.

In the investing world, the dictionary definition of risk is the chance that an investment's actual return will
be different than expected. Technically, this is measured in statistics by standard deviation. Practically,
risk means you have the possibility of losing some or even all of your original investment.

Low risks are associated with low potential returns. High risks are associated with high potential returns.
The risk return trade-off is an effort to achieve a balance between the desire for the lowest possible risk
and the highest possible return. The risk return trade-off theory is aptly demonstrated graphically in the
chart below. A higher standard deviation means a higher risk and therefore a higher possible return.

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A common misconception is that higher risk equals greater return. The risk return trade-off tells us that
the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means
higher potential returns, it also means higher potential losses.

On the lower end of the risk scale is a measure called the risk-free rate of return. It is represented by the
return on 10 year Government Securities because their chance of default (i.e. not being able to repay
principal and interest) is next to nothing. This risk free rate is used as a reference for equity markets
whereas the overnight repo rate is used as a reference for debt markets. If the risk-free rate is currently
6 per cent, this means, with virtually no risk, we can earn 6 per cent per year on our money.

The common question arises: who wants 6 per cent when index funds average 13 per cent per year over
the long run (last five years)? The answer to this is that even the entire market (represented by the index
fund) carries risk. The return on index funds is not 13 per cent every year, but rather -5 per cent one
year, 25 per cent the next year, and so on. An investor still faces substantially greater risk and volatility
to get an overall return that is higher than a predictable government security. We call this additional
return, the risk premium, which in this case is 7 per cent (13 per cent - 6 per cent).

How do you know what risk level is most appropriate for you? This isn't an easy question to answer. Risk
tolerance differs from person to person. It depends on goals, income, personal situation, etc. Hence, an
individual investor needs to arrive at his own individual risk return trade-off based on his investment
objectives, his life-stage and his risk appetite.

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V. Bonds and Stocks Valuation

Concepts of Bonds
Concepts of Stocks
Valuation Method for Bond and Stocks

Learning Outcomes:

At the end of the chapter, the learners must be able to:

a) explain the meaning of bonds and stocks

b) identify the difference between bonds and stocks
c) discuss proper valuation for bonds and stocks
d) recognize the importance of bonds and stocks in financial management
e) solve problems related to bonds and stocks valuation

Concepts of Bonds

Bonds, defined

Most people would always asked what really is the meaning of bonds? How bonds become a source of
financing ? Simply stated, bonds are a source of financing in the form of dent or borrowing. When a
business issues a bond, the money received is then considered a loan and needs to be paid over a period
of time. Like any other form of financial borrowing or debts, bonds would entail periodic interest to be
paid to the lenders.

Bonds are commonly issued by the government and corporations commonly in order to raise needed
funds or capital. The government would require funds in order to finance the building of various
infrastructure projects such as roads, schools, dams and many more. On the other hand, corporations
would use bonds to expand their business or raise capital to undertake profitable projects. Large
companies and even the government would require huge amount of money that financial institutions like
the bank would not be able to provide. Given this situation, issuance of bonds seems to be a viable
solution since it would allow individual investors to assume the role of lender and lend a portion of the
capital needed. Thus, bonds are financial funds derived from the general public in order for both the
governments and companies to raise capital and as such considered to be a form of debt financing.

Bonds becomes an attractive source of rising funds since the issuer of a bond ( normally government or
large companies) need to pay the investor ( general public) for the use of their money and interest will
be paid at a predetermined rate and schedule. Maturity date refers to the time the issuer must pay the
amount borrowed. The interest rate to be paid is known as the bond’s yield or coupon.

For example, an individual investor bought a government or corporate bond with a face value of P1,000,
with an interest rate (coupon) of 5% to be paid annually and will have a maturity date of 10 years. Given
the data , the investor will receive P50 (P1,000 x 0.05) of interest per year for the next 10 years. When
the matures after 10 years, the investor will receive the P1,000 investment.

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In the example given, the bond has a fixed interest rate of 5% for 10 year period. More often, bond
would have a variable interest rate which could come from existing interest rates in the capital market or
thru the Bangko Sentral ng Pilipinas (BSP).

Advantages and Disadvantages of Bonds

Bonds becomes an attractive source of financing because of the following advantages:

➢ Investor will receive regular income through the interest earned from the bonds over a period of
time
➢ Full amount of investment will be received by the investor on the maturity date of the bond
➢ Profit can be generated from the bonds if it can be sold on a higher price compared to the
amount when it was bought.

However certain precautions need to be exercised as investing in bond also have some disadvantages
such as:

➢ Since bond investment normally covers along period of time like 5 or 10 years, the interest
received might not be even enough to cover inflation, thus instead of gaining profit it might even
result to a loss.
➢ The risk of companies not being able to return the money to investors. This could happen if the
money borrowed is not put into profitable projects.

Any bond investor must consult an experienced fund manager to choose or pick the best selection of
bonds.

Effect of Bonds in the Economy

At the time of recession or when the economic conditions decline, the government may opt to issue
bonds in order to generate enough funds for its projects. A bond investment during this period might be
attractive as the government may offer better interest rates to attract the general public or individual
investor to buy the bonds.

On another side, if the stock market is on a decline stage, corporation will use or sell bonds in order to
attract investors and raise the needed funds to sustain business operations. Investors will not be
attracted to bonds if the stock market or investment offer better rates and return.

As such, bonds affects the economy thru the determination of the interest rate. Investors will always
compare the return from investment against possible risk. Specificcaly, lower interest rates on bonds
would mean lower costs for things to buy on credit such as car loans or company expansion. Bonds also
affect stocks attractiveness when the interest rates rise.

Concepts of Stocks

Stocks, defined

Corporation would normally raise funds by selling stocks? But what do we really mean by stocks and how
it becomes a source of financing or raising corporate capital requirement? Acquisition or buying stocks
from a corporate entity would allow an investor to own a part of the business firm. Corporation would sell

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control of the company in the form of stocks to investors or stockholders to raise or acquire funds to
sustain or expand business operations.

Most commonly known types of stocks are common and preferred. Common or ordinary stocks give the
owner to exercise voting rights in corporate decisions while preferred stockholders doesn't. However,
preferred shareholders are legally entitled to receive a certain level of dividend payments before any
dividends can be issued to other shareholders. A convertible preferred stock refers to a type of stock that
has option to be converted into a fixed number of common shares, usually any time after a
predetermined date.

Stock prices are dictated based on earnings generated by the company. If the business profit are high or
is inclined to rise in the future, companies will raise stock price. Stockholders gain from their stock
investment is when they buy a stock on a low price and later can sell it on higher price. If the business
firm do not perform well and the stocks value decreases, then the stockholders might lose part or even
all of their investment when they sell.

Stockholders are also given a share in the company’s profit in the form of dividends. This is done to
reward stockholders for their investment.

Advantages and Disadvantages of Stocks

One may wonder on what are the disadvantages in investing in stocks and among them are:

➢ Contributes to economic growth- When company performance results to profit, it

affect the growth of the economy. In the same way that if the economy grows, it
generates enough purchasing power which allows people to have enough money to
spend and thus results to businesses to grow and generate profits.
➢ Beats inflation- Dividends received from stocks ranges from 10%-12% which are
normally higher to an average inflation rate that range s between 3%-5%.
➢ Accessibility - Stocks can be bought in capital markets through a broker, a financial
planner, or online.
➢ Return on Investment – Investors would normally buy stocks when the prices are low
and later sell them when the prices are high. Thus, aside from the dividends received frm
stocks, they can also generate profit when investors resell them at the most appropriate
time.
➢ Liquidity and conversion to cash – Stocks maybe sold at any given time as it does
not carry a maturity date.

But an investor may also consider some disadvantages of owning stocks.

➢ Investment Risk – When a company performed poorly, stock price will decrease and
thus investor is at risk of losing on the investment made.
➢ Priority for payment - When the company goes bankrupt, stockholders will received
payment only after all third party creditors had been paid.

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 ➢ Time requirement - Time is needed to do research, read financial statements and
annual reports, follow company's developments in the news and monitor the stock
market in order to arrive to a decision on which company to buy stocks.
➢ Stock prices volatility - Depending on the individual intention , this could result to
some emotional high since stocks prices has a tendency to go high or low.
➢ You compete against professionals. Institutional investors and traders have more
time and knowledge to invest. Find out how to gain an advantage as an individual
investor.

Thus, it always a wise and prudent decision to consult a professional stock market expert before deciding
to put investment in stocks.

Valuation of Bonds and Stock

Bond valuation is a process to calculate the theoretical fair value of a particular bond. Bond valuation
would involve calculation of the present value of the bond's future interest payments and the bond
value when it reaches the maturity period which is also known as par or face value. Bond valuation is
needed in order to determine the rate of return and make a decision if bond investment would be
advisable.

A bond’s price equals the present value of its expected future cash flows. The rate of interest used to
discount the bond’s cash flows is known as the yield to maturity (YTM.)

a) Pricing Coupon Bonds – The formula to determine the price of a coupon bearing bond is as follows:

The component of the formula are :

C = the periodic coupon payment

y = the yield to maturity (YTM)

F = the bond’s par or face value

t = time

T = the number of periods until the bond’s maturity date

The above formula calculates that the price of the bond is the present value of its future cash flows.To
illustrate, let us take a bond with a face value of P1,000, a interest rate of 4% and will mature in 4 years
and will have an annual coupon payments. Determine the bond price based on (a) 4% yield to maturity
(b) 5% yield to maturity (c) 3% yield to maturity ?

Using the given formula, the calculation would be as follows:

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C= P1,000 x 4% = P40

a) 4% yield to maturity

P = 40 + 40 + 40 + 1040
(1.04)1 (1.04)2 (1.04)3 (1.04)4

P = 38.46 + 36.98 + 35.56 + 889 = P1,000

The results show an important relationship that if y (yield to maturity rate ) equals the coupon rate, then
the bond price will be equal to the face value. In the above example the yield to maturity and coupon
rate is both at 4%, therefore, the bond price and face value should be equal to P1,000.

b) 5% yield to maturity

P = 40 + 40 + 40 + 1040
(1.05)1 (1.05)2 (1.05)3 (1.05)4

P = 38.10 + 36.28 + 34.55 + 855.61 = P 964.54

The results show an important relationship that if y (yield to maturity rate ) is greater than the coupon
rate, then the bond price will be less than the face value. In the above example the yield to maturity is
5% and coupon rate is at 4%, therefore, the bond price will be less which is at P964.54 and face value
should be equal to P1,000.

c) 3% yield to maturity

P = 40 + 40 + 40 + 1040
(1.03)1 (1.03)2 (1.03)3 (1.03)4

P = 38.83 + 37.70 + 36.61 + 924.03 = P1,037.17

The results show an important relationship that if y (yield to maturity rate ) is less than the coupon rate,
then the bond price will be greater than the face value. In the above example the yield to maturity is 3%
and coupon rate is at 4%, therefore, the bond price will be at P1037.17 and face value should be equal
to P1,000.

Based in the foregoing example, it can also be concluded that the yield to maturity rate is low, the bond
price will be high showing an inverse relationship between the two.

b) Semi-Annual Coupon Bond Pricing - For a bond that makes semi-annual coupon payments, the
following adjustments must be made to the pricing formula:

• the coupon payment is cut in half

• the yield is cut in half
• the number of periods is doubled

As an example, suppose that a bond has a face value of P1,000, a coupon rate of 8% and a maturity of
two years. The bond makes semi-annual coupon payments, and the yield to maturity is 6%. The semi-
annual coupon is P40, the semi-annual yield is 3%, and the number of semi-annual periods is four. The
bond’s price is determined as follows:

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C= P1000 x 8% = P80

Semi annual = P80 / 2 = P40

P = 40 + 40 + 40 + 1040
(1.03)1 (1.03)2 (1.03)3 (1.03)4

P = 38.83 + 37.70 + 36.61 + 924.03 = P1,037.17

c) Pricing Zero Coupon Bonds

A zero-coupon bond does not make any coupon payments; instead, it is sold to investors at a discount
from face value. The difference between the price paid for the bond and the face value, known as a
capital gain, is the return to the investor. The pricing formula for a zero coupon bond is:

As an example, suppose that a one-year zero-coupon bond is issued with a face value of P1,000. The
discount rate for this bond is 8%. What is the market price of this bond? In order to be consistent with
coupon-bearing bonds, where coupons are typically made on a semi-annual basis, the yield will be
divided by 2, and the number of periods will be multiplied by 2:

P = 1000 = P924.56
(1.04)2

Yield Measures

There are different types of yield measures that may be used to represent the approximate return to a
bond. These include:

• yield to maturity (YTM)

• yield to call (YTC)
• current yield

a) Yield to Maturity (YTM)

The discount rate used in the bond pricing formula is also known as the bond’s yield to maturity (YTM) or
yield. This equals the rate of return earned by a bond holder (known as the holding period return) if:

• the bond is held to maturity

• the coupon payments are reinvested at the yield to maturity

A bond’s YTM is the unique discount rate at which the market price of the bond equals the present value
of the bond’s cash flows:

Market Price = PV (Cash Flows)

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The yield to maturity of a bond can be determined from the bond’s market price, maturity, coupon rate
and face value. As an example, suppose that a bond has a face value of P1,000 and will mature in ten
years. The annual coupon rate is 5%; the bond makes semi-annual coupon payments. With a price of
P950, what is the bond’s yield to maturity?

It is impossible to solve for the yield to maturity algebraically; instead, this must be done using a financial
calculator or Microsoft Excel. For example, a bond’s yield to maturity can be computed in Excel using the
RATE function:

= RATE(nper, pmt, pv, [fv], [type], [guess])

where:

nper = number of periods

pmt = periodic payment

pv = present value

fv = future value

type = 0 for ordinary annuity

1 for annuity due

guess = initial guess

The variables in brackets (fv, type and guess) are optional values; the value of type is set to zero if it is
not specified. Guess can be used to provide an initial estimate of the rate, which could potentially speed
up the calculation time.

Note that either pv or fv must be negative, and the other must be positive. The negative value is
considered to be a cash outflow, and the positive value is considered to be a cash inflow.

Also note that entering semi-annual periods and coupon payments will produce a semi-annual yield; in
order to convert this into an annual yield (on a bond-equivalent basis), the semi-annual yield is doubled.

In this example,

nper = 20

pmt = P25

pv = P950

fv = P1,000

At a price of P950, the semi-annual yield to maturity is:

=RATE(nper, pmt, pv, [fv], [type], [guess])

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= RATE(20, 25, -950, 1000)

= 2.83%

The annual yield is (2.83%)(2) = 5.66%

At a price of P1000, the semi-annual yield to maturity is:

=RATE(nper, pmt, pv, [fv], [type], [guess])

= RATE(20, 25, -1000, 1000)

= 2.50%

The annual yield is (2.50%)(2) = 5.00%

At a price of P1050, the semi-annual yield to maturity is:

=RATE(nper, pmt, pv, [fv], [type], [guess])

= RATE(20, 25, -1050, 1000)

= 2.19%

The annual yield is (2.19%)(2) = 4.38%

b) Yield to Call (YTC)

For a bond that is callable, the yield to call may be used as a measure of return instead of the yield to
maturity. The process is similar to computing yield to maturity, except that the maturity date of the bond
is replaced with the next call date. This is because yield to call is based on the assumption that the bond
will be called on the next call date. The face value is replaced with the call price since this is the amount
that the investor will receive if the bond is called.

As an example, suppose that a ten-year bond was issued two years ago and is callable in three years at
a price of P1,100. The bond’s face value is P1,000 and its coupon rate is 7%. Coupons are paid on an
annual basis; the current market price of the bond is P1,200. What is the yield to call?

In this case, the bond will mature in eight years, but it can be called in three years. If the bond is called,
the investor will receive a price of P1,100 instead of the face value of P1,000. The yield to call is
computed as follows:

The yield to call is:

=RATE(nper, pmt, pv, [fv], [type], [guess])

= RATE(3, 70, -1200, 1100)

= 3.14%

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c) Current Yield

The current yield is simpler measure of the rate of return to a bond than the yield to maturity. Current
yield is measured as the ratio of the bond’s annual coupon payment to the bond’s market price.

As an example, suppose that a bond was issued with a coupon rate of 8% and a face value of P1,000.
The bond has a current market price of P900. The current yield is computed as:

P80/P900 = 8.89%

This measure has the benefit of simplicity. It suffers from the drawback that it does not account for the
time value of money.

Common Stock Valuation Models

Common stock valuation can be done either through absolute and relative valuation models. Under
absolute valuation, the focus will be on dividends, cash flow and growth rate of a single. Relative
valuation models involve calculating multiples or ratios, such as the price-to-earnings multiple, and
comparing them to the multiples of other comparable firms. The focus in this lesson will be the absolute
valuation methods since it is most commonly used by most companies.

Absolute Valuation Model

1. Dividend Discount Method (DDM)

One of the most basic absolute valuation model is the “dividend discount method” which determine the
worthiness of the business based on the dividends paid to shareholders. This model is used since
dividends represent the actual cash flows going to the shareholder, thus valuing the present value of
these cash flows should give you a value for how much the shares should be worth. Under this model,
the dividends should be actually paid. Companies that pay stable and predictable dividends are best
suited to use this type valuation method.

To illustrate, let us take the dividends and earnings of ADP company below ( in Philippine Peso):

2012 2013 2014 2015 2016 2017

Dividends Per Share 0.50 0.53 0.55 0.58 0.61 0.64

Earnings Per Share 4.00 4.20 4.41 4.63 4.86 5.11

Based on the illustration above, it can be observed that the earnings per share and dividends grows at
an average rate of 5% which implies that the firm's dividend is consistent with its earnings trend which
makes it stable and predictable. Thus, under this scenario, the company is fit to use the dividend discount
method.

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2. Discounted Cash Flow Method (DCF)

Under the discounted cash flow method, it suited for companies that doesn't pay a dividend or payment
is irregular? The DCF method uses a firm's discounted future cash flows to determine the value of the
firm.

The DCF model use the free cash flows which are forecasted for five to ten years, and then a terminal
value is calculated for all of the cash flows beyond the forecast period. The company should have a
predictable positive free cash flows to be able to use this method.

Let us illustrate this method using the given example (in Philippine Peso):

2012 2013 2014 2015 2016 2017

Operating Cash
Flow 438 789 1462 890 2565 510

Capital
Expenditures 785 995 1132 1256 2235 1546

Free Cash Flow -347 -206 330 -366 330 -1036

Based on the example, the business shows an increasing positive operating cash flow but the high capital
expenditures indicates that the firm is putting back a lot of its cash into the business to support its
operation. As such the result is negative free cash flows for four of the six years which makes it difficult
(nearly impossible) to predict future cash flows. Thus, in order to use the DCF method most effectively,
the target company should generally have stable, positive and predictable free cash flows which is shown
in the illustration below.

2012 2013 2014 2015 2016 2017

Operating Cash Flow 438 789 1462 890 2565 510
Capital Expenditures 385 715 1355 745 2365 245 3.
Free Cash Flow 53 74 107 145 200 265
Percentage of 39.62% 44.59% 35.51% 37.93 32.50%
Increase %
Average % 38.03%

There is no perfect valuation method as it changes for every situation, but it is necessary to know the
company characteristics in order to determine the valuation method that best suits the situation.

Preferred Stock Valuation

The nature of Preferred stocks is that it pays a fixed amount of dividend and this can be used to calculate
the value by discounting each of these payments to the present day. Taking all the dividend payments
and calculate the sum of the present value into perpetuity, then the value of stock can be determined.

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Let us illustrate by looking at ADP Company that pays a 25 centavos dividend every month with a
required rate of return of 6% per year. To calculate for the expected stock value of the stock,
P0.25/0.005 = P50. The discount rate of 6% was divided by 12 to get 0.005.

Where:

V = the value

D1 = the dividend next period

r = the required rate of return

Considerations

If the company earnings are not adequate, it might result to a cut off in the payment of preferred stock
dividends. This risk of a cut payment needs to be accounted for. This risk increases as the dividend
payment compared to earnings gets higher.

Preferred shares do not have the voting rights such as those given to common shares. For investors who
has large amount of shares, this seems to be valuable feature to individuals as compared to the average
investor who looks at this voting right do not have much value. This feature is needed in evaluating
preferred shares marketability.

Preferred shares possess similar characteristics with that of the bond in terms of valuation. This means
the value will also move inversely with interest rates. When the interest rate goes up, the value of the
preferred shares will go down, holding everything else constant. This is to account for other investment
opportunities and is reflected in the discount rate used.

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VI. Cost of Capital

Cost of Capital, defined

Weighted Average Cost of Capital
Cost of Borrowing
Cost of Debt
Cost of Equity

Learning Outcomes

At the end of the chapter, the learner must be able to,

a) recognize the meaning of cost of capital

b) explain and discuss the cost of borrowing, debt and equity
c) illustrate cost of capital through the use of weighted average cost of capital and capital asset pricing
models

Cost of Capital, defined

Financing activity would include borrowing money or taking loans from a financial institution. The said
sources of funds would carry some cost in order to acquire it from the lender and the said cost is known
as the “ cost of capital”. Simple stated, cost of capital is the cost incurred in order to raise needed fund
for business operations. The said cost is also referred to as financing cost (interest rate) the company
pays when securing a loan. Business firms normally define their own "cost of capital" in one of two ways:

Firstly, "Cost of capital" simply refers to the financing cost that needs to be paid when borrowing funds,
either by securing a loan or by selling bonds, or equity financing and this comes in the form of an annual
interest rate, such as 5%, or 10%. Secondly, if it refers to investment decision making, cost of capital
may be referred to as the rate of return that can be earned on such investment.

Weighted Average Cost of Capital (WACC)

WACC is the arithmetic average (mean) capital cost that weights the contribution of each capital source
by the proportion of total funding it provides. "Weighted average cost of capital" usually appears as an
annual percentage.

Calculating WACC is a matter of summing the capital cost components, multiplying each by its
appropriate weight. For example, in simplest terms:

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WACC = (Proportion of total funding that is equity funding ) x (Cost of equity)

+ (Proportion of total funding that is debt funding) x (Cost of Debt)

x (1 – Corporate tax rate)

To illustrate, a firm has determined its cost of each source of capital and optimal capital structure, which
is composed of the following sources and target market value proportions:

Source of Capital Target After Tax WACC

Market Cost (ATC) (TMP x ATC)
Proportions
(TMP)
Long term debt 40% 6% 2.40%
Preferred Stock 10% 11% 1.10%
Common Stock 50% 15% 7.50%
Totals 100% 11.00%

It will be noted based on the above illustration that WACC is simply computed by multiplying the total
market proportion to the after tax cost. Thus, the WACC for the given example is 11%.

Cost of Borrowing

Cost of borrowing refers to the total amount a debtor pays to secure a loan and use funds, including
financing costs, account maintenance, loan origination, and other loan-related expenses.

When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Cost of borrowing may include, for instance, interest payments, and (in some cases) loan origination
fees, loan account maintenance fees, borrower insurance fees, and still other fees. As an example,
consider a loan with the following properties:

Loan properties

Amount to borrow (loan

P100,000.00
principle):

Annual interest rate: 6.0%

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 Amortization time: 10 Years

Payment frequency: Monthly

Annual borrower insurance P25.00

Such a loan calls for 120 monthly payments of P1,110.21. Therefore, the borrower who makes all
payments on schedule ends up repaying a total of 120 x $1,110.21, or P133,225. The borrower will also
pay P200 for loan origination, P600 in account maintenance fees (120 x P5), and P250 in borrower
insurance. The cost of borrowing, therefore, calculates as:

Cost of borrowing calculation

Total repayments: P133,225.20.00

Less principal repaid: (100,000.00)

Total interest payments:: 33,225.20

Loan origination fee: 200.00

Account maintenance: 600.00

Borrower insurance fees: 250.00

The total cost of borrowing: P34,255.20

Cost of Debt

Cost of debt is the overall average rate an organization pays on all its obligations. These typically
consist of bonds and bank loans. "Cost of debt" usually appears as an annual percentage.

For a company with a marginal income tax rate of 30% and a before-tax cost of debt of 6%, the after-tax
cost of debt is as follows:

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 After-tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate)
= (0.06) x (1.00 – 0.30)
= (0.06) x (0.70)
= 0.042 or 4.20%

As with "cost of capital," "cost of debt" tends to be higher for companies with lower credit ratings—
companies that the bond market considers riskier or more speculative. Whereas "cost of capital" is the
rate the company must pay now to raise more funds, cost of debt is the cost the company is paying to
carry all debt it has acquired.

Cost of debt becomes a concern for stockholders, bondholders, and potential investors for "high-
leverage" companies (i.e., companies where debt financing is large relative to owners equity). High
leverage is riskier and less profitable in a weak economy when the company's ability to service a massive
debt load may be questionable.

The cost of debt may also weigh in management decisions regarding asset acquisitions or other
investments bought with borrowed funds. The additional cost of debt in such cases reduces the value of
investment tools such as return on investment (ROI) or internal rate of return (IRR).

Cost of Equity

Cost of equity COE is part of a company's "capital structure." COE measures the returns demanded
by stock market investors who will bear the risks of ownership. COE usually appears as an annual
percentage.

One approach to calculating Cost of equity refers to equity appreciation and dividend growth.

Cost of equity = (Next year's dividend per share + Equity appreciation per share)
(Current market value of stock) + Dividend growth

For example, consider a stock whose current market value is P8.00, paying an annual dividend of P0.20
per share. If those conditions held for the next year, the investor's return would be simply 0.20 / 8.00, or
2.5%. When the investor requires a return of, say 5%, one or two terms of the above equation must
change:

• If the stock price appreciates 0.20 to 8.20, the investor would experience a 5% return:(0.20
dividend + 0.20 stock appreciation) / (8.00 current value of stock).
• When, instead, the company doubles the dividend (dividend growth) to 0.40, while the stock
price remains at 8.00, the investor also experiences a 5% return.

Calculating Cost of Equity From the Capital Asset Pricing Model (CAPM)

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Cost of equity = (Market risk premium) x ( Equity beta) + Risk-less rate

Consider a situation where the following holds for one company's stock:

Grande Company Common shares

Market Risk Premium: 4.0%

Equity beta fort his stock: 0.60

Risk-free rate: P1,800

Using these CAPM data and the formula above, Cost of Equity is as follows:

Cost of equity = (4.0%) x (0.60) + 5.0% =7.4%

In the CAPM, beta is a measure of the stock's historical borrowing usually price changes compared to
changes in the market as a whole. A beta of 0 indicates the stock tends to rise or fall independently
from the market. A negative beta means the stock tends to rise when the market falls, and the stock
tends to fall while the market rises. A positive beta means the stock tends to rise and fall with the
market.

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VII. Capital Budgeting Techniques

Significance and Importance of Capital Budgeting

Payback Period.
Discounted Payback Period.
Accounting Rate of Return.
Net Present Value.
Internal Rate of Return.
Profitability Index

SIGNIFICANCE OF CAPITAL BUDGETING

Capital budgeting is an essential tool in financial management. Capital budgeting provides a wide scope
for financial managers to evaluate different projects in terms of their viability to be taken up for
investments and helps in exposing the risk and uncertainty of different projects. It also keeps a check on
over or under investments. The management is provided with an effective control on cost of capital
expenditure projects Ultimately the fate of a business is decided on how optimally the available resources
are used

Example of Capital Budgeting:

Capital budgeting for a small scale expansion involves three steps: recording the investment’s cost,
projecting the investment’s cash flows and comparing the projected earnings with inflation rates and the
time value of the investment.

For example, equipment that costs P15,000 and generates a P5,000 annual return would appear to "pay
back" on the investment in 3 years. However, if economists expect inflation to rise 30 percent annually,
then the estimated return value at the end of the first year (P20,000) is actually worth P15,385 when you
account for inflation (P20,000 divided by 1.3 equals P15,385). The investment generates only P385 in
real value after the first year.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term investments which involve
more financial risks. That is why proper planning through capital budgeting is needed.

2) Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper
planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are
irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses.

3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the
profitability of the company. It helps avoid over or under investments. Proper planning and analysis of
the projects helps in the long run.

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CAPITAL BUDGETING TECHNIQUES / METHODS

There are different methods adopted for capital budgeting. The traditional methods or non discount
methods include: Payback period and Accounting rate of return method. The discounted cash flow
method includes the NPV method, profitability index method and IRR.

Payback period method:

As the name suggests, this method refers to the period in which the proposal will generate cash to
recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the
project and the investment made in the project, with no consideration to time value of money. Through
this method selection of a proposal is based on the earning capacity of the project. With simple
calculations, selection or rejection of the project can be done, with results that will help gauge the risks
involved. However, as the method is based on thumb rule, it does not consider the importance of time
value of money and so the relevant dimensions of profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Example
Project A Project B
Cost 1,00,000 1,00,000
Expected future cash flow
Year 1 50,000 1,00,000
Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year

Payback period of project B is shorter than A, but project A provides higher returns. Hence,
project A is superior to B.

Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of return is
expressed as a percentage of the earnings of the investment in a particular project. It works on the
criteria that any project having ARR higher than the minimum rate established by the management will
be considered and those below the predetermined rate are rejected.

This method takes into account the entire economic life of a project providing a better means of
comparison. It also ensures compensation of expected profitability of projects through the concept of net
earnings. However, this method also ignores time value of money and doesn’t consider the length of life
of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of
shares.

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 ARR= Average income/Average Investment

Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset.
These are then discounted through a discounting factor. The discounted cash inflows and outflows are
then compared. This technique takes into account the interest factor and the return after the payback
period.

Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this technique the
cash inflow that is expected at different periods of time is discounted at a particular rate. The present
values of the cash inflow are compared to the original investment. If the difference between them is
positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and
is consistent with the objective of maximizing profits for the owners. However, understanding the concept
of cost of capital is not an easy task.

The equation for the net present value, assuming that all cash outflows are made in the initial year (tg),
will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment
proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is
assumed to be known, otherwise the net present, value cannot be known.

NPV = PVB – PVC

where,

PVB = Present value of benefits

PVC = Present value of Costs

Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The discounted cash
inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries

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to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash
inflows. However, computation of IRR is a tedious task.

It is called internal rate because it depends solely on the outlay and proceeds associated with the project
and not any rate determined outside the investment.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept

If IR < k = reject

Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash
outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to
calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

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VIII. Working Capital Management

Working Capital Management, defined

Elements of Working Capital
Types of Working Capital
Objectives of Working Capital
Working Capital Cycle
Approaches to Working Capital

What is 'Working Capital Management' ?

Working capital management is all about the company's managerial accounting strategy that aims to
monitor and utilize the two components of working capital, current assets and current liabilities, to ensure
the most financially efficient operation of the company. The primary purpose of working capital
management is to make sure the company always maintains sufficient cash flow to meet its short-term
operating costs and short-term debt obligations.

Any firm, from time to time, employs its short-term assets as well as short-term financing sources to
carry out its day to day business. This management of both current assets as well as current liabilities is
described as working capital management. Working capital is formally arrived at by subtracting the
current liabilities from current assets of a firm on the day the balance sheet is drawn up. Working capital
is also represented by a firm’s net investment in current assets necessary to support its everyday
business. Working capital frequently changes its form and is sometimes also referred to as circulating
capital. According to Gretsenberg: “circulating capital means current assets of a company that are
changed in the ordinary course of business from one form to another.”

Elements of Working Capital Management

Working capital management commonly involves monitoring cash flow, assets and liabilities through ratio
analysis of key elements of operating expenses, including the working capital ratio, collection ratio and
the inventory turnover ratio. Efficient working capital management helps with a company's smooth
financial operation, and can also help to improve the company's earnings and profitability. Management
of working capital includes management of accounts receivables, inventory and accounts payables.

The working capital ratio, calculated as current assets divided by current liabilities, is a key indicator of a
company's fundamental financial health since it indicates the company's ability to successfully meet all of
its short-term financial obligations. Although numbers vary by industry, a working capital ratio below 1.0
is generally indicative of a company having trouble meeting short-term obligations, usually due to
insufficient cash flow. Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than
2.0 may indicate a company is not making the most effective use of its assets to increase revenues.

The collection ratio, also known as the average collection period ratio, is a principal measure of how
efficiently a company manages its accounts receivables. The collection ratio is calculated as the number
of days in an accounting period, such as one month, multiplied by the average amount of outstanding
accounts receivables, with that total then divided by the total amount of net credit sales during the
accounting period. The collection ratio calculation provides the average number of days it takes a

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company to receive payment, in other words, to convert sales into cash. The lower a company's
collection ratio, the more efficient its cash flow.

The final element of working capital management is inventory management. To operate with maximum
efficiency and maintain a comfortably high level of working capital, a company has to carefully balance
sufficient inventory on hand to meet customers' needs while avoiding unnecessary inventory that ties up
working capital for a long period of time before it is converted into cash. Companies typically measure
how efficiently that balance is maintained by monitoring the inventory turnover ratio. The inventory
turnover ratio, calculated as revenues divided by inventory cost, reveals how rapidly a company's
inventory is being sold and replenished. A relatively low ratio compared to industry peers indicates
inventory levels are excessively high, while a relatively high ratio indicates the efficiency of inventory
ordering can be improved.

TYPES OF WORKING CAPITAL

Working capital, as mentioned above, can take different forms. For example, it can take the form of cash
and then change to inventories and/or receivables and back to cash.

• Gross and Net Working Capital: The total of current assets is known as gross working capital
whereas the difference between the current assets and current liabilities is known as the net
working capital.
• Permanent Working Capital: This type of working capital is the minimum amount of working
capital that must always remain invested. In all cases, some amount of cash, stock and/or
account receivables are always locked in. These assets are necessary for the firm to carry out its
day to day business. Such funds are drawn from long term sources and are necessary for running
and existence of the business.
• Variable Working Capital: Working capital requirements of a business firm might increase or
decrease from time to time due to various factors. Such variable funds are drawn from short-
term sources and are referred to as variable working capital.

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

The main objectives of working capital management are:

• Maintaining the working capital operating cycle and to ensure its smooth operation.
Maintaining the smooth operation of the operating cycle is essential for the business to function.
The operating cycle here refers to the entire life cycle of a business. From the acquisition of the
raw material to the smooth production and delivery of the end products – working capital
management strives to ensure smoothness, and it is one of the main objectives of the concept.
• Mitigating the cost of capital. Minimizing the cost of capital is another very important
objective that working capital management strives to achieve. The cost of capital is the capital
that is spent on maintaining the working capital. It needs to be ensured that the costs involved
for maintenance of healthy working capital are carefully monitored, negotiated and managed.
• Maximising the return on current asset investments. Maximising the return on current
investments is another objective of working capital management. The ROI on currently invested

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 assets should be greater than the weighted average cost of the capital so that wealth
maximization is ensured.

THE WORKING CAPITAL CYCLE

The working capital cycle refers to the minimum amount of time which is required to convert net current
assets and net current liabilities into cash. From a more simplistic viewpoint, working capital cycle is the
amount of time between the payment for goods supplied and the final receipt of cash accumulated from
the sale of the same goods. There are mainly the following elements of which the working capital cycle is
comprised of:

Cash: The cash refers to the funds available for the purchase of goods. Maintaining a healthy level of
liquidity with some buffer is always a best practice. It is extremely important to maintain a reserve fund
which can be utilized when:

• There is a shortage of cash inflow for some reason. In the absence of reserve cash, the day to
day business will get hampered.
• Some new opportunity springs up. In such a case, the absence of reserve cash will pose a
hindrance.
• In case of any contingency, absence of a reserve fund can cripple the company and poses a
threat to the solvency of the firm.

Creditors and Debtors:

• The creditors refer to the accounts payable. It refers to the amount that has to be paid to
suppliers for the purchase of goods and /or services.
• Debtors refer to the accounts receivables. It refers to the amount that is collected for providing
goods and/or services.

Inventory: Inventory refers to the stock in hand. Inventories are an integral component of working
capital and careful planning, and proper investment is necessary to maintain the inventory in a healthy
state of affairs. Management of inventory has two aspects and involves a trade-off between cost and risk
factors. Maintaining a sizable inventory has its accompanying costs that include locking of funds,
increased maintenance and documentation cost and increased cost of storage. Apart from these things,
there is also a chance of damage to the stored goods. On the other hand, maintaining a small inventory
can disrupt the business lifecycle and can have serious impacts on the delivery schedule. As a result, it is
extremely important to maintain the inventory at optimum levels which can be arrived at after careful
analysis and a bit of experimentation.

PROPERTIES OF A HEALTHY WORKING CAPITAL CYCLE

It is essential for the business to maintain a healthy working capital cycle. The following points are
necessary for the smooth functioning of the working capital cycle:

• Sourcing of raw material: Sourcing of raw material is the beginning point for most businesses.
It should be ensured that the raw materials that are necessary for producing the desired goods

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 are available at all times. In a healthy working capital cycle, production ideally should never stop
because of the shortage of raw materials.
• Production planning: Production planning is another important aspect that needs to be
addressed. It should be ensured that all the conditions that are necessary for the production to
start are met. A carefully constructed plan needs to be present in order to mitigate the risks and
avert unforeseen issues. Proper planning of production is essential for the production of goods or
services and is one of the basic principles that must be followed to achieve smooth functioning of
the entire production lifecycle.
• Selling: Selling the produced goods as soon as possible is another objective that should be
pursued with utmost urgency. Once the goods are produced and are moved into the inventory,
the focus should be on selling the goods as soon as possible.
• Payouts and collections: The accounts receivables need to be collected on time in order to
maintain the flow of cash. It is also extremely important to ensure timely payouts to the creditors
to ensure smooth functioning of the business.
• Liquidity: Maintaining the liquidity along with some room for adjustments is another important
aspect that needs to be kept in mind for the smooth functioning of the working capital cycle.

APPROACHES TO WORKING CAPITAL MANAGEMENT

The short-term interest rates are, in most cases, cheaper compared to their long-term counterparts. This
is due to the amount of premium which is higher for short term loans. As a result, financing the working
capital from long-term sources means more cost. However, the risk factor is higher in case of short term
finances. In case of short-term sources, fluctuations in refinancing rates are a major cause for concern,
and they pose a major threat to business.

There are mainly three strategies that can be employed in order to manage the working capital. Each of
these strategies takes into consideration the risk and profitability factors and has its share of pros and
cons. The three strategies are:

• The Conservative Approach: As the name suggests, the conservative strategy involves low
risk and low profitability. In this strategy, apart from the permanent working capital, the variable
working capital is also financed from the long-term sources. This means an increased cost
capital. However, it also means that the risks of interest rate fluctuations are significantly lower.
• The Aggressive Approach: The main goal of this strategy is to maximize profits while taking
higher risks. In this approach, the entire variable working capital, some parts or the entire
permanent working capital and sometimes the fixed assets are funded from short-term sources.
This results in significantly higher risks. The cost capital is significantly decreased in this approach
that maximizes the profit.
• The Moderate or the Hedging Approach: This approach involves moderate risks along with
moderate profitability. In this approach, the fixed assets and the permanent working capital are
financed from long-term sources whereas the variable working capital is sourced from the short-
terms sources.

SIGNIFICANCE OF ADEQUATE WORKING CAPITAL

Maintenance of adequate working capital is extremely important because of the following factors:

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 • Adequate working capital ensures sufficient liquidity that ensures the solvency of the
organisation.
• Working capital ensured prompt and on-time payments to the creditors of the organisation
that helps to build trust and reputation.
• Lenders base their decisions for approving loans based on the credit history of the organisation.
A good credit history can not only help an organisation to get fast approvals but also can
result in reduced interest rates.
• Earning of profits is not a sufficient guarantee that the company can pay dividends in cash.
Adequate working capital ensures that dividends are regularly paid.
• A firm maintaining adequate working capital can afford to buy raw materials and other
accessories as and when needed. This ensures an uninterrupted flow of production.
Adequate working capital, therefore, contributes to the fuller utilisation of resources of the
enterprise.

FACTORS FOR DETERMINING THE AMOUNT OF WORKING CAPITAL NEEDED

Factoring out the amount of working capital needed for running a business is an extremely important as
well as difficult task. However, it is extremely critical for any firm to estimate this figure so that it can
operate smoothly and be fully functional. There are several factors that need to be considered before
arriving at a more or less accurate figure. The following are some of those factors that determine the
amount of liquid cash and assets required for any firm to operate smoothly:

• Nature of business: A trading company requires large working capital. Industrial companies
may require lower working capital. A banking company, for example, requires the maximum
amount of working capital. Basic and key industries, public utilities, etc. require low working
capital because they have a steady demand and continuous cash-inflow to meet current
liabilities.
• Size of the business unit: The amount of working capital depends directly upon the volume of
business. The greater the size of a business unit, the larger will be the requirements of working
capital.
• Terms of purchase and terms of sale: Use of trade credit may lead to lower working capital
while cash purchases will demand larger working capital. Similarly, credit sales will require larger
working capital while cash sales will require lower working capital.
• Turnover of inventories: If inventories are large and their turnover is slow, we shall require
larger capital but if inventories are small and their turnover is quick, we shall require lower
working capital.
• Process of manufacture: Long-running and more complex process of production requires
larger working capital while simple, short period process of production requires lower working
capital.
• Importance of labour: Capital intensive industries e.g. mechanized and automated industries
generally require less working capital while labour intensive industries such as small scale and
cottage industries require larger working capital.

IMPORTANCE OF WORKING CAPITAL

Working capital is a vital part of a business and can provide the following advantages to a business:

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 • Higher Return on Capital: Firms with lower working capital will post a higher return on capital
so shareholders will benefit from a higher return for every dollar invested in the business.
• Improved Credit Profile and Solvency: The ability to meet short-term obligations is a pre-
requisite to long-term solvency and often a good indication of counterparty’s credit risk.
Adequate working capital management will allow a business to pay on time its short-term
obligations which could include raw materials, salaries, and other operating expenses.
• Higher Profitability: According to a research conducted by Tauringana and Adjapong Afrifa,
the management of account payables and receivables is an important driver of small businesses’
profitability.
• Higher Liquidity: A large amount of cash can be tied up in working capital, so a company
managing it efficiently could benefit from additional liquidity and be less dependent on external
financing. This is especially important for smaller businesses as they typically have a limited
access to external funding sources. Also, small businesses often pay their bills in cash from
earnings so an efficient working capital management will allow a business to better allocate its
resources and improve its cash management.
• Increased Business Value: Firms with more efficient working capital management will
generate more free cash flows which will result in a higher business valuation and enterprise
value.
• Favorable Financing Conditions: A firm with a good relationship with its trade partners and
paying its suppliers on time will benefit from favorable financing terms such as discount
payments from its suppliers and banking partners.
• Uninterrupted Production: A firm paying its suppliers on time will also benefit from a regular
flow of raw materials, ensuring that the production remains uninterrupted and clients receive
their goods on time.
• Ability to Face Shocks and Peak Demand: An efficient working capital management will help
a firm to survive through a crisis or ramp up production in case of an unexpectedly large order.
• Competitive Advantage – Firms with an efficient supply chain will often be able to sell their
products at a discount versus similar firms with inefficient sourcing.

CASH MANAGEMENT

Cash flow management is a term used to describe the practice of balancing income to expenses.
Companies can’t spend money they haven’t yet received, which means they need to appropriately project
when they anticipate receiving cash as part of a sales, investment or contract, and have that money in
hand for expenses as they arise. Cash doesn’t always arrive in time for bills, a problem that disrupts the
progress of many businesses.

Cash flow entails the movement of funds in and out of a business. This information should be tracked on
a weekly, monthly or quarterly basis to identify where a business is currently from a financial standpoint
and where it will be several months in the future.

Positive cash flow. This means the cash coming into your business — sales, accounts receivable, etc.—
exceeds the amount leaving through expenses, salaries and accounts payable.

Negative cash flow. This means the cash going out of your business is greater than incoming cash.

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Positive cash flow doesn’t happen at random. Companies have to work at it and manage cash effectively
to control the inflow and outflow of funding.

PROJECTING CASH FLOW

Knowing when you’ll receive and need to spend money is part of the budget process. The budget
process, ultimately developed to help anticipate and create strategies for funding during shortages or
investing during surpluses, helps a company know how much it will receive and spend at any point in
time. Cash flow projections follow a similar structure to that of a company’s budget.

To successfully project cash flow, organizations look at their prior year’s checkbook as a basis of cash
flow for the following year. Adjusting for any anticipated changes, this is often the more accurate way of
projection. When looking over a previous year’s expenses, a company would then factor in changes like
new pricing, program offerings, funding sources and interest rate changes.

As the year unfolds, a company then updates cash flow projections to adequately reflect recent
developments in expenses and profits. Comparing budgeted cash flows to actual deposits and
expenditures will help in more accurately projecting cash flow in the following months. Even the most
practiced of organizations find their forecasts change on a regular basis, thus prompting frequent
revisiting.

ADDRESSING CASH SHORTAGES

For many small businesses, staying on top of cash flow management is a difficult thing, especially with
the number of expenses faced each day. In the event of a cash flow deficit, companies have a number of
finance options to work through difficult times until deposits start to come in. The following practices are
quite common among businesses of all sizes:

• Apply for a loan from a banking institution or individual

• Apply for a line of credit from a banking institution
• Speed up the collection process
• Finance the purchasing of equipment through leasing or loans
• Liquidate assets
• Delay payments to vendors

The last point is often the most popular simply because of the options available to businesses. Many
expenses can be delayed in payment if a consensus is reached between the debtor and vendor.

MAXIMIZING USE OF PROJECTED CASH SURPLUSES

An organization won’t always find itself encountering debts before revenue is generated. In some cases,
an organization may expect a revenue surplus in a cash flow projection. What the company does with
that money can affect future opportunities, which means the money shouldn’t be spent or left sitting
around. Instead, accountants recommend that companies make the money work for them. This can
mean anything from making short-term investments like U.S. Treasury Bonds and money market funds to

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putting money toward paying off debts like loans sooner. This way the money will manifest its use
through generated interest or shorter loan terms.

ACCOUNTS RECEIVABLE MANAGEMENT

There are three key areas of accounts receivable management.

• Before a company grants credit to a customer it should ensure, as far as possible, that the
customer is worthy of that credit and that bad debts will not result. Checks should continue to be
carried out on existing customers as a company would like to have early warning of any problems
which may be developing. This is especially true for key customers of the company.
• Once the decision has been taken to grant credit, then suitable credit terms must be set and the
receivables that arise must be monitored efficiently if the costs of giving credit are to be kept
under control.
• A key area of the management of accounts receivable is the final collection of cash from
customers. Any company must have a rigorous system to ensure that all customers pay in a
timely fashion as, without this, the level of receivables and the cost of financing these receivables
will inevitably rise, as will the risk and cost of bad debts.

ASSESSING CREDITWORTHINESS

The methods a company could use to assess the creditworthiness of a customer or a potential customer
include:

• a bank reference – while a bank reference can be fairly easily obtained, it must be remembered
that the other company is the bank’s customer and so a bank reference will stick to the facts. It
is most unlikely to raise any fears the bank may have about the company
• a trade reference – this is obtained from another company who has dealings with your potential
customer/customer. Due to the litigious nature of society these days, it may not be so easy to
obtain a written reference. However, you may be able to call contacts you have in the trade and
obtain an informal oral reference
• credit rating/reference agency – these agencies’ professional business is to sell information about
companies and individuals. Hence, they will be keen to give you the best possible information, so
you are more likely to return and use their services again
• financial statements – financial statements of a company are publicly available information and
can be quickly and easily obtained. While an analysis of the financial statements may indicate
whether or not a company should be granted credit, it must be remembered that the financial
statements available could be out of date and may have suffered from manipulation. For larger
companies, an analysis of their accounting information can generally be found through various
sources on the internet
• information from the financial media – information in the national and local press, and in suitable
trade journals and on the internet, may give an indication of the current situation of a company.
For example, if it has been reported that a large contract has been lost or that one or more
directors has left recently, then this may indicate that the company has problems

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 • visit – visiting a potential new customer to discuss their exact needs is likely to impress the
customer with regard to your desire to provide a good service. At the same time, it gives you the
opportunity to get a feel for whether or not the business is one which you are happy to give
credit to. While it is not a very scientific approach, it can often work quite well, as anyone who
runs their own successful business is likely to know what a good business looks, feels and smells
like!

SETTING CREDIT TERMS AND MONITORING ACCOUNTS RECEIVABLE

As soon as a customer is given credit, the credit terms of the company should be explained to them. For
instance, the normal credit period granted and any discount for prompt payment, or interest charged on
late payment, should be explicitly detailed to the customer. Very often, the credit terms a company
adopts are the terms that are most common in its trade.

To use something different can cause problems as customers will be expecting, and are likely to take,
what is normal in the trade. Having said that, variations within a trade do occur and, indeed, a company
may well offer different terms to different customers, depending on the credit rating of each customer
and their relationship with each customer.

Initially, a suitable credit limit should be set for each customer. This credit limit should only be allowed to
grow slowly as your faith in the customer grows and all attempted breaches of the credit limit should be
brought to the attention of the credit controller or other responsible person. It should be remembered
that a common trick of an unethical company is to find a new supplier, make a small order and pay for it
promptly. A large order is then made and, having taken delivery of this order, the customer delays
payment for a significant time.

The accounts receivable should be continuously monitored. In order to do this a number of reports are
useful:

• Accounts receivable aged analysis – this shows the amounts outstanding from each customer and
for how long they have been outstanding. This will indicate any breaches of the credit terms.
• A credit utilisation report – this shows the proportion of each customers credit limit that is
currently being utilised. Therefore, it will indicate where credit limits may need to be reviewed
upwards or downwards and whether any credit limit breaches have occurred.

Taken together, these reports show how exposed a company is to its accounts receivable. In larger
organisations, customers may be classified by trade and country as it is then possible to evaluate
exposure by both country and trade. Larger businesses may also create their own in-house credit ratings
for their customers.

Whether or not the basic credit terms offered by the company are suitable should be regularly reviewed.
There is no point offering unnecessarily long periods of credit – however, equally, a company may find
that extending its credit terms leads to an increase in sales. Any alteration in credit terms could be
evaluated using the techniques demonstrated in the aforementioned ‘Receivables collection’ technical
article.

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COLLECTING CASH

It may seem very obvious, but if cash is to be collected, then the customer must be invoiced. It is
essential that the invoice is sent out quickly and accurately. The receipt of your invoice is the first
indication a company gets of the efficiency of your debt collection system. If the invoice takes a long time
to arrive and is not accurate, then your accounts receivable department will be viewed as inefficient and
customers may seek to exploit this perceived weakness and delay payment.

Furthermore, if an invoice is inaccurate some customers will take this as an opportunity to claim that
there is a dispute on the account and, therefore, stop payment of all invoices until the dispute is
resolved.

Having sent out the invoice quickly and accurately, the methods a company could use to ensure
customers pay in a timely fashion include:

• monthly statements – these can be produced quickly and easily by any computerised sales ledger
system and sent to customers. Exactly how much impact they have is however debatable
• chasing letters – these should be directed to a specific person preferably at a reasonably senior
level. However, preparing and sending these letters has a cost and, like the monthly statements,
their impact is often limited
• chasing phone calls – these can often have a great impact as all businesses have to answer the
telephone and, hence, they have a nuisance value which can generate results. A credit controller
who regularly contacts a suitably senior person at their customers with overdue amounts and
politely, but firmly, demands payment can often achieve good results
• personal approach – a personal approach from a senior person in the company to a senior person
at the customer can often yield results. This is quite common in trades where the personal
relationship with clients is important. For instance, this often occurs in professional accountancy
and legal firms
• stopping supplies – this is a cash collection tool that must be used with care. If the product being
sold is built specifically to the customers design, and you are the only supplier who currently
makes the product, then it is a powerful tool as, in the short term, you are the only supplier and,
hence, payment is likely to be forthcoming. However, in the longer term it is always possible for
the customer to train up an alternative supplier to make the product. If the product is a generic
product that could be purchased from many suppliers, then quite obviously this is a weak tool
that is simply likely to lead to the loss of the customer
• legal action – this is costly and is likely to lead to the customer being lost
• external debt collection agency – as with legal action this is costly and is likely to lead to the loss
of the customer.

Many larger businesses have their own in-house debt collection departments that can be used before
external debt collection agencies are used or legal action is taken. There have been instances where
companies recently suffered reputational damage. They had branded their in-house debt collection
departments in such a way that the customer believed that it had been referred to an external debt
collection agency and, hence, was scared into making payment.

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METHODS OF SPEEDING UP CASH COLLECTION FROM ACCOUNTS RECEIVABLE

Two key methods of speeding up cash collection from accounts receivable are using factoring and using
early settlement discounts. Students should be conversant with these methods and their advantages and
disadvantages.

Furthermore, a common exam question requires students to evaluate, in ‘$’ terms, the net benefit or cost
of a proposed new debt collection policy. All of these areas are covered in the aforementioned
‘Receivables collection’ technical article.

Additionally, a question (potentially a multiple-choice question) could require the calculation of the
percentage cost of offering an early settlement discount. This is best explained through an example.

Example
A company offers its customers 30 days credit but, at present, customers are taking an average of 41
days credit. In order to speed up cash collection, the company is considering introducing a 1% discount
for payment within 10 days. The company finances its working capital requirement using an overdraft at
an annual cost of 9%.

Required – Calculate the annual cost of offering the discount and evaluate whether or not the discount
should be offered.

Solution
Let us assume a customer has purchased goods and has been invoiced P100. If the customer takes the
discount, then the company will receive P99 in 10 days rather than P100 in 41 days. This is like the
company borrowing P99 from the customer for 31 days (41 – 10) and paying P1 interest. Therefore, the
31-day interest rate is 1/99 x 100%. This needs to be compounded up to an annual rate in the following
way:

(1 + 1/99)(365/31) – 1 = 0.126

Therefore, the annual cost of offering the discount can be said to be 12.6%.

If the discount is not offered, the company will be borrowing more on its overdraft while it waits for the
customer to pay.

As the cost of borrowing on the overdraft is only 9%, the discount proposed is more costly and should
not be offered.

Please note how the 30 days credit offered is not relevant in the calculations. Such additional information,
which is not required, can be given in questions, especially multiple-choice questions where it is called a
distractor. The use of distractors is a good way of testing who is really certain and confident in their
knowledge.

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The calculations above have been carried out from the point of view of the supplier. A question could also
look at the same issue from the point of view of the customer and ask for a calculation of the customer’s
cost of refusing the discount.

Students should note that:

The customer’s cost of refusing the discount = the supplier’s cost of offering the discount

Hence, in the above example, if a customer were to refuse the discount, the cost to it would also be
12.6%. If the customer is to accept the discount, then this will often require it to borrow extra funds in
the form of an overdraft in order to make the early payment. We can assume that the customer’s
overdraft rate is the same as the supplier’s rate of 9%. This is a reasonable assumption, as if both
companies are operating in the same economy their overdraft rates are likely to be similar.

Therefore, the customer has a choice of refusing the discount at a cost of 12.6% or accepting the
discount at a cost of 9%. Hence, the discount is attractive and should be accepted.

The above calculations have demonstrated a key problem with settlement discounts. As in this example,
if the discount is attractive to the customer it may well be too costly to the supplier. It is also the case
that a discount which is attractive to a supplier may well be too costly for the customer.

The formula to remember for calculating the cost of offering or refusing a discount is:

(1 + D/(100 – D))(365/t) – 1 x 100%

Where: D = the discount (2% = 2 etc.)

t = the period by which the payment is advanced if the discount is taken

INVOICE DISCOUNTING

Invoice discounting is another method a company can use to speed up the receipt of cash from its
receivables. If a company is short of cash, it can approach an invoice discounter who will lend cash
against the security of one or a few invoices that customers have still to pay.

For instance, the invoice discounter may advance 75% of the outstanding amounts. In some invoice
discounting deals, the invoices/debts are legally sold to the invoice discounter and in others they are not.
When the customer finally pays, the invoice discounter recovers the amount lent and also receives
interest and charges.

Confidential invoice discounting is where the customer is not aware of the discounting arrangement and,
as long as they pay their debt, they will never become aware of it.

Therefore, invoice discounting is similar to factoring in the way that the finance is provided and, indeed,
many factoring companies will also provide invoice discounting services. However, with invoice
discounting the company continues to run its own sales ledger. Additionally, while factoring is an ongoing
arrangement, invoice discounting consists of one-off deals to cover temporary cash shortages.

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Invoice discounting can be of particular use to SMEs who are starting to win contracts with large
customers. While winning a contract with a large customer can be good news for a company, it can lead
to cash flow problems. This is because the contract with the large customer is likely to involve sums that
are very significant to the SME, and while large customers are generally reliable payers, they often only
pay after a significant delay.

INVENTORY MANAGEMENT

Inventory management is a collection of interdisciplinary processes that include a full circle from supply
chain management to demand forecasting, through inventory control and including reverse logistics.

Inventory management starts and ends with supply chain management because many of the
opportunities to improve efficiencies start with shortening order to receipt time without incurring
additional cost. That said, the other stages of the inventory management cycle are no less important in
attaining overall efficiency.

Given that inventory in all its forms generally represents one of the top three expense lines for nearly all
companies, there is a universal need for applying the right discipline to each step in the process.

Inventory management in its most efficient form incorporates many different technical applications of
inventory management models.

Such concepts as safety stock, economic ordering quantity, cost of goods, inventory turnover, customer
managed inventory and a vendor managed inventory, whole spectrum of underlying inventory
management tools play a critical role in what is inventory management. Different industries have different
needs when asking the question what is inventory management, but many of the concepts are the same.

While the key principles of inventory management remain the same across all industries, the areas which
require emphasis vary from sector to sector. Learning to apply the right inventory management tools is
part of executing the art and science of what is inventory management.

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Effective inventory management depends on understanding all the details of what is inventory
management. By applying lean practices to all aspects of the inventory management cycle, businesses
can reduce investment in standing inventory, plant rental, shipping costs, reverse logistics while
maintaining or improving customer service levels and in-stock metrics on critical inventory.

This is the result of having what your need, when you need it, where you thought you had it. That is the
core standard by which to measure the results of your businesses inventory management program.

ECONOMIC ORDER QUANTITY (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of
inventory management. We need to minimize the total inventory costs and EOQ model helps us just do
that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum cost

EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)

Example

ABC Ltd. is engaged in sale of footballs. Its cost per order is P400 and its carrying cost unit is P10 per
unit per annum. The company has a demand for 20,000 units per year. Calculate the order size, total
orders required during a year, total carrying cost and total ordering cost for the year.

Solution

EOQ = SQRT(2 × 20,000 × 400/10) = 1,265 units

Annual demand is 20,000 units so the company will have to place 16 orders (= annual demand of 20,000
divided by order size of 1,265). Total ordering cost is hence P64,000 (P400 multiplied by 16).

Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of P6,325 (i.e. 632.5 ×
$10).

Two most important categories of inventory costs are ordering costs and carrying costs. Ordering costs
are costs that are incurred on obtaining additional inventories. They include costs incurred on
communicating the order, transportation cost, etc. Carrying costs represent the costs incurred on holding
inventory in hand. They include the opportunity cost of money held up in inventories, storage costs,
spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize carrying costs
we have to place small order which increases the ordering costs. If we want minimize our ordering costs

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we have to place few orders in a year and this requires placing large orders which in turn increases the
total carrying costs for the period

X. Corporate Financial Planning

The Financial Planning Process

The Financial Planning Process

People would often set financial goals such as buying a new car , a new house , for education , travel and
other plans they have . However in order to achieve these goals , people need to identify and set out the
priorities. Financial satisfaction is a result of careful and controlled financial planning . Thus , what will ask
what is financial planning all about ?

Financial planning is the process of controlling and managing the use of money to achieve personal
economic satisfaction and independence. Each person has his own unique individual position and therefore
would require financial activity that must be carefully planned to meet their specific goals and objectives.

Financial planning can enhance quality of life and reduce certain uncertainties about future needs . It also
increases effectiveness in securing , using and protecting financial resources of an individual or business. As
such , the risk of indebtedness , lack of money or financial insufficiency would be reduced.

The financial planning process can be summarized into simple and logical steps as follows :

➢ assess your present or current financial situation

➢ develop financial goals and objectives
➢ identify alternative courses of action
➢ evaluate possible alternatives
➢ create and follow a financial plan
➢ re-evaluate and re-examine the financial plan

Now let us start discussing each of these process.

# 1 – Assess your present or current financial situation

Start listing down the sources of all your income, any obligations or debts and what are the expenses you or
your business incurred . In knowing these items, you will be able to identify if there are enough money left
to save or there are just enough money coming in to satisfy you standard or way of living.

# 2 – Develop financial goals and objectives

Individuals or businesses will have varied reasons on how they use the money they earn. In this process ,
one needs to identify what are his basic needs and must be able to differentiate it from wants. It is setting
priorities on the use of money and will focus only on those that are essential towards the achievement of
financial goals such as saving or investing for the future to accomplish financial security.

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# 3 – Develop alternative courses of action

Developing alternatives is critical in making good decisions. Many factors will influence the available
alternatives, possible courses of action usually fall into these categories:

✓ Continue the same course of action.

✓ Expand the current situation.
✓ Change the current situation.
✓ Take a new course of action.

Not all of these categories will apply to every decision situation; however, they do represent possible courses
of action. Creativity in decision making is vital to effective choices. Considering all of the possible alternatives
will help you make more effective and satisfying decisions.

# 4 – Evaluate possible alternatives

You need to evaluate possible courses of action, taking into consideration your life situation, personal
values, and current economic conditions. Every decision closes off alternatives.

For example, a decision to invest in stock may mean you cannot take a vacation. A decision to go to school
full time may mean you cannot work full time. Opportunity cost is what you give up by making a choice. This
cost, commonly referred to as the trade-off of a decision and will consider the lost opportunities that will
result from your decision.

Uncertainty is a part of every decision. Selecting a college major and choosing a career field involve risk.
What if you don’t like working in this field or cannot obtain employment in it? Other decisions involve a very
low degree of risk, such as putting money in a savings account or purchasing items that cost only a few
dollars. Your chances of losing something of great value are low in these situations.

In many financial decisions, identifying and evaluating risk is difficult. The best way to consider risk is to
gather information based on your experience and the experiences of others and to use financial planning
information sources.
# 5 – Create and follow financial plan

In this process you need to develop an action plan which will require selecting ways to achieve your goals.
As you achieve your immediate or short-term goals, the goals next in priority will come into focus.

For example, you may use the services of an insurance agent to purchase property insurance or the services
of an investment broker to purchase stocks, bonds, or mutual funds.

# 6 – Re-evaluate and re-examine the plan

Financial planning is an ongoing process that needs to continue even if a particular action had been taken .
Monitoring and regular assessment of your financial decisions is needed .

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Financial planning will alter and affect your life as this will serve as a tool for achieving you financial goals
that will lead to financial security and independence thus, improving the quality of your life or business.

The Financial Planning Process , illustrated

Final Output

Form a group and each group will look for the top 50 Corporation in the Philippines and
choose any of this company to evaluate.

Do a research or secure a copy of the latest 3 years financial statements of the company
chosen.

Perform the horizontal, vertical and ratio analysis. Identify the weakness and strength of the
company based on the financial analysis. Make a conclusion and recommendation.

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