FINANCIAL MANAGEMENT
Introduction of Financial Management
- Finance plays an important role in the student’s professional and even personal life.
- Each chapter of this book emphasizes the relevance of the topic to majors in accounting, management, marketing,
operations and information systems.
Financial Management
- About preparing, directing and managing the money activities of a company such as buying, selling and using money to
its best results to maximize wealth or produce best value for money
- About applying general management concepts to the cash of the company
- The key objectives would be to create wealth for business, generate cash and provide an adequate return on investment
bearing in mind the risks that the business is taking and the resources invested
Personal Finance
- Deals with an individuals’ decisions concerning the spending and investing of income
- It includes the answers as to how much of their earnings should they spend, how much should they save, and how should
they invest their savings
Business Finance
- Involves same type of decisions focusing on how the firms raise money from investors, how to invest money to earn a
profit and how to reinvest profits in the business or distribute them back to investors
Elements to the process of financial management
1. Financial Planning
- Management need to ensure that enough funding is available at the right time to meet the needs of the business
- Funding may be needed to invest in equipment and stocks, pay employees and fund sales on credit
2. Financial Control
- Helps the business ensure that the objectives are being met
- Determines if assets are secured and being used efficiently
3. Financial Decision Making
- The key aspects of financial decision-making include investment, financing and dividends
- There are always financing alternatives that can be considered, which will depend on the type of source, period of
financing, cost of financing and the net present returns generated
Scope of Financial Management
1. Anticipation
- The financial needs of the company are being estimated
- It finds out how much finance is required by the company
2. Acquisition
- It collects finance for the company from different sources
3. Allocation
- It uses this collected or acquired finance to purchase fixed and current assets for the company
4. Appropriation
- It distributes part of the company profits among the shareholders, debenture holders and some are kept as reserves
5. Assessment
- It also means controlling all the financial activities of the company
- It checks if the objectives are met, if not, it determines what can be done about it
Finance Areas and Career Opportunities
The following are the major areas in the field of finance:
1. Finance Service
- The one concerned with the design and delivery of advice and financial products to individuals, businesses and
governments
Career opportunities: Within the areas of banking, personal financial planning, investments, real estate and insurance
2. Managerial Finance
- Concerned with the duties of the financial manager working in a business
- Encompasses financial planning or budgeting, extending credit to customers or other credit administration function,
investment evaluation and analysis and obtaining of funds for a firm
Career opportunities: Financial analyst, capital budgeting analyst and cash manager
The following are the professional certifications in finance:
1. Chartered Financial Analyst (CFA)
- A graduate-level course of study focused largely on the investments side of finance
- This is offered by the CFA Institute
2. Certified Treasury Professional (CTP)
- This program requires students to pass a single exam that is focused on the knowledge and skills needed for those
working in a corporate treasury department
3. Certified Financial Planner (CFP)
- Students should pass a 10-hour exam covering a wide range of topics related to personal financial planning in order to
obtain CFP status
4. American Academy of Financial Management (AAFM)
- This administers certification programs for financial professionals in a wide range of fields
- Their certifications include the Charter Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst, Certified
Cost Accountant and Certified Credit Analyst
5. Professional Certifications in Accounting
- Include Certified Public Accountant (CPA), Certified Management Accountant (CMA), Certified Internal Auditor (CIA)
Legal Forms of Business Organization
1. Sole Proprietorship
- A business owned by one person and operated for his or her own profit
- He is legally responsible for the debts and taxes of the business and very involved in its day to day activities
2. Partnership
- A business owned by two or more people and operated for profit
- This is based on an agreement called Article of Co-Partnership
- They are legally responsible for the debts and taxes of the business
- Partners must agree upon amount each partner will contribute to the business, percentage of ownership of each partner,
share of profits of each partner, duties each partner will perform and the responsibility each partner has for the
partnership’s debts.
3. Corporation
- An entity created by law
- Corporations have the legal powers of an individual in that it can sue and be sued, make and be party to contracts and
acquire property in its own name.
- Stockholders are not responsible for the debts or taxes of the business.
- A corporation is governed by the Board of Directors in case of a profit organization or Board of Trustees in case of not-
for-profit organization.
Finance, Economic and Accounting
Economics
- A study of choice
- It is a social science that deals with individual or collective economic activities such as production, consumption,
distribution and transfer of money and wealth.
Finance
- The study of financial allocation and answers the questions like where to put your money and why.
- It is often considered a form of applied economics.
- One of the major differences in the focus of finance and accounting is that accountants generally use the accrual method
while in finance, the emphasis is on cash flows.
- Accountants recognize revenues at the point of sale and expenses when incurred.
- Financial manager focuses on the actual inflows and outflows of cash.
Goals of the Firm and the Role of the Finance Manager
- Decision rule for managers: Only take actions that are expected to increase the share price.
- Whenever the financial manager decides or chooses between or among alternatives, after assessing the risks and the
returns, only actions that would increase share price shall be accepted.
- The goal of a firm, and therefore of all managers, is to maximize shareholders’ wealth.
Sample Problem
Given the following opportunities, which investment is preferred?
Earnings Per Share
Investment Year 1 Year 2 Year 3 Total
A 14.00 10.00 4.00 28.00
B 6.00 10.00 14.00 30.00
Based on the information provided, the choice is not obvious. Profit maximization is not consistent with wealth
maximization. It may not lead to the highest possible share price due to the following reasons:
1. Timing is important
- The receipt of funds sooner rather than later is preferred
2. Profits do not necessarily result in cash flows available to stockholders
- In finance, cash is king.
- It is not unusual for a firm to be profitable yet experience a cash crunch.
3. Profit maximization fails to account for risk
- Risk is the chance that actual outcomes may differ from expected outcomes.
- Financial managers must consider both risk and return because of their inverse effect on the share price of the firm.
Key activities of financial manager that relates to firm’s balance sheet
1. Investment decisions
- The finance manager defines the most efficient level and the best structure of assets
2. Financial decisions
- The finance manager determines and maintains the proper combination of short and long-term financing
- Financing decisions generally refers to the items that appear on the liability and equity section of the balance sheet
Corporate Governance, Ethics and Agency Issues
Corporate Governance
- A system of organizational control that defines and establishes the responsibility and accountability of the major
participants in an organization (shareholders, board of directors, managers and officers of the corporation and other
stakeholders)
Business Ethics
- The standards of conduct or moral judgment that apply to persons engaged in industry or commerce
- Violations of these standards in finance include, but not limited to misstated financial statements, misleading financial
forecasts or projections, fraud, bribery, kickbacks, insider trading, excessive executive compensation and options
backdating
Shareholders
- The owners of a corporation and they purchase stocks because they want to earn a good return on their investment
without undue risk exposure
- In most cases, shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis
The agency problem and the associated agency costs can be reduced with the following:
1. Properly constructed and implemented corporate governance structure
2. Structured expenditure thru compensation plans
3. Market forces such as shareholder crusading from large institutional investors
4. Threat of hostile takeovers
Financial Statement Analysis
Introduction
General purpose financial statements contain historical information about the firm’s financial condition, operating results
and other business activities. When one reads a company’s financial statements, he gets an over-all picture of the firm’s
profitability and financial conditions. Merely reading such statements, however, is not enough when one wants to make
informed judgments or decisions. For decision-making purposes, a thorough analysis and interpretation of such statements
is required.
As these users read the financial statements, they try to find answers to the following questions:
1. Profitability of the business firms
2. The firm’s ability to meet its obligations
3. Safety of the investment in the business
4. Effectiveness of management in running the firm
Techniques in Analyzing and Interpreting Financial Statements
1. Horizontal analysis
Involves comparing figures shown in the financial statements of two or more consecutive periods. The
difference between the figures of the two periods is calculated and the percentage change from one period to the
next is computed, using the earlier period as the base.
2. Vertical analysis
Involves converting the figures in the statements to a common base
- This is accomplished by expressing all the figures in the statements as a percentage of an important item, such as
total assets (in the balance sheet) and net sales (in the income statement)
- All the figures in the statements would be expressed not in peso but in percentage terms - These converted
statements are called common-size statements, 100% statements or component statements
3. Ratio analysis
- The most widely known and most commonly used tool for financial statements analysis
- Meaningful ratios may be computed for items found in the balance sheet, income statement or both
- Ratios calculated from these financial statements provide users of the statements with relevant information about
the business firm’s liquidity, solvency and profitability
4. Analysis of variation in gross profit and net income
5. Statement of changes in a financial position
6. Cash flow statement
Categories of Ratio
Ratio - A mathematical relationship between two numbers
A. Tests of Liquidity B. Tests of Solvency
1. Current ratio 1. Times interest earned ratio
2. Acid test ratio 2. Debt-equity ratio
3. Turnovers 3. Debt ratio
4. Equity ratio
C. Tests of profitability D. Market Tests
1. Return on sales 1. Price-earnings ratio
2. Return on total assets 2. Dividend yield
3. Return on owners’ equity 3. Dividend payout
4. Earnings per share
Tests of Liquidity
Liquidity - The company’s ability to pay its short-term liabilities as they fall due
Current Ratio - Working capital ratio or banker’s ratio
- Measures the number of times that the current liabilities could be paid with the available current assets
Current Ratio = Current Assets
Current Liabilities
Acid Test Ratio or Quick Ratio - The current ratio is further refined by including in the formula only the quick or liquid
current assets
- Inventories and prepayments are excluded - Only those assets that are cash or near cash
are included so that the resulting ratio can indicate the firm’s paying ability in the very near term
Acid Test Ratio
= Quick Assets = Cash + Marketable Securities + Receivables
Current Liabilities Current Liabilities Tests
Receivables Turnover - The time required to complete one collection cycle, from the time receivables are recorded, then
collected, to the time new receivables are recorded again
- The faster the cycle is completed, the more quickly receivables are converted into cash
Receivables Turnover Average Receivables
= Net Credit Sales or Net Sales = (Beginning Balance + Ending Balance) / 2
Average Receivables
Since receivables arise from credit sales, it is but proper to use net credit sales as the numerator. However, analysts may
not have access to information about the composition of total sales (breakdown into cash and credit sales), particularly
those who do not belong to the firm. For lack of better information, the net sales figure may be used.
Average Age of Receivables - Days’ sales in receivables or average collection period
- Indicates the average number of days during which the company must wait before receivables are collected
- The faster the customers pay, the better
- This is reflected in an increase in turnover or decrease in average age of receivables, an indication of the firm’s
efficiency in collecting its receivables
Average Age of Receivables
= No. of Working Days in a Year
Receivables Turnover
Inventory Turnover - Measures the number of times that inventory is replaced during the period
- A high turnover and short average age of inventories is desirable
Inventory Turnover
= Cost of Goods Sold
Average Inventory Tests
Average Inventory = (Beginning Balance + Ending Balance) / 2
Average Age of Inventory = No. of Working Days in a Year
Inventory Turnover
Raw Materials Turnover = Cost of Raw Materials Used
Average Raw Materials Inventory
Goods in Process Turnover = Cost of Goods Manufactured
Average Goods in Process Inventory
Finished Goods Turnover
= Cost of Goods Sold
Average Finished Goods Inventory
Operating Cycle - An operating cycle for a manufacturing firm begins from the time raw materials are acquired, through
production, sale of finished goods, until the time when receivables are collected or converted into cash which may in turn
be used again to acquire raw materials
- The sum of average age of receivables and average age of inventory
Average Age of Trade Payables - Indicates the length of time or the number of days during which trade payables remain
unpaid
- The time which elapses from the purchase of materials up to the payment of accounts or notes payable arising from such
purchase
Payables Turnover = Net Credit Purchases Average Age of Trade Payables = No. of Working Days in a Year
Average Trade Payables Payables Turnover Tests
Current Assets Turnover = Cost of Sales + Operating Expenses*
Average Current Assets
*excluding depreciation and amortization
TEST OF SOLVENCY
Solvency - The company’s ability to pay all its debts, whether such liabilities are current or noncurrent
- It is similar to liquidity except that solvency involves a longer time horizon
Times Interest Earned - Determines the extent to which operations cover interest expense
Times Interest Earned = Income Before Tax + Interest Expense Debt-Equity Ratio = Total Liabilities
Interest Expense Shareholders’ Equity
Debt-Equity Ratio - To determine the amount provided by creditors relative to that provided by the owners
- If the ratio is equal to 1, this means that the creditors and owners provided an equal amount of capital
Debt Ratio - Indicates the percentage of total assets provided by creditors
Debt Ratio = Total Liabilities
Total Assets
Equity Ratio - Indicates the percentage of total assets provided by the owners or shareholders
Equity Ratio = Shareholders’ Equity
Total Assets
TEST OF PROFITABILITY
Rate of Return or Return on Investment = Income / Investment
Return on Sales - Determines the portion of sales that went into company’s earnings
Return on Sales = Income / Net Sales
Gross Profit Ratio = Gross Profit / Net Sales
Net Profit Ratio = Net Profit / Net Sales
Return on Assets - Efficiency with which assets are used to operate the business
Return on Assets = Income Before Interest and Taxes / Average Total Assets
= Net Income + Interest Expense + Income Tax / Average Total Assets
Return on Shareholders’ Equity - Measures the amount earned on the owners’ or shareholders’ investment
Return on Shareholders’ Equity = Net Income / Average Shareholders’ Equity
Return on Common Equity = Net Income – Preferred Dividends / Average Common Equity
Earnings Per Share - Measures the amount of net income earned by each common share
Earnings Per Share = Net Income – Preferred Dividends / Weighted Average No. of Common Shares
MARKET TESTS
Price-Earnings Ratio - Indicates the number of pesos required to buy P1 of earnings
Price-Earnings Ratio = Price Per Share / Earnings Per Share
Dividend Yield - Measures the rate of return in the investor’s common stock investments
Dividend Yield = Dividend Per Share / Price Per Share Market
Dividend Payout - Indicates the proportion of earnings distributed as dividends
Dividend Payout = Common Dividend Per Share / Earnings Per Share Market
Working Capital Long Term Liabilities 110,000
Current Assets – Current Liabilities 34.375%
100,500 – 40,000 = 60,500 Preferred Stock 18,000 5.625%
Common Stock (SHE-PS) 192,000 60%
Current Asset Ratio or Current Ratio Total 320,000 100%
Current Assets / Current Liabilities
100,500 / 40,000 = 2.51 Return on Sales
Net Income / Net Sales
Quick (Acid) Test Ratio 33,840 / 261,000 = 12.97%
Quick Assets / Current Liabilities
(2,400 + 1,350 + 36,000) / 40,000 = 0.99 Return on Total Assets (ROA)
Assume Tax Rate of 30%
Accounts Receivable Turnover Net Income plus Interest Expenses net of its tax effect /
Net Sales on Account / Average Accounts Receivable Average Totals Assets
261,000 / [(36,000 + 33,000) / 2] = 7.57 times [33,840 + (12,090 x 70%)] / [(360,000 + 332,550) / 2]
42,303 / 346,275 = 12.22%
Number of Days in Accounts Receivable or Average
Collection Period Return on Common Equity (ROE)
365 Days / Accounts Receivable Turnover Net Income available to Common Stock / Average
365 Days / 7.57 times = 48.22 Days Common Stock Equity
Common Stock Equity = SHE – PS
Inventory Turnover (33,840 – 1,440) / [(192,000 + 170,400) / 2]
Cost of Sales / Average Inventory 32,400 / 181,200 = 17.88%
182,790 / [(60,000 + 51,000) / 2] = 3.29 times
Earnings Per Share (EPS) or Basic EPS
Net Income Available to Common Stockholders /
Number of Days in Inventory Weighted Average Number of Shares Outstanding
365 Days / Inventory Turnover (33,840 – 1,440) / (75,000 / 10 Par)
365 Days / 3.29 times = 110.94 days 32,400 / 7,500 shares = 4.32 per share
Fixed Assets Turnover Price Earnings Ratio
Sales / Net Fixed Assets Assume Market Price Per Share of Common Stock =
261,000 / 258,000 = 1.01 times 195
Market Price Per Share of Common Stock / EPS
Total Assets Turnover 195 / 4.32 = 45.13
261,000 / 360,000 = 0.73 times
Dividend Pay Out Ratio
Debt to Total Asset Ratio Dividends Per Share of Common Stock / Earnings Per
Total Debt / Total Assets Share
150,000 / 360,000 = 0.42 or 42% (14,400 / 7,500 shares) / 4.32 = 44.44%
Debt to Equity Ratio Dividend Yield Ratio
Total Liabilities / Total Stockholder’s Equity Dividends Per Share of Common Stock / Market Price
150,000 / 210,000 = 0.71 or 71% Per Share
(14,400 / 7,500 shares) / 195 = 0.98%
Times Interest Earned Ratio
Earnings Before Interest and Taxes (EBIT) / Interest
Charges
57,210 / 12,090 = 4.73 times
Book Value of Securities
Preferred Stock
100 Per Share
Common Stock
(SHE – PS) / No. of Shares
(210,000 – 18,000) / (75,000 / 10) = 25.60 Per Share
Capitalization Ratios
Amount
Percentage
