asseThe Financial Environment

LEARNING OBJECTIVES:
AT THE END OF THE DISCUSSION THE STUDENT SHOULD BE ABLE TO:
• Define what is meant by finance.
• Explain why finance should be studied.
• Describe the basic requirements of an effective financial system.
• Identify the major financial institutions and their roles in the financial system.
• Describe the four types of financial markets.
• Identify major types of securities traded in the securities markets.
• Describe the financial functions performed in the financial system.
• Identify and discuss some career opportunities in finance.

Topics:
A. Three interrelated Areas in Finance
1. Money and Capital Markets
2. Investment
3. Financial management
B. Importance of Finance
C. Financial Management in the New Millennium
D. Role of Finance in a Typical Business Organization
E. Goals of Management
1. Maximizing shareholders’ wealth
2. Determinants of value
3. Social Responsibility
F. Forms of Business Organization
1. Sole Proprietorship
2. Partnership
3. Corporation
4. Other Types of Business Organizations
G. Organization of the Financial Management Function
H. Financial Management Other Disciplines
I. Career Opportunities in Finance
J. Business Ethics

References: Brigham, Chapter 1, pp. 1-33

OVERVIEW OF FINANCIAL MANAGEMENT

I. WHAT IS FINANCE?
The financial environment encompasses the financial system, institutions, markets, and individuals that make the economy
operate efficiently. Finance is the study of how individuals, institutions, governments, and businesses acquire, spend, and
manage money and other financial resources.
The three areas of finance within the financial environment and financial system are: institutions and markets, investments,
and financial management. Financial institutions are intermediaries that help the financial system operate efficiently and help
transfer funds from savers to investors. Financial markets are physical locations or electronic forums that facilitate the flow of
funds. Investments involve the marketing of securities, securities analysis, and the management of investment risk. Financial
management involves financial planning, asset management, and fund raising decisions to enhance the value of firms.
Within the context of the three areas of finance we cover the themes of small business management and personal financial
planning. Entrepreneurial finance studies how growth-driven, performance-focused, early-stage firms raise financial capital and
manage their operations and assets. Personal finance studies how individuals prepare for financial emergencies, protect against
premature death and the loss of property, and accumulate wealth over time.
 II. WHY STUDY FINANCE?
a. First, as a citizen, you should want to make informed economic decisions. Whatever your financial and economic goals may
be, you need to be an informed participant if you wish to “make a difference.” The operation of the financial system and the
performance of the economy are influenced by policy makers. The citizens elect important policy makers such as the President
and Congress who can pass or change laws, and through their decisions impact on the level of economic activity. Thus, it is
important that citizens be informed when making political/economic choices.

b. Second, having some knowledge about finance, particularly the financial markets or investments component, should be
important to you. An understanding of various aspects of personal finance should help you better manage your existing financial
resources, as well as provide the basis for making sound decisions for accumulating wealth over time.
c. Third, to be successful in the business world, it is important to have a basic understanding of business finance in addition to
an understanding of macro finance and investments (financial markets). Even if your “business interest” is in a non-finance
career, you likely will need to interact with finance professionals both within and outside your firm. To do so will require a basic
knowledge of the concepts, tools, and applications of business finance.

III. OVERVIEW OF THE FINANCIAL SYSTEM

An effective financial system is a complex mix of government and policy makers, a monetary system, financial institutions, and
financial markets that interact to expedite the flow of financial capital from savings into investment. Basic requirements for an
effective financial system include: a monetary system, a savings-investment process, and financial markets. The monetary system
must provide an efficient medium for exchanging goods and services. This is accomplished by an efficient system for creating
and transferring money. The financial system must also be able to allow capital formation by channeling savings into investment.
In addition, markets must exist in which to buy and sell measures of (or claims to) wealth, such as financial assets or real estate.
In a simple economy, such as a self-sufficient farm, a farmer can create capital by building a new barn. Capital formation
takes place indirectly in a highly developed economy. For example, individuals may save a portion of their current income which
is, in turn, loaned to others who want to purchase equipment.
IV. TYPES OF FINANCIAL INSTITUTIONS
The current Philippine system of financial institutions and intermediaries developed to meet the changing needs of our economy.
In addition, Philippine financial institutions and intermediaries must continually respond to changes in the global economy.
The process by which savings are first accumulated in depository and certain other financial institutions and then lent to or
invested by these institutions is referred to as financial intermediation.
Major institutions and intermediaries in the Philippine financial system can be grouped into four categories: depository
institutions (commercial banks, savings and loan associations, savings banks, and credit unions), contractual savings
organizations (insurance companies and pension funds), securities firms (investment companies— particularly mutual funds,
investment banking firms, and brokerage firms), and finance firms (finance companies and mortgage banking firms).
V. TYPES OF FINANCIAL MARKETS
There are four types of financial markets—securities markets, mortgage markets, derivatives markets, and currency exchange
markets. Securities markets are physical locations or electronic forums where debt and equity securities are sold and traded.
Mortgage markets are markets in which mortgage loans, backed by real property in the form of buildings and houses, are
originated and sometimes traded. Derivatives markets facilitate the purchase and sale of derivative securities, which are financial
contracts that derive their values from underlying securities or from other related financial assets. Currency exchange markets are
electronic markets in which banks and institutional traders buy and sell various currencies.
Creating new securities or other claims to wealth takes place in primary securities markets, while transferring existing
securities from old investors to new investors takes place in secondary securities markets.
VI. TYPES OF SECURITIES
Real assets include the direct ownership of land, buildings, machinery, inventory, and even precious metals. Financial assets
are claims against the income and assets of those who issued them.
Money markets are the markets where debt instruments of one year or less are traded, while capital markets include longer-
term debt securities and corporate stocks.
Money market instruments include: BSP Treasury bills, negotiable certificates of deposit, and commercial paper. Capital
market securities and instruments include: Philippine Treasury bonds, municipal (national and local government) bonds,
corporate bonds, and corporate stocks.
VII. INTERNATIONAL SECURITIES AND MARKETS
Debt and equity markets also are well developed in many foreign countries. Corporations and governments can sell their debt
securities in the Eurobond and share foreign bond markets. A Eurobond is a bond denominated in U.S. dollars that is sold to
investors located outside the United States. A foreign bond is a bond issued by a corporation or government that is denominated
in the currency of a foreign country where it is sold.
The euro is the common currency that has replaced the individual currencies of 12 member countries of the European
Union.
VIII. FINANCIAL FUNCTIONS IN THE PHILIPPINE SYSTEM
The basic financial functions in an effective financial system include: creation of money, transferring money, accumulation of
savings in financial institutions, lending with and investing savings, marketing financial assets, and transferring financial assets.
IX. THE GOAL OF SHAREHOLDER WEALTH MAXIMIZATION
Effective financial decision making requires an understanding of the goal(s) of the firm. What objective(s) should guide
business decision making – that is, what should management try to achieve for the owners of the firm? The most widely accepted
objective of the firm is to make the most efficient use of the firm’s resources and thereby maximize the value of the firm for its
owners; that is to maximize shareholder wealth.
Shareholder wealth is represented by the market price of the firm’s common stock. The shareholder wealth maximization goal
states that management should seek to maximize the present value of the expected future returns to the owners (shareholders) of
the firm. These returns can take the form of periodic dividend payments or proceeds from the sale of the common stock. Present
Value is defined as the value today of some future payment or stream of payments, evaluated at an appropriate discount rate.
Discount Rate takes into account the returns that are available from alternative investment opportunities during a specific (future)
time period. The longer it takes to receive the benefit the lower the value investors place on that benefit. In addition, the greater
the risk associated with receiving a future benefit, the lower the value investors place on that benefit. Stock prices, the measure
of shareholder wealth, reflect the magnitude, timing, and risk associated with future benefits expected to be received by
shareholders.
Market Value – is defined as the price at which a stock trades in the marketplace like the Philippine Stock Exchange (PSE).
Total Shareholder Wealth = No. of shares outstanding x Market Price per share
Responsibility of the firm towards stakeholders
• To sustain an optimum return on investment for stockholders
• To be perceived by customers a provider of quality product/service
• To demonstrate that employees are the firm’s most valuable resource
• To provide corporate leadership in the communities it serves
• To operate compatibly with environment standards and initiate programs that are sensitive to environmental issues

Forms of Business Organization

1. Sole Proprietorship
2. Partnership
3. Corporation
4. Other Types (Hybrid organizations)
a. Subchapter S Corporations – companies with 100 or fewer domestic stockholders, and that meet certain other
requirements
b. Limited Liability Partnership (LLP) – partnership where all partners have limited liability
c. Limited Liability Company (LLC)

IX. CAREER OPPORTUNITIES IN FINANCE Career opportunities in finance are generally found in the areas of financial
management, depository financial institutions, contractual savings and real property organizations, and securities markets and
investment firms.
Entry-level finance job opportunities also exist in government or not-for-profit organizations, as well as with international
or global businesses.

Goal of Financial Management

 What should be the goal of a corporation?
- Maximized profit?
- Minimize costs?
 - Maximize market share?
- Maximize the current value of the company’s stock
 Does this mean we should do anything and everything to maximize owner wealth? no
 The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price.
 Shareholders wealth= no. of share x market price
- Do firms have any responsibilities to society at large? Yes,

Agency relationship
 An agency relationship exists whenever a principal hires an agent to act on their behalf.
 Within a corporation, agency relationships exist between:
- Shareholders and managers
- Shareholders and creditors- bondholders
*Bondholders always receive principals/profit with/without profit

The Goal of Shareholder Wealth Maximization

 Agency Problems
 Corporate Governance
 The board of directors of a corporation should have a majority of independent directors
  The committee responsible for nominating members of the board of directors must be composed only of
independent directors
 The post of chairman of the board of directors should be split from the CEO position
 All members of the audit and compensation committees must be independent directors(no business type of the
company
 Managerial Compensation
 Properly designed compensation contracts can help to align shareholder – management conflicts
Stock Options-granted to managers
-entitle to buy shares of stocks
 Exercise Price
Restricted Stock
Performance Shares
 Threat of Takeovers
 Takeovers can serve as an important deterrent to shareholder – management conflicts

Determinants of Value
 Cash Flows – expected generated
 Timing of Cash Flows – time value of money, the earlier the better
 Risk
 FACTORS AFFECTING STOCK PRICES
Economic Environment Factors
1. Level of economic activity
2. Tax rates and regulations
3. Competition, including the threat of new competitors and substitute products
4. Laws and government regulations
5. Unionization of employees
6. International business conditions and currency exchange rates
7. Bargaining power of buyer

Major Policy Decisions Under Management Control/Maximization of Shareholder wealth:

Managerial Strategies
Managerial Actions to Influence Value
 Products and services offered for sale
 Production technology
 Marketing and distribution network
 Investment strategies
 Employment policies and compensation packages for managers and other employees
 Ownership form
  Capital structure
 Working capital management policies
 Dividend policies
Amount, timing, and Risk of Expected Cash Flows
Shareholder Wealth (Market Price of Stock)

Conditions in Financial Markets

1. Interest rate levels
2. Investor Optimism
3. Anticipated inflation
Organization of the Financial Management Function
Chief Financial Officer
 Oversees function
 Accounting
  Treasury
 Tax
 Audit
Controller
 Oversees function
 Financial Accounting
 Cost Accounting
 Taxes
 Data Processing
Treasurer
 Oversees function of:
 Cash and Marketable Securities Management
 Capital Budgeting Analysis
 Financial Planning
 Credit Analysis
 Investor Relations
 Pension Fund Management
Financial Management and Other Disciplines
 Accounting
 Financial managers are primarily concerned with a firm’s cash flows
 Economics
 Microeconomics
 Financial managers use the concept of setting marginal cost equal to marginal revenue when making long-
term investment decisions and when working capital
 Macroeconomics
 Financial managers should recognize and understand how monetary and fiscal policies affect the economy
the costs funds, and the availability of credit
Corpo – shareholders/stockholders
CEO/President – primary financial manager
Goal- to maximized the wealth of stockholders

Shareholders maximization wealth – no. of share x market price

Agency problem-conclict

Maximization of wealth – market concept

Book value – historical value of asset
Limitations of financial statement analysis
Comparing financial data across companies
• Differences in accounting methods between companies sometimes make it difficult to compare their financial data.
For example:
• If one company values its inventory using the LIFO method and another uses the average cost method, then direct
comparisons of financial data such as inventory valuations and cost of goods sold may be misleading.
• Even with this limitation in mind, comparing financial ratios with other companies or industry averages can provide
useful insights.

Looking beyond ratios

Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities
for further analysis, but they rarely answer questions by themselves. In addition to ratios, other sources of data should also
be considered such as industry trends, technological changes, changes in consumer tastes, and changes in broad economic
factors.

Statements in comparative and common-size form

An item on a balance sheet or income statement has little meaning by itself. The meaning of the number can be enhanced by
drawing comparisons.
1. Peso/Dollar and percentage changes on statements (horizontal analysis).
2. Common-size statements (vertical analysis)
3. Peso/Dollar and percentage changes on statements

Horizontal analysis (also known as trend analysis) involves analyzing financial data over time.
• Quantifying dollar changes over time serves to highlight the changes that are the most important economically.
• Quantifying percentage changes over time serves to highlight the changes that are the most unusual.
• Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages.
To compute a trend percentage, a base year is selected and the data for all years are stated in terms of a percentage of that
base year.

Common-size statements
• Vertical analysis focuses on the relations among financial statement items at a given point in time. A common-size
financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

• In balance sheets, all items are usually expressed as a percentage of total assets.
• In income statements, all items are usually expressed as a percentage of sales.
Liquidity Ratios

The data and ratios that managers use to assess liquidity include working capital, the current ratio, and the acid-test (quick)
ratio. These ratios are quick measures of a firm’s ability to provide sufficient cash to conduct business over the next few
months. The cash budget provides the best assessment of a firm’s liquidity position

Working capital = Current Assets – Current Liabilities

The excess of current assets over current liabilities is known as working capital. Working capital is not free. It must be
financed with long-term debt and equity. Therefore, managers often seek to minimize working capital. A large and growing
working capital balance may not be a good sign. For example, it could be the result of unwarranted growth in inventories.

Current ratio = Current Assets

Current Liabilities

It measures a company’s short-term debt paying ability. It measures the ability of a firm to pay its current liabilities.
However, it must be interpreted with care. For example, a declining ratio may be a sign of deteriorating financial condition,
or it might result from eliminating obsolete inventories or other stagnant current assets.
Acid-test (quick) ratio = Current Assets – Inventories
Current Liabilities

It is a more rigorous measure of short-term debt paying ability because it only includes cash, marketable securities, accounts
receivable, and current notes receivable. It measures a company’s ability to meet its obligations without having to liquidate
its inventory.

Asset management

Managers compute a variety of ratios for asset management purposes. These ratios indicate how much a firm has invested in
a particular type of asset or group of assets relative to the revenue the asset is producing. This indicates how efficient the
firm is in allocating its resources.

Accounts receivable turnover = Net Credit Sales

Average trade receivables

It measures how quickly credit sales are converted to cash.

Average collection period = Accounts Receivable or 365
Annual credit sales/365 days Receivables Turnover
It measures how many days, on average, it takes to collect an account receivable. It should be interpreted relative to the
credit terms offered to customers.

Inventory turnover = Cost of Sales

Average Inventory

The inventory turnover is computed as shown. It measures how many times a company’s inventory has been sold and
replaced during the year. It should increase for companies that adopt just-in-time methods. It should be interpreted relative
to a company’s industry. For example, grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn
their inventory over slowly. If a company’s inventory turnover is less than its industry average, it either has excessive
inventory or the wrong sorts of inventory.

Average Sale Period = 365

Inventory Turnover

A related measure is called the average sale period. It measures the number of days being taken, on average, to sell the
entire inventory one time.

Operating cycle
The operating cycle is calculated as shown.
It measures the elapsed time from when inventory is received from suppliers to when cash is received from customers.

Fixed Asset Turnover Ratio = Sales

Net Fixed Assets

This ratio indicates the extent to which a firm is using existing property, plant and equipment to generate sales. This ratio
should be used primarily for year-to year comparison within the same company, rather than for intercompany comparisons.

Total asset turnover = Sales

Total Assets

The total asset turnover is calculated as shown. It measures how efficiently a company’s assets are being used to generate
sales. This ratio expands beyond current assets to include noncurrent assets.

Debt management Ratios/Financial Leverage Management Ratios

Managers compute a variety of ratios for debt management purposes. These ratios measure the degree to which a company
is employing financial leverage and as such are of interest to creditors and owners. Both short-term and long-term creditors
are concerned with the amount of leverage a company employs because it indicates the company’s risk exposure in meeting
debt service charges like principal and interest repayment. Owners are interested in financial leverage because it influences
the rate of return they can expect to realize on their investment and the degree of risk involved.

Times interest earned ratio = Earnings before interest and taxes (EBIT)
(interest coverage ratio) Interest charges

It is the most common measure of a company’s ability to protect its long-term creditors.
It is based on earnings before interest and income taxes because that is the amount of earnings that is available for making
interest payments. A ratio of less than 1 is inadequate.

Debt Ratio = Total Debt

Total Assets

This ratio measures the proportion of a firm’s total assets that is financed with creditors’ funds. This is stated in terms of
percentage.

Debt-to-equity ratio = Total debt

Total equity
This ratio is stated in terms of percentage. It indicates the relative proportions of debt and equity on a company’s balance
sheet.
Creditors and stockholders have different views when defining the optimal debt-to-equity ratio.

Stockholders like a lot of debt if the company’s rate of return on its assets exceeds the rate of return paid to creditors.
Creditors prefer less debt and more equity because equity represents a buffer of protection. In practice, debt-to-equity ratios
from 0.0 to 3.0 are common.

Fixed Charge = EBIT + Lease payments

Coverage Ratio Interest + Lease Payments + Preferred Dividends before tax + Before tax Sinking Fund
Earnings After Taxes = Earnings before taxes – Taxes
= Earnings before taxes – Earnings before taxes x T
= Earnings before tax (1 – T) Earnings before Taxes = Earnings after taxes / 1 – T

This ratio measures the number of times a firm is able to cover fixed charges, which includes (in addition to interest
payments) preferred dividends and payments required under long-term lease contracts. In calculating the fixed charge
coverage ratio, an analyst must consider each of the firm’s obligations on a before tax basis. After tax payments must be
adjusted by dividing the amount by (1 – T).
The equity multiplier = Total Assets
Stockholders’ Equity

It indicates the portion of a company’s assets that are funded by equity.

It focuses on average amounts maintained throughout the year rather than amounts at one point in time.

Profitability Ratios

Gross margin percentage = Sales – Cost of Sales

Gross Profit Margin Ratio Sales

It measures the relative profitability of a firm’s sales after deducting the cost of sales. It should be more stable for retailing
companies than for other companies because the cost of goods sold in retailing companies excludes fixed costs. It reveals
how effectively the firm’s management is making decisions regarding pricing and control of production costs.

Net profit margin percentage = Earnings after taxes

 Sales

Operating Profit Margin Ratio = EBIT

Sales

EBIT DA Margin = Earnings before interest, taxes, depreciation and amortization

Sales

This ratio measures how profitable a company’s sales are after all expenses including taxes and interest are deducted. In
addition to cost of goods sold, it also looks at how selling and administrative expenses, interest expense, and income tax
expense influence performance.

Return on total assets (Investment) = Earnings after Taxes (EAT)

Total Assets

This ratio measures a firm’s net income in relation to the total asset investment. Adding interest expense back to net income
enables the return on assets to be compared for companies with different amounts of debt or over time for a single company
that has changed its mix of debt and equity.

Return on equity = Earnings after Taxes (EAT)

Stockholders’ Equity
Dupont Formula = Net Profit Margin x Total asset turnover x Equity Multiplier

Dupont = Earnings after taxes x Sales x Total Assets

Formula Sales Total Assets Stockholder’s Equity

This measure indicates how well the company used the owners’ investments to earn net income. The return on equity can
also be computed using the DuPont formula.

Earnings per share = Earnings after Taxes – Preferred Dividends

Average commons stockholders’ Equity

Earnings per share is computed as shown.

The average number of common shares outstanding is computed by adding the shares outstanding at the beginning of the
year to the shares outstanding at the end of the year and dividing by two. Managers analyze this ratio because earnings form
the basis for dividend payments and future increases in the value of shares of stock.

Financial leverage
Financial leverage results from the difference between the rate of return the company earns on investments in its own assets
and the rate of return that the company must pay its creditors.
Positive financial leverage exists if the rate of return on the company’s assets exceeds the rate of return the company pays
its creditors. In this case, having some debt in a company’s capital structure can benefit shareholders. Negative financial
leverage exists if the rate of return on the company’s assets is less than the rate of return the company pays its creditors. In
this case, the common stockholder suffers by having debt in the capital structure.

Market performance Ratios

The market based ratios for a firm should parallel the accounting ratios of that firm. For example, if the accounting ratios of
a firm suggest that the firm has more risk than the average

firm in the industry and haw lower profit prospects, this information should be reflected in a lower market price of that
firm’s stock.

Price-earnings ratio =Market Price per share

Current Earnings per share

This ratio tells us how much investors (market) is willing to pay per peso of earnings of the firm. In general, the lower the
firm’s risk, the higher its P/E ratio should be. A higher price-earnings ratio means that investors are willing to pay a
premium for a company’s stock because of its optimistic future growth prospects.
Market Price to Book Value = Market Price per share
(P/BV Ratio) Book value per share

EV-EBITDA Multiple = Enterprise Value

Earnings before interest, taxes, depreciation and amortization

Enterprise value is calculated as the sum of the market value of the common stock plus the market value of debt (book value
of debt). This ratio represents the aggregate measure of value that tells us the overall worth of the company per peso of
earnings (cash flow) available to all capital holders.

Dividend Policy Ratios

These ratios provide insights regarding a firm’s dividend policies and its future growth prospects.
Dividend payout ratio = Dividends per share
Earnings per share

This ratio indicates the percentage of a firm’s earnings that are paid out as dividends to its common stockholders. Investors
who seek market price growth would like this ratio to be small, whereas investors who seek dividends prefer it to be large.

Dividend yield ratio = Expected dividend per share

Stock Price

This ratio measures the investor’s rate of return (in the form of cash dividends only) when buying common stock at the
current market price.

Book value per share

It measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their
balance sheet carrying amounts and if all creditors were paid off. This measure is based entirely on historical cost. The
market price reflects expectations about future earnings and dividends, whereas the book value per share is based on
historical cost
 13-2

Financial Statement Analysis

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2016 by McGraw-Hill Education. All rights
reserved.
 13-3

Introduction

 Uses of Financial Analysis

◦ Identifies the major strengths and weaknesses of a firm
◦ Used by:
 Financial Managers- to
analyze/evaluate past financial
performance in make future
decision
 Credit Managers- to access
capability of the business to
pay its obligation
-used financial statement
analysis to assess compliance
with loan covenance
 Security Analysts-
generate advice for investors
  Bankers- short/long term
obligation
-to assess growth prospect
 Unions- organizations of
employee
-more benefit/higher salaries to the
employee
 Students/Job Hunters
 13-4

Key Financial Statements

 Balance Sheet
 Income Statement
 Statement of Cash flows
 Statement of Changes in Owner’s Equity
 Notes to the Financial statements
 13-5

Income Statement
 Net Sales
 Cost of
Sales
 Other Operating Expenses
 Interest Expenses
 Taxes
 Earnings After
Tax  Net Income
 Net
Earnings
 Net Profit
 13-6

Sample Income Statement

 13-7

Limitations of Financial Statement Analysis

Differences in accounting methods

between companies sometimes make
comparisons difficult.

We use the FIFO method to We use the average cost

value inventory. method to value inventory.
 13-8
Helpful hint: Reinforce the limitations of relying on financial statements by identifying events that would make
financial statements doubtful as a predictor of the future. Such an event would be a change in oil prices that
occurs after the financial statements are issued. An increase in oil prices would be favorable for companies with
large stocks of petroleum and unfavorable for companies that use large quantities of petroleum feedstock’s in
their manufacturing processes.

Limitations of Financial
Statement Analysis
Managers should look beyond the ratios.
- Industry trends
- Technological changes
- Consumer tastes
- Economic factors

Performance Financial Analysis:

Intra Company Analysis – comparison with in the company
-useful to detect changes in financial relationship & significant trends

Inter Company Analysis – comparison with other company

Industry Averages – companies relative position within the industry
 13-1

Learning Objective 1

Prepare and interpret

financial statements in
comparative and
common-size form.
 13-2

Statements in Comparative and

Common-Size Form

Peso and percentage

changes on statements

An itfii
iteml on a financial
statement
t ttlittl has little Common-
meaning iitlf. by itself. The size
meaningif tr of the numbers statements
can be enhanced by
drawing
riri. comparisons.
Ratios
Horizontal- From one period to another

Goal of Horizontal Analysis- Identify sustained changes/trends

Common –size statement/vertical- focus on significant relationship,

-percentages

Ratio- evaluate how well the company performed

 13-3

Pesos/Dollar and Percentage Changes

on Statements

Horizontal analysis (or trend analysis) shows the

changes between years in the financial data in
both dollar and percentage form.

Quantifying Quantifying
dollar/pesos percentage
changes over time changes over time
serves to highlight serves to highlight
the changes that are the changes that are
the most important the most unusual.
economically.
 13-4

Horizontal Analysis

The following slides illustrate a horizontal

analysis of Clover Corporation’s
comparative balance sheets and
comparative income statements for this
year and last year.
 13-5

Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
Increase (Decrease)
This Year Last Year Amount %
Assets
Current assets:
Cash ₱12,000 ₱23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets ₱315,000 ₱289,700
 13-6

Horizontal Analysis
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The peso/dollar
amounts for
last year “base”
figures.become
the year
 13-7

Horizontal Analysis
Calculating Change as a Percentage

Percentage Peso/Dollar Change

Change
=
Base Year Figure × 100%
 13-8

Horizontal Analysis
 P12,000 – P23,500 = P(11,500)

(P11,500 ÷ P23,500) × 100% = (48.9%)

 13-9

Horizontal Analysis
Industry trends

Technological changes
 Horizontal Analysis

We could do this for the liabilities and stockholders’ equity, but now let’s look at the income
statement accounts.
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase (Decrease)
This Year Last Year Amount %
Sales ₱520,000 ₱480,000
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income ₱17,500 ₱22,400

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase (Decrease)
This Year Last Year Amount %
Sales ₱520,000 ₱480,000 ₱40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income ₱17,500 ₱22,400 -₱4,900 (21.9)
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase (Decrease)
This Year Last Year Amount %
Sales ₱520,000 ₱480,000 ₱40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income ₱17,500 ₱22,400 -₱4,900 (21.9)

Trend percentages state

several years’ financial data
in terms of a base year,
which equals 100 percent.
Trend percentages state several years’ financial data
in terms of a base year, which equals 100 percent.

could d o this for

the
liabilities and
stockho

based year is always the earliest year

Trend Analysis
s’

equity, but n

o
w let’s look at the income
statement accounts. Co

nsumer tastes
Economic factors
Common-Size Statements
Vertical analysis focuses on the relationships among financial statement items at a given point in
time. A common-size financial statement is a vertical analysis in which each financial statement item is
expressed as a percentage.

In balance sheets, all items usually are expressed as a percentage of total assets.

In income statements, all items usually are expressed as a percentage of sales.

Let’s take another look at the information from the comparative income statements of Clover
Corporation for this year and last year.

This time, let’s prepare common-size statements.

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
This Year Last Year This Year Last Year
Sales ₱520,000 ₱480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income ₱17,500 ₱22,400

Sales is usually the base and is expressed as 100%.

 NORTON CORPORATION
Balance Sheets
December 31

This Year Last Year

Assets
Current assets:
Cash ₱30,000 ₱20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets ₱346,390 ₱300,000
Current liabilities:
Accounts payable ₱39,000 ₱40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, P1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity ₱346,390 ₱300,000
 NORTON CORPORATION
Income Statements
For the Years Ended December 31

This Year Last Year

Sales ₱494,000 ₱450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income ₱53,690 ₱46,200

Data last year-beginning balance

Data this year-ending balance

No of days sales in receivable/average collection period=same

*numerator
If credit sales is known it must be use not gross sales
*annual credit sales/average daily sales
*industry average < debt to liquid ratio
-uses more than the usual amount of borrowed funds to finance its activity
*Industry average>debt to equity ratio
-favorable

*if numerator is income statement and the denominator is balance statement=divide the this year and last year
into 2

Financial Ratio-comparison of company condition

Learning Objective 2
Compute and interpret financial ratios that managers use to assess liquidity.

Ratio Analysis – Liquidity- ability to make short term financial obligation

Liquidity/profitability/solvency=interrelated
Current position analysis/liquidity analysis-ability to pay current obligation
The data and ratios that managers use to assess liquidity include working capital, the current ratio, and the acid-
test (quick) ratio.

The information shown for Norton Corporation will be used to calculate the aforementioned liquidity ratios.
NORTON CORPORATION
This Year
Cash P30,000
A/R, net 20,000
Total current assets 65,000
Total current liab. 42,000

Working Capital
Dec. 31(This Year)
Current assets P65,000
Current liabilities (42,000)
Working capital P23,000

Current ratio
Current Ratio = Current Assets
Current Liabilities

The current ratio measures a company’s short term debt paying ability.
A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete
inventories.

Current Ratio = Current Assets

Current Liabilities
Current Ratio (TY) = P65,000 = 1.55
42,000
Current Ratio (LY) = P49,000 = 1.16
42,000 =
Acid- Test (Quick) Ratio
Acid-Test Ratio = Quick Assets
Current liabilities
Acid-Test Ratio(LY+TY) = P50,000 = 1.19
42,000

Quick asset Include Cash, Marketable Securities, A/R, and Current Notes Receivable.
This ratio measures a company’s ability to meet obligations without having to liquidate inventory.
Always Exclude-inventory & prepaid assets
Learning Objective 3
Compute and Interpret financial ratios that managers use for asset management purposes.
Ratio Analysis-Asset Management
Managers compute a variety of ratios for asset management purposes. The information shown for Norton
Corporation will be used to calculate the asset management ratios.
Asset management ratios- how efficiently a firm using assets to generate sales
NORTON CORPORATION
This Year
AR,net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total assets
Beginning of year 300,000
End of year 346,390
Sales on account 494,000
Cost of goods sold 140,000

Accounts Receivable Turnover

Accounts Receivable Turnover = Sales on Account
Average A/R
Accounts Receivable Turnover = P494,000 = 26.7 times
(17,000 + 20,000)/2
This ratio measures how many times a company converts its receivables into cash each year.
Average Collection period
Average Collection period = 365 days
A/R Turnover

Average Collection period = 365 days = 13.67 days

26.7 times
This ratio measures, on average, how many days it takes to collect on A/R.

Average Collection period = Average A/R

Annual Credit Sales/365
= 18,500
494,000/365
Average Collection period = 18,500 = 13.67 days
` 1,353.4247
Annual credit sales/365=
Average Daily Sales

Inventory Turnover
Inventory Turnover = Cost of Goods Sold
Average Inventory
This ratio measures how many times a company’s inventory has been sold and replaced during the year.
If a company’s inventory turnover is less than its industry average, it either has excessive inventory or the
wrong sorts of inventory.
Inventory Turnover = Cost of Goods Sold
Average Inventory
Inventory Turnover = 140,000 = 12.73 times
(10,000 + 12,000)/2

Average Sales Period

Average Sales Period = 365days
Inventory Turnover
Average Sales Period = 365days = 28.67days
12.73 times
This ratio measures how may days, on average, it takes to sell the entire inventory.

Operating Cycle
Average Sale Period + Average Collection Period = Operating Cycle
28.67days + 13.67days = 42.34 days
This ratio measures the elapsed time from when inventory is received from suppliers to when cash is received
from customers.

Total asset Turnover

Total asset Turnover = Sales
Average Total Assets
Total asset Turnover = P494,000 = 1.53
(300,000 + 346,390)/2
This ratio measures how efficiency a company’s assets are being used to generate sales. This ratio expands
beyond current assets to include noncurrent assets.
Fixed Asset Turnover Ratio
Fixed Asset Turnover Ratio = Sales
Net fixed assets
Fixed Asset Turnover Ratio = 494,000 = 1.85
(281,390 + 251,000)/2
Learning Objective 3
Compute and Interpret financial ratios that managers use for debt management purposes.
Debt Management/Financial Leverage Ratios
Managers compute a variety of ratios for debt management purposes. The information shown for Norton
Corporation will be used to calculate its debt management ratios.

Financial Leverage ratios- firms capacity to meet north short term/long term debt obligation
NORTON CORPORATION
This Year
Earnings before interest expense
And income taxes 84,000
Interest expense 7,300
Stockholder’s equity
Beginning of year 180,000
End of year 234,390
Total liabilities 112,000

This is also referred to as net operating income.

Debt Ratio = Total Debt

Total Assets
= 112,000 1.32/32%
346,390
This ratio measures the proportion of a firm’s total assets that is financed with creditors’ funds.

Times Interest Earned = Earnings before Interest Expense and Income Taxes
Interest Expense
Times Interest Earned = 84,000 = 11.51 times
7,300
This is the most common measure of a company’s ability to provide protection for its long-term creditors. A
ratio of less than 1.0 is inadequate.

Debt-to-Equity Ratio = Total Liabilities

Stockholders’ Equity
Debt-to-Equity Ratio = 112,000 = 0.48
234,390
This ratio indicates the relative proportions of debt to equity on a company’s balance sheet.

Stockholders like a lot of debt if the company’s rate of return on its assets exceeds the rate of return paid to
creditors.
Creditors prefer less debt and more equity because equity represents a buffer of protection. In practice debt-to-
equity ratios from 0.0 to 3.0 are common.

Fixed Charge Coverage Ratio = EBIT + Lease Payments

Interest +Lease Payments+Preferred dividends before tax+Before
sinking funs
*EBIT-earnings before interest & tax
This ratio measures the number of times a firm is able to cover total fixed charges, which include interest
payments, preferred dividends and payments required under long-term lease contracts

Since preferred stock dividend and sinking fund payments are not tax deductible but are paid out of after tax
earnings they must adjusted by dividing by (1-TR)

Equity Multiplier = Average Total Assets

Average Stockholders’ Equity
Equity Multiplier = (300,000+346,390)/2 = 1.56
(180,000+234,390)/2

This ratio indicates the portion of a company’s asset that are funded by equity. It focuses on average amounts
maintained throughout the year rather than amounts at one point in time.

Learning Objective 5
Compute and interpret financial ratios that managers use to assess profitability.
Ratio Analysis-Profitability Ratios
-measure how effectively a firms manage generates profits on sale, assets & stockholders investment
NORTON CORPORATION
This Year
Number of common shares outstanding
Beginning of year 17,000
End of year 27,400
Tax rate 30%
Net income 53,690
Stockholders’ equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price per share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390

The information shown for Norton Corporation will be used to calculate its profitability ratios.

Gross Margin Percentage = Gross Margin

Sales
Gross Margin Percentage = 494,000-140,000 = 71.6%
494,000
*sales-cogs=gross margin

This measures indicates how much of each sales peso is left after deducting the cost of goods sold to cover
expenses and provide o profit.
The percentage should be more stable for retailing companies than for other companies.

Net Profit Margin Percentage

Net Profit Margin Percentage = Net Income
Sales

Net Profit Margin Percentage = 53,690 = 10.9%

494,000
Also called Return on Sales, this ratio also looks at how selling and administrative expense, interest expense,
and income tax expense influence performance and measures profit percentage per peso sales.

Return on Total Assets = Net Income+(Interest Expense x (1-Tax Rate))

Average Total Assets
= 53,690+(7,300 x (1-.30)) = 18.19%
(300,000+346,390)/2
Adding interest expense back to net income enables the return on assets to be compared for companies with
different amounts of debt or over time for a single company that has changed its mix of debt and equity.

Return on Equity = Net Income

Average Stockholders’ Equity
= 53,690 = 25.91%
(180,000+234,390)/2
This measure indicates how well the company used the owners’ investments to earn income.

DuPont Formula
Return on Equity = Net Profit Margin x Total Asset Turnover x Equity Multiplier

The return on equity can also be computed using the DuPont Formula shown here.

Financial Leverage
-results from the difference between the rate of return the company earns on investments in its own asset and
the rate of return that the company must pay its creditors.
Return on investment in assets > Fixed rate of return on borrowed fund = Positive financial leverage
Return on investment in assets < Fixed rate of return on borrowed fund = Negative financial leverage

Learning Objective 6
Compute and interpret financial ratios that managers use to assess market performance.
Ratio Analysis-Market Performance
Market base ratios- measures the firm markets evaluation of a company’s performance
NORTON CORPORATION
This Year
Number of common shares outstanding
 Beginning of year 17,000
End of year 27,400
Stockholders’ Equity 234,390
Dividends per share 2
Dec. 31 market price per share 20

The information shown for Norton Corporation will be used to calculate market based ratios.

Earnings Per Share = Net Income

Average Number of Common Shares Outstanding
= 53,690 =2.42
(17,000+27,400)/2
This measure indicates how much income was earned for each share of common stock outstanding.

Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is
used in the denominator.

Earnings form the basis for dividend payments and future increases in the value of shares of stock.

Price-Earnings Ratio= Market Price Per Share

Earnings Per Share
= 20 = 8.26times
2.42
A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because
of optimistic future growth prospects.

Dividends Payout Ratio = Dividends Per Share

Earnings Per Share
= 2 = 82.6%
2.42
This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividend
(market price growth) would like this ratio to be large (small).

Dividends Yield Ratio = Dividends Per Share

Market Price Per Share
= 2 = 10%
20
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

Book Value Per Share = Common Stockholders’ Equity

Number of Common Shares Outstanding
= 234,390 = 8.55
27,400
This ratio measures the amount that would be distributed to holders of each share of common stock if all assets
were sold at their balance sheet carrying amounts after all creditors were paid off.

Notice that the book value per share of 8.55 does not equal the market value per share of 20. This is because the
market price reflects expectations about future earnings and dividends, whereas the book value per share is
based on historical cost.