CHAPTER 1: INTRODUCTION TO FINANCIAL MANAGEMENT

Finance - can be defined as the science and art of managing money.

Budgeting - is the act of estimating revenue (in the form of their allowance) and expenses over a
period of time (in this case, on a daily basis).

Finance is concerned with decisions about:

- How much of their earnings they spend
- How much they save or how much they need
- How they invest their savings
- How they raise additional funds they need

FORMS OF BUSINESS ORGANIZATIONS

1. SOLE PROPRIETORSHIP
 Has a single owner (proprietor) who generally is also the manager.
 Tend to be small service type (physicians, lawyers, and accountants) business and retail establishments,
 The owner receives all profits, absorbs all losses and is solely responsible for all the debts of the business.
 Thus, the accounting records of the sole proprietorship do not include the proprietor’s personal financial records.
2. PARTNERSHIP
 A business owned and operated by two or more persons who bind themselves to contribute money, property, or
industry to a common fund, with the intention of dividing the profits among themselves.
 Each partner is personally liable for any debt incurred by the partnership.
 Accounting considers the partnership as a separate organization, distinct from the personal affairs of each partner.
3. CORPORATION
 Is a business owned by its stockholders.
 It is an artificial being created by operation of law, having the right of succession and the powers, attributes and
properties expressly authorized by law or incident to its existence.
 The stockholders are not personally liable for the corporation’s debts.
 The corporation is a separate legal entity.

ATTRIBUTES OF A CORPORATION
1. A corporation is an artificial being with a personality separate and apart from its individual shareholders or members.
2. It is created by operation of law. It cannot come into existence by mere agreement of the parties as in the case of
business partnerships. Corporations require special authority or grant from the State, either by a special incorporation law
that directly creates the corporation or by means of a general corporation law.
3. It enjoys the right of succession. A corporation has the capacity of continued existence subject to the period stated in
the Articles of Incorporation. The death, withdrawal, insolvency or incapacity of the individual shareholders or members
will not dissolve the corporation. The transfer of ownership of shares of stocks does not dissolve the corporation.
4. It has the powers, attributes and properties expressly authorized by law or incident to its existence.

CLASSES OF CORPORATIONS

1. STOCK CORPORATION
Corporations which have share capital dividend into shares and are authorized to distribute to the holders of such
shares dividends or allotments of the surplus profits on the basis of the shares held.

2. NON-STOCK CORPORATION
One where no part of its income is distribute as dividends to its members, trustees, or officers. Any profit that a non-
stock corporation may obtain as an incident to its operation shall, whenever necessary or proper, be used for the
furtherance of the purpose or purposes for which the corporation was organized.

Non-stock corporations may be formed or organized for charitable, religious, educational, professional, cultural,
recreation, fraternal, literary, scientific, social, civic service, or similar purposes.

FINANCIAL MANAGEMENT is concerned with the maintenance and creation of economic value or wealth. Consequently, this
course focuses on decision making with an eye towards creating wealth. As such, we will deal with financial decisions such as -
 When to introduce a new product
 When to invest in new assets
 When to replace existing assets
  When to borrow from banks
 When to extend credit to a customer, and
 How much cash to maintain

KEY OBJECTIVES OF FINANCIAL MANAGEMENT

 Create wealth for the business
 Generate cash
 Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources
invested

GOAL OF THE FIRM

 Profit maximization
 Maximization of shareholder wealth

Chapter 2: Review of Financial Statement Preparation, Analysis, and Interpretation

Financial statement (FS) analysis

is the process of evaluating risks, performance, financial health,and future prospects of a business by subjecting financial
statement data to computational and analytical techniques with the objective of making economic decisions. There are
three kinds of FS analysis techniques:
- Horizontal analysis
- Vertical analysis
- Financial ratios

Horizontal analysis (Increase - Decrease Method)

also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time with the
purpose of determining the increase or decrease that has taken place. This will reveal the behavior of the account over
time. Is it increasing, decreasing or not moving? What is the magnitude of the change? Also, what is the relative change in
the balances of the account over time?

Changes can be expressed in monetary value (peso) and percentages computed by using the following formulas:

• Peso change = Balance of Current Year - Balance of Prior Year

• Percentage change = Peso Change ÷ Balance of the Prior Year
Vertical analysis
also called common-size analysis, is a technique that expresses each financial statement item as a percentage of a base
amount. For the SFP, the base amount used is Total Assets. On the other hand, sales or net sales is used as base amount
for the SCI.

FINANCIAL RATIO
Is a comparison in fraction, proportion, decimal or percentage form of two significant figures taken from financial
statements. It expresses the direct relationship between two or more quantities in the statement of financial position and
income statement of a business firm.
PURPOSE:
Through ratio analysis, the financial statements user comes into possession of measures which provide insight into
the profitability of operations, the soundness of the firm’s short-term and long-term financial condition and the efficiency
with which management has utilized the resources entrusted to it.

The four main categories of financial ratios:

• Liquidity
• Profitability
• Efficiency
• Leverage

I. Liquidity Ratio – ratios that measure the firm’s ability to meet cash needs as they arise such as payment of
accounts payable, bank loans and operating costs.
Liquidity refers to the company’s ability to satisfy its short-term obligations as they come due.

 Current Ratio = Current Assets ÷ Current Liabilities

 Quick Ratio = Cash + Marketable Securities + Accounts Receivables ÷ Current Liabilities

Illustration:

1. Current assets is PHP2,000, current liabilities is PHP3,500. What is current ratio?

2. Inventory is PHP150. Accounts payable is PHP450. Cash and accounts receivable total PHP800. What is the
current ratio? Quick ratio?
3. If current ratio is 1.7, what is the total accounts receivable if cash is PHP20,000, inventory is PHP7,500, and
accounts payable is PHP30,000.

Answer Key:
1. Current ratio: 2,000/3,500 = 0.57
2. Current ratio: (800 + 150)/450 = 2.11
Quick ratio: 800/450 = 1.78
3. Total receivables: 1.7= (X+20,000+7500)/ 30,000 = 23,500

II. Activity / Efficiency Ratio – ratios that measure the liquidity of specific assets and efficiency in managing assets
such as accounts receivable, inventory, and fixed assets.
Refers to a company’s ability to be efficient in its operations. Specifically, it refers to the speed with
which various current accounts are converted into sales, and ultimately, cash.

 Accounts receivable turnover = Sales ÷ Average Accounts Receivables

 Average collection period, otherwise known as average age of AR, days’ receivable or days sales
outstanding = 365 ÷ Accounts Receivable Turnover
 Inventory turnover = Cost of Goods Sold ÷ Average Inventory
  Average age of inventory or days’ inventory = 365 ÷ Inventory Turnover
 Accounts payable turnover = Purchases ÷ Average Inventory
 Average age of payables, average payment period, or days’ payable = 365 ÷ Accounts Payable
Turnover
 Total asset turnover = Net Sales ÷ Average Total Assets
 Operating cycle = Average Collection Period + Average Age of Inventory
 Cash conversion cycle = Operating cycle - Average Age of Payables OR Average Collection Period
+ Average Age of Inventory - Average Age of Payables

Illustration:

Answer Key:
(provide that the beginning inventory is P 247,000):
1. Accounts receivable turnover: 44.4x
2. Average collection period: 8.2 days
3. Inventory turnover: 10x
4. Average age of inventory: 36.5 days
5. Accounts payable turnover: 18.57x
6. Average payment period: 19.65 days
7. Total asset turnover: 0.41x
8. Operating cycle: 44.7 days
9. Cash conversion cycle: 25.05 days
III. Leverage Ratio – ratios that measure the extent of a firm’s financing, with debt relative to equity and its ability
to cover interest and other fixed charges such as rent and sinking fund payment. Refers to the company’s use of
debt. It defines the company’s capital structure which indicates how much of the total assets are financed by debt
and equity.
 Debt ratio – This ratio measures the proportion of total assets finance by total liabilities or money
provided by creditors (not by the business owners).
Debt ratio = Total Liabilities ÷ Total Assets

 Debt-to-equity ratio – A variation of debt ratio, shows the proportion of debt to equity.
Debt-to-equity ratio = Total Liabilities ÷ Total Equity

 Interest coverage ratio / Times Interest Earned – This ratio shows the company’s ability to pay its
fixed interest charges in relation to its operating income or earnings before interest and taxes.
Interest coverage ratio = Earnings before interest and taxes (EBIT) ÷ Interest
Expense

Illustration:

Additional note:
“Other expenses” in the Statement of Financial Performance is composed solely of interest expense. Hence,
interest expense for the period ended December 31, 2014 is Php 2,800.

Answer Key:
1. Debt ratio = 57.65%
2. Debt-to-equity ratio = 1.3614
3. Interest coverage ratio = 180.7143

IV. Profitability Ratio – ratios that measure the overall performance of the firm and its efficiency managing assets,
liabilities and equity.
Refers to the company’s ability to generate earnings. It is one of the most important goals of
businesses.

 Return on Equity - measures the amount of net income earned in relation to stockholders’ equity.
ROE (return on equity) = Net income ÷ Stockholders’ equity

 Return on Assets - measures the ability of a company to generate income out of its
resources/assets.
ROA (return on asset) = Operating income ÷ Total assets

 Gross Profit Margin - shows how many pesos of gross profit is earned for every peso of sale. It
provides information regarding the ability of a company to cover its manufacturing cost from its
sales. Remember that gross profit is just sales less cost of goods or cost of services.
Gross profit margin = Gross profit ÷ Sales

 Operating Profit Margin - shows how many pesos of operating profit is earned for every peso of
sale. It measures the amount of income generated from the core business of a company.
Operating profit margin =Operating income ÷ Sales

 Net Profit Margin - measures how much net profit a company generates for every peso of sales
or revenues that it generates.
Net profit margin = Net income ÷ Sales

Illustration:
Answer Key:
1. Return on equity = 16.98% = 352,240/2,075,000
2. Return on assets = 7.19% = 352,240/4,900,000
3. Gross profit margin = 35% = 700,000/2,000,000
4. Operating profit margin = 25.05% = 501,000/2,000,000
5. Net profit margin = 17.61% = 352,240/2,000,000

The ROE of 16.98% means that for every PHP1 of stockholders’ equity, PHP0.1698 or 16.98 centavos was earned in
2014. To be more meaningful, this rate of return is
compared with the returns on alternative investments such as the returns on time deposits and other fixed income
instruments. For example, if the interest on time deposits is only 2%, then the 16.98% ROE seems better. However,
before a conclusion is made that the 16.98% ROE is better than the time deposit rate of 2%, the risks associated
with this company earning 16.98% has to be assessed. Generally, the 2% time deposit rate is guaranteed while the
16.98% ROE is not. In 2014, ROE of Sample Company was high, but what if in the future, it will earn a negative ROE.
Is this possible for company? Yes! No manager in his/or sound mind will guarantee a specific rate of return,
especially when that rate is relatively high. Why? Because in business, there are always risks. A company which is
doing so well this year may find itself with too many competitors in the future and these competitors may eat its
share of the business in the market and can make a profitable company today a losing company in the future.

Chapter 3: Financial Planning Tools and Concepts

I. PLANNING, BUDGETING and FORECASTING are vital processes for almost all organizations. Understanding past performance
and translating that insight into forward-looking targets to align business results with the corporate strategy is key to driving
shareholder value. Leading organizations leverage driver-based planning models and shift from traditional annual budgeting
cycles into a rolling forecast focused on managing the enterprise’s performance.

What is FINANCIAL FORECASTING?

FINANCIAL FORECASTING describes the process by which forms think about and prepare for the future. The forecasting process
provides the means for a firm to express its goals and priorities and to ensure that they are internally consistent. It also assist
the firm in identifying the asset requirements and needs for external financing.

FINANCIAL PLANNING is a continuous process of directing and allocating financial resources to meet strategic goals and
objectives.

STRATEGIC PLANNING is a formal process for establishing goals and objectives over the long run. Strategic planning involves
developing a mission statement that captures why the organization exist and plans for how the organization will thrive in the
future. Strategic objectives and corresponding goals are developed based on a very thorough assessment of the organization
and the external environment. Finally, strategic plans are implemented by developing an Operating or Action Plan. Within this
Operating Plan, we will include a complete set of financial plans or budgets.

*Financial planning is managing your finances over time in such a way that you can meet your business needs. Strategic
planning is the process of determining the direction your company will take, the goals you have for the business and
how to achieve what you want.

The basic steps involved in predicting financing needs can be summarized as follows:

Step 1: Project the firm’s sales revenues and expenses over the planning period.
Step 2: Estimate the levels of investment in current and fixed assets that are necessary to support the projected sales.
Step 3: Determine the firm’s financing needs throughout the planning period.

THE SALES FORECAST

In order to develop budgets, we will start with a forecast of what drives much of our financial activity; namely sales.
Therefore, the first forecast we will prepare is the Sale Forecast. In order to estimate sales, we will look at past sales histories
and various factors that influence sales.
 Sales forecasting is the process of estimating future sales.

Sales forecasting allows companies to:

Predict achievable sales revenue;

Efficiently allocate resources;
Plan for future growth.

PERCENTAGE OF SALES METHOD

Is a Financial Forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts
vary with sales.

Example: The forecasted Sales growth rate in this example is 25%.

Balance Sheet (Php Millions)

For Year Ended 2020

Assets 2020 Liabilities and Owners’ Equity 2020

Current Assets Current Liabilities

Cash ₱ 200 Accounts Payable ₱ 400
Accounts Receivables 400 Notes Payable 400
Inventory 600 Total Current Liabilities ₱ 800
Total Current Assets ₱ 1,200
Long-Term Liabilities
Fixed Assets Long term debt ₱ 500
Net Fixed Assets ₱ 800 Total Liabilities ₱ 1,300

Total Assets ₱ 2,000 Owners’ Equity

Ordinary Shares(1 Par) ₱ 300
Retained Earning 400
Total Owner’s Equity ₱ 700

Total Liabilities and Owner’s Equity ₱ 2,000

Income Statement (Php Millions)

For Year Ended 2020

Sales 1,200
Cost and Expenses 900
Earnings before Taxes 300
Taxes 90
Net Income 210
Dividends 70
Addition to Retained Earnings 140

Step 1: Convert each asset and liability account that varies directly with firm sales to a percent of current year’s sale.

Percentage of Sales Calculations

Cash: Cash / Sales = P200/P1,200 = .1667 = 16.67%
Accounts Receivables: AR / Sales = P400/P1,200 = .3333 = 33.33%
Inventory: Inventory / Sales = P600/P1,200 = .5 = 50%
Net Fixed Asset: Net Fixed Asset / Sales = P800/P1,200 = .6667 = 66.67%
Accounts Payable: Accounts Payable / Sales = P400/P1,200 = .3333 = 33.33%

Costs: Costs / Sales = P900/P1,200 = .75 = 75%

Taxes: Taxes / Taxable Income = P90/P300 = .3 = 30%
Net Income: Net Income / Sales = P210/P1,200 = .175 = 17.5%
Dividends: Dividends / Net Income = P70/P210 = .3333 = 33.33%

Step 2: Project the level of each asset and liability account in the balance sheet using the percentage of sales multiplied by
the projected sales or by leaving the account balance unchanged where the account does not vary with the level of sales. The
accounts which do not vary directly with sales are simply transferred to the Partial Pro-Forma Financial Statements at their
current levels.

Balance Sheet (Php Millions)

For Year Ended 2020

Assets %

Current Assets
Cash ₱ 200 16.67
Accounts Receivables 400 33.33
Inventory 600 50.00
Total Current Assets ₱ 1,200

Fixed Assets
Net Fixed Assets ₱ 800 66.67

Total Assets ₱ 2,000

Liabilities and Owners’

Equity

Current Liabilities
Accounts Payable ₱ 400 33.33
Notes Payable 400
Total Current Liabilities ₱ 800

Long-Term Liabilities
Long term debt ₱ 500
Total Liabilities ₱ 1,300

Owners’ Equity
Ordinary Shares(1 Par) ₱ 300
Retained Earning 400
Total Owner’s Equity ₱ 700

Total Liabilities and ₱ 2,000

Owner’s Equity
 Income Statement (Php Millions)
For Year Ended 2020

%
Sales ₱ 1,200
Cost and Expenses 900 75
Earnings before Taxes ₱ 300 25
Taxes 90 30
Net Income ₱ 210 17.5
Dividends 70 33.33
Addition to Retained Earnings ₱ 140 66.67

Determine the forecasted Sales level. This is done by multiplying Sales for the current year (2020) by one plus the forecasted
growth rate in Sales.

S1 = S0 (1 + g) = ₱1,200 (1 + .25) = ₱ 1,500

Where
S1 = the forecasted Sales level,
S0 = the current Sales level, and
g = the forecasted growth rate in Sales

PARTIAL PRO-FORMA CALCULATIONS

Cash: (Cash %) / (Sales forecast) = (16.67%) (₱1,500) = ₱250
Accounts Receivables: (AR %) / (Sales forecast) = (33.33%) (₱1,500) = ₱500
Inventory: (Inventory %) / (Sales forecast) =Sales = (50%) (₱1,500) = ₱750
Net Fixed Asset: (Net Fixed Asset %) / (Sales forecast) = (66.67%) (₱1,500) = ₱1,000
Accounts Payable: (Accounts Payable %) / (Sales forecast) =(33.33%) (₱1,500) = ₱500
Costs: (Costs %) / (Sale forecast) = (75%) (₱1,500) = ₱1,125
Net Income: (Net Income) / (Sale forecast)= (17.5%) (₱1,500) = ₱262.50
Additional to R/E: (Addition to Retained Earnings %) (Net Income Forecast) = (66.67%) (₱262.50) = ₱175
Retained Earnings: Retained Earnings + Addition to Retained Earnings Forecast = ₱400 + ₱175 = ₱575
Taxes: Taxable Income * Tax Rate = (₱375) (30%) = ₱112.50

Balance Sheet (Php Millions)

Assets 2020 2021 Liabilities and Owners’ Equity 2020 2021

Current Assets Current Liabilities

Cash ₱ 200 ₱250 Accounts Payable ₱ 400 ₱500
Accounts Receivables 400 500 Notes Payable 400 400
Inventory 600 750 Total Current Liabilities ₱ 800 ₱ 900
Total Current Assets ₱ 1,200 ₱1,500
Long-Term Liabilities
Fixed Assets Long term debt ₱ 500 ₱ 500
Net Fixed Assets ₱ 800 ₱1,000 Total Liabilities ₱ 1,300 ₱ 1,400

Total Assets ₱ 2,000 ₱2,500 Owners’ Equity

Ordinary Shares(1 Par) ₱ 300 ₱ 300
Retained Earning 400 575
Total Owner’s Equity ₱ 700 ₱ 875

Total Liabilities and Owner’s Equity ₱ 2,000 ₱ 2,275

Income Statement (Php Millions)

2020 2021
Sales ₱ 1,200 ₱ 1,500
Cost and Expenses 900 1,125
Earnings before Taxes ₱ 300 ₱ 375
Taxes 90 112.50
Net Income ₱ 210 ₱ 262.50
Dividends 70 87.50
Addition to Retained Earnings ₱ 140 ₱ 175

STEP 3: Determine the Discretionary Financing Needed (DFN)

The Discretionary Financing Needed (DFN) can be determined from the Partial Pro-Forma Balance Sheet. It is simply equal
to the different between Partial Pro-Forma Total Assets and Partial Pro-Forma Total Liabilities abd Owner’s Equity.
DFN = ₱ 2,500 - ₱ 2,275 = ₱ 225

STEP 4: The final step is to determine how the DFN is to be raised. Firms can choose to raise the DFN by borrowing on short-
term basis (Notes Payable), borrowing on a long-term basis (Long-Term Debt), issuing equity (Ordinary Shares), or some
combination of the above. The chosen method is called the Plug.
In this example we shall assume that the DFN is to e raised through long-term borrowing. Thus, the plug is Long-Term
Debt. To determine the Pro-Forma Financial Statement simply increase Long-Term Debt by the DFN of ₱ 225 determined in the
previous step.

Balance Sheet (Php Millions)

Assets 2020 2021 Liabilities and Owners’ Equity 2020 2021

Current Assets Current Liabilities

Cash ₱ 200 ₱250 Accounts Payable ₱ 400 ₱500
Accounts Receivables 400 500 Notes Payable 400 400
Inventory 600 750 Total Current Liabilities ₱ 800 ₱ 900
Total Current Assets ₱ 1,200 ₱1,500
Long-Term Liabilities
Fixed Assets Long term debt ₱ 500 ₱ 725
Net Fixed Assets ₱ 800 ₱1,000 Total Liabilities ₱ 1,300 ₱ 1,625

Total Assets ₱ 2,000 ₱2,500 Owners’ Equity

Ordinary Shares(1 Par) ₱ 300 ₱ 300
Retained Earning 400 575
Total Owner’s Equity ₱ 700 ₱ 875

Total Liabilities and Owner’s Equity ₱ 2,000 ₱ 2,500

Income Statement (Php Millions)

2020 2021
Sales ₱ 1,200 ₱ 1,500
Cost and Expenses 900 1,125
Earnings before Taxes ₱ 300 ₱ 375
Taxes 90 112.50
Net Income ₱ 210 ₱ 262.50
Dividends 70 87.50
Addition to Retained Earnings ₱ 140 ₱ 175

II. PREPARATION OF CASH BUDGET

CASH BUDGET
- Represent a detailed plan of future cash flows and is composed of four elements: cash receipts, cash disbursement , net
change in cash for the period, and new financing needed.
- The cash budget, or cash forecast, is a statement of the firm’s planned inflows and outflows of cash. It is used by
the firm to estimate its short-term cash requirements, with particular attention being paid to planning for surplus cash
and for cash shortages.

Below is the general form of the Cash Budget:

EXAMPLE:
To demonstrate the construction and use of the cash budget, consider Salco Furniture Company, Inc., a regional distributor
of household furniture. Management is in the process of preparing a monthly cash budget for the upcoming six months
(January to June 2020). Salco’s sale are highly seasonal, peaking in the months of March to May. Roughly 30 percent of Salco’s
sales are collected one month after the sale, 50 percent two months after the sale, and the remainder during the third month
following the sale.
Salco attempts to pace its purchases with its forecast of future sales. Purchases generally equal 75 percent of sales and are
made two months in advance of anticipated sales. Payments are made in the month following purchases. For example, June
sales are estimated at ₱ 100,000, thus April purchases are .75 x ₱ 100,000 = ₱ 75,000. Correspondingly, payments for purchases
in May equal ₱ 75,000. Wages, salaries, rent, and other cash expenses are recorded in Table 4-2, which gives Salco’s cash
budget for the six-month period ended in June 2020. Additional expenditures are recorded in the cash budget related to the
purchase of equipment in the amount of ₱ 14,000 during February and the repayment of a ₱ 12,000 loan in May. In June, Salco
will pay ₱ 7,500 interest on its ₱ 150,000 in long-term debt for the period of January - June 2020. Interest on the ₱ 12,000 short-
term note repaid in May for the period January to May equals ₱ 600 and is paid in May.
Salco currently has a cash balance of ₱ 20,000 and wants to maintain a minimum balance of ₱ 10,000. Additional
borrowing necessary to maintain that minimum balance is estimated in the final section of Table 4.2. Borrowing takes place at
the beginning of the month in which the funds are needed. Interest on borrowed funds equals 12 percent per annum, or 1
percent per month, and is paid in the month following the one in which funds are borrowed. Thus, interest on funds borrowed
in January will be paid in February equal to 1 percent of the loan amount outstanding during January.
The financing-needed line in Salco’s cash budget determines that the firm’s cumulative short-term borrowing will be ₱
36,350 in February, ₱ 65,874 in March, ₱ 86,633 in April and ₱ 97,599 in May. In June the firm will be able to reduced its
borrowing to ₱ 79,875. Note that the cash budget indicates not only the amount of financing needed during the period but also
when the funds will be needed.